FINANCIAL STRESS-TEST-DUMMIES AND BANK-SIMULATORS

The Obama administration this week ordered the 19 biggest US banks to run stress tests to check how well they can hold up if the economy deteriorates much further, and to thereby calculate how much more funding they will need before recovery is underway. This is like asking jumbo-plane aircraft pilots to land with faulty instruments in fog safely with minimal damage. When recently a pilot with extremely well-honed skills landed in the Hudson River and all passengers and crew were saved that was sheer brilliance. Would any flight simulator have allowed the same result - no, the built-in tolerances and probabilities would have dictated failure! And, would any other pilot have succeeded - maybe a few, but most not! What made the difference between success and failure was partly the plane, largely the pilot and also largely the conditions including the availability of the liquid landing zone. In banking terms those are the conditions to be determined by Government. The stress-tests are not just to test the banks, but also their strategy, operations and risk management, and then also to provide evidence, clues, indicators, stories of events so Government can also determine what it is that it must do to manage the financial and economic conditions. These stress-tests should also stress-test government bail-out measures. The pilots of the economy are also to be thereby tested. Banks think this is about testing their balance sheets and detailed accounts as seemed to be what stress-testing is in the dealing rooms and in Basel II Pillar II banking regulations. No, this is big picture stuff, and this is always what this stress-testing was meant to be, to test how well bank managements understand the economic context in which they do business. The crash-test dummies are in the boardroom.
To take the analogy further, it is not about how many passengers are on board to be saved or even what the plane is like. This is about how good, how comprehensive, the instrument controls are, and how responsive they are? Markets may be more or less liquid and customers and counter-parties more or less risky, but how much finger-tip control is there and how intelligent and powerful is the auto-pilot and do the pilots decide to dump their fuel over the sea, or save fuel for a possible quick take-off again, or to fly another 500 miles to the next airport? Are the cockpit controls and the accounting system completely accurate and the pilots fully experienced and trained in all weathers. Or is your bank's stress-test capability actually less like a complex flight simulator and more like a car-crash-dummy-test, more like a metal cage with car seats, and safety-belted nodding dummies round the board table? If you don't have the systems, then car-crash -dummies is your bank's default stress-test mode and I don't care how clever you think your guys are with their spread-sheets; this is not a spread-sheeting exam, and not merely a self-assessment exam either! Just ask yourself, can your bank model and explain why and how asset prices, stock values, have disconnected so blatantly from income-stream valuations? Ask yourself if your risk accounting and general ledger actually validate each other and then whether you can compute dynamically and in full double-entry styles in both banking and trading books for the political-economy, global markets, domestic retail and corporate banking for changes in PD, LGD, EAD, ELGD for the quarters ahead and for over the credit and economic cycles. If you think the answer should be yes, think again! The results are expected by or before the end of April. Banks will then have 6 months to raise the extra funding they think they may need from private sources or accept federal aid with conditions attached. The Government, like an air traffic control tower, wants to avoid taking over the flight instructions, it wants to dictate height and heading and make sure there are no air-to-air collisions and that the runway is clear and well-lit up. But government does not want to take over flight-pilot controls, not of large banks. Fed Chairman Ben Bernanke says government may take substantial minority stakes in Citigroup and other troubled banks only if they can't raise sufficient new funding elsewhere. Six months from now the technical recession should be over and modest positive growth returning. But, banks will have a difficult time just to survive the turbulence until then and to steady themselves onto exactly the right path for a soft landing. For important advice on various ways of determining your liquidity risk and solvency tests see the attached lengthy comment below.
Barack Obama on Wednesday described some principles for new financial regulation, signaling that the government would oversee a much wider range of financial activity and take a stronger hand in doing so. Gordon Brown and his team in the UK are doing and saying very much the exact same, including calling for stress tests. And he has begun to use a new repeatable phrase that of 'cleaning out the banks', words that have now taken on a whole new meaning quite different from the Hole In The Wall Gang, the James brothers or John Dillinger. I can't recall any time in the past when respectable people were going to clean out the banks? Of course, if Governments want to do that they can. But President Obama says, "While free markets are the key to our progress, they do not give us free license to take whatever we can get, however we can get it," and "Strong financial markets require clear rules of the road, not to hinder financial institutions but to protect consumers and investors." Let the banks be warned; these stress tests are about whether your bank needs cleaning out in a good way. "Cleaning out" in a bad way is what variously happened to Bear Stearns, Merrill-Lynch, Wachovia, HBOS, Fortis, WaMu, Dexia, Citicorp, RBS and others, though I am impressed with the new managements at both RBS and LBG. These banks were variously shown up to be flown by poorly equipped pilots, and in some cases by dummies (HBOS) or crash-test fighter-pilots (Lehman Brothers). The cleaning out will also extend to restructuring the regulators and bringing in new much more solid expertise. This is happening in Europe, the UK and USA.
Speaking after a meeting with key lawmakers and senior advisers, Obama said his government needs to overhaul the frayed patchwork of regulatory agencies that oversee the financial industry. He expressed support for increased consumer protections. He indicated he favoured empowering the Federal Reserve as a regulator of systemic risk (gosh, where was that responsibility hitherto?), with authority over any financial firm or instrument that could destabilize the economy. That's the key question stress-tests have to answer, who's next for a military-style haircut and strict exercise regime? The European Commission and ECB want similar answers, the IMF too, and, in the UK, the Bank of England. This is not an academic research project taking 4 years. The answers to these complex questions are required in 4 weeks. But improving on stress-test models and cockpit risk management control systems will require banks to focus on these in the boardroom regularly for at least 4 years (cost across all banks in Europe and USA = $8bn estimate). The US Administration will present a more detailed plan for regulatory reform in early April, when leaders of the G20 wealthiest nations, each with their own stress-tested plans, meet in London. By then, round the same table, all will know the global depth of the banking industry's political-economy crisis, and no dummies any longer tolerated there. That's my expertise, all of this, and I and my colleagues at asymtopix.eu and union-legend.com and what we know of the companies we talk to, none any longer can afford to under-estimate the challenges involved here.
WHAT IS THE CHALLENGE?
If you are in or close to the executive and full boards of a major bank, let me say categorically: It is not bottom up deal by deal stress-test technology or risk models and risk policies from the dealing rooms. It is not top down, comprehensive, national and global economic modeling. It is not stressing of risk factor ratios or moving up and down risk grade tables. It is not reliant on what we already know, not about adding up all risk buckets and business lines, to collate and correlate. It is not about dumping spreadsheets and getting in the super-computers and a new general ledger system, new software, years of new external and internal data, new definitions and holistically integrating taxonomies for all credit risks and all market risks. It is not about liquidity risk and risk concentration versus asset class and economic sector diversification.
