The Citigroup Betting Pool
I’ve been catching up with my family and not on top of the news the last 24 hours or so - wasn’t there a time that the financial world shut down on weekends? - but for those of you who may not have a feed reader clogged with economics blogs (first, good for you), I wanted to point out some of the various outcomes you may want to bet on when it comes to Citigroup. Some people are betting that a deal (bailout, FDIC takeover, merger) may be announced as soon as this weekend. I doubt it, because Citi shouldn’t have a liquidity problem per se; now that the Federal Reserve is accepting pocket lint as collateral, Citi can keep functioning even after the markets have completely lost faith in it. The problem is that no one believes its assets are still worth more than its liabilities, so everyone expects the endgame will come (in one form or another) sooner or later. The big questions are whether no one will get wiped out, shareholders will get wiped out, or shareholders and creditors will get wiped out.
- Mark Thoma has an overview with excerpts from some other posts.
- The wildest idea is that Citi might merge with Goldman or Morgan Stanley, although this is only floated by unnamed analysts. What such a merger would accomplish is unclear to me. (Although various people have come up with the name for a Goldman-Citi merged entity.)
- Felix Salmon has a quick rundown with a lot of links (some of which I reproduced below); he thinks that at least creditors will not get wiped out to avoid a repeat of Lehman.
- John Hempton explains how creditors might be wiped out and why it would be a bad thing.
- Brad DeLong says to the government: go ahead, just buy the whole thing. With the change, buy a cup of coffee.
Dawn of A New Interregnum
According to the official website of the President-Elect, there are 59 days until inauguration. Let’s call it nearly two months. The good news is that President-elect Obama has begun to name his economic team, the line up looks strong, and they have plenty of time to get their plans in place. The bad news is that the banking system may not have that much time.
We are now obviously in a delicate political phase, in which the Bush Administration is winding down and the Obama Administration does not yet have real power. This matters because the US banking system is in a worse than delicate phase. Contrary to the statements of Mr Paulson earlier this week, core US banks do not appear to be stabilized. The fall in equity prices this week was a cause of serious concern, and we discussed the causes and potential (unpleasant) cures in our WSJ.com article on Thursday morning. Since then the situation has only deteriorated, seen most clearly in the credit default swap (CDS) spreads for major banks, which moved up through Friday.
This increase in CDS spreads means that the market believes the probability of some banks defaulting has gone up. This is striking because the Federal Reserve at this point can make sure these banks never run out of liquidity. So what is going on?
Partly people in the market are not sure that all parts of all (global) banks will be saved. And partly they don’t know where the money for a bailout would come from. This is not just about whether TARP is or is not available to recapitalize banks, it is also about the not-so-good relationship between Congress and the outgoing administration.
Ask yourself this. If the Bush Administration felt the need to raise, say, $1trn - see this week’s much cited FBR report on the capital needed by the banking system - and sought approval Congress in December, how well or badly would that conversation go at this point? Could the new Obama team help? What about when the new Congress arrives in the first week of January - would that make any difference?
We are in an awkward stage, facing major economic problems and with a potentially distracted executive branch. We need to find some new ways to handle this transition between presidents. And fast.
When Will the Stock Market Stop Falling?
The stock market has clearly not had a good week. The Dow Jones average was down 5.3%, the S&P 500 was down 8.4%, and it would have been much worse if the markets hadn’t jumped at the end of the day today, allegedly because Tim Geithner will be named Treasury Secretary (which I called, but it wasn’t that gutsy a call). Yesterday the S&P closed at less than half its high of October 2007. For a chart of the carnage, see Calculated Risk (click on the chart for a larger version).
At this point, stock prices are clearly beyond the short-term liquidity crisis that hit financial institutions in September, and deep into recession territory. That is, share prices will not respond particularly sharply to tactical steps such as individual bailout plans, because the big question is how long and how bad the recession will be. The problem this week was not that all the news was bad, but that all the news was worse than expected. The stock market prices in current expectations about the future, so if a report is bad but not as bad as predicted (say, unemployment goes up but less than forecast), the stock market should go up.
This week:
- New unemployment claims were higher than expected
- The Consumer Price Index fell more than expected
- The manufacturing survey of the Philadelphia Fed was worse than expected
- The Leading Indicators index of the Conference Board fell more than expected
- Oil futures fell below $50 (indicating that expectations of demand are falling)
Partially as a result, Goldman revised its economic forecast down, saying that the economy will contract at an annual rate of 5% this quarter, 3% next quarter, and 1% the quarter after that, which is worse than any forecast I’ve seen (although I certainly don’t see all of them).
For the stock market to stop falling, new data has to come in that is better than expected. Of course, guessing when that will happen is a fool’s errand.
To Bail or Not To Bail, Banking Edition
This was a bad day for the market and a very bad day for banking; the credit default swap spread for at least one major bank rose above 400 basis points - a level of implied default probability that we have not seen since mid-October.
Mr. Paulson suggested earlier this week that the government’s Troubled Asset Relief Program (TARP) take a break from bank recapitalizations, through at least January 20th (listen to today’s NPR story). After today, I seriously doubt this is a good idea. And I sincerely hope that the administration is preparing (another) policy U-turn.
Potentially more sustainable approaches are suggested in my previous post (and the associated WSJ.com article). Don’t be shy. Congress in particular needs to hear your suggestions - post them here or call your favorite representative. Just don’t urge inaction.
Banks At Serious and Immediate Risk, Again
Despite the shot of confidence provided by the recapitalization program in mid-October, equity prices and CDS spreads indicate investors are getting nervous about banks again - and some may even be betting that they will fail, or at that equity holders will be wiped out. As the recession deepens, banks’ assets (not only mortgage-backed securities, but loans in all forms) are falling in value, increasing the chance that the government will need to step in again with more capital. Peter and Simon have a guest post at Real Time Economics (WSJ) on the options - none of them pretty - that the government has.
To Bail or Not To Bail, GM Edition
For those who can’t get enough of the GM topic, Economix (NYT) has links to posts for and against bankruptcy. Right now it’s 10-5 in favor of bankruptcy, although I’m not sure that Mitt Romney’s vote should have the same weight as those of, say, Martin Feldstein, Gary Becker, and Paul Krugman.
However, the bankruptcy/bailout dichotomy leaves out what I think is the best solution: a government-brokered reorganization, which may or may not require bankruptcy - a prepackaged bankruptcy, as it’s sometimes called. This would be very different than just letting GM go into Chapter 11 and hoping for the best, especially given the lack of debtor-in-possession financing these days (thanks to the commenters who pointed this out). Andrew Ross Sorkin, for example, argues for a prepackaged bankruptcy, and even Romney calls for a “managed bankruptcy” (without many deatils) - yet they are lumped in with the the others, like George Will, who argue against any government intervention. (See the link above for all the links to individual posts.) So I don’t think 10-5 is a very accurate count.
Update: Five professors who really are experts on the auto industry (and one of whom is a colleague of Simon at Sloan) have a highly readable paper with their proposal out. They favor a non-bankruptcy restructuring plan that is overseen by the government and also has some provisions to ensure that the reorganization is in the public interest, such as increased fuel efficiency standards and a prohibition on paying dividends to shareholders.
Written Testimony to Senate Budget Committee Today
My written testimony is now attached: testimony-simon-johnson-for-senate-budget-on-nov-19-2008
Comments welcome!
Testimony This Morning: Senate Budget Committee
Wednesday morning, starting at 10am, I’m on a panel testifying to the Senate Budget Committee about the need for a fiscal stimulus. The other witnesses are Mark Zandi and John Taylor.
I’ll post my written testimony after the hearing. I expect to make three main points in my verbal remarks:
1) We are heading into a serious global recession, caused by and in turn causing a process of global leveraging (i.e., reduction in lending and borrowing). We have never seen this kind of deleveraging - synchronized around the world, fast-moving, and with an unknowable destination.
2) I do not think we can prevent this deleveraging from happening. Nor do I think we should even try to keep asset prices high (or at any particular level). But in the United States we have the ability to mitigate some of the short-run effects and to lay the groundwork for a sustainable, strong recovery. One sensible tool to use in this context is fiscal policy. I lean towards smart spending programs, but as the economy continues to worsen, I think some kind of temporary tax cut could also help - it can potentially have relatively quick effects. (Note: contrary to those who think that if tax cuts are saved by consumers, they are somehow “wasted,” I would point out that anything that improves consumers’ balance sheets is both good for them and for the financial institutions that lend to them.)
3) But there is a real limit to how far we can go with fiscal policy (and with other policy measures). Irresponsible budget policies would not be a good idea - we need to continue a process of fiscal consolidation; it is most vital that people around the world remain confident in the U.S. government’s balance sheet. Some of the highest numbers now being proposed for a fiscal stimulus are probably too high and a mega-stimulus could be counterproductive if it undermines confidence.
I’m proposing a fiscal stimulus of roughly 3% of GDP, to be spent over several years. Given the uncertainties involved, this seems like reasonable middle ground - it’s enough to make a difference, but doesn’t promise a miracle; it can be spent sensibly and at an appropriate speed; and it will not undermine our ability to consolidate the U.S. fiscal position (i.e., bring government debt onto a sustainable path) over the medium-term.
More Things to Worry About
The morning after the election, I wrote a post on our country’s long-term priorities. #3 on the list was retirement savings.
While the retirement savings problem predates the current crisis, the decline in the value of financial assets has made it tougher all around. One reader pointed me to a particular aspect of the problem I wasn’t aware of. Earlier this year, the Pension Benefit Guaranty Corporation (PBGC) shifted its asset allocation from 15-25% equities to 55% equities. The PBGC, which is part of the federal government, guarantees private-sector pension plans and is funded by premiums paid by those plans; if a company’s pension fund goes bankrupt, the obligations are shifted to the PBGC. This, as Zvi Bodie and John Ralfe pointed out back in February, is particularly problematic for the PBGC, because then an economic downturn has a triple impact on the fund: first, as equity values fall, company pension funds face larger funding gaps; second, as companies go bankrupt, their pensions get shifted to the PBGC, increasing its liabilities; third, as equity values fall, the PBGC’s assets fall, increasing its funding shortfall. Bodie and Ralfe argue that increasing the proportion of equities may increase the expected return, but only at the cost of increased risk, in any timeframe.
(By contrast, because the Social Security Trust Fund is invested in Treasury bonds, it should be doing OK. Long-term concerns about Social Security funding, of course, are still valid.)
Emerging Markets Snapshots
GM, mortgage restructuring, and the G20 have sucked up most of the attention recently, but the crisis continues to take its toll around the world. A few vignettes:
- In Ukraine, industrial production in October fell by 7.6% from September (that’s not an annualized rate) and 19.8% from October 2007.
- Russia’s second-largest coal company reported that its Q4 sales would be only one-third the planned level - and that payments from its steelmaker customers since September were only 21% of the value of shipments.
- Credit default swap spreads on Greek sovereign debt are up over 160 bp - higher than at the previous peak in mid-October. (Note that Greece is in both the EU and the Eurozone.)
On the “plus” side, Pakistan and the IMF agreed on a $7.6 billion loan, ensuring economic stability in a particularly important part of the world - at least for a few months. Pakistan’s government says they need a total of $10-15 billion.
Session Outline: MIT Global Crisis Class, at 4pm today
Outline of session; November 18, 2008
The Global Crisis, class #3
Relevant links, including background material and tracking of all relevant developments available through http://BaselineScenario.com. Details of session after the jump - Read the rest of this entry »
G20 Aftermath, For MIT Global Crisis Class
If you are only going to read one thing ahead of our class today (4pm Boston time), please take a look at my op ed on the G20 and potential aftermath, which appeared on Forbes.com yesterday. Depending on how leaders and the private sector play their cards in the next few weeks, I think this summit could have made things substantially worse in the short-term.
MIT Global Crisis Class, Tuesday November 18th
Join us for the next live webcast of my MIT class on the global crisis. Details after the jump…
Mortgage Restructuring Is Not Enough
Let’s be honest with ourselves. Even if the outgoing Bush team or the incoming Obama administration can work out a scalable nationwide mortgage restructuring scheme, we will still have a housing problem in the U.S.. Specifically, we should expect a high proportion of restructured mortgages to default again within a year. In a piece that appeared on Bloomberg this morning, Alex Stricker and I suggest that a more centralized process is needed to manage the flow of foreclosed properties onto the market, and we discuss some alternative ways to implement this idea.
There may be better ways to do this and we are completely open to suggestions - please post as comments here. We only insist that this is one dimension of U.S housing that needs further careful consideration.
Global Crisis Orientation
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Written by James Kwak
October 20, 2008 at 9:11 am
Posted in Commentary