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The Progressive Economics Forum

Bailouts and Bay St

In his latest rabble.ca column Duncan Cameron takes on a piece of the federal budget that got little play in the media:

Budget 2009 and the Bay St. bailout

Duncan Cameron

Why did the Liberals support the Conservative budget when the analysis is clear: the Finance Minister ignored the vulnerable, punished women, did not provide a serious stimulus to a flagging economy and tied up infrastructure spending in so much red tape that no shovels will be sighted this year?

The reason the Liberals did not oppose it, and would not have opposed it — regardless of the prospects of taking power in coalition with the NDP — is that Budget 2009 contains a huge spending programme directed to Bay St., and Liberals do not want to be the party that opposes Bay St.

Though you may not have read about it, the federal government is borrowing up to $200 billion to provide cash to mortgage lenders, cash to crown corporations that lend to business, cash to life insurers, and cash to shore up the reserves of our chartered banks.

Called the Extraordinary Financing Framework, or EFF, you have to go back to the Canadian postwar loan to Britain to find a financial operation anything like (though a lot bigger than) the 2009 Bay St. bailout. In 1945-6 we were lending to an overseas customer, so that it could buy our products. This time the government is providing cash to the financial sector, so its shareholders can stay afloat.

In the U.S., Joe Stiglitz (Nobel Memorial Prize in economics) calls this lending — cash for trash — because a government buys mortgage debt no one else wants to buy. Of the EFF money, mortgage purchases amount to $125 billion — a lot of cash. Another, inelegant, way to think of it is as the government covering the asses of the bankers who made bad loans, and the shareholders who stand to lose their investments.

From Davos on the weekend, where he was attending the World Economic Forum, the networking opportunity for the world financial elite, where respectability is now in short supply, Finance Minister Flaherty re-affirmed that he would do whatever was needed to protect the Canadian banking system. The $200 billion the government is borrowing to back up his words is almost what taxes will bring the government this coming fiscal year.

Central Bank Governor Mark Carney, speaking in Davos as well, complained that despite a G7 pledge on October 10, 2008 — that no large financial institution would be allowed to fail — rather than lend to each other, the major banks were accumulating cash for reserves.

What is going on is the clearest, most recent, example of common capitalist practice: when things go wrong, citizens pay the costs; when they go right, owners pocket the profits. This (socializing of risk, and privatization of gain) is also known as socialism for the rich.

Capitalism is for the graduate student who cannot get a scholarship without entering “business-related studies” (Budget 2009, pp. 106-7) or the over 60 per cent of the unemployed who pay for unemployment insurance, but do not get it when they are thrown out of work.

Under EFF, the Canadian public is on the hook for anything bank management have done wrong, or will do wrong. Who gets protected? The owners and executives of the banks get protected. They can loot their institutions, paying themselves millions in salaries and bonuses, and when things go wrong, as they now have, turn to the public for the bailout, and get it, thanks to the Conservatives, and their Liberal allies.

Finance Minister Flaherty is borrowing all this money so that he does not have to do the sensible thing, have the government take over ownership of the Canadian banking system, in order to protect depositors, not shareholders, and ensure that loans flow to deserving borrowers, not into the pockets of overpaid executives.

A much cheaper, much smarter alternative to EFF would have the Department of Finance see to that the banking system is run as a public utility, providing reliable services at cost. Instead of representing shareholders, bank boards would represent the communities they serve, and include employees, depositors and borrowers.

Bankers want to build up their capital because they know loan defaults are coming. The government borrowing under EFF gives banks the money they need to make good on losses from bad loans.

Instead of bailing out Bay St. the government could take over ownership of the banks at less cost, and use the sizable amount left of the $200 billion to stimulate the economy, so that people could make a living, and businesses not go belly up in the first place.

At the end of the day, both the banks and the economy would be in better shape using the public utility model of banking.

The message of Budget 2009 is that the Liberal party is not about to turn its back on the Toronto branch of the financial capitalists recognized once upon a time as the “masters of the universe,” and now better seen as the masters of using public credit for protection of private shareholders.

Duncan Cameron writes from Quebec City.

