Author: James Kwak

Federal Reserve Invokes Emergency Powers?

As has been widely reported, the Federal Reserve announced today that it will start buying commercial paper directly from issuing companies. (Commercial paper, as expertly explained in last weekend’s episode of This American Life, is a short-term IOU that companies issue when they need to smooth out the short-term fluctuations in their bank balances; the issuer promises to pay $1 million in 7 days’ time and, for example, gets $999,000 from the lender immediately.) Highly experienced journalists have described this action as using the Fed’s “emergency powers,” although the Fed was itself careful not to use the word “emergency” in its press release. Rather, the terms and conditions released this morning cite the authorization of Section 13(3) of the Federal Reserve Act. That section reads as follows (bold emphasis added; you don’t need to read it carefully, there won’t be a quiz):

3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

(“Discounting” just means that the Fed can loan the holder or issuer of the commercial paper a little less than the face value of the paper.)

So while the phrase “emergency powers” can be frightening, this doesn’t mean that martial law has been declared, or its financial equivalent; just that the Fed identified an “unusual and exigent circumstance” in the market. By this action, the Fed is intervening in the short-term credit market for ordinary companies directly; previously, its actions had been devoted to encouraging banks to provide short-term credit to those companies. We can infer from this that the Fed has decided that the previous strategy wasn’t working, at least not well enough. Because it bypasses the banking sector altogether to provide credit to the real economy, this should reduce borrowing costs for companies, which is a good thing. (The downside is that theoretically it creates exposure for the government, and hence the taxpayer, if any issuers default on their commercial paper.)

Still, though, this latest Fed action points out two concerns. First, the Fed still appears to be reacting to events as they arise rather than plotting a strategy to get ahead of the crisis and stop it in its tracks. (A set of steps that might stop a crisis of confidence, if announced in one fell swoop, could fail to have that effect if spread out over several weeks or months.) Second, there is no Congress in session, and there won’t be until after the election at the earliest. The election is only four weeks away, but as we have seen markets can shift significantly from one day to the next. Today’s action can be seen as a signal that the Fed will do whatever it takes to keep credit flowing until Congress can reconvene and develop a more fundamental set of solutions. Which is a good thing, assuming that Bernanke doesn’t run out of tools in his magic toolbox.

The Bailout and the Stock Market

One week ago, the House rejected the bailout bill and the Dow fell more than 700 points. That fall was a major reason why public opinion shifted from heavily against the bailout to confused, and why the bill passed on Friday. On Friday, though, the Dow fell another 150 points, and today at 1 pm Eastern it’s down another 500 or so.

Before panicking, though, we have to consider what this means. Broadly speaking, we are faced with two related crises, each of which is approximately represented by a different market. The first is a global economic slowdown that people have been talking about for months. The second is the acute credit crunch that hit after Lehman went bankrupt on September 15.

Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.

Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people’s investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don’t cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll. (See the posts tagged “real economy” for a couple examples of this.)

Now the credit and stock markets are related, because when the credit market freezes up, people’s expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. (As Simon advised me, if you write a post entitled “your money is not going to go poof,” as I did, 20% of your readers won’t see the “not.”)

So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble – given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.

As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy.

Financial Crisis – Reader Questions, 10/6/08

Since launching a week and a half ago, we’ve gotten far more attention and input than we expected. Thank you for your attention, your participation, and your comments. In addition to some of the comments I answered directly on the post in question, I answered some more below. I’ll try to do this periodically. I apologize if I didn’t get to your question; there are just too many to respond to all of them.

Update: I’m restructuring some of the blog to use fewer pages, so I copied the contents of the old page below. To do this I had to copy-and-paste the comments, but they are all still there.

For reasons of space, I’ll have to paraphrase some of the questions.

1. Why not use the bailout money to buy houses outright, which will also prop up the mortgage-backed securities everyone is worried about?

Continue reading “Financial Crisis – Reader Questions, 10/6/08” →

Financial Crisis for Beginners

Our goal is to provide analysis and commentary that are valuable not only to economists and policymakers, but also to a general audience. This is especially important today now that the workings of our financial system have become vitally important to, well, everyone. But I realize, as a couple of readers have noted, that our posts often assume familiarity with a specialized vocabulary. To some extent this is unavoidable, because we want our posts to be short, and we don’t want to explain what a credit default swap is every time we use the term. But it’s a problem.

