The Baseline Scenario

In an interview that will air Sunday on ABC, Treasury Secretary Tim Geithner says, “”We have much, much lower risk of [a double-dip recession] today than at any time over the last 12 months or so … We are in an economy that was growing at the rate of almost 6 percent of GDP in the fourth quarter of last year.  The most rapid rate in six years.  So we are beginning the process of healing.”

The timing of this statement is remarkable because, while the US is finally showing some signs of recovery, the global economy is bracing for another major shock – this time coming from the European Union.

The mounting debt and deficit problems in Greece might seem relatively small and faraway to the US Treasury – concerned as it is with China’s exchange rate and the ritual of G7 meetings, and likely distracted by the major snow storm now hitting Washington DC.

But the problems now spreading from Greece to Spain, Portugal, Ireland and even Italy portend serious trouble ahead for the US in the second half of this year – particularly because our banks remain in such weak shape. Read the rest of this entry »

I’m curious to know how banks’ 2009 final results compare to the projections in the stress tests. My suspicion is that JPMorgan and Goldman did better than projected, but Citi may have done worse. Ideally you would compare both the new loan losses recognized over the year and the profits from current operations. But there are a couple of problems with doing this. One is that the stress test results were for 2009-2010 combined, without the separate years split out. The other problem is that it’s not immediately obvious how to map the line items from the stress test results to the line items on a bank’s income statement (or to changes on its balance sheet). I might be able to figure it out with a lot of study, but I might not.

Does anyone know of someone who has already done an analysis along these lines? Or does anyone know how to do the mapping correctly?

By James Kwak

The big banks are pre-testing their main messages for bonus season, which starts in earnest next week.  Their payouts relative to profits will be “record lows”, their people won’t make as much as in 2007 (except for Goldman), and they will pay a higher proportion of the bonus in stock than usual.  Behind the scenes, leading executives are still arguing out the details of the optics.

As they justify their pay packages, the bankers open up a broader relevant question: How much bonus do they deserve in this situation?  After all, bonus time is when you decide who made what kind of relative contribution to your bottom line – and you are able to recognize unusually strong achievement. 

Seen in these terms, the answer is easy: people working at our largest banks – say over $100 bn in total assets – should get zero bonus for 2009. Read the rest of this entry »

Ben Bernanke is Person of the Year. Matt Yglesias has criticism, although he does say it was an appropriate choice. Now, the Time award is meant to recognize newsworthiness, not necessarily exceptional conduct, and it’s hard to deny that Bernanke has been newsworthy. But I think that 2008 was Bernanke’s year, not 2009–that was the year of the real battle to prevent the collapse of the financial system. As far as the crisis is concerned, I would say the face of 2009 has been Tim Geithner–PPIP, stress tests (largely conducted by the Fed, but Geithner was the front man), Saturday Night Live, regulatory “reform,” and so on. But I can see why Time didn’t want to go there. Besides, I’m not sure that the financial crisis was the story of 2009; what about the recession? They’re related, obviously, but they’re not the same thing.

But in real news, Simon was named Public Intellectual of the Year by Prospect Magazine (UK). (This year they seem to have restricted themselves to financial crisis figures; David Petraeus won in 2008.) Over Ben Bernanke, among others. (Conversely, Simon didn’t make Time’s list of “25 people who mattered”–but Jon and Kate Gosselin did, so that’s no surprise.) The article says that Simon “has also done more than any academic to popularise his case: writing articles, a must-read blog, and appearing tirelessly on television,” which sounds about right to me.

Prospect got one thing wrong, though. The article has a cartoon of Simon holding a sledgehammer and towering over a Citigroup in ruins. But no matter how many times you keep taking whacks at Citigroup, it refuses to die. One hundred years from now, maybe people will still be saying there are two common ingredients in all U.S. financial crisis: excess borrowing … and Citibank.

Update: I should have made clear that I prefer my award.

By James Kwak

On Monday, Citigroup received permission from its regulators to buy back the remaining $20 billion in preferred shares held by Treasury because of its investments under TARP. (Treasury invested $25 billion in October 2008 and another $20 billion November 2008; however, $25 billion worth of preferred shares were converted into common shares earlier this year, giving the government about a 34% ownership stake in the bank.) The stock then fell by 6%. What’s going on?