It is all of this, a triangulation, top down, bottom up and sideways along, outside and not just inside the bank, and a damn sight more than all of this too covering what's happening to the whole of banking, and in the markets and among government policy options and the bank's business strategy options, and can't be done by persons who only have silo understanding and not a full grasp of the totality. It cannot be done except by those who thoroughly and professionally understand the totality of a bank, in finance, accounting, risk and economics, and the totality of Basel II Pillar II and the coming of Basel III, and why even Pillar I implementations are deeply flawed, and why Pillar II is a dangerous distraction and probable big mistake! If you understand where this shopping list of a rant comes from, then you are halfway there and should be advising the top of your bank or already in the boardroom! Retail giants such as Bank of America, HSBC, RBS, Citigroup and specialty, less retail, and non-retail banks such as JPM, State Street, Morgan Stanley, Goldman Sachs are all now required to measure their likely losses in the event that the credit and economic gets worse before it gets better. Officials say the tests will assume that the unemployment reaches 10.3% by the end of 2010 (currently 7.6%), average home price fall from bubble-peak hits 47% (27% so far). Mortgage defaults are over 9%, sub-investment grade corporate bonds heading there, consumer debt maybe 6%, prime quality bank debts maybe still pretty low at variously around 3%. But what if default rates for many broad classes trend to some similar higher rates as the domino or systemic impacts pull down good quality with the bad?
What if it doesn't matter if your are a creditor or debtor nation, all lose similar growth, and what if most or all businesses, most or all creditors and debtors, good as well as bad banks, all suffer significantly? What if it is not about whether your balance sheet is 5%, 10% or 25% better quality than the next bank, because that will matter a lot less in 6 months time than it matters now? The test will also assume that economic activity as measured by gross domestic product shrinks by 3.3% in 2009 before recovering slightly in 2010. Great, but does your bank know how to translate that into anything meaningful. Is 3.3% inflation-adjusted GDP, 2% or 6% before subtracting for inflation? Can your bank survive better if other banks survive better, or better if your bank does better than others who are then doing significantly worse? Is it better to take government investment on board and central bank funding and insurance guarantee programmes or better to keep going without that - better for whom - your bonuses, your shareholders, your customers, and or the economy? Will your bank do better if it can somehow deleverage and behave pro-cyclically or better if it can grow lending and act anti-cyclically, better if it delivers higher profits from traditional banking or lower profitability from traditional banking?
As a bank, what is it you are legitimately doing apart from providing a transmission mechanism as a public service? Is your idea of success and benefits the same as the government's that has to care about the whole economy as you should be too? Is a much higher financial margin profitability of the whole financial sector better or worse for the economy right now? Does your economic capital model tell you anything to adjudge your answers to these questions? The answers to these questions in the longer term are no problem, but for the next 1-2-4-6 years that is another matter altogether? The Government does not care about individual players; it wants to see the whole picture of what banks need to be that fits intelligently with what the economy needs them to be right now? Do banks, or your bank, know how to think about that? Yes is easy, elaborating on that answer is not. The Government is your bridging loan, but only if your bank can determine how to be a bridging loan in turn for the economy, and maybe in several economies? There is also so much peer-review going on that looking for a presentational answer that cannot be validated in depth won't wash. Confidence is more than skin-deep, and loss of confidence is fatal. See: www.union-legend.com/index.php?page=references There is a certain rhetorical quality to these questions. Where they are not rhetorical is where we really do not have the political-economy macro-answers, and worse where not even the biggest banks have the data or the systems and completed models to find their own reliable answers with any substantial % confidence whatsoever? It is a wholly different game to forecast via scenario stress-tests for some theoretical set of future-shocks at some indeterminate time over the horizon. What can be done and how is to be done when already in the middle of the distress, in the middle of the fat-tail unexpected risk distribution, that's quite different and not to be understood in the Basel II and Solvency II regulatory advice notes, or even from the very best academic papers - they're being thoroughly revised and rewritten - who in your bank reads them?
Regulators are in the business of providing clues and indicators, not glide-paths for exactly how to do any of this. It is nothing like regulatory risk model equations. For example, regulators have calculated that there is roughly a 10% chance that economic conditions would reach say a 3.3% real GDP fall in 2009 based on a consensus of economic forecasts, which has never been much of a reliable benchmark. Therefore, prominent economists are saying the probability is much higher than 10% and banks and government should test for a more catastrophic scenario. I agree, do you? But, some analysts say the worst projections are not much more dire than what many private forecasters already expect e.g. 5% real GDP fall in 2009. And, anyway, the worst scenarios are not that, not how bad will 2009 be, it is whether the economy might remain flat for a few years thereafter i.e. not a V- or U- shaped recession but an L-shaped one. That will test banks capital reserves to destruction beyond the 200% wipe-out currently being faced. It would not be hard to show a bad year wiping out reserves by another 50% and 3 years flat growth by over 100% again! According to the new Treasury Department guidelines, the banks would have to assume that the economy contracts by 3.3% in 2009 and flat in 2010, and housing falls 22% generally on top of the 15%+ so far, then maybe recovery is regionally patchy after that, especially across the US States in 2010, while unemployment goes up to 9% then over 10% in 2010. Does your bank know what PDs and LGDs could become in these years. Can you even dynamically model for that either at portfolio, aggregated bucket, level or for every account in the books? Have you got integrated accounting and computing power to process all that in less than one month? If not, how else will you get a realistic approximation - try talking to Lloyds Banking Group, or RBS, or central banks or others?
"I don't think they (the stress conditions) are harsh enough," said David Hendler, analyst at CreditSights, who says the dire projection is too optimistic about how much growth will be generated from President Barack Obama's fiscal deficit stimulus programme. "That would be a pleasant outcome, but you have to plan for the worst." I agree. The average outlook of private-sector forecasters envisages the economy shrinking by 2% this year and unemployment peaking just below 9% in 2010. But, even the biggest banks are regional not just national and regional variations in a country the size of the USA are significant. Big banks are also internationally exposed, and globally in respect of wholesale financial markets, which hardly anyone has ever been able to soundly model in respect of national or international or global economic models, and of which there are not many around. The trading books have small RWA calculations but we know these are now unreliable. Can your bank stress-test collateral, security, hedges and cross-border financial flows, corporates and industry sectors, and interbank credit in the trading book as readily as credit risk and collateral in the banking book? The stress-tests must adjust for changes in market liquidities. Do you know how to measure the liquidity of markets, never mind liquidity risk of your own bank. By 'model' I and regulators and economists do not mean 'make assumptions' but integrate all major factors into accounting models over time whereby factors constrain each other? Is this a high-level project with top quality people do the work or a low-level delegated work relying on simply processing every combination of likely factor values?
Everyone's recent forecasts including by the Federal Reserve and most private forecasters have undershot the severity of the downturn. Big banks — those with more than $100 billion in assets — have to carry out supervised analyses by April of how much their capital would be depleted under the Treasury Department assumptions. If U.S. banking regulators conclude that your bank may not have enough capital under those circumstances, the bank has six months to sort the problem - is 6 months realistic and practical? It is only if the tests show that your minimum regulatory capital survives at least 6 months?