So we’re introducing a page called Financial Crisis for Beginners that includes information and resources for people who want to get up to speed on mortgage-backed securities, collateralized debt obligations, bank balance sheets, and the other concepts that people toss around all the time these days. It doesn’t presume any prior knowledge, and it even includes links to episodes of This American Life. So if you’re at all confused, check it out.

The Financial Crisis and Entrepreneurship

If anyone is looking for a silver lining, Michael Fitzgerald has a post called “Bad Times Are Good Times for Entrepreneurs,” and I couldn’t agree more. On September 14, 2001 – at the trough of the technology meltdown, at the beginning of a recession, and on a day when the stock market was not even open because of the 9/11 attacks – I quit my job and co-founded Guidewire Software. It was a great time to start a company for a number of reasons:

  • There were talented people looking for new opportunities.
  • The ordinary costs of doing business (space, equipment, etc.) were depressed.
  • As a private company, you don’t have to worry about quarter-to-quarter performance. Your investors (if you have them) will have a long-term perspective.
  • Most importantly, when you first start a company, you aren’t expected to sell anything, so the fact that no one is buying doesn’t matter. Your jobs are to research your market, research your potential customers, design your product, build your product, and (if you need it) raise money. Depending on the industry you are in, all of this can take a couple of years. Even then, if the recession isn’t over yet, you are selling to a small number of early adopters, who will not be making decisions based on the overall state of the economy. It will be even longer before you have the kind of sales volume that is susceptible to changes in the economic cycle.
  • This didn’t apply to us, but if there is enough dislocation in the economy, it is bound to create new business opportunities that can be captured by startup companies.

Guidewire today is a leading provider of software to insurance companies with customers in Russia, Brazil, Japan, the United Kingdom, Australia, and New Zealand, in addition to the United States and Canada. Seven years from now there will undoubtedly be dozens or hundreds of successful companies that were started in the wake of the credit crisis.

Bailout Passes; Hard Work Begins

Our position has been that the Paulson Plan is imperfect but is still a valuable first step toward restoring confidence in the financial markets, and so we are glad that it passed today. One remarkable development over the last two weeks has been a shift among both economists and the public from thinking the plan was an application of massive force to thinking that the plan is a relatively small part of the long-term solution. As discussed in our most recent baseline scenario, the next steps are to work on financial sector recapitalization, housing market stabilization, and fiscal stimulus (and, of course, regulation).

At the same time, though, implementing the Paulson Plan will be a major task, and one that will require oversight both from Congress and from government-watchers. Not surprisingly, Treasury is already moving to use fund management firms as outside contractors in buying securities. There are some valid practical reasons for this, but it creates the potential for conflicts of interest that we warned about in an earlier op-ed on governance; fortunately, the final bill includes much more emphasis on transparency of contracting than did the original proposal. Pricing the assets will be perhaps the trickiest problem, whether it be through reverse auctions (which can be difficult to implement) or through direct negotiations with banks. Price will determine how many warrants the government gets in participating companies, which are another improvement in the final bill. Finally, although the plan specifies multiple forms of oversight, figuring out how to make that oversight effective in a fast-moving environment will be difficult.

So while passing Plan A was a good thing for the financial sector and for the real economy, making it work will require a good deal more effort both inside and outside the Beltway. And the sooner work starts on Plan B, the better.

Financial Crisis and the Real Economy, Part 2

The impact of the financial crisis on the real economy can be divided into two periods: before September 15 and after September 15. Before 9/15, it was clear that we were in an economic slowdown, beginning with the construction industry, and that troubled assets on bank balance sheets would probably lead to a long-term decline in lending, which might push the economy into recession. Since Lehman failed on 9/15, this general problem sharpened into a short-term credit crunch, in which various parts of the credit markets have stopped functioning or come close to it. Still, though, people want to know, what does the credit crunch mean for me?

Bloomberg reported that almost 100 corporate treasurers held an emergency conference call yesterday to discuss the challenges they are facing rolling over lines of credit with their banks. In some industries, lines of credit are the lifeblood of even completely healthy companies. They operate like home equity lines of credit: you draw down money when you need it (like to make payroll), and you pay it back when your customers pay you back. (In most business-to-business transactions, money changes hands some time after goods are delivered; hence the pervasive need for short-term credit.)

