Brad DeLong’s question: Huh? Where did the money go?

“Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.

“Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:

• Citigroup had poor risk controls.
• As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.
• They weren't.
• And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued assets eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that The New York Times is in its death spiral: not the place to go to learn anything about an issue.”

I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage. It is simply about the question “do we trust them to repay their debts”. You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay. Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed. All estimates are a shot in the dark. In reality all that is needed is more trust.

The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout. It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts. I can not understand them and I am a pretty sophisticated bank analyst. I know people I think are better than me – and they can’t understand Citigroup either. So Citigroup was always a “trust us” thing and now we do not trust. “

John Hempton, “The Brad DeLong question - and how to design a bailout that works”, Bronte Capital Blog (25 November 2008).

http://brontecapital.blogspot.com/2008/11/brad-delong-question-and-how-to-design_24.html


John Hempton is a (semi) retired fund manager based in Sydney Australia. Brad DeLong, who Hempton quotes, is professor of economics at the University of California, Berkeley.

It’s a good question. It is said that only a relatively small percentage of U.S. homeowners, probably no more than 5 per cent of the total, had a serious problem paying their mortgage. Yet once the housing problem became generally known the price of housing did not just fall, it collapsed, and when it collapsed Wall Street and many financial institutions were brought down in a cascading tumbling of one bank and insurance company after another. How is this possible? Equally, how is it possible that Citigroup, the world’s largest financial services network and owner of a major international bank such as Citibank, can go under when only a small portion of its assets become questionable?

The answer is that Citibank, like all banks, borrows short and invests long. It has a lot of deposits -- short-term liabilities -- and it has a lot of investments -- long-term assets on which it expects to earn future income to cover its costs and generate a profit. Citibank has taken the money of a lot of people and promised them they can have it back any time they want it. The problem is Citibank doesn’t have their money, at least not in a form it can use to pay them back immediately, for it has lent that money out to borrowers or purchased securities with the cash of its depositors. In normal times, its assets far exceed its liabilities, as the prices of its assets remain stable and the number of depositors asking for their money back is small. In crisis times, however, its assets become sharply devalued and it quickly becomes insolvent.

When a crisis develops questions are raised about a bank’s ability to meet its commitments, and its troubles multiply quickly. Its assets are in the future while its liabilities are due today. To meet its obligations it must immediately sell its investments to generate needed cash. But future assets are worth less than current assets, for they are uncertain, and the more the assets a bank like Citibank holds are in the future, the lower and more uncertain their present value. Worse, if questions arise about the quality of the assets they are quickly and substantially discounted, for risky assets are worth much less than safe assets. Even worse yet, if the depositors, other financial institutions and the public in general do not trust the institution, it must dump its assets, probably to no avail, because it will in all likelihood become insolvent.

One of the purposes of the Fed is to act as “lender of last resort” to banks facing a run and needing liquidity. But the magnitude of the current crisis has overwhelmed the Fed. Moreover, the fall in asset prices is so steep, their value so uncertain, and the trust among the institutions and with the public so destroyed, that normal policies and regular mechanisms are completely ineffective in restoring financial stability.

In short, the money depositors originally put into the banks disappeared because the value of the assets the banks purchased disappeared and the value of the assets disappeared because they had to be sold at a deep discount and they had to be sold at a deep discount because people stopped trusting Citibank and the other banks. Deposit insurance and injections of funds from the Treasury and the Fed will make almost all depositors whole by shifting the losses to the general public. But until some semblance of trust within the financial community, and between the financial community and the public, is regained, there will be no end to the ongoing financial crisis.