Yesterday, Tim Geithner stated clearly – and reassuringly – that the Obama Administration will present a comprehensive and detailed economic recovery plan within a few weeks.
We know this plan involves a large fiscal stimulus, and it is reasonably clear there will be around $100bn for housing refinance/mortgage mitigation (out of TARP II funding), and probably some other symbolically important pieces intended to help consumers directly.
The big question is: what will be done about the total mess that our banking system has become? On this key dimension, we know little about the Administration’s specific thinking, but we can already see with considerable clarity the constraints that will bind as their thinking becomes concrete policy proposals.
There are three major political constraints.
First, the Plan must be different in substance and perception from the Bush/Paulson efforts. This may seem obvious and easy, but if you think that toxic asset disposal is needed, then this has to be packaged and presented quite differently from any of the previous iterations.
Second, there has to be much more buy-in from Congress. Arguably, Mr Paulson’s greatest mistake was creating the impression in September that he was trying to steamroll through the original TARP. “Do this or the financial system will die on Monday,” is not a message that conveys the impression you actually know what is going on and how to deal with the situation.
Third, whatever happens, transparency and accountability will be not just watchwords, but also a key part of any reality that Congress will be willing to support.
Of course, there are also economic constraints that imply some fairly essential principles.
- Let no bank fail in a way that causes significant losses to creditors. You might think that the massive Fed support for the financial system, put in place since September, makes it safe to let a bank default on its obligations, and you might be right. But I strongly suggest that we not find out – the risks are far too great. Also, this would violate the first political constraint above – you don’t want to do anything that could become like the post-Lehman/AIG moment all over again.
- Get it right the first time. The flip-flop policies of the fall were quite damaging. This is not a time for incrementalism or figuring things out in small steps. Even if the markets are very difficult this week and next, the Administration needs time to work out all the details and build political support – this will take at least a few weeks, perhaps even a month.
- The scale needs to be massive. A key principle of any macro stabilizing program is that it needs to be larger than the consensus suggests at the moment of announcement. Right now, people are talking in terms of $1trn-$2trn, but the numbers are rising by the day. The headline scale will depend on how long it takes to put the program in place and what happens in the meantime, but my sense is that we will be talking about sums in the $5trn range, or perhaps even close to 50 percent of GDP. (Note: this is not the expected final losses or how the Congressional Budget Office will score the program; that should be significantly lower, but of course it’s unknowable as it depends on the full set of US and global macroeconomic outcomes).
- Large parts of the banking system need capital. Private equity is available and interested, but it will hang back until it sees greater clarity on (a) the bank program and (b) the macroeconomy. The trick is to convince the leadership of this industry that the turnaround is just about to happen, and then they will pile in.
- We need a banking system, moving forward, that is free of the uncertainty overhang caused by bad assets. So the program needs to include a large degree of balance sheet clean up. There is a menu of established choices here, and any of these would work if scaled up sufficiently – this will probably be the biggest financial sanitation project the world has ever seen. But the political constraints will bind here – the central question is simply: what will Congress support?
- In the clean up, the valuation of bad assets taken or purchased from banks will be key. The essential principle here is: we will not overpay. But, of course, there are many devils in the details of how to establish that you are not overpaying. If you have good ideas on this, post them here; we’ve posted our suggestions, but no one yet has an ideal scheme.
President Obama obviously has to do more than a great sales job to get popular and congressional support; it requires persuasion of historic proportions. There is no doubt that he can do this, but it will be easier if he can propose:
1. A new structure, run by unimpeachable characters, with more transparency than you have ever seen in a public or private body. Let CSPAN cover every deliberation of this aggregator bank/RTC-type organization/control board in mind-numbing detail. Let everyone in on the complexity.
2. Not to nationalize the banking system. There would be a backlash against the idea that the US government can or should run the banking system. Also, can you imagine the explosion in lobbying activity and politically directed credit? The government needs to take the leadership role and commit capital (there is no one else available), but it also needs to get out. (One proposal is here; you can do this other ways).
3. Taxpayer value is of the essence. If you try to make sustaining jobs – either in banking or among borrowers – the key priority of the bank restructuring, things will go badly wrong. We need a cleaner, restructured banking system with new (private) owners and a complete change of management. A stronger banking system will support the change and growth in the US economy. The government, on behalf of the people who ultimately pay the nation’s debt, is willing to take on risk. But it must and will get a big chunk of the upside. Imagine the backlash if the banking system recovers through great government exertions and consequently we all have to pay the interest on additional government debt in the region of 20-30% of GDP, while a few relatively well-heeled individuals pocket massive fortunes.
