Buddy, can you spare $700 billion?

Buddy, can you spare $700 billion? It’s going to Wall Street bankers who are a bit short of a few trillion. Apparently they’ve lent too much to people who might find it difficult to pay it all back. The taxpayer can have some of those loans in return.

We are waiting for details of the package from the USA. It is unlikely the politicians will veto all of it. A deal will probably be done, offering more control over the spending than the first proposals, and offering some help to the hard pressed borrowers to show it is for Main Street as well as for Wall Street. The President and his colleagues are trying to argue that a freefall Wall Street will be bad for everyone. They need to show as well the Treasury support will not leach into Wall Street bonuses and shareholder dividends. If there are any profits to be made, the taxpayer deserves them for running the risks. What is it about modern governments that they have the nationalising instinct?

It was always strange that the Treasury settled on a whopping $700 billion as the right sum. It is small beer beside the trillions of credit in the balance sheets of the highly geared banks and shadow banks. It is a very large sum even by US government standards for a single spending programme. If it is all to be spent before the year end and the change of Presidency it will be a quick fire purchase of many instruments that will be but poorly understood and hastily valued by the taxpayers representatives. It might just work. It might go wrong in either direction, offering too little to stabilise all the financial institutions, or offering too much for the assets bought for the taxpayers comfort.

The valuation problem is not the only one. How do you stop leakage of state cash into bonuses and dividends? How do you define which assets you are prepared to buy so the auction process can work smoothly and fairly? How do you do due diligence on the underlying loans in the debt packages? How do you allow foreign institutions to participate without allowing them to transfer dodgy debts from other places? If you limit it to US institutions, how does that stabilise Wall Street with all its foreign banks?

I am not suggesting there are easy answers, or that an armchair commentator 3000 miles away from the action has insights the real players do not have. We all want the US to get it right, and hope that this large sum if approved will make a difference. It is because it so important that the politicians in Washington are right to want to see the small print and right to want to know if there is an alternative. Meanwhile the rest of us have to watch the gripping drama played out in the markets and on the Hill.

Are there other options, or is the President right to say there is no alternative? Of course there are other options. Some say it would have been better to set up a well governed body to value and buy debt, and started it off with a more modest budget. They could see how well it worked by taking it more slowly.

I think it might be better to develop the Administration’s role as lender of last resort, taking collateral without having to buy the instruments. The system already has the power to lend where needed. It would be less contentious with an American public who rightly do not wish to see hard borrowed taxpayer dollars spent on the Wall Street rich. In the UK when the government foolishly decided to nationalise Northern Rock they ignored the better alternative of lending the Rock the cash it needed whilst taking charge of all the good assets they could secure against the lending. That would have limited taxpayer risk and concentrated the minds of management on the need to find a more permanent solution. Such a policy can be buttressed by a better scheme of deposit protection to reassure small savers.

Maybe changing accounting rules from mark to market (part of the problem when there is no effective market in many of these instruments) to valuation based on estimates of repayments in due course would be an important part of a solution. Some say this would be quite wrong, as only the true doctrine of mark to market gives you reliable accounts. I would normally take that view myself, but what can we make of accounts based on market values that reflect the absence of any kind of buying owing to the squeeze? The banks cannot sell all this debt at the very low market prices being proposed for the accounts anyway – there is no market price if they are to sell lots more of it. Maybe we need an interim solution of a value based on sensible, even on pessimistic estimates of how much of the lending will be repaid over the next five or so years, which would be higher than mark to market in current conditions for some of this debt.

The whole crisis has been made more dramatic by the intervention of the electoral politics of the US Presidential contest. John Mc Cain, struggling behind Obama in recent polls, sought to turn the tables on his rival by demanding a bi partisan approach to the crisis. It looked like one of those unsettling moves Mc Cain has enlivened his campaign with. It broke the rhythm of the Obama machine and left Obama looking more defensive. However, it has two big weaknesses. It has reminded people of Mc Cain’s connections with the Bush Administration. If it results in Mc Cain support for a large Wall Street package it will upset much of Middle America who do like the idea of so much cash going to bankers. Mc Cain would not be wise to duck the Presidential debate. Obama’s best jibe when it was suggested the debate would be cancelled was that a President had to be able to handle more than one thing at a time.

