Search Results
Written Testimony Submitted To The Congressional Oversight Panel
Testimony submitted to the Congressional Oversight Panel, hearing on “The overall impact of the Troubled Asset Relief Program (TARP) on the health of the financial system and the general U.S. economy,” Thursday, November 19, 2009. (pdf version)
Submitted by Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; Senior Fellow, Peterson Institute for International Economics; and co-founder of http://BaselineScenario.com.
Summary
1) In the immediate policy response to any major financial crisis – involving a generalized loss of confidence in major lending institutions – there are three main goals:
- To stabilize the core banking system,
- To prevent the overall level of spending from collapsing,
- To lay the groundwork for a sustainable recovery.
2) IMF programs are routinely designed with these criteria in mind and are evaluated on the basis of: the depth of the recession and speed of the recovery, relative to the initial shock; the side-effects of the macroeconomic policy response, including inflation; and whether the underlying problems that created the vulnerability to panic, are addressed over a 12-24 month horizon.
3) This same analytical framework can be applied to the United States since the inception of the Troubled Asset Relief Program (TARP). While there were unique features to the US experience (as is the case in all countries), the broad pattern of financial and economic collapse, followed by a struggle to recover, is quite familiar.
Just Baffling
PPIP finally launches, Mike Konczal lays bare the subsidy, everyone just move along … hey, wait a second!
From the Times article: “[FDIC] officials announced that they had reached a deal to sell $1.3 billion in mortgages from Franklin Bank, a Houston-based lender that failed last November and was taken over by the F.D.I.C.”
Larry Summers on Preventing and Fighting Financial Crises
This fall I am taking a course on the “international financial crisis” taught by Jon Macey and Greg Fleming (yes, the former COO of Merrill Lynch). The first assigned reading is a speech that Larry Summers gave at the AEA in 2000 entitled “International Financial Crises: Causes, Prevention, and Cures,”* summarizing the state of the art in preventing and combating financial crises. It’s based on experiences from emerging market crises in the 1990s, and doesn’t even contain a hint that something similar might happen here; however, few people could fault Summers for making that oversight back in 2000, and I certainly won’t.
Many people, including Simon and me, have discussed the similarities between our recent financial crisis and the emerging market crises of the 1990s, so I’ll be brief. The main similarities are excessive optimism that creates an asset price bubble, a sudden collapse of confidence that causes the rapid withdrawal of money and credit, a liquidity crunch, and rapid de-leveraging that threatens solvency. (We have also argued that there are political similarities, but let’s leave that aside for now.) The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries, making things easier for us than for, say, Thailand. Also, to a partial extent, the parallel requires an analogy between emerging market countries and United States banks; for example, the issue of bailouts and moral hazard arises in the context of the IMF bailing out Indonesia and in the context of the United States government bailing out Citigroup.
Summers’s speech makes a lot of sense, so I’ll just highlight a few points he makes that I think are particularly instructive given our recent experience. I think these are all excellent points. For each one, I’ll quote from Summers, and then comment on its relevance to our situation.
Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products
In mid-March, the administration proposed that toxic assets could and would be safely removed from banks balance sheets. We were skeptical, and the the PPIP now seems to have slipped into irrelevance (loans; securities). But the administration still put an impressive effort into persuading independent analysts, and broader public opinion, that they should do something clearly beneficial for banks. This was “all hands on deck,” and it definitely had an impact on the debate, at least for a while.
Now, the administration’s major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public. And the skepticism – and outright opposition – comes from the banking sector.
How does the administration’s effort compare, then vs. now? Read the rest of this entry »
The Two Sides of the Balance Sheet
Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”
This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)
Brazen Tunneling and Inflation
In most societies it is traditional to be somewhat sneaky in squeezing your shareholders or the government. You might set up a complicated transfer pricing scheme or perhaps you arrange for a family-owned firm to acquire assets on the cheap from the publicly traded corporation that you control. Or you could always arrange for the Kremlin to provide foreign exchange at a “special” price.
In the New United States, life is much simpler and bank tunneling considerably more brazen. Read the rest of this entry »
Banks Want Government Subsidies to Buy Assets from Themselves
From the headlines of the Wall Street Journal: “Banks Aiming to Play Both Sides of Coin — Industry Lobbies FDIC to Let Some Buy Toxic Assets With Taypayer Aid From Own Loan Books (subscription required, but Calculated Risk has an excerpt). I thought the headline had to be a mistake until I read the article.
To recap: The Public-Private Investment Program provides subsidies to private investors to encourage them to buy legacy loans from banks. The goal is to encourage buyers to bid more than they are currently willing to pay, and hopefully close the gap with the prices at which the banks are willing to sell.
Allowing banks to buy their own assets under the PPIP is a terrible idea. In short, it allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank. I’ll take this in steps.
