But Are They Buying It?

As Simon wrote this morning, the administration strategy is to wait and see if the economy turns around, lifting banks out of the mess they created. How can you tell if this is working? One way is to look at bank bonds.

If the administration is right and the banks are healthy (and to the extent they aren’t healthy, their capital will be topped up with convertible preferred shares), then bank bonds are safe. Even subordinated bonds (the ones that get paid off after senior bonds and insured deposits) are protected by the bank’s capital – both common and preferred shares. So if the administration is correct that the banking system is adequately capitalized, and will be even more adequately capitalized after the stress tests and capital infusions, then banks will be able to pay off all of their bonds.

Even if the administration is wrong and the banks are not adequately capitalized, bondholders are only in danger if the administration decides not to protect them. This could happen in one of two ways. First, the administration could request, as a condition of a future bailout, that bondholders exchange some of their debt for equity. There is no law that says that bondholders have to exchange their bonds for equity just because the government asks, so the threat would be that the government would not bail out the bank otherwise (forcing it into bankruptcy or conservatorship).* Second, the administration could take over the banks; in that case, the regulator might decide not to pay back all of the bondholders – but it certainly could decide to pay them back. It’s just a question of whether losses are borne by the bondholders or the taxpayer (assuing the equity holders have been wiped out).

So what does the bond market think?

According to a Bloomberg article this morning, the bond market is scared. Yields on bank debt overall are 3.6 percentage higher than for industrial companies (before August 2007 they were lower); Citigroup’s subordinated debt due in October 2010 has fallen from 95 cents to 77 cents on the dollar in the last three weeks; Bank of America’s subordinated debt due in January 2011 is down from 99 cents to 80 cents. Here is some color:

“The bond market is getting more scared every day,” said Gary Austin of PDR Advisors in Charlotte, North Carolina, who manages $450 million in fixed-income securities. “At some time, the government is going to say enough is enough, the only way we will give you more cash is if the bondholders have to be hit.” . . .

“The current prices imply that the companies’ equity is worthless, the government’s investment is worthless and subordinated debt holders will lose some of their investment,” said David Darst, an analyst at FTN Equity Capital Markets in Nashville, Tennessee.

In other words, the bond market isn’t buying the administration’s story, and thinks there’s a pretty hefty risk not only that some banks will be taken over, but that bondholders will be made to suffer in the process. Correct or not, this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.

Maybe Treasury or the Fed will start buying subordinated bank bonds in order to project confidence. That would be putting its money where its mouth is. Of course, that would also guarantee that the taxpayer will suffer any potential losses, one way or the other.

* The government tried this with GMAC back in December, with only partial success. Some bondholders, including PIMCO, refused to convert, betting that the government would bail out GMAC anyway, which it obligingly did. Felix Salmon covered this extensively (short version and long version). This means that the government may not be able to go the voluntary route in the future.

28 thoughts on “But Are They Buying It?

  1. “In other words, the bond market isn’t buying the administration’s story, and thinks there’s a pretty hefty risk not only that some banks will be taken over, but that bondholders will be made to suffer in the process. Correct or not, this perception decreases confidence in the banking sector as a whole, because of the potential ripple effects of shorting creditors.”

    This interests me. As far as I’m concerned, we have implicitly guaranteed these bondholders. However, just like the flight from Agencies to Treasuries, the implicit guarantee isn’t working.

    The whole point of guaranteeing everything is not to have to actually spend the money, but stop panic and allow the investments to unwind in a more orderly and less costly manner. That’s what I support. However, I’ve also supported a tough attitude that basically says that they should be happy with whatever they get, on the assumption that we could pay them far less if we had to seize some banks.

    It seems that this bluff keeps getting called. Until there’s an explicit guarantee, we’re going to be in limbo. In that sense, what the government is doing is implicitly guaranteeing these assets, but hoping not to have to honor this guarantee by keeping the banks alive and hoping that they can dig us out of this.

    I guess that we can keep doing this. It has a kind of middle ground feel to it, which shouldn’t be lightly dismissed. The alternatives are to just come out and say that we’re on the hook for a lot of money that taxpayers are not going to be happy if it’s shelled out, or say that we will not guarantee these assets and investors need to deal with that, which leads to no one knows what.

    It’s pick your poison time. I was hoping that the government has been secretly negotiating with these bondholders, in order to try to seize the banks without bondholders fearing the worst. Maybe they are. If it was up to me, I’d go ahead and explicitly guarantee the bondholders at this point. But I have a long memory, and I don’t want to risk anything that can further escalate unemployment.

  2. contra nationalization – by a smart guy:


    beginning of post:

    From hysterical misery to ordinary unhappiness…
    March 10th, 2009
    By David Goldman

    …is the way Siegmund Freud described the objective of psychoanalysis. Market expectations seem to have shifted in a direction indicated by this blog, as well as Bronte Capital, Tom Brown’s Bankstocks, and a handful of other venues that look at banking in a traditional way. The positive feedback loop of asset writedowns, capital reduction, equity price declines, government intervention, and the fear of nationalization brought the system to a branching point.

