Wolfgang Munchau often has a dour outlook, but his Financial Times comment today, “A new plan needed as the cycle grows vicious” is gloomy even by his standards.
Munchau argues that the heroic seeming measures to aid the banks are insufficient to compensate for the losses they are and will continue to suffer, and that as they understandably rein in lending, it will make the contraction more severe, worsening credit losses and deepening the cycle. Meredith Whitney has been making similar comments, but with a tad less urgency than Munchau.
While I agree with his concern, that a contraction can slip into a vicious circle, focusing on recapitalization as the primary policy response is wrongheaded. The Swedish in their salvage operation not only took over dud banks and hived off the bad assets, but they restuctured those loans and sin some cases even extended more credit to borrowers. And bailouts to banks without banking reform is a bad idea (and I see the Geithner talk of new measures as window dressing to appease the public in the hopes of eliciting support for the inevitable next round of rescues).
The only way out of a financial crisis is default, whether overt, through writeoffs and resturcturings, or covert, through inflation. This process isn’t even seriously underway until we see a lot more renegotiation.
From the Financial Times:
So you think you can see the green shoots of recovery? You draw comfort from the recent stabilisation of forward-looking indicators such as new home sales in the US? Or you think the stock market rally marks the end of the crisis? Of course, economic growth rates are bound to improve soon for technical reasons. Otherwise, not much would be left of the global economy by the end of the year.
Even if a recovery were to start early in 2010, as some optimistic forecasters believe, most of the pain of the recession is still ahead of us: unemployment and default rates will rise sharply everywhere. Most of the pain in the financial sector is also still ahead of us. This will feel like a depression long after it has ceased to be one.
I am more worried now than I was a month ago. The main problem is that the feedback loops between the real economy and the banking sector are truly scary….
At this rate of contraction, the number of private and corporate defaults is likely to increase massively beyond some of the stress-test assumptions made by the banks themselves. After the crisis caused by toxic securitised assets, the financial industry is now hit by another crisis of potentially similar magnitude…
Economists and policymakers who wonder how much it will take to recapitalise the banking sector are discovering that rescuing the banks is a much more dynamic exercise than they thought. Whatever you think it costs – and there have been widely different estimates – it is likely to end up costing you a lot more for that precise reason….
By the end of December, global banks had written off about $1,000bn (€752bn, £699bn) in bad assets, approximately half of that in the US. Since the onset of the crisis, the writedown of assets in the US has exceeded the provision of new capital. Even the Geithner public-private partnership plan is not going to reverse the expected deterioration of capital ratios….
In the absence of such plans, the banking sector will continue to contract its balance sheet by cutting lending. This is a totally rational response by the banks. To unfreeze the global financial market therefore requires significant increases in bank capitalisation, not just to the status quo ante, and not just to account for the toxic securitised assets themselves, but to adjust for the stuff that is getting toxic right now and tomorrow. The estimate by Alan Greenspan, the former chairman of the Federal Reserve, that one needs to push the ratio of banks’ equity capital to assets from 10 per cent to 13 or 14 per cent seems plausible to me. After a long period of undercapitalisation, you need a period of overcapitalisation just to get back to normal.
In other words, you have to do quite a bit more than you think you need to do, rather than quite a bit less. This is the main reason why the Geithner plan is not an optimal policy response. …. For all its technical ingenuity, this plan is at best insufficient – and more likely an expensive distraction that delays the inevitable policy response of a government-led recapitalisation programme.
Europeans think they have less of a problem because they already put bank rescue packages in place last Octo….But we have moved beyond the immediate emergency, and need a strategic response. Europe, too, will have to start to address the problem, by forcing banks to write down their assets in exchange for new capital. And not all the banks should survive. We must allow the sector to shrink while we recapitalise. This means many painful and unpopular decisions have yet to be taken….
The Europeans need a new plan. And the US needs a better plan.
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Munchau has it exactly right … and it could get worse if a bank blows up rather than get taken over. Then there are those tens of trillions in deratives lurking on the books.
Bernanke and Geithner must be crossing their fingers everyday … Unfortunately that is not a plan.
I am telling ya, if global liquidity get sucked to asia, things are going to be very painful.
Interest rate will have to raise. Either devaluation.
The only way out of a financial crisis is default, whether overt, through writeoffs and resturcturings, or covert, through inflation. This process isn’t even seriously underway until we see a lot more renegotiation.
Yup. And covert default through inflation is vastly harder to engineer, much less cleanly, than many so glibly suggest.
I remain a devoted Mellonite: let cascading defaults occur; protect people and families with social safety nets and the FDIC to the greatest extent possible, far more than we have today; and destroy some inefficient allocation and overcapacity.
Why stop banksters defaulting?
Its called tough love
No more spoilt children
Back in the old days when navies carried horses by sea a fear was often realised. When ships sink panicking horses are notorious for climbing on top of sailors already desperately swimming for their own lives.
The above is a metaphor for the big banks trampling and destroying small businesses in an effort to save themselves. It was originally argued that saving big banks was morally hazardous, a waste of taxpayers money. True. True. But the biggest failure of governments not allowing market forces and cpaitalism to work – is that zombie banks will allow many other sounds businesses (and smaller banks) to suffer – while they desperately cling to life. We now have the worst of all options – a collapsed banking sector crushing otherwise viable parts of the economy.
It took us a couple of decades to lever up to the sky. The descent will hence take a few years. Add that the crisis is global and that there will be no extra terrestrial demand to help us.
