Ruthless Default

Now let us praise Ruthless Defaults.

In the lexicon of financial institutions that extend consumer credit, a 'ruthless default' is a decision of a consumer borrower to discontinue servicing his or her debt obligations even though current cash flow (or unused borrowing capacity) would allow that borrower to do so. Rather than being recognized as a prudent financial decision in some circumstances, it is subject to mockery and denigration on a blanket basis. The mockery tends to focus on the past bad financial decisions the borrower made to get into the current financial bind (such as overpaying for a house or incurring uninsured medical expenses). The denigration tends to focus on the sanctity of contract, which is an escalation in to the moral sphere of earlier warnings about damaging one's credit rating.

Leaving the mockery and denigration aside, as I understand the concept, a ruthless default occurs when a person assesses their current financial situation and makes a 'zero based' decision on how to go forward. The priority given to staying current on the mortgage, the credit card debt and car payment, versus buying groceries, continuing the 401(k) contribution and keeping the utilities turned on, is matter of personal decision. The borrower disregards how he or she came to be in the present situation, and prioritizes and makes decisions on the basis of what makes the most sense going forward.

To the chagrin of commercial lenders, consumers stupid enough to have succumb to all sorts of insane credit blandishments in a prior incarnation, are turning out to be intelligent enough to realize that it's more important to keep the lights turned on than to protect the vanished equity in a house that they will eventually lose to a short sale or a foreclosure. And retirement plan balances frequently have greater protection in a personal bankruptcy than the personal goods bought on credit.

So, call it ruthless, call it self-interested, default is apparently beginning to occur with sufficient frequency that it's gotten the attention of industry and of the main stream media. It's not clear whether it will become so widespread as to impact general public attitudes towards indebtedness, but is becoming clear that earlier industry and rating agncy assumptions about the behavior of consumers in financial distress are no longer operative.

There should be no surprise in this. People are going to put protecting themselves before protecting the people who have lent them money. What is a little surprising is the reasonable conclusions people are reaching about how best to protect themselves. At a minimum, people have lost faith in the proposition that house prices only go up, and that your house is the best investment you'll ever make. Beyond that, I'm getting the sense that the weird belief that a good credit rating, or credit score, was some kind of financial 'asset' is beginning to fray, though I'm not ready to announce a return to a 'pay as you go' mentality.

One interesting thing about ruthless default is that it is an alternative to entering the chute of credit counselling, debt repayment plans or personal bankruptcy. In each of those officially sanctioned alternatives, the debtor relinquishes autonomy over his or her personal finances in exchange for some form of forbearance and accomodation. By contrast, ruthless default is a zen move. The debtor simply does nothing (more precisely, stops making paymens) and leaves the response up to the creditor.

The mortgage servicer can initiate foreclosure, foreclose and pursue any deficiency. The credit cards can be cancelled. The car can be repossessed. Foreclosure takes months. The cancelled credit card issuer is still stuck as a general unsecured debtor for a bad loan. Only the repo man gets his collateral back promptly and in immediately saleable condition. But in everyone of these situations, the transaction costs and the administrative effort associated with pursing the remedy was simply not factored into the original extension of credit. And the machinery to accomplish the remedy is not in place, at least systemically at the levels of activity required to respond to widespread ruthless default.

Or perhaps I should say 'rational default'?

Animal Spirits

Not yet dead. And that carries with it an immediate and an intermediate implication.

Short term--we'll have a period of incomprehensible but irritating giddiness in the financial markets which will significantly grate on both the general public and the political classes. Ballooning bank profits will highlight the different fates of Main Street and Wall Street while rising unemployment and credit card defaults plague the middle and working classes. But, bankers will get highly publicized base salary increases, equity markets will remain bouyant (despite anemic corporate profits), and the public's suffering and misery will remain oddly invisible.

Intermediate--the adjustment to the 'new normal' will be sour and seriously constrain the ability of policymakers and the regulatory apparatus to respond to the next systemic crisis. The refusal of animal spirits to die will undermine any meaningful reform initiatives, which in turn will absolve the political classes of any meaningful commitment to defend or sustain the institutions that survive the current financial crisis. Efforts by those institutions at some point down the line to call of public resources to save their private bacon will not exactly be rebuffed, but will result in an outcome currently unforeseen by anyone and that will be the product of a gesalt that has yet to develop a recognisable identity.

