Friday, October 31, 2008

Canadian economists urge action on climate change

Canada's economists have written An Open Letter to the Leaders of Canada’s Federal Political Parties regarding climate change policy.

Here is a summary of their letter:
What Needs to be Done
  1. Canada needs to act on climate change now.
  2. Any substantive action will involve economic costs.
  3. These economic impacts cannot be an excuse for inaction.
  4. Pricing carbon is the best approach from an economic perspective.
    1. Pricing allows each business and family to choose the response that is best and most efficient for them.
    2. Pricing induces innovation.
    3. Carbon is almost certainly under-priced right now.
  5. Regulation tends to be the most expensive way to meet a given climate change goal.
  6. A carbon tax has the advantage of providing certainty in the price of carbon.
  7. A cap and trade system provides certainty on the quantity of carbon emitted, but not on the price of carbon and can be a highly complex policy to implement.
  8. Policies that impose costs on producers (big or small) affect consumers.
  9. Price mechanisms can be regressive and our policy should address this.
  10. A pricing mechanism can allow other taxes to be reduced and provide an opportunity to improve the tax system.

Friday, October 24, 2008

Roubini predicts two-year recession

The US economy is entering a two-year recession that will be longer and deeper than previously feared, said Nouriel Roubini, a well-known economist and professor at New York University.

"I believe we're going to have two years of negative economic growth," Roubini said on CNBC. "The last two recessions lasted only eight months each ... This time around this is going to be three times as long, three times as deep. This is going to be the worst recession the US has experienced since the 1980s."

A slowdown in global economic growth combined with continued problems in credit markets and housing will haunt the economy, Roubini said. ...

"I believe that the worst is still ahead of us. I think that the next few weeks and months are going to be negative surprises on the economy," he said. ...

"But we're going to have a severe recession. If this is going to be a two-year recession, that's not priced by the market. And there are significant downside risks for the stock market and credit markets in my view," he said. "Yes, we're going to avoid the Great Depression, we're going to avoid a 10-year stagnation. That's not going to be the case."
Notice that he predicts the worst recession since the 1980s, not the worst since the Great Depression. When economists say that this is the worst financial crisis since the Great Depression, many economically-challenged journalists incorrectly report that this is the worst economic crisis since the Great Depression. A financial crisis (affecting the financial system) and an economic crisis (affecting the broader economy) are not the same.

Wednesday, October 22, 2008

Deregulation didn't cause the financial crisis

Democrats, and the Democrat-friendly press, have been very eager to blame the financial crisis on deregulation. However, Wharton Business School finance professor Jack Guttentag says deregulation didn't cause the financial crisis.
Deregulation, meaning the scrapping of existing regulations, was not a factor in the crisis. The only significant financial deregulation in the past three decades applied to commercial banks. Restrictions on where they could have branches and on their involvement in investment banking were both removed. Most economists, including me, believe that these actions made the banks stronger than they would have been otherwise.

Regulation in itself is a weak defense against financial crises. One major reason is that it tends to look backward, similar to generals fighting the last war. ...

Regulators have no better foresight than do the firms they regulate. Both use statistical models based on experience. A change in the underlying structure of the economy can make such history irrelevant, which is exactly what has happened. Nobody anticipated the severity of the current crisis because, relative to the past, it is off the chart. ...

Can we prevent this sort of problem from happening again? Yes, but the next crisis will almost certainly be different.
Remember that the next time you see CNN blaming Phil Gramm for this mess, without any hard evidence. I dislike Phil Gramm, but he is not responsible for the current troubles.

S&P's recession forecast

In the current edition of The Outlook, Standard and Poors presents its forecast for the recession (source offline; no link available):
The economy will likely suffer a moderate, but long recession, and a sluggish recovery, according to S&P Economics. From the December 2007 peak to a trough in May 2009, this expected 17-month recession would be longer than the 50-year average of 10.7 months, and near the longest recessions of 1975 and 1982. ...

We’re forecasting negative gross domestic product (GDP) growth for the fourth quarter of 2008 and the first half of 2009 for a total decline of 0.9%. While business tax credits should likely provide some boost to the fourth quarter, borrowing restrictions will mean that boost will be smaller than we originally thought.

Still, this should be a moderate recession. Unemployment will likely climb to 7.5% by summer 2009 from its March 2007 low of 4.4%. The S&P 500 dropped nearly 40% through October 10, near the historical average decline of 36% during a recession. As stock prices normally lead the economy by three to six months, they should bottom in the fourth quarter.

