By Helen Thomas, CFA, Economics Research Fellow
After all the talk of a “bad bank”, the government have settled for a swath of measures centred on a large insurance scheme. Both ideas aim to draw a line under the ever-increasing losses from toxic debts and non-performing loans in order to free up bank capital and encourage them to lend. The main difference between the insurance approach and the bad bank is how quickly losses are revealed.
With the “bad bank”, losses are immediately revealed as the government finally puts a price on debts that have remained difficult to value ever since the market in such securities evaporated. In the insurance scheme, the government guarantees losses up to 90% in exchange for an upfront premium. The premium will vary from bank to bank, and from asset to asset. The benefit to the government from such an insurance scheme is that they will receive something upfront, whilst the ultimate pay-out day might never materialise.Politically this is a much easier sell, but economically it might slow down the healing process. As Keynes was forever pointing out, a lot depends on crowd psychology.
The government hopes that the very establishment of the insurance scheme will kick-start lending and halt the slide in asset valuations. That should mean that the insurance is never called upon – and as sentiment improves, so the need for the insurance itself will diminish. The government has certainly filled the deck with all the aces that it can: guarantees on mortgage-backed securities and for new corporate lending should re-start those markets, helping to unlock the credit markets and halt the slide in the securities that are covered by the government insurance scheme.
But the risks are high. We are at the beginning of a protracted recession. The risk of corporate defaults is high and rising. This increases the likelihood of large losses for the taxpayer. The insurance scheme has to improve lending and halt the slide in asset valuations before the economy takes another lurch lower. Otherwise the guarantees will become ever larger in size, and more money will disappear down the black hole that the banking system now seems to represent.
By opting for the insurance scheme, the government has ducked out of owning up to the losses currently sitting around the system. It might be that these losses never need to be announced, the insurance is never called upon, and the voters can remain safe in the absence of the knowledge of the extent of the problem.
Given that sentiment is such a large part of the persistence of this crisis, perhaps this might be a wise psychological strategy. But ignorance is not always bliss. In this climate of financial fear, leaving the bad debts still out there and still unresolved could simply prolong the problem. We could miss the chance to break out of the vicious cycle of bad debts and falling asset prices.
Indeed, it’s ironic that the government’s insurance scheme is really a huge version of the kind of derivative that has been blamed for causing the credit crunch: the credit default swap market was created precisely to trade insurance over the event of a bankruptcy. It is also ironic that this government-backed CDS is being set up to increase lending, particularly in mortgages – the other culprit behind the economic crisis.
A lack of transparency was the root of the credit crisis. The government should put transparency ahead of expediency in trying to find a solution.