How Do We Use the $350 Billion Well?

There are two problems:

1. Willingness to lend.
2. Ability to borrow.

Thus far efforts to unfreeze credit have centered around re-capitalizing banks and creating a market for otherwise unmarketable securities to reduce the fear of lending. The next discussed and tentative step of creating a "bad bank" does more of the same. This is good; but it is not enough for it does not nurture future borrowers to health.

For credit to flow, both banks and borrowers need to be healthy. For borrowers to be healthy, there must be income streams to service debt. The Obama American Recovery and Reinvestment Act is a good first step in the right direction; but more can be done through the treasury actions.

What I am hoping to see from Treasury Secretary Geithner is further action to create well capitalized "good banks" while at the same time addressing the ability to borrow side of the equation.

This crisis arose for a simple reason; borrowers assumed stable and rising asset prices would help in discharge of debt obligations. When asset prices ceased to act as expected, there were insufficient cash flows to service and pay down debt. Responsible borrowing occurs when the debt undertaken can be paid down and serviced from future cash flows; borrowing in excess of this level means consuming now what belongs to the future - and then the future arrives.

Moving the impaired debt into a bad bank works because it leaves behind adequately capitalized "good banks" - this addresses the willingness to lend factor. But for it to work better, the "bad bank" needs to re-structure/write-down impaired debt to a level where the borrowers future cash flows shall be sufficient to service the re-structured debt level. This will go a long way in restoring borrowers to health and stopping an otherwise unstoppable downward spiral in asset prices.

Of course private capital working alongside the goverment funding of $350 billion will make it more effective - private capital flowing to "good banks" once bad assets are removed can be expected. However, private capital in "bad banks" is a very viable proposition provided the non performing assets acquired are re-structured and valued at a level providing an investor an expectation of a decent rate of return.

So how do we finance it? In the present circumstances the United States cannot finance government spending through taxes; equally it is likely that financing spending using further foreign debt will be unsuccessful. That leaves seigniorage (creation of money by printing it!) as the only real option; this is a distasteful option, nevertheless in the present situation it makes sense of a kind. Since significant US$ debt is held overseas, financing government spending through seigniorage, coupled with a large subsequent devaluation is no bad thing. No doubt it will be inflationary; however this effect will be partly offset by the deflationary impact of de-leveraging.

Comments

[Erick Tippett:]

I don't have a problem with private capital flowing to "good banks" whose
bad assets have been removed. I do have a problem with any capital,
public (tax payers money) or private, going into value-less "non-performing assets" (as you classify them) then into a bottomless pit never to be seen again!

As far as the dangerous inflationary practice of printing massive amounts
of ever depreciating paper currency (instead of initiating a massive tax cut for the public) a question in conclusion to all of this; In your personal economic-historical research have you any knowledge of a single culture
that has detached from a precious metal standard, replaced it with a fiat currency system, and survived, let alone prospered?

I haven't!

Feb 12 01:40 AM

[Shiv Kapoor:]

People like Wibur Ross make a fortune on non performing assets. One example on how it may work is - A family buys house with a loan of 100. Husband loses job, they cannot afford to repay. House value has fallen to 80. NPA investor comes in and buys NPA for 80 less say 25% because it will be a distress sale. Bank owning NPA has a loss of 40; new NPA owner has a basis of 60. In a worst case scenario, NPA owner takes the house and sells it net of costs for 60 and breaks even. More likely depending on what the home owner can afford, the NPA owner will re-negotiate and let them pay back a negotiated amount > 60 and <100. The present value of those future cash flows will exceed the 60 they bought the NPA for and so they profit from it. That is why private money will actively wish to invest in NPA's (admittedly more common in corporate turn around rather than the simplified home owner example above).

An exclusive tax cut strategy will not work in the present environment; with the shock to the consumer all it will do is increase savings and not investment which is critical for recovery. The Obama plan balances decent tax cuts with investment - think of it as a larger tax cut with the decision on how much of it to invest partly removed from the hand of the recipient (this is the amount invested by the government to re ignite investment and create jobs). While printing currency is not a good idea, either a tax cut or investment needs to be financed - seigniorage is the ONLY option - taxes raised will further cripple the economy & it is unlikely that foreign trade partners shall continue to fund the US problems by taking further debt. And yes it will result in inflation + devaluation of the $ in the long term with the inflation being partly offset by deleveraging in the economy.

The $ is backed by the full faith of a nation; that stands for a lot. As nation can go bankrupt, so can a treasury run out of gold. Personally, I feel that the valuation of US is more than all the gold in the world; how then can gold back the $? Nevertheless gold shall provide investors gold standard returns as inflation rises & devaluation is triggered. My view is that devaluation will occur but perhaps to a lesser degree compared with the death of the $ advocates. Purchasing power parity is the major reason most developed nations need to devalue but this will never happen to the fullest extent until developing nations offer better comparability (for example it is difficult to compare relative values for a good neighborhood in Delhi with one in Houston; simply because civic amenities (power/water/sewage/ro... in the Indian neighborhood are all but absent - yet the prices are higher in Delhi - is that a bubble or simply demand; I suspect the prior).


On Feb 12 01:40 AM Erick Tippett wrote:

> I don't have a problem with private capital flowing to "good banks"
> whose
> bad assets have been removed. I do have a problem with any capital,

>
> public (tax payers money) or private, going into value-less "non-performing
> assets" (as you classify them) then into a bottomless pit never to
> be seen again!
>
> As far as the dangerous inflationary practice of printing massive
> amounts
> of ever depreciating paper currency (instead of initiating a massive
> tax cut for the public) a question in conclusion to all of this;
> In your personal economic-historical research have you any knowledge
> of a single culture
> that has detached from a precious metal standard, replaced it with
> a fiat currency system, and survived, let alone prospered?
>
> I haven't!

Feb 12 08:52 AM