Willem Buiter: "We are laying the foundations of the next systemic crisis"

One of the reasons I am a fan of Willem Buiter is that he is bracingly candid about his likes and dislikes. And we happen to share a major dislike, namely, the conduct and policies of Henry Paulson.

Buiter lambasts Paulson’s gift capital provided to nine large US banks. What is striking is that Buiter is genuinely outraged, seeing this as a very bad deal for the taxpayer and providing all the wrong incentives to the miscreants recipients.

I cannot recall seeing a single US commentator remotely as critical of this deal as Buiter (for the record, we have gone off the deep end more than once as far as Paulson is concerned, but not on this particular action). Why so little outrage when we are going to wind up living with the consequences of these costly handouts to an undeserving industry? AIG was put on a very short leash. Why do Goldman and Morgan Stanley deserve better?

From Buiter:

The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. This is surprising to me, because the complete or partial nationalisations of a number of US financial behemoths earlier in the year represented rather better value for money for the tax payer.

The nationalisation of Fannie, Freddie, AIG and pieces of the nine largest US banks (with more to come) was necessary to prevent a complete collapse of the house of cards we used to know as the American financial system.

Unfortunately, Treasury Secretary Hank Paulson’s injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.

In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. By contrast, in the Netherlands, the injection of €10bn worth of subordinated debt into ING bank comes with a price tag that includes two government directors on the board and a government veto over all strategic decisions by the bank.

In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks. The US tax payer is not only getting a lousy deal compared to private US investors like Buffett, (s)he is also doing much worse than the British tax payer in the UK version of Paulson’s capital injection (£37 bn so far out of provisional budget of £50bn). The UK preference shares have a 12 percent yield and come with government-appointed board members.

Even in the cases of AIG, Fannie and Freddie, unsecured senior creditors did not have to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out of this exercise whole. There were no up-front haircuts, charges or mandatory debt-to-equity conversions.

That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending to elephantesquely large financial enterprises. Unless not only the existing shareholders of the banks benefiting from these capital injections but also the holders of the banks’ unsecured debt (junior and senior) and all other creditors of the bank (with the possible exception of retail depositors up to some appropriate limit) are made to pay a painful penalty for investing in excessively risky if not outright dodgy ventures, we are laying the foundations of the next systemic crisis, even as we are struggling to escape from the current one.

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  1. Observer

    And remember that the “next crisis” may effectively just be a continuation of the current one. Looking at the Dow Jones between 1929 and 1932 gives no comfort for interim periods of market stability or even rises as we are now in, if the underlying financial footings are rotten.

  2. Anonymous

    I could not agree more. I have been raging about the conduct of “salvaging” financial markets from their mess has been very badly done, and done on the back of the taxpayer.

    That said, can somebody tell me if this will actually work. And if so, what is the price tag of such bailout mania? (other than moral hazard). In other words – will this bailout mania transform a potential Grat Depression into a normal recession? If it does, then there IS a free lunch after all!

  3. Anonymous

    I cannot recall seeing a single US commentator remotely as critical of this deal as Buiter

    William Poole stated in a TV interview that it was illegal.

  4. Anonymous

    Hi Yves, Recently dicovered you excellent blog, Thanks. Noticed there is not much commentary anywhere on the Bretton Woods 2 summit happening on November 4th.
    I think it deserves much more attention considering the people behind it and the fairly radical things they are saying about it.

    For instance;

    “Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline,” Mr Trichet said after giving a speech at the Economic Club of New York yesterday. “It’s absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline.”

    His word echo those on Prime Minister Gordon Brown, who said on Monday that the world needs a new Bretton Woods agreement to make the architecture of the global financial system fit for purpose in the 21st century.

    In 1944 the Bretton Woods conference helped draw up the post-war world financial order and created the International Monetary Fund and World Bank.

    Mr Brown said “we must devise new rules for a world of global capital flows” just as the founders of Bretton Woods “devised rules for a world of limited capital flows.”

