Those marked with * are identified as especially worthy of reading.
 

1. Fed to Buy Treasurys, Expand Balance Sheet
2. # Depression Jobs: On the Curious Capitalist blog, Justin Fox looks at why job losses where so much worse in the 1930s
3. The Baseline Scenario :What happened to the global economy and what we can do about it
4. Protectionism on Rise in 17 of the G20 — World Bank Report
5. RAHN: A talent for missing the trends
*6. Reform the architecture of regulation By Henry Paulson
7. The Case for Paying Out Bonuses at A.I.G.
**8. Do not let the ‘cure’ destroy capitalism  By Gary Becker and Kevin Murphy
** 8b. Now Is No Time to Give Up on Markets     An interview with Gary Becker
9. AIG and 'Political Risk'
10. Downpayment Insurance Could Stabilize Home Prices
11. The AIG Outrage   Lawrence Kudlow
12.  Fed to pump another $1 trillion into U.S. economy
13. Unions call one-day strike in France
14. Fed's Move Sends Dollar Lower
*15. My Plan for Bad Bank Assets By TIMOTHY GEITHNER
*16. Financial Policy Despair By By PAUL KRUGMAN
17. Dear A.I.G., I Quit!
18. Guest Contribution: The Real Geithner Plan, a ‘Nuclear Option’
19. Divided we stand On the eve of the G20 summit, countries remain split on how to respond to global recession
20. Is the Bonus Tax Unconstitutional?
21. Financial Rescue Nears GDP as Pledges Top $12.8 Trillion (Update1)
22. U.S. private sector axes 742,000 jobs in March
23. Obama’s Ersatz Capitalism
24.Manufacturing Better, but Growth Still Some Time Off
*25. From Bubble to Depression?  Why the housing crash ruined the financial system but the dot-com collapse did not.
26. Local Recession, Global Depression
27. Fedspeak Highlights: Warsh on Panics, Honoring Contracts
28. TARP Diagnostics
29. Japan The incredible shrinking economy
30. Is This the End of Capitalism? Hardly, but it's a great excuse for the antiglobalization crowd.
*31. What happened to the global economy and what we can do about it Inflation Prospects In An Emerging Market, Like The U.S.
32. The Socialist Solution to the Crisis
*33. Bankruptcy Is Vital to Capitalism
34. Greed and Stupidity
*35. The Mark-to-Market Myth
36. Did the Oil Price Boom of 2008 Cause Crisis?
37. Carl Schramm.  Giving Capitalism Its Due
*38. It Really Is All Greenspan's Fault
39. THE GEITHNER-SUMMERS PLAN IS WORSE THAN YOU THINK
40. In Defense of Derivatives and How to Regulate Them
41. Revised euro-zone GDP points to a slow recovery
42 -US to delay bank test results for earnings-source
43. Market bear Roubini sticks to dour forecasts
 

    WSJ * MARCH 18, 2009, 3:44 P.M. ET

1. Fed to Buy Treasurys, Expand Balance Sheet
 

By JON HILSENRATH and BRIAN BLACKSTONE

The Federal Reserve ramped up its efforts to resuscitate the sagging economy, saying it would purchase up to $300 billion of long-term U.S. Treasury securities in the next few months and hundreds of billions of dollars more in mortgage-backed securities.

By buying long-term government bonds and mortgage-backed securities, officials hope to push up their prices and bring down their yields, and thereby energize the economy. Interest rates on many corporate bonds and consumer loans are benchmarked to U.S. Treasury debt. (Read the Fed's statement.)

The move was a bold statement of force from the central bank, which during months of internal debate on the issue had been hesitant to begin buying long-term government bonds as the Bank of England recent began to do.

The Fed action underscores the central bank's ability to move aggressively to combat the financial crisis without any action by Congress, an important attribute at a time when the political firestorm ignited by bonuses made to employees of American International Group Inc. Other rescue efforts have made Congress hostile to approved any more taxpayer money.

Prices on U.S. Treasury bonds soared on the news and the yield fell sharply. Yields on 10year treasury notes dropped. Stock prices also rose sharply and the dollar sank.

The Fed's steps came against a gloomy economic backdrop. "Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending," the Fed said in a statement after its two-day meeting. "Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession"

The Federal Open Market Committee, the Fed's policy making arm, voted 10-0 to hold the target federal-funds rate for interbank lending in a range between zero and 0.25% and to continue using credit programs financed by an expansion of the Fed's balance sheet to stabilize markets. Richmond Fed President Jeffrey Lacker, who dissented in January, went along this time. He had wanted the Fed to focus on buying Treasury purchases as opposed to targeting its lending on various corners of the credit markets. The discount rate that the Fed charges on direct loans to banks was unchanged at 0.5%.

With rates near zero, the Fed is now essentially printing money to increase the supply of credit in the economy.

The Fed said will buy up to $300 billion in long-term Treasurys over next six months. The purchases of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac will push the maximum to as $1.25 trillion, up from the previous $750 billion. The Fed also said it would increase the size of its potential purchases of the mortgage giants' debt to $200 billion from $100 billion.

The Fed's strategy appears to be to double down on the programs that it thinks work. In addition to commercial paper and money market mutual fund facilities, which appear to have stabilized those sectors, Mr. Bernanke has repeatedly highlighted the decline in mortgage rates in response to the agency and mortgage-backed securities facilities, calling it one of the "green shoots" evident in some markets.

By expanding its securities purchase programs, the Fed also is effectively ramping up efforts they can control. The commercial paper program and a new consumer lending program that commences Thursday are driven by how much demand there is in the markets.

Demand has waned for the commercial paper program in recent weeks, a sign that market is returning to health. Meantime, the new consumer lending program the Term Asset Backed Securities Loan Facility, or TALF, has gotten off to a slow start.

The U.S. economy is expected by economists to decline at an annual rate of 5% or more in the current quarter. It plunged at a 6.2% rate in the fourth quarter of 2008, the steepest in a quarter century. The economy is now shedding more than 650,000 jobs per month, pushing the unemployment rate to 25-year highs. One nugget of good news is that consumer spending figures signaled some stabilization since the start of the year.

Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Brian Blackstone at
 
 
 
 

http://blogs.wsj.com/economics/
2. # Depression Jobs: On the Curious Capitalist blog, Justin Fox looks at why job losses where so much worse in the 1930s. “The initial sharp decline in the last few months of 1929 and first few months of 1930 was simply a reflection of how the labor market worked in those days—manufacturing made up a bigger share of the nonfarm workforce, job protections were fewer, government was smaller. The result was more volatility than we see today: When the economy hit a bump, the labor market impact was more dramatic. Nonfarm employment had dropped even more precipitously in 1921, but it bounced right back in 1922. After that initial drop in late 1929/early 1930, a lot of people believed the worst was over. Then, late in 1930, the bottom began to fall out, and kept falling until April 1933. Those happen to be pretty much the start and end dates of the banking crisis. Banks failed, people’s savings were wiped out, the money supply shrank, confidence plummeted, deflation brought more bank failures, etc. It’s basically the Irving Fisher-Milton Friedman explanation of the Depression, with a bit of Keynes thrown in. And despite being caught in a financial crisis worse in some ways than the one that unleashed the Depression, we haven’t had 1930s-style bank failures or serious deflation. Not yet, anyway. I’d guess not ever. But don’t hold me to that. The Depression ended in the spring of 1933. What followed was a disappointingly anemic recovery, then a sharp recession in 1937-1938. But the Depression proper—the truly horrible years of plummeting employment, a shrinking economy, and sharp deflation—was over almost as soon as FDR took office in March 1933. Why? I think because he fixed, or at least restored confidence in, the banking system.”

Bernanke and Political Will: Simon Johnson on the Baseline Scenario looks at Fed Chairman Ben Bernanke’s comments about whether there is a political will to fix the crisis. “How did we get to the point where the U.S., with a strong balance sheet relative to the size of problem banks, is regarded - by the markets and more broadly - as less likely to resolve the problems in its financial system than say the British (with big banks relative to a weak fiscal position) or the Germans (who talk all the time about how they are not going to bail anyone out)? You can point the finger at Congress. The parliamentary system in Britain and Germany means that the government can implement and innovate a bailout policy without worrying about being able to legislate enough financial support. The Obama Administration has much to worry about in this regard. The problem surely goes deeper - at least back to the bailouts of the fall. Poor communication, particularly by Hank Paulson, undermined popular and congressional support. And the lack of a consistent strategy exacerbated initially negative perceptions. But the underlying issues are deeper still and laid bare by this week’s latest round with AIG. We have moved far beyond financial policy and into the kind of scandal that really gets taxpayers’ backs up. The greed of bankers slaps you in the face while the hubris of their leadership remains unchecked.”
 

3. The Baseline Scenario :What happened to the global economy and what we can do about it
Political Will: Bernanke On The True Cost Of Banking

with 22 comments

Stabilization programs in emerging markets often come down to this: the government needs to do something unpopular, e.g., reduce some subsidies, privatize an industry, or eliminate the crazy credit that goes to oligarchs - no one likes oligarchs, but their factories employ a lot of people.  There is naturally resistance - pushback from legislators, riots in the streets, or oligarchs calling their friends in the US foreign policy establishment.  The question becomes: does the government have the ”political will” to get the job done?

In fall 1997, a key issue for Indonesia’s IMF program was whether the government could close the banking operations belonging to one of President Suharto’s sons.  There was an epic and fascinating struggle and, in the end, the government did not have sufficient political will or power.  The subsequent loss of US support, and further currency and economic collapse is (messy and painful for many) history.

It is striking that Ben Bernanke now asks whether the United States today has sufficient political will.

How did we get to the point where the U.S., with a strong balance sheet relative to the size of problem banks, is regarded - by the markets and more broadly - as less likely to resolve the problems in its financial system than say the British (with big banks relative to a weak fiscal position) or the Germans (who talk all the time about how they are not going to bail anyone out)?

You can point the finger at Congress.  The parliamentary system in Britain and Germany means that the government can implement and innovate a bailout policy without worrying about being able to legislate enough financial support.  The Obama Administration has much to worry about in this regard.

The problem surely goes deeper - at least back to the bailouts of the fall.  Poor communication, particularly by Hank Paulson, undermined popular and congressional support.  And the lack of a consistent strategy exacerbated initially negative perceptions.

But the underlying issues are deeper still and laid bare by this week’s latest round with AIG.  We have moved far beyond financial policy and into the kind of scandal that really gets taxpayers’ backs up.  The greed of bankers slaps you in the face while the hubris of their leadership remains unchecked.

There is no sense of responsibility, no feeling of shame, no acknowledgment of any kind of mistake: read Lloyd Blankfein’s FT article again - or print it out and tape it to your wall.  Because we now know, from the newly disclosed AIG counterparties list, that the wealth of Goldman Sachs insiders remains high solely because we saved their sorry bank, their failed risk management strategy, and their pretence of wisdom with our cash in mid-September.

This resentment against bankers pervades Congress, and even the Administration begins to get the message - being called “asinine” yesterday by Richard Kovacevich, the Chairman of Wells Fargo, may have helped underline to Treasury how deeply the bankers appreciate the help they have received.  There can be no resolution and no moving on until there has been a proper congressional investigation, with full subpoena powers, into exactly what did and did not happen around AIG.  This will take months and may well slow down the economy (Jamie Dimon’s clever point: if you vilify us, you will lose), but it is now inescapable.  And, if channeled productively, this kind of hearing may lead to a better regulatory system (and smaller big banks) than the current anemic proposals on the table - as last weekend indicated, the G20 process is currently worse than useless on this issue.

Ben Bernanke knows all this, at the same time as he sees our economy worsening and global storm clouds still gathering.  So where will he take us, starting with the Federal Open Market Committee meeting this week?  The British experiment with quantitative easing is pushing down the yield on long government debt.  It’s risky - inflation, once started, is not so easy to control.  And it may not work so well in the US (where the dollar tends to appreciate as the world becomes more scary) as in the UK (where they can successfully push for depreciation, particularly vis-a-vis the hidebound eurozone).

Inflation breaks the political and social logjam around banking.  With some luck, it helps growth - at least in the short-term.  And of course the surviving bankers win big.

Written by Simon Johnson

March 17, 2009 at 5:57 am

Posted in Commentary

Tagged with aig, Banking, Bernanke, g20, Jamie Dimon, Lloyd Blankfein

WSJ Mar 17, 2009
5:51 PM
4. Protectionism on Rise in 17 of the G20 — World Bank Report
Posted by Tom Barkley

Despite a pledge by Group of 20 leaders in November to avoid protectionist measures, 17 of the countries have since erected new trade restrictions, according to a World Bank report.

“With the global economy teetering on the abyss of severe recession, political pressures demanding protection from import competition to protect employment are surfacing with increasing intensity around the world,” said authors Richard Newfarmer and Elisa Gamberoni in the report Tuesday.

Overall, the report found that 47 trade-restricting measures had been implemented since October, though they likely had only a marginal effect on trade.

Developed countries have relied exclusively on subsidies, imposing 12 such measures, while nearly half of the 35 measures adopted by developing countries were tariffs.

“To the extent that the industry is laden with excess capacity, these subsidies impede exit and delay adjustment,” the report said. “Even worse, subsidies may be linked to requirements” forcing companies to preserve domestic employment, “even at the cost of shutting more efficient plants abroad in developing countries.”

Subsidies to prop up the auto sector amount to $48 billion, with high-income countries accounting for $43 billion of that, including $17.4 billion in the U.S. alone.

The World Bank is projecting that global growth this year contract for the first time since the end of World War II, with world trade on track to register its biggest drop in 80 years.

G20 finance ministers meeting last weekend reiterated their commitment to
avoid protectionist measures. However, the report urged the G20 to take additional measures to strengthen the “fragile consensus” for open trade, including accelerating progress on Doha
global trade talks, increasing aid for trade to assist lower-income countries, and agreeing to quarterly reports on trade restrictions.

“The cost of inaction on the Doha Agenda is rising,” the report said.
 

5. RAHN: A talent for missing the trends
Richard Rahn
Wednesday, March 18, 2009
http://www.washingtontimes.com/news/2009/mar/18/a-talent-for-missing-the-trends/print/

Buzz up!
COMMENTARY:

Did you notice that the major economic forecasters, both private and government, totally missed the global credit crisis and size of the recession?

The mainstream consensus economic forecasts made in December 2007 for the year 2008 for the United States, Europe and Japan predicted roughly twice as much growth as actually occurred. You may recall that a year ago, when oil prices were racing toward $147 per barrel, the high-paid wizards at Goldman Sachs were projecting it to go over $200 per barrel - it is now $40-something a barrel. A few economists claim to have forecast this great recession, but most have been pessimists for years, and predicting nine out of the last three recessions is not really an example of forecasting brilliance.

The foreign policy/political forecasts were even worse. A year ago, as the presidential nominees of both parties were being selected, the widely held belief was that the great issue would be Iraq. The Democratic establishment believed Senate Majority Leader Harry Reid's words, "the war is lost."

Because of that belief, the Democrats selected their most antiwar candidate, Barack Obama. The Republicans nominated John McCain, who was the champion of winning the war, in part, through the "surge," which indeed did work.

Each candidate had essentially sewed up his respective party nominations before the extent of the economic problems became clear. In retrospect, it is unlikely Mr. Obama and Mr. McCain would have become the nominees given what we know now about the economic situation. Each party had other candidates with stronger economic credentials who would have been more credible.

In the mid-1990s, when the fear of global warming was first becoming fashionable, the global warming theorists said we had only 10 years to make fundamental changes with carbon dioxide (CO2) emissions or the planet was doomed (i.e. the "hockey stick" thesis).

Well, it has now been more than 10 years. and the planet has actually been getting cooler over the last decade, which was not forecast by a single major climate model (oh, well). Also the polar ice cap has not disappeared, and the polar bear population is getting bigger, not smaller! It seems those who claim the variable output of the sun (sun spot theorists) has more effect on Earth temperature than CO2 might just be right.

A major reason the global warming misinformation is still so hyped is that government subsidizes many producers of noneconomic alternative energy sources and many scientists with an economic interest in repeating the claim. Those in the political class love the idea of a climate crisis because it gives them more power and money to "do something about it."

Getting it all wrong is not new. In 1900, Europe was enjoying unprecedented peace and prosperity. The European countries, and particularly Britain, had their global empires and great military powers. There was the widespread belief that major wars were a thing of the past and European civilization would dominate the globe forever. Twenty years later, in 1920, much of Europe lay in ruins in the wake of the World War I (a war about nothing), but there was certainty that Germany was being sufficiently constrained so as to never be a threat again. Yet, only another 20 years later, in 1940, the "German Thousand Year Reich" controlled most of Europe.

In 1980, much of the United States and European foreign policy establishment believed it was only a matter of time before the communists would win the Cold War. Fortunately, Ronald Reagan and Margaret Thatcher had a different idea, and the Soviet Union collapsed a decade later to the great surprise of much of the global establishment.

The failure to forecast the current "crisis" appears to, in part, stem from the fact that few fully understood how much risk there was in the entire global financial system. There were too many mathematicians posing as financial experts and economists who did not have enough knowledge of economic history or long enough historical periods with sufficient data to measure risk as precisely as they claimed. As a result, they underestimated systemic risks.

In addition, too few - among both investors and forecasters - understood that when the rating agencies, like Moody's, were rating packages of mortgage-backed securities, they were not ranking the individual components of the package, which turned out to cause a great understatement of the risk. Few politicians understood, or wanted to understand, that the pressure they put on the banks to lend to the unqualified was putting the whole system at risk, and many of the forecasters did not fully appreciate how much the banks had lowered their lending standards.

Economic forecasts are necessary for businesses and governments to plan and operate. Insurance companies could not exist without the science of probability and risk analysis and the existence of historical data banks. Because these organizations do have the necessary forecasting skills and data banks, they are able to offer homeowners', auto and life insurance and price them properly.

Micro forecasts, where the variables are few, well-known and the data extensive, can be quite precise, fortunately, for the insurance industry. Macro forecasts, where the variables are many and often not well-understood, such as those used in climate, political and global economic models, can be wildly inaccurate and thus should be used only with great caution - and modesty.

Richard W. Rahn is a senior fellow at the Cato Institute and chairman of the Institute for Global Economic Growth.

6. Reform the architecture of regulation By Henry Paulson
 

http://www.ft.com/cms/s/0/a2b1243c-1326-11de-a170-0000779fd2ac.html

By Henry Paulson

Published: March 17 2009 19:35 | Last updated: March 17 2009 19:35

Pinn

In the midst of the market turmoil, the pressing priority for US and global policymakers is to repair the financial system and restore the economy. Just as important, however, will be addressing the serious flaws exposed by this crisis. This process of reflection and reform will be critical to restoring confidence and enabling market-based capitalism to rebuild our economies. We must recognise the real possibility that because the crisis is not behind us, there may be lessons to learn and problems to address that are not now obvious. Yet many lessons are obvious and I take confidence from the commitment of world leaders – in the US, Europe, China and elsewhere – to pursue comprehensive regulatory reform and co-ordinate internationally.

First, this will be a big, multi-year undertaking. The crisis has exposed serious flaws in many aspects of our financial system. There will be proposals for more effective regulations in areas ranging from over-the-counter derivatives and short selling, to the practices of financial institutions, investors, mortgage originators and credit rating agencies. We will need to reflect on the long-held premise that sophisticated investors have the wherewithal to look out for themselves and require minimal, if any, supervision. In these areas and others, regulations must be crafted to foster market stability while maintaining the fundamental tenet of capitalism: if investors are to reap the rewards of taking risks they must also bear the negative results of their risk-taking.

Yet updating our regulations and market practices will not be enough. We must also fundamentally reform and modernise our regulatory architecture and authorities. While regulators have co-operated in addressing this turmoil, it is clear that their overlapping jurisdictions, gaps in jurisdictions and authorities, uneven capabilities and competition among themselves created the environment in which excesses throughout the markets could thrive. Consequently, to focus only on new regulation would fall short: we must also modernise the regulatory system and authorities in the US.

This is not a new issue, but it is a difficult one. If we search for something positive in the carnage created by this financial crisis, it may be that it will provide the impetus for doing what many, including myself, have repeatedly called for: real reform of our regulatory architecture.

In the US we have a patchwork of financial regulatory agencies. Our agencies reside at both federal and state level. A company’s regulator is determined largely by its business form. Thus two financial firms providing virtually identical products with similar economic attributes may be regulated quite differently. No one would ever design a system like this. It has evolved in an accretive way, without any real thought to long-term goals or objectives. It allows and promotes regulatory arbitrage. This system allowed unregulated state organisations and non-bank affiliates of banks and thrifts to originate thousands of risky mortgages and it allowed AIG to build a huge and essentially unregulated hedge fund on top of tightly regulated insurance companies.

