Saturday, February 28, 2009

This is the rub. Squeezing these creditors could potentially lead to a Lehman-like systemic threat

From Free Exchange:

"More perspectives on Japan and nationalisation
Posted by:
Economist.com | WASHINGTON
Categories:
Financial markets

VIEWS on the nature of the problem in America's banking system continue to roll in. Justin Fox quotes an analysis of the situation by Richard Katz, who suggests that the Japan parallel is overblown:

It took the Bank of Japan nearly nine years to bring the overnight interest rate from its 1991 peak of eight percent down to zero. The U.S. Federal Reserve did that within 16 months of declaring a financial emergency, which it did in August 2007. It has also applied all sorts of unconventional measures to keep credit from drying up.

It took Tokyo eight years to use public money to recapitalize the banks; Washington began to do so in less than a year. Worse yet, Tokyo used government money to help the banks keep lending to insolvent borrowers; U.S. banks have been rapidly writing off their bad debt. Although Tokyo did eventually apply many fiscal stimulus measures, it did so too late and too erratically to have a sufficient impact. The U.S. government, by contrast, has already applied fiscal stimulus, and the Obama administration is proposing a multiyear program totaling as much as five to six percent of U.S. GDP.

On the other hand, when Japan finally did pull out of its slump, recovery was entirely export driven. It seems extremely unlikely that America will be able to duplicate that feat, particularly since other major exporters, like Germany, China, and Japan, will be trying to do the same thing at the same time.

Also very much worth reading is Matthew Richardson's detailed explication of the advantages and disadvantages of nationalisation. There are distinct advantages to such an approach. It's the surest way to clean up a bank's balance sheet, and it addresses moral hazard issues. But there are serious risks:

Of course, the tricky part of nationalisation is the handling of the bad assets. The bad assets would be broken into two types – those that need to be managed, such as defaulted loans in which the bank would own the underlying asset, and those that could be held, such as the AAA- and subordinated tranches of asset-backed securities. With respect to the former, the government could hire outside distressed investors or create partnerships with outside investors as was done with the Resolution Trust Corporation in the 1980s savings and loan crisis.

Along with the equity of the good bank, these assets would be owned by the existing creditors. The proceeds over time would accrue to the various creditors according to the priority of the claims. Most likely, the existing equity and preferred shares would be wiped out, and the debt would effectively have been swapped into equity in the new structure. Under this scenario, it is quite possible, even likely, that taxpayers would end up paying nothing. This is because, for the large complex financial institutions, these creditors cover well over half the liabilities.

Emphasis mine. This is the rub. Squeezing these creditors could potentially lead to a Lehman-like systemic threat. That's something the government would obviously wish to avoid."

Me:

I see the problem, but I disagree in one point. Lehman caused a Calling Run in which investors even tangentially connected to the causes of the crisis began calling in cash and putting it in safer investments. In other words, it was not a localized run. I'm basically saying that Fisher's Debt-Deflation actually began then, but that it has been a slow-motion form of it because the Fed and Treasury have acted forcefully, if not to my liking. We are currently in it, but struggling to stop it.
In order to stop it, the government needs to be seen as standing as a reliable backstop to our crisis. Lehman showed the opposite. The problem was not poor intervention, but no intervention. No one here can argue that we haven't intervened.
So, in my view, the losses from the scenario in this case will in fact be localized. It will effect banking stocks and some other investments, but it will be confined to just those areas, not a general Calling Run.
On the other hand, for many of the rest of us, including investors, the Government will be seen as finally being willing to do what it takes to end this crisis, and in a way that is dedicated to the general taxpayer first, not a view which says that we are held hostage by private financial businesses. That aspect, of the government in effect saying that the banks own us, has been a real drag on confidence. As well, since the banks are considered worse than incompetent, leaving them running the show has also been a real drag on confidence. Add in the fact that this cowering by the government makes it appear that nothing will change going forward, and you have a confidence destroying brew.
If what I just argued comes true, it will be a huge confidence booster for the government and average taxpayer, and might well be the one action that can begin a real clean up of this mess and transformation to a saner financial arrangement. If what I argue comes to pass and it's a disaster, don't blame me. I'm just a guy at a PC posting his view's on a blog trying to get a discussion started.
2/28/2009 4:07 PM GST

I just read Paul Wilmott, a man I greatly admire:

"5. Finally, the shares are non voting so as to give the impression, albeit rather feebly, that RBS has not been nationalized. Look, the Taxpayer owns 90% of RBS, and can vote on 75% of the shares. Why keep up the charade? Nationalize all dangerous banks, across the globe, immediately. Guarantee the deposits of the man in the street. And clean up the mess in an atmosphere of relative stability."

http://www.wilmott.com/blogs/paul/index.cfm/2009/2/28/The-Mother-Of-All-CDOs

Let's end the charade. That's the name of this movement. I don't think that I'd be allowed in any of the clubs of St.James's, unless I came in by the servant's entrance.
2/28/2009 4:32 PM GST

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