Category: Beginners

No, Wait! You Got It Backwards!

AKA, Convertible Preferred Stock for Beginners.

There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a “preference,” which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.

When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.

But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department’s new Capital Assistance Program has this precisely backwards.

Continue reading “No, Wait! You Got It Backwards!” →

Tangible Common Equity for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

You may have seen in the news that the government is thinking about exchanging its “preferred stock” in Citigroup for “common stock.” Here’s one of many articles. Which, if you are at all sensible and have any sense of proportion in your life, should be complete gobbledygook. The first part of this article will try to explain the gobbledygood; advanced readers can skim it. The second part will offer some of the usual commentary.

Continue reading “Tangible Common Equity for Beginners” →

Welcome to New Readers

We’ve had a big surge of first-time visitors since Simon’s interview with Bill Moyers started broadcasting last night. We hope you enjoy the site and return often. You can also get free updates using an RSS reader or via email.

On the chance that some of you are new to the economics blogs, I wanted to suggest a few other sites you might also want to check out (in addition to our Financial Crisis for Beginners section). We are nowhere close to the be-all and end-all of information about the global economy, and in any case the more perspectives you get, the better.

  • Planet Money is an excellent, excellent podcast for people who are relatively new to the world of economics and the financial crisis, and for people who commute and can listen to it in their cars. I listen to it for fun.
  • Calculated Risk and naked capitalism are good sources for near-real-time news about the crisis and the economy in general. Calculated Risk has a particular focus on housing and mortgages; naked capitalism has incisive commentary from one side of the political spectrum.
  • Econbrowser is more technical and data-oriented; more advanced readers will like this one.
  • Economist’s View and Marginal Revolution provide in-depth articles applying economics to broad range of phenomena.
  • RGE Monitor is the home of Nouriel Roubini and also aggregates articles from all over the Internet.

Of course, we would love to see you again here.

(Feel free to add other suggestions in the comments.)

Is Saving Good?

For a complete list of Beginners articles, see Financial Crisis for Beginners.

Way back in October, one of our readers sent in a question which can be paraphrased roughly as: “During the boom everyone said we should be saving more. Now people are saying we should be spending more. What gives?” This question has been sitting in my inbox unanswered. Until now.

Two of the leading economics blogs in the world (OK, the English-speaking world) published posts entitled “The Paradox of Thrift” yesterday, solving my problem for me. Tyler Cowen started off with a link to Matthew Yglesias, who wrote a non-technical explanation of the sort I usually do in my Beginners posts. Read that first. (Cowen adds some semi-technical notes that you may or may not understand.) James Hamilton then gives a technical explanation, but by “technical” here I’m only referring to first-year undergraduate macroeconomics, so most people should be able to follow. Read that second, at least through the second paragraph after the second graph.

Yglesias basically says that if you save instead of spending, your bank can lend the money out to someone else to spend instead of you. It might go to your neighbor’s home equity line to buy a new flat-screen TV, in which case the economic impact is the same as if you had bought a flat-screen TV. Or it might go to some entrepreneur who is building a new factory, in which case the short-term GDP impact is the same (the money gets spent), but the long-term economic benefits are arguably higher (because in the long term we need new capital investment for the economy to continue growing). Hamilton shows the same thing with a simple equation. In the immediate term, S (personal savings) and I (private investment) both contribute to GDP, so one is just as good as the other; but in the long term, we need I, so savings are good.

However, it does not necessarily follow that every dollar saved necessarily and magically becomes another dollar invested. There are many reasons why increased savings may result not in increased investment, but simply in the same level of investment, which means total output (GDP) will be lower. Yglesias, Hamilton, and Cowen all point out various examples of why this can happen. In a dismal economic climate like the current one, entrepreneurs may not want to build new factories (put another way, demand for credit may not exist, so the banks have no place to lend the money). Or the savings may be going into zombie banks that are hoarding cash instead of lending it out. Or the economy may simply not be able to adjust fast enough: in order to shift out of cars and into anti-gravity hovercraft, it may just not be possible to retrain the workers fast enough to put all the available capital to use.

So in the long term, there are good things about a higher savings rate, not least that it will reduce the number of people facing poverty in their retirement years. But if we get there too quickly, it could exacerbate the recession we are going through.

