Everyone Get in Line

For months now, Ricardo Caballero has been proposing yet another solution to the toxic-asset problem: universal, government-provided insurance for the assets. He recently let loose a double-barrelled volley in both the FT’s Economists’ Forum and the WSJ’s Real-Time Economics blogs. I believe he is correct that this would solve the problem: if the government is insuring any bank assets that the banks want them to insure, then the banks are protected from any further write-downs, and they are healthy by construction. However, there are other ways of getting to the same outcome. One would be for the government to pay face value (or current book value) for any assets that the banks would want to sell. Another would be to take over every single bank that fails Mr Geithner’s stress test, pull out all of their bad assets, and reprivatize them. All of these solutions will result in banks that are not encumbered by the fear of further writedowns on toxic assets.

In judging between these options, we need to look at the details. For Caballero’s asset insurance proposal, this means looking at the price of the insurance. Remember, banks could buy this insurance right now on the free market if they wanted to. The problem is that the insurance is too expensive. Caballero’s proposal is only a solution if the government offers insurance at a lower price than the market (a subsidy, in other words). And this is precisely what he is suggesting:

The price of the insurance should be set at pre-crisis levels for the corresponding asset class. If there is a sense that these assets were over-rated to begin with, then we should adjust the prices accordingly (for example, use AA pre-crisis insurance prices for overly-rated AAA assets).

This arrangement should be coupled with tight monitoring of the insured institutions and with retroactive fines a few years down the road to those institutions (and their management) whose assets underperform relative to their asset class.

Essentially, this relies on the assumption that the assets will turn out better than we currently think. (“[T]here is no need to resolve the thorny issue of the insurance price and the quality of the assets right now. We can wait for the passage of time and a return to normality to determine whether their assets were worse than the representative asset in the corresponding asset class.”) If they do, then everything will turn out OK. If they don’t, then we will charge the banks fines to reflect the difference. It seems to me that those fines represent an uncertain liability that will still be hanging over the banks; or, alternatively, the fines will be so small that they won’t affect the banks materially.

In the end, this looks the same to me as the plans in which the government simply buys the bad assets. In Caballero’s plan, the government doesn’t lay out cash, but provides underpriced insurance that creates large potential liabilities. In the asset-buying plans (including Geithner’s public-private partnership), the government does lay out cash, but gets assets that have some value, and could have more value in the future. In either case, the ultimate size of the bill depends on whether or not the assets recover in price; once the risk has been transferred to the government, the rest is just details.

Now, that doesn’t make this option necessarily any worse than the others. I believe the goal is to have healthy banks, and the taxpayer will pay one way or another. So the asset insurance proposal deserves consideration.

But what I really don’t understand is Caballero’s framing of the discussion. In the FT:

In all likelihood, political constraints severely limited the ambition and effectiveness of the US financial stability package. Economists need to unite behind relaxing these constraints. Talking lightly about nationalisation, as is increasingly taking place, does exactly the opposite.

There are two types of arguments for nationalisation. One argument is a gut reaction that enough-is-enough and we must stop transferring resources to Wall Street’s “crooks and oligarchs.” This reaction only adds fuel to the fire and exacerbates self-destructive mob-mentality behaviour.

We need to stop this.

And on Real-Time Economics:

It is true that the recent announcements are lacking specific details, and perhaps revealed that the Treasury’s economic team overestimated people’s ability to distill the good news in an abstract message of principles when in panic mode. But there is good news in them, as they reflect a much deeper understanding of the fundamental uncertainty problem ravaging insurance and credit markets than commentators and politicians have. It is time for all of us to focus on facilitating their difficult task and to try to fill some of the gaps.

It seems to me that Caballero is saying that the proponents of nationalization – recently joined by Alan Greenspan – are irresponsible, and that the correct path is to support Tim Geithner and his plan – which, according to Caballero, is basically the same as his plan. (“US Treasury Secretary Tim Geithner’s proposal . . . is probably as much as he could get in a heavily-politicised environment. Coupled with the bad bank arrangement and guarantees for private asset buyers, it resembles the insurance solution described above.”) This claim is confusing to me, since Geithner’s plan is for private capital, backed by government loans, to buy up toxic assets. But there’s no need to debate that here.

