Monday, September 29, 2008

Buffett warned Congress of "biggest financial meltdown"

Buffett urged Congress to pass the Troubled Asset Relief Program:
Legendary investor Warren Buffett warned Congressional leaders Saturday night of "the biggest financial meltdown in American history" if they did not act to secure the financial system.

Buffett, by telephone, was consulted by lawmakers who were in marathon talks on Capitol Hill to forge a deal on the administration's $700 billion economic bailout plan, according to two sources.

One lawmaker in the negotiations said that the participants called Warren Buffett to get his help in gauging potential market reaction. ...

Earlier in the week, Buffett also warned that the financial crisis is "everybody's problem," not just Wall Street's. The potential collapse of financial institutions would cause industry to grind to a halt, he told CNBC Wednesday, and could have "gummed up the economy."

Paul Krugman critiques the draft version of TARP

Krugman's critique:
So there’s a draft version of the bailout out there. Pretty much as expected. Section 113, MINIMIZATION OF LONG-TERM COSTS AND MAXIMIZATION OF BENEFITS FOR TAXPAYERS, is where the rubber meets the road — it’s where the plan says something about how the deals will be done.

As I read it, Treasury can
(1) conduct reverse auctions and suchlike
(2) buy directly — but only if it gets equity warrants or, in companies that don’t issue stock, senior debt

My view is that (1) will be ineffective but also not a bad deal for taxpayers — firms that can afford to will dump their toxic waste at low prices, the way some already have on the private market, and taxpayers may end up making money in the end. Firms in big trouble will probably stay away from the auctions. The plan’s real traction, if any, is in (2), which is a backdoor way to provide troubled firms with equity — and the bill seems to say that taxpayers have to own this equity, although I wish it was clearer how much equity will be judged sufficient.

Not a good plan. But sufficiently not-awful, I think, to be above the line; and hopefully the whole thing can be fixed next year.

Add: House staff tells me that there are significant changes from this draft. More info when I get it.

Sunday, September 28, 2008

Mankiw: Obama Distorting History

Harvard economist (and Republican) Greg Mankiw is very critical of one of Obama's answers during the debate:
In the debate last night, Barack Obama asked a good question about the present financial crisis but then gave an answer that is, at best, incomplete:
The question, I think, that we have to ask ourselves is, how did we get into this situation in the first place? Two years ago, I warned that, because of the subprime lending mess, because of the lax regulation, that we were potentially going to have a problem and tried to stop some of the abuses in mortgages that were taking place at the time....we're also going to have to look at, how is it that we shredded so many regulations? We did not set up a 21st-century regulatory framework to deal with these problems. And that in part has to do with an economic philosophy that says that regulation is always bad.
The main problem, we are led to believe, was a Republican ideology of unfettered capitalism that led to insufficient government involvement in the financial system.

Senator Obama might want to read this NY Times article from 1999:
In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders....Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.
I am not suggesting that the entire crisis should be put in the lap of the Clinton team. There is plenty of blame to go around. Indeed, the problem goes back at least as far as the Johnson administration, which helped set up a housing finance system that was always fundamentally flawed.

If Senator Obama really wants to transcend partisan politics, as he would sometimes have us believe, he might want to give a slightly more balanced view of the history of how this all started. He also might want to take note that the Bush administration warned about some of these problems five years ago and had its reform efforts stymied by prominent members of Senator Obama's own party.

An Analysis of the Financial Crisis

University of Chicago economist Robert Shimer analyzes the financial crisis:
Let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues.... As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information ... makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. ... But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.

Saturday, September 27, 2008

Stiglitz: Who is to Blame for the Financial Crisis?

Nobel Laureate Joseph Stiglitz lays out the blame:
Many seem taken aback by the depth and severity of the current financial turmoil. I was among several economists who saw it coming and warned about the risks.

There is ample blame to be shared; but the purpose of parsing out blame is to figure out how to make a recurrence less likely. ...

