Let sleeping shadow banking systems lie

By J Saft
March 6, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

Rather than vainly trying to refloat the shadow banking system, the U.S. would be better off grappling with the inevitable ultimate solution — debt destruction and inflation.

The common denominator of policies like the Term Asset-Backed Loan Facility (TALF) that was detailed on Tuesday, is that they try to solve fundamental problems with indebtedness by attempting to float asset prices high enough that they are back in proportion with the debt.

Even more, they use the same structures that worked out so poorly — highly levered hedge fund like vehicles and securitisation — but this time substitute government funding and leaves the taxpayer as main bag-holder if the deals go bad.

With up to $1 trillion, the TALF is designed to re-start parts of the securitization market such as auto, business and student loans. This followed the plan to avoid foreclosures and further house price falls by cutting borrowers, many of whom made silly borrowing decisions, a break on their interest rates.

Next up: a public-private plan to buy up toxic legacy assets from banks, which should be detailed in the next two weeks. Again, that program will provide government money at sub-market rates to investors to entice them to pay more than the market price for assets that would otherwise sink many banks.

The higher the leverage supplied the higher the price hedge funds and other investors will pay for doubtful assets. After all, like a Florida condo flipper, if the asset declines in value they can just walk away and throw the metaphorical keys at the Federal Reserve and U.S. Treasury.

“We want to make sure that the prices of the assets that are purchased reflect true market values that are not overpaid. So the idea between the public-private partnership would be that there would be both public and private money involved and that the pricing decisions would be made by private-sector specialists, not by public bureaucrats,” Fed Chairman Ben Bernanke told Congress on Tuesday.

“If the government is willing to provide longer-term lending, or leverage, there are many investors who presumably would be willing to buy under those circumstances who are unwilling to buy without the credit, without the lending they need to finance those purchases.”

I simply cannot reconcile the first part of that statement with the second. What do we mean by “market values” in a situation where the government provides financing not otherwise available? Vary the leverage and achieve any price you like.


The TALF is slightly more defensible. There is a market failure when reasonably good credits can’t raise money under any circumstances. But before we try to re-start securitization and the shadow banking system, let’s recall what the problems were in the first place. For one thing the TALF relies upon imprimaturs from the credit ratings agencies which have been found wanting. That’s not yet changed, but government participation simply papers it over.

Even the obsession with banks almost seems beside the point.

“You won’t revive the economy through debt,” said Albert Edwards, global strategist in London at Societe Generale.

“Banks aren’t the problem, they are a symptom of the problem.”

The problem is that asset prices are out of line with their ability to generate cash flow. Falling prices do impose a risk premium but the real issue, for stocks or for houses, is that their prices are not in the proper proportion to the debts they carry and to their ability to generate cash. That happened in part because of the shadow banking system and was a mistake.

So, what’s the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized write-down seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head on.

University of Oregon economics professor Tim Duy thinks the U.S. will ultimately end its romance with financial engineering and get down to working through unsupportable debt the old-fashioned way — inflation.

“And therein lies the key to predicting when the Fed shifts gears; When Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth,” Duy writes.

“At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities.”

That is a dangerous and difficult to govern process, and the U.S. shows every sign of being willing to pay a very high price to avoid it.

But ultimately, the price will be too great and we will have to inflate and default in some mixture.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –


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Mr. Saft, with all due respect, I think you are obfuscating rather than clarifying this economic crisis. Only meisters of credit-default-swaps and CDO’s could love all the technical mumbo-jumbo in your blog posting. It’s best to keep it simple.

An absolute requirement in this crisis is that all U.S. homeowners, whether they hold a mortgage or not, should be forced to contribute heavily to an economic stabilization plan. The housing bubble was a giant Ponzi scheme which was in the making for about 30 years, and long-time homeowners made out like bandits. Their homes appreciated tremendously, and today most of them face no mortgage troubles at all. Yet, they are still sitting on their big, fat, pretty profits obscenely obtained. Make them pay! Replace all property taxes with a stiff federal property tax, and tax profits on the sale of residential property at a 90 per cent clip. The money generated over 30-50 years would be more than enough to honestly finance an economic recovery plan. Housing prices would tumble even more, but that is EXACTLY what is needed in such jumbo-mortgage states such as California. The U.S. cannot compete on the world-wide economic stage when the price of a necessity like shelter is artificially inflated solely to enrich those who bought shelter first (a Ponzi scheme).

