Thursday, November 13, 2008

What Paulson Said

      Brendan Smialowski for The New York Times 
Henry Paulson's news conference yesterday scared the shit out of me.  It is now clear that the US Government has no plan to deal with the crisis.  They don't even understand it.  The key thing Paulson said was:
the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit.
Full text here .

Cheap, securitized credit was what got us into this mess.  More of it won't get us out.  The system is fundamentally broken.  Restoring the status-quo is not a viable option.  The system has to get fixed.  American consumers have financed their prosperity for the last 20 years through credit and the bill is due.

As a group, US consumers have a negative savings rate of 113%.  They owe $1.13 for each $1.00 of assets they own.  And with house prices still falling, that $1.00 of assets is going to be worth less.  But the $1.13 stays the same, so the problem gets worse every day.  The reason banks and credit card companies can't finance new consumer debt is because American consumers are a bad risk.  They already have more debt than they can pay off.  All the government money in the world won't change that.

The money Paulson wants to throw at the markets comes from one of three places; taxes, bonds or the printing press.  The current lame-duck Congress can't pass significant new taxes.  Obama has promised a tax cut to 95% of US households.  With the economy burning around them, US legislators will not support new taxes next year.  So the US government will need to borrow the money through selling bonds.  At some point, foreigners are going to see the staggering levels of US public and private debt as a problem.  Then they will stop buying US bonds.  At that point, the only way the US government can continue to function is by printing money.  That risks a dollar crash.  If the current problems are like Mount St. Helens, a dollar crash would be like Krakatoa.

Things are already looking dicey for continued massive US government borrowing.  China has announced an enormous stimulus package.  The best place for them to get that money would be to sell some of the almost $1 trillion they own in US Treasuries, creating a down-draft on the US$.  Even if they hold on to their Treasuries in order to keep the Yuan from going up, they will be spending their money at home, not lending it to the US.  Likewise the Japanese and the OPEC countries.  Lower demand and/or lower prices mean that they don't have as many US dollars that need parking.  Early signs of possible trouble in the US Treasuries markets have already surfaced.

An inability to raise taxes, lower demand for US Treasuries and a continuing need to throw money at the US credit markets sets the stage for a perfect financial storm.  This crisis is far from over.  The current US administration has not come to grips with the underlying problems.  The US financial sector still seems more focused on bonuses than survival.  Unless someone like Obama comes up with a really good idea soon, things are going to get much worse before they get better.

An excellent overview of the situation for the non-MBA by Niall Ferguson is here.  Long but worth it.