Willem Buiter has a penchant for ruffling feathers with his blunt pronouncements. He caused a firestorm at the Fed’s recent Jackson Hole conference by, in his presentation, telling the central bank that it was a victim of “cognitive regulatory capture” and was excessively sensitive to the needs and special pleading of the financial services industry. Even though the hosts took umbrage, they should not have been surprised, since Buiter had been saying that sort of thing for months.
Buiter lobbed another bombshell today, but because it was presented on his blog and (needless to say) the market meltdow was attention-grabbing, it appears to have gotten little note:
It’s reasonable to assume that the banking system in the North Atlantic region is insolvent and would be bankrupt but for the reality of recent government bailouts and the expectation of future government bailouts. Certainly, for the system as a whole, the marked-to-market value of its assets is way below that of its liabilities. I strongly suspect that even the hold-to-maturity value of its assets is well below that of its liabilities. Although the system as a whole is broke, there are no doubt individual banks that are solvent. We may not, however be certain as to which banks are solvent and which banks are not.
This is a bold, troubling, and probably accurate assessment. Note (if you read the rest of the post) that Buiter uses the term bank deliberately; he is not referring to the larger shadow banking system that has clearly run aground, but to its core, the regulated banking sector (plus, of course, its new additions, Goldman and Morgan Stanley).
More important, Buiter suspects that the banks as a whole are insolvent even if they hold assets to maturity. In other words, the argument that bank distress is due in large degree to mark-to-market pricing meeting a panicked flight to quality is wishful thinking. While many readers of this blog would agree with that view, it’s quite another for an economist with considerable central bank/regulatory experience to voice that opinion.
Assuming that Buiter is correct, then efforts to relax mark-to-market accounting are completely counterproductive. As discussed here and in the financial media, it serves to heighten mistrust by making financial statements less verifiable, and worse, even trying to put a fig leaf over this mess will not improve the picture sufficiently.
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As you say, Yves, the problem is lack of price discovery. We can see why Paulson has agreed to this MLEC on steroids, but the Federal Reserve chairman's defence is more perverse. Bernanke’s defense of the evaluation process can be interpreted in two ways. He could be saying the government’s liquidity and capacity to bear risk will create a new market equilibrium, and that Treasury will pay the new market price. Alternatively, his “hold-to-maturity” price could be the output of a long-term cash flow model. The two are not necessarily exclusive.
HOWEVER, either possibility raises problems. First, the valuation models that produce hold-to-maturity prices are highly sensitive to their assumptions, and can be used to justify virtually any price, removing any constraints on overpayment. They perpetuate a lack of price discovery. The price paid is probably above the benchmark established by Merrill Lynch’s recent sale to Lone Star, but certainly less than face value. The reality is that the Paulson plan looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. And it does not recapitalize the banking system, but merely facilitates the replacement of one dodgy asset with a better one.
One can certainly understand the rationale: The price arrived at for the bank's illiquid assets determines if there is any equity left in that institution, as well as any other institution holding similar assets. If the price is less than current level 2 & 3 marks, capital shrinks for the institutions in question, and more deleveraging must occur unless recapitalization is ready to go. Which means we are back in the vicious cycle, since deleveraging forces sales of assets, which forces price discovery, which is what triggers solvency or deleveraging issues, on and on…
It is here, at this crucial stage, as the reduced capital position is being made explicit, that one would prefer to see the public authority take a dilutive equity stake. This would have not only better safeguarded taxpayers’ interests (by minimizing the upfront costs and improving the prospects of making money on the deal), but given a more accurate gauge of what is actually required to get the banking system functioning again. Only genuine price discovery helps to provide a gauge of how much taxpayer recapitalization will be required (which is why we reject the Soros/Calomiris approach of simply recapitalizing without finding out what the Level 3 assets are worth) – if they are valued at pennies on the dollar, the taxpayer at least will not be laying out a lot initially, but the resultant write-downs will result in a much bigger taxpayer contribution. If that dilutes the existing shareholders, this is a legitimate means of punishing the players responsible for creating the crisis in the first place. If price discovery also leads to insolvency, then best to root out the bad banks straight away, whilst getting government guarantees for the depositors.
Price discovery and recapitalization, then, are intimately related. Until the suspect paper gets priced, nobody can know the size of the required recapitalization – no one, not even the Mighty Soros or Buffett.
This is news? We’ve known for over a year that most of the major players in the U.S. banking system are insolvent.
That was so Matt Dubuque of you. hehe
>They perpetuate a lack of price discovery.
Officials Refuse to Provide Details on Secret Previous Bailout
http://abcnews.go.com/Blotter/story?id=5930875
“I strongly suspect that even the hold-to-maturity value of its assets is well below that of its liabilities.”
“strongly suspect” is hard to construe as very authoritative.
is there any indication he “has something” that backs up his suspicion that the entire system is insolvent?
Thx!
`Hold to maturity’ valuation in this context means: the sum of undiscounted cash receipts, so that interest payments are counted as defeasing the purchase price. And even if the miracle of being made whole on the purchase price occurs, we’re to ignore the carrying cost, which is the government’s cost of funds. In other words, they’re pricing this paper without regard to yield or carrying cost — no wonder the price is higher than the `illiquid’ (i.e. yield seeking) markets. The putrid part is that our esteemed representatives and most of the financial press doesn’t understand any of this. What Paulson has gotten away with is convincing Congress that Fred paying you $1 a year for 100 years makes his loan worth $100 (even if, wink-wink, Fred will never pay you more than $25 total).
Anon of 12:27 AM,
Buiter is within the circle of top economists, although not currently in a policy role. Although this may not seem like much compared to Roubini’s fulminating, Buiter is basically saying what the officialdom does not admit, and he is not the sort to say that sort of thing casually, despite his taste for drama. In other words, it’s pretty significant given how he is placed (the willingness to start saying candidly how bad things are).
Douglas,
What you see as hedging is a simply not overstating his data. Only bank examiners could judge mark-to-maturity values. There is no way to make a definitive determination from the outside.
Mr. Buiter uses the term “North Atlantic” not North America, and from his previous articles this means the solvency issue is for banks in the US, UK, and Eurozone. The term probably comes from the North Atlantic Treaty Organization (NATO).
Kevin,
OMG, fixing immediately. I recall typing “North American” and thinking “that’s really weird, why is he not saying the US and bothering to include Mexico and Canada?” Sheesh.
I am no genius, and I have no special access to facts other than observation from my position in California commercial real estate, but I have suspected this (and have steadfastly argued this to almost everyone in my circle of acquaintances) since at least March. I can’t tell you how many arguments I had about WaMu. I think it is highly improbable that any of the major banks (other than Wells, and then only by a whisper) have assets marked-to-maturity greater than liabilities.
Holy Cow! Really! Gosh, this is shocking news! Totally unexpected.
or, not.
Is this article part of a New Millenia Retrospective for the intellectually disadvantaged. The only ones who did not know the system has been broke for at least a year are GWB and four guys living in a cave in Tibet.
Awesome journalism. The only redeeming thing is that it wasted only electrons, not trees. Thank God for the internet.
Wow!
I guess the lesson of Buiter’s comments is:
1. take your money out of the bank no matter what the FDIC limit is.
How is it that this whole thing was built on a pyramid of sand?
I may be stating the obvious, but the term insolvent is a euphemism for “theft occurred on a scale unprecedented in human history.”
I think the really shocking news in Buitlers piece is his proposal for a solution: Nationalisation of the banking system as a whole, enforced debt-to-equity sweps and maybe wiping out the shareholders – oh, and BTW, throwing the management out of the window without a gilded parachute. Now, is this dramatic or pragmatic, I cannot decide.
While many readers of this blog would agree with that view, it’s quite another for an economist with considerable central bank/regulatory experience to voice that opinion.
A rigorous mathematical proof that 2+2=4 would take about two-three pages of handwriting.
Get on with the common sense, economics academia. Drive around the suburbs in Anywhere, USA and see for yourself that the country is broke.
If the US banks are leveraged at 30 to 1, and the UK leveraged at 50 to 1, it doesn’t take very much for the whole system to be bankrupt.
Of course bankruptcy is a nominal term phenomina, so the possiblity of inflating our way out if it always there.
I think that banks are insolvent has been in plain view for a while, but as people with more clout and reputation start stating the obvious, it will at least deal with the 1st aspect of correcting the problem: reality.
And again, not is the blog wonderful, the comments are very insightful.
O, poor editing on my part!
It should say, “Not only is this blog wonderful, the comments are very insightful”
Like lending, haste makes waste.
Buiter suspects that the banking systems in the North Atlantic region as a whole are insolvent even if they hold assets to maturity. If Buiter is correct, then efforts of government bailouts won’t work, and could make things worse. Paulson’s Plan for example, is a bailout of reckless bankers, lenders and investors and provides little direct debt relief to corporate borrowers. Recall that lending and financing for the corporate sector is the main purpose of the financial system, not interbank lending.
Given the collapse of the corporate Commercial Paper market and the banking system reluctance to provide loans to the corporate sector, the only alternative is for direct lending to the business sector from the Fed or Governments.
This could include:
• Fed/Central Banks purchases of commercial paper from corporations and other forms of financing by Governments to small businesses secured in appropriate ways.
• Use the first installment of the $350 Billion of the Paulson Plan and set up 10 banks in the US initially capitalized to the tune of $35 Billion each. Sell shares in these banks worth $35 Billion to private investors with warrants to buy out the government shares at say 5% interest on the original government investment.
With 10:1 leverage, each of these new banks will have some $700 Billion lending capability or some $7 Trillion in total, ten times the Paulson Plan. These banks having clean balance sheets could easily, along with many sound existing banks, provide the credit the economy needs, even allowing for the failure of other banks with broken balance sheets.
“A rigorous mathematical proof that 2+2=4 would take about two-three pages of handwriting.”