Sweden for Beginners

For a complete list of Beginners’ articles, see the Financial Crisis for Beginners page.

With the regularity of a pendulum, the focus of discussion has swung back to the banking system (September: Lehman and AIG; November: Citigroup; January: Bank of America, and everyone else). And as everyone waits in anticipation for the Obama team’s first big swing, there has been increased discussion of . . . Sweden, including a recent New York Times article and a fair amount of blog activity, with a broad overview by Steve Waldman. (For other accounts, see this Cleveland Fed paper and a review of the crisis published by the Swedish central bank (which, according to Wikipedia, is also the world’s oldest central bank).)

Why Sweden? Because Sweden had its own financial crisis in the early 1990s, and by many accounts did a reasonably good job of pulling out of it. A housing bubble, fueled by cheap credit, collapsed in 1990, with residential real estate prices falling by 25% in real terms by 1995 and nonperforming loans reaching 11% by 1993, while the Swedish krona fell in value by 30%, hurting a banking sector largely financed by foreign funds. As Urban Backstrom said in a 1997 paper, “[the] aggregate loan losses [of the seven largest banks] amounted to the equivalent of 12 percent of Sweden’s annual GDP. The stock of nonperforming loans was much larger than the banking sector’s total equity capital.” In other words, the banking sector as a whole was broke.

Continue reading “Sweden for Beginners” →

“Bad Banks” for Beginners

For a complete list of Beginners articles, see the Financial Crisis for Beginners page.

What is a bad bank? . . . No, I don’t mean that kind of bad bank, with which we are all much too familiar. I mean the kind of “bad bank” that is being discussed as a possible solution to the problems in our banking sector.

In this sense, a bad bank is a bank that holds bad, or “toxic” assets, allowing some other bank to get rid of these assets and thereby become a “good bank.” Continue reading ““Bad Banks” for Beginners” →

Risk Management for Beginners

For a complete list of Beginners articles, see the Financial Crisis for Beginners page.

Joe Nocera has an article in today’s New York Times Magazine about Value at Risk (VaR), a risk management technique used by financial institutions to measure the risk of individual trading desks or aggregate portfolios. Like many Magazine articles, it is long on personalities (in this case Nassim Nicholas Taleb, one of the foremost critics of VaR) and history, and somewhat light on substance, so I thought it would be worth a lay explanation in my hopefully by-now-familiar Beginners style.

VaR is a way of measuring the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%). It does this by: (1) looking at historical data about asset price changes and correlations; (2) using that data to estimate the probability distributions of those asset prices and correlations; and (3) using those estimated distributions to calculate the maximum amount you will lose 99% of the time. At a high level, Nocera’s conclusion is that VaR is a useful tool even though it doesn’t tell you what happens the other 1% of the time.

naked capitalism already has one withering critique of the article out. There, Yves Smith focuses on the assumption, mentioned but not explored by Nocera, that the events in question (changes in asset prices) are normally distributed. To summarize, for decades people have known that financial events are not normally distributed – they are characterized by both skew and kurtosis (see her post for charts). Kurtosis, or “fat tails,” means that extreme events are more likely than would be predicted by a normal distribution. Yet, Smith continues, VaR modelers continue to assume normal distributions (presumably because they have certain mathematical properties that make them easier to work with), which leads to results that are simply incorrect. It’s a good article, and you’ll probably learn something.

While Smith focuses on the problem of using the wrong mathematical tools, and Nocera mentions the problem of not using enough historical data – “All the triple-A-rated mortgage-backed securities churned out by Wall Street firms and that turned out to be little more than junk? VaR didn’t see the risk because it generally relied on a two-year data history” – I want to focus on another weakness of VaR: the fact that the real world changes.

Continue reading “Risk Management for Beginners” →

The Importance of Accounting

Or, as I thought of titling this post, SEC does something useful!

Accounting can seem a dreadfully boring subject to some, but it gets its moment in the sun whenever there is a financial crisis . . . remember Enron? This time around is no exception. During the panic of September, some people were calling for a suspension of mark-to-market accounting, and while they did not get what they wanted, they succeeded in inserting a provision in the first big bailout bill to study the relationship between mark-to-market accounting and the financial crisis.

