Defending A Peg: Lessons for the US Banking Authorities

You’ve seen it a thousand times.  A country’s exchange rate used to make sense, but now it is hopelessly overvalued.  And, consequently, your pegged exchange rate now looks like a one way bet.  Every Financial Times subscriber starts to think about how to either get out of your currency or, if they are feeling aggressive, how to more actively speculate that the exchange rate will soon depreciate.

And the beauty of this situation – from a speculator’s point of view – is that the relevant authorities will never move quickly or decisively to the inevitable end point.  Sooner or later, the currency will be devalued and, if the country’s citizens are lucky, sensible economic policies (and perhaps external financial support) will be put in place to support the new exchange rate.  But, for a surprisingly long time, the government will make statements along the lines of, “we will defend our exchange rate,” “we have plenty of reserves,” “we will never devalue,” or – my favorite – “the fundamentals are fine.”

This analogy sprang to mind when I read this morning’s joint statement by Treasury, the FDIC, OCC, OTS, and the Fed.

The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses.  The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth…

Any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory.  Previous capital injections under the Troubled Asset Relief Program will also be eligible to be exchanged for the mandatory convertible preferred shares…

Because our economy functions better when financial institutions are well managed in the private sector, the strong presumption of the Capital Assistance Program is that banks should remain in private hands.

This would be a fine statement in many contexts.  But there is now an obvious endpoint, which is very much on everyone’s mind – there is no point in pretending otherwise.  Either banks will be taken over by the government – and then reprivatized (and I insist on immediate reprivatization) – or they will not.  And “not” is fine with me, but this option is only persuasive if you can really explain how it is going to happen and provide a decent deal for taxpayers (given that this will effectively insure bankers’ bonuses).

I’m not saying there are any easy or attractive alternatives.  In particular, the lack of prior stress tests mean the government does not yet have full information on banks’ balance sheets (aside: what exactly have bank regulators been doing for the past two years?)

But this morning’s statement feels like another partial, vague, and underfunded commitment.  This does nothing to reduce uncertainty.  And, just like fears about fixed exchange rates in other contexts, this will undermine confidence in the economy more generally.  Whether it will speed or slow our movement towards the endpoint remains to be seen.

22 thoughts on “Defending A Peg: Lessons for the US Banking Authorities

  1. For about $11 billion the gov’t could stage the equivalent of a hostile bid for the outstanding stock of Citi and just buy it all.

    The stockholders would get the current value of their holdings thus removing a source of political opposition. Preferred and bond holders would remain as now.

    Once the gov’t had control it could restructure, spin off or sell segments or take whatever other steps it needed. When the bank was put back on an even keel the gov’t could hold an IPO and sell off its shares at an appropriate price.

    There is precedence for this. During WWII the gov’t seized the ownership of German owned US companies. A prominent example being the photo company Ansco (later GAF) which was a subsidiary of Afga. The gov’t owned the firm until sometime after the war ended at which point there was an IPO and the company became public once again.

    It seems like the tactics used with the banks are aimed at preserving the positions of the managerial class that runs them. The gov’t has already put four times the amount into Citi than my idea would cost.

    Today they completed the fiasco by exchanging preferred (which pays a dividend and is refundable when it matures) for common which gives them no claims whatsoever. Even with this the gov’t still will only own 40% and not have management control.

    Theft in broad daylight.

  2. robertdfeinman is exactly right. At least the preferred stock had to be paid back eventually, in theory.

    With the preferred-to-common conversion, they are giving up even that pretense. This is the most blatant gift of taxpayer money to a bank so far.

    $45 billion for a 40% stake in Citi is equivalent to a secondary offering at $12.38/share. Theft in broad daylight, indeed.

  3. Banks, banks, banks…

    You are all rearranging deck chairs on the titanic. We are witnessing a simulaneous worldwide demand collapse, concomitant with massive bankruptcies.

    There are two possible outcomes and only two: inflate worldwide currencies, or watch everyone go bankrupt.