The Fed chopped the Fed Funds rate to 1.5% from 5.25% last September. We expect the central bank to remain on hold until the recession is over before raising rates in the fall of 2009. The 10-year Treasury yield dropped to 3.8% from a peak of 4.5% last summer. However, the cost of funds for businesses and individuals has risen due to the credit crunch.

The fiscal stimulus package will likely bring the fiscal 2008 federal deficit slightly above the 2004 record of $413 billion. We expect the record to easily be broken next year, with a deficit exceeding $700 billion, depending on how the Troubled Asset Relief Plan is treated.
They also project a 30% average drop in home prices, peak to trough.

Tuesday, October 21, 2008

Investing advice from Uncle Bob

My Uncle Bob* used to work on Wall Street. Twenty-one years ago, he had completely avoided the 1987 stock market crash by pulling completely out of the market months earlier.

Last year, on August 14, 2007, he sent an email to my cousins and me warning about the credit crunch. He warned us to be cautious, conservative, and avoid financials. He rarely sends out investment advice, so his email of warning was a rare and timely event. In retrospect, he wasn't bearish enough.
For the first time since 1987, I've become a bit of a bear, though nowhere near as bearish as I was back then.

The markets continue to be easily rattled, and the Fed has stepped in very significantly because it is worried. So what does one do with one's investment portfolio at a time like this?

Be cautious and conservative. There likely will be a flight to quality: be in large cap, high dividend yielding U.S. and European stocks (but not banks and financial institutions) or mutual funds and money market funds. Bonds and bond funds are a possibility, but at some point interest rates will start going up, at which point the bonds will lose value, so money market funds yielding 4.8% are safer than longer term bonds yielding only slightly more (i.e. 5% to 6%).

I'd ease up on emerging markets, which has been the place to be for the last four and a half years, and small cap stocks or funds (especially small cap with low or no dividends).

Unlike 1987, when I was bearish because of over-valuation in the markets, this time I'm bearish because of an impending credit crunch. So it's okay to remain in the S&P 500 index, which is large cap and will be among the last to fall if things really get ugly. Also, this isn't apt to last a long time, probably only a month or two. As the credit crunch subsides, the markets will strengthen and then one will want to be in equities, which continue to be fairly valued (perhaps even slightly undervalued).

So hang in there, but get rid of the riskier holdings.
A week-and-a-half ago, I got another email from him. Now he is very bullish.
I thought I should let you know that I think we are very near the market bottom. I have been cranking numbers all morning. From the high a year ago, the Dow is off 40.3% and the S&P 500 is off 42.5%. Of the 16 recessions in the last century (since 1920; prior data unreliable), the Dow on average has fallen 31.4%. It has only fallen more than the current 40.3% four times (41.9% after the first World War, 45.1% in the 1973 oil crisis, 49.1% in 1937-8 and 89.2% in the Great Depression), so only once since the second world war.

So, unless we repeat the Great Depression, which seems highly unlikely given the steps the Fed and Treasury are taking in contrast to Hoover's do-nothing policy, we likely are at or very near the bottom for the stock market. I certainly wouldn't sell anything at these low levels, and I very timidly started buying on Friday. The safest move is investing in companies that can finance their own growth without having to access the credit market and are paying a substantial dividend (more than 3% yield).

I'm also a believer in buying TIPs (Treasury Inflation Protected Securities), as the Fed and Treasury actions seem likely to lead to inflation, though not everyone agrees with this. Vanguard has a fund that invests in these.

For you young guys, this is likely the buying opportunity of a lifetime!
* Names have been changed to protect the anonymous.

Anna Schwartz criticizes Greenspan & Bernanke

Anna Schwartz, who along with Milton Friedman, wrote the classic economics book A Monetary History of the United States, is harshly critical of Bernanke, Paulson, and Greenspan.
If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses.

Now, Alan Greenspan has issued an epilogue to his memoir, "Time of Turbulence," and it's about what's going on in the credit market. And he says, "Well, it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated."

[Greenspan] absolves himself. There was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't really want to damage.

I don't think that that's an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom.

Bill Gross on the financial crisis

Morningstar recently asked bond king Bill Gross about his thoughts on the financial crisis:
Gross was encouraged that the passage of the Treasury Department's proposed $700 billion Troubled Asset Relief Program would pay off in a few ways. In particular, he was and remains confident that the acquisition of troubled mortgages by the United States government will ultimately produce profits for Uncle Sam. As long as the government picks them up at the right price—and there's a lot of room for error given how cheaply subprime mortgages are currently being marked—returns of 10% or more are well within the range of possibility according to his analysis.

