Fragile Stability

We talk about the signals the economic data are sending out, but this is also a financial crisis that has to be resolved for there to be a broad-based recovery. As with the economy, the major panic of end-2008 has subsided somewhat, giving way to a fragile stability that will need a lot of TLC and a firm hand from the Fed and the government

1) Investors (mind, I say investors, not bank executives - that's another matter) have started to grumble about government and Fed involvement in markets. It's hard to hedge against government action - particularly given Congress' populist bent and limited attention span. Yet the mutterings are a massive shift from last year, when the cry "They (the administration or the Fed) must step in; they must do something" arose any time there was even a mere whisper of trouble. The patient, in other words, is out of intensive care, but still requires major attention. With the worst behind him, the patient is eager to leave the hospital and go home. But the doctors should refuse to discharge him - it will take a while longer to ensure a full recovery - and there is always the danger of relapse.

2) The bond market vigilantes this week stuck their heads over the parapet: punishing the BOE and the U.K. government for sending mixed messages and sending a warning signal to the U.S. and the Fed that there is a need to spell out the exit strategy. The bond market's early warning system is up and running - that's a good sign - but it bears remembering that the safe-haven bid remains an underlying support for government debt. The market's animal spirits remain subdued.
And, by the way, the exit strategy planning is well underway - in a little noticed joint press release issued by the Treasury and the Fed, the last sentence states that at some point, the Treasury will take over the three Maiden Lane vehicles that sit on the Fed's balance sheet - which would indicate that preparations are underway to rid the Fed off any credit exposure. Treasury also committed to helping the Fed achieve the tools it needs to fight inflation - i.e. withdrawing the trillions of dollars it is pumping into the system. One way to do that would be to sell Fed bills to mop up those dollars - which will require legislative action and where the Treasury's support will come in handy.

3) The Obama Administration's plan for regulatory reform. That was the most heartening of actions so far - the administration clearly has a plan and presented it forcefully this week: first on Wednesday, in testimony by Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke and New York Fed President Bill Dudley, then again on Thursday in testimony by Geithner alone. It's a year since the downfall of Bear Stearns first made it clear that the regulatory system was woefully inadequate to deal with the turbo-charged financial industry - that we finally have an energetic administration that recognizes the need to address these deep-seated problems and isn't shy in tackling them is in my mind the most encouraging sign one could hope for.

Enron, Bear Stearns & Treasury's Financial Stability Plan

The government is set to present the heart of its financial stability plan - how to deal with the toxic assets clogging up banks' balance sheets - a stark reminder how little progress has been made in dealing with the root of the financial crisis a year after the Bear Stearns bailout.
There's no harm in thrashing out the pros and cons of this plan yet again. But what is urgently needed - and what we are highly unlikely to get - is a sober debate of the big picture, the plan's framework. Transparency will once again fall by the wayside. The taxpayer will be asked to pay up, without being told what it is that we're taking on all this debt for, let alone being involved in the debate whether this is the best solution.

The arguments against the Financial Stability plan are easy to list and most involve practicalities. Private investors will be reluctant to lend because they fear arbitrary changes to the ground rules by populist lawmakers, no matter how cheap the funds are the government will offer them. Valuing these assets so that banks will be willing to sell them without overpaying for them remains a tricky issue. The mood right now is for solutions that work immediately - yet this plan is nothing if not complex and will take time to implement.

But of far greater importance is an issue that we seem to have lost sight of as the crisis has progressed: the need for transparency. We as taxpayers, whose full faith and credit are on the line, have a right to know what these purchases are that we are funding. The Treasury has a web site www.financialstability.gov. It should post the assets that are going up for sale there, including the prospectuses that the government will send out to investors. And please, spare me the "nobody would understand them, they are so complex" argument. It's irrelevant - all that matters is that anyone who is interested has the option to find out more.
What we can't have is a replay of Maiden Lane I - remember the $30 billion facility set up in June last year to take over Bear assets that JPMorgan's Dimon washed his hands off? It's faded into the mist of the financial crisis, but it's still there - just a bit diminished: at the end of 2008, the $30 billion - of which JPMorgan had put up $1 billion - had shrunk to $26 billion. Yet nobody except the New York Fed, JPMorgan and the portfolio manager Blackrock have any idea what's in that portfolio. What harm could come of making these assets public?

This insistence on obscurity is the biggest problem we face. The taxpayer must be treated as equal partner in the resolution of the financial crisis. Officials have decided that the best way to rescue the banking system and the economy is by reviving the shadow banking system - those obscure markets that allowed lenders to repackage loans and sell them on to third parties. But they have yet to explain how they arrived at this decision; they have yet to involve us, the taxpayers, in their discussions.

Off-balance sheet vehicles were instrumental in allowing banks to circumvent capital rules and take on far more risk than they should have - in a replay of what brought down Enron. They should have been banned in 2002, we are now paying for regulators' inability to act forcefully seven years on (we won't even ask where Congress was all those years. Those Congressmen baying for bonus recipients' blood should take a long, hard look at their own record.) These same regulators have now embarked on a strategy that revives those markets that allowed us to live beyond our means, borrow more than we could afford.

Is that the best plan we can come up with?