Put this morning’s articles on Bank Rescue Plans in the Financial Times and the Washington Post next to each other, and you can see where we are heading. (Remember: policy announcements need to be bigger than what is leaked, so expect headline numbers larger than floated here – the FT suggests “total buying power” of the initiative will be $1trn; I expect closer to $2trn.)
The foreclosure mitigation steps seem reasonable, although on the small side – with perhaps $80bn of the available $320bn from TARP II being committed here. The heart of the matter is the banks’ balance sheets, including their toxic assets and presumably deficient capital. The principles at work seem to be:
1. Do not compel the banks to do anything. There seems to be a great deal of concern about bank manager sensitivities. Sounds like we will be overpaying for bad assets. I can’t believe there will really be no effective constraints on executive compensation; that would be political dynamite – and I’m sure Capitol Hill is expressing itself forcefully on this point as I write.
2. Buy some of the worst assets. Relatively little capital will be committed to this, as it is a nonessential and small part of the scheme – there is no way to sort out the valuation issue unless you are prepared to be tough with the banking system. Let’s say $50bn here, with credit from the Fed to scale up to $500bn or so.
3. Use a ring fencing/government insurance scheme for most of the bad assets; this is the Citi II/BoA-type deal but now available to all banks. The mark on assets used for the insurance payout is generous to the banks, the premium is low and any claims on the banks received by the government do not constitute a meaningful share of voting stock (which makes me think we’re going to more preferred or deferred stock and fewer warrants.) The deal will be quite untransparent, but a reasonable presumption should be that if it is more complex and harder to value, it is sweeter for the banks. The government will commit about $200bn in capital to this venture; based on the funding structure and ratios we saw in Citi II, this could allow the total amount insured to exceed $2trn (hence my headline expectation).
One problem, of course, is that this exhausts TARP II without substantially addressing bank capital (although there must be some window dressing in this regard). The Administration might like to see if their approach brings in new private capital, and come back to Congress for further recapitalization funds only if necessary. They may also still be open to negotiation on this issue over the next couple of days – remember the fiscal stimulus still needs to pass the Senate.
The bigger issue is much simpler. The banks made many bad decisions and now have assets worth much less than their liabilities. We have guaranteed their liabilities, because we had a look at the alternative and it was ghastly. So who pays for the losses and on what basis?
I would prefer something much simpler and more transparent: new capital in exchange for a change in control at the major banks – presumably leading to new private owners, wholesale managerial change, and the breakup of the big banks. Instead, we are looking at the mother of all Credit Default Swaps – if things go well, we get a small premium; if things go badly, we are on the hook for a huge and hard-to-quantify amount (ask AIG). Either way, the bankers get the greatest deal of this or any century, and they emerge more powerful than ever.
The Baseline Scenario 
Great. So when do we march on D.C. with firearms?
The “executive compensation” thing is just part of the politics. As long as Congress and the media focus their energies on that issue, they will not make any noise about the far larger transfer of taxpayer wealth to the counterparties, creditors, and shareholders of the banks. Then we get a few days of “worry” that the bill won’t pass. Then the Obama administration will “compromise” by adding some minor concession on executive comp., and the Congress will “come together”, declare victory, and give the banks their trillion-dollar handout.
This is exactly what happened with TARP I, you may remember.
Allstate Insurance doesn’t sell flood insurance when the named hurricane is in the Gulf of Mexico… Insurance schemes a bad deal for taxpayers. We can only hope such a trial balloon pops.
I have some more recommended reading for the current administrations economic policy team:
Chaney, Paul K., and Anjan V. Thakor, (1985), “Incentive Effects of Benevolent Intervention, the Case of Government Loan Guarantees,” Journal of Public Economics, 26, 169-189.
China seems sensibly reluctant to buy further US Treasury bonds (see http://www.reuters.com/article/worldNews/idUSTRE50U1RJ20090131). But will this put an end to bailing out the morally-bankrupt?
Can rampant inflation from printing so much money, which impoverishes everyone, still be less “ghastly” than failing to guarantee the banks’ liabilities?
Or is it that economists and politicians stand to lose so much as individuals that they will continue to say that banking defaults are the greater evil for the community as a whole than runaway inflation?
In the fateful words of Sophocles: We must until the evening to see how fine the day has been.
Monopolies are clearly harmful to economies and consumers, and the Justice Dept. is tasked with breaking up monopolies.
It is apparent that “too big to fail” financial firms are also detrimental to economies, and actions should be taken by the government to prevent their formation and to break up existing ones.
Clearly the “financial super market” model exemplefied by Citigroup does not work.
