Wednesday, October 1, 2008

A Letter to Bedford Falls

"No, but you're ... you're, you're thinking of this place all wrong. As if I had the money back in a safe. I ... the, the money's not here.

"Well, your money's in Joe's house ... that's right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and, and a hundred others. Why,
you're lending them the money to build, and then they're going to pay it back to you as best they can. Now what are you going to do, foreclose on them?"

— George Bailey, It's a Wonderful Life

Dear Main Street —

Aunt Millie called me the other night to complain about the $700 billion financial rescue bill Hank Paulson and Ben Bernanke are trying to ram through Congress. She sounded pretty pissed off, ranting and raving about how she thinks the plan is just a big, fat bailout for the fat cats on Wall Street. She doesn't see why we need any bailout at all, since she still gets five credit card offers in the mail every week, and her local banker Joe continues to badger her to take out a loan to put that addition on the back of her house. Paulson, Bernanke, and the New York Times keep trying to persuade her that the entire US banking system is about to go kerflooey, but she just doesn't believe them.

I have to say, I sympathize with her.

One of the problems is that there seems to be a kind of exaggerated hysteria sweeping the mainstream media and commentocracy, as they desperately try to explain what the current credit crisis means to you and your fellow Americans and why it is so important to prevent a total meltdown of the financial system. Putting aside the fact that many of these reporters and pundits have no clue themselves of what credit is and why the banking system is important, most of them just have no idea how to relate to you or Aunt Millie, and, in a well-intentioned effort to explain it all to you, they end up sounding alarmist, condescending, or both. I don't know about you, but if you are anything like Aunt Millie, Joe Sixpack, or me, you probably get pretty ticked off when some Big City Fancypants tries to patronize you.

Among these, the alarmists—who try to tell you that you better meekly submit to the greater wisdom of Paulson et al. damn quick, or we will all be selling apples on street corners in six months—just end up sounding foolish or irresponsible, and are easily ignored. If, on top of everything else, they have a connection to Wall Street, their behavior just confirms to you and all of your neighbors that the fat cats are trying to put one over on you.

Sure, the commercial and investment bankers are squealing like Ned Beatty's character in Deliverance, but the rest of us look around at each other and don't see anybody else getting reamed in the butt. The wailing and gnashing of teeth from the financial sector just sounds like an exaggerated form of special pleading. You know what they say: if your neighbor loses his job, it's a recession, but if you lose your job, it's a Depression. They may have aggressive pneumonia in the canyons of Wall Street, but the rest of us just have the sniffles, if that. If you are like me, you are inclined to tell Wall Street to take some Tylenol and shut the hell up.

But even the clever, responsible commentators—like my pal over at Accrued Interest—who try to explain the importance of what is happening in plain English in a reasoned, informative way, often end up sounding as alarmist as the wingnuts, and hence lose some of their own credibility. AI, for instance, does a very creditable job of explaining the importance and centrality of banks and other financial institutions to the everyday functioning of the real economy, and the critical role that credit plays in the everyday lives of you and other citizens. But then, in an apparent effort to keep things simple (for the "simple folk?"), he stumbles into this:

So if banks and other lenders cannot get cash, they cannot lend it. So what? Isn't our society doing too much borrowing as it is? Maybe, but let's consider the consequences of a world with no lending.

First of all, there would be no housing market. Very few people can buy a house with cash. Housing prices would continue to fall for many years. The result would be that people would almost universally live in rented housing. Wealthy land lords would own all the housing in America, and would reap all the profits from rentals.

Second, there would be no secondary education. Like housing, the vast majority of people need loans to get a college education. Granted, colleges would probably pare back on the quality of the education offered in an attempt to lower their costs. Even so, it would likely be that only wealthy people could afford college. The income gap in our society would increase as a result.

