by Peter Boone, Effective Intervention
and Simon Johnson, Peterson Institute for International Economics
Post on the Wall Street Journal's Real Time Economics
January 15, 2009
© Wall Street Journal
The Great US Banking Crisis is entering Phase III. In Phase I, triggered by the collapse of Lehman and the botched rescue of AIG in September, most major banks faced a dramatic collapse of creditor confidence. The phase was ended partly by bank recapitalizations using government money on October 13, but largely by massive credit lines from the Federal Reserve. Any US bank with a household name became too big to fail.
Nevertheless, a Phase II broke out just before Thanksgiving, in which the equity price of Citigroup sank inexorably toward zero. Such an equity collapse is a silent killer of banks—just as deadly as a collapse of creditor confidence, because the view forms that a bank is not sound. This creates unattractive counterparties in the payments system (in which letters of credit and the willingness to take counterparty risk are essential) and will cause any uninsured depositors, such as corporates, to shift into Treasuries and other government-backed paper. Even insured depositors edge for the doors. Phase II was ended only by a large and very generous additional government infusion of Troubled Assets Relief Program (TARP) money on November 23, as well as a combined TARP-FDIC-Federal Reserve guarantee for $300 billion of Citigroup assets.
Phase III is a repeat of Phase II, but now the market is worried about Bank of America as well as Citigroup. Citi's total value (market capitalization) on Wednesday was around $25 billion, despite a balance sheet that—properly measured—is at least $2.5 trillion. The additional support discussed in the press for Bank of America's purchase of Merrill Lynch is a further sign that the crisis is deep and hard to eradicate. These problems are appearing against a backdrop of a steep decline in global economic activity, suggesting that other major banks will run into similar problems. The fundamental problem is no longer a liquidity crisis centered on specific classes of assets (primarily mortgage-backed CDOs), but a solvency crisis that spans the entire range of bank assets. Even J.P. Morgan Chase (the third in the new "Big 3?) has seen its share price fall sharply since the start of the New Year, and concerns over the financial system further threaten credit markets and payments systems. We should anticipate that even the best-managed banks may not be able to weather this storm.
A broad, systemic solution for the banking problem, which specifies exactly what the US government will do—with the full support of Congress—would remove a major uncertainty hanging over the real economy and help clarify everyone's economic prospects. This is particularly important now since investors and businesses are not sure how the Obama administration and the newly elected Congress will change policies. The damage caused by unclear and volatile policy changes at the Treasury over the last several months needs to be put behind us. A broad, long-lasting, systemic solution will not necessarily or immediately start banks lending again, but at least it will remove a major roadblock to growth and provide the policy clarity that is necessary for businesses, investors, and households to plan.
The problem now is politics. The goodwill and confidence of Congress with regard to the outgoing Administration's efforts is basically nil. The new administration has not yet put its bank strategy cards on the table, presumably because they were hoping to have a bit more time for preparation (and the second round of TARP money is not yet available). But key banks are in trouble now, and a decisive program of action needs to be drafted and communicated within a week. What should the Obama administration do, and with how much money?
In economic terms, the following principles would make sense:
Last fall we saw the massive disruption that can occur when the market as a whole loses confidence in the financial sector. The repeat of such a scenario would easily outweigh all of the benefits that will be gained from the upcoming fiscal stimulus package. It is time to stop pretending that the actions taken to date have been sufficient to ensure the stability of the financial system and solve the problem once and for all.
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