I also wonder if there is an economic advantage to having a bank which is national in scale in a country the size of the U.S.? Are not regional banks quite capable of providing the same services as national banks?
If anything, the financial crisis has led to even bigger firms than we had before as supposedly healthy companies such as BofA took over sick ones like Countrywide and Merrill Lynch (and became sick themselves as a result). At some point these mergers need to be reversed.
I would agree that one overriding policy goal which the country should adopt as a result of this financial crisis is the break up and future prevention of very large financial institutions.
This is not an issue of the government interfering in the private sector. It is an issue of the government doing what is necessary to maintain the integrity and health of the financial system and the economy as a whole.
Every citizen in this country can go out and purchase Bank of America or Citibank stock if they think it is such a great deal for the banks, and make a killing.
My concern is who is going to bail the U.S. out as, like the banks and investment banks who bet their future and existence on mathematical models, and theories of asset price movements that proved wrong, we bet our economy on the theory of global warming using mathematical models and theories of the greenhouse impact of a gas that represents only 0.0383% of the atmosphere. (On a flight from NY to LA, 0.0383% of the distance is not even the length of the runway.) What can you do to protect against such insanity? Buy shares in the companies that will benefit from this global warming insane policy.
I think the Obama policies (bad banks, loss insurance mortgage restructuring, or capital injection) are like Bush policies; that is to protect the benefit of private investors by using the taxpayers’ money. The best way to solve the financial mess is to let the private investors both equity holders and bondholders get losses.
The best solution is called “Value reset”. I mean we should reset the value both the assets and liabilities side of the banks to reflect fair value.
1) Value reset on assets side means that the value that banks hold such as mortgage value should reflect the fair value for lenders and borrowers. This looks like Obama trying to do to reduce foreclosure but doing this way is not going to use any taxpayers’ money but use the loss of banks but it does not add any loss for banks because banks already set aside the provision for the risk of this debt default. It help the process of capitalism go on but the way Obama is trying to do is not comprehensive and will create moral hazard that will cause more and more taxpayers’ money for the intervention. The way to reduce debts of mortgage borrowers will cause loss of banks; therefore, we have to do liabilities reset.
2) Value reset on liabilities side means the value of equity holders and bondholders must reflect losses from investment in the banks. Some banks have to write down all equities part and to transfer sub-ordinated debt or even some of unsecured debts into equities. This is not going to cause any taxpayers’ money and if governments would like to protect money of depositors; they can join debt and equity swap scheme with other bondholders. This is quite fair for taxpayers’ money and we just use Capitalism process suddenly and aggressively to solve the problem rather than delay this process and use Socialism by using taxpayers’ money to protect losses of private investors.
The role of government is to accelerate the value reset process to reflect all fair price and ensure the confidence of new investors that all price reflect the fundamentals not reflect the intervention pricing.
I think the way of US government intervention is like Japan did by protecting the wealth of investors by public money. The intervention will cause the lack of private interest on economic activity because no one can measure risk and return and no one can measure what is fundamental value of investment; therefore, private sectors decide not to invest or invest elsewhere like Japan, Russia. So, if there is too much wrong intervention like this, America will definitely live with long deflated economy like Japan.
A disaster. The Obama administration is imitating the Japanese strategy in the nineties rather than the Swedish strategy: huge stimulus spending that is ineffective, protectionist policies and a bailout of bank investors and managements that leaves a permanently crippled financial sector. The difference is that the Japanese were able to finance their deficits from savings and enjoyed a trade surplus. The stage is being set now for a global depression combined with a collapse in the dollar’s value. It will be Obama’s depression whether or not the tail gets pinned on the donkey.
My conclusion about this mess is the the business leaders and economists of the country have totally failed the rest of us in the the most elemental way and that they should not be trusted to come up with a solution within their clubs. Their worship of markets led them to rationalize what seemed (and turned out to be)absurdities and the scale of it was so vast that millions of people all over the world will lose opportuntiies for generations. The banks have reacted to the first TARP in ways that only strongly reinforce the public belief that they are motivated by personal and institutional greed to such an extent that they simply have no idea how the most obvious things look to the people who are paying for this mess. Since most of the banks have no net assets now, I think government should take them over, fire those who were supposed to be responsible and failed, split them into sensible pieces that will create some real competitution and restart them as viable private institutions. I have no confidence that government run by many people who were part of the mess, dealing with banks with massive lobbies and huge staffs who can come up with endless subtrefuges and strategies, is going to be able to work out a deal that is fair to the public and the
next generation of Americans whose future is being mortgaged.