from Follow the Money

Much to worry about

September 13, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The New York Federal Reserve Bank doesn’t use its ability to summon Wall Street’s top leadership to its downtown castle lightly.

This doesn’t seem quite like LTCM either. For one, the US Treasury did not participate in the LTCM meetings at the New York Fed, and Paulson attended last night’s meeting.

Like almost everyone else, I can only guess what is going on. But my best guess would be that as of Friday night, no “deal” to take over Lehman had been finalized – and the New York Federal Reserve and the Treasury wanted to make it clear both that a deal needed to be done and that deal needed to be done without any assumption of risk by the Fed or the Treasury. I’ll be interested to see what emerges on Sunday – and to see if China’s Investment Corporation is involved.

Saskia Scholtes and Michael Mackenzie of the Financial Times, with input from Krishna Guha, indicate that there is now an incipient discussion of how to move from to finding emergency fixes for the problems of specific institutions to addressing the broader weaknesses now apparent in the overall financial system.

"The debate over whether an RTC-style vehicle is needed – perhaps just to ring-fence troubled mortgage assets – also gained traction among central bankers at the Jackson Hole symposium hosted by the Federal Reserve Bank of Kansas City in August. The US Treasury and Federal Reserve are not working on such a plan, but they have been looking closely at how previous interventions were used to redress systemic market crises.

The problem that an RTC vehicle could help to solve is that there are very few buyers for troubled mortgage assets, and few investors now willing to inject fresh capital into the tattered balance sheets of the banks left holding them. As a result, banks such as Lehman and Washington Mutual have struggled to sell their soured mortgage portfolios, and to broker deals for fresh capital. The takeover of Fannie and Freddie, which virtually wiped out preferred equity holders, has also made banks’ access to the preferred capital market increasingly difficult.

Through a new RTC, the government could provide financial support if needed in return for a share in potential profits once the assets were liquidated. "

Essentially, there are more impaired assets out there than healthy balance sheets, creating a world where the system as a whole is structurally short of capital.

Former Treasury Secretary Summers put forward a plan – or at least the nucleus of a plan – to try to address this problem in his assessment of the crisis in the Financial Times in early August.

In all likelihood, the financial system will require very substantial capital infusions over the next year or two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have provided financial institutions with capital over the past year have been badly burned. As valuations fall, it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain market confidence, leading to further declines in valuation and yet another vicious cycle.

How can the authorities best support the financial system?

To date the focus of public policy has been on the extension of credit to banks and other financial institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity, lending can be highly efficacious. When the problems are of underlying solvency and the constraint on lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency basis, to plan policy responses to such problems.

.... There is as yet no framework in place for handling the large quantity of bad assets sitting on financial institution balance sheets. During the last US banking crisis in the early 1990s, the Resolution Trust Corporation was established to manage impaired assets of banks and savings and loan institutions that the government had taken over. But it acquired assets only after the government took over banks. Consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration ...

The core trade involves the US government receiving equity in major financial institutions in return for taking some bad assets off their hands. By taking some impaired assets out of the system, it would aim to bring the system’s assets down to a level that can be supported by the existing capital base.

After the US election, I suspect the debate will shift toward the need for such a systemic solution. If this kind of intervention proves necessary, it would need to be accompanied by a rather wholesale change to the United States’ system of financial regulation.

My main job back at the Treasury in the 1990s – when I worked for both Mr. Geithner and Mr. Summers -- was to support the United States’ efforts to improve the “international financial architecture." Right now, it looks there is a need to strengthen the United States’ own “domestic financial architecture.”

UPDATE: The latest from the New York Times on the status of the negotiations at the New York Fed. It sounds like Barclays -- not Bank of America -- is the most likely bidder for the good bank, and that all the banks would be expected to help capitalize the bad bank. The Wall Street Journal’s latest report also suggests Barclays has more folks at the New York Fed than anyone else.

UPDATE 2: The New York Times reports that Barclay’s isn’t willing to do a deal without more support from the government or other banks than it is currently getting; liquidation is possible. All I can say is wow. If Lehman’s unsecured creditors take a haircut, I would guess that the cost of funding for the entire US financial system will rise significantly.

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