To Bail or Not To Bail, Banking Edition

This was a bad day for the market and a very bad day for banking; the credit default swap spread for at least one major bank rose above 400 basis points – a level of implied default probability that we have not seen since mid-October. 

Mr. Paulson suggested earlier this week that the government’s Troubled Asset Relief Program (TARP) take a break from bank recapitalizations, through at least January 20th (listen to today’s NPR story).  After today, I seriously doubt this is a good idea.  And I sincerely hope that the administration is preparing (another) policy U-turn. 

Potentially more sustainable approaches are suggested in my previous post (and the associated WSJ.com article).  Don’t be shy.  Congress in particular needs to hear your suggestions – post them here or call your favorite representative.  Just don’t urge inaction.

Banks At Serious and Immediate Risk, Again

Despite the shot of confidence provided by the recapitalization program in mid-October, equity prices and CDS spreads indicate investors are getting nervous about banks again – and some may even be betting that they will fail, or at that equity holders will be wiped out. As the recession deepens, banks’ assets (not only mortgage-backed securities, but loans in all forms) are falling in value, increasing the chance that the government will need to step in again with more capital. Peter and Simon have a guest post at Real Time Economics (WSJ) on the options – none of them pretty – that the government has.

To Bail or Not To Bail, GM Edition

For those who can’t get enough of the GM topic, Economix (NYT) has links to posts for and against bankruptcy. Right now it’s 10-5 in favor of bankruptcy, although I’m not sure that Mitt Romney’s vote should have the same weight as those of, say, Martin Feldstein, Gary Becker, and Paul Krugman.

However, the bankruptcy/bailout dichotomy leaves out what I think is the best solution: a government-brokered reorganization, which may or may not require bankruptcy – a prepackaged bankruptcy, as it’s sometimes called. This would be very different than just letting GM go into Chapter 11 and hoping for the best, especially given the lack of debtor-in-possession financing these days (thanks to the commenters who pointed this out). Andrew Ross Sorkin, for example, argues for a prepackaged bankruptcy, and even Romney calls for a “managed bankruptcy” (without many deatils) – yet they are lumped in with the the others, like George Will, who argue against any government intervention. (See the link above for all the links to individual posts.) So I don’t think 10-5 is a very accurate count.

Update: Five professors who really are experts on the auto industry (and one of whom is a colleague of Simon at Sloan) have a highly readable paper with their proposal out. They favor a non-bankruptcy restructuring plan that is overseen by the government and also has some provisions to ensure that the reorganization is in the public interest, such as increased fuel efficiency standards and a prohibition on paying dividends to shareholders.

Testimony This Morning: Senate Budget Committee

Wednesday morning, starting at 10am, I’m on a panel testifying to the Senate Budget Committee about the need for a fiscal stimulus.  The other witnesses are Mark Zandi and John Taylor.

I’ll post my written testimony after the hearing. I expect to make three main points in my verbal remarks:

1) We are heading into a serious global recession, caused by and in turn causing a process of global leveraging (i.e., reduction in lending and borrowing).  We have never seen this kind of deleveraging – synchronized around the world, fast-moving, and with an unknowable destination.

2) I do not think we can prevent this deleveraging from happening.  Nor do I think we should even try to keep asset prices high (or at any particular level).  But in the United States we have the ability to mitigate some of the short-run effects and to lay the groundwork for a sustainable, strong recovery.  One sensible tool to use in this context is fiscal policy.  I lean towards smart spending programs, but as the economy continues to worsen, I think some kind of temporary tax cut could also help – it can potentially have relatively quick effects.  (Note: contrary to those who think that if tax cuts are saved by consumers, they are somehow “wasted,” I would point out that anything that improves consumers’ balance sheets is both good for them and for the financial institutions that lend to them.)

3) But there is a real limit to how far we can go with fiscal policy (and with other policy measures).  Irresponsible budget policies would not be a good idea – we need to continue a process of fiscal consolidation; it is most vital that people around the world remain confident in the U.S. government’s balance sheet.  Some of the highest numbers now being proposed for a fiscal stimulus are probably too high and a mega-stimulus could be counterproductive if it undermines confidence.

I’m proposing a fiscal stimulus of roughly 3% of GDP, to be spent over several years.  Given the uncertainties involved, this seems like reasonable middle ground – it’s enough to make a difference, but doesn’t promise a miracle; it can be spent sensibly and at an appropriate speed; and it will not undermine our ability to consolidate the U.S. fiscal position (i.e., bring government debt onto a sustainable path) over the medium-term.

More Things to Worry About

The morning after the election, I wrote a post on our country’s long-term priorities. #3 on the list was retirement savings.

While the retirement savings problem predates the current crisis, the decline in the value of financial assets has made it tougher all around. One reader pointed me to a particular aspect of the problem I wasn’t aware of. Earlier this year, the Pension Benefit Guaranty Corporation (PBGC) shifted its asset allocation from 15-25% equities to 55% equities. The PBGC, which is part of the federal government, guarantees private-sector pension plans and is funded by premiums paid by those plans; if a company’s pension fund goes bankrupt, the obligations are shifted to the PBGC. This, as Zvi Bodie and John Ralfe pointed out back in February, is particularly problematic for the PBGC, because then an economic downturn has a triple impact on the fund: first, as equity values fall, company pension funds face larger funding gaps; second, as companies go bankrupt, their pensions get shifted to the PBGC, increasing its liabilities; third, as equity values fall, the PBGC’s assets fall, increasing its funding shortfall. Bodie and Ralfe argue that increasing the proportion of equities may increase the expected return, but only at the cost of increased risk, in any timeframe.

