(2) make banks smaller, less powerful, and much more boring.

TO BE NOTED: From The Baseline Scenario:

"What Next For Banks?

with 45 comments

The case for keeping banks in something close to their current structure begins to take shape. It’s not about traditional claims that big banks are more efficient, or Lloyd Blankfein’s argument that this is the only way to encourage risk-taking, or even the House Financial Services Committee view that immediate resumption of credit flows is essential for preserving jobs.

Rather, the argument is: those opposed to banks and bankers are angry populists who, if unchecked, would do great damage. Bankers should therefore agree to some mild reforms and more socially acceptable behavior in the short-run; in return, the centrists who control economic policymaking will protect them against the building backlash. This is a version of Jamie Dimon’s line: “if you let them vilify us too much, the economic recovery will be greatly delayed.”

There are three problems with this argument: it is wrong, it won’t work, and it doesn’t move the reform process at all in the right direction.

The “center vs. the pitchforks” idea fundamentally misconstrues the current debate. This is not about angry left or right against the center. It’s about centrist technocrat (close to current big finance) vs. centrist technocrat (suspicious of big finance; economists, lawyers, nonfinancial business, and - most interestingly - current/former finance, other than the biggest of the big, particularly people with experience in emerging markets.)

Just as an example, a broad range of entirely centrist people (including in and around the IMF; former Treasury; you’d be amazed) are expressing support for the ideas in our Atlantic article. People on the left are, not surprisingly, also in line with this view; but we’re also hearing convergent thoughts from some on the right - many who emphasize improving the environment for entrepreneurship don’t see big finance as their friend. So far, the only person who called to complain works for an “oligarch.”

You might think the “anti-pitchfork” strategy might work, particularly as it has in the past (e.g., in the early Clinton years). The problem for this strategy now is not just the fragile state of banks - by itself this can be ignored for a long while through forbearance, behind a smokescreen of complicated schemes with confusing acronyms - but the ways in which the markets they created now operate.

Just as global financial liberalization created the potential for capital to move violently across countries and greatly facilitated speculative attacks on currencies, so financial deregulation within the United States has made it possible for capital markets to attack - or, in less colorful terms, go short or place massive negative bets on - the credit of big banks and, in the latest developments, the ability of the government to bailout/rescue banks.

The latest credit default spreads data for the largest banks show a speculative run underway. As the system stabilizes, it becomes more plausible that a single big bank will fail or be rescued in a way that involves large losses for creditors. This would like trigger further speculative attacks on other banks, much as the shorting of countries’ obligations spread from Thailand to Indonesia/Malaysia and then to Korea in fall 1997.

The government’s own policies are facilitating these attacks, because as the Fed and Treasury make progress towards easing credit conditions, this makes it easier and cheaper for large hedge funds and others to take large short positions. And keep in mind the underlying loss of confidence is self-fulfilling: as you lose confidence, you want to go short, and selling the credit causes further loss of confidence - and banks are forced out of business.

The government’s entirely reasonable and long overdue request for a resolution authority will set up runs on that authority. If the authority is not granted, the runs will be on the government’s low and failing ability to save banks - given that the trust of Congress has been lost and no more cash for bailouts is likely forthcoming (presumably until there are large further shock waves or until Goldman Sachs itself is on the line.)

The continuing pressure on banks has nothing to do with populism and everything to do with the internal contradictions of the house of cards they built. Now they will scramble to limit short selling or find other emergency measures that will protect their credit. Such partial fixes would do nothing to stop the underlying deterioration of their credit; think about how countries facing currency attacks throw up futile defenses, try to change the rules, and squander their reserves on the way down.

You can see where this is going, but do not cheer. The likely result will be misery for many and further financial chaos around the world.

The big issue is of course the financial sector reform process. Some of my colleagues expressed great satisfaction with the progress made by the G20. But progressing down a blind alley is not something to be pleased about. I have yet to hear a single responsible official in any industrial country state what is obvious to most technocrats who are not currently officials: anything too big to fail is too big to exist.

