Before it was proposed, the Paulson plan (or rather its substantive content - the TARP)  was neither necessary nor sufficient for a solution to the US banking crisis (let alone the banking crisis outside the US).  But once it had been proposed, the confusing dynamics of market confidence made it  imperative that it be passed.  Now that it has been passed, the US and the world at large have a short breathing space in which to prepare the measures necessary to achieve a lasting solution to the crisis.

The substance of the Paulson plan (ignoring the Christmas tree ornaments that Congress attached to it, except for the highly desirable improved oversight) is the $700 bn of public money made available to purchase assets for which no liquid market price exists and about whose fundamental (hold-to-maturity) value there is pervasive uncertainty.  If the TARP works well, it will price the assets above their fire-sale value and, one hopes, above the values at which they are carried on the banks’ books.  They ought to be priced well below their hold-to-maturity values, however, to give the tax payer a proper return on his/her money and to discourage future exposure to toxic assets.  For many of these assets, the hold-to-maturity value is in any case far below their notional or face value.  Many dreadful originations occurred during the craziest years of the recent credit and asset boom/bubble.

The TARP should be a mechanism for revealing something about the fundamental values of the toxic asset, and for speading up the recognition of the capital losses made by the banks that hold them.  It should not be viewed as a mechanism for recapitalising the banks on any signficant scale.

Leverage in the banking sector continues to be far too high, however, and many of the steps taken by individual institutions to lower the numerator of the leverage ratio have, in the aggregate, also lowered the denominator of that ratio.  With a limited supply of Warren Buffets and of Far Eastern and Middle Eastern Sovereign Wealth Funds and state-owned banks willing to put their money at risk by taking equity stakes in US and European banks, the only two mechanisms for reducing leverage are (1) a direct equity stake by the state and (2) mandatory debt-to-equity conversions, with or without the prior formal wiping out of the existing equity holders.  Nationalisation can, of course, occur without the input of any net new capital by the state, but from the point of view of restoring the ability of the banks to lend, it belongs to category (1).

The UK has led the way as regards the public sector nationalising failing or ailing banks, first with Northern Rock and then with Bradford and Bingley.  The US government then took the lead in socialising financial intermediation, by nationalising Fannie Mae and Freddie Mac and AIG.  Following an earlier capital injection in the Fortis Group by the governments of Belgium, the Netherlands and Luxembourg which failed to stabilise the finances of the Fortis Group, the Dutch state state now owns 100% of Fortis Nederland and of the ABN-AMRO stake bought by the Fortis Group.  Belgium, Luxembourg and France have made state capital injections into Dexia.

Many other forms of government support have been provided for the financial sector, ranging from deposit guarantees and wider guarantees for bank liabilities (Ireland, Greece, Italy), to loan guarantees (like the €35 billion (abortive) loan guarantee, partly from the German federal government and partly from other German banks, that Hypo Real Estate Holding AG, was to receive), to restrictions on short selling the stocks of financial institutions and to governments faciliating (by waving competition rules or by underwriting potential losses) the taking over of vulnerable private institutions by stronger private financial institutions.  The Russian government made $50bn available to allow Russian corporates to service their foreign debts and the Russian stock market regulator closed the stock marketon a number of occasions when the losses were becoming to painful for the policitally well-connected shareholders.

In my view, all these measures, other than the injection of government capital in return for a government equity stake, nationalisation and mandatory debt-to-equity conversions are unnecessary and unhelpful for resolving the crisis of confidence and restoring bank lending to the real economy.  They are also dysfunctional from the point of view of creating the right incentives for future private funding of and lending and investment by the private sector.

I believe that the collapse of confidence in the banks and in the rest of the highly leveraged system of financial intermediation that has developed without any effective regulation and supervision has now become so widespread and so deep that it will take the socialisation of much of the banking sector broadly defined to restored confidence, order and functioning financial intermediation.  This is true in the US, the UK and for most of the rest of Europe, including the euro area, the rest of the EU and the EU-fringe states.

