He Autographs His Overdraft While She Goes Out of Her Mind
Paul Krugman says the world’s financial poobahs hang together this weekend, or we all hang separately. Someone’s blawg today explained the greater utility of recapitalizing banks rather than buying the "toxic waste," better than any of the arguments I’d heard from politicians or commentators previously. It comes back to leverage. Right now banks are overleveraged – with capital-to-loan ratios of 20 or 30x or more. That appears to be insane, but historically typical ratios of 10:1 or 12:1 still seem reasonable. But if the government spends $20 billion buying a bad loan, the leverage rates mean it only improves the bank’s capital position by maybe a billion. Far more efficient to put $2 billion into the bank’s capital and enable it to lend out $20 billion under the new (old) leverage standards.
(Via Atrios.)
Comment by Uncle Kvetch —
October 10, 2008 @ 11:58 am
Knowing pretty much sweet FA about the financial crisis, I’ll offer my kudos on the post title (Taking Liberties!) and leave it at that.
Comment by Leonard —
October 10, 2008 @ 1:16 pm
Giving a bank $2b (can they give me $2b? I’m nice!) is not going to do much. Neither is buying crappy paper off it, but I think there’s more to be said for the latter policy.
Say a bank has $400b in demand deposits (i.e., your checking account), and it holds $20b of that in reserves (that is, more or less, cash on hand). It’s at a reserve ratio of 20:1. (The reserve ratio is the ratio of a bank’s liabilities to its cash on hand.)
This bank has lent out the other $380b as long-term loans: mortgages, construction loans, etc. Including some percentage of No Interest No Money Down No Questions Asked! type loans. Its profit model is to take advantage of the difference in interest rates that it has for its short-term borrowing (from you), vs its long term loans. If it pays 1% to depositors, and gets 6% on its loans, it makes almost 5%. (Slightly less due to the reserves.) 5% on 400b is, normally, a nice amount of profit.
If you give this bank $2b in free money, its reserve ratio is now 18.18: better, I guess, but not much. Give it $20b, and its up to 10:1.
You certainly have not solved the fundamental problem, though, which is that nobody really knows if that $380b in loans is going to repay $380b plus interest. Loans are highly illiquid and particularly. Thus, that “mark to market” number is just some guy’s idea that he pulled out of… a hat. If things continue going south, that number is eventually going to be a lot less.
If that number is really, say, $250b, then this bank is bankrupt, and FDIC ends up with $150b in taxpayer bailout. We’re on the hook already. Giving the bank $2b or $20b makes no difference, although it’s worth noting that inasmuch as the bankcorp does not pay that extra money out to itself (shareholders or workers) before going belly-up, at least we the taxpayers are not losing it (it ends up lowering the FDIC amount).
The idea of buying up the bad loans is seeking two effects. One is to adjust the reserve ratio: buy a bunch of really crap loans for $20b, and it’s similar to giving the bank $20b.
The other is restart “confidence” in the bank. There are two aspects to this. One is to make it easier to evaluate the bank’s value; it’s the crappiest loans that are the hardest to value, so by taking them off the bank’s books, you can give outsiders more confidence that they can dope out what the bank is worth.
The other part of “confidence” is more like “as in con man”: systemic confidence (or lack thereof). Right now, that $250b valuation looms as a real possibility. So everyone whose lending to the bank is not FDIC insured (like other banks) would be insane to lend any money to them.
What is this “confidence”? In the mainstream view, the belief is that there’s an objective value to all of the $380b in loans that this bank has out there. Of course that is poppycock — value is always subjective. But that’s not how people think. They think that value ought to be what it has been. (Normally a pretty good heuristic.) That value is based on what mortgages have always been worth in our lifetimes. Which in turn has been based on the relatively high short-term rates, and the relatively low long-term interest rates that have been created via government intervention in the market via the bank cartel, as well as regulations surrounding it, and other government programs including FDIC. These have inflated house prices.
Let’s look at an example. If long-term rates are 6%, borrowing $200000 to buy a house costs on the order of $12000/year. Over 30 years, the price of the house is thus $560000. At that price, there’s a certain market. Now assume that long-term rates in a free market would be 10%. So the 30-year price of $200000 of is much more: $800000. Microeconomics tells us we’ll find fewer buyers at this higher price. So the price of the house will drop — how much? How much is the trillion-dollar question. All we know is, it’s less.
So, OK, long-term rates in a free market will be higher, making house prices significantly lower. How much we don’t know, but quite possibly a lot. That’s all house prices, not just future sales. And that gets back to our bank, with its $380m in loans. A lot of those loans are against real estate, in some form. That’s what the collateral is. If all of that real estate suddenly slumps in price to, say, 2/3 of what long-term pricing has been historically, and a bunch of the borrowers just walk away from their mortgage, the bank is bankrupt. And pretty much all other banks are, too.
This is what our masters in Wall Street and Washington fear, although of course they do not think that long term rates really ought to be higher. They see this whole thing as a horrific aberration, deeply puzzling.
Comment by Joe S. —
October 11, 2008 @ 1:14 pm
Leonard conflates liquidity with capital. I have no more to say about him.
Jim Henley conflates capitalization with regulatory relief. From a balance sheet perspective, there is no difference between buying worthless collateral for–say–$2 billion, and injecting $2 billion of equity into the firm. Both improve the economic capital of the firm by $2 billion. The difference with direct capital injection is regulatory: it would allow the firm to keep pretending that the worthless collateral has value, and would thus allow the firm to lend $20 billion.
There are some arguments for calling it equity, rather than purchase of crappy assets at inflated prices. Equity shares an upside: a good thing. Regulatory relief–through the front door or the back–is defensible. (One of the biggest problems with Basel II is its procyclical bias: encouraging lending in good times and discouraging it in bad times.)
However, the point remains. Both transactions add precisely the same amount of capital to the firm.