The Treasury said that it would provide new capital in exchange for shares of preferred stock that could be converted to shares of common stock at a price slightly below the level at which the shares traded on Feb. 9. The UK seems to be offering similar but with conversion rates at markedly higher prices than current share prices. For many of the US big banks, 9 Feb price is slightly higher than today, but still at fire-sale levels. In a telephone conference call with reporters, officials from the Fed and OCC said there would be no simple measure for "passing" or "failing" a test. The FDIC has firmer standard tests and these might kick in on insurance guarantee rates sooner. It's not exactly clear if the FDIC and the fed are singing from exactly the same hymn sheet? "It sure sounds to me like they are designing this to make it sound like the banking system is in great shape," Paul Miller, an analyst at Friedman, Billings Ramsey, a brokerage firm that specializes in bank stocks, said to the Washington Post. This is his interpretation of officials says their goal is to increase confidence of investors and depositors in the big banks, providing tangible evidence that the institutions would have enough money, whether they had to raise it from private investors or get it from taxpayers.
What this is really about is trying to get a consensus view of the expected shape of the credit cycle and economic cycle from the perspective of banks' capital resources. Fed officials said there is no cap on how much money a single institution could get. But that is of course how banks got into funding gaps that proved hard to maintain, so maybe some ratio caps to current funding gap or deposits might seem sensible. Officials declined to estimate how much money the government would end up injecting before the crisis was over. This is a sensible answer given the variety of means available, but over $2 trillions would be the ballpark just for big banks. Banks and other "qualified financial institutions," which now includes investment banks and insurance companies that are part of bank holding companies, can start applying for more money immediately.
Christopher Whalen, MD at Institutional Risk Analytics, said Citigroup and other major banks would almost certainly become insolvent once they absorb the full brunt of losses from the economic downturn. That is absurd, since it fails to see that banks don't just stand still in their liquidity management. He said, "The stress test is about politics. The OCC and the Fed already know the answer. The answer is that we're going to have to come to a decision: are we going to put in more equity or are we going to resolve the banks through bankruptcy?" This is now classic doomster headlining for the media. This is not the question or the answer. Bankruptcy is not an option. replacing ownership and getting rid of managements and bad bank work-out funds and much else are options, active choices in play right now.
Europe is focusing hard on the G20 concerns to take urgent steps to overhaul regulation of big cross-border banks. President Obama met with Congressional legislators to discuss an overhaul of how the financial regulatory system manages risk in the future. Emerging from the meeting, Obama said the first principle of a new system should be that financial institutions "that pose serious risks to the markets should be subject to serious oversight by the government." The EU European Commission has exactly the same intent to be applied to the top 45 banks. Obama also said that the regulatory system should be strengthened to withstand major stresses and that the government should take steps to rebuild trust in markets by promoting transparency. This also means bringing off-exchange markets on-exchange. With the exception of government spending, every major component of the economy shrank in 2008.
Output fell 6.2% at an annualised rate in the 4th quarter of 2008 (also by 6% in 4th quarter in the UK), revised downward from a previous estimate of a 3.8% decline. The drop was steeper than the consensus estimate of 5.4% - far steeper than 0.5% of the previous quarter.This was enough to have immediate ripple effects globally. The economy took the biggest hits in exports, retail sales, equipment, software and residential fixed investment plus contraction in inventories (usual sign too of drop in loan financing) of unsold goods despite lower consumer sales. But this data will continue to be severely revised for another year. The trade gap that had been narrowing widened as exports fell at an annual rate of 23.6% shaving a full 1% of GDP and is a sign of downturn spreading through the rest of the world. This all bodes ill for business investment and sure enough it fell at an annualized rate of 28.8%, also a sign of bank credit being choked off or debt restructuring. deposit savings crept up but private savings will only jump significantly once the Government bond auctions for 2009 are well underway and hopefully banks will grow their loans by an aggregate of 10% minimum, what Government is hoping to see, and that means growing capital reserves proportionately too. For much more read comment below.

Obama's Budget and new $1,750bn deficit forecast

The Media has got suddenly animated that the US budget deficit is really going to be double that previously announced (see previous blog below). This is because, Barack Obama’s budget figures, released today, include a $250bn item for future bailout funds. This has correctly been calculated to imply the White House is planning to ask Congress for up to $1,000bn more in emergency funding for the banking sector, which seems wholly sensible to me, by the way.
A senior Oval Office source told the FT that a $250bn “placeholder” provision is part of the Aministration’s new approach to upfront budgeting, a provision in accounting terms for likely future net costs.
In line with budget accounting rules, last year’s authorisation of $700bn in emergency TARP funds was scored at $200bn net in the budget, implying a ratio of authorisation to budgetary cost of over three to one. What this means is that the $700bn of financial asset purchases would be written down by $200bn, and that writedown is then required to be taken on-budget, the balance being netted off-budget. On this way of thinking the £250bn placeholder provision implies up to $1,000bn in new funding capacity. But in his speech to the joint houses of Congress on Tuesday night, Mr Obama clearly indicated substantial new resources would be needed for the federal government to help restore the credit pipeline in the financial sector. In the UK similar measures, most recently the £500bn 'bad bank' APS, Asset Protection Scheme, are accounted somewhat differently. The writedown discount and haircut is translated into capitalisation money for taking banks' preference shares and thereby netted off-budget, with the writedown also reflected internally and variously in the banks' balance sheets. If this is not precisly clear to you, don't fuss, it is not yet precisely clear to me either?
Today’s 10-year budget will, the FT says, project a fiscal deficit this year of $1,750bn – a number that shatters all records and which is significantly higher than the near $1,200bn forecast by the Congressional Budget Office in January. The sharp jump largely reflects the cost of this year’s portion of the two-year $787bn emergency fiscal stimulus that was signed into law by Mr Obama last week.
The 10-year federal budget will be released at 11am east coast time, to include a roadmap for the creation of an economy-wide carbon emissions cap and trade system by 2012, from which the proceeds will fund the “make work pay” tax cut for middle class "working" families that Mr Obama included in last week’s short-term stimulus. The cap and trade permits are to be sold off in a 100% auction system. Additionally, the budget creates a $634bn healthcare reserve to pay for universal insurance (partly by raising taxes on the wealthiest Americans earning over $250,000). This follows Mr Obama’s speech to Congress on Tuesday night saying he would make a “substantial down payment” on the future expansion of healthcare. The analogy between affordable healthcare for the sub-prime population and financial health for the sub-prime, toxic, blood-poisoned banking sector cannot be lost on the general voter.

Small Politics, Big Economics, or vice versa?

If politics is Ajax, then economics must be Cassandra?
