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Tuesday, September 30, 2008

A Failure to Communicate

I think this is right:

What We Have Here Is A Failure To Communicate, by Stan Collender: Several of the readers who commented on Andrew's post from yesterday said that the House didn't pass the Paulson-Frank because supporters had failed, miserably, to communicate the need for the plan to those who needed to be convinced.

I'm a managing director at a public relations firm and a former national director of public affairs at one of the largest global PR agencies, so please believe me when I say that it's hard, or actually impossible, to argue with this.

From a communications perspective, this has been done about as wrong as is possible. There have been no credible spokespeople, the messages about the plan have been wrong or incomplete, the plan's supporters failed to understand the different audiences that had to be reached, and few people validated the claim that the plan was needed.

As I said earlier in the week, President Bush has been completely ineffective as a communicator on this situation. His statements have failed to close the deal and he has yet, including the statement he made this morning, to make a personal appeal that rings true.

It also hurts that his overall credibility at this late point in his administration is as low as it has ever been in the eight years he has been president...

But it's a much larger communications problem than just the president at this moment. No one else in the Bush administration has credibility on economic issues. ...

Paulson has pretty much been out there on his own on this issue. Why hasn't the White House included its other economic spokspeople in this conversation? Why haven't the chairman of the Office of Management and Budget, the chairman of the Council of Economic Advisors, and the Commerce secretary actively and very openly advocating for this plan?

The spokespeople, or lack thereof, have been only one part of the problem. Supporters of this plan only communicated with one of the key audiences -- Wall Street -- when several others needed to be included. As of 9:30 am EDT on Tuesday, September 30, I still haven't heard anything that explains to someone not on Wall Street why this plan is important to them. That information exists; it just hasn't been communicated.

Supporters also failed to appreciate that politics would be one of the keys to this. As a result, almost no one explained why passing a plan like this would be better politics than not passing a plan. As a result, voting against the plan became an acceptable alternative.

Finally, where were the validators, that is, where were the outside people who, by saying that Paulson, Frank, Dodd, and Bush were correct, would convince others to support it. This is not something that happens by accident; a typical PR effort would try to arrange such statements.

I'll have more about this later. In the meantime, let's see if the supporters of this plan communicate differently in the next few days.

I talked to three different reporters today interested in making this connection, and tried to make it myself during a radio interview, so the sales component of the legislation - explaining why people should support this - is trying to catch up. The case is there, but it hasn't been made effectively.

    Posted by on Tuesday, September 30, 2008 at 07:02 PM in Economics, Financial System, Politics | Permalink  TrackBack (0)  Comments (23)


    Another Bursting Bubble?

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    Ted Nordhaus and Michael Shellenbergers say Democrats "must break once and for all from green orthodoxy":

    The green bubble bursts, by Ted Nordhaus and Michael Shellenberger, Commentary, LA Times: ...Democrats and their environmental allies face a political challenge they could hardly have imagined just a few months ago. America's growing dependence on fossil fuels, once viewed as a Democratic trump card held alongside the Iraq war and the deflating economy, has become a lodestone instead. Republicans stole the energy issue from Democrats by proposing expanded drilling ... to bring down gasoline prices. ...

    Democrats and greens ended up in this predicament because they believed their own press clippings -- or, perhaps more accurately, Al Gore's. After the release of ... "An Inconvenient Truth," greens convinced themselves that U.S. public opinion on climate change had shifted dramatically, despite having no empirical evidence that was the case. In fact, public concern about global warming was about the same before the movie..., hovering near the bottom of the Pew Center for People and the Press' top 20 priorities.

    By contrast, public concern about gasoline and energy prices has shifted dramatically..., gas prices became the second-highest concern after the economy, according to Gallup.

    This summer, elite opinion ran headlong into American popular opinion. The train wreck ... went by the name of the Climate Security Act. That bill to cap U.S. greenhouse gas emissions would have, by all accounts..., increased gasoline and energy prices. ...Democrats brought the bill to the Senate floor in June when gas prices were well over $4 a gallon in most of the country. Republicans were all too happy to join that fight.

    Indeed, they ... relished the opportunity to accuse Democrats of raising gasoline prices in the midst of an energy crisis... Democratic leaders finally killed the debate to avert an embarrassing defeat... Republicans have been bludgeoning Democrats with it ever since. ...

    In following greens, Democrats allowed McCain and Republicans to cast them as the party out of touch with the pocketbook concerns of middle-class Americans and captive to special interests that prioritize remote wilderness over economic prosperity. ...

    The most influential environmental groups in Washington -- the Natural Resources Defense Council and the Environmental Defense Fund -- are continuing to bet the farm on ... making fossil fuels more expensive in order to encourage conservation, efficiency and renewable energy. But with an economic recession likely, and energy prices sure to remain high for years to come..., any strategy predicated centrally on making fossil fuels more expensive is doomed to failure.

    A better approach is to make clean energy cheap through technology innovation funded directly by the federal government. In contrast to raising energy prices, investing somewhere between $30 billion and $50 billion annually in technology R&D, infrastructure and transmission lines to bring power from windy and sunny places to cities is overwhelmingly popular with voters. Instead of embracing this big investment, greens and Democrats push instead for tiny tax credits for renewable energy -- nothing approaching the national commitment that's needed.

    With just six weeks before the election, the bursting of the green bubble is a wake-up call for Democrats. Environmental groups, perpetually certain that a new ecological age is about to dawn in America, have serially overestimated their strength and misread public opinion. Democrats must break once and for all from green orthodoxy that focuses primarily on making dirty energy more expensive and instead embrace a strategy to make clean energy cheap. ...

      Posted by on Tuesday, September 30, 2008 at 02:07 AM in Economics, Environment, Policy, Politics | Permalink  TrackBack (0)  Comments (100)


      Funding the Bailout: A Contingent Surtax on the Rich

      Robert Waldmann:

      What Is to be done?, by Robert Waldmann
      OK what ... to do now that the House Republicans (and some Democrats) have voted down the Paulson-Dodd-Frank bailout bill.

      The contingent consensus of the Left Blogosphere seems to have been to go for the Swedish solution if the Paulson solution is rejected -- that is nationalize banks with inadequate capital. I think this is still politically impossible. Even if the Democrats go alone and Bush is afraid to veto, the blue dogs will be blue dogs.

      I think 2 complementary and more moderate proposals might pass over Republican objections and save the financial system. They are, of course, exactly what I have already proposed here and here.

      First preferred shares. Economists of all ideologies agree that what the banks need to do now is increase their equity by selling shares. ... I think a bill which allows banks to sell a lot of preferred shares to the Treasury and makes sure that the Treasury will lose money only if the bank goes bankrupt might make enough sense ... that it would be a political winner. See the old post for details.

      I add one clause -- a contingent surtax on the rich. Withhold an extra 10% of income over $1,000,000 and, each year, return the part that wasn't needed to cover losses in the Buffet X 100 plan (plus the chained 3 month t-bill interest rate). This is very much in the interests of the rich as they will get their money back and the financial system will be saved. The under a million crowd will be protected.

      Also squabbling over exactly what to do with the profits that the Treasury will make might convince people that there will be profits (I think there will be if the purchase is at share prices as of today September 30).

      The other is Toxic Sludge Inc....

      I think these ideas might be popular enough (both have guarantees that they cost most people nothing and don't add to the deficit long term) that the Democrats can afford politically to pass them over Republican objections.

      I've proposed something similar in terms of paying for the bailout, but instead of taking the money up front and then refunding it if there are no losses, we wait until we know how much the bailout costs, then raise taxes progressvely through a temporary surcharge of some sort, e.g. as above. If there's a surplus rather than a loss, then there's no need for the temporary tax increase. The effect is the same, but somehow the plan above seems politically more platable.

        Posted by on Tuesday, September 30, 2008 at 12:42 AM in Economics, Financial System, Social Insurance | Permalink  TrackBack (0)  Comments (44)


        "How Much Will It Cost and Will It Come Soon Enough?"

        Here's Jamie Galbraith's view of the bailout plan (the Senate may try to revive the plan tomorrow):

        How Much Will It Cost and Will It Come Soon Enough?, by James K. Galbraith, TNR: There is no question that the current bailout bill represents an enormous improvement over the original Treasury proposal. ...

        The question now is could the purposes of this bill be met with a smaller appropriation. In my view, the best way to answer that question is to ask: What problem does $700 billion solve? The answer to that is, we do not really know. On the face of it, the exposure to bad mortgage-backed securities is considerably larger; the purchase plan in the bill would inevitably bail out some inessential as well as essential investors and institutions, thus wasting a fraction of the resources; and we do not know the full extent to which banks need new capitalization in order to remain solvent. The reasonable presumption, therefore, is that TARP would buy time; one hears estimates that the authority would be used at a rate of $50 billion a month, though the basis for that estimate is not clear. A smaller appropriation would buy less time.

        How much time is needed? There is in my view very little prospect that economic recovery will restore housing prices and personal incomes within a reasonable time -- that is, before the $700 billion runs out. Therefore, it seems to me unlikely that this issue will finish here; more will be needed at a later date. However, on the assumption that one can trust and monitor the actions of the Treasury to assure that it carries out its mandate in good faith, there is an argument for appropriating the full sum now: It will help ensure that the system will hold into next year. A smaller appropriation increases the risk of a major crisis in the relatively near term. By how much and when? No one can say. ...

        Many are concerned with the fiscal implications of this bill, so let me turn to that question.

        Continue reading ""How Much Will It Cost and Will It Come Soon Enough?"" »

          Posted by on Tuesday, September 30, 2008 at 12:24 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (21)


          Tax Increases under McCain's Health Care Plan

          John McCain:

          "And I want to look you in the eye, I will not raise your taxes nor support a tax increase. I will not do it." [CNN Live Feed, Employee Town Hall (Aurora, CO), 7/30/08]

          Dean Baker:

          Senator McCain’s Big Tax Hike, by Dean Baker: There is nothing intrinsically bad about raising taxes if the money is used for important public services. However for an important segment within the population, tax increases of any sort are sacrilegious. Senator McCain has sought the support of this group, pledging that he would never raise taxes.

          This is why it is striking that the media has not paid more attention to Senator McCain’s health care plan. For a substantial segment of the population, this plan is likely to lead to an increase in taxes.

          The basic logic is that Senator McCain wants to eliminate the tax deductibility of employer provided health insurance and replace it with a $2,500 tax credit ($5,000 for a family). For most people with employer provided health insurance, this will end up being close to a wash at present. However this will change through time.

          The tax credit is projected to increase at the rate of inflation. Health insurance premiums have been rising much more rapidly. ...

          On the other hand, the size of Senator McCain’s tax increase will only rise with the projected rate of inflation... [In the middles class family example] Senator McCain’s health care proposal would have raised our taxes by $550...

          A $550 tax increase for a middle income family isn’t the biggest deal in the world, if the policy is otherwise sound (it isn’t), but it is inconsistent with a no new tax pledge. Senator McCain could of course change his formulas so that fewer people would face tax increases under his health care plan, but as it stands now, he does propose increasing taxes on a substantial portion of the population. ...

            Posted by on Tuesday, September 30, 2008 at 12:15 AM in Economics, Health Care, Politics | Permalink  TrackBack (1)  Comments (12)


            links for 2008-09-30

              Posted by on Tuesday, September 30, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (51)


              Monday, September 29, 2008

              House Votes against Bailout Package

              The House voted against the bailout package. Brad DeLong says:

              Bring Congress Back into Session After the Election...: ...and go for the Swedish plan: nationalize the insolvent large financial institutions: dare Bush to veto that after the election.

              Vote Count:

              Democrats: 141 Yea,  94 Nay
              Republican:  66 Yea, 132 Nay.

              This Republican Party needs to be burned, razed to the ground, and the furrows sown with salt...

              Swamped today - quickly - and holding back the shrill reaction, this is irresponsible and needlessly puts our economy at risk. I'll update with more reactions as I find them.

              Update: Initial market reaction:

              The Dow Jones Industrial Average, which had posted a loss of less than 300 points heading into the House vote, posted a decline of nearly 700 points as the "nay" votes reached a majority.

              The market has recovered slightly. We'll see how it goes. They can revote, so there's still hope, but don't know if that is planned, or if that would do any good. But it's not the stock market I care about, it's employment and growth. Even if this is not a catastrophe, you don't take this kind of risk with the economy. Even without a major crash, it's likely a lot of people just lost their jobs, though they don't know it yet. If the problems aren't addressed, it is likely to constrain credit, that in turn causes firms to cut back on new investment projects, and as they do, employment and growth taper off. You don't see the effects as a big drop off in employment all at once since investment projects can take years to complete and momentum from the past keeps the ball rolling. But as those projects end, if they are not replaced with new ones, employment and growth will suffer. And it's not just investment, people who sell cars, refrigerators, tractors, TVs, stereos, and so on, rely upon credit markets. If the credit isn't there, they aren't needed.

              I'm worried, maybe for nothing, but why take this kind of a chance with people's lives?

              Megan McArdle:

              I didn't think it was possible to be more disgusted with politicians than I usually am, but I find it impossible to express the seething contempt that I feel at this kind of opportunism.  I don't mind when they screw with the normal operation of the economy for venal personal gain.  But risking a recession in order to get a cut in the capital gains tax?  Letting it tank because you can always blame it on the Republicans? ...

              The public doesn't quite grasp what's at stake, and there's no reason they should.  But the representatives do.  ...  But anyone who tanks a bank bailout they think might be needed, in order to get a cut in the capital gains tax, deserves to be tried for treason.

              Paul Krugman:

              OK, we are a banana republic: House votes no. Rex Nutting has the best line: House to Wall Street: Drop Dead. He also correctly places the blame and/or credit with House Republicans. For reasons I’ve already explained, I don’t think the Dem leadership was in a position to craft a bill that would have achieved overwhelming Democratic support, so make or break was whether enough GOPers would sign on. They didn’t.

              I assume Pelosi calls a new vote; but if it fails, then what? I guess write a bill that is actually, you know, a good plan, and try to pass it — though politically it might not make sense to try until after the election.

              For now, I’m just going to quote myself:

              So what we now have is non-functional government in the face of a major crisis, because Congress includes a quorum of crazies and nobody trusts the White House an inch. As a friend said last night, we’ve become a banana republic with nukes.

              Republicans are admitting they nuked the vote. Why? They are saying it's because of Pelosi's speech during the vote (read it and judge for yourself):

              Rep. Boehner and others say Pelosi’s partisan floor speech is to blame for the financial rescue bill’s defeat.

              Barney Frank wonders why a speech would cause them to change their votes:

              “Because somebody hurt their feelings they decided to punish the country.”

              Steve Benen adds:

              But more important that than is the truly ridiculous frame Republicans are establishing for themselves by using Pelosi's speech as an excuse for their own failure. The House GOP, for reasons that defy comprehension, has decided to characterize itself as a caucus of cry babies. Worse, they're irresponsible cry babies who, according to their own argument, are more concerned with their precious hurt feelings than the nation's economic stability.

              Willem Buiter:

              What is likely to happen next?  With a bit of luck, the House will be frightened by its own audacity and will reverse itself. If a substantively similar bill (or a better bill that addresses not just the problem of valuing toxic assets and getting them off the banks’ books, but also the problem of recapitalising the US banking sector) is passed in the next day or so, the damage can remain limited. If the markets fear that the nays have thrown their toys out of the pram for the long term, the following scenario is quite likely:

              • The US stock market tanks.  Bank shares collapse, as do the valuations of all highly leveraged financial institutions.  Weaker versions of this occur in Europe, in Japan and in the emerging markets.
              • CDS spreads for banks explode, as will those of all highly leveraged financial institutions.  Credits spreads generally take on loan-shark proportions, even for reputable borrowers. Again the rest of the world will experience a slightly milder version of this.
              • No US bank will lend to any other US bank or any other highly leveraged institution.  The same will happen elsewhere. Remaining sources of external finance for banks, other than the facilities  created by the central banks and the Treasuries, will dry up.
              • Banks and other highly leveraged institutions will try to unload assets at fire-sale prices in illiquid markets.  Even assets not viewed as toxic before will become unsaleable at any price.
              • The interaction of a growing lack of funding liquidity and increasing market illiquidity will destroy the banks’ business models.
              • Banks will stop providing credit to households and to non-financial enterprises.
              • Banks will collapse, both through balance sheet insolvency and through liquidity insolvency.  No bank will be safe, not even the household names for whom the crisis has thus far brought more opportunities than disasters.
              • Other highly leveraged financial institutions collapse on a large scale.
              • Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.
              • Consumer demand and investment demand collapse.  Unemployment shoots up.
              • The government suspends all trading in financial stocks until further notice.
              • The government nationalises all US banks and other highly leveraged financial institutions.  The shareholders get nothing up front and have to wait for an eventual re-privatisation or liquididation to find out whether they are left with anything at all. Holders of bank debt get a sizeable haircut ‘up front’ on the face value of the debt and have part of the remainder converted into equity that shares the fate of the old equity.
              • We have the Great Depression of the 2010s.

