Tuesday, September 30, 2008

Monday, September 29, 2008

The Growth Blog

Taking the very large perspective, a number of good economists set out to discuss growth and development.

Nationalize Banking?

Paul Krugman, Brad DeLong, and Matt Yglesias have been clamoring (among other things) for a nationalization of the banking system, following the Swedish example of the early 90s.

For why not, see Megan McArdle and Tyler Cowen.

Financial consolidation

Since I like optimism, let's give it a try.
TARP fails. No direct, blanket government help to people who made massively stupid mistakes. Hmmm, so far so good.

Financial sector bloated, needing to shrink. Citigroup, JPMorgan/Chase, BoAmerica even too-bigger-to-fail. GoldmanSachs and MorganStanley looking for more business (maybe not entirely by choice). Fed increasingly and dramatically willing to extend liquidity, especially to aid financial consolidation.
Private financial houses care of ailing and failing institutions (as in 1907 - read this chronicle), now that it seems clear that the Treasury will not help. It worked this morning with Wachovia - why not with the smaller fish out there? Hmmm, that's not too bad.

Financial sector profits (and wages) out of the stratosphere. Fewer bright people going into investment banking – more into real jobs (:-))

Joseph Calhoun agrees

Last week Goldman Sachs raised $10 billion in new capital in one day. They sold $5 billion in preferred stock and warrants to Berkshire Hathaway and also completed a secondary offering of common stock that raised another $5 billion. Friday, JP Morgan raised $10 billion in a secondary offering to help pay for the Washington Mutual takeunder. Both of these offerings were oversubscribed, meaning that the companies could have raised more capital if they wanted. There is not a shortage of capital for well run financial companies.

There is, however, a shortage of capital for companies that have acted irresponsibly with investor capital in the recent past. For some reason, our political leaders believe this is a failure of the market, but isn’t this what should be expected from rational investors? Given a choice, why would a rational investor allocate limited capital to the losers rather than the winners? If capital is really as scarce as it seems, isn’t it better for our economy if we make sure that it is allocated wisely?

What about the credit channel? What about Main Street choked to death? I guess we’d do well to watch rates on commercial paper.

How does this impact the election? The House Republicans are being blamed for the failure of the bailout. Even if Main Street is choked, and even if the bailout would have helped, I bet it won’t be within the next six weeks, and I bet it will take the public many months to realize TARP might have helped. But even if we do tailspin into depression, they are more likely to blame the greedy than to blame the representatives who refused to rescue the greedy. “It was their greed that got us to this mess!”

Obama’s party voted for $700,000,000,000 for very rich, imprudent people who put me on the verge of foreclosure. McCain’s party said no. Hmmm.

This is supported by this article in Money:

Instead, average workers read the plan as the "big guys bailing out their friends," says former House Speaker Newt Gingrich, who commissioned a bipartisan survey on the subject. Gingrich's poll - conducted by Schoen and Republican Kellyanne Conway - found that a majority of Americans don't want Congress to use taxpayer dollars to bail out financial institutions, even if their collapse means a rocky ride for investors in the stock market.
On the other hand,

The collateral damage to the business agenda will be far more sweeping. Take trade. Even with a decent economy, Bush was unable to get major trade deals passed because a rising populist tide emboldened Democrats. Now it's going to be even harder. By contrast, an Obama agenda of aiding union-organizing efforts, raising taxes on capital gains, and imposing a windfall-profits tax on oil is looking more enticing.

Why the TARP Failed

Ben Pershing at the Washington Post describes why
  1. Poor salesmanship, political hardball
  2. ""I stood up to my party and Wall Street," sounds much better" than "I gave your money to rich people because they told me to." Particularly if your seat is in danger, as it is to most Republicans.
  3. The Bush administration is weak; McCain and Obama were not particularly supportive.
  4. The Republicans were tired of being beaten with a stick by Pelosi.

House to Wall Street: Drop Dead

From http://www.marketwatch.com/news/story/story.aspx?guid=%7B6FCA5CAB%2DBFB5%2D41ED%2D8FBB%2DB4005F4169DA%7D&siteid=djm_HAMWRSSFirstH
WASHINGTON (MarketWatch) - With a firm rejection of Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, the House Republicans have told the financial markets that they'll have to solve their problems on their own, without $700 billion of taxpayer money.
In a stunning vote on Monday, the House rejected the financial rescue package on a vote of 205 to 228. Republicans voted against the bill by a two-to-one ratio, and in the process rejected their own leadership, who had worked for nearly a week to craft a bill that could gain a majority. Nearly 100 Democrats also voted against the bill, spurning their leadership.
Many Republicans in the House were never persuaded that the credit crunch in the financial system is an impending disaster deserving of taxpayer aid. Politicians who had cut their teeth on free-market principles couldn't accept the idea that the federal government should back up the banks who had foolishly bet everything on the housing bubble.
Or they didn't want to face the voters in six weeks and explain why a Republican would vote for the biggest government bailout ever.
Now we shall see if Paulson and Bernanke were right when they said the credit crisis could worsen and inflict dire consequences on the global economy. Or perhaps the plan's many critics were right in saying that credit markets and home prices can adjust on their own, once the promise of free money is withdrawn.
The leaders in Congress and in the administration will undoubtedly try again, hoping to write a compromise bill that can attract a majority. But that won't be easy, because the Paulson plan had significant opposition from backbenchers on both the Republican right and the Democratic left.
Rejection of the plan means there's no political solution to this financial crisis on the horizon. As it now stands, the markets are on their own.
The next six weeks will tell whether the coup d'etat in the House on Monday has created a political crisis to match the financial one.

Bailout Plan Fails

So, it doesn't actually matter what we smart people think ... at the end of the day it all depends on the lawmaker who has to go home and explain to a cash-strapped, about-to-be-foreclosed voter why he just signed a massive potential tax increase to save the hides of the loan shark who sold him the loan, the finance company that bought it, and the financial engineer who designed it.
Still, I am flabbergasted.
Bailout Bill Fails in House Vote Amid Defections in Both Parties

Why Goldman Survived (perhaps)

From the New York Times
Goldman’s ability to sidestep the worst of the credit crisis came mainly because of its roots as a private partnership in which senior executives stood to lose their shirts if the bank faltered. Founded in 1869, Goldman officially went public in 1999 but never lost the flat structure that kept lines of communication open among different divisions.
Perhaps this forced them to be realistic. After deciding in 2006 that the housing market was headed south, they hedged their positions and limited their losses. The result was record profits while other not-so-safe firms posted record losses.
And yet, when market turmoil put even that strategy in question, they did what they always did.
“They change to fit their environment. When it was good to go public, they went public,” said Michael Mayo, banking analyst at Deutsche Bank. “When it was good to get big in fixed income, they got big in fixed income. When it was good to get into emerging markets, they got into emerging markets. Now that it’s good to be a bank, they became a bank.”
...
Goldman is unlikely to join with a commercial bank with a broad retail network, because a plain-vanilla consumer business is costly to operate and is the polar opposite of Goldman’s rarefied culture. “If they go too far afield or get too large in terms of personnel, then they become Citigroup, with the corporate bureaucracy and slowness and the inability to make consensus-type decisions that come with that,” Mr. Hintz said.

