Back to Willem Buiter's Maverecon homepageGrandson of TARP is still alive. It now looks as though the Emergency Economic Stabilization Act 2008, rejected by the House of Representatives, will be resurrected with the addition of an increase in the limit of the FDIC’s deposit insurance scheme from $100,000.00 to $250,000.00 per person per bank. The increase in the insured deposit limit is a bad idea. Anyone holding more than $100,000.00 in a single bank should be encouraged to monitor his/her investment regularly and to spread it around if doubts about the bank’s solvency arise. With the long list of new facilities created by the Fed and the Treasury for banks to liquify their illiquid assets (through outright sale or through their use as collateral), the systemic risks associated with a deposit run on a solvent bank (that is, a bank that would be able to meet its obligations if all its assets could be held to maturity) are much reduced. Deposit runs on insolvent banks should be welcomed.
But the moral hazard created by raising the deposit insurance limit from $100,000.00 to $250,000.00 is minor compared to the benefits of having a TARP-like illiquid asset dump in place. As far as I’m concerned, the Treasury could throw in a free toaster for every depositor, signed by Obama and McCain (the toaster, that is, not the depositor), who between them have done so much to scupper the original plan.
The unwillingness/inability of the next president of the USA to display judgment, leadership and courage - come November, the ‘none-of-the-above’ box on the presidential ballot is going to look awfully tempting - is likely to do more to undermine the international prestige (and credit rating!) of the US than any increase in the public debt to GDP ratio associated with the plan. The assets acquired by the US government through TARP should in any case make the increase in the government’s net financial liabilities much smaller than the increase in its gross indebtedness.
I also hope that the new plan does not contain proposals for a suspension or watering down of mark-to-market valuation of bank assets. The long-term damage caused by a return to ‘in your dreams’ accounting would be way out of proportion to any short-run benefit. Anyway, Grandson of TARP should put a floor under toxic asset prices that is likely to be somewhat above their fire-sale value in illiquid private markets.
Why is Grandson of TARP a good first step to resolving the financial crisis?
The first fundamental problem of the US banking system is now that that there are too many banks with too little capital. The second fundamental problem is that we still don’t know what the true value of the capital shortfall is and how it is distributed. The ‘we’ in the previous sentence certainly applies to those outside the banks holding the toxic assets. It may well include the management of some of these banks also. I shall argue below that, although TARP & Sons could be used to help recapitalise the banks, it ought not to be used in that way. It could, however, make a valuable contribution to achieving clarity on the true state of the banks’ balance sheets.
TARP and its descendants are ‘value revelation mechanisms’. At the very least, if trades take place under the scheme, it will reveal the reservation prices of the sellers. Without TARP there are 3 valuations for a toxic asset. From low to high they are: its fire-sale value in illiquid private markets, the value at which it is carried on the bank’s balance sheet and the hold-to-maturity value.
For a bank to offer an asset for sale under the TARP, the TARP price has to be at least equal to its fire-sale value. Most likely, it will have to be at least as high as the fair or unfair value at which it is carried on the bank’s books. Otherwise a bank would effectively decapitalise itself by selling the asset at the TARP price. The only exception would be when the bank knows it is carrying the asset at an inflated value and expects its bluff to be called soon.
If the TARP succeeds in pricing most the toxic assets on the banks’ books, we will at least gain clarity about the true financial position of the banks. Only then can the recapitalisation of the banks be considered.
Grandson of TARP is a bad way to recapitalise the banking system
TARP could help recapitalise the banking system if the Treasury were to pay more for the toxic assets that what they are valued at on the banks’ balance sheets. That would be a terrible way to inject capital into the system, however. The banks would, of course, love it. But it would be an unconditional capital injection, giving the tax payer no upside on his risky investment and no voice in the management of the banks that are benefiting. I therefore propose that the TARP value the assets it purchases as aggressively as possible (that is, as close to the fire-sale price as possible).
How to inject capital into the banks?
Private capital is unlikely to flow into the banking system in the time scale and in the amount necessary to make a substantial contribution to the resolution of the crisis. There are only so many Warren Buffets out there. The middle-eastern and far-eastern nouveaux riches are (once bitten, twice shy) also unlikely to play a large part in the immediate crisis fighting, although over a horizon of a few years, they may well end up owning much of the US financial system. That leaves the government and the existing shareholders and creditors of the banks.