              None of this is unavoidable, provided the US Congress grows up and adopts forthwith something close to the Emergency Economic Stabilization Act as a first, modest but necessary step towards re-establishing functioning securitisation markets and restoring financial health to the banking sector.  Cutting off your nose to spite your face is not a sensible alternative.

              PS My remaining financial wealth is now kept in a (small) old sock in an undisclosed location.

              PPS The conduct of both US Presidential candidates in this matter makes them unfit for purpose.

              Washington Wire:

              “I do believe that we could have gotten there today, had it not been for the partisan speech that the Speaker gave on the floor of the House,” Boehner said. “We put everything we had into getting the vote to get there today.” ...

              Minority Whip Roy Blunt (R., Mo.) said he had 12 Republicans who would have voted for the bill but changed their minds, while Rep. Eric Cantor (R., Va.) holding up a copy of what he said was Pelosi’s floor remarks - said the speaker “frankly struck the tone of partisanship.” A senior aide to Pelosi rejected the Republican claims against the speaker, saying the suggestion that her speech motivated House Republicans to vote against the bailout plan was “absurd.”

              “You don’t vote on the speech, you vote on the bill,” said the aide.

              Frank, speaking at a press conference, mocked the suggestion. “Give me those twelve people’s names and I will talk uncharacteristically nicely to them,” Frank said.

              Jeff Frankel:

              The Revised Troubled Asset Relief Plan Deserved to Pass: When the Treasury came out with its $750 bailout plan on September 22, I  thought it lacked so many necessary ingredients that it deserved a thumbs down. ...

              But in the negotiations between the Treasury and Congressional leaders over the course of last week, the missing ingredients were inserted.    Starting with the additions that were most necessary on the merits, and moving toward the ones where the necessity was more political, they were...

              The plan (TARP for Troubled Asset Recovery Program) would still be unprecedented in magnitude and in the discretion it gives the Treasury Secretary. Even if the congress had passed it today, it would not have guaranteed an end to the financial crisis, let alone averting the recession that is probably already inevitable at this point. Furthermore it does little to begin with the reforms in regulation that our financial system now clearly needs.

              Nevertheless, as distasteful as it is to be “bailing out” Wall Street, or even bailing out those homeowners who took out loans that they shouldn’t have, or bailing out policymakers who were asleep at the switch, my view is that the program is necessary. It is better than the alternatives:   

              • better than the Treasury proposal of 9/22,
              • much better than the proposal we would have gotten from a pre-Paulson Bush Administration,
              • better than the alternative that the House Republicans were offering, and
              • (most important of all) better than the alternative of doing nothing, which would (will?) quite likely mean a severe recession.

              I suppose it is not surprising that Congressmen facing elections in 5 weeks don’t want to go on record supporting something so unpopular. What will happen now that the House rejected the deal in its vote today?   

              Most likely the stock market and real economy will plummet, until the pain gets so bad that a bailout package like this one accumulates more support.

              Are people expecting soup lines?:

              The S&P 500 retreated 106.59 points to 1,106.42, as only one company gained, Campbell Soup Co.

                Posted by on Monday, September 29, 2008 at 12:06 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (230)


                Paul Krugman: The 3 A.M. Call

                Which of the two candidates should we trust with the economy?:

                The 3 A.M. Call, by Paul Krugman, Commentary, NY Times: It’s 3 a.m., a few months into 2009, and the phone in the White House rings. Several big hedge funds are about to fail, says the voice on the line, and there’s likely to be chaos when the market opens. Whom do you trust to take that call?

                I’m not being melodramatic. The bailout plan released yesterday is ... better than the proposal Henry Paulson first put out — sufficiently so to be worth passing. But ... it won’t end the crisis. The odds are that the next president will have to deal with some major financial emergencies.

                So what do we know about the readiness of the two men most likely to end up taking that call? Well, Barack Obama seems well informed and sensible... Mr. Obama and the Congressional Democrats are surrounded by very knowledgeable, clear-headed advisers, with experienced crisis managers like Paul Volcker and Robert Rubin always close at hand.

                Then there’s the frightening Mr. McCain... We’ve known for a long time ... that Mr. McCain doesn’t know much about economics... That wouldn’t matter too much if he had good taste in advisers — but he doesn’t.

                Remember, his chief mentor on economics is Phil Gramm, the arch-deregulator, who took special care in his Senate days to prevent oversight of financial derivatives — the very instruments that sank Lehman and A.I.G., and brought the credit markets to the edge of collapse. Mr. Gramm hasn’t had an official role in the McCain campaign since he pronounced America a “nation of whiners,” but he’s still considered a likely choice as Treasury secretary.

                And last year, when the McCain campaign announced ... “an impressive collection of economists...” to advise him..., who was prominently featured? Kevin Hassett, the co-author of “Dow 36,000.” Enough said.

                Now,... the poor quality of Mr. McCain’s advisers reflects the tattered intellectual state of his party. Has there ever been a more pathetic economic proposal than the suggestion of House Republicans that we ... solve the financial crisis by eliminating capital gains taxes? (Troubled financial institutions, by definition, don’t have capital gains to tax.)...

                The real revelation of the last few weeks ... has been just how erratic Mr. McCain’s views on economics are... Thus on Sept. 15 he declared — for at least the 18th time this year — that “the fundamentals of our economy are strong.” This was the day after Lehman failed and Merrill Lynch was taken over, and the financial crisis entered a new, even more dangerous stage.

                But three days later he declared that America’s financial markets have become a “casino,” and said that he’d fire the head of the Securities and Exchange Commission — which, by the way, isn’t in the president’s power.

                And then he found a new set of villains — Fannie Mae and Freddie Mac... (...Fannie and Freddie ... played little role in causing the crisis...) And he moralistically accused other politicians, including Mr. Obama, of being under Fannie’s and Freddie’s financial influence; it turns out that a firm owned by his own campaign manager was being paid by Freddie until just last month.

                Then Mr. Paulson released his plan, and Mr. McCain weighed vehemently into the debate. But he admitted, several days after the Paulson plan was released, that he hadn’t actually read the plan, which was only three pages long.

                O.K., I think you get the picture.

                The modern economy, it turns out, is a dangerous place — and it’s not the kind of danger you can deal with by talking tough and denouncing evildoers. Does Mr. McCain have the judgment and temperament to deal with that part of the job he seeks?

                  Posted by on Monday, September 29, 2008 at 12:33 AM in Economics, Financial System, Politics | Permalink  TrackBack (0)  Comments (97)


                  "A Government Hand In the Economy Is as Old as the Republic"

                  Robert Shiller says the crisis presents an opportunity to build a better system:

                  Everybody Calm Down. A Government Hand In the Economy Is as Old as the Republic, by Robert J. Shiller, Commentary, Washington Post: It has become fashionable to fret that the current crisis on Wall Street marks the end of American capitalism as we know it. "This massive bailout is not the solution," Sen. Jim Bunning (R-Ky.) warned.... "It is financial socialism, and it is un-American." It is neither. The ... bailout would represent a thoroughly American next step for our economic system -- and one that will probably lead to better times. ...

                  Whenever the public endures a crisis, ordinary citizens start to wonder how -- and whether -- our institutions really work. We no longer take things for granted. It is only then that real change becomes possible. ...

                  The current crisis offers us a singular opportunity to reevaluate fundamentally the safety and permanence of the master financial institutions that we have come to take for granted...

                  So we ... should be open to thinking about a new set of financial arrangements... Here are some key features:

                  Continue reading ""A Government Hand In the Economy Is as Old as the Republic"" »

                    Posted by on Monday, September 29, 2008 at 12:24 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (19)


                    links for 2008-09-29

                      Posted by on Monday, September 29, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (11)


                      Sunday, September 28, 2008

                      Emergency Economic Stabilization Act of 2008

                      Here's the full text: Emergency Economic Stabilization Act of 2008.

                      Here's the CBO analysis of the proposal.

                      I'm with everyone else. The proposal could be better, but as I've argued all along, the problems are real and if this is the best we can get - and it appears that's the case - then it will have to do.

                      Others: Paul Krugman [2, 3], Brad DeLong, Economists' for Obama, Interfluidity, Justin Fox, Adam Levitin, Larry Summers, Barry Eichengreen, Stan Collender, Paul Krugman, Nouriel Roubini, Dean Baker, Greg Ip. Extra: Understanding the TED Spread.

                      Update: One section would:

                      Allow the Federal Reserve System to pay interest on certain reserves of depository institutions that are held on deposit at the Federal Reserve, starting on October 1, 2008

                      That gives banks with reserves on deposit with the Fed an infusion of capital, but not sure how large and it's unlikely that's the reason for the change (which is to stabilize the federal funds rate within relatively narrow bounds - see below - and because it no longer has to sterilize injections of reserves into the banking system through open market operations, again, see below). I've written about this before (as far as I know, removing reserve requirements isn't part of the bailout proposal, just paying reserves on deposits - the following is from March 2006 and discusses changes scheduled for 2011):

                      This (discussed previously here) brings up the possibility of a "channel" or "corridor" system for setting the federal funds rate as is currently in place in Canada, Australia, and New Zealand. A channel/corridor system makes open market operations unnecessary and allows the Fed, as proposed elsewhere on the proposed list of regulatory changes, to remove reserve requirements.

                      Continue reading "Emergency Economic Stabilization Act of 2008" »

                        Posted by on Sunday, September 28, 2008 at 07:47 PM in Economics, Financial System | Permalink  TrackBack (1)  Comments (11)


                        Summers: Taxpayers Can Still Benefit from a Bail-Out

                        This is an argument I've been making too, i.e. that "we don't have to give up our aspirations for the future." So I'm in full agreement with the points made below that the expected cost of the bailout is far less than $700 billion and hence not as constraining in terms of out ability to address other problems as many pundits have implied, that countercycical measures are needed immediately, and that fiscal policy dominates monetary policy as a stimulus tool. (And with fiscal policy, I prefer government spending to tax cuts as a means of stimulating the economy since the effect on aggregate demand is more certain, and spending can be directed toward particular, high employment, high economic return projects such as rebuilding infrastructure and addressing environmental concerns). I also agree with the final point made below that as fiscal policy measures are undertaken to stimulate the economy in the short-run, it is best if they also help with long-run problems. But right now, the short-run is the biggest concern:

                        Taxpayers can still benefit from a bail-out, by Lawrence Summers, Commentary, Financial Times: Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. ...

                        The idea seems to have taken hold in recent days that because of the ... bail out..., the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. ...[T]he events of the last weeks suggest that for the near term, government should do more, not less.

                        First,.... No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. ... It is impossible to predict the ultimate cost to the Treasury of the bail-out... But it is very unlikely to approach $700bn and will be spread over a number of years.

                        Second, the usual concern about government budget deficits is that ... government bonds ... will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

                        Third, since Keynes we have recognised 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. ...[T]he US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override ... “automatic stabilisers” by seeking to reduce deficits in the near term.

                        Indeed, in the current circumstances the case for fiscal stimulus ... is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation. Monetary policy has very little scope to stimulate the economy... And ... economic downturns caused by financial distress ... ... are almost always of long duration. ...

                        The more people who are unemployed the more desirable it is that government ... put them back to work by investing in infrastructure, energy or simply through tax cuts that allow families to avoid cutting back on their spending.

                        Fourth, it must be emphasised that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the US is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.

                        From this perspective the ... best measures would be those that represent short-run investments that ... over time ... improve the budget. Examples would include investments in healthcare restructuring or steps to enable states and localities to accelerate, or at least not slow down, their investments.

                        A time when confidence is lagging in the household, financial and business sectors is not a time for government to step back. ...

                          Posted by on Sunday, September 28, 2008 at 02:16 PM in Economics, Fiscal Policy, Social Insurance | Permalink  TrackBack (0)  Comments (17)


                          "And Now the Great Depression"

                          The financial bailout plan looks more likely now that there has been a "breakthrough." Barry Eichengreen says even with a plan in place, the crisis won't end quickly and double digit unemployment is "not out of the question":

                          And Now the Great Depression, by Barry Eichengreen, Vox EU: A couple of months ago at lunch with a respected Fed watcher, I asked, “What are the odds are that US unemployment will reach 10% before the crisis is over?” “Zero,” he responded, in an admirable display of confidence. Watchers tending to internalize the outlook of the watched, I took this as reflecting opinion within the US central bank. We may have been in the throes of the most serious credit crisis since the Great Depression, but nothing resembling the Depression itself, when US unemployment topped out at 25%, was even remotely possible. The Fed and Treasury were on the case. US economic fundamentals were strong. Comparisons with the 1930s were overdrawn.

                          The events of the last week have shattered such complacency. The 3 month treasury yield has fallen to “virtual zero” for the first time since the flight to safety following the outbreak of World War II. The Ted Spread, the difference between borrowing for 3 months on the interbank market and holding three month treasuries, ballooned at one point to five full percentage points. Interbank lending is dead in its tracks. The entire US investment banking industry has been vaporized.

                          And we are in for more turbulence. The Paulson Plan, whatever its final form, will not bring this upheaval to an early end. The consequences are clearly spreading from Wall Street to Main Street. The recent performance of nonfinancial stocks indicates that investors are well aware of the fact.

                          So comparisons with the Great Depression, which have been of academic interest but little practical relevance, take on new salience. Which ones have content, and which are mainly useful for headline writers?

                          First, the Fed now, like the Fed in the 1930s, is very much groping in the dark. Every financial crisis is different, and this one is no exception. It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros. could safely be allowed to fail. It did not adequately understand the repercussions for other institutions of allowing a primary dealer to go under. It failed to fully appreciate the implications for AIG’s credit default swaps. It failed to understand that its own actions were bringing us to the brink of financial Armageddon.

                          If there is a defence, it has been offered Rick Mishkin, the former Fed governor, who has asserted that the current shock to the financial system is even more complex than that of the Great Depression. There is something to his point. In the 1930s the shock to the financial system came from the fall in the general price level by a third and the consequent collapse of economic activity. The solution was correspondingly straightforward. Stabilize the price level, as FDR did by pumping up the money supply, and it was possible to stabilize the economy, in turn righting the banking system.

                          Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself. There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933.

                          In addition, the progress of securitization complicates the process of unravelling the current mess. In the 1930s the Federal Home Owners Loan Corporation bought individual mortgages to cleanse bank balance sheets and provide home owners with relief. This time the federal agency responsible for cleaning up the financial system will have to buy residential mortgage backed securities, collateralized debt obligations, and all manner of sliced, diced and repackaged paper. Strengthening bank balance sheets and providing homeowners with relief will be infinitely more complex. Achieving the transparency needed to restore confidence in the system will be immensely more difficult.

                          That said, we are not going to see 25% unemployment rates like those of the Great Depression. Then it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them. This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover’s in 1930. Where last time it took the Congress three years to grasp the need to recapitalize the banking system and provide mortgage relief, this time it will take only perhaps half as long. Ben Bernanke, Hank Paulson and Barney Frank are all aware of that earlier history and anxious to avoid repeating it. 

                          And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analogue for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the US economy, notwithstanding the admirable flexibility of its labour markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10%.

                          Update: Brad Delong comments.

                           

                            Posted by on Sunday, September 28, 2008 at 02:07 AM Permalink  TrackBack (0)  Comments (76)


                            links for 2008-09-28

                              Posted by on Sunday, September 28, 2008 at 12:15 AM in Links | Permalink  TrackBack (0)  Comments (12)


                              Saturday, September 27, 2008

                              "In Defense of a Giant (and Growing) Health Care Industry"

                              Now I know who to blame:

                              Without health care as the economy’s most powerful economic locomotive, economic growth during President George W. Bush’s first term would have been so anemic that he most probably would have lost the election in 2004.

                              That is Uwe E. Reinhardt writing in the NY Times new Economix blog in defense of the health care industry:

                              In Defense of a Giant (and Growing) Health Care Industry, by Uwe E. Reinhardt, Economix: If a Martian landed on earth and followed our debate on health care, he or she ... would hear politicians, business people and the talking heads ... lament the burden that health care puts on the economy and over the prospect that health care will destroy America. ... Only an ignoramus or a fool could arrive at this conclusion.

                              Alas, Mother Earth is full of such people.

                              Think about it. When you last visited a physician’s practice or stayed in a hospital, did you see people other than patients... [T]hese people call their work “jobs”... [T]heir care for you has economic value...? Did you consider that they postponed your death by many years, perhaps even decades? Would you really surmise that their work creates less value added than, say, the fast-food industry? ...

                              Can any straight-thinking person really conclude that, on balance, health care is a burden on our economy?

                              For starters, be advised that health care is a large part of a nation’s gross domestic product. In the United States, it accounts for 16 percent of gross domestic product, now projected to go to 20 percent or so within a decade. Between 2001 and 2002, for example, growth in health spending represented over 50 percent of the growth in the entire United States G.D.P.

