Larry Summers’ New Model

Larry Summers spoke on Friday afternoon at the InterAmerican Development Bank in Washington DC.  As he was addressing a group with  much experience living through and dealing professionally as economists with major crises, he spoke the “language of economics” (as he called it) and largely cut to the analytical chase.

Summers made five points that reveal a great deal about his personal thinking – and the structure of thought that lies behind most of what the Administration is doing vis-a-vis the crisis.  Some of this we knew or guessed at before, but it was still the clearest articulation I have seen. Continue reading “Larry Summers’ New Model” →

Guest Post: Too-Big-To-Fail and Three Other Narratives

This guest post is contributed by StatsGuy, one of our regular commenters. I invited him to write the post in response to this comment, but regular readers are sure to have read many of his other contributions. There is a lot here, so I recommend making a cup of tea or coffee before starting to read.

In September, the first Baseline Scenario entered the scene with a frightening portrait of the world economy that focused on systemic risk, self-fulfilling speculative credit runs, and a massive liquidity shock that could rapidly travel globally and cause contagion even in places where economic fundamentals were strong.

Baseline identified the Fed’s response to Lehman as a “dramatic and damaging reversal of policy”, and offered major recommendations that focused on four basic efforts: FDIC insurance, a credible US backstop to major institutions, stimulus (combined with recapitalizing banks), and a housing stabilization plan.

Moral hazard was acknowledged, but not given center stage, with the following conclusion: “In a short-term crisis of this nature, moral hazard is not the preeminent concern.  But we also agree that, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.”

Over time, and as the crisis has passed from an acute to a chronic phase, the focus of Baseline has increasingly shifted toward the problem of “Too Big To Fail”.  The arguments behind this narrative are laid out in several places: Big and Small; What Next for Banks; Atlantic Article.

Continue reading “Guest Post: Too-Big-To-Fail and Three Other Narratives” →

More Convergence of Views

Yesterday I highlighted an op-ed written by Desmond Lachman, a veteran of the IMF and Salomon Smith Barney (and currently at the American Enterprise Institute), comparing the United States and the current crisis to an emerging market crisis.

Saturday evening, Nicholas Brady, Secretary of the Treasury from the end of the Reagan administration through the entire Bush I administration, gave a speech at the Institute of International Finance – comparing the current crisis in the United States to an emerging market crisis, only in that case the banks were in the U.S. and the bad assets were in the emerging markets.

There are uncanny parallels between the situation we find ourselves in today and the one the Bush administration confronted a generation ago. . . . First of all there was a serious LDC [Least Developed Country] debt crisis. It’s easy to forget that in 1988 our banking system was in dire straits because the commercial banks held billions of dollars of loans in countries whose economic prospects had ground to a halt.

The solution, according to Brady, was identifying the fundamental problems and forcing all parties to recognize them.

Among the indisputable points we laid out were that new money commitments had dried up in the past 12 months and that many banks were negotiating private sales of LDC paper at steep discounts while maintaining their claim on the countries that the loans were still worth 100 cents on the dollar. There were more, and they were equally sobering. We used these irrefutable facts as a starting point in all subsequent meetings. Our rule was that no suggestions were permitted to be discussed if they didn’t accept the Truth Serum. They were off the table. Goodbye. Don’t waste time. . . . [W]e persuaded the international commercial banks—at first with great difficulty—to write down the stated value of the loans on their books to something close to market value in exchange for that lesser amount of host-country bonds backed by U.S. zero-coupon Treasuries.

Continue reading “More Convergence of Views” →

Why Pay Tuition?

One of our goals here at The Baseline Scenario is to explain basic economics, finance, and business concepts and how they apply to the things you read about in the newspaper. I think I’m pretty good at this. But if you prefer video and diagrams, I may have found something much better (thanks to a reader suggestion).

Salman Khan has created dozens of YouTube videos covering the basics of banking, finance, and the credit crisis. (There is also a series on the Geithner Plan that doesn’t seem to be on the main index page yet.) I’ve only watched a few, but they are very clear and from what I can see everything looks accurate.

