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Wall Street in Crisis

Speakers: Sebastian Mallaby, Director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations, and Roger M. Kubarych, Henry Kaufman Adjunct Senior Fellow for International Economics and Finance, Council on Foreign Relations
September 17, 2008
Council on Foreign Relations

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OPERATOR: It is now my pleasure to turn this morning's conference over to Sebastian Mallaby. Sir, you may begin.

MR. MALLABY: Good morning everyone. Welcome to the Council on Foreign Relations conference call on the financial crisis. I'm Sebastian Mallaby. I direct the Center for Geoeconomics Studies at the Council. And with me is Roger Kubarych who is a senior adjunct fellow at the Center, also chief U.S. economist for the UniCredit Bank which is one of the major players in Europe. And he is also, as he says, a man who has lived through a lot of Wall Street crises.

We apologize for starting slightly late. We had an amazing 415 people who signed up for this call, so simply getting people on to the call took some minutes. Thank you for bearing with us. And because we've got a lot of people on the call, and because some of you are absolutely in the thick of what's been going on in the past few days, we want to leave time for questions. So Roger and I are going to engage in a little back and forth for maybe 15 minutes and then we'll open it up to you, so please do have your questions ready.

Everyone wants to know what's going to happen next, what policymakers ought to do. But at the Center for Geoeconomic Studies, we also try at the same time to have a bit of perspective and to think particularly about the international and foreign policy angles on what's going on. So we're going to try and do a bit of both. And I thought I'd start off with one question which has got an international side to it.

Roger, you emailed me at 7 a.m. on Monday morning saying that the U.S. investment bank model had been discredited, that the European-favored universal bank model has come out of this pretty well. Since then, a lot of people have been picking up on what you said three days ago, which now seems like an eternity in these markets. You know, Morgan Stanley, Goldman Sachs, both down again today. And whereas European players like UBS took enormous hits on their investments in CDOs, they're still around to tell the story.

To European banks -- the universal banks, or maybe to Chinese acquirers, there's talk of a Chinese player taking a stake in Morgan Stanley today. How do you think this shakes out in terms of relative power of U.S. banks versus foreign competitors?

MR. KUBARYCH: I don't think the U.S. investment banking model can work anymore because they are dependent on so much leverage as part of their newly core business of proprietary trading and being involved in credit default swap markets and other things that require access -- continuous access to credit markets. And really the only way of guaranteeing that, being that in times of stress, is having access to the central bank. And they can't depend on special facilities forever. And my guess is that that will be the driving factor that will lead to convergence to the universal bank model for the remaining U.S. investment banks.

MR. MALLABY: So you see more of a convergence to that model. Do you think that also entails a shift in power to non-American financial institutions?

MR. KUBARYCH: Well, there's no doubt that if you talk to Asian clients, Middle-Eastern clients, what has happened here with the subprime mortgage crisis and the collapse of the CDO market, the collapse of SIVs, special investment vehicles, has left a very bad taste and it'll take a long time for U.S. names to rebuild the level of credibility and confidence that they had before this. But that's not forever because Europe has problems. Not all European banks are as skillfully managed as they might. And the Asian banks which are coming to the fore in many ways are not natural risk takers and there is a market for risk taking that U.S. firms will fill and even better when they're part of a universal bank.

MR. MALLABY: Right. One I have in the back of my mind is in that period between the Wall Street crash of 1987 and the Japanese market downturn. Some two and a quarter years after that, there was a period when people said, look, stock market based finance in the United States has messed up. Portfolio insurance, which at the time was the fancy new financial product, was blamed maybe wrongly or exaggeratedly so for that crash, but nonetheless it was blamed. And so people started saying, look, traditional bank based European or Japanese capitalism is more robust and long-termist -- that was a popular phrase then -- than this short term, this crazy gambling that goes on in the American economy. And so there was some sort of a talk of a shift in the dominant economic model. And, I'm wondering whether you see a repeat of that or whether you think there's really no alternative out there to a kind of securitized derivatives-based financial model that has been developed most dramatically in the U.S.

