Federal Home Loan Banks Leveraging Up

I haven’t read anything about the Federal Home Loan Banks since they published their preliminary third quarter results. This is just a short post to point out that Total Assets to Total Capital has been increasing while total assets (these are typically loans to banks) has been increasing dramatically. This is one of those places where taxpayers are leveraging to replace private debt contraction. To put this into perspective, I posted a couple of graphs. The first is Total Assets and the second is Total Assets/Total Capital, which hit 25 times in the third quarter. This is looking more and more like one of those investment banks, especially since almost all of the assets are mortgage related.


For additional information you can go to the FHLBank website here.

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The Money Supply And The Credit Crisis

I have been reading about monetarism around the web lately and find the topic interesting. Most of the writings I have seen look to money supply measures as an indicator of whether we should expect inflation and discuss the monetary aggregates, M1 and M2. Some commentators are stressing that M3 and MZM are better indicators of the true money supply as they include institutional money market funds ("IMMFs"). I agree with this position, but I think it misses some issues of the current economic situation. I think of it this way: Under the traditional model of monetary expansion the Federal Reserve injects reserves into the banking system which then uses the reserves to make a loan. The proceeds of the loan are then deposited into a bank and this is new money! The bank receiving the deposit can use a portion of this new deposit to make a loan, and the proceeds of that loan will be deposited into another bank – more new money. This process continues expanding the money supply and debt, limited by the portion of each new deposit that must be kept in reserve rather than loaned out and the fact that in order to make a new loan, banks need capital. But what if debt could expand without expansion of the money supply or bank capital? There would be a decoupling of the relationship between the money supply and debt creation. This decoupling has happened as debt that is originated by banks is often removed from the balance sheets of the banks through securitization, and this process converts the money supply from M2 to M3 or even out of M3 completely. To see how this happens requires a rather lengthy diversion into an example, so here goes:


To see how an everyday transaction ends up converting M2 to M3, I have drawn the diagram above. Beginning with the asterisk in Bank Reserves and assuming the Fed has injected $100 in new reserves, the Bank would want to make a loan for $100. Assume the Bank makes a loan of $100 to Home Buyer to purchase a house from Home Builder. Home Buyer takes out the loan and the cash goes to Home Builder. Home Builder now takes the cash and deposits it into the Bank. (These transactions are the black lines.) This is a new deposit and it represents growth in all the monetary aggregates. But in today’s financial markets (at least before the current meltdown) the Bank is likely to sell the loan to remove it from its balance sheet. If it does so by selling the loan (either directly or through a securitization first) to a commercial paper conduit, then the blue lines would represent the transfer of the loan in exchange for cash. But where did this cash come from? Let’s assume Investor took $100 out of its account at the Bank to purchase a share in IMMF (institutional money market fund) (the red lines). IMMF used this new cash to purchase commercial paper from the Conduit, which is where the Conduit got the cash to purchase the loan (the green lines). At the end of this series of transactions, there has been no net change in bank deposits because $100 went in from Home Builder and $100 came out from Investor (no change in M1 or M2). The original $100 of reserves injected into the bank by the Fed has been replaced by the proceeds from the $100 loan purchase by the Conduit. The money supply has grown, but it is what used to be M3 that increased through an increase in IMMF balances. The Bank is now free to lend the entire $100 again, effectively eliminating the reserve requirement and bank capital as a limitation on money supply (M3) growth from the initial reserves. Because of this off-balance sheet financing of loans by banks it can be M3 that increases as loans are made and sold rather than M1 or M2. Also note that this financing structure is speculative, funding long-term assets with short-term debt. Since the funding source (commercial paper) is not generally guaranteed (as are bank deposits) it is prone to a run. If the bank simply securitized the loans and sold them directly to investors without a commercial paper conduit we could diagram the same result with respect to M2 without an increase in M3 or MZM, but it would not necessarily be speculative. In any event, we have already created the money underlying the loan, but we have converted it to something that is not measured by M2 and sometimes not measured by M3. Because of these conversions of money from one form to another the traditional concepts of money supply and monetary expansion have been altered. As debt creation escapes the bounds of the monetary system around which traditional debt expansion occurred we should monitor debt outside banks as well as M2 or M3.


To see the change in the relationship between deposit expansion and debt creation I compared M2 to non-federal-government debt (“NFGD”) using the first graph above. (NFGD is all debt less federal government debt.) NFGD has increased from a multiple of approximately two times M2 in 1980 to over 3.2 times in 2007. Historically, as debt increased through the banking system there would be a concurrent increase in M2 as the fractional reserve system of banking would multiply the monetary base through deposit expansion. Today, however, deposit expansion and debt expansion have become decoupled as banks sell loans to third parties. In addition to decoupling deposit expansion from debt expansion, the latter is no longer constrained by bank capital since the banks are no longer accumulating loans that require capital. This can create a monetary base outside of the traditional measures of money.


We have also seen a decoupling of the relationship between incomes and debt creation. In its simplest form this is the relationship between debt and GDP. The second graph shows NFGD as a percent of GDP and M2 as a percent of GDP. The divergence is striking, and I think gets to the heart of our economic crisis – the breakdown of the relationships between money supply and debt and between debt and income. With debt ballooning to new highs relative to income, the cash flow implication for consumers is less consumption and more saving – a recession. But what supports this balloon of debt in the first place? In part it is like any other bubble - the rising prices of the assets being financed by the debt provides collateral for more debt. The difference with this bubble, however, is that we have gone from a game where the ultimate size of the monetary bubble is regulated by the Fed through banking reserves, deposit multipliers, and bank capital to a system where any bubble can create its own monetary supply to support itself using securitization to multiply bank reserves in a virtually unlimited manner. At the same time we should be monitoring broader measures of monetary expansion because of financial innovation the Fed has stopped publishing M3 in the belief that it adds nothing to what M2 tells us.

So, other than restructuring how we monitor the financial system for the future, what should be done? Lets start by recognizing that doing nothing is unacceptable as the risk of a deflationary spiral is too great and the results too dire to chance. Once consumers are overburdened with debt service we should expect a recession because not only will consumers save to pay down debt, they will stop borrowing while they do so which will further reduce consumption. Reduced consumption could lead to falling incomes and prices, in which case relative debt burden increases making things worse. Assuming savings also decline through falling asset prices (stocks, home values, etc.) there would be no reason to expect an increase in consumption (save the increase in the value of cash net of the value of liquidity, if any, in such circumstances) or investment, and we could get stuck in a long-term underemployment of great proportions. If the true driver of the current financial crisis is the creation of too much consumer debt, then the only way we exit the crisis is by reducing the burden of the debt on consumers through some proactive means. There are several ways to go about reducing the burden of debt-service on consumers (other than simply using public funds to repay private debt). (1) We can try to inflate our way out of the impending cycle of deflation and recession by adding reserves to the banking system, but this assumes more reserves will result in more borrowing, investment, and consumption. Will companies borrow to invest when the economic outlook is dreadful because consumers are overburdened with debt? Will consumers borrow to consume when they are already overburdened with debt? In short, will traditional efforts to expand the money supply expand the money supply? The evidence is not in yet on this front. (2) We can make every effort to lower interest rates thereby supporting asset prices and reducing debt service payments. This would help to reduce the debt-service in the debt-service/income ratio and provide more income for consumption. The Fed’s efforts to reduce both short and long term interest rates should have some positive impact on reducing the debt burden by lowering rates and, therefore, debt-service payments and should, in turn, support asset prices. Note this is related to the inflation scenario in that monetary policy easing means lowering interest rates on the short end. The Fed has now gone to purchasing long-term securities in an effort to reduce long-term rates that have not responded to the short-term rate reductions. We can also attempt to restructure debt obligations so as to reduce the current payment obligations of consumers by, for example, extending the term of a loan. (3) We can have a major fiscal stimulus that creates employment to increase incomes relative to legacy debt-service. By increasing incomes the debt-service/income ratio would decline. The stimulus would, in effect, replace private debt with public debt, freeing up income for consumption. Based on recent reports, a major fiscal stimulus plan is probably in the works by the new administration.

While we wait to see if our efforts are successful, we can utilize the Fed and Treasury to (i) pump public money into bank capital so the banks have enough capital to make new loans when they hold excess reserves, and (ii) lend to ever increasing elements of the financial system to prevent major systemic collapse as speculative financing evaporates. None of this is news.

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Is M3 Important?

There is interesting discussion on Paul Krugman’s NYT blog today regarding monetary expansion and the Great Depression. For the current crisis, I think you need to look at the divergence of M2 and M3. As institutional money market investors fund commercial paper that funds asset sales by originators, M2 is converted to M3. The money multiplier becomes unlimited as the original reserves used to fund loans are returned in full to the banking system with no new net increase in deposit liabilities. What’s happening right now is the reverse – M3 is liquidating and the monetary base is expanding to, in part, accommodate the conversion. If you look at Institutional Money Market Funds on Z.1 you will see the reductions in this (and, I believe other) components of M3 relating to credit expansion in the modern financial system. I have been waiting for the next Z.1 to confirm these movements.

