Month: October 2008

Baseline Scenario, 10/13/08 – Policy

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

(For an explanation of the baseline scenario and our analysis, go here.)

The U.S.

The key weapon that the United States possesses is that the U.S. balance sheet is credible.  The U.S. is not going to lose its AAA rating.  The U.S. balance sheet cannot save everyone in the world, but if necessary it can be used to draw a line in the sand and restore confidence.

Today, according to the spreads on credit default swaps – which measure the expected probability of default – investors believe a handful of large and medium-sized banks are safe.  However, these safe names may appear at risk in the future. The government needs to have a plan to protect today’s safe banks from self-fulfilling credit panics if necessary.

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

Next Up: Emerging Markets

In Washington this weekend, there seems to be remarkably little realization of the difficulties already facing emerging markets.  Even if things start to go much better in and for the G7 in the next 48 hours, you cannot easily get back to the situation before Iceland’s banks failed and effectively Iceland was left to its own devices.  And, of course, it is impossible to return to where we were before the series of unfortunate events surrounding Lehman and AIG.

But what exactly does this imply for various kinds of emerging markets?  Countries with clear pre-existing vulnerabilities were already in trouble last week, those with any kind of small cracks in their economic armour are now being tested, and even the apparently invulnerable may come under pressure.  According to our analysis, now published in Forbes.com, this will be a stress test like no other.

When’s the Make-Up Test? Tomorrow.

Saturday, October 11, 10pm.

The world’s finance ministers sat for several tests this weekend, and it’s not yet clear how they did.  If we set the bar low enough (i.e., no public criticism of each other), they did OK.  The Italian finance minister did threaten not to sign the communique on Friday afternoon, but this was not particularly meaningful (think about it: if Italy walked out of the G7, how would the markets view Italian risks on Monday morning?)  Everyone else was reasonably polite.

But if we were hoping for specific steps to be announced, then Friday’s list of principles from the G7, and the ensuing vague statements of support from other sets of finance ministers on Saturday have really not taken us very far.

Still, there is time for a make-up test (or two) on Sunday.  The US Treasury is undoubtedly working on some detailed measures to shore up parts or, hopefully, all of the banking system.  Eurozone member countries will be meeting in France on Sunday afternoon, presumably to see how far along they can bring the Germans – particularly with regard to systematic bank recapitalization.  It remains unclear whether anyone in the eurozone will suport the British ideas of blanket bank guarantees at this point.  And it is far from clear if the British will introduce the kind of overall package that in our view could turn the corner, even in a local sense.

The goal, as you know, is to get a clear strategy in place and well communicated by the time the stock market in Tokyo opens at 8pm (US East Coast time) on Sunday.  Let’s see how they do.

The Financial Crisis: What Can You Do?

On Wednesday, one of our readers posted the following comment: “This website offers hope.  Is there a way readers can help the cause?”

I’ve been thinking about that ever since, and I don’t have a good answer. The key decisions are being made by the central bankers and ministers of finance (we call ours the Secretary of the Treasury) of about ten countries, and most of the decisions they make are at their own discretion.

Continue reading “The Financial Crisis: What Can You Do?” →

Paulson Sends Fannie and Freddie to the Rescue

Many readers will see that as an ironic title, but I don’t mean it that way. Federal regulators have directed Fannie Mae and Freddie Mac to buy $40 billion per month in troubled mortgage-backed securities – the same ones targeted by the $700 billion bailout bill. As with the Paulson plan, price is still a question mark – too low and it does no good, too high and it will create losses for Fannie and Freddie – but we see this as a positive step. Fannie and Freddie were effectively nationalized, so we can think of them as part of the Treasury department at this point. One major question about the Paulson plan is whether $700 billion is enough to have a major impact on the market. Using Fannie and Freddie to increase the overall size of the program does increase taxpayers’ potential exposure, but it also increases the chances of having a meaningful effect on confidence in the financial sector. Buying assets this way may be especially important now that it seems much of the original $700 billion will go to direct bank recapitalization – which, we think, is a better use of that money.

While this is a step in the right direction, it still smacks of the incrementalism that has dogged the government’s response to this crisis. We may have reached the point where only a general guarantee of bank obligations will do the trick.

Let us know if you see other tools that Treasury picks up to attack the problem.

Zimbabwe and the Financial Crisis

Or, yet another reason why the financial crisis matters …

In Zimbabwe, site of some of the deepest suffering in the world today, Robert Mugabe reneged on a power-sharing deal with Morgan Tsvangirai and the opposition party. Sure, he might have done it anyway, but it’s a lot easier when the world’s attention is elsewhere and every major power has other things to worry about. We rarely comment on non-economic issues, but in hard times, you can watch for more and more behavior like this.

