Washington is turning its attention to the future, having put out most of the financial fires. The crisis seems to be over, but questions remain about how to manage under-capitalized banks and, especially, how to design a financial system for the future that is more robust to adverse shocks. With fiscal stimulus in place and no likelihood of more, financial policy by the Fed and the Treasury is the only active possibility for further action to offset the recession.
The current state of the economy
The stock market thinks that the economy is turning around, and the financial press greeted last Friday’s payroll report with a positive spin, for once. But the news is not good. Here’s payroll employment, compared to the severe recession of 1981-82:
The good news is only the almost invisible inflection in the downward path of jobs.
Apart from the successful effort to prevent the collapse of the financial system, the primary financial action to offset the recession has been the Fed’s adoption of an interest-rate target for interbank lending of essentially zero. Rates on short-term safe assets–Treasury obligations and private instruments enjoying explicit or implicit government guarantees–are close to zero. But, sadly, rates actually paid by most private decision makers are almost as high, or in some cases higher, than before the recession began. The Fed and Treasury’s policies to lower these rates have delivered fairly little so far. Here is the record:
Rates paid by individuals–credit cards, pesonal loans, car loans, and mortgages–have fallen slightly, but by less than the decline in inflation, so the real rates are up a bit. Rates paid by corporations, measured here as BAA bond rates, have risen substantially in nominal terms and even more in real terms. Rates paid by state and local governments have also risen in slightly in nominal terms and more in real terms.
The notion that monetary policy has been highly expansionary–promoted by those looking only at safe government (Treasury) interest rates and at the volume of bank reserves–is plainly incorrect. Rather, higher interest rates are discouraging spending and production.
The Fed is attacking high interest rates by purchasing private debt. Higher demand for any class of debt will drive down the interest rate for that class. One of the important lessons of the past year has been that various interest rates do not all move together in times of severe financial stress (or at other times either). Thus, the Fed has not run out of options after it drives the Fed funds rate to zero. Unfortunately, the Fed is not able to expand its holdings of private securities efficiently. The efficient borrower is the Treasury, which floats short-term debt at very low rates in the world credit market. The buyers placing the highest value of Treasury debt outbid the others, so the debt finds its most desirable home. By contrast, the Fed borrows only from American banks. The Fed currently pays twice as high an interest rate on its borrowings as does the Treasury for its shortest-term borrowings (25 basis points for the Fed; 14 for the Treasury). The Fed displaces other asset holdings in American bank portfolios, whereas the Treasury places its debt in many portfolios around the world. Earlier in the crisis, the Treasury did borrow and place the funds at the Fed’s disposal, providing the efficient approach to Fed expansion, but the Treasury has withdrawn most of those funds. It’s time for the Treasury to resume its past practice on a much larger scale and for the Fed to cut reserves back to more normal levels. The political obstacle to this move is the ceiling on the national debt, which fails to count reserves as part of the debt, so the government can circumvent the ceiling by creating reserves instead of issuing Treasury securities, at a somewhat higher cost.
Current policy for weak financial institutions
Economists are increasingly puzzled by the government’s treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government’s actions for Chrysler and General Motors follow the doctrine. In Chrysler’s case, bankruptcy converts the claims of debtholders into equity, making its new relationship with Fiat financially attractive to Fiat. General Motors may be able to continue as a stand-alone automaker if the claims of its debtholders, including the debt-like claims of retirees, become equity.
By contrast, the government’s current policy for all large financial institutions is to dribble taxpayers’ funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. The government injects funds into AIG, Citigroup, the Bank of America, and many other institutions to keep them just above water. The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the “lost decade.”
The celebrated stress tests, just completed, illustrate the current policy perfectly. The test asks if it is likely that a bank can sustain its current status through the end of 2010. “Sustain” means earn enough from operations and asset returns to cover losses that would occur under a pessimistic macro forecast. The Fed’s white paper describing the tests contains the following remarkable sentence: “While this approach [the stress test] likely captures the bulk of the losses that might be realized on these assets, it is important to note that it does not include the substantial losses that have already been taken.” (page 3) The stress test takes the current condition of the bank as the goal for the future. If the bank can just squeak through the next 20 months with enough profit from operations and margins of investment earnings over the cost of funds to offset increases in reserves for loan losses, then it passes the test. If the bank would have inadequate capital at the end of 2010 under the scenario, it flunks the test and needs more capital. Many large banks including Citigroup and the Bank of America flunked. They need to raise capital to be barely solvent at the end of next year. The test has nothing to do with ensuring that banks are heavily capitalized, ready to resume their normal roles in the economy. The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. The government turned to stress tests, it appears, out of discomfort with the answers the standard capital tests gave, based on seeing that properly measured capital was adequate in relation to obligations.
Unfavorable developments since the design of the stress test raise questions about its interpretation as the most pessimistic reasonable forecast. In the “more adverse” forecast that claimed that character, the unemployment rate is 8.9 percent for 2009 and 10.3 percent for 2010. The rate as of April 2009 was already 8.9 percent and almost certain to rise more during the coming months. The “more adverse” projection of 3.3 percent decline in real GDP in 2009 over 2008 is close to the current consensus. The figure for 2010 of 0.5 is below the consensus.
