There is mounting evidence that bubbles are forming again everywhere across the globe as easy money makes itself felt in asset prices. The latest evidence comes from Sweden where Europe’s lowest home loan rates have pushed up the price of residential property.

At issue is the extremely loose monetary policy in Sweden that is an outgrowth of both recession in Sweden and a massive exposure by Swedish banks to the Baltics which are presently in depression. Sweden’s central bank, the Riksbank, has cut interest rates to near zero and is charging banks interest to keep reserves on deposit. Meanwhile, the bank has also embarked on a policy of quantitative easing in order to get credit flowing again.

In my July post, “Sweden: negative interest rates and quantitative easing,” when Sweden went negative on interest rates, I wrote:

Pretty aggressive plan, if you ask me. Will it work, though?

Well, first of all, most every major central bank in the world, certainly the biggest: the Americans, the Eurozone, the British, the Swiss, and the Japanese, have rates near zero and are printing money.  The world is awash in money and the incentive to borrow is huge.  So, is the Swedish announcement qualitatively different?  On some level, it is not.  Nevertheless, it is the most aggressive policy and the fact that they are charging negative interest rates for deposits is unprecedented.  This does make events in Sweden something to watch.

So, if you have been watching, what you have seen is a financial sector which is still critically weak – so much so that the federal government has been having secret meetings with the banks to get together a game plan in a worst-case scenario in Latvia, the worst of the lot in the Baltics.

But, even so, while the real economy is in recession, one has to conclude that the aggressively expansionary policy by Sweden’s central bank is reflating asset prices in a major way. Experts are now sounding the alarm as house prices hit new highs.

Below is a translation of yesterday’s Dagens Nyheter article reporting on the warning.

Experts warn: Sweden risks housing bubble

Europe’s cheapest home loans, tax cuts and a continued housing shortage. These are some of the reasons house prices are rising to new record highs in Sweden – right in the middle of a raging recession. Now a growing number of experts warn of a new housing bubble.

Swedish mortgage customers are sitting pretty. The Riksbank’s key interest rate of  0.25 percent is unique in Europe. By comparison, the corresponding rate is 1.25 percent in Norway and Denmark, 1.0 percent in the euro area and 0.5 percent in Britain.

Variable interest rates in Sweden are currently about 1.6 percent. As DN Economics related a couple of weeks ago, short-term rates are 2-3 percentage points higher in countries such as Denmark, Germany and Britain.

Swedish low-cost mortgages are the main cause of the housing rally. House prices fell sharply after investment bank Lehman Brothers’ bankruptcy caused the financial crisis in September last year. But since the start of the year, they have risen again. Prices of flats are now 5 percent higher than a year ago. And house prices have gone up 2 percent.

Reduced income tax and the abolished property tax have also contributed to the housing rally. Likewise concerning the shortage of housing.

In 2008, there was construction of 21 500 apartments in Sweden, which was considered low. This year, new construction is expected to decline by one third, according to Swedish Construction Federation.

Six months ago many experts warned that rising unemployment could lead to falling prices in the housing market. Now they are warning of a housing bubble instead.  Nordea Chief Economist Annika Winsth has repeatedly warned of inflated prices, and SEB’s CEO Annika Falkengren said recently that she felt that both house prices and the stock market have risen too fast in the past year.

In its monetary policy report last Thursday, the Riksbank wrote, "there is evidence that house prices at present are slightly above the level that is sustainable". It also speaks to the dangers of "over-optimistic expectations about interest rates" and "more expansive lending".

Despite the warnings the banks’ barometers tell of housing prices that will continue to rise in Sweden for many months to come.

I see this ending in a very bad way.

Source

Experter varnar: Sverige riskerar bostadsbubbla – Dagens Nyheter

Related posts:

• Property more overvalued in Sweden than in US
• Denmark: the latest victim of falling house prices
• Estonia and Latvia: headed for the rails
• House prices in the U.K. up for first time since Oct 2007
• Nationwide: UK house prices down 14.6%

The following is my translation of a much-discussed article that appeared in Swedish daily Svenska Dagbladet at the weekend.  This information was being withheld from the public and leaked at an inopportune moment.

Note that the Swedish government has secretly been preparing the banks for financial Armageddon, encouraging Swedbank into a rights issue which arguably was conducted under fraudulent pretenses – very reminiscent of Bank of America’s shareholder vote for the merger with Merrill Lynch.  In August, I asked “Why is Swedbank doing a second rights issue?.” Now we know.

This is the kind of thing that topples governments.

Secret meeting on the crisis in Latvian

Finance Minister Anders Borg has had secret talks with the major Swedish banks and warned of a near economic collapse in Latvia, Svenska Dagbladet has learned. A nightmare scenario for Swedbank and SEB.

Yesterday Anders Borg issued a stark warning to the Latvian Government that it must take its financial problems seriously.

The promised cuts must be implemented when the new Latvian budget is presented in late October, according to Finance Minister.

The international community’s patience is very limited, stressed Anders Borg at the summit of European finance ministers in Gothenburg where he hosts as the finance minister in Presidency.

His statement came after recent reports from Latvia on political divisions in the ongoing budget negotiations.

But for Swedish bank heads, Borg’s move came as no surprise. According to several independent sources, Anders Borg, over the last few weeks, has contacted the senior management of major banks and warned them of an acute political crisis in Latvia. This in turn can lead to both a devaluation and eventually a default. It is a kind of national bankruptcy, similar to what hit Iceland last fall.

In secret talks with Swedish banks, Anders Borg explained the growing pressure that exists within the International Monetary Fund (IMF) to force Latvia into a devaluation.

A collapse in Latvia would have serious implications for several major Swedish banks. With a devaluation the already high loan losses would explode overnight, especially because many Latvians have loans in euro, which would become significantly more expensive.

Swedbank has up to today lent 61 billion kroner to Latvian individuals and businesses. The figure for SEB is 40 billion, while Nordea has 30 billion in loans.

For Swedbank a possible devaluation would come at an especially poor time. The bank is currently in the middle of a second rights issue in which shareholders have been asked to put up 15 billion.

CEO Michael Wolf’s message to shareholders and customers has repeatedly been that the money would be used for offensive investments. To then have to deal with a severe national bankruptcy in one of its major markets and see new issue money disappear into a black hole would be a severe blow to the bank’s credibility.

That a serious crisis approaches in Latvia has already been flagged by Anders Borg in the budget he presented a few weeks ago. On page 99 he writes:

"Since it is difficult to safely assess Latvia’s ability to pay and with conditions for recovery, one cannot completely exclude the risk of a major default."

The background to the current situation is a crash in the Baltic economies. Latvia is just the worst hit. This year, the country’s GDP is to shrink by as much as 18 percent.

This led to a rescue package cobbled together at Christmas last year. The International Monetary Fund (IMF), the EU and the Nordic countries decided on payments totaling SEK 80 billion, of which Sweden accounts for 7 billion.

An essential condition for aid money, however, is that Latvia implement substantial cuts in order to get the economy in balance.

This means wage cuts for state employees in over 15 percent, including hospital closures and major tax increases.

In July of last year Latvia went to reduce their spending for next year’s budget by more than 7.5 billion crowns.  It opened the door to  a further one billion disbursements from the IMF and the EU.

But then, the domestic political situation deteriorated. The previous Latvian government fell in February and since then the country has been governed by a coalition of five parties. The Prime Minister is Valdis Dombrovskis.  Next year come elections again.

Two of the parties in this five-party coalition have now objected to the previously announced savings of 7.5 billion. Some want to go back on parts of the promise and believe that a reasonable savings is instead about 4 billion kroner.

The goal to save 500 million lats (7.5 billion kroner) is practically impossible to achieve without eliminating several parts of the economy, Vents Armands Krauklis from the influential Liberal Party, which sits in the government coalition, said the day before yesterday.

24 hours later came the response from the EU.

"Latvia does not have much room for maneuver; It must fulfill its letter-of intent," said Anders Borg yesterday in Gothenburg to the news agency Direkt.

Original Source

Hemligt möte om lettisk kris – Svenska Dagblaget

Also see my August post, “Zombie banks Scandinavian edition and the threat of too big to fail.” This problem looms even larger now.

Update 7 Oct 2009: minor translation corrections were made resulting from reader suggestion.

Related posts:

• Transferring Swedish bank risk onto Latvian taxpayers
• Sweden: competitive auto bailouts begin with Saab and Volvo
• Estonia and Latvia: headed for the rails
• Earnings results at Swedish banks show large writedowns in Baltics
• Violence erupts in Latvia

Across the world, governments are doing their level best to shore up weak banking systems in the wake of the most significant final crisis in decades.  Most market players appear to believe these efforts successful; why else have shares risen so dramatically from lows late last year and early this year?

While I do believe the efforts have indeed been successful, I am far from certain they have addressed the underlying problem: large quantities of unrecoverable debt from reckless lending.

Witness the most recent bank merger in Scandinavia between Nordea and Fionia Bank.   This event seems to have gone largely unnoticed outside of Scandinavia. But, the core issues of socialization of losses, zombie financial institutions, unrealized loan losses, and too big to fail institutions are the same ones at work in the U.S., the U.K., Switzerland, France, the Netherlands, and many other countries.

While all is fine and good in an environment of economic recovery and rising asset prices, there remains a lot of downside risk were we to face a renewed slump in the global economy.

Socialization of losses

Fionia is a failed bank in Denmark about which I wrote in February. The bank collapsed after taking large writedowns early this year.  However, the Danish government was loath to liquidate the institution. Instead, it transferred the assets of the bank to a new Fionia Bank, which it has just sold on to Nordea, the large Scandinavian giant.

You should notice two things about this transaction. First, the price is quite low: Nordea has acquired Fionia for $173 million. This pales in comparison to the well over $200 million writedowns Fionia took which caused it to fail.  Moreover, the Danish government subsequently pumped another $169 million into the bank in order to sanitize it for sale.

I have not seen any details of the sale in regards to further contingent liabilities for the Danish taxpayer. But, to my mind it strikes me as similar to recent FDIC seizure/sale agreements for BankUnited and Guaranty, where the government took the lion’s share of losses and flogged the remaining assets off for a low price to a willing buyer.

Zombie financial institutions

But, then you have the zombie bank problem. The term ‘Zombie Bank’ was popularized during the S&L crisis by Edward Kane to connote banks which continued to operate but only as a result of government largesse as they were effectively insolvent.

Nordea had a very fine second quarter in which it showed net income of over 600 Million Euros. The Danish daily Berlingske Tidene even called the first half “one of the best in Nordea’s history.” But, how healthy is Nordea really?  It will weather the storm but the company has large residual exposure to unrealized losses in the Baltics.

More to the point, Sweden’s central bank, has lowered interest rates to effectively zero. This allows any financial institution in trouble to make a large gain due to interest-rate spreads (borrowing for much less than lending) or the carry trade (borrowing short and lending long). The Riksbank is actually running negative interest rates by charging banks to hold funds on deposit. Clearly, banks now have every incentive to lend and this will support the economy as long as rates remain low.

But, it’s not like those unrealized losses magically disappear.  The toxic assets are still there.  Asset price inflation makes them appear to become much less toxic.  But what happens when the economy in Sweden turns down or asset prices fall?

That’s when day turns to night and the zombie banks come out of their holes and terrorize the town.

Too big to fail

Flogging Fionia off on Nordea is a lot like having JPMorgan Chase buy Washington Mutual.  It only makes the acquiring company larger and more dangerous – too big to fail and too big to bail (out).  It is not a very good solution. Just ask Iceland.

By now you have seen David Cho’s piece in the Washington Post analysing this very problem in the United States.  He writes:

When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation’s leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.

Today, the biggest of those banks are even bigger.

The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.

J.P. Morgan Chase, an amalgam of some of Wall Street’s most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

But this is not just an American problem. It is a systemic problem that affects Europe even more. Look at the list of the top twenty-five European banks by asset size. Almost every Western European country is plagued by the Icelandic problem of institutions that are too big to fail, but too big to rescue.

In fact, Denmark is near the top of my list with one institution, Danske Bank, having assets nearly 200% of GDP. Were I to have added Sweden to this list, they would come in ahead of Denmark with four banks having assets of over 300% of GDP. (Nordea – 2008 assets: 474 billion euros, SEB – 213 billion euros, Handelsbanken – 212 billion euros, and Swedbank – 179 billion euros.

Germany is taking the lead on putting an end to too big to fail – or at least solve this problem on a global basis. Peer Steinbrück, the German finance minister, is trying to force the G-20 to agree to “international rules that facilitate the insolvency and liquidation of large, internationally active banks.”

Concluding thoughts

Felix Salmon suggests a surcharge on bank size.  The idea is that taxing banks, penalizing them for becoming to large, one can use a more free-market approach to curb these institutions.  I like the idea, but I do think more will be necessary.  The bank size surcharge is one most banks would willingly pay if it means in good times they can pocket more excess profit in good times than the tax penalizes them.

