The trouble is that liquidity is hard to define and can be impossible to measure

TO BE NOTED: From the FT:

"With no measure, is liquidity half-full or half-empty?

By Tony Jackson

Published: May 10 2009 17:23 | Last updated: May 10 2009 17:23

One of the more intractable problems to have emerged from the financial crisis is that of liquidity. In normal times, we assume an asset can be sold at its market price. Take that away, and the effects are literally incalculable.

How regulators and practitioners address that is plainly crucial. The trouble is that liquidity is hard to define and can be impossible to measure. There is even disagreement over how far it is a good thing.

For our purposes, liquidity can be taken as the extent to which a security can be traded, promptly and in size, without disturbing the price. Whether that is measurable depends on the type of security in question.

The liquidity of an equity can usually be measured pretty accurately, since the size and price of deals are displayed in real time on the stock exchange screen. Prices of corporate bonds, on the other hand, are mostly not displayed even daily. As for volume, figures are only available months in arrears.

If that is true of basic bonds, it is true in spades of those structured securities which – under the title of toxic assets – lie at the heart of the crisis. So far, there seems little prospect of changing that.

As one simple indicator, take the fact that whereas investment banks have devised hedges against all sorts of other risks, from inflation to longevity, they have yet to come up with a liquidity hedge. That would be a very profitable product. But it would require a common definition and measurement of liquidity itself.

Ditto for the ratings agencies, which have been roundly abused for assessing securities only for default risk and thus, by implication, looking at the wrong thing. But I am assured that they spent a lot of time and effort in the 1990s trying to devise a liquidity measure, only to give it up as a bad job.

It might be thought that regulators, in tackling the liquidity question, would have come up with definitions of their own. Apparently not.

The UK’s Financial Services Authority said last December that it would require banks to give “far more information” on liquidity risk. They should detail their holdings by asset class, maturity, currency, whether they were eligible for central bank monetary operations, and “any other characteristics considered relevant”.

But how is liquidity to be defined? None of our business, the FSA says. The liquidity of individual instruments tends to be “situation-specific”.

Given which, it is striking that the FSA’s list of criteria bears scant resemblance to those applied by UK bond traders themselves, as set out in a pilot study from two former practitioners, David Clark and Chris Golden.

The maturity of an issue, for instance, was placed 32nd by traders in a list of 47 liquidity criteria. Right at the top came whether the bond could be borrowed in the market, and whether it could be easily hedged through derivatives.

It is therefore striking that authorities in general are so exercised about the evils of shorting and credit derivatives, both of which are regarded as essential to liquidity by practitioners. But this brings us to the next point: whether liquidity is seen as desirable at all.

Keynes wrote in 1936 that the “fetish of liquidity” was profoundly anti-social. Individuals could be liquid, but not communities, which were collectively stuck with the underlying asset – the steel mill, shipyard or whatever.

The existence of a liquid market, he conceded, might lower the cost of capital. But it meant the purpose of investment became merely “to pass the bad half-crown to the other fellow”.

Something of the same distaste seems to be emerging today. Lord Turner, chairman of the FSA and author of the authoritative Turner Review on the world banking crisis, remarks in it that tightening liquidity is justified “in order to reduce risks to future financial stability”.

This is in spite of the fact that, like Keynes, he accepts the usefulness of liquidity. For the banks, he says, regulatory restraints on liquidity also mean constraints on “aggregate system-wide maturity transformation” – in effect, the supply of credit. But the price is worth paying.

It might seem we are talking here of a different kind of liquidity – the quantity of liquid assets held in reserve by the banks. The link, though, lies in the definition of what constitutes liquidity in an asset.

If the banks can only hold Treasuries rather than private securities, the less the demand for the latter. The less the scope, too, for securitisation – the vital form of lending which has yet to recover in this crisis, in spite of the best efforts of the authorities.

There are no easy answers to all that – just a lot of questions which seem not so much unanswered as unaddressed. If you wonder why the crisis is dragging on, this is part of the reason.

tony.jackson@ft.com"

But what has made the current crisis so disastrous is the behaviour of large, regulated banks

TO BE NOTED: From the FT:

"Insight: A harmful hedge-fund fixation

By Gillian Tett

Published: May 7 2009 20:00 | Last updated: May 7 2009 20:00

Almost exactly two years ago, at the craziest peak of the credit bubble, Western leaders gathered in a conference room at the World Bank in Washington to discuss what they should do about the financial world.

These days it is clear what those grandees ought to have discussed – notably the wild excesses afoot in subprime lending, structured credit, monoline insurance, credit ratings and bank leverage.

In practice, though, those issues were barely discussed. Instead, the hot topic for debate in that April 2007 meeting (as I describe in a book published this month) was how to clamp down on hedge funds – a topic dear to German leaders, who were chairing the G7 at that point.

“It was really hard to get anything apart from hedge funds on the agenda back then,” laments one international bank regulator, who tried – and failed – to divert the debate onto more pressing matters.

These days, there is an unnerving sense of déjà vu bubbling in some political quarters of Europe. Over in America the financial community is currently consumed with the matter of banking stress tests.

In London, however, there is another hot topic worrying financiers – what Brussels plans to do about hedge funds.

Last week the European Commission shocked the City of London by unveiling plans to impose potentially tough new controls on the hedge fund and private equity industry. The European parliament bayed for more.

Then, this week the French government warned that they might strengthen these measures, apparently because they, like many other Continental leaders, think that lax hedge fund controls have sparked the recent crisis.

In fairness, some of these calls for a clampdown are not ridiculous. Regulators need to get better information about what the hedge fund world is doing, and to prevent the abuse of off-balance sheet entities. There is also a strong case to reduce the scale of tax avoidance associated with the hedge fund sector.

But the real danger with the current debate – as two years ago – is that it risks missing the wider point. For sure, some unregulated hedge funds have taken crazy risks in recent years. And unregulated shadow banks have also messed up.

But what has made the current crisis so disastrous is the behaviour of large, regulated banks, which have spent the last decade operating with ridiculously high levels of leverage, and purchasing vast quantities of toxic assets.

And the only thing more remarkable than the scale of those bank follies is that they went unnoticed for so long, partly because many regulators spent the last decade so obsessed with hedge funds. Pace that Washington G7 meeting in the spring of 2007.

Given that, it seems self-evident that the real priority now in Europe is to ask hard questions about banks – and bank regulation. If I was a German voter, for example, I would want to know why nobody in Frankfurt tried to stop German banks from dashing into structured finance on such a spectacular scale – and why the only people who ever warned of those dangers before the summer of 2007 were investors who went short (ie, the hedge funds.)

I would also want to know why rumours remain widespread that German banks are still holding vast quantities of toxic assets which have been barely marked to market value. And why not ask what the German government will do if it turns out that the entire German system is insolvent (as the German press has recently suggested after leaked documents suggested German regulators privately fear that their banks hold over €800m of toxic and illiquid assets.)

Such questions, let me stress, do not entirely remove the need for some debate about hedge funds. But the issue is priority and scale. The global hedge funds sector is estimated to command about $1,500bn of assets on a global basis. The balance sheet of some individual European banks, by contrast, is not wildly different in scale – even today.

Of course, it is possible that European politicians have cannily spotted that logic and are simply focusing on hedge funds as a convenient, distracting scapegoat. It is also possible all the heat about hedge funds will disappear once the European parliamentary elections are over. That is what some senior UK government figures and bankers hope.

But even if that argument is right – and it remains a big “if” – the lesson from the spring of 2007 about the danger of policy distraction remains clear. If European politicians were squealing about the need to clean up big banks – say, by demanding that Europe hurry up and impose its own version of bank stress test – then they might have the right to worry about reforming hedge funds too.

Unfortunately, though, they are not. As a result, the likelihood is that Europe will remain plagued with doubts about the health of its financial system for the forseeable future. And that is a scenario which should worry everybody, hedge fund lovers and haters alike.

gillian.tett@ft.com"

the market was watching the auction very closely, looking for some guidance on pricing for toxic assets

TO BE NOTED: From The Economics Of Contempt:

"Failed SIV's "toxic assets" sold in auction, fetching almost 70%

The much-anticipated auction of Whistlejacket's $6bn portfolio of so-called "toxic assets" went very well, fetching an average price of 67 cents on the dollar. Whistlejacket was a large structured investment vehicle (SIV) that failed in February 2008 when its sponsor, Standard Charter, stopped providing liquidity.

Whistlejacket's portfolio included CDOs backed by mortgage bonds, CLOs, consumer ABS—pretty much a who's who of "toxic assets." The auction included well over $500 million of CDOs that were issued in 2006-2007. Even the CLOs, which are structured products backed by leveraged loans, went for an average price of 70 cents on the dollar. This was easily the biggest secondary-market sale of toxic assets in the past year, and probably the biggest since mid-2007, so the market was watching the auction very closely, looking for some guidance on pricing for toxic assets.

