Eichengreen on the Irish Bailout

Barry Eichengreen has an important, and terrifying, article on the Irish bailout.

The Irish “rescue package” finalized over the weekend is a disaster. You can say one thing for the European Commission, the ECB and the German government: they never miss an opportunity to make things worse.

The big problem is the unwillingness of anyone to force bondholders to take a haircut. But if the debt is not restructured, the problem is not solved, just postponed.

One can interpret the intransigence of the German government and its EU allies in two ways. First, they understand neither economics nor politics. As Tallyrand said of the Bourbons, “They have learned nothing, and they have forgotten nothing.”

Alternatively, policy makers in Germany – and in France and Britain – are scared to death over what Ireland restructuring its bank debt would do to their own banking systems. If so, the appropriate response is not to lend to Ireland – to pile yet more debt on the country’s existing debt – but to properly capitalize their own banking systems so that the latter can withstand the inevitable Irish restructuring.

And so it goes.

Cowen reviews 13 Bankers

Tyler Cowen has an interesting review on the Johnson-Kwak book, 13 Bankers.

Synthetic CDO's and Bubbles

There has been a chorus lately arguing that synthetic CDO's fueled the bubble and made the subprime debacle much worse. For example, Felix Salmon writes:

Then, after AIG exited the market, everything should have ground to a halt. But it didn’t, because banks continued to build synthetic subprime CDOs out of the credit default swaps which were being bought by Greg Lippmann and others. The demand for those CDOs from investors like Wing Chau was enormous, and helped to ratify the valuations that everybody else was placing on their own subprime assets. Remember that this is a market with almost no pricing transparency in the secondary market: because all securitization deals are unique, the only way to get a feel for the health of the market is by looking at where primary deals are pricing. Whenever anybody said that the marks being put on subprime assets by banks and hedge funds were delusional, it was easy to point to the booming market in synthetic subprime CDOs to prove them wrong. No one, of course, remarked on the irony that the synthetic subprime CDO market was only booming because John Paulson and others were providing a huge amount of demand for bearish bets.

Or Roger Lowenstein in the NYTimes,

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

And the famous ProPublica article on the Magnetar trade makes the same point too. Yves Smith at Naked Capitalism I think is the originator of this argument, or at least heralded as so. I presume one can also find it at Baseline Scenario, since it follows that bankers are evil. Or Felix Salmon again.

But I cannot understand the argument. When CDO's are created that finance mortgages and other asset purchases one gets price appreciation in the underlying asset that creates a bubble. When the asset price collapses there is a destruction of wealth. With a synthetic CDO, on the other hand, there is no underlying asset appreciation. The accusers all claim that synthetic CDO's are just bets. But if they are just bets then they lead to a transfer of wealth, not a destruction of wealth. Those on the long side who lost transferred wealth to those on the short side who won. But no amount of betting like that can cause a financial crisis.

If betting on the Kentucky Derby multiplied ten-fold would that cause a financial crisis? Hard to see how. Then how does the proliferation of synthetic CDO's make the underlying losses any bigger? I cannot see that. Perhaps the losses were concentrated in some banks that were too big to fail, but that is not what caused the crisis.

I don't understand why this argument has taken off, except that it makes banks look evil I suppose.

Bank Bailout

Two articles in today's NYTimes on the bank bailout. The first points out that the costs may be much larger than people think.

A sober assessment of the growing mountain of losses from bad bets, measured in today’s marketplace, would overwhelm the value of the banks’ assets, they say. The banks, in their view, are insolvent.

The second article looks at the parallels with Japan's lost decade:

The Japanese have been here before. They endured a “lost decade” of economic stagnation in the 1990s as their banks labored under crippling debt, and successive governments wasted trillions of yen on half-measures.

“I thought America had studied Japan’s failures,” said Hirofumi Gomi, a top official at Japan’s Financial Services Agency during the crisis. “Why is it making the same mistakes?”

Two points come to mind immediately. First, on the size of the losses. These come from marking to market "toxic' assets. But as I noted in previous posts these are due to information and coordination problems. The market values are low because they value an arbitrary collection of mortgages not the whole complex of them. So the amount needed to capitalize the banking system is larger with a plan that is not comprehensive. On the magnitude of the costs and the argument for nationalizing the banks, see this article by Roubini and Richardson in the Washington Post.

Second, delay just magnifies the costs, but here politics is vital. Half measures to avoid the painful costs only multiply them later. But given how difficult the stimulus plan was to pass, is it credible that Treasury will now undertake a comprehensive plan? Of course, my plan is comprehensive, and ultimately not that costly, but where is the groundswell of support?

More on TARP

Joe Nocera argues that the first formulation of the TARP was correct. The basic problem is to get the bad assets out of the banking system. Recapitalization made Gordon Brown a hero, and it prevented a deepening of the crisis, but lending will not start till the toxic assets are removed. I thought that this was the lesson we learned from Japan in the 90's.

The only quibble is that what we have to do is not the original TARP. The problem there was that they wanted to buy toxic assets. The correct solution is to take over the problem banks and corral the assets in a new RTC. Nocera actually argues this. But the important point seems to be that nobody was comfortable with an RTC-type solution in September. That is because there was not a wide enough recognition of the size of the losses.

Now that Nouriel Roubini has further revised upwards his estimate of total writedowns it may finally convince the powers that be that RTC is the way to go. Here is the money shot:

We have now revised our estimates and we now expect that total loan losses for loans originated by U.S. financial institutions will peak at up to $1.6 trillion out of $12.37 trillion loans . Our estimates assume that national house prices will fall another 20% before they bottom out some time in 2010 and that the unemployment rate will peak at 9%. If we include then around $2 trillion mark-to-market losses of securitized assets based on market prices as of December 2008 (out of $10.84 trillion in securities), total losses on the loans and securities originated by the U.S. financial system amount to a figure close to $3.6 trillion.

Will people start to believe Dr. Doom now?

Citigroup Value

Felix Salmon has a chart that shows the decline in the market capitalization and book value of Citigroup. The key point is:

The problem is that the blue bar (book value per share) can't fall much further, without Citigroup breaking minimum capital adequacy requirements. In fact, Citi is skating so close to its regulatory minimums right now that it's almost impossible not to suspect that a large part of where it's marking its assets is a function of where the CFO needs the company's book value to be.

It looks like only a matter of time before it becomes insolvent.

Saving the Banks

Some ideas for a comprehensive solution for the banking crisis are discussed in this article by Joe Nocera in the NYTimes. An important point is that until we know the extent of the losses in the banking system it will continue to rely on government funding. But banks are reluctant to recognize losses until they know they will be able to survive the shock. One type of solution is then an RTC type bank to buy all the bad assets. Sounds like TARP? But how to determine the value?