SERIOUS MONEY:The US administration should switch its focus from toxic assets to easy-to-value good assets, writes CHARLIE FELL
THE AGE of financial liberalisation is over and the economic damage in the wake of its demise is palpable.
The US economy is in the throes of the longest and most severe downturn since the 1930s as massive wealth destruction alongside an ailing financial system continue to present the threat of debt deflation.
House prices have dropped almost 30 per cent from their 2006 peak and stock market averages have more than halved and are only marginally higher in real terms than the secular peak in 1968. The corporate sector has registered quarterly losses for the first time in SP history while the unemployment rate looks set to reach double-digits before the end of the year.
Aggressive steps have been taken through the adoption of unconventional monetary policies and a large fiscal stimulus but this will matter little as long as the US administration continues to hope for the best and implement less than credible policies with regard to the centrepiece of the current crisis – the sick financial system.
Dithering just won’t do. In the words of Winston Churchill in 1925, effective action needs to be taken that sees “finance less proud and industry more content”.
The basic business of banking is vulnerable to sporadic crises because financial institutions fund their illiquid loan portfolios – that can only be priced imperfectly – with short-term liabilities that are seen as redeemable at par.
But deregulation led to greater competition and a search for higher returns – activities that increased structural vulnerabilities. The telltale signs included: an increased dependency on short-term debt over deposits; a decline in liquidity as difficult-to-value structured finance products garnered an increased share of investment portfolios; reduced diversification as the combined exposure to real estate in loan and investment portfolios grew; and increased leverage through the use of off-balance-sheet special purpose vehicles.
In essence, the banks borrowed too much relative to their capital and used those funds to purchase assets that have proved toxic. The industry is now awash in red ink.
The financial system is broken and all rehabilitation efforts to date have fallen short. The troubled asset relief programme, or Tarp, introduced last October allowed the US Treasury to purchase up to $700 billion (€548 billion) of “troubled” assets, but this approach was quickly abandoned as it proved technically unfeasible.
The programme was subsequently reoriented towards the recapitalisation of the banks through preferred shares, but this has clearly failed to restore confidence as the drain on cash flows prevents the banks from rebuilding their equity base.
The US administration also encouraged the marriage of several high-profile names. As a result, the top four now control 64 per cent of all commercial bank assets. The share prices of each of these behemoths is now wholly speculative, representing nothing more than out-of-the-money call options on the underlying assets.
Dithering has proved costly. Neither insolvent nor solvent banks have much incentive to lend. They hoard cash to maintain liquidity as short-term liabilities come due.
Forceful action is needed to return the banks to their primary role as a capital conduit from those with savings to those in need of funds for investment projects. The current stress testing does not fit the bill and assumptions for the worst-case scenario are becoming more like the base-case scenario every day.
Perhaps the US administration should switch from the focus on toxic assets to easy-to-value good assets.
An effective plan should be directed towards the creation of new banks and not on preserving the status quo.
Funds could be used to purchase the good assets. The new bank would also absorb the deposit base of the old bank.
Staff up to middle management could be transferred to the new bank so the existing franchise would be preserved.
Confidence should return quickly as long as the new bank is well capitalised from the start.
The bad bank would retain senior management and all operating functions would cease immediately. It would simply be a financial fund with responsibility for the management of toxic assets. Should further asset impairment erode the remaining equity base, shareholders would be eliminated and bondholders would be left to fight over the remaining assets.
No further government injections would be provided and both shareholders and bondholders would quite rightly bear capital losses for capitalising the bad policies of management.
The financial system remains impaired and the measures to date have not inspired confidence.
The living-dead banks are proving costly and the economy has little hope of moving forward without radical action.
Absorb the good assets and deposits into a new bank and leave the toxic assets with top management in a financial fund.
The time for action is now.
charliefell@sequoia.ie
