DAVOS, Switzerland — The European Central Bank is drawing up guidelines for European governments that are considering so-called “bad banks” to house banks’ toxic assets. The ECB is also working on guidelines for European governments that plan to guarantee toxic assets remaining on banks’ books, another form of bank bailout.
Both sets of guidelines are being drawn up with the European Commission. The ECB hopes the guidelines can help avoid competitive one-upmanship across the 27-nation European Union as nations seek to shore up struggling banks.
The ECB, which makes monetary policy for the 16 countries that share the euro currency, has no power to enforce any guidelines it develops. But in recent months, euro-zone governments have asked the bank to play a mediating role by developing guidelines for, for instance, European government guarantees of some types of bank debt.
Governments across Europe are mulling or enacting new plans to help banks deal with souring loans and other assets that remain on their balance sheets. Many European governments have been slow to consider a “bad bank” option, in which governments could sponsor vehicles into which banks could transfer assets that are hard to sell.
German Finance Minister Peer Steinbrueck told a German daily newspaper Thursday the government would not set up a centralized bad bank, but indicated the government is considering the idea that banks could set up their own individual entities to house toxic assets.
Such banks, Mr. Steinbrueck told the daily Berliner Zeitung, could then use part of the German government’s EUR 500 billion banking-sector rescue plan to shore up their remaining sound business.
The ECB is also working on guidelines for governments that hope to offer insurance against the toxic assets that remain on banks’ books. One key question: how to price the toxic assets.
Listen carefully to the first 30 seconds.Will the real Brian Lenihan please stand up.
Nationalization The Problem
An aggregator bank (the so-called "bad bank") is going to happen. So, for what it's worth, let me make a few suggestions. Banks that are technically insolvent and which will need to put taxpayer money at risk should just be "put down." The shareholders and bond holders need to be wiped out before taxpayer money is spent. And the banks should be put back in strong private hands as soon as feasibly possible. We do NOT want government agencies subject to political manipulation making decisions about lending. But deals should be structured which give taxpayers a real chance to get their investments back.
And please, no more deals that are not on the same terms that Warren Buffett or other private investors get. That was simply embarrassing for Paulson and team, or should have been.
In closing, let me quote two paragraphs from Bridgewater Associates that I think sum up the problem in a rather brilliant and clear way, and which I wholeheartedly agree with:
"The root problem is that debts that were incurred to finance assets at high price levels remain in place at their original amounts even though the assets that they financed are now worth far less. Debt that was incurred to finance extrapolated high incomes remains in place at its original amount even though incomes are now much lower. And, debts that were incurred to finance loans remain in place at their original values even though the loans that were made cannot be repaid. Until the debts are brought in line with the assets and the income, there is no moving forward no matter how much liquidity is provided or how eloquent the speech. And, until this happens, the self-reinforcing nature of the debt squeeze will only reduce incomes and asset values further.
"There is no easy way out of a debt restructuring. Someone will have to bear the cost of prior bad decisions. The people who should bear the cost are those who made the bad decisions to make the loans or those who financed the people who made the loans. They intended to profit and would have profited if they were right. But they were wrong, so they should lose. The government needs to allow the losers to lose and focus their actions on minimizing the knock-on effects of their failure on people who didn't do anything wrong (to minimize systemic risk). They should then take action to minimize the future exposure of the innocent to the future dumb decisions of the small minority, because no amount of regulation will ever eliminate dumb decisions, so you have to plan for them (through much lower bank leverage limits to cushion losses, bank size limits and non-bank entities playing bank-like roles to improve diversification, safety nets to prevent losers from poisoning the whole system, etc.)."
Hear, hear! Bermuda, Baaad Banks, and Prenatal Vitamins
I have to close with a few humorous paragraphs from my friend Bill Bonner in his essay for the Daily Reckoning:
"But if the 'bad bank' idea could work, why not create a super baaaddd bank? We could use it to get rid of all our mistakes. Writers could unload their bad novels. Businessmen could sweep their errors under its broad carpet. What the heck, let people get out of bad marriages without penalty; the super baaaddd bank could pay the alimony and divorce costs.
"The hitch with the bad bank idea is so obvious even a banker could spot it. If the cost of mistakes is reduced, people might make more of them. Like the rest of us, bankers are neither good nor bad, but subject to influence. Unlike metallurgy or particle physics, banking does not have a rising learning curve. It's not science. Instead, it's more like love and gambling ... with a circular learning pattern. They learn ... and then they forget. They get carried away in the boom upswing; then they get whacked when it turns down.
"So let them have a good beating. It will give them of a lesson that will last a lifetime ... and give the next generation a solid banking sector."
I will fly to Bermuda next Wednesday for four days, where I will take a little R&R after speaking for the local CFA group on Thursday and work on the book Tiffani and I are writing. It should be fun.
