They Don’t Know What To Do Or They Don’t Know How To Do It.

[Extradry Martini]

About a year ago, I wrote here that I was very worried about policymakers not understanding the problems and that the financial system was in a vicious circle which, if left unchecked, would lead to the collapse of the system and therefore of the entire economy. In May of last year, I thought that the Fed at least had carried out enough partial measures to avoid catastrophe for the time being, and in October, I believed – because of a very high level of awareness on the part of policy-makers - that we had seen the worst of the financial crisis (though not of that in the economy, nor the lows in the stock market). However, I think I may have been premature in that, and I now believe that the risk is as high as it was a year ago.

This time though, it is very different in nature: While policymakers do largely understand – I believe - what is going on in the financial sector, it is their inaction in the middle of accelerating events which is the real risk now.

Let’s start with the US: As you all know, the Geithner speech the other say was woefully short on detail. This, in my view, is because the problem they are facing is not that they don’t know what to do, it is that they do not know how to do it – in other words, they are finding the micro decisions too much a stumbling block for carrying out the macro decisions. For example, we can all – rightly I think – say that we may not be able to get these assets off the banks’ balance sheets and get them to lend again until we have had large-scale nationalisation and the balance sheets can be studied microscopically. But even if that is the case, how do we do nationalise the banks? A natural first answer to this question is to say that the equity holders get nothing, but the debt holders get repaid. But the very bottom rung of debt holders own what are called “tier one” bonds which are bonds, but are no different from preference shares – they pay a regular, high, coupon, are perpetual and the holders get paid out just before the ordinary shareholders in a liquidation. Do you pay those back in full? If so, how do you square that with the preference share holders who are considered equity? If not and you don’t repay them, how do you square that up with repaying the next level up in the capital structure? It is the difficulty in answering these questions which is holding them back. But they need to make a decision of some sort, bull-doze it through and live with the consequences - because the consequences of wavering before fixing the banks are likely to be worse than the consequences of not getting all the details right while doing it.

At the same time, the details in the plans to help home-owners repay their mortgages are also fraught with difficult questions. For example, if the government helps homeowners by getting the banks to refinance them, how do they get the trusts which administer the mortgage pools, and the owners of those pools, to agree? Naturally, if you own a triple-A tranche of a mortgage pool, you don’t want the mortgages refinanced, because it would take longer to get your money back – you’d rather the mortgage holders went bust so that you could repossess the properties. At the other end of the pecking order of the mortgage pool, the guy who paid pennies for his toxic waste level tranche would simply love a refinancing as it gives him a chance of getting some money back from his cheap gamble. Again, the government needs to a make a decision on this, focus in getting it through Congress if necessary, and act on it. It is this boldness with the detail that Geithner promised at the beginning of his speech but singularly failed to deliver later on in it.

At least in the US, they are trying to work it out. Elsewhere, it is worse - it seems like policymakers do not have the first clue as what to do. The ECB has no ability to bail out sovereign states and many of the countries are looking inward trying to work out how to bail out various industries along with the financial (e.g. car manufacturers in Germany and France and construction companies in Spain), and doing this without falling foul of EU internal market rules. This may be necessary, but the result of it is that sovereign states are not focussing on the systemic problems enough and not co-ordinating enough (if at all) with other countries. Bank nationalisation in many places, such as the UK, appears too politically charged for politicians to consider it. On top of that, they don’t seem to realise that any single, piece-meal, off-the-cuff domestic initiative has side effects that can be worse than the problem they are trying to solve. A good example of this is a chain of events which began in Ireland last year: 1) Ireland issues blanket guarantee on bank deposits in an effort to get interbank lending going again and prevent bank runs. 2) Other European government are forced to do something similar to stop their citizens moving their deposits to Ireland and causing bank runs in their own countries. 3) European governments, now with huge contingent liabilities get downgraded. 4) The possibility of failed auctions and sovereign default becomes very real. And this is just one chain of events – what is happening now is multi-layered and picking up pace every day.

Vague talk of pan-European bond market guarantees and a role for a beefed-up (or new) IMF or other supranational organisation so far is just that – vague talk. The council of ministers and the G7 are not meeting nearly enough to sort this out. Most European countries seem to be looking towards Germany to take a lead on some of these issues, while German policymakers still appear to be basing policy on not repeating the experience of the Weimar republic (and not only for monetary and economic reasons), yet letting a sovereign state default would be catastrophic – it would likely cause a chain reaction all over Europe, beginning with the Southern part of it plus Ireland and Britain. And yet, when we look at the European and US newspapers, policy-makers are spending enormous amount of time – everywhere - on populist side-issues such as bankers’ pay and immigration.

