Much to worry about
The New York Federal Reserve Bank doesn’t use its ability to summon Wall Street’s top leadership to its downtown castle lightly.
This doesn’t seem quite like LTCM either. For one, the US Treasury did not participate in the LTCM meetings at the New York Fed, and Paulson attended last night’s meeting.
Like almost everyone else, I can only guess what is going on. But my best guess would be that as of Friday night, no “deal” to take over Lehman had been finalized – and the New York Federal Reserve and the Treasury wanted to make it clear both that a deal needed to be done and that deal needed to be done without any assumption of risk by the Fed or the Treasury. I’ll be interested to see what emerges on Sunday – and to see if China’s Investment Corporation is involved.
Saskia Scholtes and Michael Mackenzie of the Financial Times, with input from Krishna Guha, indicate that there is now an incipient discussion of how to move from to finding emergency fixes for the problems of specific institutions to addressing the broader weaknesses now apparent in the overall financial system.
“The debate over whether an RTC-style vehicle is needed – perhaps just to ring-fence troubled mortgage assets – also gained traction among central bankers at the Jackson Hole symposium hosted by the Federal Reserve Bank of Kansas City in August. The US Treasury and Federal Reserve are not working on such a plan, but they have been looking closely at how previous interventions were used to redress systemic market crises.
The problem that an RTC vehicle could help to solve is that there are very few buyers for troubled mortgage assets, and few investors now willing to inject fresh capital into the tattered balance sheets of the banks left holding them. As a result, banks such as Lehman and Washington Mutual have struggled to sell their soured mortgage portfolios, and to broker deals for fresh capital. The takeover of Fannie and Freddie, which virtually wiped out preferred equity holders, has also made banks’ access to the preferred capital market increasingly difficult.
Through a new RTC, the government could provide financial support if needed in return for a share in potential profits once the assets were liquidated. “
Essentially, there are more impaired assets out there than healthy balance sheets, creating a world where the system as a whole is structurally short of capital.
Former Treasury Secretary Summers put forward a plan – or at least the nucleus of a plan – to try to address this problem in his assessment of the crisis in the Financial Times in early August.
In all likelihood, the financial system will require very substantial capital infusions over the next year or two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have provided financial institutions with capital over the past year have been badly burned. As valuations fall, it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain market confidence, leading to further declines in valuation and yet another vicious cycle.
How can the authorities best support the financial system?
To date the focus of public policy has been on the extension of credit to banks and other financial institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity, lending can be highly efficacious. When the problems are of underlying solvency and the constraint on lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency basis, to plan policy responses to such problems.
…. There is as yet no framework in place for handling the large quantity of bad assets sitting on financial institution balance sheets. During the last US banking crisis in the early 1990s, the Resolution Trust Corporation was established to manage impaired assets of banks and savings and loan institutions that the government had taken over. But it acquired assets only after the government took over banks. Consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration …
The core trade involves the US government receiving equity in major financial institutions in return for taking some bad assets off their hands. By taking some impaired assets out of the system, it would aim to bring the system’s assets down to a level that can be supported by the existing capital base.
After the US election, I suspect the debate will shift toward the need for such a systemic solution. If this kind of intervention proves necessary, it would need to be accompanied by a rather wholesale change to the United States’ system of financial regulation.
My main job back at the Treasury in the 1990s – when I worked for both Mr. Geithner and Mr. Summers — was to support the United States’ efforts to improve the “international financial architecture.” Right now, it looks there is a need to strengthen the United States’ own “domestic financial architecture.”
UPDATE: The latest from the New York Times on the status of the negotiations at the New York Fed. It sounds like Barclays — not Bank of America — is the most likely bidder for the good bank, and that all the banks would be expected to help capitalize the bad bank. The Wall Street Journal’s latest report also suggests Barclays has more folks at the New York Fed than anyone else.
UPDATE 2: The New York Times reports that Barclay’s isn’t willing to do a deal without more support from the government or other banks than it is currently getting; liquidation is possible. All I can say is wow. If Lehman’s unsecured creditors take a haircut, I would guess that the cost of funding for the entire US financial system will rise significantly.
The most logical reason for sure.
Re CNBC: nicely done.
Except with RTC it dealt with liquidation of commercial real estate.
HERE the bad assets are mortgages on people’s homes. Very different scenario. You can’t just sell all the homes crashing in value.
People live in them.