And it is good times that are important. if the Federal Reserve and other central banks continue to lower interest rates to extremely low levels, banks will extend credit recklessly in good times because of a false price signal the interest rates display. Only when a downturn takes place will banks recognize they have over-lent and that the size surcharge was not a good bet.

I am sceptical that anything meaningful will come of Steinbrück’s plan in an environment were everyone is talking about economic recovery.  The urgency seems to have passed. But, the threat posed by toxic assets and by megabanks has not.

Note: Originally, this article stated that Nordea had ‘huge’ exposure in the Baltics.  This has now been changed to ‘large’ and I have added the line ‘It will weather the storm.’ I do believe that Nordea is the best-positioned of the large banks headquartered in Sweden.  They are the best bank to take on a Fionia Bank. However, I am using their acquisition of Fionia as a vehicle for a larger discussion about acquisitions like this to talk about too big to fail.

Related posts:

• Earnings results at Swedish banks show large writedowns in Baltics
• Denmark: Fionia Bank collapses
• The latest bubble warning: Swedish house prices
• Consumer credit down a massive 33% in Spain
• UK: Darling confirms government to break up too big to fail banks

Today, Swedbank, a Swedish bank with huge Baltic loan loss exposure, surprised investors with a second rights issue in less than a year.  In going to investors for more money, the company said its doing so in a fully underwritten deal demonstrated “a position of strength.” “This is a forward-looking rights issue” to deal with “downside risk.”

Huh? I just reported on their dismal earnings two weeks ago (“Earnings results at Swedish banks show large writedowns in Baltics”). They had the worst results of the big four Swedish banks. It’s obvious to everyone that Swedbank needs the money; why else would they ask for it?  Didn’t they just promise not to ask for more capital in June?

The only strength I see is in timing i.e. they are getting money from investors while the getting is good and bank stocks are still a relatively hot commodity – shrewd manoeuvre but hardly a sign of strength.

Watch the CNBC video and judge for yourself.

Related articles

Swedbank Plans Second Rights Offer to Bolster Funds – Bloomberg

Related posts:

• Natixis offers rights issue at 61% discount
• UBS rights issue hits an air pocket
• RBS couldn’t raise the money
• Sweden prepares for financial collapse in Latvia and major bank losses at home
• Bradford & Bingley to issue profit warning

Earnings season is upon us and the Swedish banks have begun reporting earnings. Their results have seen huge writedowns that demonstrate large and continued exposure to souring loans in the Baltics.

Handelsbanken and Nordea reported today. Despite the writedowns, you do get the sense that things are going better than expected as the banks beat expectations. Nordea even raised its guidance. But SEB and Swedbank, major lenders to the Baltics, are still on the ropes as previous earnings from those banks attest.

Nordea

The Danish daily Berlingske Tidene calls the first six months of 2009 “one of the best in Nordea’s history.” It notes that “despite the crisis atmosphere net income was almost a record, and management will need to revise full-year guidance upwards.”  Net income was 616 million Euros against expectations of only 421 million. That’s pretty spectacular.

But what about loans to the Baltics? Berlingske Tidene reports.

Impaired loans in the Baltic region as a whole – including both non-performing and performing – have run up to 418 million Euros, equivalent to 550 basis points of total loans and receivables.

The total writedowns for the Baltic countries was 202 million Euros…

Long story short, Nordea faces the same problems with loans in the Baltics that JPMorgan faces with credit cards and residential property in the U.S. i.e. rising losses.  In both cases, these losses have been offset by large profits due to a favorable interest rate environment.  Whether this continues is the question.

Handelsbanken

It was the same story at Handelsbanken, with the company bating expectations. The bank reported an operating profit of 3.445 billion krona, which was slightly more than last year and well above the 2.924 billion krona consensus. The Swedish krona is trading at 7.69 to the dollar, so we’re talking about $450 million in profit.

Loan losses were up to 939 million krona from 571 million last year. There was no initial report of exposure to the Baltics as Handelsbanken was not one of the biggest lenders amongst the Swedish banks. All in all, this was a good report.

SEB

SEB reported yesterday and they showed a large loss of 193 million krona, compared to the 2.8 billion profit of 2008.  This huge swing is due to large credit losses, he majority of it in the Baltics. SEB had 3.6 billion krona in credit losses, 74% of which came from the Baltics.  This forced them to write down 2.4 billion in loans in the Baltics and Russia.

The contrast is striking and its all due to the reckless lending in the Baltics.  Expect more of the same going forward.

Swedbank

Swedbank is the other big lender in the Baltics with SEB.  SO they had dismal earnings as well in a report from last Thursday.  The FT reports:

Swedbank, the largest lender in the Baltics, posted net losses of SKr2.01bn ($257m), compared with net profits of SKr3.6bn a year earlier.

It was the bank’s second consecutive quarterly loss and much worse than the SKr1.27bn deficit forecast by analysts.

Loan losses soared from SKr423m a year ago to SKr6.67bn, with about two-thirds of the amount in the Baltics and a third in Ukraine.

In response, the bank said it planned to reduce staff by 3,600, about 16 per cent of its workforce, by this time next year, with most of the cutbacks in the Baltic states.

Shares were up on the announcement, but I expect more of the same going forward.  Whether Swedbank needs more capital remains to be seen.

Now, Just two weeks ago I mentioned a plan by Swedbank and SEB to write down personal loans in Latvia, the hardest hit country in the Baltics, by 10% in exchange for a Latvian government guarantee against further losses (see Transferring Swedish bank risk onto Latvian taxpayers). It is unclear whether these writedowns were taken or even if this proposal has gotten a green light, especially given the problems Latvia is now having getting more money from the IMF.  But, clearly, this would mitigate any losses at Swedbank and SEB.

The difference in profitability between the four banks does show that the banking system in Sweden is doing just fine outside of the problems with Baltic exposure.  I take that as an encouraging economic sign in Sweden that may be indicative of other countries in Northern Europe as well.

Sources

Nordea overrasker positivt – Berlingske Tidene

Nordeas vinst klart över förväntan – Dagens Nyheter

Handelsbanken överträffar prognoser – Dagens Nyheter

Baltic exposure hits Swedish bank – BBC News

Related posts:

• Why is Swedbank doing a second rights issue?
• Estonia and Latvia: headed for the rails
• Event risk in the Baltics is critically high
• Transferring Swedish bank risk onto Latvian taxpayers
• European banks have hands out for more capital

This is my translation of an article from Dagens Nyheter, a Swedish daily.

Swedish banks are planning to write down Latvian personal loans by 10 percent. However, the proposal includes only a small part of the Latvia’s mountain of debt.

The criteria for qualifying for the program, as it stands right now, is quite strict. So there is nothing which will include a very large number of private individuals in Latvia, "said Swedbank Director Thomas Backteman to TT.

On Wednesday, Latvian Prime Minister Valdis Dombrovskis on Latvian radio told of new plans to support indebted individuals.

He said that the program is based on "a certain solidarity" from the banks in the country, which are to write down the debt of the people who qualify for assistance.

But according to Thomas Backteman, the proposal comes from the banks themselves. The Latvian Banking Association has been having a discussion with the Government of Latvia on a way to restructure of private debts.

The Bankers’ Association made a proposal to provide a moratorium, that is, a temporary deferral, in the case of payments on debts to private persons.

And for those who give this concession, the state will step in and guarantee the debt. “Then we will write down the debt by 10 percent," he says.

Swedbank and SEB are the two banks with the most loan customers in Latvia. Like SEB Swedbank estimates that the economic impact of the proposal will be small:

"Our current assessment is that only a small part of SEB’s loans to households would be covered," writes Elisabeth Lennhede, press officer at the bank, in an email to TT.

And even if the debts are written down, the program would probably also mean that banks would forgo a small part of the massive credit losses that are expected to arise in Latvia in the coming years.

That’s how it is, and above all, we get a guarantee, "says Thomas Backteman.

It sounds like a transfer of risk from Swedish banks to Latvian taxpayers if you asked me.

Lettiska skulder ska skrivas ned – Dagens Nyheter

Related posts:

• Earnings results at Swedish banks show large writedowns in Baltics
• Sweden prepares for financial collapse in Latvia and major bank losses at home
• Estonia and Latvia: headed for the rails
• Why is Swedbank doing a second rights issue?
• Lessons from Swedish bank resolution policy

In the clearest signal yet that we are still in a potentially devastating global deflationary spiral, The Riksbank, Sweden’s central bank and the world’s oldest central bank, has effectively cut interest rates to minus 0.25% and has started a program of quantitative easing a.k.a printing money. These are the most dramatic moves yet by a major central bank and will be watched the world over for signs of success or failure.  Let me explain what the Swedes are doing and why.

On the 2 July 2009, the Riksbank unexpectedly lowered rates across the board.  Economists had expected the Riksbank to keep the repo rate at the low 0.5% level. The repo rate is the official bank rate at which banks can borrow from the central bank against government bond collateral. It is the floor rate, the lowest rate in the banking system.  But, the Swedes lowered the rate to 0.25%, a record low.

The interesting bits were buried deep in the accompanying press release, namely that the Riksbank was to engage in quantitative easing and to penalize banks for holding reserve deposits. The full press release is below with the important parts highlighted in bold.  I will translate this econ-o-speak into plain English after the Riksbank statement.

The weak development of the economy requires a somewhat more expansionary monetary policy. The Executive Board of the Riksbank has therefore decided to cut the repo rate by 0.25 of a percentage point to 0.25 per cent. The repo rate is expected to remain at this low level over the coming year. At the same time there are several signs that economic activity will improve.

Deep economic downturn

Economic activity abroad is very weak and this hits Sweden hard. Exports have fallen substantially and the situation on the labour market is continuing to deteriorate rapidly. The information received in recent months points to the economic downturn in 2009 being somewhat deeper than the Riksbank forecast in April.

Low repo rate over a long period of time

A lower repo rate and repo rate path are needed to counteract the fall in production and employment and to attain the inflation target of 2 per cent. The Executive Board of the Riksbank has therefore decided to cut the repo rate to 0.25 per cent. The repo rate is expected to remain at this low level until autumn 2010. The Riksbank’s assessment is that cutting the rate to 0.25 per cent will not threaten the functioning of the financial markets.

The Riksbank’s assessment is that after cutting the repo rate to 0.25 per cent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. Supplementary measures are necessary to ensure that monetary policy has the intended effect. The Executive Board of the Riksbank has therefore decided to offer loans totalling SEK 100 billion to the banks at a fixed interest rate and with a maturity of 12 months. This should contribute to lower interest rates on loans to companies and households.

Stable underlying inflation

Despite the expansionary monetary policy, production and employment will be lower than normal over the next few years. Inflation will be kept up by weak productivity and a weak krona. However, there will be large fluctuations in CPI inflation during the coming period. This is primarily due to the fact that changes in the repo rate affect mortgage rates, which are included in the CPI. The CPIF underlying inflation rate (the CPI with a fixed mortgage rate) will on the other hand remain stable close to 2 per cent during the forecast period.

Signs of a turnaround

In recent months there have been several signs that economic activity will improve. At the same time, the financial markets in Sweden and abroad have begun to function more effectively, which creates the potential for an acceleration in international and domestic demand. The low repo rate and current fiscal policy will also contribute to the recovery. GDP growth is expected to be positive in 2010, but the labour market will lag behind and employment will not begin to rise until 2011.

Considerable uncertainty

The economic outlook is still uncertain. When the turnaround comes, the upturn may be stronger than in the main scenario. However, it could also be the case that the recovery will take longer than expected. The future direction for monetary policy will therefore depend on how new information on economic developments abroad and in Sweden will affect the prospects for inflation and economic activity in Sweden.

Forecast for inflation and GDP Annual percentage change

	2008	2009	2010	2011
CPI	3.4	-0.2 (-0.3)	1.4 (1.3)	3.2 (3.2)
CPIF	2.7	1.9 (1.9)	1.9 (1.8)	2.0 (2.0)
GDP	-0.2	-5.4 (-4.5)	1.4 (1.3)	3.1 (3.1)

Inflation forecast, 12-month figures Annual percentage change

	Sept. 09	Sept. 10	Sept. 11	Sept. 12
CPI	-1.2 (-1.4)	1.5 (1.4)	3.7 (3.7)	3.7
CPIF	1.5 (1.4)	1.7 (1.6)	2.0 (2.1)	2.2

Note. The assessment in the April 2009 Monetary Policy Update is shown in brackets. Sources: Statistics Sweden and the Riksbank

Forecast for the repo rate Per cent, quarterly averages

	Q2 2009	Q3 2009	Q4 2009	Q3 2010	Q3 2011	Q3 2012
Repo rate	0.6	0.3 (0.5)	0.3 (0.5)	0.3 (0.5)	1.8 (1.8)	4.0

Note. The assessment in the April 2009 Monetary Policy Update is shown in brackets. Source: The Riksbank

Deputy Governor Lars E.O. Svensson entered a reservation against the decision and advocated cutting the repo rate to 0 per cent and a repo rate path in line with the scenario for a lower repo rate in the Monetary Policy Report, so that the repo rate would be kept at this level for one year. He considered that such a repo rate path entails a better balanced monetary policy, with lower unemployment and higher resource utilisation without inflation deviating too far from the target.
Deputy Governor Barbro Wickman-Parak supported the decision to cut the repo rate to 0.25 percentage points, but entered a reservation against the growth forecasts, and thereby the repo rate path these entailed, in the Monetary Policy Report. Ms Wickman-Parak said her stance was due to a more positive view of economic activity both abroad and in Sweden further ahead, which would mean that the repo rate would need to be raised earlier than is forecast in the main scenario of the Monetary Policy Report.

