The Educating of Hank Paulson - Too Big to Fail, but Time is on Your Side

Today Paulson switched from backing up banks to moving to the consumer lending institutions. For all the die-hard fiscal conservatives, this along with Nancy Pelosi again talking of a Detroit bailout was enough to force what must now be dry heaves. Yes we're finally getting a true experience in moral hazard - something that once was only seen in Economics classes, but is now a daily headline.

However, what should be a new class in Economics is how to deal with moral hazard. The creation of such is obviously impossible to avoid in reality given societies obvious propensities, but dealing with one is something where real education would benefit us all.

Lets say "Damn Detroit" - that is damn maybe a million jobs. Well, the problem with this statement is that we've learned that moral hazards only become a problem when everything else is falling to pieces. We've lost 1.2million jobs this year so far, how much would another 1 million help us rebound? Zilch. A better question is how big would the industry be if it could have shed union jobs at will in the past - the answer is a lot smaller and less dangerous.

Same deal here with troubled borrowers - "toss the bastards out of their homes" you might be tempted to yell. The problem here is that in so satisfying your sense of right and wrong in a feeling that is so old it has a direct latin origin - "caveat emptor" you would be exacerbating the very problem which got us here - that is the massive risk of default which created the lack of confidence in the financial market.

Finally - lets let the "wall st. banks fail" is just taking a pot shot at the people who were at most only complicit with other parties listed but not limited to the above. Unfortunately, these banks are so intertwined in the economy that a term often lamented in Detroit could be analogized to it - UNIONS. Thats right - the banks "securitizing" and "spreading" their risk around really was the equivalent of bringing other banks in on their cause, whatever it might be, which is now pure survival. Now they stand together to gain bigger bargaining power than they would get on their own when trouble arose. In reality, we can't afford to bust up this union and let them all fail, so we're propping them up and giving in to their demands.

So now what? What do we do? The answer is - you prop them up in the near term while imposing staggered later dated terms of the bailout that will force failure or payback, but the key is staggered. the reason for this is - when everyone falls together, they stick together in their failure. The news is so bad that it wrecks wealth indiscriminately. However, if you met out the potential failure in the future over months and years, it can be interspersed with successes and is less likely to become systemic at one time and failure of the lone weak member of the herd is not only expected it is condoned.

So, to summarize - provide a near term assurance, but stagger the due dates for payback or insolvency. This will re-diversify the risk over time which will allow us to deal with problems over time instead of the perfect storm in which we're currently watching.

I don't want to impute to much to Hank Paulson, but his shift to the consumer lenders is perhaps an unconcious recognition of this behavior - we need to shore up the lending to people en masse by making consumer lenders feel more confortable to lend so that the last bastion of liquidity isn't sucked out of the economy at the consumer level right as they might actually need a little to pull them through the downturn.

So, to draw back to my thesis - keep the lending lines at the consumer level open so they don't pull back too heavily en-masse and group their woes together as described above. If they do - thats called a depression - it kills small ticket items just as equally as big tickets. With a negative savings rate - consumer credit has been the base level of liquidity, so if we let this die its game over. However, if we bolster this industry - make it feel like the government is cuatiously backing them, then this industry which has the most far reaching footprint will hopefully keep the paddles charged.

We'll see. I think Hank is finally thinking a couple moves ahead of the headlines....get to work man.