"Financial system must tap the taxpayer"

Krishna Guha in the Financial Times argues that US banks need new equity ASAP to prevent the operation of a “financial accelerator,” which is basically, just as leverage feeds on itself, so to does deleveraging: falls in prices lead to margin calls, which lead to forced selling, which lead to more margin calls. We now have the institutional version of that phenomenon, which is that asset price falls lead to mark to market losses, which for banks holding similar assets on their balance sheets, generates an equal markdown of equity, which leads to deleveraging, further depressing asset prices.

Guha argues that private sources probably won’t step forward to provide the needed equity; therefore the government must, otherwise it will resort to monetary stimulus, which given the already worrisome uptick in inflation, isn’t such a hot idea.

I am not at all sure this is the right way to go about it. I have a problem with rescuing the institutions that caused the train wreck, particularly since in US style bailouts, the perps typically retain their former roles.

If the worry is a widespread run on financial firms, I’d much rather see measures that protected the customers. FDIC deposits insurance is what keeps dodgy banks still able to sell CDs (although rumor has it it actually takes a long time to get paid if the firm goes belly up. The powers that be need to remedy that). Measures that put a floor under customer exposures, rather than under the firms, seems less prone to moral hazard and a far more direct way of stemming mass customer exodus (although how you tailor this so that, say, the Fed doesn’t attempt to do something utterly implausible, like become the backstop for the credit default swaps market, would take some thought. You would probably need to identify the sort of counterparty risks that seemed to pose the greatest dangers to the market, and figure out if there was a way to put limits under them, in return for greater supervision and possibly specific restrictions on operations or gearing).

Otherwise, there seems to be a conflict in what Guha is arguing. He claims that housing prices (and presumably other inflated asset prices) need to fall. That implies losses to whoever lent against those assets. But for the government to keep trying to fill the bathtub while the drain is still open is politically fraught. Moreover, it also does not address the lousy psychology. How does it look if, say, the government puts $5 billion into, say, Lehman this quarter, only to have them come back next quarter for more?

Conversely, as Gillian Tett has argued (and I think she is correct here) there is money sitting on the sidelines that would come in and make investments, including recapitalizing banks, once investors had confidence that the bottom had been reached. Thus flushing out the losses is a vital to returning to some semblance of normalcy.

John Dizard has suggested the use of regulatory forbearance, which is code for letting the firms operate in some sanctioned manner with less than the normally required levels of equity (presumably with much closer oversight).

From the Financial Times:

The notion that the US could suffer the kind of deep and protracted recession that plagued Japan in the 1990s no longer looks as far-fetched as it did a month or two ago.

House prices are in free-fall, spreading losses through the universe of mortgage-backed securities and making it very difficult for financial markets to stabilise. The labour market is cracking, with three consecutive months of job losses in the private sector. Consumer sentiment has soured and spending is faltering.

Financial markets have taken another lurch downward – triggering emergency responses, including Thursday’s rescue of Bear Stearns, the Federal Reserve’s $436bn liquidity support package and proposals in Congress for $300bn in housing loan guarantees.

A “financial accelerator” is taking hold as banks react to losses and falls in the value of collateral backing loans by pulling back on their capital at risk, intensifying the credit crunch and aggravating the economic downturn. The pull-back in credit lines is transmitting distress from the banking sector to hedge funds – which are being forced to reduce leverage and sell assets into markets at firesale prices to meet margin calls in a classic case of financial contagion. As hedge funds cut leverage they are amplifying the effect of the contraction in bank balance sheets on the economy. This “great unwinding” is putting enormous stress on the financial system, including the market for mortgages guaranteed by Fannie Mae and Freddie Mac. Mortgage rates are much higher now than they were when the Fed resorted to emergency interest rate cuts in January.

The Fed cannot halt this negative spiral through monetary policy, even if it can mitigate its severity. Interest rate cuts have been largely offset by the rise in risk spreads. And there are limits to how much further rates can be cut amid concerns about inflation.

