Month: January 2009

Constraints On The Comprehensive Obama Plan

Yesterday, Tim Geithner stated clearly – and reassuringly – that the Obama Administration will present a comprehensive and detailed economic recovery plan within a few weeks.

We know this plan involves a large fiscal stimulus, and it is reasonably clear there will be around $100bn for housing refinance/mortgage mitigation (out of TARP II funding), and probably some other symbolically important pieces intended to help consumers directly.

The big question is: what will be done about the total mess that our banking system has become? On this key dimension, we know little about the Administration’s specific thinking, but we can already see with considerable clarity the constraints that will bind as their thinking becomes concrete policy proposals.

There are three major political constraints. Continue reading “Constraints On The Comprehensive Obama Plan” →

More on Financial Education

My earlier post on basic financial education got a fair amount of attention, so I wanted to point out one source for more information on the topic. Zvi Bodie, Dennis McLeavey, and Laurence B. Siegel hosted a conference in 2006 on “The Future of Life-Cycle Saving and Investing,” and the most of the presentations and comments can be downloaded as a PDF from this site. Some of the general themes of the conference were: people don’t save enough for retirement; people have to make important financial decisions on their own; but people tend to make suboptimal financial decisions (like not rolling over retirement accounts), so giving them more “choice” leads to bad results; and the financial advice they are getting is not necessarily helpful.

Bodie, in his concluding remarks on investor education (pp. 169-71), provides this diagnosis:

We need institutional innovation to address the problem of investor education. Most people have honorable intentions, but we all want to make a living. In that respect, we are all salesmen to some extent. The trick, therefore, is getting people to serve the public interest while they are serving their own interests. . . .

[T]he U.S. Securities and Exchange Commission (SEC) is part of the problem. The educational materials distributed by financial services firms and by the SEC are often misleading and biased in favor of products that may not be suitable for large numbers of consumers. . . .

Therefore, universities and professional associations should cooperate in designing, producing, and disseminating objective financial education that is genuinely trustworthy. In doing so, we have to distinguish between marketing materials and bona fide education.

But there is lots more interesting stuff throughout the book. Laurence Kotlikoff (pp. 55-71) analyzes the problems with the conventional method of estimating target retirement savings, and shows that small mistakes can lead to unhappy outcomes. And the sessions are full of frightening information, especially Alicia Munnell’s session; for example, in 2004 the average 401(k)/IRA balance for a head of household age 55-64 was only $60,000. The outlook for retirement security looks pretty grim. And all of this was written at the peak of the boom.

“Bad Banks” for Beginners

For a complete list of Beginners articles, see the Financial Crisis for Beginners page.

What is a bad bank? . . . No, I don’t mean that kind of bad bank, with which we are all much too familiar. I mean the kind of “bad bank” that is being discussed as a possible solution to the problems in our banking sector.

In this sense, a bad bank is a bank that holds bad, or “toxic” assets, allowing some other bank to get rid of these assets and thereby become a “good bank.” Continue reading ““Bad Banks” for Beginners” →

Global Fiscal Stimulus: Should It Be An Obama Administration Priority?

The US has the opportunity – and perhaps the responsibility – to immediately retake a leadership role in global economic policy thinking, with the pressing priority of preventing the world’s recession from becoming something more serious. But what should be Mr Obama’s priorities in this regard, for example in the run-up to the G20 summit in early April – which, given the timetable for these things, will have an unofficial dry run of sorts at the Davos meetings next week?

The obvious message could be: a large US fiscal stimulus is coming, but the rest of the world needs to do more. In this option, Mr Obama could devote considerable effort to encouraging others to expand their government spending and/or cut taxes.

While worldwide cooperation of this form may have been a constructive thought last year at Davos, when the idea was first broached publicly by the IMF, a joint global fiscal stimulus is a glorious idea whose time has for now passed. Continue reading “Global Fiscal Stimulus: Should It Be An Obama Administration Priority?” →

Pick Ourselves Up, Dust Ourselves Off . . .

Starting today, we must pick ourselves up, dust ourselves off, and begin again the work of remaking America. For everywhere we look, there is work to be done. The state of our economy calls for action: bold and swift. And we will act not only to create new jobs but to lay a new foundation for growth.

When my daughter falls down, I usually say, “pick yourself up and brush yourself off.”

