Friday, March 13, 2009

Financial chauvinism


There is a lovely comment on the last post accusing me of financial chauvinism – suggesting it is wrong to guarantee all bank liabilities.

This gets to the nub of the issue.

The current US policy is – pretty close to officially – that there should be “no more Lehmans”.  Bernanke said it this week.  Geithner has said similar.  

It is unequivocal that a policy of “no more Lehmans” requires an effective guarantee of all the large US financial institutions.  When one of them threatens to become the next Lehman it needs to be bailed out.  The US government tips $30-300 billion in and gives us a Sunday evening press release – just for me to read in my Asian time zone before our local market opens!

Face it – the current policy is to issue the broad guarantee.  That is what we have done.  That is what “no more Lehmans” means.  It means losses are covered when they are incurred by the taxpayer.

Once we have done that there is no real argument against a non-recourse funded troubled-asset program.  That is just another form of non-recourse funded financial institution.  The argument really is “how much capital should we demand the private sector put in, and on what leverage and confiscation terms?”  It is the same argument for regulation of a bank.

But it is not universally accepted that the right policy is “no more Lehmans”.  Chris Whalen (who I respect) thinks the right model for the dismantling of large financial institutions is Lehman.  As he says the model is easy to determine – just go down to the Southern District of New York and talk to the trustee.

I think the consequences of allowing several uncontrolled large bank failures would be catastrophic – and the cost to the taxpayer of the effective guarantee will be huge (but probably less than a trillion dollars by the end of the cycle) – but lower than the cost of the great-depression event that would follow from a cycle of mega-bank collapses.

In Sweden the right policy was the guarantee – and selective nationalisation – precisely because the cost of the guarantee was not large.  The institutions were not very insolvent.  In Iceland the institutions were so large that the guarantee just was not feasible.

It is however very hard to tell what is insolvent in advance.  Svenska Handelsbank was brimming with solvency and the market wrote it off for dead.  It was a rapid 20 bagger when the crisis ended.  If it were easy to tell how insolvent then there would be no big banks that were rapid 20 bagger stocks when financial crises end.

And it would be easy to tell the right policy.

The most important policy question is whether you issue the blanket Swedish guarantee.  I think the answer is an unequivocal yes in the US – and a probable no in the UK.  Krugman is edging towards a yes as he says in this post.

If it is a yes (open for debate) then the non-recourse finance model for the troubled asset funds does not pose any further problem.

The facts on the ground are that the policy is a de-facto guarantee – as officials regularly say that there will be “no more Lehmans”.

Krugman’s current position (probable yes on the Swedish position, blanket opposition to new capital on a non-recourse basis) is untenable.




John


PS.  I have stated before - and it is reiterated in the comments

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

22 comments:

babar ganesh said...

ahh, so what you were saying is that IF bank liabilities are guaranteed, funding to banks is non-recourse -- do i have that right?

John Hempton said...

Yes - but I think we crossed the guarantee threshold ages ago.

We said No More Lehmans.

We were prepared to tip 700 billion in so far.

We also tipped a few hundred billion in in contingent guarantees and into AIG.

Its done. Get used to it.

Guarantee the banks NOW - and then regulate them AS IF THEY WERE GUARANTEED.

Its the regulatory details that I now want to be concerned about - and part of that regulation is nationalisation (as opposed to just FDIC confiscation) with them running as nationalised banks.

It is nationalisation AFTER due process.

J

babar ganesh said...

john -- don't post this comment as is -- but i think you should reiterate the following point somewhere. here are your words from a previous post. i think they are very well stated:


The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Oregon Guy said...

John,

As always, there are two sides to the trade and your insistence that American taxpayers owe non-recourse backing and loans to the banks is one thing, but it is quite another to say that the taxpayer must make non-recourse financing available to the shadow banking system to purchase "toxic" assets. We could guarantee these assets and leave them on bank balance sheets or hire managers to purchase the assets for the "benefit" of the taxpayer. Wrapping up and delivering a gift from the taxpayers to hedge funds and large money-management groups is not a prerequisite for saving the banks.

