"Financial system must tap the taxpayer"

Krishna Guha in the Financial Times argues that US banks need new equity ASAP to prevent the operation of a “financial accelerator,” which is basically, just as leverage feeds on itself, so to does deleveraging: falls in prices lead to margin calls, which lead to forced selling, which lead to more margin calls. We now have the institutional version of that phenomenon, which is that asset price falls lead to mark to market losses, which for banks holding similar assets on their balance sheets, generates an equal markdown of equity, which leads to deleveraging, further depressing asset prices.

Guha argues that private sources probably won’t step forward to provide the needed equity; therefore the government must, otherwise it will resort to monetary stimulus, which given the already worrisome uptick in inflation, isn’t such a hot idea.

I am not at all sure this is the right way to go about it. I have a problem with rescuing the institutions that caused the train wreck, particularly since in US style bailouts, the perps typically retain their former roles.

If the worry is a widespread run on financial firms, I’d much rather see measures that protected the customers. FDIC deposits insurance is what keeps dodgy banks still able to sell CDs (although rumor has it it actually takes a long time to get paid if the firm goes belly up. The powers that be need to remedy that). Measures that put a floor under customer exposures, rather than under the firms, seems less prone to moral hazard and a far more direct way of stemming mass customer exodus (although how you tailor this so that, say, the Fed doesn’t attempt to do something utterly implausible, like become the backstop for the credit default swaps market, would take some thought. You would probably need to identify the sort of counterparty risks that seemed to pose the greatest dangers to the market, and figure out if there was a way to put limits under them, in return for greater supervision and possibly specific restrictions on operations or gearing).

Otherwise, there seems to be a conflict in what Guha is arguing. He claims that housing prices (and presumably other inflated asset prices) need to fall. That implies losses to whoever lent against those assets. But for the government to keep trying to fill the bathtub while the drain is still open is politically fraught. Moreover, it also does not address the lousy psychology. How does it look if, say, the government puts $5 billion into, say, Lehman this quarter, only to have them come back next quarter for more?

Conversely, as Gillian Tett has argued (and I think she is correct here) there is money sitting on the sidelines that would come in and make investments, including recapitalizing banks, once investors had confidence that the bottom had been reached. Thus flushing out the losses is a vital to returning to some semblance of normalcy.

John Dizard has suggested the use of regulatory forbearance, which is code for letting the firms operate in some sanctioned manner with less than the normally required levels of equity (presumably with much closer oversight).

From the Financial Times:

The notion that the US could suffer the kind of deep and protracted recession that plagued Japan in the 1990s no longer looks as far-fetched as it did a month or two ago.

House prices are in free-fall, spreading losses through the universe of mortgage-backed securities and making it very difficult for financial markets to stabilise. The labour market is cracking, with three consecutive months of job losses in the private sector. Consumer sentiment has soured and spending is faltering.

Financial markets have taken another lurch downward – triggering emergency responses, including Thursday’s rescue of Bear Stearns, the Federal Reserve’s $436bn liquidity support package and proposals in Congress for $300bn in housing loan guarantees.

A “financial accelerator” is taking hold as banks react to losses and falls in the value of collateral backing loans by pulling back on their capital at risk, intensifying the credit crunch and aggravating the economic downturn. The pull-back in credit lines is transmitting distress from the banking sector to hedge funds – which are being forced to reduce leverage and sell assets into markets at firesale prices to meet margin calls in a classic case of financial contagion. As hedge funds cut leverage they are amplifying the effect of the contraction in bank balance sheets on the economy. This “great unwinding” is putting enormous stress on the financial system, including the market for mortgages guaranteed by Fannie Mae and Freddie Mac. Mortgage rates are much higher now than they were when the Fed resorted to emergency interest rate cuts in January.

The Fed cannot halt this negative spiral through monetary policy, even if it can mitigate its severity. Interest rate cuts have been largely offset by the rise in risk spreads. And there are limits to how much further rates can be cut amid concerns about inflation.

The good news is that as long as inflation pressures remain, the US cannot get stuck in an outright debt-deflation trap as Japan did in the 1990s. Indeed, the more inflation, the less nominal house prices will have to fall to deliver a required change in real house prices. But asset prices could still fall far enough to generate a vicious contraction in credit – at a time when wealth is declining and inflation is eating away at real income growth. That could be a recipe for a severe contraction in demand.

Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit.

What needs to be done? There is no silver bullet. Whatever happens, house prices will have to fall further to reach a fundamental equilibrium. But the key challenge now is to stop the financial accelerator in its tracks. That means one thing above all: additional capital for the financial system to stop the process of balance sheet contraction. That capital can come from one of two places – the private sector or the public sector.

By far the best solution would be for banks and Fannie Mae and Freddie Mac to raise large amounts of new private capital quickly – allowing them to treat estimated losses as sunk costs and start expanding their balance sheets again. There is more than enough private capital (and foreign sovereign capital) available. But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion.

Many financial sector executives apparently believe that likely losses are greatly exaggerated by mark-to-market accounting in dysfunctional markets. Meanwhile, their cost of capital is very expensive. It may be in their shareholders’ interest to hunker down, preserve capital and ride out the storm rather than raise expensive new capital to provide additional cover for losses that may never fully materialise.

If this is the case, the new capital will have to come from somewhere else: the public sector and ultimately the taxpayer, as the International Monetary Fund pointed out this week. The public sector could provide capital to the private financial system – for instance, by purchasing preference shares on terms more favourable than those available in the market. Or it could deploy its own balance sheet directly: intervening either in the mortgage securities market or the housing market itself.

This could be done through the Fed (which took a half-step in this direction by offering to swap $200bn of mortgage securities for Treasuries) or the government, either on balance sheet or through a special purpose vehicle. There would be severe costs either way. Public money for the banks would bail out existing shareholders. Direct intervention would require the public sector to set a price for mortgage securities and/or houses themselves. Either would foster moral hazard and expose the taxpayer to large potential losses.

But the costs of not providing public funds could be greater. Japan showed that incremental policy initiatives may not work. Rising inflation risk signals the dangers of addressing the problem through ever greater macroeconomic stimulus rather than – albeit large-scale – microeconomic intervention.

For those who oppose the use of public money, time is running out to prove that the private sector can recapitalise and calm the credit crunch without taxpayer funds – the best solution. Meanwhile, advocates of public intervention must determine how much money is needed and how to employ it to greatest effect.