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S P E C I A L FX
13 March 2009
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Who Watches the Watchmen?
Experts told us that the odds of what is currently happening were so infinitesimally small, it was more likely the sun
fail to rise in the sky tomorrow. And yet here we are. Surely, we should be suspicious of their diagnosis and
subsequent policy prescriptions, but despite the political paralysis, there seems to be nearly universal agreement.
Informed by monetarist analysis of the Great Depression, conventional wisdom holds that credit needs to be
restored and by definition, that will resolve the economic crisis, which is understood as a credit crisis. The credit
spreads, we were told, are a measure of the patient’s fever. Alan Greenspan identified the LIBOR/Overnight Index
Swap (OIS) as such a measure, others cite the interest rate differential between U.S. T-bills and Eurodollars.
Many such spreads have narrowed considerably since those heady days that followed the collapse of Lehman and
the beginnings of the government’s macabre nationalization dance with AIG. The TED spread for example peaked
in mid-October a little above 460 basis points. By February 10th, it had fallen to 90 basis points.
Since Treasury Secretary Geithner’s disappointing congressional testimony that day, the TED spread has widened
out to slightly beyond 110 basis points, the highest level since early January. While the credit spreads have
generally been reduced, they remain at elevated levels (the TED spread averaged about 40 basis points between
1995 and 2005), and the crisis remains acute.
Beware Bank Centric Solution
There is a nearly unanimous consensus that the key is to fix the banks. They are the distributors of capital, the life
blood of the modern economy. The credit crisis cannot be resolved until the banking system is functioning again.
Everyone knows what needs to be done: One way or another, the distressed assets must be removed from the
banks. One way or another, banks need to be recapitalized.
The difficulty lies with the nature of the bad assets. They are largely unique, rather than standardized derivative
products. Many never really traded in anything resembling a market. Nor is there a market for many of these
products. Valuation remains elusive and dynamic as residential real estate prices continue to decline.
Most of the debate in recent weeks is over the minutia. How should the bad assets be taken off the banks’ balance
sheets? Can a backstop program, where the Federal Reserve or Treasury essentially absorb losses beyond a
certain amount, work? Should the troubled banks be nationalized, which Greenspan has suggested would make it
easier to transfer the toxic assets?
Ultimately these are minor variations on the common theme which gives the banks a privileged place. Frankly they
do not deserve it. They have failed in historic proportions of the one self-claimed objective: enhance shareholder
value. But this is not a moral indictment. That can be left to others. This is a historic and economic argument.
Review of the 1933-1937 Recovery
Federal Reserve Chairman Bernanke established an impressive academic career studying the Great Depression.
In recent months, judging from the news coverage and blogs, everyone has become an expert. Yet few seem to
appreciate that banks were largely inconsequential to economic recovery.
Recall what happened. Between 1929 and 1932, national income and industrial production was nearly halved.
The economy expanded between 1933 and 1937. National income and industrial output regained 1929 levels.
Work by James Livingston, an American historian at Rutgers University, found that during those recovery years,
total bank deposits rose 52%, while their holdings of government securities increased 57% and excess reserves the
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banks held at the Federal Reserve, grew 140%. Credit and loans to business and households nudged a meager
8% increase. Banks were not nationalized as much as sidelined.
The Reconstruction Finance Corporation (RFC), a government enterprise, essentially provided the scaffolding that
filled the breech left by the troubled banks. The RFC lent money to the key transportation of the era, the railroads,
and other large businesses. It also lent money to small businesses. Livingston found most of the RFC’s loans
were less than $100k. RFC loans and credit extensions during the 1933-1937 recovery ran four-times the level of
the country’s main banks.
The State and Markets
A new RFC would not have to bear as great a burden in this crisis as it did then. And that is because of the
evolution of the capital markets themselves. There are two main channels by which capital is distributed: banks
and the capital markets. For every dollar that a large business borrows from a bank, it will raise two in the capital
markets, by issuing bonds and stock (Europe and Japan are nearly the exact opposite).
The vast majority of investment by Corporate America is self-financed through retained earnings. In fact over
recent years corporate borrowings from the banks largely matched the value of the share buy-back programs.
The good news is that the capital market channel is beginning to re-open. The Federal Reserve has forced open
the commercial paper market, where businesses can raise short-term working capital. The FDIC has forced open
the market for bank bonds by offering a guarantee, but even the non-guaranteed bank bond market has seen some
interest. The non-financial corporate bond market has seen a marked increase in activity here in the first quarter.
And it is not just investment grade paper, as the high yield bond market also is seeing new interest.
The most significant aspect of Geithner’s February 10th testimony was the announcement that the Term Assetbacked securities Loan Facility (TALF) program would be increased five-fold to $1 trillion. This program is aimed to
help those who really do depend on banks, small businesses, consumers and students regain access to capital. In
recent days, as TALF is prepared to launch, the rules have been modified to make participation even more
attractive (lucrative).
Many ask who is going to buy all the bonds that the Treasury will be issuing. Let the banks. Let them rebuild their
balance sheets. But let the government do what the banks had told us previously was already taking place—
disintermediation—Banks mediate between savers and borrowers. Disintermediation refers to the process in which
bank functions have been replaced with non-bank actors (hedge funds, private equity, etc) and the further
development of the capital markets.
A new RFC and government-led efforts to re-open the capital markets can lead to an economic recovery sans the
banks. This is what happened in the Great Depression of yesterday and can happen in the depression of today. In
turn the economic recovery will buy the banks time and perhaps see their distressed and opaque assets become
somewhat less of both.
The bank-centric narrative, despite its widespread acceptance, is un-American. The pragmatic American solution
is to embrace the market-oriented distribution of capital and let the government augment it.
Marc Chandler
Global Head of Currency Strategy
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