A Plan for Economic Recovery
We are facing the prospect of global deflation and depression, similar to but potentially worse than the 1930s. That said, I believe the situation could be turned around by adopting a bold and comprehensive program. Unfortunately, Treasury Secretary Geithner did not present a convincing case. I outline the basic elements of such a program in my forthcoming Book, The Crash of 2008 and What it Means. I am providing an excerpt here in the hopes that it will stimulate discussion and help generate the necessary political will for bold action.
The bursting of bubbles causes credit contraction, forced liquidation of assets, deflation, and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of ac ulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.
It can be done by creating money to offset the contraction of credit, recapitalizing the banking system, and writing off or down the ac ulated debt in an orderly manner. For best results, the three processes should be combined. This requires radical and unorthodox policy measures. If these measures were successful and credit started to expand, deflationary pressures would be replaced by the specter of inflation, and the authorities would have to drain the excess money supply from the economy almost as fast as they pumped it in. Of the two operations, the second is likely to prove both technically and politically even more difficult than the first, but the alternative--global depression and world disorder--is unacceptable. There is no way to escape from a far-from-equilibrium situation--global deflation and depression--except by first inducing its opposite and then reducing it.
The size of the problem is even larger than it was in the 1930s. This can be seen from a simple calculation. Total credit outstanding was 160 percent of GDP in 1929, and it rose to 260 percent in 1932 due to the ac ulation of debt and the decline of GDP. We entered into the Crash of 2008 at 365 percent, which is bound to rise to 500 percent or more by the time the full effect is felt. And this calculation does not take into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. The situation has been further aggravated by the haphazard and arbitrary way in which it was handled by the Bush administration. The public and the business community suffered a shock in the aftermath of the Lehman Brothers default, and the economy has fallen off a cliff. The next two quarters will show rapid deterioration.
To prevent the economy from sliding into a depression, President Obama must embark on a radical and comprehensive policy package that has five major components:
1. A fiscal stimulus package
2. A thorough overhaul of the mortgage system
3. Recapitalization of the banking system
4. An innovative energy policy
5. Reform of the international financial system
I shall briefly discuss each of these elements.
1. A Fiscal Stimulus Package
This is conventional wisdom, and I have nothing original to contribute. The fiscal stimulus package is already well advanced, and it will be the first out of the gate, but it will take time to implement and will serve merely to moderate the downturn. In my view the next two items are indispensable. To turn the economy around, the mortgage and banking systems need to be thoroughly reorganized and restarted.
2. A Thorough Overhaul of the Mortgage System
The collapse of the financial system started with the bursting of the U.S. housing bubble. There is a real danger now that house prices will overshoot on the downside and put further pressure on the banks' balance sheets. To prevent this, foreclosures must be reduced to a minimum and house ownership facilitated both for new buyers and current owners.
But we ought to go even further than that. With the mortgage financing industry in shambles, we ought to subject it to a thorough overhaul and introduce a new system that is free of the deficiencies that are responsible for our current difficulties. It is rare that a systemic change is necessary or even possible; the present is such an occasion.
I advocate adopting, with suitable modifications, the Danish system, which has proven its worth since it was first introduced after the Great Fire of Copenhagen in 1795. Our current system has broken down because the originators of mortgages have not retained any part of the credit risk. They are motivated to maximize their fee income. As agents, their interests are not identical with the interests of the ultimate owners. In the Danish system, the service companies retain the credit risk--they have to replace the mortgages that are in default.
In contrast to our reliance on government sponsored enterprises (GSEs)--namely Fannie Mae and Freddie Mac-- the Danish is an open system in which all mortgage originators participate on equal terms, and it operates without government guarantees. Yet Danish mortgage bonds are traditionally very highly rated; often they yield less than government bonds. This could not be replicated in the United States at present because of the demoralized state of the market, but it may be achieved later.
Danish mortgage bonds are highly standardized, and their distinguishing feature is that they are identical to and interchangeable with the underlying mortgages. House owners can redeem their mortgages at any time by purchasing the equivalent mortgage bond in the market and exchanging it for the mortgage. Since bond prices and house prices normally move in the same direction, this feature--called the principle of balance--reduces the chances of householders having negative equity in their houses. The mortgage originators are strictly regulated, and their interests are closely aligned with those of the bondholders. They pass on only the interest rate risk to bondholders, retaining the credit risk. That is why the bonds are so highly rated.
When Mexico wanted to securitize mortgages in order to promote house ownership, it opted, with my assistance, for the Danish system. My proposal was supported by the U.S. Treasury, which was then under the leadership of Paul O'Neill. The Danish model is clearly superior to the GSE model. The question is, how can you get there from here? Originally, I proposed a grand scheme in which all mortgages that are under water (i.e., whose principal amount exceeds the current market value of the house) would be replaced by a new mortgage, incorporating the Danish principle of balance but being insured by a government agency.
This would have had the advantage of removing the incentive to default in order to obtain the benefits of loan modification, but it would have run into insuperable political and even cons utional difficulties. The slicing and dicing of CDOs has created such conflicts of interest amongst the holders of various tranches that neither a voluntary nor a compulsory scheme of reorganization is possible. Abandoning the search for an optimal solution, I have come to realize that a second best solution is readily available.
The GSEs have become effectively government owned, but the government is not exercising its powers of control. They are in limbo, torn between the interests of their shareholders and the public. The prospect of the shareholders emerging with a positive value is imaginary; nevertheless, the GSEs are trying to make a profit from their quasi-monopolistic position, charging heavy fees and imposing restrictive conditions on both refinancing applications and new ones. This is aggravating the housing problem, but it could easily be changed by a newly established regulator asserting its authority and using the GSEs as an instrument of public policy.
