Some lessons from the sub-prime crisis responses

There are very few counterfactuals in social sciences. The closest to such a counterfactual are the contrasting responses of US and Europe to resolving their respective financial market crises. Though in recent months, Europe has taken steps to emulate the US, the initial responses across both sides of the Atlantic bear a striking contrast.

In the US, at the first signs of the sub-prime crisis bursting, the Treasury and the Federal Reserve aggressively intervened to contain the damage. The Treasury came forward with its Troubled Assets Relief Program (TARP) to directly assist the beleaguered banks and other financial institutions with equity injections. The Federal Reserve expanded its balance sheet many times and initiated quantitative easing programs to emerge as the lender, insurer, and buyer of last resort for the financial markets.

However, across the Atlantic, driven both by lack of similar political resolve and strong ideological predilections, the Eurozone governments and the European Central Bank refrained from aggressive intervention. They let events take their own course in the hope that markets would soon resolve the issue. Credit markets froze, driving up sovereign debt yields and nearly shutting off the peripheral economies. Banks, saddled with massive sovereign debt exposures, stumbled to the brink. The ECB refused to lend either to the banks or the battered sovereigns. It stepped in finally only when the situation had worsened considerably.

The contrasting fortunes of both economies, atleast their respective financial sectors, is a clear verdict on the policy courses followed on both sides of the Atlantic. Europe stares at a potential Japan like financial dystopia, whereas American financial institutions have recovered smartly and are back to doing all those things that caused the sub-prime crisis! However, there are a few quick learnings from the situations across both sides,

1. The loudest message from the two different courses of action is that markets do not repair themselves and when faced with such deep financial market crises, governments and central banks have to step in with aggressive policies.This becomes all the more important as the complexity of our banking systems increase and the too-big-to-fail syndrome become entrenched.

2. Related to this is the central and disproportionate importance that financial markets have come to assume in determing the economic fortunes of a country. Despite the fact that the financial sector occupies a far less share of both the economy and the working population, its good health is critical to the fortunes of any modern economy.

3. Similar to the stark contrast between the US and European responses is the difference between the responses by the US Government and the Fed to the condition of over-leveraged financial institutions and debt-ridden individual households. The latter received nothing like the unlimited and cheap liquidity injections, debt rescheduling at very favorable terms, and sweeping credit guarantees offered to the financial institutions. Household foreclosures, even when it happened in a massive scale, became a source of concern only when it threatened to affect an exposed financial institution.

In other words, the disciplining elements of the free-markets are reserved for individual households and small business firms, while the financial sector behemoths, the much trumpeted success stories of deregulated free-market capitalism, face no such constraints. The negative externalities created by financial institutions do not get internalized.

4. All this highlights the increasingly sharp cleavage between the real economy and the financial markets. Are the gains of the financial markets, especially their outsized wins, coming at the expense of the real economy? Is there a recession or even a depression lurking at the end of a sustained period of financial market boom? The financial markets, especially in their current avatar, appear to have become too big a systemic risk to be left as it is.

The trans-Atlantic politics of bailouts and austerity

The distinguishing characteristic of the dismal landscape is the policy gridlock that has gripped a deeply divided American political establishment. Europe too suffers the same malaise.



But this has not prevented the US Government and the Federal Reserve from rescuing financial institutions with an extraordinary tax payer sponsored bailout. However, the equally beleaguered tax-payers themselves have not benefited similarly. The unemployment rates remain high and and large numbers of mortgage holders continue to have negative equity on their houses. It is therefore no surprise that aggregate demand remains weak and economy anemic.



The graphic below represents the stark choice facing policymakers in the US. Shockingly, the second group's request comes on the back of the massive financial sector bailouts.



Fixing the financial market regulation system is proving a difficult, with little unanimity on the details. The graphic below is illustrative of this and much of macroeconomic policy making itself. The policy responses to the sub-prime bubble and its consequent Great Recession resembles the parable of the blindmen and the elephant.



Even as US was experimenting with monetary accommodation, the Europeans pumped for fiscal austerity.



Predictably, this austerity experiment threatens to unravel the Euro Project itself.

The banking sector bailout debate resurfaces

In a recent post, Felix Salmon had a bleak assessment of the Eurozone crisis,

"In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse."

