“Reckless Myopia” by John P. Hussman, PhD

by Marilou Moursund on December 1, 2009

in Banks,Credit Crisis,FDIC,Fiscal Policy,Newsletters

I receive John Mauldin’s “Outside the Box” email newsletter, and in today’s issue there was a link to John Hussman’s current market commentary.  We have written frequently about the extraordinary measures that the U.S. government has undertaken over the past 14 months in order to stabilize the global financial system as well as our current unease with the large deficits that the Administration is running.   The concept of “too big to fail”  has perverted any rational weighing of risk and reward in our financial system.

John Hussman has some very interesting policy responses to the problem of “too big to fail”:

“From a policy standpoint, it is effectively too late to forestall further foreclosures absent explicit losses to creditors. The best policy option now is to make sure that the second wave does not result in a debasement of the U.S. dollar. The way to do that is to require three things:

First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman. If this authority had existed in 2008, Bear’s bondholders would not now stand to get 100% of their money back, with interest, as they presently do, and Lehman’s disorganized liquidation would have been completely unnecessary. As I’ve noted before, the problem with Lehman was not that it went bankrupt, but that it went bankrupt in a disorganized way. If the FDIC had authority over insolvent non-bank financials and bank holding companies, it could wipe out equity and an appropriate amount of bondholder capital, and sell the fully-functioning residual to an acquirer, as is typically done with failing banks, without any loss to depositors or customers.

Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that automatically converts to equity in the event of capital inadequacy. This would force losses onto bondholders, rather than onto taxpayers. This policy adjustment is urgent – we have perhaps a few months to get this right.

Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders. Specifically, any funds provided by the government should be contingent on the ability to exert a senior claim to bondholders in the event of subsequent bankruptcy, even if a category is created to allow those funds to be counted as “capital” for purposes of satisfying capital requirements prior to such bankruptcy. Government-provided capital should be subordinate only to depositor claims, if equity and bondholder capital ultimately proves insufficient to meet those obligations.”

While an appetite for risk has returned to the equity and fixed income markets, banks are still sitting on piles of excess reserves rather than lending.  Until their borrowing costs begin to rise, they are content to borrow at basically 0% and invest in government guaranteed securities for a slight spread.  Some of this is due to the regulatory uncertainty that the financial system is facing.  Once all the players understand the new regulatory scheme and capital requirements, the banks may begin lending again.


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