                              Some experts condemn these trends... To be sure, there is considerable waste in ... health care, just as there is in the ... defense industry and in many other sectors... But such waste at the margin does not vitiate the assertion that, on average, our health system is one of the finer sectors in the economy.

                              In a 2005 study,... Eric Topol and Kevin M. Murphy showed the American health care system to be one of the highest value-added sectors in the economy. And as the economist Michael Mandel of Business Week recently reported, health care contributed 50 percent of all new jobs over the most recent business cycle.

                              If that Martian were to land this week, in the middle of the bailout maelstrom, he’d probably tell Americans to thank their lucky stars that at least one sector of their economy is, well, still healthy.

                              My hope is that the bailout of the financial sector does not "starve" social programs, progress on health care reform, infrastructure spending, and other critical needs. One disappointment in the debate last night was to see so many questions assume this as an implicit truth, that the bailout will severely constrain our ability to do other things. So I'm not confident the hope will be realized.

                              Our economic system is in need of repair in a variety of ways. We need health care reform that gives everyone the care they need, and gives businesses a better competitive position on global markets, we need a "New New Deal" as it has been called to provide social insurance for workers and their families that works in the modern, global economy, we need to address crumbling infrastructure, and we need to go beyond replacing what has depreciated and make new investments in our future.

                              I see nothing wrong with asking the people who have benefited the most from our economic system in the past to play the largest role in helping to repair it. We don't have to give up our aspirations for the future, we just need those who have benefited so much from our economic system to step up to the plate and help us move forward.

                                Posted by on Saturday, September 27, 2008 at 03:33 PM in Economics, Health Care | Permalink  TrackBack (0)  Comments (44)


                                "The Opposite of Moral Hazard"

                                John Hempton is upset over the the seizure of Washington Mutual. Justin Fox explains:

                                Australian money manager John Hempton owned Washington Mutual preferred shares and was thus wiped out when the bank was seized and flipped to JP Morgan Chase last week. But he's not mad about that. He's mad about what happened to owners of Wamu bonds. By also wiping out senior debt holders at Wamu, he argues, the government has now botched things in a profoundly serious way...

                                Hempton thinks that if the FDIC had simply liquidated Wamu, some money would have been left for the senior creditors. By choosing not to do that--presumably because it would have meant a big hit to the FDIC insurance fund--it has discouraged anybody else from providing that kind of credit to U.S. banks.

                                Here's (a short version of) John Hempton :

                                The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC, by John Hempton: I lost money on this – so you can take my analysis with the caveat of a slightly angry grain of salt.

                                But I still think the seizure of Washington Mutual is the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle. ...

                                Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds too but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

                                If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

                                Except that the liquation rights – well established order-of-creditor rights – were denied by a swift US Government action.

                                Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made....

                                It would of course be more acceptable if there was a large body of evidence that the government put forward to justify their complete disregard for quite senior rights here. ... But in this case the Feds did very little to justify their decision. ...

                                The OTS/FDIC carried a risk – the risk being that the losses would be so large that would wind up costing the government money.

                                The government solved its problem – and it did it by taking away the rights of the senior debt holders to an orderly liquidation – when on the numbers given by the ultimate acquirer the senior debt was likely to be whole or near to whole.

                                The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

                                Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

                                In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.

                                This was – by far – the least justified government action of this credit cycle. And it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing because it is so capricious.

                                Those banks are many – but we can start with Wachovia whose destiny (failure) is now nearly certain – and for whom the precedent is set. But after that we can go for all the banks including the champions such as Bank of America and Citigroup. Creditors now face confiscation of their rights by the US Government without oversight or audit or even process.

                                At that point there is no creditors and the economy collapses. The trust needed to make capitalism worked has been removed. I am not a conservative - but I will argue - along with many conservatives - that the most important function of government in a capitalist society is provision of a framework by which property rights can be defined and enforced as this is the key to making a capitalist society function. The Government is now acting as if the framework does not apply to them. That is bad whatever your political persuasion.

                                What next

                                The FDIC and OTS have won the battle with respect to WaMu. They got rid of WaMu without any cost to the taxpayer. The WSJ lauded that achievement. They really did get out of their WaMu risk quite neatly – and I will be the heads of those organisations went to bed feeling pretty pleased with themselves.

                                But in the process they have doomed about two thirds of the US banking system.

                                I am still a believer that government – whilst not stuck with great incentives will grope for right solutions. But that belief of this former (competent) public servant is being shaken to the core.

                                And whilst Wachovia and dozens of others will eventually hit the wall because of this decision, the Government will work out that it has a bad process before Bank of America fails.

                                But I think it is time that the process is short circuited. The heads of the OTS (John Reich) and of the FDIC (Sheila Bair) should be sacked now and for cause. Mr Paulson better get control of this process and let it be known that the US has a process for dealing with senior creditors and making sure that their rights are honoured.

                                Otherwise heaven help us.

                                  Posted by on Saturday, September 27, 2008 at 12:15 PM in Economics, Financial System, Market Failure | Permalink  TrackBack (0)  Comments (33)


                                  Oil

                                  Jeff Sachs says "current energy crisis will most likely worsen before it gets better":

                                  Why the Oil Crisis Will Persist, by Jeffrey D. Sachs, SciAm: ...[F]undamental factors of supply and demand in the world economy will keep oil costly for years to come. ... Drilling in protected areas would provide little relief, and at horrendous environmental risks. Only a concerted move to new transport and energy technologies will relieve the pressures.

                                  The greatest irony about the Bush Administration is that it correctly focused on energy needs at the start of its first term, but then got everything wrong in the strategy. Viewing the world through the eyes of Texas oilmen, it focused on gaining concessions to Iraqi oil fields and opening U.S. protected areas to drilling, while scorning fuel economy standards, renewable energy sources, and climate change mitigation. But the simple arithmetic of oil and carbon was always against the strategy.

                                  World demand for conventional oil is outstripping world supply. ... There are few prospects for mega-discoveries that could keep up with fast-growing world demand. ...

                                  The boom in global driving is likely to be relentless. ... If China attains just half of the U.S. per capita ownership of passenger vehicles, it would have ... roughly twice as many as the U.S. And that prospect is not a silly scenario. Vehicle production in China has already tripled... With ... massive house building on the spreading periphery of city centers, China seems intent on reproducing America’s metropolitan sprawl and commuter-based society. A similar, though still less dramatic trend, is getting underway in India. ...

                                  Conventional oil has little prospect of keeping up with this soaring demand.

                                  What then will give? Of course a grave economic crisis—war, global depression, economic collapse of one or more major economies—would cut oil demand the hard way. There are two much better alternatives. The first is a redesigned, far more energy-efficient automobile that uses ... electricity or hydrogen. Several variants of plug-in-hybrid and all-battery cars have been promised by major auto producers as early as 2010...

                                  Many unresolved problems of cost, performance and infrastructure face these technologies, of course. Public funding for technological research, development and demonstration, and for supporting infrastructure, should certainly be deployed... Any electric or hydrogen option will require large-scale deployment of new low-emission electricity generation, such as solar, wind, nuclear, and coal plants that capture and sequester carbon dioxide.

                                  The second alternative, equally important, is a gradual reconfiguration of city life, to reduce our dependence on automobiles... We’ve learned that sprawl is not good for energy dependence, air quality, biodiversity, human health or quality of life, including commuting time. ...

                                  The current energy crisis will most likely worsen before it gets better. ... Yet it could also be the critical spur to action, prompting vital changes in technologies and lifestyles. It’s not too late to take the more productive path, but time is running out.

                                    Posted by on Saturday, September 27, 2008 at 02:16 AM in Economics, Oil | Permalink  TrackBack (0)  Comments (37)


                                    The Great Depression

                                    What was it like during the Great Depression? The first interview talks about economic policy, the rest of the interviews talk about the economic and social conditions:

                                    • Interview with Gardner C. Means, an economic advisor, on the New Deal and the difference between the Hoover and Roosevelt administrations. [terkel-a0a0p2-b.rm]
                                    • Interview with Peggy Terry, a migrant farm worker, on being unemployed, bread lines, soup kitchens, and homeless camps. [terkel-a0a0l6-b.rm]
                                    • Interview with Virginia Durr on shame and the fact that people blamed themselves and not the system. [terkel-a0a0r3-b.rm]
                                    • Interview with Ed Paulsen, a dayworker, on unemployment and the search for jobs (part 1). [terkel-a0a0k3-b.rm]
                                    • Interview with Emma Tiller, a cook who discusses how African Americans fed tramps when white people didn’t. [terkel-a0a0k8-b.rm]
                                    • Interview with Pauline Kael, a film critic, on anger, violence, and the general strike in San Francisco. [terkel-a0a0k5-b.rm]
                                    • Interview with Mary Owsley on company stores. [terkel-a0a0o3-b.rm]

                                    More here.

                                      Posted by on Saturday, September 27, 2008 at 12:33 AM in Economics | Permalink  TrackBack (2)  Comments (30)


                                      links for 2008-09-27

                                        Posted by on Saturday, September 27, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (34)


                                        Friday, September 26, 2008

                                        Bebchuk: A Plan For Addressing the Financial Crisis

                                        Via email, an alternative plan:

                                        A Plan For Addressing the Financial Crisis, by Lucian A. Bebchuk: Executive Summary This paper critiques the proposed emergency legislation for spending $700 billion on purchasing financial firms’ troubled assets to address the 2008 financial crisis. It also puts forward a superior alternative for advancing the two goals of the proposed legislation – restoring stability to the financial markets and protecting taxpayers.

                                        I show that the proposed legislation can be redesigned to limit greatly the cost to taxpayers while doing much better in terms of restoring stability to the financial markets. The proposed redesign is based on four interrelated elements:

                                        1. No overpaying for troubled assets: The Treasury’s authority to purchase troubled assets should be limited to doing so at fair market value.
                                        2. Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury’s authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.
                                        3. Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives.
                                        4. Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.

                                        Compared with the Treasury’s proposed legislation, the alternative proposal put forward in this paper would provide a far better way to use taxpayers’ funds to address the financial crisis. [link to plan]

                                        Dani Rodrik and Ian Ayres at Freakonomics discuss this proposal, and both highlight the following:

                                        Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value.

                                        There are good ideas in this proposal, but I think we need to get something done as soon as possible. So there's a tension between implementing the perfect proposal, and implementing something that is politically feasible, provides the needed stability, contains the appropriate safeguards, and can be agreed upon in a relatively short timeframe.

                                        Update: Brad DeLong says, now that "John McCain and the House Republicans have blown up the Paulson-Dodd-Frank compromise," we have three options:

                                        • Do nothing.
                                        • Bailout (a la Paulson)
                                        • Nationalization (a la Sweden 1992)

                                        Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

                                        It might work like this. Congress:

                                        • grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship
                                        • requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless
                                        • the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress
                                        • grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury
                                        • requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

                                        In addition, Congress:

                                        • grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

                                        Paulson had his shot. It's time for the Democrats to pass a nationalization in the taxpayers' interest bill and dare Bush to veto it. If he does, then announce that the congress will pass it again the day after the election. And if he vetoes it again, announce that congress will pass it yet again on January 21, 2009.

                                        Update: I'm assuming Greenspan won' have much credibility around here, but he's not alone in signing this letter:

                                        Economists’ Statement on the Federal Role in Relieving the Financial Crisis, Alan Greenspan, Robert Hall, and George Schultz: The U.S. economy is in the grip of the most severe financial crisis since the Great Depression. Even highly credit-worthy businesses are paying unprecedented premiums for borrowing. A large fraction of businesses are shut out of the credit market altogether. Past experience with financial crises shows that overall economic activity contracts soon after the crisis unless swift corrective action alleviates the crisis. Unemployment rises, employment falls, the nation’s production of goods and services declines, and consumers’ purchasing power diminishes. At worst, as in the Depression, the economy collapses.

                                        Economists often disagree about the causes of financial crises, including the present one... But there is near-universal agreement that the federal government must take aggressive steps to protect workers and businesses from the harmful effects of a financial crisis. The great majority of those deserving this protection had no role in causing the crisis.

                                        Experience has shown that the essential first step in heading off a crisis is to maintain the functions of critical financial institutions—banks and others performing bank-like functions. ... As a practical matter, at the current stage of the crisis, the only way that financial institutions can continue to function is for the government to provide financial support. The traditional form of that support calls for the government to buy assets from the institutions, swapping questionable assets for obligations of the government that are universally regarded as sound.

                                        We endorse all plans that would preserve the key functions of the threatened financial institutions. As a group, we do not advocate any particular program for restoring confidence in those institutions, but we are aware that the traditional approach has succeeded in heading off crises in the U.S. and other advanced countries. We do not take a stand on the choice of institutions eligible for emergency assistance. Rather, we urgently advocate immediate, extensive action that would maintain the functions of credit markets and prevent a serious economic contraction.

                                        We are deeply concerned about instituting reforms for the longer run that will prevent similar crises in the future. We applaud the increases in capital requirements for the institutions that have elected to become subject to the Federal Reserve’s capital requirements. But we do not believe that action to deal with the immediate crisis can wait until a comprehensive program for financial stability in the long run is developed and put in place.

                                        Update: For yet another view, that of Robert Shimer, see here.

                                        Dear Greg:

                                        ...I opposed the Paulson plan. I thought I would ... explain my reasoning.

                                        Before doing so, let me be clear that I agree with your comments about Ben Bernanke. I too know him well from the seven years I spent with him on the faculty at Princeton and I share your respect for his intelligence. I also recognize that he is far better informed about the current situation than I am. This does not, however, mean that he is perfectly informed. Indeed, looking back over the last 13 months, it should be clear that the Fed and Treasury have repeatedly underestimated the extent of the problem. In such an environment, the distributed knowledge of professional economists and other imperfectly-informed observers may be superior to the knowledge of the Fed staff. In other words, you write, "In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could." That may be correct, but I am not convinced that he understands the situation better than the collective wisdom of all professors.

                                        Next, let me explain what I think is happening in credit markets. ...

                                          Posted by on Friday, September 26, 2008 at 03:15 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (20)


                                          "Do Demand and Supply Still Drive Oil Prices?"

                                          Environmental Economics takes up the question of what drives movements in oil prices, fundamentals or something else:

                                          Do demand and supply still drive oil prices?, by Gernot Wagner: Amid all of Wall Street's woes, one bit of significant economic news almost fell through the cracks this week: oil prices increased $16 on Monday, temporarily trading as high as $25 over the previous closing price. This is an all-time record high. Surely, it can't just be demand and supply that determined the price - not on a day when the Dow just happens to fall 370 points. Or can it? [...read more...]

                                            Posted by on Friday, September 26, 2008 at 02:25 PM in Economics, Oil | Permalink  TrackBack (0)  Comments (7)


                                            Would the Cantor Plan Solve the Crisis?

                                            From Brad DeLong:

                                            **Sigh:** House Republicans and the Press, Brad DeLong: Hoisted from Comments: anonymiss:

                                            Grasping Reality with Both Hands: You gotta comment on the current House Republican insurance plan. Time Magazine seems to think it's a real plan, not a Potemkin plan. I have no idea, but I think the people at Time are morons, so you MUST let us know if this is real or more nonsense from the guys who brought you "get rid of the capital gains tax! That'll fix everything!" http://www.time-blog.com/swampland/2008/09/the_republican_alternatives.html

                                            Anonymiss is citing Karen Tumulty:

                                            Politically at least, the [Republican Deputy Whip Eric] Cantor plan has a lot of appeal. By insuring these junky mortgage-backed securities, rather than buying them, the government presumably wouldn't be spending nearly as much money. In fact, it would be getting money from Wall Street, in the form of premiums for this insurance. This scheme would function sort of like GNMA. The very process of insuring these assets would help solve one of the biggest problems: Nobody knows what they are worth.

                                            The problem, at least in the eyes of Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, is that, while it would help the situation, it wouldn't work to stabilize the markets as well as their plan would.

                                            Here's how it has been explained to me: Last winter and spring, when Treasury and the Fed analyzed a lot of options out there for what to do, they considered this insurance option. They decided that because the insurance option would leave the bad stuff on the bank balance sheets, it wouldn't give the banks the additional liquidity they need. They also believe it wouldn't create a market price that can stimulate trading, the way a purchase program would.

                                            I'm not any kind of an expert on this stuff, so I don't know who is right here...

                                            Let us see. On the one hand, the Treasury Secretary, the Federal Reserve Chair, and their staffs. On the other hand, an unstaffed Republican Chief Deputy Whip Eric Cantor who has not a plan but a plan to have a plan to ask the Treasury to design a different plan than the plan the Treasury thinks is best.

                                            Cantor calls for "the Treasury to design a system to charge premiums to [mortgage-backed security] holders to finance [government-provided] insurance" against defaults.