If the bankers were just stupid, as suggested by David Brooks, then regulatory fixes might make some sense. But we know that bankers are smart, so it is their organizations that became stupid. What is the economic and political power structure that made it possible for such stupid organizations to become so large relative to the economy? Answer this and you address what we need to do going forward.

At a high profile conference in the run-up to this crisis, someone destined to become a leading official in the Obama Administration responded to a sensible technocratic critique of the financial system’s incentive structure (from the IMF, no less) by calling it “Luddite”. By all accounts, this is the prevailing attitude in today’s White House.

But the right metaphor is not breaking productive machines, or peasants with pitchforks, or even the poor vs. the rich. It’s as if the organizations running the nuclear power industry had shown themselves to be stupid and profoundly dangerous. You might wish to abolish nuclear power, but that is not a realistic option; storming power plants makes no sense; and the industry has captured all regulators ever sent after them.

The technocratic options are simple, (1) assume a better regulator, of a kind that has never existed on this face of this earth, (2) make banks smaller, less powerful, and much more boring.

By Simon Johnson

Written by Simon Johnson

April 9, 2009 at 8:25 am"

it seems increasingly less likely that indebtedness will be serviced and redeemed in a timely manner, in our view

From Alphaville:

"Stress-testing Eastern Europe Posted by Tracy Alloway on Mar 09 18:46.

Well, not Eastern Europe per se, but Western banks’ exposure to the region.

Merrill Lynch’s Global Economics team has done a bit of analysis (emphasis FT Alphaville’s):

A simplistic stress test on Emerging European exposure at listed Western European banks shows the potential for an incremental €13bn of losses. We assume this will be spread over several years. In the context of a sector expected to generate €56bn of 2009 profits, Emerging European losses are not, by themselves, devastating.

What’s that? Good news? Not quite.

What the market giveth with one hand, it taketh away with the other, as Merrill Lynch note:
However, we highlight that Emerging European exposure is simply one of many potential problems facing Western European banks. Taken in combination with deteriorating conditions in Western Europe, incremental capital commitments owing to the pro-cyclicality of Basel II, significant off-balance sheet commitments, and earnings headwinds from de-levering, we continue to think investors should take a cautious approach to Western European bank equity.

As for the stress test criteria, Merrill’s assuming Western banks have €1070bn of exposure to emerging Europe, or roughly 3 per cent of total assets.

However, some banks are more exposed than others. All of Raiffeisen International’s loan book, for instance, is in emerging Europe, while 39 per cent of Erste Bank’s is. Of the 17 banks in Merrill’s analysis, 11 have more than 10 per cent of their loan book in the region.

Here are the test specifics:

We think it is worth noting that our stress test only assumes that Emerging European provisions rise. We make no changes to our forecast of pre-provision profits, nor do we assume that elevated risk in Emerging Europe has a negative impact on profitability in Western Europe. Further, we have not written down equity owing to currency devaluations. In this way, our stress test is admittedly simple and understates losses in a full-blown emerging market crisis.

After estimating an NPL level for each country, based on assumptions about macroeconomic NPLs varying with the degree of crisis, we assume cumulative losses equivalent to 50% of NPLs. We then compare the implied provisions from this stress test with the cumulative provisions already factored into our base-case forecasts for each bank for 2009-2011E. We have made several assumptions in this methodology, and we emphasise that the exercise is intended as a scenario analysis, rather than a base-case forecast for how the current emerging market crisis will unfold. Estimating the appropriate level of NPLs for each scenario is one of the key sensitivities in our analysis.

The results of the stress test are in the first table below. The assumed level of NPLs (non-performing loans) in the second, ranging from an “IMF-scale crisis” to a simple “Macro slowdown”. (Click to enlarge)

On average then, the stress test scenario moves the banks’ core tier 1 ratio, the key regulatory measure of banks’ capital position, from 6.9 per cent to 6.4 per cent — hardly a dire level from a regulatory perspective. But, we should note below Merrill’s own definition of a “well capitalised” bank…

In any case the really interesting thing here, as Merrill says, is the relationship between country risk and bank risk, which may be changing:

We see continued stress for parent banks in the near term as they grapple with significant goodwill write-downs, higher loan loss provisions, and the translation effects of volatile currencies. In addition, it appears that many of the major European banks have been active in making funding available to their pressured CEE subsidiaries (which is generally consolidated so less visible to investors, but exceeds US$400bn to be repaid this year alone), adding to the risk if transfer risks materialise as currencies are frozen and/or debt moratoria are imposed.