Matt Dubuque
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A unique aspect of this credit crisis is that the underlying credit event will take much longer to run its full course than is reflected in the forced rapid write-downs of financial assets associated with it. Securitization has led to the marking of expected losses for an event that depends largely on household cash flow over a longer period of time. Losses are being capitalized (negatively) in advance of their actual occurrence. There is much uncertainty in the outcome of the full underlying macro event. Ever larger risk premiums are being built into market or model valuations of assets as a result. This is being compounded in turn by liquidations forced by market to market destruction on capital positions. Value at risk has become a self-feeding nightmare. The marks produced by the service that creates index values on mortgage assets have been questioned as well. Financial institutions are struggling to recapitalize on the basis of loss estimates that in themselves are subject to considerable risk. The veracity of these estimates won’t be confirmed for years in some cases.
Twenty years ago, prior to securitization and derivative replication of the mortgage business, the same underlying mortgage experience would not have produced such an accelerated and sudden downdraft in marked to market capital destruction.
Government does have the gargantuan capital resources required to position such distressed assets. But the idea of a government funded warehouse for bad assets is in part a macro hedge against marked to market accounting in a private sector environment of vanishing liquidity and downward spiralling asset prices. Unlike the private sector, it is effectively insulated from marked to market accounting constraints, at least in term of the chosen timing of required capital coverage based purely on asset price movements. It can therefore use time to its advantage.
Marked to market accounting may be the “least bad” form of accounting for purposes of transparency, but it is an architectural death wish in a market that has no liquidity and was not even designed for such liquidity. There’s an element of insanity in the downward spiral dynamics. Conversely, the government is “buying time” for free with any structural intervention. It would hope not to lose and perhaps to gain via warrants. It can do so with the added advantage of time.
JKH, you clearly allude to substantial uncertainty in the underlying data.
Along similar lines, the Fed is in a difficult position trying to forecast accurately the effect of monetary policy upon pricing behavior and loan activity.
One of the most helpful tools the Fed has for forecasting future lending rates is the quarterly surveys it takes of projected lending stances by senior lenders at various lending institutions.
However, in a turbulent period, quarterly data quickly becomes obsolete.
Consistent with the monthly inflation expectations polling of the University of Michigan, I would like to see monthly surveys of senior loan officers instead of quarterly ones.
I think that would be helpful.
In many areas of this crisis, we need more data points.
Matt Dubuque
“a deal needed to be done and that deal needed to be done with any assumption of risk by the Fed or the Treasury.” I assume you mean “without.”
Just read a post on RGE stating that CNBC caught wind of a proposed deal this evening, that will be reviewed tomorrow morning.
They say a “bad bank” will be formed by having the other Wall Street banks commit a total of $30B to buy the assets and put them in safe keeping until liquidity returns someday to real estate.
I don’t really understand high finance. They told us in econ 101 that mortgages are 20% down and fixed rate because they aren’t liquid but banks can give a fixed rate because our economy does NOT resemble Brazil’s. But that was in the late 70s, our books were a little out of date, and no one knew what mark-to-market meant yet.
But anyway, then the only thing left of Lehman would be its good parts.
The only fishy thing about the rumor, is how did they co-ordinate with all of Wall Street’s IBs on a Saturday, and how did the IBs figure out if they have $30B?
Or does Ben just commander money like he commandeered BS stock?
More power to him if that works.
Found a fresh press release on the proposed deal. So its a true rumor anyway.
Tomorrow we see who caves in.
I’ll try and help Ben out. Get the FBI in the meeting tomorrow and tell them to bring their files.
http://www.cnbc.com/id/26691041
qingdao — yes, i meant without. i’ll edit accordingly.
“Financial Industry” is an oxymoron.
These guys don’t make anything, don’t help anybody (except fellow plutocrats), and don’t tell the truth.
Thank God, we have a strong industrial base of other industries to make up for the putrid “financial industry”.
Oh, gosh, check that. We don’t.
Remember Wall Street’s mantra: Privatize the Profits and Socialize the Costs
US Taxpayers likely to hold the bag on Lehman’s worthless subprime garbage
http://biz.yahoo.com/ap/080914/lehman_brothers.html
The investment banking official, who asked not to be named because the talks were ongoing, said the investment houses were balking at paying to polish up Lehman’s balance sheet so Bank of America or Barclays could buy a financially clean firm.
He said the investment banks were angling for the government to provide some money.
Masters of Defeat: Retreating Empire and Bellicose Bluster
By James Petras
Sep 11, 2008, 22:14
“Washington is forced to watch other powers shape events” – Financial Times
http://axisoflogic.com/artman/publish/article_28183.shtml
Everywhere one looks, US imperial policy has suffered major military and diplomatic defeats. With the backing of the Democratic Congress, the Republican White House’s aggressive pursuit of a military approach to empire-building has led to a world-wide decline of US influence, the realignment of former client rulers toward imperial adversaries, the emergence of competing hegemons and loss of crucial sources of strategic raw materials. The defeats and losses have not dampened militaristic policies nor extinguished the drive for empire building.