    It seems hard to believe that Fed Chairman Bernanke’s discussion about reducing the deleterious impact of mark-to-market losses, Presidential advisor Paul Volcker’s proposals about a return to traditional banking, Treasury Secretary Geithner’s assurances that no large institutions would be allowed to fail, and Citigroup CEO Vikrim Pandit’s claim that Citi was running a profit were entirely isolated events. What sort of profit Citigroup reports this quarter is up to the regulators. If the regulators compel Citi to write a good deal of its loan book down to market, the bank could show an arbitrarily large loss. But Citi’s cash-on-cash returns in a cheap-funding, wide-spread environment probably are reasonably strong.

    Meredith Whitney’s comments today seem a bit impertinent. It may be true that Citi is not making money on any of its businesses, but that presumes that portfolio income will be eliminated by mark-to-market writedowns. At the same time, the redoubtable Ms. Whitney argued that banks didn’t want to return to mark to market because that would eliminate their upside should asset prices recover. All this is beside the point.

    The bank regulators have a set of problems to address.

    They cannot easily nationalize the banks because

    a. Nationalization immediately would collapse the value of bank asset books relative to liabilities and balloon the negative equity assigned to taxpayers

    b. The value of bank hybrid and other capital securities would collapse, intensifying the misery of the institutions with the greatest exposure to bank capital securities, such as the insurers.

    The simplest and least costly approach is to keep the banks alive on a respirator: provide cheap liabilities through a variety of mechanisms including FDIC-guaranteed bond issues, and allow the banks to clip coupons in a very wide spread environment. The deteriorating economic environment (and it will continue to deteriorate nastily) will pile up loan losses almost as fast as the banks can generate cash flow. Cheap federal funding may just allow the banks to stay in positive territory.

    Bank stocks were artificially depressed by market fear of nationalization. I have maintained throughout that this was an irresponsible and unworkable proposal by academics (Krugman, Nourini) who did not understand or did not think clearlky about the financial system. But this is not an enthusiastic case for bank stocks. On the contrary, my view is that keeping zombie banks alive is the scenario to which regulators will iterate. What is the value of a zombie Citigroup or Bank of America? Somewhere in the low-to-mid single digits for C, and in the upper single digits for BAC. That implies a substantial percentage gain from Monday’s opening levels, but not a sustained rally.

    As loan losses (prime mortgage, commercial real estate, commercial and industrial loans, and so on) continue to pile up, the zombie existence of the banks will remain tenuous at best, and it will be years before they pay anything resembling the kind of dividends they offered as recenty as a year ago.

    Investors who own bank stocks should already be considering targets for profit-taking.

    end of post:

    and this:


    beginning of post:


    Federal Reserve officials, preparing for a policy meeting next week, are considering whether to pump more money into the economy by expanding their lending and securities-purchase programs.

    Struck by the sharp deterioration in stock markets — despite Tuesday’s rally — and renewed strains in credit markets, Fed officials are likely at next week’s meeting to assess what success they have had with existing efforts and what more they can do to ease financial strains and prop up the economy.

    View Full Image
    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.
    Getty Images

    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.
    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.
    Federal Reserve Chairman Ben Bernanke prepares for his speech Tuesday.

    The Fed has already used its main tool to the limit, having pushed its target interest rate, the federal-funds rate, to near zero. It already has ramped up lending and asset purchases. But it could decide to push harder by, for instance, purchasing long-term Treasury securities or increasing its purchases of debt issued or guaranteed by Fannie Mae and Freddie Mac. It is unclear whether the Fed will decide to take new steps at its meetings on March 17 and 18.

    Treasury purchases could help bring down long-term interest rates by pushing up the price of government bonds and thus pushing down their yields. That, in turn, could bring down other long-term rates because Treasury debt is a benchmark for many loans and securities.

    Fed officials have wavered on taking such a step, but recently have been struck by the initial success the Bank of England appeared to have with such a move last week.

    “The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy,” Fed Chairman Ben Bernanke said Tuesday in comments at the Council on Foreign Relations.

    A recovery, he added, would be “out of reach” until officials stabilize the financial system, and even if that happens the recession will persist until “later this year.”

    Adding a dose of humility to his assessment, Mr. Bernanke conceded, “My forecasting record on this recession is about the same as the win-loss record of the Washington Nationals.” The Major League Baseball team had 59 wins and 102 losses last year, the worst in baseball.

    The Fed is in the process of building up a consumer lending facility called the Term Asset-backed Securities Loan Facility, or TALF, which it hopes to expand substantially. Officials also are likely to review issues such as how to unwind programs once the economy recovers.

    Mr. Bernanke has signaled in recent months his willingness to take aggressive action to combat the crisis. His reference Tuesday to the Great Depression stood in contrast to comments earlier in the week by European Central Bank President Jean Claude Trichet, who held out hope for a turnaround.

