Nostradoofus

(Updated 10/9/08 – minor corrections)

This post attempts to explain why it may be necessary to bail out the U.S. financial system. I’m writing it because the federal government is not publicly connecting the dots, not explaining what is at stake, nor are the best blogs and news sources on the subject.

The following is NOT a defense of the Paulson plan, which may be the wrong solution. It is NOT a defense of Wall Street fat cats whose practices brought us here. It does NOT argue we need a bailout in just a few days or weeks. This is just a specific explanation of the problem, and why it is fairly urgent.

When politicians talk about a “failure of the financial system,” they are specifically referring to a panic among banks, which become unwilling to take basic day-to-day lending risks that act as the grease to keep all commerce working.

This dramatically affects your daily life, but it may be hard to see exactly how. So let’s use an example.

Say you use your credit card to buy lunch. When you swipe it, you are not actually paying, not right away. Instead, you borrow the cost of the meal from your credit card issuer. The restaurant trusts your card issuer to pay for your meal within 3 days; your card issuer trusts you to pay for your meal when your credit card bill comes at the end of the month.

But where does your credit card issuer get the money it loans to you? In almost every case, they borrow it. Credit card issuers extend billions of tiny short-term loans to their cardholders for things like restaurant meals. To pay the merchants, issuers borrow the money they need by issuing short-term bonds called commercial paper, typically with a term of only 30 to 90 days. Credit card issuers sell those bonds to investors.

Who are the investors that buy commercial paper from credit card issuers? One of the biggest buyers is banks. Banks receive cash from customer deposits, and look for places to lend it: generally writing mortgages and buying bonds. Most often, it is specifically money market deposits that are invested in commercial paper.

Lehman Brothers routinely borrowed a lot of money via commercial paper. This paper was purchased by banks and money markets, because Lehman was a trusted borrower. When Lehman unexpectedly failed, it defaulted on all its commercial paper, causing money market depositors to lose money. This shocked depositors into withdrawing massive amounts from their money markets, which greatly reduced the funds available for such funds to buy commercial paper.

Meanwhile, many banks today hold mortgages that are in default, or mortgage securities that are declining in real value. This makes bankers afraid to make risky loans, lest they lose more money.

The nightmare scenario, which we have flirted with a couple of times in the past year, is that banks and money market funds stop buying all commercial paper.

What happens to your credit card if the issuer cannot sell that 30-day commercial paper to fund its loan to you for the restaurant meal? It’s pretty simple: the credit card issuer fails, the restaurant doesn’t get paid, and restaurants across the country stop accepting credit cards. Cardholders who routinely “run balances” on their cards every month have no cash to fall back on, so they default on everything simultaneously.

Now, in my opinion, there are actually benefits to being a cash-only society, but here is the problem: the abruptness of such a transition would certainly cause a depression.

Still don’t believe it? Then consider a much bigger issue: payroll.

Thousands of US public companies fund daily operations with commercial paper, those same 30- to 90-day loans. For example, they may fund payroll with commercial paper during the month, while they await payment for their factory’s output. No commercial paper market, no payroll.

Commercial paper is not the only way they could do this. They could keep a much bigger bank balance, and pay short-term obligations from cash reserves until they are paid. As with the credit card situation above, this cash-based solution is inherently more stable: pay employees out of savings, and then refuel cash at the end of the month after receiving payment from customers. Works great, in theory.

But industrial firms all buy from each other. If all of them simultaneously needed to stop spending for a couple of months to pile up cash, then there would be no buyers for anything. All commerce would stop. Thus, as with the credit card example, it is the overly abrupt TRANSITION from credit-based to cash-based operations that would cause all payrolls and much other commerce to fail simultaneously, triggering economic collapse and depression.

The more people pull money out of their money market and bank accounts (this is accelerating), and the more mortgages and mortgage-backed securities that default (also accelerating), the less banks and money funds are willing or able to buy commercial paper, and the greater the risk that everyone’s payroll and credit cards seize up more or less simultaneously.

This is the reason everyone is so frightened. This is why Paulson, who takes risks for a living, looks like he hasn’t slept in a week.

Not to say I trust Paulson, but one part of his bailout proposal potentially makes sense.

Many MBS are illiquid because default rates are totally unknown. The fastest way to restore their liquidity would be to reduce default risk in a transparent way, e.g. write down the principal. This would require voting majority of a given MBS issue.

But ownership of these issues is spread widely. So a fast path to majority would be a Treasury reverse auction on a given issue. Once in control of a given issue, they could write it down so far that anyone would consider it investment grade, which would create instant liquidity.

Such writedowns would reduce the burden on homeowners in those pools, and restore liquidity at the same time.

Would the Treasury actually make money? Hard to say. Kinda doubt it. But if we are truly in a panic, you can construct a scenario: buy an issue at 10 cents on the dollar, write the principal down by half, and resell at 20 cents on the dollar.

UPDATE (9/26/08): A reader points out that purchasing MBS doesn’t entitle the majority owner to modify the individual mortgages, according to this and this. However, those sources also acknowledge that the mortgage servicer can make such modifications, subject to a majority or supermajority vote by MBS owners. So the situation is more complex, but substantively the same, as what I wrote above.

Longstanding US policy is to economically ostracize nations we don’t like. Hence the decades-long embargoes of Iran, Cuba, North Korea.

There is no experimental evidence that this works. No nation has changed policy as a result. In fact, the lack of economic ties to these nations means they have nothing to lose economically in a confrontation with America.

Thus, logically, the opposite policy would work better: kill them with carefully chosen kindness.

For example, Iran lacks refining capacity, so they are an oil exporter, but a gasoline importer. An interesting Mideast stabilization policy might be to build refining capacity in Iraq, and encourage gasoline sales into Iran. Increasing Iran’s dependence on a hostile neighbor creates strong incentives on both sides to stabilize both countries.

I happen to be a Republican. But before arguing about political platforms, one might consider four basic qualifications for national office: to be smart, self-made, emotionally measured, and without known health problems.

Not so long ago, in a presidential election, both candidates consistently met these requirements. Whether you liked the platform of Bill Clinton or George HW Bush, you could rest assured they were both smart, self-made, emotionally measured, and without known health problems.

This was true, with a few exceptions, of candidates for at least the past century, but it changed with George W Bush. Here, for the first time, a presidential candidate was not smart or self-made, and had a known, serious health problem in the form of past alcohol and drug dependency. Is it unrelated that his presidency is considered by most in both parties to have been a disaster?

As a Republican, I actually don’t have a problem with most of McCain’s stated policies. The problem is that he is not smart (5th from the bottom of his class), not self-made (entered the Naval Academy on family connections, married into money, entered politics on monied family connections), not emotionally measured (famous temper — physically attacked another senator in 2006, at age 71), and not in good health (four-time cancer survivor, and won’t release his medical records).

This is simply a bad bet, no matter what your political leanings.