And I would manage expectations very carefully. Cleaning up the banks, stimulating the economy through fiscal means, and reducing foreclosures are necessary but not sufficient for a return to sustained growth. They will likely give us a temporary boost, but we are in the midst of a big adjustment in the pattern of global savings – with almost everyone who is creditworthy around the world wanting to borrow less and strengthen their balance sheets. We need to ride through the ensuing storm, cushioning the blow for the weakest members of our society and the world.
We will get through this and, when we do, we’ll have stronger growth, with more opportunities for more people, if the credit system is healthier. But please do not form the impression that even the most comprehensive, carefully thought through, and brilliantly implemented plan will constitute any kind of magic bullet.
The Baseline Scenario 
It’s fair to estimate that the banks are now insolvent. And so, they should enter bankruptcy proceedings. The government can serve as debtor-in-possession, and print money to refill the coffers. In this process the government will take over and stakeholders in banks will be made good in accordance with the wisdom of their investments. With the government in charge, new management can be installed (paid in line with the current government employee pay scale), new banking regulations can be written, and the bloat in our financial sector can be cut down to size. After things have settled down a bit, in five or ten years, the banks can be sold off to investors in the private sector.
In order to deal with all the paper in the “shadow banking” sector, we need to establish an open market where these assets can be traded. A deadline should be established for registering on this market. Assets that are not registered by the deadline should be rendered null and void. After the deadline, assets traded outside these markets would be illegal, and such trading would become punishable under law.
A couple of thoughts.
I am deeply shocked by your post.
You say, “get it right the first time” and then “the scale needs to be massive”. “Right now, people are talking in terms of $1trn-$2trn”… “my sense is that we will be talking about sums in the $5trn range, or perhaps even close to 50 percent of GDP”.
That is $5trn-$7trn. What is a few trillion between friends?
Actually, there are worse things than a failed banking system. Namely a failed banking system PLUS trillions of dollars of unnecessary debt.
To mix up a few metaphors.
The way to avoid a slow-moving truck is to jump rather than stand there transfixed in the headlights wobbling. If you do not know which way to jump then jump any way and make it a big jump. Most directions will take you out of the path of that truck, and a big jump will take you well clear. You could of course be jumping straight into the truck but, hey, that’s the breaks.
On the other hand, if the light you see at the end of the tunnel is the headlight of a train coming straight towards you, and you can’t jump out of its way, then running towards it is not the smartest thing to do. For God ’s sake, run in the opposite direction!
Incurring more and more debt in the face of a GLOBAL economic collapse is lunacy. You will end up like Britain with a collapsed banking system AND £33 thousand more debt per taxpayer.
All that the trillions will have done is give the economists and politicians the get out that “we did everything we could”. Trillions to save a few red faces. A lousy deal, if you ask me.
It’s important to remember that money used to bail out the financial system does not have the fiscal impact of ordinary government expenditures. Yes, you need to issue more debt to raise the cash (assuming you don’t want to just print more). But in exchange for the cash, the government gets assets, which have some value. They may have less value than what the government paid for them, but still the government should recover most of the money. The CBO estimates the net present loss on TARP to be about 20%; 20% of $5 trillion is $1 trillion, or about 7% of GDP. That’s nothing to sneeze at. But by comparison, Joseph Stiglitz, who is a Democrat but also a Nobel Prize-winning economist, has estimated the long-term cost of the Iraq War (including long-term medical care for injured veterans) to be about $3 trillion.
Yes, we are talking about large sums of money. But they are simply large, not so horrifically large that they should be rejected simply because of their size.
I wonder about point 3 (Taxpayer value is of the essence). It sounds like a lingering attachment to the issue of moral hazard. At a certain level, it has to be accepted that a lot of money going into the bailout isn’t coming out. The “upside” for the taxpayer is not having a financial system in ruins.
I think if there’s too much focus on getting taxpayers’ money back, the bailout will end up not being a bailout at all, becaused people will just factor in all the added costs to the banks resulting from the “bailout” and maybe decide that they still aren’t in good shape. If everyone starts dumping their bank stocks, won’t the US government end up holding the bag? Isn’t that de facto nationalization?
Dealing with moral hazard is essential if you want a banking system that the little common folk like me will participate in.