I believe M3 is important, notwithstanding the Fed’s decision to stop publishing it. I have not concluded that the M3 expansion is the cause of the bubble, but it certainly shows how monetary expansion and, in particular credit expansion, contributed. I plan to post more on this after the holiday weekend.

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Credit Markets

I have heard commentators (Larry Kudlow) making the argument that the credit markets are working OK because bank loans are up by some pretty high numbers. That got me wondering, so I looked at the percentage change in total bank credit plus asset-backed commercial paper from end of September to end of September the following year. The data include Loans and Leases in Bank Credit based on Statistical Release H.8 from the Federal Reserve (the "Fed") and asset-backed commercial paper outstanding from the Fed's Data Download Program. (In 2006 I had to use the October ABCP outstanding due to a gap in the data.) The first graph shows the results.

(Loans and Leases in Bank Credit plus ABCP)

As illustrated by the graph, total credit growth is actually quite meager. The true situation is, however, much worse. I illustrated this by taking out of total credit in 2008 outstanding loans made by the Fed and securities lent to dealers*. In other words, I am trying to isolate the private banking system itself as if the Fed's loans were to be repaid (of course, they cannot be). The second graph shows the result.

(Less Fed credit)

Credit coming from the private system is down - a lot - not up. Without the Fed's interventions we could be bartering by now. Now, there are a lot of other pieces to the puzzle, but this is certainly a more troubling view of the credit markets. Granted Mr. Kudlow was referring to the most recent 13 weeks, but if you calculate credit the way I have I still do not see any increases in credit coming from the private banking system.

* This includes the net Repo position of the Fed, the TAF, the PDCF, the Bear Stearns loan, loans to AIG, the TSLF, and the new asset-backed commercial paper financing. It does not include the new facilities announced by the Fed that are scheduled to begin Monday for the purchase of commercial paper and, as of the other day, other assets by the Fed.

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Credit Problems Beyond Subprime

When the subprime credit crisis began to unfold in 2007 I believed it was a sign of deeper problems in the credit markets. Easy money and unchecked leverage puts pressure on banks to lend. First they make the good loans, then the not so good ones, and then they make bad loans. So far most of the media attention has been on the subprime mortgage crisis. Last week, to little fanfare, the Shared National Credits Program released the results of its review of loans to corporate borrowers that are shared by banks in the US, banks overseas, and other institutions such as pension funds, hedge funds, and insurance companies. The review is of:

loan commitments of $20 million or more and held by three or more federally supervised institutions

The review shows considerable deterioration in credit quality of these loans.

Criticized credits increased $259.3 billion and represent 13.4 percent of the SNC portfolio compared with 5.0 percent in the 2007 SNC review. Credits rated special mention (potentially weak credits) increased by $167.9 billion and represent 7.5 percent of the SNC portfolio compared with 1.9 percent in the 2007 SNC review. Classified credits (credits with well-defined weaknesses) increased $91.5 billion and represent 5.8 percent of the SNC portfolio compared with 3.1 percent in the 2007 SNC review.

Even more interesting is how the criticized loans are distributed:

Classified credits held by non-bank entities increased to $70.0 billion from $34.8 billion and represent 42.9 percent of classified credits. The volume of classified credits held by non-banks is particularly significant given their relatively small 19.9 percent share of the SNC portfolio.

The distribution could be due, in part, to purchases by non-bank entities of credits at a discount from face value but the report is silent on this point.

So what does all of this show us? It demonstrates the fact that subprime was one area of the credit binge of the past few years. Subprime is certainly a very big part of the credit crisis, but it is not the only part. Here is what the review states about underwriting standards for these $2.79 trillion of loan commitments with $1.2 trillion outstanding:

For the second consecutive year, the review included an assessment of underwriting standards. Examiners again found an inordinate volume of syndicated loans with structurally weak underwriting characteristics particularly in non-investment grade or leveraged transactions.

Add to this portfolio and mortgages all of the other loan portfolios, including credit cards, auto loans, corporate loans, small business loans, and so on, and this crisis goes well beyond subprime mortgages. Just how far is impossible to tell, but the rapid deterioration in the portfolios of major banks, such as the loss reserves announced by Bank of America, give us an indication. As reported in The Wall Street Journal Online Edition:

The nation's largest retail bank reported net income of $1.18 billion, or 15 cents per share, down from $3.70 billion, or 82 cents per share a year earlier. The results were worse than expected. Credit losses on mortgages and credit cards dragged down the results. Its provision for credit losses was $6.45 billion, up from $5.83 billion in the second quarter. Net charge offs were $4.36 billion, as compared to $3.62 billion in the second quarter.

Nonperforming assets were $13.3 billion, or 1.42 percent of total loans, leases and foreclosed properties. The dividend cut at Bank of America, the country's largest bank in terms of deposits, mirrors similar moves by smaller banks across the country as they look for ways to cut costs and raise capital amid the volatility that has driven some of the country's biggest financial institutions out of business.

For more on credit cards see this WSJ article.

I think the credit crisis and its impact on the economy have a long way to go. There are many reasons I believe this and I have been writing about them for the past year. What I found amazing and would like to point out is just how rapidly Wall Street greed exploded, bringing the financial system to its knees. In 2004, investment banks and commercial banks were recipients of deregulation relating to the amount of leverage, on and off their balance sheets, they could employ. There have been many reports on these events, including this New York Times article addressing the investment banking regulations, this blog piece by yours truly addressing both sets of regulations, and this one I penned last May pointing my finger at Bush appointed regulators. Two years after these regulatory changes, the system imploded. True, there are many other issues that are much longer term in nature. In particular, unregulated derivatives markets turn out, not unexpectedly nor without warning, to be a major structural problem in the financial system, and easy monetary policy plus global liquidity were certainly contributing factors. But notwithstanding these other factors that come in to play in this crisis, the simple fact is that if regulators had limited the amount of leverage financial institutions could employ we would not have necessarily reached the crisis stage.

In 2004 regulators gave Wall Street some rope, and it took a mere blink of the eye for Wall Street to hang itself (and, unfortunately, a lot of others).

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TGIF!

Today was one of the most interesting days I have ever witnessed in the markets. I am not a market expert so take all of this with a grain of salt, but it was watching history in the making.

I would say it was a really bad day like last Friday. Last Friday I wrote that it was a really bad day that did not bode well for the markets. This week certainly seemed to support that logic with the DOW having its worst week ever in its 112-year history. It was a really bad day last Friday because the credit markets were screaming with the TED Spread at historic highs and prices of everything down on the day (everything except Treasuries). Stocks, oil, and even gold fell last Friday. By that logic today was even worse.

Today the TED spread was even higher than last Friday, stocks, oil, and gold all fell again, and unlike last Friday even Treasury securities fell in price. It feels as though there is a mass liquidation going on as investors scurry to meet margin calls. Sell anything and everything – we need cash! De-leveraging is in high gear this week.

There were, however, some encouraging signs in the stock market today. After falling precipitously at the open, over 690 points down, the DOW recovered and went positive for a while in what was a stunning reversal. It then lost steam and spent the better part of the day down between approximately 250 – 500 points. At the end of the day the index made another comeback, again turning positive by over 300 points before ending down a “mere” 128 points (seems like small potatoes now). The spread between the high and low of the day, 1,018.77 points, was the largest ever in the history of the DOW. The Nasdaq ended up just ever so slightly.

Summing it up, virtually all asset classes were down today including stocks (on NYSE record volume), bonds (including Treasuries), and commodities (including gold), while the credit markets remained in shambles. This suggests the markets are in full de-leveraging mode and its sell first, ask questions later. There were, however, two remarkable intra-day rallies in the DOW and the Nasdaq ended up for the first time all week, providing a glimmer of hope. It really did seem as though bargain hunters came out in force today and scooped up stocks on the cheap when the market was under extreme pressure. Whether this is a sign that things will moderate is impossible to tell and in the end all asset classes ended down in price. It was comforting, however, to see the cash coming to the table. Even I dipped my toe in the water and I am extremely bearish. Greed got the better of me but I kept it in check by making only small purchases and putting on a hedge. Unfortunately, if nothing changes for the better over the weekend and the de-leveraging continues, next week could be another painful one. There were hopes that the G-7 Finance Ministers and Central Bank Governors would come out with a coordinated plan of action to battle the credit crisis and that may have been fueling some optimism. Unfortunately there was no plan, only a "commitment" to continue working together to stabilize the credit markets – something that has not happened yet. One thing that has happened – I have a splitting headache from following this week's gyrations. TGIF!

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More From The Federal Reserve

The Federal Reserve announced today that it will form a special purpose vehicle (the Commercial Paper Funding Facility or CPFF) that will purchase commercial paper in the marketplace from qualified issuers. This raises many questions, such as whether the Fed is now rationing credit to US companies without oversight.

