Author: Simon Johnson

Trial Balloons: Insuring The Bad Assets

The Administration is obviously floating ideas to assess potential reactions, particularly from Congress. Today’s front page WSJ article on banking should be seen in this light. It’s obviously not a fully-fledged proposal, but the concepts are there to elicit opinions and I don’t think it’s particularly helpful if we hang back.

The article raises the possibility that bad assets from banks will be divided into two parts, (a) bought by an aggregator bank, and (b) insured against further losses by the government.

We’ve covered the general principles of an aggregator bank and good/bad bank splits elsewhere. Let me focus here on the specific (and credible) permutations in the WSJ article. Continue reading “Trial Balloons: Insuring The Bad Assets” →

Global Economic Outlook (Senate Testimony)

My written testimony, submitted to the Senate Budget Committee for today’s hearing is here (in pdf) and after the jump as a post. This is essentially our new Baseline Scenario, although we’ll likely make a few small changes before putting it out as that.

You can watch the hearing here. I was struck by how many questions were about what can be done for US housing. The Senators expressed frustration that substantial further amounts are likely needed to shore up the banking system, yet little has been done for the underlying issues in housing. They are also quite dubious of any bank recapitalization/clean-up scheme that leaves existing management in place.

Several expressed a preference for tackling the fiscal stimulus, bank restructuring, and housing refinance together, to get a better handle on what we can and cannot afford. Personally, I think that’s a sensible approach – as long as we move forward quickly on all three fronts.

Continue reading “Global Economic Outlook (Senate Testimony)” →

Senate Testimony Tomorrow

From 10am until about noon on Thursday (January 29th), I’ll be testifying to the Senate Budget Committee on a panel discussing The Global Economy: Outlook, Risks, and Implications for Policy. I’ll post my testimony here after the session, and – potentially with some edits – this will also serve as the revised version of our Baseline Scenario.

Now would be a good time to tell me if you think there are important developments around the world, big or small, that we have overlooked recently. And if you have other policy-related points that you think I should consider making, please post those as comments here also.

To Save The Banks We Must Stand Up To The Bankers

The Financial Times has just published an op ed by Peter Boone and me, arguing that aggressive bank recapitalization and toxic debt clean-up is essential in the U.S. – and that this can be done with strong protections for taxpayers and without nationalization. The FT did a great job cutting our draft down to fit their print edition (of Tuesday, January 27th); I don’t think they took out anything crucial. But, just in case, after the jump is the full article as submitted.

(Note: newspapers usually like to choose their own titles for op eds, and the FT is no exception. But I like their choice and I’ve used it as the heading for this post.) Continue reading “To Save The Banks We Must Stand Up To The Bankers” →

The Emerging Political Strategy For Bank Recapitalization

Here’s a tough problem.

The nation’s leading banks are short of capital, and only the government can provide the scale of resources needed to recapitalize, clean up balance sheets, and really get the credit system back into shape. Any sensible approach will put some trillions of taxpayer money at risk. We should get most of it back but – as we’ve learned – things can go wrong.
Everyone hates bankers right now, and these feelings only deepen as we learn more about how the first part of the TARP was spent and mis-spent. No one wants to hear about anything that sounds like a bailout to bankers and their careers.

How does the Administration and Congress sort this one out? This weekend we seeing an approach take shape which, most likely, will work. There are five closely related moving pieces. Continue reading “The Emerging Political Strategy For Bank Recapitalization” →

Davos World Economic Forum: A Viewer’s Guide

The big annual economic meeting at Davos opens next week (Jan 28-Feb 1 are the official dates), and the discussion there – in both formal and informal interactions – is worth scouring for indications of the current situation around the world and where we all may be heading.

Given the likely composition of the main players this year – world corporate leaders and the non-US policy elite (with the new US policymakers stuck at home, doing real work; update: this is now confirmed by Bloomberg for Summers and Bair) – I would suggest viewers at home and on the ground keep watch for answers to the following.

Are we on the same planet? It is not unheard of for Davos participants to appear as if they are living in their own bubble. Watch for opulent parties and excessive consumption, particularly if the people involved have nominated themselves for any kind of government handout. If you meet someone from Merrill, ask if their attendance fees came out of 4th quarter earnings – or if there is still more bad news to come. Continue reading “Davos World Economic Forum: A Viewer’s Guide” →

The Long Bond Yield Also Rises

The spread between Greek government 10-year bonds and the equivalent German government securities rose sharply this week – Greek debt at this maturity now yields 6.0% vs. German debt at 3.1%. Other weaker eurozone countries appear to be on a similar trajectory (e.g., Irish 10 year government debt is yielding 5.8%) and if you don’t know who the PIIGS are, and why they are in trouble, you should find out.

