Fufill its role

The Federal Reserve came out with a press release today at 4pm.  The long version is linked here.  The short version is: If you are a large U.S. financial institution you will not be able to pay back the government capital until the system is working.  This is great news.  The Federal Reserve Board gave themselves a lot of subjective wiggle room to prevent banks from paying them back.  “Whether a BHC (bank holding company) can redeem its Treasury capital and remain in a position to continue to fulfill its role as an intermediary that facilitates lending to creditworthy households and businesses”  It seems fair to assume that the banks, besides Citi and Bank of America, could pay back that capital with some combination of public capital raising and balance sheet contraction.  This means that there is demand to shrink the capital base of the banking system and the Federal Reserve has it hands on the nozzle controlling that force.  Wha la! A new monetary policy tool, a capital escape value.  Although that was not the point (the point being they didn’t want the banks shrinking there balance sheets and thus induce a deflationary depression just to get out from of the burning wrath of congress) it doesn’t change the reality that is what happened.  And as I’m a big proponent of dealing with reality instead of what you would like to had happen.  I’m inclined to argue that it (the faucet of capital) needs to tended with care.  The Fed should think more about system level capital (in addition to the bank level capital).  This is what should have been done (and quite possibly was done) with the stress test program. Also the Fed should avoid shocking the system by having it all paid back at once.  They may also want to consider unwinding their own interactions with the financial system before letting the traditional banking sector back away from the table.

Bank Stress Tests…Missing the Point?

Quick rant…..

Admit it, we don’t really care if a bank or financial institution fails.  What we care about is unemployment and economic growth.  The two things are connected when a bank failure causes a credit collapse (ala Lehman…although that simply accelerated and extentuated a crisis).  Thus was it right to simply stress test the banks?   I want to make the point that it is part but not the whole picture.  Stress testing the banks is a good idea (hard to tell how well it was done).  A regulatory menatility of probabilistic thinking is the right one. 

That being said it is not enough…the Federal Reserve as the monetary authority should be concerned with aggregate credit creation (as that is what is driving the deflation).  The driving force behind the credit contraction is financial market deleveraging.  This is occuring both in the banking sector and the non-bank financial sector.  To put it simply the banks need to be absorb the delevering of the non-bank financial sector (or the fed has to do it…which it has done to a large degree) or a credit collapse will occur.  What does this mean?  We want the banks to have far more capital than they need to survive…like I said up top, we don’t simply care about bank survival.

I was hoping that the stress test would be the rhetoric device to get capital into the system but it doesn’t look like it worked that way (although it does look like banks are raising lots of capital to pay off TARP and if that TARP capital is sent back out into the banking system we might get closer to where we need to be).  I keep coming back to the same idea (not good but the best I’ve got) drown the banking system in capital and don’t let them pay it back until the economy is back on track.  Some argue that this would be expensive, yes but it is cheaper than everything else.  It would be cheaper than a depression and it would be less dangerous (thus cheaper) than having the Federal Reserve doing all of the deleveraging.

Negotiations or Stress Test?

The Stress came out last week and before I went through any numbers my knee-jerk response was the numbers (capital to be raised) looked small.  I like the approach (of simulation and forward looking stress test) but wonder how well it worked. 

A few comments…First off its not clear to me what type of regulatory authority the Fed/Treasury has to force banks to raise capital if they are, according to the existing rules, above thier capital requirements.  Apparently some banks considered suing to say that they didn’t need to raise the capital.  Second the stress test simple underlying assumptions which I discussed (complained about) before were a little off – particularly unemployment.  Now being wrong about something that is difficult to predict isn’t a crime (or shouldn’t be – often treated like it is) but continuing to do something incorrectly when you know that it is incorrect  is a crime (and should be treated as such (not jail but fired)).  This stupidity happens for a number of reasons such as status quo bias (the way it is done), what I call rule bias (but the rule says), what I call defered responsibility bias (but so and so said) and other reasons (including being lazy).  Nothing excuses you for being stupid (doing something the wrong way when you know it is wrong is stupid).  Now I suspect (should say hope) they updated thier projections as they went as to incorporate new information. 

