Yes, It’s A Wreck, But We Can Fix It

A Possible Solution in Private Equity
Wilbur Ross, chairman of his own private-equity firm, and chairman of AHMSI, the second-largest U.S. servicer of subprime mortgages
The Emergency Economic Stabilization Act ("EESA") may provide $700 billion of liquidity to the financial system, but the liquidity crisis is continuing. Banks have reduced their total lending over the past six months, and are charging other banks unprecedented premiums for overnight borrowing because they are especially wary of bank failures. As of the end of September, banks will have written off at least $150 billion more than the amount of new capital they have raised over the last twelve months. Regulators limit the amount of loans a bank can make to a multiple of its capital in order to provide a cushion for losses. As a rule of thumb, each dollar of loans requires 10 cents of equity. This means that the $150 billion shortfall must constrain lending by $1.5 trillion, or more. The taxpayers' $700 billion fills less than half of the hole. We need another $80 billion, or better yet, $100 billion of equity (not liquidity) simply to bring things back to normal and reopen the credit spigots. Otherwise banks will continue to shrink their lending and exacerbate the problems of sky-high interbank lending rates and declining purchases of commercial paper and other notes that raise cash for businesses and municipalities. The economy cannot grow without liquidity and liquidity cannot grow until banks have enough capital on their books.

There is a solution, and, happily, it requires neither federal funding nor congressional action, only a change in regulations. Private-equity funds have as much as $450 billion they could invest in banks. But under the current rules any private-equity fund that bought a majority of a depository institution would have to sell its other nonfinancial investments. Yet investment banks and depository institutions have been allowed to own each other since the repeal of the Glass-Steagall Act. Why would it be worse for a bank to be owned by a private-equity firm than an investment bank? Private-equity firms have long and proven track records of recruiting good management for their portfolio companies. Some argue that new management would vanish should the fund sell, but in fact, recent history in other countries shows that this is not so. Private-equity firms like mine and others have already helped Japan, Korea and Germany resolve banking crises by purchasing and rehabilitating failed banks.

The Federal Reserve has begun to allow private-equity funds to buy more of a bank without tripping the ownership wire. Let us hope for further action along those lines. Private investment is a better solution than the undesirable alternative of risking tens of billions of dollars of taxpayers' funds.

Time to Bet on the Consumer
Susan Sterne, chief economist, Economic Analysis Associates
It might well be time to bet on the consumer.net consumer borrowing has already dropped 80 percent since last year and it rarely goes negative.   Energy prices have come down, and so has the cost of food. Home prices have become more stable in some regions. Despite panic on Wall Street and hurricanes elsewhere, consumer sentiment is positive. To reduce the cost of living, consumers have been trading down but now that prices are slowing, they can buy again. In the second half of next year, we would expect to see a rebound in car sales and housing. This rebound could be stronger than it was in the last cycle, in 2001, which was not preceded by much of a decline. We are also coming out of a period with the most modest job gains in history, so it isn't unreasonable to expect job losses to be muted as well. In fact, the recent spike in the unemployment rate was not so much caused by lost jobs as by an increase in workers, which is common during a recovery. During the early stages of any recovery, workers sense opportunity and return to the labor force long before most of us realize the environment has improved, reinforcing the adage that by the time everyone realizes we are in recession, it is over.

© 2008