The Federal Reserve is already in effect purchasing asset-backed commercial paper through its Asset-Backed Commercial Paper Money Market Liquidity Facility (ABCPMMLF) where it is lending money to banks to purchase commercial paper that is then pledged to the Federal Reserve. The twist here is that the loans to the banks are non-recourse, so if the commercial paper defaults the Federal Reserve is stuck, not the bank that borrowed the funds – same risk as ownership if you ask me. This action was authorized pursuant to section 13(3) of the Federal Reserve Act (see below). The commercial paper that banks are purchasing and pledging to the Federal Reserve under the ABCPMMLF is secured by the assets backing the asset-backed commercial paper.

The Federal Reserve is now expanding its use of this authority to purchase commercial paper directly from issuers that may be non-bank companies raising the prospect that the Federal Reserve will be rationing credit to US businesses. There is also an issue of authorization, and it seems definitions are malleable in times of crisis. From today’s announcement:

The CPFF will be structured as a credit facility to a special purpose vehicle (SPV) authorized under section 13(3) of the Federal Reserve Act. The SPV will serve as a funding backstop to facilitate the issuance of term commercial paper by eligible issuers.

According to section 13(3) of the Federal Reserve Act:

3. Discounts for Individuals, Partnerships, and Corporations In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank (emphasis added): Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

According to the highlighted section of the Act the commercial paper purchased by the Fed must be SECURED. My understanding of security in lending transactions is that there is a guaranty or some form of asset available to the lender that can be sold in the event of a default, the proceeds of which would be likely to repay the debt. According to the Federal Reserve's release:

Commercial paper that is not ABCP must be secured to the satisfaction of the Federal Reserve. The commercial paper may be secured in one of the following ways: (i) The issuer pays the SPV an upfront fee based on the commercial paper initially sold to the SPV and a further fee based on subsequent commercial paper sales above that amount (emphasis added); or (ii) The issuer obtains an indorsement or guarantee of the issuer’s obligations on the commercial paper sold to the SPV that is satisfactory to the Federal Reserve; or (iii) The issuer provides collateral arrangements that are satisfactory to the Federal Reserve; or (iv) The issuer otherwise provides security satisfactory to the Federal Reserve. The Federal Reserve will consult with market participants about other methods for issuers of non-ABCP commercial paper to provide satisfactory security to the Federal Reserve.

I wonder how being paid a fee for purchasing commercial paper meets the definition of SECURED under the Federal Reserve Act quoted above. It sounds more like creation of an insurance pool to me. Shouldn't the Federal Reserve obtain Congressional approval to purchase commercial paper from issuers in this manner? The authority is not clear to me.

I do not object to the Federal Reserve taking whatever action is within its authority that could help avert a financial disaster. What I do object to is when institutions bend the meaning of laws to accomplish what they want but then speak about the rule of law and the need to police the actions of those who seek to avoid compliance. Isn't this exactly how we got into this mess in the first place? I am also troubled by the fact that the Federal Reserve can now be seen as rationing credit to US corporations and that this situation is ripe for abuse through influence. There should, in my opinion, be oversight.

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Fed Goes Nuclear

The Federal Reserve is going nuclear. The TAF is doubling to $900 billion, interest will be paid on reserves beginning October 9, and the rules prohibiting commercial banks from purchasing assets from affiliated money market mutual funds is being relaxed. This last move puts FDIC insured deposits behind money market mutual funds which is, I believe, a roundabout way to get taxpayers behind the funds. They previously did this for the investment banking affiliates. The interest on reserves is required because the Fed is flooding the system with reserves and if it did not pay interest on reserves its target rate would be meaningless, as overnight lending rates would plummet to near zero. This is amazing – unfortunately - and there is likely more to come. Who thought $700 billion was a lot?

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Why It’s a Bad Day

Today was a bad day.

First, the credit markets are screaming. The TED Spread is at historic highs. If you don’t know what the TED Spread is, it measures the difference between the interest rate paid on Treasury securities and the LIBOR rate. LIBOR is the London Interbank Offer Rate, and that is the rate banks offer to lend dollar reserves to one another in London. So why is the difference between these two rates important?

Rates on Treasuries are staying way down because investors don’t know where to put their money to keep it safe, let along make a return. So they run to the safest investment they can find – Treasuries. This is called a flight to quality. On the other side, banks don’t want to lend to each other. This is in part because they are afraid they will not get paid back and in part because they are concerned their funding sources may dry up so they are hording reserves. This is a sign that the banks are very nervous. The bigger the difference between these two rates, the more fear in the markets.

The other very troubling sign is the concurrent declines in oil, stocks, gold, and other metals on the heels of an already declining housing market. Usually, when the stock market is down, you can watch the funds flowing into gold or oil or some other investments. Now, however, that’s not happening. Stocks are being sold off and the money is going out of the markets, perhaps into Treasuries and perhaps under the mattress. This could be a sign that large investors such as hedge funds are selling to raise cash for distribution to withdrawing investors or meeting margin calls. It could also be a sign that investors appear to be coming to terms with a very poor global economic outlook. In any event what we are seeing is signs of deflation. If you have any doubts about why deflation is bad, think about paying off your mortgage as the value of your house, your wages, and everything else falls except the amount you owe. Think about a business investment when the value of the product you will produce is likely to decline while the loan you use to finance the investment does not. Deflation is a really bad thing because it hurts the wealth of anyone who is a net borrower (most households) and it discourages investment leading to more unemployment. More unemployment on top of an already weak labor market can result in a downward spiral as consumption shrinks due to job losses causing more job losses causing less consumption, etc.

Warren Buffet has been in the news lately. Many have felt comforted by his investments in Goldman and GE. I have not, because it tells us that the bluest of blue chip companies are now paying 10% plus equity warrants at or around current market prices to raise capital. This is to replace short term funding from sources such as commercial paper where rates are (or were) much lower. This tells us financing is very difficult to obtain and the higher cost of funds will likely have a negative impact on future earnings.

In the long run, it shows that Buffet has faith in the United States and that's good. What happens between now and the long term is what has me concerned. One day does not a trend make, but this is not a good day.

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Policy Implications of the Credit Crisis

I have been working on a way to conceptualize where our economy is and how we got here. I am trying to avoid all of the finger pointing that is currently going on (including my own finger pointing) in an attempt to remain somewhat objective, and I do not pretend to include all of the elements of our current economic system. What I am trying to present is a basic model that helps explain the relationships between our economic system and the need for tax, trade, energy, and education policies. I want something that can work for students, and I appreciate any suggestions that would improve the model and/or the presentation.

I have developed a framework that I think makes sense and it is represented by the two diagrams below. The first diagram, "The Way It Was", illustrates the basic wealth creation model of a country with balanced internal flows and net exports. This is the USA in the past. Note that there are net positive flows to investors from within the USA and from abroad (represented by blue items), while at the same time there are positive flows to the USA box, representing domestic wages and consumption (the red lines) from domestic investment and net flows from abroad. The INVESTMENTS box is subdivided into investments in productive assets and investments for consumption. I have labeled the consumption investments FINANCIAL to represent purchases of financial assets supporting consumption such as consumer loans, mortgage backed securities and so forth.

The next diagram represents "The Way It Is". Note the change in flows of investment in production from the USA to Non-USA recipients of investment represented by the red line. This creates a shift in the net wage gains and net consumption flows as we begin to import more from overseas production and invest less domestically than we otherwise would. Initially this model works well for investors as profits increase due to cost reductions. Adding tax cuts into the mix provides a dramatic increase in wealth to investors and a larger pool of investment capital. Adding to that profits from the gains made by NON-USA investors investing back into the USA and you have a gigantic pool of liquidity looking for profitable investments. Unfortunately, at the same time this massive liquidity pool is building, the reversal of flows to wage earners begins to put pressure on consumption. This should have caused a reduction in consumption in the USA that would have been a normal response to these changes in flows, but it did not. Rather than adjusting production down to a new level of consumption the massive liquidity pool was directed into financial instrument supporting consumption. This created the base for a large explosion in debt as USA consumers continued to consume financing this over-consumption through debt. Now, however, consumption is above the wage earners' means of supporting ownership and the debt underlying the financial instruments invested in by investors begins to go bad (defaults on home mortgages, for example).

Combining all of these factors we get both a debt bubble (represented by the green lines) and a wealth bubble (represented by the blue lines). This is where we are today, and the bubbles are unwinding. Wealth is falling as asset values decline and the debt bubble burst last year. We are currently on life support from the Federal Reserve and other government sources. At this time we should see a reversal of consumption flows as USA consumers pull back. This would help to slow the imbalance of international flows through a normal adjustment process (including a falling dollar as USA interest rates fall and the economy weakens). Unfortunately this is where energy policy (or lack thereof) comes in. As investors try to protect their asset values they are moving from financial investments to hard assets such as gold and energy products. Energy products are also priced globally in dollars, so as the dollar declines in value the dollar price of energy goes up. These factors are keeping energy prices high, and since the USA is a massive importer of energy the trade flows remain strongly negative.