 

 

Third the WSJ has an article about how the number where essentially negoitated (make me wonder if Simon Johnson is right about a Wall Street -Washington connection…I don’t think he is) down and how banks will be able to ‘earn’ the capital instead of raising it before the deadline.  I don’t like eithier of these things.  It should not be a negotiation (although the banks can provide thier opinion) but it may have become one because of the authority issue (see point one).  But more importantly the skew of these events is such that an error on the under capitalized side is a disator (deflation depression) while an error on the over capitalized side (ignoring possible non linear political problems) is a ‘bad’ return for tax payers (although the losses from a deflationary depression would be much much worse).  Also we need a well capitalized banking system now (not in 6 months while they earn the capital).   Lowering the estimates didn’t strike me as smart. 

I’ve been of the opinon that it make sense to drown the banks in capital (tell them take this massive amounts of perferred and common equity and you can pay it back when the economy is growing at an above average rates…this would make them use the capital instead of treating it like a short term loan (which defeats the point).  Admitedly there are complication to this approach as well….

Bank Stress Test: Transparency is Hard

I commend transparency when it is appropriate (note: it is not always – particularly when it simply confuses the users or is abused by the political system…read ‘where the costs are greater than the benefit’).  That being said – for the most part – the bank stress test has been fairly transparent – in a good way – releasing methodology and sending out details about the logic (even if you don’t agree with the degree of stress, you likley agree the disclosures have been nice…although everyone would have back out what they did afterward so this was the smart way to do it).  So I feel a little mean in what I’m going to say next because it seems like they are trying so hard but the fist chart in the stress test results is obnoxiously deceiving.  The chart show the stress test total loan loss rate over two years against the loan loss rate over two years going back to 1921. 

You may look at this and say, ‘good, the banks are well capitalized enough to survive even the Great Depression.’  Wrong (assuming I’m reading the chart right).  The red line is the stressed level which if that occur the banks will be right on the edge of thier capital constraints (not a comfortable place to be…read ‘failed’).  For the banks to survive the blue line going up to the red line it would have to retreat to a typical level of 1-2% instantly or they would go bust (the blue lines doesn’t move like that, its smoother..the Great Depression was more than 2 years).  Its the accumulation of losses in excess of earning that hack away at capital, not a two-year rolling window, that matter.  This presentation suggest that the Fed and Treasury are assuming we are out of this  (and back to normal) by 2011; that seems a little optomistic in the default areana (like I said…the blue line doesn’t move like that).  Its worth noting that banks are making good money on large spread so they may be able to handle a 2+ default rate without having the capital base eatten away at (and getting paid interest on reserve)

I would have like to see the presentation done as capital drawdown or capital base growth given historical loan default back to 1921 which would need to include bank earning and not be a two year rolling window.  That being said this forward looking (fix the banking/financial system) plan is the right way to go; hopefully we have enough capital in the system to make it work (and the populist rhetoric doesn’t screw it up….if it hasn’t already….we don’t want them to pay the money back).

The Knock-On by Region

Economist will often talk about volatility (often meaning something more broad like friction) in the financial markets but preface the comment that as long as the financial economy does not spill over on the real economy then the problems are ‘not real’.  There is some truth to this but it is also sort of a joke because the spill over are not discrete although they are not linear eithier.  On top of this it is tough to measure how much of the down turn is simply financial and how much is ‘true’ adjustment.  (This judgement is the call that must be made when policy officials think about bailouts – both national and domestic.  Think: is this problem simply a function of financial dislocation or is it is part of a needed economic adjustment).  One paper that kind of gets at this (I quickly skimmed it; interesting but not profound).  It tries to show (I say tried because it is based on a survey) the impact of cashing constraints.  The charts show firms that are cash constrained and firms that are not cash constrained (one could imagine that cash constrained firms are younger and emerging firms and cash rich are established businesses) and what percentage of these firms are passing up NPV (value added projects).  Cash constrained firms are passing up investment opportunities.  It is hard to know if the NPV projects are really NPV or if there are also capital problems that are correlated with the cash problems (probably) but it does suggest that good investments are being passed on because cash is hard to get.  That is what is meant by bad spillovers. 

Don’t Let Them Pay It Back.

