Banks are supposed to lend money, but they aren’t doing very much of it these days. That is not the only cause of the global recession that is unfolding, but it is hard to see how economies can begin to recover without functioning financial systems.
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Plan B: Flood Banks With Cash
By FLOYD NORRIS
9 October 2008
Banks are supposed to lend money, but they aren’t doing very much of it these days. That is not the only cause of the global recession that is unfolding, but it is hard to see how economies can begin to recover without functioning financial systems.
The American government has responded by taking over more and more of the lending itself, while using indirect means to shore up the banking system. It has not worked.
Never in history have the Federal Reserve and the Treasury announced more plans to try to fix the financial system within a span of a few months — and rarely have investors been less impressed.
The Standard & Poor’s index of 500 stocks is down 22 percent since the end of September, and 42 percent since it peaked a year ago.
It may be time to try a new approach, and perhaps to abandon the announced details of the bailout plan passed by Congress with such difficulty only a week ago. The government needs to decide which banks it is sure are worth saving, and pump capital into them directly.
Treasury Secretary Henry M. Paulson Jr. indicated this week that he was considering such an approach, which would be much simpler and could be much more effective.
The announced plan for the bailout package was for the government to buy up dubious assets from banks, paying more than they are worth now but less than they are expected to be worth later.
If that is completed, banks will get cash — $700 billion or more. But their net worth will rise only to the extent the government overpays for the assets. Pricing those assets will be anything but easy, and the expectation of the government program has further frozen those markets. No one wants to sell until they can find out what the government will offer.
The alternative is to go in the direction Britain went this week. The government could use the $700 billion, or at least a large part of it, to buy preferred stock in banks.
The government could be selective in deciding which banks get the cash, and it could impose conditions on those that seek the money. Those banks could be required to come clean about the risks that they have taken in dubious assets, and to write those assets down to what a willing buyer would pay now.
With that information, the government may decide to let some banks fail. But the others, in which the government does invest, would have a government seal of approval that was backed up by cash.
And a lot of cash. A rule of thumb might be that if the government thinks a bank needs $4 billion in additional capital, it gets $8 billion.
The terms could be arranged so that the government gets a reasonable profit if the bank can pay the money back within five years, and can convert its stake into common stock only if that deadline is not met. That would give the current shareholders hope that their stock will be worth something someday, and perhaps avoid the further sell-offs that could otherwise arrive with the plan.
For much of the 14 months this crisis has been growing, the government has believed it was one of illiquidity — a temporary inability to raise cash — rather than insolvency — the issue when a financial institution is broke. The assumption was that the banks really would be fine when worries went away, and they had to be helped over that temporary hump. The Federal Reserve expanded both the amount it was willing to lend and the collateral it would take to back up loans.
The crisis, it turns out, is one of a lack of solvency, not just liquidity, and that is why banks fear to lend to one another. Each bank knows the games it has played in valuing assets — or at least could have played — and is loath to believe the balance sheets of other banks. That suspicion has chilled the interbank lending market.
The sad saga of the American International Group is one reason for that chill. When A.I.G. first said it needed help, $40 billion was said to be all it needed. Now the total is over $120 billion, as more problems are found.
One European precedent that the Treasury could study was used this week when the government of Denmark guaranteed both deposits in Danish banks and all interbank loans. The banks were ordered to halt dividend payments and share buybacks.
Given their need for capital, it is odd that most American banks are paying any dividends at all. Even after reductions, most big American bank shares now yield more than 3 percent, and some more than 7 percent.
Yet few of the banks are confident they have enough capital, or that their competitors do, which is why they are reluctant to lend. In that atmosphere, does it make any sense to reduce capital by paying dividends? Should the government funnel money to companies whose owners are getting big payouts while the banks report large losses?
In the absence of a functioning financial system, the Federal Reserve announced plans this week to lend money to companies that cannot get credit in the free market. Those loans will be made at low interest rates, with no equity for the government and no controls over how the money is spent.
It ought to make anyone nervous to have the government allocating capital, which in this environment could mean it is making the decision to let companies live or fail.
How will the Federal Reserve deal with that quandary? What interest rate will it charge if it is the only lender willing to put up cash to buy a company’s commercial paper? There are no answers available.
The Fed does say it will not buy more commercial paper from a company than the company had outstanding in August. And it will cut off a company if one of the rating agencies downgrades it.
Doesn’t it make you feel better to know that the Fed has subcontracted its investment decisions to Moody’s and its competitors?
Ideologically, this is not what either Republicans or Democrats would have proposed a few months ago. But desperate times produce desperate tactics.
“The central bankers all learned the lesson of the 1930s,” said Robert Barbera, the chief economist of ITG, a Wall Street firm. That lesson was that if the choice is between allowing the system to collapse and writing a lot of checks, you write the checks and forget about ideology.
Unfortunately, none of them learned the lesson of the 1920s, which is that when asset prices soar, it is not a good idea to sit around doing nothing, as the Fed did for most of the housing boom. Cheerleading, which it sometimes did, is even worse.
One aspect of this crisis is that the people in charge of the financial system — in the banks, at the Fed and other central banks and at the Treasury Department and other finance ministries — consistently underestimated the damage, both to the system and to the world economies. At first, many thought the damage would be limited to losses from a small group of mortgages. Banks raised a little capital, but not nearly enough.
As the problems spread, they kept offering reassuring words, which they might well have believed. Those words provided brief comfort for some, but destroyed a lot of credibility.
As recently as Sept. 18, after Lehman Brothers had gone broke and it was clear that consumers were cutting back, the Federal Reserve Open Market Committee thought the economy could come through. “Participants agreed that economic growth was likely to be sluggish in the second half of 2008,” said the minutes of the meeting. “Several participants had marked down their near-term outlook for economic activity and some judged that downside risks had increased, but most continued to expect a gradual recovery in 2009.”
We should be so lucky as to get sluggish growth for the remainder of 2008. The gross domestic product seems likely to show significant declines, and those declines may continue into 2009.
The real problem, which many preferred to ignore because they had no ready answer, was that the financial system was breaking down. The excesses of lending and gambling had destroyed the new financial system — the one built on securities as an alternative to bank lending — and left the old commercial banks too weakened to step in.
Or, in the words of Paul A. Volcker, the former Fed chairman, “In the U.S., the market took over. The market has flopped.”
Now, added Mr. Volcker, “everybody is running back to Mother, the commercial banking system.”
Unfortunately, Mother is very ill. Even worse, her children do not trust one another, and that is why the system is frozen.
In 1933, when Franklin Roosevelt became president amid a panic, he declared a bank holiday that closed the banks while federal examiners went over their books. When the holiday was over, the government closed some banks and declared the rest were healthy.
In reality, there was no way the government could be sure of that. But the public accepted it, and the bank runs stopped.
This time, the government has offered too many assurances that turned out to be false. It will take cash to convince the public — and the other banks — that the survivors are safe.
Floyd Norris’s blog on finance and economics is at nytimes.com/norris.
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