Global Consequences of a US “Bad Bank” Aggregator: It’s Mostly Fiscal

It looks like a bank aggregator for bad assets is pretty much a done deal.  David Axelrod said yesterday we should expect a new approach within a few days, and leading reporters (NYT, Washington Post) have discerned that this is likely to include a “bad bank” into which troubled/toxic assets can be disposed.

We don’t yet know the details, and these matter a great deal (for the taxpayer and for the gradient of the road to recovery) but it’s not too early to think about the global implications, at least in qualitative terms.

The backdrop, of course, is that the international banking environment is very unsettled at present, probably worse than any time since mid-October.  Ireland just had to nationalize its previously most aggressive mortgage lender (i.e., in Irish mortgages) and the UK seems poised to announce a further scheme for helping banks (and probably forcing them to lend, although the British property sector looks highly dubious).  “Bad banks” are in the air, in all senses of the term.

Let’s say the US launches a comprehensive bank recapitalization and balance sheet clean-up scheme, with broad support on Capitol Hill.  This bolsters confidence in the US banking system, causing a rise in equity prices and – most important – a strengthening of debt, both for banks and perhaps for leading nonbank corporates.  Three international consequences seem likely.

First, this move forces the rest of the G7/G10 and the eurozone to do the same, or something very similar.  If we have very strong (and government backed) banks in the US and somewhat more dubious banks anywhere in other industrialized countries, money will flow into the stronger US banks.  Think back to the consequences of the original infectious blanket guarantees in Ireland in October; the effects now would be similar.  You can think of the UK’s upcoming moves either as a smart way to get ahead of this, or as something that will further a destabilizing wave of competitive recapitalizations – the policy is good, but doing it without coordination across countries can trigger Iceland-type situations.

Second, if all major economies need to back the balance sheets of their banks, then we have converted our myriad banking sector problems into a single (per country) fiscal issue.  Who has sufficient resources to fully back their banks?  This obviously depends on (a) initial government debt, (b) size of banks (and their problem loans, global and local), and (c) underlying budget deficit.  Ireland and Greece will be in the line of fire, but other weaker eurozone countries will also face renewed pressure.  Officials are currently (slowly) trying to work through this predictive analysis, and there is some sketchy thinking about preemptive preparations, but events are moving too fast – and the international policy community again can’t keep up. 

Third, in some countries – particularly emerging markets but also perhaps some richer countries – the foreign exchange exposure of banks will matter.  Here the issue will be whether the government has enough reserves to back (or buy out) these liabilities; the problems of Russia since September foreshadow this for a wide range of countries.  The absolute scale of reserves does not matter as much as whether they fully cover bank debt in foreign currency.  Most emerging markets face significant difficulties and need some form of external support in this scenario, particularly as both commodity and manufactured exports from these countries will continue to fall.

If, by great and fortuitous coincidence, the US and global recession is already at its deepest – as some in the private sector now hold – then we face a tough situation but the difficulties are manageable. However, our baseline view remains that the real economy is not yet stabilized, and hence we will see worse outcomes in Q1 and Q2 of 2009 than currently expected by the consensus.  Such outcomes are not yet reflected in asset prices, and the problems for banks – and the implications for fiscal sustainability – around the world will mount.

Financial support for distressed countries within the eurozone, from the G7, and across the G20 will help; the scale may be beyond what the IMF can readily handle by itself.  But this is a very big global fiscal problem, and the appetite for large-scale official rescue financing in the face of these problems remains uneven.

22 responses to “Global Consequences of a US “Bad Bank” Aggregator: It’s Mostly Fiscal

  1. Don’t we already have enough bad banks?

    Why not use taxpayer money to capitalize one or more GOOD banks, which then buy only GOOD assets from the current crop of bad banks at distressed prices? Then let the bad banks fail, so the cost of failure falls precisely where it belongs: On the shareholders, bondholders, executives, and counterparties of the failed institutions?

    As a taxpayer, I can say such an approach would go a long way toward restoring my confidence in the system.

    Or will we just continue to confiscate my wealth to reward failure in proportion to the size of the failure?