The 33% discount price was much better than most people were anticipating. Overall, I'd say the auction lends support to Treasury's argument that a lack of liquidity is artificially depressing the prices of toxic assets. Chalk one up for Tim Geithner.

Posted by Economics of Contempt "

At least six of the 19 largest U.S. banks require additional capital, according to preliminary results of government stress tests

TO BE NOTED: From Bloomberg:

"Fed Is Said to Seek Capital for at Least Six Banks After Tests

Share | Email | Print | A A A

By Robert Schmidt and Rebecca Christie

April 29 (Bloomberg) -- At least six of the 19 largest U.S. banks require additional capital, according to preliminary results of government stress tests, people briefed on the matter said.

While some of the lenders may need extra cash injections from the government, most of the capital is likely to come from converting preferred shares to common equity, the people said. The Federal Reserve is now hearing appeals from banks, including Citigroup Inc. and Bank of America Corp., that regulators have determined need more of a cushion against losses, they added.

By pushing conversions, rather than federal assistance, the government would allow banks to shore themselves up without the political taint that has soured both Wall Street and Congress on the bailouts. The risk is that, along with diluting existing shareholders, the government action won’t seem strong enough.

“The challenge that policy makers will confront is that more will be needed and it’s not clear they have the resources currently in place or the political capability to deliver more,” said David Greenlaw, the chief financial economist at Morgan Stanley, one of the 19 banks that are being tested, in New York.

Final results of the tests are due to be released next week. The banking agencies overseeing the reviews and the Treasury are still debating how much of the information to disclose. Fed Chairman Ben S. Bernanke, Treasury Secretary Timothy Geithner and other regulators are scheduled to meet this week to discuss the tests.

Options for Capital

Geithner has said that banks can add capital by a variety of ways, including converting government-held preferred shares dating from capital injections made last year, raising private funds or getting more taxpayer cash. With regulators putting an emphasis on common equity in their stress tests, converting privately held preferred shares is another option.

Firms that receive exceptional assistance could face stiffer government controls, including the firing of executives or board members, the Treasury chief has warned.

Today, Kenneth Lewis, chief executive officer of Bank of America, faces a shareholder vote on whether he should be re- elected as the company’s chairman of the board. While Lewis has been at the helm, the bank has received $45 billion in government aid.

‘Out of Our Hands’

Scott Silvestri, a spokesman for Charlotte, North Carolina- based Bank of America, declined to comment on Lewis yesterday. Lewis said earlier this month that the firm “absolutely” doesn’t need more capital, while adding that the decision on whether to convert the U.S.’s previous investments into common equity is “now out of our hands.”

Citigroup, in a statement, said the bank’s “regulatory capital base is strong, and we have previously announced our intention to conduct an exchange offer that will significantly improve our tangible common ratios.”

Along with Bank of America and New York-based Citigroup, some regional banks are likely to need additional capital, analysts have said.

SunTrust Banks Inc., KeyCorp, and Regions Financial Corp. are the banks that are most likely to require additional capital, according to an April 24 analysis by Morgan Stanley.

By taking the less onerous path of converting preferred shares, the Treasury is husbanding the diminishing resources from the $700 billion bailout passed by Congress last October.

‘Politically Constrained’

“Does that indicate that’s what the regulators actually believe, or is it that they felt politically constrained from doing much more than that?” said Douglas Elliott, a former investment banker who is now a fellow at the Brookings Institution in Washington.

Geithner said April 21 that $109.6 billion of TARP funds remain, or $134.6 billion including expected repayments in the coming year. Lawmakers have warned repeatedly not to expect approval of any request for additional money.

Some forecasts predict much greater losses are still on the horizon for the financial system. The International Monetary Fund calculates global losses tied to bad loans and securitized assets may reach $4.1 trillion next year.

Geithner has said repeatedly that the “vast majority” of U.S. banks have more capital than regulatory guidelines indicate. The stress tests are designed to ensure that firms have enough reserves to weather a deeper economic downturn and sustain lending to consumers and businesses.

‘Thawing’ Markets

He also said there are signs of “thawing” in credit markets and some indication that confidence is beginning to return. His remarks reflected an improvement in earnings in several lenders’ results for the first quarter, and a reduction in benchmark lending rates this month.

Financial shares are poised for their first back-to-back monthly gain since September 2007. The Standard & Poor’s 500 Financials Index has climbed 18 percent this month, while still 73 percent below the high reached in May 2007.

Finance ministers and central bankers who met in Washington last weekend singled out banks’ impaired balance sheets as the biggest threat to a sustainable recovery. Geithner has crafted a plan to finance purchases of as much as $1 trillion in distressed loans and securities. Germany has proposed removing $1.1 trillion in toxic assets.

To contact the reporter on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net; Rebecca Christie in Washington at Rchristie4@bloomberg.net"

She’s more sympathetic to Treasury secretary Timothy Geithner’s plan

TO BE NOTED: From City Journal Via Zero Hedge:

"Guy Sorman

Monetarism Defiant

Legendary economist Anna Schwartz says the feds have misjudged the financial crisis.

Photograph by William Meyers

Schwartz at her Fifth Avenue office

Anna Schwartz must be the oldest active revolutionary on earth. Born in 1915 in New York, she can still be found nearly every day at her office in the National Bureau of Economic Research on Fifth Avenue, where she has been tirelessly gathering data since 1941. And as her experience proves, data can transform the world. During the 1960s, with Milton Friedman, she wrote A Monetary History of the United States, a book that forever changed our knowledge of economics and the way that governments operate. Schwartz put ten years of detective work into the project, which helped found the monetarist theory of economics. “Not only by gathering new data but by coming up with new ways to measure information, we were able to demonstrate the link between the quantity of money generated by the banks, inflation, and the business cycle,” she explains.

Before the monetarist revolution, most economists believed that the quantity of money circulating in the economy had no influence on prices or on growth. History showed otherwise, Friedman and Schwartz argued. Every time the Federal Reserve (and the central banks before it) created an excess of money, either by keeping interest rates too low or by injecting liquidity into banks, prices inflated. At first, the easy money might seem to boost consumers’ purchasing power. But the increase would be only apparent, since sellers tended to raise the prices of their goods to absorb the extra funds. Investors would then start speculating on short-term bets—whether tulips in the seventeenth century or subprime mortgages more recently—seeking to beat the expected inflation. Eventually, such “manias,” as Schwartz calls them, would begin replacing long-term investment, thus destroying entrepreneurship and harming economic growth.

By contrast, by removing excess liquidity, the central bank can cause the sudden collapse of speculative excess, and it can also hurt healthy recovery or growth by constricting the money supply. There is now a near-consensus among economists that lack of liquidity caused the Great Depression. During the severe downturn of 1930, the Fed did nothing as a first group of banks failed. Other depositors became alarmed that they would lose their money if their banks failed, too, leading to further bank runs, propelling a frightening downward economic spiral.

To encourage steady growth while avoiding the pitfalls of inflation, speculation, and recession, the monetarists recommend establishing predictability in the value of currency—steadily expanding or contracting the money supply to answer the needs of the economy. “At first, central bankers and governments did not accept our theory,” recalls Schwartz. Margaret Thatcher was the first to understand that the monetarists were right, following their rules when she came to power in 1979, taming inflation and reinvigorating the British economy. The U.S. followed during the early 1980s, led by Paul Volcker, a Friedmanite then at the head of the Federal Reserve, who, with Ronald Reagan’s strong support, ended raging inflation, though not without a lot of short-term pain. “It was a strenuous experience,” Schwartz remembers. As Volcker tightened the money supply, making credit harder to come by, unemployment spiked to about 10 percent; many firms failed. But starting in 1983, the inflation beast defeated, a new era of vigorous growth got under way, based on innovation and long-term investment.

This lesson of the recent past seems all but forgotten, Schwartz says. Instead of staying the monetarist course, Volcker’s successor as Fed chairman, Alan Greenspan, too often preferred to manage the economy—a fatal conceit, a monetarist would say. Greenspan wanted to avoid recessions at all costs. By keeping interest rates at historic lows, however, his easy money fueled manias: first the Internet bubble and then the now-burst mortgage bubble. “A too-easy monetary policy induces people to acquire whatever is the object of desire in a mania period,” Schwartz notes.

Greenspan’s successor, Ben Bernanke, has followed the same path in confronting the current economic crisis, Schwartz charges. Instead of the steady course that the monetarists recommend, the Fed and the Treasury “try to break news on a daily basis and they look for immediate gratification,” she says. “Bernanke is looking for sensations, with new developments every day.”