Comments

Comment from Stephen Gordon
Time: February 3, 2009, 6:52 pm

Um, no. Duncan doesn’t understand what is going on. These are exchanges of assets that leave the banks’ balance sheets unchanged. The point of these transactions is to increase the liquidity of the banks’ capital (CMHC paper is more liquid than mortgages), not to improve their capital ratios. Neither the federal government’s not the banks’ balance sheets are affected by these activities. No-one has suggested that the mortgages purchased by the CHMC are toxic waste.

This story being told in that column is about what is going on in another country, one that happens to be a neighbour of ours. But it’s not a story of what is going on in Canada.

Comment from Partisan Hobo
Time: February 3, 2009, 9:25 pm

It’s too bad that “whatever it takes” seems to include financing dubious and/or risky and/or environmentally destructive projects in foreign countries.

Comment from duncan cameron
Time: February 4, 2009, 3:50 am

Stephen please explain why the government is borrowing up to $200 billion to help out the banks? Please explain why Carney is in Davos calling on the banks to lend? Please tell us how the banks are planning to deal with the loans out to the Detroit three equal to 50 per cent of their capital? And review for us what it takes for a balance sheet to undergo de-levering successfully.

Comment from Travis fast
Time: February 4, 2009, 7:02 am

Stephen you will have to explain it better. All most all of the risky mortgages on the books of the banks are already insured by the federal government via the CMHC. Most of the rest are covered by a 20% equity stake. So selling mortgages to the CMHC for CMHC paper seems redundant on the surface. The liquidity comes from the fact that the CMHC paper can be traded more like cash and unlike cash it is backed by a corresponding asset which is itself insured.

What do we get from the Banks for taking their less liquid assets onto the public books? Do we get the higher return because we own the less liquid assets or does the bank get the liquidity plus a stream of revenue off the CMHC paper. That is, what is the structure of the CMHC paper that the banks are getting?

Comment from duncan cameron
Time: February 4, 2009, 11:40 am

The top rated bank, the RBC, has a capital to asset multiplier of 20, one dollar in capital for 20 dollars of assets. Assets include real estate, securities, commercial, and personal loans. For a start the TSX is down about 40 percent. Maple bonds issued by U.K. and European banks in Can $ and held by our banks are down up to 80 percent. Banks carry large outstanding derivative portfolios, and nobody knows what is happening next with lots of those.
So, banks have to de-lever, and re-capitalize, as the assets shrink. If they can get their hands on things to sell, thanks to Ottawa, in exchange for things they can not sell, they will take the government bonds, and hand over the mortgages which carry a mark to market stigma.
In recessions, banks tell governments to reduce deficits while they buy up the government paper and cut back lending.
All this is being done while ignoring that the originate and distribute model of banking, based on securitization, and assuming no black swans, has to go. The least costly way to fix it, is to make the banks public utilities. Even Krugman is now arguing the U.S. needs to do this.
Generally it is the case for the OECD countries I believe, that the public model is more attractive than sticking with the gunslingers playing with other people’s money. After the takeover of the Canadian investment houses by the big 6 banks (take a bow Michael Wilson) the investment bankers no longer put their own money on the line. It makes all the difference when the public picks up the tab for your mistakes, and you get the big bucks. In the old days the partners ponied up their own money.
Gordon Brown, apparently spoke well on what to do next in Davos, but, somehow, I did not get over there to hear him.

Comment from Leigh Thomson
Time: February 5, 2009, 9:48 am

Duncan, can you elaborate on this;”…Department of Finance see to that the banking system is run as a public utility, providing reliable services at cost. Instead of representing shareholders, bank boards would represent the communities they serve, and include employees, depositors and borrowers.”

ie) can you outline the steps that would be involved in this transformation. it helps people, including me, understand the mechanisms/ options. you mentioned earlier as well that you had written some materials in ’82 on the subject. perhaps that can also be made available.

as far as i can see, given that the current bank board members have done such an abysmal job with stewarding the public assets in their keeping, that they should be replaced if taxpayers are going to unload further billions to them. There are some old metaphors for the bankers’ behaviour- burying talents.

so how does one go about replacing bank board members? also, would it not be sensible for the irresponsible risk-takers to experience the consequences of their behaviour? Stiglitz has been recommending that governments allow banks to go bankrupt, i think in that process shareholders get out what is fair, while most importantly protecting the community residents, depositors, borrowers, and taxpayers. this could be done with the benefits of the $200 billion directly along with new membership-and-voting-determined community/ public banking structures.

those with the power currently, and with our money, may be tempted to hold on to both, and their antisocial behaviour, for as long as the public lets them. what might be involved in helping the bankers ‘see the light’?

