Friday, September 28, 2012

Y u hate capital so much?!

The following text was originally posted as a comment to David Schawel's Economic Musings blog on April 19th, but it seems relevant to bring it back given the freebase scenario making the rounds. My official position is that it's going to be an adverse reality unless we stop hating capital. It's a little off-the-cuff so don't get caught up in precision and just try to to suck up the main point, which is, without new capital, the banks are decimating the private sector in order to fund the deficit (aka support the government) AKA NO BUENO

From "How Spain pays the piper",
Given that we are starting with a capital-constrained banking system (even before write-downs or 2013 EBA recommendations), we know this, holding capital levels stable, any government deficit must be matched by foreign capital or by reduced lending to the private sector to maintain leverage ratios stable--of course, due to 0%-RW on SPGBs, the EUR amt need not match centavo for centavo. Now, retained earnings (new capital) are not zero, so banks can either maintain their balance sheet size and increase their capital ratio (delever), or increase balance sheet size (fund the deficit) and maintain their capital ratio, or--most likely--something in between, where purchases of new sovereign bonds against increases in capital and levered via LTRO produce large amounts of carry.
This gives us the illusion that banks may very well be able to earn their way out of this mess (see also: LTRO), however, this all changes if we change the risk weight on SPGBs to something other than its current level of zero. Which is were we ask ourselves: In a country where almost 3/4 of private household wealth (ex expected benefits from government pensions, etc) is held as housing equity which has been borrowed against, what happens to the sovereign if that # is cut in half? After all, the sovereign's creditworthiness is just the aggregate of the households. Its credit backed by its ability to tax and/or confiscate private wealth to pay back creditors. If the households are, collectively, broke, then what is left for the government to take? Which is where I--finally--get to my point. If the government represents the collective households and the collective households are overburdened, then how will they be able to back their sovereign's increasing promises as the banks decimate the private sector through loan attrition? Or, in simpler terms, Is there any difference between extending-and-pretending with the households' mortgages and extending-and-pretending with the sovereign's obligations?
As we continue on our march to binary outcomes, I believe it becomes important to ask ourselves, why do we hate capital so much? What is so wrong about recapitalizing the banks and arresting this self-feedback loop? Is it about crystallizing losses by raising equity at prices below book? If so, why the big deal? If equity were really so under-priced, current shareholders would surely rush to a private offering before letting outsiders dilute them, no?
As a final comment, I think there is a 4th possible solution: Capital injections from the core banks and sovereigns.
Maybe this should actually be 3c, but given that we know there is no way except for "more capital" to resolve this and whether it be through debt-to-equity swaps or lower than normal real rates, Core private savings will ultimately pay for this. It might be nice to skip the whole near-financial-meltdown part that ends in core households recapitalizing their own banks after the D2E swaps and just get it over with so 25% of the worlds 12th largest economy could, you know, get back to work.


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