Almost everyone (including Krugman who should know better) thinks this banking crisis is about inadequate capital caused by losses.
They are wrong. Its about inadequate finance caused by lack of trust.
Let me explain
Nobody I know calculates the total system losses plausibly above 2 trillion dollars. I have had several goes at calculating the losses on this blog. Here is an early attempt at scoping non GSE mortgage losses. If I add the private equity disasters, GSE losses and things like car loans to this I still can't get end credit losses above 1.5 trillion.
That is a vast amount of money – enough for instance to solve most of
So far financial institutions have raised (well) above 400 billion in fresh capital – its probably nearing 500 billion. The Federal Government has absorbed losses through the takeover of Fannie, Freddie, contingent liabilities on Wachovia, AIG and others of maybe 50-200 billion (lets use the low number).
The pre-tax, pre-provision operating profit of S&P financials used to be above 400 billion and is probably still above 350 billion. Two years of that and there is another 700 billion.
The banks had some capital to start with – in some cases excess capital against regulatory standards.
All up – we have almost certainly raised or passed to the government – or within two years will have earned – something approaching 1.5 trillion.
There is no capital shortage. Get used to it. The Krugman endorsement of the idea that you can’t save the financial system if you can’t read a balance sheet is dumb.
The problem is the problem that begets all sharp-shock financial crises – which is just the sheer erosion of trust. [I consider Japan to be a slow burn financial crisis whereas Korea was more like America.]
The erosion of trust was caused by lies
Wall Street and big banks sold lies for years. I wrote once that the lies that destroyed Bear Stearns were told by Bear Stearns (note unfortunate investment theme in the link!). The lies that are now destroying the whole of American Finance were told by American Financial Institutions. The creditors simply do not believe any more.
What is needed to make this crisis go away is the re-emergence of trust. When that happens people will lend to American financial institutions and they will stop failing.
American financial institutions require lots of wholesale funding – far more wholesale funding than they require in equity. The crisis is not about the equity holders - its about the debt financiers of the US financial system.
Wholesale funding is just not available. The banks are all subject to modern bank runs – the mass failure to roll or withdrawal of wholesale funding.
There are several ways that the wholesale funding can be either replaced or rolled. One way is (dare I say it) the original (and deeply suspect) Paulson plan but on a much larger scale. The idea is that rather than securitise the mortgages and other assets on the bank balance sheet and sell the wholesale to people who no longer trust American Financial Institutions you sell them wholesale to the US Government. The US Government funds it wholesale by selling US Treasuries – which – despite weapons of mass destruction and other deceptions – are still widely trusted assets.
The only problem is that the loan – to deposit ratios of the US Financial Institutions are just too high – and pretty well the entire wholesale funding needs to be replaced. Buying 750 billion in assets simply does not do it. Idea works – scale is not big enough.
Moreover the original Paulson plan involved the taxpayer taking considerable risks – and in my view the taxpayer deserves a return for those risks. The usual solution is to give equity (ie the Democrats plan) but when the risks are large enough you wind up giving enough equity to simply nationalise the institutions. That works.
We know it works – we have Sweden/Norway as external examples – and even the takeover of Fannie and Freddie clearly worked – it gave confidence to the people who provide wholesale funding and lowered the price of mortgages.
But nationalisation works not because it injects equity – it works because it injects confidence. It makes the debt of those institutions similar to Treasuries and hence inspires confidence.
I blogged once about how this is a very different situation from
So please – I am begging here – can the pundits get their thinking straight. Its not about equity – its about funding.
Got it. And the problem I have with Sheila Bair is that she thinks it is about loan books – and she scares the funding off. Moreover her takeover of WaMu was almost designed to scare off the funding – and that was dumb and should be a sacking offence.
Please get this right though - its about FUNDING not about CAPITAL. Government action - Sheila included - should be designed as far as possible to give confidence back to the people who fund America.