Would it Be Cheaper to Just Start from Scratch?

We've had some amazing developments over the weekend with a $300 billion plus bailout of Citibank in addition to the billions it already receives in direct equity investments in addition to lending from the Fed window. In addition, the government today is going to purchase another $500 billion in mortgage related securities. Including the nationalization of Fannie/Freddie as well as the other various acronyms of programs we've got another few trillion added on to the tap in what looks like a purchase and spending plan that's going to end somewhere between $5 and $7 trillion not including any fiscal stimulus that may be planned.

Additionally, we still have not had government regulators impose or require any kind of real visibility on the exposure to derivatives at these institutions which makes many of these companies very vulnerable to runs on their debt and equity securities--often in tandem. Why not require transparency? Is it an issue that the potential liability is so large that regulators fear transparency might induce further panic? Perhaps it would.

Meanwhile, it almost seems as the bailouts, guarantees, and equity infusions never end. We've had a lot of debate on the original TARP as well as giving poor Hank Paulson's underlings dramatic grillings in Congress but what about a debate on the virtues of an alternative. Specifically, letting the market for assets in these various bubble asset classes actually clear. Doing nothing but guaranteeing deposits, various money markets, CDs etc as opposed to trying to guarantee trillions in secured and unsecured debt and equity that underpin these inflated assets with no real end in sight. It's called "catching the falling knife approach". I suppose if you can print unlimited currency, your chances of doing so are better.

The obvious peril here of such an alternative is the forced liquidation of all of our major financial institutions including Citibank, JP Morgan, Wells Fargo, Goldman, Morgan, and Bank of America and letting asset prices in real estate and other areas actually clear. No question the forced clearing process would cause asset prices to over correct. But doesn't that over correction always beget a process of recreating market viability? Didn't it do so in the S&L prices with investors and speculators and homeowners coming in finally to get the market going again. Those first investors got some great bargains but they have as of yet for this crisis not appeared.

One could argue the market intervention now prevents players on the sidelines now in private equity and elsewhere from entering the market due to artificial transactions taking place. Why enter now when it's highly probable that government support will end at some point in the future and better terms can be dictated then. Without that over correction process, you prevent the natural clearing process for assets taking place that we have seen in the resolution of every other bubble for the last 200 years.

We would have to start from scratch with new banks entering the market over time to fill the huge gap left by these exits. No question, the result of that would be fairly catastrophic with secured and unsecured lenders to these institutions wiped out and the credit markets frozen for several quarters if not a lot longer. Of course even with the government intervention now credit markets are pretty much frozen anyway.

We've had quite a few banks forming lately to get access to the governments "free money" so we seem to have an ample supply of folks ready to step in to become bankers. It might even mean foreign banks (the ones who survived the collapse of their American counter parties) would take a more active role in our economy. That would mean big hits to national pride until American institutions could stand on their feet again but maybe we need a good swift kick in the ass right now?

Right now though it seems like the ex-Goldman bankers that run Treasury can't imagine a world without these institutions and have not even considered the proposition of letting the market clear for real estate and other assets and let these institutions exit or thrive upon their own merit. Rules everyone else seems to have to live by.

This would mean a even more drastic and quick drop in consumer spending, a number that needs to go down anyway as well as big drops in the equity markets which have already dropped by approximately 50%. This kind of shock would likely put unemployment up in to double digits past 10%. Real estate prices would drop another 30-50% in some markets and interest rates to finance mortgages would be much higher (8% or higher) without the government backstop.

Right now, lenders to the "chosen banks" in effect have a guarantee on their debt. A far better deal than they probably imagined when they lent the banks money. But it has huge costs to the dollar as we print money out of thin air to support these failed institutions and our financial system and if the current approach continues, the only survivors to this crisis might be the banks and the people that lent to them with surrounding industries destroyed by the heavy burden this crisis will toll going forward. What good is a bunch of banks if long term American viability is put at risk and we have a broken currency? Those kinds of problems are much harder to fix.

At the same time, the most striking thing about the Citibank deal is other banks may need the exact same type of program and in the end, it may not be enough. These balance sheets are so complicated it's not clear where these problems end or how insolvent these institutions really are. I don't think even the managers of these companies have any idea. We could spend several trillion dollars and it still may not solve the underlying problems in these financial institutions. With global central banks heading for zero and potential scenarios for quantitative easing this sure helps its chances though. Although still the ECB has cut anywhere near where the Fed has and policy worldwide is still not coordinated well at all.