A Chronicle of the Week when Both Shoes Dropped

You can read a superb chronicle at the Wall Street Journal of the week that started with Lehman's failure and ended with the announcement of a bailout plan.
For all officials' desire to allow markets to punish the risk-taking that engendered the crisis, banks have the upper hand. "Lehman demonstrated that it's much harder than we thought to deal effectively with banks' misbehavior," says Charles Wyplosz, an economics professor at the Graduate Institute in Geneva. "You have to look the devil in the eyes and the eyes are pretty frightening."
The funny thing is, actually, that I got this link from Paul Krugman's blog, a writer not generally associated with big government handouts to rich corporations that are guilty of their own troubles ... and he quotes it most approvingly: "yes!", he seems to say, "Main Street should have come to Wall Street's rescue earlier!"

A Note of Optimism

From a new blog by University of Chicago economist Casey Mulligan:

In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it. The marginal product of capital after-tax is a measure of how much profit (revenue net of variable costs and taxes) that each unit of capital is producing during, say, the last year. When the marginal product of capital after-tax is above average, subsequent rates of economic growth (and subsequent marginal products of capital) also tend to be above average.
Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929. The marginal product of capital was also below average prior to the 1982 recession (in this case, far below average) and prior to the 2001 recession. Thus, the surprise was not that GDP continued to grow 2007-8 despite the bleak outlook from Wall Street’s corner of the world, but that GDP growth failed to be significantly above the average. More important from today’s perspective is that much capital in America continues to be productive, and that this will likely permit Americans to advance their living standards as they have in years past.
The non-financial sector today looks nothing like it did in 1930.
Plagiarized from Greg Mankiw's blog.

What to do with Mortgage Backed Securities

Via Greg Mankiw's blog.

Summers praises the TARP

Larry Summers argues that the TARP is not only good economics, it's great economics.

First, note that there is a major difference between a $700 billion program to support the financial sector and $700 billion in new outlays.
[Second, there will be no crowding out because the TARP will be finance with government debt. Come again?]
Third, since Keynes we have recognized that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. Fourth, it must be emphasized that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the United States is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.
From this perspective the worst possible actions would be steps that have relatively modest budget impacts in the short run but that cut taxes or increase spending by growing amounts over time. Examples would include new entitlement programs or exploding tax measures. The best measures would be short-run investments that will pay back to the government over time or those that are packaged with longer-term actions to improve the budget, such as investments in health-care restructuring or steps to enable states and localities to accelerate, or at least not slow, their investments.

Not a depression

One could say it better. One could argue it more tightly. One could use longer words and more jargon. But my sense is that the general drift of this article is correct.
In the crash of 1929 the Dow Jones industrials plunged 40% in two months; this time around it has taken a year to fall 22%.
The jobless rate jumped to 25% by 1933; it is little more than 6% today.
The gross domestic product shrank by 25% during the early 1930s; it is up over 3% during the past year.
Consumer prices fell by about 30% from 1929 to 1933; and the last time I looked they were still rising.
Home prices dropped more than 30% during the Depression vs. about 16% today.
Some 40% of all mortgages were delinquent by 1934 compared with 4% today.
In the 1930s, more than 9,000 banks failed compared with fewer than 20 over the past couple of years.
Instead of increasing the money supply, the Federal Reserve of that era reduced it by one-third.
Instead of lowering taxes, Herbert Hoover raised them.
And to channel whatever demand was left into U.S.-made goods, the government enacted the Smoot-Hawley Tariff Act to keep out foreign products; this only provoked our trading partners to do the same.
And according to the author, not a bailout either.

Sunday, September 28, 2008

Bailout Deal Reached

Bailout deal reached, reports WSJ. Incorporates phasing of bailout disbursement, allowance to help big and small financial institutions, including community banks, limitations on executive compensation, and measures to ensure the tax payer comes out ahead (or not too far behind).

Look at this historical example at Real Time Economics.

Bernanke's statement sounds like he learned from his own research (see here and here):

I welcome the agreement by the Congress and the Administration on a comprehensive plan to stabilize our financial system and support our economy. This legislation should help to restore the flow of credit to households and businesses that is essential for economic growth and job creation, while at the same time affording strong and necessary protections for taxpayers. I look forward to swift passage of the legislation.

In addition, the Federal Reserve Board supports the timely actions taken by the Federal Deposit Insurance Corporation, which demonstrate our government's unwavering commitment to financial and economic stability.

Crime and Crisis, Bursting Bubble

What causes a bubble to eventually burst? What causes people who buy because others are buying to all of a sudden stop following the herd? It’s difficult to say. It is particularly difficult to say with financial assets such as stocks (or with sublimated physical assets such as tulip bulbs): a thing only has the value that other people give it might reach any conceivable value.
But houses are not like that. People must live in a space, and that space typically is a house or some other similar habitation. One might be ecstatic at the booming price of one’s stock, but not at the rising property tax bill. One might choose not to buy a single share of stock in the midst of a mad rush. People with families often may not be able to choose to abstain from buying a house during a housing frenzy. So it was particularly obvious (ha!! It’s so obvious in hindsight, but so many of us told incredible lies to ourselves) that house prices must reach a plateau.
When housing prices reached a plateau, the Ponzi scheme could not longer be maintained. The game of buying a house that is too expensive could only be kept up with continued rapid housing appreciation. Lenders would only lend a extremely high loan-to-values if they were convinced there could be no losses. Borrowers could only refinance and avoid default if the value of the collateral continued to grow.
Mortgage defaults on the most egregious of loans began to occur, and projections of lightning-quick sales fell flat in the absence of the extremely easy finance on which they depended. The securities based on these mortgages became worthless and so did the shares of the companies holding them. Financial institutions that had gambled on the real estate market - directly or more often, indirectly through derivatives - began to get pinched. Finance dried up. So did sales. And prices did the unthinkable and began to drop.
The basic promise of a financial contract - to yield an uncertain return through an uncertain mechanism at an uncertain date, but to yield a future return nonetheless - could simply not be believed any more. Liquidity disappeared, first for the institutions that were most obviously connected to the mortgage market, but then to firms that would have been solvent except for mark-to-market requirements (in general a good idea, but not so when the market effectively disappears, taking along with any sense of patience).
The sense of proportion was lost, the sense of what excessive risk taking or leverage might look like, and whether we should avoid them. A sense in the credibility of a financial promise was lost, not only because the value of the securities could only be expressed in terms of an equation that was not robust to crises, but also because of the immensely bloated incomes of the financial sector at a time when their clientele was increasingly strapped). And, having lost the belief in the company’s solvency, liquidity for continued short-term operations was lost.

So it was the homeowner and the mortgage broker, Main Street and Wall Street ... and also K-Street and Constitution Avenue and Lombard Street and Madison Avenue. Todos a una, Fuenteovejuna.

Crime and Crisis, Means

The problem with ending the explanation with need and greed, as many have done, is that it explains the demand for easy and abundant home-equity financing, but not the supply. For that - which will constitute the means with which the crime was perpetrated - one must turn, perhaps first, to the Federal Reserve’s policies of easy-money during the some of the years of the first decade of the third millennium. Very low and even negative short-term real interest rates financed ultra-cheap introductory teaser rates, with the rate resetting at the third year to a level more in accord with the huge principal and the desires for extremely high-risk adjusted interest rates. Very low short-term Fed Funds rates funded very low introductory rates.
A minor but important role was played by the end of the tech bubble in 2000 and the ample use of the Greenspan Put - the generous use of expansionary monetary policy to prevent Americans from learning from their mistakes. Investors, who still had plenty of money from the Roaring Nineties, went and found somewhere else to play Casino.
But this is not enough either, because 30-year mortgage rates on fixed-interest loans were also at historic lows, not just teaser rates. Loan rates on long-term debt instruments, from mortgage to corporate to government debt, in the United States and in many other developed countries, have been falling for over a decade to unprecedently low levels. Ben Bernanke explained this phenomenon (Greenspan’s conundrum of lower long-term rate in the face of rising - at the time - short-term rates) by pointing out, first, the transformation of finance in the United States and abroad, and second, the structural reforms carried out by emerging-market economies (particularly China, but also Latin America and other Asian countries) that generated huge public and private excess savings. These savings could not be intermediated in the countries in which they were generated (because of disappointing profit opportunities) so they were sent to the United States and other OECD countries, where this flood of liquidity earned ever decreasing returns. The emergence of the Third World provided oceans of liquidity to the First World, which was only too interested in using it.