Whilst the politicians for once raise good questions and seek to negotiate a settlement in response to the Treasury Secretary’s challenge, banks on both sides of the Atlantic have become even more safety conscious and interbank lending rates have risen. Interest rates charged to lenders are on the rise, whatever the Bank of England and the Fed may want. Banks are desperate to make more profit to increase their reserves, and keen to cut their lending. They will soon become even more unpopular, as this communicates to the real economy as less available for company and individual borrowing at a higher price. That is why this Credit crunch is also deflationary and recessionary.

Banks need massive capital injections. To persuade investors they need to be more profitable, and to bolster their capital they need to make more profit. They have reported big profits in recent years, but we now know this was at the expense of their balance sheets. There are going to be further big write offs from balance sheets, as banks acknowledge that what they thought was very profitable business was loss making business because not all the loans will be repaid.

If the US package brings relief, and markets rise, that will limit the downturn. It’s not going to stop it. Enough damage has been done already. Even after $700 billion of purchases of assets banks still need to raise lots of capital, and need to retrench on the lending.

Meanwhile the German Finance Minister thinks this would be a good time to demand that banks hold even more capital relative to their loans than they have been asked to do by regulators so far. This is not a case of bolting the stable door after the horse has gone. It is a case of shooting the horses that have bolted after they have been recaptured. Or changing the metaphor, this is the ultimate scorched earth approach, that would turn a downturn into a depression. I assume the Fed and the Bank of England are not up for that. His numerical suggestion of capital required would greatly increase the amount of money banks needed to raise simply to sustain their existing loan base. It is not helpful to hear EU politicians crying “We told you so” when EU banks have been under pressure just as American ones have been. Northern Rock, after all, was a UK/EU regulated bank lending money to people in the UK that had nothing whatsoever to do with US sub prime or the US regulators.

This is a global problem. It needs global solutions. Failing international agreement, it needs intelligent central banking on both sides of the Atlantic. Intelligent central banking entails making difficult day to day judgements about how much liquidity to supply, careful behind the scenes work to help the private sector repair ailing banks, and sensible use of the lender of last resort power. There was never just 5 days to save the world banking system, and never a single policy that would sort out all the problems. If the US is to go the route of buying up the debts they need to answer the detailed questions about how it would work. It might be better to stick to doing what Central Banks should do – regulating banks and organising orderly money markets. They are going to have to do that anyway, and not just for a few days. Buying up the debts of course will give a boost, that will last until the money runs out. Only if it is enough to restore banks confidence in banks will it have worked as intended. Maybe we are going to find out.

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23 Comments

  1. Stuart Fairney
    Posted September 26, 2008 at 7:34 am | Permalink

    I don’t know if you saw this piece by Yaron Brook about the lunacy that was the federal communities’ reinvestment act

    http://www.forbes.com/opinions/2008/07/18/fannie-freddie-regulation-oped-cx_yb_0718brook.html

    but it rather suggests that far from disapproving of the lax lending practices, the US government actually forced them on the banks. Combine that with some of the insanity of pseudo-government owned fannie and freddie adding oil to the fire, and I cannot help but think that the last thing we need now is more government.

  2. no one
    Posted September 26, 2008 at 8:51 am | Permalink

    having watched the conservative spokesmen and women over the last few days the one thing i really dont get is why so few of the senior ones have working class accents

    the conservatives are not short of folk with working class roots as supporters

    why are most of the senior spokesfolk obviously public school or middle class or oxbridge?

    its not good presentationally

    • mikestallard
      Posted September 26, 2008 at 6:23 pm | Permalink

      Tony Blair started this one running. Having gone to the very top schools/universities of the land, he began to drop his "haitches". Then the "t" at the end of words. Then "Yer no" at the end of every sentence.
      Followed suit, he was, by Ruth (same origin) Kelly and Jacqui Smith (same origin) and Harriet Harman (same origin).
      I like to compare Mr Brown's English accent – like so many Scots – near perfectly Southern when he says "You know…" at the beginning of the sentence. It means "Listen up…"

  3. Acorn
    Posted September 26, 2008 at 9:22 am | Permalink

    John keep in mind that the $700 billion is the equivalent of a credit card limit. Paulson can spend more if he sells some of the junk he buys; that is the way the Bill has been written.