MR. KUBARYCH: Well the securitization fad was overdone. There's no doubt about it. But it's fundamentally useful and provides what (__?) has done right and with adequate controls and basically paying attention to the behavior, the underlying credits and borrowers that go into a pool. It provides a service and now it's part of various indexes. It's basically pooling of securitized assets in the ways that people are used to. And I think that once the current pressures wear off, we'll get back to a simpler and more understandable product and really the buy side rules.

The buy side is looking for essentially some yield improvement over U.S. treasuries without taking a lot of risk. They didn't think they were taking a lot of risk buying CDOs. But clearly the rating agencies were totally incompetent in their ability to put ratings on something that was so new and so unlike anything they'd ever done before, and intellectually, they should have stood back and said we can do that business. If the ratings hadn't been high, the buy side wouldn't have bought so much and the whole thing would have been viewed as experimental rather than as the greatest thing in history.

I'm very allergic to the term innovative because securitization was not an innovation. It was really started in force in the 1980s and was really perfected. It was an established practice. But then it got perverted and that's a whole story, but we can learn the lessons of that perversion and go back to a simpler form of securitization at which U.S. and European banks are very good at.

MR. MALLABY: Yes. I've heard people talk about a parallel between -- I mean, as you say, securitization of mortgages and other assets was perfected in the '80s. It went in the early '90s into this phase of stripping out interest-only and principal-only parts of those securitizations I think. And that was part of the story in 1994 when the hedge fund Granite Capital blew up and there was a huge bond market sell-off. And I think out of that mess there came a simplification of the types of fixed income instruments people were willing to buy, and that whole system was stabilized at least for a while. Is that how you remember it, too?

MR. KUBARYCH: Yeah. But then it went haywire again after 2002 in a very serious way and very damaging way. But that won't -- that won't come back and -- but what will come back is securitization of business loans and other things that make sense but with lots more transparency and clarity.

MR. MALLABY: Do you expect in all this to see significant consequences for the dollar? I mean, after all if the buy side, as you say, feels it was burnt by rating agencies that put the wrong A rating on these assets, the sort of medium-term willingness to buy U.S. assets that still depend on these ratings may surely be diminished. And on top of that, you've got the perception that the Fed has to target the rescue of the financial system at least as much as it has to think about preserving the purchasing power of the dollar. Put those two things together, are you looking at another bout of dollar weakness like we had before the summer?

MR. KUBARYCH: Well, the difference is that economic conditions are just as important as financial issues for the dollar, and the economies in Europe and parts of Asia are slowing much faster than people would have thought six months ago. And that's probably the reason, the main reason, why the Euro has gone from about 160 to about 145, even touched briefly under 140 the other day. That's a significant downward move in the Euro after an uninterrupted climb that lasted several years because, basically people are now saying, gee, this interest rate differential -- (audio break) -- essentially the European Central Bank will have to respond to their economic weakness and they may actually have a technical recession before we do.

And I'm not -- I don't see major economic growth in Japan. There'll be some economic growth. So basically, that is just as important. And by the way, if you saw what happened in the market yesterday when basically, the quest for absolute quality led to a treasury bill rate of 0.2 percent, the lowest since 1941. I mean this shows that there's no real lack of confidence in the role of the U.S. Treasury as being the best credit around. But there clearly was a total seizing up in the willingness of banks to lend money to each other and their ability to get funding from the main pool, buy side pools in Asia, and in the Middle East.

MR. MALLABY: Right. But I mean people like, for example, Michael Bloomberg yesterday have been talking about this question of the pull back by foreign purchases. And they're not talking, I don't think, about a pull back from U.S. government debt. And, as you say, the demand for that yesterday was absolutely stunning. It's really demand for non-government debt which has disastrously dried up.

MR. KUBARYCH: Yeah, well you have to do more investor-friendly things. You've got to add various protections in the corporate bond market. You have to add perhaps more of a mezzanine finance approach where you're actually offering a blend of both a fixed income and an equity linked product. Something that the buy side can say, that's protecting me and that's giving me more upside potential, and I can see the risks and evaluate them more clearly than the stuff you have been selling me. So basically it's up to the sell side, the investments banks as part of commercial banks, to devise products that will meet these legitimate fears and concerns of buy side investors around the world. And if you respond quickly to them and give them what they need and what they want, you retain them as customers because the sort of sour grapes attitude won't last for long if you can give them a better product.

