Feel-Good Story of the Day

Calculated Risk reports that Citigroup is livid that S&P would have the audacity to downgrade the senior tranches of commercial mortgage-backed securities.

Citigroup commented that the changes were “a complete surprise”, “flawed”, lacked “justification” and the “S&P methodology changes do not seem rational or predictable”. Ouch.

It’s nice to see that the banks – who spent the last decade shopping for favorable ratings from the rating agencies, and overwhelming them with thousands of complicated offerings backed with sophisticated models – and the rating agencies – who spent the last decade giving AAA ratings to the banks’ models and are now claiming that it was all the banks’ fault – are getting along so nicely. Some marriages truly are forever.

By James Kwak

Sheila Bair Listens to Me

Yesterday I said that Tim Geithner or Sheila Bair should come out and slap down the idea that banks will be allowed to bid on their own assets. And today she did! Rolfe Winkler, in a guest post at naked capitalism, did the hard work transcribing the audio of the press conference.

Although banks cannot buy their own assets, Bair did say, “I think there have been separate issues about whether banks can be buyers on other bank assets and I think that’s an issue that we continue to look at.” As I said yesterday, and as Winkler also said, I think this is also a bad idea. Even if you successfully deter outright collusion, you can still have outcomes where the industry as a whole is using subsidies to overpay for its own assets and shift the loss onto the government.

And no, I don’t actually think that Sheila Bair reads this blog, much less listens to what I have to say.

By James Kwak

Brazen Tunneling and Inflation

In most societies it is traditional to be somewhat sneaky in squeezing your shareholders or the government. You might set up a complicated transfer pricing scheme or perhaps you arrange for a family-owned firm to acquire assets on the cheap from the publicly traded corporation that you control. Or you could always arrange for the Kremlin to provide foreign exchange at a “special” price.

In the New United States, life is much simpler and bank tunneling considerably more brazen. Continue reading “Brazen Tunneling and Inflation” →

Banks Want Government Subsidies to Buy Assets from Themselves

From the headlines of the Wall Street Journal: “Banks Aiming to Play Both Sides of Coin — Industry Lobbies FDIC to Let Some Buy Toxic Assets With Taypayer Aid From Own Loan Books (subscription required, but Calculated Risk has an excerpt). I thought the headline had to be a mistake until I read the article.

To recap: The Public-Private Investment Program provides subsidies to private investors to encourage them to buy legacy loans from banks. The goal is to encourage buyers to bid more than they are currently willing to pay, and hopefully close the gap with the prices at which the banks are willing to sell.

Allowing banks to buy their own assets under the PPIP is a terrible idea. In short, it allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank. I’ll take this in steps.

Continue reading “Banks Want Government Subsidies to Buy Assets from Themselves” →

We’re on Kindle

At the request of a few readers, we’re now publishing the blog to Kindle. I have a suspicion that block quotes in some posts may not work properly. (I used to use a simple indent for block quotes; now I use the <blockquote> tag to try to solve this problem.)

I have never seen or touched a Kindle, so I have no way of testing it. Please let me know if you try this out and if you have any problems.

By James Kwak

“I Have 13 Bankers in My Office”

The Washington Post (hat tip Mark Thoma) has a profile of Brooksley Born, who has been credited by dozens of commentators (including us) for unsuccessfully attempting to increase regulation of derivatives in the late 1990s while serving as the head of the Commodity Futures Trading Commission. There’s much to admire, including being the first female president of the Stanford Law Review, making partner while working part-time, and, most importantly, this:

Born keeps informed, but she has other concerns, bird-watching jaunts and trips to Antarctica to plan, mystery novels to read, four grandchildren to dote on. “I’m very happily retired,” she says. “I’ve really enjoyed getting older. You don’t have ambition. You know who you are.”

Then there are the frightening flashbacks to the regulatory battles we are sure to relive this fall:

Greenspan had an unusual take on market fraud, Born recounted: “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.”

Translation: Imperfections in free markets are logically impossible.
Continue reading ““I Have 13 Bankers in My Office”” →

Feldstein on the Economy

What does it mean that Martin Feldstein (hat tip Mark Thoma) is now one of my favorite economists, when it comes to commenting on the current economic crisis? Feldstein’s analysis:

Evidence of recovery so far is thin.
The stimulus package will kick in and provide a short period of growth.
But as the stimulus wears off, growth will fade away again.
The Obama Administration’s policies are pointed in roughly the right direction but not big enough to turn the tide.

Here’s his conclusion:

The positive effect of the stimulus package is simply not large enough to offset the negative impact of dramatically lower household wealth, declines in residential construction, a dysfunctional banking system that does not increase credit creation, and the downward spiral of house prices. The Obama administration has developed policies to counter these negative effects, but, in my judgment, they are not adequate to turn the economy around and produce a sustained recovery.

Having said that, these policies are still works in progress. If they are strengthened in the months ahead – to increase demand, fix the banking system, and stop the fall in house prices – we can hope to see a sustained recovery start in 2010. If not, we will just have to keep waiting and hoping.

