A Failure of Nerve

October 2008 was a failure of nerve.  As so often happens, folks who normally support letting failing institutions fail when times are good tend to lose their nerve when the crisis is at hand, and find some way to convince themselves that somehow, this time is unique and different.  But it is not.   Only later is there remorse.  I won't want to pick on Megan McArdle too much, if for no other reason than she is generally the first person on the planet to admit she is wrong, but you can start to see some of the remorse here:

We're now making many of the mistakes that Japan did.  I know, I know--I supported TARP I.  But I did so because at the time, there seemed to be a reasonable possibility that the funds could stop a liquidity crisis from turning into a solvency crisis.  But if liquidity crises go on long enough, they become solvency crises, so whatever we had then, we now have a badly crippled banking system.  More of the same isn't going to help.

We need a plan that is going to force the banks to recognize and write down their bad loans, restructure dysfunctional borrowers, shut down the banks that are too far gone, and inject substantial capital into the banks that are strong enough to pull through.  But that kind of radical action is scary.  And whether they decide to do it by nationalizing bad banks, or by injecting capital into good ones, the political cost is going to be very high.  So we get baby steps and vague promises of major leaps forward down the road.

Another political problem is that recapitalizing the banking system involves, in the initial stage, conserving capital (read: cutting credit limits), and writing down bad loans means unpopular actions like restructuring failing companies (read:  layoffs) and foreclosing on hopeless borrowers.  One of the major arguments against bank nationalization is that a government-owned bank will find it harder, not easier, to do those things.  The temptation to keep large employers on life support will be large, and every congressman will have a list of firms in their district that can't be allowed to go bust.

I have tried to have this and other bailout arguments with a number of folks.  This is often a hard conversation, because people have trouble separating in their minds the productive assets of these companies (factories, investments, systems, deposits, trained people) from the institution itself.  So when we talk of bankruptcy of, say, GM, they think if GM goes poof, then all those factories and cars go poof.

But that is absurd.  Remember the huge gas shortages that resulted from the loss of the Enron gas trading desk and transportation infrastructure when Enron went bust?  Yeah, neither do I.  That's because all of Enron's productive assets flowed through the well understood chapter 11 (or was Enron Chapter 7) process to new owners.

By the way, by management, I mean something broader than just the CEO or the top tier of managers:

A corporation has physical plant (like factories) and workers of various skill levels who have productive potential.  These physical and human assets are overlaid with what we generally shortcut as "management" but which includes not just the actual humans currently managing the company but the organization approach, the culture, the management processes, its systems, the traditions, its contracts, its unions, the intellectual property, etc. etc.  In fact, by calling all this summed together "management", we falsely create the impression that it can easily be changed out, by firing the overpaid bums and getting new smarter guys.  This is not the case - Just ask Ross Perot.  You could fire the top 20 guys at GM and replace them all with the consensus all-brilliant team and I still am not sure they could fix it.

Bankruptcy is a scary term, but here is what makes it beautiful -- it takes assets out of the hands of failed management, failed business plans, failed management cultures, etc. and puts those assets in the hands of new owners and managers.  These new owners and managers are not guaranteed to be better at managing the assets, but the odds are they will be since the performance bar set by the last management team is by definition so low (ie, they went bankrupt!)

When we interrupt the bankruptcy process and bail out a failing company, we do two things:

  • We leave the productive assets of the company in the hands of the same failing management (again, with this term defined broadly as above) that got the company into the current straights, rather than putting the assets in the hands of new owners
  • We focus the country's limited investment capital (via taxes or government borrowing that crowds out private borrowers) towards what are by definition among the worst managed institutions in the country.   If someone asked you to invest a billion dollars either in the top 10 most successful companies or the bottom 10 least successful, where would you put the money to create the most jobs and growth?  In the top 10, right?  But the government is doing EXACTLY the opposite.

