The End of the Illusion?

Edward Harrison and Barry Ritholtz make pretty good cases that practically every step that has been taken in trying to deal with the economic downturn that began in 2007 has been wrong. Here’s Edward Harrison:

With the stimulative measures that supported recovery over, the end of the fake recovery is at hand. You need to get rid of any sense that banks are undercapitalised. Until the banks take substantially more credit writedowns and recapitalise, this crisis will continue and get worse.

and now Barry Ritholtz:

The bottom line is this: Investors do not really have a clear idea of how healthy any of these banks truly are. We do not know the state of their balance sheets. We do not know what their exposures are to mortgages, to Europe, to Greece, etc. They could all be technically insolvent, as far as any investor can tell.

And that is exactly how the bankers wanted it.

But given the trouble in Europe, and the likely problems in housing if the US goes into a recession, Investors have decided they cannot take the risk of a holding an opaque, possibly under-capitalized probably over-leveraged financial firm blindly. They are telling the banks no thanks, we are not interested, we are going to be prudent and we have to assume the worst. Hence, for the second half of 2011, they have been selling off their holdings in these opaque, potentially insolvent too big to succeed entities.

Over the period of the last four years we have undertaken a series of short term, temporary solutions for dealing with the economic downturn. There’s nothing wrong short term, temporary solutions per se. Such strategies must be supported by long term, structural reform and both Wall Street and Washington have been desperate to avoid long term, structural reform. They’ve benefited mightily by things as they are.

40 comments… add one
  • Haven’t I been saying this? That reform was impossible? That banks were still in trouble just like with Japan 20 years or so ago? That there really was no feasible solution to the problem? That all you can do now is sit back and try to enjoy what is left of the ride?

    All politicians are conservatives (note the small ‘c’). They all fear change, especially large scale change. Hence the idea of letting GM fail, letting big banks fail, and then picking up the pieces and starting over again….no, not an option. So they keep kicking the can down the road…until they can’t. And we are pretty much at the end of this road, IMO.

    I know, I know posters like steve will come in and tell me how awful things would have been. Are they going to be any better later? I think they’ll be even worse. The problems will have gotten bigger and more pervasive. We are now likely to head into a recession where unemployment is around 9%. If that brings into question the viability of these huge financial corporations again, can we stop a collapse this time? I’m thinking people are going to become more and more skeptical.

    Look at this part,

    The bottom line is this: Investors do not really have a clear idea of how healthy any of these banks truly are. We do not know the state of their balance sheets. We do not know what their exposures are to mortgages, to Europe, to Greece, etc. They could all be technically insolvent, as far as any investor can tell.

    And that is exactly how the bankers wanted it.

    Read it again and again. They wanted it this way and their political lackeys gave them what they wanted. The interventionist approach has failed…no I take that back…it has been totally and completely co-opted by large financial firms.

    But by all means continue to believe that the interventionist policies will somehow save us. That there is some sort of policy magic bullet and if we just look hard enough we’ll find it.

  • Drew

    I could have written that comment, but Steve V beat me to it.

    Government intervention, and those who support it, are a strange breed. Think of every posibble way to stifle average firms, cater to influential big business who exchange cronyism for campaign contributions…………….and then feign surprise at unemployment and sluggish growth.

    Talk aboy man’s inhumanity to man.

  • Maxwell James

    Clubber Lang had it right.

  • My gripe is that we’ve privatized the profits and socialized the pain.

  • My gripe is that we’ve privatized the profits and socialized the pain.

    You don’t see this as a natural outcome of regulatory capture?

  • Drew

    “My gripe is that we’ve privatized the profits and socialized the pain.”

    Correct.

    “You don’t see this as a natural outcome of regulatory capture?”

    Double correct.

    We always get back to lesser government intervention…..if, of course, we actually want to change the dynamics.

  • I’ve always thought it’s wrong to think of government involvement as less vs more. The context and character of government involvement matters as much or more than the scale. Less regulation isn’t doing us any favors if all the good regulation is shit-canned and the bad regulation stays.

