Author: James Kwak

“Bailing Out” Homeowners Through Mortgage Restructuring

On Capitol Hill today, attention turned back to where this all started – delinquent mortgages. Sheila Bair of the FDIC is working on a program to encourage lenders and servicers to restructure mortgages by partially guaranteeing post-modification mortgages that meet certain criteria. Christopher Dodd is also considering new legislation in November to help homeowners. Here at the blog, we made intervention into the housing market one the four proposals in our first Baseline Scenario way back when in September, and we are planning to publish something more detailed in the next several days. But first, I wanted to lay out the nature of the problem.

Remember the wave of indignation that accompanied the “bailout of Wall Street” last month? Judging by some emails and comments I’ve seen, it could be even worse when it comes time to “bail out” delinquent mortgage holders. Much as people hate the idea of bailing out Wall Street “fat cats,” for some the idea of bailing out their neighbors – especially the neighbors in the new McMansion – is even worse. I think for some people it’s the idea that someone else is getting away with something that they could have done but chose not to (buying too big a house, in this case); by contrast, most people recognize they had little chance of becoming the CEO of an investment bank. OK, now that I’ve opened myself up to a flood of nasty comments, on to the substance.

Continue reading ““Bailing Out” Homeowners Through Mortgage Restructuring” →

We Have Problems; Emerging Markets Have Big Problems

The increasing damage the global financial crisis is inflicting on emerging markets has been getting a lot of attention lately (those are four separate links, for those with time on their hands), much of it very thoughtful. I would like to immodestly point out that my co-authors Simon and Peter were early to call this one (along with Nouriel Roubini, no doubt), in an op-ed in Forbes.com back on October 12.

That aside, it seems more and more likely that we are witnessing a repeat of 1997-98, just on a grander scale. Credit default swaps on Russian sovereign debt are trading at over 1,000 basis points, which essentially means that investors think the country is more likely to default than not – this just months after the high price of oil seemed to make Russia a dominant regional economic power, and just weeks after Russia was negotiating to lend money to Iceland (as of a couple days ago, it was still possible that Russia would participate in the IMF bailout of Iceland). Argentina, as Simon pointed out earlier, has the honor of being the first country to expropriate private property under the cover of the financial crisis. The Economist published a chart showing CDS spreads on sovereign debt across Eastern Europe showing that Ukraine, the Baltics, Hungary, Romania, and Bulgaria are all at risk. (Many of those spreads are already much higher than in the chart: Ukraine at 2617 bp, Russia at 1038, Turkey at 775, the Baltics between 650 and 1000.) Hungary in particular is showing eerie echoes of 1997-98, as the government takes emergency steps, including increasing interests rates by three full percentage points, to combat speculators betting that the currency will fall – a battle that few countries were able to win a decade ago.

Continue reading “We Have Problems; Emerging Markets Have Big Problems” →

Credit Crunch: Did We Make It All Up?

There is a paper by three economists at the Federal Reserve Bank of Minneapolis that is getting a lot of attention on the Internet today. (How often can you write that sentence?) V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe set out to debunk four myths about the financial crisis:

  1. Bank lending to nonfinancial corporations and individuals has declined sharply.
  2. Interbank lending is essentially nonexistent.
  3. Commercial paper issuance by nonfinancial corporations has declined sharply and
    rates have risen to unprecedented levels.
  4. Banks play a large role in channeling funds from savers to borrowers.

In short, they are saying that despite all the hand-wringing about banks not lending to consumers and businesses, it just ain’t true, and even if it were, most lending isn’t done by banks anyway. The implication, to simplify somewhat, is that we are in a media storm of hype that may itself have negative effects.

While I would love to believe this, I don’t think they make the case conclusively. A few quibbles (for this to be understandable, you may have to look at the original paper):

  1. Continue reading “Credit Crunch: Did We Make It All Up?” →

Lehman CDS Settle; World Doesn’t End

Yesterday was the last day for settlement of credit default swaps linked to Lehman debt. One of the fears raised in the dark days of September was that the failure of a bank like Lehman would create hundreds of billions of dollars of liabilities for companies that had sold insurance on Lehman debt, and that market participants had no way of knowing who was good for that money, because many sellers were hedged and might be counting on payment from another seller, who might be counting on …

Well, the financial system is still standing. While we won’t know who lost money until the next quarterly earnings are announced, no one defaulted on the CDS. In part, this was due to the fact that as Lehman bonds fell in value, sellers of CDS had to post collateral to buyers, so a lot of the losses had already been recognized. (I believe AIG was an exception to this, because they had a AAA bond rating and hence did not have to post collateral until they were downgraded.) Perhaps things would have been worse without the many liquidity-increasing steps the Fed took over the last month; if you have to raise cash in a hurry, it is far easier to get it from the Fed now than it was in the past. In any case, it appears we have one less thing to worry about, at least for now.

Nobel Laureates Debate Financial System Regulation

The Economist is hosting a debate on financial system regulation between no less than two Nobel Laureates, Myron Scholes and Joseph Stiglitz. (Be sure to read the opening statements before the rebuttals, or it may not make sense.) The debate is less over specifics than over the general question of how much regulation there should be. They may be lying low right now, but there will surely be legions of executives and economists arguing that we actually need less regulation in order to foster financial innovation.

