Home > bailout, financial crisis > What Do They Know That We Don’t Know?

What Do They Know That We Don’t Know?

September 28, 2008

The problem with commenting on the financial rescue plan is that Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson Jr. have not told us all that they know about the financial crisis. Specifically, we don’t know about the financial health of banks individually or in the aggregate. In this entry I will offer a guess: There is widespread bank insolvency and the point of the rescue plan is to use asset purchases to save banks that are good and, just as important, to facilitate closing banks that are bad. If this is right, the rescue plan is a sensible response to the crisis. In effect the plan has a secret component: widespread and controlled bank closings.

On September 18, Bernanke and Paulson met with Congressional leaders in the office of House Speaker Nancy Pelosi. The headline in the New York Times described the attendees as “stunned”. Sen. Christopher Dodd afterwards said “Somber doesn’t begin to justify the words. We have never heard language like this.”

Subsequently, Bernanke and Paulson have not been publicly forthcoming about what they know. The original proposed Treasury rescue plan was politically clumsy, and generated a lot of criticism (including a petition that I signed).  All along I’ve been wondering what was said to Congressional leaders. Exactly what were they told and why haven’t we been told? It’s hard to assess the plan if you don’t know what’s wrong. I think there’s a good reason for the secrecy.

First, what is it that we do know? Credit has dried up: banks and other financial institutions are afraid to deal with one another. There is a lot of “toxic waste”—-mortgage-related assets—-sitting on balance sheets. There is no active trading in these assets and no readily ascertainable market value. We also know that banks have large exposures to the credit risk of other banks stemming from a variety of assets, including credit default swaps. Some banks are insolvent, others are not. You and I have no way to know which banks are solvent, but the Fed must have a pretty good idea.

The plan permits the Treasury to buy troubled assets from banks. Much of the commentary has revolved around the fact that if a bank is insolvent, buying its assets for a fair price will not make it solvent. This has lead to speculation that the Treasury plans to overpay for assets in order to rescue bad banks. There is another possibility, however, which is that the Treasury will not buy assets from insolvent banks, but rather intends to let them fail.

In this interpretation, the plan is not intended to prevent bad banks from failing, but rather to increase confidence in good banks. By identifying the good banks and shoring up their assets, those banks will be able to start lending again and dealing with other good banks. Regulators will be able to close insolvent banks quickly without starting a chain reaction. If a good bank is rumored to be in trouble, the Treasury can buy assets from it. If a bank is truly in trouble, it can be quickly closed. Thus, the plan may have a secret component, namely the pending closure of numerous financial institutions.

This would account for the credit market symptoms we’re seeing (there really are insolvent financial institutions), make sense out of the original version of the rescue plan, and explain the secrecy surrounding the diagnosis. This also explains one curious omission in the original rescue plan: The government was not planning to receive ownership interest in rescued banks because there was no intention of bailing out failed banks. Rather, the plan’s purpose was to liquify good bank balance sheets.

If the intent is what I’ve described, then it’s obvious why Bernanke and Paulson could not explain everything. We still have to be afraid of widespread runs on financial institutions. Bernanke and Paulson wouldn’t announce that the financial system is insolvent for fear of inciting just such a run. Despite deposit insurance, we still have to fear bank runs (the Flow of Funds Account published by the Fed shows $2.4 trillion in time deposits exceeding $100,000 as of June—- this is almost 30% of deposits). There was a run on money market funds earlier this month, stemmed by Paulson’s pledge of $50 billion in insurance. However, there are $3.3 trillion in assets in money market funds, so $50 billion of insurance could be used up in a flash. Widespread runs would be a disaster.

If this analysis is correct, the next few months will be very hard, very expensive, and very disruptive. But it won’t be expensive because we’re rescuing the failures, it will be expensive because we’re doing the right thing and shutting them down.

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Categories: bailout, financial crisis
  1. Entrepreneur
    September 30, 2008 at 9:00 am

    I paid enough attention to see that Bernanke used the Fed on Monday 9/29 to double the size of the “Term Auction Facility” to $300 billion and it will also create a new $150 billion program to alleviate year-end funding pressures, and it will expand agreements with other central banks that effectively send dollars abroad, increasing the amount by $330 billion to a total of $620 billion. What is the impact on this action toward inflation, interest rates and other financial measures, which alone usually would be front page news. In this environment, his action largely went unnoticed.

  2. Robert McDonald
    September 30, 2008 at 5:59 pm

    I doubt that the Fed is concerned about inflation at the moment, rather they’re just trying to keep the financial system from crashing down on us. I think the expansion of the term facility is a way to provide liquidity while the Paulson plan awaits approval. To be honest I’m not sure about the effects of the transactions with other central banks.

    Meanwhile, banks are being closed and the FDIC wants a quick increase in deposit insurance levels. Perhaps some of the urgency comes from this being the end of the quarter.

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