The minutes from the Executive Board’s monetary policy discussion will be published on 16 July. The decision on the repo rate will apply with effect from Wednesday, 8 July. The deposit rate is at the same time cut to -0.25 per cent and the lending rate to 0.75 per cent. A press conference with Deputy Governor Barbro Wickman-Parak and Anders Vredin, Head of the Monetary Policy Department, will be held today at 11 a.m. in the Riksbank. Entry via the bank’s main entrance, Brunkebergstorg 11. Press cards must be shown. The press conference will be broadcast live on the Riksbank’s website, www.riksbank.se/.

So, here’s what the Swedes are saying:

1. Economic activity abroad is very weak and this hits Sweden hard. That means the Swedes can’t export their way to prosperity because no one is buying.  Everyone is in a synchronized global downturn.  One subtext I should mention is that Sweden is greatly affected by the collapse in the Baltics because there was a huge trade flow and banking relationship between Sweden and the Baltics.  Therefore, the economic depression there is not good for the Swedes or their banking system.
2. A lower repo rate and repo rate path are needed to counteract the fall in production and employment and to attain the inflation target of 2 per cent. Output and employment in Sweden is so weak now that it is creating deflation.  We have to lower interest rates in an effort to stimulate borrowing, which we hope increases credit and ultimately production and employment.
3. The Riksbank’s assessment is that after cutting the repo rate to 0.25 per cent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. Look, we are cutting rates as low as they can go, effectively zero.  And financial markets are still not normal. Banks just are not lending enough to create the credit in the system necessary to increase production and employment.
4. The Executive Board of the Riksbank has therefore decided to offer loans totalling SEK 100 billion to the banks at a fixed interest rate and with a maturity of 12 months. Because cutting rates, the policy tool we prefer, is not getting the job done, we are going to effectively print money out of thin air. We will start making loans to banks with fictitious money that we create solely to increase the amount of money in circulation in a desperate attempt to increase consumer and business credit, consumer price inflation, and output.
5. The deposit rate is at the same time cut to -0.25 per cent. And as an extra measure, we will start penalizing banks for not lending by charging them 0.25% for holding deposits at the Riksbank.  Now, they will have every incentive to start lending…we hope.

Pretty aggressive plan, if you ask me. Will it work, though?

Well, first of all, most every major central bank in the world, certainly the biggest: the Americans, the Eurozone, the British, the Swiss, and the Japanese, have rates near zero and are printing money.  The world is awash in money and the incentive to borrow is huge.  So, is the Swedish announcement qualitatively different?  On some level, it is not.  Nevertheless, it is the most aggressive policy and the fact that they are charging negative interest rates for deposits is unprecedented.  This does make events in Sweden something to watch.

Moreover, the situation in Sweden is bleak.  GDP is expected to contract 5.4% this year and inflation is expected to be negative. Clearly, the Swedes are in a deflationary spiral.  It doesn’t help that its banks lent recklessly to the Baltics and that those countries are imploding.  The Swedish banking system is at present severely undercapitalized – this is why lending is not taking place.  The chart to the right of key figures from the Riksbank website sums it up.

So, the Swedes are lending and printing money. What’s more is they are taking economists up on their suggestions regarding negative interest rates. Back in April and May, Greg Mankiw and Willem Buiter suggested that negative interest rates were the way to go in order to deal with these problems.  Basically, you are giving people money to borrow.  There cannot be much more incentive than that.

The thing is you can lead a borrower to the bank, but you can’t make him borrow.  Do you even want him to borrow?  The last time I checked, it was savings and investment which created long-term growth.  In my view, people are terrified of over-borrowing now and no amount of easy money is going to change that overnight.

Here’s the problem.  I take a fairly Austrian School tack here.  Punishing savers by lowering interest rates to zero and printing money is not going to solve the problem.  The problem was low interest rate and easy money to begin with (and a lack of regulatory oversight never hurts too). This created a binge of reckless lending.  We are now seeing the result of that lending worldwide, Sweden included.

What Sweden needs is more capital in its banking system. Remember the whole song and dance about the Swedish solution? Supposedly, the Swedes were brave enough in the early 1990s to bite the bullet and nationalize insolvent banks in order to re-capitalise the banking system and get lending going again.  Everyone and his sister was saying this is what America needed to do (including me).  I still say this is what needs to be done: punish reckless lenders by liquidating zombie undercapitalized banks but provide enough liquidity at normal interest rates to keep the system intact.  And, I am sure taxpayers would be a lot more willing to pony up under these circumstances than under the present policy of giving the reckless lenders free handouts. If you want to prevent systemic collapse, it is the banking system, not the banks, which is important.

But, apparently, everyone just wants easy money and no one wants the Swedish solution – not the Americans and certainly not the Swedes.

Update 1300ET: Note – so as not to play too fast and lose with my terminology, I should clarify that the Riksbank is charging banks for holding deposits at the Riksbank.  They are not lending at negative interest rates as the statement “Basically, you are giving people money to borrow” suggests.  Also, regarding the lending by the Riksbank, they are not technically engaging in quantitative easing (buying government paper with new money). However, the net effect of the lending is to increase credit flow.

Related posts:

• Why should central banks cut interest rates?
• Interest rates, the pound and good news for Brits
• U.K. central bank does not follow Fed to ZIRP
• Norway makes three
• Connecting Fed cuts with credit writedowns and quantitative easing

This is the assessment of den Danske Bank as reported by Edward Hugh.  The last time I mentioned the Baltics was on May 12th in my post “A bearish view on Eastern Europe.”  I ended saying the Scandinavian banks’ exposure to the Baltics is just as worrying and should be the place to watch before we give a definitive all-clear.”  And that all-clear signal is far from coming.  In fact things seem to be reaching a critical state.

Here’s what den Danske Bank says:

The event risk has risen sharply in the Baltic markets and we advise utmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

We should be watching these developments in Scandinavia and the Baltics because things have a way of metastasising in this globalized economy. Read more at the link below.

Source

Danske Bank Warn On The Baltics – Edward Hugh

see also Devaluation Imminent in the Baltics? by Claus Vistesen (notice the allusions to Argentina, a comparison I made last July.

Related posts:

• Estonia and Latvia: headed for the rails
• Earnings results at Swedish banks show large writedowns in Baltics
• Are the Baltics the new Argentina?
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Foreign investors dump Danske Bank

You may have seen Ed’s post “Gillian Tett: Washington is talking to Swedes about banking crisis solutions” a week back about how the U.S. government was getting ready to talk to Swedish officials regarding the banking crisis. This is a very important development and I have a lot more to provide below on the issue as it pertains to today’s events and Japan’s crisis early this decade.

Bo Lundgren, one of the original architects of Sweden’s successful banking bailout program, went to Tokyo in 2001 (I wrote about it in “Prudent Bear”) and a lot of his ideas were subsequently adopted by Heizo Takenaka, Japan’s Economics Minister in Prime Minister Junichiro Koizumi’s administration.

It is also worth noting that Sweden only nationalised two banks, so the key challenge is minimising the contagion effect (i.e. if you take over Citi and BofA, how can you spare JP Morgan or Wells Fargo?).

But one of the key aspects of the Swedish plan which helped it gain widespread public acceptance was the notion of SHARED SACRIFICE. This gave the nationalisation tremendous public legitimacy. Geithner’s plan looks like it is being directed by Wall Street and in TALF you give them a huge political weapon — i.e., we don’t partner with you if you continue to adopt measures we don’t like.

US calls on Sweden’s “Mr Fix It” Bo Lundgren

The Swedish financial chief known as “Mr Fix It” has been summoned to Washington to advise on how Sweden’s model might avert a global banking meltdown.

Bo Lundgren, the steely-eyed head of Sweden’s National Debt office, played a leading role in averting the collapse of the Swedish banking sector when a property bubble burst in the early 1990s.

Sitting in his office in downtown Stockholm before his trip to Washington, Mr Lundgren chuckled at the Wall Street joke that “Swedish models used to only attract attention if they were blonde and leggy”.

Now, US President Barack Obama cites Sweden as a possible model of how best to tackle failing banks. Mr Lundgren, who was fiscal and financial affairs minister at the time of the last crisis, yesterday outlined the Swedish solution to the Congressional Oversight Panel, which supervises the US administration’s troubled asset relief programme.

“I am a market liberal. I was even called the nearest Sweden had every come to having a party one could call libertarian,” said Mr Lundgren, the former head of the Moderate Party with links to the Conservatives.

This did not stop him nationalising two failing major banks in 1992: the already majority state-owned Nordbanken, and the privately owned Gota bank.

“In the case of a crisis, the state needs to be strong,” he said. “If it decides to act, it should become an owner.”

After initial hesitation, when the Swedes chose to act they soon reached a broad political consensus.

The first, and in his eyes crucial step Mr Lundgren took was to restore liquidity by issuing a so-called “blanket guarantee” for all non-equity claims on Swedish banks.

This was vital to restore confidence, he said, and is something that has not been done in the US and UK.

It was also crucial not to put a figure on the guarantee, according to Stefan Ingves, the governor of the Riksbank, Sweden’s central bank. Mr Ingves was a finance ministry official in the early 1990s and led the Bank Support Authority, created to resolve the crisis.

“If you pick a very low figure, people will say: ‘That’s not credible, we think the problem’s bigger than that.’ If you pick a very high figure, then people say: ‘Oh gosh, is it that big a problem?’,” he said.

The government did not extend its credit guarantee to shareholders of the nationalised banks, who were wiped out.

In the UK, the Royal Bank of Scotland has refused to go this far, but the Swedes insist this acts as a wake-up call to shareholders of troubled but still solvent banks to shape up or ship out. This decision spurred two private banks to raise private capital.

A “stress test” was worked out to determine how bad the problems were in each bank for the coming three years.

Banks were then ranked as healthy or as candidates for nationalisation, and those in between were told to clean up their act or face being taken over by the state.

Next, the toxic assets of the nationalised banks were ring-fenced into two separate bad banks and run by independent asset-management companies. The good assets were placed in a single, merged bank.

As central banks and supervisors “don’t do corporate restructuring”, the Swedish authorities decided to bring in investment bankers from the private sector to run the corporate finance side of the bad banks’ assets. “Huge numbers” of bankers and auditors were flown in from London to do the “daily running of these businesses,” said Mr Ingves.

Private banks were also urged to place their non-performing loans in separate bad banks. However, unlike what has been mooted in the US, there was never any question of the authorities buying bad assets from banks that remained in any way privatised. “We refused to do that because we could never agree on the price. If you pay too much it’s a giveaway to the shareholders. If you pay very little then the transaction simply won’t happen,” said Mr Ingves.

Despite calling it a “political value judgment”, it is clear he disapproves of countries such as Britain and the US who have committed huge sums to insure bad assets of private or part-private banks.

Once split, the two Swedish bad banks managed to liquidate their assets by 1997 and the state recouped at least half the funds it had made available.

While the process worked back then, the two Swedes recognised that the 1990s crisis, essentially home-grown and involving half a dozen national banks, was very different from the current global meltdown, involving far more banks and complex “packaged and repackaged” assets. Still, the solution remains the same, said Mr Ingves, even if far more co-ordination is today required.

“Clearly, one of the lessons that comes out of all this is that in Europe, the financial integration between countries ran way ahead of the EU’s willingness to have a regulatory framework following at the same pace,” said Mr Ingves.

The Swedes also expressed concern that other countries’ handling of this crisis was still too piecemeal.

“In the US, certainly early on, there was no consistent policy over capital injection and bad assets. Now it’s better but there are still too many loose ends,” he said.

“To restore confidence you have to show exactly how big the problems are and how you are going to take care of that.”

Here’s what I had to say on this very topic in 2002 in Prudent Bear as it relates to Japan’s own struggles:

Two Visitors to Tokyo
03/26/02

“Government intervention is unavoidable if non-performing loans and bank loans are mounting in an economy…In order to limit moral hazard problems and to secure public support…it is important to enforce the principle that losses are to be covered in the first place with the capital provided by the shareholders. If that means the banks must be nationalized, so be it.” – Bo Lundgren, former Swedish Minister for Fiscal and Financial Affairs

In addition to President Bush, there have been two other important foreign visitors to Japan in the past month: the leader of Sweden’s parliamentary opposition, Bo Lundgren, and chairman of the executive committee of Citigroup, Robert Rubin. During their time in Tokyo, both men commented on the state of the country’s financial crisis, the gravity of which is being debated yet again in light of the recent strong rise in the Japanese stock market. Needless to say, the visit of the former US Treasury Secretary occasioned much more coverage and corresponding press commentary, but it was Mr. Lundgren, in his discussions of Sweden’s own banking crisis and its unstated implications for Japan, who ultimately imparted far greater wisdom to his hosts.

