The grandmother of all bailouts
The rumours of the bailout gave us a huge rally on Friday. Then came the details on Friday afternoon. The Wall Street Journal has the full surprisingly short text of the US government bailout. The scheme gives the government the right to buy dodgy debt securities from any US-headquartered financial institution, i.e. non-banks included (this was apparently later extended to cover some non-US financial institutions as well). The $700m is the amount by which Congress is asked to raise the legal ceiling for national debt – which goes up from $10.6 trillion to $11.3 trillion. But since this is Washington, the Democrats are asking for a quid pro quo, which consists of a stimulus package, so the total will be even higher. Everyone in Washington tried to assure the public that they will do their utmost that this line of funding will not be abused. This is essentially the news. You can read, for example, the Financial Times for a fully comprehensive story, including official reaction.
The first market reactions were relatively neutral on equities, whose rally appears to have ended, and negative on the US dollar. Naked Capitalism has a good comment on the expected market reaction, saying that the bailout will undermine the US’s AAA rating and exact a considerable toll on the dollar. Another big story last night is the decision by the Federal Reserve to grant Goldman Sachs and Morgan Stanley official bank status, which gives them easier access to emergency funding.
Naturally, the bailout has provoked a lot of comment. Here is a selection.
Paul Krugman makes the point that the scheme does not address the underlying problem, which is insufficient capital in the financial sector. Capital would only increase if the Treasury decide to overprice the purchase of assets, and Congress would have every right to resist that. So the financial system continues to be undercapitalised, causing a credit crunch, which the plan does not address. He advocates public injections of capital in return for a stake on the upside, and he concludes: “Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.”
Naked Capitalism, in an article entitled Why You Should Hate the Treasury Bailout Proposal, points out that the plan is going to cost a lot more than $700bn. This is merely a balance sheet item, not an expenditure limit. Furthermore, as the implementation “may not be reviewed by any court of law or any administration agency”, as the US Treasury put in the statement, this is tantamount to a coup d’etat.
Wolfgang Munchau says in his FT column that the costs to the US taxpayer will be a lot more than $700m. It will probably be measured in the trillions. While it provided short term relief, it raises troubling questions, such as the extent to which private sector default risk is being transformed into sovereign risk, about the impact on future economic growth. Furthermore, foreign investors are likely to demand risk premium, which might intensify the crisis. The main risks, including those stemming from the credit default swaps market, are still there.
As of now, there is no reason to think that the crisis is any closer to ending than it was last week.
Willem Buiter says two conditions are necessary for the scheme to work. The first is the right price. It has to be higher than what the banks get at the moment (i.e. somewhat larger than zero), but low enough not to reward the banks for taking excessive risks. Second, the US must beware of what he calls political asset stripping, yielding to the temptation to forgive large parts of the underlying debt, which consists mostly of residential mortgages.
Writing in Vox, Daniel Gros and Stefano Micossi look at the impact on Europe. They make the point that it could not happen in Europe. For once, the financial institution are not only too big to fail, they are also too big to save. Deutsche Bank’s liabilities are around €2 trillion, more than 80% of Germany’s annual GDP. Barclay’s liabilities are larger than Britain’s annual GDP. Fortis’ liabilities are several times the annual GDP of its home country, Belgium. That means if any problem arose here, the only institution that could offer any hope is the ECB, since it is the only institution in the euro area that can provide unlimited amounts of global reserve currencies. Non-euro area countries like Britain and Switzerland are an infinitely worse situation.
And looking further afield:
The German blog Herdentrieb has a nice summary, in German, of Rob Shiller’s latest book, the Subprime Solution, in which he compares the US’ public’s inability to repay debts with Germany’s situation during the 1920s. One of the predictions he makes is that the US will suffer a long period of weak economic growth.
Nouriel Roubini, writing in the Financial Times, says last week’s generalised run on the shadow financial system is likely to move into another phase, this time affecting highly leveraged hedge funds. He also said the real economic implications will be severe, for the US, but also for Europe, whose financial institutions are at risk of sharp losses. He said the financial crisis of the century will also envelop European financial institutions.
Tigher Banking regulation in Europe
Frankfurter Allgemeine has the story that the German banking and securities supervisory Bafin joined the SEC to ban short-sales of a specified number of financial stocks to prevent speculation. They have used some obscure part of German law to do this. (We still don’t get it. Why did they not ban “long sales” during the boom. From a financial stability point it is exactly the same.)
And Financial Times Deutschland has the story from Brussels that the European Commission is planning legislation to force banks to retain some of the risk when selling on credits to third parties, a practice as originate and distribute, which is at the core of the modern securities financial markets.
German government to revise growth forecast
The German government is to revise downwards its 2009 forecast to a mere 0.5%, according to Financial Times Deutschland. The article says this prognosis will almost certain mean that Germany is going to miss its self-imposed target of a balanced budget by 2011, as the automatic stabilisers are working. But the German government is currently considering to make the same mistake it always makes during economic downturn – trying to compensate for a temporary rise in a deficit through structural deficit cuts.
Belgian PM loses majority
Yves Leterme, the Belgian prime minister, has lost his majority, when one of the coalition partners decided over the weekend to pull out and move into opposition, according to Le Monde. The party in question are the ultra-nationalist Flemish separatist party NVA, who were allied to the Flemish Christian Democrats, the party of the prime minister. The NVA is effectively demanding full separation from Wallonia, while the present government is negotiating a much less ambitious scheme that would transfer some powers from the federal to the regional level, but would still leave a considerable federal government in place. The decision could plunge into another political crisis.
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