Thursday, October 02, 2008
Something Very Worth Your Time
First, I recommend reading this report on the problems and capital needs involved in shoring up the US electricity grid in the near term. PDF, 36 pages. The problem is real and legislation will be needed to smooth the way. After that, it's a problem of getting capital to do it.
Second, John Mauldin has published an analysis by the authors of the Liscio Report of an IMF database of banking crises and how the attempts work out.
You can read the Liscio entry for free here, although you might have to enter your email address. What solutions work and what don't, and how much does it cost?
One crucial lesson stands out: speed matters. This is obvious to anyone who followed Japan's dithering in the 1990s; standing aside and hoping the problem goes away is not a good idea. Relatedly, "forbearance" --regulatory indulgence, such as permitting insolvent banks to continue in business-- does not work, as has been established in earlier research. As the authors say, "The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance." This suggests that suspending mark-to-market requirements is not a good idea.In the comments to the previous post David Pearson commented that Bernanke wasn't being honest. Well, I don't think the Fed Chair can afford to talk on these lines, but the American people deserve honesty. One would expect that Congress and Treasury could discuss this more transparently. I think the Liscio exercise gives us at least a start at realism.
Since forbearance does not work, some sort of systemic restructuring is a key component of almost every banking crisis, meaning forced closures, mergers, and nationalizations. Shareholders frequently lose money in systemic restructuring, often lots of it, and are even forced to inject fresh capital. The creation of asset management companies to handle distressed assets is a frequent feature of restructurings, but they do not appear to be terribly successful. More successful are recapitalizations using public money (which can often be partly or even fully recouped through privatization after the crisis passes); recaps seem to result in smaller hits to GDP. But they're not cheap: they average 6% of GDP, which for the U.S. would be about $850 billion.
Total fiscal costs, net of eventual asset recoveries, average 13% of GDP (over $1.8 trillion for the U.S.); the average recovery of public outlays is around 18% of the gross outlay.
I am very much against suspending mark-to-market. Even if the Fed can afford to hold some securities until maturity, that isn't necessarily so for every bank. For banks on the edge, their ability to maintain capital levels in the interim is the important factor and the ambient risk for the next few years is sharply elevated. They might look fine one quarter and take an unexpected wallop the next. Therefore, suspending mark-to-market is roughly similar to allowing banks to continue running indefinitely once they drop below their regulatory capital limit. If you do that, the depository ends up sucking cash out of the economy.
The other problem with suspending mark-to-market is that it is going to make banks more wary of lending to each other rather than reassure them. If I can't even look at your official financials and tell how liquid you are, why would I lend you money? High interbank lending rates mean high costs even for borrowers with good credit profiles. The solution for lack of confidence is full disclosure.
With Libor and Euribor ascending higher and higher, carrying costs for debt are a problem in Europe and beyond. Therefore the US can't hope to be saved by demand from other countries. We need to lick our own wounds this time.
The two approaches which I think will work the best right now for the US are
- Paying interest on reserves deposited with the government.
- Recapitalizing the healthier banks ASAP.
This is one of the reasons I twitched when Paulson moved in on Fannie. Wiping out the preferred stockholders pretty much guaranteed that these smaller banks aren't going to be putting up cash for such operations in the future. The FHLB system and public/private mortgage financing really got started with the banks that had cash putting up capital to fund the operations. Now any new similar solution is out the door.
The proposal to expand FDIC insurance limits to $250,000 is related to the problem of sustaining money circulation. If the local banks can't lend enough, they will pay low interest rates. This would normally drive larger depositors to seek CDs and other time accounts at banks that can lend the money out and thus will pay higher interest rates. However, when you are not confident that your money is going to be there when you want it, you don't go hunting on the internet for the best deposit rates. Raising the FDIC insurance limit may end up being costly, however. It might be cheaper to let the banks deposit directly with a Fed facility and have the Fed turn and lend it out.
Recapitalizing the healthier banks can come in many forms, but buying some of the MBS tranches wouldn't hurt, and doing stuff like covering Citi's Wachovia deal if necessary and taking equity in return won't hurt. Simply handing banks money with no strings will hurt.
If the Fed is in essence extending a massive bridge loan for a payment in the form of equity or assets, that's one thing. If the Fed is just handing money to banks and financials, the citizenry has reason to revolt. Various forms of subsidies such as the Mexican bond bailout, the LTCM bailout etc all seem to have produced a widespread willingness to take ridiculous additional risks. Making it clear that yes, you can lose big is one of the most important tasks for financial overseers.
I hope this helps.
Could you send a few prayers out my way? My husband is in the ICU, with pneumonia in both lungs. Still not sure yet if he will pull through. Thanks!
Been there and done that with the Chief, try not to worry too much.
But the change is supposed to be temporary.
Certainly it is an issue for businesses, and $250,000 isn't that much protection anyway. If you are a business, you really need to do due diligence on your bank!
Whether that's enough to help small businesses I can't say; the definition of a 'small' business has always eluded me.
It appears to me that M2M has issues in that it essentially pushes the owner into selling things when they might bull through.
I think the actual valuation implied by M2M is relevant to investing, but in terms of specific valuation of the company, one can see how an excessively low price due to a bottomed out market can be just as deceptive as the same information in a topped out market. And how forced valuation and sale at bottomed out prices is inherently going to drive prices even lower and further down, and thus create a domino effect as one company/bank after another gets screwed by forced sales at firesale prices.
To me, M2M appears as a positive feedback mechanism, and that is virtually a lock on a system headed for out of control oscillations.
The chain reaction is obvious. The result is an atom bomb in the financial market.
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