    Simon is right to observe that absorbing bank assets is identical to defending a peg. The ultimate outcome will be US bankruptcy.

    Obama will pay a steep political price for the incompetence of his advisors – we are all hosed.

  4. The day’s events prove those in control will print trillions to give to banks and put the entire monetary system at risk–just to prevent a handful of the elite from going under. This is looking more and more like blatant corrupt cronyism that is covered by only the thinnest veneer of public policy.

  5. This entire situation could be resolved by calling in the loans. The government just says to everyone holding a mortgage:”Come in and re-fi at 4.5% for a 30yr fixed.” 80% of the outstanding paper comes right in the door. The 20% that refuse the re-fi, well, there’s the bad paper.

    But that’s just the tip of the iceberg as far as the markets are concerned. Every thinking person knows that this country will never be the same after Obama. Every incentive or program the President has implemented or proposed supports those who drink the water and not those who carry it. Therefore, all the smart and productive people who used to carry the water are going to get very thirsty. Personally, I’m going to be one of them. Now where’s my cup?

  6. This all so reminicint of Ayn Rand’s Novel”Atlas Shrugged”.Everyone is pretending that things are not what they are.Hank, Where are you?

  7. @MethodMan

    It’s even worse. We’re not printing trillions. We’re borrowing them, thereby ensuring a strong dollar, _increasing_ the implicit value of debt, and sucking money out of the broader economy. We are doing this to “cover” debt owed by financial institutions, ensuring their bond-holders get full value by forcing US taxpayers to cover their cost – the SAME US taxpayers who have watched the value of their debt skyrocket in real terms while property values plummet.

    This is called the “double-screw”.

    This last week, Treasury floated record T-bills, which received strong interest from foreign entities. This will continue right up until the point they lose confidence in the Treasury, at which point the backlash will ensue – and the dollar will collapse. The turn will be sudden and severe, unless we pro-actively deal with the debt now.

    Every day, however, our chances of success rapidly diminish. If, indeed, there is any chance left.

  8. Simon et. al.

    There are two lines of thought that I find conspicuously absent from collective discussion on the economy and banks

    1) How possible is it that the derivatives positions of the largest banks have rendered them unsavable — e.g. if the loss on outstanding primary motgages is, say, $1.5T, how/why do we think that they haven’t created enough synthetic postions (by writing CDS and buying bonds) to make that lose 2, 3, or 10x the loss on the underlying assets.

    2) Why isn’t sumultanious globaly quantitative easing the answer. If everyone just throws the same amount of money from their collective helecopters, doesn’t it just shrink the value of debt and leave exchange rates constant? Isn’t the U.S. in a position where it can just start running-up inflation and everyone else has to join in or see their economies suffer from inability to export to the U.S.?

    Just my 2c thoughts to the group. Thoughts?



  9. I hear people say “Let the banks fail” a lot nowadays. And then there are others who want to keep their investments safe and valuable, and those are the sort who want to bail out the banks…as StatsGuy says, it just seems like ‘rearranging deck chairs on the Titanic’ to me. The people who want to bail out the banks and protect the money they have…they aren’t the majority. Lots of us don’t have any money to protect because of the rising unemployment and terrible economy.

  10. Nice to have some intelligent conversation for a change. After 62 years on this planet we finally have an environment that gives a good name to Cassandras!!

    But in the end I keep coming back to KISS, keep it simple stupid. This means use what we have already done successfully and modify it a little to work in the new circumstances.

    For at least a couple of decades many people have been persuaded to reduce their total mortgage interest by making more frequent payments and/or increasing the amount of payment by a nominal amount. This is coupled with a policy that has no penalty for early repayment.

    Why don’t we simply do this in reverse with the current mortgage mess. As long as people pay some minimum amount, let the difference between what they pay and the expected payment simply be added to the total interest obligation with no penalty for mortgage extension. Do this in concert with refinancing to the lowest possible rate for a fee.