MR. MALLABY: Well, we sure better hope that the people on Wall Street still have enough energy left over after all these distractions to come up with these products that the buy side wants because otherwise financing that U.S. current account deficit is going to be pretty tough. I mean, one could --

MR. KUBARYCH: Yeah, either that or it's going to be all in direct investment and that's going to lead to a big political question of who can buy which American companies with what conditions. We've already had a flare-up of this on the Dubai Ports World fiasco, and there'll be many, many more instances of that if we rely almost entirely on direct investment and purchases of firms in whole or in part. And so it makes a lot of sense from a foreign relations point of view to have multiple sources of funding of the current account.

MR. MALLABY: Right. I mean, this financial crisis, if we just back up for a second, has hit at a time when it could almost not be worse. We sponsored two pieces of research at the Center for Geoeconomic Studies over the past few months which shed light on this, right? First is a study that looked at investment rules for foreign direct investments and detected a trend of protectionist drift in these foreign direct investment rules so that the ability of countries -- including the U.S. but not just the U.S. -- to absorb foreign capital by way of foreign direct investment has a question mark above it because of political sensitivities over sovereign wealth funds and so forth. So that's on the foreign direct investment side.

Now you've got also questions about portfolio flows, where foreigners pulled back quite some time ago -- the private sector foreigners -- in their appetite for U.S. assets. And it was really government purchases, right, of these U.S. assets, the Chinese central banks, the Russian central banks, the Persian Gulf official reserves as well piling into U.S. assets with this government demand making up the shortfall in private demand for U.S. assets. So the whole system had become dependent on a political decision by China, Russia, the Persian Gulf states and other -- (inaudible) -- countries to have their governments invest in U.S. securities. And I think basing the stability of the dollar on that platform is not a comforting position to be in.

MR. KUBARYCH: Let me tell you, Sebastian, this is a big downside of the government taking over effective control of AIG. What if the new management of AIG is confronted by a demand from the Chinese to scale back their activities because it's now a government-run organization rather than a private organization? One of the biggest crown jewels in the AIG crown is its very significant market share of the Chinese insurance market. And now, we've completely lost that argument. That's on the scrap heap because now we have an institution which is essentially government controlled and how can we make demands on other countries that we are not willing to live by ourselves, now that we've made this truly unprecedented step.

MR. MALLABY: Let met ask one last question before we open it up to people on the call. Please get your questions ready out there. My last question would be, in Washington in the last 24 hours there's been this sort of upsurge in debate in, you know, is there a different way for government to go about the management of this crisis -- a shift, perhaps, from ad hoc responses to something more systematic like the Resolution Trust Corporation in the 80s and 90s. What's your memory of how that worked out, and do you think that policy ought to be driving in a different direction?

MR. KUBARYCH: Well, RTC was typically American in that we had a problem that needed solving, and nobody could think of a particularly good way, and the people who came up with RTC had a great idea. The problem was FSLIC, which was the FDIC of the times for Thrift, was bankrupt and it needed recapitalization in amounts that just staggered the congressmen who had to vote for it. And they said, come on let's do something different that could be cheaper. RTC worked because -- partly because it was small -- it was not a big bureaucracy -- and partly because it made essentially business like decisions and it managed to basically restart an active market in the big commercial real estate ventures which had gone bankrupt which needed to be taken care of before some of the biggest banks in the country could become whole again. And based on its effective management, and Bill Seidman is still around to help coach another generation of people running a similar type organization, it saved the taxpayers anywhere from 300 (billion dollars) to $500 billion against earlier estimates of how much the Thrift Crisis and the banking crisis would cost. There was some cost to the taxpayers, but don't forget the taxpayers were always and already on the hook because of the deposit insurance guarantees.

And in fact, one economist that's got a political past to him and Fed past, argued that we should get rid of deposit insurance limits entirely which would add -- which would basically effectively nationalize the entire liability side of the banking system and make it almost imperative we have an RTC. It was quite interesting -- the proposal was a lot more sweeping than an RTC which would be a limited way of doing many of the same things and it's probably a good idea. It can be done in a way that will not be costly.

MR. MALLABY: Good. Okay, well now, operator, do we have any questions?