Reading Mr. Lundgren’s recent speech on the so-called Swedish Solution (delivered at Tokyo’s Swedish Embassy), one is struck by the government’s sheer decisiveness to overcome its problems that struck in the early 1990s. The Swedish financial crisis was entirely resolved within 6 years at minimal cost to the taxpayer, at which point the Japanese authorities were still debating the question as to whether public money was actually required for their ailing banks. In the words of HSBC Securities banking analyst Brian Waterhouse, “The Swedes have finished the ‘race’ and have dealt with their banking crisis; the Japanese are still stuck in the starting gate”. The huge costs of Tokyo’s inactivity are increasingly apparent to many outside observers. The inevitable policy response, which is coming closer in time as crisis conditions intensify, will likely be widespread bank nationalization, a collapse in the value of the yen, and the onset of a rapid rise in inflation.

This might seem an unduly alarmist viewpoint now that Tokyo’s bureaucrats have successfully engineered another year-end ramp of the Japanese stock market over the past month and familiar talk of recovery is in the air. But as appears to be always the case in Japan, the country’s politicians and bureaucrats have yet again wasted valuable time and resources on eradicating the symptoms, rather than the underlying disease of deflation, of which the inexorable rise of non-performing loans in the commercial banking system is the most visible manifestation. The rally in Japanese bank shares has merely deferred the day of reckoning as well as engendering complacency yet again amongst the country’s policy makers. Hence, the respective insights of Messrs. Rubin and Lundgren take on added significance.

First Mr. Rubin. He told Japanese Prime Minster Junichiro Koizumi that the central bank should set an inflation target as a means of alleviating the deflationary pressures current afflicting the banks real estate portfolios and, indeed, the economy as a whole. The case for inflation targeting is certainly not new. Paul Krugman urged this course of action in 1998 when he proposed that the Bank of Japan opt for a policy of controlled inflation. Krugman’s argument for a controlled inflation for Japan arises out of his application of a model that does not incorporate private debts and debt related behavior. To our mind, this would seem to miss the basic issue that most realize is paramount in the current Japanese crisis. Nonetheless, Krugman’s argument has merit and his policy prescription has since been echoed by other commentators.

Economist Andrew Smithers has argued for an eventual inflation in Japan for, in our opinion, the right reasons: namely, that the change from price deflation to price inflation would lead to a consequent reduction in private indebtedness in real terms that would allow for a recovery of domestic demand, the weakness of which is the root cause of Japan’s current economic woes. Whether one accepts the Smithers or Krugman framework, Rubin’s reiteration of this advice is a most surprising departure for a figure who prominently advocated Western style restructuring as the optimal means of turning around the moribund Japanese economy during his time as US Treasury Secretary. Indeed as Treasury Secretary, Rubin publicly warned Japan against pursuing a devaluation policy in the pursuit of economic recovery.

Yet as Japan’s deflationary pressures have intensified, even Mr. Rubin appears to have undergone a Damascene type of conversion on this issue. But the fact remains that an inevitable consequence of establishing a positive inflation target as Rubin now advocates means substantially higher rates of monetary growth and a correspondingly weaker yen. Whether he realises it or not, the former Treasury Secretary’s advice invariably leads back to the export led growth strategy for Japan that he once repudiated.

It is also difficult to speak any longer of a policy of “controlled inflation” that would lead to a gradual decline in the value of the yen. When Krugman and Smithers first began urging this course of action on Japan’s monetary authorities years ago, the deflationary pressures were not quite as severe and the non-performing loans in the banking system had not exploded to the degree they have more recently. Such has been the cost of inactivity amongst Tokyo’s policymakers, however, that far more aggressive and unorthodox measures are needed today than would have been the case some 5-6 years ago when the calls for an explicit inflation target were first publicly made.

What are the consequences of Japan’s wasted decade? If private sector (as opposed to government) estimates of the extent of the bad debt problem in the banking system are correct (anywhere from 25-70 per cent of GDP), then the scale of money now required to nationalize the banks will almost certainly entail huge additional monetary stimulus. The likely aftermath therefore will not be a yen/dollar rate of 135-140, but something closer to 200 yen to the dollar, or possibly higher. Such has been the consequences of a decade of inactivity in Japan that (in the words of AIG economist Bernard Connolly): “– there is no happy medium in Japan, we fear, between deflation and very rapid inflation, and that in turn, we think, means that a yen collapse and very rapid inflation are all but inevitable and are coming much closer in time.”

In light of Japan’s abysmal record on economic policy making over the last decade, it seems ludicrous to analyse the potential consequences of a “successful” inflation targeting strategy. But were the Japanese monetary authorities able to weaken the yen and enable inflation to develop, it would almost certainly be accompanied by a sharp fall in JGBs.

This creates two interrelated problems: The Japanese banking system, which by virtue of its high proportion of non-performing loans, is unable or unwilling to act as a financial intermediary borrowing short from the central bank and lending to Japan’s private sector. Instead, Japan’s banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up a small additional 15 or 20 basis points of yield on those government notes. This is virtually their only source of profitability right now.

In this process, Japan’s banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks. As the banks are already heavily exposed to a weak bond market, a weak yen will consequently add to their disinclination to buy more, thereby complicating the BOJ’s efforts to reflate, since bond buying on the part of the banks is essential to keep the money supply from contracting. In the absence of huge increased purchases by the Japanese central bank, the resultant losses stemming from a rout in the bond market will also put the commercial banking system one step closer to insolvency. Hence, we come back to the question of bank nationalization, since a crash in the market value of the banks’ JGB portfolio would in effect merely represent an immaterial accounting transfer within the government were the banks nationalized, rather than another huge private sector loss that would intensify existing deflationary pressures in the absence of public ownership.

The recent visit to Tokyo of Bo Lundgren, currently Sweden’s parliamentary opposition and a former minister for fiscal and financial affairs is highly significant in this regard. Lundgren was a central figure in helping to resolve successfully Sweden’s own banking crisis in the early 1990s. Unfortunately, for the Japanese, while the Swedish solution does provide a blueprint, Lundgren’s analysis also serves to highlight Tokyo’s own remarkable delinquency and the reasons why resolution of the Japanese banking crisis is likely to be more problematic and costly.

To be sure, Sweden’s crisis was not nearly as big as Japan’s, but they might have become as large had the Swedish authorities dithered to the extent that their Japanese counterparts have done throughout the past 12 years. In Sweden, troubled loans were 20 percent of outstanding credit, 12 percent of gross domestic product, compared with (by estimates other than those officially advanced in Tokyo) 20 to 25 per cent of credit outstanding and anywhere from 40 to 70 per cent of GDP in Japan. And Lundgren himself made no explicit comparison between Sweden’s banking crisis and that of Japan. His was a low-key speech made in the Swedish Embassy, in itself quite a contrast from the hectoring “gaiatsu” that one normally associates with “helpful” advice from the West. So conditioned are the Japanese to high volume public lectures, that this might explain the comparative lack of publicity.

If the scale of the problems were not strictly comparable, there are still many similarities between the two crises. Hence, there are lessons for the Japanese to draw from the Swedish experience. In each case, there was a rapid expansion in the real economy generated by an explosion of credit interacting, on the way up, with an explosion in asset prices of one kind or another. Swedish banks got into trouble when the resultant speculative bubble that inflated during the second half of the 1980s lost its air in the early 1990s. Then property prices collapsed. The markets crashed, overexposed banks headed toward the wall, and the economy was imperiled.

But the Swedes dealt with the resultant banking crisis quickly and with total transparency. There was little attempt to mask the size of the bad debts and an entity was quickly set up, the Bank Support Authority, whose political independence enabled the government to avoid any conflict of interest and thereby secure greater public acceptance for the use of public money. The Authority was quickly able to get to the root of the problem. It divided banks into three categories: long- term profitable with short-term problems; long-term profitable with uncertain capital-adequacy ratios and medium-term problems; basket cases likely to be beyond reconstruction.

These classifications allowed the BSA to decide quite easily how to handle each bank: Some required no more than increased capital contributions from shareholders, some were to be nationalized, and some were to be closed altogether. Troubled loans were transferred to a separate company. In all, the government’s intervention was devised on a commercial basis to minimize the cost to the taxpayer. But taxpayers’ money was required, as a large chunk of the banking system was de facto nationalized, given the government’s unconditional guarantees to bank creditors (which lasted for almost 6 years).

While the global recovery undoubtedly helped to mitigate the extent of the problem loans faced by the Swedish monetary authorities, it is undeniably the case that their prompt, aggressive actions prevented a bad crisis from turning into a total disaster. According to Lundgren, within 6 years the BSA was wound up, nationalized banks were sold back to the private sector, and the total cost of the bailout ended up being around the equivalent of 6 per cent of GDP, half the number originally feared by the Swedish authorities.

Needless to say, the scale of the problem is considerably higher in Japan. But the fact of the matter is with the economy in depression, Japan’s monetary and financial authorities have virtually no good options left, as Bernard Connolly clearly recognizes. In the end, even Mr. Koizumi’s determination to stick to his policy of holding new bond issues to 30 trillion yen annually will likely prove untenable, Mr. Rubin’s reported support for this fiscal restraint notwithstanding. (In fact, it is somewhat inconsistent for Rubin to laud Mr. Koizumi’s self-imposed limit on bond issuance on the one hand in order to prevent interest rates from rising excessively if the target is dropped, yet on the other hand, to propose a policy of inflation targeting, the ultimate consequence of which would almost surely be the same as renewed fiscal profligacy – namely, sharply rising bond yields.) The government must choose the least bad alternative, and that is to reflate, either proactively or reactively, to reduce the rising burden of debt that is being compounded by prolonged heavy government borrowing and by accelerating deflation. The alternative, to do nothing, simply ensures that the problem will get worse and the pain caused by a transition from deflation to reflation will be even greater.

Commenting on the “Swedish solution”, Brian Waterhouse identified eight keystones which ensured its success: 1. Early recognition of a crisis. 2. Acknowledgment that action is pressing. 3. Unconditional official support for the banking system. 4. Political leadership and unified public opinion. 5. Intervening legislation. 6. Independent supervision of the reconstruction process. 7. Nationalization if necessary. 8. Determination to denationalize as soon as possible.

There is an additional factor unmentioned by Waterhouse. Sweden had proper functioning, politically legitimate institutions, thereby enabling the government to mobilize public opinion and deal with the problem from a position of responsible and accountable public leadership. Mr. Lundgren himself noted that the job was basically achieved with a core committee of just three Cabinet ministers, a total of six senior government officials regularly involved, and the use of two independent consulting firms, rather than the usual morass of backroom committees and bureaucrats, which constitute the essence of the Japanese polity. In other words, Sweden had something approaching true democracy. We have often made the point that politically responsive institutions are totally lacking in Japan, and that the resultant policy paralysis brought about by 50 years of corrupt LDP leadership (and Washington’s continued patronage) has exerted a huge economic and social cost. The messy resolution of the country’s long-standing financial crisis, when it comes, will probably constitute the most vivid illustration of this point.

Source
US calls on Sweden’s “Mr Fix It” Bo Lundgren – Telegraph

Related posts:

• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• The Swedish roots of the UK bailout plan
• Lessons from Swedish bank resolution policy
• Lessons from Japan’s Bank Crisis
• Bernstein: America is turning Japanese

Gillian Tett has written in the Financial Times that the Obama Administration is no talking to the Swedes directly about their solution to the credit crisis, suggesting a openness to potential banking crisis solutions. Next week, Bo Lundgren, now head of the Swedish debt office, but formerly a Deputy Finance Minister under Carl Bildt, is scheduled to meet with American officials in Washington. For those of us who see positives in the Swedish crisis solution, this is positive news.

Washington’s Congressional Oversight Panel has summoned Mr Lundgren and others to explain how they fixed Sweden’s banks – presumably to glean tips on what Washington should do next.

The Nordic gods might well chuckle at this twist in the global financial saga. As recently as last autumn, the phrase turning “Swedish” was tantamount to an insult among most American politicians (and on Wall Street, the joke currently goes, Swedish models used to only attract attention when they were blonde and leggy). But these days, as the economist Nouriel Roubini recently observed, “we are all Swedes now” – at least in the sense of using state funds to fix the banking mess.

Hence Washington’s sudden invitation to Mr Lundgren and his colleagues. Whether the Americans will actually like the message that Mr Lundgren and others wish to impart, though, remains to be seen. For many Scandinavian observers are distinctly critical about what the US is currently doing with its banks. In Washington, politicians are wrapping themselves in knots about words such as “bail-out”. But to the Swedes that misses the point: the really important issue is not whether state money is used, but how it is dispersed. After all, as Mr Lundgren notes, “the word nationalisation can have many meanings” – and not all are very effective.