And speaking of Tiffani, she came in this evening with that "look" on her face. Her best friend had a baby boy this week, and she got to be in the room for the birth. You could see it had impacted her. But I didn't realize how much.
"Dad, I started prenatal vitamins this week. I am almost 32. That is older than you when you had me. And I want at least three kids. You have a lot of kids, and look how much they mean to you and how happy they make you. I want that when I am your age. I know you want us to wait a little, but it is time. I need to get started."
Not much arguing with that. Life is going to change. Henry and Angel will have a child this summer. Amanda is getting married, and soon she will get the baby bug. With seven kids my chances for more than a few grandchildren are pretty good. I guess, at 59, being called Papa John will not age me all that much. Maybe it will even keep me younger longer!
Have a great week. And remember that even if a bank won't give you money, you can always get some love from friends and family, and that is where the real value lies.
Your can't believe how we throw the word trillion around so easily analyst,
YESTERDAY’S CATASTROPHIC collapse of Irish bank shares stems directly from the Government’s proposal to nationalise Anglo Irish Bank. With the Government’s finances already buckling under the collapse of our bubble economy, financial markets began to fear that with the added burden of Anglo’s debt, the Irish State cannot afford to finance itself, let alone support the remaining national banks.
Facing the imminent collapse of the national financial system, the Government needs to perform a ruthless triage. The worthwhile banks need to be maintained by any means necessary, including nationalisation, while Anglo Irish and Irish Nationwide must be allowed to collapse. At the original crisis meeting on September 29th, Brian Cowen claimed that the blanket guarantee to all six banks was given “on the basis of the advice from those who are competent to so advise the Government”.
That does not appear to have been the case.
According to a source of mine very familiar with what happened at the meeting, extending the liability guarantee to Anglo Irish and Irish Nationwide was strongly opposed by representatives of the Central Bank and the Department of Finance (who reportedly came into the meeting with a draft Bill to rescue only four institutions). However, I am told they were overruled by the Taoiseach and the Minister for Finance, who were supported by the Financial Regulator and the Governor of the Central Bank on the grounds that a sudden liquidation of Anglo’s assets would not be in the national interest.
It is still worth asking what would have happened if Brian Cowen had listened to the Department of Finance and allowed Anglo Irish to sink? The answer is: very little.
Developers would have gone bust and commercial property would have become more or less worthless, but that is going to happen anyway, with or without Anglo Irish. Depositors of Anglo Irish would have been paid off in full, and the hit would have been taken by the international financial institutions that hold around €22 billion of its bonds.
These bondholders are professional institutional investors who signed up for higher returns on Anglo debt in the knowledge that they were facing higher risks. They are, moreover, insured against their losses through insurance contracts called Credit Default Swaps.
Extraordinary Popular Delusions and the Madness of Crowds By Charles Mackay Templeton Foundation Press; 724pp, £12.99
IT’S A pity Bertie Ahern and his cabinet colleagues hadn’t taken a look at this book during the property boom.
It was published in 1841 and has since been popular among those interested in how societies and economies become subject to short-term enthusiasms that, in hindsight, are revealed as extraordinary follies.
The book is a compendium of, as author Charles Mackay puts it, “the most remarkable instances of those moral epidemics which have been excited, sometimes by one cause and sometimes by another, and to show how easily the masses have been led astray, and how imitative and gregarious men are, even in their infatuations and crimes”. Mackay, a journalist contemporary of Charles Dickens, kicks off with examples of populations losing the run of themselves in relation to returns on investments, giving details of the Mississippi scheme, the South Sea bubble and the tulip mania. The first two involved irrational investment in the shares of two companies – the Mississippi Company in France and the South Sea Company in Britain – in the early 1700s. The third concerned investment in tulips in Holland in the 1600s.
In each case, entire societies managed to convince themselves that fortunes could be made from continued exponential growth in the value of particular items.
Shares in the South Sea Company in London could at one stage be sold for a profit within minutes of their purchase, with the shares being traded for differing prices at opposite ends of a crowded laneway.
When the unreal values placed on tulips finally collapsed in Holland, the frenzy left in its wake a welter of disputes where people who had purchased bulbs at the height of their value tried to enforce contracts for sale with people who no longer wanted to buy them. Sound familiar?
Falling prices sound good to consumers struggling to buy groceries or gas, but the work of Yale University economist Irving Fisher, whose theories were formed during the Great Depression, shows the negative effects of deflation.But broadly falling prices would be bad news for a country up to its ears in debt. Consumers and businesses have to pay back debt with money that is worth less than the original credit, essentially increasing the debt. He outlines the problems of over-consumption, over-spending and over-indebtedness, and what their effects can be. He might as well be talking about the recent housing bubble when he writes: “Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100% per annum by borrowing at 6%, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts… The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible”
Irving points to a chain of nine events that can be triggered by too much debt.
“Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.
“The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”