So, what does all of this tell us with respect to our national policies? I believe it has implications for tax policy as tax incentives to the investor class may have over stimulated the economy during globalization. I pose the unanswerable question – would real interest rates have been negative for so long in 2003 if tax cuts flowed to consumers rather than investors (thereby stimulating consumption rather than "investment")? Would the size of the debt bubble have grown so large if there were less investment chasing return? Questions that merit empirical study, I think. Perhaps tax cuts for wage earners would be better policy considering all of the money flows.

It also has implications for trade policy as sustaining the structural trade flows we currently have is a recipe for massive wealth transfer from the USA to energy producing countries (this massive transfer is currently under way). That brings us to energy policy. Perhaps we should direct future investment into energy independence. This is not a new idea, but this model helps to illustrate the need and the interdependence of energy, trade, and tax policies. Developing new sources of energy could certainly help reverse the flows back to what they were in the first diagram. I'm not suggesting we adopt an isolationist stance. What I am suggesting is that we very quickly direct our investment capacity in a massive way into energy independence and additional efficiency technologies to help offset the advantages of investing outside the USA (rather than simply driving USA wages down). You can bet that other countries are doing exactly that and we are in direct competition with them. This, then, gets us to education. Should it be a national priority that we educate the population to the maximum of our capacity? I believe it is.

What has been missing, in my humble opinion, is leadership to help guide the country through appropriate policy incentives to achieving these necessary goals. This void has left us scarred and my hope is that the current crisis will point us in the correct direction for the long term. (OK, I couldn't help just a bit of politics).

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What the Plan Does (and does not)

Now that it appears Congress will pass the bailout plan the next logical question is “what’s next?” I don’t know the answer, but I have my concerns.

This plan may well deal with the current stresses in the financial markets. If so, we can all stop panicking that the world as we know it will come to an abrupt end and get back to the real economy. But, as one commentator just said on CNBC, this may put the fire out but the furniture is still burned. The problem is that the real economy isn’t doing too well. Unemployment is up, spending is down, people are concerned, so where are we headed from here? First, lets see what the current plan hopes to accomplish.

Here is the problem. If a bank has lots of bad assets on its balance sheet, it can’t sell them because if it does it takes a loss on the sale. That loss reduces the bank’s capital, and without adequate capital a bank cannot make loans. On the other hand, if the bank just holds on to the bad assets, it can’t raise new cash to make loans because no one wants to lend it money without knowing how bad the bank’s balance sheet actually is. So as long as these bad assets are being held by the banks lending activity slows or, in the worst case, stops all together. If this gets really out of hand and these bad assets start showing up in other places (like money market mutual funds) then investors start taking their money out of all the places they invest and all lending could stop. That would be the modern day equivalent of a run-on-the-banks. No loans, no economic activity and we fall into a very bad economic shutdown. The only difference between this kind of bank run and the classic depression era run is that the taxpayers stand behind the deposits in commercial banks today through the FDIC and Treasury so we collectively insure our deposits. This prevents a run on commercial banks. We don’t, however, insure the funding sources for all of the other financial institutions in our financial system. Money market mutual funds, insurance companies, investment banks, hedge funds, and private equity raise funds that are not insured against loss. When these bad assets start showing up in those places the sources funding them run. This is why the federal government announced an insurance plan for money market mutual funds last week, and is also why we have witnessed the demise of the independent investment banks. The investors in these banks have stopped funding them – a run on the investment banks. So, although commercial bank deposits that most Americans have in their bank are insured, there is an entire system of finance that doesn’t have this protection and is prone to a classic run. That run is in progress. The current plan hopes to remove bad assets from balance sheets of financial institutions so that lending will return to the economy and investors will stop running. It is intended to “unplug” the flow of money throughout the system by taking away the source of the clog – these bad assets. But even if it works, where do we end up?

A while back I posted an article that explained how the level of household debt to personal income has grown too high and until consumers pay down their debts to a level they can afford the economy will not do well. This is parallel to what is happening in the housing market. Until prices return to a level that makes purchasing a home affordable for the average homeowner prices will decline. As far as overall household debt is concerned, until it returns to a level supportable by personal incomes debt must be reduced. How do we reduce debt? We save rather than spend. Saving more and spending less means less economic activity, and that means a possible recession. So how does the rescue plan deal with this issue? I don’t think it does because it doesn’t deal with the bottom up issue that consumers are in too much debt. How much debt are US consumers in? Total household debt is about $14 trillion, or approximately 145% of 2007 annual disposable personal income. What was this ratio the last time we went into a banking crisis in, say, 1991? It was approximately 85%. That leads us to a thought experiment. What would it take to get us back to the levels of debt to income that we had during the last crisis? If we assume disposable personal income will grow by 2% for this year, then personal income for 2008 should be approximately $9.8 trillion dollars. At 85%, household debt would be approximately $8.4 trillion. Since actual household debt is currently in the $14 trillion range, we need to de-leverage about $5.6 trillion to get back to the 85% ratio we had in 1991. In a $14 trillion economy that represents about 40% of one year’s GDP. In fact, it’s even worse than that because if we stop borrowing in order to save then we also lose the GDP funded by debt (another $880 billion). Comparing other developed countries that have seen similar increases in household debt to disposable personal income, Japan stands out as it went over 120% in – you guessed it, 1991 (see page 47). This was the start of the “lost decade” for Japan.

I don’t expect we would make up all 40% of our adjustment back to 1991 in a short period of time, nor am I convinced that we will ever actually get there without a major new boom in real economic activity (such as discoveries relating to new energy technologies) or a major bust where debt gets written down in mass quantities. The situation does, however, point us to what we can expect next. Expect a rather protracted recession and/or more government interventions into the economy before this is over. I expect the next intervention will be of the bottom up sort, and eventually if the Federal Government owns enough mortgages I can see debt forgiveness of underlying mortgages owned by taxpayers.

Debt numbers: here
Personal Income numbers: here.

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Goldman Profits Up on Short Sales of Goldman

OK, the headline is completely fictional, I think. I just re-read some articles about how Goldman Sachs was at the heart of creating so many toxic mortgage securities and how watching its former head (Treasury Secretary Paulson) pining for $700 billion of taxpayer money to clean up the mess is disgraceful. One of the points that came out again was the fact the Goldman came away from the whole mortgage crisis relatively unscathed from a profit point of view because it was shorting that market heavily as the crisis unfolded. Now, of course, regulators have prohibited short sales in Goldman stock to prevent Goldman's stock from collapsing and there is a witch hunt going on to find those evil short sellers. Wouldn't it be an absolute riot if it turns out Goldman was one of them?

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Senator Schumer Insurance Plan

Senator Schumer came up with what I think is a really good idea, although I think it could be modified a bit. His idea - rather than charging specific companies fees or equity participation for participating in the bailout program, charge a general insurance fee to all (“large”) financial institutions to provide a fund that would protect taxpayers from eventual losses. I like that idea because it socializes the losses among the financial institutions rather than the general taxpayers. It also resolves the objection Paulson has to protecting taxpayers by charging specific participants. Paulson's concern was that institutions would not participate if there is a cost involved. I think that’s a stretch for taxpayers, but Schumer’s idea isn’t a bad compromise. I would like to see a substantial required contribution into the insurance fund at the expense of dividends if necessary. After all, in the end we want capital to flow to financial institutions on a net basis but we want the ultimate protection to come from the owners of the financial institutions. If we simply charge an insurance fee over time it will ultimately be passed along to taxpayers anyway through higher costs for banking as the fee is built in to the cost structure of these institutions.

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Bailout Testimony

Chairman Bernanke’s testimony today was astounding to me for two reasons. First, he stated that by using public funds to purchase toxic assets from financial institutions we would gain a better understanding of the hold-to-maturity prices of these assets. In effect, he is saying that the market doesn’t work and only government intervention will provide a price discovery mechanism. I take exception to this conclusion because it is based on internally flawed logic. Creating a market with public funds does not provide price discovery, it provides a new market that is not based on “market” prices at all. Rather it is based on availability of funds from taxpayers and it is ripe for abuse.

Second, Mr. Bernanke said that punitive measures should not be used against institutions that participate in sales to the government because it would limit participation. The only reason this could be true is that the government will not allow these institutions to fail so, rather than participating in this plan financial institutions could blackmail taxpayers for another rescue plan. If the government made it clear that they either participate or fail they would participate. I, for one, am tired of being held hostage by financial institutions.

Treasury Secretary Paulson addressed the lack of oversight provisions in his bailout proposal by explaining that he did not intend there be no oversight in his proposed plan. Rather, he felt it should be up to Congress to figure out how to monitor this program. I figured that to be the case, but I have an exception to this. If the oversight was to be determined by Congress, then why put the following provision into the proposal?:

Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Finally, I ask again, where is the presentation?!? All I am hearing is “this is my opinion as Fed Chairman” and as Treasury Secretary. Taxpayers deserve better than this.