The defeats suffered by the US Empire have not been products of the Western Left, nor have they led to a ‘peace dividend’ or improved living standards for the working classes or peasants. To the extent that there are beneficiaries, they are found largely among the newly aspiring economic imperial countries, like China, Russia and India, among the oil rich countries of the Middle East, and especially among a broad swath of large agro-mineral export countries like Brazil, South Africa and Iran, which have carved out important niches in their region’s.
The cost of the Pentagon military driven empire building to the domestic economy has been devastating: Competitiveness has declined, inflation is eroding living standards, employment with stable living wages is disappearing, unemployment and loss of jobs is skyrocketing, the financial system is disconnected from the real economy and on the verge of collapse, home foreclosures are reaching catastrophic levels and taxpayers are being bled to death to bail out the trillion dollar home mortgage debt speculators. Political malaise is widespread.
JKH — appreciate your comment. it seems like you believe there is a need to take a more systemic approach to the crisis, and part of that is in effect removing some impaired assets from an entity that has to mark to market. here tho i would note that the RTC model includes selling impaired assets at a loss so you can find a price and not holding out for a bid, so your idea is somewhat different. then again, the underlying assets are different — which creates a different dynamic.
Cedric — the obvious (at least to me) deal at this stake is for all of the street to chip in to create a bad bank with the bad assets, and for the firm that buys the “good bank” to chip in substantially more to deal with concerns that the full street is helping out one specific firm. As for how you do that deal, well, at this stage most of the key player are in a few rooms at the new york fed, and at some stage they have to decide whether they are willing to put in capital and announce a deal or whether they would rather see the markets open without a deal in place and see what damage that does to their own stock. the fact that there is // team according to various reports (the WSJ seems to have the most details) preparing to manage a LEH bankruptcy means that the fed is working to make that threat credible. So I suspect at some point today my old boss Mr. Geithner will call the key players into a conference room and more or less say “what is it going to be?”
Don’t forget the jobs offshored. George W Bush and dimwit US Labor Secretary Elaine Chao have rarely met their monthly jobs creation target. It takes 100K-130K new jobs created per month just to absorb US graduates into the workforce. These two Republican morons have rarely met that target. The jobs sent offshore are not coming back.
Elaine Chao has chirped “become a registered nurse or anesthetist.” Alan Greenspan called it “labor specialization” and adds xray tech, physical therapist, respiratory therapist, MD, dentist. Trouble is, locating a community college or university for retraining, completing prerequisites, supporting a family, paying tuition and textbooks takes time and money.
With the collapse of the jobs in the US, how could have moron think that monthly mortgage payments would reset to a highly monthly payment? I’m glad to know leadership in the US is literally that f3ckin’ dumb.
Bad bank, good bank, this smells furiously like France’s solution to the Credit Lyonnais follies of the early 1990’s. News for the US taxpayer: French taxpayers were seriously stiffed with that solution, only gradually.
JKH et al, pretty good comments.
Problem in this case is: does an investment bank deserve to be rescued? What exactly are the public interest issues here? Commercial banks are much more special than broker-dealers. Let’s not forget that the normal bank assistance model provides only for the FDIC to protect depositors up to a point, and that bailing out the FDIC itself may be a reasonable instance of public interest outweighing the taxpayers’ immediate interests. There is protection for some clients of investment banks and all unprotected creditors of investment banks knew quite well what they were doing and were hardly unsophisticated. No one should have expected IB creditors to be assisted, or an investment banking systemic crisis to be resolved other than through the elimination of the weakest.
Apparently there is now a more “dynamic” view of the balance of public interests (investment bank creditors, parties likely to suffer from an investment banking meltdown etc against taxpayers only remotely likely to benefit in the forseable future), i.e. that preventing a systemic crisis does two things: the gvt “buys” an investment banking franchise at rock bottom hence may recover a portion of its expenditure and the reduction of market failure conditions reduces the bid-offer spread of many classes of illiquid assets, thus pushing many leveraged investors away from insolvency on a mark to market (bid) basis. That might be a justifiable form of gvt intervention but I have several problems with it:
- it is inherently intransparent, hence likely to foster corrupt behaviour, especially given the amounts involved
- After Bear and especially if Lehman equity and stakeholders were treated better than Bear’s, there is no reason why investment banks would behave prudently next time once their capital has suffered a large hit. The well known “gambling for resurrection” would then become part of the investment banking scene as well as commercial banking. I do not believe that a curse on the banking system (and the banking system is a necessary evil as long as we allow a private payment system) should be allowed to spread. Investment banks are not as necessary as banks.
Let all the investment banks and investment managers and their clients and counterparties pay the price, nationalize the banking system and let everything else fail. Someone will want to pay scrap value and build a few good businesses out of this mess. Also, it is utterly unfair towards firms that avoided the trouble and may now not be able to benefit from their discipline and patience.
