Fed Watch: Friday Can’t Come Soon Enough

Tim Duy says policymakers need to be honest that a solution to the financial crisis will not be painless:

Friday Can’t Come Soon Enough, by Tim Duy: A wild week is coming to an end, with news that US policymakers are preparing a comprehensive approach the financial crisis – see the prophetic Mark Thoma below. Details are thin at this point, although the central feature is expected to be a mechanism that will extract the bad assets from Wall Street’s balance sheets. The devil, of course, is in the details. A critical element, as described by the Wall Street Journal:

A big question still to be answered is how the government will value the assets it takes onto its books. One possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. Financial companies would likely take big losses.

But Calculated Risk makes an important point about this approach – it appears to deal with only one side of the balance sheet:

Details of how this will work aren't available yet. But one of the key problems - in addition to the risk to the taxpayer - is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!

So even after the bad assets are removed, the affected firms still need to be recapitalized, presumably via taxpayer infusions. What exactly will the taxpayer receive in return? Preferred stock? Since we are already moving toward an overarching solution, maybe we should just follow the example of Sweden. Via Yves Smith:

But in this skeletal form, this seems like a world class bad idea. The only successful example of dealing with a financial crisis is Sweden, which did not try to prop up troubled banks, but instead nationalized them, wiping out equity, brought in new top executives, and recapitalized them. The cost of failure was high to the incumbents and the solution was comprehensive, not piecemeal.

Such a high cost of failure should address moral hazard concerns, especially if the nationalization was followed by a reevaluation of regulation that left financial industry lobbyist out in the cold. With that in mind, don’t forget to visit The Big Picture for a glimpse at the inner logic of this Administration:

…the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, and Morgan Stanley. 

Mark cites this below, but it is so telling that it needs to be repeated. Again. And again.

Moving back to this new plan for the crisis, we also need to think about who will fund this operation. Yves Smith, in the piece noted above, remarks that the US government appears to believe that our foreign creditors will continue to step up to the plate and absorb upwards of $1 trillion dollars of fresh deficit spending, maybe more. And, according to Brad Setser, it really is entirely foreign official inflows that are holding the US ship together; he is banishing the illusion that private investors have much if any desire to accumulate US assets at this point:

That implies that official inflows are really more like $550-600b, and private inflows are deeply negative – not zero. And the survey also misses some official flows, notably from the Gulf.

Negative private inflows is another name for private outflows. For emerging economies, those outflows are called capital flight.

Try as policymakers might, they cannot forever ignore the fact that we are not Japan; we do not have excess domestic savings to fund such a program. Eventually that fact will come home to roost. Perhaps it already has, as pressure from the Chinese appears had some role in the Freddie/Fannie bailout. And Americans may have to recognize that the remaining storied investment banks, names that drove American capitalism for generations, may soon be substantially owned by China. Indeed if the Bank of China continues to be a dominant financer of US excess, they have found a way to dominate the US in a way that could never have been achieved militarily. They will have effectively exploited a gaping hole in the international financial architecture opened increasingly wider by US policymakers over the last 28 years. But, US citizens all get cheap flat screen TVs, so who cares?

And China is just one of the nations financing the US. We remain lucky that these counterparties have yet to ask for the restructuring program the US Treasury demanded during the Asian Financial Crisis.

What is the alternative? A tax increase? Tell Americans six weeks before an election that they need to accept a lower standard of living? I don’t see that happening. It won’t happen until the foreign credit is turned off. Otherwise, policymakers will continue to behave as if deficits don’t matter.

All of which leaves me a bit depressed tonight. To be sure, I am happy that policymakers look to be on the offensive, trying to engineer a comprehensive response to the crisis. The crisis will not end until the bad assets are eliminated and banks are recapitalized. But policymakers need to be honest that such a solution will not be painless. I have yet to see such honesty.

Maybe the final plan, likely to be revealed this weekend, before Asian markets open Monday, will ease my concerns. One can only hope; perhaps I just worry too much. I should just go to Best Buy and get a flat screen TV for myself.

Comments

[a]

"…the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1. "

The same people who are now so *shocked* *shocked* that a regulation was changed (and did they say anything *then*?), are precisely the ones applauding when the Fed suddenly accepts equity as collateral or allows banks to use FDIC-insured deposits to fund their IBs.

[Michael McKinlay]

The Solution ? : A Public Central Bank that creates money without debt. Why should we borrow our own money to pay interest on it ?

A Must Read ;

It's the Derivatives, Stupid! Why Fannie, Freddie, AIG had to be Bailed Out

by Ellen Brown

http://globalresearch.ca/index.php?context=va&aid=10265

Adam Smith on interest free currency :

Adam Smith wrote of the Pennsylvania currency in his famed 1776 work The Wealth of Nations:
The government of Pennsylvania, without amassing any [gold or silver], invented a method of lending, not money indeed, but what is equivalent to money to its subjects. [It advanced] to private people at interest, upon [land as collateral], paper bills of credit…made transferable from hand to hand like bank notes, and declared by act of assembly to be legal tender in all payments...[the system] went a considerable way toward defraying the annual expense…of that…government [low taxes]. [Pennsylvania’s] paper currency…is said never to have sunk below the value of gold and silver which was current in the colony before the…issue of paper money.

http://en.wikipedia.org/wiki/Colonial_Scrip

It is time, past time, for Americans to take back their Constitutional right to create money bearing no interest for the Common Good.