Not surprisingly, Barack Obama’s speech today was long on ambitions and short on specifics, as is customary for the occasion. We’ve been writing at length about the economic challenges that the Obama administration faces and some of its policy options, so there’s no need to rehash that in detail today. Suffice it to say that deep crisis creates a rare opportunity, and Obama has the opportunity to leave a greater mark on the economy than any president since Reagan or perhaps FDR.

On another note: Although this blog is generally about economics, I am particularly curious to hear what the new president will say about torture. I drafted a speech that I would like to hear him give over on Talking Points Memo Cafe.

Nationalization Is Not Inevitable

This week’s moves by the British government have created the impression that bank nationalization is inevitable. It is certainly the case that small-scale bank recapitalization, partial balance sheet clean-up, and various forms of financial engineering (e.g., insurance schemes for bad debt) are not only no longer enough, but may even be destabilizing. The problem is that once the market thinks you are on the move to a decisive solution but have not quite mustered the political will needed for complete resolution, it will assume that the final destination involves zero value for equity holders (and perhaps some bumps in the road for bank creditors).

The same logic is now being applied in Ireland and, to varying degrees, in other weaker eurozone countries. And the knock-on effect from assumed nationalization of bank losses to fiscal sustainability is immediate. Quoted Credit Default Swap spreads for some European sovereigns were wider than for investment grade corporates today, which of course makes no sense – but it does indicate extreme pressure in markets and deep confusion (or perhaps great clarity) regarding the impact on government balance sheets.

Nationalization is not the answer in the United States. Continue reading “Nationalization Is Not Inevitable” →

Obama Can; The Rest Of The World, Not So Much

The US will shortly have a new President. Congratulations to all concerned, particularly those who kept their cool during the intense moments of crisis during the fall and who surmised – early and correctly – that the current situation requires decisive and comprehensive action. We already have a large fiscal stimulus in the works, a significant housing refinance program was surely being signalled last week, and we are waiting to hear through exactly what kind of new structure the bulk of TARP II funding will be deployed.

If banking stabilizes of its own accord over the next week or so, the new Administration will lean towards a New Bank focused primarily on restarting consumer lending (or they can expand the mandate of a relatively clean existing structure such as Fannie or Freddie). If banking continues to deteriorate, then more of an RTC-type structure is likely to prevail, i.e., at least partially cleaning up banks’ balance sheets – presumably in return for lending requirements.

There is definite potential for inflation in this strategy, but this would not be the worst thing – the gap between the consensus and our view is narrowing on this. And in any case President Obama can, quite reasonably, blame his predesssor for almost everything that goes wrong. And Obama can also argue, plausibly, that things would be even worse without his bold actions.

Unfortunately, in most of the rest of the world the economics and politics are not so favorable. Let me remind you of the main points, illustrated with some of the latest developments. Continue reading “Obama Can; The Rest Of The World, Not So Much” →

The Importance of Education

Robert Shiller, he of the Case-Shiller Index (and therefore a reasonable symbolic candidate for 2008 Man of the Year, were it not for a certain presidential election), has an op-ed in The New York Times advocating a government program to subsidize financial advice for anyone, particularly low-income people. There is a lot to like about this idea. In Shiller’s proposal, the subsidy would only apply to advisors who charge by the hour and do not take commissions or fund management fees, so they would have no incentive to steer clients into particular investments or into unnecessary transactions. It seems reasonable that, if they had access to impartial advice, some people might not have taken on mortgages they had no hope of paying back or, more prosaically, some people might do a better job of budgeting and take on less credit card debt.

But I have one major reservation, which is that I’m not sure how good the financial advice would be. In my opinion, most financial advice floating around is worth less than nothing. To take the most obvious example: by sheer volume, the largest proportion of financial advice that exists (counting all advice that anyone gives to anyone else via any means of communication) is almost certainly advice on buying individual stocks, and the second largest is probably advice on choosing mutual funds. I am firmly in the camp that believes that whether or not stocks obey the efficent market hypothesis, it is not within the capabilities of any individual investor to identify stock trades that will have an expected risk-adjusted return higher than the market as a whole, net of transaction costs. I also believe it is not in within the capabilities of any stock mutual fund manager, and that all of the variation in risk-adjusted mutual fund performance can be explained by pure statistical variation. And even if I’m wrong about that, and there are a few exceptional fund managers out there, I don’t believe that any individual could distinguish the exceptional managers from the simply lucky ones; and even if he could, by the time he did he would be buying into a fund that had grown so big it was no longer capable of above-market returns.

If this is so, why doesn’t the market for financial advice take care of this problem?