Crime and Crisis, Opportunity

So we have supply and we have demand. Isn’t that enough? Not in the financial market, which is one of the most heavily regulated markets of them all. Understanding why it is so regulated will help us see the effects of the regulatory changes and also explain some of the nature of the present crisis. Both deregulation and inappropriate regulation provided the opportunity. Both excessive belief in the perfections of the economic model - and disbelief in the reality of economic laws opened the door to excessive risk taking.
The financial sector deals in promises. Unlike the auto industry, that sells you a very concrete object that provides well-understood services (although there is the implicit promise of the car continuing to work past the test drive), the financial industry deals entirely in a promise to pay back in the future, sometimes at an indeterminate date, oftentimes with an uncertain return, nearly always through mechanisms whose implications nearly no one understands fully.
Because the business of the financial sector is to use other people’s money - lots of other people’s money, people who may not even have an incentive to know what the financier is up to - the consensus has been developed through long and hard experience that standards must be developed and enforced to make the indeterminacy more determinate, the uncertainty less foggy, and the mechanisms less mysterious. And also to make sure that the incentives of the provider of financial services are aligned with the provision of the services they purport to offer.
Beginning in the late 1960s, but accelerating in the 1990s, there were a number of very important regulatory changes in the financial system of the United States. The slow erosion and final repeal of the Glass-Steagall act is most frequently cited, but the changes to the incentives and structure of Fanny Mae and Freddie Mac, so deeply involved in the crisis, and also the application of the Community Reinvestment Act, which intended to make sure people who couldn’t afford a loan got one, also played a major role. Purposeful regulatory forbearance and unenforcement as well as active encouragement and requirement - due to free-market ideology and to a desire to use the financial sector as a tool against poverty - led banks a) to take too many risks by lending to people who couldn’t afford the loan and b) to find ever-more-creative ways to pass off the risk to someone else.
And indeed this worked beautifully. Most buyers are overwhelmed by the immensity of a multi-decade commitment on an asset worth many times their income, especially when already in terror at their financial situation and only too willing to hear good news. And good news would be told by financial advice books at airports and infomercials and co-workers and mortgage brokers: here’s the deal of a lifetime - real estate - don’t pass it up!
A most willing victim would let himself be seduced by a mortgage broker, who would then would pocket his fee, and pass on the risk - of which he might have been too aware, since he knew that the loan could not possibly be paid back, not at that loan-to-value ratio, not at that debt-service-to-income ratio, not at the post-teaser rate - to some other institution by selling the loan. The loan would then be securitized, pooled, sliced, diced, repooled, sliced and diced again, until the original mortgage would be spread among a million people with a million incentives - and each piece would be radically different from the next, with different seniority and different proportions. Perhaps more importantly, different levels of financial alchemy would have been performed on the different parts of the mortgage, so that in the end no one had any firm clue how to price the resulting slice of the slice of the slice of the asset.
This is key. No one knows for certain what one of these pieces is worth. In tranquil times, with the economy close to the steady-state and the model near its equilibrium, the computer would spit out a reassuringly profitable number through some arcane mathematical simulation. But real people didn’t have a clue, and the mathematical models did not apply in, say, a situation of double-equilibria such as characterizes a bank run, as Diamond and Dybvig taught us several decades ago.
But if the original mortgage - not the securitized-derivated-swapped asset - was in itself completely unsustainable because the house was too expensive and the only way one could buy it was through a miniscule teaser rate, and if laws required the lender to disclose the timing of the reset, why did borrowers not balk at the terms? Because they were seduced, and they let themselves be seduced. Because they needed to borrow to pay for their kids’ college. The loan amount could continue to grow because house prices could never fall, and indeed they would continue to rise exponentially. By the time the teaser rates were up, borrowers refinanced their subprime loans in droves, postponed the Day of Judgment another couple of years. In the meantime the broker and every middle-man in the process collected fat fees, the ultimate holder of a sliver collected a high risk-adjusted rate of return, and the homeowner continued to occupy his too expensive home.

Crime and Crisis, Motive

After their country descended into deep financial and economic chaos in 1999, Ecuadorians started to reflect on the causes of their crisis. They came to the conclusion that the blame was widely shared - that, as in Lope de Vega’s play Fuenteovejuna, it had been “todos a una,” everyone together who had committed the crime, no one in particular, and no one more than anyone else.
Today, the United States is in deep financial disarray - God willing, the crisis will not spread. Why? What is the reason for this crisis?
I offer a simple explanation for the terrible crime of the destruction of the livelihood and the fortunes of many families. Motive, means, opportunity.
Motive. As many have said, high and low, greed is at the bottom of it. People wanted to make money, more money, more quickly, more easily, in ever-greater-quantities, for conspicuous consumption and excessive luxury. The problem with greed as an explanation, however, is that a) is an unavoidable part of the human condition and we wouldn’t quite know what to do with capitalism without it and b) it’s not enough. There has always been greed, no more now than ever. Why now?
Another important motive is that people, particularly working-class / middle-class Americans are financially strapped. College is ever more expensive. So is health care. Gas bills, food bills. And Americans love to consume, and after two decades of expansion in the expectations for consumption, Americans found that satisfying their needs and wants left them with little for saving. So (as Robert Kaplan has said), they did the rational thing, which is to borrow against their biggest asset, their house, to finance current and capital expenditures.
The scale of the borrowing against home equity is so astounding that it couldn’t be explained without noticing that house prices rose, consistently and breathtakingly, for years. And here is the key: consumers convinced themselves - they let themselves be convinced, they wanted to be convinced - that house prices could never fall. Betting on your house gaining in value was a one-way bet. And as Robert Shiller has pointed out, there was much evidence to support this wild-eyed conclusion, and people believed it because they wanted to believe it.

Saturday, September 27, 2008

Harvard Profs Discuss the Whys and Hows

Listen (while you clean your room maybe) to an extraordinary good 96 minutes by a Panel of Harvard Experts. http://www.harvardwood.org/events/event_details.asp?id=31342

  • Jay Light, Dwight P. Robinson, Jr. Professor of Business Administration and Dean of the Faculty of Business Administration

Crisis was caused by excessive leverage, too little transparency, and sudden drops in liquidity. To solve it, provide liquidity, design mechanisms to discover true values, and restructure system to avoid such run-ups in leverage.

  • Robert Kaplan, Professor of Management Practice

Middle-class squeeze. Stagnant real wages, higher costs: households did the rational thing, which is to borrow against your main asset.

  • Elizabeth Warren, Leo Gottlieb Professor of Law

Can I sell you a mortgage product complex enough that you can’t compare it with another investment? Can I persuade you that it is a great deal, when it in fact gives a (purportedly) much higher risk-adjusted rate of return to investors than the alternative, after the middle-men have taken their cut? But at the heart it is selling mortgages that are unsustainable from the first day.
Bailout is the wrong end of the dog. We're not dealing with foreclosure.

