Month: November 2008

Proposed Solutions to the Securitization Problem

We’ve gotten a number of questions about mortgage restructuring proposals, both in email and in comments. One reader asks: “How does one get around the securitization problem?  The Treasury seems to be able to change rules with the sweep of a wand lately, why not the REMIC [Real Estate Mortgage Investment Conduit] rules too?” Tom K also raises this issue in a comment.

I doubt that Treasury could unilaterally modify the rules governing the securitization trusts (in which a loan servicer manages a pool of loans on behalf of the many investors who own a share of that pool). Despite the ease with which Treasury seems to be flinging money around and the, um, liberties they seem to be taking with the terms of the TARP legislation, Treasury can’t really force anyone to do anything, legally. For example, Treasury has no authority to force a bank to accept a recapitalization, which (in my opinion) is why the recapitalization terms are relatively generous: they did not want to take the risk of the core banks turning them down.

The securitization issue raises similar legal barriers. A bit of background: To generalize, the loan servicer has a legal obligation to act in the interests of the investors in the loan pool; if it doesn’t, it opens itself up to lawsuits. Now, if all of the investors have the same interests, and the service restructures a delinquent mortgage in a way that provides more value than a foreclosure, then everyone is happy. There are (at least) three problems, however. The first is a coordination problem: getting all of the investors to agree that they are happy. The second is a problem of conflicting interests: because a typical CDO is structured so that some investors get the first payments and some get the last, a mortgage modification could help the interests of some investors and hurt the interests of others. The third is a tax problem: for technical reasons, a mortgage restructuring could be treated as a new loan, which creates a tax liability (this is a REMIC rule).

This is why I think this will require legislation, and even that could be challenged as an expropriation of property.

  • The Center for American Progress has a proposal to modify the REMIC rules and an explanation of why they think it would work.
  • John Geanakoplos and Susan Koniak have another proposal to use government-appointed blind trustees to make restructuring decisions and thereby protect servicers from liability to their investors (this would also require legislation).
  • Thomas Patrick and Mac Taylor have yet another proposal (thanks, Tom K) to use Fannie Mae and Freddie Mac debt to pay off all performing securitized mortgages at face value and refinance them with 30-year, fixed-rate mortgages. (I don’t fully understand this plan: it seems to involve paying face value for $1.1 trillion in mortgages, many of which are certain to default in the future, and forcing banks to pay face value for $400 billion in mortgages that are already delinquent, and also forcing banks to accept some of the losses on the government’s $1.1 trillion. But I don’t want to draw conclusions based on a newspaper description.) This one shouldn’t involve legal issues, but it will require legislation, because of the amount of money involved.
  • Then there’s the idea of allowing bankruptcy judges to modify mortgages on owner-occupied houses, which would also protect the servicer from liability. But this would be a slow, inefficient way of solving the problem.

If there are other ideas out there, please suggest them.

Systemic Risk, Hedge Funds, and Financial Regulation

One of our readers recommended the Congressional testimony by Andrew Lo during last Thursday’s session on hedge funds. Lo is not only a professor at the MIT Sloan School of Management, but the Chief Scientific Officer of an asset management firm that manages, among other things, several hedge funds. He discusses a topic – systemic risk – that has been thrown around loosely by many people, including me, and tries to define it and suggest ways of measuring it. He recommends, among other things, that

  • large hedge funds should provided data to regulators so that they can measure systemic risk
  • the largest hedge funds (and other institutions engaged in similar activities) should be directly overseen by the Federal Reserve
  • financial regulation should function on functions, such as providing liquidity, rather than institutions, which tend to change in ways that make regulatory structures obsolete
  • a Capital Markets Safety Board should be established to investigate failures in the financial system and devise appropriate responses
  • minimum requirements for disclosure, “truth-in-labeling,” and financial expertise be established for sales of financial instruments (such as exist, for example, for pharmaceuticals)

Lo also has a talent for explaining seemingly arcane topics in language that should be accessible to the readers of this site. The testimony is over 30 pages long, but it’s a good read. Here are a couple of examples to whet your appetite.

Continue reading “Systemic Risk, Hedge Funds, and Financial Regulation” →

G20 Summit: Just Disappointing or Potentially Dangerous?