    In some respects, the Fed’s existing efforts are having success. For instance, interest rates on high-rated commercial paper have come down since the Fed introduced a program to backstop that market last year. But with broader market strains unrelenting and the recession not showing signs of reversing, the next steps are on the agenda.

    New York Fed President William Dudley underscored the Fed’s concern in comments last week, noting that the deleveraging hitting markets and households was not yet done, and “as the recent employment data have underscored, the economy has considerable momentum to the downside.”

    In the past few months, officials have put aside the idea of buying Treasurys and have instead focused on programs such as TALF that they hoped would more directly spur lending to businesses and consumers. Some Fed officials also have been wary of taking a step that could be seen by markets as an effort to help the government fund large budget deficits, which could be inflationary.

    But officials have seen firsthand evidence in recent days of the potential benefits of a Treasury purchase program. The Bank of England announced last week that it would begin buying U.K. government bonds. After the announcement, yields on those instruments briefly fell below 3% from more than 3.6% beforehand.

    Treasury purchases should “certainly” be on the list of possible next steps, said Charles Plosser, president of the Federal Reserve Bank of Philadelphia. Mr. Plosser isn’t a voting member of the policy-setting Federal Open Market Committee, which is composed of Fed board members in Washington and five regional Fed bank presidents. He has been an occasional critic of Fed policy, calling for more explicit targets by the central bank to help guide its actions.

    The Fed could easily increase its purchases of debt issued or guaranteed by Freddie and Fannie, the government-backed mortgage giants. The central bank has already committed to purchase $600 billion of these securities and since December has taken on more than $90 billion toward that goal.

    Mr. Bernanke has noted in recent speeches that this effort seems to be helping mortgage markets. Rates on conventional mortgages have fallen to 5.15% from more than 6% since the program was announced, according to Freddie Mac.

    The Fed’s total assets grew from about $900 billion to $1.9 trillion as of March 4, an indication of the huge amounts of cash it is pumping into the financial system.

    That amount has shrunk by more than $300 billion in recent weeks as some of its programs are tapped less aggressively. But it is likely to grow substantially in the months ahead. The TALF program, for instance, could grow to as much as $1 trillion.

    “We’ve grown our balance sheet by a factor of about two,” said Mr. Plosser. “It’s going to get bigger before it gets smaller.”

    end of post

    first inflation – then the bank fix – if necessary

  3. In reference to the previous post, I have some questions. Every other blog or even in articles written here, I see that someone mentions inflation and further monetary policy before more fiscal stimulus or nationalization.

    I’m no economist, but is that suggesting that we can fix this whole mess without any sort of re privatization / nationalization or even fiscal policy? How would “fixing” inflation solve this world wide crisis, and how should we do it?

    I’m just noticing a rift in economic thought here, since inflation has not been a topic that has received much attention at this blog that I’m aware of. Is there another theory that provides realistic solutions to these problems I don’t know about? What are the arguments for and against the feasibility of other theories?

    If anyone can point me in a direction to help explain this, would be much appreciated.

  4. one question being where ‘they’ are allocating and hoarding their cash piles in the interim

    “…These traders are not buying the insurance on the belief that they will get paid out following an actual default. They are buying based on the belief that things will get much worse, and the fear of default will rise sharply, and the value of these contracts will rise exponentially. it’s one of the best ways to bet on future chaos. Early buyers of CDS will cash-out prior to the crashing of the system, and at that point shift to hard assets…” http://krugman.blogs.nytimes.com/2009/03/10/credit-protection-madness/

    “The government is seeking to resuscitate the nation’s crippled financial system by forging an alliance with the very outfits that most benefited from the bonanza preceding the collapse of the credit markets: hedge funds and private-equity firms… The idea is to entice them to put their huge cash piles to work to stimulate the financial system…” http://www.washingtonpost.com/wp-dyn/content/article/2009/03/05/AR2009030503762.html?hpid=topnews

    “…Does private equity pose a systemic risk?… Federal Reserve Chairman Ben Bernanke didn’t mention either in a speech this morning in which he outlined a potential path forward for regulators. (Although we wouldn’t have either, given that Carlyle Group’s David Rubenstein was moderating the speech, to the [CFR])…” http://www.nakedcapitalism.com/2009/03/guest-post-inner-circle-of-systemic.html


  5. NickB

    Yes – the suggestion is that unconventional monetary policy can go a long long way to fixing this – without much suffering – or a lost decade – or the end of the world as we know it. Absolutely. That is my firm belief.

    Read this website and petition:


    And I will post here as I have done elsewhere on this blog and elsewhere a small post from that bentley blog that makes exactly that claim.


    beginning of post:
    Puritan attitudes toward monetary stimulus

    Krugman has criticized people who view depressions as a necessary price to pay for our previous sins of profligate spending and borrowing, or as a way of purging excesses from the system. I think he is right that this attitude exists, especially (although not exclusively) among those on the right. I find that this mindset makes it especially hard to argue for monetary stimulus, even compared to fiscal stimulus.

