Wednesday, November 26, 2008


Yesterday's FT editorial credits 3 Profs with pre-figuring the Citi bailout deal (who I've joined with having quanitified US bank capital, losses & recoveries). They are Perry Mehrling, Laurence Kotlikoff and Alistair Milne. For how the plan was pre-figured here see older posts in Novemnber such as halfway down "Moneygall-Yes, we can" and yet earlier posts in October and September. Full text of the FT editorial follows below. I'm very interested in your contributory thoughts too. Talk of the Citi -Nov.25 2008
Another weekend, another bank rescue. On Sunday night, the US Treasury moved to shore up Citigroup. There was no choice - the banking giant could not be allowed to keep stumbling. The rescue seems to have been generous to Citi-group, but the insurance scheme it uses is a model that deserves wider consideration.Shaken by the announcement by Hank Paulson, the US Treasury secretary, that the troubled asset relief programme would not buy distressed mortgage assets, investors gave Citigroup a wide berth. Last week, its share price fell by more than 60 per cent. A loss of confidence in a vast bank with retail and investment banking businesses is dangerous; Citigroup is systemically important several times over. The US Treasury acted in similar fashion to the Swiss government's rescue of UBS. It injected $20bn of capital from the Tarp into the bank - on top of an earlier $25bn - and insured a tranche of its assets. The terms of the Citigroup rescue seem lenient but the insurance scheme is a good innovation. The government is guaranteeing the bank against losses greater than $29bn on a $306bn portfolio, mostly of distressed mortgage-related assets. The bank paid a fee for this guarantee in preference shares. Insurance on the value of illiquid securities has been proposed on the Economists' Forum on by Professors Perry Mehrling, Laurence Kotlikoff and Alistair Milne. It has several desirable attributes. Underwriting insurance on the value of toxic assets would solve the problems they cause by putting a floor under their value. This would create enormous contingent liabilities that some governments would not be able to bear. The US Tarp would not be able to fund both recapitalisation and insurance. But an insurance model would be cheaper and easier than trying to buy enough of these securities to allow price discovery. Governments would only need to make good falls in values of insured assets below the agreed limit.There are, however, practical obstacles. A credible scheme would need measures to prevent banks from holding back on writedowns until they had insurance. overnments would also need to find ways to prevent the banks that use the insurance from engaging in yetriskier behaviour. The authorities would find it near-impossible to write a tariff for insuring the price of an unpriceable security.There are no easy answers to this crisis. But governments should consider whether they ought to become the insurer of last resort.
For more see "More to Citi's SARP..." and "Bank SARP/TARP" 2 & 3 items preceding this one below.For sceptics I spell out here what the basic are:
What this is (Government standing surety for some of banks' assets) is a win-win-win situation (perhaps Keynesian?) where banks, borrowers, and treasury (Government & taxpayers) all make gains (economic benefits & multipliers all round); win-win does happen sometimes. The basics are:
1. Banks losses as writedowns are notional until they can see who defaults completely (usually 45% of the 10-20% of all borrowers in a recession who default - payments 90+days late) and until they see how much debt can be recovered (usually 55%), which can take 1-3years;
2. Short term views of banks' assets (fear of worst case losses) and of negative P/L when 'possible notional' losses (100% or a large proportion of that, of all defaults) are booked as writedowns and loan-loss provisions and drive down short term share prices and freeze the lending between banks, which has also become fearful (credit crunch) and credit insurers are similarly subject to insolvency fears;
3. Government steps in and goes surety for losses but only above say the first 15%. This put a floor under asset values, saves banks more on capital reserve than they pay Government in a risk premium (stock warrants) for the surety. Banks still get a large loss hit. And Government buys pref shares to add capital to banks' capital reserves in return for % ownership of bank in return for fixed return e.g. 8% (very profitable for Government when share bank prices are on the floor);
4. Banks have capital reserves part restored plus lower risk weighted assets and can survive first 100% hit on reserve capital. As second 100% hit on reserve capital arrives (from corporate and credit card loans etc.) the banks have had time to make some debt recoveries, drop costs, sell assets, sell busines units etc. and the nominal losses of the first 100% capital reserve loss is netting out at only 55%. Then when the second 100% loss also nets out at 55% and underlying profits from other business and asset sales revenue are gained they can repay Government plus the Government's profit margin;
5. Government also uses legislation and pressure to force banks to go easy on defaulters and maintain lending levels and to help the Government (that is also implementing a fiscal boost to kick-start the floundering economy) by maintaining or growing but not cutting back on bank lending so that recovery arrives faster and unemployment rise is capped and then reversed;
6. This takes maybe 3 years by which time tax revenues are rising again and the economy is back in 2%+ growth of income (wages and profits) and confidence is restored and the capitalist life is back to near normal.

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