Here is the true economic miracle of the 80's and 90's:  Not Reagan's tax cuts or Clinton's economic plan or Alan Greenspan in the Fed.  It was the fact that the government, with the American economy sweating under some very difficult conditions (worse than they are today, but you would never know it in the press) and under strong threats from Japan and Europe, basically did ... nothing.  There was all kinds of pressure to create an American MITI  (seriously, it seems like a joke today, but the push was strong).  We did not.  The American economy was allowed to restructure itself.

This is why our recessions tend to be shorter than those in Japan and Europe.  These other economies are generally more of a corporate state, with a major goal of the government to maintain the incumbents in the corporate world.   I would argue that the key determinants to recovering from a recession quickly are asset, capital, and labor mobility.  Japan has many structural limitations on these, and it dragged their recession out for years.  In the name of trying to avoid the problems Japan has faced, we are repeating the exact same mistakes.  Every step we have taken so far to deal with the "crisis" have reduced the asset, capital, and labor mobility the economy needs to right itself.


  1. Bob Sykes:

    What is really scary, is that Bush/Obama are going down the exact same road paved by Hoover/Rockefeller. Obama even had his version of Smoot-Hawley until the Euros freaked. He still has an income tax increase coming next year when the Bush tax reductions lapse.

    Will we get WWIII, too?

  2. dearieme:

    WWIII? Ah, you mean the War on Financial Terror.

  3. Michael Miller:

    "Here is the true economic miracle of the 80’s and 90’s: ...It was the fact that the government, basically did … nothing. "

    I strongly agree with this, and it all worked remarkably well. But there was one area where the government did made a strong intervention.

    That was back in the mid to late 90's when the Clinton administration coerced the mortgage industry into making a very large number of high risk loans to constituents who were not credit worthy. This action on the part of the Clinton administration was the root cause of the economic meltdown we are now experiencing.

    Before we work out a solution to this mess, I believe those responsible will need to come clean, and take accept responsibility for their mistakes. President Obama for instance sued the mortgage industry on behalf of Acorn. His public admission of his own role in this fiasco would be an excellent place to start.

  4. Link:

    We have a few different but interconnected issues to address.

    Banking system.

    This is critical. We're told that subprime and other badly underwritten mortgage loans are the source of the problem. But they only total something like $500 billion. Apparently, things like CDOs have magnified the loss, but I don't understand exactly how and why so much. Apparently, Tim Geithner doesn't know either or isn't telling.

    When banks go bad, the problem is often huge because of leverage. But the core of this problem is concentrated in a few big banks. The common stocks of Citibank and Bank of America are trading like options on a turnaround ... in other words, the market thinks they're broke.

    Consumer finance

    A large part of this used to be supported by the securitization market -- which has all but disappeared. Statements that aggregate bank lending hasn't declined much are highly misleading as they ignore this. Someone with a job should be able to buy a car. Someone with a job and a real downpayment should be able to buy a house that's no more than a prudent multiple of their income. If they can't, we'll have a negative multiplier effect. I haven't heard anything out of DC about how this will be addressed.

    Asset values

    If we've had an excess of credit, the result has been to push up market values in some sectors ... notably residential real estate. It's also allowed Detroit to avoid overcapacity issues. Unless and until asset values rationalize, we just prolong the pain. We don't want to keep asset values propped up because we'd rather not deal with the likes of Citibank. On the other hand we don't want a collapse because credit worthy consumers can't credit.

    Stimulus Bill

    Is irrelevant to any of this.

  5. Kyle Bennett:

    "So when we talk of bankruptcy of, say, GM, they think if GM goes poof, then all those factories and cars go poof. But that is absurd."

    Natural selection in the market is more Lamarckian than Darwinian.

  6. feeblemind:

    Good post, and good comments by Link. Don't know if it matters at this point whether nerve was lost in October. It is over with. I am convinced that the Bush bailout inspired the dems to spend $800 bil on 'stimulus'. It is political tit-for-tat. Even the amounts are similar. Anyway, I am deeply concerned about the future and have zero faith in the ability of the people in charge. I fear we are watching a train wreck in progress, and that little people like myself will be unable to get out of the way.

  7. ErikTheRed:

    Yeah, the only problem is that Obama owes the Unions, so he needs to kneel down, kiss the ring, and send Detroit billions of dollars until the sun explodes or they become profitable (whichever comes first).

