1995

The political realities of solving a financial crisis have often meant circumventing legislative approval to meet the exigencies of a particular situation. This was certainly the case in 1995 during the so-called Tequila Crisis in Mexico. And I believe it is the case again today in 2009. Before I go into how this applies to what is presently happening in the Obama Administration, I thought an example from 1995 would be illustrative.

This comes from a recent article in the New Republic called “Free Larry Summers.”

In December of 1994, the Mexican finance ministry alerted Summers’s assistant secretary, Jeff Shafer, that the country was nearing a currency crisis. During the early ’90s, Mexico had started down two paths that, together, proved unsustainable. First, the country ran large trade deficits. To pay for all the goods it was importing, Mexico needed dollars, which meant it had to sell government bonds. This led to the second problem: To appease all the foreign investors who worried the peso would lose value, Mexico issued certain short-term bonds–called “Tesobonos”–that were linked to the dollar.

This worked fine for a while. Foreign money flooded in as investors snatched up the Tesobonos. But, as the years passed, creditors began doubting that the government would pay off its bonds at the fixed exchange rate. Many began withdrawing their money, forcing the Mexicans to redeem the bonds for dollars. By the time Treasury tuned in, in late 1994, the dollars had almost run out and the government could no longer defend the peso-dollar exchange rate. The imminent decline of the peso would make Mexico’s foreign debt more expensive and raise the risk of a default.

Worse, Treasury itself was in limbo. Then-Secretary Lloyd Bentsen had announced his retirement, but Bob Rubin, his successor, had yet to replace him. It fell to Summers–whose team included Shafer and a young deputy assistant secretary named Tim Geithner–to figure out the consequences of a Mexican collapse. By January 10, 1995, the Summers group had a tentative answer: The fallout could be several hundred thousand U.S. jobs and a 30 percent spike in illegal immigration. If Mexico infected other emerging markets, it could wind up shaving a point off U.S. GDP growth.

That same day, Summers accompanied Rubin to his Oval Office swearing in. Once President Clinton administered the oath, Rubin recalls in his memoir, the new Treasury secretary turned to the president and urged a massive loan package. He then gave the floor to Summers, who briefed the president and concluded that something on the order of $25 billion would be necessary. Surely he meant twenty-five million, George Stephanopoulos interjected. No, Summers said, “billion with a ‘B.'” Clinton swallowed hard and, after weighing every angle, signed on.

The initial response from congressional leaders was also favorable. But the rank and file was hostile. Vermont’s then-congressman, the socialist Bernie Sanders, told Rubin to “go back to your Wall Street friends [and] tell them to take the risk and not ask the American taxpayers.” A freshman Republican named Steve Stockman accused Rubin of arranging a bailout to protect the investments he’d made while a partner at Goldman Sachs. Soon, even the once-supportive leaders were either quietly backtracking (Senate Majority Leader Bob Dole) or railing against the package outright (Banking Committee Chairman Alfonse D’Amato). It was what High Noon might have looked like if Gary Cooper had played a policy wonk.

As it became obvious that cooperation from Congress wouldn’t be forthcoming, Rubin and Summers began to consider plan B. Back in 1934, Congress had given Treasury a pool of money called the “Exchange Stabilization Fund” (or ESF) to help smooth out exchange rates. Sixty years later, the fund stood at about $35 billion, and Treasury lawyers believed they had the authority to draw on it. And so, on January 30, with no congressional help in sight, Summers, Rubin, and Clinton’s top White House aides decided to tap the ESF to the tune of $20 billion.

Still, even this amount was unlikely to restore confidence in Mexico. The only other source of money was the International Monetary Fund, and here’s where Summers’s occasional bullying actually served him (and the country) well. To help cajole what eventually became a $17.8 billion contribution out of managing director Michel Camdessus, Summers pushed and prodded relentlessly. “I remember late the night that this unfolded, in the early morning, Larry was in an adjoining office in rather strong terms telling the IMF they had to step up to the table here in a major way,” recalls one former colleague.

By early March, the first U.S. installment of the nearly $40 billion package was flowing. By mid-May, there were signs it was working. By early ’97, the Mexican government had completely paid off the loan–three years ahead of schedule.

What should be clear from the preceding article is the fact that Congress was in no mood to fund the bailout of Mexico in 1995. Nevertheless, the Clinton Administration was able to cobble together a bailout package of $40 billion that did not require any Congressional approval.

Fast forward to 2009 and you can see similar themes emerging. There is zero chance that the Obama Administration will get more funds for bailouts of the likes of AIG, Citigroup or Bank of America.

Enter the Federal Reserve and the FDIC.

The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership. The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support. Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.

As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .

The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.

Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.

I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.

These are the words of Willem Buiter in a recent piece he has written on his site at the Financial Times. While the language he uses is more colourful than what I would say, I agree with him that what we are now seeing is an end-run around on the Congress. The Obama Administration knows full well that they have to work with the money and institutions now available to them because Congress won’t stand for more bailouts because populist sentiment in the American electorate is in a critical state.

But, more worrying for me are the changes to the TALF program now operated by the Federal Reserve. It was originally created to increase lending by increasing liquid in the marketplace for new asset-backed securities. Not any more, according to the press release by the Treasury for The Public-Private Investment Program for Legacy Assets, it will fund legacy assets.

“To address the challenge of legacy assets, Treasury – in conjunction with the Federal Deposit Insurance Corporation and the Federal Reserve – is announcing the Public-Private Investment Program as part of its efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.”

Willem Buiter has a word or two to say about this in a previous missive of his:

The legacy assets to be purchased by the two legs of the PPIP are legacy securities and legacy loans. The legacy securities are toxic assets. Toxic assets are assets whose value cannot be established with any reasonable degree of accuracy, because there are no liquid markets for them and because their complexity prevents too much faith being put in mark-to-model valuations.

The legacy loans, however, are just bad assets. They are plain vanilla household and commercial loans that have become impaired. Their value can be calculated quite readily by any reasonably competent banker. It is likely to be low relative to the notional or face value of the loan. That’s sad and too bad, but not a reason for getting the state involved through the PPIP.

By bundling toxic assets and bad assets, the Treasury muddles up price discovery issues and the recapitalisation of or subsidies to loss-making banks.

The long and short here?

1. None of this requires Congressional approval.  The executive branch and the Fed are working in concert in ways that exclude the legislative branch entirely.
2. Changes in the TALF program demonstrate that the true purpose of TALF has now expanded from increasing liquidity to make new loans to helping banks get rid of so-called toxic assets.
3. The assets in question do NOT all suffer from poor market liquidity.  For example, loans are held to maturity on bank balance sheets and are NOT marked to market.  They present no writedown risk until the loans actually sour. So, they have not been a writedown problem to date.  Clearly, the PPIP is helping banks by taking these assets off their hands.

I find all of this quite troubling.

Sources
More on robbing the US tax payer and debauching the FDIC and the Fed  – Willem Buiter
The new toxic and bad legacy assets programs of the US Treasury: surreptitiously squeezing the tax payer and the Fed until the PPIPs squeak – Willem Buiter
Free Larry Summers – New Republic