Weighing the Government Action Options

Perhaps the biggest news in today's financial markets are the proposals being weighed by the U.S. government to either begin backing bank debt and/or to guarantee all banking deposits:

(From the WSJ): "WASHINGTON -- The U.S. is weighing two dramatic steps to repair ailing financial markets: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits…

...Under the U.K.'s recently announced plan, which it is now pitching to the G-7 members, the British government would guarantee up to £250 billion ($432 billion) in bank debt maturing up to 36 months. The British concept to expand its proposal to other countries has a lot of support from Wall Street and is being pored over by U.S. officials, according to people familiar with the matter.

White House spokesman Tony Fratto said the U.S. "is reviewing the idea and discussing it with our British counterparts."

The move to back all U.S. bank deposits, which is only in the discussion stage, would be aimed at preventing a further exodus of cash from financial institutions, including small and regional banks, some of which are buckling under the strain of nervous customers. In recent weeks, customers have pulled money out of some healthy community banks under the assumption that the government will only insure all the depositors of larger banks in the event of a failure...

...One major flaw in the global banking system, and a sign that problems extend beyond whether U.S. homeowners can pay their mortgages, is the fact that banks don't trust each other enough to loan beyond an overnight period. That means that cash isn't being circulated through the financial system and banks are relying too heavily on short-term loans, which does little to help pay off looming debts. Banks are hoarding cash, both to cover their debts and to improve their year-end books.

The plan in the U.K. was hammered out by Treasury Chief Alistair Darling as well as the chief executives of major British banks earlier this week after a sharp drop in U.K. bank stocks.

In the U.S., some $99 billion in just one type of bank debt is coming due between now and the end of the year. Hundreds of billions of dollars will need to be paid in the U.S. and Europe. Government backing would make it easier to issue new debt to help pay for that.

The problems in so-called interbank lending, or short-term loans made between banks, date to August 2007. Markets froze after a little-known German lender called IKB Deutsche Industriebank AG ended up with big debts it couldn't pay. More recently, the bankruptcy-court filing of Lehman Brothers Holdings Inc. sparked a new freeze in the interbank-borrowing market when money-market funds, laden with Lehman debt, yanked their cash out of the commercial-paper market, a vital cog in how companies fund their short-term obligations…

...Customers' fears have spurred bank runs across the country, especially at wounded financial institutions. IndyMac and Washington Mutual Inc. collapsed, in part, because of late runs on their deposits. Wachovia, which came close to failing twice in recent weeks, has seen large outflows of deposits since last week, according to someone familiar with the matter. Wachovia declined to comment on its deposits."

First off: It's worth noting the British Government stepped in to guarantee the deposits and debt of Northern Rock Bank last September, and was still forced to nationalize the bank after a multi-month search to find investors and/or buyers for the bank failed. Meaning: a bank in trouble is a bank in trouble and investors, customers and potential buyers will still avoid it like the plague despite the presence of a Government guarantee. The problem isn't so much a lack of faith in the strength of the guarantee per se, it's the fact that it doesn't truly address the root causes of the bank's problems.

With that said, let's quickly discuss the merits of both proposals:

Guaranteeing Deposits: the problem with this proposal is that it assumes that the people who make runs on banks are making rational decisions based on the amount of FDIC insurance available, as opposed to emotional decisions based on simply not trusting their bank, the FDIC and perhaps even the Government. The people who are making the runs on the banks (for the most part) aren't the depositors with several hundred thousand (or more) in the bank, they're the depositors who live paycheck to paycheck, just have several thousand in the bank and/or whose account balances are nowhere near the current (or past) FDIC insurance levels.

When these people make runs on banks it's never a question of the FDIC not providing enough protection as they don't have enough money for that to be an issue in the first place, instead it's a function of fear and simply not trusting the overall process (or bureaucracy) that is supposed to protect them.  They're people who need access to all of their funds and can't risk their money being temporarily inaccessible while a bank changes hands, after its closed down, etc, etc.

E.g. deposit insurance levels are only relevant to 100% rational actors and/or folks whose account balances exceed the current insurance limits.

While guaranteeing all deposits may inject some confidence into the markets, it will do very little to alter the actions of the people who are making the bank runs in the first place.

