In his most recent speech titled How Important Is Moral Hazard? the Fed’s William Poole stressed once again the Fed can provide liquidity, not capital. Poole also took a look at the concept of “Too Big To Fail”. Let’s take a look.

In the context of macroeconomic stability, the main moral hazard issue arises in the context of “too big to fail.” I believe that it was Alan Greenspan who put the issue this way: No firm should be too big to fail but some may be too big to liquidate quickly.

We have known for many years that moral hazard is a potentially serious issue. If a firm believes that it will be bailed out if it gets into trouble, that expectation encourages excessive risk-taking and increases the probability of trouble. There are two complementary ways to deal with moral hazard. First, firms in trouble ought not to be bailed out, unless the bailout takes a form that imposes heavy costs on managers and shareholders. Second, firms subject to government regulation ought to be compelled to maintain adequate capital to reduce the probability of failure. U.S. banks entered the period of turmoil last year pretty well capitalized and have been able to withstand large losses.

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector. According to the S&P; Case-Shiller home value data released earlier this week, as of December 2007 average prices had declined by 15 percent or more over the past 12 months in Phoenix, San Diego, Miami and Las Vegas. We can add Detroit to the danger list as the home price index for that city is down by almost 19 percent over the 24 months ending December 2007. With house prices falling significantly in a number of large markets, many prime mortgages issued a few years ago with a loan-to-value ratio of 80 percent may now have relatively little homeowner equity, which increases the probability of default and amount of loss in event of default.

As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.

This is the second time that Poole has point blank stated the Fed can provide liquidity, not capital. Both times were in reference to GSEs.

Previously I discussed liquidity vs. capital in No Helicopter Drop For Failed Banks. Inquiring minds may wish to take a look.

Paulson Urges Bailout, Dismisses Bailout as Bailout, Then Implodes

Treasury Secretary Paulson is in denial about bailouts, especially his own. Professor Depew picked up on this theme in Thursday’s Five Things:Congress Inadvertently Passes Economic Save-a-lot Package.

Paulson Urges Bailout, Dismisses Bailout as Bailout, Then Implodes

In an interview yesterday in the Wall Street Journal, Treasury Secretary Henry Paulson branded many of the aid proposals circulating in Washington as “bailouts” for reckless lenders, investors and speculators, rather than measures that would provide meaningful relief to deserving, but cash-strapped, mortgage borrowers.

“I’m seeing a series of ideas suggested involving major government intervention in the housing market, and these things are usually presented or sold as a way of helping homeowners stay in their homes,” Mr. Paulson told the Journal. “Then when you look at them more carefully what they really amount to is a bailout for financial institutions or Wall Street.”

You know what? The plan is working. For a moment, I almost completely forgot about the bailout proposals Paulson helped engineer last year:

The Journal article this morning noted the following caveat from Paulson: “It would be imprudent not to have contingency plans, but we are so far away from seeing something that would have me calling for a bailout that I don’t see it.”

In other words, the only thing currently separating the Treasury Secretary from those in Congress “calling for bailouts” is the magnitude of the crisis, which is ludicrous on its face. Bailouts are bad because they encourage the very behavior that necessitated the bailout. Period. There is no degree of magnitude to it, and it is both disingenuous and cynical for the Treasury Secretary to try and have it both ways.

Bernanke Expects Bank Failures

Testifying before Congress on Thursday, Bernanke stated Banks should seek more capital.

“I expect there will be some failures,” Bernanke told the Senate Banking Committee, referring to smaller regional banks who became heavily invested in real estate.

“Among the largest banks, the capital ratios remain good and I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system,” he said in response to a question during semi-annual congressional testimony.

“They have already sought something of the order of $75 billion of capital in the last quarter. I would like to see them get more,” Bernanke said.

“They have enough now certainly to remain solvent and remain … well above their minimum capital levels. But I am concerned that banks will be pulling back and not making new loans and providing the credit which is the lifeblood of the economy. In order to be able to do that … in some cases at least, they need to get more capital,” Bernanke added.

Bernanke Does Not Understand The Problem

Banks have every reason to decrease lending. There is rampant overcapacity in housing, commercial real estate, and the service sector. In addition there is over-leverage in hedge funds and over concentration of bank loans tied to real estate.

Bernanke wants banks to lend more, but all that will do is increase losses. The man clearly does not understand what the basic problem is. Yes, banks should be raising capital, but not to increase lending. Banks need to raise capital in advance of the approaching tsunamis in commercial real estate and credit card writeoffs, and the continuing tsunami in residential housing, all of which are going to further impair bank balance sheets.

Things We Don’t Need

  • We do not need more Steak n Shakes (SNS), Pizza Huts (YUM), McDonald’s (MCD), Panera Breads (PNRA), Starbucks (SBUX) or any other restaurants for that matter.
  • We do not need more Wal-Mart (WMT), Target (TGT), Lowes (LOW), Home Depot (HD), Best Buy (BBY), or Bed Bath and Beyond (BBBY) stores.
  • We do not need more Toyota (TM) dealers, GM dealers, or Ford (F) dealers).
  • We do not need more nail salons, dry cleaners, movie rental places, storage facilities, etc.
  • We do not need more houses from Toll Brothers (TOLL), Beazer (BZH), Hovnanian (HOV), Lennar (LEN), Pulte (PHM), Centex (CTX) or Ryland (RYL) . Inventory of houses is at an all time high.

Bernanke wants banks to raise more capital so they can do more lending. He never bothered to ask this simple question: For What?

Mike “Mish” Shedlock
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