Nothing Proposed Will Solve the Credit Crisis

As far as I have seen, no one has offered any solution to the credit crunch that makes any sense. Frankly, I am beginning to think there is no palatable solution. However, let's look at the plans that have been offered to see what the problems are.

First -- let's see what the basic problem is. US banks (and every other bank out there) use a fractional reserve system:

Fractional-reserve banking is the banking practice in which banks are required to keep only a fraction of their deposits in reserve with the choice of lending out the remainder while maintaining the obligation to redeem all deposits upon demand. This practice is universal in modern banking

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A demand deposit at a bank (e.g. checking account) or banknote issued by a bank (bank-issued paper money) is essentially a loan to the bank, repayable on demand, which the bank uses to finance its investments in loans and interest bearing securities. The nature of fractional-reserve banking is that there is only a fraction of cash reserves available at the bank needed to repay all of the demand deposits and banknotes issued. The reason people deposit funds at a bank or hold banknotes issued by a bank is to store savings in the form of a demand claim on the bank. One important aspect of fractional-reserve banking is that the note holders and depositors still have a claim to repayment of their funds on demand even though the funds are already largely invested by the bank in interest bearing loans and securities

So, the short version is the bank takes deposits and either makes loans or buys other higher-yielding assets. Either way, the bank makes money on the "spread" or the difference between the rate of interest they pay on deposits and the rate of interest they get on their long-term loans or investments.

Now, let's assume that a lot of banks have purchased securities with their deposits that are backed by mortgages. Also remember that we are in the middle of a really massive housing correction, meaning the price of homes is decreasing big time. As a result, the value of the assets purchased by the banks is decreasing. Whenever you hear about a bank "writing down" its assets, what they're essentially doing is saying, "these assets that we purchased that are backed by mortgages aren't worth what we thought they were." So banks are now saying these assets -- that are also backing loans they are making -- are decreasing in value. Hence, the banks have less ability to make loans. Hence, a credit crunch.

Also of importance right now is that everybody is writing down the value of their assets and their portfolios. As a result, people who would lend to these financial institutions aren't making loans for fear the borrower will announce a big writedown between the time they receive a short-term loan and the time they pay the short-term loan.

So the big problem is these mortgage-backed assets that are decreasing in value that are also owned by everybody.

Central to the government plan is that the government will put together a fund and buy the troubled mortgage assets from all the financial players. Also according to the government, most of these assets are undervalued in the market right now because of the panic. Therefore, the government will hold these assets until they rise in value to a level above the government's purchase price, thereby making the government a profit.

There are several really big assumptions in the above scenario that make no sense.

1.) The biggest stupidity is the government thinks these assets are undervalued right now and will eventually rise in value. Really. That's nice. And who is the wizard with the crystal ball? Has it occurred to anybody that these assets are correctly valued at current levels and will continue to drop? But Bonddad... Hank Paulson says that won't happen. The same thing goes for Bernanke. Neither of them saw this coming either, meaning their judgment is really suspect.

2.) What price will the government buy these assets at? If the government purchases these assets at prevailing levels, the financial institutions will have to take a big loss. That means their ability to make loans will be greatly effected. The only way this plan makes sense is for the government to purchase these assets at an above market level, thereby freeing up the banks etc.... to make loans. And that assumes the assets will increase in value over an inflated price to reward the taxpayers for their investment.

3.) If you were a financial institution with bad assets would you sell the government the best asset or the worst asset? In other words, do you think the government will get bonds that have a high or now degree of increasing in value? Simply put -- everybody is going to sell the government their worst garbage.

Raise your hand if you think this plan will work.

The progressive solution falls short for two reasons.

Mark-to-market exists for a very important reasons: it tells us what an institution is worth. The whole argument that some assets are undervalued in a particular environment is true; right now there are some assets that are valued below what you could sell the for in a roaring economy. The question now becomes, what assets would sell at higher prices in a strong economy and which ones wouldn't? The answer is simple: we have no idea. And anyone who tells you they can tell is lying because there is no way to perform that analysis with any degree of accuracy. There area simply too many variables to consider. People have been trying to do that for years. In market parlance, they are called value investors. Most aren't that good.

And that leads to the second problem, which is tied to the above issue with mark to market. The plan calls for a cash injection directly into the banks. That's fine. The problem is financial institutions have been getting infusions for the last year and their stock prices keep dropping. The reason is the issue with bank's assets, which keep dropping in value, thereby requiring more cash. Essentially, financial institutions have turned into a bottomless pit, a financial black hole into which investors have been throwing money. There has already been a ton of money poured into the financial sector in the form of equity injections. And banks still need the money. If memory serves, we've already seen over $300 billion going into banks with no end in sight. In other words, there is no guarantee this will cost less than the Paulson plan.

The basic problem is the value of the assets that are dropping in value. Everybody wants to waive a magic wand and make them more valuable. To quote the Mike Meyers' character Fat Bastard, "that's crap." These assets are cheap because they're cheap. In some cases they aren't worth the paper they are printed on. And yet everybody thinks they're worth more then the market will value them at right now. Maybe they will be, maybe they won't. But right now the market says they're not worth anything. We can't simply say "they're worth more because of all these assumptions." Those assumptions could just as easily be wrong as they are right.

And that leads to the central problem: we're in a period of massive asset deflation. Housing is dropping like a stone. Hence, lots of mortgages are underwater -- meaning the mortgage is worth more than the house. That means people increasingly default on their mortgages. That means assets backed by mortgages (like mortgage backed bonds that are causing the current problem) will continue to drop in value. And no magic wand can make those mortgage backed assets more valuable.

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