As the increasing bond yields and CDS spreads indicate, the European credit markets are pretty much freezing up. As reflected in the dismal response in recent auction, even the Teutonic credibility of the German bund has taken a dent. Governments are finding that debt refinancing has become very expensive. Banks, with heavy sovereign debt exposures, have become averse to lending anymore, not only to sovereigns but also to each other. Further, they also face rising margin calls due to heightened sovereign debt default risks. The risk of assets turning sour and demand for increased capital requirement (from margin calls), is turning an initial liquidity crisis into a solvency crisis for the banking sector.

In the circumstances, there are two options. The interventionists advocate aggressive measures to restore credit markets (through rate cuts, liquidity injections, credit guarantees, and asset purchases) and bank recapitalization with stringent conditions attached. This is effectively a call to the central bank to step in as a lender, buyer, and insurer of last resort. It would also involve governments taking stakes in banks. Felix Salmon too prefers intervention. His prognosis about the fate of Eurozone is based on this assumption. He believes that the ECB's intransigence and failure to act has driven away the confidence fairy.

The sceptics counter that such measures are likely to be futile. They oppose such bailouts as rewarding reckless and greedy bankers. They also argue that it would merely postpone the hard decisions and belt tightening that are necessary to remove the excesses and distortions created by the skewed pre-crisis growth. Finally, they associate it with trying to restore growth in the aftermath of an asset bubble by inflating another bubble. They point out that the extraordinary monetary easing and liquidity support has the potential to amplify distortions and destablize global financial markets. It would also come in the way of the much needed croeconomic rebalancing among economies of the developed and emerging world.

In this context, as Christina Romer points out, the nature of the response matters critically with any interventionist approach. She points to the contrasting experiences of Sweden in 1991 and Japan in 1992 after their respective banking crises. The former nationalized its banks, recapitalized with public funds, and then returned to private control, with the result that the country returned to its pre-crisis trend within three years. In contrast, Japan refused to clean up its banks, rolling over loans to failing companies, with the result that it continues to grapple with anemic growth and deflation for almost two decades.

It is difficult to make a satisfactory enough judgement call on either position from merely theoretical principles or historical experiences. Both sides could be right and wrong in different ways. In simple terms of a cost-benefit analysis, which option generates higher net benefits? Alternatively, which option would generate the least costs or the less worse set of distortions? Unfortunately, these questions do not have convincing enough answers.

But it is undoubtedly true that bailouts generate moral hazard by taking away the biggest disciplining factor of capitalism. And, as the recent evidence has shown, such bailouts, perversely enough, end up concentrating risk by making the TBTF institutions even bigger.

Update 1 (21/12/2011)

In its role as lender of last resort to banks, the ECB allocated 489.2 billion euros, or $644 billion, to 523 institutions through its longer-term refinancing operations, or LTROs. The loans are for three years and will be at the benchmark 1% interest rate. This is the largest amount ever allocated in a single ECB liquidity operation and first time ECB has extended loans for maturities beyond one year. ECB had started the liquidity operations in the aftermath of the Lehman collapse. It announced that another LTRO will be held in February 2012.

The three-year loans are designed to compensate for a dearth of longer-term market funding, at a time when banks are facing the need to roll over an extraordinarily high amount of their own debt. Banks in the euro zone must raise more than 200 billion euros in the first three months of 2012.

The cheap loans issued by the ECB may also indirectly help governments like Spain and Italy that have faced higher borrowing costs. Spain paid sharply lower interest on debt it auctioned early this week, as banks appeared to use cheap ECB money to buy the bonds, profiting from the difference in interest rates. However, the proceeds could also be used to re-finance existing assets as they become due in the months ahead.

The ECB, as part of its effort to prevent a credit crunch, also broadened the collateral it will accept in return for loans. It is even accepting outstanding loans as security, a measure designed to help smaller community banks that may lack conventional forms of collateral like bonds.

The "mother of all bailouts" unmasked!

A Bloomberg investigation has revealed the stunning magnitude of the post-Lehman financial market bailout. Hitherto information about only the $700 bn Troubled Assets Relief Program (TARP) was made public and the details of the liquidity injection facilities were withheld on grounds that it would stigmatize borrowers and thereby destabilize market confidence. However, it now emerges that the Fed's liquidity infusion support dwarfs the TARP and should rightly assume the moniker of the "mother of all bailouts"!

