A Bank Bailout That Works
Flawed Attempts to Restart Lending
Policy-makers have been flailing around, trying to figure out how to get lending restarted. It is not hard to do--if the government bears all or most of the risk. The Federal Reserve is, in effect, making major loans to America's corporate giants, giving them a big advantage over traditional job creators, America's small- and medium-size enterprises. We have no idea if the Fed is doing a good job of assessing risk and whether interest rates commensurate with the risks are being charged. Given the Fed's recent record, there is no reason for confidence. But there is a consensus that whatever the Fed is doing, it is not enough.
The Obama administration has floated a number of ideas, from buying the bad assets and putting them into a "bad bank," leaving it to the government to dispose of them; to providing insurance to the banks; to assisting private investors (like hedge funds) to buy the bad assets, presumably by lending to investors on favorable terms. Because of the lack of details, the market greeted the Obama administration's announcement of its so-called plan with dismay. As this article goes to press, we can only guess that the administration's plan will be an amalgam of several of these ideas. The devil is in the details, and without the details we can't be sure how things will turn out.
An early idea floated by Paulson was for the government to buy the bad assets from the banks. Naturally, Wall Street was delighted with this idea. Who wouldn't want to offload their junk to the government at inflated prices? The banks could get rid of some of these bad assets now, but not at prices they would like. Then there are other assets that the private sector wouldn't touch with a ten-foot pole. Some of them are liabilities that can explode, eating up government funds like Pac-Man. On September 15 AIG said it was short $20 billion. The next day, its losses had grown to some $85 billion. A little later, when no one was looking, there was a further dole, bringing the total to $150 billion. Then on March 1, the government agreed to another $30 billion in taxpayer money for AIG--the fourth intervention in less than six months.
Paulson's original proposal was thoroughly discredited, as the difficulties of pricing and buying thousands of assets became apparent. More recently a variant of this proposal, which involves government buying garbage in bulk, was broached. But the major difficulty with determining prices of toxic assets, whether singly or in bulk, remains: pay too much and the government will suffer huge losses; pay too little and the hole in the banks' balance sheets will still seem enormous, requiring another bailout to recapitalize the banks.
Most variants of the "cash for trash" proposal are based on putting the bad assets into a bad bank (advocates of the plan prefer the gentler term "aggregator bank"). But the banks holding only good assets would likely be short of cash, even after taxpayers had vastly overpaid for the trash. The hope is that the banks would then find private funds to further the recapitalization, though one suspects that the sovereign wealth funds, to whom many turned a little while ago, would be less interested, having been so badly burned before.
I believe that the bad bank, without nationalization, is a bad idea. We should reject any plan that involves "cash for trash." It is another example of the voodoo economics that has marked the financial sector--the kind of alchemy that allowed the banks to slice and dice F-rated subprime mortgages into supposedly A-rated securities. Somehow, it is believed that moving the bad assets around into an aggregator bank will create value. But I suspect that Wall Street is enthusiastic about the plan not because bankers believe that government has a comparative advantage in garbage disposal but because they hope for a nontransparent bonanza from the Treasury in the form of high prices for their junk.
If the government takes over banks that don't meet the minimum capital requirements, placing them in federal conservatorship, then these pricing problems are no longer important. Under this scenario, pricing is just an accounting entry between two pockets of the government. Whether the government finds it useful to gather all the bad assets into a bad bank is a matter of management: Norway chose not to; Sweden chose to. But Sweden wasn't foolish enough to try to buy bad assets from private banks, as many in America are advocating. It was only under government ownership of the entire bank that the bad bank was created. Norway's experience was perhaps somewhat better, but the circumstances were different. Given the complexity and scale of the mess Wall Street has gotten us into, I suspect we will want to gather the problems together, net out the derivative positions (something that will be much easier to do under conservatorship and a significant achievement in its own right, with major benefits in risk reduction) and eventually restructure and dispose of the assets.
More recently, another idea has been put forward: the government would insure bank losses. By removing the risk of loss, the value of these toxic assets automatically increases, improving the banks' balance sheets. Bankers love this idea. The government can give them a big insurance policy at a small premium. Politicians love this idea too: there is at least a chance they will be out of Washington before the bills come due.
But that's precisely the problem with this approach: we won't know for years what it would do to the government's balance sheet. Six months ago, what the banks told us about their losses going forward was totally off the mark. AIG had to revise its losses by tens of billions of dollars within days. Real estate prices might fall only another 5 percent, or they could fall another 25 percent. With the insurance proposal, neither the government nor the banks have to admit the size of the hole in the banks' balance sheets. It's another example of those nontransparent transactions that got Wall Street into trouble.
Even worse, the insurance proposal exacerbates incentive distortions--it moves us from a zero-sum world into a negative-sum world, where increased taxpayer losses are greater than Wall Street's gains. The insurance proposal may even inhibit banks from restructuring mortgages, worsening the problem that gave rise to the crisis in the first place. If they restructure the mortgage, they have to book a loss. If they keep the mortgage and things get worse (the likely scenario), the taxpayer picks up most of the downside risk; but if things get better and prices improve, the banks keep the gains.
Still worse are proposals to try to enlist the private sector to buy the trash. Right now, the prices the private sector is willing to pay are so low that the banks aren't interested--it would make apparent the size of the hole in banks' balance sheets. But if the government insures private-sector investors--and even makes loans at favorable terms--they'll be willing to pay a higher price. With enough insurance and favorable enough loan terms, presto! We can make our banks solvent.
But there is a sleight-of-hand here: go back to the zero-sum principle. The private sector is not going to provide money for nothing. It expects a return for providing capital and bearing risk. But its cost of capital is far higher than that of government. The losses are real, and the private sector won't bear them without full compensation. This means that the amount the government is likely to have to pay in the end is all the greater.
This proposal, like so many others emanating from the banking community, is based partially on the hope that if banks make things sufficiently complex and nontransparent, no one will notice the gift to the banking sector until it is too late. It appears as if they are at last getting the high market prices that they hoped they would get all along. But it would be a misnomer to call these market prices, since the government has taken away the downside risk. This proposal has, of course, the further advantage of drumming up support from the hedge funders, who so far have not received any of the TARP bonanza.
There is an underlying problem facing all these proposals: the hole in the banks' balance sheets is bigger than the $700 billion Congress has approved--and much of what has been spent so far has been wasted. So the financial wizards are turning to tried and true gimmicks--the same ones that got us into the mess. One strategy is to hide the costs in nontransparent accounting (easier under the insurance proposal). The other combines this trickery with the magic of leveraging and pretends that leveraging carries no risk. The government sets up a "special investment vehicle" using, say, $100 billion of TARP as the "equity." It then borrows another $900 billion from the Fed--which in rapid succession has been tripling and quadrupling its balance sheet. Of course, in doing so the Fed is risking taxpayers' money--but without having to ask permission of Congress. At best, this is a deliberate circumvention of democratic processes.