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Anna Schwartz on the crisis
She offers a clear statement of the previous default point of view:
...this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."
This is almost certainly true if the number of "problem banks" is sufficiently small. It works less well if the number of problem banks is very large. And why might you believe the number of problem banks is large?:
1. The very actions of Bernanke and Paulson -- both smart and competent people and in the case of Bernanke with libertarian sympathies -- are signaling that the number of problem banks is large.
2. The credit freeze signals that the number of problem banks is large.
3. We cannot afford to take the chance that the number of problem banks is large.
4. Direct knowledge that the number of problem banks is large.
#1-3 seemed increasingly persuasive to me as the crisis went on, but it would be nice to shore up #4, which to this day remains weak. Of course since #4 is not independent of what government is doing at any point in time, the signal extraction problem is significant. If we see banks doing poorly, it could simply be that markets do not like the chosen remedy. Furthermore share prices reflect what the market thinks banks are worth, but only conditional on what policies the market expects.
Posted by Tyler Cowen on October 20, 2008 at 09:49 AM in Economics | Permalink
Comments
That all makes sense but the current US proposal makes no sense from either persepective. Forcing money on good banks and not imposing a penalty on the weak ones is just odd.Why should Wells Fargo face dilution while the investment banks get cheap finance? Won't someone think of the taxpayers?
Posted by: Bunbury at Oct 20, 2008 10:07:45 AM
One way to think about it is by estimating the magnitude of the decline in home wealth in the U.S., which is probably around $5 trillion or higher, with maybe half that decline coming in California.
Some of that rise and fall was cost free (my house temporarily went up hundreds of thousands in market value, but it didn't affect my spending or savings habits). But, a lot of that temporary rise got spent on granite countertops and rims, much of it on credit. So, that's a few trillion in wealth less than we thought we had. You can see why banks are shaky.
Posted by: Steve Sailer at Oct 20, 2008 10:07:58 AM
It is impossible to know how large the problem is when you can't look at a balance sheet to tell if a bank is solvent or not. And that problem is wide spread.
".... The root cause of the current lack of trust in our financial
markets is threefold:
1. Nobody can trust a balance sheet. This is due to off-balance-sheet
vehicles (which were supposed to be banned after ENRON) and "Level 3" assets, which nobody can analyze the true valuation of, as identification of the claimed assets and their valuation models are undisclosed.
2. Credit Default Swaps (CDS) are "over the counter" (OTC) transactions
with no margin or capital supervision. As a consequence nobody knows if their "counterparty" can pay. In fact huge percentages of these people can't pay - but nobody knows who they are.
3. Leverage. The SEC removed broker/dealer 12:1 leverage limits in 2004.
Every firm that has failed - all five (Fannie, Freddie, Bear Stearns, Lehman and AIG) had leverage far in excess of 12:1. The bailout bill is even more dangerous as it accelerates a provision intended to go into effect in 2011 that allows Ben Bernanke to increase financial firm leverage by dropping reserve requirements on banks to zero should he so choose. It is excessive leverage that got us here in the first place, and this bill actually makes it worse.
The solution to the trust issues in our financial system is elegant and
it will work.
1. Force all off-balance sheet "assets" back onto the balance sheet, and
force the valuation models and identification of individual assets out of Level 3 and into 10Qs and 10Ks. Enact this requirement beginning with the 3Q 2008 reporting period which begins next month. Total taxpayer cost: $0.00
2. Force all OTC derivatives onto a regulated exchange similar to that
used by listed options in the equity markets. This permanently defuses the derivatives time bomb. Give market participants 90 days to get this done; any that are not listed in 90 days are declared void; let the participants sue each other if they can't prove capital adequacy. Total taxpayer cost: $0.00
3. Force leverage by all institutions to no more than 12:1. The SEC
intentionally dropped broker/dealer leverage limits in 2004; prior to that date 12:1 was the limit. Every firm that has failed had double or more the leverage of that former 12:1 limit. Enact this with a six month time limit and require 1/6th of the excess taken down monthly. Total taxpayer cost: $0.00"
For more information about the plan, read
http://www.denninger.net/letters/genesis.pdf
Also read Karl Denninger blog, http://market-ticker.denninger.net
Posted by: David S at Oct 20, 2008 10:15:55 AM
1. The very actions of Bush and Cheney are signaling that the number of WMDs is large.
2. The ________ signals that the number of WMDs is large.
3. We cannot afford to take the chance that the number of WMDs is large.
4. Direct knowledge that the number of WMDs is large.
Someone please fill in the blank for me in number 2. I just couldn't resist given Tyler's #4.