As the crisis deepened, the Fed had to expand its traditional discount window to provide liquidity support to the frozen credit markets. By the end of 2008, the central bank had established or expanded 11 lending facilities catering to banks, securities firms and corporations that couldn’t get short-term loans from their usual sources. Such credit support involved reduced credit standards and collateral requirements.

The report finds,

Add up guarantees and lending limits (to direct lending), and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the US that year... The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy.

While TARP credit had some strings attached, the liquidity injections came without any conditions attached and was a virtual doleout. And these banks, including foreign ones, profited by atleast $13 bn from the Fed's below market lending rates. It is no wonder that the Fed and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. The report writes that the witholding of this information helped the banks ward off pressures for greater regulatory oversight,

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse... While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger.

The hypocrisy of concealing the fact of being under life-support while at the same time publicly claiming stability and strength is captured in the report,

"On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed 'one of the strongest and most stable major banks in the world'. He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day."

On Sept. 21, 2008, a week after Lehman went bankrupt, Goldman Sachs converted to a bank holding company, gaining access to the Federal Reserve's last-resort lending program for banks, the discount window. While it took only $50 million from the window, New York-based Goldman Sachs had been borrowing from the central bank for six months from two temporary programs for broker-dealers: the Term Securities Lending Facility and the single-tranche open market operations, or ST OMO. On Dec. 31, 2008, Goldman Sachs had $34.5 billion of loans from ST OMO, some of it at an interest rate of 0.01 percent. "We weren't relying on those mechanisms", Goldman CEO Lloyd Blankfein told the Financial Crisis Inquiry Commission in January 2010.



The exposures of the six biggest financial institutions were staggering. The six biggest US banks, received $160 billion of TARP funds and borrowed as much as $460 billion from the Fed (measured by peak daily debt), and accounted for 63% of the average daily debt to the Fed by all publicly traded US banks, money managers and investment-services firms.



See the interactive graphic here.

Does Europe needs its version of TARP/TALF?

It is increasingly evident that the Eurozone stands at the precipice, with the serious danger of carrying the world economy down with itself.

The combined ECB-IMF bailout, operated through the European Financial Stability Fund (EFSF) appears too little to make any meaningful dent on Europe's growing list of problems. In simple terms, Europe is facing its Lehman moment. The markets are clearly unimpressed by the amounts provided under the EFSF and are ratcheting up the pressure on the peripheral economies. In recent weeks, the cost of insuring Greek and Italian debts have exploded, as have their bond yields and spreads with German bund. Europe clearly needs much more ammunition in its armoury to come out of this with the Eurozone intact and without suffering massive economic damage.

The obvious risk is the catastrophic cascading effect a sovereign default can have on the global financial markets, leave alone the European markets. More immediate danger, and one which is already playing itself out, is the credit squeeze being felt by most European financial institutions, as wary lenders from across the Atlantic and elsewhere are working out ways to pare down their Eurozone exposure.

A sovereign default by Greece, while theoretically manageable, is certain to amplify market uncertainty and risks across the financial markets, and thereby increase the pressure on countries like Italy. A run on Italy, leave alone a full-fledged default, will be well-neigh unmanageable. The European financial markets are most certain to seize as these dangers start showing up in the aftermath of a Hellenic default. And the impact of all these on the global financial institutions, on both sides of the Atlantic, including Germany, will be very damaging for their balance sheets.



The need of the hour then, as US faced in the aftermath of the Lehman default, is to immediately address the solvency and liquidity crisis that is brewing and threatening to go out of hand. The former requires a massive banking recapitalization program, while the later demands opening an expansive liquidity injection window. The Euro 440 bn EFSF, intended to inject capital into distressed banks and purchase sovereign bonds so as ease the pressure on their yields, may be too little too late to serve the purpose.

The EFSF will be able to lend up to 440 billion euros, or about $600 billion, and issue guarantees for 780 billion euros. However, a more realistic requirement is estimated at nearly 2 trillion Euros. Given the politics of Eurozone, this looks clearly unrealistic. Though announced more than three months back, the EFSF is yet to get approval in all member Parliaments, highlighting the difficulties of decision making in the Eurozone area. Even otherwise, with a total Eurozone GDP of 9.5 trillion euros, this would be more than 25% of the total GDP.