  8. John Moore:

    Would you apply the same reasoning for businesses in an area hit by a large meteor strike?

    For too many businesses, the current situation is similar. While a housing-bubble based recession was obviously coming, the credit freeze/panic was way outside the planning of a typical non-financial company could anticipate, much less protect against. In a field where use of credit was necessary to stay competitive, no choice existed. Now we have a temporary situation of extreme financial conditions. Is bankruptcy the right solution for rationally run companies overcome by a "black swan?" The company already has competent management. It's creditors may also have been completely competent. The bankruptcy may very well move those assets into the hands of those whose only qualification, by good fortune or remarkable timing, is being cash rich at the moment.

    I suppose one could argue that this would convert that entire sector to be less debt dependent in operation, but when (not if) credit becomes available again, Darwinian selection will return the sector to credit dependence. Hence, the bankruptcy would appear to have achieved nothing at all.

    This scenario applies to a significant sector of the economy. The critical sector, right now, is finance, and only the unraveling of the CDO and CDS chains will solve that - bankruptcy or not.

    None of these observations suggest any particular policy, unfortunately.

  9. ElamBend:

    Taking into account the pronouncements of some members of congress, specifically Pelosi's call for Detroit automakers to re-engineer for more 'green' products, regardless of their profitability in exchange of more funds, it seems to me that many still have a pro-MITI mindset. Even Obama with his emphasis of creating jobs with new 'green' industries and his implication that this will lead to lots of new jobs and technological advancement follows this line.

  10. Michael Miller:

    Maybe the best short and long term solution is for government to keep its sticky, gooey fingers out of the damned pie.

  11. Link:

    GM may go bankrupt next week ... or will require additional billions in support. It'll be a tough choice for the Democrats as to what to do.

    The Big Three haven't been able to downsize because of legacy commitments. For too long, they've had to maximize revenue, not profit per car. Easy credit helped support sales for awhile, but now the collapse in credit is killing them.

    If there's a way to show the dangers of where Obama-Pelosi-Barney Frank want to take us, Detroit may give us early ammunition.

    Hybrids make no sense when gas is at $2.00 per gallon. If we taxed the hell out of gas like the Europeans do, you might coerce sales of hybrids. But even Pelosi won't propose that. Electric cars make even less sense. The juice isn't free, like some think. At even $4.00 per gallon, gas is an incredible bargain ... which is the source of the "problem."

    Detroit already has a problem selling what it's making. This will show up in increasing numbers of unsold cars. But Detroit can't support its legacy commitments without a large base of revenue. The numbers don't add up. So anything DC does that doesn't sharply reduce capacity is doomed to fail. Which means the unions have to take a hit, or the US has to takeover their retiree benefits.

    Pelosi's dreams of central planning will be shown up over this. If on top of this you force Detroit to make green cars that no one wants to buy, you'll be looking at the Big Three hemorrhaging cash each quarter.

  12. Jens Fiederer:

    I'm looking forward to the McArdle/Coyote Bloggingheads!

  13. Captain Obviousness:

    I am a recovering panicker who was in favor of TARP I at the time. My concern was that every single major bank in the western world was insolvent, and we couldn't let them collapse. I now realize that every single major bank in the western world is insolvent, and we must let them collapse. It will be painful, but the pain is inevitable so let's get it over with ASAP. The "recession/depression" is not even the issue right now. The issue is the phony bubble economy of the western world that developed over the last 25 years and that must collapse at some point. We need that collapse to happen now so that it does not bring down the western world. If we preserve the phony bubble with more debt and more money printing, the western world will collapse into the stone age. That is not an exaggeration.

  14. Link:

    Captain Obviousness, you may be right if the banking system is in worst case. But I'm still having difficulty assessing how bad it is. Dodgy loans -- while a big dollar number -- aren't huge as a percentage. Wacky derivatives compounded the problem, but they tend to be concentrated in a few big banks. Mark to market accounting has added to their difficulties.