Posted by: AZ at Oct 20, 2008 10:22:36 AM
I'm also somewhat skeptical of what Anna says. She seems to be saying a limited number of banks and thus a limited number of creditors would fail if the government took a principled nothing's-too-big-to-fail approach going all the way back to Bear Stearns, with new creditors seizing higher yields. But there are only so many people with money out there and many, such as foreign governments, sour on any possible downside risk. They over-invested their piles of cash in housing markets worldwide as risk-free investments with slightly better yields than T-bills. A sudden pull-out by them into only T-bills and commodities would be nothing sort of financial apocalypse.
Posted by: mw at Oct 20, 2008 10:27:09 AM
I agree with Davis S about the accounting and leverage changes, but I also think that the capital infusions are absolutely necessary. There are too many level three assets and liabilities, and firms won't be able to publish comprehensible, comparable disclosures in their 10-k's. The fact that there is no lending indicates two things. One is that not enough banks have enough capital to lend money at a reasonable operating levarage. The other is that the normal providers of capital (sovereign wealth, etc.), don't have enough confidence that these companies will be able to pay them back by generating profits. One of the reasons for the latter is that these funds don't trust that one investment will pay off, if the other players in the financial system go down. This is why the governments are the only entities able to provide this capital. They can provide enough to ensure that enough of these players are clearly solvent, and have enough liquide cashflow to continue to operate. For this reason, the government should purchase shares in many varied companies. This includes banks, insurers, real estate companies, manufacturers, etc. Presumably, the stock market can be relied upon to give a reasonable estimate of perceived value, and is a safe investment in the long term, assuming a diversified portfolio. The government can certainly afford to buy large stakes in many companies, and hold them for a while. For this reason, it is a relatively safe use of tax payer money, and help tax payers by improving the economy that they depend on.
Posted by: Sam at Oct 20, 2008 10:35:00 AM
"1. The very actions of Bernanke and Paulson -- both smart and competent people and in the case of Bernanke with libertarian sympathies -- are signaling that the number of problem banks is large."
Again, I say unto thee that I keep reading and hearing that smaller, regional banks are doing fine.
Capitalize them and let the BoAs, Wachovias and Citis fail (if they must).
Posted by: meter at Oct 20, 2008 10:39:05 AM
Two points. First, you never make clear what you mean by large in the context of the ongoing crisis. Second, your four points are weak, very weak--there is no evidence at all that Bernanke and Paulson are competent to understand and deal with the crisis; if the credit freeze were as large as you think, the US economy would have been in recession months ago; #3 assumes the conclusion; and you cannot have the DIRECT knowledge you claim because otherwise you had shown it and not written the previous three points.
As it happens in all crises, none knows and can know how many banks and other financial institutions need to be restructured or liquidated. That's why the initial idea of the Paulson-Bernanke proposal was right (as Anna says in the interview): it could have been implemented to give an incentive for problem banks to participate in the program (remember that the original proposal didn't make explicit the terms and conditions for the purchase of assets and these terms and conditions could have been written to provide such an incentive; a point that Allan Meltzer tried to make by making reference to the experience of Chile in 1982-83).
Posted by: E. Barandiaran at Oct 20, 2008 10:39:47 AM
Hmm. Tyler describes Bernanke as having "libertarian sympathies."
I guess that's why he said this morning, "With the economy likely to be weak for several quarters, and with some risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate."
You can read the full article here: "Bernanke gives nod to more government stimulus," http://news.yahoo.com/s/ap/20081020/ap_on_bi_ge/bernanke
Sounds like a good libertarian to me. Ergh. I guess it's just more establishment apologies from Tyler in the name of "pragmatism."
Posted by: at Oct 20, 2008 10:41:22 AM
So, at what point does the number of banks go from sufficiently small to very large, and therefore cause
the principled approach to work less well?
Posted by: Ryan at Oct 20, 2008 10:43:25 AM
The basic problem is that we aren't as rich as we thought we were two years ago. The question is merely the precise mechanism by which the savers and or taxpayers will be shaken down to pay for debts run up by people who lived high on the hog.
Posted by: Steve Sailer at Oct 20, 2008 10:45:14 AM
I used to think that Anna Schwartz was a pretty good economist who knew a lot about money and banking, but it's clear that Tyler and most of the commenters here disagree. Anna coauthored what is still the single most important work in monetary economics and has been thinking about this stuff for over 50 years, but you dismiss her with a few hand waves. The hubris around here is amazing.
Posted by: Jeff at Oct 20, 2008 10:45:45 AM
Paulson is smart but his goals are not to help the people they are to help himself and his freinds.