But what’s really exciting is that he also has many, many more videos on math – from pre-algebra through linear algebra and differential equations – and physics. My wife and I watched the one on the chain rule and implicit differentiation and she gave it two thumbs up. (My wife is an economics and statistics professor.) So the next time you – or your child – needs to derive the quadratic formula, just head on over to his web site. Hours and hours of fun.

By James Kwak

IMF Emerging Markets Veteran on the U.S.

One of the central themes of our Atlantic article was that the current crisis in the U.S. is very similar to the crises typically seen in emerging markets, and that resolving the crisis will require (some of) the measures often prescribed for emerging markets. This, Simon said, would be the assessment of IMF veterans who had worked on emerging markets crises.

At the exact same time that we were writing that article, Desmond Lachman – who worked at the IMF for 24 years, and then worked on emerging markets for Salomon Smith Barney for another seven years – was writing an article for the Washington Post saying many of the same things.* Here are the first three paragraphs:

Back in the spring of 1998, when Boris Yeltsin was still at Russia’s helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to “emerging markets” throughout Asia, Eastern Europe and Latin America, and I thought I’d seen it all. Yet I still recall the shock I felt at a meeting in Russia’s dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia’s economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia’s economic czar at the time.

Continue reading “IMF Emerging Markets Veteran on the U.S.” →

The Next Big Hearing? (Bill Moyers Tonight)

Bill Moyers asked me to join his conversation this week with Michael Perino – a law professor and expert on securities law – who is working on a detailed history of the 1932-33 “Pecora Hearings,” which uncovered wrongdoing on Wall Street and laid the foundation for major legislation that reformed banking and the stock market.

My role was to talk about potential parallels betweeen the situation in the early 1930s and today, and together we argued out whether the Pecora Hearings could or should be considered a model for today.

Bill has a great sense of timing.  On Wednesday night the Senate passed, by a vote of 92-4, a measure that would create an independent commission to investigate the causes of our current economic crisis; we taped our discussion on Thursday morning.  In the usual format of Bill’s show, a segment of this kind would be 20+ minutes, but I believe that tonight our conversation will occupy the full hour (airs at 9pm in most markets; available on the web from about 10pm). Continue reading “The Next Big Hearing? (Bill Moyers Tonight)” →

Irreversible Errors

The Administration’s top thinkers on banking regard themselves as avoiding “irreversible errors” – meaning precipitate moves on banking.  They argue that “wait and see” may work out and, if it doesn’t, they can always take more dramatic action later (e.g., of the Hoenig variety).

Writing in the NYT.com’s Economix today, Peter Boone and I argue that this line of reasoning makes sense, but needs to be taken to its logical conclusion.  Specifically, we should recognize that delay in banking crises almost always and pretty much everywhere leads to lower growth and higher fiscal costs – the price of eventual bailouts increases and the amount of fiscal stimulus required goes up.  The jobs lost, the longer recovery, and the higher national debt are all costs that must be weighed in the balance.  And that balance, in our view, indicates moving faster and in a more comprehensive manner in the direction suggested by Thomas Hoenig – a senior Federal Reserve official who has a great deal of experience dealing with insolvent banks. Continue reading “Irreversible Errors” →

The Missed Opportunity

For a snapshot of what’s wrong with our banking policy, look at the front page of the business section of today’s New York Times. On the left side: “U.S. in Standoff with Banks over Chrysler.” On the right side: “Banks Show Clout on Legislation to Help Consumers.”

On the left side, a consortium of banks holding Chrysler debt is refusing to agree to the current restructuring plan, which involves bondholders holding $6.9 billion in secured debt getting about 15 cents on the dollar – roughly where the bonds are currently trading, according to the Times.* The banks are playing the ongoing game of chicken with the government, betting that the government will cave and give them a better deal rather than take a risk on a bankruptcy.

On the right side, the banks are using their lobbying clout to block the administration’s proposals to help consumers and households, including the mortgage cram-down provision (which would allow bankruptcy courts to modify mortgages on first homes) and added consumer protections for credit card customers. They currently have all 41 Republican votes in the Senate tied up, which means nothing can pass.