    Other writers here have made apt comparisons to 1990 -- a time when many banks failed, and Citibank was a toss-up. Comparatively, the amount of dodgy loans that our banks have now should be less. Also, going into 1990, our banks tended to have lower capital ratios than they had in 2007.

    TARP I was arguably necessary to avoid an even deeper liquidity crisis -- an ER-like "let's stick in some tubes and pump in some fluids, real fast!" Months later, we share collective unease with the lack of any diagnosis and recommended regimen from the big brains in DC. I suspect that the bank regulatory bureaucrats have ideas, but Obama & Co haven't decided on their own politically correct solution. In this context, Obama & Co's fixation on the Stimulus Bill is disconcerting ... to say the least.

    Unlike the Japanese approach, our resolution of banks/S&Ls in 1990 resulted in a quick and sharp decline in asset values ... but these were mostly in commercial real estate and junk bonds. The assets today are mostly residential real estate ... voters don't want their property values to go down. I expect Obama & Co to go the Japanese route, because of this. Foreclosure relief will be part of this.

  15. dearieme:

    Why don't Americans spell it "obvios"? I am labouring to think of an explanation; do me the honour of a favour and suggest one, please.

  16. rob sama:

    Extremely well put. Unfortunately, there isn't a chance in hell of that happening. I sense we're witnessing the end of the entrepreneurial era in America.

  17. The other coyote:

    The bankruptcy code has several "chapters" which each deal with a different type of bankruptcy. Chapter 7 is liquidation for businesses. Chapter 11 is restructuring for businesses. Chapter 13 is restructuring for individuals. Chapter 7 may also be for liquidation of individuals, but I don't think anybody actually does that. National banks CAN'T file for bankruptcy. All they do is fail and get taken over by the FDIC. I wish somebody would bring back the RTC (Resolution Trust Corporation) to take over the bad banks and sell them off to whomever wants to buy them. I clerked for a district court judge from '94 to '95 and worked on the tail end of the RTC litigation. Yes, litigation is expensive, but the right people went to jail, assets were sold to somebody who could make a profit off them, and it didn't cost me, the American taxpayer, $7 billion.

    TARP was a bad idea all the way around and I think history will judge Bush and anyone else who supported it very unkindly, for buying into Paulson's "chicken little" dance / power grab. It was a bad idea to throw money to demonstrated failures with no real strings attached, it was a bad idea to create a financial panic in this country, and it was a bad idea because it broke the ice for the ridiculous spending bill Congress just passed. And the spending orgies to come.

    Contrast Reagan's sunny "It's morning in America" world view with Obama's pronouncements of doom and gloom, and I fear it's the end of my great country as well.

  18. The other coyote:

    The point of listing the different chapters of the bankruptcy code was to point out that commercial bankruptcies happen one of two ways. Chapter 11 is the most common, which the airline industry has all gone through. In Ch. 11, generally, the debtor stays in possession of the company and continues to run it. When you see "DIP" in connection with a bankruptcy, you're reading "debtor-in-possession." Ch. 11 gives the debtor "breathing room" to restructure financing, assets, debts, etc. I hate the idea of Ch. 11 because the debtor can keep the contracts he likes, disavow the contracts he doesn't, and effectively screw over any and all unsecured debtors. Even worse, the same crappy managers stay in place, as Coyote pointed out.

    Often, Ch. 11 bankruptcies are converted to Ch. 7 bankruptcies, when managers no longer care enough to keep the business going (or when creditors persuade the judge that there really is no hope for getting paid back, and they'd just as soon sell off what assets are left before existing management can reduce their value further and divvy up the proceeds). Ch. 7 is where potentially productive assets get into new hands.

    Of course the hybrid solution is a Ch. 11 with an active shareholder class. If shareholders would band together with a coherent plan to turn their investment around, GM could be fixed by filing for Ch. 11, getting a trustee or receiver appointed to make the hard decisions that existing management - who is too wimpy to say no to anybody - won't make, getting some breathing room from debts, restructuring potentially favorable contracts and disavowing bad contracts, then emerging from bankruptcy with entirely new management and an entirely new board of directors, courtesy of a shareholder vote.