The important point is that Caballero’s proposal is one that would probably be welcomed by most banks, since it allows them to continue in their current form while transferring their risks to the government. This enables Caballero to write off political considerations as unwelcome intrusions into the sphere of economic reason. However, if you support a solution – like nationalization (or, as Simon prefers to call it, “reprivatization”) – that would not be welcomed by the banks, then political considerations become part of the story. In any case, I find it surprising that an MIT professor would call on his academic colleagues to stop criticizing the Treasury Department because they are “exacerbat[ing] self-destructive mob-mentality behaviour.”

Insert your own historical analogy here.

30 thoughts on “Everyone Get in Line

  1. This may not be relevant to this post, but I am yet to see an intelligent analysis of what would happen if we do nothing.

    I know LIBOR shot up quite a bit after the Lehman collapse and the credit markets “froze” as they say. But what would really happen if these systemically important banks really did collapse?

  2. Exactly.

    What I like in Caballero´s approach is the purely theoretical or philosophical aspect: after all, good fundamentalist Keynesian thinking encourages to pay heed to liquidity preference, which can be usefully seen as the insurance role of cash…Hence Caballero is well within his rights to insist that we should or at least could approach the whole financial disaster from the insurance perspective.

    Alas, as a practical suggestion Caballero´s proposal does not change anything. No matter what our philosophical or theoretical perspective on the bailout, we still have to make our minds as to who is going to take and what liabilities. Despite its sophisticated veneer, Caballero´s idea is just another proposal to dump the toxic stuff onto taxpayers backyards. Why? Because the proposal can be effective only if the price of the insurance is substantially lower than its fair price – otherwise the whole idea is just dead in the water.

    In fact, Caballero´s surprisingly intemperate rhetoric makes me wonder whether he has advising Fidelity Investments (Bloomberg Feb 19: “Fidelity More Than Doubled Citigroup Stake in Fourth Quarter”)…

  3. I have one simple question. Isn’t our problem that you have people living in homes beyond their means and they can’t afford their mortgages and they have to be moved and downsize their living arrangements? Otherwise, what you have is a shell game that basically tries to figure out how we’ve going to use government assets to forgive debt or pay off these mortgages. It’s a tax break and redistribution of wealth on an enormous scale. The bailout is a tax and the Democrats should be ripped for it.

  4. Good analysis and questions, James. I have some more simple questions. How much would it cost? Is this really a good way to spend government money, as opposed to fiscal stimulus? Can we even afford it?

  5. listen, why can’t we just auction them as had been proposed before. it seems to me the best option now. temporary nationalization is another option.

  6. This is what i don’t understand. Socialism had been discredited (already) by failure of USSR economy, so why are we still talking about nationalization as something scary.

    Besides aren’t analogies between failure of both systems to work as they had been promised to in fairy tales, have been enough to stop playing kids about left and right and start fixing the system.

    What’s the point of “luring” private investors into buying those toxic assets and at the same time insure them in case those assets default. Isn’t it much more efficient to temporarily nationalize those banks, clean them and give them back to private sector.

  7. Any way you slice it the nut of the problem is making taxpayers foot the bill for banker’s mistakes. Given that this will/must happen one way or another, it seems to me that the transparency, simplicity, openness are of first order importance. The silver lining will be if we can shred the idiotic notion that completely free markets exist or that capitalism in its pure and unregulated form is what we need. Let’s make it painfully clear—the bankers, motivated by almost unimaginable greed and political power purchased from the government, created a weakly regulated economic system and then drove it over a perfectly predictable cliff, and now the rest of us have to pay to fix this system so we don’t end up in soup lines. Whatever method we use to repair this problem, be it over paying for toxic assets or under charging for insurance premiums, it is important that it is clear to taxpayers what they are being required to do. Attempts to disguise this reality just ensure that we’re likely to repeat the disaster more quickly. If we can’t have moral hazard we should at least have complete transparency.

  8. Nationalization as punishment is just demagoguery.

    Nationalization is one tool that can be used to recapitalize banks, but not the only tool. I see nationalization as premature because more assets are going bad as the economy sours. It is hard enough to explain the $700 billion for the TARP; if you nationalize the banks and discover you need another trillion, the government owns the bank but is unwilling to provide enough capital to make the bank viable.