A brief, high-level explanation of the dispute: Under mark-to-market accounting, assets on your balance sheet have to be valued at their current market values. So if you have $10 million worth of stock in Microsoft, but that stock falls to $5 million, you have to write it down on your balance sheet and take a $5 million loss on your income statement. The criticism was that mark-to-market was forcing financial institutions to take severe writedowns on assets whose market values had fallen precipitously, not because of their inherent value, but because nobody was buying these assets – think CDOs – and that banks were becoming insolvent because of an accounting technicality. Under this view, banks should be able to keep these assets at their “true” long-term values, instead of having to take writedowns due to short-term market fluctuations.

I am instinctively skeptical of this view, and in favor of mark-to-market accounting, because I believe that while market valuations may not be perfect, they are generally better than the alternative, which is allowing companies to estimate the values themselves, subject only to their auditors and regulators. But the issue is considerably  more complicated than either the simple criticism or my simple defense would imply.

Earlier this week, the SEC released its study of mark-to-market accounting as required by the bailout bill. Their conclusions are simple:

fair value [mark-to-market, as will be explained] accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.

Continue reading “The Importance of Accounting” →

Japan for Beginners

For a full list of Beginners articles, see the Financial Crisis for Beginners page.

The most common point of comparison for our current economic crisis is, far and away, the Great Depression. The Depression is most often bracketed with some version of the phrase, “but we’re unlikely to see a depression, just a recession,” whatever that’s supposed to mean. And, fortunately for us, with the addition of Christina Romer, we now have two scholars of the Great Depression on our nation’s economic policymaking team.

But in many ways, a more relevant comparison may be the Japanese “lost decade” of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth. This is the Nikkei 225 index from 1980 to the present.

Nikkei

Continue reading “Japan for Beginners” →

Credit Default Swaps, Herald of Doom (for Beginners)

No, this isn’t another article about how credit default swaps (CDS) have ruined or are going to ruin the economy. It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. And it has pretty Bloomberg charts!

As everyone probably knows by know, a CDS is insurance against default on a bond or bond-like security. If you think about it for a while, you will realize that this means the price of the CDS reflects the market expectation that the issuer will default.

Continue reading “Credit Default Swaps, Herald of Doom (for Beginners)” →

Federal Reserve for Beginners

We had a comment last week asking for an explanation of, roughly, what it is that the Federal Reserve does, so I thought that would be a good topic for a Beginners post. (For a complete list, go here.) This would have been a relatively easy question to answer a year ago, but since then it’s gotten considerably more complicated. Like all Beginners articles, I’m going to make a number of simplifications, for example generally treating the Federal Reserve as one big bank (it’s really twelve different banks). I’m also going to ignore many of the Fed’s functions; for example, the Federal Reserve is itself a bank regulator, but I’m not going to discuss that.

Continue reading “Federal Reserve for Beginners” →

Other Good Sources of Information and Perspectives

Since the article about Simon in the WSJ earlier today, we’ve been getting a large number of first-time visitors. On the chance that some of you are new to the economics blogs, I wanted to suggest a few other sites you might also want to check out. We are nowhere close to the be-all and end-all of information about the global economy or the current crisis, and in any case the more perspectives you get, the better.

  • Planet Money is an excellent, excellent podcast for people who are relatively new to the world of economics and the financial crisis, and for people who commute and can listen to it in their cars. I listen to it for fun.
  • Real Time Economics (Wall Street Journal) gives you rapid coverage of economic issues as they arise.
  • Calculated Risk and naked capitalism are good sources for near-real-time news about the crisis and the economy in general. Calculated risk has a particular focus on housing and mortgages; naked capitalism has incisive commentary from one side of the political spectrum.
  • Econbrowser is more technical and data-oriented; more advanced readers will like this one.
  • Economist’s View and Marginal Revolution provide in-depth articles applying economics to broad range of phenomena.
  • And James Surowiecki has a blog!

Of course, we would love it if you would come back here often (or sign up for email subscriptions). But I wanted you to know some of your options.

(Feel free to add other suggestions in the comments.)