What happened to the global economy and what we can do about it
From Felix Salmon:
Why did Treasury switch from TCE to the even-more-obscure common capital metric? Quite possibly to help Bank of America and Citigroup get the amount of capital they needed to raise down to a number within the realms of possibility. After all, these tests were designed so that they couldn’t be flunked. And that might have seemed a real possibility back when Treasury was still using TCE.
By James Kwak
The Obama administration is strengthening its antitrust enforcement policy.
That said, this in itself probably wouldn’t have done anything about the “too big to fail” problem. It might have increased scrutiny over large bank mergers – like Nations-Bank of America, Bank of America-Fleet, or JPMorgan Chase-Bank One, but frankly those probably would have gone through anyway; the banking industry is just not that concentrated compared to some others. Too big to fail is a combination of size, interconnectedness, and the critical role of finance for the economy. But the signal that the administration will actually enforce antitrust law is a step in the right direction.
By James Kwak
Gordon Brown, the British Prime Minister, is in big trouble. It turns out that a medium-sized industrialized democracy like the UK can be run in pretty much the same way as a traditional emerging market – fiscal irresponsibility (cyclically-adjusted general government deficit now forecast at 12.2 percent of GDP for 2010) gives you a boom for a while, but the eventual day of reckoning is economically painful and politically disastrous. If you also need to deal with an oversized bubble finance sector, that makes the adjustment even more painful.
It is of course sensible to use fiscal stimulus to offset a fall in private demand, and to some extent this can be effective – with a lag. But if you lose control over public spending and borrow too heavily (helped by the fact people like to hold your currency), it ends badly.
From the beginning, we’ve expressed concern here that the entire Summers Plan was overweight fiscal, i.e., not enough resources for recapitalizing banks and addressing housing directly (for the context of this assessment, see our full baseline view). Back in December/January, this was a strategic choice worth arguing about; now it’s a done deal and following the (very) limited recapitalization outcome of the bank stress tests, it seems likely that household and firm spending will remain sluggish. If that is the case, the Administration’s logic implies throwing another big fiscal stimulus into the mix – and the Summers’ team is already preparing the groundwork.
The IMF is now warning against the risks of this approach, albeit using carefully worded language. Continue reading “Is Larry Summers The Next Gordon Brown?”
Back when I had time to read The New Yorker, I was a big fan of James Surowiecki. I would always look for his column; if it was there, it was usually the first thing I would read. Unfortunately, he’s no fan of mine.
Surowiecki makes three points about our recent long post on nationalization:
Sigh. I guess it’s impossible to make everyone like me.
I’ll take the points in reverse order.
Writing in the Financial Times on January 27th, 2009, Peter Boone and I expressed our opposition to bank nationalization in no uncertain terms,
If you want to end up with the economy of Pakistan, the politics of Ukraine, and the inflation rate of Zimbabwe, bank nationalization is the way to go.
Most others who recently advocated a managed bankruptcy process – or FDIC-type intervention – for big banks (with or without the injection of new government capital) were careful, at least initially, to avoid using the word nationalization. And many took pains to explain in detail why their proposals were quite different from nationalization.
But at some point this became a debate in which informed bystanders perceived the sides as being for or against “nationalization” – a semiotic transition that has obviously helped the big bankers, at least in the short term.
This weekend’s comment competition is in two parts. Who first made “nationalization” the central word for the U.S. bank discussion? And who was most influential in establishing that the national debate be defined in these terms?
There was been a lot of drama over the last week, which we have certainly contributed to, about the stress tests. It was all very exciting, finally seeing numbers purporting to show how healthy or unhealthy each bank was. But let’s recall what the point of this whole exercise was.
Depending on your perspective, the goal is either to restore confidence in the health of the financial system, or to ensure the health of the financial system, which are obviously closely related. We care about the health of the financial system because the financial system is critical for the health of the economy as a whole: without banks that are willing to lend money for people to buy houses, cars, and consumer goods, or for businesses to invest in real estate, factories, inventory, software, etc., none of these things will happen. So the ultimate goal is to ensure the availability of credit.
There are ways to measure the availability of credit directly. One of them is the Fed’s quarterly survey on bank lending practices, which was released earlier this week (hat tip Calculated Risk, as usual). For a quick overview, I recommend the charts. The charts show you, for each quarter, the change in supply of or demand for credit in that quarter – in other words, they are you showing you the first derivative.