OPERATOR: Thank you sir. Ladies and gentlemen I would like to open the floor for questions. If you would like to ask a question please press star one on your touchtone phone now. Questions will be taken in the order in which they are received. If at any time you wish to remove yourself from the questioning queue please press star two. Once again, to ask a question, please press star one on your touchtone phone now.

Our first question will come from Bruce Gelb, Council of American Ambassadors.

Q A very interesting dialogue so far.

This is a question for both Roger and Sebastian Mallaby. Between the Chinese being able to, in certain cases, dictate to the AIG operation because of U.S. ownership and the Gulf states, Saudi Arabia and Abu Dhabi with all the liquid assets in the world requiring Shari'a law compliance for financial institutions, and of course the Treasury's temptation to just turn on the printing presses, are there any other innovative approaches in the wings that we have not heard about? That's the question.

MR. MALLABY: Innovative approaches, you mean from U.S. policy makers.

Q Correct.

MR. MALLABY: It sounds like -- (audio break). We hope we don't get to that. Roger do you want to comment on it?

MR. KUBARYCH: First of all, the Shari'a opportunity -- I'd look at it as an opportunity rather than as a nuisance -- is already being worked on certainly in our bank; in UniCredit we have a whole group of people dedicated to making it work from a practical point of view rather than just from a legalistic point of view. And we have quite a sizeable presence in the Gulf and have had for some time -- we do a lot of project financing. And we're able to do it.

Now it's not -- I can't say we've perfected it. And we know American banks who are also doing it. So I would consider those things as being useful if they meet the needs of clients. And there are some things you just have to say you can't do it that way because it doesn't work out, but in many cases it does technically.

As far as -- I think in terms of innovating, look, what our friends in Europe would like to see more than anything -- and if you look at the internet today you'll see IASCO which is the International Association of Security -- sort of like a central bank group for securities regulators -- the Europeans are moving very quickly to demand significant reforms in the credit rating agency area. And one of the great innovations that I support heartily is to go back to the past when rating agencies were paid by the buy side and not by the sell side. And all the conflict of interests that have been so apparent in just the last four or five years are eliminated if you go back to that. And that would stabilize the -- a lot of people's risk concerns if we basically moved forward into the past and had brand new rating agencies with real talent that would be essentially working for the buy side for insurance companies, institutional investors, pension funds and even sovereign wealth funds. And that would really unblock a lot of the seizing up of the bond market.

MR. MALLABY: Let's move to the next question. Operator?

OPERATOR: Thank you, our next question will come from Stanley Black, University of North Carolina.

Q Yes, I'd like to raise the issue of the credit default swaps which seem to be at the heart of the problems facing AIG and which seems to be a completely unregulated market of enormous size which has grown tremendously without any oversight over the past 12, 15 years. It seems to me that this market is in serious need of a very close look and probably some serious tightening of regulations.

MR. MALLABY: Well, it always strikes me that one of the ironies about what's happening is that people have said for a while that when institutions write credit default swaps, they are essentially selling insurance but without being steeped in the tradition of an insurance company, without being regulated by an insurance regulator, without having capital adequacy rules to back up the insurance promise they're effectively making. So there's always the thought that the hedge funds, for example, that were writing these credit default swaps sometimes would end up coming unstuck because they didn't understand insurance. And the sad irony I'm afraid is that it's an insurance company that ended up getting burned by this quasi-modern form of insurance.

MR. KUBARYCH: Let me just say that I think that it's premature to say how much of the exposure that AIG's -- I always thought it was in Stamford but it's just as much in London -- derivatives operation, where those exposures are. How much of it is CDS related and how much of it is in long-term writing of options on all kinds of other things. And that we have to cease. So let's not prejudge what they -- yes, they have big exposure in derivatives but I don't know for a fact -- I know that journalists have always mentioned CDS in array, but they say CDS and other derivatives. But my contacts in the CDS world are skeptical that they are that big in CDS compared to all the other types of derivates where you can lose money.