Those who have argued that British or continental European banks were less exposed to the fruits of past excesses have been shown to be wrong.  European banks’ write-downs and write-offs of US subprimate-related assets exceed those of US banks.  European banks exposure to domestic disasters is also daunting.  In the UK this includes bank exposure to the UK’s own subprime market and to the non-residential construction sector, and to unsecured household debt.  On the European continent, even countries that are supposed to have had no construction excesses, like Germany, see property-lending institutions tottering on the edge of default.  The vulnerability of the asset-side of the Irish banks needs no elaboration.  Mid-sized Spanish banks have massive exposure to an imploded housing and construction boom.   Even of of Italy’s boring and safe banks became less boring and unsafe. Continental European banks (inside the EU and outside) are typically more highly leveraged than their Anglo-Saxon counterparts, and the words ‘transparency’ and ‘mark-to-market’ are not yet part of their ‘acquis’.  There is therefore a legitimate concern that the share of undisclosed or overvalued rubbish in the balance sheets of continental European banks may well be higher than that of their US counterparts.

My best bet is that by the end of 2009, most of the North Atlantic region’s banking sector will be in public ownership.  In case this does not happen, and for the banks that remain private, I would like to suggest to the relevant national authorities the following list of what not to do.

Don’t play around with fair-value accounting rules

Marking-to-market using asset prices set in illiquid market is pro-cyclical.  It can become part of a vicious spiral of declining funding liquidity, forced asset sales, fire-sale asset prices, mark-to-market increases in leverage and reductions in capital ratios, further reductions in funding liquidity and further distressed asset sales.  The problem is clear.  What to do about it is not.

The US financial markets regulator (and former investment bank regulator), the SEC, has ‘reminded’ financial institutions that US accounting rules allow banks in “rare circumstances”, to reclassify financial instruments from their trading book, where they are valued and reported at current market prices, to the “held to maturity” category where they are reported at what the management expects their (present discounted) value to be were they to be held to maturity.  This is an open invitation to the management of a bank to lie, that is, to deliberately overstate the value of the bank’s illiquid assets.  How anyone can want to substitute the managers’ judgement about the hold-to-maturity value of a bank’s illiquid assets for any market price, even that of an illiquid market, is a mystery to me.  It doesn’t matter whether these internal valuations are interna-model-based or obtained by looking at the entrails of a slaughtered chicken: these internal estimates are hopelessly conflicted.

If we substitute the internal valuation of an inherently biased management for the illiquid market price, we shall also end up with widely different valuations for the same underlying assets.

The solution to the procyclicality of mark-to-market accounting and reporting is not to go back to historic costs or marking-to-managers-wishes, but to keep using market prices for accounting and reporting purposes but to change the required behaviour response to these valuations.   This means keeping the mark-to-market rule, even when markets are illiquid and undervalue assets, but to leave it to the regulator/supervisor, to suspend the regulatory consequences of falling capital ratios or rising leverage ratios where this makes sense.  Second, the regulatory minima for capital ratios (or liquidity ratios) and the regulatory maxima for leverage ratios should themselves be made counter-cyclical.

Don’t provide federal government loans to the state of California and other good causes

The governor of the State of California has requested a $7bn emergency loan from the US federal government.  He should not get it, or anything like it (say a federal guarantee for the loan). First, the government of the state of California is not a systemically important financial actor. If it defaults on its debt, intermediation between savers and investors will not be materially impaired.

Second, the solution to the problems of the government of the state of California lies in the hands of its own legislature and executive.  They can raise taxes or cut spending or do both.  They acted procyclically when the going was good.  They pay the price now.

Sure, procyclical fiscal behaviour by the state government of California during the coming recession will, through the Keynesian multiplier, amplify somewhat the magnitude of the regional economic fluctuations.  If these are important at the federal level, the federal automatic fiscal stabilisers will kick in.  If is even possible that the federal government may pass a nationwide fiscal stimulus package, in which the state of California would share.  But rewarding the government of California for screwing up its finances would bring with it permanent costs, even for the citizens of California, that would outweigh any short-run gains.

The only conditions under which the federal government ought to make a loan to the state of California (or guarantee a loan) would be where the state signed over all its financial decision making powers  to the federal government.  The federal government would be able to raise existing taxes or to introduce entirely new taxes, and to cut spending.