We also know East-Central Europe (including Turkey) has major debt rollover problems and most of that region is in transit to the IMF, with exact arrival times determined by precise funding needs relative to the usual political desire to keep the party going through at least one more local election. Put the IMF down for another $100bn in loans over the next six months, and keep the G20 talking about providing the Fund with more resources.

But the big news of the week, with first-order implications for the US and the world, was from the UK where the prospect of further bank nationalization now looms. Continue reading “The Long Bond Yield Also Rises” →

Constraints On The Comprehensive Obama Plan

Yesterday, Tim Geithner stated clearly – and reassuringly – that the Obama Administration will present a comprehensive and detailed economic recovery plan within a few weeks.

We know this plan involves a large fiscal stimulus, and it is reasonably clear there will be around $100bn for housing refinance/mortgage mitigation (out of TARP II funding), and probably some other symbolically important pieces intended to help consumers directly.

The big question is: what will be done about the total mess that our banking system has become? On this key dimension, we know little about the Administration’s specific thinking, but we can already see with considerable clarity the constraints that will bind as their thinking becomes concrete policy proposals.

There are three major political constraints. Continue reading “Constraints On The Comprehensive Obama Plan” →

Global Fiscal Stimulus: Should It Be An Obama Administration Priority?

The US has the opportunity – and perhaps the responsibility – to immediately retake a leadership role in global economic policy thinking, with the pressing priority of preventing the world’s recession from becoming something more serious. But what should be Mr Obama’s priorities in this regard, for example in the run-up to the G20 summit in early April – which, given the timetable for these things, will have an unofficial dry run of sorts at the Davos meetings next week?

The obvious message could be: a large US fiscal stimulus is coming, but the rest of the world needs to do more. In this option, Mr Obama could devote considerable effort to encouraging others to expand their government spending and/or cut taxes.

While worldwide cooperation of this form may have been a constructive thought last year at Davos, when the idea was first broached publicly by the IMF, a joint global fiscal stimulus is a glorious idea whose time has for now passed. Continue reading “Global Fiscal Stimulus: Should It Be An Obama Administration Priority?” →

Nationalization Is Not Inevitable

This week’s moves by the British government have created the impression that bank nationalization is inevitable. It is certainly the case that small-scale bank recapitalization, partial balance sheet clean-up, and various forms of financial engineering (e.g., insurance schemes for bad debt) are not only no longer enough, but may even be destabilizing. The problem is that once the market thinks you are on the move to a decisive solution but have not quite mustered the political will needed for complete resolution, it will assume that the final destination involves zero value for equity holders (and perhaps some bumps in the road for bank creditors).

The same logic is now being applied in Ireland and, to varying degrees, in other weaker eurozone countries. And the knock-on effect from assumed nationalization of bank losses to fiscal sustainability is immediate. Quoted Credit Default Swap spreads for some European sovereigns were wider than for investment grade corporates today, which of course makes no sense – but it does indicate extreme pressure in markets and deep confusion (or perhaps great clarity) regarding the impact on government balance sheets.

Nationalization is not the answer in the United States. Continue reading “Nationalization Is Not Inevitable” →

Obama Can; The Rest Of The World, Not So Much

The US will shortly have a new President. Congratulations to all concerned, particularly those who kept their cool during the intense moments of crisis during the fall and who surmised – early and correctly – that the current situation requires decisive and comprehensive action. We already have a large fiscal stimulus in the works, a significant housing refinance program was surely being signalled last week, and we are waiting to hear through exactly what kind of new structure the bulk of TARP II funding will be deployed.

If banking stabilizes of its own accord over the next week or so, the new Administration will lean towards a New Bank focused primarily on restarting consumer lending (or they can expand the mandate of a relatively clean existing structure such as Fannie or Freddie). If banking continues to deteriorate, then more of an RTC-type structure is likely to prevail, i.e., at least partially cleaning up banks’ balance sheets – presumably in return for lending requirements.

There is definite potential for inflation in this strategy, but this would not be the worst thing – the gap between the consensus and our view is narrowing on this. And in any case President Obama can, quite reasonably, blame his predesssor for almost everything that goes wrong. And Obama can also argue, plausibly, that things would be even worse without his bold actions.

Unfortunately, in most of the rest of the world the economics and politics are not so favorable. Let me remind you of the main points, illustrated with some of the latest developments. Continue reading “Obama Can; The Rest Of The World, Not So Much” →

Global Consequences of a US “Bad Bank” Aggregator: It’s Mostly Fiscal

It looks like a bank aggregator for bad assets is pretty much a done deal. David Axelrod said yesterday we should expect a new approach within a few days, and leading reporters (NYT, Washington Post) have discerned that this is likely to include a “bad bank” into which troubled/toxic assets can be disposed.

