TARP will not resolve the financial crisis

October 30, 2008

Today the GDP numbers for third quarter have been published, and they came at minus 0.3, defying expectations of a worse number. My own choice is generally to ignore most of these numbers, because they are subject to dramatic revisions, and basing one’s analysis on preliminary data is usually gambling. The contraction in the third quarter of 2000, for instance, was first. reported as a 2.7 percent gain.

A more significant development is the 3.1 percent contraction in private consumption, and although it’s worse than expected, there’s no surprise in the result, as it would contradict logic if the US consumer, whose profligacy always depended on borrowing, could continue his habits during this unprecedented period of credit tightening. What must be realised is that this is only the beginning of a phase that will last for at least another year in the mildest scenario, and the chain reaction will have consequences for not only the US economy, but the rest of the world too, in particular for exporters such as Japan and China, Singapore and others, who made the most of the irrational excesses of the American consumer.

At this stage there is very little merit in preaching the obvious to the pious. The bankruptcy of Lehman was an event similar to those of August 2007, when the collapse of several hedge funds, and the reesulting inability to price mortage related assets caused a general paradigm shift in how the market valued certain asset classes. The demise of Lehman should only be seen as a further escalation of this trend, in which impossibles become possible, causing panic among speculators. It is meaningless to speak of investors at this stage, as volatility compels us to redefine “long term” within the span of a few months. Until a number of bankruptcies brings clarity to the situation, very few serious actors will be willing to assume long term exposure to the markets, and this will only make life harder for the governments.

Much is made of the recent easing in overnight rates, and the slight softening of the tensions in unsecured interbank lending. But while the governments’ massive injections of liquidity, and cash grants in the form of share and asset purchases appear to have made some banks and others more willing to accept higher levels of risk in overnight lending, with the Libor-OIS spread at 253 bp, one can only speak of lessening tensions in relative terms, comparing the situation to the period before the Lehman event. Otherwise it is clear that there’s very little lending going on between banks, and financial actors continue to be fearful in their dealings with each other. This is confirmed by the continued contraction in lending to consumers and the real sector, with both consumer credit, and corporate borrowing becoming more anemic by the day.

Others tie their hopes to the TARP and the Fed’s mergency lending and swap facilities, but while the latter may be of some use in alleviating the severity of the crisis, the former, in my opinion, will only make the problems worse, as there appears to be an irrational assumption in many quarters that throwing money at insolvent institutions can jump-start lending, and thereby the economy.

But this is deeply flawed reasoning. As I have stated here many times before, what the financial sector needs, and in fact, in an indirect way, demands, is bankruptcies. It’s very easy to gain a general idea on the status of many banks in the US by examining the FDIC’s statistics, or easier still, by visiting the FED’s website. What we see in the former is that banks have no money to cover their bad loans, and that this is a general phenomenon. The cover ratio of non current loans on banks’ balance sheets is only 70 percent at this stage, which is by far the lowest on record, and the situation is almost certain to deteriorate further from here. And on the Federal Reserve’s website one can see that they have been lending more than 100 billion dollars to commercial banks for the last two weeks, and although a bit crude as a measure, this serves well to demonstrate the difficulty in obtaining funding from other channels.

And so, why is the TARP counter-productive? Because it is funding institutions that have only one use for the funds they receive: patching up their books, covering their losses, and sustaining themselves. But what is the purpose of a bank, from the point of view of the public? It is to expand credit to the real economy and consumers. If the numerous banks that the TARP and the Fed are funding cannot expand credit, and are using the funds which they receive only for continuing their existence, isn’t the TARP prolonging and perpetuating the crisis, by helping those institutions that cannot, will not, and should not survive in the first place? If the program succeeds, and the complete mess of a system that we have now survives, will the financial system be in a better form where it is led and directed by players who exist as parasites on government subsidies, and whose only purpose is continued existence through government help? With the balance sheets that they have, and the managements that have brought them to where they are, can the American financial system have any hope of recovery if it expects the recovery to be financed by credit from institutions which are, for all intents and purposes, bankrupt, and which only exist at the mercy of the FDIC, and the federal government?

The TARP is a mistake, but given the way that the government has been reacting to each crisis, it’s not a surprising mistake.

Naturally, the reader will expect me to propose my own solution after this negative assessment of the government’s plan. In my opinion, what the economy needs is a dismantling of today’s system: the failed and bankrupt actors of yesterday should be nationalised when this is unvoidable, but for the greatest part, the government should manage a controlled liquidation of all firms that are clearly inoperable, and insolvent. Under normal circulmstances, this would have been managed by the free market, but there’s too much risk, excessive political costs, and too much uncertainty that make this choice undesirable and impractical. We should never try to forgo the cathartic period of the free market system, but the process should be managed and gradual. If this is the case, we need an organisation similar to the TARP, but its explicit purpose should be the liquidation of the firms that it helps for a brief period. The government could seek authority from the Congress for this purpose, and given the loathing that many of these financial firms arouse everywhere nowadays, such powers would be much easier to obtain than legislation that would sustain them. If, however, the government continues to throw money at these firms, it will only have the impact of feedings cancerous cells, it will surely bring no benefit, and is likely to cause much harm in the longer run.

Tomorrow I hope to write about emerging markets. Fed has recently been lending them billions over swap channels, and this is a phenomenon that is likely to go for quite a while. I believe the next phase of this crisis will be experienced in its severest form by developing nations.


One Response to “TARP will not resolve the financial crisis”

  1. […] 31, 2008 · No Comments Check out the blog here. The blog is call MoneyMill – I am not sure of the author but this is what he/she says about […]

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