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Monday, January 19, 2009

What Paul Krugman said

Stress in credit markets appeared to be easing somewhat in the last few weeks, but any optimism has since given way to utter craptimism. Bank of America was just bailed out. Citigroup will need to be bailed out, again. Things are back at square one, which will probably need to be bailed out.

The problem is that banks hold lots of "toxic assets" on their balance sheets, namely mortgage or other asset-backed securities whose underlying revenue streams have collapsed since people stopped paying their mortgages, car loans, student loans, etc, etc. These securites are more or less worthless. In better times they would have been sold to other investors but now they're stuck on bank's balance sheets.

Banks and the government are trying to pretend that the problem is a lack of liquidity due to the credit crunch. Hm, sorry, no. The reason no investors want to touch them is that they're fucking worthless. If credit markets healed tomorrow they would still be worthless because people would still be unemployed and defaulting on their mortgages. This has been the problem all along. If anything the past year has made it clearer.

Which makes the new plan to deal with them all the more worrying. FDIC head Sheila Bair is floating, and the incoming Obama team is supposedly backing, the idea of an "aggregator bank". This would be a government-run entity that would buy the shit burgers from the banks at "fair value." As my secret econolover Paul Krugman points out, "what [the fuck] does “fair value” mean?"

This problem is exactly the same as that posed by the initial TARP plan, which was originally designed to buy toxic assets to establish some kind of market for price discovery so people would start buying and selling these things again. That idea was scrapped when people pointed out that this was a raw deal for the government, because of the reasons stated above, that willingness to buy wasn't the issue, but the underlying (lack of) value.

Straight on recapitalization went ahead instead, which as events of the past week have shown, have been inadequate. Hence the new calls for the "aggregator". Krugman prefers something different:
A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.
The problem with this option, as Krugman notes, is the general fear among the supposedly socioredistributizationalist Obama administration to just fucking nationalize these things already.

While creating an aggregator bank would certainly help clean up bank's balance sheets, there would still be no guarantee banks wouldn't need to be bailed out again because of the general awfulness of the economy. Moreover, there is no guarantee banks will use their newly cleansed balance sheets to pump credit back into the economy, which is supposedly the whole point of this idea. If there were time, a deal to restructure mortgages to put a floor under losses on mortgage-backed securities would be ideal before going all out and taking over the banks. But plans to do that, while still worthwhile, are at rudimentary stages and will take far too long to implement.

So seriously, Obama people. This has gone on long enough. Don't be pussies. Enough of the serial ad hocism and muddling through. We're still stuck with the exact same problem we had over a year ago now. No one wants Japanese zombie banks eating their tax dollars and brains forever. Just nationalize them and end this.

Update:
Willem Buiter makes the same point more clearly and with less space because he's better than me.
[T]he guarantee component of the Bank of America package (like the earlier insurance of/guarantee for $300bn worth of Citigroup toxic assets provided by the US Treasury) does not avoid the problem of valuing the toxic assets. The problem of determining a price or value for the illiquid assets stopped the TARP from being used as originally intended - for buying toxic assets from banks and in the process becoming a price and value revelation mechanism for illiquid assets.

[...]

[F]ull public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks. The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks. If all the banks, and the bad bank, are publicly owned, this problem goes away. The toxic assets are simply moved to the balance sheet of the bad bank. They could be valued at anything from zero to their notional value or historic cost (or even higher). It would be a redistribution of wealth from one state-owned entity to another state-owned entity.

[...]

The bad bank would hold the toxic assets and collect the cash flows associated with it until a liquid market for these assets is re-established. This may never happen, in which case the bad bank would hold the toxic assets to maturity.

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