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FRONT PAGE CONTRIBUTOR

Fixing the Credit Markets

A Conversation No One Wanted To Have

We’re now well into the third week of extremely disordered conditions in global capital markets, with no end in sight. The world’s stock markets have started to respond to the prospect that a long period of capital-unavailability will reduce economic growth.

Henry Paulson’s $700 billion rescue plan, which seemed so radical mere days ago, is now seen to be too little, too late. Had Congress passed the plan when they first received it, instead of questioning whether the situation really was this dire, we might have forestalled the worst effects.

At this point, however, the question is what policy tools, if any, are still available. Let me tell you about one.

The acute problem in capital markets today is extreme aversion to counterparty risk. No one wants to make an unsecured loan to anyone else, for fear that the borrower may declare bankruptcy tomorrow.

And practically the only collateral acceptable for secured loans is US Treasury securities, which are now in short supply as a result.

If banks, money market funds and other intermediaries can’t lend money, then business and industry have no access to capital. You can connect the dots from there.

The fact of the matter is that on a mark-to-market basis, a high percentage of all the banks in the world are now undercapitalized. Yes, the problem stems ultimately from mortgage-backed assets. And yes, if the Paulson plan had had two extra weeks to get these assets out of banks and other financial intermediaries, things wouldn’t be so bad today.

But the situation is what it is.

What central banks, led by the Federal Reserve, have been doing for fourteen months now, is to constantly make liquidity available to the banking system. But liquidity isn’t capital. The floods of central-bank liquidity have combined to make the overnight-lending situation basically tractable, but term lending (longer than overnight) is still frozen.

In fact, and what I’m about to say you’ll hear from no one else, it may be that central bank liquidity is part of the cause of the term-lending freeze. Because people can fulfill their near-term obligations with borrowings from discount windows and other central-bank facilities, they haven’t had to face the problem of figuring out which counterparties are creditworthy and which aren’t.

Of course, that may be an oversimplification. It’s also not known whether banks even have adequate tools to assess each other’s true capital positions now. But those are questions that economists will be arguing for decades to come. Right now, we’re in a crisis.

What we’ve been doing is, in effect, to provide an official (government or central-bank) counterparty to every transaction. The Fed extended this pattern directly into the market for short-term corporate borrowing (commercial paper) today, with no discernible effect on confidence.

We need a way not to enhance liquidity, but to improve solvency. What would be the fastest way to get new capital into the global economy, so that banks both have funds to lend, and crucially, that they can trust each other again?

It’s time to consider the option of a globally-coordinated move to nationalize essentially every major bank in the world.

The obvious way to do this would be to follow the model that Sweden used in the early Nineties: sell preferred shares directly to every large bank, except those that are willing and able to meet higher capital standards on their own, and prove it.

Existing shareholders would be anywhere from significantly crammed down to wiped out altogether. Their stock is worth so little now that this barely makes a difference. Some large banks, including Citigroup, have such kludgey capital structures that this will get complicated. But not impossible.

Where would the money come from to buy the preferred shares? I’m going to pull a raw number out of a dark part of my anatomy and suggest that we’re talking about more than a trillion dollars and less than two trillion.

There’s a possibility that we could fund that much equity in the global market for US Treasuries. If ever there was a use for the extreme overvaluation that Treasury debt currently enjoys, this is it.

The other possibility is for the Fed to simply monetize a large special Treasury debt issue. Yes, that’s inflationary. How are you liking the alternative so far?

What would be the mechanics of such a globally-coordinated effort? One answer is to enlist the International Monetary Fund and the Bank for International Settlements. This answer is obvious but wrong.

Neither of these organizations has the force of single-government action. Both are bureaucratic creatures that, much like the US Congress, would laboriously produce a small, half-baked turd intended to satisfy everyone and in effect satisfying no one.

Leadership will have to come from the Federal Reserve, which should anchor a coalition including the ECB, the Bank of England, the Bank of Japan, the Swiss National Bank, and several others.

They will have to overcome the extreme aversion to inflationary policy that you find in Europe. That’s what leadership is all about. Japan may play a lead role because their banking system, which never fully recovered from their own crisis, never leveraged up as much as everyone else did.

What’s the endgame? If we do this, then the first country that re-privatizes its large banks will have a leg up in the recovery from the crisis. One hopes a healthy competition to do so will result.

At this point, the Treasury has just started gearing up operations on its just-enacted plan to recapitalize the US financial system by purchasing distressed assets at overvaluation. If they can move very, very fast, things might show signs of improvement in the near term. If not, we have to start thinking harder.

We live in interesting… oh, forget it.

-Francis Cianfrocca

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