The banks leading the charge over Chrysler: JPMorgan Chase and Citigroup. The banks opposed to cram-downs: Bank of America, JPMorgan Chase and Wells Fargo. The banks blocking credit card protections: American Express, Bank of America, Capital One Financial, Citigroup, Discover Financial Services, and JPMorgan Chase. All or almost all are bailout beneficiaries. But don’t blame them: they’re just doing what they can to maximize their profits at the expense of the taxpayer, which is perfectly legal (and even ethical, depending on your conception of shareholder rights). Instead, you should be wondering why they are in a position to be maximizing profits at the taxpayer’s expense.

Continue reading “The Missed Opportunity” →

The Missing Witness

Yesterday’s JEC Hearing on Too Big To Fail did not include any financial industry representatives.  This surprised me – surely they want to go public with their views on the future structure of the financial system?  Obviously, they have great behind-the-doors access on Capitol Hill, but surely it is not in their interest to have right, left, and center piling on with regard to breaking up Big Finance?  Yesterday, Thomas Hoenig, Joseph Stiglitz, and I were in complete agreement on this point, and my idea of using antitrust measures against major banks seemed to gain traction during and after the hearing.

Apparently, the committee invited a number of leading people from the industry (i.e., individuals who generally articulate the case for big banks) and they were all too busy to attend (Update: this statement is incorrect; the potential witnesses who were unable to attend are academics).  This is a curious coincidence, because someone else – in an unrelated initiative – has been trying to set up a discussion involving me and people from the Financial Services Roundtable and/or the American Bankers Association, to be held at the National Press Club, but their calendars are completely full (i.e., there is literally no day that works for them, ever). Continue reading “The Missing Witness” →

A View from the Inside

If you haven’t picked up on one of the dozens of recommendations from other blogs, I recommend reading Phillip Swagel’s long and detailed account of the view of the financial crisis from his seat as assistant secretary for economic policy at the Treasury Department. It’s particularly useful for people like me who make a habit of criticizing government officials.

The writing is dry, but much of the subject matter is fascinating. It often explains or defends Treasury’s actions during the crisis, but Swagel certainly owns up to plenty of mistakes or shortcomings. For example, discussing the emergency guarantee program for money market funds, he writes, “Nearly every Treasury action there was some side effect or consequence that we had not expected or foreseen only imperfectly.”

Continue reading “A View from the Inside” →

Two Hearings On Banks Today

This morning, by coincidence, there are parallel hearings on Capitol Hill dealing with the nature of our banking system and attempts to stabilize it.  In the Cannon House Office Building, starting at 9:30am, the Joint Economic Committee will hear from Thomas Hoenig, Joseph Stiglitz, and me, on whether Big Finance is too big to save (see yesterday’s preview for details).

At 10am over on the Senate side (Dirksen Senate Office Building), Secretary Geithner will appear before the TARP Congressional Oversight Panel.  We preview that event this morning on The Hearing, with a discussion of the context, the latest numbers, and our forecast of the ideas that will be expressed; it’s a viewer’s guide – but one that you can talk to by sending in comments (and, most important, your questions for the Secretary). Continue reading “Two Hearings On Banks Today” →

70% Off Sale!

There has been a fair amount of hand-wringing along Sand Hill Road in Menlo Park over the lack of “exits” – IPOs and acquisitions – for venture-backed technology companies. Given the way the stock market has behaved recently, it’s pretty near impossible for a young technology company to go public. And the large technology companies that do most of the acquiring have been unusually quiet, presumably because they are watching their cash and avoiding risks given the global economic downturn.

However, there’s one major reason why large technology companies should be buying:

orcl-java

Blue is the share price of Oracle; red is the price of Sun (the spike in March is Sun’s merger negotiations with IBM). At some point, prices fall to the point where people start buying again. While the recession has hurt almost every company, it disproportionately hurts companies that do not have fat profit margins, hordes of repeat customers, and deep cash reserves that they can rely on in hard times. The result is huge changes in the relative values of companies, creating some once-in-a-generation bargains.

I don’t think the Oracle-Sun acquisition is a sign of a bottom or anything dramatic like that. But it shows that at least some companies are doing what they should be doing.