Personally, I favor the taxpayer making the depositor base whole under all circumstances, but not the providers of leverage. The U.S. needs a debt workout, painful though it may be, and letting the debt holders fend for themselves would be a step towards that work-out. We can have a severe recession now or a depression later. Our leaders seem to be aiming for a depression circa 2020.

John Hempton said...

Only two sides of a story? There are many...

But brokered deposits guaranteed by government is just expensive government leverage.

J

septizoniom2 said...

john: i am persuaded though concerned about the unknown consequences of your recommendation of an explicit guarantee as the right policy choice. your analysis so far is compelling and clear. have you thought about speculative attack on other parts of the financial system to force another express guarantee (or the effects thereon of not being the beneficiary of an implicit or express guarantee). what about the success so far of muddling through as with the gses?

John Hempton said...

I guess the GSEs are not technically guaranteed...

But is there any difference between guaranteeing them (not done) and injecting up to 200 billion AND getting the FED to buy a trillion of their securities.

The GSEs are not that insolvent no matter how you count it. The money injected IS a guarantee.

(The 2007 pools of mortgages are tracking to 7% default - maybe 3.5% losses. That is enough to cost the taxpayer money - but not massively so...)

So just get used to it and do the deed.

J

septizoniom2 said...

ok. "not that insolvent" is not a great situtation, but the gses were not my main question.

what is your analysis on the knock on effect of the not-guaranteed part of the financial system if an express guarantee is issued (other than the gses)? your view on specualtive attack fostered thereby?

also, while your analysis is compelling and persuasive (and perhaps the clearest and most elegantly written i have read) in regards the need for an express guarantee, will you provide in future posts your views on systemic changes that would avoid this near-death experience in the future (would think you would have some brilliant insights).

John Hempton said...

I suspect that an awful lot of the stuff implemented after the Great Depression was pretty good.

For instance the securities act stopped Lehman US going under. The problem was that you just circumvented the US act by going to the UK.

So this requires a global effort. I suspect that Buiter knows mroe than I do. I have referenced some of his stuff - but I really have little solution to the regulatory arbitrage in globalisation.

J

septizoniom2 said...

thank you.

i just read steve randy waldman's latest post on interfludity, and he expresses much more elegantly than i the gaming issue with express (and for that matter implicit) guarantees. a worthy read. also, his recommendations for ameliorating future gaming are interesting.

would be great to see you, waldman, whalen, buiter, simon johnson and david goldman (of inner workings blog) set up a think tank.

Oregon Guy said...

John,

I said "trade", not "story". Trades, unlike stories, are relatively simple.

Providing leverage for private sector purchases of troubled assets is not the same as saving the banks. Your post suggests these are essentially the same in the logical and moral sense.

As distasteful as saving the banks is to me, it is even worse in my view to transfer wealth to the rentiers so they can collect cash flow off of MBS and CRBS instruments. We can save the banks without transferring wealth from taxpayers to hedge funds and money managers.

Banks were leveraging before the U.S. Government started guaranteed deposits. I'll wager that if deposit insurance was terminated in 2009, banks would operate a lot more transparently and a lot more conservatively. A radical thought is that this might prove to be a net benefit to us all.

Nate said...

I'm a regular reader and fan of your blog. However, I think that your criticism of Krugman's position depends on eliding certain distinctions which, while perhaps not crucial in your view to the resolution of the crisis, are more important in Krugman's view. To simply ignore those distinctions is to beg the question.

To wit, while it may be true that a Swedish-style guarantee (with selective nationalization) is a form of non-recourse funding, just as the TALF is, there are enough operational differences to make a distinction possible. The main differences are illustrated by the following questions: How much does the taxpayer participate in any future upside? To what extent will taxpayers reward existing shareholders, debt-holders, and management for their bad decisions? These are basic issues of fairness that will have a lot to do with how this plays out in the political process, which is key to any resolution of the crisis. Optically, there is a big difference between selective nationalization, and a TALF-style bailout. You can disagree about how important that difference is, but the idea that it may have important political consequences is not prima facie illogical.

