How Can GM Avoid Bankruptcy?

With the Big 3 back in Washington, it seems like time to resuscitate the debate over the auto industry bailout. Luckily, Felix Salmon took the time to look through GM’s bankruptcy plan, which is being advertised on GM’s new, also gag-inducing GM Facts and Fiction website. Here’s one particularly gag-worthy claim from the plan:

GM has never failed to meet a Congressional mandate in the important areas of fuel efficiency and vehicle emissions, and sets the industry standard for “green” manufacturing methods.

Let’s not mention that GM has fought increased fuel efficiency standards with every dollar it could spend on lobbyists for decades.

Anyway, Salmon’s post focuses on one issue that has troubled me as well. One of GM’s biggest problems, along with plummeting demand for cars, is $62 billion in debt. In order to become a financially viable company, they have to reduce this debt, presumably by converting some of it into equity. But that debt is held by private entities, and no amount of pleading from the Big 3, the UAW, Jennifer Granholm, Congress, or Barack Obama HIMSELF can force them to restructure the debt. My worry is that in negotiations of this sort, where each side is holding a gun to the head of the other, debtholders could very well say: “Go ahead, go bankrupt, we’ll take our chances that we can get a better deal from a bankruptcy court or, worst case, we can recover more in cash than the value of the equity you’re offering today.” One of the points of a bankruptcy is to get a court that can force bondholders to accept a settlement rather than relying on their good graces.

On a related subject, a lot of people are throwing around the 80% number: supposedly, 80% of people will not buy a car from a company in bankruptcy. A GM spokesman said (to Felix Salmon) that GM’s sales were already falling because of fears about bankruptcy. Maybe. But I strongly suspect that 80% is just a poorly worded and interpreted poll question. If you ask people in the abstract if they would buy cars from a bankrupt car company, of course they will say no. But in the real world, if the car they want is made by a bankrupt company, and they get a good deal, they will buy it. Just look at the November auto sales. GM was down 41%; Toyota, Honda, and Nissan were down 34%, 32%, and 42%, respectively. And everyone buying a car in November must have been aware that bankruptcy for GM was a serious possibility. (Besides, haven’t we been talking about a GM bankruptcy on and off for years?) Sure, bankruptcy will hurt sales a little. But 80% is just not credible.

We Are All in This Together

Dani Rodrik has a short, clear post on (a) why countries are tempted to engage in protectionism during recessions and (b) why they shouldn’t. It only uses 1st-semester macroeconomics. The bottom line is that the preferred outcome is for all countries to engage in fiscal stimulus at the same time. The hitch is that most of the developing world can’t afford to. The implication is that it is in the interests of the wealthy countries to find a way to support the developing world.

How the SEC Could Have Regulated Subprime Mortgages

From a new paper (link below):

Kafka would have loved this story: According to our current understanding of U.S. law there is far better consumer protection for people who play the stock market than for people who are duped into buying a house with an exotically structured subprime mortgage, even when the mortgage instrument is immediately packaged and sold as part of a security.

The crux of the matter is that securities transactions – notably, the sale of a security to a customer by a broker – are governed by SEC regulations, which impose a fiduciary relationship on the broker, meaning, among other things, that the broker can only sell financial products that are suitable for that customer. However, no such rule governs the relationship of a homebuyer to a mortgage broker or company, meaning that behavior by the latter must be actually fraudulent before it can be sanctioned.

Jonathan Macey, Maureen O’Hara, and Gabe Rosenberg (two of whom are at my very own Yale Law School) have a new paper (abstract and download available) arguing not only that mortgage brokers should have a fiduciary responsibility to their customers, but that they already do under two reasonable interpretations of existing SEC regulations. (It has to do with whether a complex subprime mortgage is already a security or, failing that, whether it is related to a security transaction.) This means that the SEC could have been regulating these things all along.

More Danger for the Eurozone?

Back in the exciting days of October, Peter, Simon, and I wrote an op-ed in The Guardian about the potential for cracks to appear in the Eurozone, even possibly leading to one or more countries withdrawing from the euro. With so many other things to worry about, this scenario didn’t get a lot of attention. Since then, pressures have been slowly building. For example, the spread between the 10-year bonds of Greece and Germany has grown from around 30 basis points during most of the decade to over 1.5% now. (The picture below is from last week.)

Greece-Germany

According to an FT chart (sorry, can’t find the link), Greece also has to raise 20.3% of its GDP in debt next year (the equivalent figure for the U.S. is 10.3%), so the spread should only get bigger.

The Eurozone is based on the idea that a single monetary policy can serve the interests of all of the member countries. The problem is that when macroeconomic conditions vary widely between countries, they will have different interests. In a severe crisis, some countries may be tempted to (a) engage in quantitative easing (of the sort the Fed is beginning to do) or (b) implement a large fiscal stimulus (of the sort that Pelosi, Reid, and Obama are about to do). (a) is impossible for a Eurozone member, and (b) is constrained by limits on deficit spending, although I believe those limits are honored more in the breach than in practice.

