Month: October 2008

Sentiment

I’ve spent quite a bit of time over the past week talking with people caught up in the financial crisis, one way or another.  Some of these people are deeply involved in finance, while others are quite far from finance but now see many more connections that they previously realized.

Three thoughts keep reappearing in these conversations:

1) People’s expectations have definitely been shaken up.  For some it was the original Paulson proposal ($700bn to be used at his discretion), coming only days after he and Mr. Bernanke said that the economy was “fundamentally” fine – by which they meant we would dodge a recession.  For others it was President Bush’s first speech on the subject, in which he said that if Congress did not pass the relevant legislation (now called the TARP), there would be very bad consequences.  And for others it was the dramatic sequence of events last weekend, from the meeting of the G7 to the abrupt U-turn on bank recapitalization, first by the Europeans and then by the US.  In any case, pretty much everyone I’ve talked now understands that we are no longer facing “business as usual”.

2) At the same time, there is still great confusion about what is going on, precisely why, and what are the options going forward.  I think this confusion is quite general, and I regard myself as no exception.  In fact, as one of my colleagues at the Peterson Institute for International Economics wisely noted last week, “if someone says they are not confused by the current situation, they are not leveling with you.”  As a result, we start to think about changing things we do, but it is reasonable to hesitate before taking real action.  I was asked earlier this week (for a weekend show produced by Marketplace, which will air on Saturday) what I am doing differently, compared with a month or a year ago.  The answer is nothing much, at least in terms of investment or spending, at least for now.

3) And it’s the “at least for now” part that is worrying.  Obviously the “authorities” (jargon for the people who run the country) in G7 and other industrialized countries woke up to the true situation about 5 or 6 days ago, and they took what is – for them – dramatic action.  I have never seen them move so far so fast, and we have tried to recognize and applaud those moves at every opportunity.  But now we wait, holding our breath, to see the effect on confidence.  I look at the US and European stock markets, as does everyone else, and my mood swings with it.  But I also look at what is happening in credit markets, particularly in emerging markets.  This does not look encouraging.  I think it is time to work seriously on measures that will reduce the costs of and speed the recovery from what appears to be a serious imminent global recession.  This is now our priority; to help, please post your ideas as comments here.

Can We Afford the Bailout?

Even the most casual observer will have realized that the U.S. government is laying out a lot of money to combat the financial crisis. Which raises the obvious question: can we afford it?

The first important thing to keep in mind is that the U.S. government, unlike every other government in the world, has the ability to borrow virtually unlimited amounts of money. The U.S. dollar is still the world’s reserve currency, and Treasury bonds are still the risk-free asset of the global economy. In times of crisis, when smaller countries find it harder to raise money, the U.S. actually finds it easier, because investors are ditching whatever risky assets they are holding and buying U.S. Treasury bills and bonds instead. Currently, the U.S. is paying virtually no interest on short-term borrowing (and probably negative interest in real terms).

Continue reading “Can We Afford the Bailout?” →

Credit Crunch Easing?

There is some evidence that the mood in the financial sector is very cautiously optimistic. The TED Spread is down 18 basis points to 3.89%, from a high of 4.64% a week ago. (This is 3-month LIBOR minus 3-month T-bills, and hence a measure of banks’ willingness to lend to each other rather than to the U.S. government.) Still, it may take weeks for banks to have cash in the places they need it and feel comfortable loaning money again.

The highly informative and frequently updated blog Calculated Risk (link also in our sidebar) is doing a daily post on this and other credit market measures, so if you’re addicted you may want to go there.

True junkies may prefer Across the Curve, which focuses exclusively on credit markets, including some you’ve never heard of.

Which Stimulus Package?

As I mentioned yesterday, stimulating the real economy must be one of Washington’s top priorities once the credit crunch begins to ease. The debate over how to do that is well underway. The Democratic Congressional leadership is preparing a stimulus package including increasing money for states and cities to replace their plummeting tax revenues, increased or extended unemployment benefits, increased food stamp aid, and public works (infrastructure) projects. All of these steps would have the effect of increasing spending by consumers and governments with the goal of dampening the recession, although public works projects could take months if not years to have an impact. One goal of the plan is to get money to people who are likely to spend it – hence the emphasis on lower-income people and cash-strapped local governments – to get it into the economy as quickly as possible.

Both presidential candidates are also talking about stimulating the economy, although their proposals are wrapped up in their broader campaign themes almost to the point of incoherence.

Continue reading “Which Stimulus Package?” →

The Last Six Weeks, Summarized

One of our goals is to help increase understanding of the financial crisis, so that people can understand the policy choices facing our countries today. Doug Diamond and Anil Kashyap have done two guest posts on the crisis for the Freakonomics blog: one on September 18, just after the announcement of the Paulson plan, and one just yesterday. These aren’t quite explanations for beginners – they presume some understanding of debt, equity, credit default swaps, and so on – but they summarize and explain some of the key developments relatively clearly, and also lay out their opinion of the current U.S. recapitalization plan.