Now, however, banks are demanding much higher interest rates, lower limits, and stricter terms when lines of credit expire, or are even pouncing on forgotten clauses in contracts to force renegotiations of terms. Lines of credit are priced in basis points (a basis point is 1/100th of a percentage point) over LIBOR, a rate at which banks lend to each other. One company saw the price for its line of credit rise from 90 basis points to 325 basis points over LIBOR, which is itself running at high levels. The banks aren’t doing this because they think their borrowers are in any danger of not paying them back; they’re doing it because they want to hold onto the money because they are afraid of liquidity runs. “These are very different circumstances than many of us have dealt with before,” said one treasurer. “We’re all having to learn every day about provisions that were buried in documents executed 15 years before.”

This is how fear in the banking sector translates very quickly into higher costs and less cash for healthy companies in the real economy. Fortunately there are clear steps that Washington can take to bolster confidence in the banking sector, which will cause the flow of money through the real economy to pick up.

Bailouts and Moral Hazard

Hazardous Morals

As Daniel Henninger noted in the Journal today, moral hazard is hot right now. This is the stick that commentators of all political affiliations use to beat the Fannie/Freddie bailout, the Paulson rescue plan, any proposal to restructure mortgages, or any other government action that has the effect of protecting someone from his bad decisions.

The concept of moral hazard originated in the insurance industry, and describes the problem that people who are well insured are more likely to take unwise risks. (For example, if you have comprehensive insurance on your car with no deductible, you may not bother locking the doors.) In the current context, the argument is that if the government bails out financial institutions by taking troubled assets off their hands, they will not have an incentive to be more careful in the future. In this usage, moral hazard becomes suspiciously similar to moral indignation pure and simple: many people feel instinctively that banks that took excessive risks deserve to go bankrupt, and the bankers who made lots of money on the way up should lose their jobs. (These people often also believe that homeowners who can’t pay their mortgages should lose their houses).

The problem of moral hazard is real. And moral hazard should be taken into account when designing any rescue packages and, more importantly, when the time comes to rewrite the regulation of the financial sector. But there are several reasons why it should not be allowed to simply veto any government action.

  1. Moral hazard is most important in a repeated or continuous context. When you buy an insurance policy at the beginning of the year, you know if you are fully covered, or if you will be responsible for some proportion of the losses you incur, and you behave accordingly. It applies less clearly to retrospective bailouts like the current plan, where it is not clear that a similar situation will ever arise again. For example, perhaps one of the behaviors we want to discourage is leverage ratios of 30 to 1, like those at Bear Stearns and Lehman. Well, there are no more investment banks, and commercial banks have much lower leverage limits. Besides, there is another way to discourage undesirable behavior: regulation.
  2. As Martin Wolf argued in the FT in the long-gone days of the Fannie/Freddie bailout, the moral-hazard argument to punish the shareholders has the perverse effect of discouraging private capital. Given widespread fears that many banks are undercapitalized, it would be a good thing if they could raise capital in the private markets rather than from the government, like Goldman Sachs did with Warren Buffett. But if the government is planning to take the moral high ground and let banks collapse, then no one will step up with the capital.
  3. Most importantly, there is something fundamentally illogical about the moral hazard argument. If we bail out the banks now, it goes, then they will behave in harmful ways in the future. But right now we are facing the greatest danger to the financial system since the Great Depression. What future harm are we worried about that is more serious than the potential harm we are facing right now?

“While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse.” Those words were written by no less a free-market advocate than Nobel Laureate Gary Becker.

Your Money Is Not Going to Go Poof

Readers of this blog will already know that we believe that (a) the credit crisis of the past two weeks is serious, (b) there is a real risk of a global recession,  but (c) there are practical steps that governments can take to minimize the damage to the economy. Several of my friends have asked me what this means for them. And I wanted to repeat here what I told them: nothing cataclysmic is going to happen to your money.

First, let’s start with deposit insurance. In general, your checking accounts, savings accounts, and CDs are guaranteed by the FDIC up to $100,000 per account holder per bank, and that is likely to go up to $250,000 shortly. Some people have been pulling money out of banks even though they are below this limit, because they don’t know about the insurance, don’t trust it, or don’t want to deal with the hassle. Now this is something with which I have personal experience. I had a CD (<$100K) at IndyMac Bank when it failed earlier this year. The FDIC took over the bank over the weekend and by Monday everything was exactly the same as on Friday: same web site, same call centers, same CD account, everything. The only change was that the name had changed from IndyMac Bank to IndyMac Federal Bank. I didn’t have to file a claim or even call anyone. My CD is still there, earning interest (at 4.15%, by the way). So if you have an insured account, you shouldn’t worry about it. (Some people have pointed out that the FDIC could run out of money if too many banks fail, but it’s a certainty that the government would put more money in the FDIC in that case.)