Posted by Darth Baghead | Report as abusive

Andre, the way I see it is this: The crisis
was engineered… I remember thinking about the ever increasing housing market as an oddity simply because most of us not having six figure incomes could not affort their ever increasing value!

I failed to sell and bank my cash under the matress, would I done that I would have been able to buy two deflated properties today.

To those that capitalized (selling high) and now awaite to capitalize further (buying low)
I take off my hat (that’s the nature of the beast) but PLEASE, keep the profit circulating in America!!!

Posted by RenTacus | Report as abusive

Quoting Darth Baghead: “The housing bubble was a giant Ponzi scheme which was in the making for about 30 years, and long-time homeowners made out like bandits. Their homes appreciated tremendously, and today most of them face no mortgage troubles at all”

…. Others than followed wanting to jump on the wagon in fact are the ones now crying fool… thats the nature of the beast, is it not?

Posted by RenTacus | Report as abusive

What a surprise the thompson reuters analyist want to use our money to leverage and reinflate the stock market. Thus paying off hedge funds and private equity which are the same people who got us into this mess by selling toxic assets to the world. they make money selling the junk, and now the government helps them to make money buying it back from all of us who have lost our shirt buying it. Is there something about working in the financial industry that removes all the moral fiber of your being that you’d actually think this is a good idea. Oh wait, the masters who pay your bills will make a fortune. You people are the scum of the earth, and unfortunately our legal system doesn’t allow for what should happen to you, your family, and the families of all the wall street scum who caused this mess in the first place. Since we actually have to work for a living, don’t have enough to invest in the markets, and are just getting by, we don’t care too much about wall street. People like you, out of touch with reality, interested in your own welfare above everyone’s is what got us into this mess. You are advocating a policy that is best for you and your friends, not America as a whole. You make me sick to my stomach!!! Get ready for the big spring rally!!! wow, maybe I’ll put the 200 bucks I’ve got into the market and make a fortune. Clueless!!!! How much money do you make, how much spare money do you have to put in the market? You are going to make a killing from the policy, and I’ll still be stuck attempting to figure out how to make my paycheck stretch to pay the rent. PIG

Posted by db | Report as abusive

A system that depends on debt will not forgive its life’s blood. it would seem that as long as we are stuck in this system, many will pay, few will truly benefit, it is literally designed that way.

The solution is complete change, hampered by battles with words like “socialism” and “debt slavery” being thrown everywhere, a literal quagmire of ideas that is, in my opinion, a perfect smoke screen to keep the train on track.

just shut up and pay, don’t you have to work soon?

Posted by jeremy | Report as abusive

The smoke screen to keep the train on track will burry generations to come, watch and share

http://www.youtube.com/watch?v=lNS8IY_Td 14

Posted by RenTacus | Report as abusive

All what is going on now in the US concerning the Dollar and it’s markets, is now fully manipulated to fail on purpose, they are all just buying time for foreign investors to realize that all US debt-buying is wasted wealth.

Obama & the Fed know it’s all gonna crash, but are trying to position the US into a better position than the rest of the Globe.

The moment Asia stops buying debt, is the moment the US will stop paying it’s debt.

What will happen then is basically a “global economic blackmail” as in ” MAKE US PAY”. The G20 meeting might give us all the general direction of what will unfold.

If your local leaders comes back in a total PANIK, you will know the US as blackmailed the world into a 1 currency system. I think they might just evaluate all currencies to reset the debt values and just Continue this Giant Fiat based counterfeit ring & protection-racket.

Posted by LastReplay | Report as abusive

Great read, espcially liked “So, what’s the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized write-down seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head on.”

Joseph Stiglitz discussed this recently on Charlie Rose:
http://expattitude.blogspot.com/2009/05/ charlie-rose-joseph-stiglitz-on-future.h tml