Continue reading “The Importance of Education” →

Global Consequences of a US “Bad Bank” Aggregator: It’s Mostly Fiscal

It looks like a bank aggregator for bad assets is pretty much a done deal. David Axelrod said yesterday we should expect a new approach within a few days, and leading reporters (NYT, Washington Post) have discerned that this is likely to include a “bad bank” into which troubled/toxic assets can be disposed.

We don’t yet know the details, and these matter a great deal (for the taxpayer and for the gradient of the road to recovery) but it’s not too early to think about the global implications, at least in qualitative terms. Continue reading “Global Consequences of a US “Bad Bank” Aggregator: It’s Mostly Fiscal” →

Designer Talk: Bank Recapitalization (and Bair’s Aggregator)

Sheila Bair is delivering a sensible general message: we need dramatic action to clean up banks’ balance sheets and, presumably, to recapitalize them. This initiative apparently has support from influential senators, such as Kent Conrad and Charles Schumer. Many Republicans also seem inclined to come on board.

I like an aggregator-type approach; this is quite consistent with the RTC-inspired structure that we have been advocating (see the WSJ.com article linked through that post for details; such ideas are consistent with and an update of our proposals from September, November, and December). But some of the details currently being floated seem less than ideal. Given that the design work on this program is still ongoing and the new Administration will, without doubt, seek broad support on Capitol Hill, I would suggest that the following points be considered or even stressed in the upcoming deliberations. Continue reading “Designer Talk: Bank Recapitalization (and Bair’s Aggregator)” →

Time for a Weekend

We don’t try to be a news site – it’s too much work to keep up with everything that happens on an hour-to-hour basis – and generally we try to provide analysis and commentary instead. But right now I just want to note the major turn events have taken in the last few days.

After a few weeks of relative calm – the economy was doing badly, but we knew that already, and there were no major controversies or scandals since the auto bailout and Bernie Madoff – the pace has picked up again. To summarize, in case you were on vacation this week:

Bank of America started falling into the abyss, but got a lifeline, just like Citigroup 2.
Speaking of which, Citigroup announced that its strategy for the last ten years has been a failure and that it is splitting itself into two banks, a “good bank” and a “bad bank” – but unfortunately it still owns both of them. It also announced $6.0 billion in increased loan loss reserves, $7.8 billion in writedowns on securities, and a $5.3 billion writedown on derivatives (I wonder how much of that affects the $300 billion in assets guaranteed by the government), but nevertheless made an Orwellian assertion of “Continued Capital and Structural Liquidity Strength.”
The Bank of America bailout undoubtedly made Congressmen even more mad about TARP, but at the same time all these shaky banks (and personal lobbying by Barack Obama) convinced the Senate to release the second $350 billion (both houses would have had to block it). The vote was 52-42, with 46 Democrats and 6 Republicans voting in favor. From one perspective this is not surprising: the Democrats are supposedly the party of activist government, and it was mainly Democrats who passed the bill in the first place. But seen from a long-term perspective . . . the Democrats are the party in favor of saving big banks? and the Republicans are willing to let them fail? How things have changed.
In a story that hasn’t gotten the attention it deserves (no doubt due to general bailout fatigue), Treasury is lending $5 billion in TARP money to Chrysler Financial. Now, is Chrysler Financial a healthy financial institution that just needs a little more capital to resume lending, or is it a systemically significant financial institution whose failure must be prevented? Right, I don’t know the answer either. But I guess after the GMAC bailout it was a foregone conclusion. Chrysler, of course, announced that it was relaxing credit standards and offering zero-percent financing on pickup trucks and minivans. (Full disclosure: I own a minivan.)
The CPI declined 0.7% in December (excluding food and energy, unchanged), meaning that in Q4 the CPI fell by about 3.4% (excluding food and energy, it fell 0.1%)., further stoking deflation fears. But again, most of the fall in prices is just the reversal of the run-up in energy prices in 2007-08. Now that oil prices seem to have flattened out (gasoline and heating oil are up slightly), we should be able to see what is going on. I am still in the camp that the Fed will be able to prevent deflation. It’s basically a question of how hard they want to try, and they are afraid if they try to hard they will overshoot and create too much inflation.
And Ben Bernanke gave a speech in which he floated the idea of creating a government-sponsored “bad bank” that would buy troubled assets from troubled banks: “Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank.” This idea got further support from Henry Paulson and Sheila Bair, and could be the big story of the next week (except for something else happening in Washington on Tuesday). Isn’t this original TARP all over again? Yes, it’s similar, but there are good ways and bad ways to do it. The biggest problem I had with original TARP was that it necessarily involved overpaying for assets; Simon and Peter have outlined one way of avoiding that problem.

