I found a graphic from the New York times that perfectly displays not only the root of the current economic problem, but also inadvertently shows why Geithner’s new plan to fund private investment of securitized bank assets won’t work to fix it.
Here’s the graphic:
(click to see a larger version)
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There’s a particular quote from this graphic that I’d like to excerpt here:
“The problem:
Banks have come to depend on selling mortgages and other loans to investors like hedge funds and insurance companies. This allows banks to make more loans and earn bigger profits. But the market for these securities has collapsed, contributing to a freeze in lending.”
That’s the most concise description of the problem I’ve seen in a long time. But it leaves out a few critical pieces of information, a few things that I feel are crucial to getting an accurate impression of the situation. As usual, some history is needed to fully appreciate how the current situation came to pass:
The historical origin of the current crisis
Once upon a time many years ago, banks had been heavily regulated as a result of lax lending standards that led to many of them going bust during the Great Depression. During the 70s, many European banks were being deregulated and allowed to put more and more of their money in the stock market, and they were making a killing doing so. The American banks complained to the American government that these regulations were making them no longer internationally competitive, which was true. And so they were deregulated, and by both parties, I might add. The Republicans liked it because it fit their ideology of less market interference and grew the GDP. The Democrats liked it because banks were thus able to lend to many poor people who had not previously been eligible for loans.
The deregulatory push in banking and finance continued, egged on by both parties. A little later, both parties also decided that increasing home ownership among poor people and minorities was a good idea. Again, Republicans liked this because it helped the financial and real estate industries grow the economy, and it increased the GDP, while Democrats liked this because it helped poor people acquire assets and move closer to the middle class.
Now, there was actually a good reason why poor people had a hard time getting loans and credit cards and such before deregulation: it was because they would default on their loans with great frequency. When a borrower defaults, everybody loses. The borrower gets a black mark on their credit rating, and faces pressure from banks, and the banks have to go after them for the money they’re owed and often take a loss. During this period, banks had to own the loans they made, so they were under a strong compulsion not to lend money to risky borrowers. As long banks were required to own their own loans, their solution to this problem was to simply not lend money to people they considered to be at risk of defaulting on any loans they might get. Needless to say, this was politically unpalatable to many politicians, who did not want to be seen as screwing the poor.
However, deregulation had set up a framework to deal with this messy situation. Now, banks no longer had to own their loans; they could package them up as securities and sell them to investors! It was a double win: banks could absolve themselves of the risk associated with lending to risky borrowers and make a pretty penny in the stock market doing it, and more people than ever before could get credit. The credit boom was born. All of the sudden, people started getting credit cards in the mail. You could buy a home for zero money down. Student loans were plentiful (so colleges started charging more). Appliances could be purchased with mortgage-like monthly payment plans.
Amid this credit boom, the government stepped in and told banks to increase home ownership among the lower classes. Banks said, “no problem!”, because risk was now irrelevant. They created the subprime mortgage and sold them by the truckload to poor people eager to live on property they owned. It was the age of free credit, when you could buy whatever you wanted and pay later.
But there was a problem. Because banks felt they no longer had to shoulder the burden should borrowers default, they felt comfortable fleecing them in these new credit products. Subprime mortgages in particular turned out to be a really bad deal for anybody who got one, because in addition to the fact that many of these people probably would not have been able to stomach even a traditional mortgage, the subprime kinds were even worse. A few years into these contracts, poor people started defaulting on their mortgages. What was a trickle became a flood as the real estate prices—elevated to absurd levels due to the rush to buy houses—naturally began to fall.
Banks said, “no problem!” because it was actually the investors who bought the mortgages from the banks in the form of mortgage-backed securities who bore the brunt. And as luck should have it, many of these investors insured their investments against default through AIG. But it turned out that AIG didn’t have enough cash to cover this insurance when the mortgages fell down one after another (oops), so AIG collapsed, and then panicked investors dumped their mortgage-backed securities as fast as they could until finally it was revealed that the mortgage-backed securities were actually fairly worthless.
However, banks had convinced themselves and their shareholders that they had plenty of cash by counting the mortgage-backed securities they’d sold as having an extremely high value, and they continued to maintain this story despite the fact that everybody had since agreed that mortgage-backed securities had no value. People started calling them “toxic assets.” Now that these “toxic assets” had lost their value, it turned out that banks didn’t have much money at all relative to what they’d lent out and that they couldn’t really do any more lending. But they couldn’t get rid of the toxic assets because to do so would be to admit that they didn’t have much money at all, which would likely cause a panic that would end with their destruction.
