Monday, September 29, 2008
institutional risk analyst: bailout won't work
the institutional risk analyst can run pretty warm on politics at times, which is enough to cast a shadow on credibility in spite of the fact that they are probably the best single independent analytical source regarding the banking crisis. i for one am happy to hear them in this missive step away from political persuasion and back to analytical persuasion. but the results are not cheering.
So let us try to describe in financial terms why we believe that the legislation currently being finalized in Washington will be ineffective in achieving the stated goal of restoring liquidity to financial institutions and thereby make it possible for banks to begin to expand their balance sheets and lending books, both of which are currently contracting at an alarming and accelerating rate. In a soon to be published article by Alex Pollock and John Makin, both of American Enterprise Institute, "The RTC or the RFC: Taxpayers as Involuntary Equity Investors," the two respected financial observers write:"A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital."
Pollock and Makin point out that simply buying bad assets from banks does not solve the most basic problem, naming restoring confidence in one another among financial institutions by ending questions regarding solvency.
... It is important for all Americans to understand that this financial crisis began more than a year ago with the collapse of liquidity in many types of mortgage assets, but the battle is quickly shifting to concerns about capital and solvency. The Federal Reserve System, Federal Home Loan Banks and the Treasury have already advanced huge amounts of liquidity in the form of debt to financial institutions in an attempt to help them stabilize their funding sources and slowly begin to re-liquefy. ... But unfortunately neither these existing sources of funding nor the proposal to provide even more debt-financed support gets to the core issue that is undermining in the financial system, namely worries about solvency.
... The difference between the current, RTC type model and the 1930s RFC model can be summarized succinctly: The bailout proposal now before Congress does not deal sufficiently with the issue of solvency and ensures that the US banking system will continue to deflate and de-lever, meaning that less and less credit will be available to the private economy and the recession is likely to be far longer and deeper. The present situation in the US economy is not nearly as bad as the 1930s, but if Ben Bernanke and Hank Paulson don't soon refocus their attention from liquidity to solvency of depository institutions, the US economy could end up in a situation that is much worse that the 1930s given the huge inflation of asset values seen over the past decade. This situation is soluable and can be quickly repaired, but only if we make capital and the leverage it can support work for us, not aganst us as is now the case.
With the RFC model, on the other hand, by quickly moving to inject capital into solvent banks, we can actually reverse the process of deleveraging and deflation that is currently grinding the global banking system -- and the world economy -- into the ground. By using new leverage and private capital, we can not only re-liquefy the banking system but also decrease the length and severity of the now present recession.
the whole article is must reading -- even moreso the stunning appended interview with robert arvanitis -- and some of it runs contra to bert ely's assumptions of systemic solvency. this is one of the first times that i have heard any mainstream analysis that admits the truth about american leverage -- if let to run, the delevering can bring on a disaster not as bad as the 1930s but in fact much worse. this is possible because -- as previously seen -- there is far more debt in the system as a function of income than in 1929. wolfgang munchau in today's FT (via yves smith) alludes to the ghastly size of american finance and the need for the system to shrink quite a lot before government can intervene with a hope of success, that is, without sparking a dollar disaster. to some extent, using the great depression as the yardstick by which all other crises can be measured is a failure of imagination.
this too did not escape the IRA:
Of note, in the WaMu resolution, equity and bond holders of the parent holding company were effectively wiped out - a significant landmark for bank investors that probably kills the private market for bank equity for the foreseeable future. Significantly, the advances from the FHLBs and the covered bonds issued by WaMu's bank subsidiary were conveyed through the receivership and assumed by JPM.
in other words, private capital raising is right out for the duration. government and government-brokered-and-backstopped deals are now the only game in town.
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i'm just one guy in a maelstrom. but i knew enough to sell all my bank stocks and my parents' bank stocks in 2006. i knew enough to sell my city condominium in late 2005 and start renting.
if i knew these things, clearly many, many people up the chain knew what was likely in the blind. and it would seem that most of them blundered right into it.
who listened? no one. now, i don't think anyone should listen to me particularly -- but i'd wager every single i-bank chief had more than one person who pointed out to them what now seems obvious. inertia won the day anyway.
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