    There was a big assumption by Radio 4 this morning that this money actually exists, it does not. It will only exist when the FED prints it into existence and swaps it for the junk. As the US Treasury is currently looking at a $ 1,000 billion budget deficit, a lot of the junk will be US Treasury bonds. You can understand why the US stopped publishing M3 money supply data.

    The rest of the planet will need a better return for holding all this US Treasuries debt, interest rates will rise, dollar denominated assets will inflate, the dollar value will fall. You cannot solve a debt problem by issuing more debt.

    I understand from a mate in Dubai, that there is a lot of talk in the GCC countries about introducing a new oil backed currency; probably called the OPEC. World oil and gas trading would gradually move to being priced in OPECs. How many US Dollars to the OPEC; I will leave you to work that one out.

    I would recommend to Redwoodians that you read some of the articles on the Oracle and the piece on the FT economists blog.

    http://www.marketoracle.co.uk/

    http://blogs.ft.com/wolfforum/2008/09/the-price-of-salvation/#more-192

    • Acorn
      Posted September 26, 2008 at 2:00 pm | Permalink

      [Apologies John, I am passing this through your site to one of your readers]; but it is the best I have found that explains the role of CDS and CDO instruments in the credit crunch. But I recommend it to all Redwoodians.

      At the bottom of this page link are links to Parts 1,2 & 3 of "Money Morning Special Investigation of the Credit Crisis".
      http://www.moneymorning.com/2008/09/26/creditcris

  4. Kit
    Posted September 26, 2008 at 9:28 am | Permalink

    "intelligent central banking" – Sorry but they got us into this mess.

    Why do you think they will get it right now when they got it so spectacularly wrong over the last 10-20 years?

    The solution is simple: let the banks fail. Then let the market set interest rates not the central banks and provide a varied regulatory framework.

  5. tim holden
    Posted September 26, 2008 at 10:00 am | Permalink

    According to figures in The Economist, the Current Account balance in the USA for the last twelve months is $699 billion(incidentally,that for the UK is $102bn). The coincidence of figures with the size of the bailout package worries me, as well as the US trade balance figure being $844bn,

    In addition I have read that China has instructed its banks to cease lending to the USA, and there was a run on a bank in Hong Kong yesterday.

    The Democrat intervention on the Bush rescue package has led to a deadlock, and this worries me further as the Democrats typically have a Protectionist approach to foreign trade. No better way exists to ruin competition than by denying it the cash it needs to run with.

    Could this amended rescue package be the first shots in a trade war to eclipse all others?

  6. Andrew Forbes
    Posted September 26, 2008 at 10:30 am | Permalink

    Sorry to interrupt, John, but can we talk about ID cards instead? ID cards reared their ugly heads yesterday, and unluckily for the govt, it didn’t turn out to be a particularly good day to bury bad news (nice try Jacqui, but when your luck runs out, it really runs out, doesn’t it?). Can you answer this:

    Say you win the election in 2010. At time, the govt will have only spent about £16bn of the £10bn budget, and the project might well be 80% complete. Will the new Conservative Home Secretary:
    (a) March into his office and shout “everyone stop work on ID cards now. Bin all the work you’ve done thus far. This is an outrageous infringement of civil liberty, and completely useless at counter terrorism or illegal immigration”?
    (b) March into his office and shout “everyone stop work on ID cards now. Put all the work you’ve done in storage, we might need it one day you never know”?
    (c) Quietly carry on, might as well finish it off, they’re only voluntary, you know (which we all know is a lie, given the way it’ll work)?

    I’m rather suspecting (c), since no-one is talking about it, and I’d really like some assurance that it’s (a). I know you’re against them personally, but what is Conservative policy?

    With apologies; everyone can get back to talking about banking, now.

    Reply: Yes, we are completely against ID cards and will stop it whatever stage it has reached, as I understand our policy. That is certainly my view!

