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What If It’s All A Lie?

I have argued consistently for two years that the U.S. is experiencing a solvency crisis in the overleveraged financial sector. Many companies would be effectively insolvent were they required to mark their assets to market.

Most policy makers understand this point. However, many, including the past two Treasury secretaries, have argued that this is a liquidity crisis masquerading as an insolvency crisis. With enough loan forbearance, capital injections, and time, the banking system will eventually be restored to health and the American economy will be back on its fundamentally sound path. (Update: also see FT Alphaville’s post on mark-to-market, which shows a lack of distress on average at present)

However, even the recent American economic history from the savings and loan crisis makes plain that this extend and pretend view is demonstrably false. I even pointed out that the banking industry’s main regulator holds this view and provides documentation for it on their own site.

The FDIC has a chronology of the Savings and Loan crisis on its website. I think they do a pretty good job of highlighting all the key points without slanting things for political purposes. See the link at the end of the post for the chronology.

The S&L crisis bears keeping in mind as many comparisons to that period regarding deregulation, risk, and bailouts are now being made. One note about the S&L crisis that I should make is that relaxing accounting rules caused the crisis to mushroom in size. And this bears noting as the onerous FAS 157 is creating quite a stir right now. Basically, the accounting rule mandates marking-to-market of various securities.

I am sympathetic to calls to relax the rule as it is pro-cyclical, meaning it naturally swings along with the business cycle. Marking to market causes balance sheets to be inflated during booms like the one we just had and it may cause them to be artificially deflated during busts like the present one.

However, experiences like the Savings and Loan crisis show that relaxing accounting rules in order to bail out financial institutions is probably a bad idea and leads to much greater losses. It is better to take the losses in the first place and move on.

-S&L crisis chronology and accounting rules

Of course, that’s not what we did, is it?

Nevertheless, in today’s world, we know that the government has sold off shares in Citigroup and allowed the big banks to exit the TARP program. Banks are making record profits and paying huge bonuses even if they are not paying dividends. The view propagated in the mainstream media is that all is well (see here, here and here).

But what if, in fact, it’s all just a lie? I mean what if Treasury Secretary Geithner’s bailout plan only works in a good economy?

What’s happening now in Spain is a perfect example of what I mean. Here’s how I put it early this week:

Last spring and summer I wrote a series of articles on the bleak situation in Spain, centred on the Spanish Cajas (savings banks), the imploded housing market and the high level of unemployment. The gist of these posts was that Spain faced an uphill battle since the jobs market was in a world of hurt and Spain’s Cajas were hiding billions in real estate losses via forbearance.

The problems with the Cajas, who have been frequent users of ECB liquidity, became urgent during the depths of the recession in March 2009 when Caja Castilla La Mancha was rescued. By April, reports that Spain’s savings banks may have 40 billion in writedowns were widespread. For me, it was revelations last July about GMAC and Hypo-Real-Estate’s speculations in the Spanish mortgage market that made it clear how deep the forbearance problem was. GMAC was selling Spanish mortgage assets for 14.5 cents on the dollar while Spanish house prices had only fallen 13%. I asked “What does that tell you about likely losses in the Spanish banking system going forward?”

Well, with the nationalization of CajaSur, the forced merger of two Cajas and the forced merger of yet four other Cajas this week, we have the answer. Now, the Spanish are moving forcefully to clean this mess up. But clearly, there are a lot of dud assets on Spanish banks’ books – just as there are on the books of banks in the US or Germany or Ireland to name a few conspicuous countries. As I have been saying for a while, all of these problems didn’t magically disappear, they have been lurking, waiting for economic weakness to re-assert themselves.

-CajaSur nationalization makes fragility of Spain’s banks topical

I fully expect the problems at US banks would re-assert themselves as well if the US economy runs into a rough patch too.

I think you will find this is also implicitly what the Treasury Secretary believes – a key reason for keeping the economy afloat by all means necessary. The key difference between me and Mr. Geithner is that I fully anticipate we actually will run into a rough patch – how rough and how soon are the questions.

All of this is a lead-in to the paper by Randall Wray and Eric Tymoigne embedded below. It was published last year but still reads like something that could be written today and I recommend it highly. I will leave you with the first words of the introduction.

