Sunday, September 21, 2008

authorization for the use of financial force

While I am a social liberal, when it comes to matters of economics and finance I like to think that I am non-ideological – at least to the best of my self-delusional ability, I strive to objectively comprehend economic reality. A friend describes himself as a “Warren Buffett Democrat.” I would concur. (It was Buffett, by the way, who referred to credit default swaps and other unregulated derivatives as “financial weapons of mass destruction.”)

Also, over the years I have come to the conclusion that, whatever the subject, if I try hard to comprehend something – at least at a high level of abstraction – and can’t, it probably doesn’t makes sense. (This generalization breaks down in areas like physics where the underlying phenomena exist in a space outside our experience of reality.) I studied economics and finance and have been a junkie of the subject for over 30 years, reading and thinking about events from that perspective. I don’t think it is conceit to say that I’m highly skeptical of any proposition in that field that I can’t comprehend after diligent study. I might not agree with it. But I should at least be able to understand it.

The last couple of days I have spent most of each day reading about the proposed bailout of the financial system. And I haven’t been able to fully grasp it in a way that I could explain to others -- which means I don’t really understand it or it doesn’t make sense. I have gotten the strong sense that a lot of people are in my position – including a lot of people I believe to be much more knowledgeable on the subject than I am. Experience teaches me to be highly skeptical in situations like this. I should be able to understand at least the concept in a way that makes sense (i.e., the proposed solution would – on it own terms – help solve the problem).

One conclusion I have come to: Any authority granted to the Treasury should lapse after six months. This bailout is, essentially, an Authorization for the Use of Financial Force. Congress is again being stampeded by fear into a radical grant of authority on the eve of an election – just like in 2002. The one thing that is absolutely clear to me is that a comprehensive new financial regulatory scheme is necessary (perhaps just an update – with real enforcement teeth – of the Depression-era reforms that served us so well for 70 years or so until the de-regulatory zealots got their way). That can’t be enacted in a week, and if a bailout is enacted without those reforms, Republicans will filibuster the necessary reforms regardless of who wins the White House in November. The Treasury authority – whatever it turns out to be – should expire in six months. If Republicans filibuster reforms, the authority lapses without any action required by Congress.

But that is a procedural issue. What about the substance? I finally found an explanation that makes sense to me, and it came from
Paul Krugman’s blog:

September 21, 2008, 11:12 am
Thinking the bailout through

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?

September 21, 2008, 8:06 am
Authorization for the use of financial force

Brad DeLong beat me to it. Even if
you have full faith in Henry Paulson,
Intrade currently gives John McCain a 48 percent chance of being
president. Are you willing to give essentially unlimited discretion over the use
of $700 billion — with explicit protection against any review by Congress or the
courts — to Phil Gramm?

September 20, 2008, 4:46 pm
No deal

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.

A couple of other points.

I have been hearing a lot of folks in the past few days optimistically saying, “Once the markets settle down, and given some time to unwind things, the government might actually end up making money on this deal.” That sentiment is wrong on so many levels, most of which I don’t have time to explicate right now. But simply put: The current crisis is not fundamentally a liquidity crisis – inject some short-term liquidity into the system to restore confidence and everything will soon go back to functioning smoothly. This is a solvency problem. There are trillions of dollars of “assets” on the books at all levels of our economy – but particularly in the financial sector – that are worthless (or worth less) and need to be written off. And when they are, a lot of firms (and individuals) will be bankrupt. (Wall Street firms took on 20x – 50x leverage, which means a 2% to 5% decline in the value of their assets can make them insolvent. Overall, across most asset classes, the decline in value has been greater than that.) To take just one example, there are something like $60 trillion in credit default swaps in the system. (Credit default swaps are essentially an unregulated form of tradable bond insurance.) Because they are unregulated (thanks to Phil Gramm and his fellow de-regulatory ideologues – including his buddy John McCain) we don’t even really know for sure how much of that toxic material is out there. But it was the credit default swap counterparty risk that caused the Federal government to bail out AIG (to the extent one can really know these things, their CDS exposure was probably at least a half trillion dollars or so) – they were “too big to fail”. It is safe to say that the “counterparty risk” (i.e., the plain fact that the firms that wrote those instruments couldn’t back them up if they were called upon to do so – the exposure so vastly exceeds the capitalization of the issuers) is such that in this one area alone there are literally trillions of dollars of worthless “assets” on balance sheets that will eventually need to be written off. The proposed bailout plan can’t even begin to address that problem.

One thing should be clear: Like the Iraq war, there are no good solutions to extricating ourselves from this mess. Every approach is problematic. In another post I will offer my views on some of the politics of this crisis and some elements that should be included in any near-term approach to addressing the problem.


Tim said...

UK banks — euphoria fades

A couple of inconvenient facts:
- The FSA ban on shorting financials does not prohibit analysts from saying “Sell.”
- America’s $700bn-plus Troubled Assets Relief Program (TARP) does not extinguish the banks’ need for fresh capital
In fact it may well expedite the matter. Viz. Lloyds TSB’s £767m tap on Friday afternoon.
As far as British banks go, JPMorgan estimates that Lloyds TSB/HBOS needs £16bn, RBS £12bn and Barclays £10bn. Analysts at JPM are under-weight the sector until this £38bn hole is filled.
As the downturn spreads from housing to the wider economy, so a realisation is growing that corporate exposure is even more of a risk to earnings and capital than mortgages. From JPM:
On our estimates, for every 10% fall in UK house prices this implies 3% more capital needs, whereas a 10% fall in corporate recoveries would imply 8%. HBOS and Lloyds have the most corporate RWA exposure.
The expectation is that while banks will push up the cost of credit to corporates, actual demand will fall, meaning there will be limited profitability gains from higher pricing. Meanwhile, on the pure investment banking side, higher capital demands and tighter regulation will smother returns for the foreseeable

Tim said...

Downgrading the USA

A sovereign’s future debt path can not only be determined by its existing stock of debt, its future budget balances, real interest rates, and exchange rates, it can also be determined by discrete, one-off events that add to the government’s debt burden. Such events can stem from financial difficulty at the state or local government level (which, in aggregate, draw from the same base of taxpayers as the federal government), at the level of public enterprises, or from the financial sector.
In April this year, S&P issued a report which spooked markets, titled: “For the U.S. ‘AAA’ Rating, Government-sponsored enterprises pose greater fiscal risks than Brokers.


Russ: This lot means US interest rates are going up.

Ann said...

Krugman's commentary misses a few starting steps that caused the housing bubble in the first place. Failure to address that root cause as part of the bail-out will ensure we end up right back here again at some future point (much like the never-ending bailouts of U.S. automakers, who continue to use taxpayer dollars to make products uncompetitive in the global economy).

Aric said...

I'm far from understanding this whole fiasco, but it seems any bailout should contain these three provisions as a minimum (it seems congress is going to settle on some version of 1 and 2):
1. Some way of preventing excessive foreclosures. The simplest way may be to force banks to either offer sub-prime borrowers ordinary mortgages or to return to the rates they were paying in their first two years. I'm sure there are lots of other ways as well.
2. Some means of limiting executive rewards and punishing where appropriate.
2. A full disclosure of all assets of these venerable institutions (at least to the gob'ment). Before we progress down this path we need to know how bad the situation is. It seems to me there is just too much imaginary money based on too few real assets that 700B is not going to be enough. Maybe some of this debt goes around in a big circle and can be written off by a bunch of institutions at once.