The end of the beginning

The news that the US authorities are devising a lifeboat for banks along the lines of the Resolution Trust Corporation of the 1980s – let's call the impending scheme the RTC2 – called to RebelEconomist's mind the words of Winston Churchill after the Battle of El Alamein: "this is not the end; it is not even the beginning of the end; but it is, perhaps, the end of the beginning". If media stories are correct, the idea is that RTC2 will buy unsaleable assets from the banks to allow the banks to clean up their balance sheets, and thereby restore the confidence in bank solvency necessary to allow banks to perform their normal business function. It seems to RebelEconomist that this initiative represents the logical conclusion of the accelerating sequence of bailouts that the US authorities have been conducting since at least the start of the present crisis, if not for longer. Since the debt of every American financial institution smaller than the government is now effectively government-guaranteed, attention will now turn to the solvency of the state itself. In RebelEconomist's opinion, the RTC2 initiative represents a last throw of the dice by the present administration to avoid the unpopular policies that are needed to properly fix the US economy.

In the ideal outcome, the true value of the assets bought by the RTC2 will exceed the price it pays, and with the time granted by the deep pockets of the state they will eventually prove to be profitable holdings so that the scheme costs the American taxpayer nothing. There are various reasons, however, why RebelEconomist doubts that this ideal outcome will be realised. First, reports suggest that the RTC2 facility will be a voluntary facility for the banks. Since the banks will be required to give up an equity stake in their business as well as their assets when they sell to the RTC2, they will be reluctant to go to the RTC2 unless it is their best remaining option. The danger is that the banks, which should have at least as good information about the value of their assets as the RTC2, will tend to deal with the RTC2 only when it offers more than their assets are worth. Using reverse auctions to establish a fair price for these assets will not generally be feasible, because the idiosyncratic nature of the most troublesome structured products on the banks' balance sheets means that there will often be only a single potential seller of a particular security, as well as the one RTC2 buyer. Second, the bailout culture, of which the RTC2 itself is the apotheosis, may well undermine the value of the assets it acquires. If borrowers are aware that their mortgage debt is now owed to the government, they could argue that they deserve a bailout as much as the banks and refuse to pay, emboldened by the knowledge that the government will be sensitive to the bad publicity that foreclosure and eviction would generate.

At the time of writing, there has been little information given about how the RTC2 would be funded. Presumably, it will be funded by increased issuance of treasury bonds in some form (perhaps as dedicated, labelled, RTC2 issues). Besides the effect of additional supply in terms of lower bond prices and higher yields, at some point, after the bailouts of Bear Stearns, the housing agencies and AIG, and now the RTC2, the AAA rating of the US government must be in jeopardy. The major rating agencies S&P and Moody's cannot afford renewed accusations of conflict of interest, this time as American companies rating their own government. Although the case can be made that the US government would never default on debt payments in its own currency, this argument did not dissuade the rating agencies from downgrading Japanese government yen debt, despite the fact that Japan's reliable public administration compares favourably with the US history of debt ceiling scares. The US sovereign rating of AAA by S&P and Aaa by Moody's looks increasingly out of line with Japan's ratings of AA and A1 (ie two and four notches below triple-A) respectively. CDS protection against default by the US government has been trading more expensively than Japan since at least the housing agency bailout. Any downgrade of the US sovereign credit rating will reduce the range of investors permitted to buy US government debt and can be expected to raise treasury yields. While the RTC2's demand for mortgage debt, and the reassurance it provides to financial markets, can be expected to reduce spreads between mortgage and treasury yields, some of the resulting reduction in mortgage rates could well be given back in the form of a higher underlying level of US bond yields based on treasuries.

In RebelEconomist's opinion, the US already has too much debt to take on more to finance a bailout of the whole banking system. Since there is going to be limited scope to cut public expenditure without social unrest in the developing downturn, the US government should spend more wisely, and raise taxes, especially on windfall gains remaining from the boom. Instead of spending money forestalling bankruptcies and foreclosures, the government should allow them to occur naturally, and concentrate on facilitating the adjustment and limiting the distress involved. Expand the bankruptcy administration to expedite foreclosures, but provide grants to move and re-house those dispossessed who leave graciously, and assistance for new owners to take over, especially when they have been renters, so that houses do not remain empty for long. Provide retraining for those whose jobs are permanently lost as a result of the restructuring, such as realtors and mortgage brokers. Raise taxes first on those who have benefited from the activities that led to the present bust. Even if it does not raise a large fraction of the money needed, it would be salutary to levy a retrospective income tax on financial workers' bonuses in excess of, say $10mn in the last five years. Increase inheritance tax, since much wealth bequeathed nowadays will represent unanticipated capital gains on houses and stocks during the boom years. America, it is time to stop rolling the dice; roll up your sleeves and clean up the mess!