Category: Commentary

The Citigroup Betting Pool

I’ve been catching up with my family and not on top of the news the last 24 hours or so – wasn’t there a time that the financial world shut down on weekends? – but for those of you who may not have a feed reader clogged with economics blogs (first, good for you), I wanted to point out some of the various outcomes you may want to bet on when it comes to Citigroup. Some people are betting that a deal (bailout, FDIC takeover, merger) may be announced as soon as this weekend. I doubt it, because Citi shouldn’t have a liquidity problem per se; now that the Federal Reserve is accepting pocket lint as collateral, Citi can keep functioning even after the markets have completely lost faith in it. The problem is that no one believes its assets are still worth more than its liabilities, so everyone expects the endgame will come (in one form or another) sooner or later. The big questions are whether no one will get wiped out, shareholders will get wiped out, or shareholders and creditors will get wiped out.

  • Mark Thoma has an overview with excerpts from some other posts.
  • The wildest idea is that Citi might merge with Goldman or Morgan Stanley, although this is only floated by unnamed analysts. What such a merger would accomplish is unclear to me. (Although various people have come up with the name for a Goldman-Citi merged entity.)
  • Felix Salmon has a quick rundown with a lot of links (some of which I reproduced below); he thinks that at least creditors will not get wiped out to avoid a repeat of Lehman.
  • John Hempton explains how creditors might be wiped out and why it would be a bad thing.
  • Brad DeLong says to the government: go ahead, just buy the whole thing. With the change, buy a cup of coffee.

Dawn of A New Interregnum

According to the official website of the President-Elect, there are 59 days until inauguration. Let’s call it nearly two months.  The good news is that President-elect Obama has begun to name his economic team, the line up looks strong, and they have plenty of time to get their plans in place.  The bad news is that the banking system may not have that much time.

We are now obviously in a delicate political phase, in which the Bush Administration is winding down and the Obama Administration does not yet have real power.  This matters because the US banking system is in a worse than delicate phase.  Contrary to the statements of Mr Paulson earlier this week, core US banks do not appear to be stabilized.  The fall in equity prices this week was a cause of serious concern, and we discussed the causes and potential (unpleasant) cures in our WSJ.com article on Thursday morning.  Since then the situation has only deteriorated, seen most clearly in the credit default swap (CDS) spreads for major banks, which moved up through Friday. 

This increase in CDS spreads means that the market believes the probability of some banks defaulting has gone up.  This is striking because the Federal Reserve at this point can make sure these banks never run out of liquidity.  So what is going on?

Partly people in the market are not sure that all parts of all (global) banks will be saved.  And partly they don’t know where the money for a bailout would come from. This is not just about whether TARP is or is not available to recapitalize banks, it is also about the not-so-good relationship between Congress and the outgoing administration.

Ask yourself this.  If the Bush Administration felt the need to raise, say, $1trn – see this week’s much cited FBR report on the capital needed by the banking system – and sought approval Congress in December, how well or badly would that conversation go at this point?  Could the new Obama team help?  What about when the new Congress arrives in the first week of January – would that make any difference?

We are in an awkward stage, facing major economic problems and with a potentially distracted executive branch.  We need to find some new ways to handle this transition between presidents.  And fast.

When Will the Stock Market Stop Falling?

The stock market has clearly not had a good week. The Dow Jones average was down 5.3%, the S&P 500 was down 8.4%, and it would have been much worse if the markets hadn’t jumped at the end of the day today, allegedly because Tim Geithner will be named Treasury Secretary (which I called, but it wasn’t that gutsy a call). Yesterday the S&P closed at less than half its high of October 2007. For a chart of the carnage, see Calculated Risk (click on the chart for a larger version).

At this point, stock prices are clearly beyond the short-term liquidity crisis that hit financial institutions in September, and deep into recession territory. That is, share prices will not respond particularly sharply to tactical steps such as individual bailout plans, because the big question is how long and how bad the recession will be. The problem this week was not that all the news was bad, but that all the news was worse than expected. The stock market prices in current expectations about the future, so if a report is bad but not as bad as predicted (say, unemployment goes up but less than forecast), the stock market should go up.

