Wednesday, March 25, 2009

Public-Private Investment Program - A good Start (Part I).

I like the Public-Private Investment Program. It effectively restores mark-to-model accounting by creating entities that will offer a mark-to-model price for banks' distressed assets. The banks are allowed to use mark-to-model accounting for such assets in seized up markets, but the rules are unclear, and no one would trust the banks' models anyway, so what would be the point? By creating entities with skin in the game, Messrs. Geithner and Bernanke and Ms. Bair have ingeniously allowed the banks to use mark-to-model accounting by getting someone credible to do the modeling. That's really very cool.

To understand how the PPIP fits into the "big picture," it’s important to understand why the credit markets don’t work now. And that starts with the trade deficit.

When we were not running a significant trade deficit, our banking system was essentially self-sustaining. Some part of the money we made found its way to banks, where it was recycled. And since the money we didn't save became money someone else earned, a part of that was also recycled, ad infinitum. At the end of the day, the money the economy needs was either printed by the government or recycled by savers.

But now that we are running a large trade deficit, much of the money we spend goes abroad to pay for things like oil and toys. This diversion of our money has two consequences: we need to borrow from abroad to finance things we would have financed ourselves, and foreigners have to lend to us to make the dollars they receive worth having. The recycling process continues, but with the money detoured through Dubai and Shanghai.

And New York. When there is no trade deficit, we deposit our money in our local banks. Yes, some money goes to Wall Street for investment, but we store a lot of it nearby where it can be relent to other Americans. Trade dollars do not come in through local bank deposits. They come in through money center (i.e., New York) banks and through the purchase of Wall Street securities that package loans created by banks and other lenders.

If you think of the flow of funds as a plumbing arrangement, the new setup has new pipes, and new pipes need to meet several requirements that there is no reason to believe they will meet without careful attention to their design.

Capacity. The first requirement of a pipe is that it have sufficient bandwidth to carry the water. There must be few bottlenecks in the inflow process. The entities involved must be able to operate on the scale required to process enormous volumes of money. This requirement does not exist in the non-trade-deficit scenario, where individual depositors make independent decisions and deposit their money in a wide array of banks which aggregate it into lendable pools. In the trade deficit world, the returning money is aggregated before it gets to New York; the depositors are large institutions and they want to deal with a small number of trusted large institutions. That's how we get the “too big to fail” problem.

Outflow filter. Even entities large enough to handle massive inflows of capital need a place to put the money they take in. I suspect that foreign investors returning trade deficit dollars through Wall Street are seeking, on average, greater safety than American investors would have sought if they were investing the money themselves. After all, people can speculate at home; a major attraction of investing here is (was?) safety. So we need to create securities with the right risk profile for the returning money. The problem is that American users of capital don't want or need capital with the risk characteristics that the foreign lenders are offering. Wall Street is thus charged with the job of restructuring investments to produce securities with the risk profile that foreign investors want. That process has problems, as shall see.

Leakage. Pipes can leak. The unprecedented increase in money flowing into the country through Wall Street has created opportunities for chicanery, temptations to corruption, and other ills that cause money to disappear. Liar loans, bear raids, naked shorting and credit default swaps, and corruptible ratings agencies all happen because new piping is vulnerable to corrosion. Regulation is a remedy, but remember that thickening the walls of a pipe may decrease its diameter, a metaphor that works very well for the effect of excess regulation of financial activity.

The current mess can be described as a case of the new plumbing springing a leak and foreign investors losing so much confidence in it that they have switched to an alternative inflow pipe – the U.S Treasury. The job facing our financial system, players and regulators alike, is to restore confidence in the private plumbing. The Treasury pipe just doesn't have the volume to handle the money our trading partners will need to invest if they are to continue to supply us with the oil we need and the toys we want. Obviously, reducing our demand for imports and increasing the world's demand for our exports will relieve the pressure, too, but that's a longer term project.

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