                                            The Fed and the Treasury have been looking at these issues since at least last winter. I suspect that the Treasury and Federal Reserve staff have decided that such federal government-provided insurance is indeed something we want to try to work toward as part of our financial system after the crisis is over--the "commitment fee" due in 2010 in the Fannie/Freddie nationalization makes no sense otherwise, for it is such a fee for the insurance on mortgages and mortgage-backed securities that Fannie/Freddie have gotten for free in the past but that Treasury wants to charge them for and also offer to others staring in 2010. But my belief is that Treasury and Federal Reserve staff have also judged that it won't work well enough to be a useful tool in handling the current crisis for speed-of-implementation reasons: we need to move to asset purchases--that banks need liquidity now, and we need functioning markets where securities are priced now, and you can buy assets a lot faster than you can set up insurance schemes.

                                            Confronted with these two sets of opinions--a single unstaffed guy who is an expert in rounding up and feeding Republican House members on the one hand, and the Treasury Secretary, Federal Reserve Chair, and their staffs on the other, Karen Tumulty says "I don't know who is right here" because "I'm not any kind of an expert on this stuff."

                                            So why doesn't she give her space at Time to somebody who is an expert, and does know who is right here? This is he said-she said journalism as self-parody.

                                            Why oh why can't we have a better press corps?

                                            And, beyond the fact that the proposal can't be implemented fast enough, I don't see the big savings either. The losses will still be there (assuming whatever confidence effect that would occur with this proposal wouldn't be substantially different from the confidence effect from a direct purchase of distressed assets, and I don' see why it would be), and there would be revenue from the equity warrants just like there is revenue from the insurance premiums, so where are the big savings? There are also higher administrative costs under the insurance proposal (and all the usual market failure worries such as adverse selection to worry about in the program design).

                                            It can't be accomplished fast enough to help with the current crisis, there are no big cost savings associated with using this program to solve the crisis (even if it worked), so what's so attractive about it as a solution to our immediate problems?

                                            Ah, I just found more from Justin Fox:

                                            More on the Cantor plan to insure everybody's mortgage, Curious Capitalist: I've been doing a little checking around on Eric Cantor's idea to insure everybody's mortgage, which ... is now generating some talk ... of a blended plan that would combine increased insurance with purchases of mortgage securities. ...

                                            The government already insures half the mortgage debt out there, Cantor & Co. argue, so why not just insure the rest?

                                            It turns out that people at Treasury and the Fed actually did discuss expanding mortgage insurance when they were tossing around ideas earlier this year for halting the mortgage meltdown, but decided it wouldn't have nearly the impact on getting markets moving again that buying mortgage securities outright would.

                                            When I emailed Mark Zandi ... of Moody's Economy.com ... he responded with that same worry plus some others:

                                            Seems to me it doesn't address the fundamental problem that there is no market for these securities. How can you write insurance on these securities unless you know the risks you are taking and you can't know that unless you have a market. Reminds of that pink floyd song. Anyway, this is a much less effective way of addressing the problem and would very likely cost taxpayers more than the tarp. Perhaps most importantly most immediately is that since it is not clear how and if it will work it won't stabilize financial markets.

                                            When I emailed back to ask which Pink Floyd song, Zandi was unresponsive. Anybody got any ideas?

                                            Then I talked to Lou Pizante, a veteran of the mortgage-securitization business who now runs Mavent, a maker of compliance software for mortgage lenders. He pointed out the only way for the Cantor plan to work actuarily was for every last one of those $6 trillion in mortgage securities to be insured. Otherwise you'd just get the financial institutions with the crappiest loans on their books choosing to participate--which would amount to a giant bailout of the bad guys by taxpayers. So I'm not sure how you could do a blended plan of insurance and purchases, since you've got to insure everybody.

                                            Finally, even if you do get every last mortgage in the country covered by insurance, there's the issue, mentioned in my earlier post, of figuring out to price it. Too cheap and it's a bailout, too steep and you make banks' problems worse. Which is true of the original Paulson plan as well, of course. But that plan is much more upfront about being a bailout.

                                              Posted by on Friday, September 26, 2008 at 10:53 AM in Economics, Financial System, Market Failure | Permalink  TrackBack (0)  Comments (53)


                                              Paul Krugman: Where Are the Grown-Ups?

                                              Will congress do "the grown-up thing"?:

                                              Where Are the Grown-Ups?, by Paul Krugman, Commentary, NY Times: Many people on both the right and the left are outraged at the idea of using taxpayer money to bail out America’s financial system. They’re right to be outraged, but doing nothing isn’t a serious option...— this collapse of credit reminds many economists of the run on the banks that brought on the Great Depression.

                                              It’s true that we don’t know for sure... Maybe we can let Wall Street implode and Main Street would escape largely unscathed. But that’s not a chance we want to take.

                                              So the grown-up thing is to do something to rescue the financial system. The big question is, are there any grown-ups around — and will they be able to take charge?

                                              Earlier this week, Henry Paulson, the Treasury secretary, tried to convince Congress that he was the grown-up in the room, come to protect us from danger. And he demanded total authority...: $700 billion to be used at his discretion, with immunity from future review.

                                              Congress balked. No government official should be entrusted with that kind of monarchical privilege, least of all an official belonging to the administration that misled America into war. Furthermore, Mr. Paulson’s track record is anything but reassuring...

                                              Besides, Mr. Paulson never offered a convincing explanation of how his plan was supposed to work — and the judgment of many economists was ... that it wouldn’t work unless it amounted to a huge welfare program for the financial industry.

                                              But if Mr. Paulson isn’t the grown-up we need, are Congressional leaders ... able to fill the role?

                                              Well, the bipartisan “agreement on principles” released on Thursday looks a lot better than the original Paulson plan. In fact, it puts Mr. Paulson himself under much-needed adult supervision, calling for an oversight board...” It also limits Mr. Paulson’s allowance: he only (only!) gets to use $250 billion right away.

                                              Meanwhile, the agreement calls for limits on executive pay at firms that get federal money. Most important, it “requires that any transaction include equity sharing.”

                                              Why is that so important? The fundamental problem with our financial system is that ... the housing bust has left financial institutions with too little capital....

                                              The odds are ... that the U.S. government will end up having to do what governments always do in financial crises: use taxpayers’ money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably have done this by buying toxic waste for much more than it was worth — and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that’s what the equity sharing is about.

                                              The Congressional plan, then, looks a lot better — a lot more adult — than the Paulson plan... That said..., it seems that we don’t have a deal.

                                              This has to be a bipartisan plan... Democrats won’t pass the plan without votes from rank-and-file Republicans — and as of Thursday night, those rank-and-file Republicans were balking.

                                              Furthermore, one non-rank-and-file Republican, Senator John McCain, is apparently playing spoiler. Earlier this week, while refusing to say whether he supported the Paulson plan, he claimed not to have had a chance to read it; the plan is all of three pages long. Then he inserted himself into the delicate negotiations over the Congressional plan, insisting on a White House meeting at which he reportedly said little — but during which consensus collapsed.

                                              The bottom line, then, is that there do seem to be some adults in Congress, ready to do something to help us get through this crisis. But the adults are not yet in charge.

                                                Posted by on Friday, September 26, 2008 at 12:42 AM in Economics, Financial System, Politics | Permalink  TrackBack (0)  Comments (116)


                                                Fed Watch: Regardless of Bailout, US Economy Decelerating

                                                Tim Duy:

                                                Regardless of Bailout, US Economy Decelerating, by Tim Duy: The US economy is limping through the second half of the year as the impact of this summer’s stimulus checks fades. The continued weakness, I suspect, will come as a shock to the public, who have now been essentially promised that their problems will be solved with a bailout package they really don’t understand to begin with for the financial sector they view as arrogant aggregators of wealth. But any bailout will only prevent a financial meltdown that threatens to deepen the credit crunch and worsen the ongoing slowdown, not reverse the current weakness. I doubt, however, the general public sees that distinction. And they are not likely to be convinced; this Administration sacrificed its credibility long ago. Instead, the public will see billions channeled into Wall Street as the unemployment rate climbs. And climb it will.

                                                The flow of data this week, for those paying attention, is decidedly negative in tone. The housing market continues to deteriorate, with a precipitous decline in new home sales reported today. By definition, we must be closer to a bottom on new construction – but, to say the least, that bottom remains elusive. Initial unemployment claims, reached nearly 500,000 last week, although the Department of Labor attributes roughly 50k to the impact of recent hurricanes. Still, initial claims hovering around 450k foreshadows another weak employment report next week. Perhaps the most discouraging report this week was the advance durable goods release, which revealed a 2% decline in new orders for nondefence, nonaircraft capital goods. As Spencer at Angry Bear notes, the report is a negative for third quarter GDP.

                                                Continue reading "Fed Watch: Regardless of Bailout, US Economy Decelerating" »

                                                  Posted by on Friday, September 26, 2008 at 12:33 AM in Economics, Fed Watch, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (36)


                                                  Equity Warrants and Asymmetric Information

                                                  Jonah Gelbach an Economist for Obama, explains why an argument against including equity warrants as part of the bailout proposal doesn't hold in the presence of the type of asymmetric information present in these markets:

                                                  "Smart Friend" vs. Asymmetric Information, Economists for Obama: Earlier today, Greg Maniw posted a three-point defense of the Paulson bailout plan from someone to whom he referred only as "a smart friend".  I want to address point 2 of Mankiw's friend's argument:

                                                  2. "Taxpayers will be better off if Treasury gets warrants."

                                                  This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again, assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

                                                  For a smart guy, Mankiw's friend is making a pretty dumb argument. Sure, if everyone has the same information, then an asset with a value of $10 will cost $12 if it's required that a $2 warrant comes with it. But that totally misses the point. Based on what I've read, it appears that if everyone understood what these assets were worth, there wouldn't be any need for a bailout: the bailout is necessary because people with capital are scared witless that anything they buy will just be crud. Folks like Mankiw are constantly reminding us (and they're often right) that there's no reason to think government has better information than private parties. So how will Hank Paulson or his agents know any better than folks risking their own money?

                                                  Continue reading "Equity Warrants and Asymmetric Information" »

                                                    Posted by on Friday, September 26, 2008 at 12:24 AM in Economics, Financial System, Market Failure, Policy | Permalink  TrackBack (0)  Comments (16)


                                                    links for 2008-09-26

                                                      Posted by on Friday, September 26, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (14)


                                                      Thursday, September 25, 2008

                                                      House Republicans Obstruct Bailout Plan

                                                      House Republicans are attempting to stop the Paulson bailout plan and replace it with a proposal they've developed. Here's one of their alternative plans:

                                                      RSC pitches 'market-based' alternative to bailout, by Jackie Kucinich, The Hill: The House Republican Study Committee is set Tuesday to officially unveil its proposal to address the financial crisis through a “market-based” approach.

                                                      The conservative group ... is touting its plan as a “true alternative” to Treasury Secretary Henry Paulson’s plan to rescue the financial markets.

                                                      The RSC plan, which will be unveiled at noon, calls for a two-year suspension of the capital gains tax.

                                                      “By encouraging corporations to sell unwanted assets, this provision would unleash funds and materials with which to create jobs and grow the economy,” an outline of the proposal said. “After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains.”

                                                      The group’s plan would also transition Fannie Mae and Freddie Mac to private companies “in a reasonable time,” seeks to stabilize the dollar, and would “suspend the mark-to-market regulatory rules for long-term assets.” ...

                                                      Obviously, selling off Fannie and Freddie to cronies in the private sector won't do anything to solve the immediate crisis, so let's focus on their main proposal for getting out of the danger we are in, a tax cut for the wealthy through a cut in the capital gains tax. Justin Fox:

                                                      [Do] Republican counterproposals floating around make any sense...

                                                      One, that of the House Republican Study Committee, seems to be a joke. It calls for a two-year suspension of the capital gains tax to "encourag[e] corporations to sell unwanted assets." But the toxic mortgage securities clogging up bank balance sheets are worth less now than when they were acquired. Meaning that no capital gains tax would be owed on them anyway. If you repealed the tax, banks would have even less incentive to sell them because they wouldn't be able use the losses to offset capital gains elsewhere. Seriously, where do these people come up with this stuff?

                                                      And even if there was a gain, a 15% cut in the tax rate for two years is not enough of a benefit to offset the high degree of risk in these markets. So this wouldn't unfreeze money markets even if there were gains instead of losses (and it wouldn't inflate asset values enough to provide much capitalization). Additionally, since it's a tax cut on all capital gains, people could benefit from transactions that didn't do a thing to help the banking sector. This is a giveaway of taxpayer dollars that uses the crisis as cover (and the tax cuts will increase the deficit, so the tax cut will have to be paid for in the future).

                                                      The economy is facing serious problems, as I've said before, peoples' livelihoods are at risk (see today's economic news). There's no excuse for holding the process hostage in an attempt to implement political agendas.

                                                      Update: Menzie Chinn discusses another proposal being floated by Republicans:

                                                      From the Justin Fox, regarding House Republicans' plan:

                                                      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. ....

                                                      I'm in agreement with Justin that guaranteeing even more mortgages won't be any better than the original Paulson plan.

                                                      My observation here is that the obstructionism of this group is either a manifestion of denial of reality, or a sheer indifference to the needs of their constituents -- to the extent that House Republicans purport to represent small business Main Street.

                                                      Menzie goes on to document the troubles facing small businesses - one of the few bright spots for job growth in recent years, - and concludes:

                                                      So if we end up delaying until households and small firms individually experience the credit crunch directly for the sake of ideology, well, we'll know where to locate the responsibility.

                                                      Update: Washington Monthly:

                                                      "Let The Markets Crash": Politico:

                                                      "According to one GOP lawmaker, some House Republicans are saying privately that they'd rather "let the markets crash" than sign on to a massive bailout.

                                                      "For the sake of the altar of the free market system, do you accept a Great Depression?" the member asked."

                                                      Think about that statement, and the callousness, lack of imagination, and sheer lack of concern for their country that it shows.

                                                      It staggers me.

                                                        Posted by on Thursday, September 25, 2008 at 09:18 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (24)


                                                        What Caused the Credit Crisis?

                                                        In response to Once Again, It's Not Fannie and Freddie, Barry Ritholtz emails that it's not hard to figure out what caused the financial crisis:

                                                        The Underlying Basis of Finance & Credit, The Big Picture: Here is an oddly interesting observation:  Over the entire history of human finance, the underlying premise of all credit transactions -- loans, mortgages, and all debt instrument -- has been the borrower's ability to repay.

                                                        From 1 million B.C. up until the present, repayment ability was the dominant factor.

                                                        This goes as far back as when Og lent the guy in the next cave a few dozen clam shells in order to go and purchase that newfangled wheel.  If Og didn't think his neighbor would be able to repay him those clam shells, he never would've entered into what we can describe as the first commercial loan.

                                                        Since real estate loans are at the bottom of all of our current credit woes, let's take mortgages as an example. The historical basis for making a loan for a home purchase was several simple factors: Employment history, income, down payment, credit rating, assets, loan-to-value ratio of the property, and debt servicing ability. But for some crazy reason, those factors went away during the housing boom.

                                                        That may sound simple, but it becomes even more stark when viewed over a time line.

                                                        <-1 million B.C.--------------------------- 2002-07 ---2008->

                                                        Except for that 5 year period, the entire history of human finance was rather reasonable about the basis for making loans in general, and extending mortgage loans in particular.

                                                        Makes you wonder, doesn't it.

                                                          Posted by on Thursday, September 25, 2008 at 06:44 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (26)


                                                          Will Congress Forget about Main Street?

                                                          Thomas Palley:

                                                          Saving the Financial System, by Thomas Palley: A friend told me the economist Charles Kindelberger had two rules for a credit economy. Rule one was everybody should know that if they get over-extended they will not be bailed-out. Rule two was if everybody gets over-extended they must be bailed out. The U.S. economy has over-extended itself, triggering rule two. But that still leaves open how a bailout should be designed since designs are not all equal.

                                                          Currently, two models are on the table. One is the Paulson model (also supported by Bernanke) that proposes government buy the bad assets of financial institutions. The other is a Buffett-style recapitalization model that would have government invest in and recapitalize banks, just as Warren Buffett has done for Goldman Sachs.

                                                          The underlying problem is the financial system is short of capital owing to massive asset depreciation. This shortage is impeding provision of credit, which threatens to tank the economy by interrupting normal commerce.

                                                          Banks are caught in a pincer preventing them raising capital. On one hand, if they sell assets to cleanse their balance sheets and make themselves more attractive to investors, this could cause such large losses as to trigger bankruptcy. On the other hand, uncertainty about bank worth means the market is demanding such onerous terms for fresh capital that banks are unable to meet them.

                                                          Reading between the lines, the Paulson plan appears to propose government buy securities through a “reverse” auction whereby banks (and other firms) offer to sell assets to Treasury at a price of their naming, and Treasury accepts those offers meeting its acceptable price. Implicit in Treasury’s thinking is the assumption that the market will recapitalize banks on reasonable terms once they have been cleansed.

