Bank Fiction

Last week the Financial Times ran an excellent article called "Chronicle of a Decline Foretold" by Niall Ferguson in their FTWeekend section. It was a work of fiction, an imaginary year-end summary of the economic events of 2009. You should have a look.

In it, he notes:
In 2008, the Bank of England had estimated total losses on toxic assets at about $2.8 trillion. Yet total bank writedowns by the end of 2008 were little more than $583bn, while total capital raised was just $435bn. Losses, in other words, were either being massively understated, or they had been incurred outside the banking system.

He later invents a quote from an "indignant Michigan lawmaker":
"Nobody wants to face the fact that these institutions [the banks] are bust. Not only have they lost all of their capital ... If we genuinely marked their assets to market, they would have lost it twice over."

As I noted in an earlier post, banks are lying about the amounts of unmarketable mortgage securities on their books. Existing law requires banks to mark them to market prices at each quarterly or annual earnings filing. While there is expanded wiggle room covering securities for which there is no efficient market to trade them, the banks still must make a good faith effort to value them and offer an explanation of the valuation methodology. They are simply not valuing hard-to-sell securities at what they're truly worth and they're not facing any pressure from financial regulators to do so.

You can see my earlier post for what I think ought to be done about it.

Mr. Ferguson's story also contains an amusing and accurate title for the economic event of which we are in the midst: The Great Repression, because no one wants to believe it is going to be as bad as it really will be.

posted 15:42:54 on 01/04/09 by blucas - Economy - comments

"Mixed-Income" Is a Bad Word

In the midst of a depression is not the ideal time to talk about housing developments, especially when the depression was caused by housing speculation. But here goes anyway ...

Detroit has seen numerous attempts to "revitalize" the city since people realized how much tax revenue disappeared after the white flight of the 1960s and 1970s. Many of these attempts have included proposals for mixed-income housing developments in or near downtown or the riverfront. For any of these revitalization efforts to have a chance of success, however, they cannot include mixed-income housing.

Rich people pay a lot more in taxes than poor people. If you want rich people to pay taxes in your city, you have to give them an environment where they do not have to work harder to stay rich just because of where they choose to live. If you tell them that they have to live with poor people in order to live in the shiny new downtown development in your city, they will not choose to live there. They have a fear, right or wrong, that the poor people next door will take their belongings if given a chance.

Affluent housing areas have a way of preserving and breeding other affluent housing areas nearby. Look at the West Village district. While it is not "rich", the preservation of wealth in the adjacent Indian Village neighborhood has stabilized West Village. But because it is not buffered from the poor areas of East Grand Boulevard stretching up to and past Mack, it has not prospered to the degree its excellent housing stock would predict.

The riverfront, the Cultural District, and Brush Park should be valuable and expensive areas to live in. Why have they not developed into a high-cost housing districts? My contention is that every time the powers-that-be in Detroit talk about revitalizing an area, they start talking about how it has to directly benefit all Detroiters (i.e., poor people, too). I'm sorry, but there are square miles upon square miles of available housing in Detroit. The shortage that affects them the most is employment, not housing. If you can successfully create a large high-rent district close to downtown that is buffered from concentrations of poor people, you will create jobs that will benefit all Detroiters.

The next time some community leader mentions "mixed-income" when talking about Detroit development, ask them why the upper-income segment they are targetting as customers would want to participate. And if they have an answer for that, ask them why the development should not cater completely to that upper-income segment in order to maximize the benefit for the backers of the project.

posted 11:05:25 on 12/23/08 by blucas - Economy - comments

A Crack in China's Export Economy

The value of Chinese exports dropped 2.2% in November, the first year-on-year drop since the 2001 and the biggest since 1999. Since we are only at the beginning of what might be a long recession, there are likely further falls in line. As domestic demand is not picking up the slack, China may be in a precarious position internally.

China has moved millions of citizens to urban manufacturing centers in recent years and given them a taste of hard cash and buying power. If foreign demand keeps dropping, many of these are going to be out of work. The great fear of China's leaders is that they will lose control of domestic order. Having millions of people with no money, no jobs, and time on their hands is a recipe for social unrest, especially if the recession continues or worsens into the Summer of 2009. (Summer heat feeds anger.)

What can the leaders do about it? First, they could attempt to stimulate domestic demand in order to keep people working. This may drain a big chunk of their accumulated cash reserves, but this is a huge pile of cash we're talking about. They also have to be careful in how they encourage local consumption, as other nations will be watching for signs of protectionism and may retaliate, which could drop external demand further.

Second, they could "persuade" businesses, including banks that extend credit to those businesses, to run at a loss until the crisis passes. They have done this recently with oil refiners, who had to pay market prices for crude while being restricted to price limits in selling gas and fuel oil domestically. Businesses, however, will quietly cheat on other fronts, like dropping quality or selling into shortages in the gray market. The former will cause problems with exports, and the latter will fan the flames of consumers as it pushes them into higher prices in the gray market to compensate for shortages.