By James Kwak

Your Hearing: New Blog at WashingtonPost.com

Some readers have emphasized how the current economic and financial situation leaves them feeling powerless.  Others complain that it’s hard for outsiders even to understand the process through which ideas are debated and become policies – how Capitol Hill really works is a fascinating mystery at many levels.

This morning we’re extending our efforts to address these issues with the launch of The Hearing, a new blog at the Washington Post.  James and I are the moderators and we’ll focus the discussion around Congressional hearings – including the broader debates in which these are situated.

The Post has great impact in Washington and it’s our hope that The Hearing will allow you to express ideas in ways and at a time that can have real effects on policies.  For this reason, we’ll preview public events and provide ways for you to suggest questions that need to be heard.  At the very least, we can all learn more about what is happening and exactly why.

We’re open to suggestion regarding the exact format, guest contributors, and generally how to make The Hearing more effective.  We will, of course, keep BaselineScenario as our primary outlet for opinions and analysis – The Hearing is intended to be complementary, by bringing your voices into the specifics of idea flow through Congress.  We’ll tell you here when you should consider going to look there.

My first post deals with tomorrow’s JEC hearing on “Is Big Finance Too Big To Save”?  I preview what Joe Stiglitz and Thomas Hoenig are likely to say (based on their racing form), and I anticipate where the discussion will go – or at least where I will try to push it, as I’m on the panel also. 

If you have points or questions you want raised, please post them here or on the Post’s site.  There’s no guarantee your issues will be taken up, of course, but my guess is that this new forum will help sensible requests – of the kind often seen here – gain broader traction.

By Simon Johnson

More Accounting Games

The New York Times is reporting that the administration is thinking of stretching its TARP funds further by converting its preferred shareholdings to common stock.

The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

I hope this is one of those trial balloons they float and later think better of. Most importantly, it makes no sense. That is, there’s nothing fundamentally wrong with converting preferred for common, but it doesn’t create anything of value out of thin air. I wrote a long article about preferred and common stock a while back, but here are some of the highlights.

  • If you don’t give a bank any more money, it doesn’t have any more money. By converting preferred into common, you haven’t changed the chances of the bank going bankrupt, because its assets haven’t changed, and its liabilities haven’t changed. If it had enough money to cover its liabilities, but it couldn’t buy back its preferred shares from Treasury, it’s not like the government would have forced it into bankruptcy anyway.
  • If you accept the idea that converting preferred into common creates new capital, then you are implying that those preferred shares weren’t capital in the first place. From a capital perspective, then, the initial TARP “recapitalizations” did nothing, and nothing happens until the conversion. You can’t say that JPMorgan got $25 billion of capital last fall and it’s going to get another $25 billion now just by virtue of the conversion.
  • Tangible common equity and Tier 1 capital are just two ways of measuring the health of a bank. Taking money that wasn’t TCE and calling it TCE doesn’t serve any economic purpose. There is a minor benefit to the bank because now it doesn’t have to pay dividends on the preferred. But otherwise you’ve just shuffled together the claims of the last two groups of claimants – the preferred and the common shareholders. You’ve made things look better from the perspective of the common shareholders as a group, because they no longer have preferred shareholders standing in front of them, but the total amount available to all shareholders hasn’t changed.

Is there another way to explain this even more simply?

Update: I made a mistake in interpretation last night. They aren’t floating a possible strategy here; this is already what is going to happen. I forgot that the Capital Assistance Program already announced by Treasury – the mechanism for giving more capital to banks that need it after the stress tests – specifies the use of convertible preferred shares. So imagine you are a bank with $5 billion in TARP capital already. You issue $5 billion of convertible preferred under the CAP, use the proceeds to redeem the initial TARP, and then – if and when you choose – convert the convertible preferred into common. So the mechanism to do it is there already. I guess they are floating the spin to see if anyone believes this would actually make healthier banks.

Update 2: In case it wasn’t clear from the above, I don’t have any problem with converting preferred for common. I am probably mildly in favor of it, even, for roughly the same reasons as Matt Yglesias: as a taxpayer, I’d rather have the upside and control that come with common shares.

By James Kwak