Is the $800 billion stimulus package too small, as many Democrats claim (such as Paul Krugman), or too big, as most Republicans claim? The answer is yes, too big politically and too small economically. It is too big insofar as it underestimates profitable return from funding support for the banks and too small by being spread over more than 1 year; it won't all get spent in 2009 and most of it not soon enough within the year, but that's just normal practicality of getting plans shaped and approved and the money-spend rolled out - all takes time.
If the criterion is how much annual fiscal stimulus to demand is needed to bring the economy back up to the level of potential output in 2010 and beyond, and to bring the unemployment rate back down to the monetarists' natural rate of unemployment, then $800 billions is not quite enough at 5.7% ratio to GDP. A more effective figure would be $1.1 trillion or 8% ratio to GDP, but that takes it over the psychological "trillion" number that PR people envisage triggering investor panic! The Congressional Budget Office (a depository of Republican neo-con economy spread-sheeters) estimate the economy will fall short of potential output by about 7% of GDP, in both 2009 and 2010. (As OMB Director, Doug Elmendorf testified on January 27 – ex-Brookings who seems more monetarist than 'fiscalist' see http://www.brookings.edu/experts/e/elmendorfd.aspx.) The news on jobs and other economic indicators since then shows the economy losing air like a pricked balloon, or maybe like a potholer finding the passage-ways getting narrower, or like a bunch of office-workers in a stuck lift that lurches from moment to moment downwards - choose or invent your own claustrophobic metaphor.
The $800 billion will spread over several years; the peak is to be $356 billions in 2010, which is about 2½% of GDP. The most optimistic estimate of the “Keynesian multiplier” that anyone has is 2, implying a 5% boost to GDP. That's below the 7% "gap of gloom", not enough to return the economy onto a path to full employment. The fiscal stance should not be the only impetus. There may be some restructuring of spending, but more important than this will be the push-through effect on the banks of their bailouts and how their 'funding gaps' are refinanced.
Last week's grilling in Washington of Wall Street's CEOs asked them, "why, when banks have received billions of dollars of taxpayers' money, is it harder for people to borrow?" Some bank chiefs said their lending continues - and in some cases has increased. But, reality is that availability of credit is tight and may tighten more. Critical to this is the Geithner Plan, the scale and details of TALF. The problem of the lack of detail is that TALF is being pulled in several political directions. These are funding as per the Bank of England's SLS example, or towards 'bad bank', or 'insurance cover', or direct payments to bail-out mortgage borrowers on 'Main Street'?
There is near-total collapse of the private interbank funding market using securities backed by loan assets such as payments on residential and corporate mortgages, consumer credit cards, corporate bonds, student loans, lease-finance loans etc. The straight option is for Government to step in and replace the private sector in interbank lending, and take the profits of that until the private sector clamours at the legislators doors to buy their business back. The 'funding gap' is the gap between bank customer deposits and bank customer loans. While in the UK in 2008 banks issued a record volume of ABS (£245bn) to swap for treasury bills (£185bn), in the US it was much less. In the UK in 2009 there will be another £250bn swapped, while in 2009 in the USA so far, according to Dealogic data, there has been a mere $2bn of bonds backed by auto loans and student loans. In 2007, before the credit crunch took hold, more than half of the $5.6 trillions borrowed in the US credit markets was financed through ABS. The UK banks' 'funding gap' is £800bn over 3 years (including UK banks' funding gap in US loans), in the USA it is $6-7 trillions (my estimate). See also: http://www.bankofengland.co.uk/publications/fsr/2008/FSR08Octexsum.ppt#1
Funding gap problems are the essence of the meaning of "credit crunch", but should not be confused with credit risk losses (provisional before actual realised) as in the graphic below that is worth repeating again here. The Congressional hearings came just as the biggest annual securitisation industry conference ended in Las Vegas (appropriately, where the slot machines are less noisy of late). Numbers attending the American Securization Forum event fell to 3,600 from 6,000 in 2008. The US government knows that securitisation markets remain key to interbank credit, hence it has a plan for the Fed to lend up to $1 trillion to hedge funds and others to buy banks' ABS. This is Term Asset-backed securities Loan Facility (Talf). Last week, the size of the scheme increased from $200bn to $1,000bn as a result of hedge funds lobbying for this. In my opinion TALF could be better kept entirely in-house by the Fed, but it has possibly another $5 trillions of such swaps to do and so engaging the hedge funds for 1 sixth seems sensible enough. Others estimate the US banks' funding gap, at only $2-3 trillions, hence the split between private/public funding looks for now more 50/50. Citi led the way in growing banks' funding gaps after 2003. Today, Citicorp has its funding gap mostly covered thanks to its Government deal and therefore it is not too surprising to hear the spoiling comment from Citi director Mary Kane, "The Talf will result in a two-tier market and will not do anything to help traditional, real money investors. This will hinder the recovery of the markets."
The Banks as borrowers and lenders allowed interbank funding costs (spreads) to get too high to support past business models. But by balking at the deals the result was that panic set in about the banks' funding and the result was a hundred times more was lost in shareholder value (even after discounting for recession impact). Many private investors ('traditional investors' more than hedge funds) continue to balk at buying new issues, even with mouth-watering high yields, partly because of the uncertainty about the new US government plans. Hence the so far negative impact on confidence of Tim Geithner keeping his options open by not pinning down the details. But, the administration has also learned that there is no point in rushing to precise detail only to find that a temporary stock market spike is manna to short term profit-takers and then everyone concludes that the deal hasn't got long term effectivesness!
A survey of 450 of the Securitization conference participants this month in Las Vegas found most do not expect "return to normal" until 2011. Bet-the-odds investors remain concerned about the disconnect between the high income stream from these bonds and their low market price. This is a general rabbit-in-the-headlights problem of looking a gift horse in the mouth, if it seems too good to be true, it is, etc. i.e. how can the near-perfect-information markets so mis-price income-generating assets? Answer is simple - yields change and when capital is scarce yields go up dramatically as asset prices fall - just a matter of knowing some economic history! Investors, nevertheless want some reassurance as to how far defaults (borrower delinquency) can rise, not only of the underlying mortgagees and consumer credit borrowers, but also of loan-brokers, the finance-backing banks and their securitisation vehicle intermediaries (the previously "fail-safe" SPEs and SIVs).
