Category: Commentary

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

Financial Crisis and the Real Economy

One of the biggest questions about the financial crisis – one heard from Capitol Hill to radio talk shows to casual conversations with friends – is why it matters for ordinary people. One major reason a significant proportion of public opinion is against the rescue plan is the general failure to make the connection between panics in the financial sector and the ordinary lives of everyday people; simply saying that the plan is necessary to prevent (or moderate) a recession smacks too much of “trust me” to be credible.

The connection is that much of the ordinary activity in the real economy relies on credit – think no further than the volume of purchases made using credit cards. (Although banks have been reducing credit limits, there is little risk for now that credit cards will stop working overnight.) And in today’s conditions, when many financial institutions are potential victims of liquidity runs, lending has virtually ground to a halt. The New York Times has an article today about the impact that the current crisis is having on local governments suddenly unable to raise money for ongoing projects such as highway repairs and hospital expansions. Across the country, local governments issued $13 billion in fixed-rate bonds in the first half of September – and $2 billion in the second half. A sudden 87% drop in a major source of municipal funding is a very real impact of the financial crisis, and one that will necessarily result in both fewer services and fewer jobs for taxpayers.

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

The Paulson Bailout Bill and the Need for Leadership

In case it wasn’t clear from earlier posts, our position on today’s bailout bill can be summarized as follows: the bailout is neither a complete nor a perfect solution, but it is better than the original proposal of ten days ago, and it is a valuable first step toward restoring confidence in the markets. This morning when the Dow fell 200 points shortly after opening, there were news stories speculating that the markets were not happy with the bailout plan; well, we saw this afternoon what the markets really thought about the bailout.

So if the professional investors who manage most of our money wanted the bailout, what happened? The free-market libertarians were opposed to the bill on supposedly fundamental grounds, but they were not enough to vote it down. The bill failed because enough representatives did not want to go home to their reelection campaigns having voted for a widely unpopular bailout bill. And why is it unpopular? Because no one took the time to educate the public on what the crisis means, how the bailout would operate, what the potential costs of inaction would be, what is happening to the money, and so on. These are complicated issues, but in the absence of explanation the public (based on the “man on the street” interviews” I heard on the radio today) focused on a few simplistic ideas: that this is a bailout for rich Wall Street bankers; that the $700 billion (at least) is a complete loss for the taxpayer; that the current administration cannot be trusted; and so on.

Perhaps there was not time in the last ten days for this type of education. But this only points out the importance of planning ahead. By repeating that the economy was “fundamentally sound” until suddenly discovering that it wasn’t, Bush, Paulson, and Bernanke lost the opportunity to prepare the ground for major government intervention in the economy. This bill will almost certainly be renegotiated and brought to another vote. But the underlying lesson is that intervention on the scale we are talking about requires political legitimacy, and that legitimacy requires the willingness to explain to the public just what is going on and why it matters to them.

The Paulson Bailout Plan, Version 4.0

There was the initial, 3-page proposal; the 6-page version of last Sunday; the grand compromise of Thursday, which lasted only a few hours; and now, as of this morning, a tentative agreement on a proposal that should be brought to a vote tomorrow. House Speaker Pelosi’s office issued a summary entitled “Reinvest, Reimburse, Reform: Improving the Financial Rescue Legislation,” which reads more like a set of talking points than a legislative proposal. But some of the major differences from the original proposal that have been reported on include:

Division of the $700 billion into effectively two tranches, with Congressional review of the second
Warrants on stock in firms participating in the bailout
Tax provisions intended to limit compensation for senior executives of participating firms
The ability for Treasury to use its power as the owner of mortgages and mortgage-backed securities to modify those mortgages on behalf of homeowners
An unspecified commitment that, if the taxpayers lose money on the deal, the losses will be made up from the financial services industry
Strengthened oversight, including an Inspector General, transparency of financial transactions, and some form of judicial review
An option for Treasury to offer mortgage insurance to financial institutions

#5 and #7 seem to be the main provisions added since Thursday.

It goes without saying that it is the details that matter. At a high level, the current proposal improves over the original in two main areas: oversight (#6), which was absent in the original, and taxpayer protection (#2 and #5), which was brushed off with the optimistic assumption that the government would buy assets at their long-term fair market value (whatever that is). #3 and #7 are sideshows; #1 probably is as well, although there is a small risk that this will reinforce the sentiment that the bailout is not big and decisive enough.