Stress Tests and The Nationalization We Got
The post was co-authored by Simon Johnson and James Kwak.
When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.
What happened?
Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (“Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.
The Importance of Battlefield Nuclear Weapons
I’ve been writing a lot about the game of chicken recently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.
The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it’s a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury’s fear of a bankruptcy to extract better terms at the last minute. (And it’s even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.
But there’s a much bigger, slower game going on at the same time, and the administration’s basic problem is the same: all it has is strategic nuclear weapons that it absolutely does not want to use. The New York Times had an article today about how “a growing number of banks are resisting the Obama administration’s proposals for fixing the financial system.” It didn’t have a lot of new information, but it summarized the outlines of the game.
Baseline Scenario, April 7, 2009
Baseline Scenario for 4/7/2009 (9am): Post-G20 Edition
Peter Boone, Simon Johnson, and James Kwak, copyright of the authors.
This long-overdue (and hopefully widely-awaited) version of our Baseline Scenario focuses largely on the United States, both because of the volume of activity in the U.S. in the last two months, and also because the U.S. will almost certainly have to be at the forefront of any global economic recovery, especially given the wait-and-see attitude prevalent in Europe.
Global Economic Outlook
The global economy remains weak across the board, with no significant signs of improvement since our last baseline. The one positive sign is that some forecasters are beginning to recognize that growth in 2010 is not a foregone conclusion. The OECD, for example, now forecasts contraction of 4.3% in 2009 for the OECD area as a whole – and 0.1% contraction in 2010. This is broadly with our previous ”L-shaped” recovery view.
Even that forecast, however, expects quarter-over-quarter growth rates to be positive beginning in Q1 2010. (This is not a contradiction: if growth is sharply negative in early 2009, then quarterly rates can be positive throughout 2010, without total output for 2010 reaching average 2009 levels.) While most forecasters expect positive growth in most parts of the world in 2010, those forecasts seem to reflect expected reversion to the mean rather than any identified mechanism for economic recovery. The underlying assumption is that at some point economic weakness becomes its own cure, as falling prices finally prompt consumers to consume and businesses to invest. But given the unprecedented nature of the current situation, it seems by no means certain that that assumption will hold. In particular, with demand low around the globe, the typical mechanism by which an isolated country in recession can recover – exports – cannot work for everyone.
Guest Post: Obama’s Plan for the Auto Industry
My Yale Law School colleague Ilya Podolyako comments on the Obama administration’s plan for the auto industry and the tension between public goals – preserving jobs, increasing fuel efficiency, etc. – and private goals – profitability.
By now, the dust seems to have settled around Obama’s rescue plan for two-thirds of the long-ago “Big 3″ (in 2007, Chrysler ranked 12th in the world in total auto sales; GM has ranked 2nd; Ford, which is not receiving government assistance, was 4th). The policy itself seems prudent enough. The President’s Task Force on the Auto Industry recognized that due to its small scale, reliance on light trucks, and objectively low product quality, Chrysler is not viable as a stand-alone company. On the other hand, General Motors has large economies of scale and makes certain well-received products (the report mentions the Chevy Malibu and Cadillac CTS by name, though one could add the Cavalier, Corvette, and Escalade to those lists), but faces exorbitant legacy costs for its nearly one million retirees and low margins on its fuel-efficient vehicles. Given this fact pattern, the plan does as good of a job as anyone could in offering a helping hand to iconic American manufacturers while preserving some incentives for efficient private-sector operation.
My problem with the restructuring proposal comes not from any one of its details, nor even its general spirit. At this point, I feel fairly neutral about heavy-handed government involvement in US industrial policy. Admittedly, I am from Michigan and really like cars (despite consistent problems, I keep driving Fords, though I am not sure why), so I have some emotional connection to the industry to balance against the gross, obvious inefficiency of pouring money into enterprises that, by their own admission, will at best break even by 2014. I also do believe that a GM bankruptcy would lead to the net loss of a significant number of jobs that would permanently cripple Michigan’s already desperate economy.
The Mark-to-Market Myth
Today the Financial Accounting Standards Board voted – by one vote – to relax accounting standards for certain types of securities, giving banks greater discretion in determining what price to carry them at on their balance sheets. The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets.
This makes no sense, for three reasons.
1. Investors and regulators are not idiots. They know what the accounting rules are. If banks claim they were forced to mark their assets down to “fire-sale” prices, investors can look at the facts themselves and apply any upward corrections they want. Now that banks will be able to mark their assets up to prices based solely on their own models, investors will the downward corrections they want. It’s a little like what happened when companies were forced to account for stock option compensation as expenses; nothing happened to stock prices, because anyone who wanted to could already read the footnotes and do the calculations himself.
Gaming the Legacy Loan Auctions
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.