In any case, the potential problems are getting big enough that Martin Feldstein has weighed in as well. Hopefully this will draw more attention to the issue. It may still be a low probability, but the economic and political consequences of undoing the greatest step toward European integration in, oh, the last thousand years would be huge.

Yes, But WE’RE Above Average

My former employer has published a survey of business people around the world conducted in early November. It’s not particularly surprising, but I especially liked this chart (free registration required), according to which a plurality (39% to 38%) of North American companies think that their profits this fiscal year will be better than last fiscal year. (The “current” fiscal year ends sometime between November 2008 and October 2009, so in most cases it includes the steep part of the downturn.) The global numbers are 38% up and 43% down.

Maybe being an executive at a large company selects for unnaturally optimistic people. I’ve always suspected that there is a significant, quantifiable optimism bias to the statements of business people, even their private ones. (Their public ones, of course, are colored by the desire to positively influence their stock price, which can lead to some interesting results.) It’s something I’ve thought of studying but never had the time for. If anyone knows of any research, let me know.

The Importance of China

So, the global economy is falling apart, but not in the way people expected. Under the de facto arrangement sometimes known as “Bretton Woods II,” emerging market countries pegged (officially or unofficially) their currencies to developed world currencies at artificially low rates, having the effect of promoting exports and discouraging consumption by emerging market countries and promoting consumption and discouraging exports in developed countries. Of course, the classic example of this was China and the U.S. The U.S. trade deficit and Chinese trade surplus created a surplus of dollars in China, which were invested in U.S. Treasuries and agency bonds, keeping interest rates low and indirectly financing the U.S. housing bubble and consumption binge of the last decade (and, therefore, growth in Chinese exports).

The general fear was that U.S. indebtedness would lead China to diversify away from U.S. assets, causing the dollar to fall and U.S. interest rates to rise, hurting the U.S. economy and making it harder to finance the national debt. This may yet happen someday. But instead of demand for Treasuries collapsing, it’s been demand for every other type of asset that has fallen. Treasury yields have collapsed and the dollar has appreciated about 20%. Still, despite this increased purchasing power, the fall in U.S. (and global) consumption is having a severe impact on growth of the Chinese economy. Even though the Chinese government has signaled that it will do everything in its power to keep growth above 8% per year (down from 11-12% in the past few years), the slowdown has severely constrained the ability of the urban manufacturing sector to absorb internal migration from the countryside, and there are signs of a reverse migration that is aggravating the problem of rural poverty in China. Although China may seem to have all the cards – high economic growth, large foreign currency reserves – it could yet turn out to be a major loser of the global economic crisis.

This is of course just a brief introduction. For more I recommend Brad Setser, among others: some of his posts are here, here, and here.

The Lawsuits Begin …

OK, there are probably other lawsuits already. But now a hedge fund is suing Countrywide (Bank of America), claiming that its loan modification program violates contract law and that if Countrywide wants to modify any mortgages it must buy out the existing investors at face value.

This is one aspect of the “securitization problem” that got a lot of air time on this blog a few weeks ago.

More Signs of Monetary Expansion

With the Federal Reserve’s main policy tool, the Fed funds rate, past the point of diminishing returns (although the target rate is 1%, the actual rate has been well below that for weeks), there are more signs that the Fed is willing to use new tools to stimulate the economy. Fed Chairman Bernanke’s speech today spelled out quite clearly (no more Greenspan-speak here) what the plan is (emphasis added):

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver–the provision of liquidity–remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. . . .

Second, the Federal Reserve can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market. Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets. In this spirit, the Federal Reserve and the Treasury jointly announced last week a facility that will lend against asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. . . .

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed’s balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

There have been a number of articles in the last week on the shift toward quantitative easing, and in particular the fact that the Fed is no longer sterilizing all of its liquidity injections (compensating for them by selling Treasuries to suck up cash). Here’s one from FT Alphaville with some nice graphs.

In their Real Time Economics post a week ago, Simon and Peter argued that this is precisely what we need. However, opinions differ – some fear that the increased long-term risk of inflation outweighs the benefits of monetary stimulus now.

Next MIT Class on Global Crisis: Tuesday, December 2nd

Tomorrow, Tuesday December 2, at 4:30pm (please note special start time for this week), we will webcast our next MIT class on the global crisis.  The session will run until 7pm, as usual, with a break around 5:30pm.

This is the last class on the crisis that we will broadcast & record, at least for now.  (There will also be a class on Tuesday, December 9, which will review the crisis to date; I’ll post summary materials but that session will not be recorded.)