It took Russell and Whitehead a volume and a half and 600 pages.
anon: “A rigorous mathematical proof that 2+2=4 would take about two-three pages of handwriting.”
a: “It took Russell and Whitehead a volume and a half and 600 pages.”
After the contributions to mathematics and finance by Matt Dubuque, it would only take 2 or 3 pages. Geniuses of his rank are rare.
OK, let’s see.
Is Buiter right?
The financial system, i.e. the banks, are insolvent.
Caused by, in case you haven’t noticed, a glut of debt thingies with 3 and 4 letter abbreviations.
For some reason, the solutions offered ALL involve pumping more debt, euphemistically described as capital, into the economic system?
The problem is too much debt, and the solution is even more debt.
The upside down pyramid of fractional-reserve banking is teetering.
While Hank and Ben figure new innovative ways to add more “weight” at the top.
And, thus, does not the doctor have the disease?
Isn’t there anyone out there listening long enough to see the benefits of the Chicago Plan solution?
And stop paying attention to the trees?
What is really needed is to separate out the banking function from the money-creation function.
Let the bankers lend their money, which is what everyone thinks they’re doing now.
Put the government in the proper role of creating the country’s new money.
The necessary infusion of capital should be debt-free, paid DIRECTLY to the American taxpayer on the full faith and credit of those taxpayers.
It’s time for trickle up economics.
Yes, the end of capitalism as we know it.
And the beginning of fair and honest capitalism and free enterprise.
Public credit.
Let’s get on with it.
Matt Dubuque
Buiter’s much ballyhooed paper at Jackson Hole contains an extensive portion excoriating the Fed for using a risk-based approach to monetary policy during this catastrophe, calling such discussions of tail risk “jargon”.
It’s pretty obvious to even casual readers of his blog that he has abandoned that view.
In terms of the comments about math, keep in mind that G. Spencer Brown’s Laws of Form that Russell described as “resolving” his concerns about the Theory of Logical Types only took up about 40 pages, far less than Principia.
And Wittgenstein’s comments about the inverse relationship between the elegance of a descriptive system and the inelegance of its descriptive terms informs that discussion as well.
Matt Dubuque
Buiter’s observation has been mine for fifteen months, and his proposed solution. At the end of the day we will have his solution if we don’t kill the currency first. Ben and Hank are doing their best to kill the currency first. Ahh me, if this was only a movie we could fire the screenwriter and re-cut the footage. But no.
The US and UK (at least) banking system is all but surely insolvent _in aggregate_ given what they put their money in, what the prices of that what were, where the prices of that what are going, and what the background economy is going to be like concurrently for the duration of the going forth. I only but wish we would cull the zombie banks and shepherd those still whole to keep the national financial economy from stroking out.
We have a surplus of banks of all sizes and as this process unwinds much old and new wealth will disappear with it. The illusion of wealth as a life style is coming to an end.
One element of the deleveraging underway is reluctance to create new credit. Another element is that existing debt goes bad. When one examines the aggregate commercial banking balance sheet published weekly by the Fed in the H.8 series, one cannot help wonder what the market value of the assets itemized really are — whereas we know the amount of the deposit liabilities.
If mark-to-market were temporarily relaxed to permit undercapitalized and insolvent banks to continue to operate while the Treasury’s recapitalization scheme is implemented, it would still be desirable to require banks to publish pro-forma statements for would-be investors that disclose assets valued at market value, since transparency for this purpose is essential to attract new private capital.
how can you say banks are insolvent when the financial and economic outcome is so uncertain?
market prices, driven by deleveraging, a cash squeeze, flight to quality and sheer panic, are no useful guideline to solvency.
but as marshall auerback rightly points out above, “hold-to-maturity” valuations are equally useless if these are based on cashflow forecasts, the assumptions of which (most important of which is whether we are headed into an enormous economic slump) are totally uncertain.
but the problem is not simply “price discovery”. the problem is very real “value destruction”. put simply, the financial crisis is doing brain damage to the economy. how governments and markets respond to stabilise the situation will itself do a lot to determine true value.
i personally am a big subscriber to soros’ approach, which is based on the fundamental observation that the idea of a “market equilibrium” is a sham. value does not just drive prices – the opposite can also be true, especially when a financial crisis can turn into an economic depression.
we can all agree that house prices must still fall, that a lot of debt won’t be repaid and that most banks need significant equity injections by government. but the extent of this process is very unclear, because in truth many outcomes are possible.
by simply stating the problem clearly and addressing it in a credible way, the government will do more than anyone else can to minimise the current value destruction and achieve a better “equilibrium” outcome.
for this reason i much prefer soros’ suggestion of relying on impartial government technocrats to determine the true value of banks’ assets and therefore their capital needs. hardly a perfect solution, but in reality there is no perfect solution.
what it will achieve is a recognition that the problem exists and a credible solution that will do something to stabilise expectations about the direction of the economy. i would much rather have the “price discover” determined this way than leave it to a market mechanism in the middle of a financial rout.
“I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning…It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase.”
http://tinyurl.com/3paq8t