Saturday, November 22, 2008

The Great Debtpression

This blog is normally reserved strictly for my business strategy and marketing ideas for startups,entrepreneurs and VC's. I think that what the government is doing right now however (destroying capitalism as we know it) is horribly flawed, and important enough that I want to share my ideas on what they need to do now!

I originally alluded to my idea on Stocktwits (Created by Soren Macbeth and Howard Lindzon). Since all the bigwigs in Government, On Wall St, and at the Fed read Stocktwits, I am certain they saw my idea earlier. For those not familiar, Stocktwits is the first vertical on Twitter to be wrapped up and aggregated. It allows you to view and share ideas, and investment strategy along with some of the smartest investors out there. If you have not seen or tried Stocktwits yet, I suggest you do. Even if you do not have an interest in stocks, it should give you entrepreneurial types ideas on just what you can do on the Twitter platform, and what you can build for just a few pennies.

OK now to the meat of this post. See the graph above? What you are looking at is the DJI during the 1929 Crash and subsequent "Great Depression" overlayed with a graph of the NASDAQ starting from the 90's bubble and subsequently the current "Great Deptpression".

The experts will all point to how it is much different today, because we have learned from out lessons of the past (after the 1929 crash government tightened up credit). I say BULLSHIT, it is exactly the same, and the overlayed charts echo that sentiment.

While the Government IS doing things differently in reacting to this crisis, it is still doing it wrong. The Fed is pumping BILLIONS of liquidity into the markets. The Fed is (will) spend over (at least) one TRILLION dollars on recapitalizing the banking system before this is all said and done. This is KEY to the failure. Even in the face of all this money, we are watching the Banking system as we know it fall into the abyss one by one. While I recognize that the over 80,000 banks in the US is too many - Letting them all fail in this manner is just bad for everyone.

Without our banking infrastructure, there can be no economy. Let me state that again NO BANKS = SOUP KITCHENS AND FOOD LINES!

The reason that TARP and the recapitalization (socialazation) of our banking system is a failure is a result of their recent capital structures. Banks have (had) been leveraged and allowed to loan against there asset base way in excess of their capital base. That worked fine until the FASB changed the rules and instituted "Mark to Market", and underlying assets plummeted in value "the perfect storm".

For those who might not know, this is how it works. Banks are required to have a certain percentage of assets in relation to the amount of money they loan. Mark to Market requires a bank to carry those assets on their books at their CURRENT value. For the purpose of this post, look at a typical asset as someone's house. Let's assume that the bank made a loan for someone to buy this home a few years ago, and lent $500,000. Now, that same home is only worth $400,000. So that $500k asset on the bank's books needs to now be written down to "market value" - or $400k. As banks write down all of those underlying assets to reflect the current downturn in the housing market - they fall below capital requirements and technically become insolvent.

On top of the dozens of large banks that have already failed as a result, Citibank (once the worlds largest bank) is trading as a pennie stock ($3 per share). Though a Citibank failure by itself will not bring down the entire banking system, it is just the latest one to do so. The stock market as a result can and will do NOTHING but go down, as long as the ailing financials keep failing.

The government needs to immediately STOP the TARP and bailout. Even if this was effective (it is not), they are simply printing more money = Dangerous implications for the value of our currency (US Dollar), and the inflationary pressure that will ultimately result.

What the government can and SHOULD do is change/remove the "Mark to Market" rule that is currently in place. When I pose this idea to friends, they all suggest that somehow this is simply pushing the problem out to the future. To which I say RUBBISH!

Let's revisit our earlier example of a bank that lent out on a $500k asset now worth only $400k. Yes, we have been in a housing bubble, and yes the values can decline even further but hey - What do you think that home will be worth at the maturity of the loan (30 years)? You would be hard pressed to find anyone who thought that it would not be worth AT LEAST $500k, if not more.

So Government get rid of Mark to Market, and let the banks Mark to Maturity. Any bank marking to maturity should subsequently be required to hold that underlying asset until either it is sold at par, or till it's maturity.

This action will allow banks to recapitalize organically, and without further socialising our banking system and most importantly without printing Trillions of new dollars in the process.

How would you fix the banking system? Please leave your comment.

Do you agree with the logic of my argument, if you do please consider DIGGING it.

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Anonymous said...