On December 2nd, I plan for us to cover the following topics:

  1. The Citigroup Bailout, including whether this is or is not good value for the taxpayer (search this website for Citigroup to see readings).  Robert Rubin’s interview with the Wall Street Journal on Saturday is also essential reading (the WSJ article requires a subscription; the blog naked capitalism provides a free summary and some reactions worth discussing.
  2. The situation in Europe, which continues to worsen.  We’ll review the latest developments in the real economy and indications of various kinds of pressures (think: Italy, but the UK, Spain and other countries may well come up).
  3. Prospects for global financial system reform.  We can see fairly clearly the strategy of President-Elect Obama’s team with regard to fiscal policy, and we can infer some implications for monetary policy.  But what is their likely global strategy, with or without the IMF?  How does this fit with what the rest of the G7 or emerging markets or any other influential players want?  Can we see a full overhaul of the global system coming soon?  If not, why not?  (Search for Global Reform on this website for readings.)

Feel free to post questions here or email to us, through this website.  We’ll cover as many as possible in the classroom discussion.

Details on the webcast and some potentially useful background follow: Continue reading “Next MIT Class on Global Crisis: Tuesday, December 2nd” →

Greg Mankiw Channels Keynes

I am struck by the degree of consensus among mainstream economists about how to deal with the current recession. Greg Mankiw, Chairman of President Bush’s Council of Economic Advisors from 2003 to 2005, wrote a New York Times op-ed arguing for a Keynesian response to the recession – which is what Summers, Stiglitz, and all the other Democrats are calling for.

It’s also a wonderfully clear exposition of the challenge, considering in order the logical possibilities for increasing aggregate demand. Mankiw doesn’t quite come out and endorse an increase in government spending, although he does say it’s the only component that can plausibly be increased (as opposed to consumption, investment, and net exports). He holds out some hope for expansionary Federal Reserve policy. In any case, it’s a quick read and worth it.

Oh, It’s Nice to Have the World’s Reserve Currency

When times are tough, governments have to borrow money. Luckily for us Americans, we can borrow it for free (for now at least – I know this isn’t going to be true forever): 3-month Treasuries have a yield of 0.01%, and even 3-years are at 1.25%, both below the rate of inflation. (By the way, even if you don’t have Bloomberg, you can get Treasury yields at Yahoo! Finance among other places.)

By contrast, the UK and Italy recently had unexpected trouble selling 3- and 4-year bonds, respectively, having to offer 10 basis points over similar existing debt. Mind you, this isn’t Iceland and Hungary we’re talking about here, but two members of the G7. Basically, investors are getting worried that deep recession (which crimps tax revenues) and large bailout packages, piled on top of existing debt, are creating the risk that at some point governments will either default on their debt or, in the case of the UK (which still controls its currency), inflate it away. The same concern can be seen in credit default swap spreads (remember Friday’s post?). Italy’s have climbed from single digits for most of 2007 and 40 bp in the summer to 141 bp.

Italy

Waiting for the European Central Bank, And Waiting

The European Central Bank is widely expected to cut interest rates, perhaps by 50 basis points (half of a percentage point), this week. They could, of course, follow the lead of the Bank of England or the Swiss National Bank and go for a much larger cut (150 basis points and 100 basis points respectively on their most recent rounds). But they probably won’t and not because the economic outlook in the eurozone looks so different from those other parts of Europe or because the the ECB’s Governing Council knows something we don’t or because their interest rates are already low (actually, at 3.25%, they are definitely on the high side.)

The difference really lies in two factors: extreme views about inflation, and the nature of decision-making within the ECB.  Belief that a resurgence of inflation is always imminent is, of course, Germanic but not limited to Germany.  Within the 15 central banks represented on the ECB’s Governing Council, there will always be at least one or two who see unions as looking for an excuse to push up wages.  We can debate whether or not this view is correct under today’s circumstances, but that is irrelevant – these inflation hawks still appear to strongly hold such beliefs.

Of course, there are inflation hawks among all groups that make monetary policy.  But the consensus-seeking process at the ECB is such that even just a few such people can serve as an effective brake on rapid action.  The existence of such views has plainly not prevented the ECB from taking dramatic action on some fronts (e.g., in terms of liquidity provision the ECB arguably moved farther and faster than the Fed last year), but for core monetary policy issues – i.e., when the price stability “mission” is at stake – a couple of outliers can really slow things down (particularly if one or more are members of the Executive Board.)

if the ECB puts through a fairly standard interest rate cut, then it is Business As Usual in the eurozone.  Combined with the rather anemic (or largely smoke and mirrrors) fiscal stimulus in the EU, on top of Europe’s well-known labor market inflexibility (i.e., it is hard to reduce your wage costs, even if business turns down sharply), then the eurozone is in for a rough ride. 

If the ECB surprises the market with a dramatic interest rate cut, at least we will know they are firmly in catch-up mode.  But even then, I’m afraid it is probably too late to have much effect on the recession in 2009.  Under the best of circumstances, interest rate moves affect the real economy with a lag of at least a year.  And the current disruption in the credit market is far from helping monetary policy be effective.

While we will no doubt look back on this crisis as having its epicenter in the U.S., it’s the lack of coherent policy response (monetary, fiscal, regulatory) in Europe over the past year that has really helped turn this into a sustained global crisis.