What Hope of Success with Typical Bureaucratic Efficiency?
We have criticized the “$700 billion” federal bailout of banks for the past two weeks and have done so for a variety of reasons. (We used the scare quotes to denote the unreliability of the estimate, which seems to have been grasped from thin air.) We won’t cite all of the reasons for its likely failure, because in this post, we’ll suppose that the “bailout” is perfectly executed.
Would such perfectly executed plan return us to the pre-crisis, halcyon days of early 2007? No! To anything close to it? No.
Suppose that each and every crappy mortgage, mortgage-backed security, and CDO held by a commercial bank is purchased by the government at a fair price, and so, let’s suppose that the banks have $700 billion in cash instead of semi-worthless thingies that they may or may not understand.
Now, under such an incredibly fortunate circumstance, would the dear reader have confidence in those banks? Would he or she have more confidence or less confidence in the bank that sold the most thingies to the Treasury?
This first reason explaining the bailout’s likely ineffectiveness is a “types” argument. They’re lower types than we thought.
We now know that many banks made a tremendous number of very, very costly mistakes and mis-estimations during the past several years. Thus, they now seem substantially less capable they did two years ago. (Does any reader think more highly of the banks today than in, say, 2006?) The capital markets departments, boards, senior managers, traders, risk managers, and treasurers seem less able today than one or two years ago.
Moreover, it is not just the losers. We recall a conversation with a former trader and current risk manager whose bank seems to have avoided many pitfalls that have damaged or destroyed other institutions. When asked why it was so fortunate, he replied, “it wasn’t due to any competence. In fact, it was quite the opposite. They had planned to be just like their peers but were incapable of executing it (the plan).” So, it seems that there are reasons to suspect the non-losers, too.
So, we ask, do you trust the banks with $700 Billion in new cash or do you think they will waste it or take excessive risks? Have they done anything to earn to earn your trust, and is there anything in place, like revised incentives schemes, that would indicate a change in philosophy and an improvement in control?
Secondly, we now know that for many banks, a substantial portion of their pre-2008 earnings were bogus. As those assets were losing value, the banks were recognizing income on them. Much of those earnings have now been reversed via losses, and it is likely that additional losses will be recognized in the next two quarters. (Recall: we’re assuming that the assets trade at a fair price.) So, we know that the banks’ future earnings will not return to pre-2008 levels, and it is unlikely that their equity base and capital levels will permit lending and investing at those past levels. Moreover, where will they invest? In real-estate? In sum, we expect lower earnings for the foreseeable future.
Thirdly, all of these points should be known–at least, collectively–by the surviving banks. As we wrote (tongue-in-cheek) in Financial Projection in a Crisis, if banks project their own abilities onto their peers, they may continue to be suspect of each other thereby keeping the credit markets “frozen.” How much does the dear reader trust them beyond the $100,000 or $250,000 deposit insurance limit?
Fourthly, with the mega-consolidations, and an associated too-big-to-fail mentality, moral hazard becomes an issue that exacerbates these suspicions. Will these mega-banks take outsized risks knowing that the government will cover losses? Will the government cover such losses? So, how long will it takes banks to trust each other, now that there are fewer trading partners? (Will banks trust the debt rating agencies? Do you?)
Finally, does the reader imagine that once the crisis recedes, the federal government will voluntarily give up control of the new portion of the economy that it controls? Generally, to induce the government to shrink requires, if not a literal revolution, at least a figurative one, e.g., the Reagan Revolution. Without such a revolution, what hope does the economy have with more government interference?
Those looking for regulation as a solution should note that investment banks and large commercial banks were already heavily regulated. Most reports to senior management and the board of directors are also sent to the regulators, who may question them. Did the reader not in the industry know that those regulators, maintain permanent offices in each bank’s headquarters and are almost like employees?
Besides reading such reports, the regulators also conduct frequent examinations, and, of course, they did so repeatedly during the past several years. Did they catch anything? Moreover, as we’ve written in the past, do they have the incentive to do so? Or would the discovery of an risky issue merely show that they had missed it in a previous year?
Also, remember that Fannie Mae and Freddie Mac were heavily regulated, too. Many members of Congress, e.g., Barney Frank, et. al., wanted less regulation for those two government sponsored entities. When will faith in such entities be restored? When will Congress have an approval rating above 20%? (Without searching to verify it, as low as Mr. Bush’s approval rating is, we don’t being that Congress’s is even 50% of it: somewhere between one-third and one-half.)
As we understand it, while “Spero” is not an Italian name, the word means “to hope” in Latin. We’re thinking about changing it to something more realistic when we comment on the bailout. Why not try our solution: A Better Solution (than a government takeover)?
We might add to and revise this post through time.
