Author: James Kwak

Federal Reserve for Beginners

We had a comment last week asking for an explanation of, roughly, what it is that the Federal Reserve does, so I thought that would be a good topic for a Beginners post. (For a complete list, go here.) This would have been a relatively easy question to answer a year ago, but since then it’s gotten considerably more complicated. Like all Beginners articles, I’m going to make a number of simplifications, for example generally treating the Federal Reserve as one big bank (it’s really twelve different banks). I’m also going to ignore many of the Fed’s functions; for example, the Federal Reserve is itself a bank regulator, but I’m not going to discuss that.

Continue reading “Federal Reserve for Beginners” →

The Citigroup Betting Pool

I’ve been catching up with my family and not on top of the news the last 24 hours or so – wasn’t there a time that the financial world shut down on weekends? – but for those of you who may not have a feed reader clogged with economics blogs (first, good for you), I wanted to point out some of the various outcomes you may want to bet on when it comes to Citigroup. Some people are betting that a deal (bailout, FDIC takeover, merger) may be announced as soon as this weekend. I doubt it, because Citi shouldn’t have a liquidity problem per se; now that the Federal Reserve is accepting pocket lint as collateral, Citi can keep functioning even after the markets have completely lost faith in it. The problem is that no one believes its assets are still worth more than its liabilities, so everyone expects the endgame will come (in one form or another) sooner or later. The big questions are whether no one will get wiped out, shareholders will get wiped out, or shareholders and creditors will get wiped out.

  • Mark Thoma has an overview with excerpts from some other posts.
  • The wildest idea is that Citi might merge with Goldman or Morgan Stanley, although this is only floated by unnamed analysts. What such a merger would accomplish is unclear to me. (Although various people have come up with the name for a Goldman-Citi merged entity.)
  • Felix Salmon has a quick rundown with a lot of links (some of which I reproduced below); he thinks that at least creditors will not get wiped out to avoid a repeat of Lehman.
  • John Hempton explains how creditors might be wiped out and why it would be a bad thing.
  • Brad DeLong says to the government: go ahead, just buy the whole thing. With the change, buy a cup of coffee.

When Will the Stock Market Stop Falling?

The stock market has clearly not had a good week. The Dow Jones average was down 5.3%, the S&P 500 was down 8.4%, and it would have been much worse if the markets hadn’t jumped at the end of the day today, allegedly because Tim Geithner will be named Treasury Secretary (which I called, but it wasn’t that gutsy a call). Yesterday the S&P closed at less than half its high of October 2007. For a chart of the carnage, see Calculated Risk (click on the chart for a larger version).

At this point, stock prices are clearly beyond the short-term liquidity crisis that hit financial institutions in September, and deep into recession territory. That is, share prices will not respond particularly sharply to tactical steps such as individual bailout plans, because the big question is how long and how bad the recession will be. The problem this week was not that all the news was bad, but that all the news was worse than expected. The stock market prices in current expectations about the future, so if a report is bad but not as bad as predicted (say, unemployment goes up but less than forecast), the stock market should go up.

This week:

  • New unemployment claims were higher than expected
  • The Consumer Price Index fell more than expected
  • The manufacturing survey of the Philadelphia Fed was worse than expected
  • The Leading Indicators index of the Conference Board fell more than expected
  • Oil futures fell below $50 (indicating that expectations of demand are falling)

Partially as a result, Goldman revised its economic forecast down, saying that the economy will contract at an annual rate of 5% this quarter, 3% next quarter, and 1% the quarter after that, which is worse than any forecast I’ve seen (although I certainly don’t see all of them).

For the stock market to stop falling, new data has to come in that is better than expected. Of course, guessing when that will happen is a fool’s errand.

Banks At Serious and Immediate Risk, Again

Despite the shot of confidence provided by the recapitalization program in mid-October, equity prices and CDS spreads indicate investors are getting nervous about banks again – and some may even be betting that they will fail, or at that equity holders will be wiped out. As the recession deepens, banks’ assets (not only mortgage-backed securities, but loans in all forms) are falling in value, increasing the chance that the government will need to step in again with more capital. Peter and Simon have a guest post at Real Time Economics (WSJ) on the options – none of them pretty – that the government has.