  • Gregory Mankiw, Robert M. Beren Professor of Economics

Bernanke looking at this through the lens of his research: Bernanke's (1983) is an analysis of the non-monetary factors in the Great Depression.
Obama: sheer unfettered capitalism. Freddy Mac and Fannie Mae are GSEs. Policy wonks from Harvard thought GSEs were trouble: politicians left it alone. Chris Dodd main recipient of campaign contributions from GSEs. Barnie Frank denied the problem.
McCain: greed and corruption. But this is not corruption, mainly. Stupidity and bad bets are not crimes. Greed – no doubt. Firing Cox? Hiring Cuomo, who was in HUD and behind move to get GSEs to lend to low-income people?

  • Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy

Financial sector very bloated. Huge profits and wages. Overinvested. Needs to shrink a lot more.
It’s true that bank failures were a big part of the Great Depression, but it’s not clear that a lot of the necessary shrinking would be inefficient. If financial sector is hyper-efficient intermediation, why does it have to take up such a big piece of the pie?

  • Robert Merton, John and Natty McArthur University Professor

Great loss of wealth.
Every time you plug some problem not using the market, when you substitute administration for the markets, you generate negative unintended consequences.
New fangled instruments. Complexities that no one understands.Structural relationship between financial innovation and risk of crisis: mismatch between successful innovation and necessary infrastructure to support it: regulatory, etc. Not practical to build 100 infrastructures in advance for the possible 2 successful innovations.

ISLM and the crisis

Arnold Kling at EconLog wonders if there's a macro model that we can use to explain the crisis.

I've been explaining the crisis to my class as a drastic increase in Money Demand - in demand for extremely liquid assets and a rejection of bonds. Flight to quality, rise in spreads, etc.
Could the Fed have dealt with the crisis via monetary injection? No, for the reasons that Arnold mentions ("a capital trap"), ...but also because a) they were too close to a zero nominal interest rate for comfort and b) they were aware of the fact that monetary policy is too broad an instrument (may generate inflation) even if it had been effective.
Finally, as he well knows, the fact that it isn't in undergraduate textbooks doesn't mean that Bernanke's (1983) analysis of the non-monetary factors in the Great Depression is a "theory no one has ever studied."
Today's US crisis, I am sorry to say, is a sad repetition of every post-financial de-regulation crisis that scourged the emerging markets in the last 15 or so years. It's amazing to see what we haven't learned ... and yet, we have. The people at the Treasury and the Fed (and in Cambridge, MA) dealt with this kind of problem, made mistakes, and are applying quite a few of the lessons.
I hope that another lesson we don't forget is that which the work of Tornell and Westermann (2008) has demostrated: financial liberalization is more risky - no doubt about it - but also the path to greater growth. As Greg Mankiw points out, there are some who would have us forget.

Wall Street crisis helps Main Street?

Via Marginal Revolution ... interesting
.... many smaller banks said they were actually benefiting from the
problems on Wall Street. Deposits are flowing in as customers flee riskier investments, and well-qualified borrowers are lining up for loans.
"We collect money from local savers, and we lend it in the local community," said William Dunkelberg, chairman of Liberty Bell Bank in Cherry Hill, N.J. "We're doing fine. There are 9,000 financial institutions out there, and most of them are small and most of them are doing fine."
Dunkelberg, a professor of economics at Temple University and chief economist for the National Federation of Independent Business, added that a recent survey of that
group's members found that only 2 percent said getting a bank loan was the great challenge facing their businesses.
Sure, but ultimately a) big banks have a greater share of deposits and b) small banks depend on big money-center banks for liquidity and risk-sharing.

Blame, Regulation, and the Subprime Mess

Excellent post by Greg Mankiw

In the debate last night, Barack Obama asks a good question about the present financial crisis but then gives an answer that is, at best, incomplete:
The question, I think, that we have to ask ourselves is, how did we get into this situation in the first place?

Two years ago, I warned that, because of the subprime lending mess, because of the lax regulation, that we were potentially going to have a problem and tried to stop some of the abuses in mortgages that were taking place at the time....we're also going to have to look at, how is it that we shredded so many regulations? We did not set up a 21st-century regulatory framework to deal with these problems. And that in part has to do with an economic philosophy that says that regulation is always bad.

The main problem, we are led to believe, was a Republican ideology of unfettered capitalism that led to insufficient government involvement in the financial system.Senator Obama might want to read this NY Times article from 1999:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders....Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.

I am not suggesting that the entire crisis should be put in the lap of the Clinton team. There is plenty of blame to go around. Indeed, the problem goes back at least as far as the Johnson administration, which helped set up a housing finance system that was always fundamentally problematic.

If Senator Obama really wants to transcend partisan politics, as he would sometimes have us believe, he might want to give a slightly more balanced view of the history of how this all started. He also might want to take note that the Bush administration warned about some of these problems five years ago and had its reform efforts stymied by prominent members of Senator Obama's own party.

Friday, September 26, 2008

Finance and Poverty

From the piece by Erik Hurst I cited earlier:
Knowing what we know now, what is the optimal approach to regulating the subprime sector? Some argue that we should outlaw subprime lending completely. But do we really want to return to the world where the well-off have access to credit, but the historically denied (the poor, the young, African-Americans) can’t access the housing market or other credit markets? Is it really O.K. for only some households to use credit to help them ride out bad times, while others must just do without?
It’s a strange reversal of the usual ideologies, but those of us who care deeply about the poor must care deeply about cultivating a vibrant financial sector to service the subprime market. Otherwise, we truly risk two Americas: the credit-worthy who enjoy the benefits of the capitalist system and a highly developed financial system, and the less credit-worthy, who must live with a level of financial development that we suspect keeps so many third-world nations poor.

TARP?

Here's a quiz. Does TARP stand for
  1. Taxpayer Alms to Rich People?
  2. Troubled Asset Relief Program?
  3. Total Armageddon Roll-back Plan?
  4. Transferrable Acquisition Reconstruction Proposal?
  5. Ta-ta America, Russia to Power?

A (mild) Defense of TARP

Excellent, albeit slightly technical, commentary at VoxEU. Cites lots of economists, which I particularly like.

In general, the view that, for at least some of the troubled securities, there does not exist a price which would relieve the position of financial firms without imposing a cost to the taxpayers is not robust. Available data and even pessimistic projections on default rates show that “market” prices reflect a negative bubble rather than “fair” values: a thorough analysis led the Bank of England to conclude “that using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately incur”. For a large class of securities, therefore, the alternative is not as stark as the critics maintain: as chairman Bernanke believes, there does exist an intermediate price, high enough to provide relief, but low enough as not to inflict budgetary losses. The real problem lies in how that price can be discovered. The method of a reverse auction does not by itself prevent sellers’ opportunistic behaviour based on asymmetric information. As detailed in an important statement of the Director of the Congressional Budget
Office, the conditions to avoid this outcome are that the auction should be for shares in the same asset rather that in different assets (hence not different complex products but homogeneous tranches) and that those shares be widely distributed among many potential sellers. If the auction is well designed, on the other hand, the prices it establishes may provide the floor necessary to revive the markets, thereby re-creating liquidity. (What puzzles me about TARP is why cash is offered to purchase the troubled assets instead of guaranteed liquid bonds.)
William Buiter also shows some general support for the idea
The Paulson Plan addresses market illiquidity for toxic assets but the real problem is a lack of bank capital and the risk of widespread insolvency. Fixing this requires a government injection of new bank capital or a forced conversion of bank debt into equity. This column argues against the former as it would further socialise the US financial system. The Package needs some work, but Congress must stop its infantile posturing and act soon.
Charles Wyplosz is also mildly positive

This being said, spilling blood for the sake of it is a bit silly. Banks are not oil companies. When an oil company goes bust, by definition, it is because its liabilities exceed its assets. After bankruptcy, its assets remain as valuable as before. Oil is safely tucked away under ground, refineries and gas stations stay put above ground.