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Shock And Awe

I feel like I did just before we attacked Iraq. I feel as though we are being frightened into doing things that in the long run are very bad ideas, but only those in power know all of the details. It's Paulson's way or else. I think we need debate on how to approach this crisis, and I would love to hear plans that focus on supporting market function while allowing bankrupt entities to fail. One problem is that those working on fixing the problems are the same people who created it and their view is strongly biased toward Wall Street. I have a bad feeling about this.

So far, the steps being taken don’t seem to be working while at the same time are creating the dangers of the next financial crisis. For example, I think there is real subterfuge going on with the IBanks. First, the Fed relaxed rules on using FDIC insured deposits to fund IBank operations (that happened the day Merrill & BOA merged). In effect, this is a taxpayer guaranty for Merrill without any congressional review and could be the seeds of the next disaster. This rule is only effective until the end of January 2009, but if the Ibanks are relying on depositor funds at that time what will happen – they will magically find an alternative source of funds? With Goldman and Morgan converting into national bank holding companies they will benefit from the same rule relaxation as Merrill and perhaps use more favorable accounting treatment to value their assets. If I get some time I want to look into that and I welcome all comments on it. Also, today the Fed relaxed rules on private ownership of financial institutions - another move that could contribute to the next disaster as private equity groups that control all types of businesses purchase controlling interests in taxpayer backstopped institutions. All of these moves have, in my opinion, negative implications for the future of our financial system.

What is missing from this entire debate is a clear description of what exactly we are afraid of. Now, I understand the implications of a complete meltdown of the financial system and I think we should be doing something to address the issues. But I have not heard from Paulson or anyone else a clear description of what happens if we do nothing and what the alternative actions may be. Where is the slide show? Where is the full and complete analysis? How does this flow of funds from the US Taxpayer to privately owned financial institutions that continue to pay dividends to their investors fix the problem? Why are these institutions still paying dividends? Shouldn’t there be a prohibition on dividends until taxpayers are made whole through recourse guarantees or some fund created through dividends that would have been paid to investors? Is there a way to fix this problem from the bottom up rather than the top down? Shouldn’t there be some executive compensation limitations? Etc., etc., etc. Rather than all of these issues being addressed we are getting shock and awe. Congressional hearings are beginning – let’s hope our representatives in government step up to the plate. They have certainly heard from me, and you can express your views by going here and contacting your Senator.

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Rule Manipulations for IBanks?

Just when I thought I was caught up, Morgan and Goldman are approved by the Federal Reserve to become bank holding companies. What I suspect this means is that they will now look to acquire banks that can provide stable depositor based funding. The Federal Reserve just relaxed the regulations prohibiting bank holding companies from using federally insured deposits to fund investment banking assets so we end up with FDIC (taxpayer) guaranteed deposits funding investment banking operations. I hope I am wrong, but if this is the case it is a shameless manipulation of the rules to use unsuspecting taxpayers in a bail out for equity and bond investors in these banks and it should not be allowed to proceed without full and honest disclosure and approval from Congress. If these banks are insolvent the fix should be that equity and then, as necessary, debt gets wiped out, not that a roundabout free taxpayer guarantee provides the means for funding.

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Credit Market Developments

Treasury has proposed a $700 billion taxpayer funded (through issuance of debt) purchase program to acquire real estate assets from the financial industry. This has been coming for a long time, and goes all the way back to the failed Super SIV that was being discussed last Fall. Of course, the numbers have grown from what was a $70 - $100 billion plan to the current $700 billion plus plan, and this plan has the taxpayers purchasing the bad assets directly. The accounting issues of valuation, however, have not changed. What has changed is that the crisis has become so bad we are probably willing to throw out the rules to save the game.

The plan is essentially a $700 billion revolving line to acquire real estate assets at whatever prices and from whatever sellers Treasury wants. There is no protection for taxpayers in Treasury’s proposal, and I can only assume Treasury has left this aspect of the plan for Congress to address. If this isn’t ringing alarm bells all over Washington and Main Street I don’t know what will.

Treasury Secretary Paulson has submitted a very broad plan that gives him extraordinary discretion and prohibits any agency or judicial review. You can see a copy of what was submitted in this CNN article and read a description of the plan at the Treasury’s website. The submission raises many questions, three of which I will point out.

1. There is no provision for protection of taxpayers. As written, it seems that Treasury will simply purchase, at whatever price Treasury determines,

Mortgage-Related Assets.--The term "mortgage-related assets" means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

The big question – at what price? If Treasury purchases securities at current market prices it doesn’t necessarily help the financial institutions that own them. Right now losses that would occur at market prices are being deferred through secured lending by the Federal Reserve, but this is obviously insufficient. If these assets are in addition to those pledged to the Fed, then this is a multi-trillion dollar problem. If Treasury pays more than current market prices, then how is the taxpayer protected? Not to get off on a rant here, but it seems to me that any financial institution that sells securities to taxpayers pursuant to this program should, at a minimum, direct all dividends to the Treasury until taxpayers have been fully repaid, at which time they can have the balance of the securities returned. It really irks me to think that financial institutions could sell the crap they profited from so handsomely over the past decade to taxpayers, letting us assume the risk, while the owners continue to collect dividends. Absolutely horrible result that I truly hope Congress will address. Some may argue that this would make it difficult for these institutions to raise capital, but that should be irrelevant now since the taxpayers are providing the capital if we pay above market prices for their securities. Another point – why are we purchasing commercial real estate assets and what are the limitations on commercial vs. residential?

2. I think there is a lack of transparency. The current proposal provides for a report to Congress three months after the program begins and then every six months. As a taxpayer whose money is being spent on these assets I want to know every week how much, who, when, and so on. I want to know which institutions are benefiting, how we are getting compensated for it, what is the asset rated, what is the mark-to-market value, and so on. Without full disclosure this plan is ripe for abuse and all purchases need to be fully disclosed. I suppose there is an argument that disclosing which institutions are selling assets to taxpayers could jeopardize the institutions, but since they would be receiving a capital infusion from the purchase this should not be an issue. Poor disclosure is one of the issues that got us here in the first place and any plan to address this crisis must include full disclosure.

3. The amount of this bailout is unclear. It specifies that:

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time

. This means we could be purchasing a lot more than $700 billion worth of this stuff, we just will not own more than $700 billion at any one time. How do we account for the value of these assets? If Treasury purchases an asset for $1 million and receives principal payments that reduce the face amount of the asset, do those payments reduce the $700 billion even though we may still take a loss on the balance of the $1 million we paid? If so, this is more likely a $1 trillion plan (or more).

In other bailout news (post AIG taxpayer bailout), the Fed established a line of credit that is reportedly $230 billion to purchase asset-backed commercial paper on a non-recourse basis (meaning the Fed will own the stuff). Asset backed commercial paper was at the heart of this crisis to begin with and is where funding dried up last week. What does this commercial paper fund? Everything, including auto loans, credit cards, and so on. If this market freezes your credit card may not work, and the resulting panic could be devastating. Think how you would react if told you could not charge your groceries on your credit card because Citibank doesn’t have the money to lend you. In addition, companies could find it impossible to fund payrolls causing more panic. This is one of the reasons Treasury acted on its plan – justified fear. (For a good explanation about how asset backed commercial paper works see this fitch report).

So what happened in the commercial paper market? In general, money market investors put money into money market mutual funds that then use the money to purchase assets including asset-backed commercial paper. But when a large money market mutual fund reported that it took a loss and that investors would lose money, money market mutual funds in general received calls for redemptions from investors who feared losing their money – a run on money market mutual funds. As night follows day, the mutual funds stopped purchasing commercial paper and put their liquidity into Treasury securities, driving the interest rate on short term Treasuries to negative on at least one issue and the interest rate on commercial paper way up. This is a clear dislocation in the credit markets and the Fed jumped in to provide liquidity for commercial paper. In addition to the Fed’s new plan to purchase commercial paper, Treasury reached back to a depression era law to insure money market mutual funds. Funds can buy into the plan that will insure investors against losses. This has irked some banks that believe this places them at a competitive disadvantage to insured money market mutual funds and could cause their funding to dry up – more unintended consequences (do I hear whack-a-mole?).

One more item on the list of things being done to avoid a total meltdown – relaxation of regulations on financial firms. Since these firms cannot raise any capital because their business models are in question regulators have relaxed capital requirements – temporarily, of course. Another thing regulators did was relax the restriction on using commercial bank deposits to fund investment bank operations. After the great crash of 1929 and the ensuing depression, Congress split up the investment banks and commercial banks because investments made by investment banks in equities were too prone to value fluctuation that could wipe out depositor funds. The FDIC was established to insure deposits and banks were limited as to what they could do with those deposits (to protect the taxpayers from having to bail out excessive risk taking). The law that kept investment and commercial banks separated was repealed in 1999, but there was regulation in place that prohibited these new combined banks from transferring commercial bank deposits to investment bank affiliates. Some of this regulation is currently being relaxed so that investment banks that are affiliated with commercial banks can get access to the stable deposit based funds of the commercial banks. The result is that to some extend the FDIC and taxpayer are now behind assets of the investment banking affiliates of the large commercial banks that have such affiliates. We have gone backwards (I bet Merrill Lynch and Bank of America appreciated this change that occurred the same time they merged).