Where Do We Go from Here?

(Which is, of course, a song from the great Buffy episode, “Once More, with Feeling.”)

After the last week, it was a relief to have a relatively slow news day, at least compared to the preceding days, to catch our breath and take stock of things (and get over my cold). American and European policy makers decided they needed to use overwhelming force to stop the panic in its tracks. It will take some time to see if they used enough; the credit markets have certainly not opened up, although some indicators have gotten marginally better (the TED spread is slightly down; T-bill yields are slightly up).

There are two directions things could go. First, it is possible that the credit markets will not come unstuck, and even more force will be required; blanket loan guarantees (for all bank obligations) and large recapitalizations (more than 3% of assets) would then be called for. Second, and more likely, we think, credit will gradually start flowing again. But even in that case, the global economy will be far from out of the woods. Here are the top issues that will still need to be faced:

  • Implementing the Paulson plan, including both bank recapitalization and, if still included, asset purchases. This will require dealing with all of the issues of governance and pricing that we have commented on previously.
  • Containing the damage of falling housing prices and foreclosures. Asset prices do need to fall to reasonable levels – trying to prop them up at artificially high levels will only hurt the economy in the long run – but limiting an overcorrection and limiting the collateral damage have to be priorities.
  • Stimulating the real economy. Even if the credit crunch eases in, say, the next few weeks, the last month has already done significant damage to the global economy (which was already in the midst of a slowdown). For starters, just think of all the uncertainty and anxiety that have been generated in the last month, and the impact that will have on spending and investment by consumers and businesses. The fall in the stock market will also add to the negative wealth effect of falling housing prices.
  • The international dimension and emerging markets. We could be moving to a situation where core banks in wealthy countries are considered safe, while banks in emerging markets are still considered shaky. This could trigger a repeat, on a larger scale, of the emerging markets crisis of 1997-98. And severe economic dislocation can always have political consequences as well.
  • Update: How did I forget … financial sector regulation?

These are some of the major issues we will be thinking about over hte next few weeks and months (and possibly years). Let us know what else you think should be on the agenda.

The Bailout: Yes, But Will It Work?

Every week, it seems, we see a new high-water mark for government intervention in the financial sector, culminating (?) in today’s announcement that the government is buying $125 billion of preferred stock in nine banks, with another $125 billion available for others. The recapitalization, loan guarantees, and expanded deposit insurance are the most aggressive steps taken yet in the U.S. and were all on on our list of recommendations.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.

Nationalization?

See here for a range of views (including Simon’s). On balance, the government owns some shares – and it twisted some arms to get them – but the percentages are pretty low, it has no voting rights, the conditions are pretty light (basically just the limits on executive compensation), and the bottom line is that the banks got a pretty good deal relative to what they might have hoped for from private investors. Some will no doubt complain of socialism, but these investments give the government limited if any influence over bank operations.

Of course, the government still has the power of regulation, which most people expect (and hope) will be greatly strengthened.

Bank Recapitalization Arrives in the U.S.

As you have no doubt heard by now, the U.S. joined most of Western Europe in announcing a bank recapitalization plan and additional guarantees on bank obligations this morning. The key details are:

  • $250 billion of TARP money will go to the program, with about $125 billion already allotted to 8 banks (9 including Merrill) who were given take-it-or-leave-it offers yesterday.
  • The government will generally put in between 1% and 3% of assets held by a participating bank.
  • Most if not all banks will be eligible; it’s not clear what happens if the $250 billion is oversubscribed.
  • The government gets non-voting perpetual preferred shares (no conversion to common), callable after 3 years, with a 5% dividend, increasing to 9% after 5 years.
  • The government also gets warrants to buy common shares up to 15% of the preferred investment.
  • Although the shares are non-voting, participating companies have to follow Treasury guidelines on executive compensation and corporate governance.

In addition, the government announced  a blanket deposit guarantee on non-interest-bearing deposits and a 3-year guarantee of new senior debt issued by banks.

This is definitely at least two steps in the right direction. Nevertheless, some concerns to think about are:

  1. Is it enough money? 1-3% of assets isn’t much if we are worried about additional writedowns. Besides the writedowns we expect on mortgage-backed securities, a recession will increase losses on all types of loans. Fortunately I don’t see any reason why more of the $700 billion couldn’t go into this program if warranted.
  2. Couldn’t we have gotten a better deal? Buffett got a 10% dividend and more warrants at a cheaper price on his Goldman investment. However, this plan was structured to protect the interests of existing shareholders to maximize the chances that banks would participate, which may have been the right tradeoff.
  3. How do we make sure the banks behave sensibly in the future? By getting non-voting shares – as opposed to the UK plan, which will allow the government to appoint bank directors – Treasury has given up one form of control, presumably to avoid charges that the government is meddling in bank operations. This just means that regulation will be especially important.

