Beyond the Age of Leverage: New Banks Must Arise

Call it the Great Repression. The reality being repressed is that the western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More importantly, households are groaning under unprecedented debt burdens. Worst of all are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt.

The US could end up running a deficit of more than 10 per cent of gross domestic product this year (adding the cost of the stimulus package to the Congressional Budget Office’s optimistic 8.3 per cent forecast). Today’s born-again Keynesians seem to have forgotten that their prescription of a deficit-financed fiscal stimulus stood the best chance of working in a more or less closed economy. But this is a globalised world, where unco-ordinated profligacy by national governments is more likely to generate bond market and currency market volatility than a return to growth.

There is a better way to go but it is in the opposite direction. The aim must be not to increase debt but to reduce it. Two things must happen. First, banks that are de facto insolvent need to be restructured – a word that is preferable to the old-fashioned “nationalisation”. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down. Bond­holders may have to accept either a debt-for-equity swap or a 20 per cent “haircut” (a reduction in the value of their bonds) – a disappointment, no doubt, but nothing compared with the losses when Lehman went under.

There are precedents for such drastic action, notably the response to the Swedish banking crisis of the early 1990s. The critical point is to avoid the nightmare of a state-dominated financial sector. The last thing America needs is to have all its banks run like the rail company Amtrak or, worse, the Internal Revenue Service. State life-support for moribund dinosaur banks is an expedient designed to avert the disaster of a generalised banking extinction not a belated victory for socialism. It should not and must not impede the formation of new banks by the private sector. So recapitalisation must be a once-only event, with no enduring government guarantees or subsidies. There should be a clear timetable for “reprivatisation” within, say, 10 years.

The second step we need to take is a generalised conversion of American mortgages to lower interest rates and longer maturities. The idea of modifying mortgages appals legal purists as a violation of the sanctity of contract. But there are times when the public interest requires us to honour the rule of law in the breach. Repeatedly during the course of the 19th century governments changed the terms of bonds that they issued through a process known as “conversion”. A bond with a 5 per cent coupon would simply be exchanged for one with a 3 per cent coupon, to take account of falling market rates and prices. Such procedures were seldom stigmatised as default. Today, in the same way, we need an orderly conversion of adjustable rate mortgages to take account of the fundamentally altered financial environment.

Another objection to such a procedure is that it would reward the im­prudent. But moral hazard only really matters if bad behaviour is likely to be repeated. I do not foresee anyone asking for or being given an option adjustable rate mortgage for many, many years. The issue, then, is simply one of fairness. One solution would be for the government-controlled mortgage lenders and guarantors, Fannie Mae and Freddie Mac, to offer all borrowers – including those on fixed rates – the same deal. Permanently lower monthly payments for a majority of US households would almost certainly do more to stimulate consumer confidence than all the provisions of the stimulus package, including the tax cuts.

No doubt those who lose by such measures will not suffer in silence. But the benefits of macroeconomic stabilisation will surely outweigh the costs to bank shareholders, bank bondholders and the owners of mortgage-backed securities.

Only a Great Restructuring can end the Great Repression. It needs to happen soon.

The writer is a contributing editor of the FT and the author of The Ascent of Money: A Financial History of the World. He is also senior adviser to GLG Partners. A longer version of this article is available at https://www.glgpartners.com/pdf/Beyond_The_Age_Of_Leverage_Niall_Ferguson.pdf.