Transitioning from crisis prevention to crisis management
The front page of the Sunday New York Times runs with an article that quotes a pundit from the Brookings Institute as saying "modern monetary policy puts a lot of weight on rules, but there is no rule book for an economic crisis".
Actually, there is. It's all in Charles P Kindleberger's epic Manias, Panics and Crashes and we have invoked this masterpiece frequently ever since the credit crisis broke last summer. We also happen to think that Ben Bernanke has a copy of it on his desk.
There are two very important developments that need to be fleshed out right now.
First, it is very important for everyone to understand that we are making the transition from crisis prevention to crisis management. Second, there are really two templates we can ultimately follow because we have seen financial crises unfold in two other countries over the last two decades; the choices are to either follow the Japanese model or follow the Swedish model (see below).
Expansion of the discount window and the TSLF has failed
On the first point, it is now painfully obvious that crisis prevention, which began on August 17 with the expansion of the discount window, and culminated on March 11 with the unveiling of the new Term Securities Lending Facility (TSLF), has failed. The optimists say that the Fed will do whatever it takes to get the job done. From our lens, the Fed is responding to events as they unfold -- and the fact that as early ago as March 4, we had Fed Vice Chairman Don Kohn say in a speech that "I would be very cautious about opening that window up" to investment banks shows the extent to which the central bank is now being overtaken by events. Investors became very excited after the Fed unveiled the TSLF last Tuesday and we wrote at the time that the Fed had entered panic-prevention mode. The only problem is that the panic has not ebbed just yet. The Fed has pulled nearly every non-conventional rabbit out of the hat to provide liquidity, but when we have a crisis of confidence on our hands over financial sector balance sheet quality, the Fed's medicine, as Larry Summers recently put it, is akin to "fighting a virus with an antibiotic".
Crisis management will likely be a multi-stage process
So, the way to think about all this is that we have opened up a new chapter, called crisis management, and this is likely going to be a multi-stage process. The next steps may be to try and prevent a contagion, or a domino impact, and the Fed has responded to this prospect by opening the discount window to the dealer community.
As far as the Fed is concerned, right now this is all about preserving the system and is not about bailing out any particular institutions (is anybody really "too big to fail"?). Assets are going to be priced, and part of this healing process is forced liquidation of weak financial institutions, or as Kindleberger puts it, allowing the insolvency of the "bad houses of issuance". We find it very difficult to believe that the Fed is going to jeopardize the sanctity of its balance sheet by buying the bad stuff and warehousing any subprime mortgages or exotic CDOs (and the central bank made a point of emphasizing that it will not accept as collateral any security that is liquidity-challenged). So, we are heading into a phase where prices of assets are going to be marked down. The Fed's focus is going to be to do its best to ensure that counterparty obligations are going to be met; and it will ensure that the system will be flush with liquidity. But remember that liquidity is not a substitute for capital.
The Fed cannot solve all the world's problems
According to this week's Barron's, the Fed has already thrown roughly $1 trillion at crisis prevention. It has also pledged over half of its balance sheet thus far in dealing with the liquidity problems. The Fed has also cut the funds rate 225 basis points and there is now at least a 50-50 shot that the central bank goes 100 basis points on Tuesday, and even if they go 75bps it would still be the largest proportional cut in history.
But what we are learning first-hand is that the Fed can't solve all of the world's problems; it doesn't have the power to solve everything; and it is appropriate to separate what the Fed can and cannot be effective at doing. For example, the Fed can provide ample liquidity to try and mitigate counterparty risk, and it can partly influence the cost of capital to underpin aggregate demand in the real economy. The Fed can't prevent price discovery on all the assets that are faced with inadequate free-market liquidity. Through its policies, the Fed cannot recapitalize the banking sector, nor can it renew investor confidence in the quality of opaque financial sector balance sheets.