Don said...

You've got it right. As soon as Debt-Deflation became a real possibility, we were stuck with a guarantee, but we hoped not everyone would notice, or, even sillier, that we could issue the guarantee to stop the run, and at the same time scare the bondholders into folding. This was my game, for sure.

Instead, these bondholders, including countries and insurers, keep calling my bluff. They're like the mortgage lenders and servicers, more than happy to play the hand out until the very end, betting we'll fold. And that's what we have to do.

China's telling us today that defaults aren't wise. If they go down, they'll take us with them. That's what all the bondholders have been saying. The spreads have delivered the message clearly and effectively. Enough with defaults and implicit guarantees. You've shown your hand. It's time to play it.

See, the bondholders are countries and insurers, the guys now calling for a bailout. We'll pay these insurers now or later, but we'll pay. As for the countries, they'll start demanding higher interests going forward if we default. They're going to get paid eventually as well.

Let's move on. Our one consolation is that, if we have to seize a few monsters, this should make it easier.

Just one more point. If you look at what the B of A, Citi, and even AIG have been saying, you'll notice that their "crown jewels" and profit centers are foreign holdings. Don't ask me how we keep them solvent without letting them keep these assets. Maybe somebody else can tell me.

Don the libertarian Democrat

RichL said...

This is off-topic, but..

The link below is for an article about Iceland by Michael Lewis, about the aftermath of some "creative" bank management.

http://www.vanityfair.com/politics/features/2009/04/iceland200904?printable=true&currentPage=all

Anonymous said...

hi,
i'm a regular visitor to u'r blog,u'r a doing a gr8 job presenting truly original and amazing insights.Your blog is a treasure.Not surprisingly u'r audience includes the great Krugman himself.
Here is a request:i'm not formally trained in economics/financial analysis,but very passionate to learn this stuff.Please provide a reading list that would help me acquire a thorough grip on the subjects mentioned above:
Thanks
Cheers
krishna


Cheers,

"Cassandra" said...

John,

I think your continued exploration of this topic - and attempts to champion the more optimal (or least sub-optimal) solution unblinded by historical score-settling (however just) is highly valuable. Keep it up, as the forces of rage and parochial individualism attempting to derail the more optimal solutions are loud and demanding.

William said...

I'll second Cassandra's comment. You've put out some of the best stuff that I have read on the banking situation and are a great counterweight to the hysteria that is going on in the states. People are simply angry and want to see bankers heads on pikes outside the capitol.

Keep up the good work.

JKH said...

The anonymous commenter made two very different points, both which he/she claims refute your position with Krugman.

I also believe that Krugman’s position is quite logical.

You’ve ignored in my view the more important of the commenter’s two points, that being the first one:

“It's very different at a bank. Why? The private creditors provide most of the liabilities. The government is only on the hook for any deposit insurance payout. And in a seizure, it does have something akin to recourse -- it can go and seize assets before other creditors can claim them. With the TALF, there are no other creditors it can push to one side. That is the very simple reason why Mr. Krugman is right on this one.”

I made a similar comment on the same post:

“The FDIC has recourse on seizure. That's what matters ultimately to the capital provider. Why shouldn't the Fed be in the same position directly as the FDIC?”

From an analytical standpoint, Krugman is correct in his March 3rd, March 8th, and March 11th posts. The fact that you disagree with him on TARP non-recourse funding has nothing to do with any error of logic on his part.

The implicit TARP guarantee provided by non-recourse funding is for the benefit of TARP equity investors. By comparison, in the case of a bank, an explicit guarantee is provided to bank depositors, as a result of FDIC insurance provided by the government. FDIC insurance is equivalent to contingent non-recourse funding provided by the government to bank depositors, not to bank equity investors. The idea of a blanket guarantee would extend this coverage to bank liabilities other than deposits.