Yet isn’t Bernanke a disciple of Friedman and Schwartz? He publicly refers to them as mentors, and, thanks to their scientific breakthrough, he has famously declared that “the Great Depression will not happen again.” Bernanke is right about the past, Schwartz says, “but he is fighting the wrong war today; the present crisis has nothing to do with a lack of liquidity.” President Obama’s stimulus is similarly irrelevant, she believes, since the crisis also has nothing to do with a lack of demand or investment. The credit crunch, which is the recession’s actual cause, comes only from a lack of trust, argues Schwartz. Lenders aren’t lending because they don’t know who is solvent, and they can’t know who is solvent because portfolios remain full of mortgage-backed securities and other toxic assets.

To rekindle the credit market, the banks must get rid of those toxic assets. That’s why Schwartz supported, in principle, the Bush administration’s first proposal for responding to the crisis—to buy bad assets from banks—though not, she emphasizes, while pricing those assets so generously as to prop up failed institutions. The administration abandoned its plan when it appeared too complicated to price the assets. Bernanke and then–Treasury secretary Henry Paulson subsequently shifted to recapitalizing the banks directly. “Doing so is shifting from trying to save the banking system to trying to save bankers, which is not the same thing,” Schwartz says. “Ultimately, though, firms that made wrong decisions should fail. The market works better when wrong decisions are punished and good decisions make you rich.” She’s more sympathetic to Treasury secretary Timothy Geithner’s plan, unveiled in March, to give private investors money to help them buy the toxic assets, but wonders if the Obama administration will continue to support the plan if the assets’ prices turn out to be so low, once investors start bidding for them, that they threaten the banks.

What about “systemic risk”—much heard about these days to justify the government’s massive intervention in the economy in recent months? Schwartz considers this an excuse for bankers to save their skins after making so many bad decisions. “The worst thing for a government to do, though, is to act without principles, to make ad hoc decisions, to do something one day and another thing tomorrow,” she says. The market will respond positively only after the government begins to follow a steady, predictable course. To prove her point, Schwartz points out that nothing the government has done to date has really thawed credit.

Schwartz indicts Bernanke for fighting the wrong war. Could one turn the same accusation against her? Should we worry about inflation when some believe deflation to be the real enemy? “The risk of deflation is very much exaggerated,” she answers. Inflation seems to her “unavoidable”: the Federal Reserve is creating money with little restraint, while Treasury expenditures remain far in excess of revenue. The inflation spigot is thus wide open. To beat the coming inflation, a “new Paul Volcker will be needed at the head of the Federal Reserve.”

Who listens to her these days? “I’m not a media person,” she tells me. She rarely grants interviews, which distract her from her current research: a survey of government intervention in setting foreign exchange rates between 1962 and 1985. Never before have these data been combined to show what works and what doesn’t. In her nineties, she remains a trendsetter.

Research for this article was supported by the Brunie Fund for New York Journalism.

Guy Sorman, a City Journal contributing editor, is the author of numerous books, including the forthcoming Economics Does Not Lie."

The plan distinguishes between “toxic” securities, which should fall on the shoulders of banks and their shareholders, and “illiquid” ones

TO BE NOTED: From Bloomberg:

"Steinbrueck Drafts German ‘Bad Bank’ Financial Rescue Plan

Share | Email | Print | A A A

By Patrick Donahue

April 11 (Bloomberg) -- German Finance Minister Peer Steinbrueck drew up a plan to remove toxic assets from bank balance sheets, based on government funding for financial institutions to set up so-called bad banks.

The Finance Ministry submitted the program to Chancellor Angela Merkel, and administration and finance-industry officials will decide on the details on April 21, the German government said in an e-mailed statement today.

Under the plan banks would create separate units, backed by 200 billion euros ($264 billion) in government funds, into which they’ll be able to transfer assets they can’t sell, Steinbrueck told the Frankfurter Allgemeine Sonntagszeitung in an interview.

Steinbrueck has come under pressure to develop a plan emulating those in the U.S. and U.K. to try to jumpstart lending. Six months before a federal election, the unity of the ruling coalition is being strained after Steinbrueck, a Social Democrat, drafted legislation to seize lenders, and the problem of toxic assets remains unsolved.

Steinbrueck has resisted earlier proposals to set aside funds for toxic assets, since it would require a sale of bonds. The finance minister told the newspaper he rejected the idea of a centralized “bad bank.”

The plan distinguishes between “toxic” securities, which should fall on the shoulders of banks and their shareholders, and “illiquid” ones, which the government will take over, and sell when markets improve, Steinbrueck told the newspaper.

Germany responded to the financial collapse in October by pushing a 500 billion-euro bank-rescue package through parliament in a week.

To contact the reporter on this story: Patrick Donahue in Berlin at at pdonahue1@bloomberg.net."

, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned

TO BE NOTED: From the FT:

"US banks face big writedowns in toxic asset plan

By Francesco Guerrera in New York and Krishna Guha in Washington

Published: March 24 2009 23:31 | Last updated: March 24 2009 23:31

The government’s toxic assets plan will force banks such as Citigroup, Bank of America and Wells Fargo to take large writedowns on their loans, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned.

Senior bankers say the authorities’ latest drive, announced on Monday, to cleanse financial groups’ balance sheets by encouraging investors to buy troubled residential and commercial mortgages will prompt banks to record losses on those portfolios.

The government will also use its “stress tests” to force banks to take more aggressive provisions on these loans, creating a stronger incentive to sell. This process will increase the pressure on banks that have large loan portfolios to raise fresh funds from investors or the government if capital markets remain frozen.

The possibility of further government injections is set to weigh on banks such as Citi, in which the authorities are about to buy a 36 per cent stake, BofA, Wells and other recipients of federal aid.

“The unspoken fear here is that selling off loan portfolios would lead to more government capital injections into major banks,” said an executive at a large bank.

Citi and BofA declined to comment.

Wells said it would support “any plan by the Treasury that helps financial institutions efficiently sell troubled assets while still providing an investment return to the US tax payer”, but said it had not seen all the details of Treasury’s proposals.

Accounting rules allow banks to carry loans on their balance sheets at their original value and set aside a percentage of the losses expected over the lifetime of the loan.

However, the government plan, which offers investors generous financing to buy banks’ distressed assets, will force institutions that sell loans at a discount to take a writedown equal to the difference between the original value and their sale price.

Some analysts believe the potential writedowns would deter banks from taking part in the plan, which was unveiled by Tim Geithner, Treasury secretary.

Richard Bove, an analyst at Rochdale Research, wrote in a note to clients: “[The plan] will not happen because it would destroy bank capital. It might cause a bank to fail the new stress tests under way. Banks will not take this risk.”

But while banks in theory have discretion over whether to sell loans, Sheila Bair, chairman of the Federal Deposit Insurance Corporation, said this decision would be made “in consultation with regulators” – a sign that the authorities might put pressure on banks to sell toxic assets.

Policymakers say the Geithner strategy is intended to fix the disconnect between the market and the banks by restoring investor confidence in their financial statements.

Outside investors and bank executives are miles apart in their assessments of the true capital position of the banks, making it impossible for them to agree a price at which to re­capitalise.

By forcing a more realistic and forward-looking assessment of expected losses on bank loans through the stress test, and creating a secondary market that establishes the expected credit losses on loan portfolios, the authorities intend to force banks to write down these loans.

Copyright The Financial Times Limited 2009"

The question, in truth, is not only whether the measures will work, but whether the UK can afford them.

From the FT:

"Are UK banks too big to rescue?

By Martin Wolf

Published: January 22 2009 19:55 | Last updated: January 22 2009 19:55

Is the British government on the right path with its recent package of measures to help the banking sector or, as Mervyn King, governor of the Bank of England, put it this week, “to protect the economy from the banks”? The question, in truth, is not only whether the measures will work, but whether the UK can afford them.( BLIMEY )

Here are two frightening statistics: over the past five years, the balance sheets of many of the world’s largest banks more than doubled; and, according to the Bank, the median ratio of debt to equity in big UK banks is more than 30 to one.

The government faces two challenges: it must eliminate the consequences of these past errors and prevent new ones. These errors go in opposite directions: the past one was lending too much; the present one is lending too little. The legacy of the former is destroyed balance sheets; that of the latter is collapsing lending. ( A SPOT OF BOTHER )

So what should the government be doing in dealing with the legacy of past excesses? The first action must be a brutal worst-case evaluation of balance sheets. The government cannot safely guarantee any conceivable losses( ACTUALLY, IT NEEDS TO. ). The big banks are deemed too big, too interconnected and too important to fail. Yet might they not also be too big to rescue( YOU'D BETTER HOPE NOT )?

This last is the spectre that Willem Buiter has been raising for the UK in his Maverecon blog. He notes that, with balance sheets equal to 440 per cent of gross domestic product, these institutions might imperil the fiscal soundness of the UK itself. I suspect this danger is exaggerated( LET'S HOPE SO. ). A recent analysis from Goldman Sachs suggests that the cost to the state should not exceed 8 per cent of GDP. But it is also true that we do not know what would happen to the value of the global assets of UK banks in a depression. Moreover, we have to add in the costly impact of what are likely to be huge ongoing fiscal deficits over many years.