As is the case for Western Europe, we are in the process of an unprecedented level of credit substitution in the region, whereby sovereign risk is substituted for individual bank risk, though with parent company credit metrics disintegrating in some cases faster than the CEE subsidiaries, credit markets have needed to look beyond immediate parent credit strength for the ‘second way out’. So far, such has been the virulence of the banking crisis that all credit substitution has achieved is to infect the credit quality of the supporting sovereign, while having little impact on the underlying risk premiums of the supported bank.

Our sense is that the credit market is moving on from concerns with respect to non-payment or non-redemption of bonds (the most obvious form of default) to a consideration of the various forms of debt forgiveness that might be in the offing – for example, debt exchanges or debt-for-equity swaps. We are just beginning to see these emerge in Western Europe as a tool for dealing with banking sector insolvency. Indeed, with cash prices for bonds so distressed, it seems increasingly less likely that indebtedness will be serviced and redeemed in a timely manner, in our view.

In otherwords, moderately good news for Eastern European countries themselves, somewhat more ominous for Western European banks with Eastern exposure.
Related links:
UBS: No Eastern European meltdown - FT Alphaville
CEE’s western exposure - FT Alphaville
UniCredit’s eastern exposure - FT Alphaville

This entry was posted by Tracy Alloway on Monday, March 9th, 2009 at 18:46 and is filed under Capital markets. Tagged with Banks, Eastern europe, Erste Bank, Raiffeisen International."

Me:

Don the libertarian Democrat Mar 10 03:51

"Our sense is that the credit market is moving on from concerns with respect to non-payment or non-redemption of bonds (the most obvious form of default) to a consideration of the various forms of debt forgiveness that might be in the offing – for example, debt exchanges or debt-for-equity swaps. We are just beginning to see these emerge in Western Europe as a tool for dealing with banking sector insolvency. Indeed, with cash prices for bonds so distressed, it seems increasingly less likely that indebtedness will be serviced and redeemed in a timely manner, in our view."

I've suggested on Buiter's blog that we should simply move on and discuss whether a form of default is better or inflation is better. It sounds like default is the choice, which I thought was easier to deal with, if I'm not mistaken. I'd be surprised if we don't have some form of default as a solution to this crisis.

because the current partial nationalization is actually the worst situation of all

From Clusterstock:

"Roubini: Citi Is Already Nationalized, Just Need To Finish The Job (C)

Henry Blodget|Feb. 28, 2009, 9:10 AM|2

Tags: Wall Street, Nouriel Roubini, Citi, Bailout, Stock Market, Banks, Financial Services

C Feb 27 2009, 07:41 PM EST

1.50	Change	% Change
	-0.96	-39.02%

Nouriel Roubini points out the truth in Vikram Pandit's strange statement yesterday about how the latest bailout should put nationalization concerns to rest. Yes, the concerns have been put to rest, Nouriel says, because Citi has already been nationalized. The only question remaining is whether we go all the way.

Nouriel says we should, because the current partial nationalization is actually the worst situation of all. And because we're just delaying the inevitable.

Aaron Task, TechTicker: Friday's announcement the government will convert up to $25 billion of its Citigroup preferred stock into common equity represents Uncle Sam's third direct attempt to rescue the floundering bank.

The conversion would give the government up to 36% control of Citigroup stock and leave existing common shareholders with as little as 26% of the company's common stock. That explains why the stock tumbled 39% to $1.50 Friday despite CEO Vikram Pandit's strange declaration: "In many ways for those people who have a concern about nationalization, this announcement should put those concerns to rest."

Pandit's claim is "like saying you're half-pregnant," says Nouriel Roubini and economics professor at NYU's Stern School and chairman of RGE Monitor.

"The government has already taken over the financial system," Roubini says, noting U.S. policymakers have committed $9 trillion to rescue the financial system and already spent $2 trillion. "So let's stop the delusion about 'no nationalization.'"