We don’t yet know the details, and these matter a great deal (for the taxpayer and for the gradient of the road to recovery) but it’s not too early to think about the global implications, at least in qualitative terms. Continue reading “Global Consequences of a US “Bad Bank” Aggregator: It’s Mostly Fiscal” →

Designer Talk: Bank Recapitalization (and Bair’s Aggregator)

Sheila Bair is delivering a sensible general message: we need dramatic action to clean up banks’ balance sheets and, presumably, to recapitalize them. This initiative apparently has support from influential senators, such as Kent Conrad and Charles Schumer. Many Republicans also seem inclined to come on board.

I like an aggregator-type approach; this is quite consistent with the RTC-inspired structure that we have been advocating (see the WSJ.com article linked through that post for details; such ideas are consistent with and an update of our proposals from September, November, and December). But some of the details currently being floated seem less than ideal. Given that the design work on this program is still ongoing and the new Administration will, without doubt, seek broad support on Capitol Hill, I would suggest that the following points be considered or even stressed in the upcoming deliberations. Continue reading “Designer Talk: Bank Recapitalization (and Bair’s Aggregator)” →

Bank of America Gets Quite a Deal

We have a deal. You, the US taxpayer, have generously provided to Bank of America the following: one Treasury-FDIC guarantee “against the possibility of unusually large losses” on a pool of assets taken over from Merrill Lynch to the tune of $118bn, and a further Fed back stop if the Treasury-FDIC piece is not enough. In return we receive $4bn of preferred shares and a small amount of warrants “as a fee”. There is a $10bn “deductible,” i.e., BoA pays the first $10bn in losses, then remaining losses are paid 90% by the government and 10% by BoA.

We are also investing $20bn in preferred equity, with a 8 percent dividend. There will be constraints on executive compensation and BoA will implement a mortgage loan modification program. Essentially, this is the same deal that Citigroup received just before Thanksgiving, known as Citigroup II, which was generous to bank shareholders but not good value for the taxpayer.

This is more of the same incoherent Policy By Deal that has failed to stabilize the financial system, while also greatly annoying pretty much everyone on Capitol Hill. Hopefully, it is the last gasp of the Paulson strategy and the Obama team will shortly unveil a more systematic approach to bank recapitalization; it would be a major mistake to continue in the Citi II/BoA II vein.

In addition, you might ponder the following issues raised by the term sheet.

1. The $118bn contains assets with a current book value of up to $37bn plus derivatives with a maximum future loss of up to $81bn. This is more detail than we got in the Citi deal, so there is evidently greater sensitivity to calls for transparency. But the maximum future loss is based on “valuations agreed between institution and USG.” What is the exact basis for these valuations? From the term sheet, it sounds like we are talking mostly about derivatives that reference underlying residential mortgages. Absent any other information, my guess is that they can easily lose more than $81bn – depending on how the macroeconomy and housing market turn out.

2. What is the strike price of the warrants? This was controversial in the Citigroup II deal (because it was unreasonably high), but at least it was quite explicit up front. The announcement is suspiciously quiet on this point, perhaps due to the recent spotlight on warrant pricing terms.

3. What kind of reporting will there be by BoA to Treasury, and what will be disclosed to Congress, in terms of the exact securities covered by this guarantee and how they perform? The lack of information is a big reason why TARP became discredited and Capitol Hill is so concerned to see more transparency going forward. There is nothing in the term sheet that reveals the true governance mechanisms that will be put in place, or how information will be shared with the people whose money is at stake (you and me, or our elected representatives). I understand there is market-sensitive information present, but there are obviously well-established ways to share confidential information with members of Congress.

Overall, it feels like the latest (and hopefully the last) in a long line of ad hoc deals, which have done very little to help the economy turn the corner. The new fiscal stimulus needs to be supported by a proper bank recapitalization program, as well as by a large scale initiative on housing.

The Funding for Recapitalization

Congress is now debating how to use the second half of the TARP. I suggest that all $350bn should be used for bank (and other regulated financial institution) recapitalization, providing this is done in a comprehensive manner (the details of this argument are now on WSJ.com). And I suspect that an additional budget authorization, beyond TARP, in the region of $250bn will be needed for the same purpose. If Congress sets up a Resolution Trust Corporation (RTC)-type structure, then this RTC can borrow additional money from the Fed as needed.

The important point is to keep this funding for bank recapitalization separate from the fiscal stimulus. We can continue to debate the size and nature of the stimulus, of course, but roughly $800bn seems right and the mix of spending and tax cuts currently proposed also makes sense. (On the point of whether the tax cuts would be “wasted” in any sense, remember that consumers have damaged balance sheets and that tax cuts should help on that dimension.)

Bank recapitalization should therefore be seen as complementary to the fiscal stimulus, rather than as any kind of substitute. We need both to be big and bold (and of course we also need a serious housing refinance program that would directly reduce foreclosures).