September 21, 2008
Let me begin with the point on which I am in complete agreement with Treasury Secretary Henry Paulson and Federal Reserve Chair Ben Bernanke-- it is hard to overstate just how scary this week's developments in financial markets could be.
Prior to the establishment of the Federal Reserve in 1913, the United States would periodically experience events that are often referred to as "financial panics." Rick Mishkin noted that these usually occurred after a recession began and a major financial institution had failed, and were characterized by a sharp increase in the spread between the interest rate paid by higher risk versus lower risk borrowers.
The graph below plots the difference between the interest rate on 3-month certificates of deposit and 3-month treasury bills. The alarming behavior of this spread began in August 2007, when it spiked up to 243 basis points, higher than anything seen in the previous 20 years. Aggressive responses from the U.S. Federal Reserve and other central banks last August succeeded in bringing banks' borrowing costs back down, though we saw subsequent comparable spikes in December 2007 and March 2008.
But those events would barely be noticed when compared with what happened last week. Following the bankruptcy of Lehman Brothers, the spread reached 527 basis points on Thursday.
Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply can not be expected to function in this kind of an environment. Lending institutions that had been solvent before this week would not remain so for long if this situation were to persist. Only the safest customers could be expected to obtain loans, and only after paying very high interest rates.
To respond to this situation, Treasury Secretary Paulson has proposed a plan whose key feature is the authorization to spend $700 billion to purchase troubled assets from financial institutions.
By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in "other loans", $30 billion from the Bear Stearns deal, and $100 billion in "other Federal Reserve assets". That $455 billion total does not include this week's $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.
My primary criticism of these previous unconventional actions by the Fed is that they are better characterized as fiscal policy rather than monetary policy. They unquestionably represent an implicit potential commitment of Treasury dollars. If the latest $700 billion Treasury proposal were to take these assets off the books of the Federal Reserve and put them onto the Treasury's balance sheet, and have Paulson rather than Bernanke be the guy who makes these calls of when and where to put the taxpayers at risk, I would be all for it.
But I gather that instead the $700 billion is construed to be in addition to the comparable sum that's already been committed by the Federal Reserve. And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility.
And do you think that this week's $700 billion is going to be the last such request?
Granted, these numbers I've been adding up represent loans or guarantees, which are something very different from outright expenditures. Actual losses should only amount to a small fraction of this sum. But even a small fraction of $6 trillion is still a huge number.
Before we can solve these problems, we need to agree on what caused them. In a narrow mechanical sense, that seems straightforward to answer. Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.
But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place? My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else. The loan originators offered unsound loans, but still made big profits because they sold those bad loans off to the loan aggregators. Fannie and Freddie earned themselves nice income while the loans were performing, but the taxpayers absorbed the loss when the loans went bad. CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour.
And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else's.
How you get from our current situation to one where financial institutions are adequately capitalized is of course one of the key challenges of the moment. We can't just impose tougher requirements and expect everybody to extricate themselves from the mess they're in without some federal contributions. But I do not see that a clear vision of exactly what is expected and required, in the way of modified capital standards and risk management procedures, for any institution that receives federal assistance is a key part of any of the proposals. And it should be.
Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there's a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we've been fighting. But I think the uncertainty itself may be even more destabilizing.
Before the taxpayers are asked to commit such sums, we are owed a coherent and compelling explanation of why this kind of problem is never going to occur again.
There's lots of other good analysis out there in the 'sphere. Brad DeLong has a nice exposition of the conditions in which a government intervention could be successful and desirable, and when it could fail. Calculated Risk offers details of how he would run the bailout. Yves Smith and Paul Krugman ,  express their reservations about the Paulson plan. Representative Barney Frank (D-MA) wants to see a cap on executive compensation be part of any bailout. For some comic relief (and heaven knows we could use some at the moment), see the Washington Post (hat tip: Greg Mankiw).
And your thoughts, dear readers?
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Tracked on September 21, 2008 04:11 PM
It seems to me that every bailout that comes along is supported by some because they are irrationally afraid of what may happen if there is no bailout.
There is always mumbling about taking steps so that such problems do not happen again. But do you really believe that politicians will be able to fix the system so that we eliminate future crises?
If not, then will every future crisis get a bailout? That does not sound like a free market. I thought an important principle of a free market was to allow creative destruction, so that the strong survive and the weak fade away, thus leading to a more robust and more efficient market.
Do you really think an endless series of crises, and political "solutions", will build a better system than a free market? If so, you have a lot more faith in politicians than I do.
Posted by: ErikR at September 21, 2008 03:15 PM
I suspect preventing such problems in the future will be difficult without some way to reform our political structure so that it is not so responsive to campaign contributions and to lobbying by the financial services industry. In both these sectors the financial services industry has been the number one spender for the years covered by Open Secrets (see opensecrets.org for details). The results of this pattern have been a multi-decade shower of favorable government policy toward financial services. To name only a few, we've had the "too big to fail" doctrine combined with a no-questions asked policy as the biggest financial institutions have developed balance sheets ten times the size they used to have in the 1980s; we've had preferential treatment of capital gains over the taxation of regular income; we've had repeated investor bailouts (Mexico, Korea, LTCM and others); we've facilitated the influx of cheap capital from Asia while permitting monstrous trade deficits to develop, a pro-Wall Street anti-Main Street policy bent if there ever was one; we made no attempt to 'lean against' or contain asset bubbles and indeed congratulated the Fed on its successful promotion of high asset prices; we've permitted the growth of financial innovation without oversight while simultaneously not ensuring that failures in, say, the derivatives market were ring-fenced away from the Federally insured portions of the market; we seem to have made keeping the stock market from falling a major goal of the Federal Reserve and the Treasury; we keep permitting/encouraging the evasion of what few regulatory standards we have, including off-balance sheet treatment of debt and leverage limits; etc., etc. To have such consistently favorable policy treatment capped by the Paulson bailout as proposed is a sort of masochistic climax to the process. However, as long as we allow public policy in the USA to be auctioned off via industry campaign contributions and lobbying (and the same process can be observed, say, in healthcare, agriculture, etc., etc.) the many can expect to continue to be exploited, via the government, for the benefit of the few.
P.S. I don't understand how economists can be so wrapped up in economic data, graphs and equations and expect to learn much while remaining so (comparatively) quiet on the topic of how government policy is set and its impact on economic performance. It's as though there's a huge 'dark planet' that is distorting the movement of the observable cosmic bodies but the astronomers refuse to pay more than passing attention to it.
Posted by: Friedrich von Blowhard at September 21, 2008 03:15 PM
Excellent analysis. Why can't you be voting on this instead of the economic semi-literates in Congress? Our representatives are being stampeded into supporting this out of fear that they'll cause a depression if they don't.
As your tally shows, the USG has already committed to hundreds of billions in bailout money, trillions of dollars if we count the Fannie/Freddie loan guarantees. This $700 billion would be IN ADDITION. Pretty soon our credit masters in Asia are going to refuse to finance our deficits any longer, and then the US Treasury will be sucked into this toxic debt swamp.
Posted by: Invisible Hand at September 21, 2008 04:00 PM
How did we come to this? In my opinion, the main reason was conditionally-easy monetary policy. Beginning in 1987, but perhaps worst from 1998, the Fed eased whenever a crisis theatened. This meant that the most extreme risks in risky assets were never realised, while the saver in interest-bearing assets paid for that insurance and was discouraged from saving. Worse, it was the size of the change in asset prices that prompted easing, not the level to which they had fallen. The result was a build up of what I call double-sided, cumulative moral hazard. You know, "buy on dips", "you cannot lose on a house in the long run" etc. I presented some statistical evidence of this pattern of investor behaviour on my blog in June at http://reservedplace.blogspot.com/2008/06/greenspan-put.html . Heaven knows what it looks like now.
