U.S. Treasury

Stockholm -- The best way to clear your head of the political chatter that passes for policy debate in Washington is to get out of town. I’m writing today from Stockholm, a grand old city on a picturesque harbor and archipelago, where it’s harder to care much about Larry Summers’ squabbles with White House colleagues, the cynical fulminations from Newt Gingrich or Rush Limbaugh, or even the heated discussions inside Obamaland over its legislative strategy for health care reform. With a little distance, it’s easier to focus on developments which may actually matter for the rest of us, such as the prospects of Iran electing a democratic reformer as president this week or how the unfolding, deep slump in global trade may imperil economic recovery by China, Japan and Germany.

 It’s also easier to concentrate on our own economic conundrums. Let’s start with the crying need for new financial regulation that can prevent a system whose dysfunctions have just wiped out 20 percent of America’s wealth from doing it all over again sometime soon. The current TARP program, now officially a tangled mess, isn’t much of a model. This week the Treasury announced that 10 large institutions will be permitted to repay their TARP loans, including Goldman Sachs and Morgan, while nine others, including Wells Fargo, Bank of America and Citicorp, have to stay in the system. It sounds reasonable, since the lucky 10 can afford to repay while most of the rest cannot. But the TARP system ties regulation to outstanding loans, so now we’re left with a two-caste financial market where the weaker ones operate at a market disadvantage and others who used the taxpayers to fund their comebacks are no longer constrained to operate in the interests of a public which rescued them less than nine months ago.

We also learned this week that the Treasury’s clever plan to use taxpayer guarantees to create a private market for the toxic assets of all these institutions is a flop: Even with all that largesse, nobody wants to buy much of the toxic paper. So if the economy dips again, the 10 institutions now exiting the TARP regulations will be back for more, and there won’t be enough money in the Treasury or the Fed to save Citicorp and Bank of America again.

Then there’s the matter of how to regulate the derivatives that knocked the pins out from under the vaunted U.S. financial markets last year. The Administration’s current economic mandarins, along with the most elevated mandarin of all, Alan Greenspan, all have confessed publicly to their errors in dismissing the need for such regulation in the late-1990s. With the catastrophic collapse of the multi-trillion dollar markets for mortgage-backed securities and their credit default swap derivatives, strict regulation of these transactions to protect the rest of us -- which basically means transparency and reasonable limits on the leverage used to create or buy these instruments -- should be a no-brainer.

So what’s the logic behind the Administration's decision to keep trading in large, “private” deals in derivatives outside regulated markets? Those are precisely the deals that pose a danger for the rest of us, since they’re the large ones and inevitably the deals carried out by the institutions now acknowledged to be too large to fail. That’s Washington-speak for companies important enough to demand help from the taxpayers whenever they need it. The justification is the same as in the 1990s -- it will reduce their profits. That’s correct, in order to protect the rest of us from the now well-known consequences of a mindless drive for higher and higher profits regardless of the risks.

The next time you feel yourself drawn to the insider accounts of the greasy pole inside the White House or the breakup of the Republican coalition, take a deep breath and remind yourself that these are the players actually responsible for serious matters that ultimately may determine whether you ever have the income and assets required to send your kids to college or retire before you’re 80 years old.

The leaders of the Republican Party, reeling from their painful string of defeats, seem stuck in two of the classic stages of grief, denial and anger. This week, Rush Limbaugh replaced Bobby Jindal as the leading and most colorful example. Limbaugh may seem like too easy a target, since talk radio always tends toward hyperbole. Nonetheless, the essence of the message from the presumptively addled Mr. Limbaugh is that Americans would be better off if the President’s economy program failed. Even if their homes slip into foreclosure and their kids have to drop out of college, American families would at least escape the degradations of “socialism” or, as another popular conservative pundit put it, “left fascism” (that’s from the hard-right blogger and historian, Ron Radosh).

The rhetorical excesses of talk radio and the Web would hardly be noteworthy, if the same strain of non-thinking didn’t also dominate the Republican Party’s current economic positions. Let’s set the stage: of the three natural sources of demand in a market economy, consumers have stopped spending, businesses have stopped investing, and exports have fallen off the proverbial cliff. That leaves government stimulus as the only possible source of new demand to at least slow the accelerating downward momentum of the economy and most of the people in it. Perhaps the best explanation, then, for why every Republican in the House and all but three GOP senators voted “no!” on the President’s stimulus is, well, denial and anger.

