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An unlimited guarantee requires unlimited access to financing ...

October 13, 2008

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Over the weekend, the countries of the G-7 indicated that they would do "whatever it takes" to prevent another Lehman-style bankruptcy. They pledged to "use all available tools to support systemically important financial institutions and prevent their failure. "

Many European banks need access to short-term dollar financing to support their dollar assets, as we discovered after Lehman default’s led to a run on money market funds. Today, the Fed and the major European central banks made sure that any European bank that needs dollars will get dollars:

"The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded."

Emphasis added.

Any word, when over-used, loses its impact -- but this really is unprecedented.

The US and the major European central banks have effectively agreed to lend without limit to make good on their pledge to avoid a systemic bank failure. All major financial institutions in the G-10 ultimately now have access -- through their national central bank -- to the Fed. This isn’t quite a global lender of last resort (in dollars) but it is close. Banks are different than countries, so the analogy is imprecise -- but back when emerging economies had trouble rolling over their short-term dollar debts during the crises of 97-98, the G-7 never pledged to lend "any amount" needed.

Lending to countries through institutions like the IMF isn’t collateralized -- but it also was never unconditional. The G-7’s guarantee of liquidity doesn’t seem to be linked to steps the banks could take to help themselves -- like suspending dividend payments on their common stock.

The nature of the global response to the current crisis is beginning to emerge.

Step 1 is to guarantee against failure -- or at least the kind of failure that leads to losses for unsecured creditors. If such guarantees are credible -- and money market funds stop losing funds, so they have money to lend -- that should guarantee that any systemically important institution can borrow the funds it needs to repay its maturing short-term debts, no matter how troubled its balance sheet. Short-term bank debt would be as good as short-term Treasury debt.

A necessary component to this guarantee though is a real effort to recapitalize the financial system, so that the banks will eventually be able to borrow on the strength of their own balance sheets -- not on the strength of the government’s guarantee.

France, Germany, and the UK have now pledged a sum substantially larger than the United States’ TARP to backstop their banks -- and they have indicated their willingness to take large equity stakes in their respective bank systems. France has pledged a sum of up to 2% its GDP. The UK has already committed 37 billion pounds ($64 billion), or 2.5% of its GDP. Germany has indicated that it willing to use 3.2% of its GDP to buy equity in its banks. Comparable US equity injections from the US government would imply a commitment of between $300 and $500b.

That seems to me to provide a baseline from evaluating the scale of the equity investments the TARP may need to make. The IMF has estimated that the major banks need roughly $700b in new equity capital.

The US government still seems to worry that overly punitive terms would discourage "healthy" institutions from seeking a government equity injection. I understand the need to be reassuring -- and to make it clear that the injection of government funds is considered to be reassuring rather than evidence of hidden problems.

At the same time, I would hope that the executives of America’s banks gathering at the Treasury this afternoon recognize that a lack of confidence in the quality of their balance sheets pushed the global financial system to the edge of collapse. Lehman’s default revealed that few large financial institutions can currently borrow without at least an implicit government guarantee. The market isn’t sure about the valuations they have given to their illiquid and opaque assets -- and thus isn’t convinced about their solvency in rapidly slowing global economy. No bank executive wants to dilute existing equity investors. But absent unprecedented government intervention first to provide the banks with emergency financing and now to guarantee their liabilities, many banks would have already had to shut their doors.

I am open to be being persuaded otherwise, but I would think that any institution that is now borrowing heavily from the Fed should be expected to receive an equity injection from the government if it cannot quickly raise substantial sums from true sources of risk capital -- and by that I mean sources of capital that are investing in the banks without any expectation that the government will protect new equity investment from future losses.

Absent a major equity infusion, it is hard to see how the banking system can be weaned off the need to rely on the government’s implicit -- if not explicit -- guarantee to borrow. Think of it this way: all the concerns traditionally raised about Fanny and Freddy -- privately owned companies borrowing in the market on the back of a government guarantee rather than than the strength of their own balance sheets -- now apply to the "private" financial system.

It looks like the G-7’s actions have kept the financial system from falling off the precipice. But a world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.

UPDATE: The Treasury has indicated that it will inject $250 billion in the banking system -- in a way that in effect leaves the banks no choice but to accept the Treasury’s offer to buy preferred stock. That addresses one of my concerns, namely that the government wouldn’t use the leverage associated with its de facto guarantee of bank liabilities to force the banks to accept actions that are good for the system as a whole even if they are bad for current shareholders. But as Felix Salmon notes, it isn’t clear how much preferred equity the government will get in exchange for its capital and the government is buying non-voting stakes -- leaving it to the Fed and other regulators to assure that the capacity to raise funds on the back of the government’s guarantee isn’t abused. And as Yves Smith notes, the government seems to have opted to support all the remaining large players in the system. That helps to explain the stock market rally -- but it also potentially leaves some difficult questions unresolved.

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