    Today he meets with European counterparts for talks in Brussel to discuss the financial crisis. Some European policy makers are pushing to tighten oversight of markets after the past year’s credit squeeze culminated last week in the biggest stock sell-off since 1933.
    He indicated that recent market turmoil was partly a consequence of the deregulation that occurred after Bretton Woods’ demise. That was triggered in 1971, when inflation forced the US to abandon the dollar’s peg to gold, an anchor of the system, heralding the era of floating exchange rates.

    “The explosion of the first Bretton Woods in a way could be interpreted as a rejection of discipline,” said Mr Trichet.

    Mr Trichet said: “If we don’t have discipline, then we are putting into question the functioning of the market economies and the functioning of our financial markets

    My question is, does BW2 new market discipline involve gold in any capacity? If you have any thoughts, I would love to hear them, thanks

  5. Anonymous

    “Why so little outrage when we are going to wind up living with the consequences of these costly handouts to an undeserving industry?”

    Almost everyone in my–admittedly, relatively small–circle is outraged by the entire ordeal. However, the question becomes, “Now what?”

    We can’t stop ’em. We can’t even get Congress to stop ’em. Heck, we weren’t even able to vote out our own Congressional incumbents this cycle because we are–again–a small voting block. As for the question, we’ve resorted to educating ourselves through our professional networks, through blogs such as this fine one, and through some kind of collective consensus.

    We aren’t in the street with pitchforks and torches–yet–because we are too busy trying to preserve what little resources we have and hope it is enough to get us through this Interesting Time ™.

  6. Anonymous

    some of these banks claim they didn’t need it. some of them most likely needed it more than they could let on. so to make it remotely palatable for everyone, they “force” easy terms that average joe will accept.

    literally just today i heard that the government now owns these banks.


  7. Anonymous

    From Wikipedia :
    “A kleptocracy (sometimes cleptocracy, occasionally kleptarchy) (root: klepto+kratein = rule by thieves) is a term applied to a government that extends the personal wealth and political power of government officials and the ruling class (collectively, kleptocrats) at the expense of the population.”
    Sums it up just about perfectly.

  8. Anonymous

    Dude you cant take Buiter seriously. What about dilution of existing shareholders + the fact that the cost of capital is such that the Banks could never afford buy these Govt stakes back. You and Buiter also forget that this is simply the first installement. There is more to come as their loan books go pear shaped in this recession and you can bet the Treasury will get its pound of flesh. Buiter is an idiot. He thought inflation was the bigger risk than debt deflation and has been proven wrong big time. I can also tell you he lambasted Bernanke and co at Jackson Hole earlier this year about their “misguided” easings and the risk of an inflation breakout. The Washington Governors were not impressed by his abrasive style and in case he’s been proven dead wrong on the inflation debate. he is basically held in the same “high regard” as Marty Feldstein – “all sound and furious anger”. I love your blog but jeez you can be sanctimonious…

  9. Anonymous

    It’s a variation on the “big lie”.

    Unlike developing nations where it’s taken for granted, we can’t in our American hearts believe that government officials would out and out steal. It’s too jarring, we can’t accept it, so we make up reasons.

    Paulson put $500m into a blind trust before he took his Treasury position (at least an index fund, possibly invested in his old industry, anyone know the rules exactly?). It’s one thing to put your nation before yourself, it’s another to cost yourself a few hundred million in the process. The social pressure would also be huge. If he puts bankers out of business, these are literally all his friends he will have to see for the rest of his life. And no explanation would satisfy a man and his family gone down the tubes. None. If Paulson let the chips fall where they may, it’s the right thing to do, but few are big enough to put principle ahead of gaming the system, especially in the financial industry.

    If it’s any consolation, the officials can’t believe they’re corrupt either, so they make up reasons too.