Guaranteeing Debt : more than anything this is just a stop-gap measure that will help the banks issue new debt to service their existing debt (which sounds like a problem in of itself) , as well as a desperate effort to get the banks to starting lending more to each other in general. However the problem with this measure is that it's not doing much to address the reasons why the banks aren't lending to each other in the first place: they're undercapitalized, overleveraged, suffering from increasing loan losses (across all types of loans, consumer and corporate) and know their peers are in the same boat.

While guaranteeing debt should help to stimulate things in the short-term, inter-bank lending won't increase over the medium to long-term until you address the core issues of leverage and capitalization. The problem with this measure (and others like it) is that it assumes that the credit crunch is merely a confidence issue, as opposed to systemic problem caused by banks needing to shore up their balance sheets via increasing the amount of cash on hand and paying down debt.

If the governments of the G-7 nations want to facilitate more inter-bank lending and abate the credit crunch, they need to start focusing on the bank's actual problems, stop viewing the crisis as merely a crisis of confidence and stop  looking for measures that are designed to force a broken system to operate again as if nothing is wrong. The only way to end this crisis is to start working on the bank's actual financial problems over the short to medium term, in addition to starting the planning process for rebuilding the global banking system over the medium to long-term.

While temporary measures may ease short-term pain, they will inevitably do more harm than good as they will prolong the medium term to long-term pain.

You can read more here.

Sources:

The WSJ:"The U.S. Weights Backing Bank Debt" -- Damian Paletta, Carrick Mollenkamp and John D. McKinnon, October 10, 2008.

Disclosure: At the time of publishing the author didn't own a position in any of the companies mentioned in this article.

Comments

[reph:]

If banks at risk raised deposit interest rates, they would have fewer problems getting funds. There is a lot of cash from the stampede out of riskier assets that would gladly sit in an FDIC insured account or CDs, if they paid 5-6% instead of 0.1-2.0%. Instead, bankers are crying wolf because they can't make a 5% spread anymore borrowing short to lend long, and the incompetent US govt is doing everything possible to prop up an unsustainable debt orgy without actually sweetening terms for those with capital

2008 Oct 10 01:51 PM

[mahony:]

Here-here to the above comment. I'd jump at CD's that yield 7-8%

2008 Oct 10 02:38 PM

[Smarty_Pants:]

The third unspoken option is for the government to simply let the insolvent banks fail and go bankrupt like a REAL free market. This would punish those who deserve it most and not everyone else.

Of course with only weeks to the election allowing banks to fail is not an option open for discussion. The Nanny State will save us from ourselves, whether we want it or not. It's for our own good. Really. Trust them on that.

2008 Oct 10 03:33 PM

[Markham Lee_:]

The real option should be cash infusions from the Government in exchange for preferred shares that pay HIGH I mean Tony Soprano high dividends.

That money should go towards infrastructure projects (50%) and the rest given to taxpayers as a special refund.

The banks (as r3ph said) should also just start raising the yields to 7-8% to raise capital, because at this point they're subprime borrowers so they should have to pay subprime rates for cash.

In fact the 7-8% interest rates on CDs coupled with unlimited FDIC insurance would basically solve the problem as investors would run towards that kind of yield right now.

I know I would.

Thanks for reading everyone.

-M

2008 Oct 10 07:02 PM

[Alan von Al...:]

I'm with Smarty Pants. Every atom of government distortion is both ineffective in achieving its stated purpose and has unintended adverse consequences. For instance, Cheney's program of 'liberating' Iraq to get oil. No one was freed, tens of thousands of Iraqis were killed and imprisoned, tens of thousands of US troops grievously mutilated, and Iraqi oil production collapsed, at a cost roughly 50X the advertised project cost. In the present situation, the Fed and Treasury have poured $2 trillion into a broken sewer that leaked money all over the planet. Now they propose to seize the sewer. Brilliant.

2008 Oct 10 08:43 PM

[Alan von Al...:]

From James Bianco (boldface his):

"The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them."

See? Told you so (hat tip Yves Smith, Naked Capitalism).

2008 Oct 11 03:20 AM