Please comment if you’ve seen other cases of politicians using the crisis as cover for things they might not try otherwise.

Global Crisis: Latest Analysis and Proposals

Our latest analysis and proposals have been published by the Washington Post (print edition Sunday) in an article by Peter and Simon entitled “The Next World War? It Could Be Financial.” If the world’s leading financial powers cannot agree on a coordinated response, it could be “every nation for itself” – a repeat, on a larger scale, of the emerging markets crisis of 1997-98.  We propose six concrete steps that policy makers – beginning with the G7 and IMF meetings this weekend – can take to limit the risks of such an outcome.

Feel free to comment with criticisms or suggestions.

G7/IMF: What’s Going On

As we’ve discussed previously, this weekend’s meetings of the G7 and the IMF are crucial to halting the financial crisis. This weekend, we’ll be updating you on events as they happen.

Update (Friday evening): The G7 statement is pretty much a general set of principles with which it would be hard to disagree, with very little by way of specifics and really nothing that we hadn’t seen before.  Mr. Paulson’s statement today was similarly vague, although Treasury continues to signal that it will launch some sort of recapitalization program.  I know they want to exude calm and confidence, but the sense of urgency that had building in the last couple of days seems to be slipping away from them.

Update (Saturday morning): Reaction from around the world is mostly disbelief.  Could it really be the case that the G7 does not understand that trade credit is under pressure everywhere, that financing for new projects is drying up, and that Iceland’s experience sends a dangerous signal to investors?  Our piece in the Washington Post Outlook section lays out the very real dangers.  Unless the G7, separately and jointly, act more decisively by the end of Sunday (yes, tomorrow), I’m afraid that next week could be quite difficult.

Update (Sunday morning): Reliable sources indicate that the eurozone member countries, who are due to meet today at the invitation of President Sarkozy, may well be able to announce agreement on some sort of parallel bank recapitalization scheme(s).  It is also hard to imagine that the US will let the day go by without a major announcement.  But it will take a great deal of detail in order to be credible at this point.  And the question of who is and is not given a place on the Great Ark for Bankers will be much on our minds.

G1 vs. G7 vs. G20?

We already know that at least some people in major European countries (Peer Steinbrueck, this means you) are mad at the U.S. for “causing” the global financial crisis. But while many of the rest of the G7 are at least complicit – European banks were buying large piles of the same mortgage-backed securities that set of the crisis in the U.S. – many of the world’s less-developed countries may be even madder at the U.S. Henry Paulson has called a meeting of the G-20, which includes some of the larger economies outside the G-7, for this weekend. The hope is that it will help dampen strife between rich and less rich countries, all of whom are being affected by the crisis.

Henry Paulson, Meet Warren Buffett

Bank recapitalization is in the air, which tends to prompt at least two responses: (a) what’s bank recapitalization? or (b) this is socialism!

Bank recapitalization is when an external entity buys new equity shares (stock, as opposed to bonds) in a bank in exchange for cash. The effect is to boost the bank’s assets without increasing its liabilities; since one worry about the banking sector is that it does not have enough capital (that is, it may not have enough assets to balance its liabilities), this is a good thing. (If the bit about capital, assets, and liabilities is confusing, see Financial Crisis for Beginners.) Of course, there’s no such thing as a free lunch, and in this case the bank’s existing shareholders get diluted, because they don’t own as much of the bank as before. But, in general, it’s better to own part of a bank that exists than a larger part of a bank that no longer exists.

Bank recapitalization could be as simple as this: the government (meaning the taxpayer) gets the same kind of deal that Warren Buffett got when he invested in Goldman two weeks ago. In that deal, Buffett paid $5 billion for preferred stock at $123 per share. The preferred stock pays a 10% dividend, meaning that Buffett gets $500 million per year from Goldman’s cash flow. He also got warrants that give him the right to buy up to $5 billion worth of common stock at $115 per share. At the time the deal was announced, Goldman common stock was trading at $125. Even though Goldman closed at $101 yesterday (and has fallen so far today), Buffett is still getting a 10% yield from the $500 million dividend, and if Goldman goes up he stands to make a lot of money from the warrants.

Continue reading “Henry Paulson, Meet Warren Buffett” →

A Viewer’s Guide for the G7 (Crisis) Meeting Today

For the reasons I laid out last weekend, the G7 meeting of finance ministers today could be pivotal.  The G7 and their close allies are the epicenter of the global crisis, and they most definitely have the financial resources and combined brainpower needed to turn things around, starting with bold, decisive action today.

