Stock markets love the idea of a toxic relief fund (TRF). Thursday’s announcement that the US authorities are considering ways to “address the illiquid assets on bank balance sheets” was greeted with jubilation. Global stock markets rose 4-8%. Many big UK banks’ shares jumped by 25-40%. But even if the government can figure out how to suck the pond scum of the financial system onto its own balance sheet, it may still get dragged into dealing with the over-leveraged balance sheets that created the problem in the first place.
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Details of the plan are scarce, and no wonder. The good news is that politicians, regulators, central bankers and industry leaders are all frightened enough to agree to just about anything. The bad news is that it will be tricky, expensive and rife with moral hazard.
The list of questions is daunting. What assets should be considered toxic, or illiquid? How should they be valued—implicit market prices from earlier this week, from just before Lehman Brothers Holdings Inc. collapsed, or something still higher? The higher the assets are valued, the bigger the cost to the taxpayer; the more they are valued in line with current conditions, the less it will help.
Then there’s the matter of who will participate. Can hedge funds, private equity houses and institutional investors? And how will the government detoxify its new portfolio? Who on earth can be trusted to run it?
Perhaps the intelligence and skill, which went to create all these infectious instruments, can be turned to unwinding them. But it’s almost inevitable that the most irresponsible market players will end up getting the greatest relief.
Even if TRF does somehow do what it’s supposed to, the financial system won’t be in the clear. For that, the bazooka that the government used to destroy doubts about Fannie Mae, Freddie Mac and American International Group Inc. may have to be replaced by a cruise missile.
The US financial system is massively over-levered and undercapitalized. But every effort to take debt out of the system leads to price falls for assets, which have been financed by debt—most obviously houses, but also stocks and, in this madly leveraged world, risky loans.
Worse, much of the debt used to finance these assets was short-term, creating a “maturity mismatch” that invites crisis. When the financing isn’t renewed, solid assets have to be sold into cash-short markets at pitifully low prices. The illiquid assets were just an especially toxic icing on a poison cake.
If a TRF changes the pace of deleveraging from frantic to measured, then perhaps the financial system can gradually return to balance. But a few hundred billions of extra funding from the Federal Reserve—the sort of sums being talked about—may not be enough to do the trick. The total debt of the US financial system is $15 trillion (Rs695 trillion).
So, in the event that TRF doesn’t work, Uncle Sam will face a series of further tough choices. One would be to let the deleveraging work its way through the system, causing more financial and economic chaos. But that seems unlikely given the country’s low pain threshold. The US would then be back in even bigger bailout territory. One route would be to further shore up the banks—either by pumping in equity capital, or making long-term loans to cure the maturity mismatch. This would amount to a quasi-nationalization similar to what Sweden did in the 1990s.
The other alternative would be to help borrowers keep up with their payments—either by arranging big write-offs, or allowing inflation to really take off so making their debts easier to pay.
Even if TRF succeeds, the US deficit will mount. But if not, the end result will be dramatically higher deficits and inflation. Given that inflation is already lurking and the US is a huge debtor, the outcome would be a debauched currency.