This concern takes the question of this matter on to the effectiveness of the Government's 'fiscal stance' (budget deficit) and monetary 'easing' (zero bank-rate when consumer price inflation is falling). In practice, even if interest rates stay very low, the actual multiplier effect of the government's boost to deficit-spending will be less than 2 i.e. less than 5% boost to GDP. 5% is the figure deemed necessary to return the banks' funding gap to what it was in 2003, to the point when banks competed too hard and too recklessly to gain market share by allowing their funding gaps to ballooon! Much of the fiscal stimulus takes the form of tax cuts, but what % of this will be saved (paying down debt) and not therefore contribute directly to boosting demand by not entering the stream of GDP spending and income. But, of course, banks' customer deposits should rise, if slowly, to add to closing the 'funding gap'. But, the question remains how to stimulate demand that has been lost in the crisis so that jobs are saved, stemming job-losses in the pipeline, and begin creating new jobs (the Obama 5 million jobs target)? And, the part of the tax cut that is another 'one-year AMT patch' will have no effect on spending because the beneficiaries, forecasters, and everyone else assumes they would not be paying this anyway, notwithstanding the 20-year IRS concessions to banks. If we are lucky, the American Recovery and Reconstruction Act will close half of the gap, relative to the yawning magnitude of the recession, but not enough alone to refloat the economy. Hence, we need the banks to do their bit and roll-over domestic lending and expand lending where the wider economic benefits will be greatest. In another sense, a political one, $800 billions is too much. The 2009 fiscal-year deficit is expected by some calculators to end up at about $1.2 trillion, and if so we're talking deficits thereafter of 10% or higher ratios to GDP - levels that are deemed danger signals in any other country. Until now, the US has not been “any other country.” The trade surplus world has been willing to finance American deficits by buying its bank bonds alongside government treasuries. But while there may be no choice but to continue, the fact is that US imports have slowed dramatically and the pattern of world trade generally is changing dramatically and therefore buyers for new US paper will increasingly need to be domestic not foreign. Foreign countries are all becoming nationalistic about how to apply their capital reserves and therefore international obligations are being settled first on the basis of what domestic financial sectors demand of their own governments. Global banks now recognise that they have to have national homes, the globalised world is not their new country of origin; it has no world government, no central banks, albeit that G20 is running fast to create precisely that in practical terms.
In that light it is ironic that US politicians who warn against the size of the stimulus bill, the Congressmen who voted against it, are same Republicans who supported the Bush fiscal policies that doubled the national debt via the long-term tax cuts of 2001 and 2003 and that accelerated government deficit spending. We need now a bigger Obama fiscal policy that maximizes short-run demand stimulus, that gets through to people's pockets who will spend the money, just not save it. Lots of bang for the buck (recovery with jobs), not lots of buck for the bang (jobless recovery). Conservatives/Republicans continue to argue that tax cuts give stimulus while deficit-spending does not - but without an economic theory in support (supply-sider monetarist theories now seemingly discredited); endlessly repeating “tax cut” like the Hari Krishna "OM" mantra, like a cult that believes in the god-given literal truth of the Bible but has no interest in geology or any demonstrable proof. A perfect example of this prudish insanity is Senate Republican Leader, 'Mad' Mitch McConnel saying,"Unfortunately, at this juncture, while the American People are tightening their belts, Washington seems to be taking its belt off!" He obviously doesn't get what "Financial Stabilization" means or what the economic role of Government should be in a recession. The 134 page Budget Report obviously has some reluctant readership among the country's legislators. Obama inherited a 12.5% budget deficit that he wants to cut to 3% by 2013, not in a straight line, but up and over the deep gully of this recession. The Republicans intend to fight this all the way theologically, not constructively or rationally. They are not alone of course; they do have a large constituency of like-minded opinion. What do central bankers think of all this - see comment below for a sample of their political-economy lines.

LETTER FROM SANTA BARBARA

Our MPs and Ministers and local newspapers (across Europe) could and should soon (once Spring Budgets are published in March) be able to write me letters like the one below from my friend Senator Barbara Boxer, Senator for California. The European Commission should also publish its details of the European Recovery Programme. The London G20 (April) will also have positive spending news regarding aid for the poorest countries of the world alongside its new financial world order plans and progress reports. When looking at all this budget good news, will our media be doing the usual of focusing on what it means for the taxes of a typical surburban one and a half children, one and half jobs, family with a mortgage, 2 cars, 2 votes and one package holiday fortnight? This time round they should think macro-economically like the lovely Senator is doing. Lady Shriti Vadera, when you read this or Darling, please take note!
Dear Friend:
This week President Obama signed the American Recovery and Reinvestment Act (H.R.1), which will save or create millions of American jobs -- including some 400,000 jobs here in California.
In the face of the worst economic crisis since the Great Depression, this historic legislation offers help and hope. It will put Californians to work building the highways, bridges, transit and rail systems, and renewable energy sources of the 21st century.
The economic recovery package includes major investments in programs that will create jobs right now while laying the foundation for sustained economic growth in the future. Here are just a few examples of what California will receive under these programs:
Infrastructure
* $2.6 billion in highway funding that could also be used rail and port infrastructure.
* $1.1 billion for investments in mass transit.
* $444.8 million to address the backlog of drinking water and clean water infrastructure needs.
Education
* $4.6 billion to local school districts and public colleges and universities.
* $82.7 million for Head Start to prepare children to succeed in school.
* $1.2 billion for Special Education Part B State Grants to help improve educational outcomes for individuals with disabilities.
* $74.2 million in education technology funds to purchase up-to-date computers and software and provide professional development to ensure the technology is used effectively in the classroom.
* $1.6 billion for Title I Education for the Disadvantaged to help close the achievement gap and enable disadvantaged students to reach their potential.
Energy
* $224.5 million through the State Energy Program.
* $192.1 million through the Weatherization Assistance Program.
Protecting Those Hurt by the Recession
* $220.2 million to provide quality child care services for in low-income families who increasingly are unable to afford the high cost of day care.
* $89.8 million in Community Services Block Grants to local community action agencies for services to the growing numbers of low-income families hurt by the economic crisis.
* $843.9 million to extend Unemployment Insurance for workers who have lost their jobs in this recession.
* $13.2 million for the Emergency Food and Shelter Program, which provides grants to nonprofit and faith-based organizations to provide for the immediate needs of the
* Homeless.
Tax Relief for Families and Small Businesses
* Up to $400 for workers (or $800 for married couples) in the new Making Work Pay Tax Credit for 12.4 million workers and their families.
* $250 to Social Security beneficiaries, SSI recipients, and disabled veterans.
* $2,500 for each of 522,000 additional families in California who will qualify for the new American Opportunity Tax Credit that makes college more affordable.
We know that this economic recovery package alone will not solve the entire problem; we must also address the housing and financial crises, and we will do so. Be assured that I will keep working with the Obama Administration and my Senate colleagues to enact legislation to stimulate growth, create jobs, and make American businesses more competitive in the global economy.
BB's letter to constituents in March 2009
Dear Friend:
The recently passed American Recovery and Reinvestment Plan (H.R.1), better known as “the stimulus bill,” is often described as a series of very large monetary figures. But the real goal of the bill was to create jobs, jumpstart growth, and transform our economy for the new century. Almost everyone in America will see the change that will be created by this bill. Let me provide some examples of what it will mean for average Californians.
