Lift Up Your Hearts!

I like to ignore politics as much as possible.  I want to be a well-informed voter, but I don't believe that political propaganda—whether in the form of paid advertising or news commentary—serves that purpose well, and I'd rather change a dirty diaper than listen to a presidential debate. But as Pericles said, Just because you do not take an interest in politics doesn't mean politics won't take an interest in you.  And economics even more so.

In the last month I've changed many diapers, and the worst of them did not smell as bad as the current state of our economy and what it might lead to.  I've lived through several economic downturns, and haven't yet found them worth the worry they engender, if one has adhered to a policy of regular savings, avoided the get-rich-quick mentality, stayed out of debt for depreciable assets, and been willing (and able) to take a long-term view.  "This too shall pass" has always been an effective philosophy.

Our current financial situation, however, looks to pass with all the ease of a monstrous kidney stone.  I'm afraid it was easy, at first, to take a rather self-righteous attitude to the subprime mortgage debacle.  Sure, I was sorry for people who were losing their homes, but some of them had been downright crooked in the acquisition of their mortgages (taking on debt they knew they could never repay) and most of the others had violated very basic rules of money management (purchasing homes out of proportion to their incomes).  What's more, the financial institutions that facilitated such loans were either crooked or stupid themselves.

Be that as it may, when they take you away from the accident scene in a stretcher, it doesn't make a bit of difference that you had the right of way.  The many cannot avoid paying for the sins of a few.  No one can say, "It's not my problem."  If you have not a penny in the stock market, if you don't need a mortgage or a car loan or other credit, you still need a job, gas for your car, and food on the table—and all of these are threatened by the economy's convulsions.

For an insightful look at why we should be worried, yet with minimal political spin, check out what John Mauldin has to say in yesterday's InvestorsInsight.  I tried to boil the article down to a few excerpts, since I know many of you will not read the whole thing, but I gave up.  It's worth reading in its entirety.   The excerpts below (with my own emphasis) will only give you a taste.

[Most people] don't understand why taxpayers should spend $700 billion to bail out rich guys on Wall Street who are now in trouble. And if I only got my information from local papers and news sources, I would probably agree. But the media (apart from CNBC) has simply not gotten this story right. It is not just a crisis on Wall Street. Left unchecked, this will morph within a few weeks to a crisis on Main Street.

First, let's stop calling this a bailout plan. It is not. It is an economic stabilization plan. Run properly, it might even make the taxpayers some money. If it is not enacted very soon (Monday would be fine), the losses to businesses and investors and homeowners all over the US (and the world) will be enormous. Unemployment will jump to rates approaching 10%, at a minimum.

Banks can lend to consumers and investors about 12 times their capital base. If they have to write off 20% of their capital because of losses, that means they either have to sell more equity or reduce their loan portfolios.... At first, banks were able to raise new capital. But now, many banks are finding it very difficult to raise money, and that means they have to reduce their loan portfolios.... [But now] the credit markets have stopped functioning. Because banks and investors and institutions are having to deleverage, that means they need to sell assets at whatever prices they can get in order to create capital to keep their loan-to-capital ratios within the regulatory limits.

[P]art of this started when banks and investors and funds used leverage (borrowed money) to buy more assets. Now, the opposite is happening. They are having to sell assets into a market that does not have the ability to borrow money to buy them. And because the regulators require them to sell whatever they can, the prices for some of these assets are ridiculously low.

Last week, I wrote about a formerly AAA-rated residential mortgage-backed security (RMBS) composed of Alt-A loans, better than subprime but less than prime. About 5% of the loans were delinquent, and there are no high-risk option ARMs in the security. It is offered at 70 cents on the dollar. If you bought that security, you would be making well over 12% on your money, and 76% of the loans in the portfolio of that security would have to default and lose over 50% of their value before you would risk even one penny. Yet the bank which is being forced to sell that loan has had to write down its value. As I wrote then, that is pricing in financial Armageddon....  And guess what? There are no buyers.

One of the real reasons these and thousands of other good bonds are not selling now is that there is real panic in the markets.... We are seeing massive flights of capital from money market funds, including by large institutions concerned about their capital. What are they buying? Short-term Treasury bills. Three-month Treasury bills are down to 0.84%.

It gets worse. Last week one-month Treasury bills were paying a negative 1%!!! That means some buyers were so panicked that they were willing to buy a bond for $1 that promised to pay them back only $.99 in just one month.