By James Kwak

The Crisis Is Over, And We Wasted It

Rahm Emanuel reportedly has a doctrine: Never let a serious crisis go to waste. His point is a good one – vested interests usually block change across a wide range of important issues in the US, and a major financial/economic crisis provides an opportunity to bypass or breakthrough those interests in order to introduce meaningful and substantial change. Emanuel listed (from the 1:40 minute mark) five priority areas for change: health care (cost control and expansion of coverage), energy (independence and alternatives), taxes (fairness and simplicity), education (fundamental changes to effectively train the workforce), and financial regulation (transparency and accountability).

The financial crisis is abating – although the economic costs continue to mount and new problems may still appear (ask California or Ukraine). At least among the people I talk with on Capitol Hill, there is a very real sense that business is returning to usual; certainly, the lobbyists are out in force, they want what they always want, and it’s hard to see many of them as seriously weakened. How much progress have we made on any of Emanuel’s priority areas or, for that matter, along any other public policy dimension that was previously stuck? Continue reading “The Crisis Is Over, And We Wasted It” →

What Good Is It, Anyway?

Behind the ephemeral debates over the financial crisis and the bailouts it has spawned, there is a broader debate about the financial sector as a whole: what good is it, how much of it do we need, and how do we know if it is working?

There are many descriptions of what the financial sector does, but most of them have something to do with moving capital (money) from someone who has more than he needs to someone who could use a bit more. And I think most people would agree that is a good thing, as long as the latter person has some productive use for it. Mike at Rortybomb, in “The Financial Sector We Want,” describes a doctor saving up $1,000 more than she needs for consumption and lending it to a factory, which returns her $1,100 after a year. In real life, we need some kind of a financial sector to get the money from the doctor to the factory, even if it’s just a single local bank. Everyone is happy.

When you start asking how big the financial sector should be, and whether or not it is working properly, things get more complicated. One of the Economist’s Free Exchange bloggers took the position that financial innovation is generally good in and of itself, although it has a high risk of creating “negative spillovers” – a higher risk than for non-financial innovation: “Most financial innovations are positive, and we don’t know ex ante which will be negative, so giving ourselves the power to block certain innovations because they might have negative spillovers is risky.” At first blush, this seems like a reasonable extension from real-world innovation to financial innovation.

However, Mike (Rortybomb) has an interesting counter-argument. Financial innovation, he says, is not like real-world innovation; the former only creates value if it solves an existing market imperfection. Figuring out which factories are worth investing in – so the doctor doesn’t have to worry about it – solves a market imperfection. But his point is that it’s the factory that’s creating the value; the financial sector is helping make that possible. So, he argues, if someone figures out a way to get a higher yield out of a risk-free investment (and that was the point of the CDO boom, where you could create a “super-senior, better-than-AAA” bond that paid a higher yield than Treasuries), then you either have to show what market imperfection it is solving, or it isn’t actually risk-free. In most cases, he suspects, innovation that generates a higher return does so simply by taking on more risk.

So what are we to make of the last quarter-century, when the financial sector got bigger and bigger and the people in it got richer and richer?

An instinctive free-market reaction might be to assume that the financial sector was doing great things, and that the people getting rich deserved to. But from Mike’s perspective, you have to ask: did people suddenly discover how to fix such massive market imperfections that they deserved to make that much money for so long? Ryan Avent put it this way:

Frankly, I have no idea what most of the recent growth in finance was for. . . . To get back to Mike’s original point, when you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.

And Felix Salmon, I think, pinpointed the crucial issue. If the financial sector was doing such a good job innovating, then it shouldn’t have continued making so much money.

[O]ne would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

Ordinarily, if an industry innovates, a few people make a lot of money, and then most of the benefits flow to that industry’s customers. Let’s take one of the greatest examples of recent history: Microsoft and Intel together probably created a handful of billionaires and a few thousand multi-millionaires out of their employees; but for at least the last ten years, no one going there has gotten anything more than a decent salary and a good resume credential. As computers get smaller, cheaper, and faster, the benefits flow overwhelmingly to their customers – to us. And those are near-monopolies. The general pattern in the technology industry is that a few entrepreneurs make a lot of money, and the vast majority of people make a decent salary; even the highly-educated, highly-trained, hard-working software developers, most of whom could have been “financial” engineers, are making less than a banker one year out of business school.

That’s the way innovation is supposed to work. You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

By contrast, the historical pattern of the financial sector – rising revenues, rising profits, and rising average individual compensation – is what you get if there is increasing demand for your services and, instead of competing to lower costs and prices, you limit supply. Sure, prices fell on some financial products, but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation). Why this happened I won’t try to get into here, but it would be worth understanding if we want to reduce the chances of living through this crisis again in our lifetimes.

By James Kwak

Recession and Recovery: How Long?