    • Andrew Forbes
      Posted September 26, 2008 at 4:11 pm | Permalink

      Many thanks. I really appreciate this service. To get an instant clarification to a direct question is fabulous. My own MP, Mr Ian Taylor, merely gets one of his staff to write something evasive if I question him. In common with the govt, Mr Taylor defied a manifesto promise for a referendum on the European constitution and wasn't too keen on explaining himself. I might move to Wokingham.

  7. APL
    Posted September 26, 2008 at 10:36 am | Permalink

    JR: "We are waiting for details of the package from the USA. It is unlikely the politicians will veto all of it."

    We had full details of Paulson's and Benanke's plan. It involved;

    *Not as slated one, but multiple $700 billion payments to Wall Street.

    *The total destruction of private property, with Benanke taking the right to confiscate private property at whim.

    *Placing Paulson and Benanke above the law, the clause excluding them from judicial oversight was the most blatant power grab since Blair and his civil contingency act. Unconstitutional too.

    The politicians have been surprised by the strenght of opposition from US citizens. I am full of admiration for Americans.

    It isn't over yet. Stand by for another financial crash. You know, if you can't persuade the people, scare them to death.

  8. Letters From A Tory
    Posted September 26, 2008 at 10:43 am | Permalink

    "The whole crisis has been made more dramatic by the intervention of the electoral politics of the US Presidential contest."

    This is hardly surprising, given the disgraceful vested interests that are driving this bailout which I blogged about this morning.
    http://lettersfromatory.wordpress.com

  9. Tony Makara
    Posted September 26, 2008 at 10:51 am | Permalink

    Once again those smart money-lenders have duped those dumb career-politicians into picking up the bill for their bad debt. The lending community certainly know how to play the political elite. Most troubling of all is the way that media have accepted all this as inevitable. This bail-out is a farcial and is yet another example of how politicians can be led by the nose, and made to do practically anything if it appears to play well in the media.

  10. Neil Craig
    Posted September 26, 2008 at 11:58 am | Permalink

    I don't like this bail out because it is helping those least deserving. I think it would be better in the long term for the financial system if at least some institutions failed. I would suggest that, if mass failure is unacceptable the Fed should have the option of nationalising any bank if its share price falls to 5% of its peak. That prevents bankruptcy, gives the shareholders only a nominal return but protects customers thereby preventing, or stopping, runs. They would probably have to print a significant amount of money to keep them going at first but it is quite likely that refloating them or selling them off, perhaps in bits could even be net profitable. This, in theory & with much more faffing about, is what happened to Northern Rock.

    Worth noting that our liability dor Northern Rock of £110 billion ($200 B) is, compared to the 6 times larger US economy, greater than their one will officially be. In the end though our loss should be much smaller (originally promised as zero) because we have ALL NR's propertied not merely the toxic ones.

  11. Glyn H
    Posted September 26, 2008 at 11:59 am | Permalink

    There are two underlying issues which I have not seen widely discussed. Firstly there was I believe a deal of anti discrimination legislation in the US in the late 80’s and 90’s, based with good reason upon the civil rights campaign but perhaps fed by the feminism issue. Thus in the words of Tom Lehrer’s immortal introduction to ‘It makes a fellow proud to be a soldier’ – “(one) has to admit that the army has carried the American democratic ideal to its logical conclusion in the sense that not only do they prohibit discrimination on the grounds of race, creed and colour, but also on the grounds of ability”. If you then couple that to the lack (as far as I know) in the US of an equivalent to our Sale of Goods Act and the Unfair Contracts legislation it was easy for sharks to sell duff mortgages to schmucks. The second point is put with clarity by Sir Martin Jacomb in last weeks Spectator, “many of these securitised loans turned out not to have been effectively disposed of but to have remained the responsibility of the banks which originated them. Many senior managers….. had not grasped the reality”

  12. Bazman
    Posted September 26, 2008 at 12:18 pm | Permalink

    If you won the lottery you just would not believe your luck and laugh to yourself every day.
    The people who got the most out of this mess actually believe they deserve the money and will continue to think this, as they are the ones trying to get us out. Is wrestling fixed?
    For an eighteen year old ten years ago, the temptation to take these banks for tens of thousands must have been great. Ten years later bankrupt with money hidden or amazing memories. All forgotten by forty. Probably a city banker by then.
    See where this is going? Fat fifty something financiers doing a similar trick. No? You are all respectable and pilers of society?
    My sense of deference has been fag paper thin for a long time.