A bank goes bust when its assets have collapsed. Bankruptcy means that its liabilities collapse too and these are assets of other banks and of millions of hapless citizens. This is why contagion and bank runs occur more frequently than oil runs. Sure, with patience, both assets and liabilities can regain value, but in the meantime the financial system is impaired and the resulting credit crunch provokes an economic crisis that spares no one. This is why large, systemic financial institutions cannot be summarily dispatched to receivership. Avoiding a credit crunch ought to be every one’s priority.

The Future in the Rear-view Mirror

From the Swiss bank analyst
Many observers are worrying about the impact of a bailout plan (if passed) on the US economy's government debt and deficit arithmetic. In the early 1990s, however, after the first RTC [Resolution Trust Corporation, set up to deal with the S&L crisis] was enabled, the government's fiscal deficit nearly doubled over a 3 year period. Yet it took a year for the US equity market to find a bottom, 2 years for the economy to find a bottom, 3 years for the housing market to find a bottom and 4 years for long-term yields to find a bottom.

Testimony, Bernanke and Paulson

Federal Reserve Chairman Bernanke's testimony to the Senate and the House
... The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of the broader economy. In the financial sphere, falling home prices and rising mortgage delinquencies have led to major losses at many financial institutions, losses only partially replaced by the raising of new capital. Investor concerns about financial institutions increased over the summer, as mortgage-related assets deteriorated further and economic activity weakened. Among the firms under the greatest pressure were Fannie Mae and Freddie Mac, Lehman Brothers, and, more recently, American International Group (AIG). As investors lost confidence in them, these companies saw their access to liquidity and capital markets increasingly impaired and their stock prices drop sharply.

I am particularly partial to Ben Bernanke because he's a top monetary economist, the author of a paper I quote constantly, and the coauthor of the textbook we use in the Principles of Economics sequence.

Treasury Secretary Paulson's testimony to the Senate and the House
... I understand the view that I have heard from many of you on both sides of the aisle, urging that the taxpayer should share in the benefits of this plan to our financial system. Let me make clear – this entire proposal is about benefiting the American people, because today's fragile financial system puts their economic well-being at risk. When local banks and thrifts aren't able to function as they should, Americans' personal savings, and the ability of consumers and businesses to finance spending, investment and job creation are threatened.
The ultimate taxpayer protection will be stabilizing our system, so that all Americans can turn to financial institutions to meet their needs – financing a home improvement or a car or a college education, building retirement savings or starting a new business.

Bailout Commentary

Commentary via Greg Mankiw's blog: Commentary on the Financial Mess

First, the Treasury should only buy troubled assets at fair market value. Second, the Treasury should be allowed to purchase, again at fair market value, new securities issued by financial institutions needing additional capital. Third, to ensure that asset purchases are made at fair market value, the Treasury should buy them through multibuyer competitive processes with appropriate incentives.
I'm not sure these big Wall Street banks are really necessary, and I'm not sure
we'd miss them much if they were gone.
The real estate boom in Japan ended around 1990, and it was assumed that the banks could handle the nonperforming loans on their books. The result of that assumption was more than a decade of stagnation, until measures were taken to reduce the nonperforming loans on the banks' books, recapitalize the banks and restore the flow of credit.

Any solution should observe three guiding principles: It should (1) restore the stability of the financial system quickly and at the lowest possible cost to the taxpayer; (2) punish those who are responsible for losses; and (3) address the root cause of the crisis -- the price collapse in the residential real-estate market. In doing so, the solution should respect the rule of law by spelling out the proposal in sufficient detail for the Congress and the electorate to pass judgment. To the extent possible, it should follow proven precedents.

The administration's current proposal fails to meet these principles. ... First, there is the central issue of how to price the assets. A second issue is ... why should losses (particularly in solvent institutions) be borne by taxpayers rather than the shareholders and debt holders? The final problem is potential cost.

On both questions, our bipartisan consensus is holding true to form. In a system that is chock-full of heavy regulation, they instantly blame the current collapse on the excesses of the free market, for which a still heavier dose of regulation supplies some supposed cure. That indictment contains few particulars. It typically rests on a populist broadside whose centerpiece is greed on Wall Street, but never on Main Street--where there are more voters.

How can the Treasury encourage private players to back up its purchases? The short answer is: Buy cheaply. If the government pays, say, 30 percent of what the loans were originally worth, any hedge fund that thinks they are really worth 40 percent will dive into the market. If the government pays 50 percent of what the loans were originally worth, that same hedge fund will stay on the sidelines -- or may even figure out a way of betting against the government.

... But there is a better way: Tackle the capital shortage directly.

Paulson may not like the idea of the government owning chunks of the financial system. But after the nationalization of Fannie, Freddie and AIG, it's too late to worry about that. Besides, if the U.S. government refuses to recapitalize the banking system, foreign governments may eventually do so. Sovereign wealth funds have already bought $35 billion worth of stakes in U.S. financial institutions.

Love it or hate it, the true cost of Treasury Secretary Hank Paulson's proposed rescue of the financial system is not the sticker price of $700 billion. Conceivably, the government could make money; with glum assumptions, the losses would probably be less than $250 billion. No one knows the correct answer -- not Paulson, not Federal Reserve Chairman Ben Bernanke nor anyone else -- but here's how to think about the problem.
  • And a last one, by Bill Gross of Pimco (the world's largest bond dealer)
The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic. Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed.
Commentary via the Big Picture blog

  • Analysis on the $700B bailout, with Chris Whalen, Institutional Risk Analytics and CNBC's Steve Liesman
Commentary via the Freakonomics blog


My concern about the bailout comes from the sudden shift in political discourse towards re-regulating the financial industry. Popular belief holds that if the government had better regulated the mortgage industry, the current crisis could have been avoided. At some level, this must be right: if the government outlawed mortgages altogether, there would be no one to default on a mortgage. But we must not risk throwing out the baby with the bathwater.

Financial institutions are important because they transform our savings into investment capital for productive firms. Without this bridge from lender to borrower, it would be much harder for firms to expand, purchase new machines, or invest in developing workers or new ideas. We must ensure that the new regulatory framework ensures that financial markets continue to generate these enormous productive gains. My reading of the accumulated research (which I will describe in greater detail) is that the worst excesses of previous regulatory efforts throttled these productive gains. We must not repeat these mistakes.

The Republican Market-Based Alternative

From the Curious Capitalist

Eric Cantor, the Republican chief deputy whip, has a more reasonable-sounding if still pretty vague plan to insure more mortgages rather than buy mortgage securities. Taxpayers already explicitly insure several hundred billion dollars worth of mortgages (it was $400 billion at the end of FY 2007, but I imagine it's a lot more by now) through the Federal Housing Administration, and have now also taken responsibility for the $5+ trillion in mortgages held or guaranteed by Fannie Mae and Freddie Mac. Add a couple trillion dollars of troubled private-label mortgages to that, and you don't have the big up-front expense or direct government involvement in the banking system that the Paulson plan calls for.

