Author: James Kwak

Bank Recapitalization Monday

Those of you reading the news may be having trouble keeping all of this morning’s events straight. Here’s a quick summary:

  1. The UK announced specific plans to recapitalize three of its largest banks – RBS, HBOC, and Lloyds TSB – with up to 37 billion pounds of government money. Separately, Barclays announced plans to raise money independent of the government. This seems to be the implementation of a plan that was announced last week.
  2. Mitsubishi finally closed its deal to invest $9 billion in Morgan Stanley, gaining a 10% dividend on its shares (similar to Buffett’s investment in Goldman). This deal, which had been pending for weeks and some had given up for dead, will help boost confidence in Morgan Stanley. Note that unidentified sources have claimed that the US government promised to protect Mitsubishi’s investment; it’s not clear if that’s part of the final deal.
  3. The Federal Reserve and several of its counterparts announced an expansion in the supply of credit to banks around the world in US dollars. The Fed said it will make available as many dollars as the other participating central banks need. They will then lend the money out to their banks against whatever collateral is appropriate under their rules. This is another move to increase liquidity in the financial system; however, for several weeks now it’s been apparent that liquidity alone is not enough to solve the problem.
  4. Following yesterday’s agreement in principle, major Eurozone countries are announcing their rescue plans today, including both bank guarantees and recapitalization. Germany announced 400 billion euros to guarantee bank loans and 80 billion euros for recapitalization; France announced 320 billion for loan guarantees and 40 billion for recapitalization; Spain passed legislation providing 100 billion for loan guarantees and allowing the government to recapitalize banks by buying shares. I believe Italy is expected to make an announcement soon.

In summary, governments are taking the kind of steps that are necessary to halt the crisis. Loan guarantees and bank recapitalization are two of the steps we have been advocating. However, the jury is still out on whether they are coordinated and decisive enough. The much-followed TED spread (a measure of banks’ willingness to lend to each other) is only down by 7 basis points, although that may in part be due to the fact that the bond market is closed in the US today due to a holiday. All eyes are now on Washington, where a more definitive bank recapitalization plan is widely expected. Neel Kashkari, Paulson’s point man on the crisis, said today only that “We are designing a standardized program to purchase equity in a broad array of financial institutions.” (He said a lot of other things on a broad range of other topics.) Finally, this burst of support for wealthy countries’ banks could have unintended effects on emerging markets, as we discussed previously.

Update: Austria, the Netherlands, and Italy are also on board.

The Financial Crisis: What Can You Do?

On Wednesday, one of our readers posted the following comment: “This website offers hope.  Is there a way readers can help the cause?”

I’ve been thinking about that ever since, and I don’t have a good answer. The key decisions are being made by the central bankers and ministers of finance (we call ours the Secretary of the Treasury) of about ten countries, and most of the decisions they make are at their own discretion.

Continue reading “The Financial Crisis: What Can You Do?” →

Paulson Sends Fannie and Freddie to the Rescue

Many readers will see that as an ironic title, but I don’t mean it that way. Federal regulators have directed Fannie Mae and Freddie Mac to buy $40 billion per month in troubled mortgage-backed securities – the same ones targeted by the $700 billion bailout bill. As with the Paulson plan, price is still a question mark – too low and it does no good, too high and it will create losses for Fannie and Freddie – but we see this as a positive step. Fannie and Freddie were effectively nationalized, so we can think of them as part of the Treasury department at this point. One major question about the Paulson plan is whether $700 billion is enough to have a major impact on the market. Using Fannie and Freddie to increase the overall size of the program does increase taxpayers’ potential exposure, but it also increases the chances of having a meaningful effect on confidence in the financial sector. Buying assets this way may be especially important now that it seems much of the original $700 billion will go to direct bank recapitalization – which, we think, is a better use of that money.

While this is a step in the right direction, it still smacks of the incrementalism that has dogged the government’s response to this crisis. We may have reached the point where only a general guarantee of bank obligations will do the trick.

Let us know if you see other tools that Treasury picks up to attack the problem.

Zimbabwe and the Financial Crisis

Or, yet another reason why the financial crisis matters …

In Zimbabwe, site of some of the deepest suffering in the world today, Robert Mugabe reneged on a power-sharing deal with Morgan Tsvangirai and the opposition party. Sure, he might have done it anyway, but it’s a lot easier when the world’s attention is elsewhere and every major power has other things to worry about. We rarely comment on non-economic issues, but in hard times, you can watch for more and more behavior like this.

Please comment if you’ve seen other cases of politicians using the crisis as cover for things they might not try otherwise.

Global Crisis: Latest Analysis and Proposals

Our latest analysis and proposals have been published by the Washington Post (print edition Sunday) in an article by Peter and Simon entitled “The Next World War? It Could Be Financial.” If the world’s leading financial powers cannot agree on a coordinated response, it could be “every nation for itself” – a repeat, on a larger scale, of the emerging markets crisis of 1997-98.  We propose six concrete steps that policy makers – beginning with the G7 and IMF meetings this weekend – can take to limit the risks of such an outcome.