Lax lending standards and a ready market for loans followed - the brushwood built up because the bushfires were always quickly extinguished.
The significance of this account of how we got here for the future is that ordinary mortgage borrowers and stock investors must suffer enough losses to change the financial culture; to make the US (and UK) more like Germany. Unfortunately, at the moment, that is politically taboo, so I fear that things will have to get worse before they get better (eg high inflation).
Posted by: RebelEconomist at September 21, 2008 04:08 PM
My thanks for your addressing this - I have been eagerly awaiting your thoughts.
My central concern is this - now that we collectively seem to have agreed that government bailouts of large financial institutions are essential, the key question is whether the eventual total required to stabilize the balance sheets of all sufficiently large financial institutions is manageable by the government or not. Have we allowed institutions to become so leveraged that their aggregate balance sheets are now so large, and so composed of overpriced assets, that the situation has the potential to degrade government balance sheets too severely before it can be fixed?
In particular, how could we come up with a back-of-the-envelope estimate of the total required before the whole situation bottoms out and is stabilized? I don't know but here are a few thoughts in that direction.
The prototypical institution has a current leverage factor of 20-70 (see here for examples from around the world). Presumably, to all be safe and happy, we should again have all important financial institutions with more like 10-12 leverage ratios. Thus the amount of money required just to bring leverage back to safe levels is something like 5-10% of the total size of the aggregate balance sheet of all financial institutions.
However, this understates the problem, since those balance sheets in many cases contain assets that are probably still overvalued. For example, the stock market is still only at the historically average P/E (see eg here) of around 17, and is presumably more likely to bottom out in the range of 5-10 characteristic of the ends of other serious bear markets. Likewise, the housing market has not by any means fully corrected, being perhaps something like half way from bottom to top.
It is hard to know how much these factors will weigh on balance sheets eventually, since obviously the problem is highly non-linear - the assets of institution X include loans to institution Y, and the value of those loans depend on what happens to institution Y, and this gets recursed many times around the global economy. It's not at all clear (at least to me) what is the relevant multiplier that should be used to translate losses in stocks or mortgages into overall balance sheet terms once all the negative feedbacks have played out.
Still, I might be comfortable speculating that the lower bound of what is required to ultimately repair financial institution balance sheets is 10% of the aggregate balance sheet size, and the extreme upper bound is somewhere like 50%. But then the question is what is the size of those balance sheets compared to the economy and government revenues?
For commercial banks, the answer seems to be about $11 trillion in assets (cf to US annual GDP of about $14 trillion). However, it's clear that "financial institution too important to fail" includes many things besides commercial banks - insurance companies, big hedge funds, investment banks, etc, etc.
So the question is, how could one go about roughly quantifying all those non-bank balance sheets? What order of magnitude are we talking about here?
Posted by: Stuart Staniford at September 21, 2008 04:23 PM
«How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place?»
I have been asking myself for a few years, as I have seen bubble after bubble exploding, and wall of money feed each bubble and then go on to the next (the ultimate bubble is the t-bill one).
The thing that I noticed over the past several years was that jut about any "financial" quantity changed trend in 1995. From a gently sloping trend of growth matching or being slightly higher than GDP, the trend changed to growth much faster than GDP; a set of "hockey sticks".
Some long term graphs, first the most striking:
Then growth of M3 over decades:
Then growth of foreign USA debt:
Then some "relevant" (blue chip) stock prices:
Even IBM's stock price took off in 1995 after a near bankruptcy and losing its domination of IT:
and curiously GE started to do really well only in 1995:
So something important happened in 1995. From the graphs it looks like that it was a gigantic expansion in the availability of "money", and in particular of short term credit.
The only plausible explanation that I found is amazingly from a gold bug (who was inspired by Luskin...):
«The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad money'' with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let's look at the facts.»
Now, I am fairly sure that it all began in 1995, less sure that the explanation above is the main one, but that's the best I found.
Anyhow, once the rules were changed to allow for ever increasing leverage, the system was on a hockey-stick trajectory, and one that got helped, for example with other relaxations:
especially as the financial sector became an ever larger percentage of GDP, stock market valuation and corporate profits, fueled by the seemingly endless availability of credit at a very low cost.
If there is another explanation for the sudden boom in credit availability and thus zooming leverage that started in 1995 I'd like to know.
«My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else.»
Sure, but this (the eternal sharecropper conundrum) was always the case. Yet either the problem was controlled or when it was not it had much smaller consequences (even S&L was not quite as bad). The real enabler has been the colossal credit explosion of 1995.
«And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements.»
But as someone wise said, and as you implicitly argue by saying that one important issue was "the gains went to one group", without a reform of executive compensation it is all futile.
Also, more transparent accounting is a very hopeful dream, if there is no vested interest that wants it, and higher capital requirements go against the grain of market-based politics of the past few decades, and important vested interests connected to that.
The occasion for the number of crazy bubbles has been the colossal credit explosion of 1995, and this has interacted with crazy compensation structures, but ultimately the root cause has been and is the capture of the regulatory and political process by vested interests, and that has happened because USA voters are themselves corrupt, unwilling to engage themselves in the running of their country, but all too willing to join in as accomplices in the pyramid schemes of those vested interests.
As two sayings go from very different centuries go, citizenship is not a spectator sport, and the price of freedom is eternal vigilance, and in a functioning democracy the enablers of all corruption are the voters.
Posted by: Blissex at September 21, 2008 04:24 PM
«Pretty soon our credit masters in Asia are going to refuse to finance our deficits any longer,»
It has occurred to me that while so far the Chinese leadership were clearly right that it was in the interest of China to provide "vendor financing" to the USA was tantamount to providing export subsidies and imposing import tariffs, as this encouraged USA companies to transfer whole industries to China, making it leap from North Korea to South Korea in one generation, the goal has largely been accomplished...
But now it may be in the best interests of the
Chinese to pull the rug from under the USA financial system and economy.
I have read some paper that says that right now most of China's growth rate is coming from internal investment and consumption, not exports.
If that's true, a huge USA recession and a collapse of the dollar would drive down both the price of raw materials/fuels and the price of raw
material/fuel assets, and the chinese economy in the future is probably going to be more constrained by the availability of raw materials than of export markets: its internal market may be able to sustain its growth, if enough raw materials/energy are available.
The chinese government might decide that they should stop lending to the USA, and use the dollar reserves that they have to buy up a lot of mines, agricultural land, etc. around the world at firesale prices.
After all USA corporates have already transferred a lot of their most critical production capacity and technology to China, under the control of the CCP, and that's probably good enough for China, and they no longer need to subsidize the transfer of productive capital from the USA.
It has surely not escaped the notice of the chinese leadership that it is only their loans to the USA that are keeping the USA financial system alive, USA consumption stable, and natural resource prices high.
The chinese leadership probably have thought this ahead for a while, and as soon as they think that exports to the USA and transfers of productive capital and technology from the USA need to be subsidized anymore, they are going to pull the plug, and buy lots of nice natural resource assets. Which they have been doing already even at the current high prices.