In the US in 2008, as part of the TARP and the TALF, the Treasury and the Fed carried out both operations, with the former in massive scale. Liquidity windows were opened, blanket credit guarantees provided, collateral standard relaxed, and the Fed even carried out massive purchases of certain failing assets in order to backstop the markets. The Fed almost tripled its balance sheet to emerge as an effective lender, insurer and even buyer of last resort to prevent the markets from fully seizing up.

Such aggressive actions may be required to soothen the markets somewhat and weaken the grip of widespread panic. If the liquidity infusions are in sufficient size and done without much delay, it may be possible to buy enough time for the beleaguered institutions to recover some lost ground, and bring some semblance of normalcy back to the markets, thereby preventing a full meltdown. One of the big policy successes, atleast in terms of its immediate objective, of the past four years has been the US financial market bailout initiated in late 2008. Addressing the deeper and fundamental issues of individual bank solvency and economic and financial market restructuring can be taken up once this stage is surmounted.

But there are serious doubts about the effectiveness of such policies in stemming the panic. The assumption is that equity injections and credit infusions will buy enough time for the Eurozone economies to restore market confidence, lower the cost of financing their sovereign debt, bring debt servicing burden under control, and put the economy back in a robust growth path. But critics have raised doubts about this optimism.

The biggest structural problem facing many of these economies, especially Greece, Portugal, and Italy, is the need to reduce their cost of production and regain competitiveness. This is traditionally done by devaluing domestic currency or cutting wages. The former is not an option as long as they remain within Eurozone, while the later will in all probability exacerbate the problem and push the economy further down. This could in turn trigger off a debt spiral, further increasing the debt-to-GDP ratio and sovereign debt servicing costs.

In any case, given all the aforementioned, if the Euro experiments has to survive, it is inevitable that the core economies step in with more explicit and larger support for the beleaguered peripheral ones. That support has to come either in the form of direct fiscal transfers or some mixture of monetary expansion, including some way using the Eurozone's combined balance sheet to finance the debt of the weakened economies, and partial defaults or haircuts. Preferably all of them. Further, the more this intervention is delayed, the steeper will be the recovery path and higher will be the price to be paid.http://www.blogger.com/img/blank.gif

Update 1 (6/10/2011)

The ECB and Bank of England announced measures to support the financial markets. ECB said it would start offering banks unlimited loans (banks have to put up collateral like bonds or other securities) at the benchmark interest rate for about one year, up from the previous six months. The ECB also said it would resume buying so-called covered bonds, which are a form of debt secured by packages of loans and guaranteed by the issuing bank. Covered bonds are one of the main ways that banks raise money.

The Bank of England decided to retain interest rates at 0.5% and also announced the decision to widen its so-called quantitative easing program to £275 billion, or $425 billion, from £200 billion.

Update 2 (13/10/2011)

On what needs to be done for Europe, Martin Wolf writes,

"The broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following: divide countries in difficulties into the insolvent and the illiquid; restructure the debts of the former and provide unlimited, but temporary, support for the latter; and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011."

But he identifies the formidable challenge of making crisis management compatible with fiscal adjustment,

"... there is an opposing risk, that forcing adjustment on the weak will fail, because of a lack of offsetting adjustment in the strong. That would not be a huge problem if those forced to adjust are small. It is a vast problem if they are large. The risk is of a downward spiral as austerity is exported and re-exported.

No doubt, a way must be found to deal with the immediate crisis that does not allow another panic. But that would not be a solution if it merely led to indefinite financing of fundamentally uncompetitive economies. At the same time, one-sided and unduly hasty adjustment would exacerbate the downturns in the eurozone and world economies. What is needed is financing and adjustment. Unless and until that difficult combination is achieved, we are delivering first aid not a cure."

Nuclear Power Exposed as a Product of the State (Video)

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Why You Should be Freaked Out About the Stock Market

Phoenix Capital Research
Zero Hedge

I doubt you will see this chart in the mainstream media any time soon... if EVER.

This is a chart of the US monetary base. In simple terms, it charts how much money the Fed has pumped into the system (at least that it admits). So it’s a kind of visual of the Fed hitting the PANIC button: when the monetary base explodes higher, the Fed is FREAKING out.