The Economist recruited Scholes to defend this view, but unfortunately he puts on a rather tepid defense. I read his arguments three times and I think they boil down to this: Crises stem from too much leverage, and therefore bank capital requirements should be increased. (He also says, however, that “Determining the amount of leverage to be used by financial institutions is a business decision.”) If banks need additional capital in a crisis, it should be provided by the government and priced accurately. In his rebuttal he also proposes a new accounting framework, potentially implemented by a regulator, that provides a more accurate assessment of the risk faced by a financial institution. So, as far as I can tell, it boils down to: (a) higher capital requirements; (b) government capital in times of crisis; and (c) better accounting. For the rest, we can count on existing laws against things like fraud. Unfortunately, the only evidence he provides for the thesis that “more regulation is bad” is that economic growth was lower from the 1930s to the 1970s, which he calls an era of regulation, than since the 1970s, an era of deregulation. (Like everything in history, economic growth levels are overdetermined, meaning that you can find a dozen different explanations of any given historical phenomenon.)

Stiglitz doesn’t do such a great job proving the “more regulation is good” thesis, either; his evidence is that countries with “strong regulatory frameworks” are less likely to have financial crises. But Stiglitz gets at the basic question: is unbridled financial innovation good or bad? Does it really lower the cost of capital enough to compensate for the costs of crises like the current ones? Which innovations are good and which are bad? Can we get the good ones without the bad ones?

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Want to Be on NPR?

One of my life’s ambitions is to be on This American Life. Now you can do the next best thing. NPR’s excellent Planet Money podcast is looking for people to talk about their personal economic situations; the hosts, joined by my co-author Simon Johnson, will talk about how you fit into the global economy and the financial crisis. It’s all explained here.

Why Banks Won’t Lend – My Theory

Some people have said that Americans go to hockey games to see fistfights and go to NASCAR races to see car crashes. This thought occurred to me over the past few days while reading The New York Times online. If there were a New York Times index, it would indicate that the financial crisis is over. I can’t recall the last time a financial crisis-related story was at the top of the home page. (Today’s Fed intervention into money markets may have been on top, but by the time I got there the lead story was Kirk Kerkorian selling stock in Ford.) Instead, we’re back to the presidential election and Iraq. For a while there, it seemed like we might have the car crash to end all car crashes in the financial system, with banks failing left and right. Now, it looks like we’ve just got a boring old recession, where millions of people will lose their jobs. Move along.

But even if the multi-car pileup has been averted, the cars are still just barely limping around the track. The problem seems to be a lack of fuel – credit, in this case. Andrew Ross Sorkin in that same New York Times points out that banks are taking their money and stuffing it into a mattress instead of lending it to companies. (Yves Smith at naked capitalism says that consumers are doing the same thing, which, while personally wise, is not the best thing for the economy.) Now, banks only make money by lending money. So why aren’t they lending?

Continue reading “Why Banks Won’t Lend – My Theory” →

Sign of the Apocalypse: The TED Spread Gadget

Back in the glory days of 1999-2000 (I was in Silicon Valley at the time, and for us that was the real boom, not this housing thing everyone else likes to talk about), otherwise reasonable people would spend an inordinate amount of time checking stock tickers on their computers. It was probably one of the things, along with email, that first made the Internet a mass phenomenon. (For you kids out there, no, we didn’t have YouTube.) Well, in a perverse, bizarro-world echo of those times, now you can track the TED Spread using a Google gadget (you can add it to your iGoogle home page, or, I believe, to Google Desktop). So now you can distract yourself at work worrying about the fate of the financial system, without even having to go to Bloomberg.

By the way, it’s at 2.56, down from 4.64 on October 10. So the first battle is going well, although there are many more to fight.

(Thanks to Planet Money for catching that.)

Reader Question Roundup, 10/20/08

Besides the questions we get in comments, we got a bunch in email last week because of our op-ed in the Washington Post. (By the way, I’m behind in responding to comments on the blog, so if you see one you can answer, by all means go for it.)

Here are a few.

1. Is mark-to-market accounting part of the problem? Should it be replaced by discounted cash flow valuation?

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Korea Joins the Bailout

South Korea was one of the major casualties of the 1997-98 “emerging markets” crisis. I put “emerging markets” in quotes because, at the time, Koreans were very proud that their country had the 11th-largest economy in the world. Today it is 13th, by nominal GDP.

Yesterday South Korea announced its version of the bailout plan that is sweeping the world – $30 billion in foreign currency reserves made available to its banks, and a $100 billion guarantee on new foreign debt of its banks. But in Korea, the stakes are higher than in the US and other G7 countries. Korea is another of those countries whose banks’ have a disproportionately high level of foreign currency obligations. Rolling those over suddenly got a lot harder in the last month, for reasons we all know; now as creditors fear that banks may not be able to pay them off, the currency declines, making them even harder to pay off, and so on. The central government has $240 billion in foreign currency reserves, but that may or may not be enough to support its banking sector, which has $235 billion in foreign liabilities.