Feel free to comment with criticisms or suggestions.

G1 vs. G7 vs. G20?

We already know that at least some people in major European countries (Peer Steinbrueck, this means you) are mad at the U.S. for “causing” the global financial crisis. But while many of the rest of the G7 are at least complicit – European banks were buying large piles of the same mortgage-backed securities that set of the crisis in the U.S. – many of the world’s less-developed countries may be even madder at the U.S. Henry Paulson has called a meeting of the G-20, which includes some of the larger economies outside the G-7, for this weekend. The hope is that it will help dampen strife between rich and less rich countries, all of whom are being affected by the crisis.

Henry Paulson, Meet Warren Buffett

Bank recapitalization is in the air, which tends to prompt at least two responses: (a) what’s bank recapitalization? or (b) this is socialism!

Bank recapitalization is when an external entity buys new equity shares (stock, as opposed to bonds) in a bank in exchange for cash. The effect is to boost the bank’s assets without increasing its liabilities; since one worry about the banking sector is that it does not have enough capital (that is, it may not have enough assets to balance its liabilities), this is a good thing. (If the bit about capital, assets, and liabilities is confusing, see Financial Crisis for Beginners.) Of course, there’s no such thing as a free lunch, and in this case the bank’s existing shareholders get diluted, because they don’t own as much of the bank as before. But, in general, it’s better to own part of a bank that exists than a larger part of a bank that no longer exists.

Bank recapitalization could be as simple as this: the government (meaning the taxpayer) gets the same kind of deal that Warren Buffett got when he invested in Goldman two weeks ago. In that deal, Buffett paid $5 billion for preferred stock at $123 per share. The preferred stock pays a 10% dividend, meaning that Buffett gets $500 million per year from Goldman’s cash flow. He also got warrants that give him the right to buy up to $5 billion worth of common stock at $115 per share. At the time the deal was announced, Goldman common stock was trading at $125. Even though Goldman closed at $101 yesterday (and has fallen so far today), Buffett is still getting a 10% yield from the $500 million dividend, and if Goldman goes up he stands to make a lot of money from the warrants.

Continue reading “Henry Paulson, Meet Warren Buffett” →

Mortgage Restructuring at Countrywide

We and other commentators have been saying that in addition to shoring up banks, there needs to be something for the homeowners at the bottom of the food chain. This will need to be a priority for Congress when it convenes in November (as it absolutely must, at this point) and for the next president. However, today, there may have been a small step in the right direction. Bank of America (which bought Countrywide) announced a “homeownership retention program” for customers of Countrywide, which was one of the most aggressive subprime lenders during the housing bubble.

The agreement, which was negotiated with several state attorneys general (who have been investigating Countrywide’s allegedly predatory lending practices), includes several provisions that offer hope to struggling homeowners:

  • Restructuring of first-year payments to target 34% of household income
  • Interest rate reductions
  • Principal reductions for some types of loans
  • Waivers for some loan modification and prepayment fees
  • Partial moratorium on foreclosure proceedings for borrowers who may be eligible for the program
  • $220 million in assistance for homeowners facing foreclosure

The program is supposed to go into effect on December 1. In total, it is expected to provide $8.4 billion in payment relief to homeowners. Of course, a lot will depend on how it is implemented, but at least this time (as opposed to the largely ineffectual HOPE program announced a while ago) there will be a set of attorneys general monitoring the program.

One major potential stumbling block is that “some loan modifications … will require investor approval” – meaning that if a mortgage has been securitized, all of the people who own bits and pieces of that mortgage may have to approve any modifications. This is why systematic government intervention is necessary to force people – if necessary and legal – to participate in loan modifications that do benefit all parties (investors get more than they would get in case of foreclosure; homeowners get to stay in their houses, perhaps just as renters; communities are not devastated by foreclosures). But while waiting for that to happen, this can’t hurt. Most importantly, it shows the recognition (under pressure, of course) by a major player that it is not going to get all of its money out of its borrowers, and that it is better off trying to find a win-win solution.

Paulson’s Bank Recapitalization Plan

The big news today is that Henry Paulson claims to have found, in the $700 billion TARP package passed last Friday, the power to invest some of that money directly in banks to shore up their capital. As one of the people who actually read the bill (OK, I skimmed most of it), I was puzzled by this, because my reading (like everyone else’s) was that Treasury would only be allowed to take equity stakes in companies who participated in the sale of troubled assets to Congress. However, if you look at the comments by Congressmen in the Time article and on Calculated Risk, you’ll see that there are statements in the Congressional record saying that the intent of the bill is to allow direct equity purchases. A curious fact that you learn in law school is that, in interpreting a bill, it is not just the words of the bill that matter; the record of committee and floor discussions can also be used in interpreting a bill. So it seems like, in this case, Congress consciously inserted language into the discussion in order to give Treasury this power, or Treasury is seizing on some passages in the discussion to claim that power.

