Financial Crisis Reality Check

Let’s all take a deep breath, shall we? Let’s look out the window and remind ourselves that the sky, in fact, is not falling--though you’d think it was if you’ve been following the hyperventilation competition going on in Washington. Financial crisis! Halt the political campaigns! Cancel the debates! Another Great Depression is coming!

I’m sorry, but I don’t buy it. Yes, America is in the middle of a financial crisis that is causing the banking system to seize up. But if you take a closer look at why the financial system is in so much trouble, you realize that all this Great Depression talk is way overblown.

To better understand what’s going on, let’s dive head first into some economic nitty-gritty.

The root of the financial crisis is that banks aren’t lending out enough money. Without enough lending in the system greasing the wheels of capitalism, the whole economy comes to a grinding halt and eventually goes into the tank. Banks aren’t lending out enough money because the amount of bank capital on their books has shrunk considerably of late, and the amount of bank capital governs how much money they can lend. Capital has shrunk because the hundreds of billions of dollars of mortgage-backed bonds owned by the banks are worth much less than what the banks paid for them. Basically, these mortgage-backed bonds were bad investments, thereby making the banks “poorer.” But even poor banks can write-down the cost of their bad assets, recapitalize by raising money from new investors, and start over. This write-down process makes the original investors (stockholders) in those banks lose money, but it does not bring the system to a halt because the banks go right back to their good old lending ways once they recapitalize. The problem that we face today is that banks are unable to recapitalize themselves because no one is willing to pony up the dough necessary for the banks to hit the “restart” button. The reason for this is that no one knows, with any degree of certainty, how to value the “toxic waste” mortgage-backed securities that are responsible for shrinking the banks’ reserves because of the complexity of the securities. If the value of these assets turns out to be much lower than what the banks currently estimate the price to be, then the banks will end up being an endless black hole of successive write-downs, and thus a terrible investment for someone thinking of buying in to the restart process. The sovereign wealth funds that invested in Merrill and Citigroup many months ago learned this lesson the hard way.

The bottom line is that it’s the uncertainty that is the killer. Some banks are broke, yes. They simply have too much toxic waste on their books. But most banks will live to lend another day, so long as they can recapitalize their shrunken capital base. The $700 billion “bailout” bill making its speedy way through Congress this week will help clear away some of the fog so these assets can be priced and the recapitalization process can begin.

I don’t mean to suggest that the economy is in good shape. But I do feel pretty confident in saying that there won’t be another Great Depression. So let’s all take a deep breath…and get on with the debates! Enough with the panicking, already.

P.S. It now appears that the bill making its way through Congress has lost its momentum. If the bill ends up not going through, things really could get ugly. But I think a plan will go through...eventually. And the system will start to function again.

P.P.S. Click here to read a letter to the editor about the financial crisis written by David Richards (my father) published in the Financial Times a few days ago.