One can say the Fed failed twice, both as a regulator and in the conduct of monetary policy. Its flood of liquidity (money made available to borrow at low interest rates) and lax regulations led to a housing bubble. When the bubble broke, the excessively leveraged loans made on the basis of overvalued assets went sour.

For all the new-fangled financial instruments, this was just another one of those financial crises based on excess leverage, or borrowing, and a pyramid scheme.

The new "innovations" simply hid the extent of systemic leverage and made the risks less transparent; it is these innovations that have made this collapse so much more dramatic than earlier financial crises. But one needs to push further: Why did the Fed fail?

First, key regulators like Alan Greenspan didn't really believe in regulation; when the excesses of the financial system were noted, they called for self-regulation — an oxymoron.

Second, the macro-economy was in bad shape with the collapse of the tech bubble. The tax cut of 2001 was not designed to stimulate the economy but to give a largesse to the wealthy — the group that had been doing so well over the last quarter-century.

The coup d'grace was the Iraq War, which contributed to soaring oil prices. Money that used to be spent on American goods now got diverted abroad. The Fed took seriously its responsibility to keep the economy going.

It did this by replacing the tech bubble with a new bubble, a housing bubble. Household savings plummeted to zero, to the lowest level since the Great Depression. It managed to sustain the economy, but the way it did it was shortsighted: America was living on borrowed money and borrowed time.

Finally, at the center of blame must be the financial institutions themselves. They — and even more their executives — had incentives that were not well aligned with the needs of our economy and our society.

They were amply rewarded, presumably for managing risk and allocating capital, which was supposed to improve the efficiency of the economy so much that it justified their generous compensation. But they misallocated capital; they mismanaged risk — they created risk.

They did what their incentive structures were designed to do: focusing on short-term profits and encouraging excessive risk-taking.

Friday, September 26, 2008

Bill Clinton is Right about Glass-Steagall

Recently, a lot of Democrats and left-leaning journalists have been blaming the 1999 repeal of the Glass-Steagall Act for today's financial problems. I believe they are wrong. Their reasoning is based on the post hoc ergo propter hoc ("after the fact, therefore because of the fact") fallacy. They reason that since Glass-Steagall was repealed in 1999 and we have a credit crisis today, the repeal of Glass-Steagall caused the credit crisis.

The truth is that there were far more bank failures a decade prior to the the repeal of the Glass-Steagall Act than there are today, even though today's financial crisis is much worse.

Instead, today's financial crisis is due to the decline of a housing bubble. The housing bubble was caused by unreasonably low Fed interest rates, a savings glut overseas, and the get-rich-quick mentality of home buyers.

While many Democrats and journalists are wrong about the repeal of Glass-Steagall, Bill Clinton is right:
One policy Clinton said he doesn't regret is his repeal of the Glass-Steagall Act in 1999, which, for the first time since the Depression, allowed commercial banks to engage in investment banking activities. Clinton said the commercial banks were an important moderating force on the risk-taking of the big investment firms that collapsed this week. "In the case of the current crisis, I believe the bill I signed allowed Bank of America to take over Merrill Lynch," he said.
If Glass-Steagall were still law, a troubled Bear Stearns would not have been allowed to merge with JPMorgan. Also, Goldman Sachs and Morgan Stanley would not have been allowed to become commercial bank holding companies. The repeal of Glass-Steagall has been a savior, not a villain.

Harvard Economist Greg Mankiw Endorses the Bailout

Harvard economist Greg Mankiw reluctantly endorses the bailout:
What is my opinion about all this? I am of two minds about the complex situation we find ourselves in.

On the one hand, I share many of the concerns of the letter signers and other critics of the Treasury plan.

On the other hand, I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs or editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

Thursday, September 25, 2008

Krugman: A $700 Billion Slap in the Face

Paul Krugman points out why the Paulson/Bernanke plan is severely flawed. This should have been a full NY Times article, but Krugman made it a blog post instead (probably due to a desire to make it public ASAP).
The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we should believe the proposed intervention would work. So many of us turned to our own analyses, and concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry.

Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve the crisis so far.

Before I explain the apparent logic here, let’s talk about how governments normally respond to financial crisis: namely, they rescue the failing financial institutions, taking temporary ownership while keeping them running. If they don’t want to keep the institutions public, they eventually dispose of bad assets and pay off enough debt to make the institutions viable again, then sell them back to the private sector. But the first step is rescue with ownership.

That’s what we did in the S&L crisis; that’s what Sweden did in the early 90s; that’s what was just done with Fannie and Freddie; it’s even what was done just last week with AIG. It’s more or less what would happen with the Dodd plan, which would buy bad debt but get equity warrants that depend on the later losses on that debt.

But now Paulson and Bernanke are proposing, very nearly, to do the opposite: they want to buy bad paper from everyone, not just institutions in trouble, while taking no ownership. In fact, they’ve said that they don’t want equity warrants precisely because they would lead financial institutions that aren’t in trouble to stay away. So we’re talking about a bailout specifically designed to funnel money to those who don’t need it.

It took four days before P&B offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.

As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.

So, three points:

1. They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.

2. They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?

3. Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.

Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.

Is More Regulation Really the Answer?

David Brooks points out the flaws of assuming more regulation is the answer to America's financial crisis.

Wednesday, September 24, 2008

President Bush Addresses Nation Regarding Bailout Plan

In a first for his administration, President Bush went 15 minutes without lying.

Zingales: Why Paulson is Wrong

University of Chicago finance professor Luigi Zingales opposes the Treasury's proposed bailout and proposes an alternative.

Economists Sign Petition Opposing Treasury's Proposed Bailout

Over 120 university economists have signed a petition to Congress opposing Treasury Secretary Hank Paulson's proposed $700 billion Wall Street bailout:
As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.
Hat tip: Greg Mankiw.

Buffett Supports Bailout; Says Gov't Will Make Money

In a long interview uninterrupted by commercials on CNBC this morning, Warren Buffett voiced his support for Treasury Secretary Paulson's proposed bailout. He also said the U.S. government will make a very good profit on the deal (15%+ rate of return), if it buys at market prices.

Fed Chairman Ben Bernanke stupidly suggested yesterday that the government should buy at significantly above market prices. Buffett said that is not a good idea.

Buffett didn't mention this, but I should point out that if the government follows Bernanke's stupid idea and pays above market prices, it would remove less bad debt off of bank balance sheets than if it paid market prices. (The higher the price, the less you can buy.) Bernanke needs a refresher course in microeconomics, since he's suggesting paying more than the equilibrium price.

Buffett also said that President Obama or President McCain should keep Hank Paulson as Treasury Secretary for the first year of their presidency. (I think Obama could probably do quite well with NJ Governor Jon Corzine as Treasury Secretary, if he wanted. Jon Corzine, a Democrat, was Paulson's predecessor as CEO of Goldman Sachs.)

Here is the full interview:
While on the topic of the bailout, let me point out that Carnegie Mellon University economist Allan Meltzer has his own proposal:
if they're going to do something, then what they ought to do is make loans, which the financial institutions have to repay with interest. And if you think — that's an idea which the Chileans have used in a bigger crisis than this for them in 1982, and it worked for them. People paid back the loans. They weren't allowed to pay dividends until they repaid the loans. They weren't allowed to take bonuses until they repaid the loans. I think that's the way — if we're going to do this, then that's the way we should do it.
Somehow, I doubt that if the government follows Meltzer's idea it will earn a 15%+ rate of return. However, I do like the idea of prohibiting dividend payments until the credit crisis has passed.