The government’s policies for dealing with the overhang of bad loans had been recapitalisation. Now we have what Alistair Darling, chancellor of the exchequer, told the House of Commons would be “a new scheme under which the Treasury will insure( REMEMBER PESTON'S POST. ) certain bank assets, for a commercial fee, against losses on banks’ existing loans”.

Meanwhile, the problem for new lending is the departure of foreign financial institutions and capital. The government estimates that about 30 per cent of lending capacity has consequently been lost.

The proposals announced this week include three measures to address the capacity reduction: a £50bn Bank of England fund, financed by the Treasury, aimed at buying corporate assets; a decision to let Northern Rock maintain its loan book, to “support prudent lending to creditworthy customers”; and conversion of the preference shares in Royal Bank of Scotland into ordinary shares.

In addition, “we intend,” said the chancellor, “to negotiate with each bank a lending agreement,” which would be “binding and externally audited”. In return, new support measures are offered: an extension of the credit guarantee scheme introduced in October, which already covers £100bn in loans; an additional £50bn of guarantees, initially on new mortgage lending and eventually on other assets; and, finally, a plan for the Financial Services Authority to adjust capital requirements, to encourage lending in the downturn.( NOTICE THE GUARANTEES )

So what are we to make of these proposals? I have three big worries.( THAT'S IT. AN OPTIMIST. )

My first concerns the potential cost to the taxpayers of guarantees, particularly on past loans. Guarantees on new loans may now be unavoidable. Old loans are a different matter. The idea of offering insurance against extreme outcomes is a superior alternative to buying bad assets at inflated prices( YES ). Yet these loans are bygones – sunk costs. The only question is: who bears the losses? The dangers of letting some losses fall on creditors, via debt-for-equity swaps, are evident. Yet there may be no responsible alternative, particularly in view of the UK’s vast ongoing fiscal deficits.( YES )

My second worry is management. The chancellor says that “we have a clear view that British banks are best managed and owned commercially and not by the government”. Recent performance hardly suggests banks are well managed( TRUE ). Above all, who is taking the risk and deciding what the banks should do? The answer to the former question is taxpayers; the answer to the latter is government. Private management of socialised risks is dangerous( TRUE ). This is why temporary nationalisation is logical. I suspect it is where we will end up.( YES )

My third concern is over the apparent hope of recreating securitised financial markets. I understand the appeal of such markets. But, by offering guarantees( YES ), the government could be subsidising the recreation of a market in lemons.

With international confidence in the UK weak and weakening, the government has to take a realistic view of what it can and must do. It has to come clean on the possible fiscal costs and, in the last resort, it has to focus its limited resources on the future instead."

Too true.

"Given how messy all of these alternatives are, why not simply go down the nationalization route?"

The enormously talented Felix Salmon posts:

"Why Nationalization is the Best Alternative

Kevin Drum is a bit like Joe Nocera: he's reluctant to nationalize, but he doesn't really say why.

It's wise to be wary of nationalization. It should be a last resort( FIRST ), and I've gotten a sense recently that a lot of people are talking about it awfully casually( FOR 4 MONTHS ). Still, it's true that there are some benefits to nationalization, and one of them is that it allows us to avoid the problem of valuing and buying up toxic assets from troubled banks( BINGO! ). If the government owns the whole bank, then the bad stuff can be easily hived off without any kind of valuation at all, and then left to sit for a while before it's sold off -- which is what the Swedes did.
If we have to nationalize, then we have to nationalize. But we should understand the precedents before we do, and go ahead only if we have to.

The only argument I can find in here is an argument in favor of nationalization, not against it. Why should nationalization only be a last resort?( AMEN )

Let's work from an ex hypothesi assumption that a certain bank -- let's call it Citigroup -- is insolvent. This is not an unreasonable assumption, given what happened to the likes of Lehman Brothers and Washington Mutual. But I don't want to get into the details of Citi's balance sheet here: I want to ask what we should do if we've already determined that its assets, many of which fall into the "toxic" category, are significantly smaller than its liabilities.

Now the red-blooded American way of dealing with insolvent companies is bankruptcy: either Chapter 11, where the company continues as a going concern, or some kind of liquidation. For a bank, Chapter 11 is pretty much impossible, since you're not going to find anybody to provide debtor-in-possession financing to keep it going. Except the government. And if the government is in possession, then, hey, you've just nationalized the bank.( TRUE )

As for liquidation, that's not an option, because Citigroup is too big to fail. Dumping Citi's trillions of dollars of assets onto the market in a fire sale would depress asset prices worldwide so much that we'd enter a global depression, not just one in the US. ( TRUE. THE CALLING RUN WOULD PICK UP SPEED. )

So what about the bad-bank option? The government buys Citi's toxic assets, taking them off Citi's balance sheet, and leaving behind a healthy bank. Sounds good -- except remember that, ex hypothesi, Citi is insolvent. If the government buys the toxic assets for what they're worth, then that doesn't help, since the amount of money that Citi gets in return isn't enough to pay off the loans that Citi essentially took out against those assets. In housing parlance, Citi's underwater on its recourse loan, and when you're underwater on a recourse loan, selling the house at its market price doesn't make you any less insolvent.

So maybe the government deliberately overpays for the toxic waste( WHICH IS WHAT WILL HAPPEN )? That's a recipe for opacity, and it's very hard to systematize. If you're willing to pay 150% of market prices for Citi's bad assets, shouldn't you do that for everybody else's, too? Even perfectly healthy banks which don't need the money? Or do you just decide that Citi, because it's too big to fail, is going to get a big handout which no one else qualifies for? If you do make that determination, why not just go the whole hog and write a check to the bank outright, and put it straight into Tier 1 equity? Oh, wait, you can't do that, because that's called buying equity, and if you spent that much money on Citi's equity, you'd end up with a majority stake in the bank -- which is nationalization. ( TRUE )

Essentially, any government purchase of toxic assets can be split into two components: the market price, and a subsidy. If the subsidy is greater than half the market capitalization of the bank, and the government doesn't end up controlling the bank, then there's something very fishy going on indeed.( TRUE )

It's worth bearing in mind here the first TARP proposal, which envisaged the government buying up bad assets at some kind of long-term value price which was greater than the distressed market price. That never happened, the bad assets stayed on the banks' balance sheets -- and then, in the fourth quarter, we saw some absolutely monster write-downs from those loans' end-September marks, including $15 billion at Merrill Lynch alone. You still think that the end-September marks were distressed bargain-basement prices?( THAT'S BEEN MY POINT )

Then there's the insurance proposal -- which is cropping up now in the UK after being rolled out in an ad hoc fashion with Citi and BofA here in the US. Robert Peston explains how it works:

Our biggest banks would identify their bad loans and foolish investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets.
But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.

This has all the same problems of the create-a-bad-bank idea: the government still has to come up with a price (a/k/a expected default rate) for the bad assets, and there will still be a huge implicit subsidy, in many cases greater than the bank's market capitalization, for any institution which takes the government up on its offer. After all, the mark-to-market value of the insurer is certain to be massively negative, otherwise Warren Buffett would have set up something like this already on a for-profit basis.( TRUE )

Finally, the government could take the Irish approach, and target the banks' liabilities rather than their assets. Keep the assets on the banks' balance sheets, and simply guarantee all of their unsecured debts. After all, there's a government guarantee on a lot of the unsecured debt already, and there has been for years: it's called the FDIC deposit guarantee.( TRUE )

This is basically a massive bailout for all the banks' bondholders, who thought they were buying risky leveraged single-A bank debt, and who will suddenly find it backed by the full faith and credit of the US government. At this point, it doesn't matter if a bank is insolvent, because it can roll over its debt indefinitely, since that debt has a government guarantee. Indeed, it should be quite happy to lever up as much as it's allowed, and spend its cheap new funds on all manner of risky assets, since that gives shareholders the best chance of making lots of money and recovering some of the billions of dollars that they have lost. It's akin to taking a man with a large debt, pointing him in the direction of a casino, and telling him he has unlimited credit to try and pay that debt off.( YIKES )

The best way for the government to avoid the obvious outcome in such a situation is for the government to take over and run the bank: nationalization. Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well -- i.e., ownership.( TRUE )

Given how messy all of these alternatives are, why not simply go down the nationalization route? It's transparent and easy to understand( I'VE SAID THIS FROM THE BEGINNING. ): if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too.

So I'm interested in what Kevin means when he talks about a situation where "we have to nationalize". Does he mean any situation where a too-big-to-fail bank is insolvent? Or are there further criteria he has in mind?"

Well played! However, I believe that Drum will go for nationlization.

“The time has come that we consider what sort of limitations we should be placing on the Fed"

Here's a Bloomberg article I like, so I'm going to scan a fair bit of it even though it moves around quite a bit ( Kind of like TARP ):

"The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup Inc. debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago.

The unprecedented pledge of funds includes $3.18 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis."