    When most people visualize the myriad economic crises that we face, it seems as if we carry an almost unbearable burden on our collective shoulders. If someone comes along saying that we merely have to debase our currency, and the burden will be magically lifted, the solution seems incommensurate with the problem–it seems to good to be true. Even fiscal stimulus, often called a politician’s dream, evokes thought of future sacrifice, as we eventually must repay the massive debts we incur.

    FDR was probably the only U.S. president to deliberately set out to debase the dollar. Toward the end of 1933 he joked with his aides that he had used lucky numbers when deciding how much the dollar would be devalued that day. Even Keynes found this frivolity offensive. But it worked. Industrial production rose 57% in just his first 4 months in office, regaining half the ground lost in the previous 44 months. Prices also rose sharply. If the recovery had not been aborted in late July by his high wage policy, near complete recovery would have occurred by 1935.

    The sober puritan ethic is probably well-suited for all sorts of serious, long term economic problems. (Social Security reform?) For an economy facing deflation, however, nothing could be worse.

    end of post

    the man who writes this post is not an insane person – he wants the fed to set a firm and committed price level target – not an inflation rate target but a price level target – and promise to hit it. We will believe them and so will change or expectations from deflationary to inflationary and so start to spend. Not everyone will spend – of course. But ther vast majority of working people is the country and still working, not laid off, and there are marginal buyers – people right on the cusp – marginal buyers of cars, houses, vacations and all else, some of whom will change their behavior – stop waiting for lower prices (deflationary expectations) and rather spend – which is exactly what we need. As he says, it likely that the Fed will not have to print more cash – there is plenty of it – but it is stilling in peoples accounts now – dead and lifeless. It needs to move out. Then bank assets will improve and the recap – if necessary – will be must easier.

  6. NickB

    There is sort of a rift and sort of not. People disagree as to how effective unconventional monetary policy would be – but most people do not disagree that a deflationary spiral is profoundly more dangerous than inflation – because we do know how to control inflation. Volcker has shown us. And most would also agree that we would rather have the stagflation of the 1970’s than the deflation of the 1930’s – if those are our only two choices. But I do think we have a third choice – if the Obama administration and the Fed will just ACT.

    My belief is that if we try unconventional policy we don’t have anything at all to lose. There is talk today on the WSJ that the Fed might start to buy the long bond – with fresh cash. That would be a start – but even that is not really what I have in mind. I want a commitment by the Fed – a clear statement – that they will give us a price level – three years from now – that is x % higher than it is now – and that we, the Fed, will do whatever we have to do to get that. Now that would really change expectations.

    And it would be a policy announcement that – if made jointly with this indulgent, self-protecting and self-loving president we now unfortunately have – a policy statement that he really needs – to convince people that he is dwelling on the same planet we are dwelling on – and not in some odd parallel universe of three years from now when all will be fixed up by the magic of his charm. People are real tired of that line.

  7. I’m an idiot next to the authors of this blog, but… I believe Dr. Kwak may be making the classic overestimation of the market’s efficiency. Certainly a tightening of bond spreads in the bank space is a good indicator – but why do we believe institutional bond investors are any less irrationally cautious then the rest of the world right now? I know people on bond desks, they are more influenced by Citi’s public stock price and the client reaction if they are wrong on a purchase then anyone would like to believe. In a normal circumstance their clients would give them the benefit of the doubt, but money is flying from custodians to cash at a furious pace. I’m afraid we may be in a place were the stock traders are waiting for the bonds to show them something, while the bond traders are waiting for the stock traders etc..

    Municipal Bond spreads are unbelievable right now as well, on an asset class that had a 0.6% default rate during the great depression. The red, neon sign blinking “undervalued, huge opportunity” doesn’t seem to be helping that market either. Spreads have been widening again over the last few days along with the bank bond spreads. Why has that been happening? There is no municipal agency rescue plan. Perhaps it is simply short-term traders making quick profits on the tightening and then jumping out, using the money to cover shorts in other areas? Perhaps it is a lot of things that are outside of rational market theory, you know weighing machine / voting machine stuff.

  8. why should bondholders be spared if the government has to bailout a bank? bond investors are supposed to be the smartest people. besides as simon says the bonds are already trading at a big discount. it would not hurt them to at least take a haircut in a bailout. the bad news about the banks has been out for a long while the bondholders could have sold. now there are speculators such as bill gross of pimco who regularly brags on cnbc that he is “shaking hands with the government” and buying senior unsecured bank bonds at a discount as the government will spare them. if the government’s wait and see policy to bank problem doesnt work out the burden on the taxpayer will be astronomical if senior unsecured much less subordinated bondholders are spared.