It would also be extremely difficult for average people to start a new business. Most businesses require start-up capital, most of which is normally borrowed. In addition, many small businesses need working capital, which allows the business to make payroll while waiting for accounts receivable to come in. So here again, only the wealthy would be able to start new businesses.

Wait a minute. Who said anything about no lending? Is that really a realistic consequence of Main Street not supporting the current bill in front of Congress, or indeed any potential rescue plan designed to ease the credit crisis?

Of course not.

Not to mention, it would probably do us all a world of good if those economic sectors in which value for money has become completely unhinged from reality—like real estate, higher education, health care, and private school tuition in New York City (my personal bugbear)—faced a little demand recession of their own for a while. Housing prices, while falling, still have come nowhere near reaching historical levels of affordability compared to income, and the value of a Harvard education is swiftly evaporating as the sectors where it is a prerequisite—like investment banking, corporate and securities law, and national political office—are either imploding or rapidly losing whatever social cachet they may have enjoyed in the last few years.

Could the Great Depression recur? Sure it could. Could we all end up selling apples to each other on street corners (filmed in grainy black and white footage, natch) and jumping out of our hermetically sealed highrise windows as our life savings disappear? I suppose. Especially if the credit markets remain frozen for an extended period of time, the tremendous cash inflows from foreign investors which have been financing our nation for many years suddenly stop and remain stopped, and Congress, the Treasury, the Fed, and everyone else within the Beltway conspire to come up with a series of actions and decisions so stupid and ill-informed that they would make their recent behavior look positively Solomonic. It could happen.

It just isn't going to happen next week, or even the week after.

It is ludicrous on its face to imagine that that is what will happen if we do not pass the current rescue bill, and you, me, Aunt Millie, and Joe Sixpack know it. If that is what Paulson, Bernanke, and the punditocracy are selling, we're not buying. We've read The Boy Who Cried Wolf, too.

The wolf only comes for real the third time the boy rings the alarm.

* * *

So, how does this bank/credit business work? What does a bank do?

I give you Accrued Interest again:

First let's think about how modern lending works. Pick any type of loan: student loan, car loan, credit card, home mortgage, small business loan, etc. Any time a loan is made, whether its to pay for meal with your credit card or to pay for tuition, someone actually has to come up with the cash to lend to you.

Where do lenders come up with this cash? Primarily three places.
  • Deposits.
  • Borrowing from investors or from other banks.
  • Securitization. This means that the loan isn't held by the lender, but sold to investors.
Lenders don't want to use deposits to make loans right now, because there is serious risk of depositors suddenly demanding their cash. Remember that banks don't ever actually have enough cash to give all their depositors their money on any given day. So when depositors are nervous, banks are nervous.

Simple, but not simple enough.

In their purest form, banks are simply conduits, which connect people with money to invest—savers—with people who need money to spend—borrowers.

Depositors are savers who want to put their savings in a bank to earn a little bit of interest until they need to withdraw it. They lend their money to the bank. Borrowing from investors or other banks is simply another form of the same thing, where the people with the money—the investors themselves, if directly, and the other bank's investors and depositors, if from another bank—put their money to work in the form of a loan to the first bank. Investors in securitizations simply buy a piece of paper which represents a piece of a loan to the institution selling the securitization, which is backed by whatever assets (usually other loans) the bank has stuffed in the securitization.

Having come up with a bunch of money from various sources, banks turn right around and lend it out (at higher interest rates, hopefully) to other borrowers, banks, or asset holders.

Banks match savers (lenders) with spenders (borrowers). As simple as that.

And for this valuable service, banks get to charge fees. After all, hooking all those savers up with all those borrowers requires a lot of work, especially nowadays, when connecting someone who has money with someone who needs money can involve thirty-seven different entities, a passel of offshore vehicles domiciled in the Cayman Islands, and an army of propeller heads with PhDs, lawyers, accountants, tax advisors, and investment bankers to structure, market, and paper over the monstrosity. You wouldn't deny these hard-working folks their livelihood, would you?