It also appears the Fed in cahoots with Treasury is starting to actually just print money to finance some of these programs. There are severe limits to how much of this can be done and eventually it will ruin our ability to finance our way out of problems. This particular outcome would have a truly devastating impact on our economy and our longer term growth rate. Japan left it's deflationary spiral with public debt 300% to GDP and no real growth. One could argue they still are not out of this crisis with their own money rates still near zero. We've criticized their poor policy response and congratulated ourselves on handling our own version of the crisis with alacrity but in some ways it feels we may be heading to the same place perhaps with an even more despondent ending place.

With US government debt in 2007 at 65% of GDP and total debt at 350% of GDP counting consumers debt and mortgages does it not appear like we will be moving all of this debt over to the government ledger with a similar burden just like Japan. Would it not be more prudent to write this off rather than foisting it on the US taxpayer and let those who lent imprudently take the hit?

Was the real error in the Japanese policy response not letting these banks with overvalued assets fail? Taking their pain quickly, then using bailout money instead to help the economy recover afterword? Are we simply putting off the inevitable rather than facing it thereby transforming the US economy into a walking corpse?

The pitfalls of printing Weimar money aside, at some point a huge fiscal stimulus may become so expensive to finance due to higher interest rates, it would in effect become counter productive. This is very similar to the situation we were in during the 80s/90s. It the cost of financing debt were to spiral back to interest rates even during the 90s, the spending may crowd out so much private investment it may actually shrink growth by having the government spend more. Also, there is financing risk in terms of the government borrowing money cheaply now, but when it comes time to roll it over in 2 years, the markets have adjusted and we have to pay much higher interest rates to refinance. Much like people with ARMs today- the US government is falling into the same trap of easy money now, and not being able to pay later.

We could also experience a short term boost from fiscal stimulus (looks to be about a $700 billion plan to start us off but I think the may go as high as twice that) but in several years when the debt rolls over, the interest expense could rise so sharply it could whiplash us into another recession.

On the positive side, it definitely appears that the Treasury is "working ahead of the curve" for the first time I have ever seen. These programs are huge, dramatic and are getting ahead of problems rather than just reacting to them. It may work but there is also the potential that you may get the same kind of disaster scenario of a financial system collapse but with added problems of the collapse of the dollar and huge bubbles in other sectors in the future.

Already we have seen the dollar start to fall and gold start to rise relatively substantially. These are all symptoms of the potential for problems down the road. If the dollar starts to weaken further, it may set off a spiral of events that materially limit the government's ability to finance its own operations. This would lead to debt issuance in Euros or Yen and a significant constraint on our ability to borrow as well as a big rise in rates.

There are other implications as well with the complete nationalization of mortgage debt. I am not sure I love the idea that the government control the mortgage market. A lot of these policy choices are not only high risk, they are also very difficult to undo.

One also wonders if we are simply spreading the pain out over a long period of time rather than taking it all at once, and creating longer term issues in currency risk and our ability to finance our debt. I'd almost rather have 6 months of housing prices collapse, -10% in retail sales, and other deflation while assets get repriced without risking our currency and financial future.

So what is better...letting these very complicated institutions go and letting the cards fall where they may or the current program of shifting risk onto the government balance sheet. In either scenario we would guarantee things like money market funds and deposits but all the secured and unsecured debt would have to be handled the old fashioned way by the private markets.

Either way its a huge gamble and the future direction of the country will be impacted by this choice. To be honest I don't know which path is better and I don't know that I am going to flesh the answer out here on this blog.

I guess I wonder though, has Paulson even contemplated a scenario where Goldman and Citibank fail? Has the government thought about the trade off for a "Tabula Rasa" or clean slate? What would the cost to stabilize the system compared to the trillions we are spending now? Would there be aspects where we might be better off? Is Hank Paulson even considering this as an alternative? Wasn't the big mistake Japan made that it didn't allow banks to fail and assets to clear? Didn't we say that was the one thing we were not going to do yet that's precisely what Treasury has arranged? Isn't this "tough medicine" the weak response we chastised Japan for?

Would picking up the pieces after a collapse be wiser than trying to spend a bunch of money now to prevent one? Are we preventing a Japanese crisis of our own or are we just postponing it? Instead of lambasting Paulson and Bernake how about a hearing in Congress to debate the merits of what a more hands off policy would look like.

Lots of hearing in Congress about how bad Paulson's idea is, but in fairness nobody has discussed the alternative. Didn't we attribute the Japanese solution to excessive "pride" by the Japanese in their unwillingness to admit failure? I suppose we are too advanced a society to ever succumb to pride like they did.

Or is it "Pride Always Goeth Before A Fall". Right now I don't have all the facts but in my gut it feels an awful lot like the latter to me.