  2. Phil McClelland

    (Intro: Since this is my first post here, I’d like to take a moment to thank the authors for the excellent site. As a software engineer who managed to get through college without taking a single course in economics, I’ve found the Financial Crisis for Beginners posts extremely helpful – I’ve read them all and am waiting for more!)

    The possibility (or likelihood?) of the much talked about idea of having some type of aggregator for bad assets actually coming to fruition in the near future has left me with a strange mix of optimism and cynicism.

    The optimist in me sees that the time is right for such a move. The excitement surrounding Obama’s inauguration might just be the spoonful of sugar that helps the medicine go down. Sure, there will be a group of people that see the government’s ‘bad bank’ as the ultimate betrayal of the taxpayer, but there may be a surprising number of people who interpret the change in strategy as a bold, purposeful move by Obama to start stabilizing the economy. The real economy may still be in for a lousy year, but Wall Street may finally get to see some much needed signs of stability, if not growth, in the financial sector. Who knows, maybe all that talk of recovery starting later this year wasn’t so farfetched?

    The cynic in me suspects that even if banks’ balance sheets are fixed and banks recapitalized successfully here in the U.S., and even if the rest of the G7/G10 rushes to do the same, there will be a period of extreme uncertainty over which countries will be able to ‘fix’ their banks. That period of uncertainty would wreak havoc in at least the weaker markets – who’s to say the rich countries would necessarily be spared? Bottom line, governments taking bad assets from banks and recapitalizing them could be a necessary step towards stabilizing the rich economies but would have a side effect of putting weak economies even further in the hole.

    So, that’s my ‘Joe-the-Plumber’ take on international finance. I’ve got a feeling that the end result of an aggregator solution will surprise us all…

  3. This “bad bank” concept simply begs the question that has been confronting the Treasury since day one: How do you actually price and value the bad paper? If that were truly a simple process, wouldn’t Secy Paulsen have continued on with the original intent of the TARP? I think he found out that this task is not as easy as it appears.

    Thad

  4. I sense an excessive amount of “wishful thinking” and overconfidence in this particular topic.

    Sovereign protectionist policy actions and a dramatic increase in geopolitical stress will clearly get in the way of “co-ordinated co-operation.”

    Time is the likely fix.

    I agree with Nemo; protect the “system” but let the failures fail, give the taxpayers a break – we’ve done our fair share already. Making the failed banks with the same cabal of management failures whole with more taxpayer money is just plain silly.

  5. Can someone explain why the bondholders of banks that are currently in trouble shouldn’t be taking a big haircut? They lent money to someone who can’t pay it back. How is it the taxpayer’s role to take these losses ahead of the bondholders?

  6. Pingback: self-evident » Don’t we have enough bad banks already?

  7. At the micro-economic level , does a Bad Bank could cause comercial banks to loose a lot of customers? This could mean a massive layoffs from comercial banks afecting the real economy one more time. does anyone has think about this? If this is a possibility does the Bad bank will hire employees from this comercial banks?

  8. Dear norstadt,

    The whole problem here is that creditors are not willing to lend anymore. The economy has ground to a halt because the oil that lubricates the system, credit, is non-existent.

    If you punish bond holders, in other words creditors, by making them take a haircut, you exacerbate the problem. You would make it less likely, rather than more likely, that creditors would be willing to resume lending.

    The authors of this website, along with many other experts, maintain that the credit crisis started when Lehman was allowed to go bankrupt. The bankruptcy of Lehman demonstrated that we were in a situation where creditors could expect to lose everything. Nobody knew what kind of financial health a potential counterparty was in. Under these circumstances, everybody stopped lending.

    One of the primary goals is to get creditors to start lending and to get investors to start buying corporate bonds again.

  9. I think Thaddeus raises an important point. I don’t know how the heck they are going to value those assets.

    Seems to me the people determining the value should be very conservative. That way the tax payer is likely to lose less (or even profit).

    The losses the banks take on the sale of the assets can be made up with capital injections in exchange for equity shares.

  10. David Pearson

    Norstadt,

    You assume that current creditors are future creditors. In this, you are mistaken.