But the main reason for his advocacy of the plan is that he believes it will be critical to avoiding the catastrophic outcomes of inaction that would have included massive job losses, plummeting economic productivity, and waves of bankruptcies. In fact, in the absence of an effective government policy response, Gross has described a "daisy chain" of trouble snowballing from margin calls, disappearing leverage, and institutional failures that would roll through the financial, housing, commercial real-estate, stock and bond markets. Meanwhile, he also sees the TARP as a catalyst that will put banks in a better position to make loans. ...

With the specter of such massive government spending on the horizon, though, we pressed Gross for more thoughts on the future. ... The U.S. has been living on the creation of more and more debt for some time, activity that can cheapen the value of our currency versus those of more fiscally restrained nations, notes Gross. Unless something changes, he argues that we can't expect the U.S. dollar to maintain long-term strength, a point that he and PIMCO have been making for many years.

Saturday, October 18, 2008

Warren Buffett says buy stocks now

Warren Buffett, the world's greatest investor, has a message for people who have become fearful of today's stock market: Buy stocks now!
I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.


A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over. ...

Over the long term, the stock market news will be good. ... Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset.... Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. ... Today my money and my mouth both say equities.

Friday, October 17, 2008

How bad will the recession be?

Video: Morningstar analysts discuss their expectations for the duration and magnitude of the current recession.

Thursday, October 16, 2008

The effect of lower oil prices on future oil exploration

From CNN Money:

With the price of oil falling below $75 a barrel Wednesday — down about 49% from last summer's highs — the industry's battle cry is sounding less and less convincing.

But falling oil prices are not the only reason why the air is coming out of the drilling balloon. The credit crunch has hampered oil company's ability to fund big-ticket drilling projects. Meanwhile, the prices that producers pay for raw materials and labor remain high.

"Any project that assumed oil would average $100 over the next 10 to 20 years is being seriously reconsidered at this time," said Richard Ward, senior cost analyst at IHS Cambridge Energy Research Associates (CERA).

As recently as July, tapping deep water sources and extracting crude from Canadian oil sands - two very expensive production methods - were seen as economically viable ways to deal with the energy crisis. At that time, the price of oil was above $140 a barrel.

Now that the price has fallen below $75 a barrel, and could go even lower, many experts say the future of these projects is uncertain.

Oil companies are quick to point out that big drilling projects are long-term investments, which are not based on today's oil price, but on what they think the price will be in the future.

Indeed, some deep water projects have a life span of 20 to 30 years. And some producers expect to be mining Canada's oil sands for up to 40 years.

Wednesday, October 15, 2008

AP: Oil was just another bubble

From the Associated Press, via MSNBC:
As oil prices zoomed toward an unheard of $147 a barrel this summer, it seemed every analyst prediction that oil would approach $200 was a self-fulfilling prophecy, until suddenly it was not.

Instead of $200 oil, oil is now $80. Instead of going up, U.S. demand has fallen at the steepest rate since the oil-shocked 1970s. Americans have dramatically cut down on driving over the past year.

Soaring prices for oil and other commodities this summer have turned out to be nothing short of another classic bubble, and the bursting may not be over, one analyst said Monday.

"It's just amazing that the market gets suckered into this," said analyst Stephen Schork of the Schork Report, who called the idea of $150 a barrel oil "an obscene number, a perverted, illogical number." ...

"We clearly underestimated the depth and duration of the global financial crisis and its implications on economic growth and commodity demand," analyst Jeffrey Currie said in a report.

David Fyfe, an analyst with the International Energy Agency in Paris, was a bit less critical, avoiding the word "suckered." "To be fair, there is always a tendency in parts of the analyst community to look at short-turn trends and assume it's something that will continue in perpetuity," he said.
As recently as July the price of oil was rising based on strong global economic growth, especially in China and India. Now that the financial crisis is threatening to push the entire world into a recession, global economic weakness is likely a major cause of the drop in oil prices.

Also, $4 per gallon gasoline seems to have been the tipping point that encouraged many Americans to cut back on driving and stop buying SUVs. Americans consume roughly 25% of all the world's oil, despite the fact that we make up only about 5% of the world's population.

Now let's see when the gold bubble bursts.

Tuesday, October 14, 2008

Details on the banking equity injection

Bloomberg provides details on the Treasury's investment in U.S. banks:
The Bush administration will invest about $125 billion in nine of the biggest U.S. banks...

The proposed cash injections in exchange for preferred shares are part of a $700 billion rescue approved by Congress and follow similar moves by European leaders to unfreeze credit markets by helping beleaguered banks. ...

