By Edward Harrison of Credit Writedowns
I was reading Kid Dynamite’s account of the recent Treasury – Finance Blogger meeting after having read a bunch of others (see them all in Abnormal Returns’ Nov 4th links). And I was struck by his characterization of the thinking at Treasury in regards to the financial crisis. I want to highlight two points and ask the question: didn’t the Treasury plan work as designed?
I will try not to editorialize and let you draw your own conclusions based on my (hopefully neutral) narrative of their stated goals.
Here is point #1 I want to highlight:
The first point that caught my ear was the description of the stress tests as having been designed to restore a level of confidence in the banking system. The STO mentioned that the focus was now on reducing the footprint of economic intervention cautiously, quickly and prudently…
a number of STO’s present in the room, who quickly banded together to clarify that no one knew the results of the stress tests before they happened, and that they were designed to restore confidence by identifying the levels of capital needed by the banks, and requiring them to raise such capital. I said that if they wanted to restore confidence, they should require banks to mark assets to market, and depict the true financial situation.
As I read it, Treasury wanted to show that it had a credible plan to identify any capital shortfalls amongst our biggest banks and to take corrective action. Their belief is this would restore confidence.
Here is point #2 to highlight – why the need for secrecy:
I [Kid Dynamite] mentioned that the problem was that even if we had a “Counterparty Risk Czar” who somehow managed to magically quantify the exposures of each firm (which may be quite a difficult task in itself), we’d see the same problems we saw when the government went to give out the TARP funds. The government didn’t want to “bail out” select firms (ie, BAC and CITI) because they feared that the stigma attached to such assistance would create panic and runs on the bank – so they asked a large pool of financial institutions to take the money to hide the truly sick cows.
I read this to say that Treasury feared identifying ‘loser’ institutions would have a negative impact and cause bank runs (think Washington Mutual). therefore, they had to hide the ball, so to speak. The same philosophy is behind the Fed’s refusal to release more information to Bloomberg on the Fed’s emergency lending counterparties.
The overall gist of the strategy was that Treasury wanted to identify the weak, give them time to grow stronger, and, in so doing, allow the panic phase to subside so that corrective action could be taken in a more normal economic environment.
Wasn’t the plan wildly successful? Blogger Accrued Interest thinks so.
Now, before you give a knee-jerk response, please read the following from a post I wrote in April called “Channeling my inner Larry Summers,” which was my attempt to read the intentions of Obama and his economic team (in the voice of Larry Summers). I think it dovetails nicely with what Kid Dynamite says were the actual goals of Treasury.
the question is how do we deal with this crisis. The first priority must be to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences. The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending. Is this re-flating the bubble? No, because deflationary forces will continue to extract a price even with these measures in place. The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.
But, spending alone won’t get it done. Ultimately, we will need to increase credit availability. Just because people are spending more, does not mean the economy will grow. Growth depends critically on increasing credit in line with the growth of the economy.
I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing. The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government. What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.
Let me enumerate some mechanisms:
- First we should try bank re-capitalization. Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that’s number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money. What’s more is it limits government interference. Remember – most of these institutions are having temporary problems. With enough capital, they can weather the storm. There is no need for heavy-handed government interference.
- If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks’ balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government’s limitations. The PPIP and TALF can help achieve this.
- Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.
Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.
So have Geithner and his team not avoided the pitfalls and accomplished their goals?