Willem Buiter on Grandson of Tarp

The first fundamental problem of the US banking system is now that that there are too many banks with too little capital. The second fundamental problem is that we still don’t know what the true value of the capital shortfall is and how it is distributed. The ‘we’ in the previous sentence certainly applies to those outside the banks holding the toxic assets. It may well include the management of some of these banks also.

TARP and its descendants are ‘value revelation mechanisms’. At the very least, if trades take place under the scheme, it will reveal the reservation prices of the sellers. Without TARP there are 3 valuations for a toxic asset. From low to high they are: its fire-sale value in illiquid private markets, the value at which it is carried on the bank’s balance sheet and the hold-to-maturity value.

For a bank to offer an asset for sale under the TARP, the TARP price has to be at least equal to its fire-sale value. Most likely, it will have to be at least as high as the fair or unfair value at which it is carried on the bank’s books. Otherwise a bank would effectively decapitalise itself by selling the asset at the TARP price. The only exception would be when the bank knows it is carrying the asset at an inflated value and expects its bluff to be called soon.

If the TARP succeeds in pricing most the toxic assets on the banks’ books, we will at least gain clarity about the true financial position of the banks. Only then can the recapitalisation of the banks be considered.

Grandson of TARP is a bad way to recapitalise the banking system

TARP could help recapitalise the banking system if the Treasury were to pay more for the toxic assets that what they are valued at on the banks’ balance sheets. That would be a terrible way to inject capital into the system, however. The banks would, of course, love it. But it would be an unconditional capital injection, giving the tax payer no upside on his risky investment and no voice in the management of the banks that are benefiting. I therefore propose that the TARP value the assets it purchases as aggressively as possible (that is, as close to the fire-sale price as possible).

How to inject capital into the banks?

A capital injection by the Treasury into the banks in exchange for equity (ordinary shares or preference shares with a warrant to convert into equity at a known price) would have two obvious consequences.

First, it would continue the nationalisation of the US banking sector.

Second, it would increase the total capital of the banking sector. From a longer-term perspective, that seems unwise. The sector will have to contract its employment and balance sheet to shrink the supply of financial services and products to match a much-reduced demand.

An alternative would be for the government to set a maximum leverage ratio (or a minimum capital ratio) but to give the existing shareholders pre-emptive rights to bring the actual capital up to the target level, with the government filling in the remaining gap, if any.

I would, however, prefer a mandatory debt-to-equity conversion for the banking system. Again, the government would set a maximum leverage ratio or minimum capital ratio, but now existing bank debt would be converted (in inverse order of seniority) into stock.

Effectively, a mandatory debt-to-equity conversion would be a sector-wide high-speed version of Chapter 11.

The disappearance of money and credit markets

I propose that the authorities for the time being socialise the interbank market. They can do this in one of two ways. Either the central bank becomes the universal counterparty in all interbank transactions, secured and unsecured. Banks lend only to the central bank and borrow only from the central bank, not to and from each other directly. This is already effectively the case in the overnight market.

Soros on Paulson and TARP

Hank Paulson’s $700bn rescue package has run into difficulty on Capitol Hill. Rightly so: it was ill-conceived. Congress would be abdicating its responsibility if it gave the Treasury secretary a blank cheque. The bill submitted to Congress even had language in it that would exempt the secretary’s decisions from review by any court or administrative agency – the ultimate fulfillment of the Bush administration’s dream of a unitary executive.

Mr Paulson’s record does not inspire the confidence necessary to give him discretion over $700bn. His actions last week brought on the crisis that makes rescue necessary. On Monday he allowed Lehman Brothers to fail and refused to make government funds available to save AIG. By Tuesday he had to reverse himself and provide an $85bn loan to AIG on punitive terms. The demise of Lehman disrupted the commercial paper market. A large money market fund “broke the buck” and investment banks that relied on the commercial paper market had difficulty financing their operations. By Thursday a run on money market funds was in full swing and we came as close to a meltdown as at any time since the 1930s. Mr Paulson reversed again and proposed a systemic rescue.

Mr Paulson had got a blank cheque from Congress once before. That was to deal with Fannie Mae and Freddie Mac. His solution landed the housing market in the worst of all worlds: their managements knew that if the blank cheques were filled out they would lose their jobs, so they retrenched and made mortgages more expensive and less available. Within a few weeks the market forced Mr Paulson’s hand and he had to take them over.

