Category: Commentary

The Bad Private Equity Fund

What seems like years ago, Simon and I wrote an op-ed in which we compared the initial proposal that became TARP to a bad hedge fund – a fund whose purpose was to overpay for illiquid securities and thereby shore up banks. Now that the original plan is dead, I think we can say that TARP has become a bad private equity fund, whose purpose is to buy preferred stock on overly generous terms (compare the 5% dividend taxpayers get to the 10% divided Buffett got from Goldman) in order to shore up banks and bank-like institutions (and maybe others as well). I don’t mean “bad” as a criticism here: the purpose of the Treasury Department is to protect and advance the public good, and that goes beyond the profitability of the investments themselves.

However, I do think it’s a problem that the goals of this private equity fund haven’t been well defined. Right now the bulk of the political pressure seems to be to (a) expand the scope of the bailout to other companies and industries that are being hurt by the recession (which could mean just about everyone) and (b) force bailoutees to do things in the public interest, like increase lending. (See the New York Times on both of these topics.) So the fund is being torn in two directions. To make a very broad generalization, if you want to increase lending, you should give capital to a healthy bank, like Saigon National (in the NYT article); but if you want to keep the financial system from collapsing, you should give it to very large banks (too big to fail) with balance sheet problems, like Citigroup, and they are not going to increase lending, precisely because they need the money themselves.

Paulson’s initial bet, which most but not all observers agreed with, was that the top priority was keeping a handful of core banks – Bank of America, Citi, JPMorgan Chase, Wells – from collapsing. One risk is that to protect that position, they will need more capital for those core banks (especially, apparently, Citi). While these banks were struggling with a liquidity crisis in September-October, now they are struggling with a good old-fashioned recession, in which all sorts of borrowers can’t pay them back, so they could be looking at writedowns for many months to come. (Perhaps as a result, CDS spreads on BofA, Citi, and JPMorgan are all up 30-50% from their lows right after recapitalization was announced.)

So I think Treasury needs to be clear on its goals. We know one goal is to protect the core of the system, which will not necessarily increase lending in the short term. From Paulson’s recent statements, it looks like one new goal is to increase lending. It’s not clear that $700 billion is enough for both of these goals. And $700 billion is certainly not enough to bail out everyone out there who will be hurt by the recession, including smaller banks that are unhealthy but not “too big to fail” – who will, therefore, fail.

Yet More on GM

My two earlier posts on the auto industry and GM have been among the most-commented-on posts in our brief history. For those who want a crash course on GM’s problems and whether or not bankruptcy is a possible solution, I strongly recommend two podcasts from Planet Money.

  • Kimberly Rodriguez, an economist, talks about the importance of the industry, but also the problems with simply giving GM an operational loan.
  • Steve Jakubowski, a bankruptcy lawyer, explains the risks of GM entering Chapter 11 (if you’re curious about the market for debtor-in-possession financing, listen to this), but also explains how a “prepackaged” bankruptcy, possibly funded by the government, could work.

Simon also tells me he talked through the arguments on both sides of the GM issue in his latest installment for the MIT Sloan podcast. (I haven’t had time to listen to it yet.)

If there’s a consensus between them, I’d say it’s that some kind of brokered solution is better than either simply leaving GM alone or simply handing them a loan without strings attached. (It is possible, however, that a loan might be necessary just to buy enough time to broker the solution.)

The New York Times is reporting that it could all be academic, since Senate Republicans and President Bush are opposed to doing anything for GM, and GM could be unable to pay its bills by the time Obama takes office.

MIT Class on GM, G20 and Good News (if any)

Our next MIT class on the global crisis will run Tuesday, 4pm-7pm; live webcast available through a link on this site or directly through MIT Sloan.  Likely topics include:

  • Where do we stand in terms of the overall financial crisis?  Is it over yet?
  • General Motors: to bail out or not bail out?
  • The G20 Summit: good, bad or was it surprisingly ugly?

And we’d be happy to discuss other topics that you suggest here.

The class from last week is available to download (there was no class this week due to the holiday).

Update: you can preview some of the (GM and G20) issues under consideration in my podcast from MIT Sloan today.

America Is Best Country

When I was in college, the college humor magazine did a brilliant spoof of USA Today, complete with a silly poll in the lower-left-hand corner of the front page. According to their mock poll, Americans thought that the United States was the best country in the world, with about 92% of the vote.

I was reminded of this today by President’s Bush’s speech today, which the Wall Street Journal summarized as “Bush Defends American Capitalism.” The thrust of the speech was, indeed, that American-style capitalism is the best economic system there is, and that the current global crisis should not lead to a reaction against free markets.

I consider the second half of that sentence a fairly unobjectionable position. Saying that we need transparency, cooperation, and economic growth are also fairly unsurprising. However, I wouldn’t say Bush’s arguments that American capitalism – our curious mix of free-market ideology, lobbyist-driven politics, and widespread private sector capture of regulatory agencies – is the best possible expression of free markets is very convincing. Look at what he compares us to:

Meanwhile, nations that have pursued other models have experienced devastating results. Soviet communism starved millions, bankrupted an empire, and collapsed as decisively as the Berlin Wall. Cuba, once known for its vast fields of cane, is now forced to ration sugar. And while Iran sits atop giant oil reserves, its people cannot put enough gasoline in its — in their cars.

