Author: Simon Johnson

Wake Up and Smell the European Coffee

At a Brookings panel today and even more so on a LA-based NPR radio show (“To the Point,” KCRW) just now, the impact on the “real economy,” i.e., people and businesses outside the financial sector, was the issue of the day. And people are beginning to understand the serious consequences of our financial system problems, with or without the Paulson Plan becoming law this week.

Here’s what I suggested at Brookings this morning, for the US, which is pretty close to what is in our Baseline Scenario, First Edition:

Tell everyone that their deposits are safe. Explain that no one has ever lost a penny when the FDIC has been involved and, de facto, they always pay all depositors, even those with over $100,000. I recommend removing the deposit insurance cap. In other words, do what it takes to stop the run.
Then work on bank recapitalization, right away (I think you can see the consensus moving in this direction already this week; I’ll try to post on the emergent schemes tomorrow)
And deal directly with the underlying troubled mortgages (again, I hear ideas emerging fast; give that a couple more days before I do a survey)
And get ready to provide a substantial fiscal stimulus. But don’t even think about this unless you have done 1, and much of 2 is in place, and the programs to deal with 3 are on their way.

Perhaps the overlooked issue of the week was the speed with which the crisis is clearly going global, with now a long list of European countries having banks in trouble. Europe also needs to stop the run on their banks before it gets out of hand.

One sensible way to do this would be with a large Europe-wide fund to inject capital and receive preferred equity in banks, on terms advantageous to taxpayers. Yes, this is point 2 above, on steroids. Of course, they have to deal with underlying domestic mortgages in Ireland, the UK and Spain (but not yet in other countries). The danger in Europe is that they don’t have as much fiscal space as the US (so point 4 is an issue) and their central bank is stuck with a mandate (i.e., just worry about inflation) that would have been nice to have in the 1970s, but may not be quite so appropriate today.

The severity of the global recession is going to depend, in large part, on the speed with which governments in Europe can organize swift, comprehensive and decisive support for their banking systems. And, following that, it will depend on exactly how the process of deleveraging (this is jargon essentially, meaning reduced lending by the financial sector) is handled.

The latest news from Europe (timely, thanks to the Financial Times): there will not be an immediate systematic rescue. It’s the French who seem to have understood what is really going on. Unfortunately, as of now, their European partners have not yet woken up to the new realities. In particular, Germany and perhaps the UK seem to stand in the way of a more systematic approach. This has dangerous implications for the US.

Days to the election: 34

Credit and Equity at the O.K. Corral

A long time ago in a place far, far away (i.e., February), Greg Ip had a nice piece in the Wall Street Journal entitled, “Stocks are from Venus, Credit is from Mars,” with his point being that stock prices painted a considerably more optimistic picture than did conditions in the credit market. The same point holds today, despite the large fall in stock prices Monday and the significant decline over Monday-Tuesday combined.

In fact, I feel the situation is considerably more ominous given that today, Tuesday, there was a large rebound in stock prices in the US at the same time that pressures in the credit market appeared to worsen. As I wrote in Inside Risks, way back when the world economy looked much more stable (i.e., March), the credit default swap (CDS) spreads of banks and the like have been the most consistent indicator of pressure and contagion within the financial sector around the world; see that article for examples.

It’s not so much that equity and credit are from different planets, as that would just make for a presumably difficult relationship. It’s that equity and credit are having regular showdowns, expressing fundamentally different views: the business model vs. the access to financing under stress. And in pretty much all the cases that I have followed closely, it’s credit that wins this confrontation, in part because if credit market sentiment turns negative, your access to funding dries up, you become more vulnerable to stress, the cost of funds goes up, and the viability of the underlying business model crumbles.

The CDS spreads of key large banks and some other financial intermediaries (no names please) widened today, in a familiar pattern. Within a set of institutions with a similar profile, there is usually one firm with a CDS spread that implies they are out of business. This lasts longer than you might think. Then they are out of business. And then, of course, it starts all over with the financial institution perceived to be the next weakest in that set.

The series of self-fulfilling runs appears unlikely to be broken by today’s equity rally. The credit default swap market raises many concerns about its size and nature, of course, but as an indicator of what is to come, it has worked well over the past year. And this indicator, at the end of US trading on Tuesday, was flashing red.

Days until the election: 34

Do We Need to Move the Baseline Already?

I thought it might be an eventful day when the news broke that a major bank (Wachovia) was being taken over (by Citi) while I was in the midst of posting our Baseline Scenario. But I took it in stride, feeling confident that this was consistent with what we thought, broadly, was going to happen — remember that the point of the Baseline Scenario is to make clear, to you and to ourselves, the logic that lies behind what we think will unfold.

In fact, the details of the Citi-Wachovia deal looked to be very much in line with our expectations (and, yes, we have a list of banks that we expect to run into trouble, but we’re not posting it here.)

The Baseline Scenario can also handle the Paulson Plan struggling in Congress, in two senses. First, if it doesn’t pass, there are other measures that the Fed and Treasury can take to shore up markets in the short term. None of these are attractive for the long haul, but we really need to get through November 4, so a new team can get in place (I know they don’t take office until January, and you can’t have more than one President, but there are workarounds.)

Second, even if it does pass, we’re quite skeptical that the Paulson Plan will fix the deeper underlying issues (see the long memo that is the First Edition of our Baseline Scenario). So you’ve got to get cracking in any case on discussing, educating, and negotiating around a potential Plan B.

Also, market volatility and downward pressure on equity prices are very much in our Baseline. The dollar, you will have noted, held up rather well today. Where else are you going to put your money, particularly when there may be further nasty surprises lurking somewhere in the European banking system?

