Net Bank Assets2Recently David Sirota’s been linking to a Fed report that is skeptical of the public justification of the bailout.  The entire report is worth reading, but what it basically says is that interbank lending wasn’t frozen, that if LIBOR rates were a bit high, they weren’t all that high, that consumer credit was still being issued and that corporations, on aggregate (there are some individual exceptions) were able to borrow money, as of the time of the bailout.

The charts in the back of the report don’t entirely, in my opinion, support their argument, though they mostly do. In particular there is a huge 200 billion dollar drop in commercial paper outstanding from Sept 10th to October 8th, from about 800 billion to 600 billion. That’s 25% of the market that dried up.  With a slight lag, there is a huge spike in 90 day commercial paper rates for non AA, non-financial paper from 3% to 6%, with smaller increases in AA paper.

Interbank Lending v.2However, in general they’re right, based on publicly available data, something odd is going on—there shouldn’t be a crisis.  Take a look at the top chart above, showing net assets.  It’s not that unhealthy (the late spike, I think, is when Paulson forced money down the banks’ throats).  Then take a look at the next chart — interbank lending.  It peaks in October, then collapses, hitting its lowest rate November 26th.  The total collapse is about 27%, in a period of about two months.  And bear in mind that the bailout bill was proposed in late September.  As of the point when Paulson proposed the bailout, there wasn’t a very large decline in interbank lending.

But then look at the third chart: Bank Credit.  That’s the total outstanding loans and securities held.  Sure, it peaks in October, but the decline isn’t precipitous by any means.  In fact, if you pull out the components, what you find is that loans and leases (the 4th chart) have declined, from their peak in October, by about 57 billion.  And again, as of the time of the bailout proposal, they were still rising.

Bank Credit v2What’s this all mean?  Two things.  First, according to the official data, the main issues are interbank lending and short term commercial paper.  There is not a general tightening of credit to the real economy.

Second: the official numbers are probably not real.  Here’s the problem.  Net assets are just fine, yet banks are failing.  Citigroup had to get hundreds of billions of dollars of loan guarantees and folks in the know generally assume that many banks are functionally bankrupt.  The assets on banks’ books have not been properly marked to market or even to income.  (If a loan has an income stream I’m happy to book it based on the present value of that income stream, discounted by the expected failure rate of an asset with that level of return.)  

Loans and Leases v2.But, right now, except to each other, and with the exception of commercial paper, credit is still operating, in aggregate.  The fact that banks won’t lend to each other suggests, in part, that they know that each other’s books are cooked.  After all, they know what they have on their balance sheets, listed at mark to model (aka: mark to fantasy) and they know other banks have the same crap on their sheets.

The Fed and the Treasury together have spent, loaned, and guaranteed in excess of 8 trillion dollars at this point.  That’s more than the entire loans and leases portion of the domestic banking industry.  Given the net assets of the banking industry are only about 1.3 trillion dollars, for a fraction of that price, they could have bought out the entire banking industry.

The problem, then, is that we don’t know how large the hole is.  According to the banks, there is no hole.  On aggregate, they are healthy, indeed their net assets position is healthier than it has been in ages.  So either the bailout was a complete scam, when more targeted actions by the Fed would have worked, or the balance sheets are a lie.

I’m going with both.  Targeted actions would have fixed the short term problems, and the balance sheets are a lie, and everyone knows they’re a lie.  We don’t know how large the hole is, and until we know how large the hole is, we can’t fix it.  The Fed needs to promulgate real rules for valuing assets.  They need to be clear and fair, rather than "just ignore mark to market so we can all pretend the banks are fine".  The current path is exactly the path Japan took, of allowing banks to pretend their assets were good, when they weren’t, with the end result being zombie banks and an entire generation lost from the economy.  Those of us who are old enough remember when Japan was the future, with an amazingly dynamic economy, eating everyone’s lunch.  You don’t hear that anymore, because they had a huge bubble and then completely bungled their response to it.  So far the US is doing essentially what Japan did.

In this light, look at the credit and loan charts again—up, up, up, peak, then slight drop and essentially stagnant.  If Japanification takes place, then that’s what will continue. There won’t be a collapse of credit, but new credit will be hard to get, no matter how low theoretical interest rates are.  Combine with deflation, and people will just be sitting on their money, doing almost nothing with it, in the expectation that spending money later will be better.  But later will never come.

So, is there a crisis?  Sure, but it can’t be solved just by throwing money into a deep dark hole whose depth we don’t even know.  Banks need to be forced to take their write downs.  Yes, doing that will cause much screaming and some very bad days for the market.  But once we know how bad it is, we can then decide how to fix it.  We’ll know how much money is needed, and once everyone knows which (if any) banks are actually solvent, they’ll be willing to do business with each other again.  It’s when you don’t know who’s solvent or not, but suspect everyone, that everything seizes up.

Shutting our eyes and chanting "the problem is fixed, the problem is fixed" and just throwing money about heedlessly without a plan (and lord knows, other than "spend lots of money", Paulson and Bernanke clearly have no plan) is a recipe for, at best, a generation of economic stagnation.  At best.  At worse, we’re looking at a real depression, because unlike Japan, the US is the world’s lynchpin economy and doesn’t have a trade surplus.  Japanification is not a long term sustainable solution for the US.