The rationale against nationalization is that we’ll have lobbying and politically directed influence in credit. How is that different that what we have now? It’s clear that the TARP-1 was a giveaway to certain non-performing banks who then gave bonuses to their employees early to avoid the shut-down. I guess I’d trust Obama’s group more than Wall Street at this point.
Since September, we have basically made all banks “good banks” with respect to safety of deposits. While this has forestalled public panic, it has served to leave us with few, if any, “good banks” with regard to counterparty credit or equity risk investing. I would suggest that creating at least one good bank is a requisite step toward a way out of this mess. After we have one truly good bank, we may be able to begin forcing (yes, forcing) the banks with large components of toxic assets to cleanse themselves, or die. For example, banks refusing to place their toxic assets into the aggregator bank (my earlier post suggested the price be zero, with side-pocket residual interests), would lose some, or all, of their deposit protection. If there was one “good bank”, customers would have an alternative. And large banks trading at all time lows would have a choice.
Subsidiary issues: 1) “Toxic” has been a moving target….for example, 6 months ago, GE Credit paper probably traded well. Most anything is toxic today, including Louis XIV tables purchased by brokerage executives. 2) Is it possible that the traditional banking model (deposits, loans and mortgages held in portfolio) cannot be profitable? 3) One has to wonder whether the Glass-Steagal Act made sense after all. 4) While public policy is working hard to find a way out of the crisis, bank executives still seem to be clinging to the possibility of 2007 returning…until these folks get some religion, there will only be “bailouts” instead of “reconstruction”!
Don Beane
One last point….we (via patchwork regulation and Wall Street coercion) allowed margin regulations to be either significantly reduced in regulated entities or avoided altogether by placing some instruments (most particularly swaps of all types) in non-bank, non- broker dealer subsidiaries. We need a single set of margin rules and they have to be established across entities operating in all world money market centers.
“If you have good ideas on this [valuation of assets], post them here; we’ve posted our suggestions, but no one yet has an ideal scheme.”
At the risk of being repetitive, I will repost this comment. I think it is a good idea, though not ideal. Ideal only exists in Plato’s cave.
VALUING TOXIC ASSETS
It seems the most difficult problem with the Bad or Aggregator bank is the fact that it is next to impossible to accurately value toxic assets which financial institutions now hold. To be able to do so requires seeing into the future.
This leads to a problem of great inherent risk for the government in purchasing these toxic assets to clean up the banks’ balance sheets. What is a fair value to pay for these assets?
If toxic assets cannot be valued accurately at this point, why should the final value be established now?
I think the assets should be purchased by the government in a conditional manner. Call it CONDITIONAL REIMBURSEMENT.
Under such a system, the government would offer to purchase a questionable asset for the best estimate of what the asset would currently fetch on the open market. This may be considerably less than what it is valued at on the bank balance sheet. To make up for the loss, the government would provide capital injections into the bank in exchange for equity shares.
Over a set period of time, say three years, the government would be obligated to liquidate the asset at the best price it could obtain.
If the government ended up losing money, then the financial institution would be required to reimburse the government for the difference. Because this would happen in the future, the financial health of the bank would likely be much better (the recesssion would be in the past, the housing market would be stabilized) and the bank would be able to make up the government’s loss.
On the other hand, if the government ends up selling the asset for a significant profit, then a certain percent of the profit should be awarded to the bank in the form of a tax credit.
It seems this would be one way to ensure that the government does not end up losing money on the toxic bank assets while it also allows the banks to be made sound and solvent in the here and now.
What makes this a valid proposal is the fact that banks are enormouse generators of revenue and profit in good times. If the final reckoning of the bill owed by the banks to the federal government is postponed until after the economy has recovered, the banks will be able to deliver and the tax payer will come out ahead.
That seems to be the goal we are seeking.
The problem I see with Don Beane’s suggestion is that it maintains significant uncertainty for banks’ balance sheets even after selling the toxic assets. I assume that one of the key things that has frozen credit markets is the extreme uncertainty regarding the value of major banks’ toxic assets. Resolving that uncertainty by the gov’t establishing a price would help to re-start liquidity. Even if the conditional reimbursements are to happen in the future, concern over their potential size would still make creditors and equity providers hesitate to refinance banks even after they sold the toxic assets.
Sorry – I meant to say “Tom K’s” plan, not “Don Beane’s”
Dear Andrew vonN,
I thought of the problems with uncertainty also. But I don’t think it is a problem, because the rules for CONDITIONAL REIMBURSEMENT can be structured in such a way that they are not onerous.