To be sure, economic ideology almost certainly plays a role here, too, on top of their denial (about the consequences) and anger (about no longer calling the shots). This came through vividly at a conference I attended earlier this week for the National Chamber Foundation. My panel was asked to talk about whether the Administration’s plans foreshadowed a permanent change in the relationship between the public and private sectors. Set aside the fact that the leaders of the central private institutions in this drama, big finance, have begged Washington to amend that relationship long enough to preserve their jobs and the assets of their bond holders. 

At the panel, a well-turned-out executive from a major private equity company (and former Bush Treasury official) laid out what once could have been the reasonable conservative position -- stimulus weighted to tax cuts, a banking rescue that avoids taking over anybody (or dictating anybody’s compensation), and tax-based measures to reduce foreclosures. As a matter of economics, he got his targets right, even if his approaches are weaker than those favored by the Administration. But at least his response suggested that he wants the economy to recover, regardless of who gets the credit. 

Not so from the other member of the panel, Brian Westbury, who on top of being an economist with a Midwestern financial advisory is also the economics editor of the American Spectator and a frequent writer for the Wall Street Journal. He provided an economic-cum-ideological gloss for the denial and anger expressed by the flamboyantly-frustrated Mr. Limbaugh. Westbury’s prescription was no stimulus, no banking rescue and no program for foreclosures. The only constructive government action he could imagine was to jettison current “mark-to-market” rules. Those rules say that the balance sheets of banks and public companies have to reflect the actual market value of their assets and liabilities. So, for example, when a mortgage-backed security goes bust, you have to write down its value while preserving the liability of the money borrowed to purchase it and still owed. 

In this view, none of what seems so important to the rest of us -- collapsing demand, investment and trade, huge job losses, rising bankruptcies -- matters for government policy.  The only thing Washington should do here is to change how the financial losses from these events are reported. This isn’t economics; it’s a prescription that follows from a hard-edged ideological view that government can do nothing of value for an economy, regardless of conditions.   

Unhappily, this cramped understanding isn’t limited to the pages of the American Spectator and the Wall Street Journal op-ed page. Bobby Jindal put the Republican Party on record for much the same view in his awkward response to the President’s address to Congress. He even cited the colossal inadequacies of the Bush Administration’s response to Katrina as proof that the private sector is always the best answer to any problem or catastrophe -- even if it’s under water at the time.

I honestly can’t believe that they’re really so dull-witted. A better explanation for Jindal and Limbaugh, along with commentators like Westbury and Radosh, is that they’re still grappling with the grief of losing the support of the American people -- and the power that came with it. They’re stuck in denial and anger. And that’s a very bad position from which to consider the best policies for a nation and world economy in crisis.   

President Barack Obama today announced a plan to cut foreclosures and reboot new mortgage financings, at least when the economy shows signs of new life. The fact of offering a plan is an advance, given that Bush and his people did nothing and proposed nothing, even as the crisis reached critical mass. As we have written here since the crisis first broke, keeping people in their homes is fundamental to solving the larger economic problem. Again, it’s the fast-rising foreclosures and mortgage delinquencies that are eroding and destroying the value of hundreds of billions of dollars in mortgage-backed securities and the credit default swaps that “back them up” (sic). And it’s the falling value of those securities and swaps, in turn, which has led to the effective bankruptcy of financial institutions that had leveraged themselves to their eyeballs to buy them or issued them and then kept them (and how dumb was that?).

While the act of proposing anything serious puts the Obama Administration ahead of its predecessor, passing such a low threshold is hardly very meaningful -- especially since the problems continue to worsen. More than nine percent of mortgages today are either in foreclosure or delinquent, two to three times the numbers from just two years earlier; and if everything continues to unravel, those numbers could double in another year. If that happens, there won’t be many large, U.S. banks left standing. Many of the homeowners now in trouble could manage, if they just could refinance at current rates. But banks quite naturally see someone in financial trouble as a poor credit risk for a new loan, which is what refinancing is. And the fall in housing prices means tens of millions of those people can’t qualify to refinance. That’s because refinancing is available today only if you owe no more than 80 percent of the original mortgage’s value. The catch for millions of families is that as the value of their home goes down, their existing mortgage (the one being refinanced) accounts for a greater percentage of the value being refinanced. In the worst cases, people just walk away from a $200,000 home with a $300,000 mortgage -- and who would refinance one of those? In millions of other, less extreme cases, the falling prices simply disqualify people for refinancing.

