The International Credit Crisis and the Concept of Paulson Bonds

A few months ago (April 2008), I published in Jornal do Brasil an article suggesting that the Brazilian Government should use their international reserves to mitigate the impact of the growing scarcity of credit for financing of exports. Finally, common sense prevailed recently and such measure has just been adopted in order to help Brazilian exporters who were entirely without international credit lines due to this authentic liquidity trap which was generated in 2007 and 2008, very similar unfortunately to 1929.

It seems to me that now the hour has come for the US Government to recognize that it is conducting the solution to the crisis of liquidity and credit in an erroneous fashion, by deciding to buy toxic securities from banks and non-bank financial institutions.

Yesterday a new obvious measure was taken by the Federal Reserve – an interest rate cut. The fear of inflation is being rapidly replaced by the fear of deflation and economic depression, that is, something like the thirties in the USA or in a minor scale in the nineties in Japan.

But this interest rate reduction – even if it went to zero – will not work due to the liquidity trap. Banks and companies simply cannot borrow funds due to lack of confidence in contrast to Governments – and this does not depend at all on higher or lower interest rates.

The Central Bank of Brazil acted very rapidly in contrast to the somewhat inertial attitude of the Federal Reserve in the USA. The Brazilian Central Bank is going to finance – directly or indirectly – Brazilian foreign trade through the use of international reserves (more than US$ 200 billion).

Since we are mentioning Brazil here, we must remember that in 1990 the Brady bond solution helped to solve the external debt crisis of Brazil. What happened then: The Brazilian Government as well as the Government of other Latin American countries such as Mexico issued long term Government bonds collateralized by long term bonds issued by the US Government. The nickname Brady Bonds was applied to such collaterals or guarantees given by the US Government because at that time Nicholas Brady was the Secretary of Treasury of the USA.

In the last few days, we began to watch authentic runs on banks all over the world, threatening the systemic collapse of banking and non-banking systems in many developed countries. By definition, any financial institution – bank or non-bank – needs leverage by raising funds in the markets through CDs, commercial papers, bonds, etc. in addition to its own capital.

Clearly, this depends fundamentally on confidence – from the clients and the other financial partners. When confidence is lost, the money disappears. Even worse, in many cases – just like Hyman Minsky had already pointed out in the last century when he studied financial crises – some banks transform themselves into authentic Ponzi schemes, by borrowing money at higher and higher interest costs.

How can we reestablish the confidence in the securities issued by financial institutions – and this is the crux of the matter. Simple. Exactly in the same fashion as it was done with the Brady bonds, one may have the Paulson bonds. In other words – banks ought to be authorized to issue CDs and other securities collateralized by US Government securities.

The Paulson bonds replace the Brady bonds. This is the correct way to reestablish the confidence in the banking systems – and not the purchase of bad or toxic assets or the concession of rediscount facilities.

This is the adequate solution to avoid the panic. It is only necessary to go back to the ingenious solution which was given by Nicholas Brady and others in the external debt crisis of Latin America around 20 years ago, with the brilliant concept of the Brady Bonds. By the way, from a fiscal point-of-view, it is also useful to point out that the provision of guarantees or collaterals – as opposed to the actual purchase of bad papers – should represent a major saving as far as public spending is concerned.

We need now the Paulson bonds. The public – as well as other financial institutions – will only go back to buying CDs and securities from banks with such Government collateral. This is the reality due to the existing lack of confidence. Without such guarantee or collateral – something completely different from the existing plan approved by the US Government – the confidence crisis will proceed and we are all risking to have to follow the road of deflation and depression, even with practically zero interest rates in the USA, Europe and Asia, or then we are taking the risk of the very dangerous road of nationalization of banks, something that is already occurring unfortunately in many European countries and even in the USA.

Here is a negative list of total or partial nationalizations – Icelandic banks, strong participation of the UK Government in banks such as Northern Rock and Bradford & Bindley, Fortis in Belgium, AIG, Freddie Mac, Fannie Mae, full deposit guarantees up to 100% in Ireland, Danish interventions.

This is very dangerous. The correct solution to reestablish confidence is not nationalization. On the contrary – problem banks should be treated just like problem countries where treated 20 years ago, that is, Paulson bonds in place of Brady bonds.

Ben Bernanke promised recently to Milton Friedman – when the Nobel Prize economist was alive – that there would never be again a Great Depression because it was a mistake of the Federal Reserve which did not inject liquidity and reestablished confidence. The financial world waits that such important promise be fulfilled because the consequences of a Second Great Depression in the XXI Century are simply unimaginable, particularly because of the evolution of communications all over the world as well as international terrorism.