Credit Crisis 2

Building upon the same ideas I was talking about a few days ago, I'm going to take another stab at "explaining" what's going on with banks right now.

The financial crisis is worsening, but this shouldn't really surprise anyone. What is perhaps more surprising is that it's not having a bigger impact on the economy outside of the financial sector. I will return later to the question of why this is the case. But first, let's review some of the problems:

We're like a person with the hiccups who keeps thinking he's cured, only to be surprised by the inevitable next hiccup. What will it take to shock or relax us all the way out of this mess? One of the major problems is that people keep underestimating how bad their debt portfolios are:

A bank has bad loans. Eventually it realizes some of these loans are no good, writes them off, raises some more money to meet the reserve requirements, and then for a while, things appear to be OK again. Rinse. Repeat. Why don't they get all the debts written down in one go? This is an oversimplified way of looking at the problem, but I think there are many factors that are clearly part of the answer:

1) Because they (all the way up to the CEOs) are completely unrealistic about housing prices. Underlying much of this "bad debt" are mortgages that are underwater, people that can't afford their payments, and declining real estate values. If you find yourself thinking things like, "maybe housing prices have gone down, but not around here, or only a little bit" then you are making the same mistake the CEOs of investment banks are making. If you think that -5% to +5% is a reasonable range for the rate of growth of housing prices for the next year, you are not calibrated. My analysis of the fundamentals, which I hope to organize and publish on this blog, says that housing prices could still fall by as much as 40%. I'm not saying they *will* fall by 40%, but I'm saying that anyone who's "sure" that prices couldn't fall another 20% is crazy (and wrong). There is no evidence to suggest that it's impossible or very improbable that prices could fall 25% by next Christmas.

2) Because they are making the mistake of caring about sunk costs. It doesn't matter what size "loss" you have to take. That money is gone. If, starting today, it's better to hold these debts on your balance sheet, that's what you should do. If, starting today, it's better to get these debts off your balance sheet, that's what you should do. It basically makes no difference whether they've "gone down." In fact, the more they've gone down, the bigger the tax benefit of dumping them will be. Individual consumers are making this same mistake. There are tons of people out there who *should* be selling their houses. In order to sell, they would have to accept much lower prices than they want. They think it's better to "wait it out" and sell later, when prices are higher. They are very often wrong. Many people in this situation would be better off if they sold the houses now, even at the low prices, stopped paying the mortgages, and used the cash for other purposes. But, they aren't sophisticated enough in their understanding of personal finance to actually understand their *own* financial situations.

3) Because the CDS (commonly referred to as "swaps") and other such derivative instruments are so difficult to understand that financial analysts, accountants, and executives can't easily assess their exposure to various asset value declines.

• Firms never should have let themselves get into this situation. They turned a blind eye to the risks they were taking with financially engineered derivative instruments and securitized debt.
• The regulatory scheme for these products (commonly dealt in by investment banks) was "bad."
• Many of the debt swaps, for example, were not traded on any kind of market. They were just traded between individual parties. This created complex domino chains of default and risk. It meant there was no "market price" for people to "see" and react to. It has become fairly well understood that the point of capitalism isn't just to facilitate free exchange, but also to support free "markets."
• There was a lack of adequate or logical insurance requirements for these instruments. Firms didn't have to purchase the insurance they should probably have been required to have. Because they didn't have to purchase this insurance, rising insurance premiums did not serve as a signal that something was wrong between about 2003 and 2006, while these problems were incubating.
• There is a lack of transparency to these products, making it hard even for professional investors to analyze them.
• People were greedy, and took advantage of the obscure nature of these products to take financial risks that might otherwise have been discouraged, because the potential upside was so large.

I think that I agree with McCain that the chairman of the SEC should probably be fired. The SEC had the responsibility for regulating brokerages and others. It failed to do a good job. The regulation of commercial banks, which is handled by different bodies, seems to have worked much better.

CEOs of investment banks are underestimating the "badness" of debts in part because people are irrationally holding houses they should sell, keeping them off the market, and making prices appear artificially high. Maybe this is happening more than people realize. The slow deleveraging of individuals may be hindering the "right" amount of deleveraging by banks. If this is the case, I see two possible scenarios:

1) Maybe this will start seriously affecting individuals soon because no possibility of refinancing will exist and more and more people will be foreclosed upon. With more foreclosures on the market, prices will finally fall and more people will have negative equity and finally be forced to deleverage. In this scenario, individual consumers, especially home-owners, will get hit hard by this problem over the next couple of years.

2) Maybe the values of these houses, which were largely imaginary, were exploited by the banks and mortgage brokers to such an extent that they will now pay the majority of the price of adjustment. Maybe they "captured" so much of the real estate boom that consumers won't be as affected by it as they otherwise would. We have already seen $500B in real estate wealth disappear, and I suspect that number will double or triple over the next year. Even $1T of losses would leave the real estate market overvalued, in my opinion. Even after $1T of losses, we will probably see real real estate appreciation over the next 10 years lag behind the rest of the economy (to complete its correction).

President Bush deserves some small measure of responsibility for some of this. I don't know how many people he really influenced, but his ownership-society policies that pushed people to buy houses did contribute to the irrational exuberance about the real estate market.