Sweden’s own crisis bears this out. When its banking woes first erupted, Stockholm (like the US) initially responded with procrastination and denial. Eventually, however, it nationalised two banks, wiping out the shareholders, and placed toxic assets into a special “bad bank”. That cost the government about SKr60bn-Skr70bn (although much of that sum was later recouped through asset disposals). To some extent, many western governments are copying elements of this approach. The UK and US, for example, have partly nationalised banks such as Citi and Royal Bank of Scotland. But, thus far, the UK and US have not ringfenced bad assets, preferring to urge the banks to deal with them while still on their books (supported with complex guarantee and financing schemes.) Anglo-Saxon governments have also refused to wipe out shareholders in banks such as Citi and RBS, for fear of looking too “socialist”.

Much has been made of the Swedish banking crisis solution because it involved pre-privatization of two banks and this strikes many Americans as distinctly ’socialist,’ a term reviled in U.S. political parlance. The Obama administration has repeatedly rejected the suggestion that it would nationalize any of the large American banks. Yet doubt still lingers.

I have suggested that pre-privatization should be a leading option to consider by the Obama Administration in a number of posts:

• America needs a pre-privatization plan (Feb 2008)
• Lessons from Swedish bank resolution policy (Mar 2009)
• The global economy has crashed: we need a comprehensive credit crisis plan (Sep 2008)
• The Swedish banking crisis response – a model for the future? (Aug 2008)

However, I do recognize the need to look at other solutions. Nationalization is but one option.  The key is to restore confidence in the system and this may involve guarantees for bondholders which many find unpalatable.  

But the more serious criticism lies with what is not being done. While Stockholm was nationalising two banks in the early 1990s, it also offered a blanket guarantee to any investor holding any Swedish bank liabilities (except for shares or subordinated debt). These days, that measure is not well known outside Sweden. But many Swedish officials and bankers consider that guarantee to have been the most crucial decision of all.

Moreover, it remains to be seen how applicable the Swedish crisis solution is to the United States.  Two Swedes high in the political ranks during the banking crisis there in the early 1990s have offered very different views on this subject on the site Euro Intelligence, the second highlighted here due to my preference for its analysis:

• Sweden may not be a model – Euro Intelligence
• Lessons from Swedish Bank Resolution Policy – Euro Intelligence

And, indeed there are some very negative consequences to models like the one adopted in Sweden as I argued in November in my post, “The problem with comprehensive banking crisis solutions.” Ultimately, I am heartened by the fact that the Obama administration and the Congress are looking into all available antecedents of the present crisis for potential frameworks.  This should give one a renewed sense of faith in the wisdom in Washington.

Sources
Insight: US is ready for Swedish lesson on banks – Gillian Tett, FT.com

Related posts:

• Did Sweden really nationalize its banks?
• The problem with comprehensive banking crisis solutions
• Lessons from Swedish bank resolution policy
• Roubini: Nationalization “fully on the table” in Geithner’s Plan
• Ireland guarantees bank deposits at six banks

The following is a post from the site Euro Intelligence, published just 5 days ago regarding the Swedish solution to the banking crisis.  I am providing this version with the author’s permission, who should be credited with much of the Swedish bank resolution solution’s creation.  A longer version is linked at the bottom of this post.

Lars Jonung, who wrote this piece, is now a research adviser at the European Commission in Brussels. He was previously professor of economics at the Stockholm School of Economics. He has published many books and articles in English and Swedish and is the co-author of the leading macroeconomic textbook in Swedish.

You should also note that Jonung served as chief economic adviser to the Prime Minister Carl Bildt in 1992-94 when the Swedish solution was implemented. I would also say that his characterization of events in this piece is very much at odds with what Alan Blinder recently said in a New York Times piece. Given Jonung’s prominent role in the process, this discrepancy should be noted.

Banks all over the world are in deep trouble. This has created an interest in the successful bank resolution policy adopted in Sweden in the early 1990s. But can the Swedish model of yesterday be applied in other countries today?

When Sweden was hit by a financial crisis in 1991-93, its response comprised a unique combination of seven distinctive features: 1) swift policy action, 2) political unity, 3) a blanket government guarantee of all bank liabilities (including deposits but excluding shareholder capital), 4) an appropriate legal framework based on open-ended government funding, 5) complete information disclosure by banks asking for government support, 6) a differentiated resolution policy by which banks were classified according to their financial strength and treated accordingly, and 7) an overall monetary and fiscal policy that facilitated the bank resolution policy.

Two major banks were taken over by the government. Their assets were split into a good bank and a bad bank, the “toxic” assets of the latter being dealt with by asset-management companies (AMCs) which focused solely on the task of disposing of them. When transferring assets from the banks to the AMCs, cautious market values were applied, thus putting a floor under the valuation of such assets, mostly real estate. This restored demand and liquidity, and thus put a break on falling asset prices.

The Swedish model proved successful. The banking system was kept intact. It continued to function, swiftly emerged from the crisis and remained mainly in private hands. Taxpayers did not lose out in the long run. The net fiscal cost of the bank resolution 15 years after the crisis is close to zero. The policy priority of saving the banks, not the owners of the banks, kept moral hazard at bay.

The bank resolution policy was carried out transparently and openly. The centre-right government under Carl Bildt cooperated with the social democratic opposition, creating public trust in the resolution process.

Today’s global crisis is different from the Swedish crisis of the 1990s in important respects. The Swedish financial system was small, with only half a dozen major banks. It was also bank-based, with few major non-bank financial actors, and was less sophisticated and less globalized than the current world financial system.

Still, there are lessons from the Swedish resolution policy that may serve as guiding principles today.

First, the Swedish experience demonstrates that a genuine threat of public receivership or nationalization does galvanize banks into action. With this threat hanging over them, private banks in Sweden made great efforts to solve their problems themselves by asking their owners for capital. The lesson is that no government support should be given to a financial institution with zero or negative equity until its present owners have surrendered their control and ownership.

Banks and their networks of debtors and creditors should be saved – not bank owners and not bank managers. Once this principle is commonly accepted, government rescues will be easier to carry out. Moral hazard will be reined in – today and in the future. Taxpayers will more readily accept the necessary public expenses.

Presently, policy choices are often hampered by a political dislike of public receivership (nationalization) – even if such a step would be economically more efficient and just. The Swedes, however, put ideology and fear of big government aside. Their priority, from the Conservative party to the Social Democrats, was to find a quick, workable solution.

Today, major steps towards pseudo-nationalization have been taken in many countries, creating the worst of all possible worlds: governments are financing bad banks without outright owning them and failed managers and owners are not punished. This creates public distrust in the resolution policy as a whole. Temporary public receivership with a clear exit strategy is a more efficient approach, and less costly to the taxpayers. As any student of finance knows, the value of a bankrupt bank is zero.

Second, the Swedish experience suggests that all banks that are put under public receivership should be split immediately into a good bank and a bad bank, under the control of an independent authority with the goal of terminating the operations of the bad bank in a specified time frame, say within less than 10 years. This avoids Japanese-style “zombie” banks. Alternative solutions include purchase-and-assumption transactions, in which a part of a bank’s good assets and matching liabilities are sold to another bank.

The good bank should continue operation and be re-privatized as soon as possible. The bad bank should manage the bad assets taken from the old bank with a view to selling them in due course. This will help recreate a market for such assets.

Third, the Swedish case shows that the bank resolution policy should have an open-ended financial commitment from the government to be credible and efficient. At this stage of the global crisis, it is impossible to estimate exactly the cost of rescuing a financial system in any country. However, the ad hoc measures that have been taken in many countries seem to be an open invitation for struggling banks and institutions to demand more funds. Any attempt to fix a sum for the rescue effort undermines its credibility. It should be made clear that the government is ready to mobilize the resources needed. Fighting a financial crisis is like fighting a war. Losing is simply unthinkable.

Finally, the process of bank resolution should be transparent, based on full disclosure of the steps taken and the valuations of assets made. Openness fosters public trust in the bank resolution policy and in the financial system that will emerge after the crisis. And trust is the basic building block of any banking system.

Source
The Swedish model for resolving the banking crisis of 1991 – 93. Seven reasons why it was successful. – Lars Jonung

Related posts:

• Lessons from Japan’s Bank Crisis
• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• Transferring Swedish bank risk onto Latvian taxpayers
• The Swedish roots of the UK bailout plan
• The Swedish banking crisis response – a model for the future?

Since everyone seems to be talking about nationalization and pointing to Sweden as a model for the future, one should ask whether Sweden actually nationalized anything.  No one is talking about outright Hugo Chavez-style expropriation here. The only   nationalization I see is what was done in the case of AIG and we know where that led.

I certainly believe the knee-jerk reaction against the ‘N’ word, as Barry Ritholtz calls it, is overwrought and have suggested we dub it pre-privatization.  After all, didn’t the word recession come into existence for similar reasons — fear of the ‘D’ word depression.

Back in August, I pointed to Sweden as a model as well. You can read the post, “The Swedish banking crisis response – a model for the future?.”  But, the Peterson Institute also has a fine post by Anders Åslund on what really happened in Sweden and it was not nationalization.

Here’s a bit of what he had to say:

Having lived through the Swedish banking crisis in the 1990s, I am struck by how poorly the American public understands what really was a successful cure that remains relevant to the current situation. In fact, the Swedish example would probably provide the best, most capitalist, solution for the United States…

Sweden did not nationalize its banks. It was Norway that did so, which is an alternative model. In Sweden, a temporary emergency bank authority was set up on the model of the US Federal Deposit Insurance Corporation. It had outside, mainly foreign, consultants to scrutinize all bank debts and establish objectively which were nonperforming. The banks were forced to write off their bad debts and transfer them to bad banks.

Sweden had no aggregator bad bank and the bad banks were not nationalized. Each big bank set up its own bad bank. They were given illustrious names such as Securum, Retriva, Nackebro and Diligentia. Securum was the biggest bad bank belonging to the already state-owned bank, Nordbanken, and it became a separate state company. The private bad banks, however, remained the property of the private banks from which they were removed.

Nobody traded toxic waste at the height of the crisis in Sweden. Such trade is an unnecessary complication. A bad bank is not a bank but a private equity fund, which does not need much capital or recapitalization. Its task is to isolate the rotten apples so that they do not contaminate the good loans in the cleansed banks.

The bad banks sold off their assets at a leisurely pace over several years to maximize their value, avoiding excessive depreciation of assets through fire sales. Any gain was to the benefit of its owners. In this way, Sweden avoided the problem of trading undervalued assets. In the end, even Securum made a small profit.

I have deliberately quoted only part of the post as I would like you to read the entire on the Peterson Institute site, which I have linked below. Before I add any comments, I should note that the Peterson Institute was founded by fiscal conservative and former Nixon appointee Pete Peterson, about whom links are also provided below.

Having cleared that up, it should be more evident how disingenuous the conversation regarding potential economic fixes is. What we are really seeing is guardians of the state defending the status quo at all costs, somewhat blind to alternative solutions. The Federal Reserve and the Obama Administration have decided that pre-privatization and the Swedish solution are non-starters purely for ideological reasons. Meanwhile, they have decided to continue the bailouts under TARP and instituted another back door bailout with TALF.

Given the enormous losses incurred through these bailouts already, one can expect no different in this particular go ’round. Obviously, Geithner, Bernanke, et al. believe ‘irrational despondence’ is the source of what ails us and that propping up asset prices will be the cure.

Witness remarks made by Ben Bernanke just recently before Congress:

Federal Reserve Chairman Ben Bernanke said Wednesday recent sharp declines in stock prices mostly reflected investor attitudes about risk and had become detached from real U.S. economic fundamentals.

“The risk appetite of investors changes over time and right now the standard measures of the risk premium that investors are charging to hold stocks are at very high levels relative to anything we have seen in recent decades,” Mr. Bernanke said in semi-annual testimony to Congress.

“The stock values reflect not so much the fundamentals, the long-term profitability of the economy, but they also reflect investor attitudes about risk and uncertainty which right now are at very high levels,” he told lawmakers during questions.

U.S. stocks have fallen to 12-year lows this month, with the benchmark S&P 500 down about 15% and the Dow Jones industrial average off about 16% since the start of 2009.

This goes to the mindset here. What Ben Bernanke does not say but clearly suggests is that asset prices are being depressed artificially by ‘irrational despondence.’ Stepping in to offer a bid to these assets will lift them — at which point the despondence will go away and all will be fine with the world.

This view is misguided because many asset prices are still above their long-term trend. This is certainly the case with house prices, where renting is still significantly cheaper than purchasing in many locales.

In short, the U.S. government is making a big mistake by rejecting pre-privatization and embracing bailouts. We all will pay the price. Americans, get your Japanese phrasebook out – you will need it. America is turning Japanese.