I’ve commented earlier that many economic forecasts seem to assume reversion to the mean – here, meaning average economic growth over the last two decades. For a great example, go to the Wall Street Journal and admire the GDP growth rates projected for Q3 2009 through Q2 2010, marching happily up and to the right. (The numbers are 0.6%, 1.8%, 2.3%, and 2.8%.) This recession is different, however, and even if there is a mean to revert to after U.S. households decide how much they want to save, there’s no telling how long it will take.

For one perspective, the Carnegie Endowment for International Peace had a session at the end of April featuring a few IMF economists. Marco Terrones (link to PowerPoint at the bottom of the page) looked at the typical duration of a recession and the ensuing recovery. The duration of recovery is measured to the point at which the economy reaches its previous peak output (the output level when the recession began – December 2007 in our case). He looked at 122 recessions since 1960.

Continue reading “Recession and Recovery: How Long?” →

Design A Country Rescue Package Here (Comment Competition)

Here’s your Memorial Day assignment. You have been called to the table for top-level policy discussions in a large monetary union. One of the bigger countries in this union has a serious problem. Their exports are down slightly and there are some longer-run structural issues, but the immediate issue is (1) a housing bubble just burst, resulting in a big fall in tax revenue, (2) the political system seems paralysed, i.e., cannot raise other revenues or cut spending in any sensible fashion, and (3) the market for this government’s debt appears likely to turn very sour. Sounds like a classic fiscal crisis.

Here are your possible recommendations: Continue reading “Design A Country Rescue Package Here (Comment Competition)” →

Foreclosures and Modifications for Beginners

On last week’s This American Life, Chris Arnold of NPR did a good segment on loan servicers and why they do or do not modify loans for delinquent borrowers (starting around the 10-minute mark). There isn’t a lot that avid readers won’t know already; the central message is that it would be better for everyone involved – including lenders and investors – if more loans were modified. It also doesn’t address the legal issues created by collateralized debt obligations where the tranches have different priorities. But if you’re confused about the basics, it’s worth listening to.

Still, there were a couple things that were new or interesting to me:

Scott Simon, a managing director at PIMCO (the world’s biggest bond fund manager), said that he thinks loan servicers should be modifying more mortgages; that seems like a pretty clear vote from the investor side.
The segment brings up the issue of computer systems, which is something I hadn’t thought of but should have. Apparently, most if not all of the big, bank-owned servicers don’t have computer systems (software) that can estimate the net present value of a foreclosure as opposed to a modification, taking into account zip code-specific repair costs, broker’s fees on the sale, closing costs, foreclosure-specific legal costs, and expected sale proceeds. Big-company information technology is something I know well, and I can say with a high degree of confidence that if they started designing these things in 2007, they won’t be done until sometime next year at the earliest, and there’s a good chance they won’t work, and even if they do they will have difficulty handling the load. On the other hand, one good product manager and ten good developers in Silicon Valley could probably build something better in about 12-18 months. I sure hope the fate of the economy doesn’t depend on custom homegrown software.

By James Kwak

Option Pricing for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

I’ve had two posts so far on the terms under which Treasury sold back to Old National the warrants on Old National stock that Treasury got in exchange for its TARP investment, so I thought it was time for an introduction to warrant/option pricing.

The warrants received by Treasury give Treasury the right to buy common stock in the issuing bank under predefined terms. Buying the stock is called exercising the warrant. The warrant specifies how many shares Treasury can buy; the price that it must pay to buy them (the exercise price); and the term of the warrant, meaning how long Treasury has to decide whether or not it wants to exercise the warrant. If Treasury never exercises the warrant, then it expires and nothing happens. For our purposes, a warrant is the same as a call option; there are some differences I will ignore, which are outlined here.

Continue reading “Option Pricing for Beginners” →

Warrant Sales Could Cost Government $10 Billion

Mark Pittman at Bloomberg estimates the total potential cost to taxpayers of selling warrants back to banks at low prices: $10 billion. These are the warrants that banks had to issue to Treasury in exchange for preferred stock investments under TARP. Pittman uses the Old National example as a benchmark: Old National paid $1.2 million to buy back warrants that he estimates at $5.8 million. (Linus Wilson, the first person I know of to do the calculations, estimated a range of values from $1.5 million to $6.9 million.) Extrapolating that “discount” to all the other warrants that Treasury currently holds, Pittman finds:

Under the Old National warrants formula, Bank of America Corp. would save $2.03 billion, followed by Wells Fargo & Co. at $1.48 billion and JPMorgan Chase & Co. at $1.46 billion. Morgan Stanley’s benefit would be $983 million, Citigroup Inc.’s would come in at $965 million and Goldman Sachs Group Inc. would have $693 million, according to the data compiled by Bloomberg.

If you are concerned about banks’ capital levels, that’s one way to help them out. The alternative, suggested by Wilson and others, would be for Treasury to auction off the warrants; if the bids were too low, it could create a trust, transfer them from Treasury to the trust, and release the banks of any TARP obligations triggered by those warrants.

It also contrasts sharply with the treatment of private (not publicly-traded) banks such as Centra, as documented by David Kestenbaum of Planet Money.

I’ll have more on option pricing later.

By James Kwak