Wednesday, February 4, 2009

Why do developing countries have to take IMF advice

But developed countries can choose to ignore them? The obvious answer is because they can - plus they don't need IMF blessing to get bailout funds.

Naked Capitalism rants (to sympathetic ears):
The Obama Administration, if the Washington Post's latest report is accurate, is about to embark on a hugely expensive "save the banking industry at all costs" experiment that:

1. Has nothing substantive in common with any of the "deemed as successful" financial crisis programs
2. Has key elements that studies of financial crises have recommended against
3. Consumes considerable resources, thus competing with other, in many cases better, uses of fiscal firepower.

The Obama Administration is as obviously and fully hostage to the interests of the financial services industry as the Bush crowd was. We have no new thinking, no willingness to take measures that are completely defensible (in fact not doing them takes some creative positioning) like wiping out shareholders at obviously dud banks (Citi is top of the list), forcing bondholder haircuts and/or equity swaps, replacing management, writing off and/or restructuring bad loans, and deciding whether and how to reorganize and restructure the company. Instead, the banks are now getting the AIG treatment: every demand is being met, no tough questions asked, no probing of the accounts (or more important, the accounting).

Why is this a bad idea? Let's turn to a
study by the IMF of 124 banking crises. Their conclusion:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.In case you had any doubts, propping up dud asset values is a form of forbearance. Japan had a different way of going about it, but the philosophy was similar, and the last 15 year illustrates how well that worked.

What we have from Team Obama is a bigger abortion of a :"throw money at bad bank assets" plan that I feared in my worst nightmare. And (when we get to the Post preview), they have the temerity to invoke triage to make what they are doing sound surgical and limited.

Moreover, WSJ reports:
To outline his fears about the U.S. economy, Raghuram Rajan picked a tough crowd.
It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. -- and that year they were honoring Alan Greenspan. Mr. Greenspan, a giant of 20th-century economic policy, was about to retire as Federal Reserve chairman after presiding over a historic period of economic growth.

Mr. Rajan, a professor at the University of Chicago's Booth Graduate School of Business [and then chief economist at the IMF - my note], chose that moment to deliver a paper called "Has Financial Development Made the World Riskier?"
His answer: Yes.

Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly.

He pointed to "credit-default swaps," which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.
Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: "The interbank market could freeze up, and one could well have a full-blown financial crisis."

Two years later, that's essentially what happened.

Many of the big names in Jackson Hole weren't ready to hear the warning. Former Treasury Secretary Lawrence Summers, famous among economists for his blistering attacks, told the audience he found "the basic, slightly lead-eyed premise of [Mr. Rajan's] paper to be misguided."

[emphasis mine]

No guts, no glory? How about nationalization of the financial industry? Unfortunately, I think now that it is too late for even this extreme move to make a large impact (in terms of stabilizing the market) in the short run (6-months). If the Fed were to move it would need something equivalent to a Powell Doctrine. Nationalization cannot be piece meal, i.e. one bank at a time - doing this would erode confidence in banks that are possibly marginal and driving their stock prices down so far that they become bad banks.

Indulge my wild imagination:
1. Treasury identifies 20-25 largest banks that are too big/interconnected to fail. Expand the list as needed.
2. At the end of the week or over the course of the weekend, federal authorities perhaps with SWAT team and armed police and national guard support surround all these financial institutions.
3. No one enters or leaves without permission. All records impounded and taken over by feds. Feds installs new management (possibly with same old faces).
4. Trading in all banks cease.
5. Pay of all top executives regulated. (Scratch this: The Obama administration is already doing it.)
6. Feds work on plan to combine all banks taken over into one large supernational bank that takes part in directed lending to stimulate economy. For now, let's call it the big bad bank.
7. Supernational bank to sit on toxic assets to the point that they either recover or are written off. On net these assets should pay zero anyway since the supernational bank becomes the two sides of the same asset trade. All assests that can be netted to zero should be done so. Or
8. In then next 5 to 10 years, Fed works on spinning of supernational bank back to the public.

I like #2 best along with Jack Bauer and John McClane blasting away at some pasty faced banker or lawyer.

But to return to reality, Prof. Rajan recommends the following instead (no guns are involved):
Instead of heavy regulation, he says, the incentives of Wall Streeters need to change so that punishments for losing money are in line with rewards for earning it.

At the start of 2008, he suggested that bonuses that financial workers make during boom times should be kept in escrow accounts for a period of time. If the firm experienced big losses later, those accounts would be drained.

Mr. Rajan also urges other safeguards. Along with Chicago colleagues Anil Kashyap and Harvard economist Jeremy Stein, he's come up with a plan to create a form of financial-catastrophe insurance that firms would buy into.

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