Wednesday, March 11, 2009

Paul Krugman’s false logical step

To my way of thinking Paul Krugman has finally nailed the question as to bank nationalisation that matters.  This the money quote:

That said, some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

He is absolutely right that this is the critical step in the decision making process is what parts of the banking structure you are going to either guarantee or effectively guarantee.  The critical question is not nationalisation.

Sweden could guarantee all banking liabilities because – frankly – their banks were not that deeply insolvent.

We know they were not that deeply insolvent for a few reasons – the best of which is that ex-post the Swedish bailout cost very little (and the Norwegian bailouts were actually profitable for the government).

However it is fairly easy ex-post to tell how insolvent the banking system was.  It is not very easy ex-ante to tell.  If it were easy then banks that were not at all insolvent (such as Svenska Handelsbank) would not become 20 bagger stocks quite quickly after the crisis.  The stock market would not have marked them down so much.  

The US Government’s stated position – Bernanke yesterday as well – is that there will be "No More Lehmans".  What that means is that there will be no more uncontrolled liquidations of large financial firms.  

The only way that the government can say that there will be no more Lehmans is to effectively guarantee large parts of the financial system.  That is what the statement “no more Lehmans” means.  If you want to make that statement operational you either (a) need to guarantee the banking system or (b) pour money in continuously whenever a bank (Citigroup. AIG or otherwise) threatens to become the next Lehman Brothers.

The state of US policy at the moment is nothing more sophisticated than (b) above – which is whenever an institution threatens to become Lehman the US Government tips in another 30-300 billion.  We are still in the world of the ad-hoc guarantee - of the Sunday press release.

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).

Krugman has nailed the right question.  The right question is whether the correct policy is “No More Lehmans”.  I am pretty sure it is.  I think the revisionist history about how bad the Lehman failure was is simply revisionist crap.  I am convinced that at least in some instances the “no more Lehmans” policy will be operationally expensive in some instances and will leave the taxpayer with an enormous hangover*.  The alternative is simply to allow big institutions to be pulled apart by the FDIC.  Chris Whalen by contrast is convinced the other way – he says the model is easy to determine – just go down to the Southern District of New York and talk to the Lehman Trustee.  

There is a reason why the right policy might not be "No More Lehmans".  Its about cost.  If the cost of making that promise operational was $12 trillion then you probably should just let the financial system burn.  Why – because it is so much money the taxpayer could not plausibly absorb it without decades of higher taxes.  If the cost is $1 trillion then hey – just suck it up - a fast rebound to the US economy as per Sweden after its crisis is worth more than a trillion dollars.  The cost depends on the size of the banking system and the size of the losses relative to GDP.  Iceland had to let its system burn because it could not plausibly bail out its banks.  The UK banks started with very little capital and with very big balance sheets relative to GDP.  They are also problematic.  The US banks by contrast started with lots more capital and smaller balance sheets relative to US GDP.  The upper-end estimate of losses (Roubini) is $3.4 trillion.  If that is the case the upper limits to cost of the "No More Lehmans" policy is less than $3.4 trillion.

My long post has some indication of how you might estimate the costs of making a “No More Lehmans” promise operational.  I have a forthcoming post which explains quite carefully what the least cost way of making that promise operational is.   (The costs are however potentially very large - and whilst I think substantially less than the Roubini number I can't dismiss the possibility the costs could be large indeed.)  

Anyway – if you have made the decision to have “No More Lehmans” then you have made the important decision – you are going the Swedish Route and guranteeing stuff - whether by Friday evening crisis or whether by design.  I think America will go the Swedish Route – I am just waiting.  The Swedish route is guarantee and selective nationalistion.  I have never been afraid of the Nationalisation word – and anyone who buys money center banks now can expect a few of them to be nationalised.  I have small positions - which would be larger positions if I knew the rules.

But the second part of Krugman’s paragraph contains a deeply troubling false logical step.  He says: “but of course we can’t do that unless we’re prepared to put all troubled banks in receivership”.

To see why this is a false logical step you need a little history.  A long time ago most the liabilities of almost all banks were deposits.  The government guaranteed the deposits by creating the FDIC – it hence stopped crisis driven bank runs.  It increased stability in a crisis.  However it also allowed financial firms to take huge risks or even be looted (as per Charles Keating).  The solution which was adopted (and let lapse of late) was that banks got the guarantee – but were heavily regulated to protect taxpayer interests.  There was no need to nationalise the banks simply because you guaranteed the bulk of their liabilities.  There was however a requirement to (a) regulate them, (b) assess their capital and (c) take “prompt” corrective action when that capital was inadequate.  Prompt corrective action included confiscation.  You did not take over banks because they had runs (the purpose of the FDIC guarantee was to stop runs), you took over banks when they inadequate capital.**

Nowadays a lot of banks have the bulk of their assets funded by things that are not deposits.  Indeed at many banks deposits constitute less than half the balance sheet.  