At the time that the assets are liquidated, if the there is a loss for the government, but the financial institution is incapable of making up the loss, then the liability to the government can simply be dismissed. Of course, this would mean that the government takes a net loss on the asset, but this should happen fairly infrequently. Remember, we are talking about banks which have great earning power and profitablity during good times.
Alternatively, to further protect the tax payer, financial institutions, which are incapable of making up the governments loss when the assets are liquidated, can be given extensions to make good on the loss. If after the extension they are still not capable of making up for the loss, then the liability would be dismissed.
The main point here is that finacial institutions would be allowed to recover and prosper so they could meet their obligations to make good any loss of the government on the assets the government bought from them. Knowing that these assets are guaranteed to not bring down the banks eliminates much of the uncertainty about their solvency.
Simon,
You wrote “The scale needs to be massive”, which could be amended to read “The impact needs to be massive” while the taxpayer cost could be dramatically more efficient than the TARP implementations seen to date.
I’ve been persuaded by the work of MIT’s Ricardo Caballero that there exists an efficient policy prescription. E.g., Caballero and Arvind Krishnamurthy wrote in FT.com:
I strongly recommend a careful review of Ricardo Caballero’s pair of VoxEU columns (January 23rd). In Part 1, Caballero argues “that the global financial crisis is really a run on all explicit and implicit forms of insurance, which is showing up as a freezing of credit markets at all but the shortest maturity.”
In Part 2 he offers the most promising policy prescription that I’ve seen: “Specifically, I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.”
When I first read his December 17th essay Normalcy is Just a Few Bold Policy Steps Away I thought he was on the right track. But I don’t see that his policy prescriptions are being debated — why not?
Take a look at the Bring Back the R.T.C.! – Executive Suite Blog – NYTimes.com link above.
Joe Nocera describes a plan by Mike Mayo (of Deutsche Bank) that sounds awful similar to the CONDITIONAL REIMBURSEMENT idea I describe above.
That’s not surprising. It’s an obvious and practical solution to the thorny problem of valuing and purchasing toxic bank assets.
One of the crowding-out effect of monetary and fiscal policy is the effect of capital outflow. Too much intervention both monetary policy (bailout, liquidity facility) and fiscal policy (public spending and tax reduction) would trigger the magnitude of capital outflow to exacerbate the demand. The capital outflow would occur from unreliable policy that is expected not to sustain or to cause severe effect of reversal. American should consider seriously the capital mobility effect from policy implementation.
We can see the worsening result of UK government to intervene too much in the market. The problem of UK bailout is not only bailing out assets inside UK but also assets outside UK owned by UK bank or to be owned by UK banks in the future. It means that UK government use public money from fiscal policy (causing higher debts or higher taxes in the future) or monetary policy (higher cost of fund or cost of living on high inflation) but the amount should be much higher than UK government and all expectation if you look at only the size of domesticcredit in UK.
The bailout mechanism is causing higher-than-expected public debt or higher-than-expected magnitude of central funding because of the capital mobility. When injecting money into UK banks, the money injection must cover the assets of UK-named banks, like RBS, that are flowing around the world and instead UK-named banks put money in UK, they will put most of all money elsewhere meaning that it causes the capital outflow to get the better return like ASIA-or-China assets but it would cause the higher risk if Asia or China face the same problem in the future, causing debt increase without control. Although UK banks do not put money outside UK, the liquidity in UK will cause the capital outflow from the expectation of lower return or negative return of UK currency in UK.
It is the same as the central bank facility that cannot solve the liquidity problem if there is money outflow. In case of UK, the more money injection from BOE maybe receiving from US swap line, it would rather exacerbate the higher outflow from banks and cause the uncontrollable debts and facility without exit strategy.
Doing too much (reckless intervention) may cause worse-than-expected results because of the capital mobility from the expectation on credibility of government and central bank. This is the same event happening in Asia crises, when Asia central bank support the banks at the controllable level (Asia has low public debt and affordable reserve) if considering the domestic credit figure, but the level of intervention is growing without bound until collapse due to capital outflow without bound (Asia central banks intervene near their abilities and can not reverse until all people are scare that are causing more capital outflow incentive and Asia do not control capital movement during intervention.)
No one knows whether American should consider the capital mobility effect on the intervention but the suggestion of capital control by Prof. Krugman used by Malaysia in Asia crises, may be a part of it, must be considered.