This is another example of a bank doing something stupid in order to say that it is no longer receiving TARP money, and probably more importantly so it can escape executive compensation restrictions. As Citigroup CEO Vikram Pandit himself said last October, TARP capital is really cheap (quoted in David Wessel, In Fed We Trust). Instead of paying an 8% interest rate* on $20 billion in preferred shares, Citigroup chose to issue $17 billion of new common shares while its share price is below $4/share. Citigroup’s cost of equity is certainly more than 8%, so it just increased its overall cost of capital. The stock price fell because existing shareholders are guessing that the dilution they suffered (because new shares were issued) will more than compensate for the fact that Citi no longer has to pay dividends to Treasury.

Read the rest of this entry »

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:

1. To stabilize the core banking system,
2. To prevent the overall level of spending from collapsing,
3. 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.

Read the rest of this entry »

This morning, starting at 9:30am, the Congressional Oversight Panel holds a hearing to assess the performance of the Troubled Asset Relief Program (TARP).  The hearing will be streamed live and also archived, featuring testimony from: Dean Baker (Center for Economic and Policy Research), Charles Calomiris (Columbia University), Alex Pollock (American Enterprise Institute), Mark Zandi (Moody’s Economy.com), and me.

In late September 2008, Secretary of the Treasury Henry S. Paulson asked Congress for $700 billion to buy toxic assets from banks, as well as unconditional authority and freedom from judicial review. Many economists and commentators suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands – indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that approach was shelved. Read the rest of this entry »

Yesterday morning I testified to a Joint Economic Committee of Congress hearing (update: that link may be fragile; here’s the JEC general page).  The session discussed the latest GDP numbers, the impact of the fiscal stimulus earlier this year, and whether we need further fiscal expansion of any kind.

I argued that a global recovery is underway and in the rest of the world will likely be stronger than the current official or private consensus forecast, but growth remains fragile in the United States because of problems in our financial sector.  While our situation today is quite different in key regards from that of Japan in the 1990s, the Japanese experience strongly suggests that fiscal stimulus is not an effective substitute for confronting financial sector problems head on (e.g., lack of capital, distorted incentives, skewed power structure). 

We are well into the adjustment process needed to bring us back to living within our means. Although such a process always involves an initial fall in real incomes, growth can resume quickly as the real exchange depreciates.  The idea that we necessarily are in a “new  normal” scenario with lower productivity growth seems far fetched, but continuing failure to deal effectively with the “too big to fail” banking syndrome delays and distorts our adjustment process – it also makes us horribly vulnerable to further collapses.

The fiscal stimulus enacted in early 2009 had a major positive impact, particularly as it was coordinated with other industrial countries – this prevented the global recession from being even deeper (disclosure: I testified to the need for a major fiscal stimulus in October 2008).  But a further broad stimulus at this time is not warranted and the first-time homebuyers tax credit should be phased out.  We should extend unemployment insurance and focus our future efforts on improving the skills of people with less education, e.g., through strengthening community colleges. 

Like all industrialized countries, we also need to look ahead to “fiscal consolidation” in order to stabilize our debt-GDP levels (and pay for the rising cost of Medicare).  The large contingent government liabilities implied by the existence – and potential collapse – of big banks are a major risk to medium-term outcomes.

My written testimony (with some small updates indicated) is below (pdf version).  This is now our revised Baseline Scenario. Read the rest of this entry »

Surprise, surprise — GMAC needs more money. As you may recall, GMAC was the one institution that got a C- on the stress tests this spring that were impossible to fail. I imagine the analysts at the Fed really wanted to give it an F, but they couldn’t. In any case, it seems that GMAC is too big to fail, because of its importance to the auto industry. Yves Smith says, “The reason for more dough to GMAC is so GM and Chrysler can continue to finance auto purchases, not as a result of greater than expected losses on its existing portfolio. So this is cash for clunkers under another brand name.”

Again, not surprisingly, the government is treating the 50% ownership threshold as some sort of magic line. From the Times article:

“With all three helpings of federal aid, it is possible that the government could wind up owning at least half of the company. But GMAC and Treasury officials are discussing ways to structure the investment in a way that could limit the government’s ownership interests. One possible option would be to also ask some of its private preferred stockholders to convert their investments into common stock.”

Read the rest of this entry »

Economic and financial models have come in for a lot of criticism in the context of the global financial crisis, much of it deserved. One of the primary targets is models that financial institutions widely used to (mis)estimate risk, such as Value-at-Risk (VaR) models for measuring risk exposures (which we’ve discussed elsewhere) or the Gaussian copula function for quantifying the risk of a pool of assets.

