It’s getting somewhat lonelier being a large financial institution skeptic, although there still a lot of us left. I would say that among the skeptics, the general view is that we may have seen an end to bank panics for this cycle – I’m not sure anyone is saying there will definitely be another crisis in the near future – but we may not have, and we may come to regret not taking stronger measures now. (How’s that for prognostication?)
Lucian Bebchuk, in Project Syndicate (a well-intentioned collaboration that manages to sound ominous and conspiratorial), makes the argument in clear terms. First, the recent stress tests only projected losses through 2010, ignoring the large number of loans and mortgage- and asset-backed securities that mature in later years. More fundamentally, though: “Rather than estimate the economic value of banks’ assets – what the assets would fetch in a well-functioning market – and the extent to which they exceed liabilities, the stress tests merely sought to verify that the banks’ accounting losses over the next two years will not exhaust their capital as recorded in their books.” Put another way, the focus has been on the accounting value of assets, not their economic value; so for a given asset, as long as it doesn’t have to be written down before the end of 2010, there is no problem.
Bebchuk also points out that the ability of banks to raise equity capital should not be taken as an “all clear” sign. As he and others have previously argued, equity in large banks by its very nature represents a leveraged bet whose downside risk is limited by the implicit government guarantee. That is, as a shareholder, if the economy does OK and bank assets appreciate in value, you get all of the upside (leveraged by the bank’s liabilities); if the economy does terribly and bank assets fall in value, your losses are not only limited to the amount of your investment, they are further limited by the implicit guarantee that the government will not wipe you out. That guarantee is weaker than the implicit guarantee on bank liabilities, but it is still there; given the way the government has treated Citigroup, Bank of America, and GMAC, betting on the “no more Lehmans” policy seems like a sensible bet.
Most attention is now focused on the battle over financial regulation (if it isn’t on health care and energy), which is appropriate. But it may be premature to declare victory over the financial crisis.
By James Kwak
The Baseline Scenario 
All large banks’ liabilities are now guaranteed, explicitly or implicitly, by governments. So we will not see a run on any large bank without a run on sovereign debt.
Whether this is comforting or terrifying depends on one’s personal disposition, I think.
2011, I suppose, is when it all will go down. It does look like 2012 is shaping up to be this depression’s 1932. Hey, who knows–Sarah Palin may just win the election after all. Krawk!
@The Raven
This is the sort of terrifying thing about American politics. If Obama’s band aid doesn’t work and the economy continues to tank, the standard recipe will be to oust whatever party is in power and replace it with the opposite as, “Surely they’ll know better.”
So instead of Obama’s somewhat ineffective solution of throwing a little sand on the fire, we’ll have gasoline on the fire instead.
Or to put it another way, while Obama’s solution can’t outrun the train, the Republican solution will be to run AT the train.
Unfortunately it’s just not in American blood to say, “That didn’t work, what we really need is to get someone who works harder IN THE SAME DIRECTION.” We always have to do an about face.
Again, terrifying really.
What Matt F. said. Perhaps, though, a third party will emerge. It’s not clear that the Republican rump can win any national election. I don’t think W. Bush and his advisors will be forgotten by 2012.
If one were living on Mars, it would an interesting election to watch!
Buiter is still with you, as am I:
http://blogs.ft.com/maverecon/2009/06/too-big-to-fail-is-too-big/
“Too big to fail is too big
# Legally and institutionally, unbundle narrow banking and investment banking (Glass Steagall-on-steroids).
# Legally and institutionally prevent all banks (narrow banks and investment banks) from engaging in activities that present manifest potential conflicts of interest. This means no more universal banks and similar financial supermarkets.
# Limit the size of all banks by making regulatory capital ratios an increasing function of bank size.
# Enforce competition policy aggressively in the banking sector, by breaking up banks if necessary.
# Require any remaining systemically important banks to produce a detailed annual bankruptcy contingency plan.
# Only permit limited liability for narrow banks/public utility banks.
# Create a highly efficient special resolution regime for all systemically important financial institutions. This SRR will permit an omnipotent Conservator/Administrator to financially restructure the failing institutions (by writing down the claims of the unsecured creditors or mandatorily converting them into equity), without interfering materially with new lending, investment and funding operations.”
Comment on the recent bank capitalization is the following:
All all times, investors are rarely in for the long run. So, in a bear run, the time horizon is no doubt much shorter for many more.
“if the economy does terribly and bank assets fall in value, your losses are not only limited to the amount of your investment, they are further limited by the implicit guarantee that the government will not wipe you out.”
That sounds like a pretty risky bet to me, at least for actual banks who can be seized and liquidated by the FDIC. Haven’t the equity holders of Citi and BOA taken a big haircut? Sure, they aren’t at zero (at least yet), but how much value is there is believing you will only lose 90% (random number) of what you invested? Some, but for most investors, very little.
If you’re lonely out there as a big bank skeptic, does this mean most economists believe our financial community is the picture of glowing good health today?
What a change from September, when Paulson sounded the alarm of impending catastrophe.
If only we had trillions to bailout everyone else who could use it! Like all those millions of people dropped from gainful employment without a salary or a bonus or a bailout or even health insurance to prop them up….
James,
Given that the CRE fireworks have only just begun, the Fed has trillions in rotting MBS on its books and useful employment is plummeting, I don’t see how anyone can say that we’ve dodged the bank bullet. The market is being held up by big banks program trading desks, probably at the behest of the Fed. The states are teetering on insolvency (or, in CAs case, plummeting downwards fighting a pissed off bankruptcy balrog.) The Fed, following generally accepted economic principals, is going to backstop ALL OF IT.