  • steve

    “I know, I know posters like steve will come in and tell me how awful things would have been. ”

    Remember how bad things were. Remember those record TED spreads in late 2008? Credit markets were, according to guys like El-Arian, frozen. We now know that GDP dropped about 9% in that last quarter of 2008. What made things change? Letting just Lehman, small potatoes compared with the real TBTF banks, fail created that crisis. What would have happened had we let all of the other big banks fail w/o intervention? Remember that the finance lawyers claim that they couldnt quickly resolve these banks because their assets were so complex and widely distributed, it was difficult to find all of them. Look at the rate of job loss. Is it unreasonable to suspect that we might have had a real Depression? 20%-25% unemployment?

    Suppose you do not extend unemployment. Suppose they had not extended FDIC guarantees to money markets? (How many people really use checking accounts anymore?) We know that few funds had the liquidity to outlast a run. What happens?

    The downside risk at the start was too high IMHO. However, if you can create a plausible story, no magic ponies please, with probably at least 8 of our largest banks failing at once, please do so. While you are at it, tell me what would have unfrozen those credit markets absent intervention.

    Steve

  • steve,

    You still have all that still sitting out there. That is the point. Those policies fixed nothing. So you either, let the bad times start when the banks start teetering again, or you prop them up again…and again, and again. Along with skyrocketing debt, unemployment that will probably stay stubbornly high, and anemic growth.

    Yeah, it would have been bad…really bad 2-3 years ago. But all that has been done is kick the can down the road and nothing have been done to get to the source of the problem.

    And please spare us the stuff about magic ponies, you are clearly the one who believes in unicorns and pegasi, not me. I’ve been quite clear, that until we get the painful part over with there really is not much of a way forward.

  • Oh and the kicker…if we go into another recession with unemployment at 9% where do you think it will end? 15%? 20%? Starting to look like that range you are talking about.

    But hey, since interest rates are zero, and we know they’ll be zero forever, why not just borrow and borrow and borrow.

  • Andy,

    If you sup with the Devil bring a long spoon.

  • steve and Steve V,

    The alternative was to save the banks and then deconstruct them in an orderly fashion. We were right to keep them from augering in back in 2008 but we were wrong to prop them up indefinitely. They need to be taken apart and cut up into much smaller organizations. That should have been done but wasn’t.

    If you sup with the Devil bring a long spoon.

    Ok, that’s a nice principle that I agree with. Not so easy to translate that into actual policy though….

  • Drew

    “Less regulation isn’t doing us any favors if all the good regulation is shit-canned and the bad regulation stays.”

    But Andy, that’s sort of the point. With all the regulation comes larger government what with the attendant administration and enforcement requirements. Likewise, for every program created. To deny that size and cost does not follow mandate seems rather odd.

    I’ve often been fascinated that defense spending is castigated as the root of government financial evil……and the solution. I have no doubt that absolute dollar costs can be reduced. But I’d note that it is the only significant government program I know of that displays a “scale” pattern that makes sense. Only so many oceans to patrol. Only so many conflicts to attend to. And technology replaces other expenses. Hence, defense is the only program I am aware of that declines as a percent of collective financial resources: GDP. This is as one with even just a tiny bit of financial experience would expect.

    But despite all the promises of “wars on poverty” and cure of social ills and injustices of all manner, those type of programs simply keep consuming an ever greater fraction of GDP……….and politicians invoke these social ills as a predicate for their election and even more spending.

    Would you keep going to watchmaker who never fixed your watch?

  • Drew

    “You still have all that still sitting out there. That is the point. Those policies fixed nothing. So you either, let the bad times start when the banks start teetering again, or you prop them up again…and again, and again. Along with skyrocketing debt, unemployment that will probably stay stubbornly high, and anemic growth.”

    And that, my friends, is called Japan. And we all know how that movie is playing out.

  • Drew

    “The alternative was to save the banks and then deconstruct them in an orderly fashion. We were right to keep them from augering in back in 2008 but we were wrong to prop them up indefinitely.”

    I’m not sure what “deconstruct” means. But as someone very familiar with financial restructurings my views on the bank workout solution have been well publicized here.

    “They need to be taken apart and cut up into much smaller organizations. That should have been done but wasn’t.”

    This, of course, is also Dave’s position. And I have to admit I’m flummoxed about the “right” answer. On the one hand, systemic risk is a very real problem. And who among us doesn’t understand the investment axiom to diversify? But real world businessmen must deal with real world competition. Other countries had huge banking enterprises emerging; and scale economies in banking are real. Were we to simply let our banking industry whither in the face of the competition?