I'm not sure what to say about this. In a way, I understand it. At some point, you just bet the whole ball of wax, and feel the wind in your hair, and the trade winds behind you. Do any of those work for you?

Pledging half of what we produced last year seems to validate the enormity of the undertaking. We're not fooling around here. We like our messes to be enormous. Given the situation, I have to admit to agreeing with this Bagehot on steroids approach. It somehow makes him more modern, more relevant to me.

"When Congress approved the TARP on Oct. 3, Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson acknowledged the need for transparency and oversight. Now, as regulators commit far more money while refusing to disclose loan recipients or reveal the collateral they are taking in return, some Congress members are calling for the Fed to be reined in."

There's a need, but not the means or will to fulfill it. But we acknowledge the need.

“Whether it’s lending or spending, it’s tax dollars that are going out the window and we end up holding collateral we don’t know anything about,” said Congressman Scott Garrett, a New Jersey Republican who serves on the House Financial Services Committee. “The time has come that we consider what sort of limitations we should be placing on the Fed so that authority returns to elected officials as opposed to appointed ones.”

It's good to know that you're on the case Congressman " A day late and a dollar short".

"Bloomberg News tabulated data from the Fed, Treasury and Federal Deposit Insurance Corp. and interviewed regulatory officials, economists and academic researchers to gauge the full extent of the government’s rescue effort. "

Peculiarly, because no one else would.

"The bailout includes a Fed program to buy as much as $2.4 trillion in short-term notes, called commercial paper, that companies use to pay bills, begun Oct. 27, and $1.4 trillion from the FDIC to guarantee bank-to-bank loans, started Oct. 14. "

Don't worry about this.

"William Poole, former president of the Federal Reserve Bank of St. Louis, said the two programs are unlikely to lose money. The bigger risk comes from rescuing companies perceived as “too big to fail,” he said. "

How reassuring. I love the use of "perceived", implying an illusion of some sort. Apparently, Mr.Poole, if that is his real name, doesn't believe that they are. Otherwise, there was no need to qualify the expression "rescuing companies too big to fail".

"The government committed $29 billion to help engineer the takeover in March of Bear Stearns Cos. by New York-based JPMorgan Chase & Co. and $122.8 billion in addition to TARP allocations to bail out New York-based American International Group Inc., once the world’s largest insurer.

Citigroup received $306 billion of government guarantees for troubled mortgages and toxic assets. The Treasury Department also will inject $20 billion into the bank after its stock fell 60 percent last week.

“No question there is some credit risk there,” Poole said."

Poole again. First he's very forceful, using "No question". Then he's back to qualifying himself again with "some risk", meaning, what? There's a hell of a lot, but I don't want to say so, and freak everybody out? There's a little, but not enough to worry about? What does Mr. Poole do for a living exactly, that his speech is so terribly careful.

"Congressman Darrell Issa, a California Republican on the Oversight and Government Reform Committee, said risk is lurking in the programs that Poole thinks are safe.'

Can risk "lurk"? The only meaning that I could find that didn't imply agency, and work, is the following:to exist unperceived or unsuspected. But if you know it's there, it's not lurking. It's of unknown quantity, but you know it's there.

“The thing that people don’t understand is it’s not how likely that the exposure becomes a reality, but what if it does?” Issa said. “There’s no transparency to it so who’s to say they’re right?”

Okay. It's not how likely, but what if it does? If I knew what is was, why couldn't I know what happen if it does, or at least have an idea. After all, I even have an idea about Heaven. There's no transparency. Meaning you can't see it. So who's to say they're right? Them, obviously. What's the problem, unless you don't trust them? If that's the case, just come out and say so.

"The worst financial crisis in two generations has erased $23 trillion, or 38 percent, of the value of the world’s companies and brought down three of the biggest Wall Street firms. "

I'm sorry, but every time I hear generations I begin singing "L'dor vador".

"Regulators hope the rescue will contain the damage and keep banks providing the credit that is the lifeblood of the U.S. economy. "

At least they're using organic terms, and not engineering terms.

"The money that’s been pledged is equivalent to $24,000 for every man, woman and child in the country. It’s nine times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office figures. It could pay off more than half the country’s mortgages."

It's a little more that than the $24,000, because I refuse to take responsibility for this. When you start thinking about what it could buy, your brain has an aneurysm. If I were Bloomberg, I'd be worried about lawsuits.

“It’s unprecedented,” said Bob Eisenbeis, chief monetary economist at Vineland, New Jersey-based Cumberland Advisors Inc. and an economist for the Atlanta Fed for 10 years until January. “The backlash has begun already. Congress is taking a lot of hits from their constituents because they got snookered on the TARP big time. There’s a lot of supposedly smart people who look to be totally incompetent and it’s all going to fall on the taxpayer.”

That's why they're supposedly smart.

“This is the worst capital markets crisis in modern history,” Harris said. “So you have the biggest intervention in modern history.”

This is why, if you're for smaller government, you have to have a real world plan to avert these crises. Otherwise, you might as well believe in Zeus.

"Bloomberg has requested details of Fed lending under the U.S. Freedom of Information Act and filed a federal lawsuit against the central bank Nov. 7 seeking to force disclosure of borrower banks and their collateral."

Thanks.

"Collateral is an asset pledged to a lender in the event a loan payment isn’t made."

I like this definition.

“Some have asked us to reveal the names of the banks that are borrowing, how much they are borrowing, what collateral they are posting,” Bernanke said Nov. 18 to the House Financial Services Committee. “We think that’s counterproductive.”

Huh.

"The Fed should account for the collateral it takes in exchange for loans to banks, said Paul Kasriel, chief economist at Chicago-based Northern Trust Corp. and a former research economist at the Federal Reserve Bank of Chicago.

“There is a lack of transparency here and, given that the Fed is taking on a huge amount of credit risk now, it would seem to me as a taxpayer there should be more transparency,” Kasriel said."

Does "counterproductive" here mean "it would piss people off "?

"In the three years before the crisis, such average weekly borrowing by banks was $48 million, according to the central bank. Last week it was $91.5 billion. "

I can't even compute that increase.

“Money markets seized up after Lehman failed,” said Neal Soss, chief economist at Credit Suisse Group in New York and a former aide to Fed chief Paul Volcker. “Lehman failing made a lot of subsequent actions necessary.”

I find this obvious, but some remain unconvinced. Go figure.

"Most of the federal guarantees reduce interest rates on loans to banks and securities firms, which would create a subsidy of at least $6.6 billion annually for the financial industry, according to data compiled by Bloomberg comparing rates charged by the Fed against market interest currently paid by banks.

Not included in the calculation of pledged funds is an FDIC proposal to prevent foreclosures by guaranteeing modifications on $444 billion in mortgages at an expected cost of $24.4 billion to be paid from the TARP, according to FDIC spokesman David Barr. The Treasury Department hasn’t approved the program.

Bernanke and Paulson, former chief executive officer of Goldman Sachs, have also promised as much as $200 billion to shore up nationalized mortgage finance companies Fannie Mae and Freddie Mac, a pledge that hasn’t been allocated to any agency. The FDIC arranged for $139 billion in loan guarantees for General Electric Co.’s finance unit."

They've guaranteed a hell of a lot more than that.

"Paulson told the House Financial Services Committee Nov. 18 that the $250 billion already allocated to banks through the TARP is an investment, not an expenditure.

“I think it would be extraordinarily unusual if the government did not get that money back and more,” Paulson said."

"Extraordinarily unusual" means " so unusual that you can't blame me if it happens".

"In his Nov. 18 testimony, Bernanke told the House Financial Services Committee that the central bank wouldn’t lose money.

“We take collateral, we haircut it, it is a short-term loan, it is very safe, we have never lost a penny in these various lending programs,” he said."

Oddly, he and Paulson are bald like me.

"A haircut refers to the practice of lending less money than the collateral’s current market value."

A nice definition.

"Requiring the Fed to disclose loan recipients might set off panic, said David Tobin, principal of New York-based loan-sale consultants and investment bank Mission Capital Advisors LLC.'

Earth to David Tobin, "We're in one".

“If you mark to market today, the banking system is bankrupt,” Tobin said. “So what do you do? You try to keep it going as best you can.”

You don't mark it. That was easy.

“Mark to market” means adjusting the value of an asset, such as a mortgage-backed security, to reflect current prices."

Another good definition.

"Some of the bailout assistance could come from tax breaks in the future. The Treasury Department changed the tax code on Sept. 30 to allow banks to expand the deductions on the losses banks they were buying, according to Robert Willens, a former Lehman Brothers tax and accounting analyst who teaches at Columbia University Business School in New York.

Wells Fargo & Co., which is buying Charlotte, North Carolina-based Wachovia Corp., will be able to deduct $22 billion, Willens said. Adding in other banks, the code change will cost $29 billion, he said.

“The rule is now popularly known among tax lawyers as the ‘Wells Fargo Notice,’” Willens said.

