Post by pieter on Sept 27, 2008 15:01:42 GMT -7
The US is working on the wrong solution
Published: 26 September 2008 17:35 | Changed: 26 September 2008 20:29
The confusing emergency measures taken by the US authorities with – as icing on the cake – the massive 700 billion dollar rescue package intended to rid the financial markets of bad debt, look as if they have been thought up in a state of panic, says Sweder van Wijnbergen.
By Sweder van Wijnbergen
Needless to say, something had to be done because the two largest mortgage finance banks, Fanny Mae and Freddy Mac, guarantee half of the mortgages in the US. But those who planned the rescue operation have apparently not learned any lessons from the past because they have overlooked three important factors.
To start with, it is the roots of the problem that must be addressed. If not, the problem will only return at a later date. This means that the mortgage payments of sub-prime clients should bear some relation to their financial capacity.
At present there is a huge gap between borrowers (home owners) and those who claim the debts because of mortgage securitisation - the practice of packaging and selling bundles of mortgage debts which are then used to back bonds. If the debts are sold to Washington the gap will become 700 billion dollars wider.
Free bail out
Lesson two is that governments should not give away public money on the cheap. A free bail-out sends the wrong kind of signal to bankers: they can take huge risks since the costs will be paid by the government. Of course the use of public funds is inevitable if the damage to society threatens to become too great, however the bankers must be made to feel the pain as well.
When a salary cap for managers of the troubled banks was proposed in the US congress, the person in charge of the bail-out, treasury secretary Henry Paulson, objected. He said it would not be attractive to bankers. Which is indeed the point. It should not be made attractive since the banks should not have gotten into this position in the first place.
The third lesson concerns the root of the problem. Why is the bail-out needed? If it is because the banks have assets which they cannot get rid of, then it should be possible to purchase these assets with cash.
Up in smoke
The federal reserve (FED) accepts mortgages as collateral for loans. So something else must be going on. The banks have lost so much money in the mortgage lottery that they have become under-capitalised - too much of their capital has gone up in smoke.
Of course the problem could be solved by purchasing the mortgages above market value. The tax-payer would then pay for losses caused by speculation. However paying ‘fair’ prices would mean that the tax-payer would pay even more. This too would send a signal to the financial world that it can continue taking risks.
Recapitalisation - injecting capital into the financial markets (instead of paying for bail-outs) - seems to be the inevitable answer. This is preferable to giving lenders and shareholders bail-outs, the government would in effect be giving out huge subsidies. The financial institutions would to all effects and purposes be nationalised. With the risk that recapitalisation will be necessary afterwards.
Rescue package inept
The 700 billion dollar rescue package is, according to criteria used by the IMF, inept: blanket guarantees, no incentives to stop using public funds and recapitalisation after the fact. Astonishingly, the former Dutch banker Dolf van den Brink recently suggested adopting the same kind of panic policies in Europe.
We need to find a way to solve the problem while limiting the costs for the tax-payer and at the same time sharing the burden in a fair manner amongst the private parties involved. Without providing the financial system with incentives to take unnecessary risks. The current crisis is no reason to rush through the rescue proposal – which is much too expensive and would probably prove ineffective as well.
Sweder van Wijnbergen is a professor in economics at the University of Amsterdam.
Published: 26 September 2008 17:35 | Changed: 26 September 2008 20:29
The confusing emergency measures taken by the US authorities with – as icing on the cake – the massive 700 billion dollar rescue package intended to rid the financial markets of bad debt, look as if they have been thought up in a state of panic, says Sweder van Wijnbergen.
By Sweder van Wijnbergen
Needless to say, something had to be done because the two largest mortgage finance banks, Fanny Mae and Freddy Mac, guarantee half of the mortgages in the US. But those who planned the rescue operation have apparently not learned any lessons from the past because they have overlooked three important factors.
To start with, it is the roots of the problem that must be addressed. If not, the problem will only return at a later date. This means that the mortgage payments of sub-prime clients should bear some relation to their financial capacity.
At present there is a huge gap between borrowers (home owners) and those who claim the debts because of mortgage securitisation - the practice of packaging and selling bundles of mortgage debts which are then used to back bonds. If the debts are sold to Washington the gap will become 700 billion dollars wider.
Free bail out
Lesson two is that governments should not give away public money on the cheap. A free bail-out sends the wrong kind of signal to bankers: they can take huge risks since the costs will be paid by the government. Of course the use of public funds is inevitable if the damage to society threatens to become too great, however the bankers must be made to feel the pain as well.
When a salary cap for managers of the troubled banks was proposed in the US congress, the person in charge of the bail-out, treasury secretary Henry Paulson, objected. He said it would not be attractive to bankers. Which is indeed the point. It should not be made attractive since the banks should not have gotten into this position in the first place.
The third lesson concerns the root of the problem. Why is the bail-out needed? If it is because the banks have assets which they cannot get rid of, then it should be possible to purchase these assets with cash.
Up in smoke
The federal reserve (FED) accepts mortgages as collateral for loans. So something else must be going on. The banks have lost so much money in the mortgage lottery that they have become under-capitalised - too much of their capital has gone up in smoke.
Of course the problem could be solved by purchasing the mortgages above market value. The tax-payer would then pay for losses caused by speculation. However paying ‘fair’ prices would mean that the tax-payer would pay even more. This too would send a signal to the financial world that it can continue taking risks.
Recapitalisation - injecting capital into the financial markets (instead of paying for bail-outs) - seems to be the inevitable answer. This is preferable to giving lenders and shareholders bail-outs, the government would in effect be giving out huge subsidies. The financial institutions would to all effects and purposes be nationalised. With the risk that recapitalisation will be necessary afterwards.
Rescue package inept
The 700 billion dollar rescue package is, according to criteria used by the IMF, inept: blanket guarantees, no incentives to stop using public funds and recapitalisation after the fact. Astonishingly, the former Dutch banker Dolf van den Brink recently suggested adopting the same kind of panic policies in Europe.
We need to find a way to solve the problem while limiting the costs for the tax-payer and at the same time sharing the burden in a fair manner amongst the private parties involved. Without providing the financial system with incentives to take unnecessary risks. The current crisis is no reason to rush through the rescue proposal – which is much too expensive and would probably prove ineffective as well.
Sweder van Wijnbergen is a professor in economics at the University of Amsterdam.