Third, they could pre-emptively crack down now on any signs of domestic unrest. This actually is a given. The country's cash reserves could easily compensate all the military and police needed to preserve order. This runs the risk, though, of strengthening the military's hand in internal politics, which in turn risks shifting the national priorities away from maximum employment and towards military build-up. In the long run, they may take their eye off the root of the domestic order problem.

Then again, this could all be wishful thinking if the presumed strength of the Chinese economy is what the business world says it is.

posted 14:57:55 on 12/11/08 by blucas - Economy - comments

"Troubled Assets" Need to Be Valued

The Financial Times on Monday (2008.11.10) carried an article quoting Tim Ryan, president of the Securities Industry and Financial Markets Association, as saying that the Troubled Asset Recovery Program (TARP) needed to start buying the troubled assets at the heart of the credit/financial crisis. I completely agree.

The program was created on the theory that uncertainty in the value of these troubled assets left lenders unsure of the risk of loaning to any other financial institutions. They simply would not extend any credit because they could not confirm that the borrower did not have an unhealthy amount of these "toxic" assets and would not default, even over the short term.

Pre-existing "mark-to-market" regulations regarding these sorts of assets should have had banks completing their write-downs by now. (I'll use the term "banks" here to mean all financial institutions that might own such assets.) None of these assets has appreciated this calendar year, so any financial statements before October should have reflected the difficulty of selling the assets and should have valued all of them at presumed market value, or near zero. (It was not until October 1st that the SEC issued an interpretation of the mark-to-market rule that allowed banks more latitude in evading purely market-based valuations.) It is obvious and ignored that most banks have blatantly disregarded this rule, the likely reason being that had they marked their assets to market, their capitalization would have fallen below regulatory limits, leading to credit downgrades and putting them on the road to failure.

Yet we're still hearing about more write-downs. Obviously banks are only making public a level of loss which keeps them just barely above the level at which investors will believe they are about to fail. So at the heart of the crisis still is uncertainty about the value of hidden assets on bank balance sheets. Even with increased capitalization from US Treasury infusions, we don't know which institutions will make public a level of loss on these assets that makes their survival unlikely, and we don't know when they'll choose to divulge such information.

There will be no market setting of the value of such securities without the Treasury's lead, and therefore the Treasury has enormous power to set the value of these securities to accomplish whatever priorities it sees fit. What priorities should it set?

Obviously, since it is buying (some of) the assets itself on behalf of the US taxpayer, it should intend to make a profit on them. This is easier said than done, since even a knock-down value on them could produce a loss if the US economy grinds to a halt. So targeting a price based on predicted profitability is a risky strategy.

It could try to keep the financial institutions healthy by targeting a value that it believes the assets could reach if held to maturity, but this seems to be flying into the face of taxpayer and economist revolts. Taxpayers do not want highly compensated "Wall Street" executives to get rewarded for running their banks into the ground with bad decisions, and economists similarly to not want to encourage actions that will result in the "moral hazard" of executives believing that they will be bailed out in the future after taking unwise risks. The taxpayers and economists both want bad decisions to result in failure.

So the prominent priorities in valuing the assets seem to be in pushing the prices down. How low is too low? They become too low when too many institutions fail. If too many institutions fail, the FDIC will fail, and all investor confidence in the banking system will fail with it.

This therefore leads to the sole priority the Treasury should follow in buying troubled assets: it should target a desired failure rate for banks and other financial institutions, and should value the troubled assets at the level which will achieve that failure rate. Targeting a bank failure rate will keep asset purchase prices for the US government to the lowest level possible, will satisfy taxpayers desire to punish at least some of the individuals and institutions responsible for the crisis, and will remove the uncertainty from the books of those banks which accurately report their holdings and which did not buy too many risky investments in the first place.

After the prices are set, it will be up to banks to mark their assets to the levels set by the Treasury. Some, of course, will still not report or value troubled assets on their books for fear of failure. They might fail a year or two later after trying to lie their way through it for a while. The Sarbanes-Oxley law, however, remains a tool with which to prosecute any such executives that fail to come clean when the asset values are set.

The Treasury will have to rely on Depression-era data on bank failures and sentiment in order to determine what is a "tolerable" level of failures. I'm guessing that 1 - 3% of banks might be acceptable. Some failures may lead to other failures. However, the fact that the Treasury has at its disposal the tool of making direct capital investments into banks should provide a stop-valve for any domino effect. Of course this means that it will "play God" to some degree in who survives and who fails, but this activity should be limited to the after-effects of failures as opposed to failures caused by the presence of high levels of troubled assets on banks' books.

posted 18:00:00 on 11/11/08 by blucas - Economy - comments

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