The regulation was changed to make it easier for healthy banks to buy troubled ones, said Treasury Department spokesman Andrew DeSouza."

This was the Paulson move that many just discovered. It was intended to facilitate mergers.

"House Financial Services Committee Chairman Barney Frank said he was angry that banks used the money for acquisitions.

“The only purpose for this money is to lend,” said Frank, a Massachusetts Democrat. “It’s not for dividends, it’s not for purchases of new banks, it’s not for bonuses. There better be a showing of increased lending roughly in the amount of the capital infusions” or Congress may not approve the second half of the TARP money."

Strictly speaking, Rep. Frank is correct, although the tax breaks were obviously intended to facilitate private mergers to keep the government from having to recapitalize them. Remember, originally, TARP was not going to give money to the banks, but to buy toxic assets. These tax subsidies were meant to deal with the problem of recapitalization of banks through mergers, such as the failed Citi/Wachovia deal, and the successful Wells/Wachovia deal.

"has started to buy securities backed by residential mortgages"

Here's an interesting story in the FT:

"John Paulson, the hedge fund manager who was called before Congress last week to discuss the big profits he made by foreseeing the collapse of the subprime mortgage market, has started to buy securities backed by residential mortgages.

Mr Paulson’s move marks the latest example of a famously bearish investor shifting gears to profit from depressed prices in the global credit markets.

US residential mortgage securities fell in value last week after Hank Paulson, Treasury secretary, said that the federal government had decided against buying toxic assets as part of its $700bn troubled asset relief programme (Tarp).

John Paulson, who is not related to the Treasury secretary, has told his investors that he started buying troubled mortgage-backed securities at the end of last week, hoping to capitalise on price falls that followed the Treasury announcement."

So, the chain of events:
1) TARP won't buy toxic assets
2) Toxic assets decline in value ( Now, what does that tell you? )
3) J. Paulson buys toxic assets

So, how long is Paulson planning on holding these toxic assets:
1) Short term ( Does he think that government will intervene? )
2) Long term ( They're going to appreciate? )

By the way, I was very impressed by his testimony before congress.

Here was his plan to help stop foreclosures:

"By providing funding and other support for attorneys who can
review loan documents and negotiate with loan servicers, we believe that many more
homeowners will be able to stay in their homes."

Here was my comment, where I tend to agree with him:

Since this is mainly legal help, and the loans are called abusive, maybe we should be doing what I say, which is examine the legality of these loans.

Here's a quote:

"This mechanism M_ purchases of senior preferred stock with warrants in troubled
institutions -- addresses the problems with the Treasmy plan. The financial
market is stabilized, companies get recapitalized, failures are avoidedJ debt
securities are supported, and time is gained for illiquid assets to mature.
The institutions continue to function, their cost of funding will decline as equity
capital increases, and innocent third parties like bank depositors, broker/dealer
clients and insurance-policy holders are all protected. The only difference is that
potential losses are kept with the shareholders where they belong."

Is he betting on the long term, hoping that the government will buy this stock and allow illiquid assets to mature?

"For several months Mr Paulson has been considering investing in distressed subprime mortgage securities, financial firms and debt used to back private equity deals.

He estimated there are $10,000bn in total in such assets."

Okay.

"In a letter to investors at the end of the third quarter, Mr. Paulson said his strategy was “to reduce leverage, maintain market exposure and maintain short credit bias”. He said: “The majority of our gains came from short positions in the equities of declining financials and CDS [credit default swaps] on financials. Generally our short exposure has been reduced as many of the companies we were short have failed.”

Mr. Paulson’s plans come at a time when other leading investors, including Jeff Aronson at Centerbridge Partners and Bruce Karsh at Oaktree Capital, are wading into the market for discounted leveraged buyout loans."

We'll keep an eye on this.

"Mr Paulson, who has $36bn under management, was scheduled to hold a dinner and wine-tasting at New York’s Metropolitan Club on Monday night so that he could brief his investors on his plans.'

I'm planning a hunk of Stilton, Bread, and Two Buck Chuck for my readers.

Henry Blodget on Clusterstock seems to believe that it's 2:

"John Paulson Goes Long: Buying Subprime And Other Mortgage-Backed Securities

One of the few folks who made a killing on the housing crash, John Paulson of Paulson & Co., has now started betting on a recovery. His plans to do so filtered into the market a couple of months ago, when he began raising the Paulson Recovery Fund, but now he's actually started buying"

" "Treasury Secretary Henry Paulson has finally conceded the obvious"

Where to begin with TARP and Paulson. Let's try Paul Kedrosky:

"Treasury Secretary Henry Paulson has finally conceded the obvious: There is no longer a toxic asset relief program, or TARP as it was originally called. Toxic assets are not being purchased from financial services company at below market, market, above market, or even supermarket prices, for that matter. It just isn’t happening.

Why not? Partly because it wasn’t the best first thing to do anyway. While it was a cool markets uber alles exercise – we’ll let the market solve the market’s problem! – and a neat grad school thesis project, it was wildly impractical, and it never seemed any less so no matter how many times it was explained.

Instead, there is a $350-$700b Treasury slush fund for doing … stuff to get credit markets working. Mostly consumer credit. Now, that’s not a terrible idea, but it also requires immense trust in the person/people doing the spending. It also creates a very high transparency and procedural hurdle to be cleared by the those same people. After all, the opportunities for abuse and scope creep were always large, and they have now become immense and palpable.

Let’s stop talking about TARP. It doesn’t exist. Call it the PKFKATARP, at best – or if it’s to be all about consumers, maybe just CARP. Either way, it would be nice to know more about what the hell is going on and why. I’m just saying."

Here's my comment:

I'm feeling pretty good about describing hybrid plans like TARP.

Thursday, October 2, 2008
How I've Approached The Plans Being Put Forward

I am a libertarian Democrat. As such, I'm interested in working within a party which can actually change our government over time. Perhaps I am also simply more comfortable culturally in the Democratic Party Coalition.

In any case, I accept that there is a difference between politics and political theory. Politics is the art of the possible. Political Theory is the view of the government that you would ideally like to see.

In the current crisis, I acknowledged two plans as having some merit, and fulfilling my requirement that any plan be clear and understandable:

1) A totally free market plan.

2) A version of the Swedish Plan.

In my mind, there are three points that are informing my views on which plan to favor:

A) There will be a government intervention of some sort, undoubtedly large.

B) Because crises such as these bring about government intervention.

C) If there is government intervention, it should be for as broad a purpose as possible and be as thrifty with the taxpayers money as possible.

Based on these assumptions, I favor a version of the Swedish Plan.

It's not that I don't see other plans as possibly working, but hybrid/compromise plans are generally:

1) Easier to manipulate by special interests.

2) Harder to determine what worked and what didn't.

3) Riskier financially.

That's how I've approached this crisis.

Now, Felix Salmon on this suggestion from Paulson which I wasn't sure I understood, but it's the same as Felix's, and at first I liked it as well, until I remembered how many of these trial balloons I've seen in the sky lately, so here goes:

"Hank Paulson wants the private sector to give him a helping hand with his bailouts:

We are carefully evaluating programs which would further leverage the impact of a TARP investment by attracting private capital, potentially through matching investments.

I think this is a good idea, especially in a world where even Las Vegas Sands can attract new equity capital, and where Barclays shareholders are in revolt because they feel they're being prevented from putting in new money. Clearly, there's money out there to be invested, and Treasury should take advantage of that fact.

If the private sector does end up being asked to match Treasury cash injections, that would also make explicit any government subsidy. Goldman's Treasury money was a lot cheaper than the cash it got from Warren Buffett; it'll be interesting to see whether private-sector funds continue to get a higher return than public funds under this matching program.

There might be something else going on here, though, for the conspiracy-minded. Paulson's already given out hundreds of billions of dollars of TARP money to his Wall Street buddies at bargain-basement rates. If he doesn't want similar bargains to be extended to smelly people like General Motors, then one way of ensuring that would be to insist on private-sector matching funds."

Here, I'm wondering the investors are getting besides matching funds. All that would do is assure that another investor gets in with them. I don't want an added subsidy to this partnership. Why not just invest ourselves then? This is another BS trial balloon, trying to see how people react, namely investors. Yikes.

From the comments, here's Greg Mankiw:

The WSJ reports:

the Treasury Department, signaling a new phase in its $700 billion financial-rescue plan, is considering requiring that firms seeking future government money raise private capital in order to qualify for public assistance, according to people familiar with the matter....

"We are carefully evaluating programs which would further leverage the impact of a TARP investment by attracting private capital, potentially through matching investments," Treasury Secretary Henry Paulson said in a broad speech on the Troubled Asset Relief Program, known as TARP, the global credit crunch and the government's recent steps to address the financial meltdown.

Good idea.

We all agree, in theory, but I'm wondering if it's wishful thinking.

