Thursday, August 30, 2012

The Government’s Response in the Case of a Financial Crisis Requiring a Bank Bailout

A prior post explained how financial crises develop and the need for a government bailout of banks to prevent a complete collapse of the economy.

There are two ways governments could respond to a financial crisis. One way is to take over failing banks and restructure them. This involves creating new healthy entities that can continue to operate with only loans that can be serviced, and putting loans that can’t be serviced into new entities that will enter bankruptcy where investors and lienholders will suffer the losses. The other is to give the banks money to continue to weather the storm over a long period of time by investing the money in other areas and using the income to deleverage and write off bad loans as they occur.

Political reasons have dictated the second course in the case of the current financial crisis. The financial sector has tremendous political power through contributions to politicians and influence with the national press. Both political parties are subject to this lobbying pressure and succumbed to it.

The bailout funds from the government and through the Fed’s buying of troubled assets has been used by banks primarily to speculate in foreign currencies and invest in productive assets denominated in foreign currencies that pay higher interest rates. Funds that are not invested in this way are simply left in reserve accounts at the Fed where they earn interest.

The government has done little or nothing to reduce overall debt in the private sector by forcing banks to accept losses on bad loans. Again, for political reasons, it has not embarked on any significant government programs to create demand in the economy. Instead it has chosen to allow the financial sector to use government bailouts to generate the kinds of income described above to slowly, over decades of high unemployment, to allow the deleveraging process to slowly bring the economy back to health.

To compound the problem, government  has done little or nothing to curb the excesses that caused the problem over the last several decades, in terms of reregulation of  banks and investigating and prosecuting fraud that occurred in the financial sector. The financial sector continues in much the same mode it did before the crisis, threatening the reinflation of the asset bubbles that caused the current crisis.

So what can be done about this dilemma? Stay tuned to this blog.

A Simple Explanation of the Cause of the Financial Crisis in the United States

Over the last several decades the private sector has taken on more and more debt, primarily in the real estate sector. Why has this happened?

The main reason is that many consumers don’t view debt as a problem as long as the servicing of that debt is within their budget. Furthermore, they don’t consider only their earned income when they assess their ability to pay service on their debt. They also consider the appreciation of their assets, and the possibility of refinancing these assets as their value increases to pull out money to service the debt. So asset appreciation becomes another source of income.

So, you might ask, are consumers really this smart that they can analyze their financial situation and come to these conclusions? The answer is that they don’t have to be. The financial sector will show them exactly how to do it.

The financial sector gets rich by making loans. As they compete to make loans they find ways to make them ever more accessible to consumers at lower servicing rates with schemes such as adjustable rate loans, balloon payments, securitizing the loans to hide risk, and pointing out to consumers that the appreciation of their assets will allow them to refinance over and over again to pull more money out of the assets to pay for servicing. This is the classic Ponzi scheme, paying servicing out of the appreciation of the asset, instead of out of earned income from a job.

The only problem is, eventually asset prices are bid up to way beyond their replacement value and the whole house of cards comes tumbling down as it did in the financial crisis. This can happen very quickly, but the cause builds very slowly, over decades. As more and more income is used to service debt, it is not available to create demand for consumer products. This results in businesses cutting back on expansion plans, research and development, and eventually leads to layoffs. The layoffs, in turn, lead to reduced ability to service debt, and a vicious downward cycle ensues.

Eventually, the financial sector gets in trouble as consumers default on their loans, or realize that their assets are no longer appreciating and income from refinancing disappears. This downward cycle accelerates and interlocking bank loans put the whole financial system in jeopardy. At this point the financial sector looks to government to bail them out, which it must, or see the whole economy come crashing down.

To be continued in future posts.