  13. StevenL
    Posted September 26, 2008 at 12:35 pm | Permalink

    (…it will be a quick fire purchase of many instruments that will be but poorly understood and hastily valued by the taxpayers representatives…) (JR

    I'll be the first to admit I don't understand exactly how all these mortgage-backed securities work. It's not my job to understand them and I have no intention nor means of buying them.

    But haven't government had long enough now to work out what the damned things are and a suitable way of valuing them as long-term assets?

    We've all been talking about them for a year now. If the relevant arms of US/UK government still don't understand them then there is absolutely no excuse for this.

  14. adam
    Posted September 26, 2008 at 5:31 pm | Permalink

    What is going on is mindblowing. It is the end of America, an unlimited bailout of Wall St.

    Even the Presidents sanitised cheerleading message was absurd.
    You the taxpayers pay the Bankers 700 billion (initial, minimum) and in return they will continue to extend credit ie allow you to get further into debt with them.
    Just what kind of deal is that.

    Doubtless the real bill contains all manner of other horrors as all post 911 legislation does

  15. mikestallard
    Posted September 26, 2008 at 6:26 pm | Permalink

    I want to share this one:
    From: Minister of the Treasury Paulson

    Subject: Request for urgent confidential business relationship

    Dear American: I need to ask you to support an urgent secret business
    relationship with a transfer of funds of great magnitude. I am minister
    of the Treasury of the Republic of America. My country has had crisis
    that has caused the need for large transfer of funds of US$700bn. If you
    would assist me in this transfer, it would be most profitable to you.
    This transaction is 100 per cent safe. This is a matter of great
    urgency. We need a blank check. We need the funds as quickly as
    possible. My family lawyer advised me that I should look for a reliable
    and trustworthy person who will act as next of kin so the funds can be
    transferred. Please reply with all of your bank account, IRA and college
    fund account numbers and those of your children and grandchildren to
    wallstreetbailout@treasury.gov so that we may transfer your commission
    for this transaction. After I receive that information I will respond
    with detailed information about safeguards that will be used to protect
    the funds.

    Yours faithfully, Minister of Treasury Paulson, Nigeria, Washington DC

    • Neil Craig
      Posted September 26, 2008 at 7:34 pm | Permalink

      Nice Mike. I can't see that any sensible person getting campaign donations from respectable financial institutions would have any trouble believing that.

  16. Blank Xavier
    Posted September 27, 2008 at 10:32 am | Permalink

    The US Government mandated that mortgage lenders lend to risky borrowers. It also created Frannie, implicitly backed its debt and permitted it to operate with a stratospheric gearing – and by doing so, Frannie was able to complete undermine the rest of the players in the market by being able to offer cheaper mortgages.

    Frannie gave about half of the subsidy thereby generated (by cheaper debt than it would otherwise pay due to Government backing) to shareholders – about 70 billion US dollars. Frannie also dominated the prime mortgage market and failed to fufill its mandate to lend to people who could not otherwise obtain mortgages. (They also donated a lot of money to senators and representatives and various election campaigns and a *lot* on lobbying; and came to dominate the two hundred or so State employees whos jobs it was to regulate them).

    Because of this, the other players in the market ended up focusing on those bad credit risks (as well as being required, by law, to lend to them).

    Then along came the liberalization of credit, which has caused property booms in a number of countries around the world. US housing prices went through the roof as credit is now so massively available – demand is unleashed by the huge numbers of people now able to afford property (and more expensive property) where they could not before.

    However, credit was in fact being lent unsustainably and a great deal of toxic mortgages were coming into being, which were being rolled over by the owners (refinanced) when they couldn't pay, taking advantage of various offers for easy initial terms. This led to a build up of toxic debt and it finally broke in 2006/2007.

    The problem now is that the collaterialisation of this debt means no one knows the real quality of who owns what – and this also means no one knows just how much loss there is going to be.