The GSEs could then introduce a new type of mortgage contract based on the Danish model. It would be transparent and uniform, and it would incorporate the principle of balance. The GSEs would reduce their fees, extend the limit on the size of mortgages they are willing to guarantee, and introduce a new line of guarantees--up to 90 percent of appraised value at a higher premium--effectively replacing the private mortgage insurance companies that have become inactive.
They would then introduce a streamlined and cheap refinancing process for existing mortgages. That would greatly reduce the cost of conforming mortgages and create a powerful incentive to convert nonconforming mortgages into conforming ones. Owners of defaulting mortgages could avail themselves of the provisions of the Help for Homeowners Act and realize 85 percent of the appraised value. In most cases this would be preferable to going through a costly foreclosure process. If owners failed to choose that route, it could be imposed on them by a judge in a simplified bankruptcy process. One way or another, the number of foreclosures would be greatly reduced, and with mortgages more freely available at lower cost, house prices would stabilize at a higher level than would otherwise be the case. Financial ins utions would recover some of their losses on residential mortgages and securities.
It is ironic that the GSEs, which are at the root of the problem, should provide a route to the solution. In the long run the GSEs should be phased out and their portfolios run off. They would become a government agency in charge of mortgage guarantees issued by the government. Eventually, when the modified Danish model becomes firmly established, even that function could be phased out. Under the new system, mortgage origination companies would remain responsible for the first 10 percent of any losses arising out of default. They would be allowed to charge a fee that would be determined by compe ion. As the system matures, service companies may find it advantageous to accept the entire credit risk and not pay a fee for government guarantees. The system would then come to reflect the Danish model more faithfully.
The sequence of the GSEs first becoming more important and then fading away resembles the sequence that characterizes the entire process--to escape deflation you first induce inflation and then reduce it. In implementing it we should never forget what went wrong with communism: the state did not fade away. The fading away should be part of the plan from inception.*
The whole process could be accomplished by using the GSEs and the new bankruptcy law currently under consideration by Congress. The government already controls the GSEs; all it has to do is to exercise its powers. The cramdown provisions of the proposed new bankruptcy law face active opposition from many financial ins utions holding mortgages; it should be possible to persuade them that most of them would benefit from the mortgage reorganization scheme outlined here. The costs to the taxpayers would manifest themselves through the eventual losses incurred by the GSEs, but, considering the impact on house prices and the economy, the net effect is likely to be positive.
3. Recapitalization of the Banking System
I cannot present as clear a picture of what a reformed banking system would look like as I can for the mortgage system because there are no suitable models to invoke. The Spanish banking system has weathered a bigger boom in house construction better than the U.S. banking system, and it has some desirable features, but Spain is even more adversely affected by the Crash of 2008 than the United States. What happened to the U.S. banking system after the Great Depression certainly does not present a desirable model. Banks were put into a straightjacket whose constraints began to be loosened only in the 1970s. We are in uncharted territory.
I summed up the main lessons to be learned from the current financial crisis in the previous edition of this book: Financial markets do not tend toward equilibrium, and deviations are not random. Credit creation and contraction are reflexive and tend to occur in initially self-reinforcing but eventually self-defeating boom-bust sequences. Therefore it is not enough to regulate the money supply; it is also necessary to regulate credit conditions. This involves reactivating policy tools that have fallen into disuse: variable margin and minimum capital requirements, and central bank directives on bank lending to particular sectors. Not only banks but all ins utions involved in credit creation must be subject to regulation. The objective is to maintain stability and prevent mispricing and other excesses from becoming self- reinforcing. The same applies to financial instruments: They need to be licensed and supervised to ensure that they are uniform and transparent and do not destabilize markets. Leverage must be used cautiously: It is not enough to allow for quantifiable risks; one must impose an additional safety margin for the uncertainties inherent in reflexivity. Financial engineering, structured finance, and other innovations are of dubious value; insofar as they cir vent regulations or render them ineffective, they can be harmful.
It is clear, in the light of these observations, that the financial sector became far too big and profitable. In the future it will have to shrink and remain within the control of the authorities. While financial markets became global, the authorities remained national. Since global markets are beneficial, the authorities must also become more international and the international financial ins utions must serve the interests of all their members more equitably.
Since the publication of the previous edition of this book, financial markets have completely collapsed and had to be put on artificial life support. Keeping them alive and preventing the world economy from sliding into depression has to take precedence over all other considerations. As we have seen, the economy can be turned around only in two steps. The first is to offset the collapse of credit by creating money, writing off bad debt, and recapitalizing the banks. Then, if and when that succeeds, the excess money supply will have to be drained as fast as credit begins to flow. That means the initial policy measures will take us in exactly the opposite direction from our eventual destination. Nevertheless, the ultimate destination ought to inform the design of the initial step. Unfortunately, Treasury Secretary Henry Paulson reacted in a haphazard and capricious manner. That is how the situation spun out of control. After the bankruptcy of Lehman Brothers, he forced through Congress a $700 billion rescue package without any clear idea how it should be used to adequately recapitalize the banks. I explained how it should be done in an article published by the Financial Times online on October 1, 2008, at the height of the Congressional debate. This is what I proposed:
The Treasury secretary would give bank examiners clear guidelines for how assets should be valued. For instance, it would be postulated that commercial real estate will on average lose 30 percent of its value. He would then ask the examiners to establish how much additional equity capital each bank needs in order to be properly capitalized according to existing capital requirements. If managements could not raise equity from the private sector, they could turn to the Treasury. The Treasury would offer to underwrite an issue of convertible preference shares. The preference shares would carry a low coupon (say 5 percent) so that banks would find it profitable to continue lending, but shareholders would be heavily diluted by the convertibility feature. They would be given the right, however, to subscribe on the Treasury's terms, and if they exercised their rights, they would avoid dilution. The rights would be tradeable, and the Treasury would seek to set the terms so that the rights would have a positive value. Private investors, including me, may be interested in buying the shares of some banks on the same terms as the Treasury.