What's important is that there really is a fundamental difference between writing CDSs, writing naked put options, naked call options and being a buyer of that; in other words, the unlimited liability that comes from the optionality in CDS and in regular options, which can be pretty complex, too. And that, I don't think, the regulators have had any grip on, and it has clearly been something that some of us have been worried about at least for five or six years, and certainly since CDSs became more usable. Don't forget, CDSs are a better and cheaper way of trading the economic exposures in the corporate bond market. And as such, they were bound to displace a very clunky and expensive old system or corporate bond trading. And that corporate bond market, of course, expanded immensely with securitized credits coming on top of it. And that was clunky. So don't throw out the baby with the bathwater.

Q Well, let me say that I think this baby is a giant gorilla. It's -- the last figure from the BIS was $46 trillion and I recently heard $70 trillion -- and I think that what we've got here is a form of portfolio insurance which we know messed up badly in the 80s. This is not applied to equities like portfolio insurance but applied to bonds. And exactly the same problem arises where the bond market goes into the tank, all of these swaps suddenly become expensive.

MR. KUBARYCH: I'll tell you one thing, Stan. It's very hard to hedge a CDS business if you're only on the writing side, and that's what we're worried about and not just for AIG but I think we've exhausted this really important topic. Otherwise we can spend a whole hour on it.

MR. MALLABY: Okay, next question please.

OPERATOR: Thank you. Our next question will come from Yves Istel from Rothschild.

Q Hi. Thanks again. I was hoping that you could comment briefly on how you see this playing out into what's called the real economy -- in other words, GDP, employment, inflation and so on -- because if you look at, as all of us have, at the growth of GDP, the growth of credit has grown almost logarithmically higher to create the GDP growth we've had. If you now have the unwinding of the leverage and the difficulty and the credit from a capital point of view, from a confidence point of view, how do you see that playing out in the economy?

MR. KUBARYCH: Well, I haven't had to move down our forecasts at all because I was always at the very bottom of the consensus on the pessimistic side. Because, Yves, I really have believed every since February of 2007 when New Century Financial went into the tank that that was the end of this highly leveraged world. And so we've consistently been a little surprised whenever there was a strong growth in GDP, like in the second quarter -- may be a fluke. But in any case, eventually, this is going to hurt the consumer and even more importantly parts of investment, particularly commercial real estate is being very much squeezed by a credit crunch which is definitely increasing. You can't quantify it as well as you can quantify some of the other variables in a GDP matrix, but it's definitely going to hurt. If I had to put a number on it, I would say one-and-a-half percentage points less growth over the next year to two years than we otherwise would've had without the credit crunch that's happening.

MR. MALLABY: Let's move to another question.

OPERATOR: Thank you. Our next question will come from Arthur Levitt from Carlyle Group.

Q Good morning. We haven't touched thus far on the base problem of all of this, and that's the collapse of the real estate market. Do you think that any of the two solutions, one from the right, one from the left, the right might suggest incentives to business to build or buy in the form of tax incentives? Or, on the other hand, from the left in terms of doing whatever can be done to stop the freefall either by the development of a new agency such as a RTC. Do you think that either of those two mechanisms might have a more profound and orderly conclusion than any of the other steps that have been talked about this morning?

MR. KUBARYCH: I'm often asked about what would be the sign that the crisis is bottoming out and turning around. And the answer I always give since over a year is when the foreclosures stop rising, that will be the sign that there is a bottoming out of the crisis. They have not stopped rising, and that was a big mistake by Washington when they had the opportunity with the new legislation to stop that, not entirely, but stop them rising. And so that's got to be number one job -- stop the foreclosures from rising.

Then after that, you have to deal with the big inventory of unsold homes, and that's going to require partly a market response through lower prices and partly a financing response by utilizing the FHA and other tools that you already have to enable people, particularly low-and middle-income people, to get in there and become active buyers.

But nobody is really eager to buy one of these houses when they think prices are going to go down another 10 (percent) or 20 percent. And when they read about foreclosures and houses being boarded up and sheriff's sales, that convinces them they are going to go down another 10 (percent) or 20 percent. So those are the two things that have to happen. We have the legal ability to do both.

Q But the question is, do we need a new agency, on the one hand? Or do we want to implement incentives?

MR. KUBARYCH: Well, the incentives don't make a lot of sense at a time when we've got such excess supply of houses.

Q How about the agency?