                                                          The essence of the Paulson plan is that financial markets have been hit by massive fear-based price disruption, requiring government to create a new market to break the logjam. If correct, by purchasing assets now at distressed prices and holding them to maturity, taxpayers could eventually make a profit, making the bailout costless.

                                                          The recapitalization model completely sidesteps cleansing banks and instead has government directly re-capitalize them. It can do this by buying compound cumulative preferred stock from banks, and also taking warrants that give an option to buy common stock in future at today’s low price. That way, if all works out, taxpayers are rewarded for the risks they take today.

                                                          Since preferred shares rank above common shares, existing shareholders would be hit before taxpayers should there be future unexpected losses. Meanwhile, taxpayers would get the benefit of the preferred stock dividend. Furthermore, if banks suspend dividend payments, the suspended dividend will cumulate and compound so that taxpayers ultimately recoup delayed payments.

                                                          Recapitalizations can also be accompanied by other useful provisions, including restriction of dividend payments on common stock. Additionally, banks could sign a memorandum of understanding with the Fed suspending capital standards and mark-to-market asset price accounting. Both of these practices have squeezed banks by causing further losses as asset prices fall. Since markets are not working well by the Treasury’s own admission, it makes no sense to keep using market price accounting.

                                                          The Paulson plan is subject to three fundamental criticisms. First, the Treasury may over-pay for assets, saddling taxpayers with large losses. If the Treasury sets its acceptable price too low, there is a risk it will buy insufficient assets and banks will not be cleansed. If it sets prices too high, the risk is Treasury overpays. Second, Treasury is taking a big risk as prices could fall further, yet it is not being properly rewarded for this risk-taking. That is tantamount to subsidizing banks which have created the mess. Third, markets may not provide finance even after Treasury’s purchases, in which case banks will remain undercapitalized.

                                                          The Paulson model defense is taxpayers are protected by the reverse auction design. Banks need money and will therefore offer assets for sale at true worth, knowing they may be undersold by other needy banks if they ask for too high a price.

                                                          Criticisms of the recapitalization model are twofold. First, what price should Treasury pay for preferred stock? Second, which banks should get funding? The danger is that zombie banks apply for funding, seeking to save themselves by gambling for redemption with taxpayer money.

                                                          The recapitalization model defense is accounting information exists, due diligence can be conducted, and judgment can be exercised when it comes to setting warrant prices and interest rate terms on preferred shares. Indeed, due diligence and judgment are also needed under the Paulson plan to establish the maximum price government will pay for different types of securities.

                                                          The reality is there are two fundamentally different models for addressing the financial crisis. Both have strengths and both have weaknesses. Time is needed to deliberate on them, and Congress should not be stampeded into a decision. Nor should Congress hand over a seven hundred billion dollar blank check, particularly to the Bush administration in its waning days.

                                                          Finally, both the Paulson and recapitalization models deal only with the supply of finance. Neither deals with the problems of re-regulating finance, jumpstarting the economy, and ensuring the economy delivers shared prosperity that escapes the trap of relying on debt and asset price inflation to drive growth.

                                                          It is no good fixing the supply of finance if there is no demand for finance or if the demand for finance is based on rotten foundations. That is why helping Main Street is as essential as bailing out the banks.

                                                          On the last point, I assume you've heard the news today on the troubles in the non-financial sectors of the economy:

                                                          Triple Dose of Bad News on Economy, Jeff Bater, WSJ: Demand for durable goods and new homes plunged in August, while weekly jobless claims surged, the government said in a triple dose of bad economic data.

                                                          Orders for durable goods decreased by 4.5% last month... New-home sales dived 11.5% to ... the lowest mark in 17 years... The Labor Department said new claims for jobless benefits jumped by 32,000 on a seasonally adjusted basis to 493,000... A mix of economic weakness and recent hurricanes in Louisiana and Texas pushed claims near the half-million mark.

                                                          "Though a spike in claims due to hurricane damage accounts for about 50k of the deterioration, the numbers are still weak after taking this out," Goldman Sachs said in a research report. ...

                                                          Forward-looking indicators..., durable orders excluding the transportation sector and orders excluding defense, both plummeted, down 3.0% and 5.0%, respectively.

                                                          "The worries about the economy and the inability to secure financing are causing firms to restrict big-ticket purchases," said Joel Naroff, president of Naroff Economic Advisors. ...

                                                          I'm worried that after lawmakers finish the bailout deal, they will declare "mission accomplished" and that will be that. Before the work began on the bailout plan, there was talk of a second stimulus package, and today's news indicates that we cannot forget about Main Street once the plan for Wall Street is completed. Where's the worker bailout fund? Or are we going to wait until the problems get worse and it's too late to effectively address unemployment and other problems? There are big lags in the process - the time to start is now.

                                                            Posted by on Thursday, September 25, 2008 at 11:16 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (51)


                                                            Do We Need to Act Now?

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                                                            Anne Krueger says we need "swift action" on a bailout plan:

                                                            Why We Need to Act Now, by Anne O. Krueger, Commentary, Washington Post: It is imperative that the United States act quickly to restore confidence and the flow of credit. The longer action is delayed, the more costly rescue is likely to be. Rescuing the financial system is in the interests of all Americans: Failure to do so would result in rising unemployment and falling output... A financial system incapable of appropriately assessing the trade-offs between risk and reward cannot support economic growth.

                                                            Fortunately, the reduction in U.S. construction activity has, to date, been offset by increases in net exports, and there has been no recession. But as uncertainty about the value of assets underlying various credit instruments has spread, the risks that credit will shrink, and thus lead to declining economic activity, have increased. There must be a rescue before that happens; sustaining credit availability to creditworthy borrowers is crucial for the economy as a whole. Simultaneously, viable banks must be recapitalized. ...

                                                            Japan's experience holds lessons. 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. The costs of acting a decade or more earlier would have been substantially smaller. The choice Japan faced was not whether to act but whether to act now or later. That is almost certainly the decision United States faces now.

                                                            Any rescue should not reward shareholders and those who made the risky decisions. If a fund is established to buy up some of the banks' questionable assets, accurately pricing those assets will be critical. It will also be crucial to purchase assets only from financial institutions that are healthy enough to survive. The more transparent the rules for purchasing loans from banks, the more effective the system will be. ...

                                                            Enough resources must be provided to ensure the success of the operation: If "too much" is allocated, the funds will not need to be spent. Ironically, a larger pool of resources may ultimately cost less than a smaller one. If the allocation is "too small," it will not instill the confidence necessary to ensure that capital markets function. In that case, the inevitable next rescue effort will probably cost even more.

                                                            But the focus today should be on swift action. ...

                                                            Not everyone agrees:

                                                            A Bailout We Don't Need, by James K. Galbraith, Commentary, Washington Post: Now that all five big investment banks -- Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley -- have disappeared or morphed into regular banks, a question arises.

                                                            Is this bailout still necessary?

                                                            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. ...

                                                            And, back on the it's urgent side:

                                                            The Paulson Plan: a useful first step but nowhere near enough, Willem Buiter: Given the extreme urgency of the situation, the response of the US Congress has been truly astonishing.

                                                            The House and the Senate are acting as if this is politics as usual. Some grandstanding here. The threat of delays or even a filibuster. Amendments and modifications that range from the revoltingly populist to the terminally stupid with the disgustingly opportunistic and self-serving in between.

                                                            Admittedly, Secretary Paulson laid an egg by including the following phrase in his proposal: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law of any administrative agency”. This reads as though it was personally written by Dick Cheney, the prince of absolute executive authority, no checks and balances, no accountability, no recourse. No administration that brought us WMD in Iraq and the torture camps of Guantanamo Bay and should expect anything but hysterical giggles in response to such a request. Not smart.

                                                            So, let’s put in accountability and oversight and make sure than Paulson cannot donate $700bn to Nature Conservancy. But then let’s pass the plan.

                                                            She said - He said - He said - He said. Back to the no bailout side:

                                                            Why I am opposed to the bailout, by Morris A. Davis: First, I've decided it is bad economics. Suppose the bailout costs 500 billion. Suppose the bailout is effective in avoiding a recession -- The bailout itself costs 3-1/2 percent of GDP. I think you have to go back to 1982, maybe further, to get that kind of contraction in GDP during a recession.

                                                            Second, Paulson and Bernanke have proven, repeatedly, they have no idea what is going on. ... The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on. ...

                                                            Third, what assets should be bought in a bailout? Mortgages? ... Forget the adverse selection problem for the moment. Just ask: Why would the government know which class of assets to buy and why?

                                                            Fourth and Fifth, the precedent this sets is terrible. This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use. It also tells punishes responsible investors (who did not underwrite or hold high yield junk mortgages) and rewards ex-post the participants in financial markets who took the riskiest bets.

                                                            I think a bailout is needed, but is it urgent? What's important for financial markets is not so much how long the agreement takes, though pressures are building so we can't waste time, the important thing is that it appears Congress is working toward a solution. So long as markets have confidence in the potential outcomes, and so long as it is evident that a solution will be forthcoming before too long, then there is time to get the details right. But as we saw today (here too), markets are fragile and any clear sign of a breakdown in negotiations or a long, drawn out process could start a chain reaction that causes credit to evaporate quickly. Maybe we'd get through it okay, but except in an academic sense, it's not an experiment I want to run. I expect we'll have an agreement before too long.

                                                              Posted by on Thursday, September 25, 2008 at 02:25 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (107)


                                                              "Investments in Fannie and Freddie are Uninsured Investments"

                                                              Former Treasury Secretary for the Bush administration, John Snow:

                                                              "We don't believe in a 'too big to fail' doctrine, but the reality is that the market treats the paper as if the government is backing it. We strongly resist that notion.

                                                              "You know that there is that perception. And it's not a healthy perception and we need to disabuse people of that perception. Investments in Fannie and Freddie are uninsured investments."

                                                                Posted by on Thursday, September 25, 2008 at 12:24 AM in Economics, Housing, Regulation | Permalink  TrackBack (0)  Comments (4)


                                                                Once Again, It Wasn't Fannie and Freddie

                                                                Russ Roberts:

                                                                Krugman gets the facts wrong, by Russell Roberts: Back in July, as Fannie and Freddie were starting to implode, Krugman concluded that Fannie and Freddie weren't part of the subprime crisis:

                                                                But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

                                                                Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

                                                                So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

                                                                His conclusion is quoted approvingly by Economist's View, a couple of days ago.

                                                                Alas, Krugman has his facts wrong. As the Washington Post has reported:

                                                                In 2004, as regulators warned that subprime lenders were saddling borrowers with mortgages they could not afford, the U.S. Department of Housing and Urban Development helped fuel more of that risky lending.

                                                                Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more "affordable" loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.

                                                                Housing experts and some congressional leaders now view those decisions as mistakes that contributed to an escalation of subprime lending that is roiling the U.S. economy.

                                                                The agency neglected to examine whether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable. From 2004 to 2006, the two purchased $434 billion in securities backed by subprime loans, creating a market for more such lending.

                                                                $434 billion isn't zero, and that's just from 2004 to 2006.

                                                                I'm a bit confused about the part pointing to this blog. I don't quote that passage. In fact, I don't quote that column. In fact, I don't even link that column myself - it's only linked within a post from Jim Hamilton that I echo, and that's a post disagreeing with Krugman. So, saying I "quoted approvingly" is not exactly accurate.

                                                                The title of the post was "It Wasn't Fannie and Freddie." The point from Krugman I was referring to is (and yes, I do approve of it, and I'll explain why):

                                                                ...I stand by my view that Fannie and Freddie aren’t the big story in this crisis.

                                                                Fannie and Freddie did not cause the credit crisis and nothing in the article quoted by Cafe Hayek, or anything since the article came out last June changes that.

                                                                There are two questions that are being confused in the debate over the source of the financial crisis:

                                                                1. What caused Fannie and Freddie to fail?

                                                                2. What caused the financial crisis?

                                                                Answering the first question does not necessarily answer the second. Showing that some politician, some policy, some legislation, lack of effective regulation, whatever, caused Fannie and Freddie to fail is important, we need to know why they were vulnerable when the system got in trouble, but Fannie and Freddie did not cause the crisis, they were a consequence of it.

                                                                How do we know this?

                                                                Fannie and Freddie became fairly large players in the subprime market, and they got that way by following the rest of the market down in lowering lending standards, etc. But they did not lead it down. Their actions came in response to a significant loss of market share, and it is this loss of market share that motivated them to take on more subprime loans.

                                                                We need to understand why the overall market - the part outside of Fannie and Freddie's domain - was able to lower lending standards (and increase their risk exposure in other ways as well), and how regulation which had worked up to that point failed to keep Fannie and Freddie from dutifully responding to the market pressures on behalf of shareholders by duplicating the strategy themselves, but again, they were followers, not leaders.

                                                                Tanta (via econbrowser) describes the downward plunge of the GSEs:

                                                                Fannie and Freddie .... didn't like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into "near prime" programs (Fannie's "Expanded Approval," Freddie's "A Minus") that, at the bottom tier, were hard to distinguish from regular old "subprime" except-- again-- that they were overwhelmingly fixed-rate "non-toxic" loan structures. They got into "documentation relief" in a big way through their automated underwriting systems, offering "low doc" loans that had a few key differences from the really wretched "stated" and "NINA" crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of "conforming" loan balance, which kept the worst of the outright fraudulent loans out of the pile. Lots of people lied about their income (with or without collusion by their lender) in order to borrow $500,000 to buy an overpriced house in a bubble market. They weren't borrowing $500,000 from the GSEs.

                                                                Michael Carliner continues, explaining how Fannie and Freddie took on the extra subprime debt:

                                                                Fannie and Freddie are ... subject to regulation by HUD under mandates to serve low- and moderate income households and neighborhoods. As originators and investors with more energy than brains expanded their (subprime) lending to those borrowers and neighborhoods, it was difficult for Fannie and Freddie to increase their shares. They didn't want to buy or guarantee subprime loans, correctly perceiving them to be insanely risky. Instead they purchased securities created by subprime lenders, taking only the supposedly-safe tranches. Those portfolio purchases were counted toward their obligations to lend to lower-income home buyers, but are now part of the write-downs.

                                                                Until Republicans started trying to claim that Fannie and Freddie caused the financial meltdown as a means of tying Obama to the crisis - a strategy that backfired badly when all of the embarrassing connections to Fannie and Freddie within the McCain campaign were revealed - nobody was saying Fannie and Freddie caused the crisis. Republicans simply worked backwards - they found connections between Democrats and Fannie and Freddie (never thinking to ask about their own connections), then tried to blame the crisis on Fannie and Freddie so as to make people think it was the Democrat's fault.  And it's still going on despite the fact that the data doesn't support this story.

                                                                There is no excuse for the actions of the management of Fannie and Freddie, and I'm not trying to defend them or their choices, but the idea that Fannie and Freddie caused the general credit crisis is wrong.

                                                                Richard Green is dismissive of the whole notion:

                                                                Charles Calomiris and Peter Wallison blame Fannie Mae for the Subprime Mess:

                                                                Gse

                                                                Hmmmm. The loan performance on Fannie's book of business is substantially better than the overall mortgage market. And starting in 2002, Fannie Freddie (pink line) lost market share to ABS (light blue line). [The data underlying the graph is from the Federal Reserve, Table 1173. Mortgage Debt Outstanding by Type of Property and Holder.]

                                                                It wasn't Fannie and Freddie.

                                                                [Update: Follow-up argument: Barry Ritholtz: Fannie Mae and the Financial Crisis, What Caused the Financial Crisis?. For a recent academic paper at odds with the claim, see: It Wasn't Fannie and Freddie.]

                                                                  Posted by on Thursday, September 25, 2008 at 12:15 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (25)


                                                                  links for 2008-09-25

                                                                    Posted by on Thursday, September 25, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (10)


                                                                    More links

                                                                    I've received quite a few links to posts and other writing on the financial crisis recently. I haven't had a chance to read all of them, but let me pass them along anyway:

                                                                      Posted by on Thursday, September 25, 2008 at 12:05 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (3)


                                                                      Wednesday, September 24, 2008

                                                                      Soros: Rebuild Depleted Balance Sheets

                                                                      George Soros says that "$700bn in preferred stock with warrants may be sufficient to make up the hole created by the bursting of the housing bubble":

                                                                      Paulson cannot be allowed a blank cheque, by George Soros, Commentary, Financial Times: Hank Paulson’s $700bn rescue package has run into difficulty on Capitol Hill. Rightly so:... Congress would be abdicating its responsibility if it gave the Treasury secretary a blank cheque. The bill submitted to Congress even had language in it that would exempt the secretary’s decisions from review by any court or administrative agency...

                                                                      Mr Paulson’s record does not inspire ... confidence... His actions last week brought on the crisis that makes rescue necessary. On Monday he allowed Lehman Brothers to fail... The demise of Lehman disrupted the commercial paper market ... and investment banks that relied on the commercial paper market had difficulty financing their operations. By Thursday a run on money market funds was in full swing and we came as close to a meltdown as at any time since the 1930s. Mr Paulson reversed ... and proposed a systemic rescue. ...

