Monday, April 20, 2009

A better way to calm bank fears

Bank stocks are down sharply today on renewed fears of systemic instability, as bad news out today negates much of the good earnings news of the past few weeks. Turner Radio claims to have the results of the bank stress tests, and reports that they are dreaful (Treasury says they don't have stress test results yet). Bank of America announced today they set aside $6.4 billion to cover more bad loans.

Prof. Ricardo Caballero of MIT offers a simple solution. Instead of requiring banks to raise capital to meet the demands of extreme stress-test scenarios, the government should offer to sell banks insurance against these potential risks. That would go a long way to minimizing the negative feedback loop that has been at work in recent months. Excerpts:

A bank should be required to have as much capital as needed for the central scenario. If aggregate conditions are worse than expected, the government should cover the shortage of capital without equity compensation. If conditions are better than expected, the government should be paid a fee that compensates it for the insurance it provided. The government should charge fairly for this insurance, using the same probabilities it assigns to the different scenarios used in the stress tests. A weak bank needs to contract for more insurance than a strong bank.

It makes no sense that the aggregate risk remains on the most leveraged institutions of the system – which is precisely what got us into this mess. Instead, the way to solve this mismatch is to make fair insurance available to the banks rather than to force them to deleverage at great cost for the entire economy.

HT: Don Luskin


Mark A. Sadowski said...

As bad as the Turner Radio information is with 16 out of the 19 banks insolvent (assuming this is true) things are almost certainly even worse than the stress tests imply. That is because the economy's current trajectory is much worse than even the worst case scenario in the stress tests with unemployment rising faster, GDP falling faster and housing prices falling faster. Nouriel Roubini addressed this recently in Forbes. He called the the stress tests "fudge tests":

I think the problem with Prof. Caballero's proposal is that it rests on the common but (IMO) ill founded assumption that the distressed assets are somehow worth more than the market is suggesting. It would be akin to selling home owner's insurance on a house that clearly is already on fire: no reasonable level of premiums would make the transaction worthwhile to the insurer.

I think we need to face facts and put all of these banks into forced receivership so we can start the process of rehabilitating them. All of this dilly dallying with the large insolvent zombie banks is eerily reminiscent of Japan's Lost Decade. Although forced receivership seems like government intrusion it's actually the market friendly thing to do in the long run.

P.S. Thanks for the link to Turner Radio's inside scoop.

P.P.S. On a slightly different note I came across this today. You might find it of interest based on our previous exchanges:

Scott Grannis said...

I'll disagree with several of your points.

The economy's current trajectory is not pointing to a black hole. There are lots of signs of stabilization, if not yet an actual bottoming. Commodity prices are up, shipping rates are up, retail sales have stopped falling, etc., all things that I have been pointing out for months.

I think the prices of subprime based mortgage securities are indeed distressed. I note that losses from distressed security writedowns already exceed the value of all subprime mortgages and equal a significant fraction of total mortgages. I believe that eventual losses will probably be less than the value of losses already written down. I don't believe for a minute that the market has underestimated the losses by over-pricing these securities. Many of these securities are priced to the assumption that more than half of all mortgages will default and that recovery values will be lower than ever before. While I can't rule out that possibility I think the big increase in home sales activity in many of the distressed markets indicates that prices have adjusted to a market-clearing level.

Blodget's use of the Shiller data is similar to mine, but his conclusions don't necessarily follow. Most importantly, to compare this housing market to that of the 30s and 40s is to totally neglect the fact that monetary policy today is extraordinarily loose while policy then was extraordinarily tight. That alone argues strongly against drawing comparisons of the two. Mortgage rates are now at historic lows, and it is not at all unreasonable to think that cheap mortgages and abundant money creation will put a floor under prices.

Public Library said...

The problem has never been about liquidity but rather credit and or credit quality. Based on the games banks have been playing for 12 months or more, we are not through this storm yet. Until someone gets a handle on what we are truly dealing with, consider market rallies hiccups along the way down.

"So far, central banks have diagnosed the crisis as stemming from a lack of liquidity and have flooded the system; but this is not the cause of the problem. This highlights the fundamental difference between the Great Depression and the current credit crisis. The former was due to liquidity risk, and therefore the remedy was an increase in the supply of money.

But the current crisis is mainly due to credit risk. The wrong diagnosis of the problem has led policymakers to apply the wrong medicine.

The nature of the current crisis as stemming from credit risk is prima facie evidence that the losses of financial institutions may surprise on the upside."

- The Levy Economics Institute

Mark A. Sadowski said...

There are indeed signs that the rate of decline is decreasing (if you want to call that stabilization). But the consensus right now among professional forecasters is that the bottom will not be reached until September. If anything I'm a little more optimistic than most (I currently think the last month of contraction will be July). We are nowhere near the bottom with respect to output. And unemployment will probably rise for 5-7 quarters after that if it is similar to the last two recessions. So far the stress test worst case scenario is looking way too rosy.

I'm convinced we've just seen the tip of the iceberg with respect to mortgage defaults. There's a huge wave of prime ARMs that will reset in 2010-2011. The value of these mortgages completely dwarfs the entire subprime market.

And while housing prices may be close to finishing adjusting in Las Vegas and Phoenix, my sense is that things are only just starting to gather downward momentum in New York and Boston. The different parts of the country are not sychronized.