Initial reactions to the G20 summit are fairly positive, in the sense that the communique and associated press conferences conveyed (a) there was no open acrimony, (b) the body language was broadly supportive of countercyclical policies, and (c) there may now be a serious international regulatory agenda.

None of this is really new and it could all have been arranged by finance ministers (probably over the telephone), but I agree there is some useful symbolism in having heads of industrialized and emerging market governments convene for the first time (ever?) on these kind of issues.

I will admit to disappointment that no more explicit commitments were made to fiscal stimulus.  I thought the British and the French were heading in this direction, and that they could create some momentum in the right direction.  If Europeans (or anyone else) would like to compete for a “special relationship” with the US after January 20th, they might consider coming to the next summit with substantial fiscal package in hand (as will President Obama). 

If the latest rounds of global economic diplomacy were the Olympics, then China gets gold in the fiscal stimulus category, Germany gets silver, and the UK (so far) is the distant bronze – but the UK does get one more throw next week.  Not the ordering of world economic leadership that one would ordinarily expect, but perhaps that’s a good thing.

In the category of “largest cash contribution designed to save the world from serious disruption”, Japan easily finishes first – their $100bn pledge to the IMF this week was timely, targeted and hopefully not temporary.  Sadly, there were no other entrants in this category.  Perhaps the chemistry and cooking at the White House dinner on Friday will prompt further contributions in the near future?

But there is, unfortunately, another way to read the communique – as a government or international official, for whom this text really is a set of instructions to be implemented.  The whole first part of the document is generic and definitely not new, so – as an official – one’s eye skips through that quickly.  The real issue is the deliverables in the plan of action, with a pressing deadline at the end of March (this is pretty much like saying “do it tomorrow” to an official).  This is where we – an official reader is thinking – must concentrate our immediate attention and efforts.  And most of these specific actions are about tightening regulation on and around credit, or beginning processes that definitely point towards many dimensions for this kind of tightening – accounting standards, hedge funds, risk disclosures, financial sector assessments, credit rating agencies, risk management and stress testing models, international standard setters, sanctions for misconduct, reporting to supervisors in different countries, and more.

There is, of course, nothing wrong with making regulation more effective.  This is surely needed – in both the US and Europe, and probably elsewhere – to help lower the odds of another global financial crisis developing in the future.

But we are still not out of this crisis.  And tightening regulations quickly in the midst of a worldwide credit crunch is one good way to make sure that credit contracts further and faster.  Lending standards naturally tighten in a crisis; the issue to address going forward is how to prevent standards from loosening too much in the next boom – but this is at least several years down the road.  I’m in favor of starting early, but I do not like precipitate action just because you want to look busy and you could not agree on the more pressing issues, such as fiscal policy, support for the IMF, shoring up the eurozone, and so on.

It is true that one (among many) of the stated principles is: “Mitigating against pro-cyclicality in regulatory policy.”  But that is a general statement that is not mapped into operational requirements – except that the IMF and FSF should work together on this, which is a good way to make sure it doesn’t happen.  What officials have to deliver on, by the end of March, is substantive progress with regards to tougher and tighter regulation of credit.  There is a real danger that this action plan – within such a short time frame – can actually make the global downturn dramatically worse.

Root Causes of the Current Crisis

We’ve gotten a fair amount of criticism over on our latest Baseline Scenario post for not correctly identifying the causes of the financial crisis. I understand the criticism that we don’t identify the one single, crucial cause, because historical events like this are always overdetermined: there are always multiple plausible explanations, and with a sample size of one there’s no way to know which explanation is correct. (It reminds me a key issue in torts, where you distinguish between cause-in-fact and proximate cause … well, never mind. It’s a fascinating subject, but a bit off-topic here.)

Anyway, luckily for all of us, today’s G20 communique reveals the “Root Causes of the Current Crisis.” In case you missed it:

Continue reading “Root Causes of the Current Crisis” →

FDIC Takes Mortgage Proposal to the Public

Two months after the collapse of Lehman Brothers, there has still been no broad-based action to help restructure delinquent mortgages and slow down the flood of foreclosures; the Fannie/Freddie plan announced earlier this week is a very small first step, because it is limited to a small portion of the mortgages outstanding – those controlled by Fannie and Freddie, which tend to have relatively low default rates anyway.

