Month: October 2008

Bailout Passes; Hard Work Begins

Our position has been that the Paulson Plan is imperfect but is still a valuable first step toward restoring confidence in the financial markets, and so we are glad that it passed today. One remarkable development over the last two weeks has been a shift among both economists and the public from thinking the plan was an application of massive force to thinking that the plan is a relatively small part of the long-term solution. As discussed in our most recent baseline scenario, the next steps are to work on financial sector recapitalization, housing market stabilization, and fiscal stimulus (and, of course, regulation).

At the same time, though, implementing the Paulson Plan will be a major task, and one that will require oversight both from Congress and from government-watchers. Not surprisingly, Treasury is already moving to use fund management firms as outside contractors in buying securities. There are some valid practical reasons for this, but it creates the potential for conflicts of interest that we warned about in an earlier op-ed on governance; fortunately, the final bill includes much more emphasis on transparency of contracting than did the original proposal. Pricing the assets will be perhaps the trickiest problem, whether it be through reverse auctions (which can be difficult to implement) or through direct negotiations with banks. Price will determine how many warrants the government gets in participating companies, which are another improvement in the final bill. Finally, although the plan specifies multiple forms of oversight, figuring out how to make that oversight effective in a fast-moving environment will be difficult.

So while passing Plan A was a good thing for the financial sector and for the real economy, making it work will require a good deal more effort both inside and outside the Beltway. And the sooner work starts on Plan B, the better.

Financial Crisis and the Real Economy, Part 2

The impact of the financial crisis on the real economy can be divided into two periods: before September 15 and after September 15. Before 9/15, it was clear that we were in an economic slowdown, beginning with the construction industry, and that troubled assets on bank balance sheets would probably lead to a long-term decline in lending, which might push the economy into recession. Since Lehman failed on 9/15, this general problem sharpened into a short-term credit crunch, in which various parts of the credit markets have stopped functioning or come close to it. Still, though, people want to know, what does the credit crunch mean for me?

Bloomberg reported that almost 100 corporate treasurers held an emergency conference call yesterday to discuss the challenges they are facing rolling over lines of credit with their banks. In some industries, lines of credit are the lifeblood of even completely healthy companies. They operate like home equity lines of credit: you draw down money when you need it (like to make payroll), and you pay it back when your customers pay you back. (In most business-to-business transactions, money changes hands some time after goods are delivered; hence the pervasive need for short-term credit.)

Now, however, banks are demanding much higher interest rates, lower limits, and stricter terms when lines of credit expire, or are even pouncing on forgotten clauses in contracts to force renegotiations of terms. Lines of credit are priced in basis points (a basis point is 1/100th of a percentage point) over LIBOR, a rate at which banks lend to each other. One company saw the price for its line of credit rise from 90 basis points to 325 basis points over LIBOR, which is itself running at high levels. The banks aren’t doing this because they think their borrowers are in any danger of not paying them back; they’re doing it because they want to hold onto the money because they are afraid of liquidity runs. “These are very different circumstances than many of us have dealt with before,” said one treasurer. “We’re all having to learn every day about provisions that were buried in documents executed 15 years before.”

This is how fear in the banking sector translates very quickly into higher costs and less cash for healthy companies in the real economy. Fortunately there are clear steps that Washington can take to bolster confidence in the banking sector, which will cause the flow of money through the real economy to pick up.

Bailouts and Moral Hazard

Hazardous Morals

As Daniel Henninger noted in the Journal today, moral hazard is hot right now. This is the stick that commentators of all political affiliations use to beat the Fannie/Freddie bailout, the Paulson rescue plan, any proposal to restructure mortgages, or any other government action that has the effect of protecting someone from his bad decisions.

The concept of moral hazard originated in the insurance industry, and describes the problem that people who are well insured are more likely to take unwise risks. (For example, if you have comprehensive insurance on your car with no deductible, you may not bother locking the doors.) In the current context, the argument is that if the government bails out financial institutions by taking troubled assets off their hands, they will not have an incentive to be more careful in the future. In this usage, moral hazard becomes suspiciously similar to moral indignation pure and simple: many people feel instinctively that banks that took excessive risks deserve to go bankrupt, and the bankers who made lots of money on the way up should lose their jobs. (These people often also believe that homeowners who can’t pay their mortgages should lose their houses).

The problem of moral hazard is real. And moral hazard should be taken into account when designing any rescue packages and, more importantly, when the time comes to rewrite the regulation of the financial sector. But there are several reasons why it should not be allowed to simply veto any government action.

