At the center of the global credit crisis is an endless debate about bailouts. Banks bailing borrowers out. Banks bailing each other out. Central banks bailing private banks out. Pro-bailers argue that the whole system is interdependent. Anti-bailers want excessive risk takers to suffer and flush the system clean. The debate rages with no solution … until now. Our painstaking research (translation: staring at Simpson’s re-runs to escape market-induced depression) has revealed that bailouts are the only way.
The credit markets have every disease known to mankind, and to flush one or two clean will only cause a flood of disease to destroy everything. Before we continue, please view this one minute exhibit for background on the reason why.
Just like Montgomery Burns, credit markets have Three Stooges Syndrome. Credit markets are in very, very poor health, and a stiff breeze can blow them over. Stock or bond indices can still put up record numbers on any given day, not appearing ill at all because the subprime MBS, credit default swaps, leveraged hedge funds, and global investment bank balance sheets are all jammed up trying to go through “the door” at once. All the market’s diseases in perfect equilibrium.
Credit markets showed signs of weakening in April 2007 when subprime lender New Century went under with minimal market waves, and no attempted bailout. But it wasn’t until two Bear Stearns hedge funds failed in June and then a UBS hedge fund failure led to the ousting of UBS CEO Peter Wuffli in July that the problem seemed larger. Yet the markets didn’t appear ill at all. The Dow crossed 14,000 for the first time on July 20.
Five days later, a Countrywide earnings forecast predicted doom. Then on August 1, 2007, American Home Mortgage, a top 10 US lender suddenly stopped funding loans and sank with no outside intervention. According to the Three Stooges Syndrome analogy, this is where other diseases were then free to squeeze through the door. Many smaller mortgage banks and brokers were also pulled through the door when American Home, who was both funding and purchasing their loans, stopped doing so. The whole mortgage market saw unprecedented funding and securitization disruptions.
By August 10, the U.S., European and Japanese central banks provided about $400 billion in liquidity. On August 18, the U.S. central bank slashed the Fed-to-bank Discount Rate and bank-to-bank Fed Funds Rates in an unscheduled meeting to further assist markets. On August 23, Bank of America invested $2 billion to ensure Countrywide wouldn’t collapse.
This is where the Three Stooges Syndrome analogy gets confusing, because the anti-bailout camp would argue this kind of central bank policy is “delaying a day of reckoning.” It’s very likely they’re right, but it’s the only solution. So if it makes the anti-bailers feel any better, they can just think of central bank Discount Windows, TAFs, and benchmark rates as additional diseases to jam up “the door” and ensure the Three Stooges Syndrome remains in perfect equilibrium.
If we fast forward through the rest of the timeline, it’s more of the same. More Discount Rate and Fed Funds Rate cuts. More government funds available. More bank takeovers. And in a move that may prove prescient later, Ben Bernanke even suggested that banks just forgive mortgage debt.
For those who are anti-bailout, remember that every borrower and firm and government is in this together. The Simpsons analogy is presented in jest, and whether you agree with it or not, one thing is certain: markets will always think exactly what Mr. Burns did when he found out about his own Three Stooges Syndrome … “Indestructible.” Sure markets have every disease known to mankind, but if things at least seem fine, it’s business as usual, and over the long-term … Indestructible.