Sources
Pete Peterson on Charlie Rose – Charlie Rose website
Peter George Peterson – Wikipedia
Lessons for the US from the Swedish Bank Crisis – Anders Åslund, Peterson Institute
Bernanke says stock market ignoring fundamentals – Financial Post

Related posts:

• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• Lessons from Swedish bank resolution policy
• Sweden: competitive auto bailouts begin with Saab and Volvo
• Property more overvalued in Sweden than in US
• Sweden prepares for financial collapse in Latvia and major bank losses at home

It is looking like Saab is toast. This comes from Dagens Nyheter, a Swedish daily (note: I originally saw this covered in the Austrian daily Kurier):

The government gives Saab cold shoulder

Commerce Secretary Maud Olofsson continues to give Saab the cold shoulder. It is not an option for the state to buy or take over Saab, which is threatened by the closure of American automaker GM, according to svt.se [Swedish Television]

On Tuesday, crisis-ridden Saab owner General Motors will present their plans for the future. But Commerce Secretary Maud Olofsson has low expectations that it will not mean good news for Saab.

The odds for Saab are not very good, she told SVT’s Report on Tuesday evening. According to Maud Olofsson, GM has not put forward any strategy that shows how Saab will be able to reach profitability. She also questions GM’s intentions and believe that if the U.S. carmaker was serious, it would have applied for a bailout loan from the European Development Bank.

According to TV4 news sources within the Cabinet Office, the Government will not risk taxpayers’ money to rescue the Saab from a bankruptcy.

Maud Olofsson’s attitudes on the issue of Saab are shared by others in the Cabinet. Even Prime Minister Fredrik Reinfeldt believes that the responsibility is in GM’s hands.
In connection with the car show in Detroit in January GM’s Europachef Carl-Peter Forster said, “the Swedish government has Saab’s fate in their hands.” GM needs state aid in particular to develop the new Saab 9-3.

Then it was said that GM would produce a business plan to the Swedish government, which showed that Saab had a future as a viable producer.

- The signals are very clear, the government does not want to take on any car manufacturer, said Carl-Peter Forster, who, instead is hoping for government guarantees for loans to be raised in the European Investment Bank.

Sources
Regeringen ger Saab kalla handen – Dagens Nyheter
Aus für GM-Tochter Saab? – Kurier

Related posts:

• Sweden: competitive auto bailouts begin with Saab and Volvo
• GM finding no takers on Saab?
• Lessons from Swedish bank resolution policy
• Transferring Swedish bank risk onto Latvian taxpayers
• Gillian Tett: Washington is talking to Swedes about banking crisis solutions

General Motors, struggling under the weight of a mountain of debt, is finding it difficult to raise cash.  For one, the U.S. automaker is finding no buyers for its Swedish Saab unit, according to Swedish Daily “Dagens Nyheter.”

Nevertheless, GM executives are putting on a brave face with the news media.  In fact, I found an article in another newspaper, the Australian daily “Sydney Morning Herald” claiming the opposite under the title, “No problems in finding Saab buyers: GM.”

Take a look at what this article says GM has said (I have bolded the interesting parts):

General Motors Corp has dismissed reports that it has not found any interested buyers for Saab, as it has quietly shopped around the Swedish brand.

“It’s still early in the process,” one GM official familiar with the proceedings told AFP. “It’s going to take some time.”

As recently as last summer, GM chairman Richard Wagoner said the company intended to keep Saab in the GM family and re-tool its North American product line.

But as GM’s financial crisis deepened when sales collapsed this fall, GM put SAAB up for review as part of the restructuring plan it presented to Congress in early December in order to obtain $US13.4 billion ($A18.79 billion) in loans.

GM Vice Chairman Bob Lutz recently told the trade publication Automotive News that the term strategic review is “code for ‘we realise they’re not working and something needs to be done.’”

The plans presented to Congress indicated GM was unwilling to make additional investment in Saab products.

GM put its Hummer brand up for sale back in June and so far has failed to finalise a deal, although the hulking brand has attracted some interest from potential buyers.

Paul McCarthy, a consultant with PricewaterhouseCoopers in Detroit, noted

that merger and acquisition activity in the automotive sector has declined since the mid-2008.

I find this story strange because it sounds like GM is suggesting that it will find a buyer for Saab. In the Swedish daily, one hears exactly the opposite. I have translated the text for you:

General Motors (GM) has given up hope of being able to sell Saab Automobile, the Swedish carmaker, which last year lost a quarter of its sales. On Monday, the Ministry of Industry will report on its aid talks with Ford and GM.

It is the industry newspaper, “Automotive News,” which talked to sources in GM management who now admits what analysts have argued from the outset: Saab Automobile is unsaleable.

Why?

It is a small car with outdated products. Saab 9-5 is eleven years old, which is some kind of record in an industry where the car models come out in six to seven years. Saab 9-3 is six years old.

What is worse, Saab Automobile has not shown profit since 1995. If the cost of developing new products hasn’t discouraged [prospective buyers], then the history of losses has scared most potential buyer away from the brand.

With a total sales volume of about 93,000 cars in 2008, down 25 percent, the situation looks anything but cheery. In the single most important market, the U.S., sales fell by almost 35 percent to just over 21,000 cars. In Europe, the decline was almost 22 percent, to just 67,000 cars.

These two stories are very much at odds with one another. Obviously, someone needs to get their facts straight. My instinct tells me it is the Swedish story that is probably a lot closer to the mark than the Australian one.

Sources
No problems in finding Saab buyers: GM – Sydney Morning Herald
Omöjligt hitta köpare till Saab – Dagens Nyheter

Related posts:

• Sweden: competitive auto bailouts begin with Saab and Volvo
• Swedish government gives Saab the cold shoulder
• U.S. auto sales plummet: everyone down over 30%
• Fiat as the engine for change in the auto industry
• GM’s German subsidiary may cut ties

Yesterday, I mentioned an article I caught in the German newspaper Die Welt which outlined the desire for VW and Daimler Benz to receive bailouts in response to the state aid being offered to American car makers. I warned that a competitive bailout situation was underway. Now, this competition has spread to Sweden, where the Swedish government has introduced a bailout package for its auto makers Saab and Volvo.

The state aid now being offered in Germany and Sweden to their automakers is an unintended consequence of the U.S. bailout. In my view, it is only a matter of time before the competitive response hits other countries as well. As the global auto industry suffers from a glut of manufacturing capacity, this can only serve to reduce the viability of vulnerable companies including U.S. automakers.

While I applaud the desire to do something to stop a catastrophic outcome for the U.S. auto industry, we should see the German and Swedish responses as a sign that the proposed bailouts are not going to be successful.

Sweden’s government unveiled a 28 billion-krona ($3.5 billion) support package for Volvo Cars and Saab Automobile that aims to push development of fuel-efficient vehicles and ease the manufacturers’ access to funding.

The plan provides Sweden’s carmakers with a 5 billion-krona rescue loan, additional funding of much as 3 billion kronor for research and development as well as credit guarantees of 20 billion kronor, Finance Minister Anders Borg and Industry Minister Maud Olofsson told a Stockholm press conference today.

“We will exercise significant influence in regards to how the money is spent,” Borg said at the meeting. “This is essentially a measure to secure jobs and production in Sweden.”

General Motors Corp. and Ford Motor Co., the owners of Saab and Volvo Cars, are seeking financial aid from the U.S. government to avert collapse. Ford is exploring the sale of Volvo, and GM is considering options for Saab. Volvo Cars employed 13,000 people in Gothenburg in southern Sweden last year and is cutting more than 2,700 employees in Sweden.

The U.S. House voted 237-170 last night to approve emergency loans for General Motors Corp. and Chrysler LLC, shifting the focus to the Senate, where Republican opposition threatens to delay or kill the legislation.

Source
Sweden Ties SK28 Billion Aid Package for Volvo, Saab – Bloomberg

Related posts:

• Swedish government gives Saab the cold shoulder
• GM finding no takers on Saab?
• Fiat as the engine for change in the auto industry
• Auto sales plunge in September
• A quick note on corporate bankruptcy and bailouts

Gillian Tett makes a good point in today’s FT about the clear benefits of a systemic solution to crisis. Where the UK policy makers were bumbling along until today, they have taken the problem firmly in hand, finally recognizing the systemic risk. Tett sees this sensible policy as one hearkening back to the Swedish solution last decade. The U.S. would do well to take notice.

During much of the past year, British financial authorities have looked like Bertie Wooster-style, bumbling amateurs in the face of the banking meltdown. Now, finally – albeit belatedly – they have got something right.

Alistair Darling, chancellor of the exchequer, on Wednesday announced that the government would spend up to £400bn underpinning the banks. The only thing more startling than those dazzling zeroes is that Mr Darling is now overseeing a policy package that is arguably more sensible than anything else emanating from the western world.

For this package suggests that British mandarins have finally learnt to draw sensible lessons from the past, most notably from the 1990s crises in Japan and Sweden. More striking still, these moves could also provide pointers for how the U.S. authorities could improve their own policies.

There are at least three reasons to cheer. The first is that the UK government has acknowledged something the Americans remain reluctant to admit: that when a banking crisis is this bad, it makes more sense to recapitalise banks by buying preference shares than by purchasing their duff assets.

That does not necessarily mean that a “Tarp” – the scheme the U.S. is creating to purchase toxic debt – is a bad idea. On the contrary, if the Tarp creates a liquid market for mortgage debt and removes rot from bank books, then all financial players will benefit – including those in London. This puts the British authorities in an unusually favourable position in formulating their own policies.

However, the problem with the Tarp is that the toxic assets are so fiendishly complex that they cannot be easily valued or traded. Even in good times, it can take a computer several days to price complex collateralised debt obligations. That creates daunting logistical obstacles for a Tarp, which could delay or blur the balance sheet benefits.

Putting money directly into the banks, by contrast, is a fast and transparent way to help them. Moreover, it worked relatively well when it was employed by Japan and Sweden a decade ago, in tandem with various initiatives to purchase toxic assets. Better still, while both Sweden and Japan badly underestimated the scale of their crisis when it started, once they finally produced a hefty bail-out plan, they eventually recouped most of their investment.

A second point of cheer is that the British now also seem ready to take other steps to get credit and money markets moving again. The most eye-catching element of this revolves around injections into the money markets. However, what is equally important is a pledge that debt issued by banks will be protected from default.

That may sound arcane. However, it is crucial. Until last month, European and U.S. investors assumed that bonds issued by large banks were safe, since they had been protected in previous decades. But the manner of Lehman Brothers’ collapse shattered that belief in a manner that sparked a catastrophic chain of fear. The Federal Reserve’s apparent failure to anticipate that shock represents one of its biggest single policy mistakes. Wednesday’s announcement suggests the UK authorities have no intention of repeating this disastrous error. So much the better.

However, the third reason for cheer lies not in arcane finance – but sociology. Right now many voters are understandably furious with bankers. No wonder. When the banking crisis hit Japan a decade ago, bankers bowed to show their public remorse; this time, however, barely a single western banker has even said “sorry”.

Now, there is no guarantee that the British government can assuage this anger; but on Wednesday it did at least promise to impose more “discipline” on bankers. That may turn out to be mere window dressing; but it is more than anything offered by Washington so far.

Of course, none of this guarantees the UK can now end its banking woes, let alone avoid a recession. Unlike the Japanese and Swedish crises, this one is international. As a result, the fortunes of British finance now depend on more than UK policymaking alone.

But, with a bit of international co-ordination – and a hefty dose of luck – London does now have a chance of stabilising its banking system. The tragedy is that it took so much incompetence and denial – on both sides of the Atlantic – to arrive at this point. If nothing else, the next generation of bankers and financial bureaucrats should be compelled to start their careers by spending time studying financial history books.

The writer is capital markets editor
-Financial Times

Related articles
Stopping a Financial Crisis, the Swedish Way – Bo Lundgren, NY Times

Source
A shift from bumbling to sensible policy – Gillian Tett, FT

Related posts:

• Crony capitalism in U.S. banking bailout should end
• TARP was sold to Americans under false pretenses
• Transferring Swedish bank risk onto Latvian taxpayers
• The Citigroup Bailout
• Goldman: Quote of the day – “Leopards change spots”

Marshall Auerback here. Ed has had a few posts on the Swedish bailout plan with which I agree. I think the main political argument (made by Bo Lundgren in yesterday’s NY Times) is that you have ZERO political legitimacy unless everybody is perceived to be making sacrifices and getting some long term benefit via equity.

Therefore, I have my own plan, which I recently put forward in a Letter to the Editor at the Financial Times.

How to tackle systemic malaise

Sir, Your editorial “Time for a bail-out of bust U.S. finance” (September 20) is right: the objective must be to deal with the systemic risks, but also to inject a degree of social equity to ensure that U.S. taxpayers are not completely fleeced.

It will be argued that no bank would be likely to sell assets voluntarily at below their value because such sales would leave an even bigger hole in their respective balance sheets. But why should the taxpayer pay over the odds for these “assets”? The notion that the markets in which they trade are “illiquid” and unreflective of true value is Wall Street spin.