Posted by: Blissex at September 21, 2008 04:32 PM
«evidence of this pattern of investor behaviour on my blog in June at http://reservedplace.blogspot.com/2008/06/greenspan-put.html»
Ah we no longer have just Greenspan Puts, we now also have Bernanke Swaps; not just free put options on the market indices thanks to Alan, but also free credit default swaps thanks to Ben.
«only at the historically average P/E (see eg here) of around 17»
The historically average PE is 12 (as it makes sense, it means about 8% ROI nominal). It is 17 only if you include the 1995-2008 period which is arguably just the first bull half-cycle of a full cycle.
«the lower bound of what is required to ultimately repair financial institution balance sheets is 10% of the aggregate balance sheet size»
Hehehe, considering that the GSEs were getting away with 1%...
«too important to fail" includes many things besides commercial banks»
GE has asked to be included in the list of stocks that cannot be shorted because it quite correctly points out that GE Financial is the core of its operations.
«What order of magnitude are we talking about here?»
More than you think. First of all there is the small problem of the losses to be absorbed in the current housing markets, where there is an overstock of around 3m homes, and many of the rests traded at about 3 times their trend value. That is at least $1T and probably around $2T. Filling that hole bring the financial system to roughly zero capital, and then you have to recapitalize it with another $1-$2T (commercial banks are the least of the problem right now, but next year, when non-subprime starts hitting...).
In any case Paulson knows best and his plan is to get house prices to go up again and to substantially increase systemic leverage, by hiding some of the existing leverage in Treasury SIVs.
Fortunately the chinese are known to be eager to lend several trillion dollars to the Treasury at negative real interest rates, and to accept currency risk too. :-).
Posted by: Blissex at September 21, 2008 04:46 PM
«the many can expect to continue to be exploited, via the government, for the benefit of the few.»
The many can vote (quite a few don't bother) and could make campaign donations.
But for the past few decades the many have enthusiastically voted for all of the above, repeatedly. America is still a democracy and if the many vote for that, it gets (gleefully) done.
Posted by: Blissex at September 21, 2008 04:51 PM
To my elected representative,
Please STOP the lunacy that is the proposed $700 billion bailout of the financial industry. Make no mistake, this is not a bailout of the citizens you were elected to represent. This is a bailout of the corporations from whom you've accepted money and other support, using money you are taking from the citizens you were elected to represent...and from their children...and from their children.
The citizens you were elected to represent are substantially protected from major changes in the financial industry via FDIC, SIPC, and excess SIPC insurance on their bank and brokerage accounts. Only those citizens who freely chose to invest in financial companies will suffer investment losses, just as those did who freely chose to invest in technology companies before the dot com bust. That's the way it should be.
The financial companies in trouble are the ones who freely chose to make bad decisions about what they invested in, and about how they managed risk and cash flows. They deserve to fail so that a new generation of financial companies which are better managed can flourish, making it much less likely that the current situation will ever repeat. The financial companies in trouble do not deserve to be gifted, or even "loaned," taxpayer money so that they can continue their past mistakes. If they are able to avoid failing by changing quickly into a next-generation financial company WITHOUT a taxpayer-funded bailout, then they have proven they deserve to survive. Whether new or re-born, we need better managed next-generation financial companies in our economy.
You are free to use the arguments made here to publicly justify your vote against the proposed $700 billion bailout.
I am asking you to vote AGAINST the proposed $700 billion bailout, in any form. I will record which of my representatives vote FOR the bailout, and will vote AGAINST them and their parties in the November election. I am also urging my friends, colleagues, and community to do the same.
Posted by: David at September 21, 2008 05:01 PM
Those of us who are strongly opposed to this bailout have several options:
1. We can talk about conditions that should be imposed before the bailout is accepted.
2. We can develop some alternative way to stabilize the market without the bailout.
3. We can refuse to make any recommendation to the Congress about what they should do.
In my mind, option #2 is the only responsible one. # 3 is a withdrawl from engagement. #1 is a trap because the only alternative to surrender to Paulson is unacceptable - do nothing. Paulson is too experienced at this kind of negotiations to lose that game. His opposition is far from united, so no stable, strong counterperspective will appear. Lots of ideas have been floated - therein lies the problem.
#2 is where the knowledge of the blogers here lie. However, there is no rush to explore this option.
Posted by: W. Raymond Mills at September 21, 2008 05:29 PM
"And do you think that this week's $700 billion is going to be the last such request?"
If Paulson buys derivatives -- which given the wording of his request -- seems likely, Congress will never need to authorize more funds. The more recent vintages of CDOs have been selling credit default swaps (i.e. selling insurance on mortgage assets). Their only protection from huge liabilities is the reinsurance purchased from MBIA, AIG etc -- and I don't see how Paulson's plan solves the fact that they can't afford to pay. Thus it is entirely possible that the government buys a CDO today and ends up owing billions of dollars in the future. In short derivatives have the property that they can be balance sheet assets today and balance sheet liabilities tomorrow.
To make sure that he never needs to go back to Congress for more money, our Treasury secretary will just need to make sure that the value of the portfolio he holds deteriorates.
Posted by: AnonCC at September 21, 2008 05:31 PM
This was a great post and it was followed by many lucid and terrific comments. I agree that the root cause was the structure of the system that allowed gains to go to one group and the downside risks to another group. In the morass of political philosophies that (though diametrically opposed) never seem to be able to be disproven, every argument I have with anyone seems to end with me speaking about market failure. Certainly, I yearn for as much freedom as possible, but I cannot cease to hope that government can address the market failures that persist over and over in human society. The invisible hand works often, no doubt, but I think your analysis provides backup for my instinct about market failure: that it was perverse incentives throughout the system that thwarted the chance of the invisible hand to provide an efficient outcome. Unfortunately, systems are complex, and humans want simple answers. It either is free market (almost to the point of anarcho-capitalism) or inefficient socialism. All we can do is try our best at this point, but I am not very hopeful.
Posted by: Anonymous at September 21, 2008 05:54 PM
Over at "Why Paulson is wrong" (http://voxeu.org/index.php?q=node/1670) you find a far saner approach to resolving the current financial crisis. I quote
"When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices ï¿½ the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity. The old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt holders can agree to trim the face value of debt in exchange for some warrants.
Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century."
Read the entire article. The approach outlined by the author would cost the taxpayer nothing (at least far less) and work better than the RTC II endorsed above. Furthermore it would impose the resolution costs on those who profited from this fiasco... And without putting millions of jobs at risk.
The notion that we have to pay off those crying "wolf" the loudest is both wrong and unconscionable.
Posted by: Peter Schaeffer at September 21, 2008 06:02 PM
Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply can not be expected to function in this kind of an environment. James D. Hamilton
I loan my money to these financial intermediaries at a little over 2%. So do you.
Now, just how is it that they can't make money?
I'm not an economist. Can someone help me understand how a few days of 0% T-Bills which generated -- at the margin -- the unusual TED(?) spread will have any effect on bank earnings?
So; a few hedge funds in the Cayman Islands -- there wouldn't have been bank demand if the hedgies hadn't wanted the money, right? -- had to pay a few hundred points more than they'd like. What's the big deal?
Posted by: Ellen1910 at September 21, 2008 06:06 PM
Also see "More and different - including a debt-for-equity swap for the financial sector" by Willem Buiter (http://blogs.ft.com/maverecon/2008/09/more-and-different-including-a-debt-for-equity-swap-for-the-financial-sector/) for a different and better plan.
Buiter would impose large and mandatory debt-to-equity swap on the financial sector. Overnight, balance sheets would be AAA and normal market operations could resume.
