Insurance would work much better

January 25, 2009

As I explained in my previous post, sucking all the capital out of the world in order to meet the demand for treasury issuance would allow the Fed and US politicians to play the role of central planners in the allocation of capital. There are very few powers which carry more significance than the power to arbitrarily allocate capital. This of course invites abuse from officials seeking to take advantage of populist constituents and promote the kind of spending that is not necessarily good for the economy but that which is favorable to his re-election chances. To avoid this scenario, I propose an alternative to direct purchases of debt and other assets: utilizing Federal guarantees and insurance.

Back on Sept. 24 of last year, I proposed this insurance plan to recapitalize banks:

Just spent some time thinking about my proposal and I want to clarify some points.

One, instead of being a party that borderline resembles an investor/creditor for these distressed financial institutions, the government should instead act in the capacity of an investment banker on both the buy-side and the sell-side. The government should establish the value of these assets (Mr. Bernanke being the valuation analyst here), and sell these assets to private and institutional investors at a premium in exchange for government insurance on the credit of these assets. So basically, act as the investment banker for the transaction and the insurer as well for the buy-side, which will be responsible for taking some of the investment risks of owning these securities from the taxpayers.

I think this approach is good because it leaves the government as a last option, and secondly, government guarantees plus bargain values should be able to generate a pretty sizable market. This approach retains all the positives of the current bailout plan, but also transfers a portion of the risk of ownership from taxpayers to private investors and institutions. Sounds fair?

Additional specifics to the plan: the insurance would be issued in the form of a put option. An example of a transaction would be:

Bernanke determines that the ytm of a security would give it a value of 30 cents to the dollar. The government then markets the security to a wide variety of potential buyers by offering a 7 cents premium, which would result in a selling price of 37 cents with an attached put option that would allow the investor to sell the security back to the government at 30 cents under a specified timetable. So basically, the taxpayer’s money would only suffer a write-off if the value of the underlying security drops off to less than 30 cents to the dollar, which suffers less exposure than purchasing the asset at 37 cents .

The key thing here to note is that between prices of 37 and 30, the loss is taken by private investors, rather than by the taxpayer. So this is an allocation of risk from the taxpayers to market participants.

In addition, the put options would have different expiration periods, which would suit a wider variety of potential investors, thus attracting more potential buyers.

The advantages of my plan over the current government plan:
1). encourages participation of private money and diminishing the role of the government in financial dealings.
2). better protects taxpayer money by spreading the credit risk of the underlying securities to private investors and institutions.
3). allows private investors to recapitalize the books of distressed institutions in the form of the insurance premium rather than taxpayer money.
4). having the government as an ultimate guarantor of the security would provide the needed liquidity for the market of these instruments.

Curiously, House Republicans led by Eric Cantor of Virginia came out with an identical plan the next day, which called on Federal insurance and insurance fees. My plan only differed in that I proposed a sizable insurance fee from the purchaser to recapitalize the banks.

Paulson opposed the insurance plan vehemently, but ended up utilizing its features in two of its most prominent bailouts: Citi and BoA. Systematic insurance isn’t without risks, but I would much rather take the contingent obligations than to allow centralized allocation of capital.


Crowding out in full swing

January 25, 2009

By all estimates, the Federal government will seek to raise well over one trillion dollars via Treasury instruments to fund a variety a bank rescues and spending programs. Where will the money come from? Indications are that central banks spent most of 2008 readjusting their portfolios, mostly by selling their existing holdings of corporate and agency bonds to purchase treasuries, and increasingly on the short end. Some central banks were less lucky and were battered with capital flight, which depleted their dollar holdings, but the money ended up in the treasuries anyway. With the rapid slowdown in global trade, it is unlikely that oil states and exporters will be adding significant treasury holdings, especially against the backdrop of capital flight.

The Fed was able to finance a large portion of its Treasury issuance in ’08, but at the expense of other financial markets. The collapse in the equity markets wiped off trillions in household wealth, inducing a sudden drop in consumption and bill payment from American households. The credit market certain suffered a heart-attack. And large states like NY and Cali are facing budget short falls in the tens of billions in the current fiscal year. Unless the Fed uses the money that it raised to refinance sovereign debt, countries in South America and deficit countries are looking at defaults as well.