I was talking to an old friend last night about the Chrysler bankruptcy and, in particular, whether Chrysler (and Treasury, and the UAW) will be able to get around the order of priority of creditors in bankruptcy – which ordinarily would favor the senior secured lenders who are trying to block the proposed plan. I thought I would do a little research, but then (again via Calculated Risk) I found Steve Jakubowski’s analysis of precisely this issue, which apparently everyone on the Internet has already been linking to. It’s actually Part 3 of a series; you may want to start with Part 1.
My summary, for those who don’t like reading citations from court opinions: The issue with the “restructuring initiative” agreed-upon by Chrysler, the government, Fiat, and the UAW, is that it only pays the senior secured creditors $2 billion in cash for $6.9 billion in secured debt; since secured creditors’ claims should come first, they argue they would get more from a liquidation. In particular, the VEBA created to fund retiree benefits is owed $8.5 billion; it is getting $4.6 billion debt and 55% of the equity in New Chrysler.
Continue reading “Chrysler and Bankruptcy Law in Gory Detail”
There is nothing you can teach Wall Street titans regarding the timing of news flow. Stephen Friedman, the former head of Goldman Sachs, resigned last night as chair of the New York Fed’s board, after committing essentially a rookie error. In December/January, he traded the stock of a company (Goldman) overseen by the NY Fed, while helping to pick a new head of the Fed (formerly from Goldman), and presumably being aware of other potentially nonpublic information regarding bank rescues (benefiting Goldman both directly and indirectly). The real error, given the Federal Reserve System’s incredibly lax rules on potential conflicts of interest at this level, was failing to disclose this information to the NY Fed – they learned it from WSJ reporters and that cannot have been a good moment.
If you have to resign, pick your time of day carefully, and Friedman is obviously advised by the best people in the business. I’m looking at the hard copies of four newspapers. The news of his departure does not make the front page of the NYT (not even the small stuff at the bottom) or the front page of their Business Day section. There is nothing on the front page of the FT or Washington Post. Even the WSJ only manages three paragraphs on the front page, before sending you to look for p.A10. (It was on cnn.com from 5:55pm last night, together with his resignation letter.)
I haven’t checked who first broke the news, but Friedman’s resignation was of course the major development of yesterday. The bank stress test results were hard-baked a long time ago, and almost all the icing on that cake had already been leaked. But the stress test for bankers is still underway. Continue reading “The Other Stress Test (For Bankers)”
Mark Thoma has a great analogy for the stress tests. He picks up on this statement by Tim Geithner:
Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.
Then this is Thoma:
I’ve given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that’s possible too. . . .
If we choose a score of “70” as the dividing point between being solvent and being insolvent, then the percentage of banks passing the test is a function of the difficulty of the stress test: how the items on the balance sheets – the answers to the questions – are interpreted.
The whole thing is a fun read. I don’t think it’s a crucial point, but I like this part of the analogy:
Why did the government negotiate the outcome with banks and how lenient were they in those negotiations? There are always students who want to argue about the result of a test, to have sections regraded, and how you respond to attempts to “negotiate” a grade can affect the percentage passing the class, particularly when – as with the stress tests – there aren’t a lot of students/banks taking the test.
By James Kwak
Has anyone figured out how to make the numbers in Table 3 (PDF p. 10) in the stress test results add up? I understand what all the lines mean individually, but the presentation seems incomplete. Looking at Citi for example, I know that they expect 104.7 in losses on existing assets, but they expect Citi to make 49.0, for a net loss of 55.7. Common capital on 12/31/08 was 22.9, and 22.9 – 55.7 = -32.8, so absent recapitalization that would leave Citi at -32.8 on 12/31/10. The “SCAP buffer” (which seems like the opposite of a buffer, but whatever) is 92.6, so with the buffer Citi would have 59.8 on 12/31/10. But 59.8 is well over 4% of Citi’s risk-weighted assets of 996.2.
Maybe the model has Citi’s assets climbing up to $1.5 trillion? Or maybe the losses and “resources to absorb losses” do not have a dollar-for-dollar effect on common capital?
Anyway, it seems like at least one number is missing. If you can explain this, or link to someone who can, I will . . . be grateful.
Update: The most common theory is that 59.8 is 6% of 996.2. But I don’t think that is the explanation, for the reasons I cite in this comment reply and that Nemo also flagged. Also, Erich Riesenberg points out that the fact that this works out to 6% for Citi is a pure coincidence, if you look at the same calculation for other banks.