A year ago, under the leadership of President Bush and Secretary Paulson, the financial services sector was politicized. The implicit government guarantee of the leverage of the 19 TARP institutions forever changed the character of those institutions and made them quasi public entities. They continue to be run for private purposes, but that situation cannot last forever.

And won't.

Lehman, Redux

The looming failure of CIT offers the real possibility of a repeat of the Lehman Brothers shock.

The reasons that Lehman Brothers was permitted to fail in a disorderly fashion aren't worth visiting in any detail, mostly because of the storm of post-hoc CYA bullshit that cascades forth from otherwise decent people at the first inquiry into those reasons. Suffice to say that no one adequately appreciated the consequences of the Lehman bankruptcy, and everyone immediately (okay, it took the House two tries) sprang into action when those consequences were understood.

Does the CIT failure have the same potential for systemic risk that Lehman did.

The answer is simple. No, if you are concerned only with the stability of the financial services sector. Within the financial services sector, Lehman was more systemically important.

Unfortunately, if you are concerned with the general economy and not the casino, the answer is also simple. The answer is, Yes. CIT is systemically more important to the flow of credit in the general economy than was Lehman, which was, after all, merely a capital markets player.

CIT provides financing to businesses that operate in the general economy. You can call that financing liquidity, working capital, floor planning, receivables factoring, whatever. It makes no difference how you describe it, the financing provided by CIT and its competitors is critical to the continued operation of a huge swath of the economy.

It is easy from a certain perspective to dismiss this swath as a bunch of Dunkin' Donut franchises. After all, we could all do with a few less donuts, right?

It is more accurate to describe this swath as the Main Street mom-and-pop merchants who have survived the onslaught on the Walmarts and Targets and Costcos. The businesses who are CIT's customers are hardware stores, furniture outlets, franchised tire dealerships, music stores, boat dealerships, etc. Anybody who has to finance inventory or receivables.

And times are tough for these businesses. The consumer has retrenched. Not so many big ticket consumer durables are being bought (the auto industry may be the poster child for this observation, but it extends to clarinets and baby furniture, too). Many, many of these businesses are operating on the forebearance of their lenders, they aren't making the inventory turns the floor planning arrangements contemplate, the receivables are a little hairy. Some of them have waiver letters, others are simply letting it ride. And lenders, like landlords, are working with their good tenant/borrowers.

Only a mandarin safely entrenched from the realities of the marketplace and the credit markets would blithely assume that following the failure of CIT, companies like GE Credit, Litton and Wells Fargo will step into the void and meet the credit needs of former CIT borrowers. Two reasons they won't. First, they are too busy rebuilding their own balance sheets to do much more than give lip service to meeting the broader social needs that provide the only conceivable justification for the special privileges the government has accorded them. Second, the reason CIT is teetering is that its customers are teetering. Those customers aren't very attractive credits. As new business, they are non-starters.

So, this is likely to be a learning experience. While Vikram Pandit wanders across the landscape proclaiming that the future of Citi lies in global adventures, the credit needs of Main Street will be unmet. Small and medium size businesses will fail at an accelerated rate. Unemployment will rise, the economic 'recovery' will stall. In some ways it will be like last Fall's commercial paper adventure, except that the administrative challenge of providing credit to thousands of small to medium sized business will probably prove insurmountable.

Clearly, the economy will not tank on the failure of CIT. From a cool and dispassionate perspective, it almost seems like an experiment worth running. But that perspective may be hard to maintain if bankrupt small businessmen start dousing themselves in gasoline and setting themselves on fire on the Washington Mall.

Get Ready for the Kooky Ideas

Because here they come. A veritable flood. Certain to be dismissed initially. But some, like Sarah Palin, will gain traction.

