Category: External perspectives

Making Creditors Suffer

Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.

I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.

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Taking Care of Our Grandchildren

There is a lot of rhetoric these days about making our grandchildren pay for our spending today. Like any “deficits are always bad” argument, this one doesn’t even meet the plausible metaphor test. That is, grandparents routinely spend money (thereby reducing their grandchildren’s eventual inheritances) on things that will make their grandchildren’s lives better.

As Nancy Folbre puts it in Economix (the New York Times blog):

Think of the United States economy as a family farm in need of modernization. Energy prices are going up, but all the tractors are gas guzzlers. Some of our fields have accumulated toxic levels of pesticide, and we need to develop new and better technologies of sustainable production. Our grandchildren want to run the farm, but will need good health and a college education to do it well.

Spending money on increased energy efficiency, research and development, health, and education could increase the value of their assets, helping them repay debt.

That’s just her closing metaphor; I recommend the entire article (it’s pretty short). There is a legitimate debate about what government spending actually benefits our grandchildren and what doesn’t, but it doesn’t make sense to say that every incremental dollar of current spending is hurting our grandchildren.

I tried to make this point on Planet Money, but I like Folbre’s story more.

By James Kwak

Does Size Matter?

Simon argued in the Atlantic article, and I argued in “Frog and Toad” and “Big and Small”, that the best way to regulate the financial sector is to limit the size of individual institutions. In the interests of providing a contrasting point of view, I want to point out that Kevin Drum thinks that small banks can do just as much damage as big banks:

I think crude bank size is a red herring for our current financial collapse.  Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy.  Those are the things we should be focused on.

Therefore, Drum favors systemic oversight and regulation (which I agree would also be good). Besides the first article cited above, he continues the argument here.

The Cultural Costs of Bailout Nation

This post was written, at my request, by Carson Gross, one of our regular readers and a multi-talented person I have worked with in the past. (We met one night when I needed help debugging a classpath error I was getting on my computer.) I don’t necessarily agree with what he says,  but I think he has something valuable to say. Everything below is by Carson.

James asked me to elaborate on a comment in which I worried about the public’s reaction to the real or perceived wealth transfers occurring during this financial crisis – in particular, how that reaction would manifest itself culturally.

“Wealth transfers” is a charged term, and a lot of smart people have spent a lot of time patiently explaining that, in fact, most of the bailout thus far involves loans and that, under some models (which, apparently, don’t include housing prices regressing to roughly 3x incomes, where they have been for most of history) we, the taxpayers, may actually end up making money on this whole thing.  I think that’s fanciful, but I’m not going to debate that here.  Rather, I want to focus on the bailout’s cultural impact.

I assert, without proof, that the proverbial man on the street sees the words “bailout” blaring on his TV and computer screen day in and day out, and doesn’t care to look too deeply into the details.  Who can blame him?  He has enough of his own problems to deal with without attempting to decipher deliberately impenetrable financial jargon.  Even if the government is getting reasonable compensation for the capital injections in some cases, the man on the street just sees more of his tax dollars going into banks to pay out people who make orders of magnitude more money than he’ll ever see.  That’s his reality.

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Modifying Securitized Mortgages

Amidst the gallons of ink spilt, here and elsewhere, over the nationalization debate, the AIG collateral payments, and the AIG bonuses, I neglected to comment on the details of the new housing plan, which were released on March 4. When the initial plan was announced in February, I was concerned about the seeming lack of any provision that would enable servicers of securitized mortgages to modify those mortgages without being sued by the investors who bought the securities. (In brief, the problem is that the pooling and servicing agreements (PSAs) that govern those securitizations may not allow loan modifications, or may require the servicer to gain the consent of all of the investors, which is practically impossible.) People who know housing better than I said there was something in there.

