A Scenario for a U.S. and Global Recovery, Part 2: Banks

See part 1 here.

As part of my exploration of the pieces of the puzzle that must be put together to drive a US and global recovery, I turn out now from Main Street to Wall Street.

Wall Street has been blamed long and large for the wicked financial engineering that has spread the seeds of the current financial crisis. It has been sufficiently documented that ill-conceived securitization, and the transfer of large quantities of risk out of banks' balance sheets - the so called “originate and transfer” model – were instrumental in derailing the US and global business cycle.

“There was a flaw in the model” as Alan Greenspan, the former chairman of the Federal Reserve, painfully had to recognize after years of regulatory complacency and “laissez faire” doctrine.

However, what is important now is not to cast an endless blame on people. The most important thing now is to see how we can fix Wall Street. The bad news is that the situation is very serious, as it appears from the record losses endured by major banks and other financial institutions (AIG, Fannie Mae, etc.). The good news is that the public authorities in the US and abroad have been working on solutions for months, and these solutions are now taking shape, amid the endless market doom and gloom.

Let us quickly review these solutions.

1. Banks' recapitalization with taxpayers money is painful but needed

It may be painful for the taxpayers and it may look politically sensitive, but unfortunately there is no other way out of the crisis. Textbook economics tell us that the role of government is to intervene when there is a failure in free markets. Well, we are now precisely experiencing such a failure!

As of end January 2009, the IMF estimated that banks in the US and in Western Europe needed a total of $500 billion to cope with the capital shortage arising from the financial crisis. This is probably too conservative. I guess banks may well need capital in excess of $1 trillion if they are supposed to cope with the effects of a deepening global recession.

We hear a lot the word “nationalization” nowadays, as if the communists were back with a vengeance! This is clearly overstated. While the US government may take a majority or a strong minority share in some of the nation’s largest banks – with Citigroup (C) and Bank of America (BAC) being now under close Treasury’s scrutiny – the government has no incentive to expropriate private shareholders. In any case, these same shareholders have already lost almost all of their equity investment. It will not make a big difference for them.

2. It is critical to fix the shadow banking system to avoid a Japanese scenario

According to an article in the Journal, the “shadow banking system” accounted for roughly 40% of all consumer lending before the financial crisis erupted last year. At the height of the credit boom, Wall Street issued more than $1 trillion a year of securities that were backed by consumer credit, and trillions more backed by mortgages. This is huge! Against this background, now consider that, according to the same article, the issuance of securities tied to consumer loans dropped to less than $8 billion in the final three months of 2008. Still don’t believe in a credit crunch?

The Fed and the Treasury are now adressing this problem with their initiative, known as TALF for Term Asset Backed Securities Loan Facility. TALF is expected to inject up to $1 trillion in the economy through securitized consumer lending, hence stimulating consumer expenditure. It may not force reluctant consumers to spend more, but it can prepare the ground for a consumer-led recovery, which otherwise might never happen. Remember Japan’s lost decade. It was largely due to a lack of domestic demand. You don’t want to live in a zombie economy, right ?

3. Getting rid of so called “legacy assets” is vital to head for recovery

In January, the IMF raised its estimation of the total US distressed credit assets to $2.2 trillion, warning of further possible deteriorations. Again, this is probably too conservative as an estimation. By all accounts, the total amount of distressed credit assets in the US financial system may well reach $3 to $4 trillion by the end of this year.

The first problem with these legacy assets is that, as long as they pile up on banks' balance sheets, they will prevent any serious recovery in consumer and small business lending. And the shadow banking system is of no use here. You cannot securitize loans unless, as a first step, you take these loans on your balance sheet. This is the uncomfortable truth that links the “official” and the “shadow” banking systems: they are intricately connected. On the contrary, as the recession deepens, the writedowns on these legacy assets will accelerate the capital shortage at banks, hence reinforcing the destructive forces at work.

The second problem, is that these legacy assets are concentrated on the balance sheets of a few financial institutions, which are deemed with some reason “too big to fail”. Getting rid of these legacy assets will require: first, a painful but necessary loss recognition at these major institutions, second, a price mechanism similar to the one that was found at the time of the Resolution Trust Corporation, and third, true incentives for private players – so called “vulture funds” – to join the toxic waste containment scheme.

4. Redrawing the whole set of regulations, incentives, and practices that prevail in the US financial system

Last but not least, nothing will work if the public authorities do not commit seriously to a radical overhaul of the whole financial system. Taxpayers' money can help fix the system, but if the system is not profoundly changed, this money will be lost in vain. We would have the same liquidity bubble building up over a decade, with the same crisis once again in 2020. Except that the next time, China and other foreign creditors are not likely to save the US government by holding up to their vast amounts of Treasuries. There would be a huge investor flight from US securities, skyrocketing interest rates, and a massive collapse in the US dollar. This will be nothing less than the final blast to the American economy and civilization.

Such a dreadful scenario is still avoidable. But the challenge of fixing Wall Street, and moreover the challenge of changing Wall Street, is perhaps more acute now than it was at any time in American history, including that of the Great Depression.

