I remember in my youth a moment in time when Japan was the ‘rising sun,’ an economic freight train, whose momentum was unstoppable; they were destined for global market domination. Then, poof, Japan imploded (its bubble burst in 1990), and has never fully recovered. What happened?
Most fundamentally, after the bubble burst, a too-proud nation and an intellectually dishonest banking industry refused to write-down a toxic stink pile of non-performing loans (NPLs) to their real-world valuations in a bubble burst-impaired environment – a construct known as Mark-to-Market accounting.
Instead, they kept the NPLs on the banks’ balance sheets at artificially high valuation levels, and the net effect is that it took Japan a decade to unwind an illusion, restore trust between banks, and restart a stalled lending engine (few of us realize that banks, financial institutions and Wall Street live on short-term ‘intra-bank’ loans,’ and when this lubricant is removed from our financial engine, the engine seizes).
But, what if the Japanese government had forced banks to clean up their balance sheets in months instead of years, stanching the inevitable bleeding with massive infusions of capital into the banks themselves? Japan arguably would not have lost the last 18 years of global growth to China. (Andy Kessler has some EXCELLENT analysis on this topic – read it here).
The TED Spread, and What’s a LIBOR?
As referenced above, our financial industry is dependent on the willingness of banks and Wall Street to lend money to one another. The rates that banks charge each other is known as LIBOR, or the London Interbank Offered Rate.
In less volatile times, the spread between LIBOR and three-month treasury bills (i.e., a largely non-volatile investment path) is typically less than one half of one percent (<1/2%). This spread is known as the TED Spread, and last week, it reached an unfathomable spread of 4.56% - i.e., 10X the typical TED Spread level (see chart below of five-year TED Spread).
In other words, banks last week were saying that they consider the risk of lending to one another sufficiently high that they were jacking risk premium levels into the stratosphere, which in addition to much more stringent underwriting requirements being in place, effectively means that lenders don’t want to be in the lending business right now, which trickles down to big business, small business and consumers, the crushing impact of which I covered in my post, ‘Engine Failure: When Financial Markets Fail.’
What’s a Fed to Do?
The Fed is forced to play a three dimensional chess game right now. One the one hand, history suggests that in times of financial crisis, governments can and must prevent long-lasting damage to their economies by preventing bank runs (this is a core purpose of FDIC-backing of deposits) and signaling their willingness to maintain a position as lender of last resort (to ensure liquidity and protect against fears of bank failures).
On the other, as alluded to the lesson’s of Japan’s lost decade, proactive, rapid cleanup and transparency of banks’ balance sheets is critical to restoring confidence in the system.
This task, however, is complicated by so-called Mark-to-Market Accounting rules, which requires financial institutions to reflect the real value of the loans and other securities on their books, and adjust their capitalization levels accordingly (upward) when the value of such assets fails.
Needless to say, in a TED Spread environment like we have now, this means that banks and Wall Street firms get hit with sudden liquidity crises exactly at the moment when such liquidity is prohibitively expensive (or flat out unavailable). And this doesn’t even speak to the parasitic opportunities for short sellers to prey on such vulnerable institutions.
The Fed’s Three Dimensional Chess Game
Many have argued that the perilous environment that we are in is specifically the reason that the Fed should suspend Mark-to-Market accounting rules, but happily, the Fed appears to be going a different path and wisely continuing MTM accounting.
They accurately recognize that in post-bubble scenarios, restoration of trust is most integral. In this context, mark-to-market accelerates the inevitable write-down of bad loans, in the process, defining what the fiscal ‘floor’ looks like (since these values are reflective of the current horrific market conditions, not the market once values stabilize).
For the truly sick and exposed institutions, it is effectively a death sentence. But for the nominally sick institutions, it is a form of chemotherapy that wipes out cancerous cells without killing the patient.
The key added dimension to this approach is the Fed’s use of direct capital injections into financial institutions to enable them to simultaneously achieve capitalization levels accorded by mark-to-market AND re-price toxic loans to market prices.
A wrinkle in this is that the Fed is lending to institutions whether they need it (AIG) or not (Bank of America). This avoids signaling to the market which institutions are unhealthy (and thus needing capital), thereby preventing a vicious cycle from propagating.
Net-net: the Fed is front-loading the pain in a manner that should (hopefully) clean up the industry’s balance sheets, restore confidence and re-start the lending machine that the global economy depends on.
Is this the right thing to do? As Andy Kessler, suggests, “Probably not…But it's the only thing to do at this stage.”
Is it Capitalism or Socialism? More like Capitalism 2.0.
UPDATE 1: Good analysis by Andy Kessler on Why Markets Dissed Geithner Plan: Now with TARP 2.0, renamed a friendly Financial Stability Plan, the idea is to entice private capital to buy these bad loans and derivatives in an effort to set the "market price." But Mr. Geithner hasn't solved the dilemma of banks not wanting to sell and become insolvent. Moreover, no one is going to buy these securities ahead of Mr. Geithner's action with the "full resources of the government" to bring down mortgage payments and reduce mortgage interest rates. Lower mortgage payments means mortgage-backed securities would be worth even less…Mr. Geithner should instead use his "stress test" and nationalize the dead banks via the FDIC -- but only for a day or so…First, strip out all the toxic assets and put them into a holding tank inside the Treasury. Then inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here's the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately…Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization…Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.
Related Posts:
- Engine Failure - When Financial Markets Fail: an analysis of the current financial crisis.
- Black Swans and Bank Runs: on why this crisis was predictable.
- Financial Tsunamis: connecting the dots in the sub-prime mess.
- Oil, Vinegar and Volatility: on the history of volatility in the market, and missed opportunities to move away from foreign oil dependence.
- How Speculative Markets Crush Amateur Investors: why amateur investors fail to grasp that what goes up inevitability comes (crashing) down.