Roubini, who has publicly advocated for temporary nationalization of insolvent banks, says fully nationalizing Citigroup and/or Bank of America would have a minimal effect on the Dow, which is a price-weighted average. More importantly, he believes full nationalizations (vs. the current partial, piecemeal effort) would be better for the market and the economy because it's the first step in the process of cleaning up "bad" banks so they can later be sold back to private investors, i.e. "re-privatized", as was the case last year with IndyMac.

Tune in Monday as we'll have more from Roubini on:

• Why nationalization is the right course and Bill Gross is wrong.
• Why Ben Bernanke's "reasonable prospect" for a recovery in 2010 is unreasonable.
• What the Tresaury's ongoing "stress tests" of big banks means, and doesn't mean."

Me:

Don the libertarian Democrat (URL) said:

Feb. 28, 3:14 PM

Hybrids are always a bad idea, because the government and banks have competing interests. The tug of war between them is messy, costly, and hellish to get out of. If TARP hasn't convinced people of that, say, by reading the GAO report, for example, we're in really bad shape.

an excellent article about the dangers and advantages of nationalization

From Clusterstock:

"Faster, Please: Four Lessons From Sweden's Bank Rescue

John Carney|Feb. 28, 2009, 1:55 PM|3

Tags: Wall Street, Citi, Bailout, Banks, Financial Services, Bank of America, Credit Crisis, Tim Geithner, Barack Obama

Matthew Richardson, who teaches applied economics at NYU's Stern business school, has written an excellent article about the dangers and advantages of nationalization. Most important, he says, are that we learn the four central lessons of the example of Sweden.

What are those? Here you go:

1. Decisive action in terms of evaluating the solvency of the financial institutions.
2. Some form of “nationalisation” of the insolvent firms.
3. Separation of these insolvent firms into good and bad ones with the idea of reprivatising them.
4. The management of the process was delegated to professionals, as opposed to government regulators.

But go read the whole thing."

Me:

Don the libertarian Democrat (URL) said:

Feb. 28, 3:02 PM

The whole point, from the beginning, was to have a modus operandi in place to handle the big banks. In other words, some people saw that:
1) The FDIC couldn't just swoop in and take the big banks over.
2) That meant that we needed a special FDIC entity or a separate entity to take care of the big banks.
3) We needed to begin to work out how to break them apart.
If the FDIC could have handled them, then there would have been no need of a Swedish Plan. By the way, I believe that the Swedish Plan was partly based on the RTC. The only reason the RTC wasn't mentioned is because, at least from my point of view, that's where I first heard the phrase "Too Big To Fail". We didn't need a little bank fix.

Of course, I was assuming that we didn't want to, once again, show by our actions that some banks are too big to fail. Silly me. Also, the idea that these businesses can unwind themselves is belied by the fact that nobody wants to buy anything from them for any real money, because nobody trusts them. Joe Isuzu would be a better bet to sell theses assets.

As for the people who will take losses here, it's in their interest to predict the end of our way of life. We're going to take a big gamble whatever we do. I'd prefer a road that doesn't keep us subservient to these bank's interests, but that's just me.

Update on the government's state of denial: Improving

From Clusterstock:

"US Finally Admits It May Have To Take Over Banks

Henry Blodget|Feb. 24, 2009, 7:22 AM|4

Tags: Wall Street, Bailout, Banks, Financial Services, Citi, Bank of America, Credit Crisis, AIG, Tim Geithner, Barack Obama, Alan Greenspan

Update on the government's state of denial: Improving!

NYT: “We absolutely believe that our private banking system is best off being in private hands and we are trying our best to keep it that way,” said one senior administration official, who spoke on condition of anonymity. But, he continued, the government is already deeply involved in propping up the banking system and may have no choice.

Officials said they were bracing for the possibility of new problems that might indeed require the government to take a more aggressive stance.

“Given our involvement at this particular stage, there is an element, a possibility over time, that we will end up with some ownership of these institutions,” the official said. “This is really about aggressive anticipatory action. It is an acceptance that the future is uncertain, but that we can plan on a certain basis for it.”