  9. Geitner is part of the problem -not part of the solution-or have you people forgotten that he has been heavily involved in all of this from the beginning. There is only one solution- nationalize the bad banks! Fire the CEO’s and wipe out shareholders. At least that way the bad actors suffer the consequences for their bad decisions. The government can sell off the banks along with their good stuff and holds the bad stuff until they either get some return or have to take the loss. All the rest of this talk is just crap and delaying the inevitable. Since Obama and his advisors can’t seem to make the decision -let me.

  10. “Despite its sophisticated veneer, Caballero´s idea is just another proposal to dump the toxic stuff onto taxpayers backyards. Why? Because the proposal can be effective only if the price of the insurance is substantially lower than its fair price – otherwise the whole idea is just dead in the water.”
    I’m glad you said that, Chacona, because I’m not an economist or finance guy but that was the one thing about Caballero’s analysis that I immediately understood.
    So I agree with Michael Roberts. And for those who don’t like nationalization, the idea I’m mostly hearing is nationalization only for the purpose of bankruptcy administration (not literally Chapter 11, but something like that) and, one would hope, breaking up the banks that were “too big to fail” into smaller companies, passing much-needed banking regulations, then leaving the banks to manage themselves, ASAP.

  11. “Despite its sophisticated veneer, Caballero´s idea is just another proposal to dump the toxic stuff onto taxpayers backyards. Why? Because the proposal can be effective only if the price of the insurance is substantially lower than its fair price – otherwise the whole idea is just dead in the water.”
    I’m glad you said that, Chacona, because I’m not an economist or finance guy but that was the one thing about Caballero’s analysis that I immediately understood.
    So I agree with Michael Roberts. And for those who don’t like nationalization, the idea I’m mostly hearing is nationalization only for the purpose of bankruptcy administration (not literally Chapter 11, but something like that) and, one would hope, breaking up the banks that were “too big to fail” into smaller companies, passing much-needed banking regulations, then leaving the banks to manage themselves, ASAP.

  12. I just don’t get it – why you (Simon) and many others are hung up on saving a few large banks. The public gets it: Let them die (i.e. go into bankruptcy). Let the healthy banks do the business.

    Yeah, yeah, yeah…all the complexities of the CDOs, SIVs, CDSs…all that is tied in to these banks debts. I still say, let it play out. WE HAVE TO DELEVERAGE COMPLETELY, SO WE CAN START THE NEXT GROWTH PHASE. Just let it happen, and let’s stop the interventions that are going to drag this out for a decade or more. And whatever we do, let’s not keep dumping money into the hands of the gamblers and crooks that were primarily instrumental in creating this toxic waste.

    In my book, anyone who is attached to “saving” these banks with taxpayer money is effectively a traitor to the public, a scoundrel (planning on benefitting from it), and/or a bankster (already benefitted from it and wants to continue the pilfering) – that is, evil.

  13. Dina Strange,

    “listen, why can’t we just auction them as had been proposed before. it seems to me the best option now. temporary nationalization is another option.”

    You don’t want to pretend that over-intellectualized and egregiously over-complicated alternatives are superior? What are you some kind of crazed anarchist? :-)

    Seriously, if you just auction them off or nationalize, the banksters would have to eat the consequences of the interest driven, Ponzi-economy they’ve so carefully created and nurtured since the late 1970s. And, look, after all those folks have done to insure that our dear savior had scratch during last year’s campaign, doing that would be just outrageous. So what if Bank Of America’s Ken Lewis pinched Michelle at the Inaugural Ball. Does life have to be a veil of tears?

  14. Rajesh,

    “Nationalization as punishment is just demagoguery.”

    OK, then, if you won’t let us employ punitive nationalization, how about incarceration with brutal beatings, show trials, faked confessions and sentencing in a large football stadium environment?Please, Ramesh, please. :-)

  15. Nice analysis.

    Sadly at this point the alternatives are heavy government involvement (in assorted forms) or do nothing. As far as I know history says doing nothing in the face of debt induced deflation leads to multi-year contractions, 20 years of slow or no growth and 20% unemployment – so it won’t be nothing. Especially since the majority of the top 10 US banks are completely insolvent.

