Author: James Kwak

New Cars, Mortgages, and Race

Like most forms of hardship in our society, the foreclosure crisis is disproportionately affecting minorities. The New York Times conducted a study of foreclosures in the New York area and found, among other things:

Defaults occur three times as often in mostly minority census tracts as in mostly white ones. Eighty-five percent of the worst-hit neighborhoods — where the default rate is at least double the regional average — have a majority of black and Latino homeowners.

Well, that might simply be a function of poverty: statistically speaking, minorities are more likely to be poor, and therefore more likely to become delinquent on their mortgages. But I don’t think it’s that simple.

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Be Careful What You Tweet

In Guatemala, at least. Various commenters on this blog have, at one time or another, recommended pulling your money out of those “too big to fail” banks that are getting so much government support. In Guatemala, Jean Anleu Fernandez was arrested and jailed for sending this out on Twitter:

First concrete action should be remove cash from Banrural and bankrupt the bank of the corrupt.

I guess he also said the bank was corrupt. Well, people have said that around here, too.

More broadly, the government is in crisis, with frequent popular protests, over allegations that Rodrigo Rosenberg was assassinated on the orders of the president because he uncovered evidence of murder and corruption by the government. 

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More Bank Balance Sheets for Beginners

If you read this blog and listen to Planet Money, you may have had enough of this topic, but Calculated Risk pitched in with two posts on liquidity and solvency crises, complete with graphical balance sheet illustrations. He does a better job than I have of conceptually illustrating the workings of the various bank bailout plans that have been offered. 

This is his assessment of the current strategy:

The Geithner approach is to keep injecting capital into the banks to cover the losses. This is known as the “Zombie” bank approach. . . .

Although the bank is balance sheet insolvent, the bank will never be business insolvent [unable to pay its debts as they come due] because the government will continue to provide money to cover losses.

If only a small percentage of financial assets are held by zombie banks, then this approach will probably work. These banks will be crippled, but the other banks can meet the financing needs of the economy.

I should note that CR does not say the entire banking system is insolvent, or that any banks in particular are insolvent.

The posts are from late April but I missed them, probably because they were on my birthday.

By James Kwak

Microsoft: Just Another Company

Earlier this week, Microsoft issued long-term debt for the first time in its history, selling $3.75 billion of  5-, 10-, and 30-year bonds. From a corporate finance perspective, I guess this makes sense, since it got to lock in historically low borrowing rates. Treasuries are low, and Microsoft paid only about one percentage point more than the U.S. government, which makes sense since it does have over $20 billion in cash, no other long-term debt, and – let’s not forget – a virtual monopoly on computer operating systems and basic desktop software. (In some ways, Microsoft looks like a safer place to lend mone than the U.S. Treasury, except for the ability of the latter to print its own money.) But it’s still a little sad.

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The Green Shoots Debate

Earlier today, Simon suggested that “we are out of the panic phase of the crisis.” Bond Girl said in response, “There appears to be some confusion between exiting the panic phase of the crisis and actually recovering.” That is something that I certainly agree with, and I suspect Simon does as well (although he may not agree with her entire comment.) 

There has been a lot of discussion of “green shoots” scattered around the Internet recently. Most of it, I think is premature. A lot of economic indicators seem to show that things are getting worse at a slower rate than before. One major source of optimism was last week’s jobs report, which showed a net loss of “only” 539,000 jobs. Here’s an excerpt from the New York Times coverage:

Yet the deterioration was milder than expected, prompting encouraging talk.

“The most intense spate of weakness is probably behind us,” said Michael T. Darda, chief economist at the research and trading firm MKM Partners. “Less bad is always a prelude to good. It’s going to take some time for this economy to get back on its feet, but we might be closer to the recession ending.”

Investors bought into that message, sending stock prices soaring.

To put this in perspective, I turn to the always-accurate Menzie Chinn (follow the link for a good picture):

Revisions are downward (but getting smaller over time), the growth rate becomes less negative, but hours continue to decline rapidly.

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Self-Defeating Marketing

Today I got a “Welcome Guide” from Bank of America because I was until recently a Countrywide customer. Countrywide, like many institutions that are in trouble, was offering some very high CD rates last year before being acquired by Bank of America, so I put money there – below the FDIC limit, of course – just like I put money at IndyMac and Wachovia shortly before they failed. (For people who like to chase high rates, I recommend Bank Deals.)