Note that no (at least far less) taxpayer money would be needed using his concept.
Posted by: Peter Schaeffer at September 21, 2008 06:07 PM
At the end of your explanation of what caused these problems, you write: "CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour." But, to repeat a question I remember you asking: why did these arguably experienced/sophisticated stockholders/investors buy these instruments? More specifically, why did these big-league players misprice the risk so badly?
Posted by: Phil Rothman at September 21, 2008 06:14 PM
John Hussman makes an excellent point:
The appropriate solution is not for the government to replace the bad assets with public money, but rather for the government to execute a receivership of the failed institution and immediately conduct a "whole bank" sale -- selling the bank's assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.
The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost.
For example, consider Morgan Stanley's balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?
Posted by: ErikR at September 21, 2008 06:17 PM
I'd argue that academic Bernanke is in so far over his head that he can't see the surface.
Channelling Bagehot, Dr. B's been hard at work trying to separate the economy management function of monetary policy from the liquidity provisioning function of monetary policy. What we saw last week was the abject and total failure of Bagehot's dictum to "lend at a penalty rate to solvent but illiquid banks that have adequate collateral." That may be a decent start in managing a crisis, but the Fed made a mistake of historic dimensions in NOT providing adequate liquidity to the financial system.
Essentially all of the money supply liquidity that would have been provided by the TSLF over the past six months was immediately sterilized by Fed open market sales of securities. This was necessary to maintain control of the FF rate but at the cost of completely losing control of the financial system.
What do the economics textbooks suggest would be the likely outcome of only allowing the monetary base to grow at a miserly 2% over the 6-9 months of the worst credit crisis in the past 50 years in the U.S.? I think last week was the answer, and if I have a vote I'd cast it for impeaching Dr. B for gross mismanagement ASAP.
Posted by: Anarchus at September 21, 2008 06:22 PM
Isn't Barney Frank a piece of work?
The end of the world looms large, and BF is worried about... executive compensation?!?!?!
Even more humorous, where was BF when Franklin Raines was getting paid huge sums, not to correct the problem, but to create it???
With people like BF an integral part of the process, we're doomed.
Posted by: JohnnyBucks at September 21, 2008 06:34 PM
Rebel Economist has it exactly right. The Fed's response to every economic weakness is screw the savers by artitificially depressing interest rates. Wonder why there is so much debt & so little savings.
A modest proposal: No member of the management of a company receiving gov't bail-out money shall be allowed to receive annual compensation exceeding $175,000.
Posted by: algernon at September 21, 2008 07:28 PM
As bad as the current proposed plan is, the most offensive part is not the the lack of any quid pro quo in the deal, or of any structural reforms, or of any punishment for, as Teddy Roosevelt called them, "the malefactors of great wealth." No, the most offensive part of the bill is Section 8, which reads: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."
In other words, not only are we handing Paulson a $700 billion check to do with as he pleases, we're eliminating any potential for any oversight whatsoever. This is the pure spirit of the Bush administration in action, and any bill containing such a provision ought to be shut down immediately. As Yves Smith rightly says, this is nothing less than a financial coup d'etat.
Posted by: AndrewBW at September 21, 2008 07:31 PM
The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost...Why on earth would Congress put the U.S. public behind these bondholders?
There seems to be no dispute that bondholders would take a bath in the event of receivership/bankruptcy. The point is not to protect bondholders but to try minimize the number of banks going under in order to stem the contagion (whether you agree with this or not). It's just an unfortunate consequence that bondholders dodge a bullet.
There is no access to "the cushion" except in receivership - unless it's being suggested that as a one-off recapitalization of the industry, all bondholders to insolvent banks be informed that, surprise, your bond has become a mandatory CB and is now equity, thank you very much. Of course that would create its own kind of hell...
Posted by: RAR at September 21, 2008 07:44 PM
The proposal for debt to equity swaps or any form of bankruptcy is a remedy for a company that cannot meet its current obligations because its expenses exceed its revenue. Today, firms are driven to the wall because of suspicion about future inability to perform, not current.
None of the proposals I have seen so far in this thread, including the Paulson proposal of purchasing toxic contracts, address the importance of the unknown future.
My proposal, to quarantine bad debt until the contagion is past, does address the unknown future by removing the most toxic contracts from the market temporarily. When the dust settles, the quarantined contracts can be reintroduced to the market and their value tested by sales.
Posted by: W. Raymond Mills at September 21, 2008 08:03 PM
Phil Rothman asks, "why did these arguably experienced/sophisticated stockholders/investors buy these instruments? More specifically, why did these big-league players misprice the risk so badly?" Best answers I could give would be the principal-agent problems between fund managers and fund beneficiaries and a naive reliance on flawed ratings by the supposedly sophisticated investors. Again, good readers, any better answers to Phil's question?
Posted by: JDH at September 21, 2008 08:12 PM
Raymond, I don't understand what you mean by "quarantine bad debt". We're talking about assets on the institutions' balance sheets. If assets are quarantined, how do the liabilities get paid? And why do creditors roll over those debts if the assets are quarantined?
Posted by: JDH at September 21, 2008 08:17 PM
Phil Rothman says: "More specifically, why did these big-league players misprice the risk so badly?" Answer - because they extrapolated recent trends. Mortgage failures were rare events until they became less rare. And because everybody else was making money doing it.
Having said that, many posts in this thread and others pointed after-the-fact to warning signs that were ignored.
I agree that punishment is desirable. The best way punishment can be administered now is to leave the system as it is as much as possible while still avoiding a melt-down.
Posted by: Anonymous at September 21, 2008 08:25 PM
JDH: Great post and a nice diversion from the recent political discussions which have taken over this blog recently. I agree that it was a principal / agent problem with bank CEOs and fund managers playing with Other People's Money (taxpayers included). Now, transparency is paramount to resolving this issue. In the case of Lehman, there was a good reason that potential buyers passed on the deal after examining the books...the balance sheet was more toxic than was being publicly disclosed. After Lehman everyone assumes that all of the broker / dealer liabilities look like that of Lehman and the remaining dealers have zero credibility. I agree with your call for everyone to put the cards on the table. Obviously, the big fear is that we "can't handle the truth".
Posted by: TheCaptain at September 21, 2008 08:57 PM
Me I like to start with facts.
"Shock Forced Paulson's Hand: A Black Wednesday on Credit Markets; 'Heaven Help Us All'" by Deborah Solomon, Liz Rappaport, Damian Paletta And Jon Hilsenrath in the Wall Street Journal on September 20, 2008:
* * *
The panic had formed quickly. On Monday morning, Lehman Brothers Holdings Inc. filed for bankruptcy protection. On Tuesday, the government took control of AIG. ...
On Monday and Tuesday ... investors flooded the safest investment they could find, short-term government debt. This drove the yields of short-term Treasury bonds to zero, meaning investors were willing to accept no return on their investment if they could guarantee getting their money back.
On Tuesday, the once-$62.6 billion Reserve Primary Fund, a money-market fund, saw its value fall below $1 a share because of its investments in Lehman's short-term debt. Money-market funds, which yield a bit more than basic cash accounts by buying safe, short-term debt instruments, strive to keep their share prices at exactly $1 -- and "breaking the buck" isn't supposed to happen.