The Administration wants to address this precise part of the problem, by providing $75 billion in subsidies to banks to defray half of the cost of refinancing for several million homeowners at risk of losing their homes. Mortgages owned by Fannie Mae and Freddie Mac are also eligible here, and they’re the ones most likely to actually see their interest rates reset, since the government owns Fannie and Freddie and can direct them to do it. It will be harder to convince bankers already staring at enormous losses already on their books or soon to be there, especially if they’re worried that their bondholders could sue them for resetting loans. The plan also has some $100 billion for the Treasury to keep buying more of Fannie and Freddie’s failing mortgage-backed securities since, as we also have said repeatedly, until foreclosure rates return to normal, the biggest bank bailout in the world won’t prevent more banking losses.

There are more direct ways to address foreclosures. We could provide direct loans to tide over those in trouble, or Fannie and Freddie could reset the loans of everyone in trouble. The problem is that anyone advancing such a common sense approach would become a very large political target -- and not just for reflexively-critical House Republicans.

How could the president or his advisors explain to those who work hard and spend less, so they can keep their mortgage payments up to date, why they don’t qualify for a lower interest rate from the government, when their neighbor who spent more or just had harder luck does qualify? More plainly, how does the government choose who would qualify for such direct help without enraging most of those who wouldn’t? In effect, the Administration plan finesses this problem by letting banks choose, without compelling them to do so. But what if the economy continues to worsen and the plan doesn’t work, which is a very real possibility? Indeed, don’t be surprised to see the Administration revisit it six months from now with a much less “voluntary” approach.

Congress tried late last week to stall the financial crisis by pledging to spend $700 billion on devalued securities held by financial institutions, and by Monday morning, it was clear that the pledge wasn’t enough to reassure investors or restart lending.

Instead, a classic panic has set in here and around much of the world as public confidence in banks, other financial institutions and the markets themselves has nosedived; at the same time, banks and other financial institutions are wary of loaning money to potential borrowers. This panicked mindset threatens the economy more today than the continuing turmoil in the housing and financial markets. 

We must now recreate baseline confidence before we can repair the continuing damage to our financial and housing markets.  

Financial and broader economic panics thrive on a combination of huge and unexpected setbacks and a serious absence of information. They unfold when people face enormous uncertainty about matters vital to them, such as the value and security of their homes,  retirement accounts and college savings. Panics thrive when people see everyone else, including those with the power and position to manage such weighty matters, struggling with the same uncertainty. 

People feel threatened and powerless to do anything, not because they have no options, but because they have to evaluate or choose among those options, and they worry that more unexpected calamities could overtake whatever course they decide upon. That’s where tens of millions of Americans – and Europeans and Asians as well – have found themselves this week. They don’t understand why the value of their homes and investments has plummeted so suddenly, and they see that those ostensibly in charge of the economy in Washington and on Wall Street have little grip on this as well. The result is that spending and investment are shutting down, dragging the entire economy into what seems very likely to be the worst downturn since the 1930s. 

The remedy to this panic is information, which only the nation’s leaders can generate and demonstrate they understand. For example, the Federal Reserve and the FDIC should have legions of examiners working around the clock to re-audit the conditions of all major financial institutions, starting with commercial banks. The Treasury and Fed could then report to the public on each institution’s financial health and their confidence in its continuing financial health. The largest group would still be judged healthy; another group could be designated as worth watching, with measures to help it move to the first group; those in trouble would be identified with a plan of action to help them recover, if possible. Without this information, most people have been panicking that almost every institution and every investment might well be in serious trouble.  

This program won’t solve the capitalization crisis across financial institutions, much less the crisis gripping housing markets, which itself has driven so much of the current upheaval. But it would staunch the panic as investors, business owners and families come to feel that they finally know where the problems lie and what the government and nation’s business leaders will do to address them.

At the same time, our leaders can finally begin to address seriously the housing and capitalization crises in an economic environment in which businesses and people will be able respond reasonably and predictably.

Years of reckless mismanagement by the self-styled masters of the financial universe and senior economic policy officials now leave us with no alternatives but major action – but the Administration’s proposals are neither the only alternative nor anywhere close to the best one.

The Treasury says we need its plan to address a liquidity crisis, with banks unable to secure the funds to lend to sound businesses that need to invest or just need to meet their payrolls. There is evidence that overnight lending to banks by other banks or other financial institutions is way down. But there’s no evidence of sound companies unable to get funds to meet operating requirements. Moreover, the Federal Reserve has opened its "discount" window and is prepared to lend funds to any financial institution and at below-market rates. The Bush Administration seems to be trying to steamroll Congress and the public: we have to conclude that there is no liquidity emergency that could conceivably justify the steps they propose.