It is illogical to compare a guarantee provided to TARP equity investors with a guarantee provided to bank depositors or creditors. And it is entirely consistent for Krugman to favour nationalization for non-viable institutions and the “Swedish guarantee” for viable institutions, and still be opposed to non-recourse TARP funding. (Krugman correctly corrected you on your erroneous interpretation of his position as presented in his March 3rd post.)

The “Swedish guarantee” is an effective extension of bank deposit guarantees to non-deposit bank liabilities. Opposition to non-recourse TARP funding is opposition to guarantees for TARP equity holders, not TARP debt holders (the government itself). Therefore, Krugman’s opposition to guarantees for TARP equity holders is in no way inconsistent with any support he may have for guarantees to bank debt holders.

You do agree on the combination of selective nationalization and the “Swedish guarantee”. That’s the important point. But the reason you don’t agree on TARP non-recourse funding is due to Krugman holding to a position that consistently differentiates the treatment of debt and equity, in the cases of both TARP and the banks. This is confirmed also by the anonymous commenter’s first point with great clarity.

As to the commenter’s second point, which is mostly the subject of your follow-up post here, the rough equivalence of “no more Lehmans” and a blanket debt guarantee seems valid, as well as obvious.

There’s no need to muffle your otherwise sound policy recommendations by this particular point with Krugman. Besides, you should know by now that he’s too smart to be inconsistent. Or maybe he's already covered this in an email.

Come on indeed.

babar ganesh said...

let me be sure i don't understand this.

in a 'bank', there are private creditors, including depositors and bondholders. in usual times they have varying levels of govt guarantee, but under and 'swedish guarantee' they are all guaranteed 100%. there are also equity holders and they have the first loss position plus rights to all residual gains after debt is paid off.

in a 'talf', the government takes the role of the private creditor. the equity holder (first loss / residual gain) position is still in private hands.

and JH is saying that after (and only after) you take a 'bank' and guarantee the private bondholders' money, you are very close to a 'talf'.

close -- but clearly not the same.

BailWatch Author said...

I suppose my question of the moment, given the (somewhat unsurprising) news about AIG's bonus payouts, is this: If we are truly in the era of "no more Lehmans," do we then have the right to expect conscientious behavior and accountability within institutions given guarantees? While I would like to think that those who enjoy executive status have some level of personal integrity, I don't see it here. What is an effective accountability mechanism in a "no more Lehmans" environment?

shivz said...

Query: Are we talking about the 'troubled assets'?

You maintain that "the most important policy question is whether you issue the blanket Swedish guarantee", to which, your answer is "an unequivocal yes (in the U.S.)."

My view is that this is not a matter of principle, but of degree. If you suspect that the entire stock of a bank's assets is problematic or bad, a blanket guarantee would, theoretically, be the right approach (but then, practically, such a bank will be taken over by the authorities).

But, aren't we talking about the 'troubled assets', the toxic assets, or more specifically, the mortgage-related assets? [Indeed, as recession-time goes by, and in the absence of a coherent solution, more and more 'normal' assets are becoming also problematic, but let's assume, for argument's sake, that we are still at the 'troubled assets' phase.]

Assuming, then, that the financial problem is limited to the banks' mortgage-related assets, the guarantee should not exceed the book value of these assets (and as I have said, if you know, already now, that the problem exceeds the mortgage-related assets, then the guarantee issue is anyway irrelevant).

It goes without saying that the guarantee I have in mind (as per the plan detailed in a comment on your post "Krugman's illogic extended" of the 12th inst.) is far from a donation to the stockholders or their CEO's.

P.S. – I have seen the other day an article suggesting that the CEO's of Citi and BofA want to gain time, to which I noted: give them time, with a rope… (the loop of which being the ownership apportionment which should take place after the expiry of the time given).

Nate said...

It appears that I confused the issue a bit by using the term "TALF" when I should have said "Bad Bank". The "Bad Bank" plan is the one in which the government provides non-recourse funding to private investors to buy up toxic assets. The "TALF" is a similar but different plan in which the government provides non-recourse funding to private investors to buy new-issue ABS (not the toxic assets on bank balance sheets) in order to jump-start the "shadow banking system". I apologize for any confusion this may have caused.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.