"The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. "

From the FT:

"By Ricardo Caballero

World financial markets are being ravaged by uncertainty and fear( YES ). The prices of all forms of explicit and implicit financial insurance have skyrocketed and hence, by a basic identity, the prices of risky assets have plummeted or the corresponding markets have disappeared.

Nowhere is this scenario more problematic than in institutions with strict capital requirements, such as banks, insurance companies, and monolines. For them, fire sale asset prices quickly wipe out their capital and, simultaneously, destroy their option to raise new capital since equity values implode. ( A CALLING RUN )

The conventional advice is for these institutions to deleverage and to raise capital. While this is sound advice when dealing with a single institution in trouble, I believe this is exactly the opposite of what we need at this juncture of a massive systemic crisis.

Forcing institutions to raise capital, be it private or public, at panic-driven fire sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fuelling the downward spiral. This is self-defeating.

The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. If it is, then a solution to the financial crisis is in sight since it would free up trillions of dollars of hard to raise funds, covering more than even the most extreme estimate of losses.

I believe it is feasible to run such a system for a while, because, essentially, distressed financial institutions need (regulatory) capital for two basic purposes: To act as a buffer for negative shocks, and to reduce their risk-shifting incentives by exposing them to their losses.

However these two functions can be replaced, respectively, by the provision of a comprehensive public insurance( OK ), and by strict (and intrusive) government supervision while this insurance is in place.( OK )

A few days ago the UK announced a policy package that almost got it right, by pledging to insure banks’ balance sheets and other private liabilities.( YES )

Unfortunately, it backfired and caused a worldwide run on financials because it did not dissipate, and even exacerbated, the fear of forced capital raising (or nationalisation).( IN FINANCIAL STOCKS, YES )

The events following Lehman’s demise should have taught us that this fear needs to be put to rest until we can return to normality. Financial institutions are too intertwined to predict with any precision the impact of diluting any significant stakeholder, and the markets are too fearful to feed them more uncertainty. Strong guarantees with strict supervision( I'M DUBIOUS ), and the commitment of no further capital injections at fire sale prices (directly or through convertible bonds) should go a long way in building a foundation for a sustained recovery.

With some dismay, I read that an enormous amount of time is being spent discussing what should be the price of the insurance and the first-loss threshold. It seems to me that given the extreme severity of the crisis and the asymmetries involved in failing in one or the other direction in each of these issues, the answers are rather obvious: The price of the insurance should be very low – say risk-neutral pricing plus 20 or 50 basis points of markup; and the first-loss threshold should be sufficiently low that no new capital will need to be raised in the short run if a loss arises.

The second intervention of Citi offers a micro-model of such an intervention, but it needs to be scaled up within each bank and massively across all banks and other key financial institutions. It also needs to be made much more attractive to all systemic financial institutions, even those that are not in deep distress.

What about the taxpayers? The best that can happen to all of us is that the financial crisis ends as soon as possible. This is the first priority, the rest can wait. If the transfer to the financial institutions ends up being too large for society’s taste, then it is always possible for the government to undo some of it through ex-post taxation of excessive earnings. Conversely, if the transfer is too low (the price of the insurance and the first-loss threshold too high), it may well be that we do not get another chance, at great cost not only to financial institutions but also to taxpayers.

Ricardo Caballero is head of the department of economics, the Ford international professor of economics and co-director of the World Economic Laboratory at Massachusetts Institute of Technology"

I posted this without knowing that it would only appear if I was an expert:

“We have more capital so we don’t have to sell good assets in bad markets,”

From the FT, I actually understand what Liddy of AIG is saying:

http://www.ft.com/cms/s/0/86c1cf26-aefc-11dd-a4bf-000077b07658.html?nclick_check=1

“Mr Liddy said that with the new plan, the authorities wanted to avoid a repeat of the credit markets paralysis that followed the collapse of investment bank Lehman Brothers, which went bankrupt just before the first rescue of AIG.

“The collapse of Lehman caused the credit markets to freeze up. Had AIG gone, it would have been even more significant,” Mr Liddy said.

Mr Liddy pledged to press on with a wide-ranging programme of asset sales aimed at raising funds to repay the $100bn in capital injected by the government.

He said the extension of the duration of the main government loan from two to five years and the cutting of the loan’s value from $85bn to $60bn would ensure AIG did not have to dispose of businesses at fire-sale prices.

“We have more capital so we don’t have to sell good assets in bad markets,” he said. AIG has not announced a single major disposal so far, partly because potential buyers have not been able to get funding.”

How is this any different than what you are proposing? If we loan them the money or guarantee it, it comes to the same thing, doesn’t it?

What if the assets turn out to be worthless in the case of AIG? You would tax them afterward, assuming that they survive? What if they merge? How long would it take to get the money back? Are you going to change our system of government so that they can’t lobby away onerous conditions, as they already in fact have?

The financial stocks went down because of nationalization, but I doubt that Walmart fears nationalization. The uncertainty and guarantees are the key, but your plan doesn’t offer either. Plus, it asks the citizenry to accept getting rid of capital standards when many people are calling for them. Doesn’t that add to uncertainty? And leaving proven buffoons in charge? That adds to certainty.

The only certainty that I see is that the banking lobby is damned powerful. So powerful that, after causing a systemic crisis, we’re bending over backward to save them.

I hate to keep pushing a guy named Bagehot, but how are these terms you are proposing onerous? They sound like a gift from God for the banks and their shareholders. The uncertainty is about them, not simply the government.

Posted by: Don the libertarian Democrat | January 26th, 2009 at 10:52 pm | Report this comment