Many/most banks capital will be wiped out as consequence. Governments will have to open utility banks soon to perform the basic services the economy needs.
Geithner’s toxic asset plan, the more I think about it, seems to have been intentionally designed to be opened to gaming by the large zombie banks. Why? Because it keeps them relatively intact with possible up-side at taxpayers’ expense. That way, the U.S. will continue to host some of the most powerful financial institutions in the world and will thus be able to use them as another tool to project influence and power globally. The Obama Administration will be, more or less and directly or indirectly, controlling those institutions. Obama (Summers, Geithner, etc.) will thus be commander in chief of the U.S. financial system too.
This would then be an explanation why a Swedish solution was never seriously considered. The likely outcome of that would have been the dismantling of Citi, BoA, etc.
Geithner’s plan and the Obama Administration’s policy proposals make sense if you regard them as the U.S. Government taking in the major financial aircraft carriers for serious repair with the intention to re-commission them soon.
That the performance of the U.S. economy would have been better applying an alternative solution and that most of the other alternataives would have been more equitable is beside the point.
It is up to the citizens of the U.S., really, to protest against them banking the cost of maintaining the U.S. fiancial empire.
Why is that we blindly accept the proposition that a bank with toxic assets is going cut back its lending?
Clearly if they don’t have enough capital they are forced by regulations to reduce their lending. But there is no evidence that every bank in the US is under capitalized so why are those that not picking up the slack and taking this opportunity of making “good loans”. Is it possible because nobody knows anymore what a “good loan” is. But owning or not owning a toxic asset has nothing to do with establishing that knowledge. It raises the more important question of why we are trying to rehabilitate the banks with Toxic assets rather than pump up those without them through injections of cheap capital.(including chartering brand new banks)
Secondly, sufficient capital is not a universal constant. It is something that regulators came up with- and what they gave they can change. I find it particularly insane that a bank needs to have the same level of regulatory capital before and after they have taken a large write off. Either they were under capitalized prior to write off or they are over capitalized after it.
In other words the Toxic assets are an issue only if you are trying to preserve the previous financial structure. It has nothing to do with the needs of the economy.
Swedish Lex your comments regarding the likes of Citibank being a financial aircraft carrier is very interesting. It is the best explanation for the actions of the Obama administration besides venality or a brain dead adherence to failed ideology but out by Summers and Co in the 90’s.
The Obama Administration will be, more or less and directly or indirectly, controlling those institutions. Obama (Summers, Geithner, etc.) will thus be commander in chief of the U.S. financial system too.
If so, then let’s put the top exec bastards at all these firms on GS-level pay. I say the top end should be GS-13. It is FAR more equitable to pay them GS wages as opposed to Robber Baron/Marie Antoinette compensation…though they DO deserve the Antoinette ending.
@Swedish lex
Interesting take. I hope you don’t mind but I cited you in a letter to William Greider (The Nation) with the main points of your post in hopes of eliciting his opinion.
We, the Americans, are trying to hang on to our “top dog” status. While others are trying to pull us down. The world supremacy is what Obama, Geithner, Summers are trying to retain for the US. This is a tough task. Remember W loved to state to the lesser nations that “all options are on the table” — referring to our military might, our political maneuverability, and our economic influence. The disastrous wars in Iraq, and Afghan revealed the limitations to our military, exhausted all of our political good will and capitals. And now the implosion of the Wall Street banksters damaged the remaining option of economic influence. No wonder we are in a state of confidence-deficit. The old guards know it. The new guards know it. And they all want to do something about it. Interesting time indeed.
I was hoping to be able to write a guest post on this topic over the week end but ran out of time.
It does however not seem that we will be running out of topics anytime soon.
The Rocky Horror Picture (PPIP) Show at http://mgiannini.blogspot.com/2009/03/rocky-horror-picture-ppip-show.html
Many Europeans still seem to be under the impresison that the U.S. caused this crisis, and continue to play the blame game (always very popular in Europpe). As if it was the U.S. that told European banks to get into Eastern Europe.
This was a crisis growing organically on a global scale independently of what the U.S. did or did not do.
Vinny Goldberg
anecdotal i know.. but its dead easy to borrow in the USA right now, even jumbo. rates arent that bad. All you need is good credit and a downpayment and they will give you whatever you want.
all i can think is that when they talk about getting credit flowing they mean to bad risks and likely defaulters.
here in AZ prices on houses still way too high, long way to go yet short a ‘miracle’
Cannot simply pretend to be the fairy godmother, wave a magic wand of low cost capital around and expect banks to start lending. There’s a negative feedback loop destroying value in the economy. The process is explained well by Fisher’s Debt Deflation thesis. The negative feedback loop will only be broken when the liquidation of distressed assets comes to an end. Therefore, in order to avoid the so called “zombie Japanese bank” phenomenon, debt restructuring must play an integral role in the overall process.
As recently as last month, the Treasury was saying the banking system was more than adequately capitalized. It’s the fear of future loss that’s keeping a lid on lending, not necessarily current levels of capital adequacy. If it was strictly a matter of boosting bank capital, then why didn’t the original TARP program put a dent in the problem? The banks remain risk averse — they simply took TARP funds and invested in Tresuries.
According to my understanding of Fisher, the solution should be to restructure/eliminate the bad and nonperforming assets,putting a floor under asset deflation. This then sets the stage for reflation which restores confidence and the willingness to lend.
The idea of “bailing” out banks is to prevent a massive contraction in the money supply and a 1930s style economic depression.