Saturday, 25 April 2009

Sorting out the toxic assets and the Anglo-American financial axis

In a rare act of candor, almost amounting to schadenfredue, one G7 finance minister appears to be lecturing the US on how to sort out its legacy assets problem. As reported today, in connection with the G7 meeting being held in Washington, Alistair Darling, the UK Chancellor, is quoted as advising Tim Geithner to hurry up with cleaning up the toxic asset problem.

According to the article he is quoted as saying:

"I recognise that the US Government is committed to sorting out the American banks' balance sheet problems. I recognise the political difficulty any government has when people ask 'why are you doing all this for these banks?' but the fact is that we need the banking system.

"We need an effective, functioning banking system, and we need to kick-start credit and that means you've got to sort out these toxic assets, so I hope the United States can make progress as fast as it possibly can. It is an absolute imperative."

So how good is Mr. Darling's form on this matter and what gives him any license to provide such outspoken advice? Surely, within the context of the worst performance by a G7 economy and the worst state of the UK's public finances in 60 years, this is a dreadful time for the Chancellor to be lecturing his US counterpart.

Let's see.

The UK government has taken a different stance with respect to the problems on its domestic banks' balance sheets. Through its Asset Protection Scheme, it has effectively insured the banks against any losses (or at least 90% of them) if these have to be realized in the disposition of their troubled assets.

This approach has two obvious differences to the current approach of the US government.

Firstly, the UK approach is effectively an insurance underwriting provision where the size of the claim that may have to be paid out is not only unknown but may, at the moment, be essentially unknowable. However it does not have the same impact as say nationalization where the magnitude of the "bad debt" would have to be acknowledged and taken fully on to the public balance sheet - as was done in the case of Northern Rock for example. It has the one quality, that may be the ultimate finesse of the problem at hand, which can be summed up in the phrase "Don't ask and don't tell"

Secondly, it is a very simple approach which does not require anything like the complex procedures envisaged under the PPIP scheme that has been floated in the US. In fact the lack of any need for immediate action and follow through is what makes the APS so appealing. Nobody is expecting the matter to be resolved in the short term and the government is effectively "off the hook"

The US approach, as far as it is possible to understand at the moment - it is a rather movable affair - is based upon the following three initiatives

1. The stress tests - which will presumably advise on those banks with insufficient capital based upon the TCE test (not entirely transparent what that is yet)
2. The recent changes in the FASB fair value marking protocol
3. The PPIP scheme which is designed to allow some form of price discovery on the real values of the legacy assets through a rather complex private sector/public sector procedure where the risk/rewards are heavily skewed in favor of the private sector participants (assuming that there will be any such deals done)

As I commented earlier today in regard to an article by Felix Salmon

The timing of the three separate initiatives - stress test, FASB change and the PPIP could not have been planned to lead to such total paralysis unless this had been the intention! The double bind remark "Hurry up and wait" comes to mind

Reducing things to their simplest, but hopefully no simpler, it would seem that in both cases for the UK and the US - the result essentially comes down to the same thing. If the UK banks realize eventual losses from having to liquidate their toxic assets then the public sector gets to pick up the bulk of the losses. If the PPIP scheme ever gets under way then the US public sector will get stuck with the lion's share of those losses too.

So both approaches could eventually lead to the same point - a final recognition that, once the black holes have been fully eradicated, there will almost certainly have been major damage done to the national debt levels for both governments.

But surely this could impact the credit quality of the two governments and be reflected in more ominous aggregate debt to GDP ratios. Moreover this will push up the CDS rates on both sovereign borrowers, require downgrades from the credit ratings agencies and cause even more anxiety in the government bond markets.

Well actually this maybe not the case as I discussed in an article yesterday about the manner in which Moody's has reacted to the possibility of a potential downgrade to the UK's AAA rating in the light of the woeful public finances spelled out in Chancellor Darling's budget this week.

According to Pierre Cailleteau, Team MD of Moody’s sovereign risk group and as reported in this article from the FT, a safe havens’ triple-A status, “depends on two potentially unstable notions: continued public trust in government institutions, including the currency, and sustained inter-generational solidarity mechanisms.”

The most intriguing comment from the Moody's spokesman is the notion that the UK - and surely the USA would be in an even stronger position in this regard - has a "sustained inter-generational solidarity mechanism" and this would enable both governments to avoid even the tiniest risk of sovereign default - which presumably is what a re-affirmation of the AAA rating (risk free) would imply.

I suspect we would not gain a lot of clarity to pursue in earnest from Monsieur Cailleteau what a sustained inter-generational solidarity mechanism actually means other than the rather complacent notion that just like the credit ratings agencies' approach to assessing the risk of corporate defaults, there is the implicit assumption that some countries are just too well established to ever have problems repaying their debts.

Whether or not we should take comfort from the predisposition of Moody's to see no real risk of sovereign default in the case of the US and the UK is probably not really the issue at all. There could easily be endless debate about the reliability of ratings agencies based upon their recent track record and the inherent limitations of modeling techniques for measuring sovereign risk.
But at the end of the day if the ratings are not going to be downgraded, no matter what the eventual hit to the public sector balance sheets of the UK and USA turns out to be in the fullness of time, then why should there be such concern about the US being a lot more forthcoming in admitting to the true magnitude of its toxic assets?

Perhaps Mr. Darling came to his realization and expression of candor at the G7 gathering when he saw that the world did not end - and specifically that the UK does not appear to be about to lose its AAA rating - after seeing the market's and Moody's reaction to his painful budget speech.

As long as the presumption that certain sovereigns, especially the most "established", are too big to fail, the Anglo-American financial axis is unlikely to seriously change its ways.

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