MR. KUBARYCH: I'm in favor of it, but I don't think it's the first thing we do.

MR. MALLABY: I mean, there can be incentives, if I'm understanding Arthur's question right, there can be incentives on different players in this. So there can be incentives on the lenders to forgive, or they can be incentives which act more on the borrowers.

Q That's exactly right.

MR. MALLABY: Roger, you were involved in this debate before. I think you testified in Congress --

MR. KUBARYCH: Yeah. I think that we have to do more than incentivize lenders to make arrangements. I think that it's in their own interest because the foreclosure process basically guarantees you're going to lose half the money. And a skillful and early intervention with a defaulted borrower to help them get back into orderly payments makes a lot more sense than letting it all go to foreclosure. And they haven't been doing it.

So they need more than incentives. They need their arms being twisted, and that's not being done.

MR. MALLABY: What kind of agency would you create to do the job?

MR. KUBARYCH: Well, the agency exists to do part of the job. That's the FHA. And the other agency we need is something like a new version of the RTC to deal with the properties that can't be sold.

MR. MALLABY: Okay, thanks, Arthur. Let's move to another question.

OPERATOR: Thank you. Our next question will come from Thomas Mahoney, Compass Advisers.

Q Numerous academic studies have supported the hypothesis that the covariance between global equity markets increases substantially in periods of extreme market decline, especially when the catalyst to extreme events originate in the U.S. as -- (inaudible) -- time. Do either of our speakers think, going forward, that it will different this time, particularly as it relates to emerging markets? I mean, surely, so far this year, we've, of course, seen China, India and Russia, just to name the three larger ones by total market cap, already having declined much more precipitously than the U.S., even before the federal market intervention events of the past couple of weeks.

MR. MALLABY: Roger, you want to take that?

MR. KUBARYCH: Well, I just looked at a study that somebody, a really good analyst from the Street did. And they looked at 88 countries that had stock markets. And I think only about eight out of 88 haven't been in a bear market. And we were 21st, so basically there are a lot of countries that have done a lot worse. And I do believe the academic studies are correct. And that basically when things are doing great, emerging markets outperform; and when things are doing terrible, they underperform, and there is no such thing as decoupling. Eight out of 88 doesn't sound like there's much decoupling.

Q Sounds like more of a recoupling.

MR. KUBARYCH: No, I think that that never really went away. I think that was just a slogan for a while because it was more wishful thinking than it was based on real analysis.

Q Thanks, Roger.

MR. MALLABY: Another question.

OPERATOR: Thank you. Our next question will come from -- (name and affiliation inaudible).

Q Good morning. Very interesting call. Thank you.

My question is, you know, the major newspapers say the FT and The Wall Street Journal have suggested that policymakers in Washington are now considering systemic solutions to restore confidence instead of this kind of ambulance, flash fire engine, put out the related fire. Could you talk about what the range of such systemic solutions might be and what your level of confidence is that any of those could in fact restore confidence?

MR. MALLABY: Roger.

MR. KUBARYCH: Well, systemic means that everybody is lending money to everybody else. And everybody is trying to collect that money and get out of their debt, but not everybody can do it simultaneously. And we've seen this in miniature when we had the emerging market debt crisis. Every day the Fed would have to extend the Fedwire until midnight, it seemed, because it really is a logjam because nobody will pay out until they receive. Well, we can't have a system like that.

And so the true start of restoring confidence systemically is to build an absolute ironclad fence around the payment system so that everybody trusts the payment system. And that requires everybody trusting that decisions will be made, whether a close call and who-should-pay-first type of close calls, but there's an honest referee overseeing the process.

And that does not yet exist. That is the simplest and best way to get this started. There are many other, more elaborate reform proposals, but they take forever whereas unblocking is doable.

And I definitely believe the Fed deserves a pat on the back for the liquidity-enhancing initiatives they've taken this week. And today, it came out 3:00 in the morning New York time -- so I was still sleeping, but I saw it first thing this morning -- that the Fed has expanded swap lines -- these are currency swap lines that provide dollars to the other central banks whose banks want dollars to make payments -- ECB and Swiss National Bank and new swap lines with the Bank of England, Bank of Japan and the Bank of Canada.