Tuesday, September 23, 2008

Krugman on Treasury Proposal: "The more I think about this, the more skeptical I get"

Princeton economist Paul Krugman thinks the bailout through and doubts it will be effective:
What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.
Senator Chris Dodd now has a competing bailout proposal. Krugman likes Dodd's proposal better:
I’ve had more time to read the Dodd proposal — and it is a big improvement over the Paulson plan. The key feature, I believe, is the equity participation: if Treasury buys assets, it gets warrants that can be converted into equity if the price of the purchased assets falls. This both guarantees against a pure bailout of the financial firms, and opens the door to a real infusion of capital, if that becomes necessary — and I think it will.

Can this be done? Can the Paulson juggernaut be stopped? I’m starting to think yes. Paulson displayed a lot of arrogance here — he basically marched in and said Daddy knows best, don’t worry your pretty little heads about the details. He offered no, zero, zilch explanation of how the plan was supposed to work — just “it’s a crisis and we need to act now.” And he overreached, especially with that demand for immunity from any review.

Now we’ve had a lot of pushback from economists and financial analysts, and the realization has sunk in that this particular daddy has shown very little sign of knowing best. So there’s a real chance to do something quite different.
Update: It appears that Paulson has agreed to the Dodd plan.

Monday, September 22, 2008

Regulators Still Failing to Do Their Job

Here is more opposition to the Treasury's bailout proposal. Sebastian Mallaby also points out a regulatory failure that I've been concerned about for almost a year:
Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.
Why are government regulators allowing financial institutions to pay out dividends during a financial crisis? By paying out dividends, banks are reducing their capital at a time when they should be doing everything they can to preserve capital. I suggest three new regulatory rules, one temporary, two permanent: 1) All financial institutions must suspend dividend payments during this financial crisis. 2) Any time a regulated financial institution is unprofitable, it must suspend dividend payments until profitability is restored. 3) Regulated financial institutions may not pay out quarterly dividends that are greater than quarterly earnings.

If a bank is actually healthy, suspending dividend payments doesn't mean shareholders won't get their money. It just means they will have to wait for it. The money can simply be held on the books until the financial crisis or unprofitable period has passed, and then be paid out to shareholders as an extra-large dividend when the rough period has passed. If a bank is actually unhealthy, the retained capital reduces the probability of a bank failure, which would be a benefit to shareholders.

Allowing financial companies to pay out dividends to shareholders during a financial crisis is reckless, period. The Federal Reserve and other regulators are still failing to do their job competently.

Hat tip to Greg Mankiw.

Economists Start to Object to the Treasury Bailout Proposal

Many economists are opposed to the U.S. Treasury's proposed bailout.

For starters, let's look at the objection of Princeton University economist Paul Krugman:
I hate to say this, but looking at the plan as leaked, I have to say no deal. Not unless Treasury explains, very clearly, why this is supposed to work, other than through having taxpayers pay premium prices for lousy assets.

As I posted earlier today, it seems all too likely that a “fair price” for mortgage-related assets will still leave much of the financial sector in trouble. And there’s nothing at all in the draft that says what happens next; although I do notice that there’s nothing in the plan requiring Treasury to pay a fair market price. So is the plan to pay premium prices to the most troubled institutions? Or is the hope that restoring liquidity will magically make the problem go away?

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

And there’s no quid pro quo here — nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.

I hope I’m wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work — not try to panic Congress into giving it a blank check. Otherwise, no deal.

Sunday, September 21, 2008

The High Cost of Bailouts Lies Ahead

Fortune Magazine says rather than government intervention, the financial industry needs consolidation:
Henry Paulson and Ben Bernanke have saved us, for now, from a market meltdown — but at the cost of allowing the folks who caused the current crisis to keep ducking reality. ...

The Treasury secretary and Federal Reserve chairman have spent September dashing off blank check after blank check in a bid to quell turbulent markets. ...

Ultimately, what could prove to be the most expensive aspect of the bailout spree is the message the government is sending to firms in which the market has lost confidence. Prudent management, it seems, will be punished, while the status quo — however unhealthy — must be maintained at all costs.