Cantor also seems to think Wall Street would pay the premiums on the insurance (with FHA-insured loans, homeowners pay the premiums).

I'm no expert in this, but my initial thought is that Cantor's plan wouldn't be a markedly better deal for taxpayers than Paulson's. As the insurer of all mortgages, the government would still be stuck with hundreds of billions in losses. That would be partially recouped by premiums, but not fully.

And this strikes me as significantly more complicated to administer than Paulson's bailout fund. As part of the July housing bill, the FHA is already supposed to start offering next week to guarantee up to $300 billion in renegotiated subprime mortgages, and I doubt it's really ready to do that yet.

A bit more on this from Bloomberg

Cantor said the House Republican proposal "does not leave the American taxpayers with the bag and makes sure that Wall Street pays for this recovery.''

Funnily enough, the Republican proposal (market-based, insurance set up) is eerily similar to the proposal by very-liberal James Galbraith in the Washington Post:

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. They're called "loans."

With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to take care of that.

Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture -- and as much money into that agency and the FBI as is needed or examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can't save everyone, and those investors aren't poor.


Thursday, September 25, 2008

The Ills and the Remedies

Excellent recap of the situation by The Economist

Outlines of the Plan

The WSJ reports agreement on principles for the bailout:

Congressional Republicans and Democrats came to an agreement on principles for the Treasury’s Troubled Asset Relief Program that they will take into final negotiations with the White House. It includes sections on taxpayer protections, oversight and transparency, homeownership preservation and funding authority.
–Phil Izzo
The full text follows:
Agreement on Principles
1. Taxpayer
Protection
a. Requires Treasury Secretary to set standards to prevent excessive or inappropriate executive compensation for participating companies
b. To minimize risk to the American taxpayer, requires that any transaction include equity sharing
c. Requires most profits to be used to reduce the national debt
2. Oversight and Transparency
a. Treasury Secretary is prohibited from acting in an arbitrary or capricious manner or in any way that is inconsistent with existing law
b. Establishes strong oversight board with cease and desist authority
c. Requires program transparency and public accountability through regular, detailed reports to Congress disclosing exercise of the Treasury Secretary’s authority
d. Establishes an independent Inspector General to monitor the use of the Treasury Secretary’s authority
e. Requires GAO audits to ensure proper use of funds, appropriate internal controls, and to
prevent waste, fraud, and abuse
3. Homeownership Preservation
a. Maximize and coordinate efforts to modify mortgages for homeowners at risk of foreclosure
b. Requires loan modifications for mortgages owned or controlled by the Federal Government
c. Directs a percentage of future profits to the Affordable Housing Fund and the Capital Magnet Fund to meet America’s housing needs
4. Funding Authority
a. Treasury Secretary’s request for $700 billion is authorized, with $250 billion available immediately and an additional $100 billion released upon his or her certification that funds are needed
b. final $350 billion is subject to a Congressional joint resolution of disapproval

Tuesday, September 23, 2008

And Afterwards, Change the Rules of Finance

After citing Douglas North, Andy Zelleke says in the Christian Science Monitor
The worst affront to the national interest is that these compensation arrangements created incentives for CEOs to "roll the dice" in search of the biggest possible scores for the company (and, not coincidentally, themselves), with too little regard for the downside risk if they bet wrong. And with no appreciation for the potentially dangerous consequences of such gambles, in the aggregate, for the economic security of the American people.

Economists Weigh in on the Bailout

From the Economists' Voice - very anti.
Long list of economists protest.
Pro and con from North Carolina
Thanks to EconLog for the tips

What the Heck Happened at AIG?

Great description of the whys and wherefores at http://www.culture11.com/node/32300?page_art=2

Bailout and Ideology

False Debate Over Government vs. Markets - Fareed Zakaria, Newsweek

The lesson of the almost 100 (smaller) financial crises of the past three decades is that only government intervention can stabilize the system when it chokes.

Some problems require more regulations. Firms that are deemed too large to fail should also be deemed too large to be leveraged at 35 to 1. Some problems require better regulations. For instance, the rule forcing financial institutions to mark their assets down to "market prices"—even when these are distressed prices and firms do not intend to sell the assets any time soon—created a crazy downward spiral. Still other problems require less state intervention.

Of Interventions & Conservative Principles - Don Luskin, National Review

To arrive at a principled view on this intervention, we must answer three critical questions: Is it necessary? Will it work? And even then, is it morally justifiable?

...throughout history we have periodically gone through convulsions worse than today’s and survived them without such interventions.

With each intervention the banking crisis has gotten progressively more severe. Experts differ on this, but it is my professional judgment that these interventions actually made matters worse, because of the unintended consequences that were nearly impossible to forecast at the moment of decision.

...It also seems at first blush that the government ought to not bail out banks that made terrible investments they now regret. But remember, many of these bad investments were the result of government meddling. ... Shouldn’t the government shoulder some responsibility for its own mistakes?

Commenter David Walser at Megan McArdle's blog

Even if we could hold some players as responsible for their own fate, too many institutions are at risk of failure on account of risks they could not have anticipated nor avoided. Suppose your house burns down. As a general rule, I'd say that's your tough luck. Your insurance company will take care of you -- if you bought insurance. But suppose you did buy insurance, but the insurance company has been bankrupted with the assistance of the state insurance commissioner. Worse, your house caught fire because the building two blocks away went up in flames. The flames spread to your house because the buildings surrounding yours were not up to fire code (the building inspector was bribed).
Still, the fire department could have put the fire out before it reached your home, but the fire main had inadequate water pressure. In such a case, no one could blame you for not having prevented the fire or for failure to insure yourself. Still, you'd have no claim on our resources to bail you out if it were not for the government's role in so many of the factors that led to your loss.

The $700 Billion Question

Kashyap and Stein at the New York Times on what the bailout should look like:

First, the agency could act as a deep-pocketed private investor that sees a bargain buying opportunity — Warren Buffett on steroids.

[A] second job for the agency might be to restructure the mortgages it acquires. For example, it could reduce required interest payments so that fewer homeowners default on their loans. Done well, this could avoid costly foreclosures, thereby benefiting homeowners while also raising the value of the securities that the government has bought. This sort of restructuring has been difficult until now, because individual mortgages have been sliced and diced, and the pieces widely scattered. However, if the new agency winds up owning a majority of all problem mortgages, reconfiguring them so that interest payments are lower may become practical.

...These first two tasks are probably the easiest for skeptics of government intervention to embrace — or at least tolerate. Unfortunately, they may not be enough. The financial sector is now seriously undercapitalized ... a third job for the new agency might be to directly subsidize financial firms to increase their capital. One way to accomplish this would be the agency’s purposefully overpaying — relative to underlying fundamental values — for the mortgages it acquires.

The Key Issue of the Bailout

As an academic, I think Paul Krugman was a great economist and is a fairly irresponsible commentator. But he gets this one right.
[A]ny bank that wants to remove toxic assets from its balance sheet can do it at a stroke — just declare them worthless, and poof! they’re gone. But of course, that would reduce confidence and capital, not increase it — and that’s not what Hank and Ben are talking about. They’re talking about turning the assets over to Uncle Sam, and getting cold hard cash in return. And then the question is how much cash they get in return. It’s all about the price.
Now, if the price Treasury pays is very low — anything comparable to what financial
institutions are able to sell the stuff for now — it’s going to do nothing for confidence and capital. If the price is high, confidence and capital will improve — but taxpayers may well take a big loss. The premise of the Paulson plan– though never stated bluntly — is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?
But how can we help the financial situation without making that bet? By taking an equity stake. That way, if it turns out that the feds are pumping money in at above-fair prices, at least they get ownership, just as a private white knight would have.
There is no, repeat no justification for refusing to grant equity warrants that provide some taxpayer protection. This is, for me, an absolute deal or no-deal point.

