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The Macro is in the Micro Reviving the Global Economy through Micro-economies By Ms. Marilyn DeVries and Dr. Gurram Gopal March, 2009 Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry. Lord Polonius, in Shakespeare’s Hamlet. The State of the Economy The Commerce Department reported on February 27th that GDP declined by 6.2% in the fourth quarter of 2008. Personal Consumption Expenditures (PCE) declined by 4.3%, after falling 3.8% in the previous quarter. The PCE ‘spending component for durable goods’ declined by 22.1%, after falling 14.8% in the previous quarter. These statistics, while not completely reliable, reveal the pain in the economy at least directionally. Starting in fall of 2007, the Bernanke Fed undertook extraordinary measures to fight the credit crisis. Some of the actions the Fed has taken to date [extracted and quoted from the Fed.gov site] include: Federal Reserve Board’s War against the Crisis 1. Cut interest rates from 5 ¼% in August 2007 to “0 to ¼%” in December 2008- the fastest ramp-down in recent history. 2. Lowered the spread between the discount rate and the federal funds’ rate from 100 basis points to 25 basis points. 3. Increased the term of discount window loans from overnight to 90 days. 4. Created the Term Auction Facility, which auctions credit to depository institutions for terms up to three months. 5. Put into place the Term Securities Lending Facility, which allows primary dealers to borrow Treasury securities from the Fed against less-liquid collateral. (Comment: Banks can now use other things besides cash to secure their own bank loans when in the past…cash in the vault was the only thing that counted.) 6. Created the Primary Dealer Credit Facility. (Comment: Investment banks are considered a ‘non-banking institution’. This is the first time the Fed is directly lending to Investment Banks whose security acts as collateral in this ‘repurchase agreement’ loan.) 7. Introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds. (Comment: The Fed is trying to stem the exodus from MMF by injecting liquidity to cover demands ‘rollover Federal Reserve Board’s War against the Crisis risk’ and hold the line of asset selling by banks to cover cash reserve requirements. In addition the three month time frame on the paper slows turnover period to some degree adding stability as well.) 8. Along with the Treasury, created a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. (Comment: The value of automobiles has dropped significantly, credit card loans are experiencing severe rates of default and the homes used as collateral behind the SBA loans have lost significant value. The AAA rating itself is in question.) 9. Created an asset-backed securities program, that will provide three- year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans. (Comment: With this action, the Treasury takes the risk to alleviate the banks’ balance sheets. Problem: The new loans are not happening in the numbers needed. The banks refuse to lend therefore a critical part to the logic is stymied, at least for now.) 10. Is purchasing longer-term securities including recently announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. (Government purchase of ‘Toxic Assets’ to open up lending particularly in the housing sector.) These initiatives have resulted in a notable expansion of the Federal Reserve's balance sheet. Total Fed Assets has increased from around 880 billion to more than 2.2 trillion in Jan. 2009 (currently $1.90 trillion). Despite these herculean efforts by the Fed and the Treasury to lubricate the lending function and to calm economic fears, credit markets are still clogged with credit is still tight and difficult to obtain. What does the post-mortem reveal? The cause of America’s financial instability has been pinned on derivatives involving sub-prime mortgages, a fancy package of loans stamped and sold as “solid collateral” many times over. This “solid” form of collateral consisted partly of sound mortgages but was increasingly weighed down with high-risk sub-prime loans. These ‘portfolios’ were leveraged massively at each stage of re-packaging and re-sale within the investment community producing what is now referred to as toxic assets. Rating agencies such as Moody’s and Standard’s & Poor bestowed triple-A ratings in lock-step with the wishes of the mortgage banking and investment groups. As Bernanke and Greenspan dodge any blame, they implicitly acknowledge that regulations and oversight was almost non- existent, especially since the protective banking legislations (put in place after the Great Depression) had already been systematically stripped away. There-in lay the recipe for disaster: Over-valued assets, white-envelope ratings and the government looking the other way. The growth in finance as a business should have been the first red flag. During the middle of the decade, more than 50% of the total earnings of the S&P 500 came from the finance industry. Money could be made, and a lot was at every conceivable turn. Like a pyramid plan, the people at the top would reap the most. The bottom of the pyramid, the masses, would ultimately be left holding the bag. The stock market plummeted as the lower levels of the pyramid failed to find money to feed the top end. It is not surprising that the stock market has fallen more than 50% from its all-time high in 2007. S&P 500, 1996-present 1600 1400 1200 1000 800 600 400 96 98 00 02 04 06 08 19 19 20 20 20 20 20 3/ 3/ 3/ 3/ 3/ 3/ 3/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ This leads one to ask the big question. Where do lending and debt belong? Was Lord Polonius on the right track? The 3 C’s in banking are Collateral, Character and Capacity (as in capacity to pay the loan back). Collateral, that is the tangible asset such as real estate property, has devalued sharply. For the banks this implies that the assets behind their current loans are fragile and for future loans are viewed like rapidly depreciating cars. Collateral is often a less liquid form of money, and is not always easy to estimate. Each bank, under the current “maximizing the intermediary’s profit” system must show that it has the proper