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Psalm 78
. . . we will tell the next generation the praiseworthy deeds of the LORD, his power, and the wonders he has done. .
so the next generation would know them . . . and they in turn would tell their children.
Then they would put their trust in God and would not forget his deeds but would keep his commands.

Friday, September 19, 2008

Bail! Bail! Bail! Stroke! Stroke! Stroke!

This is a favorite line from Rocky and Bullwinkle. The heroes Rocky and Bullwinkle are canoeing frantically as Boris and Natasha are stroking their paddles in unison to catch up. Alas, our heroes have a leak in their canoe and must "Bail! Bail! Bail!"

This might be the current rallying cry of the U.S. Treasury: "Bail! Bail! Bail! Or the U.S. economy will sink!" But who or what caused the leak?

The answer is so complex that most reporters don't know how to describe it. That leaves Presidential candidates puzzled as to how to squeeze it into sound-bite size solutions. And the rest of us are wondering...what is going on?

I thought yesterday's front page Wall Street Journal article * was helpful in explaining what is happening. But you must wade through daunting business reporting to discover it. Here are a few key quotes:

...Fed and Treasury officials have identified the disease. It's called deleveraging. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, partly because of the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

...Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.

...Hedge funds could be among the next problem areas. Many rely on borrowed money, or leverage, to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many use borrowed money to invest in the funds and are finding it more difficult to borrow.

...The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as market reassesses the risk that a company own't be able to honor its obligations. Firms use these instruments both as insurance--to hedge their exposures to risk--and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt--up from about $144 million a decade ago.
(My emphasis added.)

What's the sound-bite here that no one wants to point out to voters? This is the fault of greedy Americans and greedy Wall Street. Naysayers have been warning about the level of debt taken on by American households, but the rest of us have turned a blind eye. Meanwhile, financial institutions slapped respectable labels on financial contracts that are merely bets on the performance of other companies. 

I'm pro-business, but something has to change when traders and investment bankers hide behind the obscurities of their complex business and play with our money. Whether it is as taxpayers or customers, we're all providing the cash for these dubious practices. 

On the upside: Beware the talk about this costing taxpayers billions and trillions. It is true, and it is very concerning that our government is taking a stake in private companies, however, I'm noticing that the media is failing to mention the glimmer of upside here. Our government retains the ability to sell off these assets, which the government obtained for bottom dollar, and potentially reap a big profit. So don't buy the line that this means we need to raise funds from taxpayers in the form of higher taxes to foot the bill. It might turn out to pay for itself. News reports even now suggest AIG is moving heaven and earth to find a way to pay back Uncle Sam before their deadline (to avoid the government taking an 80% stake in AIG).

Both presidential campaigns are struggling to offer a political solution and to differentiate from their opponent. Ironically, the scramble that is now taking place at Treasury and in Congress will do more to determine the economic course of the next 4 to 8 years than anything either candidate proposes.

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