* * *
Trust in financial institutions evaporated Wednesday when investors stampeded out of money-market funds. Putnam Prime Money Market Fund said it had shut down after a surge of requests for redemptions. In three days, the Fed had pumped hundreds of billions of additional cash into the financial system. But instead of calming markets and helping to suppress interest rates, short-term interest rates had gone haywire. Most strikingly to some Fed staff, its own federal-funds rate, an interbank lending rate managed directly by the central bank, repeatedly shot up in the morning as banks sat on cash. ...
Fed staff discovered that one reason the federal-funds rate was behaving so abnormally was because money-market funds were building up cash in preparation for redemptions, leaving hoards of cash at their banks that the banks wouldn't invest. U.S. depositary institutions on average held excess reserves of $90 billion each day this week ... This is cash the banks hold on the sidelines that does not earn any interest. That compares with an average of $2 billion, he says, noting he estimates banks held $190 billion in excess cash on Thursday, as they feared they'd have to meet many obligations at the same time.
Through Wednesday, money-market fund investors -- including institutional investors such as corporate treasurers, pension funds and sovereign wealth funds -- pulled out a record $144.5 billion, according to AMG Data Services. The industry had $7.1 billion in redemptions the week before.
Without these funds' participation, the $1.7 trillion commercial-paper market, which finances automakers' lending arms or banks credit-card units, faced higher costs. The commercial-paper market shrank by $52.1 billion in the week ended Wednesday, according to data from the Federal Reserve, the largest weekly decline since December. ...
Officials also watched as the market for mortgage-backed securities disappeared. The government's seizure of Fannie Mae and Freddie Mac, they had hoped, would reinstill confidence in this market. But yields on mortgage-backed bonds were rising as trading evaporated, nearing levels reached before the government's takeover, which would likely translate into higher mortgage rates for consumers. Borrowers with adjustable-rate mortgages, meanwhile, were in trouble: The cost of many such loans is based on Libor, or the London interbank offered rate, which had soared as banks stopped lending to one another.
Posted by: Fat Man at September 21, 2008 10:48 PM
Now some observations:
There were at least three regulatory problems that I could see.
First. Money market funds are bank account substitutes that have been allowed to exist without capital to take the first dollar of loss. They are not unregulated entities. The SEC regulates them as mutual funds. But, in a fund capital is not necessary because the customers assume the risk of loss.
We have been whistling past this grave yard for years. The funds originated in the 70s because banks were not allowed to pay interest on checking accounts, and brokerages were not allowed to do banking.
It is past time to fix this problem by recognizing the truth. MMFs are banks and need to be regulated as such.
Second. Credit default swaps are not swaps. The parties do not have opposing exposures (e.g. fixed rate assets and floating rate liabilities). They are insurance contracts and need to be regulated as such, with reserve requirements capitalization, etc.
Due to jurisdictional issues and resource inadequacies state insurance regulators never tried to tackle the problem. Further AIG had a long history of playing a tough game against them.
At the very least financial guarantee insurances should be federally regulated.
Third. the separation between banking and the securities markets is a relic that needs to be buried. The Fed has recognized this by making Goldman and Morgan Stanley BHCs. The whole regulatory apparatus needs to be rebuilt. Pure traders, like hedge funds, can be left outside, but investment banks are banks.
Posted by: Fat Man at September 21, 2008 11:08 PM
You guys are spending too much time "debating" a proposal that should be sent to the cows who will have no trouble identifying the bullshit. There is no need to try to assess the merits of bullshit. Any self-respecting cow will say, "This Stuff Stinks."
As far as Paulson goes, I suggest he take some time off to grow some hair, otherwise he will always be known as a bald faced incompetent liar!!!
As for real solutions, relief is spelled L-A-R-O-U-C-H-E....
You know where to find him if you want to survive!
Posted by: Gerald Pechenuk at September 21, 2008 11:45 PM
The Paulson plan is socialism: national socialism.
Nouriel Roubini has proposed a very reasonable plan. Of course, I am biased because I proposed it 18 months ago.
Basically, my proposal came down to this. If the Feds pay a portion of the reset of mortgages that are presently at risk, say one-third, with homeowners agreeing to pay one-third, and mortgage holders giving up one-third, we could probably keep most people in their homes. With certainty restored to mortgage payments, certainty would be re-established in the mortgage securities market. Some paper would be worthless. Some would be whole. Some would be worth a fraction of face. We would probably have to guarantee Agencies, perhaps with a small haircut.
Nouriel's version is better developed, with a historical foundation in the Home Owner's Loan Corporation of the 1930s. But it's all based on the observation that paying the underlying mortgages is much cheaper than paying off at the level of the shadow banking system.
Posted by: Charles at September 22, 2008 12:05 AM
«If the Feds pay a portion of the reset of mortgages that are presently at risk, say one-third, with homeowners agreeing to pay one-third, and mortgage holders giving up one-third, we could probably keep most people in their homes.»
This means roughly bailing out people who bought $150k homes for around $450k; at least it has the merit that those who lent them $450k to buy a $150k home get a haircut.
The problem is that there is an overstock of around 3m homes that probably nobody wants to buy (more or less at any price). That is a lot of loan to builders, and a lot of mortgages to flippers. Why would any of these agree to pay money, even if only a third, for something that is not going to sell?
Posted by: Blissex at September 22, 2008 02:05 AM
Assuming this plan gets the go-ahead and the Treasury buys assets at more than "fair value" and takes a significant haircut, who pays? It seems to me that either (i) future generations pay, if we assume that foreigners are still willing to buy Treasuries at prices close to 2000-06 levels; or (ii) a combination of a more inflation-tolerant Fed and a foreign Treasury buyers strike could impose costs on today's consumers, through a much weaker USD and higher long-term interest rates.
There is surely an incentive for monetary policy makers to inflate away the liabilities, but the response of Treasury holders might act as a constraint.
Posted by: exile at September 22, 2008 04:49 AM
The actions of the Fed prior to the week of September 15-19, 2008 were prologues, i.e., necessary introductions to what was and is to come. Cutting the discount and federal funds rates, creating the Term Auction Facility, creating the Term Securities Lending Facility for primary dealers, etc. are designed to help markets return to orderly functioning by improving market liquidity and by pursuing salutary macroeconomic objectives through monetary policy.
Then, during the week of September 15-19, 2008, we witnessed more historic events confirming that a new financial paradigm has been spawned which will affect every market and every private, institutional and sovereign investor on the planet for years if not generations to come.
Itï¿½s a good new system or, if one prefers, itï¿½s the worst one there is until a better one takes its place. Either way it doesnï¿½t matter, because the same thing can be said about aspects of, for example, the legal system and the health care system.
The new system should not be analyzed in comparison to what was before. Comparisons are more often than not odious, and we have a much greater investment in the future than the past. It should not be considered as reactionary or as antithetical to some free market ideal. It is what it is, because we live in an imperfect world and unless and until everyone agrees to be prudent at all times without fail ï¿½ impossible for human beings ï¿½ we have to make do with what weï¿½ve got, and that is something Americans are good at.
Every epic advancement needs one or a series of events that divides history, in this case financial history, into the ï¿½Before-and-After.ï¿½ When viewed in retrospect in the future, the new financial system that is coming to life has a very good chance of being viewed as the catalyst for such. We can either wring our hands over the things that allegedly brought about the great change or we can see those events as, and paradoxically thank them for, creating the milieu in which ï¿½changingï¿½ into a new paradigm was made possible.
