By Edward Harrison of Credit Writedowns
I referenced Matt Taibbi’s latest work at Rolling Stone “Wall Street’s Bailout Hustle” recently when talking about a movie on Ponzi schemes and fraud that aired on 60 Minutes. I liked the piece and recommend you read it – fully aware of the awaiting hyperbole Taibbi uses to hype his case.
The interesting bit is Taibbi followed up his article with a blog entry “On the Bailout Hustle” in which he contrasts the American bailout hustle with the more effective but less banker-friendly approach used in Sweden after their own housing bubble and financial crisis in the early 1990s.
My feeling on that is similar to what Barry Ritholtz (check out his site if you haven’t), the author of Bailout Nation and one of the guys I spoke with at length for this story, proposed. He said that “we should have gone Swedish on their asses.” The Swedes after a similar bubble burst in 1992 temporarily seized control of insolvent institutions, forced banks to write down losses before they got aid, and gave taxpayers a huge share in the upside of recovery. It was a tough-love approach that really worked and forcefully addressed the moral hazard issue in a way we never touched.
Of course, it was Barry who pointed this passage on Sweden out. He would, do that, wouldn’t he?
I definitely agree with Barry. In fact, I am probably the first major blogger to broach the subject. See my post: The Swedish banking crisis response – a model for the future? from August 2008 which describes a piece by former Riksbanks head Urban Bäckström from way back in 1997! This is the number one entry on the Internet when you search for ‘Swedish banking crisis.’
Now, this was before the Lehman debacle. And I anticipated massive credit writedowns for the global financial system which would precipitate a major financial crisis. Of course, this is what happened. But, pre-Lehman, I was looking for a banking crisis response model which would prove effective. I looked at the Japanese model and found it wanting. The Nordic model is more promising.
Here’s what I said in August 2008:
Yesterday I pointed out that today’s global banking crisis has some historical precedents worthy of comparison. In particular, I looked at the Japanese bailout schemes from their housing bubble to see if there was anything there to learn. Unfortunately, the Japanese experience leaves doubts as to whether government intervention is helpful or harmful.
There are other examples, however. The Nordic model is a particularly useful one to look at as we move forward. Sweden’s Central Bank Chairman Bäckström shared some of his insights from that experience some eleven years ago in a speech to a Federal Reserve symposium that is available on the Swedish Riksbank website. This is a brilliant piece of work.
I use the term ‘Nordic’ because Finland and Norway also had deep, deep contractions due to a banking crisis at the same time (see Marshall Auerback’s piece on Finland here).
Now, the information about these financial crisis strategies was readily available in the public domain for years. I mean, my blog post was based on a 1997 article for goodness sake. Clearly, the Obama people didn’t want this solution because they are captured by the financial services industry. That’s why the U.S. is going the Japanese route of bailouts and accounting dodges.
The Swedes of the mid-1990s did drag their feet too; they didn’t implement a draconian solution until it was obvious the system was insolvent. And I would add that the technology bubble bailed the Finns and the Swedes out. (Oil helped the Norwegians). So, without the boon for the likes of Nokia or Ericsson, where would those economies have been? Nevertheless, this is not the course the U.S. is on. The closest we have seen to this is Ireland – but even there I have had my doubts.
The key difference is the Swedes recognized:
Their entire banking system was effectively insolvent. Yet, they were able to fashion a workout scheme that had bi-partisan political support, did not unfairly reward shareholders, dealt with moral hazard, separated regulatory and workout roles so as to reduce conflicts of interest, and that quickly wrote down valuations and liquidated the bad debts as opposed to dragging the process out.
Fifteen years later, even the Swedes are not using the ‘Swedish model’ despite their massive loan exposure in the Baltics, which are now in Depression. Clearly denial as to the severity of the banking problem is not just an American phenomenon, it is also a European thing too.
But you can only hide your head in the sand for so long. Reality has a way of making itself felt.
Update: You’ll probably have noticed that I never used the words ‘nationalisation’ in this piece – and for good reason; The nationalisation talk is just a red herring. The crux of the article is not about nationalisation – or even FDIC-style asset seizure at all. What this article is really about is what I highlighted and said it was about: The Swedes “quickly wrote down valuations and liquidated the bad debts as opposed to dragging the process out.” Put simply: we are looking at a choice between the Japanese approach and the Swedish approach.
Now, when it comes to seizure, we are really mainly discussing Citi. JPMorgan was never in doubt. Wells Fargo probably could have made it through with TARP funds alone. After the Merrill deal, Bank of America was the only other too-big-to-fail company that probably would have been seized. (Some super-regionals may have been a question as well). But, in the main, what we’re discussing here is whether Citi would have been taken into majority government ownership the way that AIG was.
As for writedowns, this could have been done using an RTC-type vehicle as we saw after the S&L crisis or using a bad bank as the Swedes did during their crisis. The key is writing down the assets quickly rather than keeping the deadweight on the balance sheet as was done in Japan.
So the article is a reminder that the bailouts were done because they were the preferred option, not because other choices didn’t exist. And this is important yet again because we are about to see this year that having avoided asset writedown and used asset appreciation to bail out the banks is going to have a very negative impact on credit – and the economy.
Above I did point out that the Swedish dilemma was tackled in a bipartisan way, so talk of ‘nationalisation’ is germane because this fictitious argument would probably have been used by Republicans purely for political purposes rather than ideological ones. After all AIG was nationalised and Citi and BofA were effectively nationalised, albeit without the requisite strings attached. The point would be to block Obama’s agenda in order to weaken him. But this is just politics.
One last point, the Swedes are playing the same game this time too! That’s because it’s politically easier to try to let banks recapitalize themselves via high margin spreads (borrowing short and lending long in a steep yield-curve environment).
The problem for banks is always that they lend long – and that means you can never know the true extent of future losses. That gives an accountant a lot of room for playing with the numbers. Writedowns are just an estimate of loan impairment of unrecoverable asset value. So all a bank has to do is pretend that assets are only temporarily impaired.
You’ve heard the term ‘extend and pretend.’ That’s what it’s all about – extending the term of the loan so that even if the asset is eventually written down, the profits earned in the interim will restore the bank’s lost capital.
The key is asset prices and accounting standards. If asset prices fail to rise, writedowns are going to come sooner than later – and that means insolvency for some banks.
If regulators change accounting standards and allow banks to pretend their assets don’t need to be written down as they did in the early 1980s, the problem could be much larger down the line, as it indeed was when the S&L crisis finally blew up – especially if asset prices (the loan collateral) don’t rise. This is indeed what has happened in the U.S. yet again.
Update II: a lot of people have bought the ‘nationalisation’ propaganda. It is Fannie/Freddie-style ‘nationalisation’ that is criminal. These companies should be wound down and eliminated. Instead, they are being used as a slush fund for bailing out the mortgage market.
Which is more free-market – a bailout and mega bonuses all around or asset seizure and recapitalization?
There is a price for bank failure in a capitalist society, you know. It’s called bankruptcy and seizure. The FDIC seizes and resells bank assets every week. That’s the right approach. But apparently, Lehman’s demise and the inadequate preparation for it scared everyone into bailouts – and that’s how it’s going to stay it seems.