amount of collateral behind the lending function of the bank. Banking regulations dictate these ratios and banks must comply to remain open. During the heydays of the last 10 to 15 years, the claim of having enough assets was covered by the ‘pay to play’ triple-A scores given by rating agencies. Today, these ratings are suspect. Homes and other forms of real estate are a major component of any collateral package. What is the value of a house that a bank owns as collateral when the owner defaults on the mortgage? Under current plans, it appears that the citizens of the country will have to eat the inflated part of the value of each home. This is the punishment for every passive bystander who did not question our regulators, our government, our financial institutions or anyone else complicit in this systemic money grab. In the modern economy credit plays a significant role in enabling entrepreneurs to bring ideas to market. Without the ability to access capital, either through equity or through debt, Google, Facebook, and other giants of today might have folded before attaining success. Unfortunately, financial institutions are purposely hoarding money despite the trillions of dollars being pumped into them. Banks are putting holds on home equity lines of credit. It’s gone so far that firms like American Express are paying the credit card holders to cancel their credit cards and the line of credit. Credit is evaporating. One of the reasons even well capitalized and solvent banks do not want to lend is that the owner of a business can walk away from its loan obligations by declaring the entity bankrupt and not suffer a personal loss. It is a reflection on society that large businesses (such as K-Mart or United) can go into bankruptcy and the lenders allow them to restructure and operate while paying the managers of the bankrupt organization millions of dollars. This is in stark contrast to the way we hold our children accountable. When a student secures a loan for his or her college education, there are assurances put into place for the lender, including the backing of the government. To the students this implies that future income streams will be used to help pay back the loans. Similarly, since this is a personal loan, any default by a student leads to his credit ratings being damaged and other ruinous measures to his future will be imposed. There is no question that students have the potential to enrich society with their energy and inventiveness. There is great hope in each child. No collateral beyond this should be needed. Our capitalist market is no longer backed by personal integrity. The character of the parties mattered, and a handshake used to be good enough. The promise to stand behind one’s commitments and pay back loans has been lost. Instead we have a system that depends on collateral - a system that is currently under siege. In addition, “character” has been reduced to Credit Bureau Ratings, a mechanical measure of one’s likelihood to repay. This has been leveraged by the credit card industry to maximize the interest they can charge and the penalties they impose. The initial purpose of the rating system was to help banks learn about hidden bankruptcies and other bad behaviors of those people they considered lending to. The Credit Bureaus have since evolved into a highly invasive network. If a person switches from a regular grocery store to the discount grocer, her credit rating takes a hit. Worse yet, if a credit card company moves the due date forward and a person’s automated payment is now late, he is punished with late fees, higher interest rates, and a lower credit score among other things. Collateral has been diminished, character has been reduced to a score (manipulated by the credit card companies) and capacity has been made subject to the economic climate. Banks can effectively use these arguments to avoid lending, but is this fair? Bringing Integrity into the System Banks are not banks anymore. They are financial businesses. Many of the larger banks have divisions that do insurance, investments, commercial banking and much more. These are entities with cross-purposes. When the TARP money was initially given out during the Bush Administration, the money given to the banks for the purpose of lending was instead spent on strengthening the financial institutions’ balance sheets, buying up weaker institutions, and giving grossly outsized bonuses to top managers. There were no incentives or specific requirements to lend. The government was duped into viewing banks as lending institutions only and not financial entities that could play the “walk- away from business with golden parachute” game. The business side of finance is clearly stronger than the service side of banking and has been for years. It’s about the ‘benjamins’ not commerce. To bring it back, the government must enforce banking regulations and separate conservative commercial banking from more risky investment banking. This would be akin to the legislation of the 1940’s to correct the rampant speculation that preceded the Great Depression. Insurance companies must be separated from other institutions to protect the privacy of policyholders. If your bank was also your insurance company and your insurance company was paying for any kind of serious illness, would your bank want to lend to you even if you recovered? Your health can now be reduced to a lending risk factor and become part of your capacity to pay. It could also affect your ability to get a job (through a background check on your credit) and in effect deprive you of life, liberty, and the pursuit of happiness. Insurance companies only want to insure the healthy, so they can maximize profits. Brokerages must be separated from other financial institutions to prevent the potential for collusion and/or insider trading. The last several years is testimony to that. Credit Bureaus should be limited to their intended purpose of giving good information to a bank for lending purposes; not function as a method for generating income for banks and operating as a cyber-debtors’ prison to the public. On that note, loan sharking (excessive interest imposed on a loan, especially a credit card loan) should be outlawed. Our