Pluck of the Irish
Friday, September 25, 2009
The finance minister of Ireland announced a plan to ransom the hostage economy. Others should follow suit.
The finance minister of Ireland, Brian Lenihan, announced a comprehensive plan to remove troubled assets from the balance sheets of national banks. It is not the first time that the Irish moved first. At the height of the financial crisis last year, Ireland stopped their bank runs by offering virtually unlimited deposit insurance coverage. The allure of that insurance, even if given by a small country relative to the size of its obligations, threatened a tsunami of deposit flows away from other European Union countries to the protected locale. Other countries followed suit in an example of policy emulation, not policy coordination. Officials at the upcoming G-20 summit meeting would be wise to emulate the Irish model once again.
The Irish government intends to proffer legislation that creates the National Asset Management Agency (NAMA). This new entity can buy assets at a 30 percent discount and manage their disposition over time.
The haircut on those purchases will be based on independent valuations of legacy loans, not the inflated prices at which they likely are currently parked on balance sheets. Thus, Irish financial champions will have to admit to losses when they offer those assets to NAMA. But NAMA's valuations will be above the fire-sale prices those banks would get if they tried to dump them onto the market now. As a result, there is a disguised subsidy to help revive intermediaries.
Any form of bailout to the financial industry is distasteful, and, given the sour mood of the electorate, politically risky.
Any form of bailout to the financial industry is distasteful, and, given the sour mood of the electorate, politically risky. But with bank balance sheets impaired as they are now, there will not otherwise be enough new lending or financial-market trading to support economic recovery. Above-market purchase prices by NAMA represent the necessary ransom to free the hostage economy.
Such a strategy is far superior to the official policy of regulatory forbearance enshrined in the stress tests required of the leading 19 firms by the U.S. Treasury this summer. Those tests emphasized opportunities for flow profits rather than recognition of legacy losses. In principle, such forbearance redirects the attention of creditors and investors away from the bad decisions of the past toward a more hopeful future. This permits bankers to delay potentially costly near-term adjustments and gives time for the market for the troubled asset to recover.
On one level, this confidence game seems to have worked, in that bank equity prices have rallied and market spreads have narrowed. Under a policy of forbearance, however, the stock of legacy assets at banks becomes more valuable sitting on the balance sheet than if resold. This freezes the market for that asset class as investors rightly recognize the huge retained stocks sitting on the sidelines.
Policy makers seem to have been willing to tolerate the cost of a dysfunctional market for the benefit of maintaining the perception that banks are still solvent on a regulatory-reporting basis. But there is an unrecognized loss as well: Economic performance usually suffers from the lingering hesitancy of intermediaries and the impairment of a key financial market.
Above-market purchase prices by NAMA represent the necessary ransom to free the hostage economy.
The “lost decades” of Latin American countries in the 1980s and Japan in the 1990s stand as warning of that risk. In 1981 and 1982, widespread defaults by Latin American countries sent several important U.S. money center banks underwater. Rather than force the recognition of those losses, U.S. supervisors allowed those banks to carry the loans forward. Those banks limped along for many years thereafter, although there were enough other sources of economic impetus to permit a robust economic expansion in the United States. Not so for the economies to the south that were shut off from credit. Economic growth in Latin America averaged 1.5 percentage points slower than the rest of the world for a decade. In the 1990s, Japanese regulators first turned a blind eye to real-estate losses. Property prices fell in each year of the decade, and the overall economy grew 1.75 percentage points slower than the world.
The painful truth is that many large, complex financial institutions still retain real-estate-related assets on their balance sheets at above their market value. As long as those assets can be valued for regulatory purposes at above-market prices, those institutions will act as a sea anchor to global recovery. If officials believe that those institutions are too fragile to trust to markets, then they should lift those assets from balance sheets themselves. In that regard, Ireland has shown the way.
Vincent Reinhart is a resident scholar at the American Enterprise Institute.
FURTHER READING: Reinhart wrote “The High Cost of Getting the Story Wrong” on how the narrative first written about the Great Depression was mistaken in many important respects, as is the initial narrative on today’s crisis. His other pieces for The American include “Simple Rules for a Complex Financial World” and “When They Were Young,” a look back to the last time that Larry Summers, director of the National Economic Council, and Timothy Geithner, secretary of the Treasury, “saved the world.”
Image by Darren Wamboldt/Bergman Group.