I’ve argued before that we don’t want the banks to pay back the capital.  The capital is one of the constraints on money creation (one being the reserve requirement and another being that capital requirement of banks); to the extent that the either of these are constraining credit, aggregate money will not be created.  And to the extent velocity is falling or the constraint is forcing deleveraging deflation may result (and thus a damaging debt deflation spiral).  Thus is is encouraging to hear (or read) that the administration is considering ways to essentially prevent the banks from paying the capital back but allow them to get out of the government oversight; thus allowing them to convert shackling political capital into not exactly shackling political capital.  Or in my view converting what is viewed as a short term loan into capital and thus repair the damage the congress did to the recapitalization plan.

According to the FT…“Our general objective is going to be what is good for the system,” the senior official said. “We want the system to have enough capital.”  Wisdom does exist in government but as is far too common it doesn’t have a name (or is too afraid to have an ill informed public know that they said something).

Let the mailbox burn

Last week I went to a speech given by a major private equity firms COO.  He was highlighting the global economic crisis from his perspective.  (He noted that being a lawyer and not an economist he wasn’t sure why people wanted to hear him talk about it….he did a reasonable job).  But before the speech began I was discussing the new PPIP (public private investment partnership) program another attendee.  She argued that it would fail because there was bound to be fraud just like with RTC (resolution trust corporation) after the SNL crisis in the early 90s.  Given, she argued, that fraud was the underlying driver of the economic crisis, we could never get out of it by bring to life another program that would be rife with fraud.  I pointed out that although fraud facilities the crisis it was not the underlying cause (global economic imbalances) and that just because a program has a bad side affect it shouldn’t necessarily be scraped.  I noted that if the PPIP gets the financial system working so that credit is moving around (new balance sheet capacity) but some fraud occurs the net is positive.  She was insistent that this was not the case. 

To me she was letting the house burn and focusing on saving the mailbox.  Or according to Nietzsche she was engaged in the most common form of human stupidity; forgetting what one is trying to achieve. 

But she did, unknown to her, have a point.  The success of any public program, in a democratic society, that requires continuous support depends on at least the tacit support (or at least not the vehement opposition) of the program.  If fraud in PPIP undermines the federal government’s ability to respond to crisis it will have serious consequences.  To fix the analogy it would be as if the firefighters had the hose cut by an angry mob because the mailbox was burning.  Foolish but if the hose is cut the house will burn.  You could see some of this as an affect of the AIG bonus fiasco; we nearly let a few million dollars undermine the legal system which is part of foundations of a 15 trillion dollar economy.

Debt Bubble II or Not?

One chart that is commonly use to explain the challenges we are having is the amount of Debt to GDP.  At a first glance it seems to suggests two things (1) we have a debt bubble just like the great depression and (2) that the aggregate level of debt is drowning us (who could support a debt 3.5x the size of their annual income). 

Part of this intuition is right.  Higher levels of debt exposure mean that the leveraged entity is exposed to a higher level of risk (call it survival or crisis risk).  But I think a closer look is warranted.  First, the ‘debt bubble’ that started in 1929 was – from my back of the envolope calculations – driven by the denominator not increased in nominal debt levels.  Nominal GDP collapsed  – both because of falls in real GDP and massive deflation.  The total debt to GDP increased by about 30% (in a X1-Xo sense) in each year between 1929 and 1933.  The below chart show where the increase is coming from.  It wasn’t an increase in debt that sunk the country but debt failures due in large part to deflation (yes, it was the Fed’s fault….Damn it; why did Ben Strong die….please don’t die Bernanke) as well as an economic collapse. 

If we can avoid deflation, the delevering process is much much easier (and if we have some inflation its even easier…although this is like playing with fire). 

My next complaint is that including finanicaldebt in the debt burden is odd.  This large increase show how much more interconnected the financial system and the degree of counterparty risk but it does not suggest an increase in real debt burdens.  If you take out the non financial debt then it looks like:

Yes debt has increased across the sectors, particularly in households, over the past 20 years but if you compare this level to the 1929 (before the deflation driven spike) its very similar.  I have a very hard time believing people who say that what has happened was inevitable.  Think about the debt level as the speed you are driving your car.  If you drive 80 it is risky, if you drive 100 it is even riskier, and if your drive 120 even riskier but you could die driven at 80 and you could live driving at 120 under the right circumstances (and the car – which in this story is the structure of your economy).  Typically you (the driver or economy) only die if there is a sudden stop or shock….which is what happen this time around (to a degree) after Lehman. 