Any Wall Street trader will tell you that everything has a price. These assets are only illiquid because the bankers holding them do not want to sell them at the price investors believe is the right price. Those that are overvaluing them certainly do not want to be forced to admit they have been misleading investors about the value of those assets, but why are the regulators protecting them?

If the Treasury buys them for pennies on the dollar, the taxpayer stands a better chance of recouping something in the deal. Yes, that does leave the issue of banks being undercapitalised, but you solve this problem by injecting equity into the “good bank” now shorn of its toxic assets.

Taking equity in the firms you bail out and selling later also minimises the long-term cost to the taxpayer. This sort of equity is preferable to warrants, so that firms cannot try to pressure the government not to exercise the warrants. It would also be wise to insist that firms that receive aid issue senior debt to the government that has rights over all other bonds. That is to make sure some money comes back right from the start.

And then with the bad assets that the Treasury now holds, the Home Owners Loan Corporation (HOLC) can be used. This Depression-era institution was created to buy mortgages from banks at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed-rate mortgage rates. This programme allowed millions of households to avoid losing their homes and there is no reason why its role could not be replicated.

A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced. But you then go to the homeowners themselves and refinance, offering significant debt relief. And later you have to reregulate. Specifically, you have to restrict leverage, probably put on reserve requirements, rules on use of depositors’ money, and so on. It is vital that derivatives trading is restricted to exchanges. If you give them the money first, reform will never happen.

All of this has to be part of the same programme so that systemic issues are resolved, future long-term costs to the taxpayer minimised and a recurrence of the problem made less likely in the future.

Marshall Auerback,
Denver, CO, US

Source
How to tackle systemic malaise – Marshall Auerback, FT

Related articles
Stopping a Financial Crisis, the Swedish Way – Bo Lundgren, NY Times

Related posts:

• Kasriel says that Fed could get stuffed under TALF
• Video: Geithner calls for single agency to oversee systemic risks
• Geithner’s Plan: one of the most regressive wealth transfers of all time
• Mark to market is beside the point
• History shows US bank lending will be soft for years

Update Mar 2009: There is a pernicious little piece of historical revisionism going around that the Lehman bankuptcy did not matter. I am reposting this as a retort.

Note the piece by James Suriowiecki which induced me to re-post:

In the past few days, though, a new meme has started circulating through the economics blogosphere, suggesting that Lehman’s failure actually did not wreak the havoc that everyone who lived through last September thought it did. This argument, which was floated by the well-respected macroeconomist Willem Buiter on Friday, is based on a paper from last November by the Stanford economist John Taylor, which purports to show (pdf) that the credit markets actually did not react all that badly to Lehman going under and that the crisis was really the product of market uncertainty about the effects of government action.

Below is the original post from 16 Sep 2008.

Yesterday was a volatile day in the global financial markets. With the Nikkei down 5% and European bourses down 2% in overnight trading, we should understand that more volatility awaits us in the coming days and weeks.

As I survey this situation in serene tranquility away from market turmoil, I realize that I am very troubled by how the Lehman Brothers bankruptcy was handled. In my estimation, it was like putting the cart before the horse – allowing a financial institution to fail before you have worked out a mechanism of how to deal with that failure.

This one action will expose the global financial system to enormous additional risk.

Hank Paulson at the U.S. Treasury and Ben Bernanke at the U.S. Federal Reserve wanted to avoid the moral hazard of supporting the acquisition of a failed institution with government funds as it had done when JP Morgan Chase bought Bear Stearns. Therefore, Paulson and Bernanke were both fairly adamant about not offering any backstops for a Lehman Brothers takeover.

This is the principal reason both Bank of America and Barclays decided not to pursue a takeover of the firm. And this is also the reason Lehman Brothers failed. Had the U.S. government offered guarantees on Lehman’s debt, Barclays or Bank of America would have bought Lehman Brothers. In fact, I reckon BofA would have preferred to buy Lehman Brothers over Merrill Lynch as the price tag was much lower.

Were Paulson and Bernanke correct? After some time to digest events, I must answer no. They were wrong.

They were wrong for three principal reasons:

1. The U.S. government has failed to provide a framework and process for dealing with failed institutions of this size and the impending wave of future bankruptcies it should expect.
2. Failure will lead to asset liquidation, depressing asset prices further and putting further pressure on the remaining solvent financial services firms to writedown asset values.
3. This will potentially result in a Great Depression-like chain of failures, credit contraction and asset liquidation.

Rather than learning from the Great Depression, we are likely to repeat it.

Why we need a framework and process
It is clear from the difficulties facing AIG and Washington Mutual right now that further large failures are likely to occur.

In the case of AIG, we are presented with a potential derivatives nightmare as this $1 trillion firm has its tentacles in all manner of Credit Default Swaps, Collateralized Debt Obligations and insurance products generally. AIG represents a much more ominous case of potential systemic risk than either Bear Stearns or Lehman Brothers.

Washington Mutual is a large bank with $300 billion in assets. It is very leveraged to Alt-A and pay-option mortgages. Unlike subprime mortgages, which have seen the maximum number of interest rate resets, the majority of these products are resetting to higher interest rates now and in the future. This means a significant number of defaults in the sector will occur and that Washington Mutual will be stressed by these events. That may create liquidity or capital concerns which would force WaMu into insolvency. Were WaMu to be declared insolvent, the FDIC would need to be bailed out as it does not have adequate funds to deal with the likes of Washington Mutual.

These two institutions are suffering even more as a result of the uncertainty that allowing Lehman Brothers to fail has created. Due to investor and counterparty jitters, AIG and WaMu are now more likely to fail than had Lehman Brothers been rescued. This fact and the systemic risk that AIG represents and the threat to the FDIC’s adequacy that WaMu represents makes the need for a government bankruptcy framework and process more evident.

Lehman’s failure will lead to asset liquidation
By allowing Lehman to fail and subjecting the likes of WaMu and AIG to greater risk of failure, Paulson and Bernanke are unleashing a tidal wave of assets into the markets. In bankruptcy, Lehman Brothers will need to liquidate positions in Residential Mortgage Backed Securities (RMBSs), in Commercial Mortgage Backed Securities (CMBSs), in Credit Default Swaps (CDSs), and in a panoply of other asset classes.

Needless to say, Lehman is a forced seller and a price taker. That means these assets will go onto the market at distressed prices, depressing the price in the market generally. For the remaining solvent securities firms, this is a nightmare because it means they must write down their holdings of these tradeable assets to the new lower distressed prices. It is analogous to foreclosed homes being dumped on the market at super-low prices. Those foreclosure sales compete with regular home sales and, thus, depress the overall price of houses — one major reason people want to stop or slow-walk foreclosures.

What this means is that Lehman’s bankruptcy will lead directly to distressed asset sales at low prices which will compel other firms to take further writedowns. These remaining firms will therefore be forced to de-leverage, creating more distressed sales and a vicious cycle of asset deflation and potential bankruptcy.

————————
Update 10 Mar 2009:

My contention that forced sales by Lehman would cause asset writedowns is false. I have since wriiten about provisions in the mark-to-market rules which exclude writedowns in the event of distressed sales. See my comments on this here and here.

————————–

The process I just described is a modern-day Depression and must be either stopped at all costs or managed effectively through a systematic and well-conceived framework and
process.

A good process and framework
I am a proponent of the free market solution: controlled liquidation through a managed process.

As we have heard nothing from the U.S. government about how they intend to deal with the impending wave of bankruptcies in the financial services sector, we should look to other models for guidance. In August, I wrote that the Swedish Banking Crisis was a model for the United States. Here is an overview:

1. Maintenance of the banking system’s liquidity through a general government guarantee of the entire system protecting all creditor losses except shareholders. (Whether subordinated debt and preferred shares should be protected is debatable).
   

   One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.

2. The provision of a separate authorities — uninfluenced by political considerations — for the administration of bank guarantees on the one side and of liquidating assets on the other side.
   

   Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries.

3. Decision whether
   1. (a) to defer reporting losses for as long as possible, using current income for a gradual writedown of any loss making assets. This is what low short-term rates and a steep yield curve help do.
      

      One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point.

      or

   2. (b) to have the government supervising authority take account of all expected losses and writedowns early, clarifying the extent of problems and support needed
      

      It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.

The Swedes went with Plan 3b.

I concluded my post in August saying:

This is an immense task that the Swedes took on. There entire banking system was effectively insolvent. Yet, they were able to fashion a workout scheme that had bi-partisan political support, did not unfairly reward shareholders, dealt with moral hazard, separated regulatory and workout roles so as to reduce conflicts of interest, and that quickly wrote down valuations and liquidated the bad debts as opposed to dragging the process out. The Swedish authorities should be especially commended for dealing with the liquidity and solvency concerns simultaneously, while keeping moral hazard to a minimum.

The United States needs this plan now, not tomorrow. Allowing more firms to fail without a comprehensive workout plan in place is another sign of the laissez-faire regulatory attitude that got us in this predicament and is the height of irresponsibility. Congress, the President, the U.S. Treasury, the SEC and the Federal Reserve need to do their jobs and act now or the United States may suffer a very nasty case of debt deflation.

Source
The Swedish Experience, Riksbankschef Urban Bäckström, Federal Reserve Symposium, 27 Aug 1997

Related posts:

• Lehman has filed for bankruptcy
• The U.S. financial system is effectively insolvent
• AIG: a short post-mortem
• FAS 157 and the significance of distress versus bankruptcy
• A quick note on corporate bankruptcy and bailouts

This weekend I am at my wife’s family reunion so I haven’t have a lot of time for blogging. But, I caught an interesting article in Swedish daily Dagens Nyheter, which cites an IMF study which claims that property values in Sweden are even more overvalued than they are in the US. And this is a bubble which hasn’t even popped yet.

The article also provides a fairly good understanding of the present U.S. and European economic situation. Overall, one should see the article as further evidence that this is not a problem in the U.S. or UK alone, the housing bubble and credit crisis has global proportions. Europe is especially vulnerable in this next leg down of the crisis.

Below is my translation of the article.

House prices in Sweden more overvalued than in the U.S.

Johan Schück
The U.S. is a step ahead. But now, Europe is increasingly vulnerable, which has become apparent for Sweden. This applies to both the economic recession and the financial crisis, as well as in the case of house prices.

The decline in the U.S. economy has not reached the end. GDP growth was decent in the first half of the year: an increase of 2.2 percent. But this was partly a result of temporary tax credits that should encourage households to consume, and partly as a result of a depressed dollar rate, which supported exports.

Now, this [situation] does not apply anymore. Tax credits have come to an end and the dollar is rising against the euro and other currencies. Rising inflation forces also pressure interest-rates. The economic outlook looks worse.

The financial crisis in the United States rushes on, while the collapse in house prices continues. This summer, mortgage giants Fannie Mae and Freddie Mac got into difficulties, which forced the Treasury Department and the Central Bank, the Federal Reserve, to jointly step in. Indy Mac, a large mortgage institution in California, then fell on the ropes and was taken over by federal authorities.

Mistrust in financial markets is still high, which is marked by the large gap between the Federal Reserve base rates and various market rates. Prices of houses are still falling, which means that banks and mortgage companies face more risk.

Households are holding back consumption to save up a necessary buffer. The gradually increasing financial crisis is hitting production and employment more and more. The consequences will be felt for years, even when the cycle turns upward.

Events in Europe looks somewhat different. Here, the financial crisis came early, as a result of European banks’ investments in U.S. mortgage paper, which lost value. By contrast, it took longer for the business cycle to turn down and house prices to buckle.

This summer, however, recession has reached several of the large euro countries, including Germany where the economy had been doing quite well. In Britain, growth has come to a sharp end and in some European countries, including Denmark, production has contracted. Reduced exports to the United States plays some role, but a weak European market is still the main cause. High inflation has pushed up interest rates, which has put pressure on the economy. Even in Europe, house prices are falling, which households meet with increased savings.

The fall in price in Europe has not gone as far as in the United States. At present, it is in several European countries, including Sweden, where house prices are more overvalued than the U.S., according to an estimate from the International Monetary Fund, IMF.

The danger of further price decline in housing looks to be, therefore, greater in Europe, even if the correction does not need to be as drastic on all sides. The risks are increasing, however, that the crises in the financial sector as well as to the current economic downturn will be deepen.

Sweden appears so far to have done better than most euro area countries. A lot of Swedish industrial companies, focusing on global markets, have felt a tailwind. Strong public finances mean that there is space to support the economic situation, mainly through tax cuts, which is lacking in many other places.

Yet, it will be felt here too with weaker export performance and a depressed domestic economy, where inflation and high interest rates grits out of household purchasing power. A sharp drop in the Swedish house prices would make the situation much more difficult, especially if it is combined with an increase in unemployment.

There are different views on how deep the downturn will be. In its new forecast, Swedbank expects GDP growth of 1.8 percent this year and 1.7 percent next year – and even some reduction in employment.