Capitalism and ... Skepticism?

Via the Curious Capitalist, from John Hopkins economist Christopher Carroll

As the twentieth century recedes in the rear view mirror, it increasingly seems that for better or worse, the defining manifesto of the recent era has been Milton Friedman’s Capitalism And Freedom. But that book’s power derived partly from its fierce independence from the orthodoxies of its time.

Friedman’s voice was a skeptical breath of fresh air when the reigning viewpoint was a kind of smug pseudo-socialism that did not recognize the astounding power of markets to accomplish desirable aims. But now, the reigning Republican orthodoxy is a kind of smug pseudo-Friedmanism which believes that markets left to themselves can do no wrong; perhaps it is time for another breath of fresh air.

The book for the new epoch has not been written yet, but I have a proposed title: Capitalism and Skepticism. Skepticism might not be as bracing as freedom, but it’s something we could have used a bit more of in the past few years.

Who's to blame?

From the Curious Capitalist, quoting an academic paper
Most significantly, we find evidence that the changing credit regime that took place in late 2003, as the GSE’s pulled back from the market for political, regulatory, and market-based reasons [Curious Capitalist notes: they're talking about accounting scandals, caps on retained loans, etc.], is suggested to be a primary factor reducing the dominance of market fundamentals in affecting house price returns and creating the price-momentum conditions characteristic of a “bubble”. Rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the “tail”) of the economic, political, and regulatory environment characteristic of the early- to mid-2000’s (the “dog”).

Diamond and Kashyap on the Crisis: A Must Read

From Steven Levitt's blog

As an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven’t got the foggiest idea what this all means. So I did what I always do when something related to banking arises: I knocked on the doors of my colleagues Doug Diamond and Anil Kashyap, and asked them for the answers. What they told me was so interesting and insightful that I begged them to write their explanations down for a broader audience. They were kind enough to take the time to do so. In what follows, they discuss what has happened in the financial sector in the last few days, why it happened, and what it means for everyday people.

The F.A.Q.’s of Lehman and A.I.G.

By Douglas W. Diamond and Anil K. Kashyap

A Guest Post

For most of the last 20 years we have been studying banks, monetary policy, and financial crises. So for us the events of the last year have been especially fascinating. The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression. In talking with reporters and our noneconomist friends, we have been besieged with questions about several aspects of these events. Here are a few of the most frequently asked questions with our best answers.

1) What has happened that is so remarkable?
This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed. The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.
On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)
On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don’t worry, Man U will be fine.) The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

2) Why did these things happen?
The common denominator in all three cases was the inability of the firms to retain financing. The reasons, though, differed in each case.
The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.
Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.
But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.
Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.
This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.
Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread. Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and
force Lehman and others to default at that time.
A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging. Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral. A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part.
A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.
In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world: nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely.
In addition, other large financial firms — including Pacific Investment Management Company (Pimco), the largest bond-investment fund in the world — had guaranteed A.I.G.’s bonds by writing C.D.S. contracts.
Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion.
3) Why did the Treasury and Fed let Lehman fail but rescue Bear Stearns, Fannie
Mae, Freddie Mac, and A.I.G.?
We have already explained why Fannie, Freddie, and A.I.G. were supported. In March, Bear Stearns lost its access to credit in almost the same fashion as Lehman; yet Bear was rescued and Lehman was not. Bear Stearns was bailed out for two reasons. One was that the Fed had very imperfect information about what was going on at Bear. The Fed was not Bear’s regulator, the amount of publicly available information was limited, and its staff was not versed in all of the ways in which Bear might have been connected to other parts of the financial system.
The second problem was that Bear’s counterparties in many transactions were not prepared for the sudden demise of Bear. A Bear bankruptcy might have triggered a wave of forced selling of collateral that Bear would have given its counterparties. Given the potential chaos that would have resulted from Bear Stearns filing for bankruptcy, the Fed had little choice but to engineer a rescue. In doing so, the Fed argued that the rescue was a rare, perhaps once-in-a-generation, event.
When Bear was rescued, the Fed created a new lending facility to help provide bridge financing to other investment banks. The new lending arrangement was proposed precisely because there were concerns that Lehman and other banks were at risk for a Bear-like run. Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night.
Once the Fed had made these changes and determined that it and the others in the market had an understanding of the indirect or “collateral damage” effects of a bankruptcy, it could rely on the protections of the bankruptcy code to stop the run on Lehman, and to sell its operating assets separately from its toxic mortgage-backed assets.
Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary; it would have also conceded that in the six months since Bear failed, neither the new facility that it set up nor the other steps to make markets more robust were reliable. Essentially, the Fed and the Treasury would have been admitting that they had lied or were incompetent in stabilizing the financial system — or both.
It was not surprising that they drew the line at helping Lehman. Based on all the publicly available information, this was clearly the right thing to do.
4) I do not work at Lehman or A.I.G. and do not own much stock; why should I care?
The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.
As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.
This is going to slow growth. We have not seen this much stress in the financial system since the Great Depression, so we do not have any recent history to rely upon in quantifying the magnitude of the slowdown. A recent educated guess by Jan Hatzius of Goldman Sachs suggests that G.D.P. growth will be just about 2 percentage points lower in 2008 and 2009. But as he explains, extrapolations of this sort are highly uncertain.
5) What does it mean for the Fed and Treasury going ahead?
A reasonable reading of the recent bailouts suggests a simple rule: if a firm is on the verge of collapse and its ties to the financial system will lead to a cascade of chaos, the firm will be saved. A bankruptcy will be permitted only if the failure can be contained.
Assuming the level of chaos is sufficiently high, this dichotomy is probably consistent with the mandate of the Federal Reserve. The rescue of A.I.G., however, raises some major challenges.
One is where to draw the line. A.I.G. was an insurance company, not a bank or a broker dealer, so the Fed had no special relationship with A.I.G. Presumably, if a very large airline or automaker had been involved in the C.D.S. market, the same reasoning that led to the rescue would apply.
A second challenge comes with defining the acceptable level of chaos. We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.
Should the government intervene if it merely postpones an inevitable adjustment? Creditor runs can make adjustment too fast; blanket bailouts can make adjustment too slow. Has the Fed found the speed that is just right?
Third, now that A.I.G. has been lent to, how will regulation have to be adjusted? Surely the Fed cannot be called upon to provide backstop financing whenever a large member of the financial system runs into trouble. How does it prevent a replay of this scenario, and can it be done without stifling innovation?
6) What does this mean for the markets going ahead?
Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon. Both of these developments are welcome. If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.
7) When will the turmoil end?
The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.
One signal is that there were apparently only two bidders for Lehman, when the ongoing value from operating most of the bank was surely far above the $3.60 share price from Friday. Another is the elevated cost of borrowing that banks are charging each other. A third indicator is the reluctance to take on certain types of risk, such as jumbo mortgages, so that the cost of this type of borrowing is unusually high.
The fear of being the next Lehman ought to convince many of the large institutions that, despite however much they already raised, more is needed. It may be expensive to attract more equity financing, but the choice may be bankruptcy or sale. The decision by the Federal Reserve to not cut interest rates suggests the Fed also recognizes that the short-term interest rate is a very inefficient way to address this problem.