Anyway, this nicely designed welcome guide had a page titled “Clarity,” with this text:

We’re working to take the guesswork out of home lending with ideas such as our Clarity Commitment. This simple one-page loan summary clearly highlights key terms of each new loan. We’ve made it easy to read and easy to understand. So when you’re ready to buy or refinance, you can be confident that you’re choosing a loan that’s right for you.

Unfortunately, there’s a footnote that say, in very fine print:

This summary is provided as a convenience, does not serve as a substitute for a borrower’s actual loan documents and is not a commitment to lend. Borrowers should become fully informed by reviewing all of the loan and disclosure documentation provided. Not available on all products and programs.

I understand the value of high-level disclosures and the need for detailed contracts. But as a marketing message, this one seems to shoot itself in the foot.

By James Kwak

The Skirmish over Credit Cards

The Senate may be voting this week on a bill to tighten regulation of credit card issuers – or not, since you can never tell with the Senate. Despite an agreement between the ranking members of the Senate Banking Committee, there is a series of amendments from both sides to go through; Real Time Economics has a summary of the issues that were open as of earlier this week.

I wrote a post on The Hearing earlier describing the debate as one between two economic perspectives: classical economics (credit card issuers should be able to offer any terms they want; if people accept them, that by definition means it increases their utility) and behavioral economics (people suffer from cognitive fallacies, like thinking that they will never pay any of those fees threatened in the credit card agreement, so regulations should help people make better decisions and protect them from bad decisions).

Looking back over that post, it was far too balanced. There is a plausible theoretical argument that tighter restrictions have the effect of limiting the supply of credit to marginal customers, but that’s not what’s going on here. First of all, there isn’t much demand for credit these days. Second, it’s really about whether credit card issuers will be able to use increased interest rates and fees to partially offset their increased default rates. And of course, this isn’t going to be decided by economics, but by power. The more relevant question is the one that Simon was asked on MSNBC: “Do the banks own the Senate?”

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New Forms of Internet Communication

Arnold Kling has developed a new form of communication across the Internet: he wrote a blog post entitled “Paging Simon Johnson and James Kwak,” pointing to a 2000 paper by a Federal Reserve economist on the usage of securitization and off-balance sheet entities to effectively lower banks’ capital requirements for the same level of asset exposure. According to Kling, “the article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon.”

I haven’t sprung for the $31.50 to download the full article yet, but it is going on my reading list.

Kling also said he is “researching the history of capital regulation,” which is something I would also look forward to reading.

Update: One of my friends pointed out that my university has online access to lots of journals, including the one this paper was published in, so I now have a copy. 

By James Kwak

Law, Economics, and Regulation

One of the curious things about coming to law school was discovering the very high regard that “economics” is held in, at least in some areas like torts and contracts, where “law and economics” has become the primary theoretical construct. In essence, this school of thought holds either that the law has developed in such a way as to promote efficient economic outcomes, or that it should promote efficient economic outcomes. There is now an empirical branch of law and economics, but historically the law and economics approach was largely theoretical. For example, in United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947), Judge Learned Hand wrote that the whether behavior is negligent should be determined by multiplying the probably of an accident by the cost of the accident and comparing that to the cost of taking precautions. Twenty-five years later, Richard Posner argued that this rule would lead to the optimal level of accident prevention, because it doesn’t make economic sense to pay more for accident prevention than the corresponding reduction in the expected costs of accidents; at that point, the firm would be better off just paying damages to accident victims. (There, now you don’t need to take first-year torts – just apply that principle everywhere.)

The Hand-Posner principle has filtered into the world of public policy and regulation as the argument that the benefits of regulation must exceed their costs. This argument is ascribed to Cass Sunstein, who “cruised through Tuesday’s Senate confirmation hearing” to be the “regulatory czar” in the new administration, which sounds much more powerful than “Administrator of the Office of Information and Regulatory Affairs” in the Office of Management and Budget. Sunstein is a widely respected law professor who specializes in just about everything (constitutional law, administrative law, regulation, and now behavioral economics – he co-authored Nudge – with a brief foray into the death penalty on the side).In principle, he would be able to review new regulations being defined throughout the executive branch. So the cost-benefit model of regulation – already favored by the previous administration – may become more firmly entrenched in the federal government.

