Uncharted Territory

September 25, 2008

Uh oh

Filed under: Credit crisis, Economics, Housing market, Markets — Tim Joslin @ 7:51 pm

The reaction in the US to Paulson’s $700bn bailout plan has been quite incredible.  Now I see in the NYT that it seems the Democrats have succeeded in adding some quid pro quos to the proposal:

“In interviews, and in testimony on Wednesday, Congressional leaders and Treasury Secretary Henry M. Paulson Jr., said that they had made substantive progress toward a deal on the rescue plan, and that the administration was prepared to make two big concessions: pay limits for executives of firms that seek government help and, in some cases, an equity stake for taxpayers in those companies so that the government can profit if they prosper in the months and years ahead.”

Let’s hope these little extras for the US taxpayer are weakly enforced, because, if not, the whole plan could be undermined.

There’s a complete lack of clarity as to what the bailout is intended to achieve.  In my view it’s just a first step in clearing up the mess.  Maybe the twin fixers, Ben and Hank, are deliberately not spelling this out.  They’ll have to fall on their swords, of course, but perhaps they are prepared to sacrifice themselves for the greater good.

The point is that the main purpose of the bailout is price discovery.  $700bn is a lot of dosh, but nowhere near enough (when I say this, I mean at least an order of magnitude too small) to buy up all the dodgy paper (and more paper is now getting more dodgy by the day).  The idea is, of course, that the Fed creates a market, or rather markets, for the various securities in question, as was done with the Resolution Trust Corporation (RTC) after the last US housing market debacle.  Other buyers of distressed debt would then enter the market.

It’s true, as many have argued, here for instance (and myself ad nauseam), that: “The real problem is the financial system has too little capital.” But price discovery is a pre-condition to raising capital.  The “credit crunch” or liquidity crisis is only a secondary problem to the losses suffered in the mortgage market, but now has to be resolved before the actual losses can be directly addressed.  Once the TARP (as the bail-out is officially titled) is in place then investors will know which institutions are insolvent – and at this point the US state takes on $100bns more debts and has to cover the losses, and Hank takes permanent fishing leave, likely with Ben, for not happening to mention this – and which are solvent.  The hope, of course, is that the solvent institutions will be able to raise fresh capital privately once people know they’re solvent and can take a stab at valuing their assets.  This would be in everyone’s interests, but don’t assume all banks will be able to raise funds if – as seems daily more likely – we find ourselves in a vicious global recession.  The US will then have to inject capital into the undercapitalised banks. Ouch. I guess at this point Hank’s successor falls on his sword, too.

So, to recap, the rescue requires 3 distinct sets of activities – not really stages (though that’s what I’ll call them), as they will overlap in time:

Stage 1: TARP: establish the value of the toxic assets.

Stage 2: nationalise insolvent institutions, using existing powers.

Stage 3: recapitalise weak, but solvent, institutions, by partial or complete nationalisation.

The trouble is, conflating these stages means that the first step can’t so easily be achieved.  How is another buyer of distressed debt supposed to know what it’s worth of the Fed has only established what price a bank is prepared to sell the debt for if the Fed also takes some shares and limits executive pay?  If prices are clearly established by reverse auctions, then other buyers can enter the market.  It’s going to be complicated enough as it is.  It really is unwise to add further conditions to state purchases.

I have to say that one of the things that’s amusing me today is Sweden boasting about how well they dealt with their crisis in 1992.  They decided to wipe out the existing shareholders in banks as a matter of policy.  It worked well.  It’s been a whole 16 years before they got into trouble again (Swedbank and others are now losing money hand over fist in the Baltics).  Maybe they didn’t end up with the right kind of shareholders this time round.  Perhaps they shouldn’t have wiped out the last lot – dead men learn no lessons!  What’s actually needed in these situations is to get more private capital into the banking system.  Biting the hand that feeds you is a big mistake, as I pointed out some time ago.  Btw, I noticed Anatole Kaletsky now seems to agree.

I can’t help also mentioning how I also laughed this morning at the indignation of the UK’s archbishops, who complained that “loosening up [the] financial regime” has become something of an ideology, “a sort of fundamentalism”.  And what would religion be exactly?  Oh, and this is the best bit: apparently, “unimaginable wealth has been generated by equally unimaginable levels of fiction”.  Whatever could he be referring to?

Back to the story…  I can’t really see any reason now why a large proportion of the US’s housing and other debts won’t eventually end up on the Fed’s books (and the rest of the world will catch the disease too).  Well, OK, the plan might still work, but if it’s fudged, as looks likely, there won’t be a lot of buyers for mortgage debt for a while yet, at least until the eventual depth of the slump in the housing market and US economy in general becomes a lot more clear.  I’d be worried about the dollar, but I can’t think what it can really fall against for very long (apart from gold, I suppose), because the whole caboodle’s going up.  The crunch is going global.  The bailout (or something smarter) was needed a year ago.  I hope it was worth it to “punish” a few people.  Still, I guess the sun will still come up in the mornings.  Interesting times.


1 Comment »

  1. It will be an interesting few years for the United States as all of this money is going to come from taxpayers and I am not sure how the American public is going to react to this.


    Comment by jwojdylo — September 25, 2008 @ 9:38 pm

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