Although the stock market is moving sideways, the credit market seems to be mildly positive: yields on 3-month T-bills are up 20 basis points (meaning that less money is fleeing to quality) and the TED spread is down 33 basis points (meaning banks are more willing to lend to each other).

US Bank Recapitalization: Waiting for Kashkari

The US stock market soared upward today, partly on the announcements by every major European country that they will be protecting their banking sectors, but largely on the expectation that the US will take similar measures – namely, bank recapitalization and loan guarantees – in the next couple of days. A fair amount of attention was drawn to the following statement by Neel Kashkari this morning:

4) Equity purchase program: We are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

However, a couple things should be pointed out. First, this was #4 out of 7 initiatives that Kashkari’s team is working on, including buying mortgage-backed securities, buying whole mortgages, insuring MBS, etc. So as I said on WNYC this afternoon (clip may not be up yet), this isn’t really new information. Second, the program is voluntary. This means that bank shareholders can take it or leave it; if they don’t like the terms the government is offering, they can choose to stay out on the thin ice and hope it doesn’t break. I’m not saying the government should be forcibly nationalizing banks, but this does raise a potential issue. Third, it is designed only for “healthy institutions,” which raises the question of who is healthy today. Perhaps the idea is to shore up a few major banks and let them buy up assets from the others – a plausible strategy – but it isn’t clear.

Luckily, word is that something will be announced tomorrow, so we won’t have long to wait. If you get any early leaks, please share.

Bank Recapitalization Monday

Those of you reading the news may be having trouble keeping all of this morning’s events straight. Here’s a quick summary:

  1. The UK announced specific plans to recapitalize three of its largest banks – RBS, HBOC, and Lloyds TSB – with up to 37 billion pounds of government money. Separately, Barclays announced plans to raise money independent of the government. This seems to be the implementation of a plan that was announced last week.
  2. Mitsubishi finally closed its deal to invest $9 billion in Morgan Stanley, gaining a 10% dividend on its shares (similar to Buffett’s investment in Goldman). This deal, which had been pending for weeks and some had given up for dead, will help boost confidence in Morgan Stanley. Note that unidentified sources have claimed that the US government promised to protect Mitsubishi’s investment; it’s not clear if that’s part of the final deal.
  3. The Federal Reserve and several of its counterparts announced an expansion in the supply of credit to banks around the world in US dollars. The Fed said it will make available as many dollars as the other participating central banks need. They will then lend the money out to their banks against whatever collateral is appropriate under their rules. This is another move to increase liquidity in the financial system; however, for several weeks now it’s been apparent that liquidity alone is not enough to solve the problem.
  4. Following yesterday’s agreement in principle, major Eurozone countries are announcing their rescue plans today, including both bank guarantees and recapitalization. Germany announced 400 billion euros to guarantee bank loans and 80 billion euros for recapitalization; France announced 320 billion for loan guarantees and 40 billion for recapitalization; Spain passed legislation providing 100 billion for loan guarantees and allowing the government to recapitalize banks by buying shares. I believe Italy is expected to make an announcement soon.

In summary, governments are taking the kind of steps that are necessary to halt the crisis. Loan guarantees and bank recapitalization are two of the steps we have been advocating. However, the jury is still out on whether they are coordinated and decisive enough. The much-followed TED spread (a measure of banks’ willingness to lend to each other) is only down by 7 basis points, although that may in part be due to the fact that the bond market is closed in the US today due to a holiday. All eyes are now on Washington, where a more definitive bank recapitalization plan is widely expected. Neel Kashkari, Paulson’s point man on the crisis, said today only that “We are designing a standardized program to purchase equity in a broad array of financial institutions.” (He said a lot of other things on a broad range of other topics.) Finally, this burst of support for wealthy countries’ banks could have unintended effects on emerging markets, as we discussed previously.

Update: Austria, the Netherlands, and Italy are also on board.

Baseline Scenario, 10/13/08 – Analysis

Baseline Scenario: Analysis, October 13, 2008
By Peter Boone and Simon Johnson, copyright

Published weekly, The Baseline Scenario is divided into two parts: analysis (this post) and policy (a separate post).  In the analysis section, we first explain how we have updated (or not) our views, based on the major developments of last week.  Then, we state our overall view of how the global economy got into its current situation and where this is likely heading. Readers who remember what we said last week can just look at the updates and then go to policy).  The policy section reports our current view on policies in the US and elsewhere.

Please note that we do not currently publish our upside and downside risk scenarios in detail.

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Updates

Europe recapitalizes

The most important recent development is the – at least partial – shift in European government attitudes during the past few days.  Over the weekend Europe announced a bank recapitalization program, along national lines.  As we prepare to publish, key details remain vague, but it appears they are trying to provide guarantees only at the margin (for new debt, etc).  Presumably this is because the total balance sheets involved are too large for the governments to take on blanket guarantees.

Continue reading “Baseline Scenario, 10/13/08 – Analysis” →