Tuesday, April 28, 2009

Democrats Did Not Win 2008 Presidential Election

I wrote this article sometime in October 2008. In the spirit of "celebrating" Obama's first 100 days in office, I have re-posted it. Here is my salute to you, Mr. President!


The Republicrats will win the next U.S. election

The Republicrats are not an officially recognized party, yet for all intents and purposes, they might as well be. They represent, I believe, the symbiotic relationship between the Republicans and Democrats. In between the rhetorical maneuvers of “change” and displays of “patriotism”, lies a commonality that is evident to any impartial observer. This interaction would be quite comical if it were not for the fact that its consequence will prove grave for the entire nation. Sifting through the glib headlines and MSNBC/Fox News sound bites that have come to encompass the “issues”, the fact of the matter is that neither party proposes alternatives to treat the root causes of the problems that bedevil our nation. Hence the term Republicrats. I will take two issues to make my point.

The U.S. currently finds itself with a public debt of about $9.6 trillion; this does not even count the $5.4 trillion liability resulting from the de facto nationalization of Fannie Mae and Freddie Mac or the tens of trillions in other unfounded government liabilities. Since the Reagan administration, Republicans have become intoxicated with spending. Hinging on their interpretation of supply-side economics, they believed that lowering taxes would increase government receipts (this is the famous Laffer Curve), thus giving them the ability to spend without little constraint. They have “reasoned correctly from this erroneous premise.” Democrats, on the other hand, have had an equally nefarious record. They will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. In fact, public debt increased during Clinton’s Presidency. According to Treasury Direct, an agency of the U.S. Bureau of Public Debt, Mr. Clinton’s administration added about $1.5 trillion public debt. Currently, our nation needs to borrow $2.5 billion dollars, primarily from foreign sources, on a daily basis to meet its bills. Making matters worst is the fact that the dollars backing the debt have been printed out of thin air—thanks to the U.S. Treasury Dept. and the Federal Reserve System. The excessive supply of dollars has not translated into higher prices in the U.S. because foreign governments have had an insatiable appetite to acquire them. If one assumes that the foreigners will always crave dollars, then the U.S. will continue to get a free ride. If one assumes the contrary, more unpalatable consequences are surely to come. Despite this ominous forecast, neither party has candidly addressed this issue. Instead they talk about more spending, giving more money away to other nations, and continuing to use government credit to bail out corporations.

On the foreign policy front, the theme repeats itself. Neither party has relinquished its imperial ambitions to embrace peaceful multilateral relations—an absolute must in order to foster international trade. Democrats offer “no imperialism without representation”; that is, a continued belligerent foreign policy, as long as there is world consensus. Republicans, well, it goes without saying that they are the party of “perpetual war for perpetual peace”. The U.S. Constitution gives authority to declare war only to Congress. Yet, hearing presumptive presidential and vice-presidential candidates these days one wouldn’t think that. In fact, rarely anyone mentions that Congress never declared war on Iraq; a resolution was passed but never a declaration. I can only come to the conclusion that continued breach of U.S. law will prevail. So as a net result, one party wants to take the U.S. citizen out to McDonalds while the other one proposes Berger King.

The solution to these problems begins with individuals once again attaching importance to an aphorism from prior generations: never believe anyone who says, “I’m from the government and am here to help you.”

Thursday, April 23, 2009

How Washington can prevent ‘zombie banks’ - My Critique

James Baker, Reagan and Bush’s former Chief of Staff and renown political advisor, recently wrote a column in the Financial Times proposing measures to stymie bank’s insolvency. I present a critique of his argument. Note that the italized sections of this missive represent Mr. Baker's words, while the bold sections represent my refutations.


Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America’s tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting “zombie banks” – neither alive nor dead – could not support economic growth.
A period of feeble economic performance called Japan’s “lost decade” resulted.Unfortunately, the US may be repeating Japan’s mistake by viewing our current banking crisis as one of liquidity and not solvency. Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover.
But if their assumption is wrong, we risk perpetuating US zombie banks and suffering a lost American decade.

[This assumption is in fact wrong. We are headed into a prolonged decline. Complicating matters more, the U.S. is in a worse financial condition in comparison to Japan when undertaking the zombie operations.]

Evidence – a mountain of toxic assets, housing market declines, a sharp economic recession, rising unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital – strongly suggests that some American banks face a solvency problem and not merely a liquidity one.

[Agree. The majority of banks requiring government fund are de facto insolvent. If this were not the case, then they would not uphold themselves to onerous additional regulations simply to obtain cheaper funding.]

We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios. We can hope for the best but should be prepared for the worst.

Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.

[I see no necessity to involve public funds in any rescue package, as this will perpetuate the moral hazard. Moreover, would anyone like to try to test the exclusivity of the too-big-to-fail idea? What if Citi of BoA would be the one dissolved? I doubt politicians would let the market take its adequate course.]

To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.