If it is, I still can’t find it in the March 4 documents (fact sheet, guidelines, modification guidelines). In any case, an important question is whether the plan will do enough to encourage servicers to modify securitized mortgages, as opposed to mortgages they own. “A New Proposal for Loan Modifications,” a short (13-page) paper by Christopher Mayer, Edward Morrison, and Tomasz Piskorski that will appear in the next issue of the Yale Journal on Regulation, describes the problem clearly and makes three proposals to solve it. (A longer version with appendices is available here.)

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Why Bail Out AIG’s Creditors?

Simon and I wrote on op-ed in the New York Times today, trying to debunk the idea that, as we put it, “A.I.G.’s traders are the people that we must depend on to save the United States economy.” The AIG bonus fiasco, as I’ve written earlier, has been particularly useful in raising the political cost of the administration’s current bailout strategy. But, as I said then, “$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another.” And as far as the cost to the taxpayer is concerned, the big bill is for bailing out AIG’s creditors. In his op-ed in the Wall Street Journal today, Lucian Bebchuk wants to know why.

Now, the government has not explicitly guaranteed AIG’s liabilities. But the main reason for bailing out AIG in the first place was the fear that an uncontrolled failure would have ripple effects that would take down many other financial institutions who were dependent in some way on AIG; most commonly, they had bought insurance, in the form of credit default swaps, from AIG and were counting on being paid. And a major usage of bailout money has been to make whole AIG’s counterparties holding those credit default swaps, primarily investment banks trading on their own account or on behalf of their hedge fund customers.

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Zvi Bodie on Personal Finance

Occasionally we get personal finance questions. Actually, we’ve gotten fewer of those questions lately, perhaps because readers realize we don’t have much to offer on that score, and that we try to avoid anything that might sound like investment advice.

Zvi Bodie, whose name you may have seen here before, has thought a lot about personal investing, and agrees with some of the positions I’ve offered here: notably, that most information about personal finance available on the market is not worth listening to. Bodie recently posted a series of 3-minute webcasts to the Boston University School of Management website where he lays out some basic advice on saving for retirement, including some of the implications of the current economic crisis. I didn’t watch all of them, but I liked how accessible they were.

By James Kwak

Nationalization and Democracy

More extra-credit reading while on spring break: Sanjiv Gupta has an article at The Huffington Post about the relationship between the financial crisis, our banking sector, and democracy. The central question, as I see it, is an old one: how to ensure that a democratic political system is not undermined by a non-democratic economic system. Gupta suggests, as one possible step, a national credit union to compete with private-sector banks. To think about this in detail, we’d have to think about why we (most of us, including me) instinctively think that the following the profit motive is generally the right way to allocate capital. That’s something I hope to devote more space to later.

Spring Break

My school is on break this week, so I’m taking some time off from now through Wednesday or Thursday. I probably won’t write anything very involved, but I will try to point out a few things I’ve been reading.

On that note, I finally read Amartya Sen’s essay “Capitalism in Crisis” from The New York Review of Books. The article meanders through a variety of topics, but two of the broad themes are: the economic systems we call “capitalist” involve much more intertwining of free markets and nonmarket goods and services (education, health care, pensions, etc.) than most people realize; and we need less to invent a new form of capitalism than to understand better the one we already have.

Bernie Madoff Day

As Bernie Madoff goes to his reward today, we should be asking how this could have happened. Not only Madoff and Allen Stanford, but also dozens of “mini-Madoffs” have been unearthed since the market collapse in September and October, which seems to have reminded the SEC that it has an law enforcement function. Not surprisingly, regulators are ramping up their enforcement divisions, and Congressmen are planning legislation to increase enforcement budgets.

A little late to close the barn door.

While Christopher Cox, SEC chairman from 2005 until this January, makes an obvious target, there is a deeper phenomenon at work than just the Bush administration’s hands-off attitude toward corporate fraud (an attitude largely shared by the Clinton administration). That is the general tendency of people – investors and officials alike – to underestimate the risk of fraud during a boom and overestimate the risk of fraud during a bust.