Although it may have a rocky beginning ï¿½ surely lots of critics will obligingly help fill up the 24-hour news cycle ï¿½ in the end and above all else if thereï¿½s a default on borrowed money from the Fedï¿½s new lending program or on the obligations that may be absorbed by some newly created agency that cause a reduction in the expected flow of funds to the Treasury, then every American stands behind the shortfall. Thus, we have committed to spreading the risk very widely and, accordingly, we have taken a great leap forward.
In transfiguring the financial system in this way all Americans are telling the world that we are stepping ï¿½up to the plateï¿½ as the greatest collective counterparty ever created. Weï¿½ll take our lumps for our mistakes, weï¿½ll punish those who actions were worse than ï¿½mistakes,ï¿½ but weï¿½re going to see to it that the bulls are standing when we hit bottom. Indeed, the proof that they are still with us is undeniable. The Dow Jones Industrial Average rose 6.4% over the last two days of the week of September 15-19, 2008, a week that the Wall Street Journal said ï¿½changed American capitalism.ï¿½ Those who delay investing in our equities now, those who are ï¿½on the sidelines,ï¿½ must reevaluate their positions.
Although there are more events to come that will refine and formalize all aspects of the new system, the contours of its core are clear. We are in the early stages of the ï¿½Afterï¿½ and we should look to the future with optimism. We are indeed fortunate that Henry Paulsen, Ben Bernanke and Timothy Geithner are now serving as Secretary of the Treasury, Chairman of the Federal Reserve, and President of the New York Federal Reserve Bank. We owe them a debt of gratitude for the savvy application of their knowledge, experience and instincts during one of the most wrenching times in the history of the free market.
Finally, let us not forget that things must be put in perspective. Here's one: The S&L debacle of the 1980s caused a hit to our GDP of 3.2%. The GDP in 1985 was $4.22 trillion. In the second quarter of 2008 the economy grew at an annual rate of 3.3%. The GDP for 2007 was $13.8 trillion.
Posted by: Edmond G. Miranne, Jr. at September 22, 2008 05:28 AM
So you're telling us that the federal government should deregulate business when things are going well so that profits can be made and force taxpayers to pick up the tab when they go badly?
This will usher in another 30 years of the same poor management practices that led to this financial breakdown.
Welcome to the Great Treasury Robbery of 2008.
Posted by: Actual Money at September 22, 2008 05:43 AM
The most disturbing aspect of this bailout is that, at least as I understand it at the moment, the financial institutions that will benefit have no skin in the game. Some clever suggestions to remedy that are offered in the previous comments. Another might be to require any institution that sells to the new facility either be required to invest in it up front, and/or commit to purchase its bonds?
Posted by: eugene linden at September 22, 2008 06:10 AM
I believe per my recent review that over the next 3 to 5 years, taxpayers will be handsomely rewarded for saving the financial system. My guess is ? all in ? the taxpayers will have gained $100 to $200 billion from this bailout; which is clearly against the conventional wisdom prevailing in the media. But a bet against the short to medium-term viability of the US economy is a sucker's bet. At least until China takes over the world in 30 to 50 years.
Posted by: Andy at September 22, 2008 07:17 AM
The only way this plan can work is if Treasury buys the impaired bank assets at prices significantly above market - ie. near the price the banks are currently carrying them on their balance sheets. If the auctions are real, at market clearing prices, then the banks selling impaired assets will potentially be forcing themselves into bankrupcy since they'll be taking the mark-to-market loss they've been trying to avoid all along, and in many cases this mark-to-market loss is evough to wipe out their capital base. Since the only way this can proceed without wiping out the banking system is at ficticious pricing, this is a defacto recapitalization of the banking system by the taxpayer. Usually in a bankrupcy / recapitalization scenario, the current shareholders are wiped out. In this case, the taxpayers are being asked to stump up and buy toxic assets, on which they are pretty much guaranteed to lose money, and the current shareholders get to keep all the future gains. It's good to be a plutocrat in America.
Posted by: Turbo at September 22, 2008 07:36 AM
Professor, very nice explanation of the emergency.
The losses on the trillions in debt will be at least 50%.
Just look at household debt to GDP, and realize that there is no way that those loans will be repaid. Just look to '29-'33 and '34-'39 to see what happened last time that household debt got to an unrepayable level.
Consumers will be defaulting and the U.S. government will dejure default or defacto (inflate out) default.
The end is near. Sell whatever assets you can, and guard those proceeds.
Posted by: jg at September 22, 2008 08:12 AM
Professor: I would very much appreciate your comments in response to the article in the Wall St.Journal in the last few days penned by former FDIC chairman William Isaac wherein he suggests that the accounting standards change from valuing assets at historical cost to the mark-to-market method has in no small part been a complicating factor in this mess.
Posted by: Mike O at September 22, 2008 08:24 AM
The foundations of the economy during the last decade were built on debt-finance consumption. Leveraged debts occurred at every level from the govt., wall street, to main street. Mainstream economists including the host here continued to believe in the debt-generated GDP number while ignoring the pile of leveraged liabilities accumulated. The way out of this economic bind is to rebuild this economy under a different paradigm of growth.
Posted by: anon at September 22, 2008 08:45 AM
I think many people are discussing detail and missing the most important point.
Regulatory authorities (Western Governments) allowed this mess to happen through lack of oversight and control. An incredible amount of "face" is at stake here. Business, geopolitics and ultimately the power and respect that the West commands are at stake. Trade and global development depends on faith and trust in counterparties.
Is the West prepared to throw the baby out with the bathwater - as some seem to propose here?
Should the fate of Global Economy and Trade be felled in one foul swoop by merciless "taxpayers", who refuxse to see this as their problem and do not support a bailout (of greedy CEO's etc.)?
Milton Friedman's Capitalism and the belief that capital freedom leads to democracy and higher standards of living for all is at stake. If a catastophe is allowed to unfold our children's children will all learn about how the "State" must control the "commanding heights" - banking, energy, major industries etc. - because capitalism does NOT work!
This is akin to War. If the authorities win this battle and save the financial system then the West will have regained faith and trust. If they lose this battle - America and the West's influence will go up in smoke - do not think for a moment that letting everything simply fail is even a remote option!
The world depends on trust and faith in the West. There is an implicit assumption in dealing with the West - you are dealing with people that our proud are respectful and will back their institutions and businesses - same as teh kind of thig printed on every fiat note.
This is how Lloyd's insurance works.
The cost of a change to a system with little or no trust is incalculable - a huge premium will apply to every transaction - at the worst you go back to "bartering" because IOU's no longer carry any meaning, as nobody trusts anybody else. This is what creates a "run on the banks" and gold bullion to be burried in the back garden - a distinct possibility if Authorties do NOT ACT.
Taxpayers cannot walk away from this obligation - these failing companies are mostly American - when at War the public should rally round and save America's reputation - not trash it for at least a generation!
The assent of China and the demise of the West will be complete if a financial meltodwn is allowed to occur. A new order will be ushered in.
Posted by: Anon at September 22, 2008 08:52 AM
Mike O, if the value at which third parties are willing to buy these assets is significantly less than their "true value", then the whole problem would indeed be one of a tragic misunderstanding as William Issac argues. If that were the case, however, I would have expected a half trillion in Fed participation, and de facto nationalization of the $5 trillion in agency obligations, would have broken the back of that little misunderstanding. It is abundantly clear today that they did not.
We have to agree that either the market was wrong in the value of these assets in 2006, or it is wrong in the value of these assets in 2008. My view is that it was wrong in 2006, and we're in a deep mess as a result. Perhaps Isaac is blaming the messenger because he does not like the message.