Second, you may have investments in stocks or bonds. Individual securities could be wiped out, and some have been already; not only did Lehman shareholders lose their money, but bondholders lost most of their money, too. But stocks are ownership shares in real companies, and most companies are not going to stop operating overnight. They will continue to buy, build, and sell whatever they buy, build, and sell today. Some will go bankrupt, as always happens, and some will lose value, but some will gain value. And it’s not likely that every company in the U.S. will lose all of its value at the same time. So you should be diversified, but you should always be diversified.

Third, there are your debit and credit cards. As long as you have money in your bank account, you will still be able to get at it using your debit card. It is unfathomable that a bank would need cash so desperately that it would block access to deposit accounts (and remember, those accounts are insured). When banks are at risk of failing, they want to preserve as much value as they can to sell to an acquirer. A large part of the value is the base of depositors and the ongoing banking operations. As for credit cards, it is possible that banks will gradually reduce the amount of credit they have extended by offering fewer cards, tightening the terms, reducing credit limits, and even unilaterally canceling some people’s cards. This could affect some people. But again, there is no reason why the credit card system as a whole would fail.

Now, if there is a recession, and that is certainly a possibility, it could have serious consequences for you: you could lose your job, your rate of salary increases could go down, your house could continue to lose value, your investments could lose value, and so on. As we’ve said, there are concrete steps that governments can take to minimize the duration and severity of any recession. In any case, you’re not going to wake up one day and find out that your money is gone. (Unless you keep your money under your mattress, in which case someone might steal it.)

Financial Crisis and the Real Economy

One of the biggest questions about the financial crisis – one heard from Capitol Hill to radio talk shows to casual conversations with friends – is why it matters for ordinary people. One major reason a significant proportion of public opinion is against the rescue plan is the general failure to make the connection between panics in the financial sector and the ordinary lives of everyday people; simply saying that the plan is necessary to prevent (or moderate) a recession smacks too much of “trust me” to be credible.

The connection is that much of the ordinary activity in the real economy relies on credit – think no further than the volume of purchases made using credit cards. (Although banks have been reducing credit limits, there is little risk for now that credit cards will stop working overnight.) And in today’s conditions, when many financial institutions are potential victims of liquidity runs, lending has virtually ground to a halt. The New York Times has an article today about the impact that the current crisis is having on local governments suddenly unable to raise money for ongoing projects such as highway repairs and hospital expansions. Across the country, local governments issued $13 billion in fixed-rate bonds in the first half of September – and $2 billion in the second half. A sudden 87% drop in a major source of municipal funding is a very real impact of the financial crisis, and one that will necessarily result in both fewer services and fewer jobs for taxpayers.

The Paulson Bailout Bill and the Need for Leadership

In case it wasn’t clear from earlier posts, our position on today’s bailout bill can be summarized as follows: the bailout is neither a complete nor a perfect solution, but it is better than the original proposal of ten days ago, and it is a valuable first step toward restoring confidence in the markets. This morning when the Dow fell 200 points shortly after opening, there were news stories speculating that the markets were not happy with the bailout plan; well, we saw this afternoon what the markets really thought about the bailout.

So if the professional investors who manage most of our money wanted the bailout, what happened? The free-market libertarians were opposed to the bill on supposedly fundamental grounds, but they were not enough to vote it down. The bill failed because enough representatives did not want to go home to their reelection campaigns having voted for a widely unpopular bailout bill. And why is it unpopular? Because no one took the time to educate the public on what the crisis means, how the bailout would operate, what the potential costs of inaction would be, what is happening to the money, and so on. These are complicated issues, but in the absence of explanation the public (based on the “man on the street” interviews” I heard on the radio today) focused on a few simplistic ideas: that this is a bailout for rich Wall Street bankers; that the $700 billion (at least) is a complete loss for the taxpayer; that the current administration cannot be trusted; and so on.

Perhaps there was not time in the last ten days for this type of education. But this only points out the importance of planning ahead. By repeating that the economy was “fundamentally sound” until suddenly discovering that it wasn’t, Bush, Paulson, and Bernanke lost the opportunity to prepare the ground for major government intervention in the economy. This bill will almost certainly be renegotiated and brought to another vote. But the underlying lesson is that intervention on the scale we are talking about requires political legitimacy, and that legitimacy requires the willingness to explain to the public just what is going on and why it matters to them.