  9. Mk

    Or maybe it is people reading the bank-nationalization-before-inflation buzz – and becoming rationally scared out of their wits.


    This guy is scared out of his wits. And he is hardly alone. Geithner thinks that the nationalization while in deflation talk – spreading into congress now – might force him to risk the end of the world – something he would rather not do.

    He has no idea what would happen – and neither do we.

  10. MK, that is a good point. Maybe I’m reading too much into bond prices. Still, though, I think there are two things to separate:
    1. Low bond prices mean that the administration is wrong and they are going to fail. This is probably not a good inference to draw, because the bond market could be irrationally pessimistic.
    2. Low bond prices mean that the market thinks the administration is wrong. This is probably a more justifiable inference.

    Unfortunately, the two are not completely independent. If we have enough of #2, that increases the risk of #1. (Fear hurts the economy, which hurts banks, etc.).

  11. Yes, the self-fulfilling prophecy possibilities are my biggest concern. But we also have to remember that if bond traders were all that smart, we won’t have this problem in the first place.

  12. Why? The bond market — and all markets — are blind to the inflation risk arising from current government monetary policy. Who can possibly forecast expected inflation given everything the Fed and Treasury are trying to do. So, per force, interest-rate expectations are impossible to formulate. As is a reasonable expectation of your reinvestment risk, and bankruptcy risk.

    In addition, we have a Fed and Treasury (under the Bush and Obama administrations) running roughshod over contract law and the sanctity of contracts in the derivatives markets: The courts have been completely obviated in the Paulson and Geithner Treasurys, with an assist from Bernanke’s Fed. No one can expect the federal government’s first principle is sanctity of contracts in the current market. So unless you’ve got “your guy” on the inside — who’ll give you a head’s up when the federal government is about allow a bank it guarantees to break the covenants in your indenture (i.e., your contract), the way it did in the CDS market — you take too much risk betting which arbitrary course of action the government will permit. If you can’t be sure “the fix is in” you’d be a true sap to play in that game.

    Besides, who, at this point, would invest in anything associated with the current bank and FIB managements? These are the folks who, by their ineptitude, have caused multiple TRILLIONS of dollars of wealth destruction — more (after everything’s been tallied up) than both World Wars of the 20th century combined (in real terms). Does any rational investor want to keep funding them so they can get back to business as usual?

  13. James,

    I think you need to be careful here and not read too much into the market. Remember, 12 months ago the market was saying that Banks are great investments.

    Didn’t reallly turn out that way, did it?



  14. This talk of the inevitability of needing to swallow a taxpayer bailout of bondholders is maddening! What is everybody so god-darned afraid of, to let the bondholders take their losses?

    I get it – if most of us of little means (public) don’t guarantee those of great means their holdings, they in turn won’t invest in the financial firms that will lend to keep the economy turning for the little folks. But must we be resigned to banks that are TBTF, whose working capital is largely from investors instead of depositors? That is the model we must recoil from.

  15. “These are the folks who, by their ineptitude, have caused multiple TRILLIONS of dollars of wealth destruction”

    That wealth did not exist anymore than it did during the late-stage Dutch tulip market.

    But it’s far worse than that, because we brought forward 5-10 years of real demand on credit. All the cheap stuff (and not-so cheap) that HELOC’s and credit cards could “buy.”

    To the other above poster: so no, the consumer is not spending. In fact, they will be liquidating.

    It also means industry, especially FIRE, extrapolated this ballistic demand and overallocated/misallocated resources on the supply-side. Unfortunately that means industry will not be producing or hiring or doing much of anything for the next 5-10 years. That of course is working wonders for the stock market that reflected underlying growth at impossible rates. Retirement funds based on these inflated equity values was also false.

    No amount of monetary chicanery is going to get us out of this. It all must deflate. The only thing monetary intervention will do is make things worse, by putting the full faith and credit of the nation on the line– just to bailout about 500 very wealthy people holding paper tulips.

  16. After reading numerous blogs in different sites I think one major ingriedient is sorely lacking in the numerous steps that had been taken by the Fed, the Treasury and Congress.


    No backbone at all. All their actions seem to be more ad-hoc and panic reactions to the deterioting conditions of the market. Nobody is showing any sign of courage except in so many words – meaning – too much noise but no action.

    We are basically leaderless at this stage.

  17. First, to prove to “the market” that they’re right on this (minor) issue, the +/- $19bn “FDIC international group” should remove their guarantees to banks new debt. Then and only should the administration at a certain point in time become »proved wrong« on this (minor) point, the banks (that proved the administration wrong) should be divided into two parts, call it
    – the good and the bad,
    – the commercial and the new investment or
    – the dull and boring and the exciting one,
    so that such action affects only asset division (their level 3 has nothing to do with the dull and boring part), but not liabilities part. The liabilities stay exactly the same in both “parts”. Then let the exciting parts take the chapter 7 route (if they choose so), while the state guarantees throughout this route both FDIC insured deposits and all the bondholders that acquired bonds under the failed FDIC bond guarantee “scheme”. This way we put some teeth where our mouth is and eliminate the wrong headed nationalization debate plus the other bondholders can for themselves decide whether to become equity holders (of exciting SIVs that hang on in level 3 of the exciting part) or not…

    Or you can print +/- 10 trillion of new $s right about 4 months ago.