Korea is important not just because my family is from there, but because it is so big, economically – three times as big as Iceland, Hungary, and Ukraine put together in GDP terms. If the crisis spreads to countries of Korea’s scale, it’s not clear that the IMF has the resources to bail them out (and an IMF bailout would be enormously unpopular in any case).

Banks Can Borrow Money; You, Not So Much

The TED spread is down again today to 3.20 (down from 4.64 at its peak ten days ago). This means that banks are beginning to lend money to each other, which means we are less likely to see serial bank failures and a complete collapse of the financial system. This is good.

However, all is not rosy. Mortgage rates unexpectedly shot up last week – from 5.87 to 6.38 percent for a 30-year fixed-rate mortgage in the US – in a demonstration of the law of unintended consequences. Apparently, what happened was this. During the panic, investors lent money only to the US government, not to banks. However, since the nationalization of Fannie Mae and Freddie Mac, they have been regarded as as safe as the US government, and hence benefited from abnormally low funding costs. As banks become more attractive places to lend money – particularly because of the government guarantee on new senior debt, which means existing debt gets safer (banks can issue new guaranteed debt and use it to pay off the existing debt) – Fannie and Freddie become relatively less attractive. So their borrowing costs go up, and because they play an enormous role in the US mortgage system, mortgage rates go up.

The short-term jump is probably not something to get too worried about, since it basically corrects an anomalous feature of the last few weeks. However, it points out a larger problem. The Fed and Treasury are like firefighters. They decided that the top priority was preventing a collapse of the financial sector, and I agree with that priority. But now that banks are beginning to lend to each other, the next priority is resuscitating the real economy, and for that banks will have to lend to real people and real companies. We aren’t there yet.

Baseline Scenario, 10/20/08

Baseline Scenario, October 20, 2008
By Peter Boone, Simon Johnson, and James Kwak, copyright of the authors
Download PDF

The Baseline Scenario is our periodic overview of the current state of the global economy and our policy proposals. It includes three sections:

  1. Updates that have caused us to modify the baseline since the last version
  2. Analysis of the current situation and how we got here
  3. Policy proposals

Please note that we do not currently publish our upside and downside risk scenarios in detail.

_______________________________________________________________
UPDATES

This edition of the Baseline Scenario has been extensively updated to reflect recent events, in particular the adoption by the world’s leading economic powers of the first two of our proposals in our original Baseline Scenario.

Continue reading “Baseline Scenario, 10/20/08” →

Capitalism = Government Intervention

OK, that may be an overstatement. When I was in graduate school, I was a “reader” (meaning I graded exams) for a course on recent US history taught by Richard Abrams. What I took away from that course was that virtually all government intervention in or regulation of the economy was done at the request of some part of the business community – most often entrenched incumbents lobbying the government for protection from new entrants.

Colleen Dunlavy of the University of Wisconsin has a blog post about the history of government intervention in the economy. Most critics of government intervention take one or both of two positions: (a) it doesn’t work or (b) it’s un-American (read: socialist). Dunlavy pretty much destroys argument (b) and, along the way, gets in some blows to argument (a). It’s useful reading as we head into a season of expanded government intervention and regulation in the financial sector.

Regulating the Financial Sector: A Modest Proposal

Building a new regulatory structure for the financial sector to replace the current, completely discredit regulatory structure will be a major task for the next administration and congress. However, at present there is a wide range of opinion over what needs to be done – believe it or not, there are those out there who think that what we need is less regulation rather than more. We’ll be pointing out serious proposals that we find out there. Note that linking does not necessarily constitute endorsement.

James Crotty and Gerald Epstein of the University of Massachusetts have put forth their nine-point plan for financial system regulation (abstract online, or download the PDF – it’s only 13 pages). Most economists (though perhaps not most people) would classify them somewhere on the heavy-handed end of the spectrum. The nine points, in summary, are:

  1. Restrict or eliminate off-balance sheet vehicles
  2. Require due diligence by creators of complex structured financial products (so if you create a CDO, you have to understand all the stuff in it)
  3. Prohibit the sale of financial securities that are too complex to be sold on exchanges
  4. Transform financial firm incentive structures that induce excessive risk-taking (so people who get big bonuses in good years have to pay them back in bad years)
  5. Extend regulatory over-sight to the “shadow banking system” (hedge funds, private equity, special investment vehicles)
  6. Implement a financial pre-cautionary principle (like with drugs, innovations have to be approved first)
  7. Restrict the growth of financial assets through counter-cyclical capital requirements (um … read the proposal yourself)
  8. Implement lender-of-last-resort actions with a sting (punish the people responsible when you bail out their companies)
  9. Create a bailout fund financed by Wall Street (use a securities transaction tax to create a bailout fund to use next time)

I’m skeptical about 4 and 8 – human ingenuity is perhaps nowhere so unparalleled as in the creation of executive compensation schemes designed to avoid any possible constraint. 3 and 6 will be extremely controversial and can be seen as infringements on freedom of contract, at least where “sophisticated” investors are concerned. 9 is also controversial, although a variant of it was actually in the $700 billion bailout bill. But it doesn’t hurt to start thinking about it now.