Tuesday, October 7, 2008

The role of aggregate uncertainty in times of crisis

In times of financial crisis, aggregate uncertainty naturally increases - not just the level but the volatility. To put this more concretely, the probability of default rises and the uncertainty surrounding the consequences of default rises.

It seems to make sense then that instead of increasing the uncertainty (assuming that the Fed/Treasury can do nothing about the level of uncertainty/probability of default) they should be directing efforts at reducing the standard deviation/volatility around this uncertainty Instead of making bold moves they seem to be stumbling:
1. Uncertainty increased by allowing Lehman to fail but saving AIG. This increase in uncertainty is due to an increase in not knowing the effects of Lehman's failure but by the apparent randomness of its actions, i.e. who will they save, who will they allow to fail.
2. Uncertainty increased by the initial defeat of the Emergency Economic Stabilization Act.
3. Uncertainty increased by the very fact that the main thrust of the Emergency Economic Stabilization Act is a reverse auction of toxic securities whose value is inherently uncertain and whose success is inherently uncertain.
4. Uncertainty increases the option value of waiting - so having the commercial paper and interbank loan market and probably eventually commercial and personal loan market dry up should not be unexpected.

I ranted about some bold moves here which I think will dampen uncertainty. There will be a short period where there is increased turmoil possibly but if the authorities act decisively aggregate uncertainty will fall. Now perhaps using some dictatorial power to force nationalization of financial institutions who will not attempt to recapitalize by issuing securities does not sound so crazy after all:
The US Federal Reserve is examining the Nordic bank nationalisations of the 1990s as a possible interim solution to the US financial crisis. (emphasis mine):
While the responses varied in each Nordic country, there a was major effort to avoid the sort of "moral hazard" that has bedevilled efforts by the Fed and the Bank of England in trying to stabilise their banking systems.
Norway ensured that shareholders of insolvent lenders received nothing and the senior management was entirely purged. Two of the country's top four banks - Christiania Bank and Fokus - were seized by force majeure.

"We were determined not to get caught in the game we've seen with Bear Stearns where shareholders make money out of the rescue," said one Norwegian adviser.

"The law was amended so that we could take 100pc control of any bank where its equity had fallen below zero. Shareholders were left with nothing. It was very controversial," he said.

Stefan Ingves, governor of Sweden's Riksbank, said his country passed an act so it could seize banks where the capital adequacy ratio had fallen below 2pc. Efforts were also made to protect against "blackmail" by shareholders.

(Other opinions on nationalization includes: Megan McArdle, Dealbook, Dan La Botz.) Unfortunately, with a Wall Street Man in charge it is unlikely that nationalization will occur and even less likely now that another Goldman Sachs alumni is in charge of the reverse auction. What was their pitch? We got you into this mess and we can get you out of it?

I think they need to act quicky to reduce aggregate uncertainty - not the piecemeal covert nationalization that has been done so far. Unfortunately, we may be too late - I fear that with contagion to Europe, we may indeed have arrived at the end of the world. As losses in the financial industry mount and affects the stock markets and hence retirement accounts, the fear can spread easily from the financial to the real sector. A crisis that could have been contained will then become out of control as herding takes over and households stop spending, saving, and earning. (Yes, I realize that having all three happen at the same time is not quite possible - but really?)

Meanwhile it looks like BoA is attempting to recapitalize:
Charlotte, North Carolina-based Bank of America said it was cutting its quarterly payout to 32 cents a share from 64 cents, which will add more than $1.4 billion in capital per quarter.
In addition, it aims to sell $10 billion in new common stock and could sell more based on demand, the bank's executives said on a conference call.

And in Britain:
According to a BBC report, RBS, Lloyds and Barclays estimate they may need 15 billion pounds ($26 billion) each to help them get through the crisis, which began in the United States last year when mortgages holders defaulted on payments. JP Morgan analysts calculated last week that major British banks had a total capital shortfall of 46 billion pounds using the Basel II capital adequacy standard.

"I think what this signals to me is that this isn't a situation where banks can muddle through," said Simon Pryke, head of global research at Newton Asset Management. "They're going to have to be recapitalized and they're going to be heavily dependent on government and the authorities for sources of funding."

Bank officials were keen to dismiss suggestions they had asked for money.

U.K. Government Considers Part-Nationalization of Banks, FT Says
U.K. Chancellor of the Exchequer Alistair Darling discussed last night with leading bankers a plan to shore up the banks by channelling taxpayers' money into them, in effect partly nationalizing them, the Financial Times reported, citing unidentified government officials.
Under the plan, the government would take stakes in banks requesting it to do so; the chancellor's team emphasized that the idea remains a contingency plan, unlikely to be put into effect this week, the newspaper said.
The meeting was also attended by Mervyn King, the governor of the Bank of England, and by Adair Turner, the chairman of the Financial Services Authority, the FT said.

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