[T]here is a silent bank run going on. There are no lines in the street, but it is a run nevertheless. It is large investment funds and corporations quietly pulling their money from some of the best banks in the country.... Any whiff of a problem and an institution that is otherwise sound could be brought low in a matter of weeks. And the FDIC could end up with a large loss that seemed to have come from out of nowhere.

There is something called the TED spread, which is the difference between three-month LIBOR (the London Inter Bank Offered Rate which is in euro dollars, also called The Euro Dollar Spread, thus TED) and three-month US Treasury bills. Three-month LIBOR is basically what banks charge each other to borrow money.... Quite literally, the TED spread is screaming panic.

Credit spreads on high-yield bonds that many of our best high-growth businesses use to finance their growth are blowing out to levels which make it impossible for the companies to come to the market for new funds. And that is even if they could find investors in this market! There are lots of other examples (solid corporate loans selling at big discounts, asset-backed securities at discounts, etc.), but you get the idea. Suffice it to say that the current climate in the financial market is the worst since the 1930s.

We are in a recession. Unemployment is going to rise to well over 6%. Consumer spending is going to slow. This is an environment which normally means it is tougher for small businesses and consumers to get financing in any event. Congress or the Fed cannot repeal the business cycle. There are always going to be recessions. And we always get through them, because we have a dynamic economy that figures out how to get things moving again.

Recessions are part of the normal business cycle. But it takes a major policy mistake by Congress or the Fed to create a depression. Allowing the credit markets to freeze would count as a major policy mistake.

Why do we need this Stabilization Plan? Why can't the regular capital markets handle it? The reason is that the problem is simply too big for the market to deal with. It requires massive amounts of patient, long-term money to solve the problem. And the only source for that would be the US government.

If we act now, we will start to see securitization of mortgages, credit cards, auto loans, and business loans so that the economy can begin to function properly.

What happens if we walk away? Within a few weeks at most, financial markets will freeze even more. We will see electronic runs on major banks, and the FDIC will have more problems than you can possibly imagine. The TED spread and LIBOR will get much worse. Businesses which use the short-term commercial paper markets will start having problems rolling over their paper, forcing them to make difficult cuts in spending and employment. Larger businesses will find it more difficult to get loans and credit. That will have effects on down the economic food chain. [We] will see stock market investments off another 25% at the least. Home prices will go down even more. Consumer spending will drop. What should be a run-of-the-mill recession becomes a deep recession or soft depression.

A properly constructed Stabilization Plan...should ultimately not cost the taxpayer much, and maybe even return a profit. The AIG rescue that Paulson arranged is an example of how to do it right. My bet is that the taxpayer is going to make a real profit on this deal. We got 80% of AIG, with what is now a loan paying the taxpayer over 12%, plus almost $2 billion in upfront fees for doing the loan. That is not a bailout. That is a business deal that sounds like it was done by Mack the Knife.

This deal needs to be done by Monday. Every day we wait will see more and more money fly out the doors of the banks, putting the FDIC at ever greater risk. Panic will start to set in, moving to ever smaller banks. Frankly, we are at the point where we need to consider raising the FDIC limits for all deposits for a period of time, until the Stabilization Plan quells the panic.

I understand that this is a really, really bad idea according classical free-market economic theory. You know me; I am as free market as it comes. But I also know that without immediate action a lot of people are really going to be hurt. Unemployment is not a good thing. Losses on your home and investments hurt. It is all nice and well to talk about theories and contend the market should be allowed to sort itself out; and if we have a deep recession, then that is what is needed. But the risk we take is not a deep recession but a soft depression. The consequences of inaction are simply unthinkable.

I've quoted much more than I meant to.  I hope some of you are still with me.  What it boils down to is that this has the potential to have consequences—not only here, but around the world—far worse than we dreamed of in the Y2K panic.  I know people who stockpiled food and water for that one...yet this is receiving a "ho, hum" from most of us.

I'm hardly a fan of most governmental intervention, and one of my greatest fears in all this is that in our panic we will subject ourselves to measures with disastrous long-term consequences, as happened with the Great Depression.  We need to analyze the causes of our woes and how best to prevent them in the future.  We probably do need a serious restructuring of how our society handles debt.  When Mauldin says, "Cheap loans with small down payments are the life blood of the auto selling business" my reaction is to see that as a major part of the problem, and something that needs to be changed.  But not now, not so drastically.  The patient needs surgery—not amputation.  Above all, let's not let the patient die on the table while we argue about who's to blame and who should wield the knife.

In the meantime—where are my old Y2K notes?