Comment from Leigh Thomson
Time: February 5, 2009, 1:02 pm

also, pertaining to global dynamics, here is the Halifax Initiative’s recent update, commenting on the Merkel/Sarkozy options, etc.

http://www.halifaxinitiative.org/index.php/issue_update/1129

Comment from Stephen Gordon
Time: February 13, 2009, 2:47 pm

Stephen please explain why the government is borrowing up to $200 billion to help out the banks?

I can’t, because it isn’t. Where did you get this number?

Comment from duncan cameron
Time: February 13, 2009, 4:41 pm

On page 74 Budget 2009 states;
“The Government is responding to gaps in credit markets by
providing up to $200 billion through the Extraordinary Financing
Framework to improve access to financing for Canadian households
and businesses …”

Comment from Stephen Gordon
Time: February 13, 2009, 5:34 pm

And here, we have:

These measures do not increase the federal debt, or accumulated deficit, as they are offset by interest-bearing financial assets.

As you no doubt are aware, the issue here is liquidity, not solvency. The assets the banks hold are not as liquid as the assets that the government can provide, even though they are (in principle) of equal value. We are not talking about toxic waste here.

The government is trading liquid assets for less-liquid assets so that banks can continue to borrow and make loans based on their capital. These activities don’t affect either the government’s nor the banks’ balance sheets.

Comment from Stephen Gordon
Time: February 13, 2009, 5:42 pm

Here’s a description of the Extraordinary Financing Framework:

The EFF is expected to generate a positive return for the Government overall and therefore has no expected fiscal cost. The Government will undertake additional borrowing to make the EFF possible; this will increase the amount of Government of Canada debt sold to financial markets (Annex 4). As this debt will be matched with sound assets, the EFF will not lead to any increase in the federal debt (accumulated deficit).

Feel free to claim that the govt is buying toxic waste. But you should be prepared to provide an explanation as to why you think that those assets are not being sold at a fair market price.

And no, you cannot point south. Canada is not the United States.

Comment from Stephen Gordon
Time: February 13, 2009, 5:50 pm

Duncan, I found those quotes after a two-minute search of the Department of Finance’s website. How much time did you spend researching that column?

Comment from duncan cameron
Time: February 13, 2009, 8:00 pm

HI Stephen,
Why do believe what you read from the Dept. of Finance? They began misleading the public some years ago on deficits, and the state of the economy and have never looked back. Plus it is standard practice for governments not to tell everything they know.
I have read just about every budget since 1966 when I joined the Dept. of Finance. The Minister has never announced purchases from the banks such as have already taken place last year, and are planned for this year, totaling $125 billion in mortgage purchases alone. To say this is unusual is understatement, it is incomprehensible unless there is a problem. You say liquidity, perhaps, but it is still government borrowing good money, and buying assets the banks cannot sell for very much, because they are of doubtful value.
The Canadian banks are counterparts in God knows how many derivatives trade that add up to trillions. If, as Martin Wolf, and others argue many commercial banks are insolvent, the risk of some of these trades going sour is very much a concern.
I have not looked at the CDS books of the big six banks, but why do you think bank stocks are trading at about a 50 per cent discount? No one knows how bad things are, so the best read is that the $200 billion the federal government is taking off the books of lending institutions in return for government bonds is insurance.
A more pessimistic account suggests that this money covers capital losses to come when bad loans get written off. See my post above for the ratios, and the likely bad debts.
You leave the impression that your economics degrees give you insight unavailable to others, including those who have the same degrees you do.

Comment from Stephen Gordon
Time: February 13, 2009, 8:48 pm

“Doubtful value?” How do you know that their value is doubtful? And how do you know that every single mortgage the CMHC bought will default? As far as that goes, most of it is insured, so if your point is that those mortgages are toxic waste, the govt is on the hook in a big way, EFF or no EFF.