                                                                      Mr Paulson’s proposal to purchase distressed mortgage-related securities poses a classic problem of asymmetric information. The securities are hard to value but the sellers know more about them than the buyer: in any auction process the Treasury would end up with the dregs. The proposal is also rife with latent conflict of interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief. But if the scheme is used to bail out insolvent banks, what will the taxpayers get in return?

                                                                      Barack Obama has outlined ... conditions that ought to be imposed: an upside for the taxpayers...; a bipartisan board to oversee the process; help for the homeowners as well as the holders of the mortgages; and some limits on ... compensation... These are the right principles. They could be applied more effectively by capitalising the institutions that are burdened by distressed securities directly rather than by relieving them of the distressed securities.

                                                                      The injection of government funds would be much less problematic if it were applied to the equity rather than the balance sheet. $700bn in preferred stock with warrants may be sufficient to make up the hole created by the bursting of the housing bubble. ...

                                                                      Something also needs to be done ...[to] prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay.

                                                                      The rescue package leaves this task undone. ... The package can, however, prepare the ground by modifying bankruptcy law as it relates to principal residences.

                                                                      Now that the crisis has been unleashed a large-scale rescue package is probably indispensable to bring it under control. Rebuilding the depleted balance sheets of the banking system is the right way to go. Not every bank deserves to be saved, but the experts at the Federal Reserve, with proper supervision, can be counted on to make the right judgments. Managements that are reluctant to accept the consequences of past mistakes could be penalised by depriving them of the Fed’s credit facilities. Making government funds available should also encourage the private sector to participate in recapitalising the banking sector and bringing the financial crisis to a close.

                                                                        Posted by on Wednesday, September 24, 2008 at 05:04 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (30)


                                                                        "A $700 Billion Slap in the Face"

                                                                        Paul Krugman doesn't like the theoretical argument being used to justify the bailout:

                                                                        A $700 billion slap in the face, by Paul Krugman: ...Before I explain the apparent logic here, let’s talk about how governments normally respond to financial crisis: namely, they rescue the failing financial institutions, taking temporary ownership while keeping them running. If they don’t want to keep the institutions public, they eventually dispose of bad assets and pay off enough debt to make the institutions viable again, then sell them back to the private sector. But the first step is rescue with ownership.

                                                                        That’s what we did in the S&L crisis; that’s what Sweden did in the early 90s; that’s what was just done with Fannie and Freddie; it’s even what was done just last week with AIG. ...

                                                                        But now Paulson and Bernanke are proposing, very nearly, to do the opposite: they want to buy bad paper from everyone, not just institutions in trouble, while taking no ownership. In fact, they’ve said that they don’t want equity warrants precisely because they would lead financial institutions that aren’t in trouble to stay away. So we’re talking about a bailout specifically designed to funnel money to those who don’t need it.

                                                                        It took four days before P&B offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.

                                                                        As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.

                                                                        So, three points:

                                                                        1. They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.

                                                                        2. They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?

                                                                        3. Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.

                                                                        Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.

                                                                          Posted by on Wednesday, September 24, 2008 at 12:33 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (49)


                                                                          Main Street or Wall Street?

                                                                          This argues that the "Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street":

                                                                          How Main Street Will Profit, by William H. Gross, Commentary, Washington Post: ...Today, our seemingly guaranteed living standard is threatened.... Finance has run amok because of oversecuritization, poor regulation and the excessively exuberant spirits of investors... [P]roduction, and with it jobs and our national standard of living, is declining.

                                                                          If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest -- a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit. That, of course, has been the attempted remedy over the past 12 months. But recent events have made it apparent that this downturn differs from recessions past. ...

                                                                          And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that.

                                                                          In effect, the Treasury will have the fate of the American taxpayer in its hands. The ... purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below "par" or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth. Politicians afraid of parallels to legislation that enabled the Iraq war are raising concerns about a rush to judgment, but the need for speed is clear. In this case, there really are weapons of mass destruction -- financial derivatives -- that threaten to destroy our system from within. Move quickly, Washington, with appropriate safeguards.

                                                                          The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street... 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. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance -- between private incentive and government oversight.

                                                                          Experts of all political persuasions are saying the same thing, something has to be done (which makes it different from Iraq). They could all be wrong, that is true, but nevertheless, they are almost all on the same page.

                                                                          Maybe we can absorb such a shock with our vaunted flexibility, some people want to find out and teach the financial industry a lesson, but me, I'm not taking that chance. People's livelihoods are at stake. A massive credit meltdown is nothing to mess around with. Period. I want action that protects people from the consequences of credit drying up, and we were perilously close to that in the wake of the Lehman failure.

                                                                          We need to make sure the bailout doesn't turn into a massive giveaway to financial institutions, no doubt about that, but I am not about to risk the jobs of so many people through inaction, and I'm convinced there are scenarios where the downturn could be very, very painful for the typical household.

                                                                          So this isn't a question of if we should act, it's a question of how we avoid a giveaway. On that front, I'm not as convinced as Gross is that the plan, as I understand it, will lead to the gains he predicts. That is part of what the current objections to the plan is about, addressing these types of concerns.

                                                                          The plan doesn't have to be completed tomorrow, there's time to get the details right, but we can't waste time either. Tensions are building and they explode without warning. Nobody knows for sure how how much time we have until the next problem erupts, and what kind of chain reaction might result.

                                                                          Peoples' lives are nothing to be toyed with, and if a bailout is the only way to avoid the chance of massive meltdown and widespread job loss, so be it. Protect Main Street first and foremost, but give away as little as possible to Wall Street in the process.

                                                                          One more issue. Why so much money, why do we need $700 billion? One problem is that we can't know the exact size of the problem. How do you determine the size of the problem when you are uncertain about which assets will be problematic? If we knew for sure which assets would have plunge in value, and the size of the plunge, we wouldn’t have a problem with uncertainty to begin with and there would be no problem to solve. So if we insist on a precise answer to this question, we won't get it.

                                                                          But still, why so much? After Lehman was allowed to fail, banks refused to lend to each other other, even overnight. If the bank you lend your money to gets in trouble before paying you back, and if the government is not going to step in and prevent failure, then you could lose all the money you loaned and go into default yourself. It's not worth taking that risk, so loans don't get made at all. That's what led to the need for a massive bailout, the problems that occurred after Lehman failed. The lesson was that the government couldn't let banks fail, not for awhile anyway, and they didn't want to keep bailing banks out one by one - that wouldn't have been politically wise or economically sound. A massive bailout to get it done all at once was the better option.

                                                                          The key to solving the problem is for banks to believe that if and when the bank failure dominoes start falling, they will still get back the money they've loaned out. It's no different than your decision to leave your money in your bank right now (you are making a loan to the bank in return for interest and services). So long as your deposits are protected by the FDIC, there's no reason to worry, but if that protection is lifted, you wouldn't feel so safe and would likely take your money out - you won't be so willing to make the loan.

                                                                          Here's Dean Baker on the question of why so much money is needed (via email):

                                                                          The issue is that banks are worried that other banks will go bankrupt, so that they won't trust them with their money, even on an overnight loan.

                                                                          If Paulson and Bernanke get up and say "don't worry, we're going to make sure that all the loan obligations get honored," but are only standing there with $100 billion, then banks may still not believe them, thinking that they don't have enough money to make good on all the potentially bad loans. This can cause them to make runs on other banks, pulling their money out and causing a crisis (as in what happened last week).

                                                                          The idea of the $700 billion is that this is supposed to be a huge sum, so that when P&B get up and say "don't worry," people believe them.

                                                                          There obviously is no way of saying how much is enough to create belief. Given the sums needed for AIG, $100b to $200b would almost certainly be too little. Maybe $300 b or $400b would be sufficient, but there is no guarantee. $700b is very impressive, so it would almost certainly do the trick.

                                                                          Update: Real-Time Economics:

                                                                          Do you think $100 billion is insufficient to assure the markets?”

                                                                          Mr. Bernanke noted that he isn’t part of the legislative or executive branches, and therefore has “no standing to negotiate this proposal.” ... But Mr. Schumer wanted the perspective from Mr. Bernanke, the economist.

                                                                          “Senator, you asked me my opinion as an economist,” Mr. Bernanke replied. “Unfortunately, this is a matter for psychology.”

                                                                          The key issue, Mr. Bernanke explained, is that “markets need to have confidence” the problem will be addressed. The government is essentially sending a signal to financial markets. An insufficient amount could be seen as “dribs and drabs” to solve the issue, he said. “It is a very big problem and we don’t want to undershoot it.”

                                                                          How did the $700 billion figure come about? “It’s not science to figure out how much is going to be needed to stabilize the firms and the markets,” Mr. Bernanke said. The amount is roughly 5% of outstanding mortgages. “It seems like an appropriate size” given the scale of the numbers, he said.

                                                                          Mr. Bernanke urged continuous oversight by lawmakers over the program as a key way to ensure that its goals are achieved.

                                                                            Posted by on Wednesday, September 24, 2008 at 02:07 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (149)


                                                                            "Do not Abandon Inflation Targets"

                                                                            Frederic Mishkin says that contrary to what some people have argued, there's no need to abandon inflation targeting because of the crisis. However, it is important to adjust the time it will take for inflation to return to its target level for the size of the shock - the larger the shock, the more time that is needed to get inflation back on track:

                                                                            Do not abandon inflation targets, by Frederic Mishkin, Commentary, Financial Times: Inflation targeting is now facing its greatest challenge... High energy and other commodity prices have led to inflation rates well above the inflation target ... at the same time that the financial markets are reeling from the worst financial crisis since the Great Depression. Some critics of inflation targeting have argued that under the present circumstances, such targeting should be abandoned.

                                                                            Is inflation targeting an idea that ... cannot cope with the stress of the present environment? ... Would the need to hit the inflation target ... kick the economy when it is down?

                                                                            To the contrary. I believe that inflation targeting, with some flexibility built in, is exactly what is needed right now. Inflation targeting establishes a transparent and credible commitment to a specific numerical inflation objective that provides a firm anchor for long-run inflation expectations...

                                                                            Additionally, the presence of a firm nominal anchor gives the central bank greater flexibility to respond decisively to adverse demand shocks. Such a commitment helps ensure that an aggressive policy easing – which might be needed to counteract the blow to the economy from the current financial crisis – is not misinterpreted as signalling a shift in the central bank’s inflation objective... A continuing, strong commitment to retain the same inflation target is exactly what is needed at the current juncture.

                                                                            But how can an inflation target remain credible if monetary policy responds to adverse demand shocks when inflation is well above the target, as has happened recently? This is where flexibility comes in.

                                                                            The modern science of monetary policy argues that it should not try to get inflation to within a tight range over short time horizons. To do so would only result in excessive fluctuations in economic activity. It argues, instead, that when shocks to the economy are sufficiently large, inflation might have to approach the target gradually over time and this could be longer than the two years that is usually assumed as a reasonable time horizon...

                                                                            Trying to get inflation down to the target too quickly will impose an unnecessary cost on the economy, and is actually likely to weaken the credibility of the central bank. Both the public and the central bank know that the central bank is unable to sustain an overly tough policy stance because if it did so the government might very well take steps to weaken its independence. An overly tough policy stance could then undermine the support for the inflation targeting policy and unhinge longer-run inflation expectations, actually leading to worse outcomes... Instead, the central bank should articulate a desired path for inflation that gets to the target over a reasonable time horizon...

                                                                            Inflation targeting has been a significant step forward in improving the conduct of monetary policy. ...[H]owever,... that inflation targeting practice needs to keep evolving in a more flexible direction, with a focus on what should be the best path for inflation...

                                                                            Indeed, a more flexible approach to inflation targeting might make it more attractive to countries that have not adopted this monetary policy strategy, such as the US...

                                                                              Posted by on Wednesday, September 24, 2008 at 01:08 AM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (10)


                                                                              links for 2008-09-24

                                                                                Posted by on Wednesday, September 24, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (18)


                                                                                Tuesday, September 23, 2008

                                                                                Keynes on Credit and Confidence

                                                                                From the Columbia Business School Public Offering blog:

                                                                                A Keynesian Lesson for Confidence, by Ray Horton: By happenstance I’m lecturing on John Maynard Keynes ... today. I don’t ask my students to read the whole of The General Theory of Employment, Interest and Money, which would indeed be cruel and unusual punishment, but I do require them to read chapters 10, 12 and 24. ... Chapter 12 certainly makes the carnage on Wall Street a bit easier to understand; it also is a reminder that recovery isn’t going to be easy. Quoting Keynes:

                                                                                A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

                                                                                So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.

                                                                                These days, Keynes is not very popular in some circles; in truth, he is a bit hard on the neo-classicists in chapter two. But behavioral economics, which is now mounting a serious attack on the neo-classicists..., owes a lot to Keynes, as the above quote makes clear. As he wrote more than seven decades ago, strengthening credit is a necessary but not sufficient condition for recovery. We need to restore some confidence too, which is probably where political leadership comes in.

                                                                                Political Leadership? Uh-oh.

                                                                                  Posted by on Tuesday, September 23, 2008 at 09:36 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (2)


                                                                                  Reich: Why Main Street Needs to be Helped Too

                                                                                  Robert Reich makes an argument for including help for Main Street as part of the bailout package:

                                                                                  Why Paulson and Bernanke are only Partly Correct, and Why Main Street Needs More Direct Help, by Robert Reich: ...Here's Paulson's and Bernanke's logic, made explicit at the Senate hearing today: There's only a certain amount of bad debt on Wall Street's books, left over from the wild and woolly days of lax mortgage lending. Once removed from the Streets’ books, credit will flow again. And once credit flows again, even Main Street can breath a sigh of relief.

                                                                                  P&B failed to mention that bad debts are growing even among people recently considered good credit risks. At end of August, 6.6 percent of mortgages were at least 30 days past due. That’s up from 5.8 percent at end of June. We’re also seeing a growing amount of credit card and auto payments past due.

                                                                                  The culprit isn’t just those sub-prime loans. With jobs and wages are dropping across America, many people who had been able to pay their bills no longer can.

                                                                                  It’s no coincidence that states where mortgage delinquencies are highest are also states with the highest rates of job losses. ...

                                                                                  [F]ewer jobs are listed on the nation’s payrolls than were there last year. Millions more Americans are too discouraged even to look for work. And as employers squeeze their payrolls, even people with jobs are putting in fewer hours. ...

                                                                                  Many of the average taxpayers being asked to take on Wall Street’s bad loans are the same people whose incomes are dropping, which means they’re struggling to pay their debts and potentially creating even more bad loans.

                                                                                  Congress should drive the hardest deal it can with Wall Street. But Congress also needs to pay direct attention to Main Street. It should extend unemployment insurance, freeze mortgage rates, and pass a stimulus package that generates more jobs.

                                                                                  Bottom line: Unless Americans on Main Street have more money in their pockets, Wall Street’s bad debts will continue to rise -- which means the Bailout of All Bailouts grows even larger, which means taxpayers take on even more risk and cost.

                                                                                    Posted by on Tuesday, September 23, 2008 at 07:38 PM in Economics, Financial System, Housing, Policy, Unemployment | Permalink  TrackBack (0)  Comments (21)


                                                                                    "Hold to Maturity" versus "Fire Sale" Prices

                                                                                    Paul Krugman says:

                                                                                    Balance sheet baloney, Paul Krugman: There's a turn of phrase I hate in the current discussion, because it sounds smart and serious but is in fact a complete evasion of the key issue. And I'm sorry to say that Ben Bernanke uses it in today's testimony:

                                                                                    More generally, removing these assets [i.e., toxic mortgage-related waste] from institutions' balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth.

                                                                                    "Removing these assets from institutions' balance sheets" what an evasive phrase.

                                                                                    I mean, any 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.

                                                                                    In his testimony today, Bernanke gave a partial answer to the valuation question:

                                                                                    Federal Reserve Board chairman Ben Bernanke said that criticism of the $700 billion plan proposed by Treasury Secretary Henry Paulson overlooked a key ingredient: it is designed to avoid forcing banks to sell or value their mortgage assets at a "fire-sale" price. In a harsher tone than he has ever used in testimony, Bernanke spelled out the benefits that would accrue when the government can buy these mortgage assets at close to "hold to maturity" prices instead of the fire-sale price. Banks would have a basis for valuing the assets and won't have to use fire-sale prices and their capital won't be unreasonably marked down, he said. Liquidity should begin to come back to the markets and uncertainty should dissipate. Credit markets should start to unfreeze, he said. If the assets are purchased near the true hold to maturity prices, taxpayer losses should be minimal, he said.

                                                                                    Now I just have to figure out how the "hold to maturity" price is to be determined, and how purchasing at that price minimizes losses. They must be thinking that if the assets are purchased at below their hold to maturity value, the losses from firms failing would be greater than the gains from charging a lower price.