The good news is that as long as inflation pressures remain, the US cannot get stuck in an outright debt-deflation trap as Japan did in the 1990s. Indeed, the more inflation, the less nominal house prices will have to fall to deliver a required change in real house prices. But asset prices could still fall far enough to generate a vicious contraction in credit – at a time when wealth is declining and inflation is eating away at real income growth. That could be a recipe for a severe contraction in demand.

Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit.

What needs to be done? There is no silver bullet. Whatever happens, house prices will have to fall further to reach a fundamental equilibrium. But the key challenge now is to stop the financial accelerator in its tracks. That means one thing above all: additional capital for the financial system to stop the process of balance sheet contraction. That capital can come from one of two places – the private sector or the public sector.

By far the best solution would be for banks and Fannie Mae and Freddie Mac to raise large amounts of new private capital quickly – allowing them to treat estimated losses as sunk costs and start expanding their balance sheets again. There is more than enough private capital (and foreign sovereign capital) available. But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion.

Many financial sector executives apparently believe that likely losses are greatly exaggerated by mark-to-market accounting in dysfunctional markets. Meanwhile, their cost of capital is very expensive. It may be in their shareholders’ interest to hunker down, preserve capital and ride out the storm rather than raise expensive new capital to provide additional cover for losses that may never fully materialise.

If this is the case, the new capital will have to come from somewhere else: the public sector and ultimately the taxpayer, as the International Monetary Fund pointed out this week. The public sector could provide capital to the private financial system – for instance, by purchasing preference shares on terms more favourable than those available in the market. Or it could deploy its own balance sheet directly: intervening either in the mortgage securities market or the housing market itself.

This could be done through the Fed (which took a half-step in this direction by offering to swap $200bn of mortgage securities for Treasuries) or the government, either on balance sheet or through a special purpose vehicle. There would be severe costs either way. Public money for the banks would bail out existing shareholders. Direct intervention would require the public sector to set a price for mortgage securities and/or houses themselves. Either would foster moral hazard and expose the taxpayer to large potential losses.

But the costs of not providing public funds could be greater. Japan showed that incremental policy initiatives may not work. Rising inflation risk signals the dangers of addressing the problem through ever greater macroeconomic stimulus rather than – albeit large-scale – microeconomic intervention.

For those who oppose the use of public money, time is running out to prove that the private sector can recapitalise and calm the credit crunch without taxpayer funds – the best solution. Meanwhile, advocates of public intervention must determine how much money is needed and how to employ it to greatest effect.

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  1. Jay


    There is an ongoing discussion on whether this process of deleveraging and Fed’s repsonse will in the end be deflationary or inflationary. Is the course of the US dollar (and possible ECB, BOJ intervention) the deciding factor in this matter? I’m kinda stuck on this issue: debt deleveraging/decreasing asset values are deflationary, while the weakening of the dollar is inflationary. These forces seems to be colliding and the ultimate outcome seems rather unclear to me.


  2. a

    “Many financial sector executives apparently believe that likely losses are greatly exaggerated by mark-to-market accounting in dysfunctional markets.” Let us note how self-serving this comment is. On the way mark-to-market accounting let these executives pull out billions and gave themselves millions. Now that it works in the other direction, it’s bad.

    What’s bad is that none of these executives feel any obligation to give back previous year bonuses. What is bad is that 2007 bonuses were the largest on record, in spite of the fact that any dork could have seen that in 2008 the banks would be asking for capital infusions. How much did Lehman pay in 2007 bonuses? How much do they need to be recapitalized?

  3. a

    Should read: On the way *up* mark-to-market accounting let these executives pull out billions and gave themselves millions.