Especially if F&F are properly handled after nationalization (i.e. incentivised to facilitate a slow but steady return to rising house prices in the US), there may be plenty of operators who would be prepared to, using existing mortgage technology, simply continue the fundamentally healthy business of sourcing and distributing reasonably robust financial instruments, based on n existing IB platform or a de novo one. Why let a bunch of (in hindsight) reckless and incompetent managers, shareholders and creditors that should have been taken out of the game, benefit from that? This is worse than socialism…
Brad:
Good point about including the sale of the “good” Lehman in the deal. Otherwise its stock would skyrocket after jettisoning the bad parts, making them too expensive to buy. And it would be “unfair” to the rest of the IBs if they found out in a few months that Lehman is making a stock swap hostile takeover for their shares.
This way a buyer of Lehman would be forced to buy a diluted chunk of the bad parts, which may make the deal more palatable than it is now.
I hope Mr. Geithner is a harda$$.
How you do that legally on a Sunday sort of boggles my mind.
I guess you would have to leave some ownership of the bad bank on Lehman’s books, then let the sale effort proceed next week?
Rein:
“Especially if F&F are properly handled after nationalization (i.e. incentivised to facilitate a slow but steady return to rising house prices in the US)”
I don’t think it can be done.
We now have a nationalized entity, F&F, which is for all intents and purposes the US Treasury, and its “assets” nearly equal the size of the US debt.
That makes the Treasury a bank with NO CAPITALIZATION, and the traditional problem of commercial banking…borrow short and lend long.
Banks hate it when interest rates go up. So now the Fed is severely restricted in using interest rate policy to fight inflation.
At the long end of the yield curve this is a problem too, especially if inflation expectations become “unanchored”.
So not only does the Treasury have to come up with new money to make loans to support new residential real estate transactions, it is quite likely they will be a very bad bank from a cash flow standpoint.
Then there is the “mark to market” value of the portfolio. Not all the loans were made at the top of the boom, but median prices have dropped 20% so far, have another 20% to go per Case-Schiller, foreclosures and late payments add up to 9% of the mortgage market, incomes are not rising, and loan standards are thankfully increasing.
We now live in old Brazil. It could take 30 years to become a BRICUS.
China’s Rise in the World Economy and the Erosion of U.S. Hegemony
http://www.globalresearch.ca/index.php?context=va&aid=10173
China is utilizing political and diplomatic ties, weapons sales and training agreements, and low-interest loans to advance its interests. It is ideologically positioning itself in parts of the Third World by criticizing U.S. domination and some of the U.S. policies that squeeze Third World countries. And it is taking advantage of the fact that the U.S. is focused and tied down in the Middle East, where its wars for greater empire are now being waged.
U.S. imperialism has been increasingly targeting China as a strategic competitor. Since 2006, the U.S. Defense Department in its annual survey of China has put competition with China over resources on par with conflict over Taiwan as a potential spark for a U.S. war with China.[19]
It is in the context of China’s rise in the world economy and rivalry with China that we can begin to see U.S. demonization and scapegoating of China: for exporting unsafe foods and medicines, for intellectual property-rights infringements, for human rights violations, and for increasing its military spending.
Don’t forget global warming.
I think that the idea that mark to market accounting generates a vicious circle process (jkh) is a red herring. Such feedback loops are part of the financial system, and it is up to participants to make proper allowance for their effects. In fact, the internal mechanisms of the financial system are irrelevant. What matters is what outcomes it delivers, in terms of market valuations.
I do not believe that there is an unprecedented lack of liquidity in the system – anyone who was around during LTCM and 9/11 saw similar disruptions. The problem is that the present holders of assets do not like their market price.
To me, there was always a significant chance that the house of cards that the Fed allowed to build up would collapse, based on a simple “what goes up must come (most of the way) down” assessment of risk. The problem was that talk of such disasters was seen as curmudgeonly.
I am tired of hearing each time that the sky is falling. My solution is to proceed with liquidating any firm that fails as normal, and windfall-tax those individuals who benefitted from the boom to pay for the clean up.
jkh – so mark to market was okey dokey when it was driving house prices beyond affordability, but not so much in the downward direction? Sounds like we want to have our cake, and eat it too.
That’s called leveraging growth, if you’re an IB guy. Great bonuses too.
But looks like the deal fell apart. But BA just bought Merrill. So now the market won’t know whether to go up or down tomorrow.
Cedric,
If you think capital matters to an entity under administration, you do not live in the real world. Once the US gvt appoints an insolvency custodian, the entity is US gvt responsibility, unless it announces (immediately) that the entity will be liquidated. That is not the case here. F&F are obligations backed by yours truly now..