Business models, financial products and markets will continually evolve. That is the nature of a dynamic market. We must have a regulatory structure that recognises that dynamism and adjusts to it. Fortunately, we are not starting this process of reflection and reform in the midst of crisis. In March 2008, after conducting a year-long process of study, I put forward a series of comprehensive recommendations to modernise our regulatory architecture in the Treasury’s Blueprint for a Modern Financial Regulatory Framework. The blueprint identified an optimal structure that was not designed to be accomplished overnight.

The ideal regulatory structure would reflect the reasons we regulate and would recognise that the financial system has changed dramatically since our regulatory architecture was designed. Last March the Treasury proposed a system of three primary federal regulators: one charged with maintaining market stability across the entire financial sector, one for supervising the soundness of those institutions with explicit government support and one responsible for protecting consumers and investors. Our proposed structure recognised that there would sometimes be a need for the Federal Reserve to provide liquidity support to institutions that it did not regulate historically. This would be a drastic realignment and simplification of regulatory agencies – in order to clarify responsibilities, provide powers commensurate with those responsibilities and improve accountability. A regulatory structure organised by objective is far more likely to withstand the test of time. In an objectives-based model no business can change regulator simply by changing its form.

The dedicated business conduct regulator would be responsible for vigorously protecting consumers and investors, through its regulation of disclosures, business practices, chartering and licensing of certain types of financial institutions and rigorous enforcement programmes. Consumers and investors would benefit from greater consistency across product lines and centralised accountability so that no product or service fell through the cracks. Mortgages are an example of a consumer financial product that has suffered from uneven and inadequate treatment in our current regulatory and enforcement regime.

A single safety and soundness regulator would supervise all institutions that are ultimately backed by taxpayer-funded guarantees and other forms of government support. It would end the division of such regulation among several regulators, which promotes ?“charter-shopping” and a race to the bottom. It would mean that businesses would compete on an economic basis, not on the basis of their regulators.

Finally, the crisis has made abundantly clear that our financial system would benefit from a regulator whose focus is on risks across the financial system. While the Fed is assumed to have this role, it does not have the mandate or powers to carry it out effectively. There is already growing support for the blueprint’s recommendation that Congress explicitly give this responsibility to the Fed, and provide it with the tools to meet that mandate. It would require the Fed to have access to information from a broader set of financial organisations, including hedge funds and systemically important payment systems. This authority should also have the power to intervene if it concluded that the financial system was at risk. Because the breadth of authority provided must be great, the standard for using such authority – to protect the system as a whole – should be high.

Dissemination of information by this regulator should also help maintain market discipline, a concept that is still important. While it is true that both our regulators and market discipline failed in curtailing the run-up to this crisis, we are witnessing a strong dosage of market discipline today as investors require financial firms to deliver.

Another important reason to charter a market stability regulator is to provide an authority with the responsibility to examine and attempt to mitigate the too-big or too-interconnected-to-fail problem that we face. Congress should create regulatory authorities capable of ensuring that any institution, no matter its size, can fail with minimal systemic impact. That requires authorities that balance market stability with private capitalism by imposing an orderly wind-down of the failing institution.

We have a process in place that gives the Federal Deposit Insurance Corporation ample and flexible authority to deal with a failing bank. After Bear Stearns’ collapse in March of last year, the Treasury and the Fed expressed concern that the government lacked this type of wind-down authority for a failing non-bank. That concern became a reality when Lehman collapsed in September, and there was no authority at the Treasury or the Fed to save the institution, and no authority to manage the wind-down outside bankruptcy. A regulatory system that treats systemically important institutions differently solely because of their charter does not make sense in today’s globally interconnected markets. Any rewrite of financial regulatory authorities must include the explicit federal authority to intervene and wind down a failing non-bank in an orderly manner.

Defining the proper wind-down authorities and their scope will require thoughtful analysis. Necessary authorities include the power – in exigent circumstances – to guarantee liabilities, provide loans and take other stabilising measures. But the circumstances that would trigger these authorities must be narrowly defined, to minimise moral hazard and preserve incentives for proper risk management.

Creating a fundamentally different regulatory system is complex and will take months, if not years. But policymakers can achieve significant near-term regulatory reforms that represent progress towards the ideal. These include giving the Fed expanded powers to regulate market stability, combining the Office of Thrift Supervision and the Office of the Comptroller of the Currency to strengthen regulation by reducing duplication, centralising the scrutiny of mortgage origination, creating an optional federal insurance charter, beginning the process of integrating the Securities and Exchange Commission and Commodity Futures Trading Commission and continuing to improve arrangements for clearing and settling over-the-counter derivatives, including development of well regulated and prudently managed central clearing counterparties for OTC trades.

Wrenching as this period is, the cost to our nation will be even larger if we do not learn lessons from it and overhaul our regulatory system so federal regulators have clear missions, powers to execute them and accountability for carrying them out. A new regulatory architecture accountable to investors, with flexibility to adapt to changing markets and clarity of responsibility to interact with international counterparts to forge a seamless global market infrastructure, would inspire the confidence for the financial system to create prosperity in all sectors once again.

The writer is former secretary of the US Treasury and currently distinguished visiting scholar at SAIS. To join the debate go to www.ft.com/capitalismblog

March 17, 2009
DealBook Column
7. The Case for Paying Out Bonuses at A.I.G.
By ANDREW ROSS SORKIN NYTimes

Do we really have to foot the bill for those bonuses at the American International Group?

It sure does sting. A staggering $165 million — for employees of a company that nearly took down the financial system. And heck, we, the taxpayers, own nearly 80 percent of A.I.G.

It doesn’t seem fair.

So here is a sobering thought: Maybe we have to swallow hard and pay up, partly for our own good. I can hear the howls already, so let me explain.

Everyone from President Obama down seems outraged by this. The president suggested on Monday that we just tear up those bonus contracts. He told the Treasury secretary, Timothy F. Geithner, to use every legal means to recoup taxpayers’ money. Hard to argue there.

“This isn’t just a matter of dollars and cents,” he said. “It’s about our fundamental values.”

On that last issue, lawyers, Wall Street types and compensation consultants agree with the president. But from their point of view, the “fundamental value” in question here is the sanctity of contracts.

That may strike many people as a bit of convenient legalese, but maybe there is something to it. If you think this economy is a mess now, imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right.

As much as we might want to void those A.I.G. pay contracts, Pearl Meyer, a compensation consultant at Steven Hall & Partners, says it would put American business on a worse slippery slope than it already is. Business agreements of other companies that have taken taxpayer money might fall into question. Even companies that have not turned to Washington might seize the opportunity to break inconvenient contracts.

If government officials were to break the contracts, they would be “breaking a bond,” Ms. Meyer says. “They are raising a whole new question about the trust and commitment organizations have to their employees.” (The auto industry unions are facing a similar issue — but the big difference is that there is a negotiation; no one is unilaterally tearing up contracts.)

But what about the commitment to taxpayers? Here is the second, perhaps more sobering thought: A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it.

A.I.G. employees concocted complex derivatives that then wormed their way through the global financial system. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.

So as unpalatable as it seems, taxpayers need to keep some of these brainiacs in their seats, if only to prevent them from turning against the company. In the end, we may actually be better off if they can figure out how to unwind these tricky investments.

Not that any of this takes the bite out of paying these bonuses. For better or worse — in this case, worse — someone at A.I.G. decided this company needed to sign bonus agreements last year to keep people before the full extent of its problems became clear.

Now we can debate why A.I.G. felt it necessary to guarantee seven executives at least $3 million apiece when the economy was clearly on shaky ground. Perhaps we will find out these contracts were a bit of sleight of hand to enrich executives who knew this financial Titanic had hit the iceberg. But another possible explanation is that A.I.G. knew it needed to keep its people.

That is the explanation offered by Edward M. Liddy, who was installed as A.I.G.’s chief executive when the government effectively nationalized the company last fall. (He is being paid $1 a year.)

“We cannot attract and retain the best and brightest talent to lead and staff” the company “if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” he said.

There’s some truth to what Mr. Liddy is saying. Would you want to work at A.I.G.? Sure, maybe for $3 million. But not if you could go somewhere else for even more — or even much less.

“The jobs are terrible,” said Robert M. Sedgwick, an executive compensation lawyer at Morrison Cohen who represents a number of employees of banks that have taken government money. “You have to read about yourself in the paper every day. These people are leaving as soon as they can.”

Let them leave, you say. Where would they go, given the troubles in the financial industry? But the fact is, the real moneymakers in finance always have a place to go. You can bet that someone would scoop up the talent from A.I.G. and, quite possibly, put it to work — against taxpayers’ interests.

“The word on the street is that A.I.G. employees are being heavily recruited,” Ms. Meyer says.

Of course, if taxpayers had not bailed out A.I.G., these contracts would not be worth anything. Andrew M. Cuomo, the attorney general of New York, made the point on Monday, when he subpoenaed A.I.G. for the names of the people who received the bonuses. If A.I.G. had spiraled into bankruptcy, its employees would have had to get in line with other unsecured creditors.

Mr. Cuomo wants to know who A.I.G.’s lucky employees are, and how they have been doing at their jobs. So here is a suggestion for him. Get the list, and give those big earners at A.I.G. a not-so-subtle nudge: Perhaps they will “volunteer” to give some of their bonuses back or watch their names hit the newspapers. But in the meantime, despite how offensive and painful it might be, let’s honor the contracts.

The latest news on mergers and
acquisitions can be found at

8. Do not let the ‘cure’ destroy capitalism  By Gary Becker and Kevin Murphy

Published: March 19 2009 20:04 | Last updated: March 19 2009 20:04

Ingram Pinn illustration
 
 

Capitalism has been wounded by the global recession, which unfortunately will get worse before it gets better. As governments continue to determine how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

Consider the following extraordinary statistics about the performance of the world economy since 1980. World real gross domestic product grew by about 145 per cent from 1980 to 2007, or by an average of roughly 3.4 per cent a year. The so-called capitalist greed that motivated business people and ambitious workers helped hundreds of millions to climb out of grinding poverty. The role of capitalism in creating wealth is seen in the sharp rise in Chinese and Indian incomes after they introduced market-based reforms (China in the late 1970s and India in 1991). Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism, and it deserves a good share of the blame, the recession-induced losses pale in comparison with the great accomplishments of prior decades. Suppose, for example, that the recession turns into a depression, where world GDP falls in 2008-10 by 10 per cent, a pessimistic assumption. Then the net growth in world GDP from 1980 to 2010 would amount to 120 per cent, or about 2.7 per cent a year over this 30-year period. This allowed real per capita incomes to rise by almost 40 per cent even though world population grew by roughly 1.6 per cent a year over the same period.

Therefore, in devising reforms that aim to reduce the likelihood of future severe contractions, the accomplishments of capitalism should be appreciated. Governments should not so hamper markets that they are prevented from bringing rapid growth to the poor economies of Africa, Asia and elsewhere that have had limited participation in the global economy. New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. This runs counter to a common but mistaken view, even among many free-market proponents, that it is better to do something to try to help the economy than to do nothing. Most interventions, including random policies, by their very nature would hurt rather than help, in large part by adding to the uncertainty and risk that are already so prominent during this contraction.

Government reactions have demonstrated the danger that interventions designed to help can exacerbate the problem. Even though we had well-qualified policymakers, we have gone from error to error since August 2007.

The policies of the Bush and Obama administrations violate the “do no harm” principle. Interventions by the US Treasury in financial markets have added to the uncertainty and slowed market responses that would help stabilise and recapitalise the system. The government has overridden contracts and rewarded many of those whose poor decisions helped create the mess. It proposes to override even more contracts. As a result of the Treasury’s actions, we face further distorted decision-making as government ownership of big financial institutions threatens to substitute political agendas for business judgments in running these companies. While such dramatic measures may be expedient, they are likely to have serious adverse consequences.

These problems are symptomatic of three basic flaws in the current approach to the crisis. They are an overly broad diagnosis of the problem, a misconception that market failures are readily overcome by government solutions and a failure to focus on the long-run costs of current actions.

The rush to “solve” the problems of the crisis has opened the door to government actions on many fronts. Many of these have little or nothing to do with the crisis or its causes. For example, the Obama administration has proposed sweeping changes to labour market policies to foster unionisation and a more centralised setting of wages, even though the relative freedom of US labour markets in no way contributed to the crisis and would help to keep it short. Similarly, the backlash against capitalism and “greed” has been used to justify more antitrust scrutiny, greater regulation of a range of markets, and an expansion of price controls for healthcare and pharmaceuticals. The crisis has led to a bail-out of the US car industry and a government role in how it will be run. Even one of the most discredited ideas, protectionism, has gained support under the guise of stimulating the economy. Such policies would be a mistake. They make no more sense today than they did a few years ago and could take a long time to reverse.

The failure of financial innovations such as securities backed by subprime mortgages, problems caused by risk models that ignored the potential for steep falls in house prices and the overload of systemic risk represent clear market failures, although innovations in finance also contributed to the global boom over the past three decades.

The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments had large declines in their wealth, while investors that funded these institutions without proper scrutiny have seen their wealth cut in half or much more. Households that overextended themselves have also been badly hurt.

Given the losses, actors in these markets have a strong incentive to correct their mistakes the next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private sector adjustments. The uncertainty from muddled Treasury policy on bank capital and ownership structure, the willingness of the government to change mortgage and debt contracts unilaterally and the uncertain nature of future regulation and subsidies help prevent greater private recapitalisation. Rather than solving problems, such policies tend to prolong them.

The US stimulus bill falls into the same category. This package is partly based on the belief that government spending is required to stimulate the economy because private spending would be insufficient. The focus on government solutions is particularly disappointing given its poor record in dealing with crises in the US and many other countries, such as the aftermath of hurricane Katrina and failure effectively to prosecute the war in Iraq.

The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better, and in many ways worse. Regulators got caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them.

Output, employment and earnings have all been hit by the crisis and will get worse before they get better. Nevertheless, even big downturns represent pauses in long-run progress if we keep the engines of long-term growth in place. This growth depends on investment in human and physical capital and the production of new knowledge. That requires a stable economic environment. Uncertainty about the scope of regulation is likely to have the unintended consequence of making those investments more risky.

The Great Depression induced a massive worldwide retreat from capitalism, and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India and Africa.

Partly owing to the collapse of the housing and stock markets, hostility to business people and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the “only game in town” that can deliver further large increases in wealth and health to poor as well as rich nations. We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for 30 years.

The writers are professors of economics and the University of Chicago and senior fellows at the Hoover Institution. Gary Becker was awarded the 1992 Nobel prize in economics and Kevin Murphy was awarded the Clark Medal in 1997. To join the debate go to www.ft.com/capitalismblog

Copyright The Financial Times Limited 2009
 
 

8b. Now Is No Time to Give Up on Markets     An interview with Gary Becker
    WSJ *  MARCH 20, 2009, 7:36 A.M. ET
 
 

By MARY ANASTASIA O'GRADY

"What can we do that would be beneficial? [One thing] is lower corporate taxes and businesses taxes and maybe taxes in general. Particularly, you want to lower the tax on capital so you raise the after-tax return to investing and get more investing going on."

Gary Becker, the winner of the 1992 Nobel Prize in Economic Sciences, is in New York to speak to a special meeting of the Mont Pelerin Society on the global meltdown. He has agreed to sit down to chat with me on the subject of his lecture.
[Gary Becker] Ismael Roldan

Slumped in a soft chair in a noisy hotel coffee lounge, the 78-year-old University of Chicago professor is relaxed and remarkably humble for a guy who has achieved so much. As I pepper him with the economic and financial riddles of our time, I am impressed by how many times his answers, delivered in a pronounced Brooklyn accent, include an "I think" and sometimes even an "I don't know the answer to that." It is a reminder of why he is so highly valued. In contrast to a number of other big-name practitioners of the dismal science, he is a solid empiricist genuinely in search of answers -- not the job as the next chairman of the Federal Reserve. What he sees is what you get.

What Mr. Becker has seen over a career spanning more than five decades is that free markets are good for human progress. And at a time when increasing government intervention in the economy is all the rage, he insists that economic liberals must not withdraw from the debate simply because their cause, for now, appears quixotic.

As a young academic in 1956, Mr. Becker wrote an important paper against conscription. He was discouraged from publishing it because, at the time, the popular view was that the military draft could never be abolished. Of course it was, and looking back, he says, "that taught me a lesson." Today as Washington appears unstoppable in its quest for more power and lovers of liberty are accused of tilting at windmills, he says it is no time to concede.

Mr. Becker sees the finger prints of big government all over today's economic woes. When I ask him about the sources of the mania in housing prices, the first culprit he names is the Fed. Low interest rates, he says, were "partly, maybe mainly, due to the Fed's policy of keeping [its] interest rates very low during 2002-2004." A second reason rates were low was the "high savings rates primarily from Asia and also from the rest of the world."

"People debate the relative importance of the two and I don't think we know exactly," Mr. Becker admits. But what is clear is that "when you have low interest rates, any long-lived assets tend to go up in price because they are based upon returns accruing over many years. When interest rates are low you don't discount these returns very much and you get high asset prices."

On top of that, Mr. Becker says, there were government policies aimed at "extending the scope of homeownership in the United States to low-credit, low-income families." This was done through "the Community Reinvestment Act in the '70s and then Fannie Mae and Freddie Mac later on" and it put many unqualified borrowers into the mix.

The third effect, Mr. Becker says, was the "bubble mentality." By this "I mean that much of the additional lending and borrowing was based on expectations that prices would continue to rise at rates we now recognize, and should have recognized then, were unsustainable."

Could this behavior be considered rational? "There is a lot of debate in economics about whether we can understand bubbles within a rational framework. There are models where you can do it, but it's not easy," he says. What he does seem sure about is that "the lending would not have continued unless there was this expectation that prices would continue to rise and therefore one could refinance these assets through the higher prices." That mentality was at least partly related to Fed action, he says, because the low interest rates "generated an increase in prices and I think that helped generate some of this excess of optimism."

Mr. Becker says that the market-clearing process, so important to recovery, is well underway. "Construction in new residential housing is way down and prices are way down. Maybe 25% down. Lower prices stimulate demand, reduced construction reduces supply."

That's the good news. But he complains about "counterproductive" government policies "designed to lower mortgage rates to stimulate demand." He says he was against the Bush Treasury's idea of capping mortgage rates (which was only floated) and he has "opposed the mortgage plan of President Obama." "It goes against both these adjustments . . . it would hold up prices and increase construction. I think that's a bad idea at this time."

Yet the professor is no laissez-faire ideologue. He says we have to think about what the government can do to "moderate the hit to the real economy," and he says it should start with "the first law of medicine: Do no harm." Instead it has done harmful things, and chief among them has been the "inconsistent policies with the large institutions . . . We let some big banks fail, like Lehman Brothers. We let less-good banks, big [ones] like Bear Stearns, sort of get bailed out and now we bailed out AIG, an insurance company."

Mr. Becker says that he opposed the "implicit protection" that the government gave to Bear Stearns bondholders to the tune of "$30 billion or so." So I wonder if letting Lehman Brothers go belly up was a good idea. "I'm not sure it was a bad idea, aside from the inconsistency." He points out that "the good assets were bought by Nomura and a number of other banks," and he refers to a paper by Stanford economics professor John Taylor showing that the market initially digested the Lehman failure with calm. It was only days later, Mr. Taylor maintains, that the market panicked when it saw more uncertainty from the Treasury. Mr. Becker says Mr. Taylor's work is "not 100% persuasive but it sort of suggest[s] that maybe the Lehman collapse wasn't the cause of the eventual collapse" of the credit markets.

He returns to the perniciousness of Treasury's inconsistency. "I do believe that in a risky environment which is what we are in now, with the market pricing risk very high, to add additional risk is a big problem, and I think this is what we are doing when we don't have consistent policies. We add to the risk."

On the subject of recovery, Mr. Becker repeats his call for lower taxes, applauds the Fed's action to "raise reserves," (meaning money creation, though he said this before the Fed's action a few days ago), and he says "I do believe one has to try to do something more directly to help with the toxic assets of the banks."

How about getting rid of the mark-to-market pricing of bank assets [that is, pricing assets at the current market price] that some say has destroyed bank capital? Mr. Becker says he prefers mark-to-market over "pricing by cost because costs are often completely out of whack with what the real prices are." Then he adds this qualifier: "But when you have a very thin market, you have to be very careful about what it means to mark-to-market. . . . It's a big problem if you literally take mark-to-market in terms of prices continuously based on transactions when there are very few transactions in that market. I am a mark-to-market person but I think you have to do it in a sensible way."

However that issue is resolved in the short run, there will remain the problem of institutions growing so big that a collapse risks taking down the whole system. To deal with the "too big to fail" problem in the long run, Mr. Becker suggests increasing capital requirements for financial institutions, as the size of the institution increases, "so they can't have [so] much leverage." This, he says, "will discourage banks from getting so big" and "that's fine. That's what we want to do."