After recapitalization, minimum capital requirements would be lowered to, say, 6 percent. This would encourage banks to lend because they could suffer a further 25 percent depreciation of assets without violating statutory limits. They would be eager to take advantage of the rich margins currently prevailing. The economy would be reactivated. With everyone sitting on a lot of liquidity and suddenly eager to put it to work, there would be a sudden rush into less liquid assets. Deflation would be replaced by the specter of inflation, and liquidity would have to be drained as fast as it had been pumped in. Minimum capital requirements would then be raised first to 8 percent, then higher. In this way, the leverage of the banking system would be reduced, which is a desirable long-term objective.
If TARP (the Troubled Asset Relief Program) had been implemented in this way originally, the banking system could have been recapitalized with $700 billion, or perhaps even less. Unfortunately, half that money has already been spent, and most of the second half of TARP will also be needed to plug the holes that have already developed. What would have been possible then is no longer realistic. That is a distinguishing feature of financial crises and other far-from-equilibrium conditions: What is appropriate at one point in time is no longer valid at the next one.
Adequate recapitalization of the banking system now faces two seemingly insuperable obstacles. One is that Treasury Secretary Henry Paulson has poisoned the well by the arbitrary and ill-considered way he forced through and implemented the $700 billion TARP program. The Obama administration feels that it cannot ask Congress for more money. The other is that the hole in the banks' balance sheets has become much bigger since TARP was introduced. The assets of the banks--real estate, securities, and consumer and commercial loans--have continued to deteriorate, and the market value of banks' stocks has continued to decline. It is estimated that something in the neighborhood of an additional trillion-and-a-half dollars would be required to adequately recapitalize the banks. Since their total market capitalization has fallen to about a trillion dollars, this raises the specter of nationalization, which is politically--and even culturally--unpalatable.
Consequently, the administration is constrained to do what is possible even if it falls short of what is necessary. It plans to carve out up to $100 billion from the second tranche of TARP in order to set up an aggregator bank that would acquire toxic assets from the banks' balance sheets. By obtaining 10:1 leverage from the balance sheet of the Federal Reserve, the aggregator bank could have a trillion dollars at its disposal. That is not sufficient to cleanse the balance sheets of the banks and restart lending, but it would bring some welcome relief. The aggregator bank could serve as a useful interim measure except for the fact that it is liable to make it more difficult to obtain funding necessary for a proper recapitalization in the future. It will encounter all kinds of difficulties in valuing toxic securities and even if these could be overcome it will still end up as a covert subsidy to the banks by bidding up the price of their toxic assets. There will be tremendous political resistance to any further expenditure to bail out the banks. This will make it much more difficult to mobilize additional funds in the future. It would be a pity to take the aggregator bank route, especially when there is a way to adequately recapitalize the banks with the currently available resources.
Let me spell out how it could be done. The trick is not to remove the toxic assets from the balance sheets of the banks but to put them into a "side pocket" or "sidecar" as hedge funds are now doing with their illiquid assets. The appropriate amount of capital--equity and subordinated debt--would be sequestered in the side pocket. This would cleanse the balance sheets and create good banks, but leave them undercapitalized. The same trillion dollars that is currently destined to fund the aggregator bank could then be used to infuse capital into the good banks. Although the hole is bigger, a trillion dollars would be more than sufficient because it would be possible to mobilize significant amounts from the private sector.
In the current environment a good bank would enjoy exceptionally good margins. Margins would narrow as a result of compe ion but by then the banking system would be revitalized and nationalization avoided. The situation is analogous to a devastating hurricane depleting the capital of property insurance companies, raising insurance premiums, and attracting additional capital into the industry. The scheme I am proposing would minimize valuation problems and avoid providing a hidden subsidy to the banks. Exactly for that reason it is likely to encounter strong resistance from vested interests. Losses would first accrue to shareholders and debenture holders; only if they exceed a bank's capital would the FDIC be liable for the deficiency, as it is already. Shareholders would be severely diluted, but they would be given tradable rights to subscribe to the good bank, and if there is a positive residue in the side pocket, it would also revert to the good bank as of the date of the new issue, giving shareholders the benefit of any subsequent appreciation. The fact that debenture holders may lose money will make it more difficult to sell bank debentures in the future. But that is as it should be: Banks should not be as highly leveraged as they have recently been. Pension funds would suffer heavy losses; but that is preferable to taxpayers taking over those losses.
In addition to restarting bank lending, my scheme would resolve the moral hazard issue for a long time to come. The banking industry is accustomed to turning to the state in a crisis and effectively demanding a bailout on the grounds that financial capital has to be protected to ensure the proper functioning of the economy. Given the aversion to state ownership of banks, the blackmail has always worked. That is how the bubble grew so large. The Obama administration ought to resist the blackmail and adopt the scheme outlined here as a prelude to building a better financial system. Our future depends on it.
4. An Innovative Energy Policy
Energy policy could play a much more innovative role in counteracting both recession and deflation. The American consumer can no longer act as the motor of the global economy. A new motor is needed. Alternative energies and energy savings could serve as that motor, but only if the price of conventional fuels is kept high enough to justify investing in them. That might also help to moderate price deflation. A high price on conventional fuels would be beneficial on both counts, but it would be hard to sell to the public. Until now, no politician dared to do so.