    I don’t have the answer, but I’m trying to point out while “we should have prevented them or we should cut them into little pieces” seems a tad simplistic.

    Of course, I suppose we could have survived the existence of Big Banks if we hadn’t adopted the suicidal, government driven social policy of forcing banks to make sub-prime loans for CRA reasons etc……and then facilitating what everyone knew was just shoveling off bad assets into the secondary market………………………..but I digress.

  • Drew,

    To deny that size and cost does not follow mandate seems rather odd.

    I’m not denying that size and cost does not matter – I’m suggesting that it’s too simplistic. What exactly does “less regulation” or “more regulation” mean?

    Maybe it’s pie-in-the-sky, but I think we we should focus on effective regulation and utilize the KISS principle as much as possible. The goal to should be to make compliance cheap and easy.

  • Maxwell James

    In all seriousness – as Andy noted, the government could have nationalized the banks and then unwound them slowly but safely. Republicans would still be howling about socialism, but the outcome would have been to restore competitiveness to the sector. The failure to pursue that was the first by the Obama administration, and also the most fundamental.

  • Drew,

    I don’t have the answer, but I’m trying to point out while “we should have prevented them or we should cut them into little pieces” seems a tad simplistic.

    For me, the big banks had their shot and they failed. We can’t continue to socialize losses and privatize profits in order for them to remain competitive with big banks overseas. We gave them trillions with few strings attached.

    What I’m suggesting is that when these banks fail, they need to actually fail and go through the process like any other bank. The government would have to take additional steps to keep them from crashing the financial system, but they’ve got to be allowed to fail.

    Of course, I suppose we could have survived the existence of Big Banks if we hadn’t adopted the suicidal, government driven social policy of forcing banks to make sub-prime loans for CRA reasons etc……and then facilitating what everyone knew was just shoveling off bad assets into the secondary market………………………..but I digress.

    Well, it takes two to tango, doesn’t it? It’s not like the banks were trying to exercise restraint and they certainly didn’t go out of their way to insure they were making sound loan decisions. Did they lobby to tighten up lending standards? No, quite the opposite….

  • Drew

    “I’m not denying that size and cost does not matter – I’m suggesting that it’s too simplistic. What exactly does “less regulation” or “more regulation” mean?”

    “The goal to should be to make compliance cheap and easy.”

    Actually, Andy, I think you are dodging the issue and taking the Dorothy from Kansas stance: “if we just had the right people, if we just had the right attitude, if we just did the right thing.”

    Of course.

    But its hard enough to get that sober view in private enterprise, especially large corporate, where there is some sort of governor – like budgets and profits. But in government? Are you serious? If you dare push back a press conference will be called with all but too willing press to let some guy describe how you want to poison women and children. These are zealots, and people who’s pay and power accrues from getting bigger, not smaller and more efficient or rational. The regulatory register gets bigger every year, not smaller. Hell, you might even get a guy telling you to quit Bank of America. (snicker)

    In a rational world the proposition to government regulators would be the same as exists in the private sector: economize. “OK, you want to add 20 regulations to regulatory register? Fine, go find 15 regulations you want to eliminate. We can’t afford it all.”

  • Drew

    “We can’t continue to socialize losses and privatize profits in order for them to remain competitive with big banks overseas.”

    Who wouldn’t agree? But I simply don’t see this as the limited and stark set of options. Every single day in America equity and debt is wiped out due to poor managment and bad investment decisions. And if the enterprise is viable in some fashion fresh money steps in. Happens every single day.

    Bailing out GM was also a horrific example of cronyism and bailout for political interests. But it had nothing to do with size. It had to do with exactly what I’m talking about: you let government be the decider – with taxpayer money – and with pols self interests at stake – you have one hell of a mess on your hands.

    Markets have to clear. Competitors in those markets have to suffer the risks of bad decisionmaking. Regulators are a very weak reed to rely on when you won’t let my first two points occur.

  • steve

    ““I’m not denying that size and cost does not matter ”

    Simon Johnson has written quite a bit about size and banking performance. As I recall, there is literature on both sides of the issue, but the preponderance suggests that banks can be much smaller than they are without any loss of economy of scale.

    “Other countries had huge banking enterprises emerging; and scale economies in banking are real.”

    Those same banks are now going down the tubes also. I think this suggests the problems inherent in groupthink, or maybe even a sort of Gresham’s dynamic.