Moral hazard is most important in a repeated or continuous context. When you buy an insurance policy at the beginning of the year, you know if you are fully covered, or if you will be responsible for some proportion of the losses you incur, and you behave accordingly. It applies less clearly to retrospective bailouts like the current plan, where it is not clear that a similar situation will ever arise again. For example, perhaps one of the behaviors we want to discourage is leverage ratios of 30 to 1, like those at Bear Stearns and Lehman. Well, there are no more investment banks, and commercial banks have much lower leverage limits. Besides, there is another way to discourage undesirable behavior: regulation.
As Martin Wolf argued in the FT in the long-gone days of the Fannie/Freddie bailout, the moral-hazard argument to punish the shareholders has the perverse effect of discouraging private capital. Given widespread fears that many banks are undercapitalized, it would be a good thing if they could raise capital in the private markets rather than from the government, like Goldman Sachs did with Warren Buffett. But if the government is planning to take the moral high ground and let banks collapse, then no one will step up with the capital.
Most importantly, there is something fundamentally illogical about the moral hazard argument. If we bail out the banks now, it goes, then they will behave in harmful ways in the future. But right now we are facing the greatest danger to the financial system since the Great Depression. What future harm are we worried about that is more serious than the potential harm we are facing right now?

“While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse.” Those words were written by no less a free-market advocate than Nobel Laureate Gary Becker.

Your Money Is Not Going to Go Poof

Readers of this blog will already know that we believe that (a) the credit crisis of the past two weeks is serious, (b) there is a real risk of a global recession, but (c) there are practical steps that governments can take to minimize the damage to the economy. Several of my friends have asked me what this means for them. And I wanted to repeat here what I told them: nothing cataclysmic is going to happen to your money.

First, let’s start with deposit insurance. In general, your checking accounts, savings accounts, and CDs are guaranteed by the FDIC up to $100,000 per account holder per bank, and that is likely to go up to $250,000 shortly. Some people have been pulling money out of banks even though they are below this limit, because they don’t know about the insurance, don’t trust it, or don’t want to deal with the hassle. Now this is something with which I have personal experience. I had a CD (<$100K) at IndyMac Bank when it failed earlier this year. The FDIC took over the bank over the weekend and by Monday everything was exactly the same as on Friday: same web site, same call centers, same CD account, everything. The only change was that the name had changed from IndyMac Bank to IndyMac Federal Bank. I didn’t have to file a claim or even call anyone. My CD is still there, earning interest (at 4.15%, by the way). So if you have an insured account, you shouldn’t worry about it. (Some people have pointed out that the FDIC could run out of money if too many banks fail, but it’s a certainty that the government would put more money in the FDIC in that case.)

Second, you may have investments in stocks or bonds. Individual securities could be wiped out, and some have been already; not only did Lehman shareholders lose their money, but bondholders lost most of their money, too. But stocks are ownership shares in real companies, and most companies are not going to stop operating overnight. They will continue to buy, build, and sell whatever they buy, build, and sell today. Some will go bankrupt, as always happens, and some will lose value, but some will gain value. And it’s not likely that every company in the U.S. will lose all of its value at the same time. So you should be diversified, but you should always be diversified.

Third, there are your debit and credit cards. As long as you have money in your bank account, you will still be able to get at it using your debit card. It is unfathomable that a bank would need cash so desperately that it would block access to deposit accounts (and remember, those accounts are insured). When banks are at risk of failing, they want to preserve as much value as they can to sell to an acquirer. A large part of the value is the base of depositors and the ongoing banking operations. As for credit cards, it is possible that banks will gradually reduce the amount of credit they have extended by offering fewer cards, tightening the terms, reducing credit limits, and even unilaterally canceling some people’s cards. This could affect some people. But again, there is no reason why the credit card system as a whole would fail.

Now, if there is a recession, and that is certainly a possibility, it could have serious consequences for you: you could lose your job, your rate of salary increases could go down, your house could continue to lose value, your investments could lose value, and so on. As we’ve said, there are concrete steps that governments can take to minimize the duration and severity of any recession. In any case, you’re not going to wake up one day and find out that your money is gone. (Unless you keep your money under your mattress, in which case someone might steal it.)

Don’t Cry (or Cry Out) for the ECB

I would like to express some sympathy for the current predicament of the European Central Bank (ECB). They will undoubtedly come in for a great deal of criticism in the weeks ahead, particularly following their refusal to move interest rates today – if our Baseline Scenario view continues to hold.

But you have to keep in mind that they, unlike the Fed, have a very explicit mandate focused on just one variable: inflation. It is true that there is some scope for interpretation both broad and narrow. The broad scope exists because, for example, if actual growth slows below what is called “potential growth” (a very elusive number), inflation will decline eventually. So when you think about what inflation should be, you are really thinking about where growth is relative to potential – and this is what interest rates can affect (keep in mind all these effects are lagged, i.e., take between one and two years to work their way through the system). And the narrow scope means there is some choice over exactly what inflation measure you aim for and whether you can look at other things (such as money supply). This quickly slips into monetary theology and I’m not going there, at least today.