President Obama would need great courage and great skill to do the right thing. This would involve putting a floor under the price of fossil fuels by
a) imposing a price on carbon emissions by (a) a carbon tax or (b) auctioning pollution licenses (the former would be more efficient, the latter is politically more acceptable) and
b) imposing import duties on oil to keep the domestic price above, say, $70 per barrel.
The anticipated income from carbon emissions should then be distributed to households in full and in advance. This would compensate them for the higher cost of energy and hopefully make the scheme politically acceptable. It would also act as a temporary fiscal stimulus at a time when it is most needed, although most of it can be expected to be saved rather than spent. Gradually the price of carbon emissions would have to be raised to a level where it would pay to remove carbon from coal. This is indispensable for bringing climate change under control because there is no adequate subs ute for coal-fired power plants except clean coal.
It is essential to convince the public that the cost of energy will remain high for some time in order to encourage investment in alternative energy and energy-saving devices. Eventually the cost of energy may decline as new technologies travel down the learning curve. We cannot depend on the price mechanism alone to ensure the development of new technologies. Tax concessions, subsidies, vehicle emissions standards, and building codes are also needed. Even so, neither energy security nor the control of global warming can be achieved without putting a price on carbon emissions. The United States cannot do it alone, but it cannot be done without the United States taking the lead.
5. Reform of the International Financial System
The fate of the United States is intimately interconnected with the rest of the world. The international financial system as it has evolved since the 1980s has been dominated by the United States and the Washington consensus. Far from providing a level playing field, it has favored the United States, to the detriment of the countries at the periphery. The United States exercises veto rights over the international financial ins utions (IFIs)--the International Monetary Fund (IMF) and the World Bank. The periphery countries are subject to the market discipline dictated by the Washington consensus, but the United States is exempt from it. This has exposed the periphery countries to a series of financial crises and forced them to follow pro-cyclical fiscal policies, and it has allowed the United States to suck up the savings of the rest of the world and maintain an ever-increasing current account deficit. This trend might have continued indefinitely because the willingness of the United States to run a chronic current account deficit was matched by the willingness of other countries to run current account surpluses. It was brought to an end by the bursting of the housing bubble, which exposed the overindebtedness of the household sector.
The current financial crisis has revealed how unfair the system is because it originated in the United States, but it is doing more damage to the periphery than to the center. This damage to the periphery is a recent development, following the bankruptcy of Lehman Brothers, and its significance has not yet been fully recognized. The countries at the center have effectively guaranteed their bank deposits, but the periphery countries cannot offer similarly convincing guarantees. As a result, capital is fleeing the periphery, and it is difficult to roll over maturing loans. Exports suffer for the lack of trade finance. The IFIs are now faced with a novel task: to protect the countries of the periphery from a storm that has emanated from the center, namely the United States. The IFIs' future depends on how well they cope with that task. Unless they can provide significant assistance, they may become largely irrelevant. Global, multilateral arrangements are in danger of breaking down, turning the financial crisis into global disorder and depression.
Assistance is needed to
- protect the financial systems of periphery countries, including trade finance, and
- enable periphery governments to engage in countercyclical fiscal policies.
The former requires large contingency funds available at short notice for relatively short periods of time. The latter requires long-term financing.
When the adverse side effects of the Lehman bankruptcy on the periphery countries became evident, the IMF introduced a new short-term liquidity (STL) facility that allows countries that are otherwise in sound financial condition to borrow five times their quota for three months without any conditionality. But the size of the STL is too small to be of much use, especially while a potential stigma associated with the use of IMF funds lingers. Even if it worked, any help for the top-tier countries would merely aggravate the situation of the lower-tier countries. International assistance to enable periphery countries to engage in countercyclical policies has not even been considered.
The fact is that the IMF simply does not have enough money to offer meaningful relief. It has about $200 billion in uncommitted funds at its disposal, and the potential needs are much greater. What is to be done? The simplest solution is to create more money. The mechanism for issuing Special Drawing Rights (SDRs) already exists. All it takes to activate it is the approval of 85 percent of the membership. In the past the United States has been the holdout opposing it. Creating additional money supply is the right response to the collapse of credit. That is what the United States is doing domestically. Why not do it internationally? Ironically, SDR would not be of much use in providing short-term liquidity, but it would be very helpful in enabling periphery countries to engage in countercyclical policies. This would be done by rich countries lending or, preferably, donating their allocations to poor countries. The scheme has the merit that the IFIs would retain control over the disbursement of the lent or donated funds and ensure that they are spent in accordance with the poverty reduction programs that have already been prepared at the behest of the World Bank. This would especially benefit poorer countries that are liable to be hardest hit by the worldwide recession.
If it were implemented on a large scale--say $1 trillion--the SDR scheme could make a major contribution to both fighting the global recession and fulfilling the United Nations' Millennium Development Goals. This seemingly selfless act by rich countries would actually serve their enlightened self-interests because it would not only help turn around the global economy but also reinforce the market for their export industries. Since the SDR scheme is not of much use in providing short-term liquidity to periphery countries, that task would have to be accomplished by other means, notably the following three:
a) Chronic surplus countries could contribute to a trust fund that supplements the new STL facility. This would greatly enhance the value of that facility by removing the five-times-quota limitation. For instance, under STL Brazil can draw only $23.4 billion, while its own reserves are over $200 billion. A more flexible supplemental fund would give the STL facility more heft. Japan held out the promise of $100 billion. Other chronic surplus countries probably would not contribute unless the quota issue was reopened. Holding out the prospect of higher quotas could serve as an inducement to put together a supplemental fund that would be large enough to be convincing.
b) The central banks of the developed world should extend additional swap lines to developing countries, and they should accept assets denominated in local currencies to make them more effective. The IMF could play a role by guaranteeing the value of assets denominated in local currencies.
c) In the longer term, international banking regulations should facilitate credit flows to periphery countries. In the short term, the central banks of the developed countries should exert pressure on commercial banks under their aegis to roll over credit lines. This could be perhaps coordinated by the Bank for International Settlements.