Mr. Becker is underwhelmed by the stimulus package: "Much of it doesn't have any short-term stimulus. If you raise research and development, I don't see how it's going to short-run stimulate the economy. You don't have excess unemployed labor in the scientific community, in the research community, or in the wind power creation community, or in the health sector. So I don't see that this will stimulate the economy, but it will raise the debt and lead to inefficient spending and a lot of problems."

There is also the more fundamental question of whether one dollar of government spending can produce one and a half dollars of economic output, as the administration claims. Mr. Becker is more than skeptical. "Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way."

As the interview winds down, I'm thinking more about how people can make pretty crazy decisions with the right incentives from government. Does this explain what seems to be a decreasing amount of personal responsibility in our culture? "When you get a larger government, when you have the government taking over Social Security, government taking over health care and with further proposals now for the government to take over more activities, more entitlements, the rational response is to have less responsibility. You don't have to worry about things and plan on your own as much."

That suggests that there is a risk to the U.S. system with more people relying on entitlements. "Well, they become an interest group," Mr. Becker says. "The more you have dependence on the government, the stronger the interest group of people who want to maintain it. That's one reason why it is so hard to get any major reform in reducing government spending in Scandinavia and it is increasingly so in the United States. The government is spending -- at the federal, state and local level -- a third of GDP, and that share will go up now. The higher it is the more people who are directly or indirectly dependent on the government. I am worried about that. The basic theory of interest-group politics says that they will have more influence and their influence will be to try to maintain this, and it will be hard to go back."

Still, there remain many good reasons to continue the struggle against the current trend, Mr. Becker says. "When the market economy is compared to alternatives, nothing is better at raising productivity, reducing poverty, improving health and integrating the people of the world."

Ms. O'Grady writes the Journal's Americas column.
 
 
 

    WSJ *  MARCH 20, 2009, 7:36 A.M. ET

9. AIG and 'Political Risk'

By IAN BREMMER and SEAN WEST

After quietly tolerating $170 billion in bailout money for AIG, why have the public, Congress and the administration suddenly blown up about a tiny fraction of that amount that is being paid out in retention payments and bonuses? After all, the AIG bailout channels U.S. taxpayer dollars to foreign banks and even potentially covers hedge-fund profits.

The reason is one of political expediency: The bonuses represent greed in the face of dire circumstances, which resonates with Joe the TARP-funder. The public now has an Enron-like target on which to unload its collective frustration about the financial meltdown. While public outrage is understandable, pandering to it jeopardizes the administration's credentials in a sloppy attempt to score populist points. This raises the political risk for all investors in the U.S. (both domestic and foreign) significantly.

The financial-sector rescue necessitates unpopular actions that will only be politically worth it if the administration actually solves the crisis. Until recently, the Obama administration had taken pragmatic if slow actions that it deemed necessary to fend off disaster, as opposed to pursuing an ideological agenda in how it implements the bailout.

But this week, under pressure to show a strong hand and positive results, the administration latched onto the AIG bonus flap as an angle for currying populist favor. When it became clear that the bonuses were going to be big news, President Obama led the anti-AIG charge with instructions to "pursue every legal avenue" to get the money back. Never mind that the administration was responsible for the TARP provision that (sensibly, from a legal standpoint) exempted pre-existing legal agreements from the bill's limits on compensation. Mr. Obama now says he'd like to create a new "resolution authority" to deal with "contracts that may be inappropriate." Meanwhile, Congress seems poised to undo the bonuses through special taxes -- a move that in other circumstances would clearly be labeled retroactive and unfair.

It was not long ago that Mr. Obama assailed the Bush administration for its dangerous expansion of executive power during a complex crisis. The Obama administration's antics around the AIG bonuses suggest a similar effort to use political power to contort the law. But rather than doing so for reasons of national security, this administration is doing so to pander to an angry public. When the Obama administration and Congress flex this kind of muscle, they attach a new political-risk component to all contracts negotiated in the shadow of the bailout.

That risk may scare potential investors away from bailout recipients because they cannot trust our government's will in the face of public outrage. It destroys our moral high ground the next time Mr. Obama wants to criticize a foreign country for ignoring the rule of law by nationalizing private assets or repudiating international debt. It will certainly make Mr. Obama's task much more difficult when he tries to sell the public on his administration's ability to manage the rest of the bailout, and when he tries to sell private firms on the public-private partnership that will be needed to make the recovery work.

The administration could have let Congress have its week of grandstanding over bonuses, while issuing a public statement acknowledging the bonuses as deplorable, but not important enough to detract from the real work that lies ahead. The tragedy here is the extraordinary amount of time that is being wasted on this issue when the Treasury Department remains understaffed, a detailed toxic-asset plan remains perpetually forthcoming, and the economy continues to shed jobs.

It's predictable that the administration and Congress would rather abuse an easy target over something every voter can get mad about than actually confront the hard issues of managing the financial crisis, including progress on the "stress test" of banks and the restoration of normal credit operations, establishing genuine oversight of the use of bailout funds, and coordinating international efforts on global economic stimulus and changes to financial-industry regulations. That type of governing is far more troublesome, as it involves making difficult decisions on complex topics and communicating unpopular news to constituents.

This is a hallmark moment for the administration. Congressional anger over AIG's bonuses foreshadows the battle looming if and when the administration asks for more financial-sector rescue funds. The administration may rightly sense that failing to join hands with Congress and the public in outrage over the bonuses would complicate release of those funds. But Mr. Obama does not need to show solidarity by diminishing confidence in the rule of law. That bit of populism will cost the president far more in future credibility than he stands to gain in present popularity.

Mr. Bremmer is president of Eurasia Group, a global political-risk consulting firm, and co-author of "The Fat Tail: The Power of Political Knowledge for Strategic Investing" (Oxford, 2009). Mr. West is a Washington-based analyst with Eurasia Group.
 

WSJ # MARCH 21, 2009
10. Downpayment Insurance Could Stabilize Home Prices

By PETER NICULESCU and BETH A. WILKINSON

Much of the government's housing policy to date has focused on helping struggling homeowners stay in their homes and resolving the problems caused by declining asset values. Both are important. But unless policies encourage people to buy houses and work off the current inventory backlog, house prices will continue to tumble.

One step toward this goal is to stabilize housing prices by reducing the risk of buying a home with little or no cost to the taxpayer. One solution is a government-sponsored downpayment insurance program for new home buyers. This could bring responsible home buyers back into the market and create a floor for home prices.

Here's how the program would work. Home buyers could purchase insurance for their downpayments: To qualify, they would have to keep the home for at least five years. The insurance policy would be written on an assessment of average home values in the neighborhood. If a homeowner can maintain or improve the home and sell it for more than his neighbor's, he gets any profit above the original purchase price. If home prices are lower when he sells, the homeowner gets to keep the downpayment.

To mitigate the risk to the taxpayer, the policy should be capped at 25% of the home value. Larger downpayments would not be fully insured, nor would larger declines in home prices. The program we're outlining is meant to temporarily stabilize home prices. Thus it should have a relatively short life, perhaps two years.

How much will it cost taxpayers? Maybe nothing. Housing is going through a powerful correction but will revive over time, and the economy will too. If, as is most likely, the insurance helps to arrest the drop in home prices before five years are up, taxpayers will pay no claims but keep the premiums.

Even if prices do keep dropping, the cost will likely be less than most of the other stimulus measures being proposed. To incur a monetary cost to the taxpayer, the person who bought a home over the next two years would have to sell it, and average prices in his neighborhood beyond five years would have to fall. Most homeowners at that point would choose to stay in their homes, knowing their downpayment is still safe. For those who are at risk of default and have to sell, the taxpayer will make payments straight into their pockets, reducing the chance of foreclosure.

At that point, downpayment insurance becomes an automatic stimulus package that only kicks in when it is really needed.

Since virtually all conforming mortgages are now being underwritten by an arm of the government (the Federal Housing Administration, Fannie Mae or Freddie Mac) the taxpayer is already exposed to the risk of default. For the Federal Housing Administration programs in particular, the government is bearing the full risk of further home price declines on home purchases with loan-to-value ratios frequently above 90% or 95%. This program merely extends the taxpayers' exposure by a fraction: the downpayment on home purchases going forward.

Mr. Niculescu, a financial consultant, is the former head of capital markets at Fannie Mae. Ms. Wilkinson, an attorney, is the former general counsel of Fannie Mae.
 
 

11. The AIG Outrage   Lawrence Kudlow
Tuesday, March 17, 2009

Copyright © 2009 Salem Web Network. All Rights Reserved.
Realclear politics

This whole AIG fiasco -- where the entire political class is suddenly screaming over bonuses paid to derivative traders in AIG’s financial-products division -- is just a complete farce. What it really shows is how the government has completely bungled the AIG takeover. Blame the Bush administration and the Obama administration. It also shows, once again, why the government shouldn’t run anything, because it cannot run anything.

AIG should have been placed in bankruptcy last fall under some sort of government sponsorship. While in bankruptcy, all the salary contracts (and every other AIG contract) would have been nullified and voided. At the same time, there would have been an orderly liquidation and sale of AIG’s assets and separate divisions.

But as things stand now, there still is no clear roadmap for the dissolution of AIG. There are ideas, but nothing is set in concrete.

And as for the $165 million or so in AIG bonus payments, the Obama administration -- including the president, Treasury man Tim Geithner, and economic adviser Larry Summers -- knew all about them many months ago. They were undoubtedly informed of this during the White House transition.

So there’s no big surprise. Nobody should be shocked. But President Obama is doing his best play-acting ever. He knows full well that the nationwide outcry against federal bailouts and takeovers is only going to get worse on his watch. His poll numbers are already falling, and this AIG episode is going to pull them down more.

Incidentally, has anybody asked Team Obama why it is more than willing to break mortgage contracts with a bankruptcy-judge cram-down, but won’t cram-down compensation agreements for AIG, despite the fact that the U.S. government owns the company? Kind of odd, don’t you think?

The Wall Street Journal editors get it right when they ask: Who’s in charge and what’s the game plan? The whole AIG story is an outrage.

What’s more, AIG is acting as a conduit for taxpayer money that is being sent to dozens of derivative counterparties, including foreign banks and American banks like Goldman Sachs. If we’re going to bail out all these other firms, why not bail them out in full taxpayer view? Why is the money being laundered furtively through AIG? And where exactly is the end game for AIG? How are the taxpayers going to be repaid?

And what is Treasury man Geithner’s role in all this? He appears to be the biggest bungler in what has become a massive bungling. My CNBC friend and colleague Charlie Gasparino thinks Geithner can’t survive this. I am inclined to agree.

Nevertheless, behind the furor over AIG, there is some good news to report on the banking front. This week’s decision by the Federal Accounting Standards Board (FASB) to allow cash-flow accounting rather than distressed last-trade mark-to-market accounting will go a long way toward solving the banking and toxic-asset problem.

Many experts believe mortgage-backed securities and other toxic assets are being serviced in a timely cash-flow manner for at least 70 cents on the dollar. This is so important. Under mark-to-market, many of these assets were written down to 20 cents on the dollar, destroying bank profits and capital. But now banks can value these assets in economic terms based on positive cash flows, rather than in distressed markets that have virtually no meaning.

Actually, when the FASB rules are adopted in the next few weeks, it will be interesting to see if a pro forma re-estimate of the last year reveals that banks have been far more profitable and have much more capital than this crazy mark-to-market accounting would have us believe.

Sharp-eyed banking analyst Dick Bove has argued that most bank losses have been non-cash -- i.e., mark-to-market write-downs. Take those fictitious write-downs away and you are left with a much healthier banking picture. This is huge in terms of solving the credit crisis.

In a column last week I suggested that not one more dime of government money is necessary for the banks. Instead, the marriage of the cash-flow valuation of bank assets and the upward-sloping Treasury yield curve will do the trick. Net interest margins are rising as banks purchase money for near-zero interest and loan it out at profitable rates. And the new mark-to-market reform will allow banks to hold their toxic assets for several more years and work them out -- just as they did back in the 1990s.

We don’t need more TARP. We don’t need to take over more big banks. And we don’t need to have the government run things it simply isn’t capable of running.
 

12.  Fed to pump another $1 trillion into U.S. economy
By Edmund L. Andrews
Wednesday, March 18, 2009
http://www.iht.com/bin/printfriendly.php?id=20912321
 

WASHINGTON: The Federal Reserve sharply stepped up its efforts to bolster the economy on Wednesday, announcing that it would pump an extra $1 trillion into the financial system by purchasing Treasury bonds and mortgage securities.

Having already reduced the key interest rate it controls nearly to zero, the central bank has increasingly turned to alternatives like buying securities as a way of getting more dollars into the economy, a tactic that amounts to creating vast new sums of money out of thin air. But the moves on Wednesday were its biggest yet, almost doubling all of the Fed's measures in the last year.

The action makes the Fed a buyer of long-term government bonds rather than the short-term debt that it typically buys and sells to help control the money supply.

The idea was to encourage more economic activity by lowering interest rates, including those on home loans, and to help the financial system as it struggles under the crushing weight of bad loans and poor investments.

Investors responded with surprise and enthusiasm. The Dow Jones industrial average, which had been down about 50 points just before the announcement, jumped immediately and ended the day up almost 91 points at 7,486.58. Yields on long-term Treasury bonds dropped markedly, and analysts predicted that interest rates on fixed-rate mortgages would soon drop below 5 percent.

But there were also clear indications that the Fed was taking risks that could dilute the value of the dollar and set the stage for future inflation. Gold prices rose $26.60 an ounce, hitting $942, a sign of declining confidence in the dollar. The dollar, which had been losing value in recent weeks to the euro and the yen, dropped sharply again on Wednesday.

In its announcement, the central bank said that the United States remained in a severe recession and listed its continuing woes, from job losses and lost housing wealth to falling exports as a result of the worldwide economic slowdown.

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability," the central bank said.

As expected, policy makers decided to keep the Fed's benchmark interest rate on overnight loans in a range between zero and 0.25 percent.

But to the surprise of investors and analysts, the committee said it had decided to purchase an additional $750 billion worth of government-guaranteed mortgage-backed securities on top of the $500 billion that the Fed is already in the process of buying.

In addition, the Fed said it would buy up to $300 billion worth of longer-term Treasury securities over the next six months. That would tend to push down longer-term interest rates on all types of loans.

All these measures would come in addition to what has already been an unprecedented expansion of lending by the Fed. The central bank also said it would probably expand the scope of a new program to finance consumer and business lending, which gets under way this week.

In effect, the central bank has been lending money to a wider and wider array of borrowers, and it has financed that lending by using its authority to create new money at will.

Since last September, the Fed's lending programs have roughly doubled the size of its balance sheet, to about $1.8 trillion, from $900 billion. The actions announced on Wednesday are likely to expand that to well over $3 trillion over the next year.

Despite a trickle of encouraging data in the last few weeks, Fed officials were clearly still worried and in no mood to cut back on their emergency efforts.

Fed policy makers sharply reduced their economic forecasts in January, predicting that the economy would continue to experience steep contractions for the first half of 2009, that unemployment could approach 9 percent by the end of the year and that there was at least a small risk of a drop in consumer prices like those that Japan experienced for nearly a decade.

The Fed rarely buys long-term government bonds. The last occasion was nearly 50 years ago under different economic circumstances when it tried to reduce long-term interest rates while allowing short term rates to rise.

Ben S. Bernanke, the Fed chairman, has been extremely cautious in recent weeks about predicting an end to the recession, saying that he hoped to see the start of a recovery later this year but warning that unemployment, a lagging indicator, would probably keep climbing until some time in 2010.

In contrast to several recent Fed decisions, with the presidents of some regional Fed banks dissenting, the decision at Wednesday's meeting of the 10 members of the Federal Open Market Committee, the central bank's policy making group, was unanimous.

Jan Hatzius, chief economist at Goldman Sachs, said the Fed had adopted a "kitchen sink" strategy of throwing everything it had to jolt the economy out of its downward spiral.

But while Mr. Hatzius applauded the decision, he cautioned that the central bank could not solve the economy's problems by expanding cheap money.

"Even if the Fed could make interest rates negative, that wouldn't necessarily help," Mr. Hatzius said. "We're in a deep recession mainly because the private sector, for a variety of reasons, has decided to save a lot more. You can have a zero interest rate, but if you just offer more money on top of the money that is already available, it doesn't do that much."

Fed officials have been wrestling for months with the fact that lenders remain unwilling to lend and borrowers are unwilling or unable to borrow. Even though the Fed has been creating money at the fastest rate in its history, much of that money has remained dormant.

The Fed's action is an expansion of its effort to bypass the private banking system and act as a lender in its own right.

The Fed and the Treasury are starting a joint venture this week called the Consumer and Business Lending Initiative in their latest effort to thaw the still-frozen credit markets. The program will start out with $200 billion in financing for consumer loans, small-business loans and some corporate purposes.

Fed officials have said they hope to expand the program next month, possibly to include the huge market for commercial mortgages, and both the Fed and Treasury hope the program will eventually provide up to $1 trillion in total financing.

13. Unions call one-day strike in France
Published: March 19, 2009 at 6:45 AM
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French Prime Minister Francois Fillon arrives at the Elysee Palace before a meeting between French President Nicolas Sarkozy and U.S. President George Bush in Paris on June 13, 2008. As part of his farewell Europe tour, Bush is holding talks with Sarkozy as France prepares to take over the six-month presidency of the European Union. (UPI Photo/ David Silpa)
French Prime Minister Francois Fillon arrives at the Elysee Palace before a meeting between French President Nicolas Sarkozy and U.S. President George Bush in Paris on June 13, 2008. As part of his farewell Europe tour, Bush is holding talks with Sarkozy as France prepares to take over the six-month presidency of the European Union. (UPI Photo/ David Silpa)

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PARIS
, March 19 (UPI) -- French union leaders said they expect a good turnout Thursday for a one-day strike to express dismay with the government's handling of the economic crisis.

Labor unions called the protest to pressure the government to reverse its cuts to public service jobs and demand more assistance for companies, a move French Prime Minister Francois Fillon said was unlikely, Radio France Internationale reported.

Government officials said they expect the number of protesters to top more than 1 million workers, about the same number who participated in a one-day work stoppage in January. Demonstrations were planned in about 200 locales across France, the BBC said. Union officials said they expected more than 2 million people to participate.

Bus and train service was disrupted and numerous schools were closed. Several cancellations and delays were reported at Paris Orly Airport.

France hasn't been as badly hit by the global economic downturn as Britain, Ireland or Spain but unions want job protection guarantees and a higher minimum wage, reported The Guardian, a British newspaper.

French President Nicolas Sarkozy said he will address the crisis by focusing on public and private investment instead of tax cuts or higher welfare spending.
 
 
 
 

France braced for huge street protests over economic crisis

Private and public sector workers in second general strike against Sarkozy cuts

    * Angelique Chrisafis in Paris
    * guardian.co.uk, Thursday 19 March 2009 08.12 GMT
    * Article history

Continental employees burn tyres during a demonstration in Compiègn

Continental employees burn tyres during a demonstration in Compiègne, north of Paris Photograph: Michel Spingler/AP

France is bracing for a wave of street protests in the second general strike over Nicolas Sarkozy's handling of the economic crisis.

Traditional public sector strikers such as teachers, transport workers and hospital staff will join an unprecedented new protest movement by private sector workers from banks and supermarkets to multinationals. Together they are protesting against both Sarkozy's cuts to France's public sector and welfare state, and accusing him of failing to protect workers from the economic crisis. Most of those involved fear the dreaded French scourge: unemployment, which is now rising at the fastest rate in more than a decade.

Unions predict the demonstrations will be bigger than the estimated 2.5 million people who took to the streets in a strike over pay and job losses in January.

Today's protest has the widest public support of any French strike in a decade, with three quarters of the population in favour.

It comes amid government concern that French protests are becoming more radical. Last week angry factory workers took Sony France's chief executive hostage over redundancies.

Yesterday morning, students clashed with riot police in Paris after a demonstration over university reform. Universities across France have been barricaded and picketed for almost two months in a standoff over higher education reform. The satirical weekly Le Canard Enchaîné yesterday reported that Sarkozy wanted student protests calmed by May, fearing echoes of the student-led protests of May 1968.

"The situation is getting worse day by day ... Who doesn't know someone touched by the crisis? The government hasn't come up with a strong response," said Jean-Claude Mailly, head of the Force Ouvriére union.

France, which has a more rigid and cautious financial system and a weak private sector, has not yet been as badly hit as Britain, Ireland or Spain by the economic crisis. But unions want guarantees of job protection and a higher minimum wage.

Sarkozy insists he will stick to his handling of the economic crisis - focusing on public and private investment instead of boosting consumers' pockets with major tax cuts or higher welfare spending. Last month, he moved to defuse tension by introducing certain tax cuts and welfare payments for poor families. Unions say it was not enough, but the president insists there will be no more concessions.