They cannot do it with a Business-as-Usual approach, and there are already signs that some of them (US, UK) are inching in a more dramatic and even coordinated direction.  It would be unreasonable to expect them to make one gigantic leap today to a complete solution.  Even if major players now think this is the only sensible way to go, such a sudden move would be inconsistent with how G7 governments operate internally or interact with each other.  Nevertheless, there will be unmistakable signs today, in their communique and related communications, regarding how long we will have to wait for decisive action.

Here are three things to look for:

1. The extent of recriminations.  These are obviously unproductive at this stage.  If the German finance minister (Peer Steinbrueck) can refrain from saying negative things about the United States, that would be encouraging.

2. Statement of the problem.  Jointly and separately the language used to describe the severity of the situation is important.  In the Business-as-Usual approach, officials hate to use negative language about the direction of the economy, for fear it would be self-fulfilling.

3. Detail on next steps.  Ideally, there will be a road map, with a timetable on when different countries will adopt various kinds of measures.  If all they can agree on is a vacuous statement of principles, we are in trouble.

Update (by James): PRI’s The World led off Friday’s show with a discussion of the G7 and IMF meetings, including an interview with Simon.

Mortgage Restructuring at Countrywide

We and other commentators have been saying that in addition to shoring up banks, there needs to be something for the homeowners at the bottom of the food chain. This will need to be a priority for Congress when it convenes in November (as it absolutely must, at this point) and for the next president. However, today, there may have been a small step in the right direction. Bank of America (which bought Countrywide) announced a “homeownership retention program” for customers of Countrywide, which was one of the most aggressive subprime lenders during the housing bubble.

The agreement, which was negotiated with several state attorneys general (who have been investigating Countrywide’s allegedly predatory lending practices), includes several provisions that offer hope to struggling homeowners:

  • Restructuring of first-year payments to target 34% of household income
  • Interest rate reductions
  • Principal reductions for some types of loans
  • Waivers for some loan modification and prepayment fees
  • Partial moratorium on foreclosure proceedings for borrowers who may be eligible for the program
  • $220 million in assistance for homeowners facing foreclosure

The program is supposed to go into effect on December 1. In total, it is expected to provide $8.4 billion in payment relief to homeowners. Of course, a lot will depend on how it is implemented, but at least this time (as opposed to the largely ineffectual HOPE program announced a while ago) there will be a set of attorneys general monitoring the program.

One major potential stumbling block is that “some loan modifications … will require investor approval” – meaning that if a mortgage has been securitized, all of the people who own bits and pieces of that mortgage may have to approve any modifications. This is why systematic government intervention is necessary to force people – if necessary and legal – to participate in loan modifications that do benefit all parties (investors get more than they would get in case of foreclosure; homeowners get to stay in their houses, perhaps just as renters; communities are not devastated by foreclosures). But while waiting for that to happen, this can’t hurt. Most importantly, it shows the recognition (under pressure, of course) by a major player that it is not going to get all of its money out of its borrowers, and that it is better off trying to find a win-win solution.

Paulson’s Bank Recapitalization Plan

The big news today is that Henry Paulson claims to have found, in the $700 billion TARP package passed last Friday, the power to invest some of that money directly in banks to shore up their capital. As one of the people who actually read the bill (OK, I skimmed most of it), I was puzzled by this, because my reading (like everyone else’s) was that Treasury would only be allowed to take equity stakes in companies who participated in the sale of troubled assets to Congress. However, if you look at the comments by Congressmen in the Time article and on Calculated Risk, you’ll see that there are statements in the Congressional record saying that the intent of the bill is to allow direct equity purchases. A curious fact that you learn in law school is that, in interpreting a bill, it is not just the words of the bill that matter; the record of committee and floor discussions can also be used in interpreting a bill. So it seems like, in this case, Congress consciously inserted language into the discussion in order to give Treasury this power, or Treasury is seizing on some passages in the discussion to claim that power.

At this point this is unlikely to generate too much controversy, because most people involved, including the authors of this blog, think it would be a good thing for Treasury to take some of the $700 billion and invest it directly in recapitalizing banks (which is what the UK is doing). Of course there will be issues of detail to be worked out, and the Treasury Secretary has an awful lot of discretion in this matter, but this is definitely a step forward.

Oh, and I should mention: Planet Money broke this story first.

More Economists for Coordinated Recapitalization and Debt Guarantees

The Center for Economic and Policy Research has rushed out, and I mean that in the best sense of the term, a survey of economists’ recommendations for the world’s economic policymakers and, specifically, for the meeting of G7 finance ministers this week. The economists who contributed to the 40-page report (once there, click on the title to download the PDF), while presenting a range of views, generally agree on the need to recapitalize the banking sector and, with some dissent, to guarantee short-term bank liabilities in order to calm fears in the financial markets. They also agree on the urgent need for coordinated action across countries. These are positions we have been advocating on this site, and we are glad to see many other people on the same page.