Search This Blog


Thursday, 27 November 2008


Here are some Questions & Answers that spell out what and why Government has to intervene in bailing out the banks and fiscal measures (via the size of the budget deficit) to kick-start economic recovery. Note that in 2009 the US and UK economies are on track for a 2.5% fall in GDP (business profits, earnings and unearned incomes). They are each planning an 8% fiscal boost to their respective economies that should feed through to a +4% growth impulse to the GDP trend by late 2009 or by 2010. Think of what is happening as Government seeking to place itself as a hard rock-solid support under the finance sector (and the economy) so that the banks will confidently pull up business on the one hand and households on the other hand and not let them both fall into the sea to sink or swim by themselves. Q: We are nationalising and/or Government-guaranteing private sector companies (commercial banks), thereby turning them into more versions of Fanny Mae & Freddie Mac with a wider class of assets secured beyond just residential housing mortgages?
A: Yes, but temporarily, and only where there is a greater systemic cost of not doing so. This is akin to Government taking over any failed companies that are responsible for essential services that everyone relies on in their daily lives. In the case of banks there are choices of how to do this:
1. let them merge and net-off obligations between them, effective where 2 or more large banks merge or large banks take over smaller banks (this too may allow for writedowns and capital savings sufficient to ride out losses) except that merger costs are high and banking competition suffers;
2. let well capitalised non-banks buy ailing banks - but not when the buyers are private equity (whose accounts are private and hidden) opportunist asset-strippers merely seeking to profit hugely after banks have been oversold and their share prices far below net assets (book value); it is better therefore for the taxpayers' interest (i.e. the Government's best interest too) to buy banks and gain the profit instead of 'the privateers';
3. let weak banks fail a la Lehman Brothers - but not if the result is a domino effect (systemic) of unfair losses to countless innocent others (costing years to sort out and net-off all the credits and debits from whatever can be salvaged). If a major traditional bank fails then all outstanding loans are called in and deposits & funding have to be repaid causing a massive economic knock-on cost including too possibly massive losses in tax and net cash-flow to Government itself.
Q: Is it not right to hold to the concept of fair valueand that banks' insolvencies should be allowed. the financial service sector is overbanked and banks oversupplied credit (excess money) that led to asset bubbles and far too many people in work, working with illliquid non-marketable assets? A: Don't neglect that Government is also to blame for the bubbles including policy of offloading public housing provision onto banks by getting banks and mortgage brokers to extend mortgages to sub-prime (dirt-poor) borrowers, a quarter of whom defaulted on payments as soon as the economy stumbled. This lending to the poor and even welfare classes had, it may be validly argued, valuable social benefits for many deserving poorer people (even if we all must pay something for that) who now could accumulate tangible assets, but could also borrow more, whetehr responsibly or not?! The credit boom also encourage consumer spending and sucked in imports without which hitherto 'dirt-poor' countries such as China and India would not have grown so well and gained marked improvements to the material welfare of several hundred million people in the past decade. Q: Is that what you mean by 'fair value,' how good the boom was for China?
A: It felt good at home too. No, of course, we mean 'fair value' when pricing assets at something different from the prices they would fetch today sold in the marketplace. When thinking of 'fair value' should it be always where the market is today, always PIT (point-in-time), or TTC (through-the-cycle) values? My answer is that values must be stated as both measured together. This is how home-owners think; if the house is falling in price now, it will however be worth a lot more longer term Therefore, for example, banks are right to switch some holdings from Assets-for-Sale on trading books to Hold-to-Maturity on banking books . Q: What about the falling prices for Asset-Bancked Securities (ABS) that have triggered the whole Credit Crunch?