With regard to enabling periphery countries to engage in countercyclical policies:
1. The major developed countries should, in addition to donating their SDR allocations, jointly guarantee, within agreed limits, longer-term government bond issues of periphery countries. Regional arrangements should be encouraged, provided they are within an international framework. For instance, the European Investment Bank and the European Bank for Reconstruction and Development should finance public works in Ukraine in conjunction with the IMF package. China's interest in Africa and other raw material-producing areas should be encouraged, provided China observes the Extractive Industries Transparency Initiative and other international standards.
2. The chronic surplus countries could be induced, by offering them additional voting rights, to invest a portion of their currency reserves or sovereign wealth funds in longerterm government bonds of less developed countries. This could be connected with the proposed trust fund supplementing the STL facility.
None of these measures is possible without opening up the vexed question of quota redistribution. This would be in the enlightened self-interest of both the United States and the European countries that would give up some of their voting rights, because in its absence the newly rich countries would have no interest in cooperating with the IMF. They would turn to bilateral or regional arrangements, and the IMF would become largely irrelevant. The question probably cannot be avoided anyhow, but it will take a long time to settle. The best course would be to obtain support for a large-scale SDR scheme by agreeing to open negotiations. President Obama would be fulfilling the world's expectations by championing this course. The main opposition is likely to come from Germany, but with U.S. leadership and broad international support it could be overcome.
In addition, many other international arrangements are needed:
- Banking regulations need to be internationally coordinated. This would be the task of a Basel Three accord. (Basel Two has been discredited by the financial crisis.)
- Market regulations also need to be global.
- National governments need to coordinate their macroeconomic policies in order to avoid wide currency swings and other disruptions.
- Commodity stabilization schemes ought to be considered. They could be particularly helpful for commodity dependent periphery countries and in counteracting the prevailing worldwide deflationary tendencies.
This is a condensed, almost shorthand, account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is. It remains to be seen whether any of ideas laid out here are adopted as policy.
Last edited by Winehole23; 02-13-2009 at 10:53 AM.
Crap I wish I had time to read that whole thing today.
As it is my time is up, and I will simply have to add this to my subscription list and get back to it.
My brief skimming of it leads me to believe that his solution has some good grounding in reality and offers a damn good chance of working, if implemented.
Related:
A Proposal on How to Clean Up the Banks
by Jeffrey Sachs
The Treasury is still without a plan to clean the banks. Treasury Secretary Tim Geithner told us yesterday that a new "Public-Private Investment Fund" would remove up to $1 trillion of toxic assets from the banks' balance sheets, but he didn't tell us how. In fact, they're still trying to figure that out. If the government pays too much for the bad assets, it bails out the banks. If it pays too little, it de-capitalizes them, leading to a further squeeze on lending.
There is a way, however, to be both fair and efficient. The taxpayers should take over the bad assets in return for bank equity, but with a twist: the amount of equity transferred to the taxpayers would not be determined immediately, but only after the government has sold off the toxic assets. Rather than guessing their eventual market value, or forcing a "fire sale" of the toxic assets now, the bad assets would be sold off gradually, with the realized losses "booked" against the holdings of the private shareholders by transferring equity to the government. The lower the sale price of the toxic assets, the more equity will be transferred to shareholders to make up for the losses. In the meantime, the banks would be fully re-capitalized and back in business.
Here's how the process would work. Consider a bank balance sheet with 100 in assets at face value, 90 in liabilities, and 10 in shareholder equity. For simplicity, suppose that the 90 in liabilities are in government-insured deposits. The assets are worth less than face value. Suppose that 80 of the assets are actually worth face value, while 20 are at a deep discount. If the true value of the 20 is 15, the true shareholder value is 5, while if the true value is only 5, the bank is insolvent, with zero true shareholder value and a government net liability of 5 to honor the deposit guarantee (once the bad assets are realized).
The problem is that the market value of the assets is not known now because the credit squeeze has temporarily eliminated the liquidity in the markets of the toxic assets. There is an added problem. If the government pays fair value for the 20 of toxic assets, it willy-nilly forces a severe write down on the balance sheets even if it pays fair price. This in turn can lead to a further squeeze of lending. If the toxic assets are indeed worth 15, and these are swapped for 15 of government bonds, the recognized bank capital falls to 5, and capital adequacy standards would induce a further retrenchment of loans.
The bank can be recapitalized at fair value to taxpayers and without inducing a squeeze on bank capital and lending in the following way. The government would swap 20 in government bonds for the 20 in toxic assets plus contingent warrants on bank capital, the value of which depends on the eventual sale price of the toxic assets. The government would then dispose of the 20 in toxic assets at a market price over the course of the next year or two and exercise its contingent warrants at that time.
The cleaned bank now has true market capital of 10, equal to 100 in good assets minus 90 in deposit liabilities. The 10 in equity would then be shared between the original shareholders and the taxpayers, with the division to be determined by the eventual sale price of the toxic assets. If the 20 in toxic assets end up selling at their face value, the taxpayers end up with zero ownership of the bank. If the toxic assets end up selling for less than 10, the bank ends up wholly owned by the taxpayers, because the bank is in fact insolvent at the time of the swap.