At this point this is unlikely to generate too much controversy, because most people involved, including the authors of this blog, think it would be a good thing for Treasury to take some of the $700 billion and invest it directly in recapitalizing banks (which is what the UK is doing). Of course there will be issues of detail to be worked out, and the Treasury Secretary has an awful lot of discretion in this matter, but this is definitely a step forward.

Oh, and I should mention: Planet Money broke this story first.

More Economists for Coordinated Recapitalization and Debt Guarantees

The Center for Economic and Policy Research has rushed out, and I mean that in the best sense of the term, a survey of economists’ recommendations for the world’s economic policymakers and, specifically, for the meeting of G7 finance ministers this week. The economists who contributed to the 40-page report (once there, click on the title to download the PDF), while presenting a range of views, generally agree on the need to recapitalize the banking sector and, with some dissent, to guarantee short-term bank liabilities in order to calm fears in the financial markets. They also agree on the urgent need for coordinated action across countries. These are positions we have been advocating on this site, and we are glad to see many other people on the same page.

Interest Rate Cuts vs. Recapitalization

Global rate cuts: attacking the symptom?

After yesterday’s move by the Fed into the commercial paper market, today’s big news is a global interest rate cut, including the Fed, the European Central Bank, and the Bank of England, among others. The effect of an interest rate cut should be to reduce borrowing costs across the board, which is a good thing for the real economy. However, the rate cut may not have a direct impact on the crisis at the heart of the financial system, which is that banks are not lending to each other. To put this in perspective, the spread between 3-month inter-bank lending rates and 3-month Treasury bill rates – a measure of how willing banks are to lend money to each other, as opposed to socking it away in risk-free Treasury bills – is running at about 4 percentage points. Ordinarily, it should be about 0.5 percentage points. As a matter of simple arithmetic, a 0.5 percentage point cut in central bank interest rates is small compared to a 3.5 percentage point increase in risk premia. As long as lenders are afraid their borrowers could go bankrupt, lowering the cost the lenders pay for money will only slightly lower the price that they charge for money.

Still, though, today’s move is a valuable signal that the world’s central bankers are on the same page and that they will do whatever they can to fight the crisis. And the good news may have come from the United Kingdom, where the government announced a straight-up bank recapitalization plan, in which 25 billion pounds will be used to buy preferred shares in eight banks, and another 25 billion pounds will be allocated to buy shares in those or other banks. Banks that have more capital are less likely to go bankrupt, making other players more willing to lend to them. As we’ve pointed out before, the Paulson Plan may have the indirect effect of increasing bank capital (because we expect Treasury to overpay for the securities it buys under the plan), but uncertainty over how that will work has diluted its impact on the markets. Explicit bank recapitalization is a more direct way to attack the problem.

Simon on NPR Planet Money Today (10/8)

Simon Johnson will be on NPR’s Planet Money podcast today. Planet Money is a new, daily podcast focusing on the financial crisis, and is one of the best places for friendly, accessible reporting on daily events. You can find the podcast feed on the NPR web site, or you can look for Top Podcasts in iTunes. (Planet Money is currently #1, which means it has displaced my favorite radio show, This American Life.) Today’s episode will be available after 5 pm U.S. Eastern time. Once it’s up, I’ll put a direct link on this post.

Update: The podcast is up, and you can listen to it here. Simon is about 12 minutes in, but he is preceded by Amir Sufi, who does a good job describing the relationship between the credit crunch and the ongoing slowdown in the real economy.

European Response to the Financial Crisis

Just a couple weeks ago, European finance ministers were insisting that the credit crisis was an American invasion that they were adequately prepared to repel, with German Finance Minister Peer Steinbrueck insisting that an American-style rescue plan was not required in Europe because the financial crisis was an “American problem.” As we’ve learned over the past few weeks, things change very fast. Although European leaders now appreciate the seriousness of a crisis that threatens their economies every bit as much as the American one – perhaps more, judging by the number of bank bailouts over the last few days – they have not been able to implement solutions even on the scale of the Paulson plan. The on-line Economists’ Forum of the Financial Times published (Tuesday morning in the US) a new op-ed by Peter Boone and Simon Johnson describing the challenges facing European policymakers and presenting some concrete solutions – including interest rate cuts and bank recapitalization, for starters.

Update: Martin Wolf’s latest column for Wednesday’s paper, just out (Tuesday evening in the US), takes similar positions.  In the column, Martin discusses how the deepening crisis over the last week has led him to change his position.  Many in European leadership positions follow Martin’s views closely, so hopefully his forceful arguments will have an immediate effect.