Analytical Wealth

Last week Martin Wolf of the Financial Times had a great article on the bailout plan that I neglected to post, here is a quick excerpt:

(From the Financial Times): "What then is the challenge? The answer given by Hank Paulson, the all-action US Treasury secretary, last Friday, in announcing his “troubled asset relief programme”, is that “the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy.” The core challenge, then, is viewed as illiquidity, not insolvency. By creating a market for the toxic assets, Mr Paulson hopes to halt the spiral of falling prices and bankruptcies.

I suggest we should take a broader view of events. The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007. Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.

Graphic courtesy of the Financial Times

Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity and would net out to zero. But when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending. The result can be the “debt deflation”, described by the American economist, Irving Fisher, in 1933 and experienced by Japan in the 1990s.

Given the recent explosion in leverage, the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly.

Now turn to the criteria to be used in judging the intervention. First, it would deal with the systemic threat. Second, it would minimise damage to incentives. Third, it would come at minimum cost and risk to the taxpayer. Not least, it would be consistent with ideas of social justice.

The fundamental problem with the Paulson scheme, as proposed, is then that it is neither a necessary nor an efficient solution. It is not necessary, because the Federal Reserve is able to manage illiquidity through its many lender-of-last resort operations. It is not efficient, because it can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors"

I think the key to all of this is that if the government buys assets on which the banks are levered up 7,12,15,20:1 (or more), it won't solve their insolvency issues even if Paulson pays the full "Mark to Model" price from the time of the credit boom. Forget the arguments over the lack of penalties for the banks, lack of respect for the taxpayer, the nonsensical notion that the government will make money from the bailout, etc, etc, the fact that's not sufficient enough to address the issues of over leverage, under capitalization and over insolvency is all that matters.

Now this was written on 9/23/08 back when Paulson's initial proposal was first created, and despite all of the machinations in Congress, the plan's changes, etc, the plan's fatal flaw with respect to its inability to address the insolvency problem remains. If that doesn't articulate why this plan is a bad idea than I don't know what does.

Finally something else that really needs to be discussed is that our nation's debt addiction has reached a veritable crescendo that threatens to throw the nation (if not the global economic system) into ruin. The nation's consumer, corporate and government(taxpayer) has reached a level that is simply unsustainable over the short-term, let alone the medium or long-term. If we really want to address the roots of the current economic crisis, we as a nation have to start making some tough choices and reset our expectations around consumption, money management and use of debt.

You can read more here.

Sources:

The Financial Times: "Paulson’s plan was not a true solution to the crisis" -- Martin Wolf, September 23, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.