    And no matter what the government does it won’t be completely “fair” but there are definitely options that seem more fair than others. Personally I think the most fair option is to nationalize and give EVERY US citizen (including kids) a share of the resulting banks. Perhaps not completely fair but a true economic depression would be unfair as well – in a depression people could have done everything right (not taken on too much debt, lived within their means, worked hard, etc) and still wind up losing their jobs and homes.

  16. What a bunch of drivelized non-sense-izmand mental masturbation! The amount of monies being printed and thrown at the banking institutions to maintain and prop up the fractional lifestyles simply amazes me. Humanity, in the long run would be much better served by using the gold standard, again.

  17. Oh two more points on why it won’t be nothing

    1) The FDIC currently has $36 billion, and can borrow another $30 billion at will. The FDIC insures $4.5 trillion in deposits at 8,394 institutions with $13.6 trillion in “assets” (link below but w/o the quote around assets). Even if the insolvent mega banks only account for 10% of the deposits, bankruptcy would mean the FDIC is going to need BILLIONS in government aid just to pay out deposits.

    2) You may or may not agree with Yves but she raises at least some of the problems with just letting the mega banks go bankrupt. As she notes “who would buy Citi’s deposits and branches, pray tell? And even if such a bank existed, do we want that much concentration? And what do we do with the junky assets, the private equity portfolio, the asset management business, its credit default swaps book, its various trading operations (many, ranging from FX, Treasuries, structured credits, money markets instruments, equities, junk bonds, derivatives, and I’m sure I’ve missed quite a few). These banks are not simply bigger; they are in a far wider range of businesses than the typical FDIC basket case, with a much larger geographical footprint (typically substantial foreign operations) and more complicated operations (meaning management information systems, financial reporting, transaction processing, customer reporting, risk controls).”

    http://www.bloomberg.com/apps/news?pid=20601109&sid=aJPIFIU8lSCA&refer=home

    http://www.nakedcapitalism.com/search?updated-max=2009-02-19T00%3A40%3A00-05%3A00&max-results=5

  18. I have already told Caballero that this issue of insuring and guaranteeing is like cheating in the market of lemons. If you have lemon banks and products you do not put an insurance on it just to price and sell them. Your car remain a lemon. I suggest that Caballero look more into the aspects of markets for lemons and discover that his proposal just maintain the status quo and defend the existing banks.

  19. The economy does not exist in isolation. The people are firmly against bailing out the banks. The seven hundred billion stimulus is just an attempt to buy the people’s silence. Most people do not yet know that the banks have already been given ten trillion dollars with another ten trillion is needed. Nor do they know that the bad derivatives are estimated to be between seventy and five hundred trillion. Attempting to socialize this pig simply will not work. Economists continue to disguise the pig in a never ending parade of loss socialization schemes. The People are bucking hard against it. There is a deadlock between the politicians who represent the oligarchy, and the people. It’s a hell of show and the more the tree is shaken the uglier it gets. It is the very best of hair raising entertainment.

  20. I find Caballero’s analysis very elegant and very expensive. And I still don’t understand why the simple purchase by the Federal Government of the underlying impaired mortgages is not the way to go.

    By purchasing the underlying mortgages, the Government essentially extends its timely payment guarantee to all the derivative securities. It does not «pay» the fat fees that were included at origination. And automatically rehabilitates the investment and trading accounts of the banks holding those securities.

    As the mortgage holder, the Government can then turn to the borrowers and modify the terms.

    I estimated in October 2007 that this (net) cost would not go above US$ 75 billion. One year later, I re-estimated that it would not go above US$ 450 billion. I do not believe that it would be much higher today.

    Thank you.

  21. Like F in Lisbon I am befuddled. Why doesn’t the government buy the mortgages? If they are the root cause of this crisis then do a root canal. Feldstein asserts that syndication has made direct negotiation with creditors impossible. Ok, then pay off the nice folks who are acting as the contact point between the creditors and the mortgagees, convert the properties into (temporary) public housing, and collect rent from the residents until a private buyer steps up. Property management could be outsourced even! (Just keep Rep. Waters away from the bidding process.)

