Friday, January 25, 2008

Superleverage

The problems faced by the US economy were mostly caused by “easy credit”, so they will not be resolved be resolved by more “easy credit”.

Sub-prime borrowers have bought houses that they cannot afford with borrowed money. Borrowing more money is not the solution to their problem. The only solution for those who cannot hang on where they are would be to sell up and move to housing that they can afford.

Easy credit has allowed US consumers to spend a large on their credit cards. If they have bought SUVS and LCD TVs that they cannot afford, they really need to learn to live with in their means. Easy credit will only encourage more unwise behaviour.

Easy credit allowed Investment Banks to wrap up mortgages into collateralized debt obligations (CDOs) and sell them to investors all round the world. The problem with these CDOs is that borrowers are defaulting on the mortgages and no one knows who is carrying the risks. Easy credit will not solve this problem. The only solution is for the investment banks is to unwind some of the links and decide who owes what to whom and establish who will bear the loss. May the bankers who have earned million dollar bonuses will bear some of the pain.

Easy credit has allowed hedge funds and others to undertake leveraged buy outs (LBOs) of large listed companies. If some of them have paid too much, more easy credit. They will just have to take their losses on the chin and the price for being in what has been a profitable.

Easy credit has allowed bond insurers like Ambac and MBIA to provide credit insurance way beyond the value of their capital. Insurers should be able to make good decisions about the size of risk. If they have been getting risk wrong, easy credit will just reward their mistakes. Taking their losses might be better education.

Easy credit has allowed business to expand without increasing their equity. They have been able to get the benefits without paying the price, but reality is now catching up. More easy credit will not strengthen their balance sheets.

George Soros says that the “era of superleverage” is coming to and end. He is probably right. Easy credit has allowed households, businesses and bankers to be heavily leveraged, without understanding the risk, but this is not the way of blessing.

You will lend to many nations but will borrow from none. The LORD will make you the head, not the tail. If you pay attention to the commands of the LORD your God that I give you this day and carefully follow them, you will always be at the top, never at the bottom (Deut 28:12-13).
Providing easy credit is like providing “another drink” to an alcoholic. It does not help them to get off the wagon. Banker Ben is the disease of the US economy, not the cure.

Of course, "Will it work?" is the wrong question (positive economics). The really important question is, "Is it morally right? (the normative issue). I will answer that question tomorrow.

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