On September 30, 2008, the Irish government announced that it had put a guarantee on the entire liability side - except for the equity - of the balance sheets of the six largest majority-Irish-owned banks.  This includes all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II). The guarantee will cover all existing and new facilities  issued from midnight on 29 September 2008, and will expire at midnight on 28 September 2010. 

Unlawful

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I would like to thank my colleague Nick Barr for drawing my attention to the following quote:

“With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets, cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.”

(Former Chairman Alan Greenspan of the US Federal Reserve Bank - Fourth Annual Community Affairs Research Conference Washington, D.C.  April 8, 2005).

All fundamentalism is blind and dangerous.

Grandson 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. (more…)

The US House of Representatives has voted to reject the Emergency Economic Stabilization Act - the $700bn Treasury-funded facility for purchasing and managing toxic assets held by the US banking system.

Opposition to the proposal came from two different sources.  A few remaining libertarians and believers in unfettered free enterprise voted against.  Even when they recognise the risk that a calamitous collapse in economic activity may result, they view this as a form of creative destruction that is an integral part of a Darwinian market economy.  I don’t know anything about Gresham Barrett, a Republican congressman from South Carolina but his statement fits the bill: “My fear is the government will be forever changing the face of the American free market. Because I believe so strongly in the principles of the free market and the belief in freedom, I will be opposing this bill.”  Those who genuinely hold these views are mad, but honest and principled.  I wish them a good depression. (more…)

The most important financial crisis-related news this morning is not the tentative agreement on TARP-lite reached over the weekend in the USA.  At best this is a holding operation that buys (a little) time for the US banking system while the industry and the authorities figure out how to recapitalise the banking sector.  It is also not the nationalisation of Bradford and Bingley, a systemically unimportant UK bank specialising in residential and buy-to-let mortgages.  B&B is less than half the size of Northern Rock (at its peak). The nationalisation demonstrates that the UK government will not let even the smallest remaining deposit-taking bank go under.  By the British tax payer effectively underwriting the entire UK banking system, the authorities now may have a short window of relative calm to decide on the further consolidation and recapitalisation of the UK banking sector.

The most important development was, however, the rescue of Fortis through the Belgian, Dutch and Luxembourg governments taking 49% equity stakes in Fortis’s banking operations in each of these three countries.  The ability of the euro area fiscal authorities to co-ordinate on a bail-out for a bank with not-only strong cross-boundary operations, but indeed with a strong multi-national (almost supranational) identity was untested until today.  They passed the test.  Everyone who mattered, the national monetary authorities, the President of the ECB, the national regulatory authorities, the three national ministers of finance and the President of the Eurogroup chipped in and played their part.

Especially remarkable is the fact that it took much less time and effort to put together the multi-country fiscal rescue effort of the three EU member states than it took to cobble together the son-of-TARP in the US.  Incipient federalism triumphs over disfunctional established federalism.

A bad day for Benelux banking.  A great day for European cooperation and unity.

With a banking crisis in full swing, the US Congress futzes around as if it has all the time in the world to come up with a solution.  Perhaps the demise of Washington Mutual - the largest ever failure of a US deposit bank, will motivate the Congressional sloths to move forward. Populists  will have to put their desire for bankers’ blood on hold.  Libertarians will have to swallow hard and think of Ayn Rand.  Unless you really want to be able to tell your grandchildren stories of how you coped with the hardships of the Great Depression of the 2010s, the TARP proposal should be passed.

UK prime minister Gordon Brown believes that the financial crisis that now threatens to destroy the UK banking system is just the spill-over of the residential mortgage financing crisis in the US and is manageble with the existing institutions, arrangements and policies. According to the prime minisnter, the UK banking sector and financial system are sound. He sees no need for a US style TARP or similar facility, let alone for further radical proposals for recapitalising the banking system through the injection of capital by the government, in exchange for a government equity stake, or through a mandatory conversion of bank debt into equity.  With Bradford and Bingley about to share Northern Rock’s fate (unless a private solution can be found at the last minute), one hopes prime minister Brown may exit from his state of denial.

In the rest of Europe, the financial crisis is considered an essentially Anglo-American problem, whose spillovers to the euro area and other parts of the European continent are limited to some careless exposures on the asset side of the balance sheet to the US subprime markets.  With a number of large banks domiciled in small continental European countries tottering near the edge of the abyss, one hopes that the public protestations of confidence are not preventing the preparation of emergency rescue plans to prevent a financial meltdown. (more…)

In the UK, as in the US and much of continental Europe, the liquidity crunch has become but the epiphenomenon of the threat of insolvency of a large chunk of the banking sector (’banks’ being defined broadly to include such companies like AIG and GE, which in addition to their non-banking activities, have become engaged in highly leveraged financial intermediation involving massive asset-liability mismatch.

Since solvency is the main issue now, the central banks are no longer central to the management of the crisis. At most they can act as the agents or hand-maidens of the fiscal authorities, offering their expertise and reputations, but not their financial resources. (more…)

On the Vox blogsite of the Centre for Economic Policy Research, I have written a piece called The Paulson Plan: a useful first step but nowhere near enough. The title is rather self-explanatory.  In the blurb preceding the column it reads: “The Package also needs some goodies for US homeowners”. The column in fact argues the opposite.  The populist, re-election oriented faction of Congress is asking for such goodies and they may be politically necessary to get the rest of the plan through, but both from an economic efficiency and from a fairness perspective, sops to over-stretched mortgage borrowers are undesirable.

It’s time to revisit the ‘Five Tests’, to declare them passed and, subject to the UK being deemed, by our EU partners, to meet the Maastricht criteria, for the UK to adopt the euro.

Remember the ‘Five Tests’ designed at the behest of then Chancellor Gordon Brown (whatever happened to him)? Passing these economic tests was presented as a necessary condition for the UK to apply for full membership in the Economic and Monetary Union (EMU).

For those who have a life and therefore don’t remember what the Five Tests were, here they are again:

1. Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
2. If problems emerge is there sufficient flexibility to deal with them?
3. Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?
4. What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?
5. In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs? (more…)

It’s too bad that what the Bank of England does well - setting the official policy rate (Bank Rate) - is much less relevant to our economic wellbeing in this crisis that what it does poorly - maintaining financial stability through liquidity management.  Adding to the vulnerability of the UK’s financial system, the UK Treasury continues to stand on the sidelines, fiddling while London burns.

With the real economy slowing down and inflation showing signs of softening at last, interest rates will be cut.  The Treasury also knows enough basic macroeconomics not to engage in active pro-cyclical behaviour by raising taxes or cutting spending today.  Tax increases and spending cuts will have to wait until, sometime in 2010, the economy strenghthens again.  The combined actions of the Bank of England and the Treasury, however, will do little or nothing to unfreeze key financial wholesale markets, including the markets for securitised residential mortgages, or to recapitalise the tottering British banking system. (more…)