To Bail or Not To Bail, GM Edition

For those who can’t get enough of the GM topic, Economix (NYT) has links to posts for and against bankruptcy. Right now it’s 10-5 in favor of bankruptcy, although I’m not sure that Mitt Romney’s vote should have the same weight as those of, say, Martin Feldstein, Gary Becker, and Paul Krugman.

However, the bankruptcy/bailout dichotomy leaves out what I think is the best solution: a government-brokered reorganization, which may or may not require bankruptcy – a prepackaged bankruptcy, as it’s sometimes called. This would be very different than just letting GM go into Chapter 11 and hoping for the best, especially given the lack of debtor-in-possession financing these days (thanks to the commenters who pointed this out). Andrew Ross Sorkin, for example, argues for a prepackaged bankruptcy, and even Romney calls for a “managed bankruptcy” (without many deatils) – yet they are lumped in with the the others, like George Will, who argue against any government intervention. (See the link above for all the links to individual posts.) So I don’t think 10-5 is a very accurate count.

Update: Five professors who really are experts on the auto industry (and one of whom is a colleague of Simon at Sloan) have a highly readable paper with their proposal out. They favor a non-bankruptcy restructuring plan that is overseen by the government and also has some provisions to ensure that the reorganization is in the public interest, such as increased fuel efficiency standards and a prohibition on paying dividends to shareholders.

More Things to Worry About

The morning after the election, I wrote a post on our country’s long-term priorities. #3 on the list was retirement savings.

While the retirement savings problem predates the current crisis, the decline in the value of financial assets has made it tougher all around. One reader pointed me to a particular aspect of the problem I wasn’t aware of. Earlier this year, the Pension Benefit Guaranty Corporation (PBGC) shifted its asset allocation from 15-25% equities to 55% equities. The PBGC, which is part of the federal government, guarantees private-sector pension plans and is funded by premiums paid by those plans; if a company’s pension fund goes bankrupt, the obligations are shifted to the PBGC. This, as Zvi Bodie and John Ralfe pointed out back in February, is particularly problematic for the PBGC, because then an economic downturn has a triple impact on the fund: first, as equity values fall, company pension funds face larger funding gaps; second, as companies go bankrupt, their pensions get shifted to the PBGC, increasing its liabilities; third, as equity values fall, the PBGC’s assets fall, increasing its funding shortfall. Bodie and Ralfe argue that increasing the proportion of equities may increase the expected return, but only at the cost of increased risk, in any timeframe.

(By contrast, because the Social Security Trust Fund is invested in Treasury bonds, it should be doing OK. Long-term concerns about Social Security funding, of course, are still valid.)

Emerging Markets Snapshots

GM, mortgage restructuring, and the G20 have sucked up most of the attention recently, but the crisis continues to take its toll around the world. A few vignettes:

  • In Ukraine, industrial production in October fell by 7.6% from September (that’s not an annualized rate) and 19.8% from October 2007.
  • Russia’s second-largest coal company reported that its Q4 sales would be only one-third the planned level – and that payments from its steelmaker customers since September were only 21% of the value of shipments.
  • Credit default swap spreads on Greek sovereign debt are up over 160 bp – higher than at the previous peak in mid-October. (Note that Greece is in both the EU and the Eurozone.)

On the “plus” side, Pakistan and the IMF agreed on a $7.6 billion loan, ensuring economic stability in a particularly important part of the world – at least for a few months. Pakistan’s government says they need a total of $10-15 billion.

Proposed Solutions to the Securitization Problem

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

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

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

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

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

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

Systemic Risk, Hedge Funds, and Financial Regulation

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

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

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

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

Root Causes of the Current Crisis

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

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

Continue reading “Root Causes of the Current Crisis” →

FDIC Takes Mortgage Proposal to the Public

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

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

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

The Bad Private Equity Fund

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

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

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

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