Mr Paulson’s proposal to purchase distressed mortgage-related securities poses a classic problem of asymmetric information. The securities are hard to value but the sellers know more about them than the buyer: in any auction process the Treasury would end up with the dregs. The proposal is also rife with latent conflict of interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief. But if the scheme is used to bail out insolvent banks, what will the taxpayers get in return?

Barack Obama has outlined four conditions that ought to be imposed: an upside for the taxpayers as well as a downside; a bipartisan board to oversee the process; help for the homeowners as well as the holders of the mortgages; and some limits on the compensation of those who benefit from taxpayers’ money. These are the right principles. They could be applied more effectively by capitalising the institutions that are burdened by distressed securities directly rather than by relieving them of the distressed securities.

The injection of government funds would be much less problematic if it were applied to the equity rather than the balance sheet. $700bn in preferred stock with warrants may be sufficient to make up the hole created by the bursting of the housing bubble. By contrast, the addition of $700bn on the demand side of an $11,000bn market may not be sufficient to arrest the decline of housing prices.

Something also needs to be done on the supply side. To prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay.

The rescue package leaves this task undone. Making the necessary modifications is a delicate task rendered more difficult by the fact that many mortgages have been sliced up and repackaged in the form of collateralised debt obligations. The holders of the various slices have conflicting interests. It would take too long to work out the conflicts to include a mortgage modification scheme in the rescue package. The package can, however, prepare the ground by modifying bankruptcy law as it relates to principal residences.

Now that the crisis has been unleashed a large-scale rescue package is probably indispensable to bring it under control. Rebuilding the depleted balance sheets of the banking system is the right way to go. Not every bank deserves to be saved, but the experts at the Federal Reserve, with proper supervision, can be counted on to make the right judgments. Managements that are reluctant to accept the consequences of past mistakes could be penalised by depriving them of the Fed’s credit facilities. Making government funds available should also encourage the private sector to participate in recapitalising the banking sector and bringing the financial crisis to a close.

Bungled and Badly

Bradford and Bingley has the classic balance sheet of a bank in big trouble. On the left side there is not much right. On the right side there is not much left

Buffett bails out Goldman

Mr Buffett’s downside is protected. His $5bn of perpetual preferred stock is essentially permanent capital, but with a cushion of Goldman’s $50bn of shareholders’ equity beneath it. It carries as sweet 10% yield. It is basically a very big insurance premium against another vicious leg-down in capital markets. Throw in Mr Buffett’s warrants to buy $5bn in Goldman’s common stock at a price that is already well in the money, and he looks to have played a blinder.

Daniel Gross and Stefano Micossi on how Europe can't afford TARP

The crucial problem on this side of the Atlantic is that the largest European banks have become not only too big to fail, but also too big to be saved. For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to about €2,000bn (more than Fannie Mae) or more than 80 per cent of the gross domestic product of Germany. This is simply too much for the Bundesbank or even the German state, given that the German budget is bound by the rules of the European Union’s stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. Similarly, the total liabilities of Barclays of around £1,300bn (leverage ratio 60!) are roughly equivalent to the GDP of the UK. Fortis bank has a leverage ratio of “only” 33, but its liabilities are three times the GDP of its home country of Belgium.

Gavekal research ask WHY DO HEDGE FUNDS EXIST?

Why do hedge funds make money?...After all, virtually every industry, every business, everything that makes money, does so because it makes our lives better. The provision of investment capital is a vital function in society. Is that the function hedge funds provide? Not really. That is the function of long-only investors. Hedge funds and investment banks on the other hand, are both long and short - and long and short and long and short and long and short ad infinitum. And that's just the stocks. They can also be long and short the options, futures, and corporate bonds, credit default swaps, convertible bonds, etc. And that's just the corporate cpaital structures! We still have interest rates, commodities and currencies to think about.

...They may not provide investment capital, but they still make capital markets work better. They maket them more liquid. As speculators, they take the other side of derivative contracts from hedgers who need to transfer risk to someone willing to take it for a price. In short, they make markets more efficient.

...By the late 1990s, the prop desks were feedign their top students into the hedge fund industry and we witnessed a wholesale migration on efficiency capital from investment banks to hedge funds.