How can the Fed be most effective as we make this transition from crisis prevention to crisis management? Remember, the Fed's role as lender of last resort means that as it allows the insolvent institutions to fail, it also ensures that the system does not become impaired by counterparty failure. As per the Kindleberger roadmap, the central bank has to ensure that the sound lenders or "good houses of issue" are still functioning because they are the ones that are going to ultimately help us emerge from this crisis. The Fed's role is definitely not to save any particularly weak institution because in the final analysis, the system is built on trust, and there is nothing trustworthy about providing artificial support to asset values. It is absolutely imperative that we don't end up making the same mistakes Japan did in the early- and mid-1990s.
Intervention by the federal government has to happen
This brings us to the second development, which is that in this new chapter of crisis management, the solution is going to necessarily transcend the Federal Reserve and inevitably require intervention by the federal government. And there are two templates we can learn from: Japan or Sweden. Both experienced banking sector crises at around the same time in the early 1990s. But one lasted more than 10 years and one lasted two years. We have been working hard to try and get a handle on what the roadmap is going to look like going forward, and we think these two bookends, Japan and Sweden, provide tremendous insights on what to do and what not to do to get through this credit crisis.
We may well end up doing something in between, but what is clear is that Japan did not let its badly capitalized banks fail until the crisis was already almost a decade old. Japan spent the early 1990s denying much of the problem existed at all. By the mid-1990s, it was out of denial mode but doing the least amount possible to rid the economy of its bad debts – selectively bailing out small lenders and that was it. Only in the late 1990s were Japanese policymakers addressing the root of the problem head-on by letting the "bad houses" fail when the Long Term Credit Bank of Japan and Nippon Credit collapsed. Only then did the authorities get serious, but dragging the process out meant more than a decade of stagnant economic growth.
The Japanese credit crisis is usually cited as the benchmark for what not to do. But few cite Sweden's crisis as a template on what might actually work. As was the case in the United States, Sweden's crisis followed dramatic deregulation in its financial sector and lax supervision during the mid-1980s. Combined with a highly expansionary set of macro policies, this contributed to a speculation-fueled asset price boom – in what else? -- residential real estate. As property prices doubled, the banks dramatically eased their lending standards and this culminated in private-sector debt relative-to-GDP soaring from 100% to 150% during the second half of the 1980s. But in the aftermath of a policy tightening cycle, as is so often the case after a leveraged-asset bubble forms, a bust follows and triggers a downward price spiral in asset values, resulting in surging bankruptcies and massive credit losses. (Sound vaguely familiar?)
Sweden's financial sector was in a full-blown crisis by 1990. At the peak, loan losses amounted to about 20% of total outstanding private sector credit or 12% of GDP (not that far off Japan's nonperforming loans, which are estimated to have been around 15% of GDP at the peak). But the fact that so few know about the Swedish experience is testament to how effective the response was – in stark contrast to Japan. We should add here that we relied on various academic literatures on this file, but one real authority is Peter England and his acclaimed book "The Swedish Banking Crisis: Roots and Consequences").
What Swedish policymakers did after realizing that it could not prevent a crisis was to move to manage the situation in such a way as to save the entire financial system. But this required heavy doses of government intervention. The key finance official at the time (Bo Lundgren) quickly examined the historical record regarding banking crises with particular emphasis on the 1930s (which Bernanke is an expert on). He concluded that if the government did not take decisive action right away "the financial crisis may become very serious, protracted, and very costly to resolve."
So, the Swedish authorities realized early on that a banking crisis cannot be resolved until the problem is properly defined. That means assessing who the "bad" and "good" houses of issues are and be willing to allow the "bad houses" to fail (as an aside, "good houses" do not necessarily imply "big" houses).
In describing the Swedish approach to crisis management, Mr. Lundgren told BusinessWeek in an interview five years ago that "a great deal of work began on valuing loans and collateral in each bank in order to arrive at a need for support that could be provided without delay." To that end, Sweden established a Bank Support Authority to undertake "reality testing" on the loan books of Sweden's largest banks and had a 'board of valuation" experts go in and value the assets on the books of all the lenders. Call it invasive if you will, but then again, the government was doing the work that market players could not or would not do – value the collateral and do it quickly. This is similar to what Barney Frank is proposing in the US mortgage sector today.
