Monday, October 31, 2011

This time is different if and only if the FDR Framework is implemented

Are the US, UK and European economies condemned like Japan to a long hard slog to rebound from the bursting of the credit bubble or is there an alternative?

Ken Rogoff and Carmen Reinhardt have documented the aftermath of credit bubbles covering several hundred years and have concluded that it will take a long time to recover.  The reason is that the credit machine that allowed individual, businesses and countries to borrow too much goes into reverse as they look to repay their debts.

The question I have is does this long time to recover have to occur in both the real economy and the financial sector or can it be isolated to the financial sector?

Regular readers know that I think that the long recovery period could initially have been and probably still can be "confined" mostly to the financial sector.

Why do I think this?

Under the FDR Framework, banks are the safety valve between excesses in the financial system and the real economy.

Specifically, with full disclosure made possible using 21st century information technology forcing banks in the words of Walter Bagehot to be "well-run", banks can absorb the losses on the excesses in the financial system and continue to operate.  As he said, "a well-run bank needs no capital."

Banks can show a negative value for book equity without fearing a run on the bank by depositors.  The depositors are protected by a guarantee from the government.

In the aftermath of all the credit bubbles that were studied, there was not one bubble where the banking system could be fully utilize as a safety valve to prevent the excesses in the financial system from causing a multi-year (think decade) drag on the real economy.

In every case, the ability of the real economy to recover was limited by the capacity of the banking system to continue to show positive book capital while generating the earnings to both absorb the losses caused by the financial excesses and support new lending.

What makes this time different is that there is information technology available and deposit insurance that eliminates bank earnings as a constraint.

What I am proposing that makes this time different is that banks should use up all of their capital plus whatever additional capital is needed to absorb the losses caused by the credit bubble.

Clearly this will leave the banks with a negative book value for their equity.  But, as Walter Bagehot observed, this is not a problem if they are "well-run" banks.

The way to force them to be well-run is to require disclosure of their current assets, liabilities and off-balance sheet exposures.  With this data, market participants, including their competitors, can exert market discipline to ensure that the banks retain a low risk profile as the banks steadily retain earnings to restore a positive book value.

Following a credit bubble, rebuilding bank book equity is where the lengthy recovery identified by Rogoff and Reinhardt should be.

This is not unreasonable given the existence of deposit insurance.  Deposit insurance is similar to an option.  When the market value of the bank's assets is less than the book value of its liabilities, the option is in the money -- its value is at least the book value of the insured deposits minus the market value of the bank's equity.

What is being proposed is having the banks rebuild their book equity and in the process reduce the value of the deposit insurance option.

There are many benefits to my approach.

For example, Greece's debts could immediately be written down to a level that the country could afford to pay without the need for austerity.  After all, why should the citizens experience all the negatives associated with austerity for the failure of the lenders to consider Greece's ability to repay its debt?  On the other hand, if Greece hopes to access additional debt in the future, it is going to have to make changes that would make lenders willing to extend this credit.

Trust me when I say that what I have just proposed is a radical departure from the approach that is currently being taken globally to address the impact of the credit bubble.

Let me spell out a couple of the critical assumptions that underlie my approach.

First, I think that market participants understand that we had a credit bubble that burst and as a result most, if not all, the major banks in the US, UK and Europe are insolvent.  Where insolvent means that the market value of these banks assets and off-balance sheet exposures is less than the book value of their liabilities.

So acknowledging this fact allows us to change policies.

Why is this important?

Because the "extend and pretend" policies that are effectively ever-greening loans to bad borrowers so that banks can show a positive value for book equity, can be stopped as they are not fooling anyone.

All these policies have done is hurt the real economy by effectively discouraging investment as it is easier for a bad borrower to get money from the banks to continue the myth their loan is performing than it is for a good borrower to get money from the banks to invest in the real economy.

Second, I think that market participants understand that the credit bubble drove real estate prices much higher than they would have been in the absence of the credit bubble.  The size of the credit bubble impact being the difference between prices before the bubble burst and what prices would have been assuming they had continued to appreciate on a trend line reflecting long term growth and demographics.

Market participants expect a significant decline in real estate prices as a result of the credit bubble bursting as the prices decline to the level consistent with the long term growth and demographics trend line.

Why is this important?

Because the policies of artificially propping up the real estate market can be stopped as they are not fooling anyone nor have these policies stopped the ongoing decline in real estate prices.  In fact, Japan has shown that despite these policies prices can continue to fall for a long period of time with real estate prices declining for 18 of the last 20 years.

All these policies do is hurt the real economy by forcing it onto a suboptimal growth path as it makes lenders reluctant to lend when there is great doubt about the value of real estate pledged as collateral.  For small businesses, this doubt lowers the availability of credit as real estate is typically the largest asset that they have to pledge.

Third, I think that market participants can value every asset and off-balance sheet exposure that a bank has. It is not important if "every" market participant can value "every" asset and off-balance sheet exposure.  What is important is that there are a significant number of market participants, including each bank's competitors, that can.

Why is this important?

Because it forces banks to address their losses and restructure the assets to a level where the borrowers can afford the terms of repayment.  It is only when this restructuring takes place that individuals, businesses and countries can move forward without the debt overhang.

In addition, it ensures that there will be market discipline on the banks going forward.

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