If the toxic assets end up selling for over 10 and less than 20, the taxpayers get an equity stake equal to 20 minus the eventual sale price. A sale price of 12 (of the 20 face value) leaves the taxpayers with 8 in stock ownership (20 minus 12) and the original shareholders with the remaining 2 (10 minus 2). The taxpayers are thereby fully compensated as long as the bank is solvent, and are left to cover the deposit liability in the event that the bank is in fact insolvent. The shareholders also get the true value of their claims, ranging from zero (if the bank is insolvent) to the face value of equity (if the toxic assets turn out to be good assets).
In this process, there are no taxpayer bailouts, and there is also no squeeze on bank capital resulting from the exchange of toxic assets at less than face value. In practice, the conversion of taxpayer warrants into bank equity would proceed step by step. Suppose that the taxpayers already own 2 and the shareholders own 8 as a result of partial liquidation of the toxic assets. Now, at a later date, additional sales of the toxic assets cause a further realized loss of 1. The bank would then issue further equity at that date equal to 1 (at the contemporaneous market value), further diluting the existing shareholder claims by 1 and raising the taxpayer stake to 3.
During the period of liquidating the toxic assets, the government would exercise a kind of receivership over the banks, preventing the stripping of remaining assets through bonuses, balance sheet transactions, or "Hail-Mary" lending (in which shareholders of zombie banks gamble recklessly because they have nothing to lose and possibly something to gain). In practice, this could be exercised in the form of a "golden share" which gives the government the right of refusal over major bank decisions, including executive compensation. Once the warrants are exercised, the government would sell its ownership stake to private investors.
The bank cleanup has been stymied to this point over the valuation conundrum, stuck between paying an unduly high price for the toxic assets, and thereby bailing out the shareholders, and paying a low price, and thereby expropriating them while inducing a further credit squeeze. A "contingent warrant," as recommended here, can combine bank recapitalization with a fair value divided between the taxpayers and original bank shareholders.
This is all you need to know.
He is asking for a one world govt.
Not a bad idea, in theory. We are all human beings after all. It would be nice to have us all united under one system.
As long as I'm going to be the one in charge...I'm all for it.
If your going to centralize anything, as long as I'm at the top rung of the new centralized chain, you got my support sweetheart. As my favorite quote in one of my favorite movies "Braveheart" goes..."Hey, I'm going to be ok...but, your ed."
SIG
You focus on one aspect of a very detailed essay, in order to dismiss the rest. Nice tunnel vision.
You can't teach Southern Fried a thing; he's already got it all figured out.
Brilliant post...your insights would be much valued by this administration.
Instead of just assuming you know something about me -- like an asshole -- do yourself a favor and use the search function. It can be illuminating.
If you're not allergic to reading, that is.
I'm barely motivated enough to respond to these dumbass attacks as it is. Why don't you say something worth responding to, and let me decide if your as stupid as you sound, or not. Right now, your posts lead me to beleive you ain't worth the effort to click the search button.
If you want my attention, talk political issues...make good political points...state your political case cleanly and concisely (without the use of cutting and pasting other peoples thoughts.)
Continuely batting your eyes at me and following me around, while understandable with ex-girlfriends, is just creepy in a political forum.
Last edited by SouthernFried; 02-15-2009 at 09:20 AM. Reason: To provide opportunity in keeping my attention. Magnanimous reasons.
Nationalize the Banks! We're all Swedes Now
By Matthew Richardson and Nouriel Roubini
Sunday, February 15, 2009; B03
The U.S. banking system is close to being insolvent, and unless we want to become like Japan in the 1990s -- or the United States in the 1930s -- the only way to save it is to nationalize it.
As free-market economists teaching at a business school in the heart of the world's financial capital, we feel downright blasphemous proposing an all-out government takeover of the banking system. But the U.S. financial system has reached such a dangerous tipping point that little choice remains. And while Treasury Secretary Timothy Geithner's recent plan to save it has many of the right elements, it's basically too late.
The subprime mortgage mess alone does not force our hand; the $1.2 trillion it involves is just the beginning of the problem. Another $7 trillion -- including commercial real estate loans, consumer credit-card debt and high-yield bonds and leveraged loans -- is at risk of losing much of its value. Then there are trillions more in high-grade corporate bonds and loans and jumbo prime mortgages, whose worth will also drop precipitously as the recession deepens and more firms and households default on their loans and mortgages.
Last year we predicted that losses by U.S. financial ins utions would hit $1 trillion and possibly go as high as $2 trillion. We were accused of exaggerating. But since then, write-downs by U.S. banks have passed the $1 trillion mark, and now ins utions such as the International Monetary Fund and Goldman Sachs predict losses of more than $2 trillion.
But if you think that $2 trillion is high, consider our latest estimates at the financial Web site RGE Monitor: They suggest that total losses on loans made by U.S. banks and the fall in the market value of the assets they are holding will reach about $3.6 trillion. The U.S. banking sector is exposed to half that figure, or $1.8 trillion. Even with the original federal bailout funds from last fall, the capital backing the banks' assets was only $1.4 trillion, leaving the U.S. banking system about $400 billion in the hole.
Two important parts of Geithner's plan are "stress testing" banks by poring over their books to separate viable ins utions from bankrupt ones and establishing an investment fund with private and public money to purchase bad assets. These are necessary steps toward a healthy financial sector.
But unfortunately, the plan won't solve our financial woes, because it assumes that the system is solvent. If implemented fairly for current taxpayers (i.e., no more freebies in the form of underpriced equity, preferred shares, loan guarantees or insurance on assets), it will just confirm how bad things really are.
Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume. Of course, the economy would still stink, but the death spiral we are in would end.