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Insurance and Health Insurance

I’ve been meaning to write a post on health insurance ever since hearing Karen Tumulty on Fresh Air. (She was discussing her Time article on underinsurance.) I happen to think that a free market for insurance works pretty well in most circumstances (and I did co-found an insurance software company); for example, if you can afford the house, you can generally afford the insurance for the house. But it doesn’t work very well for health care, because many people are simply uninsurable under free market principles (expected health care costs exceed their income, let alone their ability to pay), and hence would be left to die. We think we have a private, for-profit insurance  system today, but we can only avoid its disturbing implications by hedging it in with public backstops and regulations.

Since the Senate Finance Committee is taking up health care reform this week, I finally wrote that post today for The Hearing.

By James Kwak

Stress Tests: The Questions Continue

From Felix Salmon:

Why did Treasury switch from TCE to the even-more-obscure common capital metric? Quite possibly to help Bank of America and Citigroup get the amount of capital they needed to raise down to a number within the realms of possibility. After all, these tests were designed so that they couldn’t be flunked. And that might have seemed a real possibility back when Treasury was still using TCE.

By James Kwak

That Was Fast

The Obama administration is strengthening its antitrust enforcement policy.

That said, this in itself probably wouldn’t have done anything about the “too big to fail” problem. It might have increased scrutiny over large bank mergers – like Nations-Bank of America, Bank of America-Fleet, or JPMorgan Chase-Bank One, but frankly those probably would have gone through anyway; the banking industry is just not that concentrated compared to some others. Too big to fail is a combination of size, interconnectedness, and the critical role of finance for the economy. But the signal that the administration will actually enforce antitrust law is a step in the right direction.

By James Kwak

James Surowiecki and Me

Back when I had time to read The New Yorker, I was a big fan of James Surowiecki. I would always look for his column; if it was there, it was usually the first thing I would read. Unfortunately, he’s no fan of mine.

Surowiecki makes three points about our recent long post on nationalization:

  1. If the government were to take over a large bank like Citigroup, it would not be able to sell it into the private sector quickly, but would most likely own it for several years, which constitutes nationalization.
  2. Recent U.S. history, by which he means the S&L crisis, shows that the right strategy is “exercising regulatory forebearance, cutting interest rates sharply (which raises bank profit margins), and helping the banks deal with their bad assets” – not bank takeovers.
  3. We were misleading in citing the IMF’s $4.1 trillion number instead of the lower $1.1 trillion number for U.S. financial institutions. “I assume they used the $4.1 trillion number because it’s much scarier, and offers a much gloomier picture of the state of the U.S. financial system. Unfortunately, it also offers a much more misleading picture of the system.”

Sigh. I guess it’s impossible to make everyone like me.

I’ll take the points in reverse order.

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Stress Tests: What Was the Point Again?

There was been a lot of drama over the last week, which we have certainly contributed to, about the stress tests. It was all very exciting, finally seeing numbers purporting to show how healthy or unhealthy each bank was. But let’s recall what the point of this whole exercise was.

Depending on your perspective, the goal is either to restore confidence in the health of the financial system, or to ensure the health of the financial system, which are obviously closely related. We care about the health of the financial system because the financial system is critical for the health of the economy as a whole: without banks that are willing to lend money for people to buy houses, cars, and consumer goods, or for businesses to invest in real estate, factories, inventory, software, etc., none of these things will happen. So the ultimate goal is to ensure the availability of credit.

There are ways to measure the availability of credit directly. One of them is the Fed’s quarterly survey on bank lending practices, which was released earlier this week (hat tip Calculated Risk, as usual). For a quick overview, I recommend the charts. The charts show you, for each quarter, the change in supply of or demand for credit in that quarter – in other words, they are you showing you the first derivative. 

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Chrysler and Bankruptcy Law in Gory Detail

I was talking to an old friend last night about the Chrysler bankruptcy and, in particular, whether Chrysler (and Treasury, and the UAW) will be able to get around the order of priority of creditors in bankruptcy – which ordinarily would favor the senior secured lenders who are trying to block the proposed plan. I thought I would do a little research, but then (again via Calculated Risk) I found Steve Jakubowski’s analysis of precisely this issue, which apparently everyone on the Internet has already been linking to. It’s actually Part 3 of a series; you may want to start with Part 1.

My summary, for those who don’t like reading citations from court opinions: The issue with the “restructuring initiative” agreed-upon by Chrysler, the government, Fiat, and the UAW,  is that it only pays the senior secured creditors $2 billion in cash for $6.9 billion in secured debt; since secured creditors’ claims should come first, they argue they would get more from a liquidation. In particular, the VEBA created to fund retiree benefits is owed $8.5 billion; it is getting $4.6 billion debt and 55% of the equity in New Chrysler.

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