Category: Commentary

Which Stimulus Package?

As I mentioned yesterday, stimulating the real economy must be one of Washington’s top priorities once the credit crunch begins to ease. The debate over how to do that is well underway. The Democratic Congressional leadership is preparing a stimulus package including increasing money for states and cities to replace their plummeting tax revenues, increased or extended unemployment benefits, increased food stamp aid, and public works (infrastructure) projects. All of these steps would have the effect of increasing spending by consumers and governments with the goal of dampening the recession, although public works projects could take months if not years to have an impact. One goal of the plan is to get money to people who are likely to spend it – hence the emphasis on lower-income people and cash-strapped local governments – to get it into the economy as quickly as possible.

Both presidential candidates are also talking about stimulating the economy, although their proposals are wrapped up in their broader campaign themes almost to the point of incoherence.

Continue reading “Which Stimulus Package?” →

Where Do We Go from Here?

(Which is, of course, a song from the great Buffy episode, “Once More, with Feeling.”)

After the last week, it was a relief to have a relatively slow news day, at least compared to the preceding days, to catch our breath and take stock of things (and get over my cold). American and European policy makers decided they needed to use overwhelming force to stop the panic in its tracks. It will take some time to see if they used enough; the credit markets have certainly not opened up, although some indicators have gotten marginally better (the TED spread is slightly down; T-bill yields are slightly up).

There are two directions things could go. First, it is possible that the credit markets will not come unstuck, and even more force will be required; blanket loan guarantees (for all bank obligations) and large recapitalizations (more than 3% of assets) would then be called for. Second, and more likely, we think, credit will gradually start flowing again. But even in that case, the global economy will be far from out of the woods. Here are the top issues that will still need to be faced:

  • Implementing the Paulson plan, including both bank recapitalization and, if still included, asset purchases. This will require dealing with all of the issues of governance and pricing that we have commented on previously.
  • Containing the damage of falling housing prices and foreclosures. Asset prices do need to fall to reasonable levels – trying to prop them up at artificially high levels will only hurt the economy in the long run – but limiting an overcorrection and limiting the collateral damage have to be priorities.
  • Stimulating the real economy. Even if the credit crunch eases in, say, the next few weeks, the last month has already done significant damage to the global economy (which was already in the midst of a slowdown). For starters, just think of all the uncertainty and anxiety that have been generated in the last month, and the impact that will have on spending and investment by consumers and businesses. The fall in the stock market will also add to the negative wealth effect of falling housing prices.
  • The international dimension and emerging markets. We could be moving to a situation where core banks in wealthy countries are considered safe, while banks in emerging markets are still considered shaky. This could trigger a repeat, on a larger scale, of the emerging markets crisis of 1997-98. And severe economic dislocation can always have political consequences as well.
  • Update: How did I forget … financial sector regulation?

These are some of the major issues we will be thinking about over hte next few weeks and months (and possibly years). Let us know what else you think should be on the agenda.

The Bailout: Yes, But Will It Work?

Every week, it seems, we see a new high-water mark for government intervention in the financial sector, culminating (?) in today’s announcement that the government is buying $125 billion of preferred stock in nine banks, with another $125 billion available for others. The recapitalization, loan guarantees, and expanded deposit insurance are the most aggressive steps taken yet in the U.S. and were all on on our list of recommendations.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.

Nationalization?

See here for a range of views (including Simon’s). On balance, the government owns some shares – and it twisted some arms to get them – but the percentages are pretty low, it has no voting rights, the conditions are pretty light (basically just the limits on executive compensation), and the bottom line is that the banks got a pretty good deal relative to what they might have hoped for from private investors. Some will no doubt complain of socialism, but these investments give the government limited if any influence over bank operations.

Of course, the government still has the power of regulation, which most people expect (and hope) will be greatly strengthened.

Bank Recapitalization Arrives in the U.S.