The purchases represent a new approach for Treasury Secretary Henry Paulson, who first promoted a bailout targeted at illiquid mortgage-related assets. The urgency for a more immediate infusion has grown as banks struggle to regain the confidence of investors, counterparties and clients after bad loans caused more than $635 billion of writedowns across the industry. Paulson will discuss his plan at a press conference at 8:30 a.m. today in Washington. ...

The Treasury plans to spend $25 billion each for stakes in Citigroup and JPMorgan, people said. Another $25 billion will be divided between Bank of America and Merrill, which agreed last month to be acquired by Bank of America. Wells Fargo is to get at least $20 billion, Goldman and Morgan Stanley will each get $10 billion, and State Street and Bank of New York will get about $3 billion each, people said.

The government will obtain its stakes with a type of security designed not to dilute the value of common shares.

None of the nine banks getting government money was given a choice about it, said people familiar with the plans. All of the banks involved will have to submit to compensation restrictions as mandated by Congress, people said.
I find the second to last sentence disturbing. Is America still a free country? Government has made a big grab for power under President Bush, starting with the Patriot Act. Now the government is forcing banks to sell parts of themselves. I wouldn't be as bothered if banks were voluntarily letting the government invest. But force? Does JPMorgan even need the money?

More details from The New York Times:
The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock. For instance, if the government makes a $10 billion investment, then the government will receive $1.5 billion in warrants. If the stock goes up, taxpayers will share the benefits. If the stock goes down, the warrants will be worthless.
By comparison, the U.S. inflation rate over the past year has been 5.4%.

Warning: Big Government Ahead

David Brooks gives us forewarning.

WSJ on the history of stock behavior during recessions

The Wall Street Journal has an overview of how the stock market behaves before, during, and after a recession.

Monday, October 13, 2008

Warren Buffett wisdom

Stock market thoughts from the Sage of Omaha:
You know, five years from now, ten years from now, we'll look back on this period and we'll see that you could have made some extraordinary (stock market) buys. That doesn't mean it won't get more extraordinary a week or a month from now. I have no idea what the stock market is going to do next month or six months from now. I do know that the American economy, over a period of time, will do very well, and people who own a piece of it will do well.

Friday, October 10, 2008

Former FDIC chairman: Mark-to-market causing credit crunch

In a CNBC interview, a former FDIC chairman blamed mark-to-market accounting for the credit crunch:
Financial markets are frozen throughout the world, and former FDIC Chair William Isaac puts the blame squarely on the Securities and Exchange Commission and fair-value accounting—especially the accounting method's requirement that banks "mark to market" their assets.

"The SEC has destroyed $500 billion of bank capital by its senseless marking to market of these assets for which there is no market, and that has destroyed $5 trillion of bank lending," he said.

"That’s a major issue in the credit crunch we’re in right now. The banks just don’t have the capital to start lending right now, because of these horrendous markdowns that the SEC’s approach required."

Thursday, October 9, 2008

Barney Frank and Christopher Dodd deserve blame for Fannie and Freddie

The Independent, a British newspaper, blames the Democrats for the failure of Fannie Mae and Freddie Mac:
What is the proximate cause of the collapse of confidence in the world's banks? Millions of improvident loans to American housebuyers. Which organisations were on their own responsible for guaranteeing half of this $12 trillion market? Freddie Mac and Fannie Mae, the so-called Government Sponsored Enterprises which last month were formally nationalised to prevent their immediate and catastrophic collapse. Now, who do you think were among the leading figures blocking all the earlier attempts by President Bush — and other Republicans — to bring these lending behemoths under greater regulatory control? Step forward, Barney Frank and Chris Dodd.

In September 2003 the Bush administration launched a measure to bring Fannie Mae and Freddie Mac under stricter regulatory control, after a report by outside investigators established that they were not adequately hedging against risks and that Fannie Mae in particular had scandalously mis-stated its accounts. In 2006, it was revealed that Fannie Mae had overstated its earnings — to which its senior executives' bonuses were linked — by a stunning $9.3billion. Between 1998 and 2003, Fannie Mae's executive chairman, Franklin Raines, picked up over $90m in bonuses and stock options.

Yet Barney Frank and his chums blocked all Bush's attempts to put a rein on Raines. During the House Financial Services Committee hearing following Bush's initiative, Frank declared: "The more people exaggerate a threat of safety and soundness [at Freddie Mac and Fannie Mae], the more people conjure up the possibility of serious financial losses to the Treasury which I do not see. I think we see entities that are fundamentally sound financially." His colleague on the committee, the California Democrat Maxine Walters, said: "There were nearly a dozen hearings where we were trying to fix something that wasn't broke. Mr Chairman, we do not have a crisis at Freddie Mac and particularly at Fannie Mae under the outstanding leadership of Mr Franklin Raines."

