It is an axiom of Austrian economic theory that the quickest road to recovery is to liquidate malinvestments as soon as possible. That is, sell off or bankrupt those failed projects invested in on the way up the boom phase of the business cycle. Those projects which seemed profitable at the time turned out to be a mirage created by the Fed’s expansion of fiat money and fiat credit. As the money steroids wore off, the mirage faded, and their lack of economic reality was revealed for all to see.
Such liquidation is never pretty but it is inevitable and, as an economic reality, cannot be avoided. If companies and governments try to avoid it, the recovery is delayed, often for years. Japan is the classic example of this during the 1990s and even still during the first ten years of the 21st Century. Japan’s growth stagnated for almost 20 years, mostly because of the lack of liquidation of malinvestments. The same thing is happening in the U.S.
Our government has done everything it could to forestall the liquidation of malinvestments. Initially their goal was to prop up failing banks, especially the Too Big To Fail banks, through the now infamous TARP program. In addition to TARP, the Fed’s money window was opened wide for the many banks who were in trouble. Also, mark-t0-market rules requiring banks to mark down assets to market value, thus obligating them to come up with more capital or, if not, to fail, were suspended. This led to the buzz words, “mark-to-make believe,” “extend and pretend”, “stay and pray,” all of which referred to the fact that banks were allowed to stay in business rather than liquidate nonperforming loans or raise capital.
And there was more. The bailouts of Fannie and Freddie kept alive failed institutions with billions of dollars of guaranteed home loans. Programs such as HARP, HAFA, HAMP and other failed policies seemed to work against each other and further delayed the necessary liquidation of bad assets.
Of course, all this backfired and the result was a credit freeze, or what Keynesians call the “liquidity trap,” where credit is difficult to obtain as banks would rather protect their capital and reserves rather than lend it out.
There is a basic question which needs to be answered by those in favor of the bailout policies, and that is: Is it crueler to workers to be unemployed and on welfare for years as the economy fails to recover, or quickly liquidate malinvestments, take all the bad results of the boom up front, and then provide the way to a sooner recovery and more employment? I would opt for the latter.
One would like to be able to point to some empirical evidence to support a theory. Austrians develop their theories through logical deductive analysis rather than empirical inductive analysis. I don’t want to get too far afield here, but this is an old argument going way back to the mid-19th Century (“Methodenstreit“) about the best way to know things economic. But, let’s just say that Austrians figure out their theories first through rigorous logical analysis. Everyone else looks to data to come to conclusions and then develop a theory—in practice this is a fallacy because you’ve got to have some idea (theory) before you start looking for things in the data. Whatever.
A recent article in American Banker brought out the correctness of the Austrian theory of malinvestment liquidation with absolute, unambiguous clarity. It is almost a case study in Austrian economic theory. The title of the article is, “Investors Embracing Banks That Complete Bulk Loan Sales.”
Some banks might be skittish about selling nonperforming assets in bulk, but the market clearly likes it when banks shed problems en masse.
In banking, the sale of nonperforming assets is much like debating religion. Some bankers’ ideology calls for long workouts to maximize a recovery and to squeeze as much as possible from borrowers.
Others may consider bulk sales, but are unable to hold such a fire sale because of thin capital. Then there are some bankers who are exhausted after four years of elevated problems, have a cushion and just want a reprieve.
Investors may hold some sway over the decision-making process. “Sellers of problem assets are outperforming, and they are outperforming by a lot,” says Jacob Eisen, a managing director at Clark Street Capital, which has been delivering that message to gun shy bankers.
The bottom line is that banks which got rid of assets quicker through bulk sales of bad loans are outperforming banks which did not do so. The reason: ”Sometimes it is not the best economic deal, but it moves you beyond the problems. These bankers are tired of discussing the same problem loans.”
But here is the key to recovery, according to Jack Choi, Wilshire Bancorp’s chief credit officer:
Beyond the emotional change, Choi says the sales allowed the company to redeploy the money that was locked up and not earning anything. Wilshire can improve net interest income by finding new loans or replacing more expensive funding.
Yes, it hurt, but Wilshire was able to reduce its nonperforming assets down to $69 million or 2.84% of total assets (they are a $3 billion company) and rebuild its loan book in profitable ventures.
This is the story of our banking system. As I have written about many times before, it isn’t the large banks that are having the most problems with bad loans (except maybe Citigroup), it is the local and regional banks who are the lenders to most of the SMEs (small to medium business enterprises), and who had the biggest hits to their balance sheets. Note that SMEs employ about one-half of the workforce, and a restoration of credit to them is a huge step toward recovery.
This is a complex issue, but as banks clean up their balance sheets, and as private individuals and SME resolve their debt issues, the economy will recover. This article proves that had banks done what Wilshire had done early on in the recession, we would be much farther along the road to recovery.