financial crisis

From his Washington Post column today:

Suddenly there seem to be lots of people who think our biggest economic problem is that President Obama and the Democratic Congress are about to saddle our grandchildren with a mountain of government debt so high that they -- and the U.S. economy -- will never be able to get out from under it.

Before we get to the substance of the complaint, allow me to bring a bit of old-fashioned journalistic skepticism to the rants of Republican politicians and talk-radio bullies who are trying to pass themselves off as born-again deficit hawks. These are many of the same folks who saw no problem running up record deficits in the middle of an economic boom by pushing through the biggest tax cut in history, increasing entitlement spending, and waging a terribly long and costly war. Their recent moralizing about the evils of government debt has the distinct odor of hypocrisy and political opportunism.

That's not to say there isn't good reason for people of good will to worry about the federal debt. Largely because of the profligacy of the Bush years, the debt is already too big and will only get worse unless we begin to slow the growth in spending for Social Security, Medicare and Medicaid. Let's keep our eye on that big problem -- the $66 trillion unfunded liability -- not the $2 trillion or so in additional borrowing that the government is about to take on to rescue the financial system and stimulate the economy.

What's missing in all this sudden hand-wringing over the deficit is any sense of perspective. Two trillion dollars sounds like a lot of money, but in a pinch we could pay it all back in just one year if we were willing to reduce household and government spending by about 15 percent. It would require temporary sacrifice on everyone's part but would hardly be the death of the American dream.

The more important point, however, is that by having the government borrow this extra $2 trillion, our grandchildren will be better off financially than if we did nothing and let economic nature take its course.

Strongly recommend his latest, Who's Really Being Propped Up in the AIG Bailout?

I showcased his must read original piece Saturday.

What the global financial system is going to look like in a few months is anyone's guess.  From the FT:

AIG will on Monday announce a radical plan to break itself up after 90 years as a global insurance conglomerate by ceding control of its two largest divisions to the US government in exchange for a $30bn-plus lifeline.

The move, aimed at helping the stricken insurer absorb the blow of huge losses, is the third time in five months AIG has been bailed out by the authorities. Coming shortly after the third government rescue of Citigroup, the decision to save AIG could fuel mounting public anger.

Or as Jake wrote the other day, welcome to The Dukes of Moral Hazard. Be sure to read Joe Nocera's great piece about AIG from yesterday's NYTimes.

Is this now nationalization by another name?  

The financial crisis and the profound economic reversals reverberating around the globe caught up last week with Citigroup, the world's largest financial institution. Citigroup is still solvent, but it holds several hundred billion dollars of heavily-leveraged, troubled assets – and once the market began to focus on the potential losses, as it did last week, the bailout became a foregone conclusion. But the terms of that bailout -- on top of the deals for AIG, taxpayer infusions for solvent institutions such as Wells Fargo and State Street, and new Federal Reserve loans for any financial firm holding a wide range of assets -- are beginning to look like an American version of crony capitalism. The critical distinction lost or forgotten in much of Treasury and Fed’s dealings is that the government’s proper role in rescuing or bolstering private companies during a crisis is to help them only under specific terms that directly benefit the taxpayers footing the bill.

Crony capitalism is usually associated with the way many governments in Africa, Asia and Latin America conduct public business, where government contracts, budgets and other public activities are routinely channeled to the families, friends and associates of political elites, rather than being allocated through some open bidding or other democratic processes. Variants of crony capitalism occur in the United States, too. In one infamous example, Halliburton “won” billions of dollars in no-bid contracts for Iraq while its former CEO was Vice President; and crony capitalism lurks behind billions in pork barrel appropriations passed every year by Congress. But when it begins to infect huge government operations taken to deal with an emergency, it has more serious and insidious effects. Japan famously practiced crony capitalism in its multi-trillion-yen “rescue” operations for its failing banking system in the 1990s, and bought itself a decade of stagnation and at least another decade as the worst-performing advanced economy in the world.

The terms of the Citigroup deal raise the specter of crony capitalism. The taxpayers will invest $20 billion in the company, receiving preferred stock that will pay 8 percent dividends, and Citigroup will bear the first $29 billion in losses from its current portfolio of $306 billion in troubled loans and assets. After that, the taxpayers absorb 90 percent of any additional losses in exchange for another $7 billion in preferred stock. The likelihood that Citigroup’s losses will far exceed the first $29 billion is disturbingly high. The financial crisis almost certainly will deliver additional shocks, because the current policies have done little to address the forces driving the crisis. The housing market continues to unravel; and with business investment, consumption and jobs all contracting rapidly, foreclosures continue to rise. As they do, more mortgage-backed securities and the derivatives based on them will go bad, and the consequent losses could claim much of the capital infusions that taxpayers have already provided. As the IMF and others have warned, large additional losses also could come from other sources. Most notably, the spreading global recession, on top of national banking crises in other countries, are producing enormous pressures on government financing operations in a number of nations, including some in the Eurozone, which in turn may produce sovereign debt defaults. And most of the sovereign debt that could well default in coming months is held today by financial institutions, especially ours.

