Dead Men Walking: The Credit Crisis And The Financial Stimulus

In a recent interview on NPR, Raghuram Rajan, who was the Chief Economist at the International Monetary Fund between 2003 and 2006, described the situation facing many of the nation’s leading banks and financial institutions by saying:

"Well, the banks are making significant losses coming from the mortgage-backed securities that they held, coming from people who've lost their jobs and are now defaulting on credit card loans…And some of the banks are essentially completely decapitalized — that is, their liabilities exceed the value of their assets. So to that extent, some of them are in fact dead men walking."

According to some economists, the problem is rooted in the unrealistically low cost of risk that was common in the financial markets leading up to the popping of the housing bubble. “The problem was that risk was too cheap.” New financial instruments, such as “mortgage-backed securities” combined good and bad mortgages into packages and sold them as investments. The financial institutions making the loans were not responsible for their risk since they had sold it to others who had no idea which of the loans in a package were good and which were bad. This encouraged consumers and financial institutions to take on more risk then they could handle. Lending institutions pushed mortgages to those who could not normally qualify for them and consumers were encouraged to take on more house then they could afford since they believed that prices would always go up. This led to a “housing bubble.” When the housing bubble popped this caused a downturn in the housing market, a drop in house prices and a wave of foreclosures, which further increased the unsold housing inventory and drove down property values even further. This left banks and other financial institutions with assets worth far less than they had paid for them which caused a severe lack of liquidity. This may be defined as the ability to convert an asset into cash quickly by selling it without having its price affected or causing it to lose much of its value. It also refers to the ability of a business to meet its payment obligations by possessing enough liquid assets to cover their debts. The crisis also left the credit markets unwilling or unable to make loans. The drying up the credit markets severely impacted the business community by cutting off new investment as well as the lines of credit that companies depended on to pay their employees and to meet expenses. It also depressed the ability of consumers to buy, driving down demand, which led to lay-offs which further suppressed demand, causing consumption and jobs to go into a “death spiral.” The original intent of the Emergency Economic Stabilization Act of 2008 was to get credit flowing again, and it planned to do this by buying up bad assets and by injecting cash directly into the troubled companies. It was hoped that buying these “toxic assets” would increase confidence in the remaining assets, and restore investor confidence in the credit markets. One method of “injecting” cash into the troubled financial institutions was for the government to buy “preferred shares” of stock in the company. While preferred stock does not have voting rights it is considered safer than common stock since it has superior priority in the payment of dividends and upon liquidation. In other words the owners, of preferred stock are the first ones in line for repayment. There have been numerous criticisms leveled at the program, not least of which was caused by the lax standards the previous administration used in distributing the money and managing the program. There has also been a great deal of public trepidation caused by the huge size of the program. Some of this is justified, but buy no means all. For one thing, much of the money will be spent to buy assets that could eventually be sold, perhaps even turning a profit. For another, the purchase of preferred stock assures that the government, and by proxy the taxpayers, are first in line for repayment should the companies go bankrupt or turn profitable. A far more telling criticism is that as large as the sum is it is simply not enough. With all the money that has already been spent, some $400 billion, credit institutions are still woefully under capitalized and therefore unable or unwilling to lend money, which is the whole point of the exercise. Another danger is that if the program buys assets at above market value then institutions that receive the money might be tempted to gamble on bad assets, rejecting good loans and accepting bad loans knowing that it can shift the risk onto its creditors. One way to avoid this, according to Nobel-Prize-winning economist Paul Krugman is for the government to not buy the toxic assets but rather, to buy the banks themselves, thereby getting not only the bad debt but the good debt as well and allowing the government to restructure the ailing companies. This is similar to what the Swedes did back in the 1990’s. The government assumed the debts of the bad banks in return for common stock. The bad debts were then transferred to asset-management companies who sold the assets, mainly real estate, with the proceeds going to the state. Once the banks were back on their feet the government recouped its investment by selling its shares back into the private market at a profit. This sort of policy is already being tried by the current administration, which recently announced that it is converting some $25 billion of the TARP money it gave to Citicorp from preferred shares to common shares, thereby giving itself a controlling interest in the corporation. Krugman warns that to properly implement this program would not be cheap, and would mean a temporary nationalization of large parts of the financial system. In order to prevent a recurrence of such a disaster Krugman also believes that we need to reverse the last three decades of deregulation and that “anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn’t a crisis so that it doesn’t take excessive risks.” I believe that Krugman is correct and that the consequences for failing to act, or for the current fiscal stimulus to succeed, would be a very long, very deep world-wide economic slowdown. Not many economists are using the term depression—yet. This in part because that word is no longer fashionable. But depression or really long recession the effects are almost the same and should be avoided at all costs.