Here's another comment:

Posted: Nov 12 2008 3:49pm ET

I'm sorry, this has trial balloon written all over it. We need Air Traffic Control to keep up with T(A)(E)RP's trial balloons.

It is a good idea, but it's so murky I can't find a clear description of it. I'll keep looking. Foolishly, of course.

By DonthelibertarianDemocrat

Here's Justin Fox:

"Here's what the Treasury Secretary has to say for himself this morning:

The actions taken by Treasury, the Federal Reserve and the FDIC in October have clearly helped stabilize our financial system. Before we acted, we were at a tipping point. Credit markets were largely frozen, denying financial institutions, businesses and consumers access to vital funding and credit. U.S. and European financial institutions were under extreme pressure, and investor confidence in our system was dangerously low. ...

As I assess where we are today, I believe we have taken the necessary steps to prevent a broad systemic event.

It's may also be true that actions by the Treasury and the Fed in September precipitated that almost broad systemic event. But still, Paulson is right. We've pulled back from the financial brink, which is why now we all have time to argue about loan modifications and AIG bailouts and GM bailouts and fiscal stimulus plans and the future profitability of Goldman Sachs and all that.

Oh, and here's Paulson explaining why he changed his mind about TARP:

We asked for $700 billion to purchase troubled assets from financial institutions. At the time, we believed that would be the most effective means of getting credit flowing again.

During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets – our initial focus – would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks."

Here's my comment:

1. donthelibertariandemocrat Says: Your comment is awaiting moderation.
   Wednesday, November 12, 2008 at 4:01 pm

   "Before we acted, we were at a tipping point. Credit markets were largely frozen, denying financial institutions, businesses and consumers access to vital funding and credit. U.S. and European financial institutions were under extreme pressure, and investor confidence in our system was dangerously low. ...

   As I assess where we are today, I believe we have taken the necessary steps to prevent a broad systemic event."

   I'm sorry, Lehman was the tipping point. He's describing a system that had tipped. The problem with systemic thinking is the same problem I have with hybrid plans like TARP: Namely, they're decidedly dicey to assess, and easy to lobby.

   "During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets – our initial focus – would take time to implement and would not be sufficient given the severity of the problem."

   The problem is that this plan without a plan is impossible to assess. All we can really say is that things are better. Right now, I believe, it's too early for him to take credit for anything. He's the captain of a boat that's stop sinking for now, but whether someone plugged a hole, or the boat's running aground, or the boat's temporarily sitting on the back of a whale, he doesn't know.

Now, here from Clusterstock, is Paulson. I want to keep this:

John Carney | Nov 12, 08 10:52 AM

Hank Paulson is still talking about what he's going to do to gin up the securitization market. It sounds a lot like he's planning on providing financing for private market actors to buy up consumer credit and mortgage assets.

Here's the text of his remarks:

Good morning. I will provide an update on the state of the financial system, our economy, and our strategy for continued implementation of the financial rescue package.

Current State of Global Financial System

The actions taken by Treasury, the Federal Reserve and the FDIC in October have clearly helped stabilize our financial system. Before we acted, we were at a tipping point. Credit markets were largely frozen, denying financial institutions, businesses and consumers access to vital funding and credit. U.S. and European financial institutions were under extreme pressure, and investor confidence in our system was dangerously low.

We also acted quickly and in coordination with colleagues around the world to stabilize the global financial system. Going into the Annual IMF/World Bank meetings in early October, I made clear that we would use the financial rescue package granted by Congress to purchase equity directly from financial institutions – the fastest and most productive means of using our new authorities to stabilize our financial system. We launched our capital purchase program the following week when we announced that nine of the largest U.S. financial institutions, holding approximately 55 percent of U.S. banking assets would sell $125 billion in preferred stock to the Treasury. At the same time, the FDIC announced it would temporarily guarantee all newly issued senior unsecured debt of participating organizations for up to three years. In addition, the FDIC provided an unlimited guarantee on non-interest bearing transaction accounts that expires at the end of next year.

As I assess where we are today, I believe we have taken the necessary steps to prevent a broad systemic event. Both at home and around the world we have already seen signs of improvement. Our system is stronger and more stable than just a few weeks ago. Although this is a major accomplishment, we have many challenges ahead of us. Our financial system remains fragile in the face of an economic downturn here and abroad, and financial institutions' balance sheets still hold significant illiquid assets. Market turmoil will not abate until the biggest part of the housing correction is behind us. Our primary focus must be recovery and repair.

Housing and Mortgage Finance

Overall, we are in a better position than we were, but we must address the continued challenges of a weak economy, especially the housing correction and lending contraction.

On housing, we have worked aggressively to avoid preventable foreclosures and keep mortgage financing available. In October 2007, we helped establish the HOPE NOW Alliance, a coalition of mortgage servicers, investors and counselors, to help struggling homeowners avoid preventable foreclosures. HOPE NOW created a streamlined protocol to assist struggling borrowers who could afford their homes with a loan modification. The industry is now helping 200,000 homeowners a month avoid foreclosure. In addition, HUD has created new programs to complement existing FHA options, and to refinance a larger number of struggling borrowers into affordable FHA mortgages.

Most significantly, we acted earlier this year to prevent the failure of Fannie Mae and Freddie Mac, the housing GSEs that now touch over 70 percent of mortgage originations. I clearly stated at that time three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers – both by minimizing the near term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

Fortunately we acted, citing concerns about both the quality and quantity of GSE capital. Unfortunately, our actions proved all too necessary. The GSEs were failing, and if they did fail, it would have materially exacerbated the recent market turmoil and more profoundly impacted household wealth: from family budgets, to home values, to savings for college and retirement.

Earlier this week, Fannie Mae reported a record loss, including write-downs of its deferred tax assets that make up a significant portion of its capital. We monitor closely the performance of both Fannie Mae and Freddie Mac, and both are performing within the range of our expectations. The magnitude of the losses at Fannie Mae were within the range of what we expected, and further confirms the need for our strong actions.

Eight weeks ago, Treasury took responsibility for supporting the agency debt securities and the agency MBS through a preferred stock purchase agreement that guarantees a positive net worth in each enterprise – effectively, a guarantee on GSE debt and agency MBS. We also established a credit facility to provide the GSEs the strongest possible liquidity backstop. As the enterprises go through this difficult housing correction we will, as needed and promised, purchase preferred shares under the terms of that agreement. The U.S. government honors its commitments, and investors can bank on it.

When we took action in September, I said that we would be entering a "time out" – a period where the new President and Congress must decide what role government in general, and the GSEs in particular, should play in the housing market. In my view, government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policymakers must address the issue of systemic risk. In the weeks ahead, I will share some thoughts outlining my views on long term reform.

In the meantime, the GSEs now operate on stable footing. They have strong government support backing both future capital and liquidity needs. We have stabilized the GSEs and limited systemic risk, and our authorities provide us with additional flexibility to use as necessary to accomplish our objectives.

Implementing the Financial Rescue Package

More recently, we have also taken extraordinary steps to support our financial markets and financial institutions. As credit markets froze in mid-September, the Administration asked Congress for broad tools and flexibility to rescue the financial system. We asked for $700 billion to purchase troubled assets from financial institutions. At the time, we believed that would be the most effective means of getting credit flowing again.

During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets – our initial focus – would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.

Of course, before that time, the only instances in which Treasury had taken equity positions was in rescuing a failing institution. Both the preferred stock purchase agreement for Fannie Mae and Freddie Mac, and the Federal Reserve's secured lending facility for AIG came with significant taxpayer protections and conditions. As we planned a capital purchase plan to support the overall financial system by strengthening balance sheets of a broad array of healthy banks, the terms had to be designed to encourage broad participation, balanced to ensure appropriate taxpayer protection and not impede the flow of private capital.

Capital Purchase Plan

We announced a plan on October 14th to purchase up to $250 billion in preferred stock in federally regulated banks and thrifts. By October 26th we had $115 billion out the door to eight large institutions. In Washington that is a land-speed record from announcing a program to getting funds out the door. We now have approved dozens of additional applications, and investments are being made in approved institutions. Although we are moving very quickly it will take time to complete legal contracts and execute investments in the significant number of institutions who meet the eligibility requirements and are approved, but we are on the path to getting this done.

Although this program's primary purpose is stabilizing our financial system, banks must also continue lending. During times like these with a slowing economy and some deterioration in credit conditions, even the healthiest banks tend to become more risk-averse and restrain lending, and regulators' actions have reinforced this lending restraint in the past. With a stronger capital base, our banks will be more confident and better positioned to play their necessary role to support economic activity. Today banking regulators issued a statement emphasizing that the extraordinary government actions taken by the Fed, Treasury and FDIC to stabilize and strengthen the banking system are not merely one-sided; all banks – not just those participating in the Capital Purchase Program – have benefited, so they all also have responsibilities in the areas of lending, dividend and compensation policies, and foreclosure mitigation. I commend this action and I am particularly focused on the importance of prudent bank lending to restore our economic growth.

