Richard Koo's Views On The Macroeconomy, On Volcker's Plan, And Why "Extend And Pretend" Will Be With Us For A Long, Long Time
Richard Koo, whose expansive interview with Kate Welling we presented earlier, is not only well-versed on topics of broader economic consequence, but on the proposed regulatory overhaul and the Volcker plan. Koo is particularly well suited to provide his insights due to his employment at the NY Fed under Volcker's chairmanship.
Mr. Volcker’s plan is based on the principle that the government must protect those banks—commercial banks—responsible for the settlement system. In fact, all of his ideas start from the idea of protecting the settlement system.
When I worked at the New York Fed during Mr. Volcker’s time as chairman, there were a number of events—including the Latin American debt crisis and the failure of Continental Illinois National Bank and Trust Company—that could easily have caused a financial system shock similar to that of the Lehman bankruptcy in 2008. But the problems were addressed with almost no damage to the real economy because of Mr. Volker’s efforts to maintain the settlement system using every means at his disposal....I think Mr. Volcker believes that if we can change the behavior and culture of the banks at the center of the credit-creation mechanism, the financial capitalism resting on top of that structure can also be reined in.
Also, taking a hint from the Japanese deflationary experiment, Koo provides some advice to the Obama administration:
Mr. Obama’s $787bn fiscal stimulus actually owes much to Japan, including the strong warnings and advice offered by former prime minister Taro Aso to President Obama. Unfortunately, Messrs. Obama, Summers, and Geithner have yet to explain to the public how this recession differs from ordinary recessions and why fiscal stimulus is needed. Japan’s experience shows that it is extremely difficult in a democracy for the government to persist in providing fiscal stimulus without explaining why it is necessary. It is like trying to give a patient an expensive treatment for pneumonia without first explaining to her that she is suffering from pneumonia and not merely a bad cold. It was perhaps because of the lack of sufficient explanation that the Democrats experienced an unexpected loss in last week’s special Senate
election in Massachusetts. It may be difficult for Mr. Obama to tell voters one year after he was elected that, in fact, we are dealing with a different kind of economic sickness. But the longer the Administration waits, the further its approval ratings will fall.
If you have been wondering why bad loans are still carried at par (or close to) on banks' book, Koo has the answer to that as well:
While announcing what would appear to be tough new regulations for the banks, the US authorities have substantially eased the rules on bad loan write-offs and are moving to prevent the recent plunge in commercial real estate prices from causing further damage at US banks. Nationwide commercial real estate prices have fallen 43% from the 2007 peak on average. Many properties are now worth less than the outstanding balance on the loans secured by them, preventing banks from rolling over the loans. The sharp drop in property values also means that the loan-to-value (LTV) ratio on all real estate-related loans has probably exceeded an appropriate level. If US banks start refusing to roll over existing loans or tighten the criteria for extending new loans because LTVs are too high, they could trigger a wave of commercial real estate-related defaults. That, in turn, could inflict fatal damage on a banking sector already weakened by problems in residential mortgages. Many of the loans issued during the bubble are due for refinancing between late-2009 and 2011. Consequently, there is no time to waste for either the authorities or the banks themselves. If lenders refuse to roll over these loans, the US could experience another Lehman shock.
On explaining the regulators' fascination with ignoring reality as long as possible:
If the bank can make a case that the price of a given property has fallen excessively, the authorities will not intervene if the bank decides to roll over the loan. In other words, they will not treat it as a nonperforming loan. Even if the outstanding loan balance exceeds recent estimates of the property’s market value, the bank may be allowed to roll over the loan if, for example, the owner has long-term contracts with good tenants and rents do not appear likely to fall substantially from current levels. This implies a major shift from the traditional stance of US authorities, which was to demand that banks write off impaired loans as quickly as possible. It also represents a change in the stance of Treasury secretary Geithner, who originally argued that the US would not experience the kind of drawn-out recession seen in Japan did because it would deal with its banking problems quickly. The pronounced weakness in the commercial real estate market has forced US authorities to abandon their traditional preference for quick write-offs. Instead, they will encourage US banks to roll over loans (even effectively nonperforming loans) and thereby prevent the crisis from surfacing. This suggests that the banks will be allowed to clean up their problems over time by funding write-offs with earnings.
Lastly, some amusing observations on why the "hyenas" will not see real mark-to-market for many years:
The authorities’ change in stance has also largely eliminated the possibility of a sudden selling climax that would bring a true bottom in prices. It appears that a handful of “hyenas” were awaiting just such an event. But with financing extremely difficult to obtain in the current environment, it is difficult to anticipate just how far prices might fall. Such a decline would further weaken bank balance sheets, making it impossible for many people wanting to purchase real estate to obtain financing.
The implications of a selling climax are utterly different when (1) potential buyers are able to obtain financing, as was the case during the cleanup of the savings and loan crisis of 1989, and when (2) most banks are experiencing severe bad debt problems and there is a severe nationwide credit crunch. In the former case, a selling climax can mark the beginning of a new bull market, but in the latter case it represents a one-way ticket to a depression. It would appear that the US authorities have finally recognized this.
I have previously argued that two policies must be implemented to leave the US economy on a firm footing: (1) sustained fiscal stimulus until the private sector completes the deleveraging process; and (2) a gradual, pragmatic program for the disposal of banks’ bad loans. The recent changes to the guidelines for commercial real estate loans (often dubbed “pretend and extend”) suggest that the second may actually be implemented, and to that extent I think are a positive development.
Recent moves by the US authorities—the use of strict new regulatory proposals to reduce moral hazard complemented by the flexible application of bad loan disposal rules in light of actual conditions—are something straight out of Mr. Volcker’s playbook and suggest that the Obama administration is finally beginning to utilize his experience.
Full Richard Koo note: