The Baseline Scenario

With our myriad banking problems, rapidly rising unemployment, looming political battles over the budget and much more on the pressing domestic agenda, is the G20 summit in London (dinner Wednesday and meeting Thursday) really worth all the time and effort that the President and his team have devoted to it?  And, granted that President Obama has to attend this heads of government meeting for protocol reasons, is there much that this summit can realistically achieve – i.e., are there actions that will be taken as a result of the summit that would not otherwise have happened and that can really make a difference to the parlous state of our economy?

These are all reasonable questions.  And the answer is simple: in terms of the obvious major issues of the day, this summit is unlikely to achieve much.

But every global economic recovery has to start somewhere and it probably has to begin small.  And there are some slight glimmers of hope because (a) President Obama is taking a global leadership role, (b) he is doing this in a creative way that might seem surprising, but which should reduce the chance of a further global meltdown. Read the rest of this entry »

With all the material and moral support for U.S. mega-financial institutions currently on the table, why are bank holding company credit default swap (CDS) spreads at new highs?  (For more on how and why you might want to think about CDS spreads, we have a basic guide.)

Read the rest of this entry »

The draft G20 communique, as published on the FT’s website, is not encouraging. To be sure, there are humorous moments, such as:

each of us commits to candid, even-handed, and independent IMF surveillance of our economies and financial sectors, of the impact of our policies on others, and of risks facing the global economy;

Major countries have never allowed this and never will, despite a long tradition of such statements (e.g., ask about whether Gordon Brown welcomed frank assessments of the UK economy during the time he was chair of a ministerial committee that oversees the IMF).  Asserting something blandly in a communique does not make it true, but it does - amazingly – often convince much of the media to applaud politely.  Watching the spinmeisters at work is always entertaining although, under these circumstances, also more than a little scary.

On the real substance, the G20 punts on most of the big issues – as predicted, the language on monetary policy and fiscal policy is completely vacuous (paragraphs 3 and 4; the Europeans won big and the US lost on these issues), and the “regulatory reform” initiative amounts to building more ornate structures (we’re to get a new Financial Stability Board?!?) on the same weak foundations that got us into trouble.  There is simply nothing substantive here that would not have happened without the G20 process; under current dire circumstances, window dressing is not a good reason to hold a summit.

Only three interesting points are apparently still open for discussion, all about some dimension of the IMF. Read the rest of this entry »

The G20 summit is headed for disaster.  The Europeans have circled their wagons and determined that no sensible policy proposal shall pass.  The background briefings indicate (a) the US has given up on global fiscal stimulus (“declare victory and retreat” springs to mind), (b) and the manifest failures of financial regulators will be addressed through, well, a manifest of failed regulators.

None of the important issues are on the table or even allowed in the building: changing the European Central Bank’s monetary policy, persuading European politicians to acknowledge they were and largely still are asleep at the wheel, and the future of big banks everywhere.

The summit will begin with dinner on April Fool’s Day.  The organizers have clearly not thought much about the symbolism. Read the rest of this entry »

For a complete list of Beginners posts, see Financial Crisis for Beginners.

This is more of an advanced beginners topic – I already covered CDOs (collateralized debt obligations) in my first Beginners article – but I imagine that most of our readers are already familiar with structured products. At least, many people know that first a bunch of securities are pooled together, and then they are “sliced and diced,” in the common media parlance I find incredibly annoying. But Joshua Coval, Jakub Jurek, and Erik Stafford have a new paper, “The Economics of Structured Finance,” which does a brilliantly clear job of describing what these securities are and why they were so widely misunderstood, with the results we all know.

The paper is 27 pages long, not counting references, tables, and figures, and if you are comfortable with probabilities and follow it carefully you can understand everything in it. I will provide a summary to whet your appetite. I am not going to use numerical examples because the examples they use throughout their paper are so good.

Read the rest of this entry »

My colleague Ilya Podolyako is back with a comment on the Geither Plan to buy toxic assets, as well as an update to his previous post about the constitutionality of government takeovers of private property. He discusses in particular the possibility (also suggested by one of our readers) that the government could “seize” toxic assets and pay “just compensation,” even in the absence of a bankruptcy or a takeover. Ilya is a 3rd-year student at the Yale Law School and, among other things, an executive editor of the Yale Journal on Regulation. The post below is by Ilya.

PPIP for Legacy Loans = Free Put Options for Banks

I finally got a chance to read through the PPIP plan in detail. I noticed one curious point: under the program as announced, auctions for the legacy loans do not appear to be binding on the contributing entity.

The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:

. . .

Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

This is quite odd, since, if I read it correctly, it turns the entirety of the program into a put option for participating banks. That is, they could identify certain assets, put them up for auction seemingly risk-free, check the result, and reject anything below their internal valuation without any further capital contribution.

Read the rest of this entry »

Simon argued in the Atlantic article, and I argued in “Frog and Toad” and “Big and Small”, that the best way to regulate the financial sector is to limit the size of individual institutions. In the interests of providing a contrasting point of view, I want to point out that Kevin Drum thinks that small banks can do just as much damage as big banks:

I think crude bank size is a red herring for our current financial collapse.  Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy.  Those are the things we should be focused on.

Therefore, Drum favors systemic oversight and regulation (which I agree would also be good). Besides the first article cited above, he continues the argument here.

We know already much of what the G20 will produce: a communique that looks very much like the last one (dubious reassurances about the great progress being made along vague dimensions), no progress on fiscal stimulus (as we have been projecting for some time), and promises to clamp down on regulation for hedge funds and the like (fine, but how relevant is this to either what caused the crisis or what can sustain a recovery?)

Almost all the important issues are kept off the table by anachronistic diplomatic niceties: monetary policy around the world, Europe’s impending crisis, and how to escape the overweening power of major banks in almost all industrial countries.  The G20 summit has substantially failed even before it begins. Read the rest of this entry »

Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

1. Increased power and regulatory centralization to deal with the problem of systemic risk
2. Increased protections for consumers and investors buying financial products
3. Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions
4. International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner’s discussion of systemic risk – the topic he focused on yesterday – I kept thinking it had been too long since he read Frog and Toad to his children.

Read the rest of this entry »

Once upon a time there was a president named George. He liked to do things his own way, which annoyed some of his “friends” in Europe. But then a new president named Barack was elected, who not only promised to be nicer to his friends, but was actually very popular in most parts of the world. And the people of the world thought we would see a new era of international cooperation, at least between the U.S. and Europe.

Not so much.

On this side of the Atlantic, the Obama administration and the Fed have been working night and day in an attempt to turn around the economy: Fed funds rate reduced to zero, $800 billion stimulus package, new plan to aid struggling homeowners, new plan for buying toxic assets, new budget, decision by the Fed to buy long-term Treasury bonds, new domestic regulatory framework outlined this week, etc. We’ve been plenty critical of various aspects of the U.S. response, but at least they’re trying.

(Continental) Europe, by contrast, has decided they’ve done enough and it’s time to sit back and watch.

Read the rest of this entry »

From 1945 until around 1980, the financial sector was one industry among many in the United States. Then something happened.

People in finance started making more money,* jobs in finance became more desirable, financial institutions became more influential, and the linkages between the financial sector and the political establishment became stronger. At the same time that our financial sector became more leveraged and more risky, it also became more powerful. The result was a confluence of interests between Wall Street and Washington – one more normally found behind the scenes of emerging market crises, the kind the IMF is called on to resolve.

Simon and I tell this story – and the story of what happened next – in “The Quiet Coup,” an article in the May issue of The Atlantic. (Many thanks to The Atlantic for putting the online copy up as early as they did.) The working title of the article was, “What the IMF Would Tell the United States, If It Could.” Enjoy.

* The data in that chart are from Table 6.6 of the National Income and Product Accounts tables available from the Bureau of Economic Analysis.

Update: Henry Seggerman recently sent us an article he wrote in 2007, comparing the Korean crisis of 2007 to the then-current situation in the United States. He discusses not only the economic similarities, but also some of the political ones.

Update 2: A reader sent us an article about Mark Patterson, formerly Goldman’s chief lobbyist and now Tim Geithner’s chief of staff. Unfortunately, the article was published too late for us to use any of it in our Atlantic article.

By James Kwak

Writing in the FT yesterday, Nick Stern made the case for a new international organization to monitor global risks. Drawing on a decade of dealing with governments as board members of such organizations, he is blunt – keep them out of day-to-day oversight, by giving the institution an endowment and a leader appointed for 7 years without possible recall.

Lord Stern is right to be cynical about governments in this context, but his solution feels a bit too much mid-20th century. If the organization got off the ground, governments would compete madly to appoint the leader – trying for someone over whom they have a hold (it has happened). And if the organization really were independent, who would pony up the endowment or be comfortable with the (low) implied level of democratic accountability – it’s hard to see Senate Foreign Relations or Banking (both of which have jurisdiction over the IMF) getting excited about this arrangement.  Without the US there can be no meaningful deal.

And, thinking more about 21st century formats, don’t we already have – albeit in still emergent form – exactly what Professor Stern wants? Read the rest of this entry »

My two-year-old daughter loves Frog and Toad.

There is a Frog and Toad story called “Cookies.” It is the only Frog and Toad story I remember from my childhood. Toad bakes some cookies and takes them to Frog’s house. They are very good. Frog and Toad eat many cookies, one after another. They try very hard to stop eating cookies, but as long as the cookies are in front of them, they cannot help themselves.

So Frog puts the cookies in a box. Toad points out that they can open the box. Frog ties some string around the box. Toad points out that they can cut the string. Frog gets a ladder and puts the box on a high shelf. Toad points out .  . .

Finally Frog takes down the box, cuts the string, opens the box, and gives all the cookies to the birds.

“Read more, Daddy,” my daughter says.

“One moment, I have to tell all the nice people the moral to the story.”

Read the rest of this entry »

One of the determinants of how you feel about the Geithner Plan is what you think will happen if it fails. By “fails,” I mean that the buyers’ bids are lower than the sellers’ reserve prices, so the toxic assets don’t actually get sold.

Brad Delong, for example, is moderately in favor of the plan, even though he thinks it is insufficient. In his words, “I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul [Krugman] thinks that the longer Obama delays proposing bank nationalization the lower it’s chances become.” (“Voinovich” is DeLong’s hypothetical 60th senator, whose vote would be needed in the Senate.) In other words, DeLong thinks that if this plan fails, the administration will be more likely and able to go forward with nationalization.

Paul Krugman, by contrast, is strongly against the plan, first because he thinks it has no chance of succeeding, and second because he thinks there is no Plan B. “I’m afraid that this will be the administration’s only shot — that if the first bank plan is an abject failure, it won’t have the political capital for a second.”

Read the rest of this entry »

The more aggressive the government’s responses to the economic crisis become, the more likely that they will end up in the courts. Changes in regulation can be interpreted as constraints on the ownership of property – especially by the people who own that property – and therefore such changes have occasionally ended up in the Supreme Court. The article below is by Ilya Podolyako, a third-year student at the Yale Law School and the co-chair (with me) of a reading group on law, economic policy, and the economic crisis.

As the New York Times reported today, Geithner and Bernanke were on Capitol Hill to ask for greater power to wind down non-bank financial entities like AIG. During the hearing:

[Representative Barney] Frank said the different fates of Lehman Brothers and A.I.G. illustrate the need for options beyond the “all or nothing” approach. “One was the Lehman Brothers example, where they were allowed totally to fail and there was no help to any of the creditors,” Mr. Frank said. “The other is the A.I.G. example, where there was help for all of the creditors. Neither one is what we should be doing going forward.”‘

Geithner and Bernanke largely concurred. Basically, the key actors want to be able to apply a receivership/conservatorship-type system that currently covers members of the FDIC, Savings and Loan institutions, and Fannie/Freddie to any entity whose financial activity poses a systemic risk to the economy.

James has pointed out that proponents of nationalization for Citigroup and Bank of America have essentially the same thing in mind: have the government take over an entity, preserve the rights of depositors, and sort out which liabilities deserve payment and which do not. Baseline Scenario has consistently and persuasively argued that such an approach would be prudent. Indeed, it would avoid the awkward political fallout of the type that arose when AIG disclosed that $60+ billion worth of federal aid went directly to its various derivatives counterparties. The problem is, this policy might not be constitutional.

Read the rest of this entry »