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What I think is wrong with the banking sector

Major banks around the world hold trillions worth of “toxic” securities that they need to get off their balance sheets. The U.S. government thinks it might be able to rescue U.S. banks by finding a market for these securities. Here’s the problem: Most of this paper is deeply illiquid — when it was written there was most likely only one plausible buyer and one plausible seller — and the transaction was a function of the inflating credit bubble.

Here’s an analogy: Imagine you invested $100,000 in a hotdog cart on Wall Street, reasoning that with thousands of hungry traders passing every day, you’d have a constant stream of customers and profits. This is a highly liquid transaction because any sane capitalist would be glad to take this business off your hands and earn the same money you were earning. Here’s the thing: the constant stream of customers is a fundamental function of the transaction: without it there is no business.

Say al-Qaida sets off a dirty bomb on Wall Street and makes the area poisonous to human occupation. Your $100,000 hotdog stand is still sitting there, waiting for customers who will never return. Your 100 grand is now 100 percent illiquid, and you have to write off the investment because the conditions enabling the original transaction don’t exist anymore.

My theory (refutations welcome): the recently collapsed credit bubble was the stream of customers that enabled the market for these now-toxic securities. No credit bubble, no market for toxic paper.

Everybody on Wall Street knows this, especially the banks. They know they have to write these assets off as lost causes, but they cannot bear the damage such write-downs will inflict on their credit ratings, because if their credit ratings sink too low, they risk a run on their assets that are still worth something.

In a way I’m glad that I can visualize simplistic, hotdog-stand scenarios that seem to make sense. In reality, these securities are a radioactive Brillo pad the size of Manhattan. Think about being charged with trying to clean that up for awhile and you’ll be first in line for the next opening for a greeter at Walmart.

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Tom Mangan posted at 12:37 pm February 10th, 2009 |