Questions and an analogy.

[randomness]

My previous post elicited some answers to questions I wasn't asking, e.g., "should we avoid a financial meltdown" or "what happens if the financial system melts down". One could debate those, but I'm not.

The questions which I think need to be answered are:

Are we in danger of a financial meltdown? (and how quickly will it happen?)

What do we do about it? (and is this proposed plan the right one to fix the problem?)

It's as if we're on a ship, and a crew member discovers there's water in the bilge. Crewmembers point at the water and saying if the ship sinks we'll all drown. They keep talking about all the awful things that will happen if the ship sinks (sharks, drowning, exposure), and tout this great idea of plugging a hole in the hull with a big ball of money which they're going to collect from the passengers.

When we ask if maybe the hole might be patched with something else, or if it's small enough that maybe the pumps will work, or the watertight doors can be closed to keep the rest of the ship from filling up with water, or even if the water didn't splash in in heavy seas...they go back to talking about the sharks. Moreover, it wasn't that long ago that the captain claimed there wasn't any hole in the hull at all.

It's up to the people who want our money to convince us that using that big ball of money to plug this hole in the hull is the right idea.

Comments

[fuzcat.livejournal.com]

I love your analogy and it is sadly fitting.

[st-rev.livejournal.com]

Technically, it's up to the people who want our money to convince a small number of other people (who also want our money) of that.

[r-ness.livejournal.com]

Sure.

(A significant difference, but hard to fit in the analogy.)

[babasyzygy.livejournal.com]

There's an interesting point going around now, having to do with accounting rules.

The upshot is that accounting rules changed in recent years (I don't know if it was Sarbanes-Oxley or something else) that stated that assets had to be accounted for at current market rates. So if your net assets have a large percentage of (say) tulips and tulips suddenly (but foreseeably temporarily) crash in value, your net assets accounting must go down.

Now, banks are typically allowed to loan up to 10 times their net assets.

So, because the market for mortgage-backed securities went into spasms, anybody with a large exposure to them suddenly can't loan anywhere as much money. This would not have happened under prior accounting rules, which allowed more flexibility in stating net assets.

I have to wonder whether simply changing this rule to something a little less sensitive to market fluctuations would patch the issue.

[silk-roses.livejournal.com]

ditto.

[drwex]

I do think we're in the middle of a crisis. Meltdown is probably too strong for it. The problem is that lending in a time of high risk and uncertainty is frelling hard-to-impossible. In theory, if you lessen the uncertainty then you make it more likely that the flow of money will resume. If it does not resume then you have a serious problem.

As to whether this particular proposal is the best way to remove uncertainty I'm less convinced. There are alternative proposals that I like more; for example, this AM I listened to an MIT prof (and former head economist for the World Bank) propose that a better approach would be to have the government loan the banks T bills, with the risky mortgage-backed securities as collateral. The banks can then use their stock of T bills to guarantee the kind of short-term inter-bank loans that have been so hard to get.

The advantage here is primarily that the risky assets remain with the banks. If the assets perform well then great everyone makes out. If they don't, then the banks have to find other assets to collateralize the loans. And since T bill valuations increase with time there are a number of options for limiting potential Treasury losses. For example, the Treasury could withhold interest on defaulted loans. The gov't is out the initial value of the bill, but that's often 50% or less of the eventual end value. Alternatively, on demonstrating continued good performance of the mortgage security the government can issue the coupons for the bond, increasing its value to the bank. In effect the banks are rewarded for cleaning up their act.

The downside of this proposal is that it doesn't get the bad assets out of circulation. Someone, somewhere is going to get socked and the amount of sockage remains unknown. It's possible that this uncertainty would be too much and the problem wouldn't be solved.

[frotz.livejournal.com]

I have an interesting and visceral reaction to your analogy, in that (like anyone else who's spent a lot of time on larger boats) I have a very clear idea and have drilled endlessly on what to do, how to do it, what the useful tools are, contingencies, et cetera, ad nauseam. It's unlikely but always possible, and not the end of the world but desirous of prompt and appropriate action.

That, then, makes me wonder: shouldn't investment bankers have an equally good idea how to contain this sort of problem? Shouldn't they have been lying awake at night during previous storms mentally reviewing the locations of their economic emergency gear? Why all the (feigned?) surprise and shock?

Whether it's a sinking ship or a sinking bank, either way they've got major liquidity problems.

[marginaleye.livejournal.com]

Some of us are beginning to think "There are too many idiots and weaklings aboard this damn-fool ship anyway. Give the sharks a chance to do their work."

[emilymorgan.livejournal.com]

Isn't convincing Congress supposed to be a proxy for convincing us, what with representative government and all that?

[r-ness.livejournal.com]

Sure. Mostly I'm using the "us" rhetorically. You can substitute "our representative government" for "us". It just doesn't work so well in the analogy.

(You're about the third person who has pointed this out, so it's clearly my writing that's a problem, but I'm too fond of my analogy to change it. :) )