It is unclear what the federal policy is regarding the bad debt on banks’ books. Aside from shuffling some of it from certain banks to the Federal Reserve banks, not much has been done, except to abandon that effort.
As I have written recently, one approach would be to have bankruptcy-like bank reorganizations, presumably in the form of FDIC proceedings. This would enable the government to scrape the bad debt off, along with the stockholders and management of the banks, and sell the reorganized and smaller banks back to the public. No moral hazard attends this solution. Yet if deeds and actions could speak, it seems that this alternative is not acceptable to our government, probably because of the politics of it –banks want their cake and to eat it too.
Many other options entail moral hazard, and they are certainly not on the table as they would rile the public too much, who is growing sensitive to being gouged.
My preferred solution is to have the Fed buy the bad debt of banks at face value with newly created money. They would then take equivalent stock back for the difference between face value and market value, diluting existing shareholders. The new money, when deposited in the banking system, could then be mopped up using a higher reserve requirement. Some bad debt could be sold at market and some held.
The government might actually make some money here if bank stocks later appreciated. The real losers under this option are the shareholders. However, the government and the Fed have not shown any recent interest in any option like this one either, probably again for political reasons. Those associated with banks may not be harmed unless they are solely depositors who can recover.
The Fed and the government’s approach seems benign, not wanting to injure anyone associated with banks, except perhaps the taxpayers in passing. This interpretation is consistent with the observed political lay of the land. It also comports with the reasons for setting aside the mark to market rule.
So what is federal policy here? My take, based on what is being done or not done, is that the unexpressed policy has two components. The first is to let the housing market reach what we can agree is the bottom and let it settle out. The other component is to then assess what I will call the “Latin America default” model.
Consistent with the thoughts underlying suspension of the market to market rule, the implicit view here is that the housing market is out of whack and does not provide fair valuations for the debt on banks’ books. Once that market stabilizes, and the economy recovers, we can then gauge the situation and determine whether the Latin American default model is workable and if so, use it. What is that model? Let me explain.
The relevant history in a nutshell is as follows:
Beginning in the late 1960s and through most of the 1970s, many Latin American countries, notably Brazil, Argentina and Mexico, borrowed huge sums of money from international creditors and US banks for industrialization, especially for infrastructure programs. These countries had rapidly growing economies at the time, and the banks were happy to continue to provide loans. Between 1975 and 1982, Latin American debt to commercial banks increased at a cumulative annual rate of 20.4 percent. Latin America quadrupled its external debt from $75 billion in 1975 to more than $315 billion in 1983, or about 50 percent of local GDP.
Then the world economy went into recession in the late 1970s and early 1980s, with oil prices skyrocketing, and the debtor Latin American countries found themselves found themselves in a real liquidity crunch. At first, the oil exporting nations financed some of the Latin American debt interest, but as interest rates rose, the Latin American countries could not repay their debt when much of it came due and they defaulted.
US banks, which held much of the debt, were basically rendered insolvent over night. The question was what to do. The answer was essentially nothing -- just to sit on the situation. By the late 1980s, many Latin American countries had recovered and were experiencing strong economic growth and much development. Under pressure to do so, they initiated debt management, repayment and rescheduling programs. The net effect was essentially to make good on enough of the Latin American debt held by the US banks to bring their insolvency down to manageable levels which could be eliminated over time from profits.
It seems as though the Fed and the government have adopted the Latin American default model for the current insolvency crisis of the banks. But the question is, is that reasonable? I suggest that it is not.
Defaulting countries in a recession differ markedly from defaulting home buyers who have already gone through foreclosure or repossession, especially in states with anti-deficiency laws. As the economies pick up in both situations, the public debt of foreign countries can be repaid and rescheduled, but not the debt of defaulted home buyers who have long since left their homes. This difference is enormous.
While it is reasonable to expect an entire economy to recover to at least its previous level, it is patently absurd to expect the housing market in the US to recover to its former bubbled up condition, with such high and unsustainable prices and attending mortgage levels. For these reasons, I believe that the Latin American default model is not a good federal policy for the US for three reasons.
That leaves us only waiting for the housing market to level and bottom out to decide what we should do about the insolvency problem with our banks. There is no silver bullet here. A perpetual stall mode will not work. A recovery is not going to increase banks profits sufficiently to let them dig out over time by themselves. Not even mega trading profits will permit that. At some point, our government is going to be forced back into one of the options I have outlined here or earlier.
Stalling may help a bit and clarify the situation, but there is no way out along the present path, though many might wish that were so.
Disclosure: No positions