For a time I was keeping tabs on the total cost of this credit implosion and the risk to taxpayers but the numbers are getting hard to follow. Based on current media reports the Fed is now up to $700 - $800 billion in credit and commitments, Treasury is asking for a $700 billion revolving credit facility from the taxpayers that is likely to be more than $700 billion in aggregate purchases, and so far the Federal Home Loan banks have issued some $250 - $300 billion in new taxpayer guaranteed debt to lend to banks against mortgage collateral. Oh yes, FHA has approximately $100 billion in new loan guarantees from FHA Secure and has another $300 billion authorized guarantee capacity to refinance defaulted mortgages. Are we at $2 trillion yet? If not, just add the GSE loans and MBS purchases Treasury plans (there are no limits on the amounts here) and whatever funds the GSEs need to stay solvent, and we have taxpayer exposure of well over $2 trillion even before the federal guarantees of the GSEs’ debt. These numbers don’t include losses that banks have reported on write-downs of securities. The result so far - Treasury has asked for an increase in the debt ceiling twice, this time to $11.3 Trillion (approximately 80% of GDP). One more point. If the total of all residential mortgages in The United States is in the $10.6 trillion range, and taxpayers now explicitly guarantee $5.5 trillion through Fannie and Freddie and are or will be at risk for say $2.5 trillion through all of the interventions noted above, then taxpayers could ultimately be on the hook (either through guarantees or ownership) for some 75 - 80% of the entire outstanding amount of residential mortgages in The United States. I find that staggering.

A couple of nits that I have:
1. Too bad Treasury didn’t go out and raise the money last week when interest rates on Treasuries were at historic lows. Probably would have saved a lot in interest.
2. CNBC should stop praising Jim Cramer as though he is some sort of visionary for talking about a bailout plan like this one. Everyone has always known that the government could step in and get behind lots of private debt to shore up the markets. In fact, everyone has been talking about it for some time. Treasury just didn’t until it was necessary because if it did it wouldn’t get approval for it. No great vision here. When Cramer comes up with a way to protect taxpayers that Congress will pass and that will resolve the credit crisis call me.
3. If there was ever a time to fix the unfair and disproportionate tax treatment for hedge fund and private equity managers (the 15% rate on “carried interest”), now would be it. In fact, several years ago would have been better. When this was in the public discourse several months back industry pundits argued that if you taxed hedge funds you would get less of them. Right now that sounds like a good idea. Fewer hedge funds, fewer credit default swaps, less systemic risk.
4. Like many of the talking heads on television, I am angered by all of the blatently excessive amounts of compensation paid to Wall Street bankers and executives over the past six years or so that is ultimately proving to be gains from the largest Ponzi scheme in the history of the world. There should be some recourse, though I don't claim to know how that could work.
5. With absolutely no proof that trickle down Reagan/Bush-onomics has ever worked, an exploding national debt, an exploding national deficit, and the impending baby boom retirement isn’t it time to stop talking about tax cuts for the investor class?
6. And finally, when will we, as a taxpaying and voting public, stop allowing the politicians to distract us with witch hunts for evil short sellers from the real issues – the fact that the political system has been for sale to the highest bidder and the highest bidder often turns out to be Wall Street and Wall Street.

PS - there are other developments, such as the Fed now accepting equities as collateral for certain loans under the Primary Dealer Credit Facility. To find out more about what the Fed is up to you can go to its website and click around the press releases.

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Trickle Up or Trickle Down?

Now that I got the details of the GSE takeovers out of the way with my last post, I wanted to write a more controversial opinion piece about this socialization of the mortgage market. As with many opinion pieces the topic is overly simplified in order to get the opinion across, but that's where all the fun is!

First let me note that although it is socialization now, the plan is to wind down the GSEs to approximately one quarter of their current size so ultimately this is a mortgage market privatization plan as much as it is a socialization plan. What has caused all of this turmoil? How did we get to this point? Here is one perspective for your consideration.

First, lets put a few factors into play. The divide between rich and poor has gotten very wide – the GINI coefficient has risen from under 40 in 1967 to 47 in 2006 (from Wikipedia.org). Second, we have seen falling or flat real wages as globalization has put pressure on labor’s ability to negotiate increases at the same time labor has become more productive by leaps and bounds. Third, corporate profits have been excellent over the past several years prior to the “credit crunch”. Finally, we have witnessed a huge increase in the level of debt owed by the average American household. Are all of these things related? I think they are, and my conclusion may not sit well with free marketeers.

At the heart of a capitalist system is the drive for profits. This drive, in an environment of free market competition, should result in innovation and, in turn, a rising standard of living. I agree with this concept and believe that there should be competition in markets. But does this system always work without unacceptable excesses? Of course not, and the current fallout is just one example. I believe that the imbalance of power between capital and labor has had a lot to do with our current situation, and if that sounds Marxist so be it.

Capital seeks profit. This is what drives a capitalist system. It gets profits by taking some of the value created by labor and keeping it for the owners of capital rather than sharing it with the producers – labor. Whether you believe this is good or bad is irrelevant for my purposes, so I will dispense with value judgment here. In order to maximize profits owners of capital seek to compensate labor at lower levels, and modern globalization together with governmental trade policies have enabled owners to take the upper hand in labor/wage negotiations. This is clearly evident in the fall of unionization and falling real wages, and is currently playing out at Boeing as labor seeks to limit management’s ability to outsource production. By successfully seeking lower labor costs owners created increased profits (lower labor costs net of increased transportation expenses). The higher levels of profit meant more new capital seeking profit. That means more investment in productive capacity. If the system gets out of balance, there is too much capital seeking profit and we get over-production. The problem is, who will purchase the surplus production, especially when real wages are falling? In theory this would result in declining prices and capital would be allocated away from production because profits would fall. So what got in the way of this process? Where is the invisible hand?

Enter leverage, the elixir. All of the excess capital was turned into even more excess capital through leverage in the financial industry. This leverage is evident in all of our financial institutions, from the failure of Bear Stearns to the liquidity crisis to the socialization of the GSEs. Leverage was enabled by our government through regulatory steps that opened the door for massive levels of debt relative to the existing pool of capital. This partnership between Wall Street and Congress is, I believe, bi-partisan and well entrenched. The result – consumers had the capacity to borrow and purchase even though they did not have the income to support the ongoing cost of ownership. Therein lies the imbalance between capital and labor that has resulted in our current situation. Too much capital allocated to production and lending for consumption, not enough wages to support ownership. The signs are there – rising inequality between rich and poor, outstanding corporate profits (until recently), consumption exceeding production, and stagnant or falling real wages. Now, as losses mount in the capital and money markets from all of the foolish extensions of credit (capital seeking profit), the process goes into reverse. Credit is difficult to come by and only allocated to the most worthy of borrowers. Consumers can no longer consume above their incomes and the price adjustment process that should have occurred a long time ago arrives with ferocity. Welcome to the credit crunch! What was the cause? Unrestrained and under-regulated capital.

As we de-leverage business profits will suffer from falling demand, asset prices will fall, and unemployment will rise. For the less well off there is the struggle to maintain the household, obtain food, and keep up with payments. For those with capital there is the struggle to preserve and grow it in an environment where prices are unstable. The current struggle is also playing out in the context of the political contest for President. Whether both parties are actually shills for the wealthy interests is a matter for debate and many believe this to be the case. Taking the candidates at face value, however, the Democratic party is calling for a redistribution from wealth to wage, while the Republican party is calling for a reduction of social benefits for wage earners to pay for ongoing tax cuts that benefit high income earners and owners of capital. Trickle up or trickle down. That is the question.

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The Plan for GSEs

The Federal Housing Finance Agency (FHFA), the regulator of the GSEs (Fannie Mae and Freddie Mac) announced today that it is putting these two behemoths into conservatorship. I have read through the announcement from Treasury Secretary Paulson and the statement made by James Lockhart, both of which are available at the Treasury Press Room online. (Please note that any quotes in this article not otherwise noted refer to this release.) There are some interesting aspects to this plan, as well as interesting questions.

The first question is why. Why put these entities into conservatorship now? According to today’s statements, the root cause of the problem is the inherent conflict within these organizations of being run for profit but with a purpose of serving a public interest. Of course, these institutions have existed in this form for quite some time (1968 for Fannie Mae and 1970 for Freddie Mac), so this would not be why they are being put into conservatorship now. They are being put into conservatorship now because they are no longer able to accomplish their mission of helping to provide liquidity to the mortgage market and “respond appropriately to the private capital market,” (see the legislation that created Freddie Mac here) and they are at risk of failure which could have devastating ripple effects in the financial industry and the broader economy. Mismanagement, excessive lobbying success, and the rapid decline in home prices have left them inadequately capitalized to carry out their missions.