As you have no doubt heard by now, the U.S. joined most of Western Europe in announcing a bank recapitalization plan and additional guarantees on bank obligations this morning. The key details are:

  • $250 billion of TARP money will go to the program, with about $125 billion already allotted to 8 banks (9 including Merrill) who were given take-it-or-leave-it offers yesterday.
  • The government will generally put in between 1% and 3% of assets held by a participating bank.
  • Most if not all banks will be eligible; it’s not clear what happens if the $250 billion is oversubscribed.
  • The government gets non-voting perpetual preferred shares (no conversion to common), callable after 3 years, with a 5% dividend, increasing to 9% after 5 years.
  • The government also gets warrants to buy common shares up to 15% of the preferred investment.
  • Although the shares are non-voting, participating companies have to follow Treasury guidelines on executive compensation and corporate governance.

In addition, the government announced  a blanket deposit guarantee on non-interest-bearing deposits and a 3-year guarantee of new senior debt issued by banks.

This is definitely at least two steps in the right direction. Nevertheless, some concerns to think about are:

  1. Is it enough money? 1-3% of assets isn’t much if we are worried about additional writedowns. Besides the writedowns we expect on mortgage-backed securities, a recession will increase losses on all types of loans. Fortunately I don’t see any reason why more of the $700 billion couldn’t go into this program if warranted.
  2. Couldn’t we have gotten a better deal? Buffett got a 10% dividend and more warrants at a cheaper price on his Goldman investment. However, this plan was structured to protect the interests of existing shareholders to maximize the chances that banks would participate, which may have been the right tradeoff.
  3. How do we make sure the banks behave sensibly in the future? By getting non-voting shares – as opposed to the UK plan, which will allow the government to appoint bank directors – Treasury has given up one form of control, presumably to avoid charges that the government is meddling in bank operations. This just means that regulation will be especially important.

Although the stock market is moving sideways, the credit market seems to be mildly positive: yields on 3-month T-bills are up 20 basis points (meaning that less money is fleeing to quality) and the TED spread is down 33 basis points (meaning banks are more willing to lend to each other).

US Bank Recapitalization: Waiting for Kashkari

The US stock market soared upward today, partly on the announcements by every major European country that they will be protecting their banking sectors, but largely on the expectation that the US will take similar measures – namely, bank recapitalization and loan guarantees – in the next couple of days. A fair amount of attention was drawn to the following statement by Neel Kashkari this morning:

4) Equity purchase program: We are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

However, a couple things should be pointed out. First, this was #4 out of 7 initiatives that Kashkari’s team is working on, including buying mortgage-backed securities, buying whole mortgages, insuring MBS, etc. So as I said on WNYC this afternoon (clip may not be up yet), this isn’t really new information. Second, the program is voluntary. This means that bank shareholders can take it or leave it; if they don’t like the terms the government is offering, they can choose to stay out on the thin ice and hope it doesn’t break. I’m not saying the government should be forcibly nationalizing banks, but this does raise a potential issue. Third, it is designed only for “healthy institutions,” which raises the question of who is healthy today. Perhaps the idea is to shore up a few major banks and let them buy up assets from the others – a plausible strategy – but it isn’t clear.

Luckily, word is that something will be announced tomorrow, so we won’t have long to wait. If you get any early leaks, please share.

Bank Recapitalization Monday

Those of you reading the news may be having trouble keeping all of this morning’s events straight. Here’s a quick summary:

  1. The UK announced specific plans to recapitalize three of its largest banks – RBS, HBOC, and Lloyds TSB – with up to 37 billion pounds of government money. Separately, Barclays announced plans to raise money independent of the government. This seems to be the implementation of a plan that was announced last week.
  2. Mitsubishi finally closed its deal to invest $9 billion in Morgan Stanley, gaining a 10% dividend on its shares (similar to Buffett’s investment in Goldman). This deal, which had been pending for weeks and some had given up for dead, will help boost confidence in Morgan Stanley. Note that unidentified sources have claimed that the US government promised to protect Mitsubishi’s investment; it’s not clear if that’s part of the final deal.
  3. The Federal Reserve and several of its counterparts announced an expansion in the supply of credit to banks around the world in US dollars. The Fed said it will make available as many dollars as the other participating central banks need. They will then lend the money out to their banks against whatever collateral is appropriate under their rules. This is another move to increase liquidity in the financial system; however, for several weeks now it’s been apparent that liquidity alone is not enough to solve the problem.
  4. Following yesterday’s agreement in principle, major Eurozone countries are announcing their rescue plans today, including both bank guarantees and recapitalization. Germany announced 400 billion euros to guarantee bank loans and 80 billion euros for recapitalization; France announced 320 billion for loan guarantees and 40 billion for recapitalization; Spain passed legislation providing 100 billion for loan guarantees and allowing the government to recapitalize banks by buying shares. I believe Italy is expected to make an announcement soon.