(By contrast, because the Social Security Trust Fund is invested in Treasury bonds, it should be doing OK. Long-term concerns about Social Security funding, of course, are still valid.)

Emerging Markets Snapshots

GM, mortgage restructuring, and the G20 have sucked up most of the attention recently, but the crisis continues to take its toll around the world. A few vignettes:

  • In Ukraine, industrial production in October fell by 7.6% from September (that’s not an annualized rate) and 19.8% from October 2007.
  • Russia’s second-largest coal company reported that its Q4 sales would be only one-third the planned level – and that payments from its steelmaker customers since September were only 21% of the value of shipments.
  • Credit default swap spreads on Greek sovereign debt are up over 160 bp – higher than at the previous peak in mid-October. (Note that Greece is in both the EU and the Eurozone.)

On the “plus” side, Pakistan and the IMF agreed on a $7.6 billion loan, ensuring economic stability in a particularly important part of the world – at least for a few months. Pakistan’s government says they need a total of $10-15 billion.

Mortgage Restructuring Is Not Enough

Let’s be honest with ourselves.  Even if the outgoing Bush team or the incoming Obama administration can work out a scalable nationwide mortgage restructuring scheme, we will still have a housing problem in the U.S..  Specifically, we should expect a high proportion of restructured mortgages to default again within a year.  In a piece that appeared on Bloomberg this morning, Alex Stricker and I suggest that a more centralized process is needed to manage the flow of foreclosed properties onto the market, and we discuss some alternative ways to implement this idea.

There may be better ways to do this and we are completely open to suggestions – please post as comments here.  We only insist that this is one dimension of U.S housing that needs further careful consideration.

Proposed Solutions to the Securitization Problem

We’ve gotten a number of questions about mortgage restructuring proposals, both in email and in comments. One reader asks: “How does one get around the securitization problem?  The Treasury seems to be able to change rules with the sweep of a wand lately, why not the REMIC [Real Estate Mortgage Investment Conduit] rules too?” Tom K also raises this issue in a comment.

I doubt that Treasury could unilaterally modify the rules governing the securitization trusts (in which a loan servicer manages a pool of loans on behalf of the many investors who own a share of that pool). Despite the ease with which Treasury seems to be flinging money around and the, um, liberties they seem to be taking with the terms of the TARP legislation, Treasury can’t really force anyone to do anything, legally. For example, Treasury has no authority to force a bank to accept a recapitalization, which (in my opinion) is why the recapitalization terms are relatively generous: they did not want to take the risk of the core banks turning them down.

The securitization issue raises similar legal barriers. A bit of background: To generalize, the loan servicer has a legal obligation to act in the interests of the investors in the loan pool; if it doesn’t, it opens itself up to lawsuits. Now, if all of the investors have the same interests, and the service restructures a delinquent mortgage in a way that provides more value than a foreclosure, then everyone is happy. There are (at least) three problems, however. The first is a coordination problem: getting all of the investors to agree that they are happy. The second is a problem of conflicting interests: because a typical CDO is structured so that some investors get the first payments and some get the last, a mortgage modification could help the interests of some investors and hurt the interests of others. The third is a tax problem: for technical reasons, a mortgage restructuring could be treated as a new loan, which creates a tax liability (this is a REMIC rule).

This is why I think this will require legislation, and even that could be challenged as an expropriation of property.

  • The Center for American Progress has a proposal to modify the REMIC rules and an explanation of why they think it would work.
  • John Geanakoplos and Susan Koniak have another proposal to use government-appointed blind trustees to make restructuring decisions and thereby protect servicers from liability to their investors (this would also require legislation).
  • Thomas Patrick and Mac Taylor have yet another proposal (thanks, Tom K) to use Fannie Mae and Freddie Mac debt to pay off all performing securitized mortgages at face value and refinance them with 30-year, fixed-rate mortgages. (I don’t fully understand this plan: it seems to involve paying face value for $1.1 trillion in mortgages, many of which are certain to default in the future, and forcing banks to pay face value for $400 billion in mortgages that are already delinquent, and also forcing banks to accept some of the losses on the government’s $1.1 trillion. But I don’t want to draw conclusions based on a newspaper description.) This one shouldn’t involve legal issues, but it will require legislation, because of the amount of money involved.
  • Then there’s the idea of allowing bankruptcy judges to modify mortgages on owner-occupied houses, which would also protect the servicer from liability. But this would be a slow, inefficient way of solving the problem.

If there are other ideas out there, please suggest them.

Systemic Risk, Hedge Funds, and Financial Regulation

One of our readers recommended the Congressional testimony by Andrew Lo during last Thursday’s session on hedge funds. Lo is not only a professor at the MIT Sloan School of Management, but the Chief Scientific Officer of an asset management firm that manages, among other things, several hedge funds. He discusses a topic – systemic risk – that has been thrown around loosely by many people, including me, and tries to define it and suggest ways of measuring it. He recommends, among other things, that

  • large hedge funds should provided data to regulators so that they can measure systemic risk
  • the largest hedge funds (and other institutions engaged in similar activities) should be directly overseen by the Federal Reserve
  • financial regulation should function on functions, such as providing liquidity, rather than institutions, which tend to change in ways that make regulatory structures obsolete
  • a Capital Markets Safety Board should be established to investigate failures in the financial system and devise appropriate responses
  • minimum requirements for disclosure, “truth-in-labeling,” and financial expertise be established for sales of financial instruments (such as exist, for example, for pharmaceuticals)

Lo also has a talent for explaining seemingly arcane topics in language that should be accessible to the readers of this site. The testimony is over 30 pages long, but it’s a good read. Here are a couple of examples to whet your appetite.

Continue reading “Systemic Risk, Hedge Funds, and Financial Regulation” →