representatives in Congress should set the maximum chargeable rate assuming that their own children had to pay it, and make it retroactive. This would immediately relieve the financial pain experienced by struggling workers and set the tone for responsible repayment of responsible lending, lowering future bankruptcy rates. Rebuilding the Micro-economies Mohammed Yunus, who won the Noble Peace Prize in 2006 for his work on Micro- Loans (making very small zero-interest loans to people of the poorest means to start micro businesses) laid out a lesson for all of us. During an interview on PBS1, he outlined a beautiful concept – that “People are human capital.” They enrich the world with creativeness, determination and the will to improve the human condition. The money that one woman borrowed from Mr. Yunus’ Grameen Bank to buy a sewing machine to begin her small enterprise raised the standard of living for her family and because she grew the business and hired others to work, the community began to rise from poverty as well. The sewing machine was never used as collateral. The bank only had her promise to repay. She was the collateral. It is important to note that the “zero-interest” loans made by Grameen Bank demonstrates the ability of the system to survive purely on its own, to perpetuate unendingly as long as everyone feels the obligation to repay and does exactly that. Money is only the oil that allows the economic machine to run. The enterprising 1 Nobel Prize Winner Yunus Discusses the Impact of Microfinance. PBS.org. Originally Aired: November 22, 2006 . woman who borrowed from Mr. Yunus knew that by repaying the loan, the money could go out yet again and thus would recycle and repeat the good work. Micro-economies are to macro-economies just as the cellular level is to the whole body. If our cells do not get adequate blood and oxygen, organs fail, disease sets in and eventually the body dies. Micro-economies are composed of a large number of small businesses that employ a small number of workers. These workers then spend their earnings on products and services provided by other small businesses. The small business itself purchases its supplies and equipment from other companies in the micro-economy. Thriving micro-economies result in more hiring and higher spending and enhance the larger economy. Larger businesses owe their existence to small businesses. Lending at the micro level and supporting the startup businesses and very small enterprises is critical to improving the American economy. Forces of globalization and technology have enabled the multi-national firms to effectively arbitrage labor, downsizing their employment base in the U.S. while increasing employment in lower-wage nations or substituting technology for labor. These mega enterprises are using the United States as a market to sell to, not as a market for labor. This attack on the “macro labor economy” can be defended only if each “Micro Economy” is supported and allowed to develop. This means that the smallest flicker of enterprises must be given a chance to succeed. Without the micro economies the premise of having the US as a buyer nation falls apart. Any discussion with the college graduates of today reveals the need for these micro economies. Character as Collateral For those still willing to start businesses, lending institutions must be willing to consider character as collateral. The current credit crisis demands an alternative formula to encourage lending. If the government applies a program similar to subsidized student loans where the owner is highly obligated to pay back that loan, the banks would be better able to justify the risk to its depositors. This avoids the scenario of nationalized banks and places the responsibility squarely on the entrepreneur. Talented people will always want to create and run businesses. Collateral, a major barrier to entry in our current economic environment, could be sidestepped until a later date when the business is ready to expand. Helping little businesses launch will boost employment within US borders. In the US the small community banks including the local credit unions that followed traditional lending formulas, are in much better shape. They generally kept the loans they made and did not play with derivatives. Their assets were not toxic. They had knowledge of “who” they loaned money to. “Who” is important. These small community banks did not go after the large gains that the big players did in the previous years but rather chose a course of protecting their community’s assets while holding a steady course of growth. The lessons from the 1930’s were probably still present in the minds of older depositors. We do have sound lending institutions on which to build. How does the world dig out of this deep recession? Fear spreads fast and the worst kind of fear is of the unknown. Today fear rules our economy. Confidence is built with jobs and individual security. The more people employed the more fear is abated. Job creation is the ultimate answer to pulling out of a downward cycle such as this. It causes spending to happen, spending…the critical element to economic expansion. The government should compel banks to create lending programs for individuals starting micro businesses, where the funds are guaranteed by the government in the same manner as student loans. The government guarantee and the promise of repayment by the person signing for the loan (i.e.: Character) will serve as the collateral. Repayment of the loan should begin four years later at a low interest rate and cover the span of ten years. The lowest interest rates should be given to labor-intensive industries, firms that encourage educational training and industries that promote innovative, ecologically friendly products and services. The borrower should also have the option to start payment sooner and pay off in full with no penalty for early settlement of the loan. The aim is to create jobs. People who are earning incomes buy products and services and initiate a positive impact on their micro-economies. This in turn set into motion a positive mandate for the greater macro economy and this how we dig out.
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