AI to Paulson: A Jedi Must Have the Deepest Commitment

Hank… Hank… you’ve got to be kidding me. Its clear to you that buying illiquid mortgages “is not the most effective” way to use the TARP. Seriously. Can some one please let Secretary Paulson know that mortgages are, in fact, the crux of the problem. Why do we have a problem with banks lending to each other? Because no one trusts anyone else’s balance sheet. Because the mark-to-market price of mortgage assets just keeps falling.

Let’s talk about the reality here. This doesn’t represent a shift in strategy by Paulson. Banks have forced his hand.

There was whispers for a week or two that banks didn’t want to participate in the TARP asset purchases. As individuals, they can’t see the incentive. Its a classic free-rider problem. All banks would benefit if all banks participated, but each bank looking at its own situation individually isn’t incented. Or more accurately, it isn’t clear whether a bank would benefit individually or not, and given all the strings attached to participation in the TARP, banks are passing.

So where does this leave us? Worse. Undoubtedly worse.

We’ll still get through this, but now you have to figure that home prices will bottom well in advance of the general economy. Why? Consider a possible progression:

1) Home prices bottom. Put whatever time frame on this that you’d like. I actually think it could happen sooner than many expect, but I digress.

2) Home lending is relatively robust for borrowers with good credit (It must be, or home prices wouldn’t have bottomed!), but this is solely because the GSEs are there to securitize these loans. If the government is actively supporting the ABS markets, then credit card, auto and student lending markets will be performing OK as well.

3) But actual bank capital will remain challenged. By the time home prices bottom, banks will have taken more losses on foreclosures and commercial loans. And beyond the TARP, most banks will not have been able to raise significant outside equity capital.

4) So commercial lending will become very rare indeed until such time as banks have rebuilt their capital base. Therefore new business formation, acquisitions, capital projects, all will become difficult if not impossible.

What kind of economy does that leave us with? A long recession that’s what. Recessions are caused by misallocated economic resources. Some businesses need to downsize or be eliminated, and those resources need to be allocated elsewhere. The recession is the pain that occurs in between.

But resource reallocation takes capital. And if banks won’t lend, its going to take a long time indeed for that reallocation to occur.

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