In any case, the ECB has a pretty clear mandate and it also has a board on which almost all countries that belong to the eurozone get to vote (there are now slightly more members than seats). The management of the ECB comprises the best minds in the business, with impressive experience in the private sector, academia and central banking.

But the basic point comes down to this. The ECB is in Frankfurt. And the real deal is that it represents all that is great and good about post-1945 German monetary policy, with its emphasis on trampling on inflation at every opportunity. This worked well for Germany for a long time and it might even be a good idea now (although I’m a bit skeptical).

The problem is that it is very unclear that this focus on fighting inflation will be appropriate for all eurozone countries. Spain and Ireland are clearly slowing down. The latest data, put out by the European Commission, points to recession in France and Italy.

But the ECB was given a job to do. They have a clear mandate, and they are not supposed to be flexible (unlike the Fed). And the German authorities are watching. The ECB will cut interest rates only when they see eurozone-wide recession definitely “in the data”. Of course, by then it will be too late. But they are really only doing their job. And there is nothing in their job description about preventing the world from slipping into depression.

Wake Up and Smell the European Coffee

At a Brookings panel today and even more so on a LA-based NPR radio show (“To the Point,” KCRW) just now, the impact on the “real economy,” i.e., people and businesses outside the financial sector, was the issue of the day. And people are beginning to understand the serious consequences of our financial system problems, with or without the Paulson Plan becoming law this week.

Here’s what I suggested at Brookings this morning, for the US, which is pretty close to what is in our Baseline Scenario, First Edition:

Tell everyone that their deposits are safe. Explain that no one has ever lost a penny when the FDIC has been involved and, de facto, they always pay all depositors, even those with over $100,000. I recommend removing the deposit insurance cap. In other words, do what it takes to stop the run.
Then work on bank recapitalization, right away (I think you can see the consensus moving in this direction already this week; I’ll try to post on the emergent schemes tomorrow)
And deal directly with the underlying troubled mortgages (again, I hear ideas emerging fast; give that a couple more days before I do a survey)
And get ready to provide a substantial fiscal stimulus. But don’t even think about this unless you have done 1, and much of 2 is in place, and the programs to deal with 3 are on their way.

Perhaps the overlooked issue of the week was the speed with which the crisis is clearly going global, with now a long list of European countries having banks in trouble. Europe also needs to stop the run on their banks before it gets out of hand.

One sensible way to do this would be with a large Europe-wide fund to inject capital and receive preferred equity in banks, on terms advantageous to taxpayers. Yes, this is point 2 above, on steroids. Of course, they have to deal with underlying domestic mortgages in Ireland, the UK and Spain (but not yet in other countries). The danger in Europe is that they don’t have as much fiscal space as the US (so point 4 is an issue) and their central bank is stuck with a mandate (i.e., just worry about inflation) that would have been nice to have in the 1970s, but may not be quite so appropriate today.

The severity of the global recession is going to depend, in large part, on the speed with which governments in Europe can organize swift, comprehensive and decisive support for their banking systems. And, following that, it will depend on exactly how the process of deleveraging (this is jargon essentially, meaning reduced lending by the financial sector) is handled.

The latest news from Europe (timely, thanks to the Financial Times): there will not be an immediate systematic rescue. It’s the French who seem to have understood what is really going on. Unfortunately, as of now, their European partners have not yet woken up to the new realities. In particular, Germany and perhaps the UK seem to stand in the way of a more systematic approach. This has dangerous implications for the US.

Days to the election: 34

Financial Crisis and the Real Economy

One of the biggest questions about the financial crisis – one heard from Capitol Hill to radio talk shows to casual conversations with friends – is why it matters for ordinary people. One major reason a significant proportion of public opinion is against the rescue plan is the general failure to make the connection between panics in the financial sector and the ordinary lives of everyday people; simply saying that the plan is necessary to prevent (or moderate) a recession smacks too much of “trust me” to be credible.

The connection is that much of the ordinary activity in the real economy relies on credit – think no further than the volume of purchases made using credit cards. (Although banks have been reducing credit limits, there is little risk for now that credit cards will stop working overnight.) And in today’s conditions, when many financial institutions are potential victims of liquidity runs, lending has virtually ground to a halt. The New York Times has an article today about the impact that the current crisis is having on local governments suddenly unable to raise money for ongoing projects such as highway repairs and hospital expansions. Across the country, local governments issued $13 billion in fixed-rate bonds in the first half of September – and $2 billion in the second half. A sudden 87% drop in a major source of municipal funding is a very real impact of the financial crisis, and one that will necessarily result in both fewer services and fewer jobs for taxpayers.