* About 95 percent of all working families will qualify for the Making Work Pay tax cut. Working families will receive between a $400 and $800 tax cut, with an estimated 12.5 million Californians eligible for this tax cut.
* If you have children in California schools, they may see classroom, lab or library improvements as part of the plan to modernize schools. More than 1,200 California schools will receive modernization funding. Other funding for schools will also help to update technology and enable disadvantaged students to excel.
* If you have children in college, 522,000 families in California will be eligible for the American Opportunity Tax Credit to make college more affordable. This program creates a partially refundable tax credit for four years of college and puts higher education within reach of more Californians. The Pell Grant for college loans will also be increased to provide more funds to pay for college.
* If you receive Social Security benefits, or SSI, you will likely receive a one-time payment of $250.
* If you become unemployed, you can receive an additional $100 per month in unemployment insurance benefits, and your benefits will be extended if you remain unemployed. More than 2,395,000 Californians have lost their jobs in this recession and this extra money will help boost them and our economy with their added purchasing power.
* If you or a family member have become unemployed and you had health insurance, you will receive assistance in continuing your employer-provided health insurance coverage for up to nine months. The federal government will pay up to 65 percent of your health insurance premiums during this period of unemployment.
* If your neighborhood has foreclosed and abandoned houses, funds are provided to help local governments buy up and improve homes and make them available to renters or future buyers.
* If you are in the military, funds are provided to upgrade military medical facilities, housing, and childcare facilities. Funds are also provided to upgrade veteran medical facilities and to make repairs at veterans facilities.
* If you are a first-time home buyer, you may be eligible for an $8,000 tax credit toward the purchase of a home. And if you live in a high-cost area, you will have greater access to low-interest mortgage loans.
* If you are concerned about increasing crime in these hard economic times, the bill provides federal funding to hire more police officers through the COPS program.
* If you have a health problem, or even if you just regularly visit your doctor, your medical records will be computerized, enabling faster access to medical records and saving billions of dollars in health care costs.
* If you travel on America’s roads, freeways, bridges, or transit, you are likely to see improvements, upgrades and modernization including freeway construction, modernization of infrastructure that includes energy savings, and rail and transit construction to reduce traffic and gas consumption.
These are just examples of the good programs included in this historic legislation. And while it is just a step in a long road to economic recovery, it is a crucial one.

Sincerely,

Barbara Boxer
United States Senator

ROUBINI'S RGE & STERN SCHOOL COLUMBIA ESTIMATES OF US ORIGINATED BANK ASSET LOSSES

GEITHNER PLAN PASSES WOLF AT THE DOOR

The above graphic is from the FT (11 Feb).
Congress and then the Senate agreed a compromise $789bn fiscal stimulus deal on 11 Feb (as Tim Geithner faced criticism that his separate US financial rescue plan for how to deploy the remaining $350bn of TARP funds lying with Congress that his plans lack specifics). The Stimulus package was caught up by the 'earmarks' that legislators can't resist attaching - it's how they pay their voters and their corporate sponsors - i.e. constituency-specific and industry-specific spending schemes, while TARP2 was unclear about whether to use the 'bad bank' option or credit insurance approach (my preference). Arguing about these matters is the political equivalent of head-banging by rutting bulls.
The stimulus package that tops up almost $500bn budget deficit based on election promises will signed by President Barack Obama by his target date of Monday 16 Feb, is smaller than both versions individually passed by the House and Senate.
After days of debate, speedy agreement reflected pressure by the White House. It trimmed tax cuts and health and education spending to keep the figure below $800bn, a ceiling insisted on by some Republicans and Democrats in the Senate. Geithner will urge other nations to join the US in taking aggressive action to fight the crisis at this weekend’s meeting of finance ministers and central bank chiefs from the G7 industrialised nations. Brown has gathered similar support among EU states (including the €80bn European Recovery Plan) to match the proportionality of the UK fiscal stance that is in turn proportionate with that of the US (8% ratio to GDP).
A US Treasury spokesperson said, “We will certainly be asking the others about their plans and encouraging them to take bold measures to help sustain the global economy.” The US understands countries had “different scope for actions” and indicates the US would seek to establish whether countries were doing all they are able to do, given their existing debt burdens. “That discussion needs to take place,” the official said.
Mr Geithner will set out the US Administration’s position in favour of reform of financial regulation that would make regulation “more consistent across the globe” and ensure “high regulatory standards that are applied across jurisdictions”. This is central to the G20 agenda. He told the Senate regarding the financial rescue plan: “I completely understand the desire for details and commitments. But we are going to do this carefully.” He left the door open for more bail-out funds at a later date. “We want to be careful before we come to you and ask for additional resources or authority that we have done so with as much care and consideration on design as possible.”
Most importantly he said regulators would use a stress test for big banks under the rescue plan to “provide a more realistic, forward-looking assessment” of the losses they might face. This could require banks to step up provisioning. The federal Reserve, like the Bank of England and the ECB are capable of doing these aggregate stress tests for the whole of their banking sectors. This data is essential to the banks own stress tests, because only by correlating themselves to the aggregates can they see the macro-picture of their risk stance.
They then must detail their own economic capital models. This requires a host of techniques and computing power that can be gleaned from www.union-legend.com and also www.bis.org for detailed quidance. It is this precise and complex area that banking regulators such as the FSA and the other EU national regulators have been chronically weakest on in advising their respective banks, insurers and other financial institutions! Weakness here is a failure of their fiduciary duty under the law as much as it is a faikure of the European banks under the law (Basel II, Solvency II, CRD, and now also IFRS7 accounting standards etc.)
The rescue plans are still attracting political criticism in the US. But Lawrence Summers, director of the National Economic Council (Economic Advisors to the President), said it reminded him of the initially negative reaction to the successful 1994 Mexico bail-out.
A second senior administration official said the plan was intended to ensure banks had access to a larger capital cushion to withstand the recession. This is somewhat disengenuous insofar as it presupposes that it is merely additional to minimum regulatory capital reserves, when actually double these are required. But, my view presupposes the results of the stress test, given that I've already done one for US banking (see www.union-legend.com). He also said the administration decided against providing insurance-style guarantees across the banking system because “guarantees could leave the government with risks it cannot price and cannot manage, and it looks like you are trying to avoid dealing with the reality of the situation”. This is opposed to my advice and the work undertaken at Columbia University that specifically recommends the insurance option. If the insurance option is couched in Basel II terms it is possible to provide a cap and therefore not to leave the matter open-ended. In any case, it is not the open-endedness that categorises the matter of the insurance option.
One reason for preferring the bad bank approach - essentially buying in illiquid assets - is to get these right off the banks' books. But, then while this frees he banks in the short term, they still should register the asset writedown losses and that hit their p/l severely short-term. After that, freed of having to work their way out of the illiquid assets, what are the safeguards in place to ensure they restore lending levels and do not build up new toxic assets oe become liable for credit derivatives they no longer have the underlying to support?
