By any measure Paulson and
Co have made two significant policy mistakes in confronting the banking and
soon to be economic crises. Paulson let Lehman fall putting a premium on
moral hazard and underestimating the interconnectedness of this investment bank
and then addressed a solvency problem with a liquidity plan called TARP.
The question now is whether the policy missteps are fatal. In my
humble opinion the mistakes are not fatal.
As it turns out TARP allows
the injection of capital (public funds) directly into banks va the purchasing
of equity stakes â€“ likely preferred shares a la Warren Buffet.
Politically turning a ship sailing to liquidity horizon (reverse auctions in
heterogeneous ABS) is difficult to turn to the solvency horizon (buying equity
stakes or nationalizing).
But it is inevitable and we
may get that message today from President Bush. And delays in buying
shares needs to end and will end. I think by next week the US government will hold stakes in a number of financial
institutions including investment banks (now bank holding companies),
commercial banks and insurance companies.
Let it also be said that the
WSJ is reporting the US government is considering the Irish option (more or
less followed by the UK this week)â€¦guaranteeing all deposits in banks and
guaranteeing all bank liabilities. This may require the President
declaring an emergency and warranting special executive powers to deal with the
crisisâ€¦equivalent of declaration of war. Frankly it may be optimal that
Bush is a lame duck and no longer has much skin in the political game not to
mention his utter abandonment of free market ideology. I am not sure if
Congress will need to pass emergency measures bill freeing up the executive
branch to address the crisis â€“ and there may be a way for the FDIC to do this
indirectly without an act of Congress.
It is also clear that G7-G20
will need to pledge FX reserves to fund a clearing house or insurance pool to
guarantee interbank lending. Japanese officials seem to be floating this
idea based on press reports. Look for this measure to find traction at G7
today in Washington and over the weekend as G20 meets (presumably
I would also expect another
joint rate cut next week though the holidays in the US (partial with the Fed and banks closed Monday for
Columbus Day but stocks open) and Japan (closed for health and fitness day) â€“ yes Japan will be involved in the next half point coordinated
While I would not bank on a
global bank holiday next week, it makes sense to me and especially so in light
of what officials need to get organized this weekend in Washington and because
of the scheduled holidays in the US and Japan. Again this is a remote
option, but not to be ruled outâ€¦all I am saying.
Finally I would take time to
read Paul Volckerâ€™s op-ed in the WSJ today (attached below). At the end
of the day governments are bigger than markets as they create fiat money.
Anyone who has taken a look at the Fedâ€™s and ECBâ€™s balance sheets in the last
three weeks should have little doubt that central banks can keep banks (and
some non-bank financials like AIG) liquid. Governments however can and
must keep banks and key non-bank financials solvent. The central banks
are holding up their half of the sky in this crisis in remarkable fashion and
since Wednesday the ECB is fully on board signaling they get itâ€¦finally.
The governments need to show they can hold up their half of the sky and time is
running out. I am betting large that by Sunday, markets will have a
greater appreciation for government action on solvencyâ€¦Ireland, UK and Holland
are already thereâ€¦yes a small part of the global financial system but all large
events in physics start with near imperceptible changes.
So today is not about where
Lehman CDS gets auctioned at â€“ cents on the dollar and
implying large writedowns â€“ but on government efforts to restore solvency in
the banking system and that event and process will be taking place in Washington not on Wall Street.
We Have the Tools to Manage the Crisis (Volcker)
we need the leadership to use them.
Today, the financial crisis has reached a critical point.
The sharp decline in the stock market and its volatility dramatically make the
point. More important if less visible, the flow of credit through the banking
system and the financial markets is seriously impaired -- even in part frozen.
For months, the real economy, apart from housing, had not
been much affected by the developing crisis. Now, a full-scale recession
appears unavoidable. Important state and local governments face deficits they
may be unable to finance. Recessionary forces are apparent in other important
countries and exchange rates are unstable.
Those are facts.
They are the culmination of economic imbalances, a succession
of financial bubbles and financial crises that have been building for years.
It's no wonder that confidence in markets, banks, and financial management has
been badly eroded. Without effective action, fear might take hold, threatening
Fortunately, there is also good reason to believe that
the means are now available to turn the tide. Financial authorities, in the
United States and elsewhere, are now in a position to take needed and
convincing action to stabilize markets and to restore trust.
First of all, there is now clear recognition that the
problem is international, and international coordination and cooperation is
both necessary and underway. The days of finger pointing and schadenfreude are
over. The concerted reduction in central bank interest rates is one concrete
manifestation of that fact.
More important in existing circumstances is the clear
determination of our Treasury, of European finance ministries, and of central
banks to support and defend the stability of major international banks. That
approach extends to providing fresh capital to supplement private funds if
In the U.S., with higher limits of deposit insurance in
place, the FDIC has demonstrated its ability to protect depositors, to arrange
mergers, and to provide capital for troubled banks. Most other countries now
have a comparable capacity.
Recent U.S. legislation has provided authority for
large-scale direct intervention by the Treasury in the mortgage and other
troubled markets. Along with increased purchases by Fannie Mae and Freddie Mac,
now under government control, means of restoring needed liquidity are at hand.
Other key sectors of financial markets are now protected
or supported by either the Treasury or Federal Reserve, specifically by temporary
insurance of money-market funds and by direct purchase of commercial paper.
Active efforts are underway to develop stronger netting,
clearing and settlement arrangements for certain derivatives, in particular the
notional trillions of credit default swaps, the absence of which has
contributed to uncertainty and large demands for scarce collateral.
None of that is easy. Some of it poses risks for the
taxpayer. All of it is decidedly unattractive in the sense of large official
intervention in what should be private markets able to stand on their own feet.
Unattractive or not in normal circumstances, the point is the needed tools to
restore and maintain functioning markets are there. Now is the time to use
them. To that end, the immediate and critical need is determined, forceful and
persistent leadership -- extending across administrations and Congresses. Both
the public and private sectors must be involved.
The inevitable recession can be moderated. The groundwork
can be laid for reconstructing the financial system and the regulatory and
supervisory arrangements from the bottom up. The extraordinary interventions by
the government (and taxpayer) should be ended as soon as reasonably feasible.
That rebuilding will be the job of another day -- of a
new administration here in the U.S., of finance ministries and central banks
working together. It must draw upon the strength of the now chastened private
sector. It will require more understanding of the risks embedded in so-called
financial engineering and of the perverse compensation incentives that have
exalted risk over prudence.
There is, and must be, recognition of the essential role
that free and competitive financial markets play in a vigorous, innovative
economic system. There needs to be understanding, in that context, that
financial ups and downs -- and financial crises -- will be inevitable, even
with responsible economic policies and sensible regulation. But never again
should so much economic damage be risked by a financial structure so fragile,
so overextended, so opaque as that of recent years.
Mr. Volcker was chairman of the Federal
Reserve from 1979-1987.
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