Since announcing the Capital Purchase Program, we have been examining a wide range of ideas that can further strengthen the financial system and get lending going again to support the broader economy. First and foremost, because the system remains fragile, we must continue to stand ready to prevent systemic failures. That is the basis for Monday's action to purchase preferred shares in AIG. The stability of our system remains the highest priority.

We must also allow markets and institutions to absorb the extensive array of new policies put in place in a very short period of time. The injection of up to $250 billion of capital into individual banks, the FDIC's temporary guarantee of bank debt and the Federal Reserve's multiple liquidity facilities for banks, money funds and commercial paper issuers have all significantly enhanced liquidity and helped improve market conditions.

Priorities for Remaining TARP Funds

We have evaluated options for most effectively deploying the remaining TARP funds, and have identified three critical priorities. First, we must continue to reinforce the stability of the financial system, so that banks and other institutions critical to the provision of credit are able to support economic recovery and growth. Although the financial system has stabilized, both banks and non-banks may well need more capital given their troubled asset holdings, projections for continued high rates of foreclosures and stagnant U.S. and world economic conditions. Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit. Third, we continue to explore ways to reduce the risk of foreclosure.

Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets.

Further Strategies

First, we are designing further strategies for building capital in financial institutions. Stronger capital positions will enable financial institutions to better manage the illiquid assets on their books and better ensure that they remain healthy. Any future program should maintain our principle of encouraging participation of healthy institutions while protecting taxpayers. We are carefully evaluating programs which would further leverage the impact of a TARP investment by attracting private capital, potentially through matching investments. In developing a potential matching program, we will also consider capital needs of non-bank financial institutions not eligible for the current capital program; broadening access in this way would bring both benefits and challenges. Non-bank financial institutions provide credit that is essential to U.S. businesses and consumers. However, many are not directly regulated and are active in a wide range of businesses, and taxpayer protections in a program of this sort would be more difficult to achieve. Also before embarking on a second capital purchase program, the first one must be completed, and we have to assess its impact and use this information to evaluate the size and focus of an additional program in light of existing economic and market conditions.

Second, we are examining strategies to support consumer access to credit outside the banking system. To date, Fed, FDIC and Treasury programs have been targeted at our banking system, and the non-bank consumer finance sector continues to face difficult funding issues. Specifically, the asset-backed securitization market has played a critical role for many years in lowering the cost and increasing the availability of consumer finance. This market is currently in distress, costs of funding have skyrocketed and new issue activity has come to a halt. Today, the illiquidity in this sector is raising the cost and reducing the availability of car loans, student loans and credit cards. This is creating a heavy burden on the American people and reducing the number of jobs in our economy. With the Federal Reserve we are exploring the development of a potential liquidity facility for highly-rated AAA asset-backed securities. We are looking at ways to possibly use the TARP to encourage private investors to come back to this troubled market, by providing them access to federal financing while protecting the taxpayers' investment. By doing so, we can lower costs and increase credit availability for consumers. Addressing the needs of the securitization sector will help get lending going again, helping consumers and supporting the U.S. economy. While this securitization effort is targeted at consumer financing, the program we are evaluating may also be used to support new commercial and residential mortgage-backed securities lending.

Third, we are examining strategies to mitigate mortgage foreclosures. In crafting the financial rescue package, we and the Congress agreed that Treasury would use its leverage as a major purchaser of troubled mortgages to work with servicers and achieve more aggressive mortgage modification standards. Now that we are not planning to purchase illiquid mortgage assets, we must find another way to meet that commitment.

FDIC Chairman Bair has given us a model, in the mortgage modification protocol she developed with IndyMac Bank. Through the end of October, the FDIC has completed loan modifications for 3,500 borrowers, with several thousand more modifications currently being processed. These modifications have reduced payments for participating homeowners by an average of $380 month, or about 23 percent. We have worked with the FHFA, the GSEs, HUD and the Hope Now alliance who yesterday announced a streamlined industry-wide modification program that for the first time adopts an explicit affordability target similar to the model pioneered at IndyMac. With this commitment, the GSEs and large portfolio investors are setting a new industry standard for foreclosure mitigation. Potentially hundreds of thousands more struggling borrowers will be enabled to stay in their homes at an affordable monthly mortgage payment.

Beyond these efforts, there has been significant work to design and evaluate a number of proposals to induce further modifications. Each of these would, however, require substantial government subsidies. The FDIC, for example, has developed a proposal that Treasury and others in the Administration continue to discuss. I believe it is an important idea. As we evaluate the merits of any new proposal, we also will have to identify and justify the means to finance it. We must be careful to distinguish this type of assistance, which essentially involves direct spending, from the type of investments that are intended to promote financial stability, protect the taxpayer, and be recovered under the TARP legislation. Maximizing loan modifications, nonetheless, is a key part of working through the housing correction and maintaining the quality of communities across the nation, and we will continue working hard to make progress here.

We will continue to pursue the three strategies I have just outlined: how best to strengthen the capital base of our financial system; how best to support the asset-backed securitization market that is critical to consumer finance, and how to increase foreclosure mitigation efforts. All of these strategies are important, but ensuring the financial system has sufficient capital is essential to getting credit flowing to consumers and businesses and that is where the bulk of the remaining TARP funds should be deployed --- in a program to support the system and as a contingency reserve for addressing any unforeseen systemic events.

We are focused on developing and preparing programs which can be implemented for each of these strategies. We will continue to brief President-elect Obama's transition team on all of these issues.

Global Challenge

Of course managing through this market turmoil while mitigating the impact of the credit crisis is a global as well as a national issue. We in the U.S. are well aware and humbled by our own failings and recognize our special responsibility to the global economy. The U.S. housing correction exposed gaping shortcomings in the outdated U.S. regulatory system, shortcomings in other regulatory regimes and excesses in U.S. and European financial institutions. These institutions found themselves with large holdings of structured products, including complex and opaque mortgage-backed securities. Some European institutions were characterized by high leverage, exposure to their own housing markets, exposure to Central European institutions, weak business models or overly aggressive expansion, while others faced weaknesses because of inadequate depositor protection systems. It should not be surprising that after 13 months of stress in the global capital markets, banks from the U.S. to the U.K., from Germany to Iceland, from Russia to France, had difficulties that exposed some of these weaknesses for the first time. For some of these banks, this proved to be a hurdle too high and government action was necessary to support financial stability.

In that regard the G7 Finance Ministers meeting last month represented a major turning point in stabilizing the global financial system as the ministers came together to support a number of powerful strategies that were soon turned into effective actions in the United States and Europe. It is also clear that our first priority must be recovery and repair. And of course we must take strong actions to fix our system so that the world does not have to suffer something like this ever again. The Leaders summit President Bush will be hosting this weekend marks a very important step in what will be an ongoing process of recovery and reform.

And to adequately reform our system, we must make sure we fully understand the nature of the problem which will not be possible until we are confident it is behind us. Of course, it is already clear that we must address a number of significant issues, such as improving risk management practices, compensation practices, oversight of mortgage origination and the securitization process, credit rating agencies, OTC derivative market infrastructure and regulatory policies, practices and regimes in our respective countries. And we recognize that our financial institutions and our markets are global, but our regulatory regimes are national, so we will examine how best to improve cooperation and information sharing to foster global financial system stability.

But let us not forget one fundamental issue which lies at the heart of our problems. Over a period of years, persistent and growing global imbalances fueled a dramatic increase in capital flows, low interest rates, excessive risk taking and a global search for return. Those excesses cannot be attributed to any single nation. There is no doubt that low U.S. savings are a significant factor, but the lack of consumption and accumulation of reserves in Asia and oil-exporting countries and structural issues in Europe have also fed the imbalances.

If we only address particular regulatory issues – as critical as they are – without addressing the global imbalances that fueled recent excesses, we will have missed an opportunity to dramatically improve the foundation for global markets and economic vitality going forward. The pressure from global imbalances will simply build up again until it finds another outlet.

The nations attending this weekend's summit represent the 20 largest economies in the world – over 77 percent of global GDP. President Bush is convening this group of countries to discuss and address problems such as global imbalances, making regulatory regimes more effective, fostering cooperation among regulators, and reforming international institutions to better address today's global economy. We can't simply task the IMF, the FSF or other International Financial Institutions to solve the problems, unless member nations all see that they have a shared interest in a solution. There are no easy answers, because until we reach a consensus on a broad-based reform agenda, we will not reach a solution. This weekend provides an opportunity for nations to take an important step, but only one step, on the necessary path to reform.

Conclusion

The road ahead, for the U.S. economy and the global economy, is full of challenges. And it will take strong leadership to address them. I am confident the United States, under this and the next Administration, will rise to these challenges. I will do everything I can to put us on the right path, both by working diligently through the end of my term and by working closely to ensure the smoothest possible transition.