Now that the 44th President of the United States is learning his way around the White House, we can get back to adding our two cents to the discussion of how to improve the world's economy and financial markets. All readers will have noted that today had the worst performance of the Dow on an inauguration day in the Dow's 112 year history. This is not Mr. Obama's fault. The news stank. Once again, it was dominated by the financials. Now that BofA stock has already been clobbered, one of the small Wall Street firms' analysts pointed out that it may need $80 B of add'l capital. With a then-market cap of thirty-something billion dollars, to raise that amount of equity would perforce have brought the stock price down by two-thirds. The gods of the market were merciful. The stock was only down by 29%. It is allegedly still worth $25 B.
With that introduction, which we hope is appropriately grateful, we would like to refer readers to a piece written by a Brit about British banks, but which is almost completely apropos here in the former Colonies. Dr. Buiter writes in "Can the UK government stop the UK banking system going down the snyrting without risking a sovereign debt crisis?" (Ed. "Snyrting" is Icelandic for bathroom, or in context, apparently also a toilet.) The post is quite long, but the recommendations are so on point, I am copying them here:
"So here is my proposal:
(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.
(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.
(3) Don’t issue any more guarantees on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.
(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter. If the gratis transfer of the toxic or dodgy assets to the bad bank would violate laws, regulations or market norms, let an independent party organise open, competitive auctions for these assets - auctions in which the bad bank, funded by the government, would be one of the bidders. Whatever price is realised in these auctions is paid by the new bad bank to the old banks.
Capitalize the bad bank with the minimum amount of capital required to meet regulatory norms. Fund the rest of the assets through a loan from the state to the bad bank or through a bond issued by the bad bank and bought by the state.
As regards the bad bank, that’s effectively it. With toxic and dodgy securities on the asset side of its balance sheet and with the state owning all the equity and as the only creditor, the assets can either be sold off, if a market develops again, or held to maturity, earning whatever cash flows they may yield.
(5) As a special case of (4), take the high street banks into full public ownership and treat these existing banks in their entirety as bad banks. Close the existing banks for all new business. Transfer the deposits of the high street banks (now the bad banks) to new (state-owned) ‘good’ banks (or perhaps rather, not yet bad banks). Replace the deposits on the books of the bad banks with loans from the state to the bad banks or with bond issues by the bad banks purchased by the state. Let the new banks (New Lloyds, New RBS, New Barclays and New HSBC) acquire, in a competitive bidding process also open to other market participants, any of the assets of the old banks. Run the new banks as competing publicly owned, profit maximising banks until they can be privatised again, when a sensible regulatory regime for banks is in place and the market for bank shares recovers. Don’t guarantee or insure any items on the balance sheet of the old banks. Use guarantees/insurance exclusively for new lending and new investments by the new banks. Gradually run down the old banks as their assets mature, as under (4).
The miracle of limited liability applies also when the state is the owner. As long as the state-owned bad banks (which could be merged into a single super bad bank) don’t obtain sovereign guarantees for their obligations, the financial exposure of the sovereign is limited to its equity stake and the existing guarantees and insurance it has provided in the past.
It is key that there be no further injections of funds by the state into the bad banks until there are no longer any private creditors. If a bad bank becomes balance-sheet insolvent or liquidity insolvent and it still has private creditors (as it would, in general, under the model of item (5)), the bad bank should be put into administration and its debt to parties other than the British state should be converted into equity. That equity would be then be purchased by the UK state. With the bad bank now not just 100 percent state-owned but also without private creditors of any kind, the assets can be managed as the state sees fit - one hopes in such as way as to maximise the present discounted value of their held-to-maturity cash flows.
The balance sheets of the British banks are too large and the quality of the assets they hold too uncertain/dodgy, for the British government to be able to continue its current policy of extending its guarantees to ever-growing shares of the banks’ liabilities and assets, without this impairing the solvency of the sovereign. Britain risks becoming a victim of the new inconsistent quartet: (1) a small open economy with (2) a large internationally exposed banking sector, (3) a currency that is not a serious global reserve currency and (4) limited fiscal capacity. It risks a triple crisis and a threefold run: on its banks, on its currency and on its sovereign debt.
Limiting the exposure of the sovereign to what is fiscally sustainable may imply giving up on saving (all of) the banks. If my proposal for institutionally and legally separating existing stocks of assets and liabilities from new flows of credit and lending is acted upon, the flow of new lending and the supply of new credit need not require the survival of all (or indeed any) banks hitherto deemed systemically important.
I look forward to the time when I will be blogging on the best way of privatising the banks again, under new regulatory and governance regimes."
As discussed in my recent post, "UK and US Play Leapfrog in Making New Mistakes", it appears that the head of the Bank of England and the Fed head, Mervyn King and Ben Bernanke respectively, keep teaching each other how to take ever more drastic steps in the wrong direction. Sort of a "Simon Says", one to the other.
Willem Buiter for King! (That was a pun. Hope you got it.)
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