Many across the left and right accuse Sarkozy of comforting the rich while workers suffer. When the French oil giant Total announced job cuts just after reporting record profits, more than 80% of the public voiced their disgust in a recent poll.

This week Sarkozy was urged to reverse one of his first reforms that effectively cut taxes for the mega-rich in an attempt to woo back France's exodus of wealthy citizens.

Those on the left and some in Sarkozy's own party now want the very rich to pay more to boost state coffers in the crisis. Sarkozy has refused. "I was not elected to increase taxes," he said.

    * MARCH 19, 2009, 9:40 A.M. ET

14. Fed's Move Sends Dollar Lower

By RIVA FROYMOVICH

NEW YORK -- The dollar continues to fall to multiweek lows versus the yen and euro Thursday morning after the U.S. Federal Reserve's decision a day earlier to purchase longer-term Treasury debt.

The euro gained to a 10-week high of $1.3685, while the dollar declined to about a three-week low of ¥94.47. Just Wednesday, before the decision, the euro was trading below $1.30 and the dollar was as high as ¥98.85.

The Fed's announcement has knocked down both the longer-term and shorter-term view of the dollar.
Foreign Exchange Data
[foreign-exchange prices]

In the long run, traders fear the inflationary impact on the currency and "currency debasement," as Sacha Tihanyi, a currency strategist at Scotia Capital in Toronto, noted.

More immediately, the move by the Fed has spurred risk appetite among foreign exchange traders, leading them to drop the major funding currency, the dollar, in favor of riskier assets.

"Given the dollar was the last man standing as a good place to lodge cash under risk aversion environment, it is only natural that now the dollar sell off," said Neil Jones, head of hedge fund sales at Mizuho Corporate bank in London.

The yen is also gaining on its correlation to U.S. bond yields, which rallied in response to the Fed plan.

"The yen is the most sensitive currency to changes in bond yields," said Ian Stannard, a currency strategist at BNP Paribas in London.
[currencies] Getty Images

Thursday morning, the euro was at $1.3623 from $1.3480 late Wednesday, and the dollar was at ¥95.14 from ¥96.21, according to EBS. The euro was at ¥129.57 from ¥129.70. The U.K. pound was at $1.4476 from $1.4288. The dollar was at 1.1294 Swiss francs from 1.1432 Swiss francs Wednesday.

The Canadian dollar is sharply higher Thursday in the wake of the general U.S. dollar weakness, although it has retreated somewhat from its daily high, which was its highest level since Feb. 10.

"We are continuing to see general U.S. dollar weakness move its way through the market after the Fed news from [Wednesday]. That's still the primary driver of what's been pushing dollar/Canada lower," said George Davis, chief technical analyst for foreign exchange at RBC Capital Markets.

Statistics Canada reported early Thursday that the headline consumer price index was up 0.7% in February versus the previous month, and rose 1.4% from a year ago. Core CPI, which excludes energy and some food prices, gained 0.5% from the previous month, and was 1.9% higher year-over-year.

The market had expected weaker yearly gains of 1% for the headline index and 1.5% for the core.

The data had little immediate impact on the U.S./Canadian dollar pair, but is helping underpin the Canadian dollar's gains, Mr. Davis said.

The U.S. dollar dropped to a low of C$1.2196, just above key technical support at C$1.2195, before rebounding. The C$1.2196 level also marked the U.S. dollar's lowest point since Feb. 10. Thursday morning, the dollar was at C$1.2235 from C$1.2465 Wednesday.
—Don Curren in Toronto contributed to this article.

Write to Riva Froymovich at riva.froymovich@dowjones.com

   WSJ  * MARCH 23, 2009

15. My Plan for Bad Bank Assets By TIMOTHY GEITHNER

The private sector will set prices. Taxpayers will share in any upside.

By TIMOTHY GEITHNER

The American economy and much of the world now face extraordinary challenges, and confronting these challenges will continue to require extraordinary actions.
[Commentary] AP

No crisis like this has a simple or single cause, but as a nation we borrowed too much and let our financial system take on irresponsible levels of risk. Those decisions have caused enormous suffering, and much of the damage has fallen on ordinary Americans and small-business owners who were careful and responsible. This is fundamentally unfair, and Americans are justifiably angry and frustrated.

The depth of public anger and the gravity of this crisis require that every policy we take be held to the most serious test: whether it gets our financial system back to the business of providing credit to working families and viable businesses, and helps prevent future crises.

Over the past six weeks we have put in place a series of financial initiatives, alongside the Recovery and Reinvestment Program, to help lay the financial foundation for economic recovery. We launched a broad program to stabilize the housing market by encouraging lower mortgage rates and making it easier for millions to refinance and avoid foreclosure. We established a new capital program to provide banks with a safeguard against a deeper recession. By providing confidence that banks will have a sufficient level of capital even if the outlook is worse than expected, more credit will be available to the economy at lower interest rates today -- making it less likely that the more negative economy they fear will take place.
[Commentary] Getty Images

We started a major new lending program with the Federal Reserve targeted at the securitization markets critical for consumer and small business lending. Last week, we announced additional actions to support lending to small businesses by directly purchasing securities backed by Small Business Administration loans.

Together, actions over the last several months by the Federal Reserve and these initiatives by this administration are already starting to make a difference. They have helped to bring mortgage interest rates near historic lows. Just this month, we saw a 30% increase in refinancing of mortgages, which means millions of Americans are taking advantage of the lower rates. This is good for homeowners, and it's good for the economy. The new joint lending program with the Federal Reserve led to almost $9 billion of new securitizations last week, more than in the last four months combined.

However, the financial system as a whole is still working against recovery. Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions -- so-called legacy assets -- are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.

Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program to address legacy loans and securities is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.

Moving forward, we as a nation must work together to strike the right balance between our need to promote the public trust and using taxpayer money prudently to strengthen the financial system, while also ensuring the trust of those market participants who we need to do their part to get credit flowing to working families and businesses -- large and small -- across this nation.

This requires those in the private sector to remember that government assistance is a privilege, not a right. When financial institutions come to us for direct financial assistance, our government has a responsibility to ensure these funds are deployed to expand the flow of credit to the economy, not to enrich executives or shareholders. These provisions need to be designed and applied in a way that does not deter the participation by the private sector in generally available programs to stabilize the housing markets, jump-start the credit markets, and rid banks of legacy assets.

We cannot solve this crisis without making it possible for investors to take risks. While this crisis was caused by banks taking too much risk, the danger now is that they will take too little. In working with Congress to put in place strong conditions to prevent misuse of taxpayer assistance, we need to be very careful not to discourage those investments the economy needs to recover from recession. The rule of law gives responsible entrepreneurs and investors the confidence to invest and create jobs in our nation. Our nation's commitment to pursue economic policies that promote confidence and stability dates back to the very first secretary of the Treasury, Alexander Hamilton, who first made it clear that when our government gives its word we mean it.

For all the challenges we face, we still have a diverse and resilient financial system. The process of repair will take time, and progress will be uneven, with periods of stress and fragility. But these policies will work. We have already seen that where our government has provided support and financing, credit is more available at lower costs.

But as we fight the current crisis, we must also start the process of ensuring a crisis like this never happens again. As President Obama has said, we can no longer sustain 21st century markets with 20th century regulations. Our nation deserves better choices than, on one hand, accepting the catastrophic damage caused by a failure like Lehman Brothers, or on the other hand being forced to pour billions of taxpayer dollars into an institution like AIG to protect the economy against that scale of damage. The lack of an appropriate and modern regulatory regime and resolution authority helped cause this crisis, and it will continue to constrain our capacity to address future crises until we put in place fundamental reforms.

Our goal must be a stronger system that can provide the credit necessary for recovery, and that also ensures that we never find ourselves in this type of financial crisis again. We are moving quickly to achieve those goals, and we will keep at it until we have done so.

Mr. Geithner is the U.S. Treasury secretary.
 

16. Financial Policy Despair By By PAUL KRUGMAN
Published: March 22, 2009 NY Times

Over the weekend The Times and other newspapers reported leaked details about the Obama administration’s bank rescue plan, which is to be officially released this week. If the reports are correct, Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy — specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.
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Paul Krugman
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This is more than disappointing. In fact, it fills me with a sense of despair.

After all, we’ve just been through the firestorm over the A.I.G. bonuses, during which administration officials claimed that they knew nothing, couldn’t do anything, and anyway it was someone else’s fault. Meanwhile, the administration has failed to quell the public’s doubts about what banks are doing with taxpayer money.

And now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.

It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street. And by the time Mr. Obama realizes that he needs to change course, his political capital may be gone.

Let’s talk for a moment about the economics of the situation.

Right now, our economy is being dragged down by our dysfunctional financial system, which has been crippled by huge losses on mortgage-backed securities and other assets.

As economic historians can tell you, this is an old story, not that different from dozens of similar crises over the centuries. And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

That’s what Sweden did in the early 1990s. It’s also what we ourselves did after the savings and loan debacle of the Reagan years. And there’s no reason we can’t do the same thing now.

But the Obama administration, like the Bush administration, apparently wants an easier way out. The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.

And so the plan is to use taxpayer funds to drive the prices of bad assets up to “fair” levels. Mr. Paulson proposed having the government buy the assets directly. Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea, says Mr. Obama’s top economic adviser, is to use “the expertise of the market” to set the value of toxic assets.

But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.

The likely cost to taxpayers aside, there’s something strange going on here. By my count, this is the third time Obama administration officials have floated a scheme that is essentially a rehash of the Paulson plan, each time adding a new set of bells and whistles and claiming that they’re doing something completely different. This is starting to look obsessive.

But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

All is not lost: the public wants Mr. Obama to succeed, which means that he can still rescue his bank rescue plan. But time is running out.
 

March 25, 2009 NYTimes
Op-Ed Contributor
17. Dear A.I.G., I Quit!

The following is a letter sent on Tuesday by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of A.I.G.

DEAR Mr. Liddy,

It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:

I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.

After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.

I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.

You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream.

I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable — in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses. In this way I have personally suffered from this controversial activity — directly as well as indirectly with the rest of the taxpayers.

I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it.

But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut.

My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees.

That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.”

That may also be why you authorized the balance of the payments on March 13.

At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts — until several hours before your appearance last week before Congress.

I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that you either misunderstood the agreements that you had made — tacit or otherwise — with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds.

You’ve now asked the current employees of A.I.G.-F.P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust.

As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house.

Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree.

That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need.

On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.

This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear.

Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses — especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer — there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.”

Sincerely,

Jake DeSantis
 
 

 18. Guest Contribution: The Real Geithner Plan, a ‘Nuclear Option’

Posted by Guest Contributor

http://blogs.wsj.com/economics/
 

The Obama administration is seeking broad new resolution authority for banks, Peter Boone and Simon Johnson argue that the powers should be approved by Congress and used quickly and decisively. Boone is chairman of Effective Intervention, a U.K.-based charity, and a research associate at the Centre for Economic Performance, London School of Economics, and Johnson is a former IMF chief economist, and is currently a professor at MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. They run the economic crisis Web site http://BaselineScenario.com.

The Obama administration last week proposed draft legislation for a “resolution authority” that would effectively permit the government to liquidate or restructure large systemic financial institutions. If passed by Congress, these powers would allow the governments to treat nonbank financial institutions more like regulated deposit-taking banks. This authority offers a clear path to recapitalize institutions without using taxpayer money and therefore avoiding some dimensions of moral hazard but, if implemented poorly, the existence of this “nuclear option” can cause panic in financial markets and substantially delay recovery. This fear may be with us already — despite all of the material and moral support already on the table, the market is pricing in the highest ever risk of default for Citigroup senior debt, i.e., about a one in three chance over the next five years. (See the credit-default spreads for major banks.)

Imagine what happens when these powers are passed. The U.S. Treasury and FDIC would immediately have the tools need to walk into America’s largest financial institutions, such as Citibank or Bank of America, and liquidate them, or rewrite their contracts and capital structures. Such powers are clearly useful: if the banks are undercapitalized, and private money is not available, then the government could force creditors to swap claims into equity, thus instantly recapitalizing the banks while avoiding use of taxpayer funds. With such steps, the problem of moral hazard, where creditors to banks are bailed out by taxpayers, would at once be forgotten. Shareholders in banks would lose through dilution, some (unsecured?) creditors would lose with debt-equity swaps, while the nation would be better off having a well-capitalized banking system. The banks would remain private but now be controlled by (ex)creditors.

However, today these powers don’t exist, and none of us know exactly how this authority would be used if it ever lands on Mr. Geithner’s desk. We’ll now have a healthy debate in Congress and then see revised versions passed and signed into law. But as this debate proceeds, creditors and shareholders in all such institutions will be nervous. We’ll be giving the Treasury a “nuclear option” and no one can be sure who is safe. A natural reaction by clients and investors of these banks will be to edge towards the exit immediately and to stay away until the dust has settled. It won’t matter whether institutions are solvent: Due to the uncertainty and risk of losses, investors and clients may run. We’ve seen repeated waves of such panics over the last year, and we can live through them, but each successive one hurts the institutions we are trying to save and delays recovery.

What should the administration do to prevent the panics that can ensue from this legislation? First, if they plan to use it soon, they need to pass this legislation quickly. There is good logic behind requiring creditors to bear part of the cost of restructuring, but we can’t afford to have this hanging over credit markets for months to come.

Second, once passed, the new authority should be used. There is no point in incurring the political and financial costs of passing this legislation now unless it is really needed.

Third, as in any major crisis, the aim should be to use this weapon once and decisively. If the government first hits one “weak” institution then another, and piecemeal restructures the sector, then investors and creditors will constantly “game” the system. This will drive down share and debt prices, forcing the government into action, gradually moving down the chain of institutions. We’ve seen this with successive panics at Bear Stearns, Lehman, AIG, Citigroup, etc. The most solvent institutions today could be made insolvent through higher credit costs brought on by the uncertainty, and the recession will be deeper.

To be decisive, the government needs to implement this authority on large scale at once. For example, they could use a very rigorous stress test to triage institutions (i.e., more serious than the current stress test). Those that would be clearly insolvent in the face of a severe recession can be intervened over a weekend. The government could force a debt-equity swap to recapitalize the institutions, and then reopen them the following Monday as highly capitalized entities. While not all creditors with the same seniority would be treated equally — this would be a major difference and potential advantage relative to bankruptcy — the benefits of rapid actions can be justified for the economy as a whole. The institutions that are solvent, but require more capital, could be given a short timeframe to raise funds in private markets. If they cannot raise funds, the government could still intervene. With a gun to their head, there is no doubt they will find new capital, at very low share prices, that will ensure they are highly solvent.

This route to recapitalization would not be pleasant. Bank shareholders and creditors will cry foul. There will be several months of turmoil in markets, and there will be substantial disruption since bond holders and some creditors may be required to take losses when they receive equity. It will also send shockwaves to other undercapitalized institutions around the world, and could lead to their share and debt prices falling in anticipation that other governments will follow America’s example.

However, it is surely better than doing nothing, or too little, and waiting to see what happens. America needs a well capitalized financial system to restore confidence in general and the flow of credit in particular. Given there is little chance of new funding for banks from Congress, there is no easy path to recapitalize banks. Creditors probably do have to pay — this legislation will simplify and help manage that process. Let’s hope the Treasury understands how to use the weapon it is seeking.
 

19. Divided we stand On the eve of the G20 summit, countries remain split on how to respond to global recession
 
 

Apr 1st 2009
From Economist.com
On the eve of the G20 summit, countries remain split on how to respond to global recession

WORLD leaders are descending on London, just as anti-capitalist protesters prepare to unfurl their banners. Barack Obama, who remains widely popular at home and abroad, met Gordon Brown, the British prime minister, on Wednesday April 1st. Mr Obama conceded that “We're not going to agree on every point”. On the eve of the G20 summit the two men should be concerned that too little is being done to respond to the worst economic slump since the 1930s. This week the OECD, for example, concluded that global output will shrink by 2.7% in 2009, sharply down on previous estimates.

As worrying, the various leaders gathering in London are not agreed on how to sort out the economic mess. One risk is that the group, if it seeks consensus, will produce an anodyne statement that adds little or nothing to the existing efforts to respond to the global slump. A greater risk is that the summit is so badly divided, and the outcome is so feeble, that dashed expectations actually worsen confidence.

Broadly, the leaders are trying to tackle five sets of issues. The first, and perhaps least contentious, is the need to recapitalise banks and get credit flowing. All big countries with troubled banks have acted assertively on this. America, long the laggard, at last has a detailed plan that has been, mostly, well-received. Now it is a question of waiting to see whether and how the bail-outs, more lending and other initiatives will help to stimulate economies.

But no consensus exists on the need for fiscal stimulus. Just how much governments of rich countries should borrow and spend to boost their economies is disputed. America would like them to commit to stimulus packages of 2% of GDP for this year and again for 2010. But Germany and France disagree vehemently. They argue that their economies rely much more on what are known as “automatic stabilisers”—tools such as unemployment insurance payments, which increase automatically in a recession—thus they do not need as much discretionary stimulus spending as countries, such as America, where welfare payments are much less generous. Deep differences remain. On Tuesday the Japanese prime minister, Taro Aso, said that Germany’s reluctance to use public spending aggressively stemmed from its lack of understanding of the importance of fiscal mobilisation.

A failure to agree on co-ordinating fiscal plans opens the door to forms of protectionism in stimulus packages motivated by worries about stimulus benefits “leaking” abroad. Such policies could complicate the G20’s efforts to come up with ways to deal with what is already the biggest collapse in trade since the second world war. That collapse is not the result of countries imposing tariffs or devaluing currencies, as happened in the 1930s. Still, the World Bank has tracked the actions of the G20 countries in recent months and found that 17 have taken steps that retard trade, often by subtle means. Thus the leaders in London need to commit to much more than a vague promise to resist protectionism. Ideally, they will lay out a comprehensive list of measures going beyond tariffs and export subsidies—to include, for example, domestic subsidies and discriminatory procurement provisions in stimulus packages—and commit to not use them even where permitted by their existing international trade commitments. A general commitment to free trade, though welcome, would not suffice.

On financial regulation, transatlantic differences have narrowed, with America agreeing to broaden its scope to encompass institutions such as hedge funds. But open disagreement remains possible. Mr Sarkozy’s reported threat to “get up and leave” rather than endorse a G20 statement that promises too little on regulating financial markets could make it all the harder to get a deal on fiscal stimulus.

The last big issue for the G20 is what to do about the dramatic collapse in financial flows to developing and emerging economies, the largest of which are represented in the group. The least contentious part of the response is likely to be commitments to meet aid budgets and support more lending by institutions such as the World Bank and the regional development banks, possibly through greater rich-country lending to these institutions.

More fraught, though within reach, are efforts to augment the resources of the IMF and to get the fund to deploy this money rapidly, something which emerging ones are ambivalent about. Success will probably involve getting China to offer to lend the IMF a large sum of money from its massive reserves. But this is unlikely without at least a clear promise of more say in running the fund, hitherto an institution dominated by Europe and America. Reform of the fund will mean giving emerging members more vote shares. Inclusion as part of the Financial Stability Forum, a group of regulators and central bankers charged with the technicalities of financial supervision, may also make them more willing to support an expansion of the fund. But China and other large emerging economies want more than incremental reform. Aware of the complexity of negotiating far-reaching changes to vote shares at the IMF, they would like interim measures demonstrating good faith, such as a commitment to let the leadership of the fund to be decided “irrespective of nationality”. But this is something that G20 finance ministers failed to endorse at a meeting in March.
 
 

   WSJ  * MARCH 26, 2009

20. Is the Bonus Tax Unconstitutional?
The Supreme Court defers too much to Congress.
 

By RICHARD A. EPSTEIN

Bills now winding their way through Congress would tax between 70% and 90% of bonuses paid to any executive earning in excess of $250,000, if he or she is employed by a business that received more than $5 billion from U.S. bailout funds. With popular outcry at a fever pitch, too few Democrats and only some Republicans are prepared to stand up to this juggernaut.

But would the courts uphold this legislation? The AIG bonuses were made pursuant to valid contracts entered into before the receipt of the bailout money. They were ratified in the legislation that provided for the bailout, and efforts to find loopholes in these contracts have proved unavailing.

Thus any sensible system of limited government should consider the proposed bills unconstitutional. Special taxes on some forms of income (but not others) and retroactive taxes put in place after business transactions are complete both merit strong condemnation. The bills in Congress are rife with both elements.

Nevertheless, a constitutional attack against any such law that might emerge faces an uphill battle. Since the New Deal, if not earlier, the courts have allowed Congress and the states to decide which economic activities to tax, and how.