Overall, this pace of news, primarily from the financial sector, has not been a good sign over the past several months. It’s usually a sign that things are going to get worse, although there is always some chance that this time we will solve these problems once and for all. And there is a new crew moving into town on Tuesday.

Bank of America Gets Quite a Deal

We have a deal. You, the US taxpayer, have generously provided to Bank of America the following: one Treasury-FDIC guarantee “against the possibility of unusually large losses” on a pool of assets taken over from Merrill Lynch to the tune of $118bn, and a further Fed back stop if the Treasury-FDIC piece is not enough. In return we receive $4bn of preferred shares and a small amount of warrants “as a fee”. There is a $10bn “deductible,” i.e., BoA pays the first $10bn in losses, then remaining losses are paid 90% by the government and 10% by BoA.

We are also investing $20bn in preferred equity, with a 8 percent dividend. There will be constraints on executive compensation and BoA will implement a mortgage loan modification program. Essentially, this is the same deal that Citigroup received just before Thanksgiving, known as Citigroup II, which was generous to bank shareholders but not good value for the taxpayer.

This is more of the same incoherent Policy By Deal that has failed to stabilize the financial system, while also greatly annoying pretty much everyone on Capitol Hill. Hopefully, it is the last gasp of the Paulson strategy and the Obama team will shortly unveil a more systematic approach to bank recapitalization; it would be a major mistake to continue in the Citi II/BoA II vein.

In addition, you might ponder the following issues raised by the term sheet.

1. The $118bn contains assets with a current book value of up to $37bn plus derivatives with a maximum future loss of up to $81bn. This is more detail than we got in the Citi deal, so there is evidently greater sensitivity to calls for transparency. But the maximum future loss is based on “valuations agreed between institution and USG.” What is the exact basis for these valuations? From the term sheet, it sounds like we are talking mostly about derivatives that reference underlying residential mortgages. Absent any other information, my guess is that they can easily lose more than $81bn – depending on how the macroeconomy and housing market turn out.

2. What is the strike price of the warrants? This was controversial in the Citigroup II deal (because it was unreasonably high), but at least it was quite explicit up front. The announcement is suspiciously quiet on this point, perhaps due to the recent spotlight on warrant pricing terms.

3. What kind of reporting will there be by BoA to Treasury, and what will be disclosed to Congress, in terms of the exact securities covered by this guarantee and how they perform? The lack of information is a big reason why TARP became discredited and Capitol Hill is so concerned to see more transparency going forward. There is nothing in the term sheet that reveals the true governance mechanisms that will be put in place, or how information will be shared with the people whose money is at stake (you and me, or our elected representatives). I understand there is market-sensitive information present, but there are obviously well-established ways to share confidential information with members of Congress.

Overall, it feels like the latest (and hopefully the last) in a long line of ad hoc deals, which have done very little to help the economy turn the corner. The new fiscal stimulus needs to be supported by a proper bank recapitalization program, as well as by a large scale initiative on housing.

The Funding for Recapitalization

Congress is now debating how to use the second half of the TARP. I suggest that all $350bn should be used for bank (and other regulated financial institution) recapitalization, providing this is done in a comprehensive manner (the details of this argument are now on WSJ.com). And I suspect that an additional budget authorization, beyond TARP, in the region of $250bn will be needed for the same purpose. If Congress sets up a Resolution Trust Corporation (RTC)-type structure, then this RTC can borrow additional money from the Fed as needed.

The important point is to keep this funding for bank recapitalization separate from the fiscal stimulus. We can continue to debate the size and nature of the stimulus, of course, but roughly $800bn seems right and the mix of spending and tax cuts currently proposed also makes sense. (On the point of whether the tax cuts would be “wasted” in any sense, remember that consumers have damaged balance sheets and that tax cuts should help on that dimension.)

Bank recapitalization should therefore be seen as complementary to the fiscal stimulus, rather than as any kind of substitute. We need both to be big and bold (and of course we also need a serious housing refinance program that would directly reduce foreclosures).