In summary, governments are taking the kind of steps that are necessary to halt the crisis. Loan guarantees and bank recapitalization are two of the steps we have been advocating. However, the jury is still out on whether they are coordinated and decisive enough. The much-followed TED spread (a measure of banks’ willingness to lend to each other) is only down by 7 basis points, although that may in part be due to the fact that the bond market is closed in the US today due to a holiday. All eyes are now on Washington, where a more definitive bank recapitalization plan is widely expected. Neel Kashkari, Paulson’s point man on the crisis, said today only that “We are designing a standardized program to purchase equity in a broad array of financial institutions.” (He said a lot of other things on a broad range of other topics.) Finally, this burst of support for wealthy countries’ banks could have unintended effects on emerging markets, as we discussed previously.

Update: Austria, the Netherlands, and Italy are also on board.

When’s the Make-Up Test? Tomorrow.

Saturday, October 11, 10pm.

The world’s finance ministers sat for several tests this weekend, and it’s not yet clear how they did.  If we set the bar low enough (i.e., no public criticism of each other), they did OK.  The Italian finance minister did threaten not to sign the communique on Friday afternoon, but this was not particularly meaningful (think about it: if Italy walked out of the G7, how would the markets view Italian risks on Monday morning?)  Everyone else was reasonably polite.

But if we were hoping for specific steps to be announced, then Friday’s list of principles from the G7, and the ensuing vague statements of support from other sets of finance ministers on Saturday have really not taken us very far.

Still, there is time for a make-up test (or two) on Sunday.  The US Treasury is undoubtedly working on some detailed measures to shore up parts or, hopefully, all of the banking system.  Eurozone member countries will be meeting in France on Sunday afternoon, presumably to see how far along they can bring the Germans – particularly with regard to systematic bank recapitalization.  It remains unclear whether anyone in the eurozone will suport the British ideas of blanket bank guarantees at this point.  And it is far from clear if the British will introduce the kind of overall package that in our view could turn the corner, even in a local sense.

The goal, as you know, is to get a clear strategy in place and well communicated by the time the stock market in Tokyo opens at 8pm (US East Coast time) on Sunday.  Let’s see how they do.

The Financial Crisis: What Can You Do?

On Wednesday, one of our readers posted the following comment: “This website offers hope.  Is there a way readers can help the cause?”

I’ve been thinking about that ever since, and I don’t have a good answer. The key decisions are being made by the central bankers and ministers of finance (we call ours the Secretary of the Treasury) of about ten countries, and most of the decisions they make are at their own discretion.

Continue reading “The Financial Crisis: What Can You Do?” →

Paulson Sends Fannie and Freddie to the Rescue

Many readers will see that as an ironic title, but I don’t mean it that way. Federal regulators have directed Fannie Mae and Freddie Mac to buy $40 billion per month in troubled mortgage-backed securities – the same ones targeted by the $700 billion bailout bill. As with the Paulson plan, price is still a question mark – too low and it does no good, too high and it will create losses for Fannie and Freddie – but we see this as a positive step. Fannie and Freddie were effectively nationalized, so we can think of them as part of the Treasury department at this point. One major question about the Paulson plan is whether $700 billion is enough to have a major impact on the market. Using Fannie and Freddie to increase the overall size of the program does increase taxpayers’ potential exposure, but it also increases the chances of having a meaningful effect on confidence in the financial sector. Buying assets this way may be especially important now that it seems much of the original $700 billion will go to direct bank recapitalization – which, we think, is a better use of that money.

While this is a step in the right direction, it still smacks of the incrementalism that has dogged the government’s response to this crisis. We may have reached the point where only a general guarantee of bank obligations will do the trick.