With employment numbers dropping rapidly, the finances of state governments, households, and businesses worsening, and highly leveraged financial institutions overwhelmed by a mountain of “legacy” assets, the Obama administration has had a lot to deal with in its first few months in office. Unfortunately, like the Bush administration before it, the Obama team appears to be trying to re-create the bubbly financial conditions that led to disaster. This tack is not likely to succeed, and it is displacing policies that might actually prevent a recurrence of the Great Depression. Even if the $23.7 trillion the federal government has so far allocated in the form of spending, lending, and guarantees does preserve the status quo,we believe it will merely set the stage for another—bigger—financial crisis a few years down the road. This is why we recommend an abrupt change of course and the pursuit of a more radical policy agenda.

Instead of trying to revive the productive economy, most of the recovery effort so far has consisted of CPR for Wall Street. Fearing what it might find if it actually examined the books of financial institutions in detail, the administration put a chosen handful through a wimpy “stress test” after announcing that none would fail. Rather than closing massively insolvent institutions, Washington continues to allow them to conduct “business as usual,” and to show questionable profits so that they can pay out big bonuses to the geniuses who created the toxic waste that brought on the crisis.

In short, current policy serves to preserve the interests of big financial companies rather than to implement government programs that would directly sustain employment and restore state finances. To make matters worse, the Obama administration is already preoccupied with “paying for” additional spending through tax hikes, or through spending cuts elsewhere. It does not appear to be willing to let the fiscal position of the federal budget grow as needed to meet current challenges. We suspect the balanced-budget craziness will get worse during the next election season—much as President Roosevelt’s 1936 campaign tied him to fiscal tightening that threw the economy back into depression in 1937.

Exactly. I wouldn’t call it "craziness." No one likes to see massive deficits. But fiscal austerity is coming to America in due course. And the result will be an economic slowdown. It is then that we will learn if the bailouts have actually worked.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

15 Comments

  1. Element says:

    Warning: contrarian hard-hats required

    Financial Sectors Must Balance:

    “…Conclusion: the financial sectors must balance
    Notice I haven’t talked about government as the creator of currency and the private sector as the user of currency. I haven’t focused on any misallocation of resource or malinvestment issues. I haven’t raised the spectre of inflation or currency depreciation. I have simply presented the economics and accounting of budget deficits.

    The other stuff is where the politics and the ideology come into play but the accounting of federal government deficits is clear. When the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. Draw your own conclusions about what this means in an era of government fiscal austerity.” – MMT: Economics 101 on government budget deficits – Posted by Edward Harrison on 13 May

    The thing that bothers me about the EMPHASIS on financial sector re-balancing is that it’s not actually a product of actual re-balance. Yes, the books are re-balanced, fine, I don’t question that nor do I even have a problem with deficit spending per-sec – as long as it will work and prevent instant collapse (which is its current role).

    But the spending is not a re-balance in the present circumstances.

    Commercial banks create credit-money loans from thin air – ‘funny-money’.

    [Ideologically speaking: a mechanism for legally obtaining private assets of others, via doing remarkably little that's constructive, or worthy of it, and routinely creating immeasurable social harm during the course of the process. When heavily overseen, plus fraud is rigorously quashed and punished this can still produce NET benefit for society, so funny-money is encouraged at best a nominal 10:1 ratio of funny-money to deposits/savings.]

    Is that funny money creation counter-balanced elsewhere?

    No.

    That’s why the numbers keep getting bigger. No re-balance there but there should be, there needs be, else it just inflates.

    Nor do I have a problem with Fiat money or a problem with the need to ‘print’ money.

    That’s not my angst, I have no illusion that no major developed country will ever consider abandoning Fiat money for metals. There are far too many people on Earth for that. Like it or not we have to make fiat money sustain the economy long term.

    But I’m satisfied we are nowhere near that – on the contrary.

    Private borrowers leverage up and can not pay their debt schedules on the assets they purchased but could not afford (effectively on the bank’s behalf), because they were made unaffordable, so they spend all their saved reserves trying to pay up, then default on the invented funny-money (the loan).