When Mr Raines himself was challenged by the Republican Christopher Shays, to the effect that his ratio of capital to assets (that is, mortgages) of 3 per cent was dangerously low, the Fannie Mae boss retorted that "our assets are so riskless, we could have a capital ratio of under 2 per cent".

Nobel laureate Gary Becker gives his thoughts on the financial crisis

Nobel Prize–winning economist Gary Becker says the current financial crisis is minor compared to the Great Depression:
The magnitude of this financial disturbance should be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25% unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. So far, American GDP has not yet fallen, and unemployment has reached only a little over 6%. Both figures are likely to get quite a bit worse, but they will nowhere approach those of the 1930s.
He is not fond of government bailouts, but he has this to say about TARP:
Taxpayers may be stuck with hundreds of billions of dollars of losses from the various government insurance provisions and government purchases of assets. Although the media has made much of this possibility through headlines like "$700 Billion Bailout," such large losses are highly unlikely except in the low probability event that the economy falls into a sustained major depression. Indeed, with efficient auctions, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many savings-and-loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, the government may have a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvement is wise, but the likely losses to taxpayers are being greatly exaggerated.

Wednesday, October 8, 2008

Jeremy Siegel's take on the bailout

Wharton Business School finance professor Jeremy Siegel gives his thoughts on TARP:
It is possible that the plan can be a "win" for both taxpayers and banks. One of the central tenets of economics is that a trade often involves gains to both parties and this is no exception.

The collapse of the housing market has sharply lowered the price of real estate, so many of the mortgages and securities issued against homes are now "under water," or worth less than the value of the house. If a lender wrote a $300,000 mortgage on a house that is now worth only $150,000, the "intrinsic" or underlying value of the loan is now 50 cents on the dollar. ...

But in these stressed times, the lot for mortgage lenders is even worse. Because of the current illiquidity of the mortgage-backed security markets and the confusion of ownership rights of some of these complex securities, investors are willing to pay only 30 cents on the dollar or less for an asset with a 50 cent intrinsic value. It is in this situation where the government has an opportunity to improve the lot of the buyer and seller. The Treasury has the ability to hold these assets until the mortgage is restructured in order to realize the intrinsic value of the loan.

This does not mean a recovery of 100 cents on the dollar, but, if the government can buy the loan for 40 cents, it can still receive a good return on the investment if prices eventually rise to only 50 cents. In the meantime, the financial institution has swapped a distressed asset for a highly liquid security.

IMF: Major downturn ahead

From Bloomberg:
Global growth is headed for a "major downturn'' next year, as U.S. gross domestic product grinds close to a halt, the International Monetary Fund said in a staff report prepared for a Group of Seven meeting this week.

"The global economy is entering a major downturn,'' the fund said in the report, dated Oct. 4 and obtained by Bloomberg News. "Many advanced economies are now close to recession, while emerging economies are also slowing rapidly.''

Growth is slowing across the world as policy makers struggle to contain the worst financial crisis since the Great Depression. ...

"All the advanced economies are stagnant or in mild recession now,'' John Lipsky, the IMF's first deputy managing director, in a Bloomberg Television interview. The slowdown is removing "inflationary dangers,'' making it appropriate for central banks in some countries to respond with lower interest rates, he said.

Tuesday, October 7, 2008

Stocks in worst yearly slump since Great Depression

From Bloomberg:
U.S. stocks fell, sending the Standard & Poor's 500 Index below 1,000 for the first time since 2003, on speculation banks and real-estate companies are running short of money as the credit crisis worsens. ...

The S&P 500 slid 60.66 points, or 5.7 percent, to 996.23, extending its 2008 tumble to 32 percent in the market's worst yearly slump since 1937. The Dow Jones Industrial Average dropped 508.39, or 5.1 percent, to 9,447.11, giving it a 29 percent retreat in 2008 that would also be the worst in 71 years. The Nasdaq Composite Index lost 5.8 percent to 1,754.88.

WSJ: The hearings congressmen want to forget

Monday, October 6, 2008

Tyler Cowen's views on the financial crisis

Tyler Cowen, economics professor at George Mason University, presents his views on the financial crisis:
1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced "minority lending."

2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.

3. The crisis represents a massive conjunction of both market and governmental failure.

4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.