...In recent years, hedge funds started to compete with investment banks as the primary source of the world's efficiency cpaital. Investment banks fought back by inceasing salaries and increasing leverage. In short, as hedge funds started to steal away the business of banks, the banks, rather than learn to live with lower returns, elected to take on more risk in a bid to continue making just as much money. Worse yet, in their battle against hedge funds, banks were forced to fight with a hand tied behind their by the very governments now spending billions to rescue them.

Since 1998 and the LTCM hedge fund crisis, every year, domm-monger have been predicting that the hedge fund industry, the least regulated entity in our financial markets, would see massive bankruptcies and engender large scale destruction of capital. Meanwhile, at the first hint of a liquidity squeeze, it is the banks (again, the most regulated entities), that are going bankrupt in alarming numbers. Is this a coincidence? We do not believe that is. Meanwhile, and very alarmingly, policymakers are getting ready to prescribe yet more regulation to solve a crisis which finds its source in...excessive regulation.

....From 2000 to 2003 we had a huge bear market in equities, created by the previous Ponzi scheme called indexation. As a result of the indexation craze, pension funds, banks and insurance companies around th world found themselves undercapitalised. The regulators, always keen to close the barn door once the horses have fled, decided to prevent the undercapitalised institutions from buying any more equities. This left them with a pressing question: how to replace equities, the high return part of their portfolios? Since, according to the new regulations, they could ony buy bonds, they were forced, if they wanted to boost returns, to buy very low quality bonds, offering very high immediate returns.

...Now the beauty of capitalism is that a demand usually does not have to wait too long until a supply emerges....We have also learnt that there is no such things as a simulation which does not look good. And sure enough, the mathematical geniuses in charge of building new produces started to "design" portfolios of mortgages, mixing them in a way that, in the past, would have guaranteed the high returns needed, and the repayment of the principal at the end.

...The fact that the historical sample on which they built their computations had nothing to do with the current issus was of course never discussed. The ratings agencies, impressed by the soundness of the computation, and even more by the huge fees that they were getting for rating these (toxic) products, started to deliver investment grade ratings to products that had never met a free market...We had, at last, a junk bond with an AAA rating....


...It is thus fair to say that everything started with regulatory or political intervention, forcing a change in the asset or liability side of the balance sheets of financial institutions, without changing the other side. Preventing insurance companies, pension funds or banks from buying equities at the bottom of a bear market was a mistake of massive proportions. This decision reduced the future returns without reducing the future costs (since they are a function of contracts signed long before the intervention).

...Every crisis needs a scapegoat. Rather than take ownership of the monster that they have created, or simply explaining the temporary measures needed to be taken to reduce volatility and allow for an orderly clearing of markets, policymakers seem a little too eager to point the finger at "evil hedge funds".

...Instead of trying to figur out which hedge fund made the most moeny out of this crisis, and then attacking that manager for doing his job well, the public would be better served if journalists started to ask policymakers why the books of Lehmans et al were loaded with paper bought just a year or two ago and now worth cents in the dollar? And why was almost all of that toxic paper on the banks' balance sheets and not the hedge funds? Is it because people who work at hedge funds are so much smarter than people who work at investment banks? Or is it because hedge funds are free to look for returns in placess that make sense while banks and insurance companies, because of regulations, were made to chase yields in places where they did not really exist?

E M Forster - daring to be a liberal humanist....

From Zadie Smith's review of The BBC Talks of E.M. Forster, 1929–1960, published in the New York Review of Books.

.....He was free of many vices commonly found in novelists of his generation—what's unusual about Forster is what he didn't do. He didn't lean rightward with the years, or allow nostalgia to morph into misanthropy; he never knelt for the Pope or the Queen, nor did he flirt (ideologically speaking) with Hitler, Stalin, or Mao; he never believed the novel was dead or the hills alive, continued to read contemporary fiction after the age of fifty, harbored no special hatred for the generation below or above him, did not come to feel that England had gone to hell in a hand-basket, that its language was doomed, that lunatics were running the asylum, or foreigners swamping the cities.

Still, like all notable English novelists, he was a tricky bugger. He made a faith of personal sincerity and a career of disingenuousness. He was an Edwardian among Modernists, and yet—in matters of pacifism, class, education, and race—a progressive among conservatives. Suburban and parochial, his vistas stretched far into the East. A passionate defender of "Love, the beloved republic," he nevertheless persisted in keeping his own loves secret, long after the laws that had prohibited honesty were gone. Between the bold and the tame, the brave and the cowardly, the engaged and the complacent, Forster walked the middling line.