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When Wi​ll the Pain Stop?

October 16, 2008 By:
Edward L. Snitzer, JE Feature
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On Oct. 3, Congress passed a controversial $700 billion financial rescue plan. It did so with great misgivings, and only because it had been warned of the need to stem the frozen credit panic gripping the financial markets with some plan, any plan.

Given the panic, all that was on the table for congressional consideration was the Treasury plan: Will it work?

The purpose of the plan is to stop a worsening worldwide credit freeze that, according to Warren Buffet, is "sucking blood" from the American economy.

Why is this happening? Financial assets, held by financial institutions, are so rotten in so many places that no financial institution wants to risk doing business with any other financial institutions without a government backstop.

This mess occurred from a combination of imprudent financial borrowing by all concerned; huge leverage; the insidious results of new kinds of opaque and complicated financial paper; and a financial bubble in the one asset most Americans own -- real estate -- together with the total underestimation of risk by all those concerned.

The basic idea of the plan is simple: Give the banks lots and lots of money, in place of the rotten assets they now hold. Once they get the money, and sell the junk to the government, banks will be willing to lend to others, including financial institutions that have been given a clean bill of health.

Executing this "simple" idea will be enormously complicated, starting with the first question: Which banks will live to see another day and which will not, since even $700 billion may not be enough to buy all the junk from all the troubled banks?

A September 2008 International Monetary Fund study of 42 systemic banking crises across the world between 1970 and 2007 found 32 cases in which there was governmental intervention. In most cases, multiple forms of government recapitalization of banks were used. "Above all," the study concluded, "speed appears of the essence."

What is next for the real economy? It is clear that we are going to have a global recession of unknown duration and unknown severity. Usually, a recession occurs when government, through its central bank, makes it hard to borrow at a reasonable cost, thus slowing down economic activity. Today, it is not the government that is restricting borrowers, it is the banks, which will have the same economic effect.

Prices will come down, not up. It is estimated that a 4 percent to 6 percent contraction of bank credit will occur, which is something when the global economy needs a 10 percent to 15 percent expansion of credit to grow by 3 percent in real terms. The governmental response will be to save the banks; keep interest rates low; and spend enough money to keep the economy from falling into a deflationary collapse, while the credit system adjusts.

Through Sept. 30, the S&P 500 is down more than 20 percent, which is only the third time it has been down that much in one year since 1937. International stocks are down almost 30 percent.

There will be an end to this mess. We will not have a rerun of the 1930s. There will be plenty of pain to go around and plenty of mistakes made. We are rescuing those who took more risk than they should have and paying for it with money from those who were more prudent. There will be a rethinking of a system that has this unfair a result.

When the financial system and the economy right themselves, we'll be in a new era: Thrift and save will replace borrow and spend. Scarce capital will be invested more productively, and the financial wizards who brought us this mess will be doing something else.

Edward L. Snitzer is managing partner in the investment-management firm of Prudent Management Associates, specializing in high-net-worth and tax-deferred asset management. For information, go to: www.prudentmanagement.com.

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