(The rest of the article, meanwhile, is too depressing to read. Among other things, it contemplates what the government will do once it actually takes over all these companies.)"

Me:

Don the libertarian Democrat (URL) said:

Feb. 24, 9:25 AM

“They are desperate to not nationalize the banks,” said Robert J. Barbera, chief economist at ITG. “They know what happened when they took Iraq and they would just as soon not take over the banks, because if you own it, you gotta fix it.”

I hate to tell Mr. Barbera this, but it's our country, and we do have to fix it. This is the second "Can Do" American Spirit post of the morning. Maybe I'll start collecting them, for a wreath.

Temporary receivership and restructuring. Fast, simple, effective. And, most importantly, it works.

From Clusterstock:

"Geithner's Flip-Flop: The Untold Story

Henry Blodget|Feb. 17, 2009, 7:19 AM|12

Tags: Economy, TARP, Treasury, U.S. Government, Financial Crisis, Recession, Timothy F. Geithner, Banks, Credit Crisis

Tim Geithner spent 19 months hammering out his plan for how to save the banking system. Then, at the last minute, after realizing that the whole thing was a gigantic, fabulously expensive hairball, he junked it.

So now we're back to square one.

Neil Irwin and Binyamin Applebaum, Washington Post:

Just days before Treasury Secretary Timothy F. Geithner was scheduled to lay out his much-anticipated plan to deal with the toxic assets imperiling the financial system, he and his team made a sudden about-face.

According to several sources involved in the deliberations, Geithner had come to the conclusion that the strategies he and his team had spent weeks working on were too expensive, too complex and too risky for taxpayers.

They needed an alternative and found it in a previously considered initiative to pair private investments and public loans to try to buy the risky assets and take them off the books of banks. There was one problem: They didn't have enough time to work out many details or consult with others before the plan was supposed to be unveiled...

At the center of the deliberations with Geithner were Lawrence H. Summers... Lee Sachs, a Clinton administration official.... and Gene Sperling, another former Clinton aide. The debates among them were long and vigorous as they thrashed countless proposals and variations. Sometimes, Fed Chairman Ben S. Bernanke, Federal Deposit Insurance Corp. Chairman Sheila C. Bair and Comptroller of the Currency John C. Dugan joined in...

Senior economic officials had several approaches in mind, according to officials involved in the discussions. One would be to create an "aggregator bank," or bad bank, that would take government capital and use it to buy up the risky assets on banks' books. Another approach would be to offer banks a government guarantee against extreme losses on their assets, an approach already used to bolster Citigroup and Bank of America.

As the first week of February progressed, however, the problems with both approaches were becoming clearer to Geithner, said people involved in the talks. For one thing, the government would likely have to put trillions of dollars in taxpayer money at risk, a sum so huge it would anger members of Congress. Officials were also concerned that the program would be criticized as a pure giveaway to bank shareholders. And, finally, there continued to be the problem that had bedeviled the Bush administration's efforts to tackle toxic assets: There was little reason to believe government officials would be able to price these assets in a way that gave taxpayers a good deal.

By Wednesday, Feb. 4, Geithner was leaning toward a different approach that his former colleagues at the Federal Reserve had developed months earlier, the source said. This involved a joint public-private fund to buy up the assets. Private investors, likely hedge funds and private-equity funds, would put up capital, and the government would loan money to the fund. If the private investors made wise decisions about which assets they bought, they would be able to pay back the government and make money for themselves...

And if the private investors made dumb decisions, hey, no worries--the taxpayer would pick up the tab. (Our assumption). (Keep reading >)

Geithner had 19 months to work through this and the problems only became clear in the first week of February?

Here's a simpler plan: Temporary receivership and restructuring. Fast, simple, effective. And, most importantly, it works."

Me:

Don the libertarian Democrat (URL) said:

Feb. 17, 9:39 AM

He didn't really change direction. The whole point was to avoid nationalization at any cost. In that, he kept going merrily off a cliff, costing us time and money. We've wasted months now while Debt-Deflation has gotten much worse. Hold on tight!