The Paulson Bailout Plan, Version 4.0

There was the initial, 3-page proposal; the 6-page version of last Sunday; the grand compromise of Thursday, which lasted only a few hours; and now, as of this morning, a tentative agreement on a proposal that should be brought to a vote tomorrow. House Speaker Pelosi’s office issued a summary entitled “Reinvest, Reimburse, Reform: Improving the Financial Rescue Legislation,” which reads more like a set of talking points than a legislative proposal. But some of the major differences from the original proposal that have been reported on include:

  1. Division of the $700 billion into effectively two tranches, with Congressional review of the second
  2. Warrants on stock in firms participating in the bailout
  3. Tax provisions intended to limit compensation for senior executives of participating firms
  4. The ability for Treasury to use its power as the owner of mortgages and mortgage-backed securities to modify those mortgages on behalf of homeowners
  5. An unspecified commitment that, if the taxpayers lose money on the deal, the losses will be made up from the financial services industry
  6. Strengthened oversight, including an Inspector General, transparency of financial transactions, and some form of judicial review
  7. An option for Treasury to offer mortgage insurance to financial institutions

#5 and #7 seem to be the main provisions added since Thursday.

It goes without saying that it is the details that matter. At a high level, the current proposal improves over the original in two main areas: oversight (#6), which was absent in the original, and taxpayer protection (#2 and #5), which was brushed off with the optimistic assumption that the government would buy assets at their long-term fair market value (whatever that is). #3 and #7 are sideshows; #1 probably is as well, although there is a small risk that this will reinforce the sentiment that the bailout is not big and decisive enough.

But that still leaves two huge open issues. First, as Simon and I discussed in an op-ed on Wednesday, there is the issue of the price: too low and no bank will want to sell; too high and the taxpayers will not get the warrants they deserve. Second, although the proposal will exhort Treasury to modify mortgages, it’s not clear how, or whether Treasury has to do anything at all. We’ll see what the final legislation looks like, but this could be a grand gesture intended for the electorate. If so, even after the current crisis of confidence is averted, the problem of repairing the direct damage of mortgage delinquencies and foreclosures will remain.

So, our provisional grades (pending the full bill):

  • Restoring confidence in financial sector: B
  • Recapitalizing financial sector: C
  • Addressing underlying mortgage problems:D
  • Preserving value for taxpayers: too vague to tell

Who Will Be the Blackwater of the Bailout?

Where there are $700 billion of funds to manage, there will be fund managers. And whether because of the ideological (small-government) preferences of the administration, or because mortgage-backed securities really are hard to analyze and value, or because of the speed required, it is highly likely that those fund managers will be working as contractors, not as employees of the Treasury Department.

Simon and I wrote our first op-ed last week on the challenges of aligning fund managers’ incentives with those of investors (in this case, taxpayers), but with all of the events of the last week this topic has not received a lot of attention. Christopher Dodd did add language addressing the problem of conflicts of interest, but it’s not clear how conflicts will be avoided in practice. Fortunately, Philip Mattera at Dirt Diggers Digest has been focused on just this issue for the past week. His prediction? The big winner could be the bond specialists at Pimco – who boast a special advisor named Alan Greenspan.

Henry’s Ark

In case you missed it, Simon (my co-author) was interviewed by Scott Simon this morning on Weekend Edition. One point he made, that I don’t believe has gotten a lot of attention in general, was about the global implications of the bailout plan. One way of putting this is that the plan creates a “Noah’s Ark” for financial institutions to escape the storm, but the next question is who will get a ticket onto the ark. The original legislative proposal would only have authorized Treasury to buy assets from “any financial institution having its headquarters in the United States.” While there was talk over last weekend about possibly including foreign banks, or their subsidiaries in the U.S., that was not mentioned in Thursday’s bullet-point agreement between the Executive Department and Congress (the one that was blocked by the House Republican caucus). Indeed, it seems hard to believe that Congress or the American public would be able to stomach a bailout of foreign banks. But if the reason to save financial institutions is the risk of cascading disruption to their counterparties – and that was the reason cited for both Bear Stearns and AIG – we have to be aware of the risk presented by global banks such as UBS that would have similar counterparty effects. While I’m not suggesting that the U.S. bail out every major non-U.S. bank, someone may have to, and right now there is a distinct lack of a coordinated global response.

Update: 9:20pm, Saturday, September 27th, the Financial Times on-line edition is reporting that Bradford and Bingley, a UK mortgage lender, will be nationalized tomorrow.  Sounds like Gordon’s Ark just got a bit bigger.