    Steve

  • steve

    Steve V- To be clear, I was talking mostly about the initial response. After the first 6 months or so, when things had stabilized, a lot of what was done made little sense. Stuff like trying to keep housing prices up were not productive. We should have broken up the big banks, made bond holders take a hit and moved on, but we did need to stop the panic.

    “forcing banks to make sub-prime loans for CRA reasons”

    A minority of bad loans were associated with the CRA. Europe demonstrates you did not need the CRA, you just need to have money as a motivator. TBH, this is something I cannot figure out. People who claim that a couple of percentage points on their income tax will change their behavior, but cannot see that the opportunity to make billions was not a motivation for bankers.

    Steve

  • Drew,

    Actually, Andy, I think you are dodging the issue and taking the Dorothy from Kansas stance: “if we just had the right people, if we just had the right attitude, if we just did the right thing.”

    I’m not dodging anything. All I’m doing is pointing out that you can’t simply look at the “amount” of regulation (whatever that means in real terms – how is that defined?) and only think of it in terms of “more” or “less.” This more vs less dichotomy misses the fact that some regulation is simply bad and some of it is good and/or necessary.

    It’s a similar problem to people over-focusing on marginal rates when debating taxes. Marginal rates are important, but they are only part of the picture.

  • Icepick

    And we all know how that movie is playing out.

    yes, 20 years later Godzilla attacks and they try to cover it up with some story about an earthquake/tsunami.

  • Andy,

    The alternative was to save the banks and then deconstruct them in an orderly fashion.

    Yes, and tomorrow I’ll demonstrate my super powers on television.

    Seriously, while that might have been one policy option in theory, it was not in the set of feasible policies. Wall Street, which donates to senators, representatives, and the President would be pulling in as many favors as necessary to stop that one.

    Breaking up big banks, great in theory, never ever gonna happen though. Too many on Wall Street, K Street, and Pennsylvania Ave. who are making money or plan on making money via big banks.

    Welcome to the corporatocracy. America; of the big banks, by the big banks, for the big banks, oh and GM too. So lets go right ahead and expand the power of government, the big firms will be happy.

  • yes, 20 years later Godzilla attacks and they try to cover it up with some story about an earthquake/tsunami.

    Heh, if Dave had a reputation/rating system I’d give you a +1, go home log in again and give you another +1 for that.

  • jan

    Markets have to clear. Competitors in those markets have to suffer the risks of bad decisionmaking. Regulators are a very weak reed to rely on when you won’t let my first two points occur.

    Very crisp, clear thinking, Drew.

  • Steve V,

    Breaking up big banks, great in theory, never ever gonna happen though. Too many on Wall Street, K Street, and Pennsylvania Ave. who are making money or plan on making money via big banks.

    Maybe, maybe not. The big banks are probably still under capitalized. They are probably still vulnerable to failing. What will happen to them when Greece and the Euro fold? I’m not sure the big banks can buy themselves into another bailout – the public outcry would be too great.

  • Maybe, maybe not. The big banks are probably still under capitalized. They are probably still vulnerable to failing. What will happen to them when Greece and the Euro fold? I’m not sure the big banks can buy themselves into another bailout – the public outcry would be too great.

    Sure they will be bailed out. Somebody somewhere has suddenly grown balls and will tell them no?

  • Icepick

    Sure they will be bailed out. Somebody somewhere has suddenly grown balls and will tell them no?

    With a volatile election season coming up I would expect a lot of pols to tell them no. Then I would expect some form of hidden bail-out. We know the Fed will be involved. No idea what else they’ll think of. But I doubt we’ll get Son of Tarp. Probably something more like Son of the Invisible Tarp.

    Perhaps what will happen will be a big Fed program to help prop up the ECB, with the understanding that a lot of the money will flow back to “American” banks through some agency or another, kind of like the bail-out of AIG ended up pumping money back to Deutsch Bank and SocGen.

  • Icepick

    Other countries had huge banking enterprises emerging; and scale economies in banking are real. Were we to simply let our banking industry whither in the face of the competition?

    Given what we’re seeing in Europe right now, perhaps we should have let them deal with the mega-banks while we ignored them. Besdies, what was going to happen if we didn’t have mega-banks? Were they going to move all the factories to China?

  • Icepick

    Were they going to move all the factories to China?

