Sunday, April 04, 2010

The coming financial crisis

There's yet another financial crisis coming.

According to Gonzalo Lira, the Obama administration is attempting to reproduce the solution to the Latin American banking crisis of 1982.

During the 1982 crisis, banks with large loans to Latin America became technically insolvent, because the value of the loans declined substantially due to actual or potential default. Federal Reserve chairman Paul Volcker effectively turned a "blind eye" to the banks technical insolvency while forcing them to renegotiate and write down (or off) their bad assets. By 1984 the banks had eliminated bad debts from their balance sheets and grown their way back into solvency. Had Volcker insisted on immediately restoring the banks' solvency by forcing them to sell assets at "fire sale" prices, there would almost certainly have been a severe general economic recession.

The Obama administration is attempting to replicate this approach. On April 2, 2009, the Financial Accounting Standards Board suspended rule 157 (presumably with the approval of the Obama administration and Securities and Exchange Commission), which requires that assets be accounted for at their market value. There's some justification for temporarily suspending this rule: As in 1982, there's some value in temporarily allowing technically insolvent banks to continue operations when there's a large, systemic decline in asset values. (It seems more sensible to simply allow the banks to operate while technically insolvent, rather than cover up the insolvency, but sometimes it's easier to game the system one way rather than another.)

However, a critical component of Volcker's 1982 strategy was pressuring the banks to actually adjust their balance sheets to reflect the decline in the value of Latin American debt. While the Obama administration has given the banks some "breathing room" by allowing them to cover up their insolvency, they have not also pressured the banks to clean up their toxic assets.

Worse yet, the banks are using the supporting funds provided by the Congress and the Federal Reserve not to actually invest in productive or socially useful activity, but rather to trade amongst themselves and create yet another speculative bubble:
Instead of being banks, since March of ’09, the Big Six US banks have effectively become hedge funds. They have been trading themselves into profitability. Worst of all, these banks qua hedge funds have been making money by trading with each other. Price-to-earnings ratios bear this out—their general upward trend, across sectors and industries, even as the economy has been severely weakened, is indicative of a speculative bubble. A massive bubble—the kind that makes the Hindenburg look puny.
It's all paper profits, and sooner or later this newest bubble will burst.

It doesn't have to be as dramatic or extensive as the bursting of the housing price bubble. Unlike 2008, the economy is today on the ropes: one more hard punch and we'll be down for the count, in another Great Depression... a depression that will be blamed on the Democratic party, leaving only the Republicans as a supposedly "viable" alternative.

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