Sheila Bair, head of the FDIC, said that that plan “falls short of what is needed to achieve wide-scale modifications of distressed mortgages.” Apparently frustrated by the failure of negotiations with the Treasury Department, yesterday the FDIC posted its mortgage modification proposal to its web site (Washington Post summary), basically breaking with the rest of the administration and hoping the Congressional Democrats can make it happen.

Continue reading “FDIC Takes Mortgage Proposal to the Public” →

The G20 Summit: Europe’s Greatest Moment, Or Not? (And a Quiz)

From their pre-meeting, it is reasonably clear what Europeans (except probably the British) want from the G20 summit on Saturday: a road map towards a great deal more regulation, together with agreement that the necessary powers and resources will be provided to implement these new rules at some international level (which could be the IMF or the Financial Stability Forum or the G20, or some combination).

And the Europeans are now apparently saying, on the sidelines, that victory – and a concrete action plan – is within their grasp.  This, of course, raises our expectations and makes us more prone to disappointment.  The White House, on the other hand, has been trying to manage our (and the Europeans’) expectations downwards. 

While we are waiting to learn the outcome of what is probably still a fairly intense conversation, here is a (relevant) pop quiz.

Below is the list of locations for press conferences to be held by participating countries after the conclusion of the summit, kindly provided by Planet Money.  The question is: which of these countries is not actually a member of the G20?  (Answer after the jump)

European Union & France — Willard Hotel
Japan — National Press Club
Italy — Embassy
Australia — National Building Museum
United Kingdon— Ambasssador’s residence
Canada — Embassy
Germany— Ritz carlton Georgetown
South Africa — Park Hyatt Hotel
South Korea –Paloma Hotel
Argentina — Park Hyatt Hotel
Mexico — Embassy of Mexico
Spain — Mandarin Oriental Hotel
Russia — The Washington Club

Continue reading “The G20 Summit: Europe’s Greatest Moment, Or Not? (And a Quiz)” →

The Bad Private Equity Fund

What seems like years ago, Simon and I wrote an op-ed in which we compared the initial proposal that became TARP to a bad hedge fund – a fund whose purpose was to overpay for illiquid securities and thereby shore up banks. Now that the original plan is dead, I think we can say that TARP has become a bad private equity fund, whose purpose is to buy preferred stock on overly generous terms (compare the 5% dividend taxpayers get to the 10% divided Buffett got from Goldman) in order to shore up banks and bank-like institutions (and maybe others as well). I don’t mean “bad” as a criticism here: the purpose of the Treasury Department is to protect and advance the public good, and that goes beyond the profitability of the investments themselves.

However, I do think it’s a problem that the goals of this private equity fund haven’t been well defined. Right now the bulk of the political pressure seems to be to (a) expand the scope of the bailout to other companies and industries that are being hurt by the recession (which could mean just about everyone) and (b) force bailoutees to do things in the public interest, like increase lending. (See the New York Times on both of these topics.) So the fund is being torn in two directions. To make a very broad generalization, if you want to increase lending, you should give capital to a healthy bank, like Saigon National (in the NYT article); but if you want to keep the financial system from collapsing, you should give it to very large banks (too big to fail) with balance sheet problems, like Citigroup, and they are not going to increase lending, precisely because they need the money themselves.

Paulson’s initial bet, which most but not all observers agreed with, was that the top priority was keeping a handful of core banks – Bank of America, Citi, JPMorgan Chase, Wells – from collapsing. One risk is that to protect that position, they will need more capital for those core banks (especially, apparently, Citi). While these banks were struggling with a liquidity crisis in September-October, now they are struggling with a good old-fashioned recession, in which all sorts of borrowers can’t pay them back, so they could be looking at writedowns for many months to come. (Perhaps as a result, CDS spreads on BofA, Citi, and JPMorgan are all up 30-50% from their lows right after recapitalization was announced.)

So I think Treasury needs to be clear on its goals. We know one goal is to protect the core of the system, which will not necessarily increase lending in the short term. From Paulson’s recent statements, it looks like one new goal is to increase lending. It’s not clear that $700 billion is enough for both of these goals. And $700 billion is certainly not enough to bail out everyone out there who will be hurt by the recession, including smaller banks that are unhealthy but not “too big to fail” – who will, therefore, fail.