Two basic principles that animated our Constitution appear to have no traction today. One holds that property is the guardian of every other right. The second asserts that voluntary exchange is the source of general peace and prosperity. Today's Supreme Court looks to neither principle for guidance.

What about the suggestion that the current tax is either a bill of attainder -- legislation directed at punishing particular individuals -- or an ex post facto law, both of which are forbidden? No luck. A bill of attainder has to name a small group of individuals, and the class of financial executives affected by the legislation under consideration is too large to fit comfortably into that category. The prohibition against ex post facto laws has been held to cover only criminal laws, not taxes. And as for the constitutional provision against the impairment of contracts, that only limits state, not federal, power.

Today the last, best hope of a constitutional counteroffensive relies on substantive due process and the takings clause. But the courts have resisted both arguments on numerous grounds. First, it's not clear whether contract rights would be held as a species of property, or whether taxes count as a taking of private property. Deny both these propositions, and the constitutional inquiry reaches a dead-end.

Yet even if these knockout blows are averted, the Supreme Court is quick to accept justifications for presumptive constitutional lapses. It may seem laughable after the recent Congressional hearings, but our Court supinely defers to Congress's supposed "expertise" on complex matters of taxation and regulation.

Worse, the Supreme Court has eagerly embraced the toxic theory that parties are deemed to assume the risk of regulation and taxation when they are given sufficient notice of Congress's extensive legislative activities in these areas. Hence the more Congress broadcasts its intentions, the fewer rights ordinary individuals have against it.

In the 1980s, for example, the federal Pension Benefit Guaranty Corporation (PBGC) lured in multiemployer plans with the express promise they could withdraw without penalty if they did not like its fund management. But when the funds went south, the Court used the sufficient-notice theory to bless Congress's decision to tax these companies on the withdrawal of their funds.

Double crosses are now fair game. In good times they won't happen, because sensible legislators know that capital and labor will flee our shores if we engage in senseless acts of plunder. But these are not ordinary times, nor is this an ordinary Congress. The $165 million in bonus payments may be small potatoes compared to the $700 billion at stake in the AIG bailout, no less to the damage caused when investors, foreign and domestic, lose confidence in our institutions. But populist fury and Congressional fecklessness continue.

People are right to ask when this cycle will end. Can Congress pass retroactive tax increases on all high-income earners? Can it give tax breaks to TARP-friendly banks as it hammers those who stay out of its bailout clutches?

Who knows? But if Congress doesn't stop its descent into the abyss, the Court should confess its past sin of constitutional passivity and stop it for them.

Mr. Epstein is a professor of law at the University of Chicago and a senior fellow at the Hoover Institution.
 
 
 
 
 

 21. Financial Rescue Nears GDP as Pledges Top $12.8 Trillion (Update1)
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http://www.bloomberg.com/apps/news?pid=20601087&sid=armOzfkwtCA4&refer=worldwide
 

By Mark Pittman and Bob Ivry

March 31 (Bloomberg) -- The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s.

New pledges from the Fed, the Treasury Department and the Federal Deposit Insurance Corp. include $1 trillion for the Public-Private Investment Program, designed to help investors buy distressed loans and other assets from U.S. banks. The money works out to $42,105 for every man, woman and child in the U.S. and 14 times the $899.8 billion of currency in circulation. The nation’s gross domestic product was $14.2 trillion in 2008.

President Barack Obama and Treasury Secretary Timothy Geithner met with the chief executives of the nation’s 12 biggest banks on March 27 at the White House to enlist their support to thaw a 20-month freeze in bank lending.

“The president and Treasury Secretary Geithner have said they will do what it takes,” Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein said after the meeting. “If it is enough, that will be great. If it is not enough, they will have to do more.”

Commitments include a $500 billion line of credit to the FDIC from the government’s coffers that will enable the agency to guarantee as much as $2 trillion worth of debt for participants in the Term Asset-Backed Lending Facility and the Public-Private Investment Program. FDIC Chairman Sheila Bair warned that the insurance fund to protect customer deposits at U.S. banks could dry up because of bank failures.

‘Within an Eyelash’

The combined commitment has increased by 73 percent since November, when Bloomberg first estimated the funding, loans and guarantees at $7.4 trillion.

“The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets,” said Dana Johnson, chief economist for Comerica Bank in Dallas.

“Everything the Fed, the FDIC and the Treasury do doesn’t always work out right but back in October we came within an eyelash of having a truly horrible collapse of our financial system, said Johnson, a former Fed senior economist. “They used their creativity to help the worst-case scenario from unfolding and I’m awfully glad they did it.”

Federal Reserve officials project the economy will keep shrinking until at least mid-year, which would mark the longest U.S. recession since the Great Depression.

The following table details how the Fed and the government have committed the money on behalf of American taxpayers over the past 20 months, according to data compiled by Bloomberg.

===========================================================
                                  --- Amounts (Billions)---
                                   Limit          Current
===========================================================
Total                            $12,798.14     $4,169.71
-----------------------------------------------------------
 Federal Reserve Total            $7,765.64     $1,678.71
  Primary Credit Discount           $110.74        $61.31
  Secondary Credit                    $0.19         $1.00
  Primary dealer and others         $147.00        $20.18
  ABCP Liquidity                    $152.11         $6.85
  AIG Credit                         $60.00        $43.19
  Net Portfolio CP Funding        $1,800.00       $241.31
  Maiden Lane (Bear Stearns)         $29.50        $28.82
  Maiden Lane II  (AIG)              $22.50        $18.54
  Maiden Lane III (AIG)              $30.00        $24.04
  Term Securities Lending           $250.00        $88.55
  Term Auction Facility             $900.00       $468.59
  Securities lending overnight       $10.00         $4.41
  Term Asset-Backed Loan Facility   $900.00         $4.71
  Currency Swaps/Other Assets       $606.00       $377.87
  MMIFF                             $540.00         $0.00
  GSE Debt Purchases                $600.00        $50.39
  GSE Mortgage-Backed Securities  $1,000.00       $236.16
  Citigroup Bailout Fed Portion     $220.40         $0.00
  Bank of America Bailout            $87.20         $0.00
  Commitment to Buy Treasuries      $300.00         $7.50
-----------------------------------------------------------
  FDIC Total                      $2,038.50       $357.50
   Public-Private Investment*       $500.00          0.00
   FDIC Liquidity Guarantees      $1,400.00       $316.50
   GE                               $126.00        $41.00
   Citigroup Bailout FDIC            $10.00         $0.00
   Bank of America Bailout FDIC       $2.50         $0.00
-----------------------------------------------------------
 Treasury Total                   $2,694.00     $1,833.50
  TARP                              $700.00       $599.50
  Tax Break for Banks                $29.00        $29.00
  Stimulus Package (Bush)           $168.00       $168.00
  Stimulus II (Obama)               $787.00       $787.00
  Treasury Exchange Stabilization    $50.00        $50.00
  Student Loan Purchases             $60.00         $0.00
  Support for Fannie/Freddie        $400.00       $200.00
  Line of Credit for FDIC*          $500.00         $0.00
-----------------------------------------------------------
HUD Total                           $300.00       $300.00
  Hope for Homeowners FHA           $300.00       $300.00
-----------------------------------------------------------
he FDIC’s commitment to guarantee lending under the
Legacy Loan Program and the Legacy Asset Program includes a $500
billion line of credit from the U.S. Treasury.
 

To contact the reporters on this story:
Mark Pittman in New York at
mpittman@bloomberg.net;
Bob Ivry in New York at
bivry@bloomberg.net.
 
 

Last Updated: March 31, 2009 14:20 EDT

22. U.S. private sector axes 742,000 jobs in March
Wed Apr 1, 2009 9:29am EDT

http://www.reuters.com/article/newsOne/idUSTRE5303F820090401

NEW YORK (Reuters) - Job losses in the U.S. private sector accelerated in March, more than economists' expectations, according to a report by ADP Employer Services on Wednesday.

Private employers cut jobs by a record 742,000 in March versus a 706,000 revised cut in February that was originally reported at 697,000 jobs, said ADP, which has been carrying out the survey since 2001.

The big drop foreshadows a huge decline in the non-farm payroll reading in the government's employment report that will be released on Friday, some analysts said.

"It's a terrible number. It is almost a loss of three quarters of a million jobs which is possibly the highest we have seen so far over the length of this crisis," said Matt Esteve, foreign exchange trader with Tempus Consulting in Washington.

U.S. stock futures and the dollar fell after news of the bigger-than-expected job losses, while U.S. Treasury bonds regained some of their lost ground.

Economists had expected 655,000 private-sector job cuts in March in the ADP report, according to a recent Reuters poll.

(Reporting by Richard Leong and Nick Olivari, Editing by Chizu Nomiyama)
 
 

23. Obama’s Ersatz Capitalism
By JOSEPH E. STIGLITZ

http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1&ref=opinion&pagewanted=print

THE Obama administration’s $500 billion or more proposal to deal with America’s ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win — and taxpayers lose.

Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency.

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets. In the process, they used overly complex instruments like collateralized debt obligations.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently. Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest — $12 in “equity” plus $126 in the form of a guaranteed loan.

If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.

Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset.

But Americans are likely to lose even more than these calculations suggest, because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets that they think the market overestimates (and thus is willing to pay too much for).

But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government’s picking up enough of the losses overcomes this “adverse selection” effect. With the government absorbing the losses, the market doesn’t care if the banks are “cheating” them by selling their lousiest assets, because the government bears the cost.

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold).

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high costs of the administration’s plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.

Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel prize in economics in 2001.
 

  WSJ   * April 1, 2009, 12:08 PM ET

24.Manufacturing Better, but Growth Still Some Time Off

By Sudeep Reddy

The Institute for Supply Management’s overall index edged up for the third straight month, the latest sign that the manufacturing sector is close to bottoming out. But the index is still indicative of shrinking factory activity. How long will the sector take to stop contracting and show growth?

If past deep recessions are any indication, it’ll be at least a few more months (and probably a bit longer). The ISM index, now at 36.3, has been under 50 (the line between contraction and expansion) for 14 months. It’s been under 40 for six months. In the 1981-82 recession, the ISM index sat under 40 for 13 months from November 1981 and November 1982, the chair of the ISM’s manufacturing survey committee, Norbert Ore, said in an interview. After World War II, the index sat under 40 for eight months from December 1948 to July 1949.

The ISM’s new orders index showed a strong 24% leap in March (to 41.2), but Mr. Ore expects that reading to take at least two to three months before showing growth (above 50). “There’s a tremendous purging of inventories taking place,” he said. “And I think there’s still more that needs to be worked through because demand just isn’t absorbing it fast enough.”

The headline purchasing managers index only needs to top 41.2 to indicate expansion of the overall economy (beyond manufacturing). So the improvement in new orders, if it remains on track, would suggest that the economy stops contracting and returns to growth sometime in the third quarter. Could forecasters’ expectations for a mid-2009 turnaround actually be right?
 
 

    * WSJ APRIL 6, 2009, 8:34 A.M. ET

25. From Bubble to Depression?  Why the housing crash ruined the financial system but the dot-com collapse did not.

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By STEVEN GJERSTAD and VERNON L. SMITH

Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which -- when first studied in the 1980s -- were considered so transparent that bubbles would not be observed.

We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer.

But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? Key characteristics of housing markets -- momentum trading, liquidity, price-tier movements, and high-margin purchases -- combine to provide a fairly complete, simple description of the housing bubble collapse, and how it engulfed the financial system and then the wider economy.
[Review & Outlook]

In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.

The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.
[Review & Outlook]

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.

The unraveling of the bubble is in many ways the most fascinating part of the story, and the most painful reality we are now experiencing. The median price of existing homes had fallen from $230,000 in July to $217,300 in November 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Shiller index, prices were falling. Serious price declines had not yet begun, but the warning signs were there for alert observers.

Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of how Goldman Sachs avoided the fate of many of the other investment banks that packaged mortgages into securities. Goldman loaded up on the Markit ABX index of credit default swaps between early December 2006 and late February 2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. But the market was not yet in free-fall: The insurance on AAA-rated parts of the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2007, concern spread to the AAA-rated tranches of MBS.

At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing-market conditions deteriorated further in the first half of 2007. Case-Shiller tiered price sequences in Los Angeles, San Francisco, San Diego and Miami all show serious declines by the summer of 2007. Prices in the low-price tier in San Francisco were down almost 13% from their peak by July 2007; in San Diego they were off 10% by July 2007. Startling developments began to unfold that month. Between July 9 and Aug. 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront plus a $9,000 annual premium for $10 million of insurance to over $900,000 upfront (plus the annual premium).

Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined. Subprime originations plummeted from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007. Mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. Other measures of new loan originations were falling at the same time. The liquidity that generated the housing market bubble was evaporating.

Trouble quickly spread from the cost of insuring mortgage-backed securities to problems with credit markets generally, as the spread between short-term U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% between Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally considered secure, but a bank's loans to another bank carry some risk of default, the spread between these rates serves as an indicator of perceived risk in financial markets.

In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%. Moreover, housing prices have continually declined in every market in the Case-Shiller index. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy.

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Mr. Gjerstad is a visiting research associate at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics.

Please add your comments to the Opinion Journal forum.
 
 

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26. Local Recession, Global Depression
 

By Phil Izzo

Most economists will be quick to say that the current recession in the U.S. may be bad, but it isn’t anywhere near the Great Depression. Two economic historians say that view may be too limited in scope. They say the Great Depression was a global phenomenon, and in that sense the current crisis is as bad if not worse.

Writing for voxeu, Barry Eichengreen of the University of California, Berkeley, and Kevin H. O’Rourke of Trinity College Dublin say: “Globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimize this alarming fact. The ‘Great Recession’ label may turn out to be too optimistic. This is a Depression-sized event.”

However, there is one spot of good news. Eichengreen and O’Rourke note that the policy response to current crisis has been different and swifter than during the Depression. “The question now is whether that policy response will work,” they say.

 
WSJ blog
27. Fedspeak Highlights: Warsh on Panics, Honoring Contracts
Posted by Phil Izzo

The role of panic in the current recession has been debated, with some economists such as Paul Krugman and Nouriel Roubini saying that the crisis is more one of solvency than confidence. In a speech at the Council of Institutional Investors’ 2009 Spring Meeting in Washington, Federal Reserve governor Kevin Warsh made the case for panic as a fundamental cause of the crisis. In the speech, he also provides indirect defense for paying AIG bonuses, saying that the rule of law (specifically honoring contracts) is necessary to avoid panic. Here are some excerpts from this speech:

Characterizing the current period as a “recession” is still wanting, insufficient in some important respects. In my view, this period should equally be considered a panic, one that preceded, if not made more pronounced, the official recession. Hence, the Panic of 2008, which preceded the calendar year, is a more revealing description of the recent economic and financial travails. As I will describe, panics involve generalized fears–often related to financial firms–that magnify economic weakness. The encouraging news, I should note, is that panics end. And this panic is showing meaningful signs of abating…

…

Headlines have been dominated in recent weeks by the legal rules that govern contracts. To be sure, markets function best when economic actors comport themselves in a manner consistent with the rule of law. Fidelity to the rule of law is not just some aphorism for a judicial system to protect property right disputes among private parties. Nor should it be just some preachy truism of economic development for emerging economies. Rather, it is the linchpin of modern market economies like ours. And it suffers its greatest blow when the governing authorities are unwilling to uphold their end of the bargain. Nonetheless, despite some highly publicized suggestions to the contrary, I remain highly confident that the government will work tirelessly to uphold its obligations. Hewing to the rule of law, however, may be the easier part.

The panic bred by the loss of confidence in the underlying financial architecture is difficult to remedy beyond the purview of statutes and regulations. A weighty accumulation of unwritten, but no less critical, practices and understandings governs behavior and establishes expectations in market economies. Over time, these informal understandings attract deep and loyal followings by economic actors. They become articles of faith. Deviations from them tend not to be illegal, but they can markedly change perceptions of risk and return. When that happens, the resulting expectations are unmoored, with significant and often highly detrimental consequences for market functioning and economic progress.

Panics can thus be understood as periods in which key articles of faith are cast in doubt…

Some key articles of faith have been undermined with respect to some financial institutions. And that is as it should be. Risk-management failures at some large, systemically significant financial institutions are now legendary. In some cases, investors and counterparties came to rely to their detriment on these entities and their financial wherewithal. As wholesale funding markets became tougher to navigate, many financial institutions suffered, some rightly so. But their stronger peers with significantly more robust risk-management practices also appear to be paying a heavy price. It is difficult for the strong to thrive, let alone survive, when they reside in a neighborhood that is being decimated. And when panic conditions persist and long-held articles of faith lose their following, markets often react indiscriminately. Government policies, in my view, should encourage differentiation among firms, even those in seemingly close proximity. For policymakers to act otherwise is to risk their own credibility and risk undermining the pace of economic recovery…

Across a broad range of financial institutions and financial markets, an unhealthy mix of recession dynamics and panic conditions appear at work. But, in my view, it is predominantly the latter–the uncertainty with respect to financial intermediation and the corresponding breach of articles of faith–that have exacerbated the downturn.

…

The Panic is the result of both faulty private practices and flawed public policies. To place blame either exclusively on private financial firms or chiefly at the doorstep of the official sector is incorrect.

28. TARP Diagnostics
Posted by Damian Paletta

An audit by the Federal Deposit Insurance Corp.’s inspector general shines a little light on the process that banks have to go through in order to ask for capital under TARP.

The IG report said the FDIC had received 1,615 applications for TARP money from banks, asking for a total of $34 billion as of Jan. 15. The FDIC had recommended 408 of those applications on to Treasury for approval, and 267 of those banks received money.

The inspector general’s office looked closely at 172 of the applications and found that 155 met viability criteria set out by Treasury, with 17 that didn’t meet those criteria.

Thirteen of those 17 were sent on to an interagency council for review, but four weren’t, an issue that the IG’s office said needed to be addressed.

“The ability of the FDIC, and other federal bank regulators, to consider mitigating factors when making application decisions adds discretion to the process and inherently increases the risk of inconsistency,” the IG’s report said. “The use of secondary review panels such as the [interagency council] helps to address that additional risk.”

Other interesting data:
 
    * Of the banks that the FDIC recommended to Treasury for approval:
      77, or 19%, had a CAMELS rating (Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk) of 1 (which is the best on a scale of 5).
      312, or 76%, had a CAMELS rating of 2.
      19, or 5%, had a CAMELS rating of 3.
    * The IG’s office also provided information on 57 banks that withdrew their applications. Roughly 20 had a CAMELS rating of 4 or 5, and another bank was asked with withdraw because of foreign ownership.
    * Of the 172 applications reviewed by the IG, 33 were either under formal or informal enforcement actions.
    * Of the 172 reviewed by the IG, 76 provided details on how they planned to use the TARP money, though banks could select more than one category.
      49 wanted to use the money to increase lending to consumers.
      26 wanted to increase or preserve capital.
      22 wanted to use it to acquire other institutions.
 
 

29. Japan The incredible shrinking economy

Apr 2nd 2009 | TOKYO
From The Economist print edition
Japan is in danger of suffering not one but two lost decades

Illustration by S. Kambayashi

TO LOSE one decade may be regarded as a misfortune; to lose two looks like carelessness. Japan’s economy stagnated in the 1990s after its stockmarket and property bubbles burst, but its more recent economic performance looks even more troubling. Industrial production plunged by 38% in the year to February, to its lowest level since 1983. Real GDP fell at an annualised rate of 12% in the fourth quarter of 2008, and may have declined even faster in the first three months of this year. The OECD forecasts that Japan’s GDP will shrink by 6.6% in 2009 as a whole, wiping out all the gains from the previous five years of recovery.

If that turns out to be true, Japan’s economy will have grown at an average of 0.6% a year since it first stumbled in 1991 (see top chart). Thanks to deflation as well, the value of GDP in nominal terms in the first quarter of this year probably fell back to where it was in 1993. For 16 years the economy has, in effect, gone nowhere.

Was Japan’s seemingly strong recovery of 2003-07 an illusion? And why has the global crisis hit Japan much harder than other rich economies? Popular wisdom has it that Japan is overly dependent on exports, but the truth is a little more complicated. The share of exports in Japan’s GDP is much smaller than in Germany or China and until recently was on a par with that in America. During the ten years to 2001, net exports contributed nothing to Japan’s GDP growth. Then exports did surge, from 11% of GDP to 17% last year. If exporters’ capital spending is included, net exports accounted for almost half of Japan’s total GDP growth in the five years to 2007.

Exports boomed on the back of a super-cheap yen and America’s consumer binge. Japan did not have housing or credit bubbles, but the undervalued yen encouraged a bubble of a different sort. Japanese exporters expanded capacity in the belief that the yen would stay low and global demand remain strong, resulting in a huge misallocation of resources.