While all of this happens, the vicious circle continues and banks lend less, credit prices fall partly because of this in itself and partly because of a worsening outlook, banks take more write downs, deplete their capital and are forced to reduce their balance sheets.

The one exception I can see to the threats of policy-maker inaction is Japan. This is not because they are not being inactive – they are probably being less active than anywhere, but because it is genuinely very difficult to see how they come out of this situation. They have savings, but they aren’t spending them, and every time the government launches an initiative to boost spending, they hoard even more because 1) policy-makers there have had a 15 year history of turning off the tap too quickly and 2) the public now have see any such initiative as a measure of desperation and another reason to hold onto their cash.

If we knew roughly what was going to happen and how painful it would be, it almost wouldn’t matter so much how bad it looked, short of complete collapse. In other words, be able see to the other side no matter how deep the valley in between. But we can’t and this is far, far worse.

[the primitive]

So it's still deflation then

[Extradry Martini]

So it's still deflation then

For the time being, I think, yes.

[bogbrush]

Am I being dim in suggesting the following;

1. Declare that any bank that is technically bankrupt will be allowed to fall.

2. Set up emergency finance centres where anyone requiring loans can come to with their case. Leave in place until private sector can take up capacity. Just wear a smart suit and have your requirements well set out and justified, you know, like a bank used to be.

3. Put on tin hat and ride it out for a couple of years.

4. Make investment and retail banking legally incompatable in the same organisation.

Is any other solution actually going to do anything better than that?

[spivT]

you seem to be calling for coordinated action......and gordon has trumpeted often enough about leading the way and coordinated responses. But isn't it just the case that this is......

the depression we have to have.

[interestrateripoff]

The problem is debt.

I have seen no evidence of any govt / central bank addressing this issue.

Until they do we increasing the crash factor speed.

Naturally, if you own a triple-A tranche of a mortgage pool, you don’t want the mortgages refinanced, because it would take longer to get your money back – you’d rather the mortgage holders went bust so that you could repossess the properties.

If you where an investor why would you want to reposses? The likely outcome is that you would realise big losses. Instead of getting all your money back you might get 50% back.

If you are a pension fund this is going to be a bit of a problem, stretching out the time of the loan may be very beneficial to you in the long term. However I accept you might increase your losses. But this is the catch 22 scenario you need to avoid at all costs but yet the policy makers have got here.

[Injin]

You've assumed they want to help.

Why?

[Extradry Martini]

Am I being dim in suggesting the following;

1. Declare that any bank that is technically bankrupt will be allowed to fall.

2. Set up emergency finance centres where anyone requiring loans can come to with their case. Leave in place until private sector can take up capacity. Just wear a smart suit and have your requirements well set out and justified, you know, like a bank used to be.

3. Put on tin hat and ride it out for a couple of years.

4. Make investment and retail banking legally incompatable in the same organisation.

Is any other solution actually going to do anything better than that?

Nice idea, but you wouldn’t be able to do no.2 there in time before the entrie eonomy collapsed as a result of no.1.

[Extradry Martini]

you seem to be calling for coordinated action......and gordon has trumpeted often enough about leading the way and coordinated responses. But isn't it just the case that this is......

the depression we have to have.

My worry is that this becomes much, much worse than a simple depression....

[Extradry Martini]

The problem is debt.

I have seen no evidence of any govt / central bank addressing this issue.

Until they do we increasing the crash factor speed.

If you where an investor why would you want to reposses? The likely outcome is that you would realise big losses. Instead of getting all your money back you might get 50% back.

If you are a pension fund this is going to be a bit of a problem, stretching out the time of the loan may be very beneficial to you in the long term. However I accept you might increase your losses. But this is the catch 22 scenario you need to avoid at all costs but yet the policy makers have got here.

The holders of the triple-A tranches get piad out first, so they get 100% back, while those further down get nothing.

[getdoon_weebobby]

thanks EDM

appreciate your honest post.

this does feel the quiet before a massive storm

this g20 meeting seems to be the defining moment. if they dont come up with a miracle i dont know what is going to happen

[Converted Lurker]

My worry is that this becomes much, much worse than a simple depression....

eh?

[bogbrush]

Nice idea, but you wouldn’t be able to do no.2 there in time before the entrie eonomy collapsed as a result of no.1.