    That is of course a rhetorical question.

    Hat tip.

  • Drew

    “As I recall, there is literature on both sides of the issue, but the preponderance suggests that banks can be much smaller than they are without any loss of economy of scale.”

    steve – I’d certainly like to see that citation. A big balance sheet is the motherload in banking. Else you need to be Mr. Peabody, the friendly President of “Tiny Bank,” who attends the local PTA meetings and makes “character loans” to people who live within a 3 sq mile radius and want to buy a car or remodel the kitchen. The industry became bymodal. McKinsey did a huge study on the issue in the 90’s. Also, there is a book called The Future of American Banking written by a Stern School guy that if I can find on my shelves I will cite in more detail.

  • Mish Shedlock, whose view of banks is pretty much from in the trenches, interprets the recent moves by Citi and BofA as evidence that banks can no longer make money by enlisting large numbers of accounts. Some of the economies of scale in big banks may rely on very specific ranges of interest rates.

  • steve

    Behind a paywall.

    http://www.cepr.org/meets/ltm/5560/

    Will look for others later if I remember. Johnson claims $300 billion is the cutoff beyond which bigger banks dont add much.

    Steve

  • Icepick

    Well, there’s no longer any point in talking about how bad things were in 2008. Between what one of the IMF advisers said on the BBC and Mervyn King’s comments following the latest round of QE in England, 2008 is no longer the worst crisis since the 1930s. Fun times ahead.

    Oh, and steve, this kind of kills the argument that if we hadn’t bailed out the banks in 2008 we would have had a liquidity crisis. We’ve had a low grade crisis for the last three years and now we’re going to have the real deal. I just hope it hurries up and gets here before the end of the month – it’s traditional to do these things in October….

  • With a volatile election season coming up I would expect a lot of pols to tell them no.

    Yeah, the one’s who are in safe seats, or if they are damn sure they’ll be in the minority. But those in the majority and the President…sorry no, they’ll capitulate again saying it is for the greater good (of the big banks creditors and the big money on Wall Street). We have to protect the financial system at all costs even if it allows these knaves to continue the very practices that got us in this mess to begin with.

    What is that colloquialism…”the definition of insanity is doing the same thing over and over expecting different results.”

    Our political system couldn’t be worse even it was set up by an insane idiot child…wait that description fits most of our politicians.

    Regarding economies of scale….

    Bigger is not always better (long run average cost curves are not everywhere decreasing with quantity produced). Or if that is the case, then banks are natural monopolies and I highly doubt that. Second of all economies of scale are a long run concept, so if you are going to talk about economies of scale seriously, but trot out the “in the long run we are all dead” quote (actually a misquoting) of Keynes you should be beaten with a stick.

  • Well, there’s no longer any point in talking about how bad things were in 2008. Between what one of the IMF advisers said on the BBC and Mervyn King’s comments following the latest round of QE in England, 2008 is no longer the worst crisis since the 1930s. Fun times ahead.

    As I said, we kicked the can down the road. I also seem to recall that I claimed the next crisis would be bigger than the 2008/2009 crisis. But hey, we’ve spent trillions doing…fuck all. Good policy move by our Dear Leaders.

    Keep voting suckers.

  • Icepick

    But those in the majority and the President…sorry no, they’ll capitulate again saying it is for the greater good (of the big banks creditors and the big money on Wall Street). We have to protect the financial system at all costs even if it allows these knaves to continue the very practices that got us in this mess to begin with.

    Steve, I don’t disagree that this fuck all (as you put it) has been bad. I just think that when it comes time to do it again that enough of the pols will be in dangerous enough electoral positions (from their perspective) to balk at doing it – or at least doing it openly. I fully expect them to try something clandestine, so that those looking for votes from the Occupy Wall Street useful idiots can claim they didn’t help the banks, and those seeking votes from the Tea Party useful idiots can claim they didn’t help the banks. And both can go to the bankers and say, “Hey buddy, we helped out, so give us some scratch.”

  • Icepick

    Also, I believe that a lot of ‘safe’ seats for Congress will be contestable next year. The economy is getting worse even if Europe doesn’t completely go down the toilet, and an increasing number of people are coming to the realization that neither party has a clue. “Throw the bums out” might actually have meaning next year. Not that it will do any good, as we’ll just be switching bums….

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