    Most current “creditors” need to de-lever. Their ability to offer new credit is zero as long as they cannot de-lever by accessing more capital. Since equity issuance is near-impossible, the only solution is to reduce debt. By definition, you cannot reduce and increase debt at the same time. This is simply indisputable.

    So who are these “investors” that need to buy corporate bonds again? I would argue they are unlevered, and if they are unlevered, then they are not the creditors harmed by the Lehman bankruptcy.

    The best way to help unlevered investors is to provide them with rich returns. Remember, un-levered returns must be much greater in order to provide the same post-interest return as levered returns.

    The only way to create rich unlevered returns is to mark down assets as much as possible. Only then will new lending begin. The only way to mark down assets as much as possible is to HARM current creditors.

  11. David Pearson

    Sorry, the above post was directed at Tom K, not Nordstat.

  12. Dear Mr. Pearson,

    There is a tremendous amount of money on the sidelines right now, not invested in anything that pays a reasonable return. This is true of the stock market. It is true of the bond market.

    This is one reason why Treasuries have risen so high and pay such a lousy return (in some cases negative interest). People don’t want to invest in anything that is not 100% safe. They want a safe place to park their money, regardless of any yield.

    The creditors and bond holders are ordinary people like you and me with 401 Ks. They are wealthy individuals like Kerkorian or Buffet. They are financial institutions like banks and also other corporations and businesses.

    All these people and entities are licking their wounds now and waiting for the right moment to invest in stocks and bonds. They don’t want to do it until they know that things have returned to normal and they are not going to get burned like the creditors of Lehman.

  13. Sorry for all the comments.

    It appears that it would be helpful if the IMF had ready access to much larger funds sources. They need the ability to tap lines of credit from large, wealthy countries when the need arises. These lines of credit could be arranged with the central banks of China, US, Japan, Europe, etc.

    The lines of credit should be drawn upon only in the most extreme circumstances.

    If we are going to have an extremely integrated global economy (and we are definitely headed there, if not there already), then there needs to be a global institution with the ability to put out brush fires.

  14. It seems to me that markets are smarter than the smart people attempting to solve this mess. The prices of bank securities already reflect the fact that the values of their troubled assets are far less than the amounts carried on the books. Most financial enterprises have steadfastly avoided taking the losses while the markets have steadfastly reduced banks’ market equity to more realistic levels reflecting likely value realizations on these assets. On trading desks, this is called a “hope trade”. The hope trade and the uncertainty about any institution’s credit value is one reason the entire credit system remains at least congealed and the reason why over 90% of the $0.9 trillion of new bank reserves created in the past year remains on deposit at the Fed. I think the “aggregator” concept may be the means by which a serious amount of uncertainty gets removed.

    Aggregator issues: A critical element remains pricing of troubled assets into whatever vehicle is to own them. I have been in hedge funds where “side pockets” are employed to wall off the assets deemed not marketable…investors that have effectively contributed those assets receive their pro-rata share if, as and when some value is realized. I would suggest that the banks get nothing in direct immediate return for taking troubled assets off their books. They would receive credits toward whatever value eventuates and enough capital to meet reserve requirements based on their remaining assets. I suspect that this is alot of money. That capital would be repaid from eventual proceeds of however the bad assets realize when disposed. I suspect that the taxpayers will foot a large bill, but the interim reduction of uncertainty may be worth the price relative to the never-ending sinkhole that the current incrementalist strategy represents.

    Finally….we will need one really good accounting system to track all the side-pockets….a very difficult, but not impossible, task.

  15. Guys before you continue to whinge, whine, and moan about having to rescue US banks with your tax dollars ponder the following: at least the US if need be can print its own currency to prop up its own banks. Sure tax payers end up with more debt, and a currency that is worth less, but the financial system survives more or less intact.

    This is not the case in Europe. The biggest downside risk to the global economy is not in the form of the US banking system blowing up, but those in of some European countries. Pause for a moment to consider the list below of countries and the liabilities of their banking systems as % of GDP:

    1. Small countries, large banking system, own currency:
    Sweden 900%+
    Switzerland 900%+
    Denmark 300%+

    2. Small country large banking system, Euro:
    Luxemburg 3400%
    Ireland 950%
    Malta 760%
    Cyprus 620%

    Ooops! If push comes to shove how are the tax payers of those countries going to bail out their banking systems? They can not print dollars or Euros. The German tax payer isn’t going to rescue Irish banks — well, he might have to but there is no mechanism for that. If you thought Lehman was a mess you might have to think twice….