Still, I would mark the day overall as slightly below expectations. I think it was the general tone and sense that order was lacking (and that expected votes in the House did not materialize). Also, I wonder what will happen tomorrow, which is not a working day for Congress while the markets will be open.

Days until the election: 35

The Baseline Scenario, First Edition (Our Plan)

This first edition of our Baseline Scenario makes three main points. First, we are facing a serious crisis of confidence in much of the world’s financial system. Second, the Paulson Plan may well bring this crisis under control, at least for a while. But, even so, we should plan ahead for measures to deal directly with the deeper underlying problems of bank capital and restructuring mortages. Third, if as we expect, further serious measures are needed (particularly bank recapitalization and dealing with the underlying mortgage problems), these are entirely feasible and well within the resources available to the US government. Governments in Western Europe and some other countries also need to act, and they also have more than sufficient resources at their disposal; however, we remain worried that some of these governments do not yet understand the gravity of the situation.

Update: to be clear, our plan for pulling the global financial system out of its nose dive is at the end of the document; feel free to skip straight to that and then work your way backwards to see our reasoning.

Update: the next edition will appear by 9am Monday morning, October 6.

Editor’s Note: The original version of this document was a separate page with a link from the short blog post above. I have since consolidated the long document into this blog post. It follows after the jump.

Continue reading “The Baseline Scenario, First Edition (Our Plan)” →

Plan A, Plan B

We’ve been getting quite a few questions about our views on the big picture. Let me try to set this out clearly, in terms of where we are (September 27, 2008, early Saturday morning) and where we are heading.

Let’s call the $700bn package currently under discussion Plan A. Despite the roadblock thrown up by the House Republicans, we think some form of this plan will pass Congress soon, and so it should. The situation in the financial system is serious and inaction would be a recipe for disaster, especially now that the government has created the expectation of action. We are also of the view that the package could have been better designed (e.g., we emphasized governance and transparency in the articles posted here). And we are encouraged that its design has improved this week, at least in the draft agreement of Thursday afternoon.

Plan A is obviously not comprehensive, and again we’ve covered the two main missing issues (a direct approach to defaulting mortgages and deficient bank capital) here and in various other on-the-record remarks. (We’ll post more of these to help complete the picture regarding our views.)

If Plan A comes out of Congress in reasonable shape, as seems likely, we will support it. We need it to work. But we also need to start discussing what would have to be done if Plan A does not work, or if the cracks now visible in the global financial system continue to widen.

Yes, we need a Plan B. Even if the odds of success for Plan A are high (ask us again on Monday about that), it makes sense to plan for contingencies. And we really don’t want to repeat the experience of this week, in which the initial proposal is weak and has to catch up with economic and political realities in a hurry.

And it strikes us that the discussion on Plan B needs to be public, in places like this. This does not undermine Plan A, in our view, because Plan B will not be so difficult. It will not be business (lobbies) as usual, but it will be doable. Our submission, longer than 2 1/2 pages, will be up here by 9am Monday, Washington time, at the latest.

The Feldstein Proposal

There’s a resurgence of interest in the proposal originally made by Marty Feldstein. The link to his recent Financial Times piece is here. He wants the Treasury to borrow and on-lend to homeowners, in a way that would improve their cash flow and make it easier for them to avoid defaulting on mortgages. Of course, anyone who participates would reduce their mortgage (a claim on their house) but create a debt to the government (to be collected, if necessary, by the IRS.)

I must say that I find this broadly appealing, in the moment we now find ourselves. I know it doesn’t address mortgages already in default, and there are many questions about how it could be implemented. And I agree that Congress, at this juncture, would need a lot of convincing.

Still, it’s one way to use the Treasury balance sheet to directly reduce likely mortgage defaults. And, if it’s part of a comprehensive approach (including recapitalizing banks), I think this general approach could make sense.

I hope others will post reactions, or links to any variants with plausible details.

There Is No Alternative. Really?

This morning (September 25, 10am) I was on the Diane Rehm show, on WAMU. The guest host, Frank Sesno, did a great job of moving the conversation from today’s White House Summit on the bailout plan to the likely impact on the global economy, with relevant stops along the way. We spent a great deal of time on alternatives.

It turns out, of course, that there are alternatives to the current bailout plan — even if you agree that there is a serious problem and we need to move fast. In fact, perhaps the one thing all three guests could agree on is the availability of workable alternatives.

I was really struck by Ken Rogoff’s points about the need to take over and close down many banks. I think he puts more weight on that part of any sensible approach than I do at present, but I’m definitely taking his points on board.

The more I talk with people, the more I hear agreement that we really need to address the problems of homeowners who are having trouble with their mortgages. It’s actual and expected defaults that got us into this mess, and attacking that issue directly is the best way to make sure we really get out.

Think of it like this. The Treasury wants to use its balance sheet (i.e., it’s ability to borrow at low interest rates) to help the banking system get back on its feet. If a substantial amount of taxpayer money is on the table, which it apparently is, let’s talk more about how to use the Treasury balance sheet to help homeowners get back on their feet.

It’s All About the Price

The debate on what the Treasury should or will pay for mortgage-backed securities has moved fast in the last week. Last week, Mr Paulson said it would be “market prices.” On Tuesday, Mr Bernanke said it would be “close to mark-to-model prices,” which you can presume would be above, and perhaps substantially above market prices. Since then, Mr Bernanke seemed to back track from that statement, towards some version of market prices.

But what are market prices or any other prices in this situation? You need to answer this question to know whether the Treasury is intending to overpay — or whether, after the fact, you can figure out if they did in some meaningful sense overpay.

We attempted to sort this out in The Price of Salvation on the Financial Times website (Economist Forum). It’s hard to say if any of this is getting through, but we are a little bit encouraged by the reaction.