Bad Debt Still Threatens Economy

Image: Kagan McLeod

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No sooner had the credit crisis been declared the “worst since the Great Depression” than, pffft, it was winding down. Epic poems will be written about the terrible weekend in March when Bear Stearns sort of almost nearly went under but then was actually just sold to another bank. You’ll regale your kids with the story of where you were when that hedge fund in London had to close down.

What a relief it’s over. The financial sector has raised tens of billions of dollars in new money—some of it literally overnight. A.I.G., Bank of America, Citigroup, Lehman, Merrill, UBS, and dozens of others have held out their hands and been rewarded with cash. That money-raising has been offered up as evidence that the economic tide has turned. It seems almost unnecessary to go through a recession, though it promises to be short and shallow if it happens at all, Wall Street economists assure us.

Somehow it all seems too easy. Something nags. Why did Federal Reserve chairman Ben Bernanke strongly urge banks in mid-May to continue raising capital, arguing that it would help the economy, if everything was okay? The rampant optimism, which has bolstered financial stocks, makes little sense. We are in deep denial. This loose-lending house party won’t end with just a vase smashed and a scratch on the dining-room table.

Think the investors who are pouring money into financial institutions know something special? They don’t. Since the banks and insurers don’t really know the value of their own books, neither do outside investors. These financial institutions are sitting on huge piles of assets for which there is no market. There is still no good outside gauge of prices for many of these holdings, so banks must rely on internal calculations of value. Sure, accountants vet these assessments. But one doesn’t have to be a cynic to think that they’re guesses. Clearly, these investors aren’t acting on carefully calibrated, unique insights. They’re guessing, hoping, and praying. Some will be right; some will be wrong. I don’t know, you don’t know, and they don’t know.

These hearty rounds of capital bingeing shouldn’t make investors happy. Because of them, the banks’ per-share profit will be spread more thinly. That the banks mostly opted to raise money by selling more stock rather than by selling off assets suggests that nobody wants their dodgy loans and mortgage-backed securities.

Everyone who invests in these banking companies knows this. We like to think that professional investors do prodigious amounts of due diligence before they make their moves. In reality, their research largely boils down to a set of simple assumptions: that the economy will recover sooner rather than later, that the brands of the banks are strong, that the price is right, and that regulators won’t let financial institutions fail.

They’re buying because they see an opportunity. They’re buying because their buddies are. And they’re buying because people have the money. Many banks first turned to sovereign wealth funds, the equivalent of the rube tourists who think they can win a game of three-card monte in Times Square. Citigroup hit up the Abu Dhabi Investment Authority. The government of Singapore invested in UBS. Kuwait and Korea sent billions to Merrill Lynch. Since then, the situation has deteriorated in spite of the insistence by the new management at all three banks that things are turning around.

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