It’s also curious how Bush trots out those red herrings, like “authorities in every nation should take a fresh look at the rules governing market manipulation and fraud.” Sure, I’m against market manipulation and fraud, too, but saying they were a significant part of the global crisis is misdirection akin to calling the corporate scandals of the beginning of the decade (Enron, WorldCom, etc.) the fault of “a few bad apples.” The vast majority of the behavior of people who were selling mortgages, securitizing mortgages, rating securities, and trading credit default swaps was completely, 100%, tell-it-to-Santa-Claus legal.

Then there’s the disingenuous argument par excellence:

History has shown that the greater threat to economic prosperity is not too little government involvement in the market, it is too much government involvement in the market. (Applause.) We saw this in the case of Fannie Mae and Freddie Mac. Because these firms were chartered by the United States Congress, many believed they were backed by the full faith and credit of the United States government. Investors put huge amounts of money into Fannie and Freddie, which they used to build up irresponsibly large portfolios of mortgage-backed securities. And when the housing market declined, these securities, of course, plummeted in value. It took a taxpayer-funded rescue to keep Fannie and Freddie from collapsing in a way that would have devastated the global financial system.

The idea that Fannie and Freddie were the cause of the crisis is simply false, at least in the form it usually takes, and one I’d hoped I’d heard the last of once the Presidential campaign was over. During the peak of the subprime boom, Fannie and Freddie were buying a smaller and smaller share of subprime loans in comparison to private sector institutions. Fannie and Freddie got into trouble because they were private companies using their implicit government guarantee to fund risky investments in search of higher profits; the problem was not too much government, but management and shareholders making a quick buck off the government.

For the record, I’m for free markets, not socialism. But I’m not for a lame-duck president making campaign speeches when what we need are real solutions.

Update: Hey, Felix Salmon agrees with me on this. He even uses the word “disingenuous” in roughly the same place that I do.

Not with a Bang but a Whimper

Two days ago, in my post about AIG, I had the following passage:

In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)

I meant to expand on that throwaway parenthesis, but I was busy all day today and didn’t get around to it. By the time I got home, I found out that Henry Paulson had scrapped the idea of buying troubled assets altogether (something we’ve favored for a while), saving me the effort of arguing against it.

Unfortunately, after reading Bloomberg, The New York Times, the Wall Street Journal, and the text of Paulson’s remarks, I can’t figure out what they’re doing with the remaining money instead. The main emphasis of the news articles was on the new idea to create a new entity, seeded by TARP money, to lend money against consumer loans, in order to stimulate demand for those loans and hence consumer lending. But this was just one of three possibilities that Paulson mentioned: the others were additional recapitalizations (potentially with a public-private structure, or expanded to a broader range of financial institutions) and a loan-modification program.

While I agree with Andrew Ross Sorkin that it’s a good thing Paulson was able to change his mind about buying illiquid assets, I would feel better if he knew what he was changing his mind to.

Russia Tries to Stop Ruble from Falling, Gives Up

The emerging markets rout continues: Russia, she of the $500 billion war chest of foreign currency reserves, spent 19% of those reserves trying to fight off a currency devaluation. Today, Russia didn’t quite give up the fight, but conceded some ground, widening the allowed trading range and at the same time increasing interest rates. Just goes to show: fighting those nasty currency speculators rarely works, if ever.

(Thanks to Free Exchange for catching this.)

Why Not Let GM Go Bankrupt?

GM is mounting a massive PR campaign to convince Washington that a GM bankruptcy would be catastrophic to the national economy, resulting in the loss of millions of jobs, costing taxpayers over $100 billion, and plunging the economy into a depression (whatever that is). In addition to Nancy Pelosi and Harry Reed, Barack Obama has now called for an auto bailout.

I don’t want the US auto industry to go away. Yes, if GM and every one of its suppliers and dealers stopped operating tomorrow, that would cost hundreds of thousands or millions of jobs. But it’s not clear to me why bankruptcy would have the same effect. Ordinarily, when a company goes bankrupt – especially a big one – it goes right along doing whatever it was doing before, except now it doesn’t have to pay off all its creditors, and its operations are monitored by a court. The bankruptcy process is intended to find a reasonable outcome for all of the stakeholders that reflects the order of priority of their claims, but also (in the case of a company as big as GM) reflects the public interest. Airlines, for example, have been going in and out of bankruptcy for years in order to force their unions to negotiate long-term cost reductions, and even use the threat of bankruptcy as a negotiating tool.

Continue reading “Why Not Let GM Go Bankrupt?” →

The Overpayment Begins

Way back in the heady days of September, we criticized the original version of TARP because it seemed designed to ensure the government would overpay for toxic assets. Instead, we recommended splitting the transaction into two parts: (a) buy the assets at market (cheap) prices, and (b) explicitly recapitalize the banks. In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)

Until now.