The strong stock-market rally of the past two days aside, intervention that fails to foster a shakeout of weaker firms will only delay the reckoning that must occur before a sustainable economic recovery can take shape.

"We continue to believe that the financial sector is in need of massive consolidation because the sector simply has too much lending capacity left over from the credit bubble," Merrill Lynch investment strategist Rich Bernstein writes Friday. "History shows well that consolidation is the primary driver of post-bubble economies." ...

Though the free fall in financial shares over recent weeks wasn't pretty to watch, it had the sanguine effect of forcing businesses with questionable fundamentals to confront an uncertain future. ...

But for the rest of us, the feds' rush to defend teetering financial firms only defers the tough decisions that will need to be made before this crisis subsides — at the expense, perhaps, of repeating Japan's so-called lost decade of economic stagnance after its property bubble collapsed around 1990.

History shows that setting up bad banks without forcing financial firms' managers to confront their problems won't solve anything.

"This seems to us," Bernstein writes, "to be a very Japanese approach to solving a credit crisis."
Fortune Magazine obviously disagrees with The Wall Street Journal about whether we're repeating Japan's mistakes. We don't need to keep guessing who is right. In time, we'll all know the answer.

Saturday, September 20, 2008

Stiglitz: How to Prevent a Repeat of this Financial Crisis

Nobel Laureate Joseph Stiglitz gives his prescription for preventing this type of crisis from happening again:
This is not the first crisis in our financial system, not the first time that those who believe in free and unregulated markets have come running to the government for bail-outs. There is a pattern here, one that suggests deep systemic problems — and a variety of solutions:

1. We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns.

2. Secondly, we need to create a financial product safety commission, to make sure that products bought and sold by banks, pension funds, etc. are safe for "human consumption." Consenting adults should be given great freedom to do whatever they want, but that does not mean they should gamble with other people's money. Some may worry that this may stifle innovation. But that may be a good thing considering the kind of innovation we had — attempting to subvert accounting and regulations. What we need is more innovation addressing the needs of ordinary Americans, so they can stay in their homes when economic conditions change.

3. We need to create a financial systems stability commission to take an overview of the entire financial system, recognizing the interrelations among the various parts, and to prevent the excessive systemic leveraging that we have just experienced.

4. We need to impose other regulations to improve the safety and soundness of our financial system, such as "speed bumps" to limit borrowing. Historically, rapid expansion of lending has been responsible for a large fraction of crises and this crisis is no exception.

5. We need better consumer protection laws, including laws that prevent predatory lending.

6. We need better competition laws. The financial institutions have been able to prey on consumers through credit cards partly because of the absence of competition. But even more importantly, we should not be in situations where a firm is "too big to fail." If it is that big, it should be broken up.

These reforms will not guarantee that we will not have another crisis. The ingenuity of those in the financial markets is impressive. Eventually, they will figure out how to circumvent whatever regulations are imposed. But these reforms will make another crisis of this kind less likely, and, should it occur, make it less severe than it otherwise would be.

Thursday, September 18, 2008

U.S. Learns from Japan's Lesson

The Wall Street Journal says that the U.S. is making sure not to repeat the mistakes Japan made when its banking system ran into trouble.
When Japan was mired in economic crisis, the U.S. urged it to take decisive action to deal with its ailing banks. Japan didn't follow the advice and the crisis dragged on for years. Now, it is the U.S. that is mired in crisis and facing the prospect of swallowing the bitter medicine it once proffered. ...

"One of the lessons we took from Japan was the hesitation and refusal to own up to the problem was a disaster," says University of Chicago Graduate School of Business economist Anil Kashyap.