Nationalization -- call it "receivership" if that sounds more palatable -- won't be easy, but here is a set of principles for the government to go by:
First -- and this is by far the toughest step -- determine which banks are insolvent. Geithner's stress test would be helpful here. The government should start with the big banks that have outside debt, and it should determine which are solvent and which aren't in one fell swoop, to avoid panic. Otherwise, bringing down one big bank will start an immediate run on the equity and long-term debt of the others. It will be a rough ride, but the regulators must stay strong.
Second, immediately nationalize insolvent ins utions. The equity holders will be wiped out, and long-term debt holders will have claims only after the depositors and other short-term creditors are paid off.
Third, once an ins ution is taken over, separate its assets into good ones and bad ones. The bad assets would be valued at current (albeit depressed) values. Again, as in Geithner's plan, private capital could purchase a fraction of those bad assets. As for the good assets, they would go private again, either through an IPO or a sale to a strategic buyer.
The proceeds from both these bad and good assets would first go to depositors and then to debt-holders, with some possible sharing with the government to cover administrative costs. If the depositors are paid off in full, then the government actually breaks even.
Fourth, merge all the remaining bad assets into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers.
The eventual outcome would be a healthy financial system with many new banks capitalized by good assets. Insolvent, too-big-to-fail banks would be broken up into smaller pieces less likely to threaten the whole financial system. Regulatory reforms would also be ins uted to reduce the chances of costly future crises.
Nationalizing banks is not without precedent. In 1992, the Swedish government took over its insolvent banks, cleaned them up and reprivatized them. Obviously, the Swedish system was much smaller than the U.S. system. Moreover, some of the current U.S. financial ins utions are significantly larger and more complex, making analysis difficult. And today's global capital markets make gaming the system easier than in 1992. But we believe that, if applied correctly, the Swedish solution will work here.
Sweden's restructuring agency was not an out-of-control bureaucracy; it delegated all the details of the cleanup to private bankers and managers hired by the government. The process was remarkably smooth.
Basically, we're all Swedes now. We have used all our bullets, and the boogeyman is still coming. Let's pull out the bazooka and be done with it.
Matthew Richardson and Nouriel Roubini, professors at New York University's Stern School of Business, contributed to the upcoming book "Restoring Financial Stability: How to Repair a Failed System."
===============
Can America's "adults" actually learn something from other nations?
or even know anything about even recent history?
no, Americans are "exceptional", totally different and of course better than every other nation, all freedom with no responsibility.
Govt intrusion into just about everything...is what is causing the system to fail in the first place!!
Fanny Mae and others were directed to give out these stupid loans to people who couldn't afford them...by the same govt these idiots want to take them over totally!! Barney Franks and others crafted the legislation and forced the lenders to make these dumbass loans.
Now you want these same morons to completely take it over??
In an Era when giving people their own money back (tax cuts) is a bad idea, and exponentially expanding DEBT to pay for "reviving" the economy is a good idea...Idiot like this is to be expected I guess.
And there's a lot more "precedence" for nationalization of private industries than just Sweden's. Look to the entire Eastern Bloc, China, etc...
Christ, have people totally lost their minds?
Yes. The answer is yes.
I already did, but you ignored it. Since you're probably too lazy to review the thread, I'll sum up for you.
The OP is divided into five themes:
1. A fiscal stimulus package
2. A thorough overhaul of the mortgage system
3. Recapitalization of the banking system
4. An innovative energy policy
5. Reform of the international financial system
1-4 are purely domestic in import, and relate to the present financial collapse. You may disagree with any of these, but the nuts and bolts are not straightforwardly derived from -- nor do they necessarily lead to -- the political result implicit in 5.
You pretended 5 covered 1-4. You were wrong. All it covers is your ignorance of the rest of the essay. If you had had something substantive to say, instead of a just stupid throwaway, I wouldn't have ed.
That's some imagination you've got there. I don't really care. You're welcome to it.
Failure at delivery. Did the government cause dealer/brokers, megabanks and insurance companies to ignore the risk underlying their investments and to leverage their firms at 30/1 and 40/1 ratios? No. The hit in the mortgage market we could have faded. It's the derivatives based on mortgages -- i.e., instruments not regulated by the government -- that sank the banks and dealer-brokers. You seem to have swallowed the myth that our present difficulties were caused by mortgage lending to minorities. If you do, you're a simpleton.
More fail. You have no idea how this works. Treasury would run the receivership. Are you familiar with the RTC?
Because shoveling money into a black hole with zero accountability has worked so great...let's just keep doing that, instead of letting insolvent banks fail.
You do know that's what happens to banks that go s up, don't you? The government takes over. That's the normal procedure. the banks are pulled apart, bad debt is purged, and the pieces are reorganized and reprivatized.
Apples and oranges. You seem to think the differences between USA/Sweden and communist bloc countries is erased by the mere fact of government ownership. If you really do, then you're an idiot.
If the banks go into receivership, they will be reprivatized.
I have zero information as to the background on this, so let me say as a fairly impartial observer:
He posts threads like this all the time AND you came into HIS thread.
Claiming that someone is "following" you around when you come into a thread started by that person, um, doesn't really reflect well on you, to put it politely.
Again, this guy is a "world economy" lover thru and thru. I dont much give a flying about the "periphery". Honestly, I dont...if that makes me a bad person, so be it. England/France/Germany/Japan/China/Tanzania/whomever.The current financial crisis has revealed how unfair the system is because it originated in the United States, but it is doing more damage to the periphery than to the center. This damage to the periphery is a recent development, following the bankruptcy of Lehman Brothers, and its significance has not yet been fully recognized. The countries at the center have effectively guaranteed their bank deposits, but the periphery countries cannot offer similarly convincing guarantees.
Hearing this guy go thru points 1-4 sounded "okay" until I got to #5 and realized the entire article hinges on the US "leveling the playing field" with the rest of the world.
