The US detox lunancy

The US Government has come up with its latest plan to solve the financial crisis which has now well and truly become a real (GDP and employment) crisis. While the initial reaction from the financial markets is generally favourable (and why wouldn’t it be), if you appraise it from the perspective of modern monetary theory and impose an equity bias then you conclude: (a) it will represent a major redistribution of nominal wealth to the already wealthy; and (b) it probably won’t help reduce unemployment because it is not tackling the real problem.

In an article in the Wall Street Journal entitled My Plan for Bad Bank Assets US Secretary of the Treasury Timothy Geithner outlined how the US Government plans to address public anger (about huge executive payouts and more) and the gravity of the crisis that confronts them. He started out:

No crisis like this has a simple or single cause, but as a nation we borrowed too much and let our financial system take on irresponsible levels of risk. Those decisions have caused enormous suffering, and much of the damage has fallen on ordinary Americans and small-business owners who were careful and responsible. This is fundamentally unfair, and Americans are justifiably angry and frustrated.

The depth of public anger and the gravity of this crisis require that every policy we take be held to the most serious test: whether it gets our financial system back to the business of providing credit to working families and viable businesses, and helps prevent future crises.

It is interesting that he draws causality between the public anger and the Government’s willingness to act. Don’t they have a charter to maintain full employment and all times irrespective of the current sentiment of the population that they represent? Apparently not. Given this is the first real offering from the new US administration, the motivation is suspect.

What is this new plan? The previous US Government had already introduced what it called the TARP (aka the Troubled Assets Relief Program) which allowed the government to purchase various sub-prime assets and rated “mortgage-backed securities” (derivative assets that are derived from some initial mortgages and then packaged up – the package containing various grades of risk in the initial loans). So the new plan – the so-called Public-Private Investment Program (PPIP) is an extension of the TARP. In Australia a TARP is someting we cover our rubbish with as we take the trailer load to the tip … and the analogy may extend to this case!

After outlining various initiatives the US Government has attempted – housing market stabilisation; capital injections into banks; a major Federal lending program to help small business – the Secretary admits that there is still more to do:

However, the financial system as a whole is still working against recovery. Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions — so-called legacy assets — are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.

Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.
More Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

So the TARP extension draws in private investors like hedge funds and private-equity funds. Under the new PPIP, the banks holding various “toxic” assets will be encouraged to sell these assets, thus clearing their balance sheets (more about which later).

The Secretary says:

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors.

So if the banks sell these assets, private investors will contribute 7.5 per cent as equity matched by funds from the TARP (which means the US Treasury). The remaining purchase price will come from loans provided by the Federal Deposit Insurance Corporation (FDIC), an independent agency of the US government.

The FDIC in their own words:

… preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for up to $250,000 (through December 31, 2009); by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails

These FDIC loans will be provided at low interest rates and will be non-recourse. What does that mean? In the US, a non-recourse loan means that if the borrower defaults the lender gets the asset (in whatever condition it is in) but has no further claim on the borrower. So go broke, default and walk away – that is the end of it.

In other words, if any of the assets turn out to be profitable, the investors benefit and the FDIC will get repaid. But if the assets do not deliver returns, then the small investment percentage from the private funds will be lost and the so-called “toxic” assets will end up on the books of the FDIC – worthless. The Treasury contribution (that is, government spending) also would be spent on worthless assets (that is, certainly not jobs!).

So you understand from this that the US Government is guaranteeing the private investors against any significant downside risk.

But the PPIP seems to have some conflicting parameters apart from its flawed underlying logic. The US Treasury Secretary says:

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

For the banks currently holding the assets, the best outcome will be a high purchase price. But for the investors and particularly the FDIC the best chance is that the initial purchase price is low. The price will be determined apparently by an auction process. But if the banks are still getting cash flow from the assets then why would they want to sell them at a discount on their current book value? Alternatively, if the banks want to get rid of the assets, then why would the private investors want to buy them? If they are worthless – they are worthless. The private sector will only invest if there is a satisfactory return on equity for their owners. That is the logic of the private market.

Moreover, the banks are not compelled to participate in the auction. So we know in advance that the banks will only sell assets that match their current price. There is also the claim that if the discount on the book value was too large, the written off capital would generate negative equity for the banks – that is, they would be technically insolvent. But against this is the unwillingness of any buyers to take the assets on at current “book value”. If there was a viable bid-ask combination then this plan would not have been dreamt up at all!

So the logic of the plan is very favourable to the banks.

But it gets worse. The FDIC guarantees on the loan mean that the private investors (being levered 6 to 1 – meaning: public money goes in at a rate of $US6 for every $US1 of private money) face virtually no downside risk. In the event that the assets fail (mortagees stop paying), the risks are as follows:

  • Private hedge funds – 7.5 cents per $1 invested;
  • US Treasury – 7.5 cents per $1 invested;
  • FDIC – 85 cents per $1 loaned minus the final sale price of the assets, most likely 85 cents!

The private holders of the debt – bankrolled by the US Government – will come out of it very well indeed if some of the “assets” end up being viable, They will lose very small amounts if all the assets fail. The easier solution would be to formally take over the banks (they are already substantially guaranteed by the public purse) but that is unlikely given the neo-liberal persuasion of the Government and its coterie of advisors who seem intent on imposing the wrong responses.

