A Simpler Solution

Some real common sense like this would go a long way in restoring my confidence in the system. I have not heard a politician yet that has any clue as to what to do. Most are blaming the other party, which is probably the worst thing to do right now. Hank Paulson just says we need to do the recovery package or everything is going to fall apart, but I think it is going to do that anyway. The whole bail out does not pass the smell test. Keep offering ideas!

Maybe the Swedes got the incentives right:

Sweden didn’t just bail out its financial institutions by having the government take over the bad debts. It also clawed its way back by pugnaciously extracting pounds of flesh from bank shareholders before the state started writing checks.

That strategy kept banks on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. Even the chairman of Sweden’s largest bank got a stern answer to the question of whether the state would really nationalize his bank: yes, we will.

[…]Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. In a similar situation later in the decade, Japan made the mistake of dragging the process out, officials in Sweden and elsewhere note, delaying a solution for years.

Then came the imperative to bleed shareholders first.

Lundgren recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden’s largest bank. Wallenberg, the scion of the country’s most famous family and steward of large chunks of its economy, heard from the finance minister that there would be no sacred cows.

The Wallenbergs turned around and arranged a private recapitalization, obviating the need for a bailout at all. SEB turned a profit the following year, 1993.

“For every krona we put into the bank, we wanted the same influence,” Lundgren said. “That ensured that we did not have to go into certain banks at all.”

By the end of the crisis, the Swedish government had seized vast swathes of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

“I worry about the sheer glee that the Left is experiencing as they chorus, “The market failed! The market failed! We need government to take over everything. Dictate executive compensation! Take equity stakes in private firms! Increase regulation by orders of magnitude!”

Not to be contrary regarding the glee the Left is theoretically experiencing (or will be soon), but isn’t a right wing, supposedly neo-conservative government banging the drum loudest here for your socialist wet dream?

And isn’t this same government responsible for the largest increase in government spending in 30 years?

Despite ideological archetypes, the Republican party is the current champion of socialist enthusiasm.

There is a bit of a paradox with capital requirements, just like reserve requirements. The requirements mean that the reserves or capital cannot serve their purpose.

A bank builds up reseves so that it can face adverse clearings or currency withdrawals without selling off assets or borrowing money. But if the reserves are held to meet a regulatory requirement, then must do just that.

Similarly, a bank builds up capital (net worth) in good times to avoid default when there is a run of losses. Then, profits from good assets allow capital to be built back up. But capital requirements mean that the cushion cannot be used. While it is possible that the bank can find new investors, the usual practice is to shrink the balance sheet to meet the requirement.

I would note, however, that free bankers, (like me) have emphasized past practices of reporting capital in order to reasure depositors. That sort of informal capital requirement could have much the same result.

And, of course, forebearance in the Saving and Loan crises involved are reduction in capital requirements. (Though I suppose Kling is suggesting going from, say, 10% to 6%, rather than 4% to something negative.)

Something we should all note: a lot of this is zero sum, so, in some sense, a lot of the “costs” people are talking about aren’t really costs we should be worrying about.

For instance, people who overpaid for a house are mirrored by people who were overpaid for their houses. So current occupants of big houses transferred money to the people who sold their houses to them, most notably retirees who moved to rentals or much smaller houses.

For people who built houses, there may have been no loss since money was spent and a house built. That is not obviously a bad thing. There might have been some inefficiency because the costs of building was driven up by the demand and too many houses were built, but that is a much smaller cost than the cost of the houses built.

In mortgage lending, there was no net cost since group A gave money to group B who are not going to give it back (because they gave the money to the people who sold them their houses). There are externalities which are costly, such as the possible breakdown of the financial system and the very real psychic costs of worrying about your mortgage, but this is (hopefully) not equal to the loss numbers being thrown around.

Also, your desire to give mortgage holders a break could easily be done in a free-market way. Mortgage holders should be treated like any other parties to a financial contract. The bank made a non-recourse loan to them on collateral which cannot support the loan anymore. Rational re-negotiation would write down the loan to the new equity and reduce the interest payments accordingly. Government could help grease the skids to this outcome. You don’t have to sell this as social do-gooding, it is something companies do all the time. The home-owner has every right to walk away from the loan the banks willingly made. This is a potent threat and so the banks should write down the loan. Walking away is a big pain for the homeowner and the bank, so the efficient outcome is renegotiation.

Thinking in this way suggests that the real objective here is not to minimize the “costs” which aren’t really costs; the objective is to work through who should bear these losses with a minimum of damage to the financial system.

Here, it baffles me as to why people seem to assume that bondholders should be protected from losses on their investments. Bonds go kablooie all the time, and bondholders know that. I don’t see why we have to give any of these bondholders or institutions money. And a lot of the bondholders are foreign. Why should American taxpayers give money to foreign bondholders?

It seems like we should just allow institutions to start up a fresh bank with fresh capital and leave the old assets in the old bank to be run off as best they can. The old bondholders get as much money as the old assets will generate, and take their lumps from any shortfall. The equityholders, of course are out of luck. So, it seems like the government should be smoothing the path to let this happen, perhaps by providing liquidity for the new, solvent banks. Managment of failing banks should, of course, be fired and sued en masse somehow. Not sure how, but the old equityholders have good grounds to sue and have the authority to fire.

The argument for rescinding “mark to market” rules is that it is the rules themselves that drive down the underlying asset values in a destructive feedback loop. This part of the plan is the “no-brainer” part, but this does nothing to solve our remaining problems, foremost of which is our weak dollar. For whatever reasons, bankers astonishingly got it into their heads that building housing stock in Modesto, Ca. was a better use of funds than building manufacturing plants, or exploring for oil, or supporting new product development. These competing activities produce tradeable goods which would help float the dollar. The immediate reaction to the current liquidity crisis is solvable in many ways, but if the overarching outcome doesn’t disabuse bankers of their mindless love affair with home building, our troubles are going to get much worse. Even a reallocation of resources starting now will take years to bear fruit as tradeable goods.

If these MBS and derivatives are so worthless under the mark-to-market rules why isn’t that reflected in their investiment ratings (or is it?)? How did the rating agencies get these rated so incorrectly for so long? How can the market ever accurately price them if their ratings don’t accurately reflect their value?