    Overseeing stopped years prior and banking fraud is out of control and unpunished.

    So productive investments reduce to a low level, but leverage ratios must increase, because saving/deposits are now rather low, everywhere.

    But that’s ok, you’re having a spectacular boom of GDP! But not of productive endeavour. It’s all funny-money still.

    Debt is funny money, GDP is the product of funny money.

    So it’s really the funny-money to the product of the funny-money ratio that people are getting all ‘Sovereign-defaulty’ about.

    The deficits are ‘Helicopter-money’ – another form of funny money (that steals away the national resources in an inappropriate an avoidable way).

    All based on the invention of funny-money out of thin air, by banks, and that funny-money has become so large so fast that its UNAFFORDABLE by the large low-rung of society.

    And yes, slice it or dice it, that’s inflation, i.e. commercial bank’s funny-money creation ultimately propels the inflation you all experience, conversely, deflation is when the bank’s funny-money loan did not get repaid by the borrower’s savings and assets, which then leads to delevering and funny-money originator collapse. (We really focus a bit too much on the Central bank me thinks, as the commercial banks are doing tremendous damage, and getting off far too lightly. We are still far too sympathetic and accommodating of their plight even now.)

    Then the massive lay-offs hit – even small business – as UNAFFORDABILITY spreads generally.

    Suddenly the Kleptocratic Govt ‘gets-religion’ about financial regulation, and makes terrific gushy speeches about the need to protect ‘the people’, from the asset stripping machine, that the Govt set in motion to rip the people off.

    Govt systemic arrangements are also getting off far too lightly as well. The US SEC should be abolished, it’s beyond redemption and its endless excuses can not be taken seriously.

    But private borrowers are onto the rorts, and of necessity and also strategically, have stopped paying for the funny-money ‘loans’, but are also loosing assets en-masse, and getting rather uppity.

    The bank’s funny-money leverage-ratios book suddenly looks very dicey – if not absurd.

    They could invent more funny-money (and do) but they may get caught in double dealings now, and prosecuted (yeah, right…).

    Plus none of them can trust each other, as they all know they’re really just a bunch of thoroughly untrustworthy and endlessly deceptive rorters, to put it in the mildest possible terms.

    So the system freezes, … again … and again.

    All from inflating to unaffordability.

    And the answer is; Re-inflate!

    The Govt says, “Hey Ben, warm up the helicopter, the Wall Street guys can’t sell the assets they ‘contractually appropriated’ (again, putting it very mildly), with their funny-money traps.

    So we need the Central Bankers to set up rate arbitrage freebies, to try and make their funny-money move again, and to try and make ‘their’ assets seem worth … well, something … perhaps even worth buying and owning … one day.

    Else, we’re all porked.

    So instead of the commercial banks inflating, now the central bank does it, only they are re-inflating the bank, not the assets.

    The assets are still porked!

    Oops, the wild democratic savages of the land will demand our blood! So you print some more, to make them less blood thirsty – for a while.

    Thus the Govt tries to prop-up and maintain a GDP level that was the in large part a product of invented funny-money all along.

    Heaven forbid that a funny-money inflated GDP should fall, that would be a ‘recession’.

    Or that funny-money originators should almost all close their doors, for that would be a ‘Depression’.

    So we must resort to extravagant and impossible levels of deficits and public debt burden, and use indulgent theoretical argumentation’s along the lines of, “look kids, financial sectoral balances must balance, it’s an accounting identity, so do get a clue please”, etc., to justify protection of non-performing funny-money from banks full of Bill Black type control-fraudsters.

    (yes, I know, heard it all before, but there is a point coming)

    All protecting an apparatus and policy-making framework that allowed this to occur.

    Thus;

    * We charge higher taxes, raise levies and fines etc.
    * We cut services – deep!
    * We increase debt-servicing as a proportion of revenue.
    * We print money to make up the yawning chasm between deficits and actual debt growth.
    * Thus we debase the currency and monetise public and also private debt.
    * While encouraging banks to take over inflating duties with more funny-money.
    * While intensifying misallocation of resources and deterring investment.
    * While protecting the guilty behind a veil of secrecy.
    * Then the crowning glory – Govt policy inflates away debt for 30 years.