This week:

  • New unemployment claims were higher than expected
  • The Consumer Price Index fell more than expected
  • The manufacturing survey of the Philadelphia Fed was worse than expected
  • The Leading Indicators index of the Conference Board fell more than expected
  • Oil futures fell below $50 (indicating that expectations of demand are falling)

Partially as a result, Goldman revised its economic forecast down, saying that the economy will contract at an annual rate of 5% this quarter, 3% next quarter, and 1% the quarter after that, which is worse than any forecast I’ve seen (although I certainly don’t see all of them).

For the stock market to stop falling, new data has to come in that is better than expected. Of course, guessing when that will happen is a fool’s errand.

To Bail or Not To Bail, Banking Edition

This was a bad day for the market and a very bad day for banking; the credit default swap spread for at least one major bank rose above 400 basis points – a level of implied default probability that we have not seen since mid-October. 

Mr. Paulson suggested earlier this week that the government’s Troubled Asset Relief Program (TARP) take a break from bank recapitalizations, through at least January 20th (listen to today’s NPR story).  After today, I seriously doubt this is a good idea.  And I sincerely hope that the administration is preparing (another) policy U-turn. 

Potentially more sustainable approaches are suggested in my previous post (and the associated WSJ.com article).  Don’t be shy.  Congress in particular needs to hear your suggestions – post them here or call your favorite representative.  Just don’t urge inaction.

To Bail or Not To Bail, GM Edition

For those who can’t get enough of the GM topic, Economix (NYT) has links to posts for and against bankruptcy. Right now it’s 10-5 in favor of bankruptcy, although I’m not sure that Mitt Romney’s vote should have the same weight as those of, say, Martin Feldstein, Gary Becker, and Paul Krugman.

However, the bankruptcy/bailout dichotomy leaves out what I think is the best solution: a government-brokered reorganization, which may or may not require bankruptcy – a prepackaged bankruptcy, as it’s sometimes called. This would be very different than just letting GM go into Chapter 11 and hoping for the best, especially given the lack of debtor-in-possession financing these days (thanks to the commenters who pointed this out). Andrew Ross Sorkin, for example, argues for a prepackaged bankruptcy, and even Romney calls for a “managed bankruptcy” (without many deatils) – yet they are lumped in with the the others, like George Will, who argue against any government intervention. (See the link above for all the links to individual posts.) So I don’t think 10-5 is a very accurate count.

Update: Five professors who really are experts on the auto industry (and one of whom is a colleague of Simon at Sloan) have a highly readable paper with their proposal out. They favor a non-bankruptcy restructuring plan that is overseen by the government and also has some provisions to ensure that the reorganization is in the public interest, such as increased fuel efficiency standards and a prohibition on paying dividends to shareholders.

Testimony This Morning: Senate Budget Committee

Wednesday morning, starting at 10am, I’m on a panel testifying to the Senate Budget Committee about the need for a fiscal stimulus.  The other witnesses are Mark Zandi and John Taylor.

I’ll post my written testimony after the hearing. I expect to make three main points in my verbal remarks:

1) We are heading into a serious global recession, caused by and in turn causing a process of global leveraging (i.e., reduction in lending and borrowing).  We have never seen this kind of deleveraging – synchronized around the world, fast-moving, and with an unknowable destination.

2) I do not think we can prevent this deleveraging from happening.  Nor do I think we should even try to keep asset prices high (or at any particular level).  But in the United States we have the ability to mitigate some of the short-run effects and to lay the groundwork for a sustainable, strong recovery.  One sensible tool to use in this context is fiscal policy.  I lean towards smart spending programs, but as the economy continues to worsen, I think some kind of temporary tax cut could also help – it can potentially have relatively quick effects.  (Note: contrary to those who think that if tax cuts are saved by consumers, they are somehow “wasted,” I would point out that anything that improves consumers’ balance sheets is both good for them and for the financial institutions that lend to them.)

