Or why the bail out is a bust.
I’ve never been prouder of the blogosphere than in the last week. The opposition to an ill-considered bailout has spread from every direction. From people insiders and outsiders, from in the popular press and in their own journals, to who knew that this was a free three martini lunch . Negotiations have not made it better. We are told, for the third time, that a deal is close, it is done, and yet, the vote slipped from today, to tomorrow. The platitudes have poured forth, but the mean nothing.
There is still time to kill this bill. There is still time to do what is right. Opposition is across the political spectrum, this is not a matter of left or right, but of inside against outside. Many people have seen their political heros bow and crumble before the onslaught of insiderdom, while others have emerged from the most unlikely of places. This bill is bad policy, bad politics and bad economics.
It is predicated on a lie, a lie that this one picture exposes. This is not a crisis of confidence, but a failure of management. The way to fix this crisis is not by trying to bribe the banks to keep lending, but to understand why they are not lending overnight. What does this picture mean? I will explain, but a bit of background first.
Why there is a panic
Over the last year, on three separate occasions, interbank lending ground to a halt. On each occasion the Federal Reserve stepped in, organized a bail out or fire break of some kind, on the theory that it was fear of contagion that was causing bankers to cower in fear. The bail out bill is the latest iteration of the “confidence” theory of this crisis. The word for this, is “Hooverism.” It was Herbert Hoover who, over and over again, claimed that the deepening depression was the result of a lack of business confidence, and that the solution was to balance the budget.
The panic over financial Armageddon was proportional to the complacency that preceded it. But what was the source of the panic?
The explanation offered is that there is a contagion from highly complex very leveraged instruments based on mortgages. That because of these everyone in the banking world is afraid to lend to everyone else. Under this “fear” theory of the problem, the American economy is healthy, but for the financial fear.
The specific symptom that is pointed to is the spread between corporate bonds and treasuries, the “TED” spread. The people pushing the fear thesis argue that the solution is to purchase the “toxic waste” and hold it until it can be sold for more reasonable sums of money.
Leaving aside for the moment the details of the bill. Are they right?
The pictures says, not even close.
The Greed Theory
We all know that in finance there are two emotions that rule the markets. Fear. And Greed. Greed. And Fear. To work in the financial industry, you must dedicate yourself to these principles. The Fear Theory of the crisis says that banks are terrified of being caught lending to a bank that may go under.
The graph says otherwise. What is it? It is the London Interbank Offer Rate, minus the 12 months’ preceding inflation rate. It is a quick and dirty measure of how much money banks make, making loans to each other. Poor banks will be often short of reserves and borrowing, rich banks will be lending out. Most will borrow sometimes, and lend others. The basic internbank rates are set by central banks, and those central banks try and get banks to follow. Usually, and this means almost all the time, banks lend only a small amount above the rates set by central banks. Central bankers are often known to follow the LIBOR, or try and lead it by a bit. Historically speaking, the difference between central bank rates and LIBOR is small.
However, three times in the last year the LIBOR has spiked well above the rates set by central banks, and banks have stopped lending to each other. Was this fear? Or was it greed? Realize that which ever it is matters for fixing the problem. If the problem is that banks are terrified of lending, then the answer is to insure and clean up balance sheets. If the problem is greed, then the answer is to bring back into alignment incentives, so that banks are no longer doing things that are good for them, but bad for every one else.
According to this chart, the answer is greed.
Lending, if you recall, is giving someone money now, and hoping to get it back later, with interest. Now if the money that comes back later buys less than the money that is given today, then the lender has lost buying power. It doesn’t matter what the numbers come out to, he’s behind. That’s why we have concepts like “inflation,” because they take away how much buying power has been lost. I’m going to leave aside all kinds of arguments over inflation, because the number we want here is whether banks think they are ahead.
This means the “real” rate of interest is the interest rate the lender charges, minus the loss in buying power, or rate of inflation.
That means that taking 12 month trailing inflation, that’s an economist’s way of saying “over the last year” and subtracting that from LIBOR gives an idea of what a bank is earning for it’s overnight loans. This graph tells a story, and that story is the story of the Bush war years.
Before the war the LIBOR minus inflation is behaving rather normally, that is, it is around the trailing rate of inflation. Since making an overnight loan to another bank is, basically, keeping the value of that money, this is pretty reasonable. When a recession is looming, the spread can get quite wide, because the central bank hasn’t started lowering interest rates, and there is less lending in general. Banks are taking profits as they can, knowing that it might be their last chance. Instead of lending to ordinary people, better to lend to other banks that are caught short.