In the case of Sweden in the 1990s, the critical feature for resolving its banking crisis was the splitting of distressed financial institutions into so-called "good" banks and "bad" banks. This may serve as a model for the inevitable financial failure procedures here in the United States. Good bank/bad bank restructurings simply involve the separation of the good assets of a bank from the bad assets during a time of crisis, and calls for separate management of the disposition of these two categories of assets. As the Swedish experience indicates, such a restructuring can provide an effective means for disposing of nonperforming loans and return the financial sector back to health.
It should also be noted that it was Sweden's equivalent of the US Treasury, and not the central bank, that played the primary role in this crisis management stage (though the Riksbank maintained an accommodative monetary stance and lowered interest rates right through to December 1993, more than a year after the markets had bottomed). And, it obviously required the heavy hand of government intervention; there are solid grounds for this when there is market failure in the private sector, in this case, insufficient information regarding the quality of financial sector balance sheets. Both the US Senate and the House of Representatives are already proposing legislation that would trigger much more public sector involvement in re-dressing the housing crisis -- either through an expansion of the FHA's existing mandate (from Barney Frank in the House) or the revival of the 1933 Home Ownership Loan Corporation (from Christopher Dodd in the Senate).
So let's not delude ourselves. A government-backed solution to the intensifying financial strains is probably going to be part and parcel of this new crisis management phase we are about to enter, though there is a question over timing in view of the ideological differences between the current Administration and the Congressional leadership. But in our view, any durable solution will likely require tremendous political compromise, just as it was in Sweden in the early 1990s.
It is easy to jump to the conclusion that Sweden's economy has always existed with a heavy reliance on the "state", but if truth be told, the government during its credit crisis was a non-socialist coalition that worked very closely with the opposition Social Democrats. Mr. Lundgren, who was Sweden's Hank Paulson equivalent at the time, emphasized in the BusinessWeek interview that "broad political consensus and resolute political actions taken by the political system are probably more important than any of the technical aspects on how to deal with the crisis".
In fact, former Fed Chairman Alan Greenspan, in a prophetic speech he delivered back on September 27, 1999 before the IMF on "Lessons from Global Crises", said much the same thing, and invoked Sweden as the template to follow in a credit crisis:
"Bank loans in Sweden in the early 1990s were concentrated in the real estate sector, and when real estate prices also collapsed there, a massive government bailout of the banking sector was initiated … the speed with which the Swedish financial system overcame the crisis offers a stark contrast with the long-lasting problems of Japan ...
...The Swedish case, in contrast to America's Savings and Loan crisis of the 1980s and Japan's current banking crisis, also illustrates another factor that often comes into play with banking sector problems: Speedy resolution is good, whereas delay can significantly increase the fiscal and economic costs of a crisis.
Resolving a banking-sector crisis often involves government outlays because of implicit or explicit government safety net guarantees for banks. Accordingly, the political difficulty in raising taxpayer funds has often encouraged governments to procrastinate and delay resolution, as we saw during our savings and loan crisis. Delay, of course, can add to the fiscal costs and prolong a credit crunch."
Do not think for a second that Bernanke and Paulson are not preparing for this "crisis management" stage. We can't be sure if we end up following the Swedish example tit for tat, but we are fairly certain that our two primary financial statesmen are examining that experience right now.
To add some perspective, Sweden today has a vibrant economic and financial sector backdrop, so it's important to note that this is not about the end of the world or financial Armageddon. At the same time, even with an effective government solution in Sweden, the process of extinguishing the bad debts was painful. The equity market incurred a 28-month long bear market that saw Sweden's major index decline 45% from peak to trough and the economy undergo a 20-month recession that saw domestic demand contract by 2½%.
But unlike Japan, within three years after the crisis broke, both the level of economic activity and the stock market in Sweden were retesting new all-time highs. By way of comparison, the level of domestic economic activity in Japan is no higher today than it was 12 years ago; and the Nikkei is still 68% below its late-1989 peak. This is why acknowledging that crisis prevention has not worked and making a quick and effective transition to the crisis management stage is so vital to the longer-range macro and market outlook.