  10. Anonymous

    BWII is just another attempt to stick save factional reserve compounding interest banking. The debt is of proportion that the reserve currency in circulation can not service it. Creating a new world currency (nominalize debt) and/or (re)institute standard accounting principles appears a bit disingenuous. More than likely they just want the ponzi scheme to continue unabated. Any gold backed system will be perverted. Something about controlled grow that greed detests.

    Deflation will happen just as soon as they are done inflating, delays or not, an implosion is the final unavoidable destination.

  11. john bougearel


    Here, Here,

    We all share the sense of outrage, not so much at the moment of past mistakes, but the ones that are being made to patch up the old mistakes.

    Anon 10.59, we all make bad calls, Buiter can make them as well as the next person, but he is 100% right in remonstrating against and pointing out the ongoing series of policy mistakes. We all benefit from the details he and others flesh out in this crisis. Remonstrations can help all of us grasp the core mistakes being made and help redirect our policymakers toward a better path.

    Note Paulson’s TARP plan improved moderately with the initial preferred stock purchase program, which was absent until after weeks of howling from folks like us.

  12. Independent Accountant

    I touched on some of this stuff in my comments to your 15 October post “Paulson vs. Bank Executives”. The taxpayers got less than Buffett got. There was no Paulson v. anyone. It’s all “guerilla theater”.

  13. Bas

    While it’s true, as Buiter states, that the Dutch government forged a somewhat better deal (from the taxpayer’s point of view) with the ING bailout – the government getting two board directors with veto power over strategic decisions – ING only pays the 8,5% interest over the $13,5 billion loan if and when it also pays out dividends.

    Dividens have already been suspended for the rest of 2008, and are now for obvious reasons likely to be suspended until loan maturity (5 years maximum).

    Payment of dividend is a non-vetoable decision. Ergo, ING gets a free ride from the Dutch taxpayer, even more so than US banks in the Paulson bailout (they at least have to pay a meagre 5 % interest).

  14. Jojo

    Anon said “
    Almost everyone in my–admittedly, relatively small–circle is outraged by the entire ordeal. However, the question becomes, “Now what?”

    We can’t stop ’em. We can’t even get Congress to stop ’em. Heck, we weren’t even able to vote out our own Congressional incumbents this cycle because we are–again–a small voting block.

    Don’t give up. There are many people who claim they will follow through with their commitment to vote against anyone who said yes to this poor thought out bailout plan that was shoveled through Congress with the addition of $150 of pork.

    Here’s an article that confirms that voters are going to do something about this in this election. Meanwhile, Congress is pushing the new stimulus program to try to buy back some votes.

    I’m still wondering where their field of money trees is hidden…

    October 18, 2008
    Off the Charts
    How Voters See the Bailout

    THE most important legislation passed by the current Congress almost certainly was the bank bailout bill. Whether it will do much good is still unclear, but there is little doubt that most Americans were not impressed, even though the bill was backed by Congressional leaders, the president and both major presidential candidates.

    Passage of the bill appears to have pushed the approval rating for Congress to a record low, leaving Congress far less popular than President Bush, whose standing with voters is close to historic lows. It may affect several legislative races next month, in which senators and members of Congress who backed the legislation have slipped in polls.

    Full article


  15. Maurice

    Regarding the ING deal, suspension of dividends is actually a good effect of the bailout, instead of a bad one. It strengthens its balance sheet at the cost of the shareholders instead of the tax payers.

    What is outrageous is banks being bailed out while still paying dividends and bonuses, i.e. the bail out is partly used to pay out the shareholders and top brass.

    So I see the Dutch bail out as a pretty good one (also no bonuses for the top brass this year).

    The sharing in the dividends later on is excellent as banks tend to pay out dividend whenever they can.
    So no heavy interest payments at a time the bank can’t afford them, and once they are in better health sharing in the resulting dividends. Plus a seat to prevent ING from misusing this money.