Posted by: JDH at September 22, 2008 08:56 AM
JDH - I thought the problem was that no one knew how to assess the value of these assets because no one knows the future defaults. If the value of the assets depends upon the default level and that level changes over time, the value of the assets change over time. We can only value assets based on the information available at each point in time.
Mark-to-market accounting comes in the picture because some firms (the public ones) are required to estimate the value of their assets each quarter and mark-to-market requires an estimate based on the last sales. This system forces evaluation of the value of assets at a time when no one wants to buy. That is false indication of the value these assets will have when buyers and sellers are active.
The best escape from this problem is to allow firms caught in this system who do not want to sell their toxic assets while they are falsely priced, to "park" them temporarily in a Federal agency. A new agency must be created to perform this function.
More on this proposal can be found at Econbrowser for Sept. 20 at 6:27 AM.
As far as I know, this is the only proposal available which proposes to stop the melt-down with minimum expenditure of Federal Funds. It is superior to the Paulson proposal for several reasons.
Posted by: w. Raymond Mills at September 22, 2008 09:43 AM
Don't forget Kuznet's demographics.
This would not have happened if we did not have a baby boom generation on the cusp of retirement with a vanishing safety net.
They all wanted to get their million. (For nothing!)
Greed made them Baby Busters. Now they'll be thugs to the next generations and the world.(woops they are already are!)Until they get their way.
Posted by: ld at September 22, 2008 09:46 AM
I love to participate in this discussion but my computer is down. This is being typed from a library computer. So, I can read what others say but I will be muzzled for a while. Please take the opportunity to read the post of the previous day and then tee off on my outrageous claim that this huge problem can be solved by creating a Federal agency to take possession of these toxic assets temporarily, while the owners do not want to sell them.
A crucial part of this proposal is that the law creating this new option will specify that the value of these assets will remain constant while in the possession of the federal agency. That will prevent the write-downs that have plagued the system. If the owners have no interest, in fact, no ability to sell while in possession of the Federal agency, the public should have no interest is what these asserts are valued at currently. These assets will be carried on the books of the original owner at the value they had when parked with the Federal agency.
Call this a gimmick or accounting trickery if you wish. In my mind, it is simply a refusal to follow an accounting convention that was not designed to be used when no one wants to buy or sell.
Posted by: W. Raymond Mills at September 22, 2008 09:56 AM
Raymond, it is correct that no one knows how far house prices will fall and therefore what the ultimate capital loss will be. But there is an unambiguous answer to the following question:
If you had to sell these off today, at whatever price necessary to get someone to buy them, what would that price be? That is the number that is so low as to cause all these problems. The question under debate is whether it is that low because of some kind of liquidity problems or herd mentality, or whether it is so low because the underlying loans are going to be so poorly performing.
Posted by: JDH at September 22, 2008 10:14 AM
Phil Rothman asks, "why did these arguably experienced/sophisticated stockholders/investors buy these instruments? More specifically, why did these big-league players misprice the risk so badly?"
There seems to be a few issues. One is that it became difficult to assess the risk in, for example, the super senior tranche of a CDO, CDO-squared or CDO-cubed. Instruments from some of these tranches were inappropriately rated AAA.
Another relates to fraud in the origination process, such as improper income verification or faulty appraisals.
A third relates to the CDS market. If the MBS/CDO is "insured", then the holder is hedged. But what if your insurer is not sufficiently diversified?
A fourth issue may, in part, be poor liquidity, as apparently suggested by the Treasury. Possibly, the fundamental value is greater than the current market prices.
Posted by: John Elder at September 22, 2008 10:46 AM
One of the biggest contributors to this crisis was the lack of regulations on capitalization and leverage. After all, these CDOs were no great shakes. They only yielded 50 basis points or so above treasuries. So why would anyone take on the risk? Leverage. If you can leverage 50 basis points by 30 to 1 or 60 to 1 you're talking real money.
Since we have apparently seen the end of independent investment banks, hopefully the remains of Goldman Sachs and Morgan Stanley will come under better regulation (although I'm not so sure about that). But hedge funds also need to be regulated.
Posted by: Joseph at September 22, 2008 10:52 AM
1. John Hussman has argued that the bondholders of the companies that hold these toxic assets should be the first once to take the losses. It is only after the shareholders and the bondholders have been wiped out, that the US treasury/Fed should think about the U.S. Garbage Barge Trust.
What is wrong with letting the bondholders absorb the losses before committing the public money to buy the toxic assets?
2. Both Hussman and Barry Ritholtz have proposed draft proposals that focus on the distressed mortgages, rather than the toxic securities.
Shouldn't the focus of the government action be the underlying distressed assets, not the toxic securities that nobody understands?
3. I have not heard any compelling arguments from Paulson or anybody else as to (a) Why the Paulson plan is not a corporate giveaway? (b) Why the paulson plan isn't anything else but a very very expensive confidence booster that will help to unfreeze the credit markets only temporarily?
Posted by: APB at September 22, 2008 10:56 AM
"Phil Rothman asks, "why did these arguably experienced/sophisticated stockholders/investors buy these instruments? More specifically, why did these big-league players misprice the risk so badly?" Best answers I could give would be the principal-agent problems between fund managers and fund beneficiaries and a naive reliance on flawed ratings by the supposedly sophisticated investors. Again, good readers, any better answers to Phil's question?"
It depends on what you mean by mispricing so badly. In retrospect, the path of prices has been quite different from what was expected for a variety of important assets. What is less obvious is whether a sophisticated investor would have been able to detect such mispricing in real time.
Technological and financial innovations have played important roles in past market "bubbles" (the dot-com bubble, the 1980 gold & silver bubble, the railroad bubbles of the late 1800s, the South Seas bubble.) These innovations can make it difficult to determine what expected value or what distribution returns will have in the future. I think that the widespread use of new financial instruments (particularly CDSs, CDOs, sub-prime mortgages and their close relatives) may have played 2 roles in contributing to the asset repricing that we now see.
a) being relatively new instruments (that is, new relative to their maturity) they had limited track records on which to check the assumed distribution of their returns. Obviously, this problem was particularly acute in the tails of their distributions.
b) It was possible that these financial innovations could change the returns on the underlying fundamental assets. (e.g. it was plausible that making housing more affordable *financially* would affect the demand for housing and therefore the price of existing houses.) This further compounds the difficulty in detecting asset mis-pricing in real-time.
The problems of pricing "novel" derivatives are well-known and widely taught, even in MBA cirricula. (For example, see chapter 23 in Hull's Fundamentals of Futures and Options Markets.)
Posted by: SvN at September 22, 2008 11:09 AM
Glad to see JDH lead off with some economic history. "Past is prologue."
In the pre-regulation world, panics happened when expectations of trustworthy credit evaporated. Suddenly, the collapse of trust that underlie the creation of money supply (beyond species) collapsed money supply.
With the creation of the Fed, we now supposedly had a steady hand at the wheel to replace a nervous herd. Of course, they failed their first big test by shrinking the money supply drasticly in 1929 - they over-reacted. Read Friedman and Shales for how there was no money to be had during the Depression. (Tariffs and higher taxes and Roosevedt's experimentation contributed.)
The problem today is that the structures build to allow a balancing of risk (specifically bank reserve requirements) are obsolete since so much money creation is now happening someplace other than commercial banks. Leverage is the key to profits, at least in the short term. but everyone is interconnected with everyone else.
