WSJ's David Wessel on why crisis persists: who wants to pay the bill?

The Wall Street Journal's David Wessel wrote an interesting column on why financial crisis persists.  He argues that at the end of the day, the delay is caused by the argument over who gets stuck with the tab for losses that resulted from financial excess.

I might phrase it slightly differently as the delay is caused by the search for and exhaustion of ways to stick the taxpayer rather than the banks with the tab.

It has been two years since the flames were first spotted in Greece.... It's been five years since the U.S. housing bubble burst.... 

On both continents, there is no longer any doubt about the severity of the threat or the urgent need for better policies. Yet the players seem spectacularly unable to act. 

What's taking so long? 

Deciding who will get stuck with the tab. 

"In every crisis, you have to allocate the losses between debtors, creditors and taxpayers," says Anna Gelpern, an American University law professor and former Treasury official. "It's a shockingly simple concept, and completely intractable." 

"By definition, it's a political problem," she adds. "Even if you came up with an optimal allocation, if it's not politically salable, it can't happen." 

One of the benefits of implementing the FDR Framework is that deciding who will get stuck with the tab is a non-issue as it is well known beforehand.

Under the FDR Framework, market participants (think banks and investors) are responsible for all gains and losses under the principal of caveat emptor (buyer beware).

Governments provide market participants with access to all the useful, relevant information in an appropriate, timely manner so that market participants can use this data to assess the riskiness of any investment and adjust the amount and pricing of the investment appropriately.

Market participants, knowing they are responsible for any losses, will only invest what they can afford to lose.

Equally importantly, market participants will adjust the size and pricing of their exposure to firms, and sometimes there are rogue firms like MF Global, that do bet more than they can afford to lose.

With each market participant managing their exposure to loss to what they can afford to lose, contagion is also not an issue.

This time, the scale is daunting. The International Monetary Fund estimates that holders of U.S. mortgage and other debt lost $2.7 trillion in the U.S. phase of the global financial crisis, some of that already shifted to taxpayers....

The big step untaken: reducing the principal on mortgages. The big hurdle: Who takes the hit? The banks? Mortgage investors? Taxpayers?

Under the FDR Framework, the answer would be the banks and mortgage investors.

In Europe, delays in admitting that Greece borrowed too much turned what might have been a difficult but manageable problem into a calamity. One big reason for the delay: deciding who would take the hit. German taxpayers? French-bank shareholders? Foreign bondholders?

Under the FDR Framework, the answer would be French-bank shareholders and foreign bondholders.

Under the FDR Framework, it is clear that taxpayers do not foot the bill.  They do not provide a bailout to any market participants.

One of the problems with the focus on meaningless bank book capital is that it justifies using taxpayer money to fund unnecessary bank bailouts.  Banks that could function perfectly well with negative book capital and disclosure of their current asset, liability and off-balance sheet exposure detail are bailed out in the name of maintaining positive book equity.

When a borrower—a bank, a company, a country—runs into trouble, the initial reaction is to say, well, they're good for the money, just short of cash. That's often true. So the lender cuts the borrower some slack, the company hocks its receivables, or the "lender of last resort," the central bank, makes emergency loans because it is certain it'll be paid back. The problem, it is said, is one of "liquidity" (meaning no one will lose money in the end) rather than "solvency" (meaning someone will lose money). 

The Bank of England's Mervyn King said this is a solvency crisis from the very beginning.  

The temptation to extend that logic beyond reason is strong. Admitting that, say, some European governments won't pay 100 cents on the dollar, or that some mortgage loans aren't worth as much as bank books say, would force lenders to take losses. 

If the losses are large, then the solvency of the banks is in doubt.... 

This is argument is fundamentally flawed.  It assumes that if we don't let anyone see the bank losses, then the losses don't exist and everyone believes the banks are solvent.

Market participants, including banking competitors, are not stupid.  They know the losses exist - heck, some of them have losses hidden on their own balance sheets.  The question is which banks are solvent (where solvency is the market value of the bank's assets exceeds the book value of its liabilities).

Then, too, banks and investors lend, often at interest rates that reflect the risk they won't get paid back. If all goes well, they make a lot of money. If not, and there's a lot of money at stake, the taxpayers get the tab. 

And why should taxpayers get the tab if banks and investors lend at interest rates that reflect the risk they won't get paid back?

"Parties that have contractual losses try to shift those losses to counterparties, especially taxpayers," says Edward Kane, a Boston College economist. "These crises tend to drag on as long as there's a chance of sticking taxpayers with the losses." 

And thanks to policymakers and financial regulators, banks have a chance to transfer their losses onto taxpayers.

So first there is denial, then delay, then disguise....

All of which require opacity.

If banks were required to disclose their current detailed data, denial, delay and disguise would be avoided.

• There would be no reason to deny the losses, because everyone could see what they are.  

• There would be no reason to delay taking the losses, because the market would already have taken them into consideration - please recall how bank stocks did not crater when John Reed and Citicorp finally acknowledge that loans to less developed countries were worth far less than book value.

• There would be no reason to disguise because disclosure would force the disguise to be removed.

There are costs to all this dilly-dallying. Bank lending is one. "The banks aren't anxious to extend credit, because they don't know how much capital they have [after taking still-unacknowledged losses], and it's hard for them to raise money, because investors are uncertain about their financial condition," says John Makin of the American Enterprise Institute and hedge fund Caxton Associates. 

Italy is another. On the fundamentals, Italy should be good for the money, as long as it can borrow at rates paid by similarly situated governments. Unlike Greece, it's running a budget surplus, excluding interest payments. But it can't survive long if it has to keep paying 7%-plus.  

Italy has sinned, no doubt, but Europe's delays in managing Greece's insolvency have led markets to question the sovereign debts of half the euro zone. 

Taxpayers are going to take a hit. How big a hit? Until that's decided, the crisis will go on, and the cost will grow.

As I have repeatedly said, taxpayers do not have to take a big hit.  Banks are capable of taking the hit and would if policymakers and financial regulators stopped focusing on bank capital.

It is the policymakers and financial regulators who give a meaningless, highly manipulated number - bank capital - the ability to force large losses on taxpayers.

That is just wrong.