Wednesday, October 15, 2008

Credit is not the solution

I'm curious why we would want to take ownership in banks that have bad assets, bad risk management, and an environment where there are not many good places to make loans? Banks make loans based on their risk of repayment. When people and businesses are cash starved there is obviously a high repayment risk. If supplies of real estate exceed the demand for them, there is also repayment risk because the value of the home that they are mortgaging may fall below loan value. If a business has a debt service coverage ratio close to 1, there is huge repayment risk.

What needs to happen is to let the market correct itself. Price deflation is mandatory because asset values are below current market values. When market values reflect a lower risk to creditors and investors economic growth will resume. But until this happens there will continue to be a "liquidity" problem. Banks will not lend and investors will not invest because value does not exist. Japan tried this same trick and experienced a 15 year deflationary bust. It is still recovering. What we don't need is intervention in a market that was caused by too much intervention and band aids by the Fed and the government.

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