By James Kwak
Calculated Risk has a table listing all of the leaked stress test figures so far. As a percentage of assets, the big banks need between 0% and 1.4% in additional capital. But there is one outlier: GMAC, with $189 billion in assets, needs $11.5 billion in capital.
This implies that GMAC is not just low on capital, it has negative capital. If you were to give GMAC $11.5 billion in new cash, it would have $200 billion in assets. The minimum tangible common equity requirement being used for the stress tests is probably in the 3-4% range. If it’s 4%, then the post-recapitalization GMAC would have $8 billion in tangible common equity – which means that right now it has negative $3.5 billion in tangible common equity. (The situation is slightly worse if you assume that it will be recapitalized through a preferred-to-common conversion, or if the threshold is 3%.)
The thing that confuses me is that, on paper, you can’t recapitalize a company with a negative net worth. No investor would pay $11.5 billion to own 100% of the common shares in a company that is worth $8 billion. (You can recapitalize a company that is under-capitalized: if it has $5 billion in capital and needs another $5 billion, then the new investors get 50% of the company.) This is why it is important (from the government perspective) for the stress tests to show that some banks are low on capital, but not that they have negative capital.
Maybe there’s some clever accounting mechanism or financial wizardry I’m missing.
Update: OK, now that I read the stress test document (I must be the last economics blogger to do so), I see there’s a mistake above. According to the stress test, GMAC is sufficiently capitalized now; the problem is that under the “more adverse” (realistic) scenario, its 2009-10 losses will be greater than its capital. So its expected capital at the end of 2010, absent recapitalization in the interim, would be negative.
It is not arithmetically impossible to recapitalize such a company, because we don’t know that this outcome will occur with certainty. I might pay $11.5 billion to own a company that, in the more adverse scenario, will be worth less than $11.5 billion at the end of two years – if I think that the possibility of a better outcome makes the bet worthwhile. Put another way, even if its end-2010 expected value is negative, its current value is still at least a little positive, because of option value. Still, though, it’s a pretty dodgy investment, so GMAC will probably have a difficult time raising new capital by selling common stock to the private sector.
The comment Nemo made below about the difference between market value and book value is true, but I also think my response is true: if anything, market values are below book values these days.
Finally, Felix Salmon also noticed that GMAC is the outlier on the bad end.
By James Kwak
See NYT.com’s Room For Debate. I like what Yves Smith says. Post your reactions there or here.
By Simon Johnson
Update (by James): My last pre-results thoughts are at Foreign Policy.
Regular readers will know that we are fans of Thomas Hoenig, president of the Kansas City Fed (see here). I was catching up on the week’s news via Calculated Risk and came across Hoenig’s recent op-ed in the Financial Times, which I recommend as a follow-up to (or shorter version of) our previous post. Nor surprisingly, Hoenig argues that large bank holding companies should be allowed to fail, meaning:
Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible.
Hoenig provides a list of arguments in support of this position. He starts with moral hazard, which would not have been at the top of my list. But I particularly like these:
So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.
As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role.
A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable.
Here’s a link to the whole thing again.
By James Kwak
The post was co-authored by Simon Johnson and James Kwak.
When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.
What happened?
Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (“Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.
Continue reading “Stress Tests and The Nationalization We Got”
The public relations campaign packaging the bank stress tests is kicking into high gear and our professional information managers are really hitting their stride. They face, of course, a classic spin problem: you need to get the information out there, but you don’t want to be too definitive on the first day or soon after – if you’re easy on the banks, that looks bad; if you’re tough on the banks, that might be dangerous.
The best way to handle this is by jamming your own signal – which they are starting to do in brilliant fashion. To the WSJ you leak that BoA needs to raise a great deal of capital ($35bn); they run this story on the front page, next to a great frown on the face of Ken Lewis. But you tell the FT that Citi will need “to raise less than $10bn” (note that the on-line FT version of this story, as of 8:30am Eastern, seems to have been adjusted downwards relative to the print edition that arrived at my house 4 hours ago.) The NYT yesterday sounded quite upbeat.
Of course, deliberately or inadvertently confusing people is made much easier by the fact that the experts are in sharp disagreement. Goldman’s Jan Hatzius says that the worst is now behind us in terms of loss recognition and pre-provision earnings will be much higher in the US than they were in Japan during the 1990s – here he and others are taking on the IMF’s Global Financial Stability Report. And he has two good points in this regard, Continue reading “Is Everyone Confused Yet? (Bank Stress Tests)”
The Baseline Scenario 