A capital injection by the Treasury into the banks in exchange for equity (ordinary shares or preference shares with a warrant to convert into equity at a known price) would have two obvious consequences.
First, it would continue the nationalisation of the US banking sector. The US banking sector would end up looking rather like the French banking sector of the 10980s. That may well be the model of the future, but we should not blunder into it without thinking it through carefully.
Second, it would increase the total capital of the banking sector. From a longer-term perspective, that seems unwise. The banking sector in the US (including all highly leveraged shadow-banking institutions) has grown way beyond what is socially desirable and now also way beyond what is privately profitable and financially sustainable. The same is true in the UK and in many other European countries. The sector will have to contract its employment and balance sheet to shrink the supply of financial services and products to match a much-reduced demand.
Although I expect all surviving banks to have higher capital ratios and lower leverage than they did before the crisis, I still expect the total amount of capital in the banking sector to be lower. A key challenge will to get banking sector capital to flow from the losers and the duds to the winners, through a range of consolidation mechanisms.
Should the government decide on a capital injection for the banking sector, it is key not to link such a dilution of the existing shareholders to participation in Grandson of TARP. The simplest way to proceed would be for the government to set a maximum leverage ratio for the entire banking sector (0r a minimum capital ratio) and then to inject capital so as to just achieve those ratios.
An alternative would be for the government to set a maximum leverage ratio (or a minimum capital ratio) but to give the existing shareholders pre-emptive rights to bring the actual capital up to the target level, with the government filling in the remaining gap, if any.
I would, however, prefer a mandatory debt-to-equity conversion for the banking system. Again, the government would set a maximum leverage ratio or minimum capital ratio, but now existing bank debt would be converted (in inverse order of seniority) into stock. This could again be preference shares or ordinary shares. Unlike the Treasury-funded capital injection, which lowers the leverage (debt-to-equity) ratio by raising the denominator. The mandatory debt-to-equity conversion would lower the leverage ratio by both lowering the numerator and raising the denominator. The total size of the balance sheet (debt plus equity) would remain unchanged while with a Treasury capital injection it would increase, which makes little sense if the banking sector is too large and needs to shrink.
Effectively, a mandatory debt-to-equity conversion would be a sector-wide high-speed version of Chapter 11. The financial restructuring it involves would hit the holders of bank debt. This is one of its main attractions. Except in the case of Lehman and WaMu, bank debt holders have been made whole in the other state-funded or state-promoted rescues and consolidations. From the point of view of moral hazard (incentives for future reckless lending and investment), this protection of the debt holders is highly undesirable. They earned the risk premia when the going was good. They should eat the risk when the going gets tough.
The disappearance of money and credit markets
It is clear that, until clarity is achieved about what banks hold on their balance sheets, and until those banks that are likely to survive have been recapitalised, banks will not lend to each other, no-one will fund the banks and the banks will cease extending credit to households and non-financial corporations. The unsecured interbank markets are drowning in liquidity at the overnight end and starved of liquidity at any maturity of a week or longer. Unsecured interbank lending has vanished. Libor spreads are at historical highs and even secured interbank lending is pathetically low. The perception of prohibitive counterparty risk is killing all interbank transactions. This is already having an effect on the cost and availability of credit for households and non-financial corporates. Unless it is addressed immediately, this will get worse.
I propose that the authorities for the time being socialise the interbank market. They can do this in one of two ways. Either the central bank becomes the universal counterparty in all interbank transactions, secured and unsecured. Banks lend only to the central bank and borrow only from the central bank, not to and from each other directly. This is already effectively the case in the overnight market. It could be extended by the central bank forming a judgment on the appropriate term structure of interbank rates for all maturities up to a year, say, and transacting freely at these rates, against a fee. This would apply to both secured and unsecured borrowing. The spreads between the central bank’s lending and borrowing rates in the interbank market should be wide enough to encourage a return to private interbank intermediation when order is restored.
Much the same effect can be achieved through a Treasury guarantee of interbank lending (against a fee, of course).
If all banks participating in the interbank markets were under state-ownership, the counterparty risk would effectively disappear. This would be a third mechanism for restoring life to the interbank market. It may well be what we’ll end up with if the Grandson of TARP and subsequent plans for privately financed recapitalisation of the banks don’t get enacted and implemented soon.
Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.