    This approach would repay principal and wipe out projected revenue, i.e. asset value based on exponential interest. Because the impact would be devastating for institutions that were particularly irresponsible the government could focus on one quarter of the properties in question and produce sufficient stability in the housing market to restore lending.

    Hudson might argue that this would allow re-inflation of asset values and initiate another bubble. But the immediate impact would be to reduce reduce real estate prices and expose banks that have been irresponsible. And the cost to future generations of taxpayers would be less than the government’s current practice of shovelling treasure upwards. Try shovelling treasure downwards! And don’t give me any of that crap about the administrative costs of paying off the mortgages and acting as landlord. Where are all the complaints about the administrative costs of this collapse, of the health care system, of the war in Iraq?

    Caballeros idea makes little sense because weren’t the mortgage-backed securities insured with credit default swaps? So I guess he is tacitly acknowledging that these swaps were not insurance (they were in fact commission generators) and arguing that the time has come for some real insurance, which by the way would be underwritten by the taxpayer. I don’t like it.

  22. btraven is correct: “WE HAVE TO DELEVERAGE COMPLETELY, SO WE CAN START THE NEXT GROWTH PHASE”

    The state will unfortunately have to play a much greater role in that process than anyone would like. This will go far beyond the financial, housing and car sectors and will take a long time.

    To illustrate, consider WWII as an analogy where the state ran the economy and society in what became the war effort. The state will now have to step in to ensure that the delevering does not end in chaos.

    I was a neo-liberal until the Swedish Government had to step in to save the country during the crisis in the 90s. I was then part of that effort and saw first hand that had it not been for the state stepping in, the economy would have self-destructed. I then realised that 1. you can not choose an ideology that only works in good times (me, the neo-liberal) and 2. half measures will only prolong/deepen the crisis.

    This time, believing in TARPs, including Geithner’s versions, is a waste of resource and time.

  23. “WE HAVE TO DELEVERAGE COMPLETELY”

    Yet another variation of “burn the forest, let new trees grow”.

    The advocates of this approach, who idolize the 1870s, generally believe in a dark future for the world, and have aligned their investments accordingly.

    To succeed, they do not need to prevent all action – they simply need to water it down until it is a half measure, and doomed to fail. Then they can use it as evidence of failure.

    Obama has been a tremendous disappointment. Many who had some degree of faith that we had learned from the past have now given up. Obama had a fantastic window of opportunity which has now closed. The reason for Simon’s (and others’) pessimism this week is because it’s game over. The inaction, incompetence, and indecision of the last six weeks has prolonged this downturn by 6 months or more.

    It’s gut wrenching – like watching a Shakespearean tragedy.

  24. Will Obama’s housing plan slow default rates of these assets enough to make this plan (or any of the presented alternatives) work?

    I agree with John Hussman that a massive coordination effort is needed to put together the pieces of troubled mortgages, making modifications possible in order to dramatically reduce defautlt rates. Without this step, aren’t we just transferring risk instead of reducing it?

  25. Chacona and StatsGuy have it right. Caballero’s insurance scheme is ridiculous. First of all these banks need to be RID of the toxic assets that are dragging down their earnings. Paying an insurance premium – no matter how much – is adding more misery on these banks without solving the problem.

    I proposed awhile ago that this plan NOT be voluntary for the affected banks. ALL mortgages on owner occupied homes that are over three payments delinquent should be bought by the government at PAR. The loans would be restructured so that homeowners could keep their homes and not become a blight to their neighbors.

    The government should take back warrants to purchase stock of the banks benefiting from removal of these “toxic” assets. That way, when the banks start to make SOUND loans once again and return to profitability the government could exercise the warrants and recoup any loss or expense suffered in the restructure of the loans to keep people in their homes (worked for Chrysler).

    I am extremely disappointed with what I hear from the White House. The banking oligarchs need to be dismantled – not cow toed to by a former disciple.

    The Resolution Trust Corporation should be brought back and these irresponsible banks should be intervened, cleaned up and sold. FDIC Liquidation Division needs to be beefed up to handle disposition of toxic assets.

  26. This is a great idea. A windfall freebee for the US taxpayer collecting premiums for assets that cannot go down. Remember, housing prices have never declined Y/Y in the history of civilization, except in Pompeii.

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