Gillian Tett ponders the conundrum that, given the dearth of logical suspects to replenish US bank equity if credit markets continue to deteriorate, the Federal government will have to step into the breach. But bailouts are profoundly unpopular even in the best of times, and an election year is a particularly ill-fated juncture for this problem to arise.
Tett believes that the folks in DC will resort to under-the-radar mechanisms such as greater reliance on Freddie, Fannie, and the Federal Home Loan Banks. However, they are no longer as unnoticed as she might think. As readers know well, the increase in agency spreads is largely due to the market’s negative reaction to the idea of filling up Freddie’s and Fannie’s not all that wonderful balance sheets with refinancings of stressed borrowers. When you have negative coverage in Barron’s, it isn’t the same as having the same story run in USA Today, but it’s sufficient bad PR to add to the negative reaction among investment professionals. Similarly, the Federal Home Loan Banks have already doled out enough cash to dodgy banks that their efforts are eliciting criticism. From Greg Ip in the Wall Street Journal Economics Blog;
Nouriel Roubini, a New York University economist better known now through his research service, Roubini Global Economics, cast an unflattering light on a little-discussed risk to the financial system in testimony to the House Financial Services Committee yesterday: The Federal Home Loan Banks, 12 federally banks (like Fannie Mae and Freddie Mac) that are privately owned and primarily lend to their owner-banks against illiquid collateral such as mortgages.
Mr. Roubini said:
The widespread use of the FHLB system to provide liquidity — but more clearly bail out insolvent mortgage lenders — has been outright reckless. Countrywide alone — the poster child of the last decade of reckless and predatory lending practices — received a $51 billion loan from this semi-public system; in the absence of this public bailout Countrywide would have ended up where it should, i.e. into outright bankruptcy. And the largesse of the FHLB system does not stop at Countrywide. A system that usually provides a lending stock of about $150 billion has forked out loans amounting to over $750 billion in the last year with very little oversight of such staggering lending. The risk that this stealth bailout of many insolvent mortgage lenders will end up costing massive amounts of public money is now rising.
While Roubini may be early (as usual) in calling attention to the downside exposure of the FHLB, its role in the rescue of Countrywide has come into view. Senator Charles Schumer was so upset he called for an investigation (although it was in large measure due to his well founded view that Countrywide is a bad actor not worthy of salvaging).
So Freddie, Fannie, and the FHA are increasingly in the spotlight, and the formerly closeted FHLB is finding it harder to hide. So Tett’s notion that the powers that be can craft a backstage solution may be wishful thinking. I suspect we will see more desperate measures from the Fed, more “free market” non solutions from the Treasury, and increasing difficulty in resorting to covert financial rescues, given the heightened scrutiny of everything mortgage and housing related. If things deteriorate sufficiently in the next two to three months, it’s possible we’ll get a hail Mary pass of a radical reform package too close to elections to get passed, just so the Republicans can blame the Democrats.
Yesterday, David Wessel in the Wall Street Journal also discussed options for shoring up banks, including nationalization (mind you, to be limited to ones truly too large to fail). Of the many suboptimal solutions, I find that less offensive than others, provided the existing shareholders are wiped out and management is put on lean salaries (they can get performance bonuses, but not overly lavish ones. Frankly, they should be grateful they are not going to jail or having their previous comp clawed back, and if they could be given that stick along with a bit of carrot, they might go along. If not, I don’t believe that people who are capable of running banks are as scarce a commodity as search firms would lead you to believe. If someone with as little relevant experience as Vikram Pandit can head Citigroup, there is a large universe of candidates.). The advantage, aside from greater acceptability to the public, is that the government will get the full upside of its risk-taking when the banks are re-privatized.
While I differ with Tett’s conclusion, the bulk of her piece is analysis, which is very much worth reading. From the Financial Times:
When is a bail-out not quite a bail-out? When it occurs in a US election year, it might seem. Or that, at least, is the cynical thinking floating around some well-informed market minds.
For as the credit crunch grinds on, pressures in the financial system are rising by the day. Never mind the fact that hedge funds are now imploding; in a sense that is only to be expected (and arguably overdue).
Instead, what is really worrying investors, ahead of the release of broker results next week, is the risk that serious capital pressures will emerge at some banks if they are forced to mark their books to (ever falling) market prices. There is also growing concern about the capital position of housing behemoths, such as Fannie Mae and Freddie Mac, as mortgage defaults rise.
Thus the trillion-dollar question haunting the markets is where on earth will the capital to plug these potential gaps come from? Will private sector investors (such as sovereign wealth funds) step to the plate again? Or will the next chapter in this saga entail the US taxpayers footing the bill, through covert or overt means?
Unsurprisingly, this latter scenario is not something that anybody in Washington is keen to debate in public right now. And the Federal Reserve, for its part, is working overtime to avoid this worst-case scenario by devising ever-more creative measures to tackle pockets of market illiquidity.
But while this week’s $200bn Fed package should earn points for lateral thinking, the Fed now seems to be running to keep still: as soon as it announces one set of confidence-boosting measures, a fresh set of market brushfires break out.
Even if the Fed’s measures ease liquidity pressures, they cannot by themselves solve the most fundamental source of capital pressures on banks. After all, the banks’ woes do not entirely stem from mark-to-market accounting practices; behind the drama of tumbling securities prices there are tangible credit losses.
And whether you think these credit losses will eventually total $300bn or four times that level (which is roughly the range of current forecasts), what is clear is that losses will exceed the $60bn to $100bn of capital injections so far garnered from sovereign wealth funds. It is also clear that these funds have growing qualms about writing new blank cheques. Hence the rising question about how to plug the capital gap.
So will the US government step in instead? Not in a classic sense anytime soon, I suspect. After all, no politician in his (or her) right mind wants to be seen rescuing greedy Wall Street bankers right now – or not unless it is presented as a collective action plan in which plenty of bankers go to jail.
But producing a coordinated deal between multiple stake holders looks hard right now, particularly given the US election. Thus the US faces the reverse of Japan’s problem a decade ago: where Japan was hobbled by an excess of collectivism, the US is now hobbled by extreme individualism. Forging proactive plans requiring shared pain and sacrifice is not something that comes easily in America now.
Of course, this situation might change if a full-blown financial fiasco erupts. Further ahead, the next administration may find it easier to take radical steps by blaming the problems on the past.
But in the meantime, I expect to see the intensified use of more subtle forms of public support, via ill-understood institutions such as the Federal Home Loan banking system or Fannie Mae and Freddie Mac. There could soon be more measures to help subprime borrowers to stay in their houses (which helps the banks by reducing future mortgage defaults).
Perhaps these subtle approaches will quell the crisis or even turn sentiment sufficiently to enable the banks to attract more capital from private sources. But the longer the turmoil lasts, the greater the risk that sooner or later, taxpayer money will end up propping up the system. The only uncertainty is just how many euphemisms will be invented in the coming months by whizz-kids in Wall Street or Washington who want to avoid saying “bail-out” in an election year.