After all, even George Bailey from the Bailey Building and Loan needed to make a living, didn't he? He matched up the people in the community who wanted to earn some interest on their savings with the people who wanted to borrow to build new homes, or start a business, or whatever. For his efforts, he charged just enough fees, in the form of net interest margin—the excess of what he earned from loans to his borrowers minus the interest he paid to his depositors—to support himself, his staff, and operate the bank's day to day business. It's pretty simple, when you think about it.

If you really want to understand this stuff, Main Street, I can recommend nothing better than breaking out that old Christmas chestnut, It's a Wonderful Life, a little early this year and watching it. About fifty minutes in, you get the scene quoted above, where George tries to talk his depositors out of a run on the Building and Loan, which has been triggered by the start of the Great Depression. You can have no clearer explanation of what a bank is and does than what George says. Cut through the crap of thousands of pages of documentation, regulation, and obfuscation in today's credit market, and what he says in that movie is as true today as it was then.

Watching that scene, you can see at once three important things. First, a bank only functions on the faith and credit it inspires in its depositors (and the people who lend it money), and it profits on the creditworthiness of its borrowers and their reliability in repaying their borrowings. Credit, or confidence, is the sine qua non of banking. The word "credit," after all, comes from the Latin verb credere, "to believe." Without belief, or faith, or forbearance, there is no credit.

Second, because a bank acts as a conduit between savers and borrowers in a community, its proper functioning is critical to avoid disruption and breakdowns in the general economy. If the financial plumbing system freezes up, all of a sudden it becomes much more difficult for nonfinancial businesses to invest, borrow, operate, and build. Payrolls can't be met, factories can't be built, people lose their jobs, and everything slows down. Lending does not normally stop, but it does become more difficult and more expensive, and that cost is spread throughout the economy in multifarious ways.

Third—and more hopefully—you can see that unless there is some extraordinary additional disruption, a run on a bank or a freeze in the credit system should be self-correcting. After all, as long as savers still have money to invest, they are going to want to lend it out. Sure, they may charge more, and they may be more reluctant to do so, but show an investor a solid credit willing to pay a juicy interest rate, and eventually they will make the loan. Any particular bank or banks may be toast, but credit and lending will find a way.

One factor which worsened the Great Depression, as I understand it, was that legions of savers actually lost their money when banks failed. The borrowers went bankrupt, but so did the lenders, and there was not enough savings or credit in the system to get things started again. Now, with FDIC deposit insurance, we have the US government standing behind the curtain to guarantee the safety of at least some of those savings, so widespread bank failures should not necessarily lead to a permanent freeze on lending.

Furthermore, we have literally tons of greenbacks or their foreign equivalents burning holes in the pockets of the governments and countries we have been buying stuff from for decades, and they have few good alternatives for their money to investing in this country. As long as the rest of the world does not lose complete faith in the USA—a scenario which, I grant you, is no longer as far-fetched as any of us would like—we should muddle out of this mess with a few bruises and a nasty recession, but otherwise intact.

So, color me skeptical about the urgency of this bailout. I think temporarily raising the limit on FDIC depositor insurance from $100,000 to $250,000 is a great and relatively inexpensive idea. The rest of it, frankly, strikes me as little more than a shot in the dark. Let hundreds of banks fail. Let tens of thousands of financial workers lose their jobs and their personal wealth. Let the entire country suffer through the recession which is surely coming no matter what the Fed and the Treasury do. The financial sector has had a really, really good run for a lot of years. It is time for it to pay the piper, and I, for one, have little interest in using my taxpayer dollars to cushion the blow. After all, I am just another heartless Wall Street bastard myself.

Well, that's it for now. I've got another letter to send you soon about who is to blame for this whole mess, but now it's time for me to walk the dog.

Say hi to Madge and the young-uns for me.

Your pal,


© 2008 The Epicurean Dealmaker. All rights reserved.