So you get the drift – the big losers will be the US public whose spending goes down the drain. Public spending will be used in part to guarantee not only the safety of these investments but also the required margin for profit. One might construct this as being a new financial asset being created by the US Federal government – a jumbo-mega virtually risk free public bond – which provides mostly upside return to the wealthy segments of the economy.

In one policy, the US Government who came to power professing equity ambitions are redistributing nominal wealth towards the rich like never before. Why would they be doing that? One answer is that they have succumbed to the neo-liberal economic theory and do not fully understand the options that they have available to them as the sovereign government.

Flawed underlying logic

The aim is to take the so-called “toxic assets” off the balance sheets of the US Banks. The assumption is that these assets are causing the banks to restrain their lending and have increased the cost of borrowing – that is, choking up the liquid that fuels private commerce.

In the words of the US Secretary of Treasury, the PPIP will:

… initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

Why is this necessary to get credit rolling?

The assumption is that the uncertainty surrounding the value of the “toxic” assets is throttling the credit lines. It is believed, erroneously, that if the banks no longer have these assets on their balance sheets, then they will become more attractive to private investors which will provide them the funds which they can on-lend.

Spot the flawed reasoning? You might like to refresh your understanding of the way the banks operate by reading my blog on Quantitative Easing. There you will learn that mainstream economists erroneously believe that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But this is a completely incorrect depiction of how banks operate. Bank lending is not reserve constrained. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

So we have to be very dissapointed given this is the first major response by the new US Government to the crisis. The response is disappointing because it reveals a lack of understanding of the power of fiscal policy in directly meeting the challenge to increase aggregate demand and get production and employment rolling again. From activity, credit will flow. Banks would see that firms would be starting to enjoy more robust sales conditions and workers were spending again because their jobs were more secure or more likely because they had jobs again.

The policy response continues the belief that the private market is the way ahead.

The US Treasury Secretary says:

We cannot solve this crisis without making it possible for investors to take risks. While this crisis was caused by banks taking too much risk, the danger now is that they will take too little.

Excuse me! The crisis in the real economy can easily be solved with a single dollar of private investment being required in the first instance. The US Government has the fiscal capacity to boost aggregate demand sufficiently to get employment and production rolling again which, in turn, will provide the boost to private confidence to invest. Then the Government isn’t going cap in hand to the private sector virtually paying them to do what they should do anyway.

What has happened to the logic of capitalism? The capitalist system of today seems to be – attack public spending and undermine the capacity of the US government to generate full employment while you go for as much return as you can. Then when that comes unstuck because risk levels go beyond what is reasonale it is time to start advocating large public bailouts and huge subsidies to allow the private sector to buy assets at rock-bottom prices.

It is time, the proponents of capitalism realised that the system is reliant on corporate welfare and the debate should become one of how welfare should be prorated. The captains of industry seem to hate welfare being provided to the most disadvantaged citizens; they hate public sector job creation which would allow all workers to gain income security through productive employment; but they are always ready for the public hand to fill their own pockets.

You don’t have to read Marx to comprehend the immense hypocrisy in all this and that the capitalists are ultimately reliant on a strong public sector for sustainable outcomes.

Pity us in Australia too. Our august prime minister apparently said that the “rescue package heralded the world’s first step towards economic recovery.” And he wanted the British and European governments to follow suit and give their “top-end-of-town” investors the same massive free kick.

And not a word in all of this about something which is more simple and which gets at the root of the problem: direct public sector job creation.

Digression: John Howard’s old electoral office

I was travelling to Sydney by train yesterday (Wednesday). I often look at the shopping strips along the railway as an indication of the way in which the urban settlement is faring. Urban blight – lots of empty shops and for lease signs – is a sign that local commerce is in trouble. At Epping I noticed a lot of “urban blight” – many shops empty. Along Beecroft Road, Epping, which you can see from the train, I noticed one clustering of blight and in the centre of it was a shop front with the hoarding – John Howard, Member for Bennelong, Prime Minister in white letters on a blue background. Here is a snapshot of it (click for a wider image):.

howard_office_blight

He certainly blighted Australia and now his memory is being retained as localised urban blight!

Digression: Manila

I am currently working in Manila, Philippines for the Asian Development Bank which has its central office here. It took nearly 3 hours last night to travel around 6 kms from the International Airport to the ADB building in central Manila. Traffic chaos. The city is locked into chaotic capitalism without much development evident – lots of shanties, lots of street vendors, a seeming absence of urban planning, and people everywhere with handkerchiefs over their mouths as they wait for the public transport system amidst the car and truck chaos. Not a place to be!

Update: Saturday quiz

Tomorrow the tradition continues … (well the tradition is one week old but you have to start somewhere) … the Saturday quiz. I have been dreaming up questions all week. The blog will appear Saturday evening (AEST).

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    One Response to The US detox lunancy

    1. Rahul R says:

      Bill,
      thanks for a great article. Re: bank lending – dont you think that banks in the US are not lending because of lack of ‘economic/risk capital (equity)’ and not necessarily availability of loanable funds. There is a lot of uncertainty around the value of these toxic assets and banks dont know how much they should provision for losses on these assets that are still on the books, in turn limiting their ability to lend.
      Its sad to see the misguided neo-liberal economic policies of the Obama administration, in stark contrast to the theme of his campaign.

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