Which brings us to today
Banks won’t lend because the money they claim to have (in the form of mortgage-backed securities) is actually worthless. They can’t write off their bad assets because they’ll probably have to go into bankruptcy. Giving banks money isn’t working because their toxic assets have an on-paper value of many trillions, and there’s no way the government or taxpayers can afford to give just a few banks trillions of dollars. So the banks are basically dead but won’t admit it, and they’re able to continue the fiction because they can claim that they have assets worth trillions of dollars. But the proof is in the pudding because if they were in good health, they’d lend some of it out, and we can all plainly see that mortgage-backed securities are worthless; the little boy has shouted out that the emperor has no clothes.
This is an ongoing, intractable problem. The longer time goes on, the more obvious it becomes that the banks are zombies, but what do we do about it?
Why Geithner’s plan won’t work
Geithner sees the seizing up of the mortgage-backed securities market as the root of the problem of why banks won’t lend, so he wants the government to subsidize private investment of securitized loans to the tune of about a trillion dollars. He’s right about one thing: since banks have come to depend on selling their loans on the stock market, the fact that they no longer can has indeed put a crimp on their lending.
But at the same time, this analysis is about as astute as looking as a man bleeding to death from a knife wound and exclaiming, “The problem is that he hasn’t enough blood in him! Let’s pump him full of blood!” The lack of blood is a symptom, not a cause; the freezing of the market for securitized loans is the same.
In other words, the problem isn’t that investors aren’t buying securitized loans anymore, it’s that loans are being securitized to begin with. As the New York Times piece indicates, “Banks have come to depend on selling mortgages and other loans to investors like hedge funds and insurance companies”. But this dependence is itself the root of the problem; by translocating risk and responsibility for managing it onto another entity (investors and insurance companies), banks were no longer under any financial obligation to lend responsibly, and it was precisely this freedom that led them to lend money to those who they knew full well would not be able to repay their loans.
As long as banks can securitize and sell loans, they will lend to risky or irresponsible people, because they think they will not be the ones to bear the consequences. And the only way to get them to stop doing this is to outlaw the securitization of loans and stop government support of banks that do it.
The solution does not lie in propping up this failed relationship, but rather in severing it once and for all. When banks again have to take ownership of their own loans, they will once more be cautious and prudent about lending it out. To allow this disastrous system of buck-passing from banks to investors to insurance companies to continue is to invite more speculative bubbles and dangerous, credit-fueled consumption.
Geithner’s plan is essentially a lot like saying, “all the junkies have come to depend on a steady flow of crack cocaine, but the supply has dried up and now the junkies are robbing and stealing to get their fix, so the solution is to encourage more sales of crack cocaine.” NO! The solution is end the junkies’ addiction, not prolong it!
If Geithner gets his way and pumps a trillion dollars into subsidizing the securitization of bank assets, there is absolutely no guarantee that we won’t have a similar crisis in a few years time.
Why people want this
It’s not all doom and gloom. There were benefits to easy credit. Home ownership did increase. Poor people were able to send their kids to college by borrowing. The latest and greatest gadgets were within reach of even the most impoverished McDonalds employee. But these luxuries did not come for free; indeed, their very possibility created the largest speculative bubble and its corresponding crash since the great depression.
There are people who want this credit-fueled luxury-fest to continue. Banks and investment houses loved it because they got rich. Economists loved it because it grew the GDP. Politicians loved it because it made them look good. The middle-class loved it because they no longer had to delay their gratification. The poor loved it because they got opportunities they had never before had.
I think that most people actually want free-flowing credit without any of the nasty side-effects of speculative bubbles. Sadly, THIS IS NOT POSSIBLE. As nice as it was when you could send your kids to $40K college on a $40K salary, buy houses without paying a cent upfront, pay off your credit card bills with other credit cards, and buy LCD TVs on monthly installment plans, it is impossible to have such things without their corresponding drawbacks the likes of which we see every day we turn on the TV only to hear new, more dismal employment figures.
The point is this: you can’t have your cake and eat it, too. The Age Of Credit is over, as well it should be, and those who created it should be allowed to die if they set themselves on fire. Only by clearing way the old can the new be ushered in, and unless we would like to loiter for a while in mortgage-backed security hell, I for one am very interested in seeing what type of banking system will be built out of the rotting husks of our current one.
is doing fantastically well. So it’s not like nobody buys these things. But remember, this is a fantasyland we’re conjuring up, one in which silver dollars pour forth from the backs of pens at a rate commensurate to how fast the author furiously scribbles down her manifesto. I know that gazillions of people don’t read e-books.