U.S. financial firms, too, have struggled with owning up to the extent of their credit losses, partly because those losses are a moving target. A year ago, Bear Stearns Cos. was reluctant to sell mortgage-related credit at a loss. That decision came back to haunt the firm as declining home prices continued to pummel mortgages, and Bear ended up in a government-backed fire sale to J.P. Morgan Chase & Co. Meanwhile, Merrill Lynch & Co. Chief Executive John Thain said in a January interview that the firm's troubles were "for the most part behind us" — but in July the firm agreed to sell more than $30 billion in mortgage-related assets at a large loss.

Still, U.S. financial firms have been much quicker to acknowledge losses than their Japanese counterparts were. While the slicing and dicing of mortgages into tradable securities played a part in the mortgage mess, accounting rules make it difficult for firms to ignore losses on those securities, says Princeton University economist Hyun Song Shin. In contrast, by continuing to extend credit to bad borrowers, Japanese banks were able to put off recognizing the extent of their debt problems.

"The denial strategy is harder to pull off — it will catch up to you in the accounting," says Mr. Shin. "That's one of the more encouraging and hopeful signs in the U.S." ...

Just as Federal Reserve Chairman Ben Bernanke has been intent on not repeating the Fed's Depression-era mistakes, Treasury Secretary Henry Paulson is intent on not repeating Japan's mistakes in the 1990s, says Brad DeLong, an economic historian at the University of California at Berkeley.

Friday, September 12, 2008

Do We Even Need Fannie and Freddie?

Does the United States even need organizations like Fannie Mae and Freddie Mac? Most developed countries don't have such organizations. Why do Americans assume they are necessary for a functioning mortgage market? Professor Richard Green ponders, "What has been the real benefit of Fannie and Freddie?"
It is almost certainly not homeowning, and it is almost certainly not funnelling money into underserved neighborhoods or toward underserved borrowers.

Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties. When interest rates rise, borrowers are protected; when they fall, they are not made immobile by yield-maintenance and lockout clauses. The low down payments (and five percent equity seems to be OK) effectively give households with modest incomes access to capital markets. I have written elsewhere that I believe that the peculiar structure of Fannie and Freddie has helped bring about the unique American mortage.

One could argue that the current environment shows that none of this has been worth it. But I would disagree with that argument.

More on Financial Speculation and Oil Prices

Two new reports contradict each other regarding whether financial speculation was behind the rising price of oil earlier this year.
Conventional wisdom in Washington holds that speculative money flooding into the market from index funds pushed up oil prices earlier this year.

But a regulatory report released Thursday shows that those funds actually were cutting their stake in the oil market as prices were soaring.

That data, based on private trading data gathered by market regulators, contradicts parts of a report released by Washington lawmakers on Wednesday.

That earlier report, by Michael W. Masters and Alan K. White, blamed high commodity prices on the growing role of institutional investors, specifically index funds. It was cited by several lawmakers as proof that new rules were needed to curb the impact of speculation on commodity prices.

But the new 69-page study, by the Commodity Futures Trading Commission, shows that, rather than rising, the stake of index funds in the oil market actually declined in the first half of this year.
Regarding the Masters report, you should know that Princeton economist Paul Krugman has taken Michael Masters to task in the past:
Some correspondents have asked me what I think about the Congressional testimony of Michael Masters, who told a Senate subcommittee that “index speculators” — institutions that buy commodity futures as an investment — are responsible for the price surge.

The short answer is that I think his testimony is just stupid. Here’s what he says:
Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.
That quote pretty much epitomizes what’s wrong with a lot of what people say about speculation. Buying a futures contract for oil does not reduce the quantity of oil available for consumption; there’s no such thing as "virtual hoarding".

And Masters really is confused about the difference between paper contracts and physical stuff. He compares the growth in the futures market with increased consumption from China, and says
The increase in demand from Index Speculators is almost equal to the increase in demand from China!
Again, the fact that someone bought a futures contract (which means that someone else sold one) doesn’t reduce the amount of oil available to consume.

I’m willing to listen to serious arguments about how speculation might be affecting the price, but you do see a lot of dumb stuff. And this is really, really dumb.
Krugman attacked Michael Masters' reasoning in a bit more detail here.