It aggregates into a big number and is just the kind of thing that we need to get rid of some of these systemic fears. Congratulations to all involved.

MR. MALLABY: There is also, oddly enough through fantastically lucky timing, a book about to published, I think tomorrow, by some researchers at the International Monetary Fund which gets to the question of how do governments handle banking crises?

And in terms of the alternative to rushing around chasing the latest fire and trying to put it out with some kind of government bailout, as we've seen in the last few days, the sort of more systematic approaches include this RTC type option we've discussed already where the government comes along and says, okay, we're setting up a bank effectively to absorb bust institutions, and, in an orderly fashion, dispose of what remains of their assets.

And so, for example, it's not just the RTC. Sweden used that when it had a banking crisis as well, put bad assets into a bad bank and let the residual bank carry on in a healthy manner. So that's one option. And it appears to, I think, get the thumbs up from my cursory look at this book. If it's managed well, it just seems to work.

Forbearance is another option where you simply say to financial institutions, we're going to suspend the normal accounting and reporting rules so that you can count -- (inaudible) - mark to market, you can count non-performing loans as real assets and so forth.

And of course, the case study in how that does not work everywhere is Japan in the 1990s where the Ministry of Finance essentially turned a blind eye to the fact that Japanese banks were way underreporting the extent of their nonperforming loans because they were not collecting on people and still, by lending them new money, had aligned them to appear to pay the interest by throwing good money after bad. They kept the reported number of nonperforming loans down. As we all know, that just created the 1990s stagnation where the thing went on much longer than it should have done.

And the third option which isn't terribly attractive either is inflation. If you've got everyone weighed down with bad debt, you inflate them away. Obviously, that's another systemic -- it's not a case-by-case ad hoc approach, that's a systemic across-the-economy approach, but it's not an attractive one.

So I think that when you've got President Bush's Press Secretary, yesterday, Dana Perino and Paul Volcker and others, when they talk about systemic as an alternative to this ad hoc stuff, they are really talking RTC as the precedent.

Perhaps, operator, we have time for one final question.

OPERATOR: Thank you, sir. Our last question will come from Adrian Basora, Foreign Policy Research.

Q Good morning. I realize that the traditional role of the IMF has been different and has focused on countries, not on private financial institutions. But my question is, has there been any behind-the-scenes role? And is there a future role in the surveillance area or in other ways that IMF could play constructively in the future?

MR. KUBARYCH: Well, let me just say that the Bank for International Settlements has been ahead of this issue for a long time. They're not quite the same as the IMF, although many of the same countries are members of both. They have the technical expertise and they have the market context that the IMF really would not have. And look to them and their analyses and their recommendations, and you'll go a long way to identifying best practices and putting them in place.

So there is already an agency, international organization providing this kind of research and expert advice. And we just need to have people pay attention to the very well thought out recommendations they've been making for some time to reduce risk.

MR. MALLABY: That's right. I might add that there are a lot of people I know who have been at the International Monetary Fund who, within the last 12 months, have tried to get jobs at BIS and because the International Monetary Fund has been in a sort of downsizing phase, there's been a transfer of expertise slightly to the BIS.

The thing that makes the IMF grab the headlines and occupy a sort of larger-than-life role in some times of crises, is that it can actually provide money as well as just analysis and advice. Without any work in the old world of emerging market crises which are currency crises, such as you had in '97, '98, and even there it turned out that the IMF's war chest was insufficient to deal with currency crises in deep and liquid international markets. So many of those bailouts failed, and the ones that worked did so because they were backed with enormous lines of credit organized by the U.S. Treasury, from other sources as well.

So that is the particular circumstance in which the IMF emerged at the center of the storm. It's now in a very different kind of storm with the U.S. at the center. There isn't so far a currency component to the crisis. So it's not a typical thing for the IMF. And in any case, the IMF just doesn't have the kind of capital that it would take to deal with a crisis in the world's biggest economy.

Well, thank you to all of you for joining Roger Kubarych and me, Sebastian Mallaby, on this Council on Foreign Relations call. I hope you all learned something. And thank you for taking time in one of the most hectic weeks in recent memory.

OPERATOR: Thank you. This call has now concluded. You may now disconnect at this time. Thank you, and have a wonderful rest of the day.

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