For example. AIG supposedly held $600M of Fannie Mae/Freddie Mac STOCK as assets to be counted against it reserve requirements. When the government took over those two, the asset was now marked to market and was hence worthless. Plus the European banks are more levered than American ones and used AIG to cover their positions in mortgages as insurance. They piggy backed on the American guarentees.
A question I have to ask is, where are the PetroDollars? With the run-up in oil prices, a lot of cash left the country, and quickly. Where did they go? Who's holding them now? Sure seems to me that there was enough cash leaving fast enough that they had to have had some impact on the money supply unless they were recycled quickly.
Posted by: Joseph Somsel at September 22, 2008 12:04 PM
I want to know if Paulson saw what was happening to the banks as Treasury Secretary. I want to know why he didn't say something sooner, was this an inside job to let the dollar fail? Why would anyone want to pay a banks debt for free!! I don't think the government has the right to make me pay for these rich investment banks when I'm not making enough to survive as a single mom! This is an outrage on the American people, to allow one man to control whats left of the dollar to his advantage when he never let us know this was happening...how much will he want, no one knows and we as American citizens should show our anger by standing up to these leaders who put us here!!
Posted by: Renee at September 22, 2008 12:30 PM
"If you had to sell these off today, at whatever price necessary to get someone to buy them, what would that price be? That is the number that is so low as to cause all these problems."
This is a correct statement of our problem. How important is this low number? Since companies must reevaluate its assets each quarter based on this number, continuous write-downs of assets has become the norm. However, if a scheme could be devised to allow firms to ignore this number, for those assets they do not wish to sell, then periodic write-downs would be reduced by the volume of toxic assets removed from the market.
Posted by: w. Raymond Mills at September 22, 2008 01:20 PM
The credit rating agencies appear to be getting off rather lightly to me. If the mortgage backed securities had not received investment grade ratings would they have infected so many portfolios across the economy.
Posted by: JR at September 22, 2008 01:59 PM
Looks to me that the prices of homes will continue to fall.
There is clearly lots of volatility in the price of homes and in the mortgage interest rates. Even availability of mortgaging is risky.
My wife and I went out looking Sunday and for the first time in our school district, there were decent family homes for less than $500K. For Silicon Valley, that's a huge surprise as most family homes start at $700 to $800K. (Believe me when I tell you they are modest homes!) Add some lost jobs (not a problem here so far), and foreclosures will skyrocket as lots of people are already underwater.
This tells me that there will be more degradation of mortgage-backed securities to come. looks like the federal government will be the lender of last resort.
Posted by: Joseph Somsel at September 22, 2008 03:04 PM
Blissex - Thanks for providing the Links describing the history of the Credit Crunch, to your opinion about the stupidity of American voters, and your skepticism that the US Government and the FED can solve the underlying problem.
Friedrich von Blowhard - Thanks for the many can expect to continue to be exploited, via the government, for the benefit of the few , and asking the obvious question... how economists can be so ... (comparatively) quiet on the topic of how government policy is set and its impact on economic performance.... ANSWER: Economists communicate about the effects of government policy all the time. They do not however fixate on the negative reprocussions because they don't want to be labled a Chicken Little, and for many their status and to some degree their incomes depend on supporting the status quo.
My perspective is that the mortgage securities problem is just the exposed portion of the iceberg. The vulnerabilities run deep, from LBOs, to consumer finance, to many corporations' almost total dependence on government contracts. Essentially, households can not afford to service their existing debt. Asking them to service more by nationalizing insolvent financial institutions is fraudulent.
Posted by: MarkS at September 22, 2008 03:53 PM
The S&L crisis arose because of the way the shock of the inverted yield curve was propagated. The propagation mechanism being the change in the accounting principles that were used to assess the S&L balance sheets --changing from GAAP to RAAP (Generally Accepted Accounting Principles to Regulatory Accepted Accounting Principles).
The current crisis was caused by the shock of low interest rates: "John Bull can stand many things, but he cannot stand two percent' (Walter Bagehot, "Lombard Street"). The propagation mechanism was again an easing of regulatory standards. Yesterday's post by Menzie explains this in more detail.
It seems that once this mess gets sorted out, a consensus needs to be reached on what are acceptable standards for all the parties involved in home lending and we need to stick to them.
Posted by: smg at September 22, 2008 05:13 PM
I'm no expert, but isn't part of the problem liquidity or lack therof? What if the government let any 401K holder take up to $20,000 out tax free as long as they used it to pay down debt immediately? Say there are 50,000,000 people in the US that fit this category, that's $1 Trillion pushed into banks and credit - some of which would trickle down to the banks that need liquidity. A benefit is this uses mechanisms and infrastructure set up to handle large amounts of money quickly and it lets americans help each other by being selfish. However, it doens't squarely solve the poor regs/oversight problem and some banks will still fail and some mortgages will still foreclose, but I can't see why overall this would be a bad thing as part of the solution.
Posted by: Jeff at September 23, 2008 04:14 PM
I want them investigated, arrested and whatever assets they have left seized. I think the members of Congress that helped let this happen should undergo financial investigation of all assets as well. This wild west financial nonsense is nothing more than large scale con-artistry.
Not every financial institution played. Why aren't the reputables speaking up?
How did your senator vote on the 1999 Gramm bill? Check it out at the political stray. Some of these names look familiar?
Posted by: The Political Stray at September 23, 2008 08:33 PM
Pelosi is expanding the instutitions that can sell their junk to the US taxpayers. Isn't this just opening the floodgates of having losing bets dumped into the US deficit? Is anyone looking into the details of this?
Posted by: Anonymous at September 28, 2008 09:27 AM
Stop the Great Bailout!
Given the now likely passage of the Great Bailout, I'm mad as hell and I'm not going to take this anymore!
This is our last chance.
Visit http://ImMad.net to stop the passage of the Great Bailout right now!
Then spread the word to as many people as you can right away.
Posted by: David at September 28, 2008 09:45 PM
Maybe everyone opposed to the bailout that pays taxes that do not agree with this should stop paying taxes. That way they get the point across to the government that they cant do what they want and need to listen to the people who put them in office.
Also a flat tax would make the playing field even for everyone on a tax basis. If you buy it you get taxed, period. EVERYONE PAYS
Posted by: Bill at September 29, 2008 01:02 AM
This bail-out idea makes me want to punch everything in the face.
Posted by: Nick at September 29, 2008 01:41 AM
Politicians should be watched and if not voting for the people instead of the New World Order should be voted out. Go to sweetliberty.org and click on shadow government to see what the NEW WORLD ORDER has in store for us and what it has already brought to bear.
Posted by: mari at September 29, 2008 03:59 AM
Here is a cartoon of the bailout:
Mr Robin Hoodlum .
We are socialists now (for the rich) !!
Posted by: pixer at October 2, 2008 04:21 AM
So long as we have a "pay for play" regulatory scheme in the US with Obama leading McCain 2 to 1 in donations (kickbacks) from financial institutions, we won't see much change. Please note the carbon credits schemes create similar joint ventures between government policy and utility polluters who can buy "credits" and pass the cost and more along to consumers. In fact, we probably will see a deluge of Fannie and Freddy type hybrids that produce even more income opportunities for present and retired Congressmen, Presidents, their staff and families, their lobbyists, etc. as the next crop of crooks lands in the Beltway.
It is sad to see so little (if any) reform discussed in this election. Only way Congress could even do the bailout was with 25% pork attached.
Posted by: Don at October 6, 2008 04:25 AM