Why not? We already own some significant banking infrastructure, just turn it over to that purpose. With a will, it's doable in a week.

[Blue Peter]

As always, thanks for this.

Is it fair to say, in a nutshell, that we, as a world, have spent more than we possess? The only solution to this is to find ways of getting the less feckless now and all of us in the future to pony up the difference. The micro problems which you describe lie in:

1. How to do this in a vaguely fair (= "politically acceptable") way;

2. How to do this without causing some inbalance in things, so crashing the system.

Do you see the problems lying more with (1) or (2)? or something else?

Peter.

[Extradry Martini]

You've assumed they want to help.

Why?

That's right - I am indeed assuming they want to avoid starvation and disease, yes.

[getdoon_weebobby]

My worry is that this becomes much, much worse than a simple depression....

what exactly do you think could be about to happen?

[Extradry Martini]

As always, thanks for this.

Is it fair to say, in a nutshell, that we, as a world, have spent more than we possess? The only solution to this is to find ways of getting the less feckless now and all of us in the future to pony up the difference. The micro problems which you describe lie in:

1. How to do this in a vaguely fair (= "politically acceptable") way;

2. How to do this without causing some inbalance in things, so crashing the system.

Do you see the problems lying more with (1) or (2)? or something else?

Peter.

The problems I see are more in no.1 there, but I think an Alexandrian solution is needed.

In answer to your other question, no on a global level, savings and borrowings match, but we have an enormous crisis of confidence (far more extended than the pre-crisis over-confidence) in just about everything, which means that those with savigns aren't spednign them or lending them.

[Injin]

That's right - I am indeed assuming they want to avoid starvation and disease, yes.

You misunderstand.

Youve assumed they want to avoid those things for everyone, instead of just them.

Why?

[Extradry Martini]

thanks EDM

appreciate your honest post.

this does feel the quiet before a massive storm

this g20 meeting seems to be the defining moment. if they dont come up with a miracle i dont know what is going to happen

They have a lot of work to do - let's hope they do it.

[R K]

Denninger has been talking about "cramdown" for some time.

i.e. bank equity holders get wiped out, pref shares get converted to equity and so on.....

I agree Geithner is not giving any sort of message that he has a plan. I'm hoping Volcker may have one behind the scenes.

I don't understand why the politicians here for instance don't just nationalise the bank and be done with it. Taxpayer is ultimate back stop for the liabilities anyhow so what's the difference? Nobody seems to have any cojones.

[bogbrush]

You misunderstand.

Youve assumed they want to avoid those things for everyone, instead of just them.

Why?

I think they probably do want to avoid it Injin, but only because revolutions are awkward things to control and can result in unplanned outcomes.

[Extradry Martini]

eh?

what exactly do you think could be about to happen?

A sudden and complete collapse of the economy caused by the inability to access finance of any sort. Supply chains of food, medicine, fuel and other energy forms breaking, causing widespread starvation and disease - even if the supply chains are down only for a few weeks.

[wonderpup]

Watching CNBC the Americans seem to be terrifed that they are turning into Sweden (Apparently their worst case scenario of a socialist state )

It seems bizzare to me, watching this pundit guy called Reilly agonizing about wether the US is turning into a socialist state, whilst sitting in a bankrupt country being propped up by the Chinese???

To what degree do you think this pathological aversion to 'socialisem' is staying the government's hand over there?

[Methinkshe]

My worry is that this becomes much, much worse than a simple depression....

Mine, too - whether it proves to be a deflationary depression or an inflationary depression - but let's not go there again!

Good initial analysis, btw.

Whichever way I look at the problems facing policy-makers, and I do so with very little knowledge, but even so I keep coming up against the potential for undesirable side or knock-on effects and worse still a potential for unintended consequences.

Thus, helping out home-owners, for instance, could result in a counter-productive rush into housing by those who do not have mortgages but do not want to miss out on what could be perceived as a freebie. Or, if such measures were so cleverly implemented as to exclude any band-wagonners, it could lead to an, it's not fair type of social unrest.

Whichever aspect of the crisis one examines, it is this type of issue that makes any action so difficult - and that's just at a social level.

I'm more and more inclined to think that the global financial system is imploding/has imploded to a point where it cannot be resurrected and that` therefore the only solution will be a new global electronic currency administered by a global bank/financial centre.

[Extradry Martini]

Why not? We already own some significant banking infrastructure, just turn it over to that purpose. With a will, it's doable in a week.

Better to nationalise the banks and use their infrastructure - you have a chance of avoiding the meltdown that way.