But that still leaves two huge open issues. First, as Simon and I discussed in an op-ed on Wednesday, there is the issue of the price: too low and no bank will want to sell; too high and the taxpayers will not get the warrants they deserve. Second, although the proposal will exhort Treasury to modify mortgages, it’s not clear how, or whether Treasury has to do anything at all. We’ll see what the final legislation looks like, but this could be a grand gesture intended for the electorate. If so, even after the current crisis of confidence is averted, the problem of repairing the direct damage of mortgage delinquencies and foreclosures will remain.

So, our provisional grades (pending the full bill):

Restoring confidence in financial sector: B
Recapitalizing financial sector: C
Addressing underlying mortgage problems:D
Preserving value for taxpayers: too vague to tell

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 Death of Washington Mutual

Poor Washington Mutual … on any other day, its government-brokered takeover by JPMorgan Chase would have been the lead story, as opposed to Henry Paulson begging Nancy Pelosi on bended knee to save his bailout plan. At first glance, the purchase raises a glimmer of hope: is it really as simple as having the healthy banks buy up the unhealthy banks? But there is still a clear loser here, besides WaMu’s shareholders, who must have seen this coming: anyone holding non-secured debt is not covered by the transaction, since that liability remains with the WaMu holding company and was not transferred to JPMorgan along with the assets and the banking operations. According to Bloomberg, WaMu had $28.4 billion in outstanding bonds, which have just gone up (mostly) in smoke, triggering an unknown volume of credit-default swaps. (Remember AIG? Those are now the taxpayers’ credit-default swaps).

The transaction raises another worrying issue. Before yesterday, Washington Mutual had taken $19 billion in losses on mortgage loans. In the acquisition, JPMorgan acquired $176 billion in mortgage-related assets and immediately wrote them down by $31 billion, or 18%. This seems to be more evidence that some banks have these assets on their books at inflated prices, which is the problem that everyone is working so hard to solve.

Bailout Plan – The House Republican Alternative

And Now, Behind Door #2 …

Whatever the motivations of the House Republican plan – as distinct from the plan agreed upon by the Republican President, Republican Treasury Secretary, Republican Fed Chairman, Senate Republican leadership, and Democratic leadership of both houses – it is still a plan, and as such merits consideration. The “Common Sense Plan to Have Wall Street Fund the Recovery, Not Taxpayers”has two main elements: first, a Treasury Department insurance program for mortgage-backed securities that will be entirely financed by premiums collected from the holders of those securities, not taxpayers; and a combination of tax breaks and deregulation intended to attract private capital to the banking sector.

The insurance proposal amounts to more of the wishful thinking that has allowed the financial crisis to last as long as it has. Such a proposal would only work if the fundamental problem were an inability to distribute risk, and if there were no available insurance mechanisms. But the fundamental problem is not that banks can’t distribute the risk of deteriorating assets, but that they are holding assets that are already not worth very much, and therefore the insurance premiums for those securities would be prohibitive. (Instead of paying by writing down the assets, they would have to pay insurance premiums.) And there are insurance mechanisms already (remember credit-default swaps?), but that insurance is too expensive to buy. The only way a Treasury insurance program could change things is by offering insurance at artificially low premiums, which is just another way of handing taxpayer money to banks – with no recompense to shareholders.

The proposal to attract private capital to the industry is too little, too late. Washington Mutual, for example, was unable to find a buyer until the government used a forced bankruptcy to wipe out $28 billion of its debt; no one is lining up to offer capital to Wachovia. It is hard to see how offering tax breaks to banks (which is yet another way of handing taxpayer money to banks) will encourage new capital investment, at least as long as their mortgage-related assets remain under a cloud of uncertainty.

Given that few people want to lend to or invest in banks these days, it’s hard to see how a solution is possible without taxpayer money. The important thing is to make sure that the taxpayers get something in exchange for their money.

Update: Politico has a survey of economists’ reactions to the House Republican plan. The short version: economists were concerned by the original Paulson plan, but baffled by the House Republican plan.