    This will never happen because there are entirely too many shares of GM on the street for anyone to ever get a majority, and because the biggest chunks are held by institutional investors, who in my experience like to try to influence really stupid aspects of company policy, but won't step up with useful business solutions. Here's an example: the company I work for got hammered last year with shareholder proposals to amend the company's non-discrimination policies to include sexual orientation and transgendered status. I wanted to call up these mutual fund managers and say "Really, seriously, with all the crap going on in the world, and that's the best you can do? Demanding equal rights for the millions of transgendered who are working in the oil patch?" (the reference to the millions of transgendered in the oil patch is sarcasm, although it's probably not coming through well).

  19. epobirs:

    I remember when the first TARP was looming and I tried to tell people that this would only be the first of many outrageous expenditures if allowed to pass. "But we have to do something!" they screamed. No, we did not. What was needed was for the guilty to realize the jig was up and be willing to admit why these horrendous liberal policies had broken the system in exchange for some aid of a more rational sort.

    One of the panic cries was that these assets couldn't be priced and thus couldn't be unloaded. This was utter nonsense. The same methodology of determining worth that has worked for millenia still applies: A thing is worth what someone will pay you for it. You cost is only a detail. If you've made something or offer a service at a price that gives you a profit but finds no customers, then you have failed. You can either swallow the total loss or try to break even on your sunk costs by selling what you have for whatever you can get and getting out of the business until you figure out a way to do it better.

    A more rational approach would have been for the government to place an arbitrary value on the assets and offer to buy them for that price. That price would be far less than the bank or institution hoped to get but far better than nothing. Then the government puts the items up for auction and that is the end of it. Much money has been lost but the credit issue is negated. Oh, and while we're at it, CRA gets repealed along with some other similar bits of idiocy that are guaranteed to pile up delinquent debts.

    This could have been done for a small fraction of what TARP consumed and this leadership in the face of crisis could have turned the election.

    But that would have required too much rationality on the part of the previous administration while the folks who've dedicated their lives to the destruction of this nation have been working towards this for decades. Look at CRA. First, you initiate a very bad policy but make it weak and relatively harmless. Then, after enough time has passed that everyone is accustomed to its existence, you boost it into something much stronger that can do serious damage. The Cold War took decades to play out. Will we realize we're being warred upon by different means before it's too late?

  20. Link:

    to epobirs

    I'm not saying you're wrong, but I hear a lot of people saying that letting Lehman fail was a big mistake ... and that we're paying a big collective price for it.

    I still don't have a good detailed understanding of how $500B in bad mortgages got turned into trillions of bank losses. We haven't been told the full story.

    In practice, CRA didn't have much bite. Only when a big bank wanted to do a big M&A deal, ACORN came out of the woodwork invoking CRA. Banks had to promise to do $xxx million in community lending to get their approvals. But I doubt this had significant adverse impact in relation to the mistakes institutions would have made anyway.


  21. epobirs:

    Link, how could CRA, only the most visible of the bad policies requiring looser lending practices, not have had serious bite? I saw one person trying to defend by saying only 25% of sub-prime lenders were covered by it. That is like trying to claim good health by saying your lungs are only 25% cancerous. Once it became policy to give loans to unqualified people, it was just a matter of time before it broke the system. Not if but when.

    The cost of the bad mortgages multiplied because Wall St. did what it always does: shuffled around semi-imaginary properties in an endless quest to sell them for a profit. (Add in the default credit swaps and the properties get truly imaginary in a way that would get you sent to prison in any other field.) This isn't a problem so long as the properties can be assigned a meaningful value. Like a house. We've had periods of high foreclosures before but they were weathered by the market being allowed to do its thing. But first the boom in loans given under foolhardy condition grotesquely inflated the value of the houses and the inevitable bursting of the bubble made many of those who could make the payment find that they owed far more than the joint was now worth. Although it meant a big hit on their credit rating, that was less severe than being stuck paying $600,000 for something that could sell for half that much after reality set in. Thus we get get state of the art ghost town in the Inland Empire region of Southern California.