3) But there is a real limit to how far we can go with fiscal policy (and with other policy measures).  Irresponsible budget policies would not be a good idea – we need to continue a process of fiscal consolidation; it is most vital that people around the world remain confident in the U.S. government’s balance sheet.  Some of the highest numbers now being proposed for a fiscal stimulus are probably too high and a mega-stimulus could be counterproductive if it undermines confidence.

I’m proposing a fiscal stimulus of roughly 3% of GDP, to be spent over several years.  Given the uncertainties involved, this seems like reasonable middle ground – it’s enough to make a difference, but doesn’t promise a miracle; it can be spent sensibly and at an appropriate speed; and it will not undermine our ability to consolidate the U.S. fiscal position (i.e., bring government debt onto a sustainable path) over the medium-term.

More Things to Worry About

The morning after the election, I wrote a post on our country’s long-term priorities. #3 on the list was retirement savings.

While the retirement savings problem predates the current crisis, the decline in the value of financial assets has made it tougher all around. One reader pointed me to a particular aspect of the problem I wasn’t aware of. Earlier this year, the Pension Benefit Guaranty Corporation (PBGC) shifted its asset allocation from 15-25% equities to 55% equities. The PBGC, which is part of the federal government, guarantees private-sector pension plans and is funded by premiums paid by those plans; if a company’s pension fund goes bankrupt, the obligations are shifted to the PBGC. This, as Zvi Bodie and John Ralfe pointed out back in February, is particularly problematic for the PBGC, because then an economic downturn has a triple impact on the fund: first, as equity values fall, company pension funds face larger funding gaps; second, as companies go bankrupt, their pensions get shifted to the PBGC, increasing its liabilities; third, as equity values fall, the PBGC’s assets fall, increasing its funding shortfall. Bodie and Ralfe argue that increasing the proportion of equities may increase the expected return, but only at the cost of increased risk, in any timeframe.

(By contrast, because the Social Security Trust Fund is invested in Treasury bonds, it should be doing OK. Long-term concerns about Social Security funding, of course, are still valid.)

Emerging Markets Snapshots

GM, mortgage restructuring, and the G20 have sucked up most of the attention recently, but the crisis continues to take its toll around the world. A few vignettes:

  • In Ukraine, industrial production in October fell by 7.6% from September (that’s not an annualized rate) and 19.8% from October 2007.
  • Russia’s second-largest coal company reported that its Q4 sales would be only one-third the planned level – and that payments from its steelmaker customers since September were only 21% of the value of shipments.
  • Credit default swap spreads on Greek sovereign debt are up over 160 bp – higher than at the previous peak in mid-October. (Note that Greece is in both the EU and the Eurozone.)

On the “plus” side, Pakistan and the IMF agreed on a $7.6 billion loan, ensuring economic stability in a particularly important part of the world – at least for a few months. Pakistan’s government says they need a total of $10-15 billion.

Proposed Solutions to the Securitization Problem

We’ve gotten a number of questions about mortgage restructuring proposals, both in email and in comments. One reader asks: “How does one get around the securitization problem?  The Treasury seems to be able to change rules with the sweep of a wand lately, why not the REMIC [Real Estate Mortgage Investment Conduit] rules too?” Tom K also raises this issue in a comment.

I doubt that Treasury could unilaterally modify the rules governing the securitization trusts (in which a loan servicer manages a pool of loans on behalf of the many investors who own a share of that pool). Despite the ease with which Treasury seems to be flinging money around and the, um, liberties they seem to be taking with the terms of the TARP legislation, Treasury can’t really force anyone to do anything, legally. For example, Treasury has no authority to force a bank to accept a recapitalization, which (in my opinion) is why the recapitalization terms are relatively generous: they did not want to take the risk of the core banks turning them down.