Because they are undercapitalized investors have not been snapping up GSE liabilities. The poor demand for their debt results in the GSEs paying higher interest on borrowings, and this translates into more expensive mortgages for borrowers. So, even though the Federal Reserve has the target Federal Funds rate down to 2%, a negative real rate, interest rates in the mortgage markets are going up. Some believe this situation goes well beyond the GSEs and is a reflection of the entire financial system in the United States, but don’t expect to hear any politician or regulator tell you that in public. A Heard On The Street Column in The Wall Street Journal Online Edition makes that point this morning.

In order to provide liquidity to the mortgage market (which means demand for mortgage backed securities and debt issued by the GSEs), the Federal Government has decided to step in with a four-point plan. The hope is that if this plan is successful, mortgage interest rates will decline causing increased housing demand softening the housing price declines we are seeing. In turn, this should speed a recovery in the overall economy as falling home prices represent a huge drag on consumer spending. In addition, the systemic risk from a failure of the GSEs goes away (is transferred to the United States taxpayer).

One point I want to mention before getting into the details of how the plan works is that according to the statement released by James Lockhart, “all political activities – including all lobbying – will be halted immediately.” I find this ironic, and I would like to know when this rule would be applied to Wall Street.

That’s the why, now to the how. Step one is placing the GSEs into conservatorship, meaning they will now be run by FHFA. Investors who own stock lose all of their rights although they can keep the stock in the hope that at the end of all of this there will be some value in it. There will be no dividends paid to common or preferred shareholders. There is a ripple effect to this part of the plan, as any financial institution that holds a large amount of stock in the GSEs will likely realize a sudden and dramatic loss. The agencies involved in the financial system

encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares … are likely to reduce their regulatory capital below ‘well capitalized.’ The banking agencies are prepared to work with the affected institutions….

In any event, the largest players in the mortgage markets are now in the hands of regulators.

Treasury announced an additional three steps it will take to shore up confidence in the GSEs so their debt costs will come down and to provide liquidity to the mortgage market. These are (i) taxpayer guarantees of GSE debt backed by taxpayer purchases of Senior Preferred Stock of the GSEs as required (initially up to $100 billion for each GSE), (ii) “market” purchases of GSE mortgage backed securities (MBS) in an unspecified amount, and (iii) a taxpayer credit line of an unspecified amount for loans to the GSEs and the Federal Home Loan Banks secured by GSE MBS (or, in the case of the Federal Home Loan Banks, advances). These steps are all in addition to the $400 billion of liquidity provided by the Federal Reserve, the recent $300 billion taxpayer guaranteed FHA refinance plan, and the $250 billion of taxpayer guaranteed debt issued by the Federal Home Loan Banks since this “contained” “subprime” mortgage crisis began.

First, the Treasury (that would be the taxpayers) has guaranteed the solvency of the GSEs. So, if these entities lose money and become insolvent, the United States taxpayer will purchase up to $100 billion of Senior Preferred Stock in each entity that will be senior to existing preferred stock and common stock outstanding. This amount is not necessarily a limit on what taxpayers will invest – rather it is an amount chosen by Treasury as an initial facility size. Just to put this amount into perspective, the current common equity of Freddie Mac is approximately $12 billion. This taxpayer investment program is aimed at shoring up demand for GSE debt in the hope it will reduce the cost of debt and, in turn, bring down mortgage interest rates. In order to protect taxpayers, Treasury also gets warrants to purchase, at a “nominal” cost, up to 79.9% of each GSE. Senior and subordinated debt issued by the GSEs and the MBS they issue and guarantee remain senior to taxpayers and are, in fact, guaranteed by taxpayers because if the GSE can’t pay them taxpayers purchase more Senior Preferred Stock to provide the funds. The total amount of this debt is massive, but these are backed by mortgages and so losses are what we should be focused on. Even so, we are talking about a total principal exposure of over $5 trillion dollars.

As part of the agreement between Treasury and the GSEs, each GSE must shrink its on-balance sheet mortgage assets by 10% per year from $850 billion (a little more than what they are today) on December 31, 2009 to $250 billion. The impact of such a reduction in size on the GSEs’ ability to act as a conduit between lenders and the secondary market is likely to be substantial. According to FHFA this should address the systemic risk posed by the size of these institutions. It seems a shame, however, that publicly assisted housing finance that had worked so well until a few years ago is being forced to all but disappear. The ultimate losers would be the general public and the ultimate winners – well – whoever will satisfy all the mortgage demand when the GSEs are too small. Hopefully Congress will figure out a way to preserve the public benefit (Representative Frank?).

The second step Treasury is taking is initiating a program of purchasing GSE MBS that are credit guaranteed by the GSEs. Now remember that pursuant to the step just discussed these guarantees are now guarantees of the Treasury. Yes, the taxpayers will be purchasing taxpayer guaranteed debt with taxpayer funds. This part of the plan hopes to provide additional liquidity to the market for mortgage backed securities – something that the $400 billion or so that the Federal Reserve has provided, plus the $250 billion or so the Federal Home Loan Banks have provided, plus the $300 billion FHA plan, have not accomplished. Treasury will designate “independent asset managers as financial agents” to make purchases of mortgage backed securities on behalf of Treasury. Of course, none of these people know one another so we can rest assured that there will be no favoritism regarding who Treasury purchases the GSE MBS from (hummm). Two glaring mysteries in this part of the plan – how much will taxpayers purchase and from who?

Finally, Treasury is providing a collateralized loan facility to the GSEs AND the Federal Home Loan Banks. So, if the market for GSE debt is unfavorable even after all of the other steps, taxpayers will lend the money to the GSEs taking MBS as collateral, and if the Federal Home Loan Banks run into problems issuing their taxpayer guaranteed debt they too can borrow from the taxpayers directly (this type of borrowing would fund advances at these banks that are collateralized by mortgage assets of financial institutions). These lines of credit are available until December 31, 2009, as authorized by the recent legislation passed by Congress. There is no stated limit on the overall size of this facility.

If you are interested in following your money Treasury will be releasing information on borrowing by the GSEs and Federal Home Loan Banks in the Daily Treasury Statement. Purchases of MBS will be reported monthly in the Monthly Treasury Statement.

All of this raises some very interesting questions about our overall economic system. If time permits I will publish a perspective on possible root causes of all of these deviations from our “free market” system.

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Oil and Speculation - Again

OK, more on speculation and oil prices. I have followed Paul Krugman’s reasoning for a while on the oil price/speculation issue. His reasoning is very solid and at first blush seemed unassailable to me. His basic model on spot and future prices can be found here and I think is really worth a read. To give a brief summary, the logic is that if excessive speculation in the futures market was driving prices in the spot market there would be a couple of signatures we could observe. The first signature would be future prices that exceed spot prices (a condition called contango) providing the incentive for producers to withhold product from the market. Why deliver it today for $120/barrel when I can deliver it tomorrow for $125/barrel? Sell it tomorrow at a higher price rather than today at the lower price. (Note that holding current supply from the market would cause spot prices to increase and the aforementioned inventory build.) The other signature is that there should be a build in inventory as oil is held off of the market for delivery in the future. Neither of these signatures is evident in today’s market, however, so the conclusion is that speculation in the futures market is not impacting oil prices. To see this on his graph I have reproduced a modified version here.

The blue lines represent the original graphs (as drawn by me using crude tools). Expected appreciation is the curve on the left graph, and if future prices are expected to exceed spot then expected appreciation is positive (contango). If spot prices exceed future prices we get negative expected appreciation (backwardation). Equilibrium that determines the spot price is the intersection of expected appreciation and carrying costs. Looking at the blue lines, the typical argument that future prices are driving up current prices suggests there is excess supply (the supply being held off of the market). This would be the other signature – inventory build.

This model assumes, however, that supply is fixed. If I want to deliver less oil today, I must store the excess. What if instead producers are making output decisions that are influenced by future prices. Strong future prices at lower volumes of output would suggest less elastic demand, which in turn would suggest lower output for profit maximization. I illustrate this using the red lines. If the supply curve shifts to the left because of distortions caused by strong future demand, current output equals current demand and we are in backwardation at the same time spot prices are impacted by future prices. If strong future demand is impacting the output models of oil producers this model could explain why the signatures we would expect to see are absent. I have no particular experience with the oil industry and don’t know whether they set production based on models or based on maximum capacity. If they use supply and demand models, as I would suspect they do, then strong speculative demand for future delivery, particularly in the physical delivery market, could have a meaningful impact on spot prices through output model distortions. (I note that if in fact producers are setting output at lower levels than they otherwise would the lower level of supply could appear as a peak oil issue.)

All input welcome. I am not an expert on this topic and want to learn!

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Oil and Speculators – Anecdotal Evidence

There has been a lot of debate going on about whether or not speculation is driving up oil prices. I haven’t taken a position one way or the other. I am not an expert in the commodity markets and I have been impressed with the evidence on both sides of the argument. Paul Krugman has done some interesting analysis (see this post and follow-up posts throughout the month of June) on this issue ultimately arguing that speculation is not driving oil prices. He points to the lack of inventory build that would be present in a traditional speculative driven market resulting from owners holding product off the spot market to sell at higher future prices. On the other hand, some very smart investors and former regulators have been arguing that speculation has caused somewhere in the neighborhood of $50/barrel of the price increase in crude. Finally, there is the common sense issue. Financial markets fall apart, stocks and bonds become less attractive investments, the housing bubble bursts, and suddenly there is a sharp increase in the price of a commodity that just happens to be in a market that was partially deregulated several years ago. This last part sounds too familiar to me to be ignored.