Which brings us to this point: If the Fed is successful in raising the full amount of Treasuries without having to monetize the debt, the world’s financial markets will again stare in the face of bankruptcy. Private enterprises and nations will be shut out of the capital market, causing massive defaults in the private sector. Consequence would be dire if the US government choose to use this money for long term infrastructural projects, which does little to provide goods and services that people need today. A political consequence could be that nations friendly to the US may get special treatment in the form of currency swaps so that they can effectively finance their external obligations with their own currency indefinitely. And the corporations that operate the largest workforces may get friendlier responses to requests for access to working capital from the Treasury than smaller ones. The potential for political abuse is unlimited. Lenin could not have dreamed this one up any better.

As I have been saying from day one, the Fed needs to systematically insure all classes of debt in order to avoid the scenario where it becomes the central allocator of capital of the world.


Paulson’s ‘Mandarin’ plan to deal with toxic debt

January 16, 2009

Henry Paulson’s connections with the Chinese elite, nortured by more than 70 visits to the mainland as a private banker, have been widely acknowledge by the media. Perhaps that explains why Paulson latest plan to dump financial system’s toxic assets into a single ‘aggregator bank’ looks eerily similar to the Chinese effort in the late 90s to dump nonperforming loans into state-financed ‘asset management companies’ (AMCs). In a paper titled “The Chinese Conundrum: External Financial Strength, Domestic Financial Weakness”, Brad Setser, now a fellow at Council on Foreign Relations, elaborates on the Chinese model:

In 1999, RMB 1400 billion ($169 billion at 1999 exchange rates) in bad loans—roughly 20 percent of total loans at the time—were taken off the banking system’s books and given to four asset management companies.

Furthermore,

In addition to taking the banks’ bad assets, AMCs also assumed some of the banks’ liabilities to the People’s Bank of China. As a result, both the central bank and the SCBs ended up with large claims on the AMCs. Early recovery rates on the bad loans transferred to the AMCs were around 30 percent of book value, but recovery rates subsequently fell to 15 to 20 percent of the book value. Formally, the finance ministry has not guaranteed AMC bonds (Ma, 2006)—but there is little doubt that taxpayers ultimately will need to bailout the AMCs.

The gov’t will probably take the ‘carve-out’ approach, which means that they will purchase toxic assets at book value (or higher, possibly at par) and thus avoid write-downs on equity (or  to recapitalize by cash inject if they are to buy at par).

Presumably, the government does not have to mark its assets to market if the public does not demand strict supervision. But if the recovery rate is low and if the Dem. congress uses this as a tool to further impair the assets  in order to bail out the segment of the constituents facing default, the ultimate cost will be levied on all taxpayers.

footnote:

Setser, Brad. (2006),  The Chinese Conundrum: External Financial Strength, Domestic Financial Weakness (May),  CESifo Economic Studies. <http://cesifo.oxfordjournals.org/cgi/rapidpdf/ifl005v1.pdf&gt;


How to foster employment in the short term…

January 14, 2009

A few days ago I blogged about the fallacy of supplanting household consumption with government spending as the predominant driver of aggregate demand by arguing that public spending often does not produce the goods and services that consumers hold dear. So pushing gov’t spending aside, how do we best put people to work in the short term against the waves of negative reinforcement?

I believe the answer is to export inflation to surplus countries. According to Bloomberg, roughly half a million retail jobs have been lost since last fall. Imagine if the Treasury were to issue debit cards to every American consumer with $1000 of funds to spend within 60 days. The result would be an immediate spike in retail activity. Hopefully this would work its way into the banking system as the number of corporate and consumer bankruptcies decline, and fewer corporations are forced to draw on contingent loan facilities to access operating cash.

Here’s an excerpt from Business Week on Robert Mundell’s prescription for the economy:

To stoke U.S. demand, Columbia University’s Robert Mundell, who won the prize in 1999, proposed the government hand out to consumers a half-trillion dollars’ worth of spending vouchers that have to be used within three months. “It would be a tremendous boost to the economy,” he said.