    This rapidly erodes away any remaining savings, that may still have been hiding away, somewhere, leading to general national impoverishment, if productivity-based wage rises can not compensate (like, fat chance!).

    All of which harms the poor more and more and more.

    So, if a Fiat currency is necessary we have a long way to go, to get it to actually work.

    And this is why (for me) the MMT emphasis on ‘sectoral balances must balance’ is theoretically cogent.

    But also pointless theoretical drivel that misses the point of what has (and is still) occurred, and will get much worse.

    We are just using invented ‘helicopter-money’ to prop up a GDP built on the legalised rapine of funny-money even while people are ready to immolate the Govt, and Wall Street on the dip.

    Deficit spending, in the absence of toxic asset destruction, is mostly wasted in my view. At best it is acting as a time buyer, but what is being done with that time? I do hope our respective Govts are using this time to prepare for the collapse of ~10,000 banks in the OECD.

    Hence, to me the “sectoral balances must balance” mantra is being emphasised by MMT, as an excuse to use spending to elicit aggregate demand increase, that can’t increase much now, because the bad loans have been sheltered by helicopter-money, but the older funny money is still preventing a protracted recovery and business and employment growth.

    That’s not a re-balance nor is it an automatic-stabiliser, there’s nothing stable about that.

    The funny-money system is porked, and the helicopter-money is just ‘Uncle Ben’s Famous Apple-Sauce’ heaped up on top of a dead pig.

    The GDP level is all funny-money, so why on earth should anyone think a sectoral re-balance would work (or is even proper)?

    However;

    *If you destroy the bad funny-money loans.
    *Then zero-out and expunge the originators dodgy funny-money book.
    *Let people keep the assets, or buy what’s left cheap.
    *Reset the regulatory environment.
    *Jail crooks and officially censure failed high-public officials to salve the heaving snorting Democratic beastie threatening to charge the China shop.

    Then you can restart the economy faster and even put the helicopter back in the hanger after a few years and pay less tax (I’m not saying don’t use it – just use it on something that’s realistic and viable).

    Then you don’t need (and generally won’t want) most of what MMT theoretically pretends to provide, any more than you would want what the Austrian mob pretends to provide. (and you sure don’t want what the gold-bugs pretend to provide, i.e. security in a total global collapse)

    When funny-money is unaffordable the GDP created by that funny-money must fall and the attempt to prop it up with helicopter-money means it will fall much further – just later.

    Its plain nothing is re-balanced by helicopter-money deficits that seek to protect unaffordable funny-money originators and the heist of legalised private assets stripping.

    So maybe we can move on from “sectoral balances must balance”, and double-entry bookkeeping’s accounting identities, as fig-leaf.

    Funny-money that can not be repaid, will not be repaid.

    That’s the trump card.

    Making things affordable is far more important than making credit cheap.

    Cheap credit for unaffordable stuff = BANKING SYSTEM FAILURE

    The coming GDP deflation and price deflation and closure of thousands of banks will make things affordable again by cash – and make credit suitably more expensive – and promote conservative budgeting according to actual realistic capacity to pay.

    That’s a sectoral re-balance that will actually work long-term to provide aggregate demand growth.

    I’m interested in how to make that re-balance transition because that’s the re-balance that we’re actually going to get thrust on us.

    Ready or not.

    The process of credit writedown is what it will all be about, and not about trying to maintain the ‘rebalance’ of a GDP based on unpayable loans.

    • John Haskell says:

      your comment doesn’t require a hard hat. It requires a blue pencil.

  2. John Haskell says:

    This “GMAC sold mortgage assets for 14c” keeps popping up on this site like a bad penny.

    What kind of mortgage assets?

    • Spanish mortgage assets. Read the links, that’s why they’re there.

      • John Haskell says:

        (clears throat). Yes, I clicked through to a previous CW post, which linked to an Ambrose Evans-Pritchard artlcle which mentioned some unspecified “mortgage assets” being sold for 14 cents on the dollar.

        It’s reminiscent of George Bush saying we know that Saddam Hussein is trying to buy uranium because we have a British source who says so… but then the British source turns out to be, well, not very specific.