The old FDIC guarantee can’t stop runs because the run that happens is wholesale – it happens outside FDIC guarantee limit.  If you want to stop bank runs the way that the original FDIC stopped bank runs you need to bite the “Swedish Bullet” – that is you need to effectively guarantee everything.

However just as the creation of the FDIC did not require you to be “prepared to put all troubled banks in receivership” a Swedish guarantee also does not require you to put all troubled banks into receivership.

What the FDIC guarantee required – and what a Swedish Guarantee will require – is you be prepared to (a) regulate banks heavily on an ongoing basis, (b) test the capital of banks, (c) force them to be adequately capitalised (rasing money if they can), and (d) nationalise the banks that cannot raise adequate capital.  

When the good times return you probably need walk away from this general guarantee.  In other words you have to regulate banks in such a way that they can’t become large enough to destroy the whole economy - so that you reduce the systemic risk at the cost of stifling "financial innovation".  That means that the recidivist Citigroup – a bank that seems to blow up every cycle – will never be allowed to become as big and nasty again.  It would be a terrible policy outcome if we did not learn from this crisis and did not regulate in such a way that it was less likely to happen again.  Willem Buiter's call for "over regulation of banks" looks right to me.

Krugman’s illogic however does not help the debate.  There is a need to guarantee all banking assets – and it should be done provided it is affordable.  There is no consequent need to nationalise the whole system – though there will be a need to have a process which will result in nationalisation of some institutions – what I call “nationalisation after due process”.   

Oh, and the number of losses in the system is not fixed.  If the ability to borrow to fund risk assets is not restored then commercial property for instance will fall until its yield becomes attractive to an unlevered buyer.  My guess is that is about 15%.  As the economy will be in a slump at the same time and rents will also fall that might mean a top to bottom move in commercial property of 80%.  If the move is that big then all the banks (good, bad, otherwise) are insolvent.  However if the banks had guaranteed funding then (a) they could lend so the slump in the economy would not be so bad and (b) people could borrow to buy commercial property so its price does not need to fall until the yield is 15%.  The top to bottom fall might be 35%.  The system losses would be smaller.

If we do not guarantee all bank funding then I am afraid that Christopher Whalen will be right - the macroeconomic wave going through the economy will just smash up everything fast.  

The longer we wait before biting the Swedish bullet the larger the system losses will be - and hence the higher the cost of biting that bullet.  Either do it now or give up saying that there will be "No More Lehmans".  If you wait too long everything becomes Lehman.  

It took Krugman a long time to realise that the "Swedish Guarantee" is the important question.  And it is.  Nationalisation (which should happen for some institutions) is only the secondary question.

John Hempton

Some post scripts

*The instances in which I think the “no more Lehmans” policy will be operationally expensive are (obviously) AIG (almost certainly) Fannie and Freddie and speculatively a few others that are properly insolvent.  My biggest problem child is Barclays – which is technically a UK institution – but it is too big for the UK to bail out – and which has a lot of its operations in the US.  I suspect that the US can – as a technical thing – let Barclays be the next Lehman – saying – hey – its not one of ours!  But that is a post for another time.  

**This is one of the things that most annoys me about Sheila Bair’s confiscation of Washington Mutual.  WaMu had a run.  The old role of the FDIC was not to make banks fail when they had runs – it was to stop runs.  I would have no objection to confiscation of WaMu if it was demonstrably insolvent.  However it was not demonstrably insolvent – and Sheila Bair’s own press release said it was capital adequate when confiscated.  It was a very strange interpretation of her role indeed that she should close a bank because it had a run.  


Donald Pretari said...

Actually, I realize now that I agree with you. In the last post, I said that we had already agreed to guarantee everything, if we have to. But, from my point of view, the main reason to announce the guarantees is not to have to spend the money, but to stop the panic, which would allow for a more orderly unwinding of these investments, saving money in the long run. So, I was wrong. Even though we have signaled that we have guaranteed everything, an explicit statement, in theory, would help.

Also, since, from my point of view, we've guaranteed foreign bondholders implicitly by our actions with Citi, we might as well make it explicit. It could be huge, but there's really no other good choice.

Don the libertarian Democrat

m said...

Great analysis.

Some questions:

If you guarantee/bailout the wholesale funders (bondholders) how do you credibly avoid moral hazard down the road.

Why shouldn't some, not all, of the bond debt be converted to equity. Share the risk with the taxpayers.

Are the bondholders going to take their marbles and go home going forward if they take a haircut now?

John Hempton said...

If you do this you have to REALLY TIGHTLY regulate the banks down the road.

Buiter is right in his call for financial institutions to be OVER-REGULATED.