Today, I was watching the testimony of Ben Bernanke before Congress when the subject of speculation in the energy markets was raised. It was clear that Congress is serious about passing some regulations to address margin requirements and possibly other issues in this market. Suddenly oil dropped $9.00 a barrel from around $145 to $136. That’s a 6% decline within minutes. Now, whether this price drop was caused by the congressional testimony or not is something I cannot determine. The CNBC commentators are saying the cause of the price drop is banks liquidating their energy positions to meet capital requirements. Isn’t that speculation? And look at this coincidence: the investment banks decided it was a good time to unwind their energy position right at the moment it became clear Congress is going to act on the issue of speculation in the oil markets. Do you believe in coincidences like these?

Rational economic arguments aside, the anecdotal evidence suggests that “speculation” is having a meaningful impact on oil prices.

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What Caused The Credit Crisis?

I have been following and writing about the credit crises for some time. Watching the stock prices of the financial companies plummet over the past few months has been painful if you own any of them. As I wrote in March I have been expecting this decline, but its acceleration in recent weeks has been breathtaking.

I have been reading a lot of commentary about what caused the credit crisis. Most recently I read the first section of “The First Global Financial Crisis of the 21st Century” published by VoxEU.org. This is a collection of articles written by renowned economists addressing the credit crisis, and part one deals with the causes. Unless otherwise noted my references in this article to other writers refers to their article in this collection. There is a rather long list of suspects, but in my opinion the cause of the credit crisis was a failure of the regulators of the financial system to adequately protect it from systemic risks that they should have seen at the time. Determining why they failed under such circumstances should be the primary path of inquiry. This involves uncovering the reasons why, in the face of compelling evidence of a major financial storm in the making, financial regulators did nothing. The same can be said for Congress.

I believe there is plenty of blame to go around and there were many bad actors involved in generating loans that should never have been made. In one of my early articles I pointed the finger at many of these actors. But it is the job of regulators to monitor the financial system and prevent excessive, systemic credit problems and they failed to do so. When banks are lending people 100% of the value of a home, waiving income verification, and basing the borrowers ability to pay on a loan payment that is based on a temporary teaser rate there is abject foolishness in the market. This condition existed for at least two years while bank regulators and Congress looked on and did nothing. As if this wasn’t enough, at the same time there was obvious chicanery in the credit markets relating to housing we experienced a housing bubble of massive proportions. Regulators and Congress still did nothing, except that Congress and the President began to brag about home ownership rates.

Some commentators (see Tito Boeri and Luigi Guiso, pg 37) (see also Theodore Forstmann, “The Credit Crisis Is Going To Get Worse”, The Wall Street Journal Online Edition, July 5 2008) argue it was classic supply-push in the credit markets caused by excessive monetary easing from 2001 – 2004 that caused the stupidity that led to this crisis. I tend to agree that monetary policy has been too accommodative and is one of the root causes of the current crisis. However, we have always known that monetary policy easing increases risk taking so to blame this as the cause of the crisis misses the point.

Some argue that new innovations, such as CDOs, where not fully understood (see Guido Tabellini, pg 45). I find humor in this though I am not happy with the result. If we take a lot of crappy assets and put them together, will the resulting “diversified” pool of crappy assets have less risk? Well, when all the assets are correlated to the housing market and are the most sensitive to any price changes (subprime) then obviously all you have done is made a bigger pool of crap. Add to this the fact that history exists in the subprime lending world and it is not good. Where the assumptions came from underlying the ratings on CDOs is a mystery to anyone who has seen subprime lenders crash and burn. To say this was a failure of the statistical models is a nice way of saying the assumptions were wrong and upon further inspection this should have been obvious. Statistical complexity aside, what happened to common sense? Isn’t this where the regulators are supposed to come in? When the market is doing things that are clearly high risk and in large magnitude? Where were they?

Some argue it was the rating agency conflicts that enabled this debacle to occur. I agree this was a contributing factor, but Congress and the regulators knew this problem existed since, at the latest, 2002 when it was presented to Congress in testimony relating to the Enron bankruptcy by Frank Partnoy (see part II. D). There were very clear and explicit warnings that this type of crisis was waiting to happen yet Congress and the regulators turned a blind eye.

Some argue that it is the over reliance on statistical modeling that led to this crisis (see Jon Danielsson pg. 13). The lack of backtesting data for those once in 100 years events meant that the science was flawed. In addition, the correlations are all wrong when everyone acts the same way at the same time (the heard). I buy this argument, but what I don’t buy is the argument that the regulators were fooled by all of this. This was clearly a movement to allow financial institutions to self regulate using their own internally developed models. Whether this was politically driven or truly a belief among regulators that this was a better way I do not know, but it takes a lot of the burden off regulators to monitor and regulate! Now regulators are calling for additional powers. I ask, where were they when this crisis developed?


I actually know part of the answer to my last question. One thing the regulators were working on was providing the financial system with large amounts of leverage that would ultimately be at the root of the liquidity part of this crisis. In 2004 regulators codified banks’ use of off balance sheet entities, those SIVs and asset-backed commercial paper conduits that leapt onto the front pages last Fall, with minimal regulatory capital requirements. At the same time there were regulatory changes for the investment banks that have been referred to as the “Bear Stearns Future Insolvency Act of 2004”. With respect to the banks, the result is easily discernible from the graph above. Asset-backed commercial paper outstanding skyrocketed as banks utilized their newly codified leverage structure to take on the CDOs and other securities where the true risk of all this absurd lending was being hidden. Especially notable here is the absence of the SEC. These securities that were being rated and issued were, apparently, not understood by anyone. By extension, they were not understood by the SEC – isn’t that part of its job? Unfortunately, when investors discovered that there was excessive risk in these vehicles they stopped purchasing the commercial paper that funded them. The result was a severe liquidity crisis as the banks had to honor lines of credit they provided to these entities securing the repayment of commercial paper under just these circumstances. The Federal Reserve has received great admiration for its creative tonics when this crisis broke out, but I believe that is like honoring a firefighter for extinguishing a very dangerous fire that the firefighter ignited in the first place. I can’t finish this part of my rant without pointing out a couple of issues here. First, a crisis in the commercial paper market would certainly present a systemic risk to the financial system if all the banks had credit lines backing their $1.2 trillion in asset-backed commercial paper. Given this fact, together with the knowledge from Enron that off balance sheet treatment does not eliminate risk but increases risk taking, how did the bank regulators determine that is was 10 times safer to fund assets this way than the traditional method of holding them on a bank’s balance sheet? This seems like an extraordinary conclusion, extraordinarily wrong headed.

Of course the current crisis is well beyond a mere liquidity event. The off balance sheet leverage combined with excessive monetary easing provided much too much liquidity to the markets, and the resulting stupidity in the credit world will ultimately cost institutions their solvency. As of this writing Bear Stearns no longer exists (although the taxpayers now own $29 billion (and falling) of mortgage-backed securities that Chase didn’t want while the shareholders walked with cash) and the FDIC has seized IndyMac, a large bank with extensive mortgage operations. I don’t believe this will be the last, and taxpayers will be paying for this debacle for years to come.

So what caused this crisis? Those responsible for ensuring a sound financial system failed, plain and simple. Regulators and Congress are to blame as they were well aware of the risks of rating agency conflicts, off balance sheet financing and excessive leverage yet they turned a blind eye when it came to the financial sector. The fact that rating agency conflicts and other abuses by Wall Street and others played a role does not change the fact that those responsible for regulating these activities failed. In fact, these issues should have made the regulators even more watchful in light of the fact that they were warned of rating agency conflicts that go to the heart of the regulatory system they set up.

In hindsight all of this looks obvious, and what is obvious in hindsight is not always so clear at the time. Perhaps it was not so obvious to regulators or Congress at the time. But why didn’t they figure it out? These are the best and brightest in the field and it is their job to figure this out and monitor and protect the financial system. What forces were at play such that this set of events could be set in motion and play out without any reaction from the Fed or Congress? Perhaps there is something structurally wrong with having the Fed involved in bank regulation at the same time it is responsible for monetary policy. Perhaps there is an issue with the appointment of regulators such that a given administration’s policies become too pervasive. Perhaps too many key people in the regulatory authorities come from the very institutions they are there to regulate or get jobs at those institutions when they leave. Perhaps the financial industry has too much influence in Congress and it is the broken political system where money buys influence that caused the credit crisis. In my opinion these are the fundamental issues raised by the credit crisis and I believe they should get more attention than they are getting now. I also believe that these very same regulators should not be setting the agenda for the new regulatory regime that will follow this crisis, but as of now they are.

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