Wednesday, April 1, 2009

The Penny Drops

I'm usually swift on the uptake, if nowhere else. But its only in the last few days that it occurred to me what Obama is taking about when he says "get the credit flowing again". On the face of it, banks have not stopped lending. If that were the case, few cars or houses would be sold in the US, and a large percentage of businesses would have gone out of business. An apocalypse, in other words. Things are bad, but so-far, not apocalyptic.

The general problem for US banks has been that they have massive amounts of Collateralized Debt Obligations* (CDOs) on their books which have little or no value. These represent unrealized losses. Nobody knows what they are worth, if anything. When the banks have to finally account for these "assets" some of the big ones will go broke. Additionally, interbank lending is said to be down substantially. This cannot be true in the traditional sense, or the whole system would have frozen up. This was a real possibility in October, but less so now. So what's Obama talking about? New CDOs.

Over the last 10 years, CDOs became the vehicle for financing all kinds of US consumer loans, most prominently mortgages. But CDOs came to include credit card debt, student loans, car loans and all kinds of other consumer lending. These loans were sliced and diced with magic tricks that turned them into virtually risk-free investments for mutual funds, hedge funds, retirement funds, schools and municipalities. The process became a money machine for everyone involved, including the consumers that took out the loans. Obviously, the magic tricks turned out to be imaginary, and the slicing and dicing has only served to make the CDOs completely opaque. Take a slice of any CDO floated by anyone in the last five years. What's it worth? Nobody knows. More importantly, nobody can know because their structure is too byzantine for anyone to figure out. It will be sorted out eventually, but that could take years.

In the meantime, nobody wants to buy any new CDOs. The mighty CDO market that brought unlimited debt to US consumers has almost completely shut down. That's what Obama means when he talks about freeing up the credit markets. He's trying to put Humpty Dumpty back together. It probably won't work, but not positively. So there is a clever political calculation involved. As a new President, his choice is to tell Americans that they need to give up the growth and prosperity they enjoyed in the last 20 years, or he can try to restore the status quo. In a general sense, he can't be blamed for trying as long as he doesn't make a mess of it. He could, however, be blamed for not trying. Americans won't accept a new, lower, standard of living unless they believe there is no choice. The political problem is potentially larger than the economic problem, but its not on the mass media radar yet, so nobody's talking about it. But Obama's thinking about it. I like that. It means that even if he is unsuccessful at getting the parade rolling again, he may retain enough political capital for plan B, whatever that turns out to be.

Incidentally, this thesis explains the Europeans' disagreement with the US over how to handle bad assets. Their banks are in the same shape, but most European economies don't depend on easy consumer credit like the US. Those who did, like Ireland, Greece and Hungary, are in deep trouble. Those that didn't, like Germany, don't see the point of spending trillions to resuscitate a discredited system they don't depend on.

*There's a great 11 minute film that explains CDOs, previously posted here.