  16. baychev

    anybody dares to say this is socialism?
    it perfectly fits the description of crony capitalism, whereas what is done in europe seems socialist.

  17. baychev

    what is all this yapping about Bretton Woods II?

    it is really cynical to see Trichet complain about the instability of golabal markets. it all felt too good when capital flowed from developed countries to emerging pumping up stock prices. and yes, europe was a big receiver of us money (german equities) and hence the very fast depreciation of the dollar.
    now the chickes are coming home to roost and everyone is screaming. this money that pumped you equity markets was never yours in first place dear Trichet and other populists. no wonder why after the hot money went back home your equities are worth just as much as before.
    how about constraining credit growth? that is part of your duties and you kept it growing at 12% until Q4 2007. is the system unfit for 21st century or you are unfit for your position?

    what about a gold standard? should a country's economic future depend on it's ability to mine gold? certainly not.

    there is plenty that can be done to keep the current system function smoothly. To name a few:
    – enforce strict leverage rules on all banks & broker/dealers;
    – move CDS to exchanges. coverage should not exceed outstanding notional;
    – no bank capital requirement relief programs;
    – actively manage credit growth expansion;
    – require collateral on all loans over $100,000 (home,auto,boat,investment, etc.).

    but of course when we are incompetent to play a game by the rules, we will change the game's rules. really pathetic.

  18. Anonymous

    It helps to examine what’s really happening here.

    Bank hands over piece of paper that says “Preferred Stock” on the top: “X Billion”, “Pays 5%”.

    Treasury hands over piece of paper that says “Treasury Bond” on the top: “X Billion”, “Pays 5%”.

    Now, what happens down in the Accounting Departments? Treasury books Bond as a liability, Stock as an asset. No net change to the balance sheet or the budget.

    Bank books Stock as a liability, Bond as an asset that goes 100% to regulatory capital, effectively curing the solvency problem caused by the introduction of FASB Rule 157 (mark-to-market) on Nov. 15 2007. No net change to the balance sheet.

    This a case of one regulatory agency (Treasury) throwing on a blowout patch to fix a bonehead move by another regulatory agency (FASB). With a little luck, this won’t cost the taxpayer a nickel.

    This, by the way, wasn’t a Treasury idea: the Brits came up with it.

    Far more worrisome is people with no insurable interest collecting on CDS’s.

  19. a

    I’m outraged.

    Any government bailout should be accompanied by:

    1/ Suspension of dividends
    2/ Suspension of bonuses

    Everyone notices, of course, that the government’s injection into GS and MS don’t even pay for this year’s bonus pool.

  20. Richard Kline

    I’ve expressed my extreme disgust of Paulson’s Plot before, but it’s good to hear someone of Buiter’s platform put on Jeremiah’s wig and sandals over it. And no, this is not a ‘partial nationalization,’ it is a partial annexation: The Nine Wide Boys annexed as much of the Treasury’s credit as they need to make nice visuals for the credit markets and to get a Government Saved ™ sticker like the European banks got. Nationalization implies public control, or at least influence; in this scheme, that potential was specifically abdicated by Hank. And fair: If you have the best Treasury Secretary that money can buy, ‘fair’ isn’t your problem. It’s only a problem if you’re a taxpayer.

    Bear this in mind, though. We are now entering Year Two of what shapes as a five year financial crisis. In both the 1929 event and in the 1989 event in Japan, it was only several years in that the lies, evasions, old boy choke chains, and politician son the payroll finally buckled under serial insolvency, to put the public somewhat more in control of the process of resolution. The US banks were still lying and stealing with their pens in _1934_ before a more activist Congress finally wrote them a different ticket. We will see something like that now, too, I think. It will take several seasons of hidings on the hustings for Our Public Servants to get on top of this, and to begin curing the hide of the Nine Wide Boys and their ilk rather then tenderly kissing it nighty-night. We have LBO ASBs imploding; another bailout. Commercial Re imploding; another bailout. When T-bills jack up their rates, as they must under any currency realignment, we’ll have a major bond bust; another bailo—Wait! Stop! TIME OUT! . . . Of course, by then, most of that first $125B and probably the second $125B will have been syphoned off in dividends and sweetheart share puts to the Guvmint (wait for it, it’s coming, at least in concept) by present stakeholders, but this may be the price we have to pay for our venal complacency as a citizenry. *blecchhhh*

    Don’t bother with pitchforks: Whenever you see a senior banker or public financial official, throw your shoes at them. Greed is NOT good for children and other growing things.