As foreign demand collapsed and the yen soared last year, Japan’s export “bubble” burst. Total exports have fallen by almost half in the past year. Japan’s high-value products, such as cars and consumer electronics, are the first things people stop buying when the economy sours.

Richard Jerram, an economist at Macquarie Securities, argues that the worst may soon be over for industrial production. This year, output and exports have fallen by much more than the drop in demand, because firms have temporarily closed plants in order to slash excess stocks. For instance, Japan’s vehicle production in the first two months of 2009 was 50% lower than a year before, but global car sales fell by only 25%.

Mr Jerram reckons that the inventory rundown is coming to an end, which will lead to a short-term bounce in output as factories reopen. If so, car output in June could be around 50% higher than in March (but still down by 25% on a year earlier). This means that GDP growth might turn positive in the second quarter even if foreign demand remains weak.

Unfortunately, the economy is likely to totter again as the second-round effects of tumbling profits and rising unemployment squeeze investment and consumer spending. According to the latest Tankan survey of the Bank of Japan (BOJ), in March business sentiment among big manufacturing firms was the gloomiest since the poll began in 1974. Manufacturers say they plan to cut investment by 20% this year. They are also trimming jobs and wages. The seemingly modest unemployment rate of 4.4% in February understates the pain. The ratio of job offers to applicants has declined to only 0.59, from around one at the start of 2008, and average hours worked have also fallen sharply. Average wages (including bonuses and overtime pay) went down by 2.7% in the 12 months to February. Household spending fell by 3.5% in real terms over the same period; department store sales plunged by 11.5%.

The weakening domestic economy has prompted the government to man the fiscal pumps. A stimulus of 1.4% of GDP is already in the pipeline for 2009, and a further boost of perhaps 2% of GDP is expected to be unveiled in mid-April. The package is likely to include measures to strengthen the safety net for the unemployed and so ease concerns about job security. There will also be new infrastructure spending. Much of the expenditure on public works in the 1990s is now considered wasteful, so this time the focus is meant to be on projects that boost productivity, such as an expansion of Tokyo’s Haneda airport. Better crafted stimulus measures which raise long-run growth are also less likely to spook bond markets concerned about the government’s vast debt.

So long as the extra measures are not delayed by an early election (which must be called by September), Japan’s total fiscal stimulus in 2009 could be the largest among the G7 economies. But it would not be enough to prevent a sharp widening of the output gap (the difference between actual GDP and what the economy could produce at full capacity). This had already risen to 4% of GDP in the fourth quarter of 2008, and it is likely to approach 10% by the end of 2009, twice as much as in the 1990s downturn (see bottom chart, above).

This gaping economic hole is again putting downward pressure on prices. By late summer consumer prices could be more than 2% lower than a year before—a faster decline than during Japan’s previous bout of deflation. The risk is that deflation will squeeze profits and hence jobs, thereby further depressing demand and prices. The BOJ cut interest rates to 0.1% in December and it has introduced several measures to keep credit flowing, such as buying commercial paper and corporate bonds, as well as shares held by banks, which boosts their capital ratios. In contrast to the 1990s, bank lending is still growing.

The BOJ has also stepped up its purchases of government bonds, but after its experience in 2001-06, the bank remains sceptical that such “quantitative easing” can lift inflationary expectations and spur demand. One big difference is that the previous episode of quantitative easing coincided with stringent budget-tightening under Junichiro Koizumi, the then prime minister. The budget deficit was reduced from 8% of GDP in 2002 to 1.4% in 2006 (which partly explains why domestic demand was weak). The combination of fiscal expansion and government-bond purchases by the BOJ should work better.

The OECD predicts that public-sector debt will approach 200% of GDP in 2010, so the scope for further fiscal stimulus will be limited. Nor can Japan rely on exports for future growth; to the extent that it had enjoyed an export bubble, foreign demand will not return to its previous level. Japan needs to spur domestic spending.

One possible option, which the government is exploring, is to unlock the vast financial assets of the elderly. Japanese households’ stash of savings is equivalent to more than five times their disposable income, the highest of any G7 economy, and three-fifths of it is held by people over 60 years old. Gifts to children are taxed like ordinary income, but if this tax were reduced, increased transfers could boost consumption and housing investment since the young have a much higher propensity to consume. In theory, this could give a much bigger boost to the economy than any likely fiscal stimulus.

Of course, one reason why the elderly are cautious about running down their assets is concern about the mismanaged pension system and future nursing care. Services for the elderly should be among Japan’s fastest growing industries and create lots of new jobs, but they are held back by regulations which restrict competition and supply. Deregulation of services would not only help to improve the living standards of an ageing population, but by helping to unlock savings might also drag the economy out of deep recession.

Japan’s second lost decade holds worrying lessons for other rich economies. Its large fiscal stimulus succeeded in preventing a depression in the 1990s after its bubble burst—and others are surely correct to follow today. But Japan’s failure to spur a strong domestic recovery a decade later suggests that America and Europe may also have a long, hard journey ahead.
 
 
 

   WSJ * APRIL 1, 2009, 10:00 P.M. ET

30. Is This the End of Capitalism? Hardly, but it's a great excuse for the antiglobalization crowd.

 
Heads of state, perplexed finance ministers, inflated retinues and journalists from 20 nations arrived in London yesterday to address "the greatest financial crisis since the Depression." By 4 p.m. London time today they will hold a press conference and go home.

Is there any chance we can adopt this system for Congress?
[Wonder Land] AP

A protest banner hangs outside the Bank of England yesterday.

Possibly the G-20 kept it short to minimize the potential ruin visited on London by the professional street fighters fronting the anti-capitalism mobs on global TV screens.

In truth, the G-20's goal was accomplished before the first plane landed. The mere announcement of the meeting brought forth a torrent of pent-up "global" agendas.

The German magazine Spiegel crammed all of them into one headline: "Can the G-20 Save the World?"

"Who is going to save capitalism?" the Germans asked. Many, it appears, have been waiting for their 15 minutes to offer the answer.

Anticapitalist forces are taking advantage of the global financial crisis. Daniel Henninger explains. (April 2)

China wants a new global currency to replace the inflatable dollar. The managing director of the International Monetary Fund, Dominique Strauss-Kahn, has said the world financial system needs an "early warning system," which one guesses the rocket scientists at the IMF would provide. France's Nicolas Sarkozy wants a global "financial regulator." On Sunday the New York Times raised its hand to announce the crisis "has led to a fundamental rethinking of the American way as a model for the rest of the world."

Here's my two cents worth: Beware of real-estate salesmen.

The housing bubble that floated into view in 2007 is turning into the blob that ate the world. Real-estate mortgages and their derivative securities are a significant problem. That discrete problem, however, has been pumped up to an historic "crisis of capitalism."

Capitalism didn't tank the U.S. economy. Overbuilt housing did. Overbuilt housing tanked the economies of the U.K. and Ireland and Spain. If little else, we've learned that artificially cheap housing sets loose limitless moral hazard.
Podcast

Listen to Daniel Henninger's Wonder Land column, now available in audio format.

Virtually every white-shoe financial institution in the world, plus the Russians, stuffed their balance sheets with securities carved out of the dreams of real-estate developers. This plunge had less to do with capitalism than with psychosis, defined in textbooks as "a mental illness that markedly interferes with a person's capacity to meet life's everyday demands." For sane bankers that includes due diligence and risk management.

In a normal environment, the problems revealed by the crisis in mortgage finance would produce fixes relevant to the problem, such as resetting the ratios of assets to capital for banks and hedge funds, or telling the gnomes of finance to rethink mark-to-market and the uptick rule. More energetic reformers might consider Gary Becker's suggestion that as financial institutions expand in size, their capital requirements tighten, so that compulsive eaters like Citigroup can fit inside their capital base.

Nothing's normal about now, however. After the full folly of the mortgage plunge became public in September 2008, the broad credit markets locked up, stock indexes fell and the world's economies spiraled into a severe recession. The loss of savings and jobs has been brutal. Someone has to take the fall for this, and it had to be more than the boys in mortgage-backed securities.

Two signal events in history are shaping the politics of the current economic crisis: the Great Depression and the Reagan presidency (and in Europe, Thatcherism).

The Depression put in motion an historic tension between public and private sectors over who sets a nation's course. After 50 years of public dominance, Reagan's presidency tipped the scales back toward private enterprise. The economic life of the ensuing 35 years became "the American model." Every waking hour of this economically liberal era, the losing side has wanted to tip the balance back toward public-sector power. The opportunity to achieve that goal finally arrived -- with the great recession of 2009. Thus rather than fixing just what the mortgage crisis broke, the G-20 suddenly became a meditation on the "future of capitalism."

No surprise that the French and Germans, who for years have wanted to slow such American fast runners as Microsoft and Intel, came to London seeking ponderous new bureaucracies euphemized as a "new global financial architecture." It's been a long time since anyone thought to elevate the IMF as an economic driver.

Meanwhile, the new U.S. president is attempting to replace the American model of some three decades with the Obama model, which promises to grow the U.S.'s $14 trillion GDP (something else he "inherited") with government investments in national health insurance and renewable energy technologies.

I'm thinking that the two happiest G-men in London are Hu Jintao of China and Lula da Silva of Brazil. Their game is catching up with the West. It's a lot easier to play ball in the G-20 league if in the future the competition will be running in slow motion.

Write to henninger@wsj.com
 

The Baseline Scenario

31. What happened to the global economy and what we can do about it Inflation Prospects In An Emerging Market, Like The U.S.

with 20 comments

http://baselinescenario.com/2009/04/06/inflation-prospects-in-an-emerging-market-like-the-us/

There are two ways to think about inflation in today’s economy.  The first, suggested by conventional macroeconomic frameworks for the US, is that, with rising unemployment and actual output sinking further below “potential” output, inflation will stay low - and we could actually experience the dangers of falling wages and prices (think what happens to mortgage defaults in that scenario).  This is the view, for example, expressed by Fed Vice Chair Don Kohn last week, and the Obama Administration seems to be on exactly the same page - talking already about a further very large fiscal stimulus.

Some people in this camp do see a danger of inflation, down the road, as the economy recovers - and resumes its potential level (or growth rate).  As a result, many of them stress that the Fed will need to start “withdrawing” its support for credit and raising interest rates as soon as the economy turns the corner.  One informed insider’s reaction to our piece on Ben Bernanke in the Washington Post on Sunday was that we were too easy on Bernanke for failing to tighten monetary conditions as the economy began to recover after the last big easing earlier this decade (specifically, our correspondent argues that Bernanke provided the intellectual underpinnings for what Greenspan wanted to do.)

In today’s post-G20 summit situation, some of my former IMF colleagues are worried that further monetary easing around the world will create inflationary pressure in middle-income emerging markets, where inflation is often harder to control than in richer “industrial countries.”  But if you think the broader political and economic dynamics of the United States have become more like those of emerging markets, e.g., the concentrated power of the financial elite and their ability to access corporate welfare, doesn’t that also have potential implications for inflation?

In discussions of emerging markets, you rarely hear discussion of “potential output.”  This is a slippery concept even for the United States, with origins in the idea of running factories at “full capacity” but also reflecting the traditional bargaining power of labor - macroeconomists argue about the exact reasoning but most agree it’s a magical place where inflation is stable.  If output (or growth) is too high relative to potential, inflation rises and, depending on where you are relatively to some sort of inflation goal, the central bank needs to tighten monetary policy in order to bring it down.

Emerging markets traditionally experience big movements in relative prices (e.g., entire sectors collapse), big ups and downs in credit (i.e., regular banking crises and recoveries), and waves of government bad behavior (think expropriation of people’s pensions or other assets).  Potential output simply isn’t stable, or perhaps even measurable, in situations with a lot of investment (in  good times) and much disinvestment or scrapping of capital (when times turn sour).

So what determines inflation in emerging markets?  This is simple, but also very hard to manage: the balance of supply and demand for money.  The government issues money through its financing of budget deficits and various credit-support operations; this obviously tends to push up inflation (i.e., more money tends to reduce the value of money outstanding).  People’s demand for money depends on what they expect in terms of inflation, and this is often affected by what the exchange rate is doing - a depreciating currency both raises the prices of imports directly and moves people’s inflation expectations upwards.  In the background, of course, a growing economy has an increasing demand for money, so the economy can handle - and perhaps even needs - money issue.  In practice, policymakers watch the inflation rate like a hawk and move rates up or down accordingly - but subject to the political pressures coming from higher or lower growth, perhaps relative to their perception of “trend” but without reference to any kind of “potential” concept.

What kind of economy is the US today?  The financial sector has taken a huge hit and is almost certainly going to contract.  The credit system remains disrupted and levels of investment are almost certainly down across the board.  Many firms, nonprofits, and consumers overexpanded relative to what they now see as their more permanent prospects, so there is a big move to “repair balance sheets” (pay down debt; invest less).  Potential output, if that is still a meaningful concept for the US, must be falling; and potential growth (based on some idea of where productivity can go) must also be down.

Even more important in the short-run, inflation expectations are on the move.  There are different ways to think about this (naturally elusive) concept, but take a look at the latest data from the inflation swap market (we’ll do an explainer on this; for now, just look at how expectations have rebounded already from their low at the end of last year; if you want technicalities on this market, try the beginning of this document).  If you prefer to focus on the implied inflation expectation in indexed 10 year US Treasury bonds this stood at 1.4 percent on Friday and shows a similar rebound over the past few months.  (For some reason, my official colleagues prefer bonds; my financial market friends prefer swaps.)

As we explained in our Washington Post article yesterday, we strongly support what Ben Bernanke is doing - there is a lot of uncertainty and the alternatives are much worse.  But we don’t accept the premise that the Fed’s actions today cannot cause inflation quite soon.  Arguing more about this, here and elsewhere, should help us think about how to manage the consequences and minimize the costs.

Excessive inflation is a typical outcome in oligarchic situations when a weak (or pliant) government is unable to force the most powerful to take their losses - high inflation is, in many ways, an inefficient and regressive tax but it’s also often a transfer from poor to rich.

Written by Simon Johnson

April 6, 2009 at 5:57 am

Posted in Commentary
 
 

 WSJ   * APRIL 1, 2009, 9:46 P.M. ET

32. The Socialist Solution to the Crisis
Thatcherism and Reaganism have failed on a momentous scale.
 

By POUL NYRUP RASMUSSEN

The job losses, repossessions, uncertainty, fear and misery faced by the people of Europe, the United States and Japan are a terrible stain on the consciences of those bankers and politicians whose doctrine of neo-liberal markets plunged us all into this crash. But the effect of the crisis on the Third World is of an entirely different magnitude. While developed countries scramble to save their economies, half of humanity languishes. For many, this means hunger, disease and death.

In Europe, we have been protected from the worst effects of the crisis thanks to welfare states built up over the past 60 years to cushion citizens from the threats posed by the free market. We can all count on state health care, social housing, education, unemployment support and other universal, tax-funded services.

The task facing us is to extend and adapt this unique recipe for prosperity and solidarity to the developing world, where according to the World Health Organization between 200,000 and 400,000 additional children will die each year due to the global economic downturn. Prices for natural resources are falling, the stream of earnings sent back to developing countries by migrant workers is drying up, government debts are being called in, and spending slashed.

In Asia, Africa and Latin America this will mean job losses in industry and strains on agriculture. Children are being pulled out of school to work in fields or to provide an extra income, livestock are being sold, and unscrupulous employers are extracting even more from overworked and underpaid sweatshop laborers. Political instability has already claimed governments in Guinea Bissau and Madagascar, and unrest is building elsewhere.

It is vitally important that we fight the global financial and economic crisis, but we must remember that this crisis comes on top of a number of crises in the developing world. It adds further misery to the food crisis, the migration crisis, the climate and energy crisis, and the environmental crisis.

So now, as we react to the near-collapse of the international financial system, and as people recognize the fundamental flaws in the neo-liberal recipe of deregulated, market-led globalization, we have a unique opportunity to develop a new approach.

The simplistic dictum of more markets and less government -- championed by Reagan, Thatcher and their ideological heirs -- has failed on a momentous scale. In the White House, President Hope has replaced President Tax Cuts for the Rich. As we go into the G-20 meeting in London, even European conservatives such as Nicolas Sarkozy and Angela Merkel are calling for a new global financial architecture, better financial regulation and a crackdown on tax havens. The previously unimaginable idea of a "Global New Deal" is suddenly on many people's lips.

We must press harder than ever for the implementation of the eight Millennium Development Goals agreed to by the United Nations in 2000, which include halving extreme poverty, achieving universal primary education, and reversing the spread of HIV/AIDS. A global crackdown on tax havens and tax avoidance could provide the funds to take the fight against such scourges as infectious diseases, maternal mortality and poverty to a whole new level. We could base our stimulus spending on smart green growth, making real progress in protecting the environment. Would that not be an inspiring way to combat the recession?

We must press for the strongest possible international agreement on climate change, and make it politically impossible for conservatives to argue that we cannot afford this. We must show that the costs of doing nothing far outweigh the costs of switching to a carbon-free economy, not least because the actions required have the potential to create millions of jobs.

We must also renew our faith in diplomacy as a means to achieve peace. The West now has no excuses for failing to establish dialogue with countries like Iran, countries whose aggressive strength is only augmented if we do not engage all players in peaceful conflict resolution.

I am hopeful that the G-20 will make progress on these areas. But we cannot just leave it to them. We must keep up the pressure by demanding a globalization that works for everyone, and forge new alliances and new lines of communication across national boundaries. We must develop new, progressive ways to achieve global justice.

That's why, as the G-20 meets in London, an even larger group will meet in Brussels -- a group of progressive politicians, trade unionists, NGOs, academics and figures from major international institutions. This is the world conference of the Global Progressive Forum (GPF), which will bring together speakers from five continents to develop a new vision of a globalized world which benefits all. The GPF will take place in the European Parliament and will be opened by Bill Clinton. It will feature debates and discussions on the issues of global governance, trade, financial markets, decent work, migration and climate change, all aimed at coordinating global answers to what are global crises. It shows that the world's progressives are serious about making a solidaristic social model a reality for all.

In ancient Greek drama, the word "krisis" refers to the pivot on which the plot turns, the point at which its resolution, the moment of death or triumph, is decided. How will our crises be resolved? The systemic failings brought to light by the economic crisis offer us a once-in-a-lifetime opportunity to make a proactive new start on all fronts. Now is the time to ensure that this pivotal moment is not wasted. Now is the time for change.

Mr. Rasmussen is president of the Party of European Socialists and a former prime minister of Denmark (1993-2001).
 

    WSJ * APRIL 2, 2009

33. Bankruptcy Is Vital to Capitalism

    *
      By DAVID WESSEL
 

America is relearning an old lesson: Failure and bankruptcy are essential to capitalism.

Bankruptcy is an orderly way to give an overburdened debtor a fresh start and to decide which creditors get paid back and which don't. As Nobel laureate Joseph Stiglitz teaches: Bankruptcy is a way to cope with those times when markets fail to allocate capital wisely and monitor its use.

In good times, bankruptcy is a way to encourage risk-taking. After all, an economy in which everyone fears trying something that might fail is a stagnant one. But the roots of modern American business bankruptcy date to bad times like today.
Read More

    * David Moss, author, "When All Else Fails: Government as the Ultimate Risk Manager"
    * David Skeel, author, Debt's Dominion
    * Ayotte & Steel paper

At the end of the 19th century, nearly 20% of the railroad track belonged to insolvent railroads, says David Skeel, a University of Pennsylvania law professor who has written a history of bankruptcy. With state governments unable to deal with railroads that stretched beyond their borders, and Congress hamstrung by a narrow interpretation of the Constitution, creditors turned to courts. Judges fashioned an approach to divvy up assets among creditors that was codified in an 1898 law, the spirit of which survives today.

General Motors and Chrysler are 21st century analogs of 19th century railroads. They cannot pay their debts; the only issue now is how, not whether, their creditors take a hit. The only difference between GM today and GM in bankruptcy court is that the president and his appointees are making the decisions, instead of a bankruptcy judge constrained by federal law.

Avoiding bankruptcy requires consent of creditors. "In theory, you can do a full bankruptcy through agreement among the parties, but that usually doesn't work," says David Moss, a Harvard Business School professor. "You usually have at least one holdout," in this case GM's bondholders. New Deal changes to the law made cutting deals harder. The view was that an open process with clear rules was more likely to produce a fair result, not one that favored Wall Street types.

With that view in mind, President Barack Obama's critics say the government has no business picking GM's chief executive and apportioning losses among auto workers, pensioners, suppliers and lenders. They fear "politics" will produce unfair or unwise decisions, such as protecting lenders and workers in the domestic auto industry at taxpayer expense while lenders and workers in less politically salient industries suffer.