Let us know if you see other tools that Treasury picks up to attack the problem.

Zimbabwe and the Financial Crisis

Or, yet another reason why the financial crisis matters …

In Zimbabwe, site of some of the deepest suffering in the world today, Robert Mugabe reneged on a power-sharing deal with Morgan Tsvangirai and the opposition party. Sure, he might have done it anyway, but it’s a lot easier when the world’s attention is elsewhere and every major power has other things to worry about. We rarely comment on non-economic issues, but in hard times, you can watch for more and more behavior like this.

Please comment if you’ve seen other cases of politicians using the crisis as cover for things they might not try otherwise.

G7/IMF: What’s Going On

As we’ve discussed previously, this weekend’s meetings of the G7 and the IMF are crucial to halting the financial crisis. This weekend, we’ll be updating you on events as they happen.

Update (Friday evening): The G7 statement is pretty much a general set of principles with which it would be hard to disagree, with very little by way of specifics and really nothing that we hadn’t seen before.  Mr. Paulson’s statement today was similarly vague, although Treasury continues to signal that it will launch some sort of recapitalization program.  I know they want to exude calm and confidence, but the sense of urgency that had building in the last couple of days seems to be slipping away from them.

Update (Saturday morning): Reaction from around the world is mostly disbelief.  Could it really be the case that the G7 does not understand that trade credit is under pressure everywhere, that financing for new projects is drying up, and that Iceland’s experience sends a dangerous signal to investors?  Our piece in the Washington Post Outlook section lays out the very real dangers.  Unless the G7, separately and jointly, act more decisively by the end of Sunday (yes, tomorrow), I’m afraid that next week could be quite difficult.

Update (Sunday morning): Reliable sources indicate that the eurozone member countries, who are due to meet today at the invitation of President Sarkozy, may well be able to announce agreement on some sort of parallel bank recapitalization scheme(s).  It is also hard to imagine that the US will let the day go by without a major announcement.  But it will take a great deal of detail in order to be credible at this point.  And the question of who is and is not given a place on the Great Ark for Bankers will be much on our minds.

G1 vs. G7 vs. G20?

We already know that at least some people in major European countries (Peer Steinbrueck, this means you) are mad at the U.S. for “causing” the global financial crisis. But while many of the rest of the G7 are at least complicit – European banks were buying large piles of the same mortgage-backed securities that set of the crisis in the U.S. – many of the world’s less-developed countries may be even madder at the U.S. Henry Paulson has called a meeting of the G-20, which includes some of the larger economies outside the G-7, for this weekend. The hope is that it will help dampen strife between rich and less rich countries, all of whom are being affected by the crisis.

Henry Paulson, Meet Warren Buffett

Bank recapitalization is in the air, which tends to prompt at least two responses: (a) what’s bank recapitalization? or (b) this is socialism!

Bank recapitalization is when an external entity buys new equity shares (stock, as opposed to bonds) in a bank in exchange for cash. The effect is to boost the bank’s assets without increasing its liabilities; since one worry about the banking sector is that it does not have enough capital (that is, it may not have enough assets to balance its liabilities), this is a good thing. (If the bit about capital, assets, and liabilities is confusing, see Financial Crisis for Beginners.) Of course, there’s no such thing as a free lunch, and in this case the bank’s existing shareholders get diluted, because they don’t own as much of the bank as before. But, in general, it’s better to own part of a bank that exists than a larger part of a bank that no longer exists.

Bank recapitalization could be as simple as this: the government (meaning the taxpayer) gets the same kind of deal that Warren Buffett got when he invested in Goldman two weeks ago. In that deal, Buffett paid $5 billion for preferred stock at $123 per share. The preferred stock pays a 10% dividend, meaning that Buffett gets $500 million per year from Goldman’s cash flow. He also got warrants that give him the right to buy up to $5 billion worth of common stock at $115 per share. At the time the deal was announced, Goldman common stock was trading at $125. Even though Goldman closed at $101 yesterday (and has fallen so far today), Buffett is still getting a 10% yield from the $500 million dividend, and if Goldman goes up he stands to make a lot of money from the warrants.

Continue reading “Henry Paulson, Meet Warren Buffett” →