Three excellent posts

By Megan McArdle at Asymmetrical Information

How close was the financial system to melting down?
Living on borrowed prosperity
Why we need a bailout, even if not this bailout

Monday, September 22, 2008

The Dodd Plan

The not-Paulson plan is reported by Bloomberg. The full text is at Politico.

I think that Dodd is a bit more Sherman-esque than Paulson.

Easy, topical reading

The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (Hardcover)
by Charles R. Morris

Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis (Hardcover)
by Paul Muolo and Mathew Padilla

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Hardcover)
by Richard Bookstaber

Irrational Exuberance (Paperback) -- 2nd edition
by Robert J. Shiller

The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It (Hardcover)
by Robert J. Shiller

The New Financial Order: Risk in the 21st Century (Paperback)
by Robert J. Shiller

Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics) (Paperback)
by Charles P. Kindleberger

Extraordinary Popular Delusions and the Madness of Crowds (Paperback)
by Charles MacKay

The Great Crash 1929
by John Kenneth Galbraith

Devil Take the Hindmost: A History of Financial Speculation (Paperback)
by Edward Chancellor

Confessions of a Subprime Lender: An Insider's Tale of Greed, Fraud, and Ignorance (Paperback)
by Richard Bitner

Financial Shock A 360ยบ Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis (Hardcover)
by Mark Zandi

The World Is Curved: Hidden Dangers to the Global Economy (Hardcover)
by David M. Smick

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means (Hardcover)
by George Soros

The Alchemy of Finance (Wiley Investment Classics) (Paperback)
by George Soros

The Black Swan: The Impact of the Highly Improbable (Hardcover)
by Nassim Nicholas Taleb

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (Paperback)by Nassim Nicholas Taleb

The Clouds in the Silver Lining

The blog Naked Capitalism really, really dislikes the bailout plan.
The Treasury has been using the formula that it will buy assets at "fair market prices". As we have noted, there is simply huge amounts of cash ready to bottom fish in housing-related assets (we saw an estimate of $400 billion a couple of months ago). The issue is not lack of willing buyers; it's that the prospective sellers are not willing to accept prices that reflect the weak and deteriorating prospects for housing. Meredith Whitney, the Oppenheimer bank analyst who has made the most accurate earnings and writedown calls of her peer group, has noted how the housing market price decline assumptions used by major banks fall short of where the market is likely to bottom, given traditional price to income ratios and expectations reflected in housing futures prices. In addition to the factors that Whitney (and others) have cited, the duration of the 1988-1992 US housing bear market and major financial crises suggests that that a peak-to-trough decline of 35-40% is realistic (obviously, this average masks substantial variation across markets and housing types). We are thus only a bit more than halfway through, as measured by the fall in prices.Yet as we discussed, the plan makes no sense unless the Orwellian "fair market prices" means "above market prices." The point is not to free up illiquid assets.

Saturday, September 20, 2008

I like optimism

From Anatole Kaletsky's Times article
If banks are stabilised with government support, and then gradually slimmed down, the non-financial economy should suffer only a modest slowdown. In America, by contrast, an outright recession would be avoided if financial stability could be quickly restored. The worst of the housing slump there appears to be over, consumer confidence is rising and a gradual economic recovery should soon be under way. In Britain, further big job losses and falls in house prices, especially in London, because of the economy's dependence on the financial sector are likely. The recession, however, could still be a fairly mild one, assuming that financial stability is quickly restored.

The Cause of the Housing Crisis

As described by a true expert. Listen to this Podcast with Robert Shiller, author of several books on the topic and professor at Yale.

Are Bailouts Socialistic?

Not so, says the Angry Bear. They are kleptocratic.
Socialism is a form of government that seeks to equalize the playing field for all, insuring that that the fruits of labor are shared equally (but not fairly, necessarily. That’s one of the major reasons why socialism doesn’t work). Does anyone seriously think that captains of finance have embraced the philosophy of “workers of the world, unite!”? The same guys with multi-million dollar “golden-parachutes”, sometimes taking home more than a billion dollars in a year. The same guys who have embraced shady accounting practices so that they and their companies pay as little in taxes as possible, sometimes percentages of income far less than the average American worker. The same guys who have broken union after union over the decades. We’re supposed to believe that just this week this crew has decided to abandon Friedman and embrace Marx with open arms? Come on…

Roundup of Opinions

Great post at EconLog by Arnold King.

Who was asleep while financial markets ran amok? On Freddie and Fannie, the Bush Administration says, not us. Read the whole timeline. Greg Mankiw, who is mentioned in the statement, provided the pointer.

Is Henry Paulson a hero? Not to Luigi Zingales. Zingales articulates a concern that has been near the surface of some of my own recent posts, which is that the government officials making these decisions are seeing things from the perspective of Wall Street, which is kind of like seeing the auto industry from a Detroit viewpoint or seeing the movie industry from a Hollywood viewpoint or seeing elections from a Washington viewpoint. Tyler Cowen found this one.

Tyler also dug up an old blog post from an investment banker who used the pseudonym Mindles H. Drek. He points out that the expanded use of derivatives was largely a response to regulation. He points out, en passant, that the credit rating agencies' role in financial markets is driven by regulators, as well. I've talked about the credit rating agencies in recent posts. I'll talk about the role of derivatives in another post, soon.

Brad DeLong has a long post. It is worth reading to understand his point of view. Basically, he throws the kitchen sink of market imperfections at financial markets--moral hazard, adverse selection, multiple equilibria, and so on, and then says that we should never again allow private decisions to be made without wise technocrats like himself overseeing things. He and I could have a long, long debate. Thanks to Mark Thoma for the pointer.

Stiglitz's diagnosis and prescription

Nobel Laureate Joseph Stiglitz gives his diagnosis and prescription:

This is not the first crisis in our financial system, not the first time that those who believe in free and unregulated markets have come running to the government for bail-outs. There is a pattern here, one that suggests deep systemic problems — and a variety of solutions:

1. We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns.

2. Secondly, we need to create a financial product safety commission, to make sure that products bought and sold by banks, pension funds, etc. are safe for "human consumption." Consenting adults should be given great freedom to do whatever they want, but that does not mean they should gamble with other people's money. Some may worry that this may stifle innovation. But that may be a good thing considering the kind of innovation we had — attempting to subvert accounting and regulations. What we need is more innovation addressing the needs of ordinary Americans, so they can stay in their homes when economic conditions change.

3. We need to create a financial systems stability commission to take an overview of the entire financial system, recognizing the interrelations among the various parts, and to prevent the excessive systemic leveraging that we have just experienced.

4. We need to impose other regulations to improve the safety and soundness of our financial system, such as "speed bumps" to limit borrowing. Historically, rapid expansion of lending has been responsible for a large fraction of crises and this crisis is no exception.

5. We need better consumer protection laws, including laws that prevent predatory lending.6. We need better competition laws. The financial institutions have been able to prey on consumers through credit cards partly because of the absence of competition. But even more importantly, we should not be in situations where a firm is "too big to fail." If it is that big, it should be broken up.

These reforms will not guarantee that we will not have another crisis. The ingenuity of those in the financial markets is impressive. Eventually, they will figure out how to circumvent whatever regulations are imposed. But these reforms will make another crisis of this kind less likely, and, should it occur, make it less severe than it otherwise would be.