    (the (minor) issue here being the effect of the collapse of many levels of “assets” held off onto the BS, regardless of market or otherwise marked)

  18. “…They also called for the burden to be divided fairly among many nations… including cash-rich China and Saudi Arabia… China in particular needs to make more substantial contributions…” http://www.washingtonpost.com/wp-dyn/content/article/2009/03/11/AR2009031104346_2.html

    BEIJING, March 7 – “China should speed up reforming its financial system to make the yuan an international currency, said political advisors Saturday. “A significant inspiration to draw from the global financial crisis is that we must play an active role in the reconstruction of the international financial order,”…” http://news.xinhuanet.com/english/2009-03/07/content_10964698.htm

  19. Deflation is hardly the only option – but it is an option.

    The challenge with deflation is that it will destroy leveraged wealth – including the last 7 years of homebuyers (many who saved, bought with equity, and had decent jobs). While some might say, “too bad, lousy luck for them”, the externalities associated with massive simultaneous bankruptcies are enormous – made more so by the securitization and the complexity of the legal contracts.

    The “sanctity of contracts” people fail to recognize that contracts are only as good as enforcement. Which brings up two points – if everything goes boom, good luck getting restitution/enforcement through courts with a 5 year backlog of cases. (And if the US goes boom, good luck getting those CDS contracts fulfilled.) The courts aren’t built for that kind of load. Second, govt. has no obligation to enforce contracts that it deems to be contrary to the public good (in the long term). There is a strong case and common law basis for this. (You cannot willingly sign a contract committing yourself to effective slavery, for instance.)

    And to all those people who are now scared to write contracts for fear that they won’t get enforced – perhaps that is good. We’d all be better off if those CDS contracts had never been written, and the CDOs had never been issued.

    The other challenge, btw, is that if deflation/depression occur (and depression would occur with mass deflation in the US), the US and many other countries are so burdened by debt that the rate of debt accumulation could exceed long term expectations for economic growth (and hence, tax revenue growth). That means insolvency for the US.

    While deflation and mass bankruptcy is an option, it is not the only option. The other option is inflation.

    Why the resistance? Aside from free market religion, there are distributional consequences.

    Standard revenues are a tax on income (generally, work and to a lesser degree capital gains/interest), but inflation is a tax on dollar-denominated wealth. Like fixed bonds, T-bills, etc.

    Many individuals who argue passionately against inflation are the same individuals who stand to lose, or who seek to benefit from mass bankruptcies – that is, those who started the crisis heavily in cash and are looking to get their windfall and retire on everyone else’s woes. Not all, but many.

    These really are the two options. What is interesting is that the Fed and Treasury are trying to engineer a third option – mild inflation (standard 2% target), fiscal stimulus, borrow like heck to pay for it from abroad, restore confidence, and create an illusion of growth that might eventually become real. As part of this, channel gobs of money into the banks through means obvious and obscure to reflate the money supply without officially printing money (that way, the banks keep the money that gets created rather than the federal government).

    Frankly, I don’t think this “middle road” will work. And because govt. is being so timid in their efforts, I suspect we will end up undershooting rather than overshooting, meaning we will ultimately get the deflation you seem to want.

  20. MethodMan: Asset values may have been inflated, but that does not mean wealth was not destroyed. Yes, the expansion of credit brought forward consumption that would have occurred years hence to the present, and yes that does mean there likely will be less demand among highly levered firms and households over the near term. As a matter of policy and economics, this is a positive reality (there is no normative prescription): Firms and households — given current information (e.g., cost and availability of credit, cost of goods, etc.), budgets, and income constraints — allocated as they saw fit. This is a process that cleared the market. The market will now clear at a lower level of aggregate demand, which aggrgate supply will have to adjust to, as it always does. The role of government here is to ensure markets continue to clear, given new information, budgets and income constraints. Full stop.

    StatsGuy: I obviously am among those “sanctity of contracts” folks. Mostly for the reasons laid out by Hayek and Aron in the 1900s. Both developed their formulations contra centralized control (i.e., vs. A. Hitler’s German Democratic Republic, and V. Lenin’s Union of Soviet Socialist Republics). My comments will make more sense if you’re familiar with “The Road to Serfdom,” by Friedrich August Hayek, and a follow-on examination entitled “A legal theory without law,” by Ernst-Joachim Mestmäcker. I also would commend Raymond Aron’s “The Opium of the Intellectuals.”