But sometimes "politics" is just another word for "democracy." The people are having a hard time understanding why big banks and insurers get bailouts and GM gets bankruptcy. It's hard to convince laid-off auto workers that banks and their credit are the vital circulatory system of the U.S. economy, more important than any one industry, even one as large as domestic auto makers. Mr. Obama knows he almost certainly will need more taxpayer money to resuscitate the nation's banks; that won't be popular. If making a very public effort to avoid bankruptcy fails, he will say: I tried, but it just couldn't be done. That may help him get Congress to approve money for the banks.
video
Bankruptcy Is Not a Death Sentence
2:10

Although taxpayers fear bankruptcy, it's an essential part of a functioning capitalist economy, economics editor David Wessel says.

What about big financial houses, though? Why can't they go through bankruptcy the way Macy's and Delta Air Lines did? One reason is that a retailer or airline can shed debts and then operate stores and airplanes. Financial institutions have nothing so tangible: They basically have their names, their people and their ability to borrow a lot of money short term. All of that can vanish instantly while a judge ponders the matter. So the U.S. devised a bankruptcy substitute for banks: The Federal Deposit Insurance Corp. does the deed quickly without a judge.

The Treasury and the Federal Reserve want a similar pseudo-bankruptcy process for big financial institutions to avoid the problems of Lehman Brothers (whose bankruptcy coincided with a bad turn in the crisis and some say caused it) and American International Group (which didn't go into bankruptcy, at substantial cost to taxpayers). They want better choices next time, and they don't think conventional bankruptcy is practical.

Not everyone sees it that way. "The usual reaction if one mentions bankruptcy as a mechanism for addressing a financial institution's default is incredulity," Mr. Skeel and Northwestern University's Kenneth Ayotte wrote recently. "Those who favor the rescue of financial institutions...treat bankruptcy as anathema. Everyone seems to argue that nothing good can come from bankruptcy." They disagree, and would tweak bankruptcy laws to deal with the peculiarities of finance so the rules are clear to all -- and the Treasury secretary and Fed chairman have less discretion.

Bankruptcy is not a death sentence. It's more like an organ transplant. It can save a company's life, but sometimes the patient dies. Bankruptcy is unpleasant and should never be so easy that it encourages foolishness. Headline-making bankruptcies of several brand-name companies at a moment of severe economic crisis can so undermine confidence in the economy that avoiding them makes sense.

But bankruptcy, or some other orderly process to share the pain, is the only way to prevent mistakes and debts of the past from hobbling an economy's future.

    * Write to David Wessel at capital@wsj.com.
 
 
 
 
 
 
 

NYTimes April 3, 2009
Op-Ed Columnist
34. Greed and Stupidity
By DAVID BROOKS

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic (available online now).

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The U.S. economy got finance-heavy and finance-mad, and finally collapsed. When it did, the elites did what all elites do. They took care of their own: “Money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves,” Johnson writes.

In short, he argues, the U.S. financial crisis is a bigger version of the crises that have afflicted emerging-market nations for decades. An oligarchy takes control of the nation. The oligarchs get carried away and build an empire on mountains of debt. The whole thing comes crashing down. Johnson’s remedy is clear. Smash the oligarchy. Nationalize the banks. Sell them off in medium-size pieces. Revise antitrust laws so they can’t get back together. Find ways to limit executive compensation. Permanently reduce the size and power of Wall Street.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing. They thought they had these sophisticated tools to reduce risk. But when big events — like the rise of China — fundamentally altered the world economy, their tools were worse than useless.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one. In Wired, Felix Salmon described the false lure of the Gaussian copula function, the formula that gave finance whizzes the illusion that they could accurately calculate risks. Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. You’d think that with thousands of ideas flowing at light speed around the world, you’d get a diversity of viewpoints and expectations that would balance one another out. Instead, global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. What’s new about this crisis, he writes, is the central role of “opacity and pseudo-objectivity.” Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

 
35. The Mark-to-Market Myth
http://baselinescenario.com/2009/04/02/the-mark-to-market-myth/#more-3150

with 70 comments

Today the Financial Accounting Standards Board voted - by one vote - to relax accounting standards for certain types of securities, giving banks greater discretion in determining what price to carry them at on their balance sheets. The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets.

This makes no sense, for three reasons.

1. Investors and regulators are not idiots. They know what the accounting rules are. If banks claim they were forced to mark their assets down to “fire-sale” prices, investors can look at the facts themselves and apply any upward corrections they want. Now that banks will be able to mark their assets up to prices based solely on their own models, investors will the downward corrections they want. It’s a little like what happened when companies were forced to account for stock option compensation as expenses; nothing happened to stock prices, because anyone who wanted to could already read the footnotes and do the calculations himself.

However, the situation is not symmetrical, and the change is bad for two reasons. First, fair market value (”mark to market”) has the benefit of being a clear rule that everyone has to conform to. So from the investor’s perspective, you have one fact to go on. The new rule makes asset prices dependent on banks’ internal judgment, and each bank may apply different criteria. So from the investor’s perspective, now you have zero facts to go on. It’s as if auto companies were allowed to replace EPA fuel efficiency estimates with their own estimates using their own tests. We all know the EPA estimates are not realistic, but we can find out exactly how they were obtained and make whatever adjustments we want. If each auto company can use its own criteria, then we have no information at all.

Second, this takes away the bank’s incentive to disclose information. Under the old rule, if a bank had to show market prices but thought they were unfairly low, it would have to show some evidence in order to convince investors of its position. Under the new rule, a bank can simply report the results of its internal models and has no incentive to provide any more information.

So what we get is less information and more uncertainty. That was all reason number one.

2. Between the two options, this is the unsafe choice. Accounting in general is supposed to embody a principle of conservatism. Given plausible optimistic and pessimistic rules, you are supposed to choose the pessimistic one. But think about what happens here. Let’s say the bank has to mark to market, but it turns out the economy recovers and the asset increases in value. In this scenario, the writedown reduced the bank’s capital, so it had to get more. When the asset recovers, the bank is profitable and can buy back the shares it sold.

In the opposite scenario, the bank marks to its own imagination, but in reality the market price was the long-term price. At some point in the future, the bank will have to write down that asset, but it may not have the capital to absorb that writedown, in which case it will fail.

The choice is between the risk of raising too much capital and the risk of not raising enough capital. FASB chose the latter.

3. Mark-to-market is a red herring to begin with. Accounting rules are much more complex than “all assets must be marked to market” and “all assets can be marked to model.” There are different types of assets (Level 1, 2, and 3); different types of impairments to asset values (temporary and other-than-temporary); different accounting impacts (some writedowns on the balance sheet affect income statement profitability, some don’t); and, most importantly, different ways of holding assets. How a bank accounts for an asset depends in part on whether it says that asset is held for trading purposes, is available for sale, or will be held to maturity. Wharton has a high-level discussion of some of these issues, but if you really want to understand them you should read Sections 1.B-D of the SEC’s study of mark-to-market accounting, which I helpfully summarized for you in an earlier post.

The SEC’s conclusions were, in short:

    * Most bank assets are not marked to market to begin with, and half of the ones that are marked to market are the type that don’t affect the income statement.
    * Marking assets to market had only a very small impact on bank capital through September 2008.
    * The bank failures of 2008, including Washington Mutual, were not caused by marking assets to market (increasing loan loss provisions were a bigger culprit). In each case, stock prices started falling before the banks took writedowns, implying that investors already knew something was fishy before the accountants did anything.

I don’t know any of the back-room dealing, but it seems like the banking industry is taking advantage of the confusion to push through a change it wants, because it will make it easier for banks to massage their balance sheets and harder for investors to see what is really going on.

Update: Here’s a thought. What if the function of these rule changes is to make it easier for banks to ignore the results of the PPIP auctions? For example, Bank A puts up a pool of loans for auction, but doesn’t like the winning bid and rejects it; Bank A doesn’t want to be forced to write down its loans to the amount of the winning bid. Or, alternatively, Bank B sells a security to a buyer, and Bank A holds the same security; Bank A doesn’t want to be forced to write down the security to the price of Bank B’s transaction.

The change to fair value accounting (Rule 157) may make it easier to claim that the sale by Bank B was a “distressed sale,” meaning it can ignore it for valuation purposes. Even if it can’t ignore the sale, the change to other-than-temporary impairment may make it easier for Bank A to classify any impairment as temporary and therefore avoid an income statement hit. You’d have to be a specialist to know the answers for sure, but in any case these rule changes don’t make it any harder.

By James Kwak

Written by James Kwak

April 2, 2009 at 4:19 pm

Posted in Commentary

Tagged with accounting
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36. Did the Oil Price Boom of 2008 Cause Crisis?
Posted by Justin Lahart

econbrowser

Reeling from the housing bust and the banking crisis, it’s hard to think that the energy shock — the one that carried the average price of gasoline to a peak of $4.11 a gallon last July — was much more than a minor player in the economic downturn. But there’s the uncomfortable fact previous oil shocks, like the ones that came with the 1973 oil embargo, the 1979 Iranian revolution and the 1990 invasion of Kuwait, were also associated with recessions. And the 2001 recession, too, came on the heels of a run-up in oil prices.

In a paper presented at the Brookings Panel on Economic Activity Thursday, University of Calif.-San Diego economist James Hamilton crunched some numbers on how consumer spending responds to rising energy prices and came to a surprising result: Nearly all of last year’s economic downturn could be attributed to the oil price shock.

As he writes on his blog, that’s a conclusion that he doesn’t quite believe in himself. We’d like to think that, say, the seizing up of the credit markets this fall had something to with the economy falling off the table in the fourth quarter.

But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.

A more controversial argument on energy’s role in the credit crunch could go like this. Housing prices kept on climbing, but the Federal Reserve – laboring on the idea that it couldn’t identify bubbles and that even if it could, it shouldn’t pop them — didn’t do anything about them. But then rising oil prices started adding to inflationary pressures, so the Fed kept pushing rates higher,

WSJ econ blog

Fedspeak Highlights: Warsh on Panics, Honoring Contracts
Posted by Phil Izzo

The role of panic in the current recession has been debated, with some economists such as Paul Krugman and Nouriel Roubini saying that the crisis is more one of solvency than confidence. In a speech at the Council of Institutional Investors’ 2009 Spring Meeting in Washington, Federal Reserve governor Kevin Warsh made the case for panic as a fundamental cause of the crisis. In the speech, he also provides indirect defense for paying AIG bonuses, saying that the rule of law (specifically honoring contracts) is necessary to avoid panic. Here are some excerpts from this speech:

Characterizing the current period as a “recession” is still wanting, insufficient in some important respects. In my view, this period should equally be considered a panic, one that preceded, if not made more pronounced, the official recession. Hence, the Panic of 2008, which preceded the calendar year, is a more revealing description of the recent economic and financial travails. As I will describe, panics involve generalized fears–often related to financial firms–that magnify economic weakness. The encouraging news, I should note, is that panics end. And this panic is showing meaningful signs of abating…

…

Headlines have been dominated in recent weeks by the legal rules that govern contracts. To be sure, markets function best when economic actors comport themselves in a manner consistent with the rule of law. Fidelity to the rule of law is not just some aphorism for a judicial system to protect property right disputes among private parties. Nor should it be just some preachy truism of economic development for emerging economies. Rather, it is the linchpin of modern market economies like ours. And it suffers its greatest blow when the governing authorities are unwilling to uphold their end of the bargain. Nonetheless, despite some highly publicized suggestions to the contrary, I remain highly confident that the government will work tirelessly to uphold its obligations. Hewing to the rule of law, however, may be the easier part.

The panic bred by the loss of confidence in the underlying financial architecture is difficult to remedy beyond the purview of statutes and regulations. A weighty accumulation of unwritten, but no less critical, practices and understandings governs behavior and establishes expectations in market economies. Over time, these informal understandings attract deep and loyal followings by economic actors. They become articles of faith. Deviations from them tend not to be illegal, but they can markedly change perceptions of risk and return. When that happens, the resulting expectations are unmoored, with significant and often highly detrimental consequences for market functioning and economic progress.

Panics can thus be understood as periods in which key articles of faith are cast in doubt…

Some key articles of faith have been undermined with respect to some financial institutions. And that is as it should be. Risk-management failures at some large, systemically significant financial institutions are now legendary. In some cases, investors and counterparties came to rely to their detriment on these entities and their financial wherewithal. As wholesale funding markets became tougher to navigate, many financial institutions suffered, some rightly so. But their stronger peers with significantly more robust risk-management practices also appear to be paying a heavy price. It is difficult for the strong to thrive, let alone survive, when they reside in a neighborhood that is being decimated. And when panic conditions persist and long-held articles of faith lose their following, markets often react indiscriminately. Government policies, in my view, should encourage differentiation among firms, even those in seemingly close proximity. For policymakers to act otherwise is to risk their own credibility and risk undermining the pace of economic recovery…

Across a broad range of financial institutions and financial markets, an unhealthy mix of recession dynamics and panic conditions appear at work. But, in my view, it is predominantly the latter–the uncertainty with respect to financial intermediation and the corresponding breach of articles of faith–that have exacerbated the downturn.

…

The Panic is the result of both faulty private practices and flawed public policies. To place blame either exclusively on private financial firms or chiefly at the doorstep of the official sector is incorrect.
 left them high even as housing prices collapsed, and was to slow to lower them when the credit crisis got rolling.
 

37. Carl Schramm Giving Capitalism Its Due
The head of the Kauffman Foundation on the importance of entrepreneurship.
 

By NAOMI SCHAEFER RILEY

Carl Schramm doesn't buy the idea that some businesses are "too big to fail." That notion, says the president of the Kansas City-based Kauffman Foundation, only creates obstacles for entrepreneurs. Instead, he sees the failure of big companies as the "moment when 1,000 flowers can bloom."
[The Weekend Interview] Zina Saunders

The Kauffman Foundation, known to National Public Radio listeners and a few others as "the foundation for entrepreneurship," is difficult to categorize, but its president seems to like it that way. Last Sunday afternoon at the largely deserted Harvard Club in New York, I sat down to talk with Mr. Schramm, an unassuming man with distinctive round spectacles who oversees an almost $2 billion endowment.

Kauffman was founded in 1966 by pharmaceutical magnate Ewing Marion Kauffman. In 1950, he launched a drug company in the basement of his Kansas City home. Forty years later, when he sold the business to Merrell Dow, it had become a diversified health-care company with nearly $1 billion in annual sales and more than 3,000 employees.

Kauffman gave a lot of thought to his journey from poverty to wealth, according to Mr. Schramm. "He saw this as the central theme of his life."

So what exactly is a foundation for entrepreneurship? Aren't foundations supposed to give money to charity? And aren't entrepreneurs supposed to get money from investors, not philanthropists?

On the theoretical level, Mr. Schramm, who started his own health-care company and merchant bank, believes that the foundation has a duty to foster an environment hospitable to entrepreneurship. And so, for instance, Mr. Schramm brags that Kauffman has "dragged economists into considering the importance of firm formation to the overall growth of the economy." The foundation has commissioned some 6,000 papers on this and related topics in the past several years.

Then there is the question of the public perception of entrepreneurship. In the most recent survey that the foundation sponsored, pollsters found that 63% of respondents "prefer giving individuals the incentives they need to start their own businesses as opposed to allowing the government to create new jobs directly." Conducted last month, the survey also showed that instead of the government's stimulus package, two-thirds of respondents would prefer "reducing legal barriers and red tape for new business development" as a way to jump-start the economy. Finally, 89% of respondents said that "capitalism is still the best economic system for our country."

Despite this popular attitude, Mr. Schramm worries that there is a tendency on the part of some citizens to want the government to prevent market chaos. Prior to the financial meltdown this fall, "I think we were in full tide of entrepreneurial capitalism and now there's an introspection, where the vocabulary is all about regulation and the importance of the government to restart the economy," he says. While Mr. Schramm believes that the government has a role to play, he argues that "historically through the last seven recessions it's been entrepreneurs who essentially restarted the economy."

Kauffman is dedicated to cultivating such innovators. Mr. Schramm is intent on dispelling the common misperception that "If you don't have it done by the time you're 19 or 21, it ain't gonna happen," and according to Inc. magazine, he says, "the fastest growing firms in the United States are started by people who are 39 years old" on average.

In order to educate young people about the history of entrepreneurship in America, the foundation has partnered with 18 college campuses. "When I was in high school, the word entrepreneur was in zero use, it was not part of the American vocabulary. If you were to ask about inventors, they were pretty much dead people, you know, George Westinghouse and George Eastman." Today, Mr. Schramm thinks that kids do see more entrepreneurship around them with Internet startups and the like, but schools still don't encourage it. Even business schools, Mr. Schramm says, seem to offer only a "very rigid formalistic perspective about writing business plans."

Kauffman has tried to provide more direct and practical aid to those trying to start their own businesses. Through a program called FastTrac, for instance, Kauffman will help 1,000 current and new small-business owners in New York City over the course of the next year learn the skills they need to succeed.

FastTrac helps budding entrepreneurs with the important decision of picking a lawyer, for instance. "The bad choice of a lawyer at the start of a business or the bad choice of an accountant can screw the business up in a way that is fatal," says Mr. Schramm. The program also advises budding entrepreneurs never to let their lawyers or accountants invest in the company. "You have to develop your own sense of the value of the advice you're getting. And the minute people say well I want to own 25% of the company, all the alarm bells ought to go off."

Finally, the foundation goes out of its way to support minority entrepreneurship. Mr. Schramm doesn't use any social-justice lingo to explain the program, but reverts to a kind of charming nerd-speak. He says that after a lot of analysis, Kauffman has found that there is "the greatest delta among black males." In other words, for a given amount of entrepreneurial investment, that group will see the greatest improvement in its economic status. While there are many activists out there saying that foundations should give more to minorities, you won't find many who offer the Kauffman philosophy: "We should have a proportionate number of black billionaire owners of businesses as exists in the majority community," says Mr. Schramm.

In addition to encouraging entrepreneurship of all sorts, Mr. Schramm says the foundation itself is supposed to act entrepreneurially. In the past couple of decades, a veritable army of professional nonprofit workers has grown up. But Mr. Schramm was not among them. Before arriving at Kauffman, he taught at Johns Hopkins (he has a law degree and a doctorate in economics). When he applied to foundations for funding during his time as a professor, he recalls, "You had to be very good at using language to sound like you were out on the frontier, but in fact you couldn't go too far because . . . foundations are very cautious."

For a while, he wondered what was behind that tendency. He concluded that "the foundation culture had developed a sort of consensus": Foundation money is "quasi-public." In a prescient article that Mr. Schramm wrote for the Harvard Journal of Law and Public Policy in 2006, he notes that "the foundation appears to lack any coherent theory of its own role in society and the economy." The result, he warned, is that "government can impose expectations that may destroy the foundation's ability to achieve the purposes for which it was conceived."

Lately, some in the government have been trying to do exactly that. A few members of Congress, including Rep. Xavier Becerra (D., Calif.), have recently suggested that foundations need to be giving a greater percentage of their dollars to minority groups and other "marginalized communities." And various activist groups, including the National Committee for Responsive Philanthropy and Greenlining, have made the case that philanthropic dollars really belong to the public since they are tax exempt. Mr. Schramm responds: "I don't think as a legal matter that it holds because under that theory my 401(k) is public money."

So who are the real stakeholders in foundations? Mr. Schramm can think of only one: the donor. "At Kauffman I think the trustees and I are very, very clear: We work for Mr. Kauffman," says Mr. Schramm, acknowledging that his boss passed away in 1993. Kauffman not only left extensive writings but also videotape of himself describing how he wanted the foundation to operate. Mr. Schramm says that one board member told him he was hired because he was the only candidate who had read Kauffman's book.

Despite, or perhaps because of, his familiarity with Kauffman's thought, Mr. Schramm did not have an easy time taking over the foundation in 2002. Over time Kauffman had grown unwieldy, with one of the highest overhead costs of any foundation in the country. And its mission had become diluted. For example, Mr. Schramm notes, Kauffman said he was interested in education. "What was read into it was he was really more interested in general youth development. So we found ourselves supporting sports programs." Kauffman owned the Kansas City Royals for a time and Mr. Schramm notes that "he loved sports, but when it came to his foundation, he was crystal clear about what he wanted to have done and the word 'sports' never shows up in hundreds of pages of discussion."

And so within a year of taking over, Mr. Schramm began a serious overhaul of the foundation. He laid off about half of its 150-person staff and cut off funding to some of its biggest grantees, many in Kansas City. There was a public outcry from local nonprofits and from some former members of the board. One told the New York Times that "Carl doesn't seem to understand that there isn't an 'I' in team." It reached the point where Missouri's then attorney general, Jeremiah Nixon, launched an extensive investigation. He determined that Mr. Schramm had not led the foundation astray. What ultimately saved his job, says Mr. Schramm, were the detailed writings that Kauffman left before his death.