While the administration’s program barely acknowledges the implications of these dangerous dynamics in its bailout policies, President-elect Obama has at least pledged to address the underlying foreclosure problem and provide very large stimulus that could begin to ease the U.S. downturn and, with it, the global recession. The larger question is whether the new administration will also reject creeping crony capitalism by requiring that the bailouts almost certain to come next year oblige the financial institutions claiming all that cash to conduct themselves in ways that directly benefit the taxpayers picking up their bills.

Remarkably, the current administration has imposed no such requirements while doling out hundreds of billions of dollars to insulate our large financial firms from the worst consequences of their own decisions. In fact, even last week, as the Treasury was bailing out Citigroup, the Federal Reserve announced another $200 billion program for financial companies holding securities backed by consumer debt, now threatened by the recession triggered by the financial meltdown. Here’s a notion for the next administration: Since the essential reason to bail out all of these various institutions is to unfreeze the routine lending that keeps the U.S. economy going, tie future bailouts to specific commitments to reboot lending American businesses and households. This is precisely what Sweden did in the early 1990s when its financial sector melted down, and the strategy of tying capital assistance to renewed lending helped produce a genuine recovery.

Crony capitalization may be the signature moral hazard of an administration which continues to believe that, even when taxpayers provide hundreds of billions of dollars to bail out powerful institutions, the government should have as little say as possible in the way they conduct themselves. It shouldn’t be good enough for an Obama presidency. When the next shocks hit our financial system and those institutions come back for more, the new administration should opt for democratic capitalism over crony capitalism, and apply lending requirements to actively open up the nation’s credit markets.

As President-elect Barack Obama turns to the enormous challenges facing the nation, his first priority will be to set his priorities. Already, there are more urgent problems than any president could tackle successfully in a single term, and even more will almost certainly emerge. Moreover, he now will have to lead in ways he did not have to as candidate, by taking real and contentious actions. His historic, landslide election will give him greater, initial political capital than any president since Ronald Reagan. Even so, capital gets spent, and a president’s power and influence are finite, so he will have to choose precisely where he intends to focus all that capital, power and influence.

The lead items on his domestic agenda must be the nation’s financial and economic crisis. That will require, first, steps to slow housing foreclosures. He has pledged to initiate a 90-day moratorium on foreclosures, but that would be only a first, modest step. He also could also create a new fund to lend tide-over funds to homeowners facing foreclosure after the 90 days are up, and while Fannie Mae and Freddie Mac work out a responsible plan for them to renegotiate the terms and interest rates on the mortgages of homeowners in distress. He also can help banks get credit flowing again with a temporary, reduced tax rate on an estimated $700 billion in profits now held abroad by the foreign subsidiaries of American companies.

That step also could provide a measure of stimulus for an economy currently entering what is likely to be a long, nasty recession, and addressing the recession also must be one of President Obama’s first priorities. Tax rebates won’t work, since most Americans would most likely save any new checks rather than spend them. So Washington will have to jumpstart the nation’s additional spending, with a new spending package of $200 billion to $250 billion. And President Obama should focus most of it on the long-term investments he called for during the campaign, including grants to digitize health care records and provide access to computer training for current workers, and new supports to modernize the electricity grid and accelerate the development and spread of alternative energy. On top of that – and grants to cash-strapped states so they can avoid large cuts in their Medicaid programs and their workforces – the new president should focus the infrastructure piece of his stimulus on creating a national infrastructure financing bank and initiating new commitments for low-polluting light rail systems in major metropolitan areas.

The president will also hear demands and pleas for a new regulatory framework for the financial sector. That task is clearly a necessary and urgent one, but getting it right will be a long, complex process. His best move would be to create a national, expert commission with a mandate to figure it out over the next six months and report back to the nation.

The president’s serious priority-setting can only really begin once he addresses those emergencies – and it won’t be easy. The stimulus measures can be the first steps toward meeting his pledge to help build a more energy-efficient and climate-friendly economy. And since he will have to choose, the rest of that agenda should probably take lower priority than health care reform. One reason is that while the recession will cut energy prices and energy use with no help from Washington, for at least a time, it will only worsen out health care problems. The recession will further increase the numbers of people without coverage, perhaps by millions, without making a dent in the steady, sharp increases in health care costs that will continue to cut into jobs and wages. And any further delay will only make it all worse. It’s time to carry out his plans to make coverage much more nearly universal, and tie those extensions to a hard-nosed program of cost controls that will require hospitals and clinics to adopt the best practices of the country’s most cost efficient medical centers.

This will leave President Obama with plenty to tackle in the second half of his term. That can be the time to take further steps to help make America more climate friendly and energy efficient. It also has to be the time to build on the cost-control lessons from health care reform and finally address the serious and treacherous business of reforming Medicare and other entitlement spending for tens of millions of Baby Boomers.

And if President Obama can make real progress in these priority areas over his first term, it will almost certainly earn him an even bigger national landslide for a second term. 

