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.


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.