[Oupoot]

In effect: the US Govt has 2 options: bail out the system (and somehow agree on who will absorb the losses) and/or accept that the US will default on their foreign loans. It wont be a public/govt default, as was the case in many emerging market financial crises, but a private sector default.

All I can say to the US: Welcome to the Real world :)

[hari]

Look American Capitalism, as we have known it until Aug'07, is finally on life-support...if Paulson/BB/Geitner get their wish - a $500 Billion rescue fund will be established to bring about somewhat smoother transfer from laissez faire to a state-controlled nationalization of finncial banks. Once recapitalized, there will be fire sales to redeem taxpayer's injection of capital and whatnot.

All this is fine, for now. The larger q' is direction of change...and what policy framework will now dictate the way forward on hi street, in particular.

Sweden's exmple is severe and may not be adopted by Cogress for various reasons...But do they've an alternative?

[esb]

The People's Republic of America, and not a single shot had to be fired to achieve it.

So goes the joke of the day this afternoon in Beijing.

Now all the PRA needs is a Central Committee.

Oh, it already has one, and it met yesterday afternoon.

(GWB probably thinks he is the Chairman, but I'll bet you dollars to doughnuts he was not the one doing all [or any] of the talking.)

[Robinia]

As the US does not have the savings of the population to tap, it is true, a painless solution is not possible. Which leaves us only with the option of possibly making a rational choice about where pain is to be concentrated. Rather than do the politically expedient-- use the poor and powerless as the true "risk absorbers of last resort"-- why not look at what sector of the economy is relatively fat and over-grown compared to other industrialized economies?

Socializing, and shrinking, the healthcare/health insurance sector could bring the US tremendous efficiencies, delivering the same healthcare product with much less transaction cost. Why is it that we determine that we can afford socialized banking, but not socialized medicine? Instituting a single-payer healthcare system could help us save the funds to do the necessary payback-to-China for the excesses and profligacy of our financial services sector; in the process, our greatest asset-- our workforce-- could receive better and more comprehensive healthcare, with less anxiety and personal bankruptcy. And, it would offer precisely the stimulus to entrepreneurship and small business start-ups that would be needed to create scads of new jobs to replace inevitable losses, this time at a smaller, not too-big-to-fail scale.

Democrats do, indeed, have the current lame-duck administration over a barrel, if only they are able to grow spines and stand up to their wealthy campaign contributors. Bail out financial services, but make single-payer healthcare a part of the deal. And put Americans to work doing productive things, not pushing paper and processing transactions.

[Sandman]

This is the typical reaction of bankers and capitalists as they lose control. Ever read Jack London's Iron Heel? It sure will feel like it.

The desperation, the crisis of capitalism.

The 30's depression was a civil affair. This may not be if allowed to deleverage. They are walking scared.

[esb]

Yes, Sandman, "stuff happens,"

esp. when the fleecees understand the fleece and know the "fleecors".

Paulson and his crew will have one crack at this and if it all goes sideways, then the personal security business will be booming.

[Blissex]

«What is the alternative? A tax increase? Tell Americans six weeks before an election that they need to accept a lower standard of living? I don’t see that happening. It won’t happen until the foreign credit is turned off. Otherwise, policymakers will continue to behave as if deficits don’t matter.»

The colossal inflows of foreign government money is obviously, OBVIOUSLY, to influence the outcome of the election.

Those foreign governments, by supporting the status quo with absolutely massive subsidies to the USA, are supporting the record of the administration, and trying to maintain whatever goodwill voters have for the Republicans.

So far the crisis for the median Usian has been mostly a lot of sound and fury in hated Washington; if foreign governments were not supporting the Republican administration with massive inflows of zero-nominal-rate lending, the rise in the dollar and the widespread recession that would shortly follow would directly upset the median voter, who would be far more receptive for Obama's "yes we can" and "change" message.

Why would foreign governments want to buy the election for the Republicans?

Well, because they have had for the past 10-15 years common interests and common enemies: the jobs of the media USA worker, as it is in the interests of both the business executives that sponsors the Republicans and of the leadership of those foreign government that as many USA productive activities and jobs be exported to those foreign countries and as many foreign goods be imported to the USA.

It is in the interests of the USA executives because this means getting rid of expensive, undocile headcount and getting far higher profits and bonuses from labor arbitrage and from trade and financial intermediation; it is in the interests of the leaders of those foreign countries because it means better jobs and standards of living for their citizens that legitimizes their rule.

[Restoration]

TD..."What is the alternative?"