The market for bank debt tells an interesting story about the current policy (data are available to the public from FINRA’s TRACE database). Citigroup’s debt maturing in the next few years sells at par. The market believes the government’s pronouncement that it will keep Citigroup solvent in the near term. For longer maturities, the debt is deeply discounted. A large issue maturing in 2032, with a coupon rate of 6.625 percent, sold on May 8 for $65 per $100 of par value, to yield 10.8 percent. The market assigns a significant probability to default after the crisis clears up.
The effect of the government’s current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued, had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. This policy is hugely expensive and stands in stark contrast to the losses that the government has expected investors in the debt of automakers to recognize. The Treasury has proposed legislation to empower the government to reorganize financial institutions but has not indicated that the new powers would focus on reorganizations that would recapitalize financial institutions without handing debtholders huge capital gains. The continuation of current policy would automatically give those capital gains. Holders of the Citigroup debt mentioned above would enjoy a large capital gain (from $65 to somewhere near $100) if investors came to believe that the government would keep dribbling funds into Citigroup to enable it to meet all its future obligations, including paying the interest and principal on that debt issue.
Because Congress, acting on behalf of the taxpayers, seems reluctant to vote new bailout funds for most financial institutions and is firmly opposed in the case of AIG, the government needs a better alternative for stabilizing weak institutions. There are much better uses for federal money than handing capital gains to debtholders.
We can easily describe the desirable policy in terms of goals, though implementation is more of a challenge. A primary goal is to avoid interference with the high-speed transactions of modern financial institutions. As the unwinding of Lehman Brothers shows, traditional bankruptcy can be a disorderly method for reorganizing modern financial institutions. The reorganization needs to start with a clear statement that the institution will meet its short-run obligations in full. In other words, some minimal amount of capital gains to claimants is involved in a practical reorganization. If an institution has substantial amounts of debt outstanding that is subordinated to all other claims, reorganization is fairly simple. The danger to the institution is that the subordinated claimants will put the institution into barnkruptcy at some future time when the institution fails to make required payments to those debtholders and that the bankruptcy will plunge the entire organization into Lehman-like chaos. To sidestep this danger, the reorganization alters the claims of the subordinated debtholders so that they cannot trigger a bankruptcy or so that the bankruptcy that they can trigger does not interfere with the activities of the institution.
The first approach is easy. It is the one that the government pushed on the debtholders of the automakers–convert debt to equity. With new powers granted by Congress, the government could figure out a conversion value for a large amount of debt that gave the debtholders the same market value as equity as they currently enjoy. The debtholders would suffer no capital gain or loss. As the experience with automakers’ debt showed, it is virtually impossible to achieve such an exchange voluntarily, because both sides will play “chicken” until adult supervision intervenes. The compulsion of new law is necessary. Finding the conversion value is easier said than done, but is at least a well-posed question.
If a borderline institution lacks enough fully-subordinated debt to achieve an adequate level of capital by converting debt to equity, longer-term debt could be treated as if it were fully subordinated. Again, the debtholders could be given equity equal in value to the market value of the debt they gave up. In this case, the claimants subordinate to the converted debtholders would enjoy a captial gain, at the cost of the shareholders. One could imagine some kind of redistribution to deal with this inequity, but it is a complication. In the case of Citi, the claimants subordinated to the debt to be converted are mainly the foreign depositors. Foreign depositors stand to absorb losses before the debt-holders do. Because the foreign deposits can be withdrawn on demand, even a hint of a policy that failed to deliver full value would trigger a run. Averting the potential for a run in the midst of a bankruptcy, which would surely bring chaos, is the point of the reorganization.
Actual exchanges of debt for equity are not needed to recapitalize shaky institutions. Recall that the goal is to prevent bankruptcy from interfering with substantive business, not to prevent bankruptcy entirely. Reorganizing an institution so that the debtholders retain a debt claim is practical. If the institution suffers further losses in value which cause it to default on the debt, a bankruptcy will occur. Our earlier post described how to do this. In brief, the debtholders’ and existing shareholders’ claims are moved to a holding company (if they are not already in a holding company) which owns all of the equity in the operating institution. Some people, including us in our earlier post, called the holding company the “bad bank” and the operating entity the “good bank.” If the earnings of the operating institution are insufficient to meet the obligations to the debtholders at some future time, the holding company does a simple Chapter 7 bankruptcy in which the debtholders become the shareholders in the holding company, with no implications for the operating institution. This type of reoganization involves quite a few alterations in the contracts between the operating institution and its customers and counterparties, so it definitely requires the kinds of new powers that the Treasury has sought recently from Congress.
The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones, and that Congress should enact legislation promptly that would make these reorganizations possible.
Reform for the longer run
Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government’s protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the statement of the Squam Lake Working Group, an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank. As we discussed above, if the operations of the bank, paid as dividends to the holding company, could not meet the obligations to the debtholders, the holding company would go through a Chapter 7 bankruptcy and the bondholders would take over as shareholders. The Squam Lake proposal would sidestep the bankruptcy by designing the debt to convert to equity on its own terms under adverse conditions.
The idea that banks should have large amounts of fully subordinated debt is hardly new. The only novelty in this line of thought is methods for protecting banks and similar institutions from breakdowns in high-speed financial transactions. And this novelty arises because our financial institutions have new moving parts they did not have even 25 years ago, and because it has been such a long time since our largest banks were so close to insolvent. The regulatory structure has not kept up.
Under a requirement of substantial amounts of subordinated debt, bank deposits would become almost completely safe. Banks would be limited to financing their activities through deposits to the remaining fraction, 60 percent in our example above. For larger banks, this would not be a binding limitation.