Thursday, September 11, 2008

Fannie and Freddie: A Lot Has Changed in 6 Months

Six months ago, Fannie Mae and Freddie Mac were supposed to be the saviors of the housing market. Congress even placed them at greater financial risk by raising the conforming loan limit, so they could help rescue the California housing market. These housing market superheroes don't look so super anymore.

From The New York Times:
The seizure of Fannie and Freddie is all the more surprising because, as recently as late March, Washington viewed the companies as saviors of the housing market and the economy, rather than as risks to them. Instead of requiring Fannie and Freddie to scale back, regulators gave them a green light to buy and guarantee more and bigger mortgages.

On March 19, James B. Lockhart, their chief regulator, dismissed swirling rumors about their financial health. “The actions we’re taking today,” Mr. Lockhart declared, referring to a decision to ease restrictions on how much capital they were required to hold, “make the idea of a bailout nonsense in my mind. The companies are safe and sound, and they will continue to be safe and sound.”

Why Fannie and Freddie Failed

Dean Baker on why Fannie Mae and Freddie Mac failed:
These mortgage giants went under because they were somehow unable to recognise the housing bubble and to adjust their lending to protect themselves against the inevitable crash. Fannie and Freddie are very far from innocent victims. It is their job to know the housing market and to recognise a bubble. Furthermore, if Fannie and Freddie had begun to tighten credit five or six years ago, when house prices were already clearly out of line, they could have stopped the growth of the bubble before it reached such dangerous proportions.

Tuesday, September 9, 2008

Dividend Taxes Cause Over-Investment in Housing

Harvard economist Greg Mankiw says taxes on dividends "induce people to invest too much in housing and too little in businesses":
Before 2003, when a person received dividends from his stock holdings, this income was taxed at ordinary income tax rates. That is, a dollar of dividends generated the same individual income tax liability as did a dollar of wages.

But many economists have long argued against taxing dividends this way. Dividends are a stockholder’s payment from corporate profits, and these profits have already been subject to the corporate income tax. Any tax on dividends represents a second tax on essentially the same income.

One can question whether this double taxation of income from corporate capital is fair. But fairness aside, there is also the problem of incentives. Taxing dividends twice substantially raises the overall tax burden on this form of income and distorts various decisions. Whenever taxes, rather than true costs and benefits, drive the allocation of resources, the economy shrinks below its potential.

Here are five ways a heavy tax on dividends messes things up:

CONSUMPTION VS. SAVING When the tax system depresses the return on a major asset class like corporate equities, households have less incentive to save for the future. Reduced saving means less funds for capital accumulation, which in turn impedes economic growth.

HOUSING VS. BUSINESS CAPITAL Wealth invested in your own home has several tax advantages. These include the mortgage interest deduction and the absence of any tax on imputed rent (the value that homeowners earn implicitly by getting a place to live). By taxing business capital highly, the tax laws induce people to invest too much in housing and too little in businesses.

NONCORPORATE VS. CORPORATE Because noncorporate businesses like partnerships are taxed only once, they have an advantage over twice-taxed corporations. As a result, too much of the economy’s capital stock ends up in the noncorporate sector.

DEBT VS. EQUITY FINANCE Because interest payments on corporate debt are deductible for corporate income tax calculations, this capital income is taxed only once. This asymmetric treatment of debt and equity finance induces companies to issue more debt than they otherwise would, increasing leverage and the economy’s financial fragility.

RETAINED EARNINGS VS. DIVIDENDS Companies can avoid the dividend tax by retaining earnings rather than paying dividends. Excessive retained earnings, however, impede the movement of capital from older cash-generating companies to newer ones with better prospects.

Friday, September 5, 2008

Bond Fund Manager Bill Gross Calls for a Mortgage Bailout

Bill Gross, manager of the world's largest bond fund, asks for a government bailout of the mortgage market:
Bond manager Bill Gross wants to spread the bailout wealth. Gross says in a commentary posted on the Pimco Web site Thursday that the government must “open up the balance sheet of the U.S. Treasury” to support Fannie Mae (FNM), Freddie Mac (FRE) and, in a new twist, “Mom and Pop on Main Street U.S.A.” as well.

Gross has previously said he believes the Treasury will have to assist Fannie and Freddie in any efforts to raise new capital. His Pimco Total Return bond fund has major positions in mortgage-backed bonds issued by the government-sponsored enterprises, so it’s no surprise that he sees it that way. But now he’s calling on Treasury Secretary Henry Paulson to use federal funds to buy more housing-related assets, in the name of preventing asset-price deflation from spiraling out of control.

Gross writes that the government should be more aggressively issuing subsidized home loans and creating funds to buy distressed properties, to help inject cash into U.S. households and slow the plunge in home prices. He writes that federal assistance is required because the deleveraging sweeping the financial sector has moved from asset liquidiation to debt liquidation — a process, he writes, that “can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami.”

Gross argues that Paulson and other policymakers must overcome their unwillingness to offer relief to households, after a decade in which Americans went on a record spending spree using borrowed money. He says that regardless of the source of the problem, plunging asset prices will only become more intractable as time marches on.

“The bill for our collective speculative profligacy, obvious in the deflating asset markets, can be paid now or it can be paid later,” Gross wrote. “The tab will be less if paid up front, than if swept under a rug of moral umbrage intent on seeking retribution for any and all of those responsible.”

Thursday, September 4, 2008

When Will the Housing Decline End?

Economist Irwin Kellner gives his opinion:
Three years ago, the housing bubble burst. That set the stage for a pullback in new-home construction and consumer spending as home sales and prices began to fall.

When it became apparent that many home loans were not held by the banks, but turned into securities and sold, a financial crisis developed, since holders of these securities had no way of knowing their value. This led to a credit crunch, and a severe pullback in bank lending. ...

Since this whole mess started with housing becoming irrationally exuberant, it must end with a return to sanity in this key sector of our economy. And in spite of what you may have read or heard about the "unprecedented" decline in home prices, normal housing prices are still beyond the horizon.

According to the latest data from the Census Bureau and the National Association of Realtors, median home prices in July equaled 3.6 times median household incomes. This may be down from the peak of four times incomes set back in 2005, but it is still far above the 2.9 times of the 1980s — when housing was more affordable and sales and construction grew at a steady pace.

In the halcyon days of the early 1970s, when home sales and construction were at their peaks both in absolute terms and relative to the size of the population, the ratio of home prices to incomes was less than 2.5.

To get back to the average of the 1980s, home prices would have to fall another 20%, on average. Add another 10 percentage points decline for housing to be as affordable as it was in the 1970s.
These numbers are for the U.S. as a whole. The declines needed in bubble markets would be greater. The declines needed in non-bubble markets would be less.

Wednesday, September 3, 2008

Fed President Hoenig Says Financial Institutions Must be Allowed to Fail

From Bloomberg:
Federal Reserve Bank of Kansas City President Thomas Hoenig said for economies to work best, institutions must be allowed to 'fail.'

Economies must "find a balance between financial stability and a stable price environment and in doing so must be able to allow individual institutions to fail," Hoenig said in a speech today in Buenos Aires. ...

"Financial crises will occur despite our best efforts to prevent them," Hoenig said in prepared remarks at an event hosted by Argentina's central bank. "The 'Too Big to Fail' issue will only grow in importance as the consolidation of the financial industry grows in both size and scope in future decades." ...

Hoenig, 61, dissented from a rate cut on Oct. 31 because of inflation concerns. Hoenig doesn't vote this year and will vote next in 2010. Dallas Fed President Richard Fisher has dissented from Federal Open Market Committee votes five times this year, preferring to raise interest rates last month.