    It would be in the homeowners interest to minimize the use of this payment opt-out because it would compound their interest over time. Only if the the added interest exceeds 50% of their equity would foreclosure be possible.

    Call it the foreclosure modified mortgage (FM2) and let the people who have taken the risks bear the ultimate penalty or appreciation over time. This is the way the market is supposed to work.

    Foreclosure is everybody’s worst nightmare except for the bottom feeders. Lets get rational here and stop subsidizing banks or people when basic changes in approach can alleviate these problems.

    An added plus is that if the supposedly toxic mortgages suddenly become sustainable, then the looming disaster from the CDS collapse recedes in size and and reassures the markets. If such a plan were put into place we might have recovery beginning in a few months. Without some technical fix….. do you hear that enormous flushing sound????

  11. eric: 1) In a sense the losses are the losses, based on falls in housing values and the resulting mortgage defaults. I haven’t heard of anyone actually making a big profit off the derivatives. Certainly though we would all benefit from an untangling of the derivative mess. 2) Competitive devaluation may very well come into vogue, moreso than already. The benefit is you gain an export edge. The cost is you impoverish your people (relative to what their purchasing power should otherwise supply as consumption).

  12. “the government does not yet have full information on banks’ balance sheets”

    Hello? Let me introduce you to a new term that obviously got left out of your copy of the dictionary:

    Bank Regulator: a agency that has unlimited authority to inspect bank accounts, records, loans, physical assets, personnel in order to determine whether a bank meets solvency regulation. Bank regulators are judge, jury and executioner. If they say you are insolvent, you don’t get to show evidence, you don’t get to call witnesses, you don’t get to appeal.

    Go strait to jail; Do not pass GO. Pack your bags and adiós.

    Bank regulators are the authority on whether a bank is solvent or not. Other people can have opinions about the bank but they aren’t worth warm spit. Regulators probably have looked at the value of every questionable asset on the bank’s book and if they don’t like the bank’s answer; they can impose their own value on it. This whole “we don’t know what the bank is worth” assumes that the regulator are completely asleep (which is actually probably true for OTS, but OCC and Federal Reserve are wide awake by now.)

  13. @Eric

    You are correct – simultaneous global quantitative easing is the rational answer.

    As to why this is not a major topic of conversation… well, that is a grand mystery isn’t it? A true puzzler. As Sherlock Holmes would say… It’s the case of the dog that didn’t bark.

    Geithner, Bernanke, and Obama are dumping a lot of debt on the US Taxpayer in the name of protecting a “system” they tell us is essential to world prosperity. This debt represents a claim upon our childrens’ lives.

    The issuance of this debt in combination with asset devaluation represents a massive transfer of wealth from homeowners (whose equity just got wiped out) and stockholders (whose 401ks just got wiped out) and employees (who are losing jobs) to bank bondholders and T-bill holders.

    One of the only asset classes to rise in value has been US treasury debt. There’s over 10 trillion dollars (and growing) US treasury debt in the world. The total value of all equity markets stood at nearly 70 trillion prior to the crisis, and is now 28 trillion.

    Do the math.

    Meanwhile, our economy is shrinking. Jobs are vanishing. Businesses are not investing. Tax revenue is declining.

    In the wake of this, the downside of inflation (which is very real) seems rather less frightening. Yet it remains the ‘third rail’ of modern economics.

    Academic economists are afraid to even speak the ‘I-word’ (which is why Bernanke invented the term ‘quantitative easing’).

    So to answer your question, here are two hypotheses:

    1) There’s a grand conspiracy, and someone who controls the strings of power stands to gain a lot of wealth.

    2) Most modern economists are intellectually bankrupt, having been conditioned through Pavlovian training to break into a cold sweat whenever anyone says the I-word.

  14. The reason inflation won’t work is that too many savers have protected themselves and too many lenders have protected themselves. Balloon mortgages and ARM’s are just one example of inflation hedging by lenders. Only hyper-inflation can dynamite these out of the way, but ask Zimbabwe how that works out.

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