  4. crmorris

    A clean repricing of asset values to sustainable levels will probably leave banks ~$200B or so capital short. We could fake the books with the LDC crisis in the 80s, but all the adjustment went on overseas in Brazil, Mexico et al. Won’t work now.
    Impractical to raise that much without the swfs, which — you can argue about the rationality — will make too many people uncomfortable.
    There are some $2T in treasuries sitting in the SS Trust Fund. Converting 10% of those holdings into bank equity/conv etc on terms like Dubai has been getting would probably be a great investment over the lt. Hard part will be to force the restatements and get it over with and do them on economic terms, instead of buying out the bad debt at near-face value as the Fed is starting to do.

  5. RK

    Henry Kaufman argued a few months ago that the
    2007 bonuses equalled the amount raised from the sovereign wealth funds. In other words, they borrowed their bonuses by dilution of shareholder capital.

  6. Anonymous

    Jay,one way to think about deflation/inflation picture is to distinguish capital markets from markets for goods, services and distribution. Deflation is happening in capital markets. Inflation in goods, services and distribution. And, this isn’t surprising given that the capital markets have de-linked from the goods, services, distribution markets — or, put differently, the capital markets bear too little relation to any ‘real economy’. They’re a a ponzi, casino, lottery game in which, it appears, the losers will be those who didn’t get rich quick enough. That is, the real economy will bail out the fake economy — and, in doing so, the two sides will become reconnected until the next wave of ‘free market ideology’ crashes down on the planet.

  7. Mel

    If we left Iraq asap, we would free up $12 billion/month to shore up the banks. If we “stay the course,” all our books are out of whack and there’s no way to put Humpty Dumpty back together again.

    Part of the problem is the budget deficits the war and tax cuts caused, part is the lack of income growth for the average worker. If Joe Average doesn’t see an increase in his paycheck, he can’t afford to buy “things.” The banks found ways to lend him money by winking at assets, this won’t stop until Joe gets a raise and the robber barrons pay their share in taxes. Bushism must go!

  8. Anonymous

    Public money is only going to drive commodity prices higher and the dollar lower the only way out of this mess is let prices fall, let firms go under and let this hit bottom the more they try to stop it the worse it will get.

    “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
    Human Action: A Treatise on Economics
    Ludwig von Mises (1881-1973)

  9. The Hube

    Why the F should the taxpayers give these Aholes any bailout when they are still paying dividends and bonuses, and even changing bonus formulas to prevent the perps from having to feel the consequences of their actions.
    Let these free market champions deal with a free market.

  10. Anonymous

    What is the economic meaning of this de-leveraging? On a macro level it means that holders of assets are re-evaluating whether or not these assets will provide the returns expected in the future. The deleveraging is action to prevent future disappointment (losses) . To support efforts by the FED (and Fannie, the FHA, Congress, etc.) to slow the pace of deleveraging is to trust that a few politicians have greater insight into this crisis than do millions of market participants. Do we really want to believe this? Let us consider that the present crisis had its origins in the vanity of one man. He simply didn’t want his star diminished by being known as the man who pumped up the stock market bubble (and cost Al Gore the Presidency). Of course, he did succeed in limiting that stock market collapse. At what cost? Five years later millions must confront the same issue, viz. that they are much more poorly provisioned for the future than they thought. Seen in this light, it is the continued high price of income producing assets and long term consumerable durables (i.e. houses) that diminishes confidence.

  11. S

    THis guy also argues in the piece that inflation is GOOD becasue it reses the nominal prices closer to the price of houses. Oh great so everything but wages go up. Unless this guy is imnplying that becasue companies are just going to raise wages to meet the inflating costs at a faster clip then how exactly does that help the problem? The only thing missing in this screed is to tell the public that their being systematically devalued. Off base on so many levels

  12. Alan

    Just capitalize them? You have to be kidding. If there is any capital flowing that way, it has to be targeted. Too big to fail has failed. Now these guys are too big to bail out.

    They showed what they do with capital. Without structure and regulation, what confidence will throwing money at them create?

    Better to lop off the investment arms, the securitizing offices, and capitalize the consumer and business credit operations. Repealing Glass-Steagall was a major mistake. Rectifying that ought to be first.

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