One of the factors that has supposedly fueled the current financial crisis is the mark to market rule. Under this rule, financial firms must keep securities on their books at the market price. The idea behind mark to market was to provide greater transparency into a firm's real value by providing a close to real time snapshot of the value of its holdings. However, in a declining market, the mark to market rules have forced companies to write down the value of securities to the point where the firm itself may appear insolvent. At this point rating agencies have no choice but to downgrade ratings which may force firms to increase collateral on loans, trigger default covenants in loans and make firms unattractive borrowers. Accordingly, some have called in the current crisis for relief from mark to market rules which make an entire firm's solvency dependent on the vagaries of the market.

While there is something to the argument that mark to market accentuated the current crisis, as John Kay writes today in the Financial Times, problems with mark to market in a decline are nothing compared to mark to market in a rising market.

Jeff Skilling at Enron supposedly broke open bottles of champagne upon receiving an SEC letter allowing Enron to make wide use of mark to market rules. The SEC ruling allowed Enron to book unrealized fluctuations in the value of securities as profits. As Kay notes, it gave Enron instant credit for the discounted present value of traders' ideas at the moment of inspiration--regardless of whether the ideas ultimately panned out. Under this logic, Sir Isaac Newton should have been a very rich man until the theory of relativity wiped him out. As Kay explains mark to mark during the bull market in housing and stocks that preceded the current financial crisis, helped bankers, prop traders, hedge funds and others make huge profits out of nothing.

Ultimately, behind the mark to market debacle is the central belief of our age: boundless, unlimited faith in markets. As Adam Smith discerned, markets are a wonderful way to allocate scarced goods relative to the alternative--some version of central planning. However, the same enthusiam cannot attach to the wide gyrations in market prices as money sloshes around the globe that clearly reflect not only animal spirits but old fashioned chaos, accentuated by human passions. The wild gyrations of the last few weeks are not guides to long term value. While instant prices are a tool in understanding value, they should not be the final word. Interestingly, even free market zealots like Newt Gingrich have come out in favor of suspending mark to market rules because of their impact in downturns. But as Kay points out, our real concern should be their impact in upturns.

It is time to re-examine the mark to market rule--and the idea behind it that market prices are infallible.

New York City -- Stuff happens, but in dissecting financial disasters, more often than not, it turns out that some singular event--usually regulatory--not mere chance, opened the gates to abuse.  In the S&L fiasco in the 1980s, one such event was the success by lobbyists in winning a rule change that allowed them to take unlimited brokered deposits, ie deposits not from you and me opening accounts, but through financial markets. From that point on, many banks bid for deposits with little thought of the interest rate, lent the money without oversight and, when markets turned downward, a disaster ultimately occured.

This time around, while there is still a sense that our current crisis just happened, the New York Times reports today that, once again, it was not an accident.  As revealed in the article, in 2004, in an obscure meeting held in the basement of the SEC building, Commissioners voted to approve a proposal by lobbyists of Wall Street's biggest firms, led by Goldman Sachs, to change the rules to allow the firms to increase their rates of leverage on equity up to 33 to 1. As long as their returns were greater than the cost of borrowing, this allowed them to juice their returns.  However, one or two bad investments at this leverage--for example in sub-prime loans--had the ability to go diastrously awry, wiping out the firm's entire equity.  This, in essence, is what has happened to the entire financial industry. It turns out there is a smoking gun in this crisis, a rule change secured by lobbyists--that had disastrous effects.

The Times goes on to report that in exchange for the unprecedented leverage, the firms promised to monitor their risk and the SEC set up an office to monitor risk as well.  Unfortunately, the office never became functional.  A software consultant and MBA who designed software used by banks to monitor risk was the lone dissenter in a letter to the SEC.  However, his letter and advice were ignored and the rule was approved unanimously.

Had the SEC followed through on the oversight it was supposed to perform, the consequences might not have been so dire.  But dergulation combined with abdication of all responsibility by the regulator, the SEC, provided fatal.  And we are now seeing the consequences. 

With news coming that the Senate has loaded up the bailout bill with a number of tax provisions, including an AMT patch and crucial tax credits for renewable energy, the House vote on the proposal, should it pass the Senate, looks to be a defining moment for pay-go.

Pay-go has been the largest stumbling block in extending renewable energy tax credits – a package so popular that it recently passed the Senate with a vote of 93 to 2. Now, a bipartisan agreement by Leaders Reid and McConnell to include these provisions in the bailout bill, which is predicted to pass the Senate tonight, will only be derailed if some in the House continue to insist on pay-go.

NDN has long argued that pay-go creates far too much arbitrary, artificial rigidity in the legislative and governing processes, and this bailout serves as a perfect example. Should a bipartisan bill designed to rescue the economy on the order of $700 billion fail due to a pay-go fight over far less costly tax provisions that are partially offset, the legacy of pay-go, a provision that doubtless has limited life to it anyway, will go from murky to downright laughable.

As the economy slides into recession, one can only hope that the popularity and job creation benefits of the tax credits, especially those for renewable energy, will garner enough votes to more than offset the votes lost from pay-go proponents.