Today’s government re-re-bailout of AIG (WSJ article; Yves Smith commentary) can be hard to follow, but one provision is the creation of a new entity with $5 billion from AIG and $30 billion from the government to buy collateralized debt obligations (CDOs). The goal is to buy CDOs that AIG insured (using credit default swaps), because if those CDOs are held by an entity that is friendly to AIG, that entity will no longer demand collateral from AIG. The theory is that in the long run these CDOs will not default and that the new entity will make money on the deal.

The rub is that this entity is planning to pay 50 cents on the dollar for these CDOs. This has two problems. First, 50 cents is almost certainly more than these CDOs are worth on their own (hence the title of this post). If they were really worth 50 cents on the dollar, AIG wouldn’t be having the problems it is having posting collateral; like the original TARP plan, this is an unfounded bet that the market is mispricing these assets. Second, and more bafflingly, the CDS contract is presumably separate from the ownership of the CDO; that is, buying the CDO from the counterparty doesn’t eliminate AIG’s obligation to pay if the CDO defaults, and hence doesn’t serve its stated purpose. If, on the contrary, the CDS contract is contingent on the counterparty holding the CDO, then the CDO is worth a lot more than 50 cents to the counterparty, because it is insured for 100 cents by AIG – and we all know the government isn’t going to let AIG default on those swaps. And no sane counterparty would sell for 50 cents.

Supposedly Treasury had enough time to think about how AIG should be bailed out and this is a better bailout than the original. If it is, I must be missing something.

China’s Stimulus, the IMF’s Forecast, and France’s G20 Agenda

What exactly is on the table for the G20 heads of government meeting in Washington at the end of this week?  One possibility is some sort of synchronized or joint fiscal policy stimulus in most G20 member countries.  (Yes, I know that the communique from this weekend’s meeting of finance ministers and central bank governors was somewhat on the vague side.)

Continue reading “China’s Stimulus, the IMF’s Forecast, and France’s G20 Agenda” →

If You’ve Got It, Flaunt It

Other countries can only drool with envy. China today announced a $586 billion stimulus package – that’s 17% of 2007 GDP. Spread through the end of 2010, it’s still more than 7% of GDP per year. By comparison, the US stimulus package earlier this year was just over 1% of GDP, and after causing a small uptick in spending in Q2 it vanished into the sea of bad news; our recent proposal was for 3% of GDP, and that was at the higher end of the range.

Of course, the stakes for China are very high. GDP growth ranged between 11 and 12% in 2006 and 2007, but the IMF recently cut its estimate for 2009 to 8.5% (down from the 9.3% estimate just a month ago), and according to the New York Times article the annualized rate for this quarter could be as low as 5.8%. While these are growth rates that the developed world hasn’t seen for decades, the huge population migration from countryside to city requires high growth simply to keep unemployment in check. So the Chinese government brought out the heavy economic artillery.

The current crisis has proven, if it needed any proof, that even China is susceptible to the fortunes of the global economy. If it can lead to greater participation by China in the global financial system, including institutions like the IMF, that would be one positive outcome.

The Paulson Legacy

With the footsteps of a new Treasury Secretary audible around the corner, Henry Paulson’s days running the country are essentially at an end. The best he can do now is delay whatever changes the Obama administration will make.

Looking back over the last two months, Paulson’s record (and that of the rest of the Bush administration) in combating the greatest financial crisis of our lifetimes is poor, though not catastrophic. The one thing that can be said in his favor is that the financial system did not completely collapse and Ben Bernanke’s supposed warning in the dark hours of September 18 that “we may not have an economy on Monday” did not come to pass. We have said on this site that stabilizing the financial system was job one, and the patient is stable.

Continue reading “The Paulson Legacy” →

419,000 Jobs Vanish

240,000 jobs lost in October; September revised from 159,000 to 284,000; August from 73,000 to 127,000. That’s 419,000 jobs less than we thought we had a month ago. It’s 651,000 less than there were three months ago. And because we need 140,000 new jobs each month just to keep place with population growth, that’s over 1 million fewer jobs than the economy would need to maintain unemployment where it was three months ago. Unfortunately, everyone expects this quarter and next quarter to be worse than last quarter. On top of that, unemployment is a lagging indicator: because of the transaction costs in firing and hiring workers, companies exhaust their other cost-cutting opportunities before laying people off, and they don’t hire again until they are certain that the economy is growing again.

More than 22% of the unemployed have been out of work more than six months, which is usually when unemployment benefits expire. For this and other reasons, only 32% of the unemployed were receiving state benefits in October. These are more reasons to expand unemployment benefits in multiple directions, at the very least for a limited time period. Alan Krueger has described the other ways our unemployment insurance system is broken.

Unfortunately, there is fear that President Bush (remember him?) will veto the stimulus package, including extended unemployment benefits, that the Democrats want to pass in November, thereby accomplishing nothing except delaying it by two months. Sigh.