Dont get me wrong now...I understand the point he was making in that we (the US) have exploited the world's surpluses to our national benefit and without that symbiotic/parasitic relationship, our standard of living wouldnt be the same.
But how much different? Ok, we wont suck the life out of other countries....thats fair. But I will be damned if America is somehow going to make concessions in some attempt to lessen the burden on others.
Thats where my " them" at ude comes from. Yeah, yeah...the relationship was totally unfair, sucks to be you. This isnt divorce court and you dont get alimony.
Dude you can't just ignore the world. As much as you'd like to shut the US in a bubble its infeasible so why even lament its disappearance at all? We're in a world economy whether people want to acknowledge it or not.
The concessions will be made whether or not you like it. Its happening right now! You seem to simultaneously believe that we need to change our economic policies and general financial policies without understanding the fundamental reasons why we have to do this.
The world started to catch up to us decades ago. We've maintained a fake lead over them through borrowing. So now we either revamp our system or we come back down to earth.
Indeed. One of the norse countries, Sweden or Norway, I can't remember which, privatised their banks a decade or two a ago, nursed them back to health and re-privatised them.
There is virtually no political will, even on the "socialistic" left, for a total, permanent nationalization of banks.
What is needed is simply an orderly process no matter what we do. The problem is that we have a lot of so-called "zombie" banks, kept alive unnaturally by infusions of cash, but unable to really "live" and do what live banks normally do, i.e. lend money. Any funds we give them will simply go into their equity/surplus account to improve their bottom-line solvency.
We need to whack them in the head with a shovel, and put them out of their/our misery.
The shareholders of these banks will lose everything, as they should, and the government will simply take them and their ty portfolios over and soak up the losses.
Eventually the losses will shake themselves out, and we can take what is left and worth salvaging and re-privatise that portion of the business.
As the new owners, we will have the capacity to do whatever loan modification it will take to start staunching the tide of foreclosures. As it is the banks now have proven more than unwilling to do so, because doing so formalizes the losses on their books, and makes the true scope of their losses more plain to everyone involved, something that the management is unwilling to do, for obvious reasons.
In essence, yes.
The global economy has room to grow FAR more than the US economy, and even with the recent brewhaha, the percentage of the world economy that the US represents has been shrinking, and will continue to do so.
We still have a huge impact on the rest of the world, but we MUST accept that the rest of the world is catching up and competing with us for the same resources, i.e. ore, energy, etc.
To shut the rest of the world out, means removing ourselves from the ability to export as well, which would end up hurting us doubly, as we will be deprived of that rather vast market for our goods and services.
Globalization has happened, and will continue to happen, the process will continue with or without our participation.
Either we deal with it in a constructive way, or we pretend things haven't changed, and use less than optimal solutions.
I let his nitwittedness get under my skin, so I picked on him some. He sounds like a right wing sock puppet, so I figured I might either goad him into sentience or drive him away.
So far, it has had the intended effect.
Remember thread about the national debt? It all come down to who we owe. them, indeed, but they can us right back. The unipolar moment is over.
The thing is that it will happen no matter what we end up doing.
In the US, the federal government has left virtually all regulation of insurance to the states. This is roughly analogous to the balkanized way that banking regulation is done in the world.
Over time the pressures from having to deal with 50 different sets of laws, enforcement regimens and accounting standards led both the states and the insurance industry to set up a commission to standardize the laws to make it easier for a large company to offer policies in more than one state. I.e. "model laws" that are passed almost word-for-word in the participating states, and commonly accepted accounting rules.
In the end we all benefit from this, as it makes the companies a bit more transparent, and insurance a bit more available than it would be if a company had to deal with 50 different laws/accounting standards.
Most states have some variation still according to their own preferences.
The same thing is happening today with accounting standards, and I will bet this natural process will start to take form for the banking regulatory sector as well.
Is it ultimately a loss of sovereignty to come up with a common standard that is the 95% same in most countries?
I would say no.
The benefits of such a regimen would be to make banking more accessible and probably more transparent than it has been. The world needs that.
Except Fannie and Freddie didn't originate all of the loans.
Freddie and Fannie, although large, were by no means the majority of mortgages.
You implied that you seem to think the present problem was completely their fault.
Just to clarify:
What percentage of mortgages in the last 10 years do you think originated in those two ins utions?
I know how much credibility to give a person who parrots the Fannie and Freddie bull . Its simply a marker of who to ignore, IMO.
(winces)
Yup.
I find it very sad that the right wing produces so many people who lack enough critical thinking skills to know that they aren't getting 100% of the picture when they listen/watch Fox News et al.
Looking at a complex world in black/white terms is emotionally comforting, but hardly condusive to finding efficient solutions to the complex problems of the real world.
Just to be 100% clear:
Both Democrats and Republicans share portions of blame here. The Republicans hate the government oversight that makes for stability in banking systems, and the Democrats went along with it, because it seemed that the ty loans were helping the poor.
Any one who only talks about the latter, without acknowledging the former's role in the problem is shoving something you don't want to be stepping in.
I love Spurstalk. There are so many dudes here who think they know what is going on and they are all clueless.I know how much credibility to give a person who parrots the Fannie and Freddie bull . Its simply a marker of who to ignore, IMO.
These statements can so easily be mirrored back at them and they have no idea
Because with 12 posts, you have been here long enough to see enough of anybody's posts and general goings on that you can say that definitively?I love Spurstalk. There are so many dudes here who think they know what is going on and they are all clueless.
These statements can so easily be mirrored back at them and they have no idea
If you say so.
There are currently 1 users browsing this thread. (0 members and 1 guests)
Posting Permissions
Reply With Quote