What comes next is the long years of the war, when banks were making short term loans at below the rate of inflation. This too, makes sense. The Federal Reserve was making money available to the world at below the inflation rate, and not lending while there was a major conflict in the Middle East would have been foolish. What would happen to the financial system if Iraq broke out of control?
But then something happens, namely, the under inflation rate lending comes to an end, and the spread spikes. The central bank was raising interest rates, and banks were charging based on this. Inflation however, does not come under control, but merely falls. What this was saying to policy makers at the time was that they dodged the bullet, that the interest rate increases had been enough to lower inflation, but avoid recession. However, as soon as these rate increases stopped, inflation zoome back upwards in mid-2007. And with it, banks were lending overnight at less than the rate of inflation. In fact, the longer it went on, the worse it go. Down, down, down into depths not even seen in the war era.
Now when there is inflation, those lending at less than the rate of inflation are getting burned. They want to stop doing this. Since the central banks were still lending at their stated rates, why lend reserves at a loss? Why not park the money in treasuries, use these as reserves, and just lend? Why not make more toxic waste and see if it can be sold? And this is what happened: banks stopped lending to each other, but mortgage rates didn’t make a panic climb, even as Freddie and Fannie, the companies that bought these mortgages from banks, got into trouble.
In otherwords, if the fear thesis were correct, and banks were afraid of getting caught, then why would they lend on the mortgage market with the fear of not being able to resell the loans hanging over them?
The other piece of data that obliterates the fear theory comes from some data from the collapse of Lehman Brothers. When Lehman was allowed to collapse, itself a suspicious decision, it was holding a large overnight loan from Citibank. The Federal Reserve paid back that overnight loan, rather than had Citibank sit with billions tied up while Lehman was disposed of. This was done, correctly, to prevent turbulence on the financial markets. But what it says is there is no overnight loan risk. If banks were afraid of being caught lending to a bank that went under, then there would be a very large spread between overnight loans, that the Fed will make good, and whatever length of time that the bank will have to just eat and wait for. There is no such spread, the longer term LIBOR rates are well behaved compared to the overnight rate.
In otherwords, I am shocked to find that there is rampant greed on Wall Street.
The state of the bill.
From the above, it is clear that the “Fear” theory which has been used to railroad this bill through is not supported by the evidence. Banks aren’t lending to each other not because they are afraid of contagion, but because the overnight loan business is a bad idea. Better to buy treasuries, so long as they get any interest at all, use these as reserves, and lend them to people who will pay a positive real rate of interest.
And that is what banks are doing, buying up short term treasuries, and continuing to lend. Mortgage rates, and even credit card rates, are not sky rocketing, nor are home equity loans, which if this were fear of bad home values, should be up in the stratosphere.
So where is the bill right now? A huge and complex version has just been issued, the last I checked the servers were still swamped to download copies of it. It contains dozens of provisions, but it is still the Paulson Proposal. Namely, he will issue new debt, and buy up unnamed assets. It is better than the original bill in a host of ways ”“ a bill that was so bad that it exhausted the four letter words in the English language, and that is by people who were working to pass some form of the legislation.
Even in the best of times, it would be a huge risk to hand this much power to any executive branch. With an administration that has a track record of lawlessness and favoritism it is folly.
The reality is that there aren’t the votes to pass this bill. There aren’t the votes to pass this bill.
The provisions that have been added are improvements, but they are window dressing on granting wide discretionary authority to the Treasury Secretary, and un-needed authority. As Ian Welsh notes, Paulson said himself that 150 billion would get us through January, just give him that, and then come back after we’ve had an election about this.
What you should do
It’s simple really. Call your representatives and say No. Say it over and over again. Not to this bill, nor to any Paulson Panic bill. The bill is flawed, it is based on a lie. The truth is that the problems in the financial system are based on a bloated war spending binge that now hangs over us. The truth is that we don’t need to give this blank check to Paulson now, but could give him a stabilization fund, and come back with a new Congress.
The right wing has already rev’ed up the racism engine, trying to blame the Community Reinvestment Act. This is a pure lie, in that foreclosure rates have spiked where the economy is bad, not where there are high concentrations of CRA loans. Instead, it was the exotic loans that were not underwritten by any government program that went sour first, and the derivatives that were based on them? Well those aren’t in the CRA, and it wasn’t minorities that made them, bought them, or traded them.
This is our democracy at risk, both from the powerful elites that are trying to roll our democratic system, and from the spewing sewer of the right that wants to advance an apartheid state, and has never given up on the dream of reverse the Civil Rights Movement, the New Deal and if they could, the Civil War.
We must do a better deal, but to do that, there must be a clear and definitive statement by the public, that any bill based on Paulson’s Panic, is a bad bill.