Johm Hempton disagrees with me and others that the problem in financial markets is fundamentally one of solvency, i.e. lack of adequate bank capital. He says it is a matter of trust, trust that was destroyed by lies and deceptive practices among other things. If he is right, bank recapitalization alone will not bring back the trust that is needed - well capitalized banks can still lie - and because of that he believes some sort of "full guarantee of all sorts of bank debt" is needed to get bank credit flowing again from financial wholesalers to financial intermediaries. His preferred solution to provide the necessary trust is bank nationalization - the government won't default on its obligations to provide payment - and this allows taxpayers to fully participate in the upside in return for assuming the risk inherent in guaranteeing debt payments:
The Brad DeLong question - and how to design a bailout that works, Bronte Capital: Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.
Le Citi Toujours Dormer...: Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:
• Citigroup had poor risk controls.
• As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.
• They weren't.
• And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.
To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.
I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.
The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage. It is simply about the question “do we trust them to repay their debts”. You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay. Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed. All estimates are a shot in the dark. In reality all that is needed is more trust.
The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout. It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts. I can not understand them and I am a pretty sophisticated bank analyst. I know people I think are better than me – and they can’t understand Citigroup either. So Citigroup was always a “trust us” thing and now we do not trust.
The long answer has to be a replay of the various themes of this blog. So lets do it in pieces.
1). The losses in the banking system in America are not unmanageably large. Anyone that tells you otherwise just hasn’t done the maths (and that is most people). I have written this idea uphere… and nobody yet has an adequate response though Mark Thoma has tried and even Kevin Drum on the Mother Jones blog has commented on it.
One offender not doing the maths is (very surprisingly) Paul Krugman - although his last post in which he blamed lack of capital for the crisis was March - so maybe he has done some maths since. Krugman usually does the maths and is spot-on in his analysis of Fannie and Freddie. I am usually an unabashed fan of the Shrill Professor – so his various diagonoses leave me perplexed.
2). The problem with the banking system is that it is structurally short of stable funding. America has a loan to deposit ratio that is collectively well above 100. So does the UK, Iceland, the Baltics and most of Eastern Europe, Australia and New Zealand. This means that collectively the banks need an awful lot of wholesale funding. ...
3). The crisis will end when people are convinced to roll the wholesale funding. Government policy that brings us closer to that point is probably effective. Government policy that does not bring us closer to that point is almost certainly ineffective. Policy that takes us further from that point is counter-productive. My case examples of counter-productive policies are the confiscation of the rights of the debt holders of Washington Mutual, and the pointed refusal to issue government guarantees even when it is utterly obvious that the government is on the line (as in Fannie Mae and Feddie Mac). The confiscation of Washington Mutual convinced bond holders that their positions would be compromised by government fiat and with little notice. As I have posted many times I thought that was reckless and that Sheila Bair should resign. The refusal to guarantee Fannie Mae and Freddie Mac at this point looks like sheer stubbornness but I think is driven as much as anything by government accounting concerns – a full guarantee means the assets and (more importantly) liabilities get bought onto the government balance sheet.
The cause of the crisis
This is a wholesale funding crisis and the cause of the crisis is plain. It is lies told by financial institutions. Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap. They sold it to people who provide wholesale funding.
Now they need to roll their own debt. The people who would normally wholesale fund them are the same people who have had a large dose of defaulting AAAs. They no longer believe. It is “fool me once, shame on me, fool me twice, shame on you”. As I have put it the lies that destroyed Bear Stearns were not told by short sellers. They were told by Bear Stearns.
Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him. In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold. The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.
It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them. When they tell the truth now, nobody will listen.
Robert Rubin racks his brain about how he would have done things differently. Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth. The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup. Even Robert Rubin. ...
Anyway given that the crisis is a wholesale funding crisis we need to do something to make the people who provide wholesale funds happy.
What of course would make the people who provide the funding happy is a plausible government guarantee. ...
The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt. The problem of course is that is hugely risky for the taxpayer. My view – and I think the only way in which such a guarantee is viable – would be that if the taxpayer takes the risk they should also get the upside. That is full nationalisation. The advantage of full nationalisation is that since the system is actually solvent (but illiquid) the government will make a profit out of it. That is fine. Take the risk – make a profit – it’s the capitalist way. Incidentally the Sheila Bair approach of confiscation from the equity holders and subordinate debt holders works fine in this scenario. Indeed the sub-debt holders should wear it – but they will still be willing to lend again because they will be lending again to the government. In a full nationalisation I see no reason for Sheila Bair to resign. ...