Don’t engage in direct intervention in the housing market

The only thing wrong with house prices in the UK, the US, Ireland and Spain is that they are still too high (in the case of Spain they have hardly begun to fall, if we can believe the official data, which I do not).  The sooner house prices are at or below their fundamental value, the sooner the right signals about the right size of the residential construction sector and all other housing-related sectors will start to move resources out of housing-related activities towards more viable uses.

Help for those who bought houses that are too expensive and/or took on mortgages that are not affordable would just slow down the necessary process of getting people into houses and financing arrangements they can afford.  As social policy it would also be terrible.  Why does hardship or even poverty caused by someone taking on an unaffordable mortgage give that person a stronger claim on the public purse for financial support than hardship or poverty resulting from other causes - unemployment, disability, ill health, alcoholism, drug addiction or gambling?

Measures that would speed up, simplify and render less costly the process of repossession of a property following default by the owner on a mortgage backed by that  property, would help restore balance in the housing market and create favourable conditions for future lending.  Unfortunately, all proposals touching on this subject go in the exact opposite direction.

Don’t sponsor panic-driven shot-gun weddings between financial institutions; nationalise instead

Examples of this now abound.  JP Morgan-Chase acquired Bear Stearns for next to nothing and with the benefit of a $29bn Fed first-loss facility for Bear Stearns’ most toxic assets.  The British authorities pushed HBOS into the arms of Lloyds-TSB (a take-over that may still come unstuck). The retail-banking part of Wachovia was pushed by the US authorities into the willing arms of Citi Group, again with the US government guaranteeing some of the losses.  With a bit of luck this deal may have been scuppered by the subsequent bid for all of Wachovia by Wells Fargo.

These shot-gun weddings or government-sponsored take-overs always leave a bad smell and are likely to distort competition once the crisis is over.  The absorbing bank always gets an outrageously good deal; the regulator, the central bank and the Treasury always end up appearing to be playing favourites (even if they aren’t). The conditions under which these forced consolidations take place are murky and non-transparent.  The excuse for such lack of accountability and transparency is always that in a panic/crisis/fire there is no time to worry about such luxuries.  Much better therefore to take the tottering bank into public ownership for the duration of the crisis.  Once the crisis is over, the long-term future of the institution can be determined without the distortions created by widespread fear of insolvency, illiquid asset markets and systemic shortages of funding liquidity.

Nationalisation of HBOS by the British authorities and of Wachovia by the US authorities would be preferable to their acquisition by private competitors, provided a number of conditions are satisfied.  First, the existing shareholders take a hammering, even beyond what they have endured up till now.  Second, the top management and the entire board are fired without even the tiniest golden parachute.  Third, the unsecured creditors - even the senior creditors - are subjected to a signficant haircut.

Even lite versions of government-sponsored private bail-outs, like the deal under which Germany’s second-larges commercial-property lender, Hypo Real Estate Holding AG, was to receive a €35 billion loan guarantee, partly from the government and partly from private banks, are inferior to government-only rescue actions.  As this bail-out also appears to have come unstuck, there may be an opportunity to replace itwith a government-only guarantee, in exchange for a suitable equity stake of the state in the company.

Don’t guarantee more of the liabilities than you absolutely have to

Through their blanket guarantee of all liabilities (other than equity!) of (initially) the six largest majority-Irish-owned banks, the Irish government has scored a massive own goal.  Apart from incurring the eminently justified ill will of all other European countries (and not just those in the euro area or the EU - I doubt, for instance, that the Icelandic government is really chuffed at the Irish decision), it represents a straight transfer from the Irish tax payer to the shareholders of these banks.  There is no upside in it for the government, either through an ordinary equity stake or through warrants.

I hope appropriate pressure will be brought about on the Irish government to change its ludicrous policy of not only guaranteeing all retail and wholesale deposits (individual and corporate) but also all unsecured debt.  Regrettably it is not possible to deny the banks favoured by this arrangement access to TARGET (the real-time bank clearing and settlement mechanism) or to suspend their access to the discount window of the Eurosystem or to its repo facilities.  There ought to be, however, a way to impose euro-area-wide or EU-wide sanctions on this blatant beggar-thy-neighbour-while-shooting-yourself-in-the-foot behaviour.

October 5, 2008 7:30pm in Economics, Ethics, European Union, Financial Markets, Monetary Policy, Politics | Comment