[For the most part, I agree. Bank runs in our time are a highly improbable event because it would mean everyone at the same time would eschew depositing currency in and removing deposits from financial institutions. A bank might fail from a run, but if that money is deposited in another bank, the system survives.]

This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan’s secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment.

[The trouble is that once an industry comes under the claw of government bureaucracy, it is challenging to undue it. And when they do de-nationalize, there is a tremendous risk that the process will be conducted politically. That is, the ripe fruits would go to those politically connected.]

After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations.

The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership. We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts.
To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.

[It is difficult to see politicians who rarely agree on anything substantive suddenly consent to engage in such a complicated operation.]

This approach is not pretty or easy. It will cost a lot of money, with the lion’s share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly.

Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country’s economy collapsed.

Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes. Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy.

[But aren’t these some of the consequences of government manipulation in any sector? All government involvement in economic activity produces a winner and a loser. Both will lobby hard, given that they recognize rent seeking is the way to increase profits, not capital investment and productivity.]

Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach.

[To use a bit of sarcasm to highlight the error in this statement consider your response to a doctor who will treat your symptoms without analyzing what caused it. That will not assist us in preparing the cure for our malady, correct? We need to finger-point the culprits, otherwise we may have a case where the lunatics are running the asylum.]

During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan’s economy. Today, it would be irresponsible if we did not heed our own advice.

[A Biblical Proverb says that like a dog returns to its vomit, so a fools returns to his folly. Fools have been in charge in this country for quite a while. The same folks who never saw this crisis coming are the ones cheerleading when presumably “green shoots” are visible and are advising the end of the recession is nigh. Fortunately, reality cannot be mocked for too long. Or like Moses once utter, “be sure your sin will find you out.”]

Tuesday, April 21, 2009

Why The Treasury Plan Will Fail

The recent economic plan endorsed by Treasury Secretary Geithner will not succeed for two reasons. I will not discuss the complexities of the proposal, but rather point to its inadequacy. The first pitfall of the plan is that it’s based on massive subsidies for economic agents participating in it. Subsidies by their very nature cause distortions in the price mechanism. So while the objective of the Treasury plan is to augment the price discovery process for opaque financial instruments, the government handouts will prevent this from taking place in full measure. Recognizing they have the support of the government (who presumably represent the taxpayers), bidding firms will overpay for the assets. Therefore the situation will create the environment where the latter will reap potentially unlimited rewards but cap its losses in a worst-case scenario. In essence, the government is writing an enormous call option for potential investors. Buyers and sellers will benefit. Assuming no additional regulatory burdens to investors arising for participating in the plan, the cost of the subsidies incurred by government will exceed the benefits for buyers and sellers—a characteristic of all subsidies. The notion that there is such a thing as an optimal subsidy concedes that a committee of economic advisors is superior to private parties interacting in an unhampered market.

The second issue relates to the continued distress banks’ balance sheet will experience, in particular to loan deterioration. The current crisis has dealt primarily with the trading side of financial institutions. The next phase will take place in the so-call banking book, which makes up the non-tradable assets (e.g. loans). Consider the ratio of Net Loan Charge Offs-to-Total Loans at commercial banks: It has climbed significantly since 2006, where it stood just below .2 to the current figure of .95. This same pattern is exhibited for all data series presented in this missive since the aforementioned period. But during the late 1980s/early 1990s, the ratio peaked at around 1.8 (see here). Another key statistic is the Loan Loss Reserves-to-Total Loans ratio, which is lower today (2.30) in comparison to where its peak in 1993 (2.75). But this hides the fact that for commercial banks with assets whose assets fall between $1 billion to $15 billion the gap is much larger. The ratio currently stands at 1.89, significantly lower than its peak of 2.90 registered in 1992 (see here). Those banks with average assets exceeding $15 billion, the ratio is currently 2.53 vis-à-vis approximately 4.70 in 1987 (see here). As can be expected given the severity of the economic crisis, these ratios will increase.

Considering Net Loan Losses-to-Average Total Loans for banks resemble the same behavior. For all banks, the ratio currently reported is of 1.33 compared to its peak of approximately 1.6. For banks with average assets of $1 billion to $15 billion, the ratio currently stands just below 1.2, much lower than the peak amount of about 1.8 in 1991 (see here). For institutions exceeding the $15 billion average assets threshold, the figures are equally abysmal: The ratio currently stands at 1.5, which is much lower than the amount of 2.3 reported in 1990 (see here). But what evidently demonstrates that more difficulty awaits the banking industry, consider the ratio of Non-Performing Loans-to-Total Loans. Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. At its peak for all commercial banks, the ratio stood at 4.88, which is much higher than the current figure of 1.70 (see here). The same ominous gap is present for all banks exceeding $1 billion in average assets (see here, here, and here).

Therefore, we can assess that banks’ balance sheets will continue to get worse. Non-performing loans will increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, is not sufficient to cover the potential losses. Banks starving for capital will be forced to increase this amount and reduce lending to risky borrowers. All this points to more bailouts and failures ahead. The Treasury plan does not address any of these looming troubles.