Saturday, May 1, 2010

Bail or let fail?

Systemic risk.Too big to fail.Too small to bail.All buzzwords since the financial crisis began.Not as clear cut an issue as it may seem.

The cause of the crisis is clear cut.Loose monetary policies by the Fed for decades along with government enabling thru it's regulatory policies are what laid the groundwork.Investors simply walked right through the open door with the irresistible urge for seemingly unending,easy profits and we have our bubble/burst cycles.

The issue is how to deal with these scenarios in the future.Government is not going to stop meddling in private industry and it's policies of picking winners and losers.The Fed still has a deathgrip on monetary policy that will continue fueling the bubble cycles.In short,we are destined for a repeat of the crisis and it will be worse with each cycle if we don't completely implode on the next one.

The consensus amongst clear thinking people is that we would be better off without TARP and should let capitalism work by allowing businesses to fail.Agreed 100%.Where I part ways with most people is how to proceed when the government has created such a large scale problem.The so called systemic risk.

Take any particular business with a poor business model.Eventually it will fail.This is good.Let it fail and allow the market to work when other companies and investors move in to salvage any worthwhile remnants left over from the crash.Capitalism at work.

However,the government throws a monkey wrench into the formula.They involve entire industries in engaging in poor business practices.The housing market is the perfect example with the packaging of risky mortgages into financial instruments.All part of the master plan to create systemic risk on such a large scale.This creates the dilemma.You're not simply allowing a company to fail,you're allowing an industry to fail.Capitalism is not designed to work in this manner.

Capitalism supports letting a poorly run business fail and then having another succeed in it's place.The strong survive.But you can't do that with an entire industry.No one really knows what would have happened without TARP.But we can speculate.

The domino effect would have most certainly come into play.It's unavoidable due to the structure of the derivatives market.Mortgages were packaged together and resold in slices.Sometimes they were even sliced up more and resold again.You end up with a whole chain of investors dependent upon the homeowner making their mortgage payment.The fallacy was that housing would just continue to appreciate endlessly making these seem very safe investments.

This is why so many municipalities bought them.Municipal bonds are considered about the safest investment you can make.Little did the common investor realize that the bond they owned was built on such a shaky foundation.

This is the problem had we just sat back in Sept. of 2008 and let the chips fall where they may.A massive,global chain reaction crash due to the intertwined financial instruments would have brought down entire industries.I don't think anyone really disputes this.

The comparison is between what-ifs.Would we have been better off with a steep crash that allows the garbage to flush out all at once?Are we better off with the taxpayers on the hook for the TARP funding?Or is there a 3rd alternative as we are once again progressing toward another bubble burst cycle?

The best solution would be to elect an administration and Congress that would simply step aside and let the free markets work.However,that's not in the cards anytime soon.Even if you elect Ron Paul,he would have massive hurdles to overcome in the form of the entire progressive left opposed to such policies.

The fallout from allowing such a large scale crash is unknown.We already know the credit markets would freeze up.This would kill many businesses alone that rely on credit access for payroll.You would,of course,have massive unemployment with so many businesses going bankrupt.Factor in the state and local municipalities that had invested in the derivatives markets.

Remember,unemployment is key.People stop working and the trickle down is wide.Consumer spending drops.Tax collections drop.Defaults and foreclosures increase.It's all an intertwined web that feeds on itself.

Not only do you have the shareholders of the failed companies losing everything,but the bondholders take a huge hit.If it's a bank,the FDIC only insured up to $100k at that point so those depositors in excess of that would have lost their money as well.

I don't see where it's possible to limit the effects to just the frontline businesses that would go bankrupt.There is simply too much weaved into the mix that is collateral damage.Again,all speculation and nobody knows just how far the entire economy would have fallen.

TARP is not the answer.The pending financial reform is certainly not the answer.Bean counters like to look at numbers in a black and white world.Economists solutions to this problem seem to be in the same vein.They don't properly factor in things like human behavior,or in this case,politics.Far to many politicians aren't concerned with the free market,only power and getting re-elected.

There are more that want the Fed dictating policy than do not.There are more that want government to have a bigger role in private markets.Thus,the problems created by the bubble cycles are sure to continue.

The holy grail here is to find a system that somehow accommodates both capitalism and politicians hellbent on destroying it and somehow protecting the common man who takes the brunt of the fall every time.It doesn't exist and I've never even heard it proposed.For now,simply more of the same.More to come...

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