Andrew, I totally agree that bailouts are actually worsening the situation, in the long run. It's alarming how almost all governments around the world are mindlessly increasing state deficits with risky bailouts. This simply shifts the underlying problem to a higher, even worse level (state bankruptcies or inflation like in Zimbabwe vs. bankruptcies of some, even major private companies).

Bailing out as observed would probably work under the following conditions:

1) The base markets are healthy as such, what we currently experience is an emotional exaggeration only

2) State deficits are reduced quickly again after markets recovered

I think most people are still too optimistic in regard to 1). The basic problem isn't the current emotions in the market, it's the emotions that were fed during at least the last two decades. We simply bet on values that didn't exist and won't exist anytime soon (i.e. not as soon as expected). This used to work for quite a while, so everybody was happy and helped growing the bubble. However, with all bubbles it's just a matter of time till they burst. And we can all hope they burst rather sooner than later to minimize the impact of the explosion.

It's true that mark to market can start a downward spiral as we currently see it in the markets. It's literally deadly for many businesses and individuals, however, it has the benefit of sucking the air out of the bubble quickly, resulting in a hard but quick landing on solid ground.

Mark to maturity would take some of the momentum out of the downward spiral, but I doubt it still worked as well as intended anyway. By now, enough people realized they were betting on air to keep the spiral going. Let's remember that values at maturity are speculative by nature (unless hedged). Air won't turn into gold (or food) just by waiting longer. The basic assumption is a healthy economic development, i.e. steady growth and eternal increase of productivity. Both of which are less than certain as the world is finally starting to realize that the theory of steady growth and productivity increase is flawed. From this point of view, mark to maturity indeed promotes growing bubbles (or in the current case, delays the landing, making it a bit softer, less shocking, but more frustrating, as it takes longer).

My take is that we need to get to solid ground to get confidence in basic values again, so we can restart at smaller, realistic and sustainable growth rates.

So, 1) isn't met, which alone is reason enough against bailouts already. What about 2)? As 1) isn't met, 2) won't be met either. Even for states, the future growth rate (after hitting the ground) will be too small for a quick payback within one or two presidential terms. So basically, all that bailout money is indeed lost money either paid through taxes (further supporting false assumptions and wrong incentives). Or it isn't paid for at all, risking high inflation and finally a state's bankruptcy. Experience shows that governments almost never reduce deficits. Usually, the best they achieve is slowing down further debt, giving the economy some more time to catch up and improve the debt ratio.

What's my advice? It's "keep it real". Let fail what has to fail anyway. Let's no longer pretend that air is gold, let it be air again. Expectations need to match with reality and very basic values again. Punish those who deserve it - if you don't, don't be surprised if they continue to exploit the system at the cost of the fair people. Minimize governmental market interventions, even if other governments do the opposite - in the long run, you'll have the stronger, more reliable economy.
This means: People who can't afford it won't be able to buy housing, cars, new TVs and so on. Modesty is trump. Credits both for private households and businesses will be much smaller. Sluggish businesses with an offering that doesn't meet the market (think of many major car manufacturers) will fail, creating new opportunities for more agile, more sustainable businesses. Lots of businesses and individuals won't survive this crisis, but that's just how it is. There's no "too big to fail".

fred said...

that chart is great but it doesn't go far enough out on the NASDAQ. If you take the NASDAQ out to today, it's at roughly 1500 having bottomed at roughly 1300 last frday.

just like the DOW in the 1930s, the NASDAQ has indeed been through a terrible run. But just like the DOW finally bottomed in early 1938, the NASDAQ may have bottomed last friday.

history does repeat itself but you just need to know where you are in the timeline

Anonymous said...

I'd like to comment on the following piece from your blog:

"So Government get rid of Mark to Market, and let the banks Mark to Maturity. Any bank marking to maturity should subsequently be required to hold that underlying asset until either it is sold at par, or till it's maturity."

It is too late for this. Mortgages have been securitized so there isn't an identifiable asset for the bank to mark to maturity or sell at par. i.e. there isn't the $500K mortgage tied to House X.

Todd Dewell said...

This makes sense. The only person I saw talk about Mark to Market was the chairman (or CEO) of AIG, and he said that was the cause of the problem.

Most of us think the problem is foreclosures, but that is in the Billions and we are throwing Trillions at the problem which makes no sense to me.

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