Bernanke is smart but he is not libertarian he is a servant of the people who wish to increase the power of the fed and the treasury.
What is the evidence that Paulson and Bernanke want to help the people more than Goldman Sachs and JP morgan? there isn't any. They have engaged in direct robbery from the people to the benefit of the establishment who has been destroying our free markets for 90 years.
Posted by: gabe at Oct 20, 2008 10:49:28 AM
Colin Powell is smart with libertarian sympathies so we have to trust his thoughts on WMD's and mobile death trailers in Iraq.
Posted by: Gabe at Oct 20, 2008 10:52:25 AM
Aren't there thousands of small banks still around? I agree with her in this case. We should save only the best banks for now,and let them get going, and then deal with increasing the number of banks later.
Posted by: Don the libertarian Democrat at Oct 20, 2008 11:14:53 AM
What if the credit freeze and such is the banks effectively saying, "Let's just wait until Obama is elected. He'll appoint an economic transition team, and we can start moving forward with the folks who'll be in charge for the next 4yrs instead of accepting the decisions of a lame duck administration." Then, the thaw should begin in the first week or two after the election, assuming they like what Obama's team would be offering.
Posted by: RSaunders at Oct 20, 2008 11:22:48 AM
2. The ________ signals that the number of WMDs is large.# of imported aluminum tubes.
Posted by: kurt at Oct 20, 2008 11:25:28 AM
Also, keeping alive "firms that should be shut down.", doesn't make a lot of sense on the face of it.
Posted by: Don the libertarian Democrat at Oct 20, 2008 11:26:00 AM
From above:
1. The very actions of Bernanke and Paulson -- both smart and competent people and in the case of Bernanke with libertarian sympathies -- are signaling that the number of problem banks is large.
2. The credit freeze signals that the number of problem banks is large.
3. We cannot afford to take the chance that the number of problem banks is large.
4. Direct knowledge that the number of problem banks is large.
I'm starting to wonder how closely Tyler read the cited article. Since the discussion centers around point 1, we cannot use point 1 as an argument against the article. Doing so assumes the article is wrong, which is obviously what we are discussing.
Point 2 is covered in the article. The argument there is that the credit freeze results from uncertainty, not a clear knowledge of a large number of problem banks. Again, we cannot use point 2 as an argument against the article without first proving the point. I see no efforts to do so in Tyler's post.
Point 3 is just fearmongering. We can "afford" anything we want. We just don't want to afford it. It would make our lives less comfortable for years to come. We'd much rather throw money at the problem and hope it goes away.
By Tyler's own admission, point 4 is going to be very hard to prove.
Gee, we're out of points to consider...
Posted by: George at Oct 20, 2008 11:44:24 AM
I could understand the argument that we needed to TEMPORARILY prop up the system in order to prevent a crash that would have massive collateral damage.
I cannot understand why we need to keep LOTS of insolvent banks alive indefinitely. We should be trying to transition from a large number of problem banks to a smaller number of sound banks without breaking the rest of the economy.
If we are never going to let problem banks fail, it would be more honest to nationalize the banking system outright and admit that we have given up on markets entirely.
Posted by: Matt C at Oct 20, 2008 11:45:48 AM
The FDIC is "signaling" that about 107 banks are a problem. I think we can live without 107 banks.
Posted by: David at Oct 20, 2008 12:03:30 PM
Bank of America CEO Ken Lewis on 60 Minutes Sunday indicated (indirectly) that BoA was one of the problem banks. By stating 3 to 5 years to pay off the federal government's preferred stock taking, he is projecting going 1 to 3 years into high interest rate period for those holdings. If the bank is solid, it should pay off the loan during the low interest period - two years.
But, hey, I'm probably wrong about this.
Posted by: Peripatetic Entrepreneur at Oct 20, 2008 12:25:06 PM
The banking system: All banks are insolvent if depositors start lining up at the door.
Individual banks: Some banks are more insolvent than others.
Back to the banking system: When you see people lining up at the bank around the corner do you get in line at your bank?
Posted by: Andrew at Oct 20, 2008 12:36:24 PM
By the way, Calculated Risk has a (daily?) post on various credit indicators showing day over day deltas.
Posted by: meter at Oct 20, 2008 12:52:05 PM
We cannot afford to take the chance that the number of problem banks is large.
By what criteria?
As for number 1, that's never a good argument to make. The "very smart people believe this" argument is always a flimsy substitute for looking at the case for something on its merits. It could be that "very smart people" such as Bernanke and Paulson benefit personally from what they advocate. Or it could be that being "very smart" doesn't necessarily always mean "very accurate".
Posted by: Adam at Oct 20, 2008 12:54:37 PM
