Saturday, September 27, 2008

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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Thursday, September 25, 2008

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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Wednesday, September 24, 2008

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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Tuesday, September 23, 2008

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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Sunday, September 21, 2008

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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Monday, September 8, 2008

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 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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