  21. Henry

    In thinking about ‘a new Bretton Woods’, it makes sense to know a bit more than most of us do about the first one!

    You could try Armand van Dormael’s detailed history of it, or look at the coverage in the bios of Keynes (Skidelsky, Moggridge), or Markwell on Keynes and International Relations, or Horsefield, or…

    There are striking siilarities, as well as obvious differences, with ‘last time’

  22. DownSouth

    Richard Kline,

    Sad but true. The kleptocrats will be the last to suffer.

    But the really sad thing is that, if this thing unfolds as it did during the 1930s, that will be the “good” outcome. Things could turn out much worse than that.

  23. Bendal

    Count me as one of those voters outraged at the ease that Congress rolled over and passed Bush’s Bailout Bill with only a glance at adding more oversight and regulatory authority to it.

    Courtesy of my state’s early voter program, yesterday I voiced my full displeasure at ALL my Congressional incumbents, and from the numbers of early voters (5% of the state total # of voters so far), there’s a LOT of unhappy voters out there…

  24. Anonymous

    BWI made the US$ as good as gold and entrenced the US$ as the worlds reserve currency. ECB council member Ewald Nowotny on sunday 19th talked about a tri-polar global currency system.At the very least it looks like Europe and Asia want to cut themselves free of the drowning US.

  25. Matt Dubuque

    AIG was put on a short leash because the Fed was involved. The Fed is a lot more concerned about the quality of their balance sheet than the clowns at the Treasury.

    For those who do not understand that the Fed has been pretty prudent, all things considered, throughout this catastrophe, recall that Fed swap lines are extended on a short term basis to major solvent central banks.

    Those lines are being sterilized. To ask for the Fed to ALSO bring toxic third world central banks on to their balance sheet is a recipe for catastrophe.

    Why was Rogoff’s warning about the risk to central bank balance sheets so quickly forgotten?

    Paulson is a fool, only interested in making it a better world for Goldman.

    The Fed is playing its cards, although they are limited, rather well.

    AIG is just one small case in point of how the Fed does things far more competently than the clowns at Treasury.

    These words will be soon forgotten among the pitchfork crowd of knee jerk Fed bashers and Ron Paul types.

    That does not make them false.

    Matt Dubuque

  26. dlr

    The FIRST step that has to be taken before lending any money to these banks is for ALL of their top level executives to be removed. Who in their right mind would give these crooks any more money to line their pockets with? They have already proven themselves to be incompetent or criminal.

    Right now approximately 50% of REVENUE at each of these major banks is going to massive bonuses and billion dollar employee payouts. The executives are looting these institutions, just hollowing them out, stealing from the shareholders with opaque accounting tricks and MASSIVE payouts to themselves in terms of bonuses. Nine banks are going to hand out 90 BILLION dollars in employee compensation and bonuses THIS YEAR ALONE. Giving them more money just lets the game continue a little longer.

    The fact that the bailout money was given without any meaningful curbs on employee compensation or bonuses PROVES that Paulson is as corrupt as the rest of them.

  27. DMD

    It comes down to radical individual action: stop spending. Don’t borrow any money at all. Don’t put anything on a credit card, not even if you pay it off every month.

    It’s going to be painful.

    But it’s going to be painful anyway.

    This is literally the only thing I can think of that will honestly express the will of the general public. It’s the only weapon in our arsenal.

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