5. The modified Paulson plan was better than nothing -- especially after the market had been scared -- but far from my first choice. In any case the plan would have been revised almost immediately. The Paulson and Dodd plans were never that far apart.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

7. In the meantime the Fed should not worry much about inflation.

8. The critical deregulatory mistake was allowing excess leverage. Many deregulations get blamed but in fact contributed little to the problem.

9. Everyone says that letting Lehman die was a big mistake but I'm not yet convinced. Maybe a bracingly high TED spread is what we need.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious. Also beware of anyone pretending to offer you simple answers.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan's easy money policies.

13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.

14. I agree with Arnold Kling about relaxing capital requirements though at this point I don't expect it to help much.

15. The crisis is complex and has many causes; there won't be a simple or quick solution.

Outdated policies are making the financial crisis worse

Economist Thomas Palley explains the current financial crisis:
The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system...

This parallel banking system financed vast amounts of real estate lending and consumer borrowing. The system ... made loans but had no deposit base. Instead, it relied on roll-over funding obtained through money markets. Additionally, it operated with little capital and extremely high leverage ratios.... Finally, loans were usually securitized and traded among financial firms.

This business model has now proven extremely fragile. First, the model created a fundamental maturity mismatch, whereby loans were of a long term nature but funding was short-term. That left firms vulnerable to disruptions of money market funding, as has now occurred.

Second, securitization converted loans into financial instruments that could be priced according to market conditions. That was fine when prices were rising, but when they started falling firms had to take large mark-to-market losses. Given their low capital ratios, those losses quickly wiped out firms’ capital bases, thereby freezing roll-over funding.

In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms. ...

The traditional banking system is more protected for two reasons.

First, traditional banks are significantly funded by customer deposits. Ironically, such deposits can be withdrawn on demand and are in principle even more insecure than short term roll-over funding. However, they stay in place because of federally provided deposit insurance.

Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans. These loans are therefore priced by auditors on a mark-to-realization basis. However, if they were securitized their market value would be significantly lower owing to current disruptive market conditions.

The bottom line is that the banking system is in better shape not because of its virtues, but because of policy. Deposit funding is safe because of deposit insurance. Banks are spared mark-to market losses because of different accounting rules. And the Federal Reserve is providing banks with massive liquidity infusions through its discount window and its various emergency auction facilities. ...

The urgent implication is the Fed (and other central banks) must extend its safety network to include the parallel banking system.

Friday, October 3, 2008

Obama wrong on Glass-Steagall; Clinton & Biden right

Again, Barack Obama, left-wing Democrats, and the mainstream press are wrong about the 1999 repeal of the Glass-Steagall Act; Bill Clinton and Joe Biden were right.

Buffett suggests improvement to TARP

From Fortune Magazine:
Warren Buffett suggested Thursday that the U.S. Treasury team with private investors to buy the distressed mortgage assets at the center of the controversial $700 billion Wall Street bailout, and said the price tag of the rescue plan may have to rise.

Buffett, the chairman and CEO of Berkshire Hathaway, called the problems facing world markets "unprecedented" and warned of a "disaster" if Congress does not move faster to shore up the economy.

"We had an economic Pearl Harbor hit," he said ... "For a couple of weeks we've been arguing about who's at fault [and] fooling around while things have gotten a lot worse." ...

"It will cost more to solve this problem today than it did two weeks ago," said Buffett...

But he described a plan he thought of Thursday morning on the way to the Summit that would allow Treasury and private investors to buy assets together. He said his proposal would kickstart demand for mortgage-backed securities, help find a market price for these troubled assets and make it more likely that taxpayers would be made whole or even come out ahead in the bailout.

Under Buffett's plan, Treasury would lend hedge funds, Wall Street firms or any other investors 80% of the price for distressed assets. Investors would benefit from borrowing at lower rates available to the Treasury. But the government would get first claim on the sale of those assets, which means it would get its loan back plus interest and possibly turn a profit. Only then would investors see a penny.

"Now you have someone with 20% skin in the game," explained Buffett. "Believe me, I won't be overpaying if I'm buying with that kind of leverage. And you have someone [the investors] to manage the assets to the extent they need to be managed."

Buffett also noted that the presence of the government in the transactions would raise the price of assets above the absolute firesale levels for which they could now be sold. That would benefit the banks trying to unload them. ...

He said the [financial] problem boils down to widely-held assumption during the housing boom that prices could only go up.
Under this scenario, the private investors would benefit by being able to borrow at ultra-low interest rates that normally only the government can get. They could also get higher potential returns by having higher leverage. Meanwhile, taxpayers are protected because the private investors would take a 100% loss before the government lost a penny. This gives the private investors a very strong incentive to protect taxpayers from a loss.

