John Allison, CEO of BB&T Corp., sent his own letter to Congress on Tuesday. Here is the letter itself, here is a story about it. It's a nice bullet-pointed take on the current situation. I think the most important gist to be take from it is that this is a Wall Street problem, not a Main Street problem-- that is, it's large national banks that are in trouble. The smaller, more responsibly managed ones are doing just fine. BB&T, it should be noted, posted a $428 million profit in the second quarter.
BB&T is the nation's 14th largest financial institution. For the initiated, BB&T refuses to make commercial loans to companies seizing private land via eminent domain, which makes them heroes in my book.
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Allison was also an excellent guest on EconTalk:
http://www.econtalk.org/archives/2007/05/allison_on_stra.html
Let's talk about CDS contracts for a moment. CDSs, or Credit Default Swaps, are essentially insurance contracts on bonds. If a bond defaults, and you bought a CDS on that bond, you would be made whole. Like insurance contracts, CDS prices are quoted in terms of their premiums, which are stated as a percentage of the total amount insured.
To insure a McDonald's bond, for instance, costs 28 basis points (i.e., 0.28% of the face value of the bond). Strangely, you can also buy CDS contracts on the ultimate risk-free asset: Treasury Bonds. Historically, Treasury CDSs have traded around 1 to 2 basis points. They closed Thursday at 25 basis points. Market participants believe that the US is only slightly less likely to default on its debt than McDonalds.
I would tend to think defaults by the U.S. Treasury would affect Main Street.
I agree. I think that this whole situation is being looked at as some isolated market, but it is not. The problem may start on Wall Street, but the effects it may have could hit Main Street. Normally, I would say let the markets fix the problem, but the spillover effects are such that even those who did not make "bad" choices (i.e. the "good" risks) could be affected.
Why did this happen? Is more regulation needed? I don't think so. I think these new financial instruments were not understood by the market yet and therefore, many parties made big mistakes. Over time, participants will learn how to use these financial instruments, but in the meantime the downside effects must be dampened. Will there be long-term moral hazard issues? Yes, but those are now already there and need to be dealt with later.
One of the main reasons the Great Depression was so great was the lack of liquidity provided by the Fed. Instead of loosening monetary policy and getting off of the gold standard, we stayed on (for 3 or 4 more years) and I believe monetary policy was tightened. Now, the Fed has to make sure that the market does not choke for lack of liquidity. If it does provide liquidity, the market will then cure itself and then we can deal with moral hazard problems.
"Market participants believe that the US is only slightly less likely to default on its debt than McDonalds." ~Thomas
That's an awesome observation that I find very concerning. This seems like it would be a function of the U.S. government taking on so much (possibly) bad debt with social security and medicare/medicaid insolvency on the horizon. Agree or am I off?
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