I suspect that wholesale nationalisation is the cheapest (and most sure) way to end the financial crisis. But it would be difficult to find a Deputy Secretary of the Treasury for Citigroup (and Bank of America, JPM etc). Still as I think the system is eventually solvent if the government nationalised pretty well the whole system as it failed then the government would make a shocking profit. It would not be the first time – Norway made such a profit.
But I am not sure that the American politic is ready for a wholesale nationalisation of the financial system. Indeed they are determined it seems not to control financial institutions. If you are not convinced of that see the Deal Professor’s wonderful piece on who controls AIG.
A cost effective TARP
[If] nationalisation ... is not on the table let’s do the next best thing. Suppose the Treasury takes the “fat tail only”. Then the banks are solvent. Imagine for instance if the treasury agreed to capture the losses at Citigroup above say $90billion. Why did I chose 90 billion – well – it is the stated capital of Citigroup.
As Citigroup has at least its net worth guaranteed then Citgroup is solvent. Funding should come back.
Note that excess of loss insurance policies are almost certainly the cheapest way in which to guarantee banks. The reason of course is that you take on only the losses you need to take on. However you leave the upside with the banks.
The Federal Government should logically charge for the excess of loss policy. There will be some banks with very big losses that will claim on it – and so there will be losses recognised even if the system is solvent. My rule – which is a little arbitrary – the government should take 20% of the equity of all institutions that want to buy an excess of loss policy. I figure in five years time selling the equity should pay most government losses.
To be precise the excess of loss policies should not be for 100% of losses beyond an attachment. In reality the government should guarantee only 90% of the losses beyond the attachment. The reason for that is when the attachment point is hit you want the bank in question to have an incentive (be it 10% of recoveries) to actively mitigate the losses. A better incentive is also to have the losses covered by the government – but with the government receiving equity in the institution dollar for dollar for the losses covered. This will still mean that institutions are nationalised – precisely those with the biggest losses. ...
Mr Paulson seems however to be wanting to give government money inefficiently to financial way too cheap. The bailout of Citigroup is a case in point. They gave a capital injection (subordinated debt) for which they charged the princely sum of 8 percent. Hey – that was what bank preferred stock yielded in 2006 – and way below the fair value of such money now. Then they just guarantee 300 billion of assets – admittedly subject to an excess of loss rule (above 40 billion). This excess of loss threshhold is way too low. It could be 80 billion and Citigroup would remain solvent. Then the government also did not take anything like a large enough equity stake in Citigroup even though Citigroup would have willingly handed one over. Why not? Because they play fast-and-loose with taxpayer resources.
That said – the excess of loss policy is the right idea and for that (and for once) I applaud Mr Paulson. This is the first bailout I have seen with a decent design. ...
We agree that fear is the problem, people will not be willing to provide financing if they are worried about getting their money back, the question is what is driving that fear, insolvency, something else, or both. If it is insolvency alone, then recapitalization ought to work, but if it is a lack of trust that a solvent bank balance sheet means what it says it means, then the problem is harder to fix unless you are willing to inject massive amounts of capital - enough to remove all doubt - or remove uncertainties from the books through a massive toxic asset purchase program (a public relations nightmare).
I believe there are a lot of uncertainties about the causes of the crisis, and hence about the solutions to it, so I have tried to adopt a portfolio approach to policy rather than insisting that all the eggs go into one basket. For example, I saw no reason to just do monetary or fiscal policy, or do as many advocated and wait to see if monetary policy would work before trying fiscal policy, I thought we should do both, and do them early and aggressively, then back off if it looks like the economy is overheating.
And I have the same reaction here. I think John Hempton could be correct in his assessment that solvent balance sheets will not be believed, at least not at the level of capitalization we are willing to provide, and that therefore some sort of guarantee is needed (when I said I disagreed as quoted above, I thought he was saying that Sheila Bair alone caused the preponderance of fear rather than being part of a general mishandling of the policy response to the crisis, e.g. lack of consistency, problems with ratings agencies, accounting standards, saving some banks but not others, etc., etc.). Given the performance of ratings agencies, risk assessment models, deceptive balance sheets, etc. I'd be wary of parting with my life savings right now (such as it is). I also fully agree that compensation for providing that guarantee is for taxpayers to receive a stake in the action, and that the stakes they have received to date for providing guarantees and bailouts have been very inadequate.