Investors (hedge funds) said they could be interested in investing in toxic assets alongside the government providing there was attractive government financing and guarantees – but that is a wholly unclear prospect. The FT has become during the credit crunch, the global paper of record, noit just for facts but for expert opinion and global debate. In the FT, Martin Wolf, engaged in a most unusual and important questioning (under the above cartoon, which while funny is an extreme simplification unfair to both Obama and Wolf's article). Woilf asks, "Has Barack Obama’s presidency already failed?" His political catchphrase for this is, "Doing too little is now far riskier than doing too much." By this line, Wolf is saying timing is more important than precision or trying to be so efficient that there is no redundency. It has been always part of democratic governments self-proclaimed prudence on behalf of the shareholders (taxpayers) interest that it should only spend the minimum necessary to achieve anything. In this case, facing the unknown, Wolf's argument is like that of a bridge engineer or dutch sea defences, better over-engineer, build higher, there may be worse to deal with than we think we know now. "If he fails to act decisively, the president risks being overwhelmed, like his predecessor. The costs to the US and the world of another failed presidency do not bear contemplating."
From a risk management perspoective this is sensible thinking, sound warning. The opponents of the idea are in various forms, those who view markets as incredibly delicate and complex that we can only tamper with gingerly, and those who are positioning to profit out of the crisis, the carpet-baggers who don't want to see the knocked-over chess pieces and broken china all set upright and glued together again occupying in their old places just as before. Wolf says, "Hoping for the best is foolish. He should expect the worst and act accordingly."
The banking programme seems to Wolf to be "yet another child of the failed interventions of the past one and a half years: optimistic and indecisive". Central to this view is how to balance two views of the crisis:
1: CONFIDENCE: it is a matter of restoring confidence, essentially to end the panic. Loss of confidence drove prices of bank assets below their long-run value.
2: SOLVENCY: it is a problem of insolvency i.e. financial, a matter of capital reserves because large systemically important financial institutions are technically insolvent: assets worth less than liabilities.
Taking the first view, governments step in to make a market, buy assets or insure banks against losses, the rationale for the original Tarp and the “super-SIV (special investment vehicle)” and the liquidity infusions by other central banks.
Taking the second view, given potential losses on US-originated credit assets alone of $2.2 trillion (€1,700bn, £1,500bn), $800bn more than estimated last October. (from possible peak losses on US ABS of $3.6tn, of which half were sold abroad).
Personally, I see this really as a timing probably, buying time. Confidence is a complicated phenomenon. It is very political. The US public did not want to vest confidence in the outgoing discredited Bush administration, but the want to find it in Obama. Brown found himself on both sides of that transition. He went through a period of dramatic loss of political support and is not clawing it back. Industries and many others including taxpayers and local governments all are scrambling to stake their claims to relief aid, sometimes to cope with budgetary difficulties they would have less grounds to complain about if there was not a recession and a banking crisis to blame.
The official response to the crisis has been to solve the financial crisis first and then to partner with the banks to solve the economic recession by together acting counter-cyclically to climb out of the trough and up into recovery and expect the good sense of this to be recognised and confidence then is restored. That gameplan may now have to be reconsidered? The answer depends on which will take longer to achieve, restoring confidence or restoring financial solvency? Both look as though they have long unravellings yet to come. The finance sector, the major banks especially, is proving to have more unplumbed depths and ramifications that are international/global as the world economy deteriorates, and will become ever more so. Tha answer may have to be tackling confidence and solvency, credit crunch and recession together at the same time as rapidly as possible, a shock-recovery as rapid nearly as the shock-collapse. One reason why is because time is not necessarily the healer when there is so much that has to unravel.
There are those who won't want a rapid recovery. They want to know the who, what and why of how we got into this mess and have those questions answered and the problems solved first. There are others who are positioning to be the new financial powerbrokers, the carpet-baggers, all those waiting to buy productive and financial and property assets dirt cheap. The idea of replacing the chess men on the board, the broken china figurines re-glued and back on the mantlepiece is anathema to many; they want radical change. That response is intllectually as well as emotionally a very strong one. An alternative to to put everything back as fast as we can so that economic dusruption to the world and our economies is less not more, and then at our leisure sort out the problems and fix the regulation etc. But, of course, do that and many will start saying where was the problem really, not a problem really that much at all? After all, Spring will come again and the flowers bloom around the Old Lady of Threadneedle Street. But is this the heart of the matter? Buying time and providing some cushioning still relies on the sensible shape of our capitalist system having enough shape-memory that all will spring back into good and sensible working? This is hoping for the best. Wolf's answer is that "rational policymakers must assume the worst". If the delicat swiss watch system of our financial economy is broken do we know enough about the bits and pieces to put build it all back again in good working order? Do we understand out own system that well? To some such questions may appear pointless or plain daft - of course we do and if nothing else we have to assume we do! Well, just as we are finding that the 1930s are not buried in the past, so too may other nightmares of the twentieth century be less lost to history than we have hitherto hoped and expected.
If governments over-respond now with excessive money generation and credit capital support, we may end up with an over-capitalised financial system. That we can fix. If the optimistic choice of doing least turns out wrong, we have zombie banks for years and zombie economies and discredited zombie governments. When democratic governments all lose popular support the alternative is the greatest nightmare of all. Therefore that much choice is surely a “no brainer”.
US Obama's new Geithner Plan and our UK Brown Darling Plan and their EU equivalents seem to make sense if and only if the principal problem is illiquidity. By that we mean wholesale funding of the banks 'funding gaps' that large amount of banks 'liabilities' filling the gap between total loans and total deposits. In the UK it is about £800bn or more than $1 trillion. In the USA it must be (say) about $6-8 trillions. We do not know what the cost of securing and pump-priming these are. We could assume something like £140bn and $1,200bn and this should be the order of the discount on covered bonds offered as collateral respectively by BoE and The Fed. BoE has already taken in £245bn collateral for £185bn treasury bills (discount writedown plus haircut of 25%). It is therefore not yet half-way there. The Fed’s ability to create money by purchasing assets is only limited by its balance sheet. Its balance sheet liabilities consist of bank reserves held on deposit and financial securities collateral plus Treasury deposits. Recently the Treasury sold a substantial amount of debt for the purpose of depositing the proceeds at the Fed. This allowed the Fed to double its balance sheet to about $2tn. The Fed is using this extra leverage to buy assets as collateral. Chairman Ben Bernanke says the Fed is taking an appropriate haircut and the Fed can sit on assets until they mature. This is a version of the Bank of England's SLS, which launched last April and has just been closed to be replaced with a permanent "son of SLS" to include a wider range of ABS than mainly RMBS hitherto. The Federal Reserve launched the Term Asset-Backed Securities Loan Facility TALF in November limited to ABS backed by credit cards, student loans, auto loans and SBA-backed small business loans, and has announced revisions to include investors, beginning this month, February. The additional facility is permits investors (probably only banks' originated SPEs, prime brokers' collateral holdings, and maybe hedge funds) to pledge recently issued AAA-rated ABS to the New York Fed in exchange for non-recourse loans. The Fed has said it would offer these loans for three years, rather than one year. It also said it would make loans available to "all investors" rather than picking recipients via an auction.