So what does this mean going forward.  Don’t know for sure but I think low growth is obtainable and a depression avoidable.  If deleverging is done in the context of new capital and increasing money/balance sheet capacity (not deflationary) instead of shirking balance sheets, we are not in for a depression.  If deleverging is done in the context of a paradox of thrift and deflation balance sheet contraction then we are in for a rough ride.

It’s not unprecedented

The current banking crisis has lead to large gov’t purchases of securities (both capital injections into the banks via the treasury and purchases of risk assets and now treasuries via the fed).  This helps stabilize the underlying money supply and prevent a deflationary/depressions dynamic from further collapsing the economy.  People seem to think that this it unprecedented (and many vigorously debate its validity).  Its not (and it has helped).  Look at the Banking Crisis of 1792.  To this I ask, ‘where is our Hamilton?’

Now it is hard to compare the relatives sizes (in large part because it is hard to get the data from 1792) but Hamilton invented on the fly a impressive response to a horrid banking crisis.  He realized that if the banks were allowed to fail it would undermine the credit system which greased the wheels of commerce and damage the ability of the capital markets to function (both of which would hurt the federal governments ability to raise funds).  Hamilton opened in effect a lender of last resort, he also had the treasury purchase federal securities (was this the first U.S. quantitative easing?), and increased money/extended credit by allowing merchants to pay import duties in notes payable.  Now Hamilton’s banks did not have to deal with mark-to-market and thus liquidity was all that was need to help them through.   I suspect if they had MTM the banks would have had capital problems.  But that being said the response was fairly impressive. 

Of course who want to bail out the bankers and the Jeffersonians (or Democratic Republican) who view this as a bailout of evil speculators where not happy.  They were able to get out their anger less than 20 years latter by refusing to re-issue the charter for the First Bank of the United States (in 1811).  This wasn’t a disaster because the bank was taken into private hand and continued to operate but using existing private capital (at the end of the day balance sheet capacity was used up) and thus (or at least in part) the Federal government reopened the Bank of the United States 5 years latter after enduring the pain involved in not having one.  [The purpose of the Bank of the United States was to be a backbone to the financial system, help expand credit and ensure a stable currency: Think the federal reserve].  Although not perfect and not politically popular a functioning credit system (which was aided by having a Bank of the United States) greatly help the nation grow. 

Who cares?  We’ll here some practical advice for today: If we wish to get back to reasonable growth we must have functioning banking system.  This means more balance sheet capacity; so tell your congressmen that you want more capital sent out to the bank and you don’t want them paying it back until we are on the path to recovery.  And remind him we’ve done this before; if we have the political will it is a solvable problem.

The Language of Market to Market

FASB recently adjusted the rules regarding to mark-to-market accounting.  This give a timely opportunity to reflex on why this matters.  On the surface it doesn’t.  Accounting is the measurement of businesses books in order for interested parties (manager, investors, clients, regulators, ….) to make better decisions.  And given that accounting is (if designed well) like the physics  experiments where the result differs based on observation (except in trivial ways – you have to pay the accountants).  Regardless of which way the language is taken the end users should be able to interpret the information and with that technical choice known and their conclusions should only change if the information is somehow better.  Mark to market (seems like) it should provide information about firms so wouldn’t it be better?  So what’s the big deal about market to market? 

Well, MTM is creating its own reality.  The clearest example is that losses that are being marked at banks are pushing their capital levels close to regulatory problematic levels.  If there was no mark to market the regulatory capital would not be a problem (the banks would hold the loans at historical cost and only market them down as losses were realized and thus quite possibly survive the downturn).  Now this suggests that due to MTM the same bank (in terms of risks, losses, and capital) would survive if they took risks through loans (no MTM) instead of securities (MTM).  This is the measurement of reality taking over reality due to a third party constraint (the regulators). 

I highly doubt that anyone discussed that bring on-line MTM was the equivalent of a large increase in economic capital requirement for banks, but in fact it was.  I’m inclined to argue that accountants should be conceptual instead of rules based and focusing on presenting reality; this makes me lean toward MTM.  Solving the problems created by MTM can be done by hiding reality but could be done better by improving the capital requirements (and investigating third party constraint that allow measurement to artificially inflict damage). 

Update/Side Comment: Now that banks can mark these assets to something other than market; the pressures to sell them off are lessened which makes the option to sell into the PPIPs less attractive.  This makes the question of will there be seller a little bit tougher.