"What happened was not atypical in foundations. Often around 10 years after the death of the donor there's a moment of truth." People who were close to the donor will say, "Yes, he said that but he didn't mean that." Mr. Schramm concludes: "If there was one piece of advice I'd give to someone who was starting a foundation it is this: Think very, very hard of the long term and write down what you want your foundation to look like in 30 years or 40 years."

Despite the fact that the foundation's endowment has fallen by $722 million since the end of 2007, Mr. Schramm sees this as Kauffman's "moment." While "no one hopes for a recession," it's during economic crises that entrepreneurs "challenge companies that have gotten big and lazy." The downturn, he says, will even challenge Kauffman to "think about how we can do our work better, like every business." In fact, Mr. Schramm adds, "The only people immune from thinking hard in moments like this are in government."

Ms. Riley is the Journal's deputy Taste editor.
 
 
 

38. It Really Is All Greenspan's Fault
usan Lee, 04.03.09, 12:01 AM EDT Forbes online
Ask John Taylor ...
pic

It's been quite a spectacle for those who have followed Alan Greenspan's career for decades. Gone is the financial rock star or even the statesman testifying before Congress in a measured baritone. Instead, over the past several months, Alan Greenspan has morphed into a totally new person.

The first incarnation was the shaken Greenspan who was stunned that greedy and reckless short-term behavior could overwhelm long-term, rational self-interest. That was rather amazing all by itself. But now, there's a newer Greenspan--a decidedly prickly and whiny one.

I'm talking about Greenspan's recent op-ed in The Wall Street Journal. A 1,500-word attempt to move blame for the financial crisis away from himself and onto ... China.

It was, writes Greenspan, Chinese growth that led to "an excess" of global savings. That growth kept long-term interest rates low, which fueled the housing bubble. As for himself, the lowly chairperson of the Fed, he says he was helpless. He only had control over short-term rates.

Why this recent incarnation as a self-pitying victim of historical forces? Most likely, it's because of John Taylor, a mild-mannered professor at Stanford and former colleague of Greenspan's at the Fed.

In his Getting Off Track, a nifty little book, Taylor exposes, as plain as day, the culprit behind the financial boom-bust: Greenspan. His weapon of choice is the "Taylor rule" (discovered by Taylor--but not named by him, as he modestly points out.) (The Taylor rule is a recommendation about how the Fed should set the short interest rate--suggesting the amount it should be changed given economic conditions.)

Here's Taylor's take. Short interest rates fell in 2001 in response to the dot-com bust. But--and here's the important moment--beginning in 2002, the Taylor rule indicated that Greenspan ought to have tightened. Indeed, from 2002 to 2005, rates ought to have climbed to a touch over 5% and then stayed there through 2006.

But the Fed kept to a loose monetary stance, and rates kept falling during the period 2002 through 2004. Rates didn't start back up until middle of 2004 and didn't reach 5% until 2006. You can check this out in Figure 1, below.
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chart1_fed-funds-rate.gif

The result? The Greenspan Loose policy went on to fuel a boom, while the Taylor Tight would have avoided one. As Taylor says, all the Fed needed to do was follow "... the kind of policy that had worked well during the period of economic stability called the Great Moderation, which began in the early 1980s."

The connection between Greenspan Loose and the housing boom is also clear. Housing starts took a sharp spike up in 2003 and then continued to climb through 2006. If the Fed had followed Taylor Tight, however, housing starts would have peaked at a much lower level at the end of 2003, and drifted down through 2006.

chart2_boom-bust.gif

What about Greenspan's argument that he only controlled short-term rates? And that short rates became decoupled from long-term rates in 2002?

Nonsense, says Taylor. Surely the existence of adjustable-rate mortgages (accounting for about one-third of mortgages starting in 2003) linked the mortgage market and short-term rates. Moreover, says Taylor, whatever minor decoupling occurred, happened because bond investors were flummoxed by the Fed's odd behavior.

Taylor also takes on Greenspan's excuse that he was helpless in the face of a global saving glut. Cutting off the feet of Greenspan's excuse, Taylor says there wasn't a glut, there was a shortage. Figures from the International Monetary Fund show global saving rates, as a share of world GDP, were low during 2002 to 2004--way lower than rates in the 1970s and 1980s. In fact, the global saving rate fell at the end of 1990s, hitting bottom about 2003.

chart3_global-savings.gif

Greenspan's monetary excess was also crucial in setting off a chain of bad government policies. As Taylor argues, Greenspan Loose was amplified by the popularity of subprime mortgages, especially adjustable-rates, which promoted risk taking. And it made for a lethal brew in a pot of policies to promote homeownership.

Greenspan pulls out many stops in his defense. He even quotes the great Milton Friedman's approving assessment of Fed policy between 1987 and 2005. Well, Friedman died in 2006 and, in 2009, his equally great colleague, Anna Schwartz, has this to say: "There never would have been a subprime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for." As for Greenspan's argument that the whole mess is China's fault, she says tartly: "This attempt to exculpate himself is not convincing. The Fed failed to confront something that was evident. It can't be blamed on global events."

As fine a last word as there could be.

Susan Lee has written several books on economics, including a college text. She is an economics commentator for NPR's "Marketplace" and writes a weekly column for Forbes.

39. THE GEITHNER-SUMMERS PLAN IS WORSE THAN YOU THINK
------------------------------------------------------------------------

The Geithner-And-Summers Plan (GASP) to buy toxic assets from the banks
is rightly scorned as an unnecessary give-away by virtually every
independent economist who has looked at it.  Its only friends are
the Wall Street firms it is designed to bail out, say Laurence J.
Kotlikoff, a professor of economics at Boston University, and Jeffrey
Sachs, a professor of economics at Columbia University and director of
the Earth Institute.

One defect is the systematic overbidding entailed by the
proposal.  Others have since made similar calculations, including
Joseph Stiglitz and Peyton Young.  The situation is even worse
that it looks, however, since the GASP can be gamed by the banks that
own the toxic assets to boost the purchase prices for their bad assets
even higher than has been suggested to date, say Kotlikoff and Sachs.

Suppose that Citibank holds $1billion face value of toxic assets that
will pay $1billion with 20 percent probability and $200 million with 80
percent; the market value is $360 million:

   o   The GASP calls on investors to establish a Public-Private
       Investment Fund (PPIF) to bid for the toxic assets.

   o   For each $1 that a private investor brings in equity to the
       PPIF, the Treasury will put in another $1, and then the FDIC
       will leverage the $2 in equity with $12 of non-recourse loans
       (6-to-1 leverage).

It's easy to show that a risk-neutral and arms-length PPIF will bid
$636 million, financed with an Federal Deposit Insurance Corporation
loan of $545 million, Treasury equity of $45 million and private equity
of $45 million, explain Kotlikoff and Sachs:

   o   The expected profit to the private investor is one-half of 20
       percent of $1 billion minus $545 million, or $45 million.

   o   The private investor therefore has a net expected profit of
       zero.

   o   The PPIF overpays by $276 million, which equals the expected
       loss to the Treasury.

   o   The ultimate beneficiaries are Citibank's shareholders and
       bondholders, whose net worth rises by $276 million at the
       taxpayers' expense.

The Geithner-and-Summers Plan should be scrapped.  President Obama
should ask his advisors to canvas the economics and legal community to
hear the much better ideas that are in wide circulation, say Kotlikoff
and Sachs.

Source: Laurence J. Kotlikoff and Jeffrey Sachs, "The
Geithner-Summers plan is worse than you think," Financial
Times/Economists Forum, April 6, 2009.

For text:
http://blogs.ft.com/economistsforum/2009/04/the-geithner-summers-plan-is-worse-than-you-
For more on Economic Issues:
http://www.ncpa.org/sub/dpd/?Article_Category=17

    *WSJ  APRIL 6, 2009, 10:38 P.M. ET

40. In Defense of Derivatives and How to Regulate Them
The much-maligned financial instruments have legitimate uses.

By RENé M. STULZ

The dictionary defines a derivative in the field of chemistry as "a substance that can be made from another substance." Derivatives in finance work on the same principle. But if you read the headlines these days, you might think derivatives were made from arsenic by Wall Street institutions bent on causing financial destruction.

There are two sides to derivatives -- one positive and beneficial, one exploitive and negative. Of the latter, the most visible example today comes to us courtesy of the American International Group (AIG) and reveals what happens when a lightly regulated but highly interconnected financial institution ends up positioned in a way that it cannot survive a housing crash and then such a crash occurs.

The other side of derivatives, however, involves the less-publicized but widespread use of these financial instruments in ways that benefit companies. Derivatives have been immensely valuable tools and will be instrumental in providing the liquidity needed to jump-start the economy. Derivatives are used by a vast number of U.S. companies, both small and large, to manage various risks that arise in connection with their businesses.

From the perspective of Main Street companies, derivatives are not just about high finance, quants and politics, but about investing in America's core industries, jobs and economic recovery. Companies find that over-the-counter derivatives are essential to their day-to-day operations. Derivatives help insulate them from risk, which allows them to borrow capital at better prices than they would otherwise. And derivatives are more useful than ever in these days of unusual volatility in financial markets.

For example, not being able to hedge currency risk through the use of a derivative can leave a company exposed to fluctuations in currency markets. Without derivatives companies could see movements in exchange rates turn a profitable export contract into a money-losing agreement.

In its current annual report, Caterpillar Inc. makes the case for why it relies on derivatives: "Our risk management policy . . . allows for the use of derivative financial instruments to prudently manage foreign currency exchange rate, interest rate, commodity price and Caterpillar stock price exposures."

For those unfamiliar with market jargon, credit default swaps, which are most often in the news, are simply financial contracts between two parties. If, for example, you own bonds in a company and are worried that the company will default, you can manage your risk and protect your holdings with a credit default swap. Under it, you would make regular payments to maintain the contract. If the company does not default, you're out-of-pocket the payments. But if the company does default, the swap serves as a form of insurance by giving you the right to exchange the questionable bonds for the principal amount, or to be reimbursed in other ways. There's nothing exotic or complex about these contracts. They can be highly valuable for Main Street firms, because they enable them to protect themselves against the failure of large customers.

However, Main Street firms cannot afford derivatives unless there is a competitive market for them with participants willing to take the opposite position. Restricting access to derivative markets, which is being proposed by some in Congress as well as by some regulators, would make the costs of derivatives prohibitively expensive and eliminate liquidity.

That derivatives benefit our financial system and our national economy is well established. Twenty-nine of the 30 companies that make up the Dow Jones Industrial Average use derivatives. According to data from Greenwich Associates, two-thirds of large companies (those that have sales of more than $2 billion) use over-the-counter derivatives and more than half of all mid-size companies (those that have sales between $500 million and $2 billion) are very active in derivatives markets. Derivatives are necessary and helpful tools for companies seeking to manage financial risk.

The most important benefit of derivatives is that they allow businesses to hedge risks that otherwise could not be hedged. This does a number of positive things. It transfers risk, allowing firms to guard against being forced into financial distress. It also frees lenders to offer credit on better terms, giving companies access to funds that they can use to keep their doors open, lights on and, even, invest in new technologies, build new plants, or hire new employees.

It's important for regulators not to overreact by pushing for counterproductive new rules. The regulators, after all, were no better at foreseeing the current crisis than the private sector, proving that regulation has obvious limits and cannot replace efforts by financial institutions to devise risk-management approaches that enable them to cope with crises in the financial markets of the 21st century.

At the same time, some sensible regulations are in order. With the interconnectedness of markets today and the systemic problems facing the world's economies, there is a lot that can be done to limit systemic risks. One beneficial step would be for Congress to adopt some version of a systemic-risk regulator that would place every participant in the financial markets that poses a systemic risk, including derivatives traders, under federal regulatory oversight.

Unbelievably, the arm of AIG that dealt with derivative products was not subject to serious scrutiny by a federal agency with relevant experience. A systemic-risk regulator, or markets-stability regulator, should oversee every kind of financial institution that is found to be systemically important, including banks, broker-dealers, insurance companies, hedge funds, private equity funds and others. That regulator should have the authority to ensure that such financial institutions have sufficient capital to reduce the risks they pose to the financial system, to examine parent companies and subsidiaries, and to bring enforcement actions.

Additionally, a clearinghouse for standardized credit default swaps was launched in March, and other competitor clearinghouses are under construction. Clearinghouses clear and settle trades and limit the risk to the larger financial system if any one dealer, like AIG, fails to meet its obligations. A clearinghouse also allows regulators to monitor the exposure firms have to these products, while simultaneously ensuring that each firm posts the necessary collateral to cover its obligations under its trades.

However, clearinghouses should be reserved for established and standardized derivatives, leaving participants in capital markets free to engage in bilateral contracts for derivatives that fulfill specific needs as well as for new products. Further, use of a clearinghouse should not be compulsory, but capital-requirement regulations should recognize that derivatives positions that are not put through a clearinghouse may pose greater systemic risks than those that are.

The subprime mess triggered one of the most destructive financial crises in decades. It's not surprising, then, that the hunt is on for culprits. But derivatives are not the culprit. They had little to do with the rise and collapse of housing prices. Wider availability of housing derivatives would have actually reduced the impact of the collapse of housing prices if homeowners had been able to hedge against possible decreases in home values.

Our businesses need derivatives. Most of us choose to drive cars even though they sometimes crash. But we also insist that cars are made as safe as it makes economic sense for them to be, and that speed limits and other rules of the road are enforced. The same logic should apply to derivatives.

Mr. Stulz is a professor of finance at the Fisher College of The Ohio State University.
 

    * APRIL 8, 2009

41. Revised euro-zone GDP points to a slow recovery
 

By NICHOLAS WINNING

LONDON -- The record contraction in the euro zone's economy in the fourth quarter was even sharper than initially estimated, fueling fears that it will take longer for the currency bloc to recover from recession.

Gross domestic product contracted 1.6% from the third quarter and 1.5% from a year earlier in the final three months of 2008 in the 15 countries that then used the euro -- the biggest contraction by both measures since records began in 1995, the European Union's Eurostat statistics agency said. The euro zone added a 16th country, Slovakia, on Jan. 1.

Eurostat's preliminary reading, issued a month ago, had shown fourth-quarter GDP falling 1.5% from the third quarter and 1.3% from the fourth quarter of 2007.
[EU GDP and economy]

"Worryingly, it is far from inconceivable that euro-zone GDP contraction was even deeper in the first quarter of 2008, given largely dire data and survey evidence," said Howard Archer, chief U.K. and European economist at IHS Global Insight.

The euro zone slipped into its first recession in the third quarter after registering a second consecutive quarterly drop in GDP. In the third quarter, euro-zone GDP fell 0.3% from the second quarter, but grew 0.6% from the year-earlier period.

Eurostat said annual euro-zone economic growth slowed to 0.8% for all of last year, from 2.6% in 2007. That compares with a 1.1% increase in GDP in the U.S. last year and a 0.6% contraction in Japan, Eurostat said.

The revised fourth-quarter GDP figures are likely to fuel concerns that the recession will be deeper and more protracted than expected.

They are also likely to increase pressure on the European Central Bank to loosen monetary policy further.

The ECB cut its main interest rate to 1.25% last week, down from 4.25% in October, but it has been less aggressive than the U.S. Federal Reserve and the Bank of England. ECB President Jean-Claude Trichet has indicated that rates could drop again.

The fourth-quarter figures showed exports were 6.7% weaker than the third quarter as the credit crisis hit demand in the euro zone's main trading partners, while imports dropped 4.7%. That compares with a 0.2% drop in exports and 1.3% rise in imports between July and September.

Write to Nicholas Winning at nick.winning@dowjones.com
 

UPDATE 142 -US to delay bank test results for earnings-source

Tue Apr 7, 2009 1:09pm EDT http://www.reuters.com/article/marketsnews/idINN0747118320090407?rpc=33
 
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* Delay would avoid 1st quarter results period

* Source: Treasury still mulling stress test disclosure (Adds details on stress tests, byline)

By Karey Wutkowski

WASHINGTON, April 7 (Reuters) - The U.S. Treasury Department is planning to delay the release of any completed bank stress test results until after the first-quarter earnings season to avoid complicating stock market reaction, a source familiar with Treasury's discussions said on Tuesday.

The Treasury is still talking about how results of the regulatory stress tests on the 19 largest U.S. banks will be released, and may disclose them as summary results that are not institution-specific, the source said.

The government is testing how the largest banks would fare under more adverse economic conditions than are expected in an attempt to assess the firms' capital needs. The tests are due to be completed by the end of April, but Treasury has said they may be finished before then.

The source, speaking anonymously because the Treasury has not made a final decision on what to disclose, said officials do not want any test results released before the earnings season wraps up for most U.S. banks on April 24.

Treasury did not immediately respond to a request for comment.

U.S. regulators have reached the closing phase of the stress tests, with many of the top banks having already turned in their internal versions of the test to officials. Bank of America Corp (BAC.N) Chief Executive Kenneth Lewis said last Thursday that his bank has already completed its test.

Bank regulators are at the stage of reconciling their own versions of the results with the banks' internal assessments.

Officials realize it may be hard to keep the results under wraps, and they are looking for ways the banks could disclose some details without unduly disturbing the markets. They are also looking at providing some summary information about how the banks fared.

"There will be definitely be some information that will be provided at the end of it, but exactly what that will be, and when it will be provided, will come forth later," Comptroller of the Currency John Dugan, who supervises some of the nation's largest banks, said last week.

The stress tests at the biggest banks are part of a wide-ranging effort to restore stability to a sector hit by huge mortgage-related losses.

The tests are designed to determine the depth of banks' capital holes if conditions deteriorate further. After the tests are completed, the banks will have six months to either raise private capital to compensate, or accept government funds.

But officials are worried about how the market will react to the stress test results if there is not a clear recovery path for a bank that is deemed to have a large capital need.

The last thing Treasury wants to do is set off a panic, the source said. (Reporting by Karey Wutkowski, additional reporting by Glenn Somerville; Editing by Tim Dobbyn)

43. Market bear Roubini sticks to dour forecasts
http://finance.yahoo.com/news/Market-bear-Roubini-sticks-to-rb-14876221.htmlApril 8, 2009

    * Tuesday April 7, 2009, 9:29 pm EDT

    *
      Buzz up!
    * Print

By Jennifer Kwan

Reuters - Dr. Nouriel Roubini, a professor at the New York University, answers questions in New York, February 19, 2008. ...

TORONTO (Reuters) - There's still bad news ahead for the U.S. economy -- and by extension for Canada -- and the bear market for stocks is not over yet, according to a prominent economist who foretold much of the current turmoil.

Nouriel Roubini, a professor at New York University's Stern School of Business and chairman of economic research firm RGE Monitor, said on Tuesday that he expected more dour macroeconomic data and problems in the banking and housing sectors, as well as pressures on consumers.

Big stimulus packages will eventually slow the rate at which economies contract, but that will take time, he added.

"There will be a light at the end of the tunnel somewhere down the line, later rather than sooner," he said at a Toronto news conference, which took place ahead of a Sprott Asset Management event entitled "A Night with the Bears."

Roubini, who made a name for himself by sounding early warning signs about housing bubbles and credit crises, earlier told Canada's BNN television that he still believed the recent market upturn represented a bear market rally, and not a change in sentiment.

"Macro news, earnings news and financial shocks are going to be worse than expected and that's why I believe this is still a bear market rally," he told BNN.

Markets logged four straight weeks of gains until this week on optimism that unprecedented interest rate cuts and billions of dollars of stimulus will eventually fight off the worst global downturn since World War Two, and on upbeat comments from U.S. banks on their performance so far in 2009.

The fact that some indicators did not match pessimistic expectations was also a positive factor, as were last week's pledges by world leaders to do more to fight the crisis.

But Roubini played down the rally.

"I am more a realist than a pessimist. I'll be the first one to call for the bottom of this economic contraction, recovery of the market when I see a sustained economic and therefore financial recovery," he said.

Meredith Whitney, chief executive of Meredith Whitney Advisory Group, said stabilization in the banking sector would hold the key to a turnaround. Whitney, one of Wall Street's most bearish bank analysts, has forecast another rough year for banks as they shed assets to raise capital.

"It's not just the banks that have to stabilize their own lending it's that they have to make up for the void of the shadow banking industry that has been shut down since the summer of 2007. We've got a ways to go," she said.

Canadian banks have largely shrugged off the severe banking troubles south of the border.

But commodity prices have fallen sharply from the peak of last summer and the Canadian auto sector is hurting badly.

"The fundamentals of the (Canadian) economy are robust, but when the U.S. sneezes the rest of the world catches a cold," said Roubini. "This time around the U.S. is not just sneezing, it's a severe case of pneumonia and the biggest trading partner next door is Canada."

Sprott Asset Management's Eric Sprott said his pessimistic view on the economy is based on the "overleveraging of the banking system."

"When we look at the systemic financial system we're in -- and it affects every country in the world including Canada -- I think staying bearish is the route to go," he told BNN.

(Reporting by Jennifer Kwan, Editing by Janet Guttsman)