This goes beyond offering guarantees and buying some portion of the toxic assets, limited to the $350bn left in the TARP, which is what the legislators and the public see happening, and which experts know cannot alone deal with the insolvency problem.
TARP began as a one year program, but is now extended to three years. $250bn was used as 'capital infusions' into banks. These pay dividends. The stock may be redeemed after three years and the dividend amount rises to 9% after five years. (see Emergency Economic Stabilization Act). Other measures include:
Fannie, Freddie Loan Modification Program. The Federal Housing Finance Agency, Fannie Mae and Freddie Mac announced Nov. 11 a streamlined system to modify troubled mortgages. The plan is aimed at high-risk borrowers who have missed three or more payments, who occupy the house as their primary residence, and who have not filed for bankruptcy. The goal is to achieve an “affordable” monthly payment, which is defined as a payment of principal, interest, insurance and taxes that takes no more than 38% of the borrower’s gross income. Options to reduce monthly cost include lowering the interest rate, extending the maturity of the loan, and deferring payment for part of the principal. There is no requirement to use these three tools in any particular ratio. Servicers will be paid $800 per modification, a move that ensures they have a financial incentive to use the program. (Federal Housing Finance Agency) Shiela Bair, Chair of FDIC, Comptroller of the Currency John Dugan, and Director of Office of Thrift Supervision John Reich.
The Office of the Comptroller of the Currency on Nov. 21 unveiled a shelf charter, for how private equity firms can be approved in advance to buy a bank. This is important as private equity firms typically couldn't secure approval fast enough to bid for the assets of a failing bank. The FDIC followed that on Nov. 21 by announcing its own streamlined approval process for private equity firms that want to own banks. Both actions are intended to make it easier for private equity firms to purchase banks. (Office of the Comptroller of the Currency, FDIC) Private Equity Investments, whereby The Federal Reserve issued a 15-page policy analysis that expands acceptable private equity investment in banks and bank holding companies. Minority investors with between 10% and 24.9% of the voting stock of the company will be permitted to have a voting member on the board. It also expanded beyond 25% of equity the stake an investor may buy without gaining control of the institution. An investor may own up to 33% of total equity if it does not own 15% or more of any one class of voting stock. Finally, the Fed clarifies that non-controlling minority investors may communicate with bank management and advocate for changes in the bank’s policies and operations without being deemed to be in control. (Federal Reserve authority)
Money Market Insurance, wherebyThe Treasury insures money market mutual fund balances on deposit prior to Sept. 19, 2008. In effect, Treasury is guaranteeing the funds will not break the buck. (Treasury authority) Money Market Investor Funding Facility whereby to provide a means for money market mutual funds to become liquid even if they are investing in longer duration assets. The New York Fed will provide secured financing to five private-sector SPVs. These vehicles will purchase CDs, bank notes, and highly rated CP. This only is open to regulated money market mutual funds, and total size is capped at $600 billion.
Mortgage/MBS Purchases limited to troubled assets that are residential and commercial mortgages and related securities as well as other financial instruments that Treasury and the Federal Reserve believe it needs to buy to ensure stability. Treasury shall make purchases at the lowest cost consistent with market stability and it should use market mechanisms. For direct purchases, the price must be reasonable and reflect the underlying value of the asset. Purchases and prices must be disclosed within two days. Financial institutions in the program must provide warrants for nonvoting common or preferred shares. It does not specify the stake, but says it must be “reasonable participation” for the benefit of taxpayers. Stakes are not required for purchases of less than $1 million. This was on hold, though the new administration could revive it. (Emergency Economic Stabilization Act)
Interbank Loan Guarantees, using the FDIC debt guarantee program to effectively guarantee interbank loans. As a result, there is no need for a separate interbank guarantee. (FDIC authority) IRS Tax Change on Carrying Losses Forward. A new change permits a bank that incurs losses through an acquisition to carry all of those losses forward over 20 years. As a result, this becomes a lucrative way to reduce future IRS tax bill. Commercial Paper Market. Federal Reserve assurance to investors that if they purchase commercial paper that they will get repaid even if the company cannot rollover the debt. (Treasury, Federal Reserve Plan). Treasury officials believe they have the power to use TARP to take second loss positions and provide other types of credit enhancements, using enhancements and leaving the assets at the bank rather than purchasing them outright (e.g. the FDIC mortgage modification plan). This was used as part of the Citigroup stabilization effort. (Emergency Economic Stabilization Act).
It is hard to say, but my guess is that all these measures, the ones that are active so far, to date should have taken in about $2.5 trillions of assets in exchange for $2 trillions in liquidity infusions. This is only covering one third, possibly only one quarter, of the US banks funding gap.
Any toxic asset purchase or guarantee programme are only an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions, if government must buy vast amounts of doubtful assets at insufficiently discounted prices or provide over-generous guarantees, to render essentially insolvent (in liquidity risk terms) banks solvent.
But, I would be amazed if the discounts and haircuts are not at least 25%, which for assets that are broadly representative of bank loan assets should easily provide profitable security in short, medium and even longer term. These assets are wrapped up as long term paper. In the case of UK banks the paper is 40-50 year paper. Thus the securities have a far longer life than the underlying loans. If the banks can roll-over the treasuries obtained and continue to do so, in which case holding the treasuries on deposit at the Fed would seem a good idea, they then have a long term high grade funding program and will not need to return to interbank markets for that portion. Where government is obtaining a good interest above LIBOR this income should compensate for corporation tax losses in the coming years.
It would be inefficient if big capital injections or conversion of debt into equity are better ways to recapitalise banks, and inequitable, if big irrecoverable subsidies would go to failed institutions and private buyers of bad assets. What is at risk is if the administration trades broader economic gains for giving up the profitability to it and taxpayers of how its recapitalises and provides liquidity to the banks. That would be a weak form of just hoping for the best.
We have to precisely ask what is the exact scale of what needs to be done to be sure of a solution? The answer concerns the following: the banks' funding gaps and their losses that have to be taken against capital reserves. The capital reserves I estimate will be wiped out twice and the funding gap could need 100% funding. In total this is $10 trillions. But this can be treated as busines sinvestment and not as aid. If Government supports the banks, they surive and government should earn a business return. Currently that varies between 9% for shares and about 4% for loans. Assuming a 5% return on $10 trillions, all of which can be off-budget, then the return is (say) $500 billions, this business balances the Federal Budget.
In fact $500bn currentl exceeds the total stock market value of all US commercial banks (about $400bn).