As the revenue from sales are repatriated to Asian manufacturers, Asian monetary authorities must print home currency in order to purchase the dollar at the pegged exchange rate. In the short term, the newly created money could be sterilized by the local gov’t at relatively low cost. But as the supply of gov’t notes eventual outstrips demand, the borrowing rates of the sovereign goes up along with those for  corporations and consumer. At some point, the Asian monetary authorities would be faced with the choice of either to allow inflation spire out of control or to stop active intervention in the forex market and allow the value of the dollar to slide. A weak dollar would make US exports more competitive.

Why must the US export? David Goldman at Inner Workings explains:

A stimulus concentrated in the US will disappear into the bottomless pit of demand for financial assets. To save and work at the same time, Americans need to export. And the amount of financial and real infrastructure that has to be built to accomplish this is daunting.

It is not a matter of turning the supertanker around. First the supertanker has to be built.

Once the Asian monetary authorities give up on the dollar, the adjustment of the excess workforce from the retail service sector to the manufacturing sector in the US can then begin.


Going down the road of socialism

January 13, 2009

Responding to an article that appeared in the Boston Globe about the need to address foreclosures, I wrote the following post on 9/24/08:

While I agree that some carefully selected measures to help debtors may be successful, they are not without some major risks and long term issues. For one, this would set a precedent for the government to be able to step into a contract where one party is not able to perform, tear up a perfectly legal contract (whether it’s perfectly moral is not the question here), and restructure the terms of the contract, arguably just to score some votes come election time. To do that you would have to have the consent of the creditors, or this country would certainly be going down the socialist road for sure.

It appears for now that the gov’t does in fact have the consent of the creditors by the virtue of the fact that the gov’t is the majority owner of the banks.

This is David Goldman’s perspective at Inner Workings:

Take sub-prime mortgages, for example. After hitting a low of $32.5 in mid-November, the ABX 2007 vintage AAA index of sub-prime mortgage-backed securities rose to $45 at the end of December, before tumbling back to $37.5 today. The proximate cause for the reversal was Friday’s agreement among Congressional Democrats to “cram down” mortgage payments in the event of bankruptcy, a prospective change in law that in enacted will impair mortgage cash flows.

It increasingly looks like that the bailout is not merely a passive investment but a nationalization in the true populist sense of the word.


The myth about government spending

January 12, 2009

Calls for increased government spending are heard everywhere. Some even have gone as far as to claim that fiscal spending can replace private consumption as a driver of aggregate demand. Such notions are ill-founded. It’s very simple to see why.

To the average laid-off worker hired by the government to perform a task for $20/hr, it makes no difference to him whether he is asked to build highways or simply to dig holes in the ground in the middle of a desert. In other words, the worker who gets paid doesn’t worry whether there is any demand for the product of his labor, as long as he gets paid. But in the real world, the effect would be the same as the government printing and transferring cash to those who do not produce desired products and allowing them to chase after real goods and services. Absent of adjustment to demand conditions by the private sector, the result would be bread lines and inflation.

In practice, when workers have more cash in their pockets and start to demand more real goods, businesses respond by investing in additional capacity, often accompanied by expanding payroll. That’s how temporary gov’t spending drives up private demand and restores private sector activity.

Keynesian policies provide employers of the last resort in times of economic distressed and should not be confused with long term economic vitality.  No amount of highway construction can replace the need to produce the goods and services that people really demand, which come mostly out of the private sector.


Banks’ ‘Catatonic Fear’ (of insolvency) Means Consumers Don’t Get TARP Relief

January 5, 2009

I added ‘of insolvency’ in parenthesis to the title of an article that appeared today on Bloomberg.com to stress a central point that the article failed to emphasize. Solvency means having enough assets to meet liabilities in the long run. To ensure solvency, the enterprise needs to correctly price the production value of its assets and also have an adequate cushion for losses suffered on unproductive assets. The former has been expedited by the mark-to-market account rule, which has also stripped banks of the flexibility to gradually absorb their losses on the asset side. This rapid decline in asset value is what prompted central authorities to inject capital and shield banks from insolvency.

While government ownership is unquestionably a viable solution in the short run, there must be an exit strategy to prevent the government from exerting greater management control in the long run. Private money may be too shy to invest in common shares without government guarantees, so the banks have to rely on their earning power to build up equity.  In order to earn their way up, banks are justifiably propping up the spread by maintaining a high lending rate.

It’s easy to see how banks would maintain high lending rates until private capital is confident enough to jump back into the fray.