Right now we (the collective 'we') have framed up our economic, political and social issues with a shared set of assumptions that are themselves becoming a casualty of the current unpleasantness. A mainstream articulation of that framework can be found in the Larry Summers interview in today's Financial Times. From one flank a more offbeat expression is offered by Nouriel Roubini on a very regular basis. On Summer's other flank, (if any still survive) can be found the pollyannish house economists of various organs and organizations promoting real estate purchases and equity investment (current faves, 'this is a stock picker's market', and 'buy and hold is a dead strategy'). Up above, from the academic highground, Krugman lobs his contributions down on us (to his credit, asking rhetorically last week who defines this framework and why there are 'unpersons').

But, the framework exists. And it exists for good reason. Nobody wants to have to listen to the kooks who think there is a pill that can turn water into gasoline, or who believe they've invented a perpetual motion machine (the call for economic salvation through a War on Global Warming comes close to these, IMHO, but it enjoys bizarre credibility that I personally chalk to the need even in a secular society for public demonstrations of faith).

I think the framework may be about to shred, in part because it's losing its objective utility, and in part because the participants are losing their faith in it. On the one hand, it may be possible to salvage the intellectual fabric and construct a workable, if makeshift set of policy responses using the salvage. On the other, it may be time to put the 'political' back into 'political economics'. And if that's the case, the current lineup and the current teams need to be recast.

"Paging Dr. Reich? This is central casting. Governor Palin would like to meet with you. We know you've heard of her, and are probably skeptical, but she's an empty headed vessel just waiting to be filled. You be da guy."

Personally, I've immunized myself (more or less) to all this by spending the last few months reading the Cantos of Ezra Pound. Pound was a guy who gave kooky economic theories the full monty. (Other kooky theories, as well--notably, anti-semiticism). He fell for a guy named Clifford Douglas, who was sort of an unhousebroken Hyman Minsky. Yes, folks, when it's broke it gets a great deal more baroque that H.M.

And EP ended up under indictment for the capital crime of treason, finally going over the edge sitting in a prison cell near that of a fellow named Till (who was one day led from his cell and hanged for 'murder with all the trimmings'). That Till was the father of the Emmet Till who was murdered in a racist incident in the mid-50s that contributed mightily to the emergence of the Civil Rights movement (and whose coffin is currently playing a bit part in a rather lurid bit of graveyard crime in Chicago).

You can immunize yourself however you want to. Just don't go deaf to reason listening to the siren songs of Bristol Bay.

Financial Reform A.D. 600

"Bankers shall not file coins,
nor make false ones
Nor put a slave . . . in charge of their business
. . . .
if they do not notify counterfeits that come in
and from whom
shall be flogged, shaved and exiled
And in this there can have been few innovations"

Pound, The Cantos of Ezra Pound, Canto XCVII (p. 687, New Directions Edition)

That being a rough translation (per Pound) of the Code of Justinian, coming after the rules for the notaries, goldsmiths and bakers and such.

It does tend to put the current rather modest proposals for financial reform in perspective. And the suggestion that there need be few innovations resonates of the observation that the only indisputably beneficial financial innovation of the last generation has been the ATM. But do not despair, ye serfs of finance, at least Justinian's Code did not proscribe branding, blinding or cropping (as in amputating the offending hand) for your transgressions.

The Forty Percent Problem

In 2007, approximately 40% of the earnings of the S&P 500 were attributable to the financial services sector. It is difficult at this point to estimate with any assurance the extent to which those financial services sector earnings were inflated by fraud, aggressive accounting practices, overleverage and a cyclical spike in levels of transactional activity, but all of those factors contributed. And it's difficult to say the extent to which appropriate regulatory reform and consumer protections initiatives will undermine the core earnings power of the predatory franchises on which so much hope for sector recovery in pinned.



If you remove that 40% of the earnings from the price earnings ratio of the S&P 500, and you look at the 40% decline in the price level of the S&P 500 since 2007, one nicely offsets the other. That is food for thought.



There are other factors at work, of course. Earnings in 2007 outside the financial services sector were at a cylical high, and can be expected to deteriorate sharply in a recession (just as recovery from recession-depressed levels to some idealized norm can be expected). No one really knows what the price/earnings ratio of a stock, much less of a market index 'should' be--though much ink has been spilled on the subject.