It’s another can-kick up the exponential debt curve by prostituting the U.S. sovereign credit rating, which will ensure that the eventual collapse will be all the more spectacular. The last can-kick, after the dot com crash, bought us five or six years. This one buys us one or two, tops.
Cheers,
Carson
Erp. Mistyped: “billions in MBS” not “trillions”
Although, given how things are going, maybe I’m just early to the party.
Cheers,
Carson
“Perhaps, though, a third party will emerge.”
I can only hope so. How about one that represents the lower and middle class instead of the rich “free marketers” (republicans) and instead of the rich “big gov’ters” (democrats)?
Here’s a good question and post:
What if the Fed were a Bank?
http://www.ritholtz.com/blog/2009/07/what-if-the-fed-were-a-bank/
“The market is being held up by big banks program trading desks, probably at the behest of the Fed.”
If “people” were trying to create another asset bubble to replace the housing bubble, what would these people do?
Would “they” bailout AIG counterparties using gov’t debt so that “big banks” could borrow at near zero percent to raise the stock market and oil prices then pass cap and trade?
Would “they” being trying to blow an alternative energy bubble in this manner?
“First, the recent stress tests only projected losses through 2010, ignoring the large number of loans and mortgage- and asset-backed securities that mature in later years.”
The stress tests were a marketing campaign (as you and Simon have said repeatedly) and not meant to structurually improve the banking system. They restored some confidence in the markets as evidenced by the fact that some banks can today raise capital wo an FDIC guarantee. I don’t think Summers cares about unemployment and probably sees it as a laggind indicator…with (perception of) bank health as a leading indicator. How else could the administration treat Citigroup and GM so differently?
The banks failed as private institutions last fall. They exist today by the grace of a series of political decisions. It will take time, and the operation of a dialectic (feedback loop, if you prefer) for it to all play out. From the behaviors shown so far by the leadership of the financial services sector, I suspect that, without realizing it, the financial elite is progressively forfeiting the trust and respect of the political class.
Look for some serious problems next year in the regionals among the TARP 19, especially those that have big real estate exposures outside their traditional footprint. These will be solvency, not liquidity issues. Ahem. Resolving those situations (and the experience with AIG and Lehman Brothers) will help develop the regulatory skills required to administer the utility functions necessary to the general economy.
But, this isn’t an elevator, and there isn’t a linear descent. It’s a matter of two steps forward, one step back. I just wonder who the American Peronistas are.
For that to happen, we’re going to have to come out and vote our own interests, which so far we have not been doing. I’m puzzled as to why you think “small government” is in the interest of the lower and middle classes. The small government advocates have totally failed to deliver anything useful to us and have, instead, delivered us into the hands of our enemies. Conversely, big government programs like Social Security, Medicare, Medicaid, and the military are very popular with us, and (except for the military) deliver genuine benefits in our lives.
To be successful, I think a new party would have to include members of all classes and many regions that are currently Republican. For a new party to be successful, I think it would have to take seats from the Senate Republicans. It’s hard for me to imagine red staters making common cause with urban liberals but “politics makes strange bedfellows” and it looks like many people will be desperate by 2012.
James and Simon, I find it fascinating that your columns are among the most honest, but then, you two seem to have virtually no political linkage. This makes the difference. The folks I read who are in “your corner” seem to be the others with no or less linkage. Paul Krugman seems somewhat aligned, although he’s a little to enamoured by Obama, and a little to dedicated to his Democrat/liberal label to be cogent all of the time.
I think that the next big drop will happen this year, although it won’t be the worst. That will happen in a couple of years, maybe. But there will be a serious decision point for our government this year, where they will be forced to choose between the country and the banks. That will come as the states find it impossible to stay in balance, and the government bond (federal, state and municipal) market crashes as those bonds all lose their ratings. The non-federal bonds are in deep trouble, and the chances of default go up by the day, as those governments lay off more and more of their workers to try to balance budgets which can’t be.
I just don’t know how much banks hold these as hedges against losses on the toxic (bond related) assets. If the big banks has strong positions, they could be headed down with the states.
Then, who will pay the piper? Given the choice of bailing out the states or the banks, it is my bet the both the White House and Congress will choose the former. Then: armageddon!!!
Thus far we have seen the causality run from:
financial market instability -> economic weakness
Very soon we will see the causality change direction to:
economic weakness -> financial market instability
Keep your eyes on:
unemployment
corporate profits
bankruptcies (personal and corporate)
Financial institutions will not return to health as long as people are out of work and businesses are failing.
Keep in mind that the military does have benefits. Even looking past the “preserving freedom” flag waving stuff that usually gets squawked about by neocons, you have simple things like the internet, CAT scans, cell phones, radar, WD40, Vaseline, insect repellent, portable water treatment systems, and tang courtesy of the military and it’s sibling NASA.
While much of it might be wasteful, not all of it is.
Oh, and the 4th of July fireworks: military. Self indulgent there…
Now if politicians would only recognize that US energy independence is a national security issue and spend DOD money to make that happen, it might actually help the economy (and security) much more than bailing out banks or bombing people…
[old business]
The problem with a large standing military is the temptation to use it in places like Vietnam and Iraq. Lots of crow food there! And lots of debt to fight those wars. It’s true that the one of the best ways to unlock the public purse for research in the USA is to hint at a military threat, but I am surprised that this is regarded as a positive.
And, yeah, there are real uses for a military for defense in this highly militarized world. But you hominids get much less from the money spent on it than most of you imagine. Do the benefits of military research outweigh the costs of the wars you have fought in the past 60 years?