Wednesday, November 19, 2008

A New Crisis for the Financial Crisis: The Presidential Transition

On November 6, 1860, Abraham Lincoln was elected the 16th President of the United States. The country was in a political crisis, with some Southern states threatening to secede. At that time, Presidents-elect were not sworn into office until early March of the year following their elections. During the four months between Lincoln's election and his inauguration on March 4, 1861, seven Southern states seceded, establishing the Confederacy. Lincoln's predecessor, James Buchanan, who may possibly have been the worst President ever, was entirely ineffectual in dealing with the dissolution of the Union. In the ensuing civil war, 600,000 Americans died.

Things are nowhere nearly as bad today. The Civil War turned the country from these United States of America to the United States of America, and so unified it has grown to be the most powerful nation on Earth. But we have a nasty financial crisis on our hands that shows every indication of getting worse. Today, the Dow Jones Industrial Average fell 5% and the more comprehensive S&P 500 index fell 6%, mostly on more bad economic news and lowered prospects of immediate assistance for the American auto companies. The Bush Administration has taken down its tents and packed up for its departure. The Treasury Department has suspended further application of its bailout powers under the $700 billion TARP (the now troubled Troubled Assets Relief Program), leaving some $60 billion uncommitted and another $350 billion untapped that can be spent only if Treasury requests it from Congress (and no request has been made). The Federal Reserve will continue to prop up the financial services industry, but its ability to support and stimulate the larger economy is virtually gone. While it may lower interest rates again, there's little reason to believe that such a step would do much good. The level of interest rates has little to do with the amount of lending these days.

Banks aren't lending because their continuing losses from mortgages, real estate, consumer credit and myriad other sources compel them to deleverage and hoard funds. The $250 billion from TARP that Treasury is investing in a number of banks will help to keep them afloat. But it won't have much impact on ordinary folks whose home equity lines of credit, credit card limits and other sources of credit are being cut back by the banks. Securitization of loans, the primary way banks have offloaded loans in recent years so that they could lend more, has virtually stopped. Vast numbers of investors were burned badly by the securitization of bad, dumb and fraudulent mortgage loans, and that way of doing business will never come back. Perhaps a new form of securitization will some day rise from the ashes. But, at least for now, the phoenix remains a mythological figure in the world of finance.

The stock market had risen yesterday, partly because of a perception that the market might be bottoming out and partly due to signs of potential progress on an auto company bailout. These hopes were dashed today; and there's nothing on the horizon to indicate near term improvement. The G-20 conference last weekend in Washington turned out to be a marshmellow roast where prominent leaders from around the globe sang "Kumbaya" in their native languages. It was a short seller's dream.

Two months--the time until Barack Obama is inaugurated--is an eternity in the financial markets. Two months ago, the stock market was mostly trading over 11,000. Since then, we've lost 3,000 points, or around 27%. Another 27% drop from today's price levels would produce a Dow of around 5840. That would make a lot of people unhappy. Could it happen? That's anyone's guess at this point. A couple of months ago, some market professionals were calling a market bottom around the mid-11,000s. They probably now have a heightened appreciation of the undesirability of egg on one's face.

If the Treasury Department had begun purchasing mortgage-related assets immediately after TARP was enacted on October 3, 2008, some of the banks selling those assets might have gotten higher prices than they could get today. Secretary Paulson's plan to buy such assets, and his recent decision to drop that idea, left the banks holding the bag. Mortgage-related assets have fallen in value since October 3, 2008 (as foreclosures have increased and real estate prices fallen). Selling banks will have to book larger losses now than they would have had they sold in early October. This illustrates the price of delay in today's hyperfast financial markets.

The unpleasant but unvarnished truth is that only swift and substantial government action can have any significant impact on the economic downturn. Two months delay means another two months during which layoffs increase, consumers pull back further, credit disappears, stock, real estate and other asset prices drop, bank losses build and confidence evaporates. Government policy and action for the economic crisis can't wait two months while George W. Bush ruefully packs boxes and entertains pardon petitions.

President-elect Obama should make the selection of his Treasury Secretary the top priority for the transition. Selection of the rest of the Cabinet can come later. Planning the Inaugural celebrations can come later. He must name a Treasury nominee now; every day could be costly in the stock markets. He and his nominee should immediately begin coordinating with Treasury Secretary Paulson, Fed Chairman Ben Bernanke and their staffs about what to do now (i.e., as in not in January). The Obama camp will have to call the shots. They'll have to make decisions with only incomplete information and not enough time to think things through. They'll have everyone in the world screaming at them for every mistake they make; and they'd better expect some of those along the way. The outgoing administration may have to swallow hard, avert their eyes and do some things they dislike for the sake of Old Glory. They may have to abandon their own policies and let the incoming administration have its way, because it will anyway. If there ever was a time to rise above partisan politics, now is that time.

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