    The focus on sanctity of contracts is only remotely related to the moral-hazard arguments being advanced by those opposed to the bailout of banks, former investment banks (FIBs), and hedge funds (HFs). This concern is valid, and we should resist anything that incentivizes the sort of reckless abandon demonstrated by the managements of banks, FIBs and HFs in pursuit of their own enrichment at the taxpayers’ ultimate expense. This is largely seen in the terminal phase of market breakdowns, when elites’ tunneling behaviour — c.f., the looting of the US Treasury in the waning days of the Bush administration — becomes rampant.

    Tunneling can be reversed: Culprits can be held to account, funds can be disgorged, and the system can be repaired. The far larger concern is the destruction of the legal foundations underpinning market economies generally: Contracts. This arises when the government sanctions the destruction of contractual rights and responsibilities, as it did in the CDS market and elsewhere. Here Hayek’s and Mestmäcker’s discussions are most illuminating.

    Contracts memorialize a current and shared understanding of the present and establish rights and obligations in the future. This is the only thing that allows strangers to plan for and allocate their resources now for current and future use with a high degree of certainty. This is what allows for rational risk taking. This is what permits banks to lend, and investors to invest. Without the contracting mechanism there is no market. There is no market-based capitalist economy. There is no future. There is only the immediate present, because nothing in the future can be relied upon. The pain and loss that arises from court-imposed penalties for breaking contracts is what gives them their force, and makes contracting parties do everything in their power to abide by their contractual obligations. The fact that the courts have at their disposal the full support of the government — with its monopoly on force to impose its will — is critical for any society that would substitute contractual markets for command-and-control centralization in the allocation of scarce resources.

    Abrogating contracts in our economy means you have to replace it with an alternative mechanism for allocating resources. We’ve seen this sort of transformation in the recent past, when, as Hayek and Mestmäcker recount, the National Socialists’ initially, and subtly, transformed German legislative and administrative structures, such that they ultimately would accommodate various centrally controlled cartels. The first step in this process, as the national socialists understood, is to insist on a shared vision of the common good in a period of confusion and chaos.

    The evolution of our form of Common Law, inherited from the English and codified here in America, decidedly favors individual and contractual rights over the government’s presumed right to act unilaterally to advance the “common good.” Our Declaration of Independence and Constitution are, without doubt, the wellspring of this understanding, even as they themselves are the culmination of centuries of active resistence to excessive government over-reach into the private sphere.

    This is why the destruction of contracts is so frightening: A small cadre of insiders creates a set of cartels — the financial cartel, the military-industrial cartel, the propaganda cartel, etc. — and determines who wins and loses; who’s on the inside and can receive preferential terms in its loans and tax treatment; who will avoid the messy outcomes associated with reckless financial behaviour; who grows what; who fights the wars; etc. … This is the ultimate perversion of our system of government and economic organization. The perversity is such that these elites have a vested interest in convincing the populace that things are so dire, so dangerous, so certain to cause the collapse of everything we’ve come to know and trust, that only they — acting in our best interests — can salvage a vestige of what we used to know. This is the Road to Serfdom.

  21. Wish I’d caught this post sooner – thank you. Very well written.

    I’m familiar with Hayek et. al. I respect that body of work immensely.

    However, I find myself more in the camp of William James. That is, pragmatism, and I tend to believe that James’ attitude is widely shared among Americans. Moreover, I would argue that history shows that pragmatic thinking has impacted US law and morality at least as much as any other economic principle (including sanctity of contracts).

    Pragmatism would never deny that contracts have served the world greatly. Nor would a pragmatist argue against the huge body of evidence that links property rights to economic growth. (Though a pragmatist notes that property rights were a necessary but not sufficient pillar of growth.)

    However, a pragmatist would argue against enforcing property rights (e.g. contracts) that are decidedly against the long term interest of the country. A pragmatist would also note that all contracts are written with certain implicit restrictions – that is, there are certain types of contracts that _cannot_ be written.

    In addition, just as markets have their flaws, so does a very strict interpretation of property rights. For example, how does strict adherence to contract enforcement deal with intergenerational equity?

    For example: one generation – let’s say the Baby Boomers – votes itself a huge consumption splurge and finances this with taxpayer debt (e.g. the Reagan/Bush tax cuts & deficits). They pass a law that says that the country will pay it off after they retire – meaning, the next generation will pay it off.

    Does the next generation have any recourse?

    A strict advocate of the sanctity of contracts might say no. The nation made a pledge, the nation must keep that pledge. (Perhaps there should have been a Constitution that prevented such a pledge from being made, but it _was_ made.)

    A pragmatist would say that there is an optimal level of contract enforcement – that is, contracts should be enforced to the degree that the social harm from failing to enforce them (e.g. moral hazard, inability to commit, higher costs to conduct exchange) is balanced by the social harm of excessively enforcing contracts (intergenerational equity, common utility, etc.)

    In a pragmatic world, the debt would be partially honored (perhaps by inflating the currency) – and indeed, this would be socially optimal. Future lenders would need to consider the possibility that they should not issue credit to people who would spend it on pure consumption while leaving their children the bill… And that would be a good thing.