In September, the Subcommittee on Oversight and Investigations of the House Science and Technology Committee held a hearing on the role of risk models in the financial crisis and how they should be used by financial regulators, if at all. The hearing focused largely on VaR models, which attempt to quantify the amount that a trader (or an entire bank) stands to lose on a given day, with a certain confidence level. (For example, a one-day 1% VaR of $10 million means that on 99% of days you will lose less than $10 million.) Read the rest of this entry »

CIT Group is apparently in trouble and now negotiating with Treasury, the Fed, and the FDIC for some sort of “bailout”, e.g., in the form of a guarantee for its debt.

Traditionally, CIT provided vanilla loans to small and medium-sized business. “But under its current chief executive, Jeffrey M. Peek, a well-liked Wall Street veteran who lost out several years ago in a race to run Merrill Lynch, CIT made an ill-timed expansion into sub-prime mortgage and student lending” (NYT today).

What happens to CIT will help define exactly where we are with regard to “too big to fail.”  Read the rest of this entry »

The commercial real estate industry would like a bailout – see my preview/links to testimony before the JEC today.  This is not a surprise – even some of the most libertarian people I meet think the government should help them personally when times are bad.  Is there a case treating commercial real estate as special?

The sector is definitely taking a beating, but who is not?  This lobby’s most sophisticated advocates are arguing that various Fed facilities can be extended to support commercial real estate financing, i.e., so there is no cost to the government’s budget or your future taxes.

This is illusory. Read the rest of this entry »

It’s getting somewhat lonelier being a large financial institution skeptic, although there still a lot of us left. I would say that among the skeptics, the general view is that we may have seen an end to bank panics for this cycle – I’m not sure anyone is saying there will definitely be another crisis in the near future – but we may not have, and we may come to regret not taking stronger measures now. (How’s that for prognostication?)

Lucian Bebchuk, in Project Syndicate (a well-intentioned collaboration that manages to sound ominous and conspiratorial), makes the argument in clear terms. First, the recent stress tests only projected losses through 2010, ignoring the large number of loans and mortgage- and asset-backed securities that mature in later years. More fundamentally, though: “Rather than estimate the economic value of banks’ assets – what the assets would fetch in a well-functioning market – and the extent to which they exceed liabilities, the stress tests merely sought to verify that the banks’ accounting losses over the next two years will not exhaust their capital as recorded in their books.” Put another way, the focus has been on the accounting value of assets, not their economic value; so for a given asset, as long as it doesn’t have to be written down before the end of 2010, there is no problem.

Bebchuk also points out that the ability of banks to raise equity capital should not be taken as an “all clear” sign. As he and others have previously argued, equity in large banks by its very nature represents a leveraged bet whose downside risk is limited by the implicit government guarantee. That is, as a shareholder, if the economy does OK and bank assets appreciate in value, you get all of the upside (leveraged by the bank’s liabilities); if the economy does terribly and bank assets fall in value, your losses are not only limited to the amount of your investment, they are further limited by the implicit guarantee that the government will not wipe you out. That guarantee is weaker than the implicit guarantee on bank liabilities, but it is still there; given the way the government has treated Citigroup, Bank of America, and GMAC, betting on the “no more Lehmans” policy seems like a sensible bet.

Most attention is now focused on the battle over financial regulation (if it isn’t on health care and energy), which is appropriate. But it may be premature to declare victory over the financial crisis.

By James Kwak

Slides for speech to World Bank conference (Lessons from East Asia and the Global Financial Crisis), Tuesday in Seoul (1pm local time), are attached.  This post summarizes my main points.

There are two views of the global financial crisis and – more importantly – of what comes next.  The first is shared by almost all officials and underpins government thinking in the United States, the remainder of the G7, Western Europe, and beyond.  The second is quite unofficial – no government official has yet been found anywhere near this position.  Yet versions of this unofficial view have a great deal of support and may even be gaining traction over time as events unfold. Read the rest of this entry »

What is the essence of the problem with our financial system – what brought us into deep crisis, what scared us most in September/October of last year, and what was the toughest problem in the early days of the Obama administration?

The issue was definitely not that banks and nonbanks could fail in general.  We’re good at handling some kinds of financial failure.  The problem was: a relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy.  And – at least in the view of Treasury – these banks were so large that they couldn’t be taken over in a normal FDIC-type receivership.  (The notion that the government lacked legal authority to act is smokescreen; please tell me which statute authorized the removal of Rick Waggoner from GM.) 

But instead of defining this core problem, explaining its origins, emphasizing the dangers, and addressing it directly, what do we get in yesterday’s 101 pages of regulatory reform proposals? Read the rest of this entry »