Tuesday, June 2, 2009

But I think all we’ve done is replace an explicit guarantee with an implicit guarantee.

From the Baseline Scenario:

"Explicit and Implicit Guarantees

with 9 comments

Note: I wrote this post on May 18 but somehow forgot to publish it; I just found it in my drafts. It’s a bit out of date, but I think the point still stands.

I’m not sure if it’s official, but it’s been widely rumored that large banks that want to repay their TARP money will have to be able to sell new debt without the FDIC guarantee they got back in October. As a result, banks are falling over themselves with new, non-guaranteed debt offerings. The idea, I guess, is that banks that can raise money without the guarantee are showing that they are sound enough to operate without government support.

But I think all we’ve done is replace an explicit guarantee with an implicit guarantee. In October, no one was sure whether the U.S. government would bail out bank creditors in a pinch; after all, Lehman creditors got back less than 10 cents on the dollar, and AIG creditors took a big haircut because the Fed’s credit line came in senior to them. So the explicit guarantee was necessary for banks to issue debt.

Since then, however, the government has shown in many ways that it isn’t going to let major banks fail or force a restructuring (indeed, it insists that it can’t force a restructuring). The message of the stress tests, ultimately, was that Treasury is standing by to provide whatever capital is needed. In that situation, what risk do bank creditors face? Virtually none, except maybe political risk (the risk that the government’s policy will change). So the banks get to raise money without the stigma of a guarantee, they don’t have to pay a premium to the FDIC, then they get to pay back their TARP money, and the government can say that the banking sector is healthy. Everyone’s happy.

And if things go badly, the taxpayer is still there to make good on all those non-guaranteed bonds – at least for the banks that are, still, too big to fail.

By James Kwak"


Let’s look at China. China sold Agencies, Implicitly Guaranteed, and bought Treasuries, Explicitly Guaranteed. Now, they did this, apparently, after the way that Fannie/Freddie was bailed out, and Lehman was allowed to fail, and WaMu was seized. China immediately stated that they had previously believed that these implicit investments were really explicit. After they heard that we might haircut the bondholder’s of banks, they stated this point even louder, and threatened negative consequences.

My answer, and Geithner’s, was to guarantee everything. Explicitly. Now, were there any negative consequences to China’s shift from Agencies to Treasuries? In my opinion, there were. For one thing, it was part of a massive deflationary flight to safety that almost led to Debt-Deflation. Had that occurred, unemployment could have doubled, from these current levels. The point is that no one knows.

If the question is whether or not these banks are guaranteed, the answer is yes. See, we deregulated, but also guaranteed, these big banks. Does that remind you at all of the S & L Crisis, which was a bipartisan foul up, which is why it never really came up in the 1988 election. Neither party could get an advantage from the issue.

The Federal Government will never allow Debt-Deflation, or a serious threat of it. That reality, combined with the fact that we have a Lender of Last Resort, the Fed, and, now, the Treasury and FDIC as well, mean that we will always have guarantees going forward. The answer, then, needs to be regulation. Since I’m no big fan of regulators, I prefer Narrow/Limited Banking on the one hand, and an insured Investment Industry, on the other. Either self-insured, or by government. This part of my view is very close to Gorton’s view.

Without these kind of changes, we’ll be back here again soon. I’m sorry to have such a jaded view of regulators, but these foul ups just keep coming. Hence,although I used to favor Bagehot on Steroids, meaning a very tough regulator, I just can’t seem to believe in that possibility any longer.

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