The Cure for the U.S. Financial System?

I don’t care if Monday’s black

Tuesday, Wednesday – heart attack

Thursday, never looking back

It’s Friday, I’m in love

Goes a rock band The Cure’s 1992 hit “Friday I’m in Love.” Lots of love in the stock market on Friday after the Treasury announced a program to deal with the financial crisis comprehensively. Will this be the cure for the U.S. financial system?

In the last posting on September 18, I wrote:

Perhaps we would be better off with a similar mechanism of temporary nationalization of systemically important investment banks, insurance companies, and other financial institutions, but it will take time (and the Congress’s involvement) to institute that. Until then, the Treasury and the Federal Reserve may have to continue improvising. The financial market will continue guessing. The financial crisis may not end until the regulators establish a rule on these interventions and the market comes to clear understanding of the rule.

The government announcement on a comprehensive plan is welcome in this sense, because that can start the process of establishing a clearly understood rule of interventions. The plan announced on Friday, however, has many problems.

According to the news reports, the core of the plan includes (1) insurance for money market funds provided by the Federal Reserve, (2) government facility set up by the Treasury to buy troubled mortgage assets, and (3) the SEC’s ban on short-selling on financial stocks.

The insurance for money market funds is a response to the seizure of the short-term credit markets following the failure of Lehman. To the extent that the problem comes from a bank run-like phenomenon on short-term credits, the insurance would help stopping the run. But this also introduces all sorts of problems associated with deposit insurance to the market that did not have those problems. Most importantly, the insurance reduce the incentives for investors to evaluate the risk of money market funds and blunts the market discipline.

In many episodes of financial crises in various parts of the world, we have observed many governments set up asset management companies to buy problem assets. Except for a few exceptions, such as RTC that the U.S. set up to resolve the S&L crisis in the 1980s and the asset management companies in the Scandinavian countries in the 1990s, these government-run asset management companies just turned into warehouses of bad assets: they bought the assets but did not sell for a long time. The problem loans are thus kept on the balance sheet of the governments without serious restructuring. Thus, many asset management companies just ended up delaying the resolution of the bad assets.

As Anil Kashyap and I discussed a few years ago (“Solutions to Japan’s Banking Problems: What Might Work and What Definitely Will Fail” in Hugh Patrick, Takatoshi Ito, and David Weinstein (Eds.) Reviving Japan’s Economy: Problems and Prescriptions. Cambridge, MA: MIT Press, pp.147-195, 2005.), Japan also had a series of asset management companies, many of which removed some bad loans from banks’ balance sheets but just held on to those assets. Only in the 2000s, the true restructurings of the problem assets started. IRCJ (Industrial Revitalization Corporation of Japan), which was set up by the government in 2003 to deal with the restructuring of bad loans, and the development for the market for distressed loans participated by many private equity funds, finally changed the situation. Thus, Japanese experience tells us that dealing with troubled borrowers is more important than just buying up troubled assets, which supports Nouriel Roubini’s argument that HOLC-like institution would be more useful than RTC-like institution.

Finally, the ban on short-selling reminds many observers of the Japanese finance the episode of PKO following the collapse of the stock prices in Japan in the early 1990s. PKO stands for Price Keeping Operation (dubbed after UN’s Peace Keeping Operation). To prevent the stock prices from falling further, Japanese government used postal saving and other funds they can use to intervene in the stock market. Of course, the procedures are different, but both government buying of stocks and ban on short-selling (if successful) reduce the excess supply in the stock market, and they are the same in this sense. We all know the PKO did not stop the fall of the stock prices in Japan: it just delayed the process of decline (and recovery eventually).

What I find most important is what is not included in this plan. The plan does not include any clear government approach on (near) insolvency of large financial institutions. Would the AIG case become the norm or the Lehman case? Where will they draw the line? The plan as of now is silent on this issue. So the market has no choice but keep on guessing.

One Response to "The Cure for the U.S. Financial System?"

  1. Chris   September 21, 2008 at 5:55 pm

    I have been watching with dismay, over the last several years, the developments in USA economy and her financial system. The financial and banking elite led by the Wall Street created an enormous credit bubble which eventually encompassed the whole world. These people were selling worthless paper all over the world extracting huge, hundreds of billions of dollars worth of fees in the process. Now when the whole Ponzi scheme was exposed and the paper that the Wall Street sold turned out to be nothing but the worthless toxic waste, the resulting trillion dollar loses are being dumped onto the innocent US taxpayer.This is socialization of loses and privatization of profits at its worst. When will the looting of the taxpayer end? This is the greatest transfer of wealth from the Main Street to the Walls Street in US history and it MUST be stopped. Giving absolute power and mandate to deal with the crisis to Mr. Paulson, unelected official, the man who while working at Goldman Sachs, was the chief architect of the Wall Street generated Ponzi scheme that is underming the world financial system is beyond comprehension. To add salt to injury, the people who looted the entire world are not only allowed to keep the spoils of their crime, but are also rewarded with the job of running the new program. How many more trillions of dollars are they going to steal from the taxpayer? By voting for this heinous bill you give Wall Street green light to embark on the next round of looting, and another one, ad infinitum. This is an ultimate moral hazard. Where will it stop? When US Treasury is completely bankrupt? NO BAIL OUT FOR GAMBLERS AND FRAUDSTERS. By voting for this legislation you will mortgage not only future of your children, but the children of their children. Although I can?t participate in November 4th elections I can vote with my valet. I will, if this bill is adopted, lose confidence in your legislative, governmental and financial systems, and I will liquidate all my holdings of US treasuries and convert the proceeds into Canadian dollars. I AM AFRAID TO HOLD YOUR CURRENCY AND I REFUSE TO FINANCE THE MOTHER OF ALL FRAUDS.I pray to God that you will fulfill your duty to the American people and vote against this bill. GOD BLESS AMERICA.