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Everyone Has a Banking Plan Now

Another day, another banking plan, this one from two senior partners at McKinsey and Company, which may be the most influential company you may never have heard of.

The authors recognize the toxic-asset pricing problem: If the government buys them at market value, the banks become insolvent instantly; if the government pays book value, it is paying a massive subsidy. They also recognize the rough scale of the problem, predicting another $1 trillion in writedowns. And here’s the proposal:

[W]e propose that the government step in and establish a voluntary program to create a real market price and terms for the sale of bad assets. Rather than use modeling for valuation, the program would set discounts from either of the two basic approaches to accounting value [fair value and “hold-to-maturity,” which isn’t quite accurate, but that doesn’t matter], based on some recent past date (for instance, December 31, 2008). A reasonable level might be 10 percent off for securities already marked to fair value and 20 percent off for loans being held to maturity. Upon their sale to the government, existing shareholders would absorb the loss taken on the discount, and that loss of common stock value would be replaced by converting TARP preferred stock to nonvoting common (which would be vested with voting rights if sold to private parties).

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KC Fed President for Temporary Nationalization

Nemo alerted me (after in turn being alerted by Calculated Risk) to a recent paper by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, brilliantly entitled “Too Big Has Failed.” Here is an excerpt:

[T]he current path is beset by ad hoc decision making and the potential for much political interference, including efforts to force problem institutions to lend if they accept public funds; operate under other imposed controls; and limit management pay, bonuses and severance.

If an institution’s management has failed the test of the marketplace, these managers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached.

You could call this a free market argument in favor of temporary nationalization.

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Everyone Get in Line

For months now, Ricardo Caballero has been proposing yet another solution to the toxic-asset problem: universal, government-provided insurance for the assets. He recently let loose a double-barrelled volley in both the FT’s Economists’ Forum and the WSJ’s Real-Time Economics blogs. I believe he is correct that this would solve the problem: if the government is insuring any bank assets that the banks want them to insure, then the banks are protected from any further write-downs, and they are healthy by construction. However, there are other ways of getting to the same outcome. One would be for the government to pay face value (or current book value) for any assets that the banks would want to sell. Another would be to take over every single bank that fails Mr Geithner’s stress test, pull out all of their bad assets, and reprivatize them. All of these solutions will result in banks that are not encumbered by the fear of further writedowns on toxic assets.

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YLS Conference on the Financial Crisis

If you are a true crisis junkie (or you are having trouble falling asleep tonight and need more to read), my own Yale Law School held a conference on the financial crisis, its causes, and potential solutions (including better regulation) on Friday. There were a number of famous names present, including Lucian Bebchuk, Christopher Mayer (of the Hubbard-Mayer proposal), Anil Kashyap, and others. You can look at the agenda or check out the readings for sessions one, two, three, and four (each includes links to PDFs of the papers).

And where was I during all of this? I was home with my daughter.

(Let me know if you find something particularly important that I should read – I’m finding it impossible to keep up.)

The “Good Bank” Proposal

There has been a small but increasing amount of attention being given to the “good bank” idea: instead of creating a government entity to buy toxic assets from existin banks – or nationalizing existing banks, removing their toxic assets, and then reprivatize them – why not create brand new, good banks with the same government money, enabling them to lend money unencumbered by previous bad decisions, and then privatize them? (Willem Buiter floated this idea on January 29, and Paul Romer has a similar proposal in the WSJ,  although I’m proud to say that Nemo, who has his or her own blog, raised it in a comment on this blog two weeks earlier.)

Romer suggests using government capital to create new, healthy banks that can essentially compete with the existing banks, which can then be treated under existing rules and regulations – if they become insolvent, they get taken over; some of their liabilities (like FDIC-insured deposits) are guaranteed, and some aren’t – and that’s that. Buiter goes a step further and recommends taking away banking licenses from the legacy bad banks and making them institutions that just run off their existing assets, in part by selling their good assets to the new good banks.

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