Comments

[ResourceWise:]

Alexandre, I agree with your assessment. The shadow banking system and all the players involved in it must be brought out of the shadows and their business models examined in the bright sunshine viz., how do they make money, what purpose do they serve for the economy/financial markets, where is the opportunity for conflict-of-interests, what leverage do they create - thereby adding to the volatility and instability of the system. Without these reforms, we're condemned to serial destruction of value for the investor and huge profits for the speculator. We have to separate the stock markets from the casinos and clearly label them for what they are. Then individuals can choose to participate or not with a clearer view of the choices they make.

Mar 05 03:17 AM

[Yahoo User:]

As a BAC shareholder it makes a huge difference to me if the government expropriates my shares or even converts their preferred shares to common. The U.S. Treasury and Federal Reserve are the source of BAC’s problems. They forced shareholders to eat the mud sandwich of MER so that Bush and Paulson could scurry out of town without another LEH. The fact that the treasury made Ken Lewis lie to share holders through omission probably makes the entire merger illegal, and it certainly shows that neither the fed nor treasury are impartial regularity bodies. The government needs to follow through on their obligations to backstop MER assets (per the merger agreement) and then goes away and lets BAC pay back the Tarp as quickly as possible. It wouldn’t hurt if the SEC started to enforce the laws on naked short sales but that is probably too much to expect from the criminals of both parties in Washington

Mar 05 03:17 AM

[JohnL:]

-- Textbook economics tell us that the role of government is to intervene when there is a failure in free markets. --

Why do you put much faith in textbook economics? With so many economists in academia, government and banking, how did we get into such a predicament? Based on their recovery efforts to date, does it seem like those textbooks have brought them clarity on the root cause of the problems or effective solutions?

I submit that those textbooks can't tell us where government intervention has ever worked to cure an economic slump and they can't tell us that the free market actually failed. Isn't it more likely, after decades of continuous growth in government, that we are actually experiencing a failure of government and it is now time to let the free market intervene?

Mar 05 03:27 AM

[socrateazz:]

I think financial organizations should not become too big to fail. If they are too big to fail then they should be divided into more companies. Behemoths need to be the exception not the rule. If any one company would seriously pull others down, then that company should be divided when it is healthy.. A model could easily be developed regulators could use to determine when any one company could be a serious problem initiating a company split

Mar 05 03:49 AM

[Jason Rines...:]

Regulations on monopolies exist and would be useful. Big money players are very clever to keep there monopoly on money business. This is far easier said then done what you are suggesting in the global banking system, but I agree.

On Mar 05 03:49 AM socrateazz wrote:

> I think financial organizations should not become too big to fail.
> If they are too big to fail then they should be divided into more
> companies. Behemoths need to be the exception not the rule. If any
> one company would seriously pull others down, then that company should
> be divided when it is healthy.. A model could easily be developed
> regulators could use to determine when any one company could be a
> serious problem initiating a company split

Mar 05 01:13 PM

[User 366653:]

Here's a bank rescue plan that requires no initial outlay to isolate "legacy assets".

It would apply to the nineteen largest banks, and would work as follows:
The government would insure each bank's entire portfolio at the current value, subject to all applicable regulations and FASB valuation methodologies.
As a down payment for this insurance, the bank would issue non voting common shares to the government representing twenty-five percent of the bank's common equity. For each year that the insurance remains in force, the bank would issue an additional three percent non voting equity to the government, for up to ten years.
The bank would have the right to cancel the insurance at any time after three years.
The advantages of this strategy are:
Virtually no up-front costs to the taxpayer. In fact, the taxpayer would immediately receive tens of billions in equity.
Public confidence in the bank(s) would be fully restored immediately. The fear of government interference, as a result of "nationalization", would disappear because the government's equity stakes would be non voting. Confidence in the entire financial sector would most likely improve dramatically and immediately.
The value of the bank's common stock would probably appreciate immediately, resulting in a profit to the government/taxpayer.
The value of the bank's preferred stock, trust preferreds, and debt would immediately increase dramatically. This means the bank(s) would now be able to raise new PUBLIC and PRIVATE capital, and would not need additional Government funds. In fact, the bank(s) would be able to use the proceeds of new preferred stock to repay TARP ahead of schedule.
Furthermore, as compared to the plans already in place, and those being considered, the advantage of my idea is that virtually all the costs are POTENTIAL, and DEFERRED, rather than DEFINITE, and IMMEDIATE.
Additionally, it is likely that gains in the bank's share prices would offset a significant portion of any losses that may accrue from the insured portfolio(s). Since implementation of this plan would certainly hasten the recovery of our national economy, the assests insured by the government would be more likely to improve in value than to decline any further. In any event, the government will be in a better position to absorb losses, since the TARP money will have been returned, and no additional TARP funds would have been dispursed.
To summarize, my plan would "nationalize" the current loans of the banks, while leaving the banks intact, with no additional up front costs to the taxpayer. The "moral hazard" issue - helping the "shareholder" at the expense of the "taxpayer", is handled by making the taxpayer a shareholder. Confidence in the security of our financial system would be restored, and we could get on with trying to solve some of our other problems.

Mar 05 10:04 PM