The Treasury also says Americans have to be prepared to bankroll their plan, because more financial institutions are on the verge of insolvency, which would trigger serious problems for the economy. The insolvency or capital problem is self-evident, since these institutions created it. They borrowed hundreds of billions of dollars to buy mortgage-backed securities and to sell the default-protecting derivatives of those securities, all of which were patently speculative: they bought and sold them precisely because they produced very large streams of monthly income, and since financial markets trade off risk and return, their initial high returns signaled that they were very risky.

Now that the securities have fallen sharply in value, these institutions owe much more on the debt they took on to buy them than the securities themselves are worth. That means capital losses that come out of their equity and leave many of them technically insolvent or close to it. So there is a real capital or equity problem across much of our financial system. The Treasury plan won’t solve it, however, not at least on terms that any sensible legislator, regulator or taxpayer should consider.

The Treasury plan originally contemplated providing that capital by paying financial institutions more than their securities are currently worth – since it’s the current market value of those securities that threatens these institutions with insolvency. So that means ordinary taxpayers would have to overpay for the assets of institutions owned and operated by the richest people in America. That’s the Bush economic doctrine, but it’s not mine – is it yours?

At a minimum, if taxpayers are to overpay rich people for their risky investments, they should get a big equity stake in all the institutions in return. That would make it a version of a debt-equity swap – but if that’s what it is, we alternatively could use regulation to require debt-equity swaps between the institutions and those they actually owe to debt to. That would be cleaner, less intrusive over the long run, and create no taxpayer exposure.

Alternatively, Congress could mandate that these institutions halt dividend payments and raise more capital, since we’re in this fix because they haven’t been subject to capital/equity requirements. Anything can find a buyer at the right price, and as a result of these institutions’ mismanagement, they’ll have to trade more of their equity for the capital -- as Goldman Sachs is doing now with Warren Buffet.

That still leaves the most serious business. Congress needs to take serious steps to address the underlying cause of the crisis by stabilizing the underlying assets: provide a new loan facility for homeowners facing foreclosure or new mechanisms to renegotiate the terms of the mortgages of people facing foreclosure. It also leaves one more thing: the stark and unhappy recognition that the Treasury, the Federal Reserve and the White House have produced an unworkable, inequitable and inefficient plan that Congress need not and should not accept.

The price of what are called “credit default swaps” for U.S. Treasury debt is rising sharply. Credit default swaps are financial instruments by which one investor holding debt pays another investor to guarantee that if that debt defaults, he will make the first investor whole. 

This week, the Treasury assumed responsibility for $5.2 trillion in outstanding debts held by Fannie Mae and Freddie Mac. A modest but significant share of that is headed for default, and the Treasury will have to absorb the losses. And the result is a rising price for credit default swaps on the U.S. Government: It now costs $18,000 to insure $10 million of U.S. Treasury debt. The market sees a very small - but not negligible - prospect that the U.S. Government would actually default on its debt, which would be, well, the end of the American and global economies as we know them. That’s how bad it is.

Credit default swaps for subprime mortgage based securities, of course, have played a significant role in the current unraveling in the financial markets. But conservative/Republican disdain for normal regulation of those markets has played the larger, underlying role.  Such regulation isn’t intended to “manage” those markets, but to ensure that the rest of us are protected from serious repercussions when problematic choices by financial market players (for example, to double down on subprime mortgages or their derivatives) collide with adverse conditions that make those problematic choices very reckless.

That’s the essential meaning of the Fannie Mae and Freddie Mac regulatory bailouts. Setting aside the many years of astonishingly reckless and self-interested management at Fannie Mae and Freddie Mac, the mortgage market would freeze up if these two institutions suddenly couldn’t operate. Here’s a brief course in why that’s so: there’s always plenty of credit for new mortgages, because those creating the mortgages promptly sell them, in bundles, to investors, so that the credit can cycle back to finance more mortgages. 

Fannie Mae and Freddie Mac both create and buy trillions of dollars in these mortgage-backed securities, and there’s no financial institution that could step in if they were taken out of the picture. That’s why we need to keep them operating, even if it requires a bailout. By the way, the other major holders of these securities include U.S. banks – expect a line of them to go belly-up in the next six months – and foreign central banks. 

The potential unpleasant fallout for our relations with other countries if their holdings went bust is the other reason that the Bush Administration has taken the largest interventionist step in U.S. financial markets since the Great Depression. Once again, the Bush Administration is moved to act not by what’s happening to Americans, but by the implications for our relations with other countries