    We've been here before. Near Los Angeles is an area called the Antelope Valley. The two primary cities are Palmdale and Lancaster. These places have extremely little to recommend them. The only two good things to come out of Lancaster were Frank Zappa and Capt. Beefheart, and they got the hell away from there at the first opportunity. In the mid-80s new home development started going crazy in the Antelope Valley. At the same time there was the growing meme among young adults that if you didn't own a home before you hit 30, you were a hopeless failure. This was largely because some idiots in Washington noticed that home ownership rates went higher during economic good times and came to the fallacious belief that high home ownership drove a strong economy rather than the other way around. This is a big part of the rationale behind CRA getting put on Carter's desk.

    Anyway, Palmdale sucked. It wasn't the worst place on the planet but there weren't much well paying jobs locally except the nearby aerospace companies (Edwards Air Force Base is where a lot of their stuff gets tried out.) So a big portion of the newly added population was commuting into Los Angeles every day. A miserable way of life. On top of this, the honest working folks who enthusiastically tried to make the most of their new homes tended to ignore the severe shabbiness of the adjoining tracts, which were only a few years older. They eventually found that a lot of their neighbors were the sort who thought the patch of dirt in front of the house was a large combination broken vehicle display lot and weed farm. These were the folks who got CRA-driven loans or were renting from same.

    Of the two dozen friends, acquaintances, and relatives I knew who moved to Palmdale/Lancaster during 1985 to 1995, every one left. Most came back to LA or Ventura Counties, some left the state entirely. Almost half of them sold their homes at a loss or defaulted on their mortgages when they couldn't find a buyer within an acceptable loss range. It just sucked that much living in Palmdale and working elsewhere. Home ownership wasn't worth it under those conditions.

    So there was a LOT of foreclosures going down then, on top of a lot of general madness in the real estate market here. Boom, bust, boom, rinse, repeat. But it didn't threaten to topple most banks and lenders, because the market was still being run by mostly sane rules. Things weren't piled so high and made so volatile that nobody was sure what a house whose mortgage had changed hands a dozen times in a year was worth in the real world. ACORN soon had that fixed.

    Letting Lehman fail wasn't the big mistake. Not letting more of them fail was the big mistake. (The auction I suggested would not have prevented several big names from disappearing and good riddance. It would just have prevented it from becoming a massive burden on the taxpayers.) The villains responsible for this wanted to prop up the financial institutions rendered impotent by their idiotic laws because too many failures would make too many people look at where this started and get angry.

    It takes a lot to wake up the average American to consider things beyond his tiny sphere of interest, just as with most people everywhere. That Barney Frank is secure in his position rather than being hounded out of office is a perfect example of this. I'd be surprised if more than 10% of Americans even knew who he is and his role in all of this.

    We've put the lunatics in charge of the asylum. Our new President litigated for ACORN to create the enhanced version of CRA Clinton signed. Our Teasury Secretary was at the helm of the NYFR when the signs became plain that the wheels were soon to fall off. His duty was to raise a hue and cry before the exposed axles were digging into the pavement. Instead he help plot the greatest bit of pickpocketry in recorded history.

    Never attribute to malice where stupidity will suffice, the saying goes. So are these people stupid or evil? In either case, why are they still in charge and being cheered as they only make things worse?

  22. markm:

    On Katie Couric tonight: a schoolteacher losing her home to foreclosure, after getting an entire year behind on payments. She hadn't lost her job, and most teachers get the best medical coverage imaginable, so the only conclusion I could come to was that she signed a contract for payments grossly over her ability to pay. IOW, "Here's another teacher who cannot do arithmetic."

  23. Link:

    I Saw a crony who is a senior exec at Merrill and still there. What he said was "Merrill screwed up but that the writedowns have been so big in relation to the underlying problems that it shouldn't be the end of the world ... the market melted down -- so that illiquidity, a buyer's strike and mark-to-market caused problems -- but the underlying mortgages are -- today -- delivering cash in excess of where they've been marked to." Unfortunatley, BoA / Merrill are in the government's roach motel.