The securitization issue raises similar legal barriers. A bit of background: To generalize, the loan servicer has a legal obligation to act in the interests of the investors in the loan pool; if it doesn’t, it opens itself up to lawsuits. Now, if all of the investors have the same interests, and the service restructures a delinquent mortgage in a way that provides more value than a foreclosure, then everyone is happy. There are (at least) three problems, however. The first is a coordination problem: getting all of the investors to agree that they are happy. The second is a problem of conflicting interests: because a typical CDO is structured so that some investors get the first payments and some get the last, a mortgage modification could help the interests of some investors and hurt the interests of others. The third is a tax problem: for technical reasons, a mortgage restructuring could be treated as a new loan, which creates a tax liability (this is a REMIC rule).

This is why I think this will require legislation, and even that could be challenged as an expropriation of property.

  • The Center for American Progress has a proposal to modify the REMIC rules and an explanation of why they think it would work.
  • John Geanakoplos and Susan Koniak have another proposal to use government-appointed blind trustees to make restructuring decisions and thereby protect servicers from liability to their investors (this would also require legislation).
  • Thomas Patrick and Mac Taylor have yet another proposal (thanks, Tom K) to use Fannie Mae and Freddie Mac debt to pay off all performing securitized mortgages at face value and refinance them with 30-year, fixed-rate mortgages. (I don’t fully understand this plan: it seems to involve paying face value for $1.1 trillion in mortgages, many of which are certain to default in the future, and forcing banks to pay face value for $400 billion in mortgages that are already delinquent, and also forcing banks to accept some of the losses on the government’s $1.1 trillion. But I don’t want to draw conclusions based on a newspaper description.) This one shouldn’t involve legal issues, but it will require legislation, because of the amount of money involved.
  • Then there’s the idea of allowing bankruptcy judges to modify mortgages on owner-occupied houses, which would also protect the servicer from liability. But this would be a slow, inefficient way of solving the problem.

If there are other ideas out there, please suggest them.

G20 Summit: Just Disappointing or Potentially Dangerous?

Initial reactions to the G20 summit are fairly positive, in the sense that the communique and associated press conferences conveyed (a) there was no open acrimony, (b) the body language was broadly supportive of countercyclical policies, and (c) there may now be a serious international regulatory agenda.

None of this is really new and it could all have been arranged by finance ministers (probably over the telephone), but I agree there is some useful symbolism in having heads of industrialized and emerging market governments convene for the first time (ever?) on these kind of issues.

I will admit to disappointment that no more explicit commitments were made to fiscal stimulus.  I thought the British and the French were heading in this direction, and that they could create some momentum in the right direction.  If Europeans (or anyone else) would like to compete for a “special relationship” with the US after January 20th, they might consider coming to the next summit with substantial fiscal package in hand (as will President Obama). 

If the latest rounds of global economic diplomacy were the Olympics, then China gets gold in the fiscal stimulus category, Germany gets silver, and the UK (so far) is the distant bronze – but the UK does get one more throw next week.  Not the ordering of world economic leadership that one would ordinarily expect, but perhaps that’s a good thing.

In the category of “largest cash contribution designed to save the world from serious disruption”, Japan easily finishes first – their $100bn pledge to the IMF this week was timely, targeted and hopefully not temporary.  Sadly, there were no other entrants in this category.  Perhaps the chemistry and cooking at the White House dinner on Friday will prompt further contributions in the near future?

But there is, unfortunately, another way to read the communique – as a government or international official, for whom this text really is a set of instructions to be implemented.  The whole first part of the document is generic and definitely not new, so – as an official – one’s eye skips through that quickly.  The real issue is the deliverables in the plan of action, with a pressing deadline at the end of March (this is pretty much like saying “do it tomorrow” to an official).  This is where we – an official reader is thinking – must concentrate our immediate attention and efforts.  And most of these specific actions are about tightening regulation on and around credit, or beginning processes that definitely point towards many dimensions for this kind of tightening – accounting standards, hedge funds, risk disclosures, financial sector assessments, credit rating agencies, risk management and stress testing models, international standard setters, sanctions for misconduct, reporting to supervisors in different countries, and more.

There is, of course, nothing wrong with making regulation more effective.  This is surely needed – in both the US and Europe, and probably elsewhere – to help lower the odds of another global financial crisis developing in the future.