The Economist: Bailout "deserves support"

The Economist endorses the bailout:
No government bail-out of the banking system was ever going to be pretty. This one deserves support.

Saving the world is a thankless task. The only thing beyond dispute in the $700 billion plan of Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, to stem the financial crisis is that everyone can find something in it to dislike. The left accuses it of ripping off taxpayers to save Wall Street, the right damns it as socialism; economists disparage its technicalities, political scientists its sweeping powers. ...

Spending a sum of money that could buy you a war in Iraq should not come easily; and the notion of any bail-out is deeply troubling to any self-respecting capitalist. Against that stand two overriding arguments. First this is a plan that could work (see article). And, second, the potential costs of producing nothing, or too little too slowly, include a financial collapse and a deep recession spilling across the world: those far outweigh any plausible estimate of the bail-out’s cost. ...

Mr Paulson’s plan relies on buying vast amounts of toxic securities. The theory is that in any auction a huge buyer like the federal government would end up paying more than today’s prices, temporarily depressed by the scarcity of buyers, and still buy the loans cheaply enough to reflect the high chance of a default. That would help recapitalise some banks—which could also set less capital aside against a cleaner balance sheet. And by creating credible, transparent prices, it would at last encourage investors to come in and repair the financial system...

The economics behind this is sound. Government support to the banking system can break the cycle of panic and pessimism that threatens to suck the economy into deep recession. Intervention may help taxpayers, because they are also employees and consumers. Although $700 billion is a lot—about 6% of GDP—some of it will be earned back and it is small compared with the 16% of GDP that banking crises typically swallow...

Mr Paulson’s plan is not perfect. But it is good enough and it is the plan on offer. The prospect of its failure sent credit markets once again veering towards the abyss. Congress should pass it—and soon.

Thursday, October 2, 2008

Two centuries of American real per-capita GDP growth

Chris Blattman has a message for all the pessimists out there:
This is the best estimate of real income per capita in the United States since 1820.

Over these years we had violent financial crashes of various types, bank panics, piles of recessions and a huge depression, many foreign wars and one enormous domestic war, had a central bank and didn’t, were on the gold standard and weren’t, had governments topple in scandal and multiple leaders assassinated, and what did it all amount to in the medium to long run? In per-capita income terms: Nothing. The overall trend does not bend or shift. Every bad year was followed by a good year that returned us to trend.

The US average growth rate of real per capita incomes over the last 190 years has been 1.8% a year, and the same rate over the last 10 years has been…. 1.8% a year.

Stare at that graph: The Great Depression was traumatic in countless ways, but astonishingly, it’s not clear that we are any worse off today than we would be if the whole thing never occurred. Anyone who made such a claim in the 1930s would have been scoffed at, but that’s what happened.
We may be headed for a tough time over the next few years, but we'll get through it. We always do. And no, it's not different this time.

Note: The graph is showing real per capita GDP growth. That is, per capita GDP growth adjusted for inflation.

Lessons from the Great Depression

From The New York Times:
In 1929, Meyer Mishkin owned a shop in New York that sold silk shirts to workingmen. When the stock market crashed that October, he turned to his son, then a student at City College, and offered a version of this sentiment: It serves those rich scoundrels right.

A year later, as Wall Street’s problems were starting to spill into the broader economy, Mr. Mishkin’s store went out of business. He no longer had enough customers. His son had to go to work to support the family, and Mr. Mishkin never held a steady job again.

Frederic Mishkin — Meyer’s grandson and, until he stepped down a month ago, an ally of Ben Bernanke’s on the Federal Reserve Board — told me this story the other day, and its moral is obvious enough. Many people in Washington fear that the country is starting to spiral into a terrible downturn. And to their horror, they see the public, and many members of Congress, turning into modern-day Meyer Mishkins, more interested in punishing Wall Street than saving the economy. ...

At the start of the 1930s, despite everything that had happened on Wall Street, the American economy had not yet collapsed. Consumer spending and business investment were down, but not horribly so.

In late 1930, however, a rolling series of bank panics began. Investments made by the banks were going bad — or, in some cases, were rumored to be going bad — and nervous customers besieged bank branches to demand their money back. Hundreds of banks eventually closed. ...

“If a guy has a good investment opportunity and he can’t get the funding, he won’t do it,” Mr. Mishkin, who’s now an economics professor at Columbia, notes. “And that’s when the economy collapses.” Or, as Adam Posen, another economist, puts it, “That’s when the Depression became the Great Depression.” By 1932, consumption and investment had both collapsed, and stocks had fallen more than 80 percent from their peak. ...