Yet More on GM

My two earlier posts on the auto industry and GM have been among the most-commented-on posts in our brief history. For those who want a crash course on GM’s problems and whether or not bankruptcy is a possible solution, I strongly recommend two podcasts from Planet Money.

  • Kimberly Rodriguez, an economist, talks about the importance of the industry, but also the problems with simply giving GM an operational loan.
  • Steve Jakubowski, a bankruptcy lawyer, explains the risks of GM entering Chapter 11 (if you’re curious about the market for debtor-in-possession financing, listen to this), but also explains how a “prepackaged” bankruptcy, possibly funded by the government, could work.

Simon also tells me he talked through the arguments on both sides of the GM issue in his latest installment for the MIT Sloan podcast. (I haven’t had time to listen to it yet.)

If there’s a consensus between them, I’d say it’s that some kind of brokered solution is better than either simply leaving GM alone or simply handing them a loan without strings attached. (It is possible, however, that a loan might be necessary just to buy enough time to broker the solution.)

The New York Times is reporting that it could all be academic, since Senate Republicans and President Bush are opposed to doing anything for GM, and GM could be unable to pay its bills by the time Obama takes office.

Other Good Sources of Information and Perspectives

Since the article about Simon in the WSJ earlier today, we’ve been getting a large number of first-time visitors. On the chance that some of you are new to the economics blogs, I wanted to suggest a few other sites you might also want to check out. We are nowhere close to the be-all and end-all of information about the global economy or the current crisis, and in any case the more perspectives you get, the better.

  • Planet Money is an excellent, excellent podcast for people who are relatively new to the world of economics and the financial crisis, and for people who commute and can listen to it in their cars. I listen to it for fun.
  • Real Time Economics (Wall Street Journal) gives you rapid coverage of economic issues as they arise.
  • Calculated Risk and naked capitalism are good sources for near-real-time news about the crisis and the economy in general. Calculated risk has a particular focus on housing and mortgages; naked capitalism has incisive commentary from one side of the political spectrum.
  • Econbrowser is more technical and data-oriented; more advanced readers will like this one.
  • Economist’s View and Marginal Revolution provide in-depth articles applying economics to broad range of phenomena.
  • And James Surowiecki has a blog!

Of course, we would love it if you would come back here often (or sign up for email subscriptions). But I wanted you to know some of your options.

(Feel free to add other suggestions in the comments.)

MIT Class on GM, G20 and Good News (if any)

Our next MIT class on the global crisis will run Tuesday, 4pm-7pm; live webcast available through a link on this site or directly through MIT Sloan.  Likely topics include:

  • Where do we stand in terms of the overall financial crisis?  Is it over yet?
  • General Motors: to bail out or not bail out?
  • The G20 Summit: good, bad or was it surprisingly ugly?

And we’d be happy to discuss other topics that you suggest here.

The class from last week is available to download (there was no class this week due to the holiday).

Update: you can preview some of the (GM and G20) issues under consideration in my podcast from MIT Sloan today.

America Is Best Country

When I was in college, the college humor magazine did a brilliant spoof of USA Today, complete with a silly poll in the lower-left-hand corner of the front page. According to their mock poll, Americans thought that the United States was the best country in the world, with about 92% of the vote.

I was reminded of this today by President’s Bush’s speech today, which the Wall Street Journal summarized as “Bush Defends American Capitalism.” The thrust of the speech was, indeed, that American-style capitalism is the best economic system there is, and that the current global crisis should not lead to a reaction against free markets.

I consider the second half of that sentence a fairly unobjectionable position. Saying that we need transparency, cooperation, and economic growth are also fairly unsurprising. However, I wouldn’t say Bush’s arguments that American capitalism – our curious mix of free-market ideology, lobbyist-driven politics, and widespread private sector capture of regulatory agencies – is the best possible expression of free markets is very convincing. Look at what he compares us to:

Meanwhile, nations that have pursued other models have experienced devastating results. Soviet communism starved millions, bankrupted an empire, and collapsed as decisively as the Berlin Wall. Cuba, once known for its vast fields of cane, is now forced to ration sugar. And while Iran sits atop giant oil reserves, its people cannot put enough gasoline in its — in their cars.

