Financial crisis. Losing sight of the core problem?

November 10, 2008

During my obligatory daily leafing through the Financial Times today I was struck by one little article squeezed in between headline news on the enormous amounts of money the Chinese want to inject into their economy, the subsidies US carmakers could receive – a few weeks after a the German and French governments announced they would help their car producers -, the big schemes the G20 is lost in planning, the chorus of commentators calling for fiscal stimuli and the like. This short article was entitled: Buying of US toxic assets urged.

It says:

Plans for the US government to buy troubled assets as part of its $700bn financial sector rescue should not be abandoned or delayed in the transition to the Obama presidency, a top securities industry official has warned.

The plan to buy so-called toxic assets from banks was the original centrepiece of the $700bn financial sector rescue approved by Congress, but was overshadowed when the first $250bn was diverted to buy stakes in banks.

There are still few details as to which securities the government will buy, and how, and many question whether the Obama administration will implement the asset purchase scheme at all (…)

Some experts think asset purchases should be abandoned and the entire $700bn used for recapitalisation. However, Mr Ryan said that would be a mistake (…)

Mr Ryan, a former head of the Resolution Trust Corporation which cleaned up the mess after the Savings and Loan crisis, added: “I am a big believer in government establishing the market clearing price for these assets because nobody else is doing it.”

He said as long as banks remained unsure about what their assets were worth, capital injections would have only limited impact on their willingness to extend credit.

This reminded me of an interview the Wall Street Journal held with Anna Schwartz, co-author in 1963, along with Milton Friedman of the famous Monetary History of the United States (article commented over at Marginal Revolution). In there, Schwartz basically argues that the US authorities are fighting the wrong war:

In the 1930s, as Ms. Schwartz and Mr. Friedman argued in “A Monetary History,” the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they’d lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: “If the borrowers hadn’t withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress,” deepening the crisis and causing still more failures.

But “that’s not what’s going on in the market now,” Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”

“Why are they ‘toxic’?” Ms. Schwartz asks. “They’re toxic because you cannot sell them, you don’t know what they’re worth, your balance sheet is not credible and the whole market freezes up. We don’t know whom to lend to because we don’t know who is sound. So if you could get rid of them, that would be an improvement.” The only way to “get rid of them” is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson’s original proposal to buy these assets from the banks was “a step in the right direction.”

The problem with that idea was, and is, how to price “toxic” assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail.

Ms. Schwartz won’t say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly (…). But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. “They should not be recapitalizing firms that should be shut down.”

Rather, “firms that made wrong decisions should fail,” she says bluntly. “You shouldn’t rescue them. And once that’s established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich.” The trouble is, “that’s not the way the world has been going in recent years.”

This is echoed by the head of the Global Bank per se, HSBC, today too:

The chief executive of HSBC on Monday criticised the state-sponsored bail-outs of western banks, arguing that they risked rewarding management teams for failure.

The comments by Michael Geoghegan reflect a deep frustration at recent bank bail-outs among executives at HSBC which, despite suffering heavy losses in the US, has weathered the credit crisis in better shape than many of its rivals.
There is no question that guarantees have been given to failed managements,” Mr Geoghegan said, adding that they risked distorting the market. “I hope these guarantees don’t last too long because they may create the wrong type of behaviour by managements in those banks.”

The big risk of politics and policy today is moving from needed but well-designed rescue packages and real reflection on how to avoid major financial disasters (this would require time, not urgency) to an indiscriminate spending binge that will ultimately lead to supporting coddled sectors and to more economic stagnation. John Meynard Keynes, the godfather of fiscal stimulus package ideas, himself, would, if he had been alive today, probably have questioned the rationale of many a government’s plans and actions. At least if we believe Nobel-prize winner Edmund Phelps.


One Response to “Financial crisis. Losing sight of the core problem?”

  1. Ambrosio Says:

    Always a pleasure to be led by you Iana. This post provides us with very useful keys not only to better understand an aspect of the financial crisis but also to face with the miscommunication on propositions to solve it. Thanks for pointing out this “little” and yet rich FT article!

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