    The killer here is not just the losses, but the uncertainly of now knowing how much they are and where they are. This results in paralysis.

    There is a common – extermely common – mistaken made when studying failures to determine the cause. People track the chain of events back to the *first* point where a change could have been made to have prevented failure and argue that was the cause.

    In fact, the correct solution is to track the failure back to the *first* point where a change could have been made to prevent failure.

    The original cause of failure here is US Government interference in the market. This was combined with later further US Government interference in the market. Finally, with the scene set for failure, we see private companies making major errors of judgement in lending.

    Liberalization of credit would still have happened with Government interference and so the housing boom and most likely the errors of judgement in lending would have occurred.

    However, the existance of Frannie – vast and unstable – and the gross weakening of the position of other lenders by forcing their books into the risky end of the market – this falls directly at the feet of the US Government.

    Frannie would not have *existed* to be bailed out, if it were not for the US Government. The other lenders would have much stronger, broader mortgage books – being that much more able to survive what is ocurring.

    In the end, it seems to me this is all about ethics.

    The US Government behaved unethically in its actions – if I do not wish to lend money to someone, then no third party has a right to come along and force me to do so. This is exactly what the US Government did by requiring lenders to lend to high risk individuals.

    Similarly, the US Government acted unethically in the creation of Frannie. If an individual wishes to obtain credit and they cannot, why can someone else come along and use my money to support a company to lend to them? this is exactly what the US Government did in the creation of Frannie.

    It seems to me the US Government (and our own, and many others in the West) has lost sight of the fundamental ethical issues involved in consuming other peoples money.

    We pay tax to permit the State to perform tasks we individually could not perform – defence, social security, etc.

    The State has *no other role*. It has NO business FORCING people by law to behave as IT sees fit. What right does anyone have to interfere in the life of another, except that of self-defence? this applies to the State as throughly and deeply as it does to each and every one of us.

    We do not exist and pay tax for the State to interfere as it sees fit in our lives – we pay tax and permit the State to exist so it can perform tasks we cannot individually perform which we collectively feel must be done.

    The States we have now in the West – in the US, in the UK, France, Italy, Germany, etc – are monsters. They are so vastly spread beyond their reason for existance they spend most of their time consuming our money to dictate to us about how we live our lives.

    • mikestallard
      Posted September 28, 2008 at 1:59 pm | Permalink

      I am not sure I agree with you on this. In times of laissez faire which you seem to be advocating, the weak and the workers really do go to the wall while a few people get really rich by swindling them out of their wages. This really did happen in Victorian Britain and now, I believe, it is happening in India and China where a virtual slave economy is poised to dominate the world.
      The sufferers, of course, are the workers, the honest, the ones who strive to serve the poor and so on. These people have to look on while apparatchiks roll round in big cars full of "airforce WOMEN" and so on.
      However, your analysis of the way the crash has come about is masterly. Also, I believe, your analysis of the power of the states in the West, too, is masterly.

      • Neil Craig
        Posted September 28, 2008 at 5:49 pm | Permalink

        The people at the bottom of the pile in India & China are getting richer as fast as anybody. The alternative for them is not choosing between being as rich as them & as rich as our ordinary people but between what they have now & what they used to have. In the same way the income differential in Victorian times was not, by most measures, greater than now though the difference then between Dickens & somebody starving in the street is harsher than the difference today between Rowling & somebody on benefit.

        I do, nonetheless, believe that society should exert pressure to level the results by a worthwhile welfare state & by progressive taxation. This may not be advised on economic theory but, apart from common decency, a society with great differentials is not cohesive & does not inspire loyalty.

        • mikestallard
          Posted September 29, 2008 at 11:03 am | Permalink

          Last paragraph: who could disagree with this excellent aspiration?
          First paragraph: in China people were, under Mao, walking around naked because they could not afford clothes. They were also eating mud because all their food had been stolen and used to pay for atomic power. Millions died of poverty. And nobody much cared. So, I warmly agree with the first sentence.
          However, with their docile and servile attitude, they are dragging the rest of us down to their level. They are destroying our industry. (Look, to take one example of many, at Dyson the English Hoover). I don't want to live in a Chinese society, thank you. Do you?

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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