It’s also curious how Bush trots out those red herrings, like “authorities in every nation should take a fresh look at the rules governing market manipulation and fraud.” Sure, I’m against market manipulation and fraud, too, but saying they were a significant part of the global crisis is misdirection akin to calling the corporate scandals of the beginning of the decade (Enron, WorldCom, etc.) the fault of “a few bad apples.” The vast majority of the behavior of people who were selling mortgages, securitizing mortgages, rating securities, and trading credit default swaps was completely, 100%, tell-it-to-Santa-Claus legal.

Then there’s the disingenuous argument par excellence:

History has shown that the greater threat to economic prosperity is not too little government involvement in the market, it is too much government involvement in the market. (Applause.) We saw this in the case of Fannie Mae and Freddie Mac. Because these firms were chartered by the United States Congress, many believed they were backed by the full faith and credit of the United States government. Investors put huge amounts of money into Fannie and Freddie, which they used to build up irresponsibly large portfolios of mortgage-backed securities. And when the housing market declined, these securities, of course, plummeted in value. It took a taxpayer-funded rescue to keep Fannie and Freddie from collapsing in a way that would have devastated the global financial system.

The idea that Fannie and Freddie were the cause of the crisis is simply false, at least in the form it usually takes, and one I’d hoped I’d heard the last of once the Presidential campaign was over. During the peak of the subprime boom, Fannie and Freddie were buying a smaller and smaller share of subprime loans in comparison to private sector institutions. Fannie and Freddie got into trouble because they were private companies using their implicit government guarantee to fund risky investments in search of higher profits; the problem was not too much government, but management and shareholders making a quick buck off the government.

For the record, I’m for free markets, not socialism. But I’m not for a lame-duck president making campaign speeches when what we need are real solutions.

Update: Hey, Felix Salmon agrees with me on this. He even uses the word “disingenuous” in roughly the same place that I do.

India in the Global Economy

One of our commenters pointed out that we have failed to say anything about India, despite its large and growing importance in the global economy. Simon’s colleague Arvind Subramanian (whom we have linked to before, including this morning) has a new opinion piece, originally posted at the Peterson Institute.

India and the G-20

The upcoming G-20 summit meeting in Washington provides an opportunity for India to help shape the new global economic architecture in line with its strategic and economic interests. India should propose short-term, crisis response actions to help limit the economic downturn; advance a clear, medium-term agenda; and push for a political commitment by all countries to keep markets open and prevent trade barriers from going higher.

Although the G-20 has been in existence for nearly a decade, this is the first G-20 summit meeting, and many participants will be looking to Prime Minister Manmohan Singh, a respected economist in India and throughout the world, for a particular contribution.

What does India bring to the G-20 table? As a long-time spokesperson for the G-77, India has a record of assuming a leadership role. But in the past, this role was often used to assert India’s right to retain sovereignty. In the words of Strobe Talbott, the former diplomat who now leads the Brookings Institution, India has been on many issues a “sovereignty hawk,” protecting its own interests at the expense of global cooperation on issues ranging from nuclear proliferation to trade. But with India’s growth, and in an era of globalization, its interests—and its perception of its interests—have changed. India now has a keen stake in sustaining an open global trading system. Accordingly, its leadership should now be harnessed for a different cause. Moreover, India has begun to realize that it needs to contribute to sustaining this system rather than assuming that the status quo can be taken for granted. But trading partners are wary of India, viewing India’s role in the trade negotiations as unhelpful. It would be a singular achievement if India can manage to reassure G-20 participants on this score. In short, leadership comes naturally to India. The question is going to be the cause for which India harnesses this leadership role.

As Aaditya Mattoo of the World Bank and I have argued [pdf], for India the medium-term agenda should include: First, reforming the financial architecture, including by strengthening the International Monetary Fund’s capacity to respond to crises and enhancing its legitimacy through radical governance reform to give greater say to the emerging powers. Second, securing the future openness of the trading system, which would require a commitment to go beyond completing the current Doha agenda in two ways: deepening rules in existing areas (especially services) and developing rules in new areas (to deal with undervalued exchange rates, cartelization of oil markets, investment restrictions and environmental protectionism). Third, reforming the makeup of the bodies involved in global decision-making, including the creation of a more representative membership than the G-7.

Arvind Subramanian is a Senior Fellow, Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor, Johns Hopkins University