His expression - self regulation is to regulation as is self importance to importance.

Just bite that bullet too.

Banks will never be as profitable as they once were. The days of unbridled financial innovation are over.

We will get real engineers rather than financial engineers - and it will be a good thing.


Note - as someone who is somewhat expert on financial regulation I am talking against my class.


John Hempton said...

As for why some of the debt should not be converted to equity - maybe it should - but there are plenty of things that it is parallel to - such as derivative obligation - and I have no way to convert those to equity.

Moreover - if you do try you get an event of default - and that would result in an uncontrolled liquidation. That is more Lehmans.


Anonymous said...

One of the key issues with the swedish model that was adopted was
that the banks were required to disclose expected loan losses
and assign realistic values to real estate and other assets. Urban Backstrom, a swedish central bank governor, and financial ministry official at the time, stated in a speech at the Fed Symposium in 1997 this process served to" restore confidence".

The thing with banks and trust, is that its not about the absolute amount of capital you have but rather than your counterparties with whom you seek to do business believe you have what you say you have (granted this may be a gross oversimplification).

The question remains whether these institutions are prepared to accept realistic values - if we were flies on the wall at the US Treasury, one might expect to hear that this is one of the sticking points with the implementation of such a model.

m said...

I don't see a credible commitment from congress and the fed to increased regulation down the road.

If I did, then I would be with you, since Buiter's and your degree of re-regulation is what is called for if the Gov is going to guarantee the financial system.

John Hempton said...

I agree that Congress won't easily re-regulate the financial system to that extent. Indeed that is the trouble here...

Too powerful lobbyists - but there are other ways of doing it - which is to progressively charge more and more and more for the guaranteed funds - unless some higher regulatory standards are dealt with.

And if they don't deal with the regulatory standards progressively remove guarantees and talk down the books. There is a LOT of power of persuasion.


m said...

"Moreover - if you do try you get an event of default - and that would result in an uncontrolled liquidation. That is more Lehmans."

Which is why CDS's should be banned or severely restricted.

Query though: Since the FDIC expropriated the bondholders in WAMU, is there some parallel legal regime that could achieve the same result wrt to the CDS obligations.

John Hempton said...

It did not matter that there was an event of default at WaMu - the derivative exposures of WaMu were approximately zero.

That meant it was possible to do that.

Isn't possible for Citigroup. The liquidity call is so large the even would be uncontrolled.

Anonymous said...

As ever, thank you for blogging.

Re: too big to fail --- I don't see any political/regulatory will to prevent banks from becoming TBTF. If there were, we wouldn't have seen the BoA/ML or Lloyds/HBOS takeovers. In both cases, it seems the government pressured the buyer to consumate the deal.

In addition to that, it would seem that antitrust/competition policy would have to be changed to address systemic risk rather than just monopoly issues. I haven't seen any discussion of this so far.

Regards, MW

Isam Laroui said...

Actually John, I think you and Paul Krugman agree 100%.

When he says "unless we’re prepared to put all troubled banks in receivership", my understanding is that he doesn't mean we SHOULD put them all in receivership. He just says that, if worse comes to worse and all the troubled banks fail the stress test, we may NEED to put them all in receivership.

Which is exactly what you're saying, no? You're just expecting most of them to pass the test and therefore that we'll only have to nationalize a few of them. He might be a little more pessimistic than you,that's all:)

septizoniom said...

this is an extremely enlightening, consise and clear post. i wonder if you have an direct contact with treasury. they clearly need to be talking to you. do you reach out to washington?

Anonymous said...

The REIT yield is around 15% now, so your commercial real estate guess might be reasonable. Leverage should probably be reduced overall, but it must be unwound in an orderly fashion. In the case of REITs, for example, they should permanently be allowed to retain maybe 50% of earnings to expand. That way they would no need to take on so much leverage in the future.

For now, dumping a significant fraction of commercial real estate onto the cash buyer market all at once is not a reasonable solution. So rollover of previously existing debt may be needed for now. This probably requires public guarantees.

Anonymous said...

If banks auction off toxic debt and their long-term prospects are as rosy as they project, banks shouldn't have a problem with parting with LEAPs as a bonus to purchase toxic debt.

Neil said...


I'm looking forward to reading your opinion of WAMU suing the FDIC for $13 billion.

Neil a/k/a Financial Gauges

Merc said...

"However just as the creation of the FDIC did not require you to be “prepared to put all troubled banks in receivership” a Swedish guarantee also does not require you to put all troubled banks into receivership."

I think the important distinction is that you have to be prepared to put all troubled banks into receivership. The way the bank stocks have all been moving up and down together shows that most people believe what's good for one bank is good for all the banks, and what's bad for one bank is bad for all the banks.

If putting one bank into receivership makes everyone lose confidence in the other banks, they may all fall at once.

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