    Perhaps predatory credit card lenders would think twice about trying to sell credit to people they suspect cannot pay it back.

    As to other practical areas of the law – patent law and bankruptcy law are good areas to discuss. Recent changes to bankruptcy law may (or may not) lower interest rates, but at what social cost? I’m certain that capital punishment and/or a debtors prison would also lower default rates (and hence interest rates), but can you really say this is socially beneficial?

    Add to these situations the classic problems with markets – incomplete contracting, asymetric information (of which fraud is a special case), liquidity, transaction costs…

    All of these make it impossible to _perfectly_ regulate any system ex ante. In a financial system such as a bank, this means the bank will always have the opportunity to commit the country to contracts that are bad.

    How so? By issuing promises that – if enforced – cause tremendous harm to the country.

    And, in particular, to future generations who had no hand in fashioning the contracts.

  22. Good stuff. Thank you.

    This sounds a lot like the Jefferson v Hamilton debates re our national debt in the days following the Revolution. This time around, tho, the federal government’s been completely compromised by self-serving behaviour among our financial elites. Not that that hasn’t always been the case — but this time around appears to be the most egregious and rapacious in our history. Even the fraud and looting of $10+ billion by US defense contractors in Iraq pales in comparison.

    I too am a pragmaticist, as Charles S. Peirce, a co-founder of American pragmatism along with William James, would say. They would insist that what we seek is truth, first and foremost. We have to find the right way of thinking about the problem before we can propose a solution. The truth of the matter is, Hank Paulson and Ben Bernanke, and now Tim Geithner, have allowed a very bad actor — in the form of AIG Financial Products, and its co-evals in the credit default swap markets — to declare all of their contracts null and void, so that the US Government could step in and make sure AIG’s counterparties get paid off.

    There is a plausible case to be made that this contract abrogation was sub-rosa, and that tunneling on a massive scale occurred in this instance. At the very least this should be investigated by Congress à la the Watergate Hearings, and the fiduciary malfeasance at the banks and former investment banks should be prosecuted.

    This contract abrogation is one-way only, however: Now that same management at AIG FP is claiming it is contractually bound to pay out $165 million in bonuses the firm agreed to pay them last year. The firm also contracted $2.7 trillion of notional CDS last year and in years prior, a far larger obligation, yet it refuses to perform on those contracts. AIG shareholders have been pretty much wiped out, but the bad actors on the other side of the swaps they wrote are kept whole, despite their obvious wrongdoing.

    I can’t be the only person out there to see how destructive it is to global markets and society as a whole if this sham is allowed to be perpetrated. The US taxpayer is now the majority owner of a failed corporation. Can it be we bear all the losses and pay excessive comp to those that have visited this destruction on the global trading and capital markets. And we leave these people in place to negotiate further payments and make-whole structures with our Treasury? This is madness.

  23. One more note: I just read the NY Times lead story today — “At A.I.G., Huge Bonuses After $170 Billion Bailout” — and was struck by the note Ed Liddy, AIG’s government-appointed chairman, wrote to Geithner explaining why these payouts were vital to AIG and, presumably US taxpayers, since we are majority owners of the firm. And I quote, “We cannot attract and retain the best and the brightest talent to lead and staff the A.I.G. businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury.”

    This is laughable. Truly. The “best and brightest” at AIG led the company and global markets to complete and utter destruction. And now they’re going to be rewarded? A rational person would suggest they need to be run off and driven to the far corners of the world, where they cannot ever inflict this kind of damage again.

  24. @Markets – I can dispute nothing that you’ve said…

    In the immediate term, I’m simply concerned that the US govt. is “filling holes” in a sand bank when the tide is coming in. Back in September/October, if the US had put an immediate moratorium on foreclosure and implemented a streamlined renegotiation process, along with more aggressive monetary and perhaps even fiscal policy, the ultimate cost would likely have been far less than it is today.

    In the long term… I suspect that even if we did let the institutions fail – and paid the economic price – we still would have banks and financial companies doing absurd things. The tulip mania did not require an overly sophisticated financial system.

    We could try more creative solutions – aggressive regulatory agencies (until the next President cripples them with abusive internal regulations and crony appointees) – perhaps a strong whistleblower law?

    I still doubt it would work.

    Simon believes the issue is “too big to fail”, but even if we whittled down the size of our banks, how long will it be before the laws that prevent bank mergers are undone?

    Unless we are prepared to make dramatic changes to the financial system, the best we can hope for is another 70-80 years before everyone forgets again.

    Meanwhile, such dramatic change is almost certain to bring its own problems. The two most dramatic options – public banking and returning to a gold standard – either grant even more power to government, or reduce govt. control over the monetary supply to such a degree that we cripple our ability to respond to national emergencies.

    I cannot imagine such fundamental change having a chance to succeed. Not unless the crisis dramatically worsens.

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