  16. Tom K

    I know of no one who cannot obtain financing using traditional underwriting criteria.

    Credit standards are returning to normal. Long overdue.

    A related issue does perplex me. Banks’ loan to deposit ratios are near 100%. At one time, 85% was considered high.

  17. Many millons of US workers (but likely very few economists) have lost their jobs to the “creative destruction” of the free markets. And those same folks watched the free market cause alot of misery by driving crude prices to $147 this past summer.
    As the financial crisis has exploded,most of the US voters are have been sideline spectators and haven’t had much input to the solution. Whilst the folks who caused this problem and their apologists have tried to resolve it, partially successfully.
    The crisis of confidence extends beyond bank lending. There is a developing crisis of confidence among US voters in the existing US free market and in the religion of globalization.
    We cannot, in a democracy, have a system of economic beliefs that lets poor decisions dramatically disadvantage so many. Unlike the laws of physics,the the “laws” of economics can be modified by government.
    So it is time to subject banks to the “creative destruction” of nationalization. And it is time to have a nationalistic economic policy. For instance, if Pres. Obama wants to put Americans back to then he cannot allow the jobs created to be outsourced or filled by nonresidents via work visas or immigration.
    At least the US has the resources and hopefully the political will to tackle its problems.

  18. Tom K says: “The economy has ground to a halt because the oil that lubricates the system, credit, is non-existent.”

    You are exaggerating, Tom K. The economy hasn’t ground to a halt. There’s still almost as much activity this year as last year.

    Basic fairness says that those responsible for financial losses should bear them. Without fairness we don’t have a society worth defending, which is a lot more important than having extra “oil to lubricate the system”.

  19. Great idea, efw! Let’s nationalize everything, pool all individual assets (your wealth, my wealth, Bill Gates wealth, ….) and create a one big, happy family. Let’s put everyone to work, but pay them in bread and meat (not money). I guess that is your idea of America. Not mine.

  20. Dear Roy H,

    Your knowledge of the current state of lending seems to differ from that of the New York Times. In an article posted yesterday, “Cost of Borrowing Zooms Up for Corporations”, the authors of the article state:

    “Companies with poor credit ratings are virtually locked out of credit markets or face the prospect of paying 20 percent interest. Many of them are slashing costs, canceling projects or putting assets up for sale to avoid defaulting on their debts.”

    This is the URL: http://www.nytimes.com/2009/01/19/business/economy/19debt.html?adxnnl=1&ref=business&adxnnlx=1232398820-OoSEcRm5FUE+bVclkuS3yA

    It would seem that many businesses, particularly small businesses, cannot find credit that is not attached to exhorbitantly high interest rates. Such high interest rates undercut the bottom line and threaten to throw many of these firms into bankruptcy if they choose to accept them.

    You state, “Credit standards are returning to normal. Long overdue.” I would agree. But I don’t think we are there yet.

    Dear Mr. norstadt,

    Are you familiar with the term HYPERBOLE? Please look it up.

  21. william schwartz

    Not economist but if root of problem is bad mortgages (toxic assets) that remain a moving target because values of homes and/or homeowners resources continue to spiral down, then stopping the spiral is key. There is money out there (treasury) but giving to banks, the very institutions that got us here, why not feed the system from the bottom up, give money to the homeowners who are in trouble, in the form of Housing Stamps, returns stability to debts and floor to the downward spiral.. ??

  22. Don F….Today in the NYT, Paul Krugmann writes in support of temporary nationalization of banks that have so many toxic assets that they are already dependent on government capital to avoid failure. And because there is no market for some of their assets there is no way of knowing how much additional capital they will need.
    It could be that if the toxic assets only are removed from these banks, they may not resemble banks at all. Investors don’t trust the value of their mortgage backed securities, nor their credit card loans, nor their commercial loans, nor their car loans… so what would be left (I know that Citi has stored alot of crude in super tankers, so i guess that would be left).