                                                                                    Ah, here's more from the WSJ economics blog, and it looks like that is the thinking behind the hold to maturity valuation proposal:

                                                                                    Bernanke Goes Off Script to Address Fire-Sale Risks, RTE:  After listening to Senate lawmakers' opening statements for 90 minutes, Federal Reserve Chairman Ben Bernanke took a highly unusual step of ditching his prepared remarks, which ... leaked out early this morning. Bernanke used his time to argue for not buying assets at fire-sale prices in the Treasury's $700 billion bailout proposal.

                                                                                    Uncertainty in housing markets and the economy are forcing financial institutions to mark mortgage securities at fire-sale prices, rather than their value if held to maturity, effectively creating a vicious circle of more write-downs that further depress asset values, Mr. Bernanke explained.

                                                                                    Mr. Bernanke said the Treasury plan should have taxpayers buy the assets and hold them at close to their maturity value. Removing the assets, he said, would bring liquidity back to markets, unfreeze credit markets, reduce uncertainty and allow banks to attract private capital.

                                                                                    Forcing assets down to even lower fire-sale prices would protect taxpayers the most, since the government would own the assets below the value if held to maturity. As long as those securities didn't flat-out default, the government's purchase would have a substantial upside. However, Mr. Bernanke essentially argued that doing so would hurt markets even further and wouldn't solve the problem facing the economy. In pushing back against congressional efforts to change the Treasury proposal, Mr. Bernanke said: "We cannot impose punitive measures on institutions that choose to sell assets." The beneficiaries would be not just the companies selling, but markets and the overall economy, he said.

                                                                                    Still, he acknowledged that the precise approach to doing so hadn't been determined, arguing for flexibility. "We do not know exactly what the best design is," and that would come from consultation with experts, Mr. Bernanke said.

                                                                                    "We believe that strong and timely action is urgently needed to stabilize our markets and our economy," he said.

                                                                                    Still not sure exactly how the hold to maturity valuation will be done, but this is an attempt to provide an additional capital cushion to firms over and above the fire sale prices and help with both liquidity and insolvency problems (at current market prices).

                                                                                    As Krugman notes, taxpayers need compensation for their participation in this. The argument above seems to be that the government will be paying fair prices, not prices above true values, so there is nothing to be compensated for. But as I've noted previously, taxpayers are assuming sunstantial risk by holding these assets, and they need to be compensated for that exposure.

                                                                                    But, again, here I want to be careful. If we reduce the future profitability of these firms at all (by that I mean the amount available to private investors), say by demanding a share of future profits for the government, that will make it harder for the firms to raise private capital since expected future profits will be lower. So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization. That's not a deal breaker, not at all, taxpayers need a stake in any upside, but it is something to think about, and to try to minimize (all else equal). Or have I missed something here and this is not a problem? (Comments argue that I have, but here's what I am thinking. Suppose that a firm has zero in assets, and has liabilities of $100,000, but that it is expected to be profitable it it can become solvent. E.g., it just experienced a once in a lifetime event that wiped out its assets. So it needs $100,000 to continue. Suppose that it sells ten shares at $10,000 each, nine to private investors, and 1 to the government in bailout.  In scenario 1, the government grants firm the $10,000 it needs for a bailout, but leaves future profits unencumbered. If the firm then makes, say, $10,000 in profit the next year, that will be divided 9 ways. In scenario 2, rather than giving the money away for free, the government demands 1/10th of the profits. Now, each investor in the private sector will get less than in scenario 1, they will only have $9,000 to distribute over the 9 shares rather than $10,000 like before - they no longer receive the benefit of the free government investment. I don't want to dwell on this since it detracts from the main point, but have I missed something? That's more than possible...)

                                                                                    I will try to update as I learn more.

                                                                                    Update: Krugman again (and it appears auctions will be used to try to reveal the hold to maturity price, but I still want more details):

                                                                                    Getting real - and letting the cat out of the bag: Whoa - it seems that Ben Bernanke ditched his prepared testimony and, instead, let the cat at least partly out of the bag.

                                                                                    I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

                                                                                    First, banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down ...

                                                                                    As I wrote earlier this morning, the whole "take these assets off the balance sheets" line is fundamentally disingenuous; the key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it's going to pay above-market prices - prices that allegedly reflect "hold-to-maturity" value, but still more than private investors are willing to pay.

                                                                                    This should be read in the context of Brad Setser's calculations: he finds that if Treasury pays a price that seems appropriate given the poor quality of the assets, "The hit to the banks balance sheet might be too big" - the losses would be much larger than the amounts banks have already acknowledged, so that their capital position would be severely weakened.

                                                                                    So the plan only helps the financial situation if Treasury pays prices well above market - that is, if it is in effect injecting capital into financial firms, at taxpayers' expense.

                                                                                    What possible justification can there be for doing this without acquiring an equity stake?

                                                                                    No equity stake, no deal.

                                                                                    All I am saying above is that the design of the equity stake mechanism (there is more than one way to do this) should minimize any secondary effects, but as I said, this is of secondary importance.

                                                                                    Update: Let me try to give a defense of paying above current market prices (in a devil's advocate sense). For markets to function according to competitive ideals, full information must be available to all market participants. When information is lacking, or when it is asymmetric, the outcome is inefficient relative to the full information outcome.

                                                                                    The nature of these assets - their opacity as it has come to be called - makes full information unavailable. I'm not sure how asymmetric information is, people holding the assets don't know themselves whether a particular asset might blow up and lose it's value or not, but there is some degree of asymmetric information in these markets (a standard lemons problem).

                                                                                    This is market failure due to lack of full information, and asymmetric information to the extent it does exist, is depressing prices. The idea is for the government to hold the assets while the information is revealed, and then resell them later at closer to their full information price.

                                                                                    I think of bank asset portfolios as containing bombs, but nobody knows for sure where the bombs are hidden (though the banks may have a slightly better idea than outsiders). At somepoint, they will explode and cause big disruptions. The idea is for the government to gather up these assets, put them in the bomb containment chambers, and let the ones that are going to explode do so. This reveals the information that is lacking, the ones that don't blow up after a certain time period are just fine, and these will be sold at their "hold to maturity" prices.

                                                                                    The problem here is that not all assets are worth their hold to maturity value - some are going to blow up - so the entire stack is not worth (number of assets )*(hold to maturity value), it is worth (number of assets -number that blow up)*(hold to maturity values), and that means discounting each asset slightly below the hold to maturity value (on average since you don't know which will blow up). [I've assumed assets that blow up are valued at zero, and that all assets are identical a priori, but the formula can be easily adjusted to handle heterogeneity and a non-zero scrap value without changing the main point].

                                                                                    This value will be above (number of assets)*(today's market price), but it will be less than (number of assets )*(hold to maturity value), so it seems to me that the correct price (setting aside the need to recapitalize) is between the two values. Essentially, if all assets are valued at hold to maturity values, taxpayers will get stuck paying for the ones that blow up. For this, and the risk they are assuming overall, they need a stake in the outcome. [Update: I probably should have noted that this depends upon how hold to maturity is defined, i.e. the degree to which it incorporates the probability of default - this may already be accounted for in the definition - that's why I want to know how this will be calculated. I'm not completely happy with the example, but the point is simple - it's not clear this plan accounts for assets that default - it might but that's not clear yet - and if it doesn't, taxpayers will be on the hook for the assets that default.]

                                                                                    Update: Arnold Kling makes, essentially, the same point:

                                                                                    The fair price depends on the probability that you will default. If there is a 50 percent chance that you will default, the fair price is more like $50,000.

                                                                                    The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices.

                                                                                    It's hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the "hold-to-maturity" prices of the mortgage securities, properly calculated, pretty low in many cases.

                                                                                    Update: Real Time Economics : How Will Troubled Assets Get Priced?.

                                                                                      Posted by on Tuesday, September 23, 2008 at 10:17 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (95)


                                                                                      "Bill Clinton Revisits His Economic Legacy"

                                                                                      Bill Clinton on deregulation and the bailout:

                                                                                      Bill Clinton Revisits His Economic Legacy, Dana Goldstein: At a meeting with progressive bloggers and journalists ... Monday night, Bill Clinton ... spoke freely about the financial crisis, and reexamined his own administration's economic legacy in light of the meltdown.

                                                                                      "I have thought about that," Clinton told me when I asked whether he was reconsidering any of the de-regulatory economic policies his administration pursued under Treasury Secretary Robert Rubin. ...

                                                                                      Clinton said he has two regrets: First, not pursuing more aggressively an aborted attempt to provide stricter oversight of Fannie Mae and Freddie Mac. According to Clinton, the move was stymied by Democratic and Republican members of Congress and by mayors, who saw the lending giants as "the New Jerusalem" and "pure" because of their role in increasing home-ownership to historic levels. But "it just didn't feel good," Clinton said of Fannie and Freddie's outsized political influence.

                                                                                      Clinton also said he should have subjected derivative trading to more public oversight. "We would have failed, but at least we could've sounded the alarm."

                                                                                      One policy Clinton said he doesn't regret is his repeal of the Glass-Steagall Act in 1999, which, for the first time since the Depression, allowed commercial banks to engage in investment banking activities. Clinton said the commercial banks were an important moderating force on the risk-taking of the big investment firms that collapsed this week. "In the case of the current crisis, I believe the bill I signed allowed Bank of America to take over Merrill Lynch," he said.

                                                                                      Also during the interview, Clinton urged Congressional Democrats to work quickly to pass a bailout package for Wall Street, but said Democrats must lobby in the current weeks to pass a comprehensive package of "Main Street" economic measures, including a moratorium on foreclosures, and should create a homeowners loan corporation similar to the one active during the Depression. Such an agency would refinance sub-prime mortgages into traditional ones, but should do so only for borrowers with steady incomes, Clinton said. ...

                                                                                      The former president mentioned his wife frequently during the meeting... "Hillary called and said it's really interesting how this is going down [in Kentucky]," Clinton said. "She said, out here, they don't yet see it as a big crisis requiring an urgent response, because they've been in trouble for years."

                                                                                      That is why, Clinton reiterated, Democrats must sell the bail-out of Wall Street as an investment in regular Americans' retirement savings and the security of their mortgages.

                                                                                      From the Washington Post:

                                                                                      Near the end of the Clinton administration, some of its officials had concluded the companies were so large that their sheer size posed a risk to the financial system.

                                                                                      In the fall of 1999, Treasury Secretary Lawrence Summers issued a warning, saying, "Debates about systemic risk should also now include government-sponsored enterprises, which are large and growing rapidly."

                                                                                      It was a signal moment. An administration official had said in public that Fannie Mae and Freddie Mac could be a hazard.

                                                                                      The next spring, seeking to limit the companies' growth, Treasury official Gensler testified before Congress in favor of a bill that would have suspended the Treasury's right to buy $2.25 billion of each company's debt -- basically, a $4.5 billion lifeline for the companies.

                                                                                      A Fannie Mae spokesman announced that Gensler's remarks had just cost 206,000 Americans the chance to buy a home because the market now saw the companies as a riskier investment.

                                                                                      The Treasury Department folded in the face of public pressure.

                                                                                      There was an emerging consensus among politicians and even critics of the two companies that Fannie Mae might be right. The companies increasingly were seen as the engine of the housing boom. They were increasingly impervious to calls for even modest reforms.

                                                                                      As early as 1996, the Congressional Budget Office had reported that the two companies were using government support to goose profits, rather than reducing mortgage rates as much as possible.

                                                                                      But the report concluded that severing government ties with Fannie Mae and Freddie Mac would harm the housing market. In unusually colorful language, the budget office wrote, "Once one agrees to share a canoe with a bear, it is hard to get him out without obtaining his agreement or getting wet."

                                                                                      And, for those trying to blame Democrats for the problems with Fannie and Freddie, from the same article:

                                                                                      In June 2003, Freddie Mac dropped a bombshell: It had understated its profits over the previous three years by as much as $6.9 billion in an effort to smooth out earnings. ...[A]n outside accountant ... reported in September 2004 that Fannie Mae also had manipulated its accounting, in this case to inflate its profits. ...

                                                                                      The companies soon faced new bills in both the House and the Senate seeking increased regulation. ...

                                                                                      Fannie Mae and Freddie Mac succeeded in escaping once more, by pounding every available button. ... Most of all, the company leaned on its Congressional supporters.

                                                                                      In the Senate, Robert F. Bennett (R-Utah) added an amendment giving Congress the ability to block receivership, weakening that bill to the point where the White House would no longer support it. Bennett's second-largest contributor that year was Fannie Mae; his son was then the deputy director of Fannie's regional office in Utah.

                                                                                        Posted by on Tuesday, September 23, 2008 at 12:24 AM in Economics, Housing, Regulation | Permalink  TrackBack (0)  Comments (55)


                                                                                        links for 2008-09-23

                                                                                          Posted by on Tuesday, September 23, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (14)


                                                                                          Monday, September 22, 2008

                                                                                          Anti-Intellectualism

                                                                                          Jeffrey Sachs says anti-intellectualism "could end up getting us all killed":

                                                                                          The American anti-intellectual threat, by Jeffrey D. Sachs, Commentary, Project Syndicate: In recent years, the United States has been more a source of global instability than a source of global problem-solving.

                                                                                          Examples include the war in Iraq, launched by the US on false premises, obstructionism on efforts to curb climate change, meager development assistance and the violation of international treaties such as the Geneva Conventions. While many factors contributed to America’s destabilizing actions, a powerful one is anti-intellectualism...

                                                                                          By anti-intellectualism, I mean especially an aggressively anti-scientific perspective, backed by disdain for those who adhere to science and evidence. The challenges faced by a major power like the US require rigorous analysis of information according to the best scientific principles.

                                                                                          Climate change, for example, poses dire threats... that must be assessed according to prevailing scientific norms... We need scientifically literate politicians adept at evidence-based critical thinking to translate these findings and recommendations into policy and international agreements.

                                                                                          In the US, however, the attitudes of President Bush, [and] leading Republicans ... have been the opposite of scientific. The White House did all it could for eight years to hide the overwhelming scientific consensus that humans are contributing to climate change. It tried to prevent government scientists from speaking honestly to the public. The Wall Street Journal has similarly peddled anti-science and pseudo-science to oppose policies to fight human-induced climate change.

                                                                                          These anti-scientific approaches affected not only climate policy, but also foreign policy. The US went to war in Iraq on the basis of Bush’s gut instincts and religious convictions, not rigorous evidence. ...

                                                                                          These are ... powerful individuals out of touch with reality. They reflect the fact that a significant portion of American society, which currently votes mainly Republican, rejects or is simply unaware of basic scientific evidence regarding climate change, biological evolution, human health and other fields. ...

                                                                                          Recent survey data by the Pew Foundation found that while 58 percent of Democrats believe that human beings are causing global warming, only 28 percent of Republicans do. Similarly, a 2005 survey found that 59 percent of self-professed conservative Republicans rejected any theory of evolution, while 67 percent of liberal Democrats accepted some version of evolutionary theory.

                                                                                          To be sure, some of these deniers are simply scientifically ignorant, having been failed by the poor quality of science education in America. But others are biblical fundamentalists... They reject geological evidence of climate change because they reject the science of geology itself.

                                                                                          The issue here is not religion versus science. All of the great religions have traditions of fruitful interchange with -- and, indeed, support for -- scientific inquiry. ...

                                                                                          The problem is an aggressive fundamentalism that denies modern science, and an aggressive anti-intellectualism that views experts and scientists as the enemy. It is those views that could end up getting us all killed. ...

                                                                                          It is difficult to know for sure what is giving rise to fundamentalism in so many parts of the world. ... Fundamentalism seems to emerge in times of far-reaching change, when traditional social arrangements come under threat. The surge of modern American fundamentalism in politics dates to the civil rights era of the 1960s, and at least partly reflects a backlash among whites against the growing political and economic strength of non-white and immigrant minority groups in US society.

                                                                                          Humanity’s only hope is that the vicious circle of extremism can be replaced by a shared global understanding of the massive challenges of climate change, food supplies, sustainable energy, water scarcity and poverty. ...

                                                                                          The US must return to the global consensus based on shared science rather than anti-intellectualism. That is the urgent challenge at the heart of American society today.

                                                                                            Posted by on Monday, September 22, 2008 at 07:29 PM in Economics, Politics, Religion, Science | Permalink  TrackBack (0)  Comments (227)


                                                                                            It Wasn't Fannie and Freddie

                                                                                            It's time to run this again, and add a bit more to it:

                                                                                            Did Fannie and Freddie cause the mortgage crisis?, by Jim Hamilton: Some thoughts about the role played by the GSEs in the run-up in mortgage debt and house prices. ...