So I am not opposed to this line of thinking. Whether the guarantee of 90% beyond attachments is the best way to provide wholesalers with the insurance (trust) they need is an open question, but I'm not so sure the particulars of the guarantee are critical so long as some sort of insurance is in place. It does, however, seem like if you are going to go this route, full nationalization provides better incentives (particularly the moral hazard issues that arise when wholesalers have no incentive to monitor risk, and when the people using the funds realize the downside is government protected giving them an incentive to take on too much risk).
So, what are your reactions? I'm not certain I have this right, so tell me what have I missed in acknowledging that a form of general insurance as described above could be helpful. Have I given in too easily and not worried enough about the incentives this gives to those providing the funding, or missed other big problems?
Update: From The Economist's Forum:
Finally, System-Risk Insurance, by Laurence Kotlikoff and Perry Mehrling, FT: As we advocated two months back (Bagehot plus RFC: The Right Financial Fix), Uncle Sam is finally starting to sell systematic risk insurance on high-grade securities in exchange for preferred stock. This is a critical function for the U.S. government; Uncle Sam is the only player capable of hedging systemic risk because he’s the only player capable of taking actions that keep the overall economic system on the right course.
The real question now is whether the U.S. government will begin selling system-risk insurance on a routine basis and, thereby, help refloat trillions of dollars in high-grade mortgage-related securities owned by banks and other financial institutions - institutions that are in desperate need of more capital to support new lending.
Writing one-off insurance deals with a few large players, like Citigroup, is not the same as standing ready to write system-risk insurance to all players that issue conforming high-grade paper - something that’s needed to support ongoing securitization of such obligations. We stress the word “conforming,” because it’s vital for the government to begin stipulating which securities are “safe” under normal conditions and which are “toxic” and, thus, no longer to be held by financial intermediaries.
Like any insurance underwriter, Uncle Sam needs not only to know and approve what he’s insuring; he also needs to make sure there are appropriate deductibles and co-insurance provisions to limit moral hazard on the part of the insured. The moral hazard in this case is that financial institutions try to pass off low-grade loans as high-grade.
The weekend deal with Citigroup is instructive in clarifying the nature of the insurance the government should sell on an ongoing basis. The deal to support $306bn of Citigroup’s mortgage-related securities puts a floor under the value of the best such securities at about 90 cents on the dollar. This deal represents the first use of the insurance capability authorized by Section 102 of the TARP.
The structure of the deal is convoluted, so it takes some probing to see precisely what insurance is being sold and for what price. We are told that Citigroup itself is on the hook for the first loss of $29bn (plus whatever loss reserves are already on its books) on the cash flows due on the $306bn in mortgages. This amounts to roughly a 10 percent deductible.
Any losses beyond $29bn will be shared by the government (90 per cent) and Citigroup (10 per cent). This is the co-insurance (co-pay) element. This insurance runs for the next 10 years, and Citigroup is paying a one-time $7bn premium for it, using preferred stock. Our article with Alistair Milne (Recapitalizing the Banks is Not Enough) advocated deductibles, but not co-pays. But co-pays seem a good idea.
As predicted, the insurance deal with Citigroup has refloated its assets, with its stock rising by 53 per cent immediately after the deal’s announcement. Citigroup will now be able to use its newly insured assets as collateral for borrowing in the repo and commercial paper markets. ...
At the moment, it is only these specific assets on the balance sheet of one specific institution that are affected, but the structure of the deal could easily be applied to a similar class of assets on any balance sheet. The effect would be to backstop the value of this entire class of existing assets, and so restart secondary markets in these existing assets. ...
Given Citigroup’s heavy involvement with mortgage securities, most notably through the ill-fated Structured Investment Vehicles (SIVs), it makes sense to start with Citigroup. But the plan will work to restart capital markets only if it is extended beyond Citigroup.
Furthermore, the insurance structure needs to be made clearer if the markets are to understand its consequences for the valuation of the underlying securities. The government needs to be in the business of selling credit insurance explicitly, not through the back door.
The government should be offering insurance on the highest quality assets regardless of who happens to be holding them. ...