But we are still not out of this crisis.  And tightening regulations quickly in the midst of a worldwide credit crunch is one good way to make sure that credit contracts further and faster.  Lending standards naturally tighten in a crisis; the issue to address going forward is how to prevent standards from loosening too much in the next boom – but this is at least several years down the road.  I’m in favor of starting early, but I do not like precipitate action just because you want to look busy and you could not agree on the more pressing issues, such as fiscal policy, support for the IMF, shoring up the eurozone, and so on.

It is true that one (among many) of the stated principles is: “Mitigating against pro-cyclicality in regulatory policy.”  But that is a general statement that is not mapped into operational requirements – except that the IMF and FSF should work together on this, which is a good way to make sure it doesn’t happen.  What officials have to deliver on, by the end of March, is substantive progress with regards to tougher and tighter regulation of credit.  There is a real danger that this action plan – within such a short time frame – can actually make the global downturn dramatically worse.

Root Causes of the Current Crisis

We’ve gotten a fair amount of criticism over on our latest Baseline Scenario post for not correctly identifying the causes of the financial crisis. I understand the criticism that we don’t identify the one single, crucial cause, because historical events like this are always overdetermined: there are always multiple plausible explanations, and with a sample size of one there’s no way to know which explanation is correct. (It reminds me a key issue in torts, where you distinguish between cause-in-fact and proximate cause … well, never mind. It’s a fascinating subject, but a bit off-topic here.)

Anyway, luckily for all of us, today’s G20 communique reveals the “Root Causes of the Current Crisis.” In case you missed it:

Continue reading “Root Causes of the Current Crisis” →

FDIC Takes Mortgage Proposal to the Public

Two months after the collapse of Lehman Brothers, there has still been no broad-based action to help restructure delinquent mortgages and slow down the flood of foreclosures; the Fannie/Freddie plan announced earlier this week is a very small first step, because it is limited to a small portion of the mortgages outstanding – those controlled by Fannie and Freddie, which tend to have relatively low default rates anyway.

Sheila Bair, head of the FDIC, said that that plan “falls short of what is needed to achieve wide-scale modifications of distressed mortgages.” Apparently frustrated by the failure of negotiations with the Treasury Department, yesterday the FDIC posted its mortgage modification proposal to its web site (Washington Post summary), basically breaking with the rest of the administration and hoping the Congressional Democrats can make it happen.

Continue reading “FDIC Takes Mortgage Proposal to the Public” →

The G20 Summit: Europe’s Greatest Moment, Or Not? (And a Quiz)

From their pre-meeting, it is reasonably clear what Europeans (except probably the British) want from the G20 summit on Saturday: a road map towards a great deal more regulation, together with agreement that the necessary powers and resources will be provided to implement these new rules at some international level (which could be the IMF or the Financial Stability Forum or the G20, or some combination).

And the Europeans are now apparently saying, on the sidelines, that victory – and a concrete action plan – is within their grasp.  This, of course, raises our expectations and makes us more prone to disappointment.  The White House, on the other hand, has been trying to manage our (and the Europeans’) expectations downwards. 

While we are waiting to learn the outcome of what is probably still a fairly intense conversation, here is a (relevant) pop quiz.

Below is the list of locations for press conferences to be held by participating countries after the conclusion of the summit, kindly provided by Planet Money.  The question is: which of these countries is not actually a member of the G20?  (Answer after the jump)

European Union & France — Willard Hotel
Japan — National Press Club
Italy — Embassy
Australia — National Building Museum
United Kingdon— Ambasssador’s residence
Canada — Embassy
Germany— Ritz carlton Georgetown
South Africa — Park Hyatt Hotel
South Korea –Paloma Hotel
Argentina — Park Hyatt Hotel
Mexico — Embassy of Mexico
Spain — Mandarin Oriental Hotel
Russia — The Washington Club

Continue reading “The G20 Summit: Europe’s Greatest Moment, Or Not? (And a Quiz)” →