Markets have plunged since Congress passed the Emergency Economic Stabilisation Act (also known as Tarp). And financial institutions aren’t the only ones suffering.
Bread and butter companies can’t access the credit they need to buy inventory and raw materials, transport goods to market, invest in new businesses and employ people. Consumer spending is declining along with financing for homes, cars and appliances.
The US government is beginning to recognise that buying up $700bn of toxic assets will not solve the credit crisis or restore financial and economic stability. It will simply shift toxic risk to taxpayers. We need a different solution.
Stabilisation requires either significant recapitalisation of financial institutions – such as those seen in the UK and continental Europe – or government purchases of trillions of dollars of high quality (rather than troubled) assets.
The US government seems inclined toward equity injections. But the latter approach is preferable. It is more transparent, avoids public sector selection of winners and losers, shifts much less risk and offers much greater reward to taxpayers.
Central banks have tried to inject liquidity by cutting rates, expanding access to discount windows and creating new funding programmes, but the flow of credit has been interrupted because the intermediation system is broken.
The root cause of the problem is insufficient equity capital (and too much debt capital) supporting the assets in the system. In other words, too much leverage.
Leverage has increased for two reasons. First, equity has decreased due to write-offs of mortgage loans and their derivatives. Second, assets have increased: assets that were previously hidden have been uncovered and forced back into the leverage equation; assets that were supposedly only in transit got stuck with the banks when the markets closed down; and as collateralised loans to leveraged investors are called in, banks end up holding those investors’ assets, too.
To fix the problem, equity has to be increased or assets reduced. The most realistic estimates suggest the financial sector needs to raise $600-$800bn of capital or sell $6,000-7,000bn of assets (or some combination of the two).
Financial institutions are unable to raise anywhere near that amount of equity in the market. Hence talk of government equity injection. But how will the government decide which institutions to invest in, and at what price? If prices are too low, the strongest institutions will hold out for markets to improve and the taxpayer will end up owning the worst institutions. If prices are too high, the taxpayer will end up with too much risk for too little return and we will have rewarded institutions responsible for their own troubles. How will the taxpayer be protected against excessive risk-taking with the new capital? On the other hand, how can we be certain banks won’t hoard the capital instead of lending it?
Looking at the problem from the asset side, $700bn of Tarp asset purchases won’t help when the system needs to shed $6,000bn-$7,000bn of assets. Moreover, if the Treasury buys bad assets at real market prices, banks will face further write-downs and capital deterioration. Alternatively, if Treasury buys bad assets at inflated prices the taxpayer gets hit and again, institutions responsible for their own troubles are rewarded.
A better approach would be for the government to use $300bn of the Tarp to capitalise a “good bank”. The bank could have access to Fed funding to buy several trillion dollars of high quality corporate and consumer credit from banks or other investors. This could stem the price plunge by effectively allowing the system to deleverage slowly rather than abruptly. These assets are more transparent, less complicated and less risky.
When markets stabilise, the government would unwind the good bank at a profit. In the meantime, assuming the good assets yield 3 per cent more than government debt, the taxpayer would realise an annual profit of up to $150bn. All this on a much less risky portfolio than $700bn of toxic waste, and without the government taking equity stakes in existing financial institutions.
The writer is chief executive for BlueMountain Capital Management.