Betting on a “Depression”

A friend of mine who bets on Intrade (he made money correctly betting that Rod Blagojevich would survive into this year) alerted me to the fact that Intrade now has a market for whether the U.S. will go into “depression” in 2009 (warning: that link will resize your browser window). Their definition of “depression” is “a cumulative decline in GDP of more than 10.0% over four consecutive quarters,” but they don’t really mean that. What triggers the payout is if the sum of the quarterly annualized GDP growth rates for four consecutive quarters is less (more negative) than -10.0%. (To see the difference: GDP in Q3 2008 was 0.13% smaller than in Q2 2008, but this was reported as an annualized rate of -0.5%.) This would mean that the total economic contraction over those four quarters would be more than (about) 2.5%. This would make the current recession the worst since at least 1981-82 (which had a total peak-to-trough decline of 2.6%), but not necessarily anything that anyone would call a depression.

On to the interesting bit: the last price for this market was 56.3, meaning that the market assigns a 56% probability to the occurrence of a “depression” as defined by Intrade. The average forecast collected by the Wall Street Journal shows a “cumulative decline” of 7.8% (from Q3 2008 to Q2 2009 the forecasts are for contractions at annual rates of 0.5%, 4.3%, 2.5%, and 0.5%), or a peak-to-trough contraction of about 1.9%. Of the 54 individual forecasts collected by the Journal (you can download the data to a spreadsheet), 22, or 41%, are predicting a depression by Intrade’s definition.

So Intrade is more pessimistic than the experts. There has been a lot of talk about the accuracy of prediction markets like Intrade, but a lot depends on the liquidity of the individual market, and this one doesn’t have much (you can see all the outstanding bids and asks). We’ll just have to wait and see who wins this contest.

Here We Go Again . . .

The Wall Street Journal (subscription required; shorter Bloomberg article here) is reporting that Bank of America will receive billions of dollars more in government aid, probably in a deal that looks something like the second Citigroup bailout, ostensibly to help absorb losses incurred by Merrill Lynch since the acquisition was negotiated in September but more generally to shore up B of A’s increasingly shaky balance sheet. At least someone involved knows how this looks: the reports say the deal will be announced on January 20 – yes, the day of Barack Obama’s inauguration – thereby keeping it from being the main story of the day.

It looks bad for all sorts of reasons:

Wasn’t B of A supposed to be a healthy bank? Isn’t Ken Lewis (CEO) the person who told Henry Paulson he didn’t need the first round of TARP money, but he would take it to show solidarity and for the public good?
The money is going to finance an acquisition? Isn’t that the thing that (according to most people) banks aren’t supposed to be doing with their bailout money?
The B of A-Merrill deal closed on January 1. So it looks like – as the WSJ is reporting – the deal only closed because Treasury gave B of A a verbal commitment to supply the needed bailout money later.
Isn’t this more policy by deal?

That said, I think some sort of deal has to be done. Even Yves Smith at naked capitalism (one of the most consistent and sharp critics of the way TARP has been implemented), who says this deal “stinks to high heaven,” says that “Merrill is a systemically important player” and “letting the deal with BofA ‘fail’ is a non-starter.” But I predict that when the terms are announced I will think they are too generous – especially since B of A now has all the negotiating power, since they closed the acquisition based on a promise from Treasury.

To recap – because I have this pathological fear of not being understood – I think that TARP’s primary purpose is to protect the financial system against the collapse of any systemically critical financial institutions (I leave it to others to define what those are, but Bank of America definitely is one, GMAC I’m skeptical about), and it has suffered from three main problems:

The initial round was too small, with banks only getting 3% of assets or $25 billion, whichever was smaller – which is why Citi and now B of A have had to come back.
The terms were too generous; I can make an exception for the first round, but I don’t understand why Citigroup 2 and GMAC were so favorable to shareholders.
Except for the very generous initial round, it’s just a pile of money to be used in ad hoc deals, not a comprehensive program with a coherent strategy, so no one is quite sure how or if it will be able to protect the financial system.

The B of A bailout will only sour public and Congressional opinion further against TARP, making it less likely that the second $350 billion will ever be released, and more likely that if it is released it will be packaged with all sorts of conditions (not necessarily bad) or allocated to community banks (beside the point).

It is true that one price we are paying in these bailouts is the creation of a new tier of mega-banks that, because they are Too Big To Fail, have the competitive advantage of being essentially government-guaranteed. What we really need as a condition on TARP money is a new regulatory structure to make sure that these mega-banks do not abuse the oligopolistic position we have just handed them, and perhaps a commitment to break them up when economic circumstances allow. That would be considerably more valuable than a cap on executive salaries and corporate jets. But it will also be a lot more difficult to define and to agree on.