A: These now illiquid assets are essentially normal bank loans packaged into fixed income bonds supported by interest and repayments revenue from the underlying mortgages and other loans (which for a fee continue to be managed by the loan-finance originating banks). Over a recession up to 15% (very worst case, up to 25%) of loans become 'impaired' (payment defaults) but only half will become terminal defaults and net loss will be about half that. The damage to banks and investors in the interim is that they have to writedown the maximum possible loss as reflected in market prices (even though there is insurance cover and standby loans to mitigate the losses). If banks had kept these loans on their banking books smaller losses would need to be posted against profit. So banks have big paper losses to charge against their capital reserves. And investors who bought the ABS with short-term borrowings and who could not pay margin calls and maintain collateral against loans were forced to sell the bonds at fire-sale prices thereby dragging down the market prices below the bonds' cash-flow value. Insurance companies creditworthiness also fell execessively long before compensation claims for credit losses. So Government had to step in to buy more time for everyone and is able to do so at an economic profit for taxpayers and he whole economy, profitable compared to the cost of further economic collapse. Q: You mean bailing out the finance sector and insuring it against losses?
A: Banks and insurers are not being bailed out of all their losses (which will include many legals suits too), not at all; banks and insurers are still getting 1x capital wipeouts and Government is merely saving them from 2x capital wipeouts.
Q: is it not better for the loss-making assets to be liquidated over time and let prices will fall to "real values," to market-clearing prices. Deferring this is just that a deferral, not a realisation of value. So your solution of installing a price floor under these assets is simply a tax burden on the future and unsustainable? A: ABS asset prices should rise to find their "real values" not fall further, not now, and not when measured logically in net cash-flow terms especially against a lower central bank rate and a slowly falling LIBOR rate. And, yes, it is a deferral, but a deferral only until a firm footing is achieved on rising ground.- Ultimately, all others (not just the banks alone) will, one way or another, pay for losses as they filter through all components of the 'real' or 'underlying' economy in recession, making recession deeper and longer. This, Government wants to mitigate. To let major banks fail also lets the whole economy fail, a system-wide failure with multiplier effects that will greatly amplify the original losses! Trust & confidence are critical to how any economy operates. We live in a circular money-flow 3-D world of innumerable financial 'roundabouts', not just 'swings' or 'see-saws'. There is 4-7 times as much value to be found in banks' books and balance sheets than appears to be the case among those many large banks whose share prices have falled 0-90%! Government is intervening on a basis of helping banks but also helping itself (aka taxpayers) to gain the benefit of much of this yet to be fully realised value. Q: What about the future tax burden to pay for all this?
A: You must ask whether 'the burden' will be lower or higher if Government does not run a higher budget deficit so as to spend more, and how it spends it when all others are too fearful to keeping spending and investing, across the whole economy, including to stand surety for more of banks' troubled assets? Government Deficit Spending is not extra-terrestrial, as some critics appear to believe. It is cheaper than private spending and generates benefits throughout the economy including short term return flows into Treasury coffers. Therefore there is not a 1 for 1 ratio between future tax burden and the rise in Government debt. Q: Is this just putting a floor under the economy or actually growing it?
A: Government intervention (both US and UK budget deficits for 2009 expected to be 8% in ratio to GDP) will support the economy by putting a floor under how far GDP (incomes) fall and pay for this by generating more tax revenue across whole economy than the gross cost of the fiscal deficit. Many taxpayers worry about Government debt because it is a debt accepted on everyone's (taxpayers') behalf. But, we should not lose sight of the context. Household, corporate and bank debt have all grown far faster than Government's National Debt such that the former are 3x, 3x and 6x Gross National Debt (GND). But actual 'net' US GND is only half of gross GND and UK net GND is only 75% of gross GND, the balance in each case being merely debt internal to Government. So the real ratios of private to government debt are even higher than 3,3 and 6. Of course, each of these sector debts have counter-balancing assets, but also much bank, corporate and household debt is unsecured (insofar as only secured by income not by tangible property or financial assets). In general, all assets that can be sold (marketable) are currently depreciating, and corporate profits are falling rapidly, and personal incomes are under threat or falling, if more slowly. Government is seeking to defend incomes (earned and unearned) by placing assets in quarantine, at least to the extent of building a floor under the falling prices.
Q: What about inflation or is it deflation and the money supply? A: Money supply was rising fast but now is rising too slowly. If inflation rises, carrying corporate and personal incomes up, this would devalue the cost of repaying of debts (though at a cost to cash savings), but we now face a deflation threat doing the opposite! Hence, Government is also seeking to put a floor under inflation. All assets and incomes are in real world measured in current cash not real inflation-adjusted. Therefore, Government wants to keep cash-flows inflation-wise moderately up (2.5% target) to make it easier for debts to get repaid or when unsecured to default less.. Q: Where you have excess banking capacity shouldn't banks be allowed to fail? It may be sad but true, that slow liquidation of 'troubled assets' and deleveraging (banks cutting their lending) is crippling to the economy and maybe to the finance sector also, which is thereby slowing up or dragging down any recovery!?
A: Banking capacity is falling with all banks facing a general 30% fall. Government wants to make sure that falling capacity does not hit household and small business lending. The capacity fall is mainly in investment, not retail, banking, but coincides with a 2-3 years 30% fall in all property and real estate (the biggest collateral class). When asset bubbles expanded the balance between wealth gains from assets values (unearned income) compared to gains from earned incomes became very unbalanced, too skewed in favour of financial & real estate asset gains. Now, arguably, there is a better balance, except the adjustment process is painful insofar as it is now feeding into lower earnings and higher unemployment. Governments are trying to maintain everyones earnings (& employment) until a new balance between unearned and earned incomes is stable.
Q: Why are banks so important to Government, compared say to the automotive industry of retail and transport services?
A: Banks are the closest to Government in how they are positioned across the whole economy. Banks less so, but like Government, have a stake in whole economy. Who banks lend to is decided, however, more by who asks to borrow from them. In recent years that demand has come overwhelmingly from real estate, from mortgage borrowers, property developers and construction companies. Property-related lending has been twice that of all lending to all other industrry sectors. Property is a big economic sector, but banks are over-exposed to it. This may not be entirely banks' fault insofar as they respond to what the economy demands. They did try to grab market share in the rising demand and thereby forced the demand up higher. No-one in authority challenged the banks for growing their assets at a speed that far outpaced the economy and for generating twice the profit rate of the rest of the economy! Governments could do the same, but have a political constituency to care about. Banks differ from Government by being commercial corporations with a more self-centred 2-dimensional view of profit/loss. When recession hits banks' p/l, they respond pro-cyclically, usually with a 2 quarter lag. Government also responds late except for 'automatic stabilisers' (spending on transfers e.g. social welfare, and services such as education and health, which are maintained or grow in recession). But, only Government feels obliged (politically) to act counter-cyclically (by fiscal & monetary means). Banks do not feel so obliged, except that if they call in too many loans they may trigger a domino effect of customer insolvencies. Therefore, when recession strikes, it is Government alone that truly manages its response to the problems of the economy. Ideally, Government would like to partner with banks in this role. But, if banks can't or won't agree to act counter-cyclically alongside Government, then nationalisation (by command or by ownership) may be necessary. The choice can be either that or Government simply has to break with normal standards of financial prudence to a degree that may cause a political panic among taxpayers. An important difference between banks and Government is the triple-A creditworthiness of Government. Its debt is safest and it can borrow most cheaply. This is important in allowing Government the luxury of balancing its financial risks in the much longer term than any other sector, whether banks or the auto industry. Government is not subject to the volatility of stock market prices or the same solvency risks, at least not the OECD Governments! More on Bail-out solutions see: and
On UK budget and recession?
UK Government meeting with banks to browbeat them into maintaining lending levels:
What US banks have lost and impacts on capital
On Obamanomics & Obama's team and policy on the US election result and then on the new team and

No comments: