Thursday, January 22, 2009

Good bad bank vs. Bad bad bank

(No doubt Obama Smartypants is struggling to get the porridge just right for Goldilocks. My gut feeling on this is that just like it was obvious that anything Shrub and his minions proposed would be of, for, and by the banksters ... justified by the 'shock and awe' of the situation ... Obama's solution will be nuanced to balance taxpayer interests with investor interests and will attempt to go full monty learning from the bashing the Brits are taking on their guarantee(d to be back with more gruel sir) program. Of course that assumption is based on Barry Dunham being Obama Smartypants and not Obama NancyPants. If the former, would think 'Da plan' would involve a RTC-type entity (that will go bust the banksters with a 'data SWAT team') and a partnership with private money to find the clearing cost of cancer. Gotta make it worth their (pirate equity and assorted booty buds)while ... whilst not giving away the taxpayer-financed farm. The movement in financial equities as of late has been stunning as the market tries to figure out who the sucker at the table is now that there isn't a certainty that the taxpayer will be the one losing all the chips. -AM)

Wall Street Journal
JANUARY 22, 2009

As bank shares plunge to new lows around the world, it seems we have entered the next stage of the financial crisis -- most likely the last chapter in this horror story. The final word will probably be nationalization of the major financial institutions in the United States and the United Kingdom and in many other countries.(Not likely that would be too bloody complicated and inevitably would create zombie banks doing lending based on political as opposed to financial merits. - AM)

How has it come to this? The global credit crisis and the ensuing economic slump we are now entering have both ultimate and proximate causes. The ultimate cause was the ingrained social behavior of the U.S., the U.K. and many other economies over the past two decades that put instant gratification of consumption over the ability to pay for it. Thrift gave way to borrowing and excessive spending. That in turn led to huge global imbalances and distortions. The proximate cause of the crisis was how these excesses were financed through liquidity creation in innovative ways and in huge proportions.(Yes and the little chestnut that without prudential regulation, Marx looks prescient- AM)

Understanding these causes can explain why it has become so difficult to solve the crisis. Desperate to preserve the value of asset prices inflated by this huge liquidity bubble, policy makers have avoided the painful solution. The liquidity injections, the bailout programs, and the fiscal-stimulus packages try to sustain asset prices, when these prices need to fall to market levels so they can be cleared. The policy makers have just prolonged the crisis.(Nancy capitalists think that ignoring the door makes the bad man go away.- AM)

I am reminded of the clear conclusions of the World Bank's thorough analysis in a 2002 paper "Managing the Real and Fiscal Costs of Banking Crises," which examined banking crises over the past 50 years: "Accommodating measures such as open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated recapitalizations and debtor bailouts appear to increase significantly the costs of banking crises. Did these accommodating policies achieve faster economic recovery? We failed to uncover evidence that they did. Indeed, they seem to have prolonged crises because recovery took longer." (Don't you wish Georgie had been just a tad curious and told folks to do some research?- AM)

As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker.(That is assuming that it ain't Austrian this time and you can avoid the deflation. - AM)

There is nothing mysterious about the policy steps that need to be taken to get us out of this mess as quickly as possible. It is not rocket science. In fact, it was successfully carried out by the Scandinavian authorities back in 1991. The banks must be forced to disclose their "toxic" assets (the German banks have about 300 billion euros, the U.K. banks probably 200 billion pounds, and the U.S. banks maybe $800 billion)( Multiply that number friend. - AM). Then these must be written down to market prices with the hit being taken by shareholders and bondholders -- but not depositors. If that means most banks become insolvent, then so be it.

In effect, this function can be executed by the setting up of a "bad bank," as the Swedes did in the early 1990s. The bad bank clears the toxic assets off the books of banking systems by buying them at market prices and forcing write downs by the banks. A good bad bank forces banks to write down their bad assets and cleanse their balance sheets with those made insolvent being recapitalized, nationalized or liquidated by the state. But it is equally possible to use a bad bank to buy the banks' toxic waste at inflated prices so that the bank can start lending again. That's when it becomes a bad bad bank.(This is the test for our new President. For this young charismatic leader we'll call it the Bray of Pigs. - AM)

Unfortunately, so far, all the policy makers in the U.S., the U.K. and Europe have rejected the good bad-bank approach and we are now entering the third year of credit crunch with most banks already on their knees. Both the new U.S. administration and the current U.K. leadership are still in denial.

Last October, when the U.K. came up with a better blueprint for dealing with the credit crisis through recapitalization than the Bush administration's poorly conceived Troubled Asset Relief Program (TARP), I gave the Brown government credit for doing so, but faulted it for omitting the good bad-bank function. And now the latest U.K. bailout program, introduced because the October bailout is not working, has also eschewed the good bad-bank option and opted instead for an insurance guarantee scheme.

This new bailout package proposes to insure banks against losses on their remaining toxic assets. Banks will pay a 10% insurance fee, payable with either cash or equity. The taxpayers will take on the risk of losses on 90% of the toxic assets insured. The toxic assets remain on the banks' books, but the banks no longer have any risk in their exposure to them.

The government shied away from the good bad-bank solution because if toxic assets had been written down, most of the U.K. banking system would have been bust and forced into nationalization. In the U.S., the Obama administration is also apparently considering both the bad bank and the insurance solution. I fear they will opt for the latter.(Let's hope not. -AM)

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