Restore the confidence of domestic citizens in the dollar as a long term store of value. Then they will once again save in banks, instead of inflation hedges. Savings in banks can be loaned out, inflation hedges can't.

[Loss of Confidence]

Brad..."Negative private inflows is another name for private outflows."

Okay, so domestic savers long ago stopped loaning to domestic citizens. Now foreign citizens have stopped loaning to domestic citizens. Only foreign central banks are loaning forced savings to domestic citizens, but they are starting to complain.

Giving domestic borrowers a really good deal (low rates, little money down, etc...) may be popular with borrowers, but it is not working out at a national level. Virtually no one will lend to domestic borrowers any more because they get ripped off by inflation/high default rates.

[ken]

The Bush administration has ushered in a new era: the New Deal Re-Deux.

Leave it to a Republican to embrace the French version of a great American legacy.

[bakho]

Who gets the housing stock? Are foreclosed properties mostly asset or liability? The housing piece of the puzzle seems to be missing.

[Bruce Wilder]

td: "Maybe the final plan . . ."

True words

[john c. halasz]

So long as the U.S. runs mammoth trade deficits, FCBs will need to recycle their dollars back to the U.S., but if oil keeps falling and the import/export gap continues to narrow, there will be fewer dollars needing and available for recycling. And, to that degree, increasing fiscal deficits will need to be financed domestically, ("crowding out"). Already the quasi-nationalizations that have occurred imply an inflationary monetization of the debt, hence sharp rises in long rates and major stagflation. Paulson's still grander scheming will only deepen the running up against the hard strata of fiscal limits. Indeed, they would likely amount to a covert transfer of control of the U.S. financial system to FCBs via the U.S. Treasury Dept.

But one way or another, there needs to and will be a massive destruction of fictitious capital to rebalance the financial system with underlying real productive capacities and needs. The question is how to do so, in ways that both reallocate investment capital needed to rebalance and resume real productive purposes and distribute the pain in sustainable, if not exactly equitable fashion. I've long held the intuition that standby bank nationalization would be the most economically efficient approach, while allowing for the restructuring, re-regulation and downsizing of excessive financial sector and reduction of the over-financialization of the real productive economy. (Though again, in implicit, mediated fashion, it wouldn't quite be the U.S. government that was doing the nationalization, though that might, at least, bring out squarely into the open the need for the U.S. to address international imbalances). In addition, a HOLC combined with, say, a 5% annual wealth tax surcharge as clawback financing might be in order. (Incentives, you say? But I don't think anybody ever can calculate all the incentives and their consequences, but at least some bad incentives might be eliminated). No, I don't think any of that would be politically/ideologically acceptable and hence it's unlikely, though I think the likely alternatives would at least put claims for vaunted market efficiency to shame. But I tremble to think what President Paulson and Chairman Bernanke of the Wall Street Politburo will come up with, to be rubber-stamped by the "bipartisan" People's Deputies in Washington.

[john c. halasz]

So long as the U.S. runs mammoth trade deficits, FCBs will need to recycle their dollars back to the U.S., but if oil keeps falling and the import/export gap continues to narrow, there will be fewer dollars needing and available for recycling. And, to that degree, increasing fiscal deficits will need to be financed domestically, ("crowding out"). Already the quasi-nationalizations that have occurred imply an inflationary monetization of the debt, hence sharp rises in long rates and major stagflation. Paulson's still grander scheming will only deepen the running up against the hard strata of fiscal limits. Indeed, they would likely amount to a covert transfer of control of the U.S. financial system to FCBs via the U.S. Treasury Dept.

But one way or another, there needs to and will be a massive destruction of fictitious capital to rebalance the financial system with underlying real productive capacities and needs. The question is how to do so, in ways that both reallocate investment capital needed to rebalance and resume real productive purposes and distribute the pain in sustainable, if not exactly equitable fashion. I've long held the intuition that standby bank nationalization would be the most economically efficient approach, while allowing for the restructuring, re-regulation and downsizing of excessive financial sector and reduction of the over-financialization of the real productive economy. (Though again, in implicit, mediated fashion, it wouldn't quite be the U.S. government that was doing the nationalization, though that might, at least, bring out squarely into the open the need for the U.S. to address international imbalances). In addition, a HOLC combined with, say, a 5% annual wealth tax surcharge as clawback financing might be in order. (Incentives, you say? But I don't think anybody ever can calculate all the incentives and their consequences, but at least some bad incentives might be eliminated). No, I don't think any of that would be politically/ideologically acceptable and hence it's unlikely, though I think the likely alternatives would at least put claims for vaunted market efficiency to shame. But I tremble to think what President Paulson and Chairman Bernanke of the Wall Street Politburo will come up with, to be rubber-stamped by the "bipartisan" People's Deputies in Washington.

[Oupoot]

My guestimate is that between $60 trillion and $100 trillion of fictitious capital must be destroyed in the various financial derivatives markets. This is no small amount.

[ken melvin]

Fictitious capital does roll off the tongue. Pairs well with non-performing assets.