I don’t understand why you’re conflating the situation of Canadian banks with the situation of banks in other countries. Why would you jump from ‘Martin Wolf … and others argue many commercial banks are insolvent’ to the assertion that Canadian banks are insolvent? No-one else seems to be willing to say that. At least, no-one else seems to be able to point to evidence that suggests that this is indeed the case.

Comment from Leigh Thomson
Time: February 14, 2009, 7:36 am

‘EFF or no EFF’- that’s why it’s doubly obscene Stephen.

and you seem to have no concept regarding global electronic trade in financial products.

Comment from duncan cameron
Time: February 14, 2009, 10:14 am

Stephen, a Canadian bank does not have to be insolvent, to have a derivatives contract with a bank that is insolvent, in which case the Canadian bank takes a hair cut, when the counterpart cannot pay off on the bet. Meanwhile the Canadian bank has to pay off on its losing bet.
What part of borrowing $125 billion in order to pay cash for something that cannot be sold on the open market do you not understand to be assistance to the banks aka a bailout? It has nothing to do with whether or not our banks are illiquid or insolvent, and has everything to do with mortgaging public credit to help out private investors to the tune of “up to $200 billion”.
This morning in the Globe the Vancouver downtown Eastside gets pages of ink and photos for supposedly sucking up about $1.4 billion in the last nine years.
Where is the story on our $200 billion going to support management, and shareholders of our banks aka to help them cover their asses? I for one would like to know a little bit more. Why did they get the money? What are they doing with it?
See the post above: “Laughing all the way to the err bank” for some additional commentary.

Comment from Stephen Gordon
Time: February 15, 2009, 7:11 pm

Again, you’re asserting something about the value of those mortgages that no-one else seems to be able to verify. If you have inside information, you should make it public.

This morning in the Globe the Vancouver downtown Eastside gets pages of ink and photos for supposedly sucking up about $1.4 billion in the last nine years.

Why on earth do you think that this is relevant?

You leave the impression that your economics degrees give you insight unavailable to others, including those who have the same degrees you do.

Oh, well played. Look through the thread. Do you see anything that I’ve said that amounts to anything beyond my claim of being able to do a routine google search and my mastery of Grade 4 arithmetic?

But hey, if you think that pointing at me and screaming “Economist! Economist!” will win you points among non-economists, then go ahead.

Comment from Travis Fast
Time: February 15, 2009, 8:22 pm

So much heat and no light.

I blogged about this back in October

http://rppe.wordpress.com/?s=Bank+of+canada

http://rppe.wordpress.com/2008/10/11/conservatives-announce-partial-nationalization-of-mortgage-market/

http://rppe.wordpress.com/2008/10/14/conservatives-expand-nationalization-of-mortgage-market/

What seems to be pushing the confusion is that the government did not want to be seen to be nationalizing the mortgage market but banks needed liquidity but did not want to be seen to needing liquidity.

What we do know is the government started buying up mortgages back in October–mortgages they already were insuring through CMHC. 200 biliion equals about half the value of the mortgages on the BIG Banks books and 25% of the market.

What we do not know is why the Banks need liquidity. To date it has been justified along two lines. One was that it was to help CDN banks do their bit to keep credit flowing and lower interest rate spreads.

The second was that the CDN banks needed to say competitive with their foreign counterparts who were receiving massive injections of cash.

Duncan has suggested a third: the Banks need liquidity because they have some junk on their books from any number of origins.

SG has not said why the banks need liquidity they apparently just need it and the tax payers just apparently need to own 25% of the mortgage market.

No one has explained the structure of the deal in clear terms: there is some vague description of a reverse auction with a price floor 95% and price ceiling 101%. But that only related to the first 25 billion back in October. It is interesting that money was spent then and just authorized now in the Budget.

If I had the time I would email one of these CMHC PR people and see if I could get an explanation as to the mechanics and size of the program.

Stephanie Rubec
CMHC Media Relations
Tel: 613-748-2300 ext. 3064
srubec@cmhc-schl.gc.ca

Julie Girard
CMHC Media Relations
Tel: 613-748-4684
jagirard@cmhc-schl-gc.ca

Comment from Marc Lee
Time: February 15, 2009, 8:28 pm

OK you two, back to your corners. This exchange has ceased to be enlightening for the rest of us.

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