The crucial point is that a modern economy can’t function when people can’t easily get credit. It takes a while for this to become obvious, since most companies and households don’t take out big new loans every day. But it will eventually become obvious, and painfully so. Already, a lack of car loans has caused vehicle sales to fall further. ...

In the end, this really isn’t about Wall Street. It’s about reducing the risk that something really bad happens. It’s about limiting the damage from the past decade’s financial excesses. Unfortunately, there is no way to accomplish that without also extending a helping hand to Wall Street. That is where our credit markets are, and we need them to start working again.

“We are facing a major national crisis,” as Meyer Mishkin’s grandson says. “To do nothing right now is to do what was done during the Great Depression.”

Wednesday, October 1, 2008

IBD: Mark-to-market accounting not responsible

Investor's Business Daily says mark-to-market accounting is not to blame for the current financial troubles.

U.S. Government: Screw the Savers!

BusinessWeek says "American savers have drawn the short straw":
American savers, take a bow. This is your moment of vindication. Your hour of glory. And you earned it (in a manner of speaking).

You resisted the siren call of plastic teaser APRs, dutifully living within your means to store money for a rainy day. You never took out an interest-only mortgage. Never had to pawn the copper pipes from your exurban McMansion to pay the reset on your liar loan. Your credit score would have gotten you into Harvard at age 12.

Good for you! Your reward: injurious savings yields, inflationary rot, and election-season neglect, all served up with a dollop of institutional insecurity.

Even with a current account deficit that, starved of domestic savings, requires $2 billion a day in foreign financing, economic policymakers are fixated on propping up credit and giving the participants in the housing bubble second chances. In order to do so, they are stripping the hides off of net savers.

Since August of last year, the Federal Reserve has slashed interest rates from 5.25% to 2.00%—wielding a blunt instrument that was swung enough to bend the yield curve in favor of suffering banks. You know, the institutions that screwed up but were too big and important to be deprived of an inalienable right to cheap deposits that they can loan out at several points higher. ...

Wholesale inflation has soared 9.8% in the past 12 months, the highest clip since 1981. The more widely cited consumer price index jumped to 5.6%. In other words, while your saved buck was adding 2 cents or so on one end (and even less after taxes), three times as much was getting singed off the other end of that dollar bill. "Inflation is just deadly to savings," says David Gitlitz, chief economist at TrendMacrolytics, an investment adviser. ... "It steals your purchasing power and sets less and less of an incentive to keep money in the bank." ...

Commodity inflation has also been exacerbated by concurrent weakness in the dollar, which is stuck between a Europe that is loath to cut interest rates and a Washington that is too scared to hike them. Even with its recent rally, the greenback is only worth two-thirds of a euro. You practically have to wheelbarrow dollars to places like Madrid and Berlin.

All of which might be tolerable to the lonely and beleaguered saver if he weren't taunted daily by lopsidedly pro-spending, pro-creditor news stories. Forget about moral hazard. Forget about rewarding profligacy. Washington is hell bent on putting a floor beneath the housing market. ...

Maybe savers' ultimate vindication will arrive when and if every asset is so deflated, credit is so choked off, and misery is so prevalent that only those with cold hard cash can lob in lowball offers for homes, cars, and everything else. Assuming, of course, they didn't stash all their money in one of the many banks that is about to go under; the feds are closely watching 117 of them—and counting. The phone lines have never been so jammed with nervous clients.

Oh, the joys of saving.

Larry Summers on TARP

Larry Summers, Harvard economist and former U.S. Treasury Secretary under Bill Clinton, gives his thoughts on the proposed bailout:
It is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers. ...

Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. ...

Indeed, in the current circumstances the case for fiscal stimulus — policy actions that increase short-term deficits — is stronger than at any time in my professional lifetime.

Whitney says TARP would be a loser for taxpayers

Oppenheimer star analyst Meredith Whitney says taxpayers would lose money with TARP:
Taxpayers will lose money in the $700 billion government rescue plan for the nation's banking system, Oppenheimer analyst Meredith Whitney said.

Contrary to predictions from some supporters of the bailout plan, Whitney said on CNBC that the continued slump in housing prices will make a profit from the bailout unlikely.

"I think you definitely lose money on this $700 billion structure," Whitney said. "There's no idea where house prices bottom, and as a result how can you make money on this transaction?"

She said home ownership rates are still too high at about 69 percent and need to fall below 66 percent as more subprime mortgages given to less-qualified borrowers unwind.
We should put Meredith Whitney and Warren Buffett in an octagon and have them fight over this thing.