Earlier this week came Sven-Arne Svensson at Erik Penser Funds came out with a more optimistic assessment that GDP growth will be 2.2 percent in 2008 and 2.4 percent in 2009.

In both cases, however, this means that Sweden has a chance to get on quite well, even if the economy loses pace. But as usual, there is great uncertainty. The only thing that is certain is that no predictions hold completely true because reality is in constant motion.

Source
Bopriserna i Sverige mer övervärderade än i USA, Dagens Nyeter

Related posts:

• The latest bubble warning: Swedish house prices
• European House Prices are slowing
• Denmark: the latest victim of falling house prices
• Sweden: competitive auto bailouts begin with Saab and Volvo
• Europe is next

Late last month, I made a big to-do about the Baltics becoming the next Argentina. Well, part of that mess is unraveling as we speak. Estonia is in recession and Latvia is headed for recession.

Read my translation of a Dagens Nyheter article from Sweden. The Riksbank, Sweden’s Central Bank, has reason to worry about Swedish banking exposure to the Baltics and its effect as a drag on the Swedish economy. SEB and Swedbank have the most exposure.

Estonia: another EU country in recession

More and more countries are reporting a falling economy. Estonia is the second European country which has entered a recession.

Earlier, Denmark reported a negative GDP development. On Wednesday, it was Estonia’s turn. GDP declined by 1.4 percent in the second quarter compared with the same period last year.

There will be negative numbers even in the third and fourth quarter. Yes, we are in a recession, “said SEB economist Box Eire about the Estonian economy.

SEB, along with Swedbank, has a lot of banking activity in the Baltic countries. The GDP figure, which was weaker than expected, put pressure on the two banks’ stock prices, which were down over four percent each.

Even the Latvian economy is at a standstill. Year-on-year growth in the second quarter came in at +0.2 percent.

Notice that this is second quarter data and Q3-Q4 data should be even weaker. Writedowns for Swedish banks are coming.

For my U.S. and UK readers who could give a t%ss about the Baltics, know that these downturns are all inter-related. With the likes of Japan, South Africa, and the Baltics all separatly hitting the wall, it is obvious that there wil be some negative feedback for economies like the U.S. and the UK as well.

Source
Estland andra EU-landet i recession – Dagens Nyheter

Related posts:

• Baltics: Fitch downgrade and more downgrades to come
• Earnings results at Swedish banks show large writedowns in Baltics
• More trouble in the Baltics as S&P downgrades
• Event risk in the Baltics is critically high
• Why is Swedbank doing a second rights issue?

Yesterday I pointed out that today’s global banking crisis has some historical precedents worthy of comparison. In particular, I looked at the Japanese bailout schemes from their housing bubble to see if there was anything there to learn. Unfortunately, the Japanese experience leaves doubts as to whether government intervention is helpful or harmful.

There are other examples, however. The Nordic model is a particularly useful one to look at as we move forward. Sweden’s Central Bank Chairman Bäckström shared some of his insights from that experience some eleven years ago in a speech to a Federal Reserve symposium that is available on the Swedish Riksbank website. This is a brilliant piece of work.

Below are a number of snippets with my usual commentary.

First a word of thanks to the Federal Reserve Bank of Kansas City for the invitation to discuss the financial problems Sweden went through in the early 1990s. I shall also try to draw some conclusions from our experiences that may be relevant for other countries.

Before I came to Sveriges Riksbank I was state secretary at the Ministry of Finance and involved among other things in the management of Sweden’s financial crisis. While there had, of course, been a good many indications of mounting problems, I was personally made formally aware of the acute and severe financial crisis by a phone call. At the beginning of October 1991 I had been in the job just a few days when I got a call from the head of the Financial Supervisory Authority (banking supervision in Sweden is performed by this authority, not by the central bank). He wanted to inform the Government that a large Swedish bank had more than exhausted its equity capital and would have to go bankrupt if a reconstruction could not be arranged.

While working at the Ministry of Finance on the initial problems in the banking sector we started to study historical and international records of financial crises. Irving Fisher’s well-known paper in Econometrica, “The Debt-Deflation Theory of Great Depressions,” from 1933 provided inspiration. We also came across a new volume, The Risk of Economic Crisis, edited by Martin Feldstein and containing interesting contributions by, among others, Benjamin Friedman, Paul Krugman, Lawrence Summers and our chairman today, E. Gerald Corrigan.

The conclusion from these sources was that a fall in asset prices, such as we had in Sweden, may create problems for private sector balance sheets, affect the supply of credit and result in payment system disturbances. Step by step this may affect spending decisions by households and firms, thereby impinging on general economic activity. A destabilised financial system can bring the economy into what Fisher termed “debt deflation”, that is, a situation where the financial crisis may become very serious and protracted.

Thus it was important both to avoid a widespread failure of Swedish banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis.

Here, Bäckström has set the scene. Basically, he outlines why central bankers fear deflation more than inflation — because of its negative effect on the banking system and credit as the real burden of debt increases. Below, he outlines what happened in Sweden.

Note, the key role that de-regulation played in the Swedish problems. De-regulation, while helpful in theory, often lets animal spirits run wild and leads to bubbles.

The Swedish crisis – what happened?
The economic problems in Sweden in the early 1990s should be seen in their historical context. For several reasons, economic growth in Sweden has been relatively weak ever since about 1970. Following the collapse of the Bretton Woods system the creation of a stable macroeconomic environment turned out to be difficult. Wage formation functioned badly, fiscal policy was unduly weak and this was gradually compounded by structural problems.

Credit market deregulation in 1985, necessary in itself, meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, a tax system that favoured borrowing, and remaining exchange controls that restrained investment in foreign assets. In the absence of a more restrictive economic policy to parry all this, the freer credit market led to a rapidly growing stock of debt (Fig.). In the course of only five years the GDP ratio for private sector debt moved up from 85 to 135 per cent. The credit boom coincided with rising share and real estate prices. During the second half of the 1980s real aggregate asset prices increased by a total of over 125 per cent. A speculative bubble had been generated.

The expansion of credit was also associated with increased real economic demand. Private financial saving dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable current-account deficits, accompanied by large outflows of direct-investment and other long-term capital (once exchange control had been finally abandoned in the late 1980s), led to a growing stock of private sector short-term debt in foreign currency.

Step by step the Swedish economy became increasingly vulnerable to shocks. During 1990 matters came to a head. Competitiveness had been eroded by the relatively high inflation in the late 1980s, resulting in an overvalued currency. This caused exports to weaken and meant that the fixed exchange rate policy began to be questioned, leading to periods with relatively high nominal interest rates. Moreover, the tax system was reformed in order to reduce its harmful economic effects but this also contributed to higher post-tax interest rates. Asset prices began to fall and economic activity turned downwards. Between the summers of 1990 and 1993 GDP dropped by a total of 6 per cent. Aggregate unemployment shot up from 3 to 12 per cent of the labour force and the public sector deficit worsened to as much as 12 per cent of GDP. A tidal wave of bankruptcies was a heavy blow to the banking sector, which in this period had to make provisions for loan losses totalling the equivalent of 12 per cent of annual GDP.

Below is the core of the regulatory response. I will highlight the key passages in bold.

Looking back, one can see that in the course of the crisis the seven largest banks, with 90 per cent of the market, all suffered heavy losses. In these years their aggregate loan losses amounted to the equivalent of 12 per cent of Sweden’s annual GDP. The stock of non-performing loans was much larger than the banking sector’s total equity capital and five of the seven largest banks were obliged to obtain capital contributions from either the State or their owners. It was thus truly a matter of a systemic crisis.

In connection with a serious financial crisis it is important first and foremost to maintain the banking system’s liquidity. It is a matter of preventing large segments of the banking system from failing on account of acute financing problems.

In September 1992 the Government and the Opposition jointly announced a general guarantee for the whole of the banking system. The Riksdag, Sweden’s parliament, formally approved the guarantee that December. This broad political consensus was I believe of vital importance and made the prompt handling of the financial crisis possible.

The bank guarantee provided protection from losses for all creditors except shareholders. The Government’s mandate from Parliament was not restricted to a specific sum and its hands were also very free in other respects. This necessitated close cooperation with the political opposition in the actual management of the banking problems. The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard.

The political system concluded that in the event of widespread failures in the banking system, the national economy would suffer major repercussions. The direct outlays in connection with the capital injection into the banking sector added up to just over 4 per cent of GDP. However, it is now calculated that most of this can be recovered.

One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.

A separate authority was set up to administer the bank guarantee and manage the banks that landed in a crisis and faced problems with solvency, though the crucial decisions about the provision of support were ultimately a matter for the Government. A clear separation of roles was achieved between the political level and the authorities, as well as between different authorities. Naturally this did not preclude very close cooperation between the Ministry of Finance, the Bank Support Authority, the Financial Supervisory Authority and the Riksbank.

It was up to the Riksbank to supply liquidity on a relatively large scale at normal interest and repayment terms but not to solve problems of bank solvency. Collateral was not required for the loans to banks, neither intraday nor overnight. The banking system was free to obtain unlimited liquidity by drawing on its accounts with the central bank. The bank guarantee meant that the solvency of the Riksbank was not at risk. In order to offset the loss of foreign credit lines to Swedish banks, during the height of the crisis the Riksbank also lent large amounts in foreign currency.

Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries.

The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank’s current income for a gradual writedown of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point. With the other method, an open account of all expected losses and writedowns is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.

The Swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets. This method was consistent with other basic principles for the bank support, such as the need to restore confidence. Looking back, it can be said that in general the level of valuation was realistic.

Conclusion
This is an immense task that the Swedes took on. Their entire banking system was effectively insolvent. Yet, they were able to fashion a workout scheme that had bi-partisan political support, did not unfairly reward shareholders, dealt with moral hazard, separated regulatory and workout roles so as to reduce conflicts of interest, and that quickly wrote down valuations and liquidated the bad debts as opposed to dragging the process out. The Swedish authorities should be especially commended for dealing with the liquidity and solvency concerns simultaneously, while keeping moral hazard to a minimum.

I thoroughly suggest you read this memo, save it and pass it on to your local elected official. It should be mandatory reading for the BoE, the Fed, the ECB and key government officials in the UK, US, Ireland, and Spain where the magnitude of the housing bubble is largest. See the link below for the full article.

Why this plan has not been more widely discussed remains a mystery.

Update 27 Seo 2008: On Sep. 23rd, I compared the U.S. bailout plan to the Swedish plan and enumerated the points that a good bailout plan must have. These points have since been echoed by Nouriel Roubini and incorporated into his site as well.

Source
The Swedish Experience, Riksbankschef Urban Bäckström, Federal Reserve Symposium, 27 Aug 1997

Related posts:

• A few thoughts about the banking crisis response in the United States
• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• The problem with comprehensive banking crisis solutions
• Nouriel Roubini: Bloomberg Interview on Banking Crisis Plan
• Did Tim Geithner blow it?

For those of you who actually care about anything international, there is an Emerging Markets crisis brewing right now in the Baltics. After reading posts from Alpha Sources, naked capitalism, Market Movers, and Bronte Capital on the subject, I started to think people actually cared about the tiny Baltics. So, let me add my two cents.

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many banks I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event.

Claus Vistesen at Alpha Sources says:

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat’s data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

More to the point, the Baltics have a lot of hot money invested in their economies as much of the lending growth came on the back of foreign financial investment. When distress hits, one should expect a giant sucking noise from foreigners repatriating funds. This will leave the Baltics subject to credit deflation just as the economy is entering recession.

When one adds the slow economy and the high inflation to a fixed exchange rate and high current account deficits it says: the Baltics do not have the appropriate fiscal and monetary policy for a fixed exchange rate.

One of two things must give: the exchange rate peg or the economy. In Argentina, it was both.

Related posts:

• Baltics: Violence from an Argentina-style collapse
• Event risk in the Baltics is critically high
• Baltics: Fitch downgrade and more downgrades to come
• Latvia as the new Argentina redux
• More trouble in the Baltics as S&P downgrades

Food Price Inflation Changes How We Shop – Chicago Tribune (3/31/2008)
Fed eyes Nordic-style nationalisation of U.S. banks – UK Telegraph (4/1/2008)
UBS writes off $19 billion – Yahoo! News (4/1/2008)
Deutsche Bank Expects $4B Subprime Hit – Yahoo! News (4/1/2008)
WaMu Alt-A Pool Deteriorates Further – Michael Shedlock (4/1/2008)
Lehman raises $4 bln of capital to quell critics – Yahoo! News (4/1/2008)
The Wheels Fall Off China’s Boom – Charles Hugh Smith (4/1/2008)
Ireland: The End of the Miracle – Business Week (3/27/2008)
Only the money was cheap – Martin Hutchinson (3/31/2008)

Related posts:

• News round-up: 9 Sep 2008
• News round-up: 15 Aug 2008 – blog edition
• News Round-up: 18 Jul 2008
• News round-up: 18 Aug 2008
• News Roundup: 28 Apr 2008