It's sufficient to say that the market has discounted the collapse of the financial services sector, though the sequence of events through which that occurs has yet to unfold. And the ramifications of that haven't yet been fully felt--nor, perhaps, fully discounted by Mr. Market.



My own guess is that unemployment will continue to rise, the magnitude of commercial real estate problems will be revealed with ghastly consequences for any number of traditional bank lenders, house prices will, in the aggregate, continue to decline until residential real estate has roughly half the value prevailing at the peak in 2006 or so, credit card delinquencies will rise, and so on. And an already crippled financial services sector will founder. Someone along the way, it will lose its place at the table.



It will be interesting to see what the new world looks like. I suspect that the transition issues and difficult adjustments of the formerly middle class, the elderly, upside down homeowners, the structurally unemployed, etc., will dominate the discussion, and strategies for restoring the global edge of the American financial services sector, if any, will have a distinctly archaic ring. My gut feeling is that the developed world is in for a prolonged period of painful adjustment, and deteriorating public sentiment will be fueled by reports of relatively progress in those parts of the developing world that have sufficiently large domestic demand that their economic growth in not dependent on the American consumer. I'm not predicting blood in the streets, or even bread riots. Just an opaque and heavy economically glum environment that sours the social mood, and contrasts with the innocent happiness of the furriner on holiday, using the cheap dollar to rub it in.

Not Quite Ready for Prime Time

Let's get real. There seems to be a great deal of dissatisfaction with and disappointment in the Obama Administration's approach to the reforming the financial services sector and and outlawing the current (admittedly toxic) executive compensation practices. I think the disappointed are confusing cognitive recognition of a problem and identification of potential solutions with the actual process of change.

So why isn't meaningful reform in the cards for the next year or two?

Team Obama did not exactly enter the 2008 presidential race focused on the economy or the financial services sector in particular. As I recall, the global hot button was the Middle East (a/k/a Islamic terrorism, the wars in Iraq and Afghanistan) and the domestic hot button was reforming the health care delivery arrangements. Not much bandwidth was devoted, until around Labor Day, to the general economy, much less Wall Street (except when it came to fundraising).

So, if the first reason expectations should be low at this point in time is simply that financial reform wasn't on the agenda, the second has to do with that second little fact--the fund raising business. The financial services sector has bought and paid for the government and its regulators for at least a generation. It is easy to get angry about this, but it is also pointless to do so. Big campaign contributions and the machinery of retained lobbyists buy access and mindspace, and influence policy and regulation. But there is a limit to their impact. The Marc Rich pardon notwithstanding, it is very difficult to actually buy an outcome. When the result is controversial and the groups opposing it have made their campaign contributions and hired their own lobbyists, the impact of it all is, if not neutralized, at least offset (and can lead to truly bizarre outcomes and terrible policies with unbelievable real world outcomes--viz., the attempted privatization of military services by the like of Blackwater).

Right now, sitting here today, the financial services sector retains its seat at the table and is still regarded as a participant in the process, a patient whose informed consent is required for the procedure. Soon, enough, unless there are magic reversals in the unemployment rate and the direction of commercial and residential real estate prices, the financial services sector will come to be regarded as a corpse to be harvested for useful organs and dissected for the enlightenment of future generations of medical students. Not yet.

Then there is the issue of executive compensation. Given the extent to which Summers, Emmanuel and Geithner's wife have all suckled at the Wall Street teat over the last decade, I think it is impossible for those guys to approach the issue without trepidation. What made Larry Summers worth over five million dollars to Wall Street or Rahm Emmanuel worth over fifteen million? Politicians are not notoriously introspective, but it would be hard not to question yourself under the circumstances, and that is disregarding entirely the public embarassment and political advantage to one's adversaries of the situation, and without even reaching the ethical implications of either betraying a constituency you have allowed to buy you or failing to act in the public interest while in public service.

There are three reasons not to have high expectations. They are all grounded in the realpolitik of expediency. In the short term they are insurmountable. In the intermediate to longer term, they fall away, depending on the course of future developments. But for the time being, expect experimenting with the cosmetics and some serious rearranging of the deck chairs. And don't get mad or excited about it. Just wait patiently.