                                                                                            Fannie and Freddie had purchased $4.9 trillion of the mortgages outstanding as of the end of 2007, 70% of which the GSEs had packaged and sold to investors with a guarantee of payment, and the remainder of which Fannie and Freddie kept for their own portfolios. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

                                                                                            Hamilton1

                                                                                            Sum of retained mortgage portfolio and mortgage backed securities outstanding for Fannie and Freddie (from OFHEO 2008 Report to Congress) divided by (1) total 1- to 4-family home mortgage debt outstanding (from Census for 1971-2003 and FRB for 2004-2007) and (2) annual nominal GDP.

                                                                                            The fact that the volume of mortgages held outright or guaranteed by Fannie or Freddie grew so much faster than either total mortgages or GDP over this period would seem to establish a prima facie case that the enterprises contributed to the phenomenal growth of mortgage debt over this period. Krugman nevertheless concludes that the GSEs aren't responsible for our current mess. ...

                                                                                            For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

                                                                                            Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

                                                                                            Is that the answer...? I'm not sure...

                                                                                            In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today.

                                                                                             Paul Krugman, also from the previous post:

                                                                                            Why Fannie and Freddie got so big, by Paul Krugman:...Jim Hamilton asks why Fannie and Freddie grew so much in the years before the surge in subprime lending. Justin Fox had already suggested that Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s. Well, if I’m reading this data (xls) right, that’s pretty much the whole story. This graph shows the share of savings institutions and “agency and government-sponsored enterprises-backed mortgage pools” in total mortgage holdings:

                                                                                            INSERT DESCRIPTION
                                                                                            The big switch

                                                                                            Now here’s the thing: S&Ls are private, profit-making institutions whose debt (in the form of deposits) is guaranteed by the federal government. Fannie and Freddie are private, profit-making institutions whose debt is implicitly guaranteed by the federal government. It’s not clear to me that the switch shown here led to any net socialization of risk. ...

                                                                                            What did happen was an explosion of risky lending by other parties, which crowded out the GSEs; you can see that at the end of the figure (which runs up to 2006). So I stand by my view that Fannie and Freddie aren’t the big story in this crisis.

                                                                                            Here's another graph with a bit more detail from the old post Jim Hamilton references above. Note the spike in asset backed securities at the end that matches the decline in lending from GSEs:

                                                                                            Hamilton2

                                                                                            Richard Green says the unique hybrid nature of Fannie and Freddie - which gives it the implicit guarantee - isn't the problem:

                                                                                            Could we please stop saying that it was the hybrid feature of Fannie/Freddie that caused them to fail? I think we have enough failures across enough different types of financial institutions (Investment Banks, Commercial Banks, Thrifts,Insurance Companies and GSEs), and sufficiently (ahem) large rescue packages for them that we can say that the US financial system has very few purely private financial institutions (sorry Lehman Brothers).

                                                                                            But I want to go back to Krugman's point because it has been overlooked in this debate. If, as the data suggest, "Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s," then there was no change in the level of socialized risk. Since S&Ls also have a guarantee from the government, all that happened is that loans moved from one guarantee under S&Ls to another guarantee under Fannie and Freddie. So this could not have substantially changed the degree to which markets were distorted.

                                                                                            Let me add one more piece that may not be widely recognized. Brad Setser notes that since 2000, much of the new debt guaranteed by Fannie and Freddie has been absorbed by foreign central banks, leaving private citizens in the US with a riskier pool of assets:

                                                                                            Were the Agencies responsible for the current crisis?, Brad Setser: The role of the Agencies in the current crisis is something that has come up in the Presidential campaign. It is also something that can be assessed using real data — including the recent Flow of Funds data produced by the Fed.

                                                                                            I would argue that this data suggests a more complex story than is commonly told. The Agencies certainly played a role in turning US mortgages into an asset that credit risk adverse central bank were willing to hold: the availability of Agency bonds with an implicit government guarantee interacted with the acceleration of global reserve growth to help make too much credit available to American households.

                                                                                            At the same time, it wasn’t just a story of a market hopelessly distorted by the Agencies’ implicit guarantee. The Agencies implicit guarantee isn’t exactly a new development. Moreover, at the peak of the lending boom, regulatory restrictions kept the Agencies from growing their books rapidly. The big surge in risky, exotic mortgages was made possible by a surge in demand for so called “private” MBS — that is to say mortgage backed securities that did not have an Agency guarantee. ... Central bank demand for Agencies freed up private funds to invest in riskier assets rather than directly financing the most risky mortgages...

                                                                                            Agency lending has been absolutely essential to avoiding an outright recession over the past few quarters. A surge in Agency issuance has offset a total collapse in “private” MBS issuance. Without the Agencies, US households probably wouldn’t have had any access to credit over the past year. The US government actually started to intervene heavily in the market last fall, when it reduced limits on the growth of the Agencies to keep credit flowing. It isn’t an accident that the Agencies provided $1.1 trillion in new credit to the US last year, while ABS issuance fell from $900b a year to less than zero. ...

                                                                                            The overall result was that central banks took on dollar risk..., while private investors took on the credit risk associated with the housing boom. In hindsight, that looks to have been a bad trade on the part of private investors. Central banks have taken currency losses (though those are mitigated the more Asia sells off). But those losses are a lot smaller than the losses US banks (and European banks that borrowed in dollars to buy dollar-denominated MBS — i.e. institutions like UBS) took on their mortgage book. ...

                                                                                            Agencies remain modest relative to the total outstanding stock of Agencies. Central bank holdings of Agencies only surpassed US commercial bank holdings of Agencies in q2 2008... So why have I emphasized central bank demand for Agencies?

                                                                                            To start, central bank demand absorbed a significant share of the incremental growth in Agency bonds outstanding since 2000. If you believe flows matter — and I do — central banks have been big players...

                                                                                            But this effect - the concentration of risk in the US as the guaranteed assets issued by Fannie and Freddie went primarily to foreign central banks - is a consequence of our need to borrow from foreigners to finance our budget and trade deficits. Without those deficits, more of the safe assets stay home and the overall pool isn't as risky. So to the extent that this concentration of risk is a factor in causing the problems (and I don't know how important it was), it was caused by trade and budget deficits, not the actions of Fannie and Freddie.

                                                                                            So, overall, perhaps the implicit asset guarantee did distort markets, but those distortions did not start with Fannie and Freddie, and they did not substantially worsen when Fannie and Freddie took over where the S&Ls left off. And even if there was some distortion, it's hard to find any linkage between the onset of the financial crisis and changes in the net socialization of risk through Fannie and Freddie. There was, apparently, some concentration of risk due to central banks buying the safe assets and leaving the riskier ones behind, but even so, it's not clear to me that this was a primary factor in bringing about the crisis. And even if it is the cause, or part of it, the behavior of central banks was not driven by changes in the behavior of Fannie and Freddie.

                                                                                              Posted by on Monday, September 22, 2008 at 04:32 PM in Economics, Financial System, Housing | Permalink  TrackBack (1)  Comments (15)


                                                                                              It Wasn't the Community Reinvestment Act

                                                                                              This needs to be debunked again:

                                                                                              The New Talking Points, Washington Monthly: For about a week now, Republicans have been looking for a way to blame the crisis on Wall Street on Democrats. The search hasn't gone well...

                                                                                              But conservatives kept on trying. In fact, the right seems to have finally come up with a new line: Democrats forced banks to give mortgages to low-income minorities, those low-income minorities couldn't keep up with their mortgage payments, and the banks struggled as a result. Voila! Blame the Dems!

                                                                                              Fox News' Neil Cavuto helped get the ball rolling. Media Matters reported that Cavuto conflated giving home mortgages to minorities with risky lending practices...

                                                                                              The National Review is on board with a similar line of thinking, blaming the Community Reinvestment Act for much of the crisis: "The CRA empowers the FDIC and other banking regulators to punish those banks which do not lend to the poor and minorities at the level that Obama's fellow community organizers would like. Among other things, mergers and acquisitions can be blocked if CRA inquisitors are not satisfied that their demands -- which are political demands -- have been met. There is a name for loans made to people who do not have the credit, assets, income, or down payment to qualify for a normal mortgage: subprime."

                                                                                              All of this seems rather silly on its face, but thankfully, Matt Yglesias went to the trouble of setting the record straight.

                                                                                              For one thing, the timeline is ludicrous. The Community Reinvestment Act was passed in 1977. Are we supposed to believe that CRA was working smoothly throughout the Carter, Reagan, Bush I, and Clinton years and then only under Bush II did overzealous anti-"redlining" enforcement come into play, perhaps a result of Dubya's legendarily close relationship with ACORN? Or maybe overzealous enforcement back in the late 1970s is somehow responsible for a real estate blowout that only materialized 30 years later? It doesn't even come close to making sense.

                                                                                              Beyond that, the mere existence of "subprime" loans -- i.e., mortgages given to less-creditworthy individuals at higher interest rates -- isn't the problem here. The problems have to do with what was done with the loans after they were packaged, sold and used to make leveraged plays.

                                                                                              Sorry, conservatives, you'll have to keep looking for a way to blame Democrats for this mess. Good luck with that.

                                                                                              See also: Did Liberals Cause the Sub-Prime Crisis?, by Robert Gordon, and Ezra Klein:

                                                                                              As Robert Gordon shows,... this is crap. First, there's the timing. CRA came in 1977. The crisis came in 2007. Indeed, by 2004, the Bush administration had weakened the CRA -- and after that (though not, presumably, because of it), bubble lending really took off. Further, CRA only governs a certain class of federally insured banks. Problem is, half of the subprime loans came from mortgage companies with no CRA involvement at all. Another 25%-30% came from companies with very little CRA exposure. For those who left their abacus at home, that's 80% of the loans which were fully or largely outside CRA jurisdiction. More than that, the non-CRA mortgage firms made subprime loans at twice the rate of CRA-covered firms. Which basically leaves a stake in the heart of this particular theory. Indeed, until now, some conservatives have been moaning that no one is talking about the CRA part because it's so racially charged. Poppycock. It's just a false charge...

                                                                                                Posted by on Monday, September 22, 2008 at 01:08 PM in Economics, Financial System, Housing | Permalink  TrackBack (1)  Comments (70)


                                                                                                Paul Krugman: Cash for Trash

                                                                                                The Paulson plan is not acceptable in its present form:

                                                                                                Cash for Trash, by Paul Krugman, Commentary, NY Times: ...Henry Paulson’s $700 billion rescue plan for the U.S. financial system..., as far as I can see, doesn’t make sense. ...[And] what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? ...

                                                                                                So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

                                                                                                1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities...

                                                                                                2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. ...

                                                                                                3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

                                                                                                4. Financial institutions have been trying to pay down their debt by selling assets,... but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

                                                                                                The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets... How does this resolve the crisis?

                                                                                                Well, it might — might — break the vicious circle of deleveraging, step 4... Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

                                                                                                Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

                                                                                                The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital..., it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place. That’s what happened in the savings and loan crisis... It’s also what happened with Fannie and Freddie. ...

                                                                                                But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this ... that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal.

                                                                                                I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications... Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

                                                                                                But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

                                                                                                  Posted by on Monday, September 22, 2008 at 12:42 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (117)


                                                                                                  Fed Watch: The Beginning of Another Wild Ride

                                                                                                  Tim Duy is "less than enthusiastic" about the Paulson plan:

                                                                                                  The Beginning of Another Wild Ride, by Tim Duy: The sheer amount of commentary over the weekend regarding US Treasury Secretary Hank Paulson’s first pass at an ultimate solution to the credit crisis is simply overwhelming. The response is, justifiably, less than enthusiastic. I can be counted among that group.

                                                                                                  No one should expect that taxpayers will come away unharmed by a comprehensive solution. That said, the Paulson plan is a virtual giveaway to the financial industry. As commentators noted early on, the objective of any rescue effort needed to be the recapitalization of the financial community. This could not be done by acquiring weak assets at what was initially claimed to be “steep discounts.” The weakness was publicly revealed over the weekend, via an amazing transcript delivered by Yves Smith:

                                                                                                  Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

                                                                                                  Paulson is trying to swap $700 billion of US Treasury assets in return for $700 billion of assets valued what I suspect effectively amounts to their original value when the asset was created. Presumably, once this swap was complete and the questionable assets were purged from the system, financial institutions could raise any additional new capital needed via private sources. Such a swap would make sense if the assets the Treasury was purchasing could be sold back into the market at some future date at their purchase price. But no one actually believes this is possible; those assets will undoubtedly fetch less than their $700 billion purchase price, and the taxpayer will eat the difference.

                                                                                                  Now, as I said earlier, the taxpayer should not expect to remain unharmed, but should expect to be compensated as much as possible (Mark Thoma notes that even if taxpayers were expected to break even, they still need to be compensated for the risk of harm). And it is on this point that the plan is woefully insufficient. See Steve Waldman at Interfluidity for a very nice, concise reaction to the deficiencies of the plan, with a variety of links. I don’t see how any plan can commence that does not include substantial equity dilution for existing shareholders of firms that transfer their bad assets to the government.

                                                                                                  Perhaps, in the name of expediency, you are willing to accept the taxpayer burden implicit in the Paulson Plan. A rational justification can be made for quick action when faced with a complete collapse of the US financial sector. Indeed, the consequences for the taxpayer from inaction may greatly exceed that of even a poorly structured rescue effort that nonetheless begins the important task of recapitalizing the financial sector. But what cannot be accepted, under any circumstances, is this clause:

                                                                                                  Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

                                                                                                  That Paulson should even propose that he be given authority that supersedes all other should be grounds for demanding his resignation. I am not prepared to anoint Paulson or Federal Reserve Chairman Ben Bernanke or anyone to the position of economic dictator, regardless of the danger to the economy. How ironic would it be if the unbridled push toward free market capitalism brought about the same dictatorship via economic chaos that a worried Frederick Hayek opined would be the end result of socialism in The Road to Serfdom?

                                                                                                  Congress is still mulling over the Paulson proposal. We can only hope that less economic dictatorship and more taxpayer upside emerge in the final document. The only sure thing is that the range of assets to be purchased will only increase. From Bloomberg:

                                                                                                  Officials now propose buying what they term troubled assets, without specifying the type, according to a document obtained by Bloomberg News and confirmed by a congressional aide.

                                                                                                  The change suggests the inclusion of instruments such as car and student loans, credit-card debt and any other troubled asset. That may force an eventual increase in the size of the package as Democrats and Republicans in Congress negotiate the final legislation with the Bush administration, analysts said.

                                                                                                  Yes, Virginia, $700 billion is only the beginning. Will markets be willing to finance this debt? That remains the elephant in the room…if our foreign creditors finally balk at the never ending stream of debt they are expected to absorb, the consequences for Treasuries and the Dollar will be devastating as the financial crisis evolves into a balance of payments crisis. If, however, global policymakers maintain the current arrangements of Bretton Woods II, they will absorb the debt via an expansion of foreign central bank balance sheets – raising the specter of inflation at a time when all eyes are on deflation again. What a tangled web…one that I will be taking up later in the week.

                                                                                                  The only thing to expect this week is the unexpected. Indeed, the surprises are already starting – tonight the Fed agreed to convert Morgan Stanley and Goldman Sachs to traditional bank holding companies. Wall Street as we knew it for generations is officially gone. I anticipate another rollercoaster week; time to buckle your seat belt and get ready for the ride.

                                                                                                    Posted by on Monday, September 22, 2008 at 12:33 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (17)


                                                                                                    Illiquidity and Insolvency

                                                                                                    Someone asked how the bailout is supposed to work:

                                                                                                    I'd say it this way, there are two problems.

                                                                                                    1. Financial firms are stuck holding securities they can't sell and can't borrow against. Since these firms borrow short and lend long, that's a killer. The problem is that there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up (so everyone tries to get rid of their securities causing prices to fall rapidly [and this leads to the "paradox of deleveraging", see Krugman's description]). By having the government trade for these frozen assets (some of which are perfectly fine) and replace them with safe, low risk or risk free assets, the firms ought to be able to sell the assets and/or borrow against them again (since there will now be buyers willing to take them), prices will stabilize, and credit will resume flowing.

                                                                                                    That's an illiquidity problem. It's caused by toxic assets, the hidden ones freeze up the whole system since nobody wants to end up with them. Why give up cash unless the interest rate is really, really high, too high?

                                                                                                    2. The other problem is solvency. Now, some people think that if you solve the illiquidity problem, that's enough, it will allow the firms to borrow within the private sector (perhaps internationally) and recapitalize themselves.

                                                                                                    Others think the solvency problem can only be solved with additional injections of safe assets - say cash or bonds - solving the illiquidity problem alone won't be enough.

                                                                                                    I don't want to take chances, so I say (1) get rid of the toxic stuff, that helps the liquidity problems and gets credit markets moving again (they froze up severely after Lehman was allowed to collapse, that was a mistake), (2) add additional capital to help with solvency, this is extra insurance in case freeing up credit markets by solving the liquidity problem isn't enough by itself, and (3) give taxpayers a stake in all of this for their troubles. The exact form of that stake isn't as important as the fact that they have one.

                                                                                                      Posted by on Monday, September 22, 2008 at 12:24 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (29)