Notes on the Financial Crisis

New York Ciy--Felix Rohatyn used to remark, in telling the story of the New York City bailout,  that the Latin root of the word credit is credo, to believe.  When people believe they will get repaid they lend.  When they no longer believe, credit dries up.  This is what has happened in recent weeks as one financial institution after another has fallen victim to runs, most recently Washington Mutual.  In some cases, investors pulling their money were fellow firms as in the case of the runs on Bear Stearns and Lehman Brothers.  In these cases, some investors may have first shorted the stock, then pulled their money from the firm, news of which caused the stock to drop, and then covered the short to make sizable profits.  In the case of Wamu, ordinary savers pulled their deposits based on rumors of collapse.  While most of the discussion of the crisis has centered on bad loans, it is important to keep in mind that what has actually precipitated the collapse of the failed firms so far are runs on the bank. 

The air of desparation created by Hank Paulson with his emergency plan announced last Friday (after Goldman Sachs, his alma mater, was itself the victim of shortselling, dropping from 170 to 108 in about a week) and the desparate effort of President Bush and Ben Bernanke to sell the plan on the basis of fear, have, themselves, fueled the panic.

Had Treasury put forth a careful plan to deal with the mortgage crisis six months ago that included homeowner relief such as a proposal endorsed by Senator Clinton yesterday that has been floating around for some time to create a new Home Owner's Loan Corporation, similar to the one created in the 1930s to buy up bad mortgages and replace them with good ones and a mechanism to liquidate bad loans, this crisis might very well be over.

Instead, the release of a three page plan that gave sole authority for spending $700 billion to one man, the Treasury Secretary, and explictly barred judicial and other review, the clumsy effort to speed it into law, and exhortations by the sober stewards of our financial system, Mssrs. Paulson and Bernanke to pass this or else face doomsday, have if anything hastened doomsday.  At yesterday's White House meeting, the New York Times reported that Secretary Paulson actually got down on one knee to implore Speaker Pelosi to save the deal.

In finance, perception is a large portion of reality.  The crisis is navigable but only if our financial stewards take a deep breath, step back and provide a plan that addresses the real issues. 

What are the real issues?  They are twofold.  First, a number of large financial institutions have ended up holding large quantitites of depreciated paper that they acquired using leverage or borrowed money on their books.  They owe the money they used to buy the paper.  But the paper has declined in value.  They thus resemble homeowners that borrowed money to buy a house that has declined in value.  They may actually have negative equity.  What they need therefore is a capital infusion in the form of more equity--or equivalently for the government to buy the paper for more than its market value--what the Treasury plan proposes to do.  Overextended as they are, they are susceptible to runs--or investors taking back their money.

The second important issue is that millions of Americans are saddled with mortgages they can't afford.  The answer to this problem is what in commercial real estate is quite common and is called a workout.  Workouts amount to making a deal where the loans terms are modified so that the bank does better than it would through foreclosure but the borrower is able to make the payments.

The plan introduced to date is a form of creditor relief but offers no corresponding debtor relief.  It simply authorizes a transfer of funds from taxpayers to Wall Street.  As the New York Times said, it is shocking that so far, Secretary Paulson is unwilling to give bankruptcy judges the right to modify loan terms for mortgages when they have this right for other types of debt.  Missing from the deal is a meaningful plan to modify onerous loan terms to keep people in their homes.  A further deficiency of the deal is its extension to include any trouble assets such as credit card receivables as opposed to mortages, particularly in the absense of meaningful credit card reform.

There is time to resolve this crisis.  The Republicans who blocked the deal may well have done every one a favor by slowing down a proposal that does not go far enough to keep Americans in their homes.  There is time to develop good legislation but only if the principals stop their fear mongering and agree to something that works for Main Street as well as Wall Street.


Effects of Financial Crisis by PaydayLoanAdvocate (not verified)
Effects of Financial Crisis by PaydayLoanAdvocate (not verified)
Financial Freedom! by PaydayLoanAdvocate (not verified)