You'll note that during the Financial Crisis the Fed didn't do much until the autumn of 2008 when it pumped nearly $1 trillion into the system. Think about that, the Fed didn’t go nuts pumping money until the stuff REALLY hit the fan.

You'll also note that there's only one other time when the monetary base went absolutely vertical: TODAY.

Indeed, the Fed has pumped nearly $500 billion into the system since the start of 2011. Don't even try to tell me  this is QE 2. If it was then the monetary base should have spiked in late 2010, NOT in 2011.

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Portugal braces for govt collapse over debt vote

Wikimedia image Lars Aronsson

Barry Hatton
Yahoo/AP

LISBON, Portugal (AP) -- Portugal's government is on the verge of collapse after opposition parties withdrew their support for another round of austerity policies aimed at averting a financial bailout.

The expected defeat of the minority government's latest spending plans in a parliamentary vote Wednesday will likely force its resignation and could stall national and European efforts to deal with the continent's protracted debt crisis.

The vote comes on the eve of a two-day European Union summit where policymakers are hoping to take new steps to restore investor faith in the fiscal soundness of the 17-nation eurozone, including Portugal.

Last year, both Greece and Ireland had to accept multibillion dollar rescue packages after markets lost faith in their governments' efforts to deal with their debt burdens.

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US bank bailout was 'critical': Congress watchdog

© AFP/File Nicholas Kamm

AFP

WASHINGTON (AFP) - The US government's multi-billion-dollar bank bailout helped avert a second Great Depression and cost taxpayers much less than expected, but was far from perfect, a congressional watchdog said Wednesday.

The Congressional Oversight Panel said the controversial $700 billion dollar bailout, launched in 2008, provided "critical" support for financial markets at a key time and will cost $25 billion -- a fraction of the original estimate.

The Troubled Asset Recovery Program (TARP), which was signed into law by then president George W. Bush and taken up by Barack Obama, "provided critical support to markets at a moment of profound uncertainty," it said in its final report.

The comments come nearly three years after the government stepped in to oil the wheels of the financial markets after Lehman Brothers' collapse prompted vital inter-bank lending to dry up, leaving many household names in jeopardy.

TARP's main success, according to the report, came not just through the massive sums injected but "by demonstrating that the United States would take any action necessary to prevent the collapse of its financial system."

"Through a combined display of political resolve and financial force, the TARP quelled the immediate panic and helped to avert an even more severe crisis."

"TARP will cost taxpayers $25 billion -- an enormous sum, but vastly less than the $356 billion... initially estimated," it said.

The Treasury Department, according to the panel, deserved credit for lowering costs through the "diligent" management of assets and "careful restructuring" of AIG, Chrysler, and GM.
But the oversight panel was not wholly supportive of the policy.

"Although this much-reduced cost estimate is encouraging, it does not necessarily validate Treasury's administration of the TARP," it added, citing poor transparency and the failure of some programs.

The policy was a dangerous gamble with taxpayers' money, the congressional watchdog concluded.

The panel detailed how 18 large financial institutions at one stage received a staggering $208.6 billion in TARP funding almost overnight as the government tried to prop up the system.

"At one point, the federal government guaranteed or insured $4.4 trillion in face value of financial assets.

"If the financial system had suffered another shock on the road to recovery, taxpayers would have faced staggering losses."

TARP was also criticized for compounding the sense that some "too-big-to-fail" banks can get away with wildly reckless trading.

"By protecting very large banks from insolvency and collapse, the TARP also created moral hazard," the report said.

"Very large financial institutions may now rationally decide to take inflated risks because they expect that, if their gamble fails, taxpayers will bear the loss."

But whatever the report's verdict, the bailout is unlikely to become popular among US taxpayers and voters.

With nearly 14 million workers unemployed, it is widely seen as a Washington sop to vested interests on Wall Street that did little to help Main Street.

"Because the TARP was designed for an inherently unpopular purpose -- rescuing Wall Street banks from the consequences of their own actions -- stigmatization was likely inevitable," the report noted.

It added that the Treasury Department's failure to clean out failed executives and clamp down on high salaries added to the stigma.

© AFP -- Published at Activist Post with license 

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