REALITYBASE

Many comparisons of current US economic conditions with the beginning months of the Great Depression indicate that things are not as bad as they were 80 years ago, but if one looks globally, as Eichengreen and O’Rourke have, the situation is worse today than then. “[W]orld industrial production, trade, and stock markets are diving faster now than during 1929-30.” They include graphs of these metrics and of policy responses (central bank discount rates, money supply, and government deficits) comparing now to then. They conclude:

[T]he world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.

The good news, of course, is that the policy response is very different. The question now is whether that policy response will work.

A recent analysis by Daniel Gros of data from the Great Depression reveals that profits of commercial banking held up much better than profits in other financial services and non-financial businesses. This was a reason why the Glass-Steagall Act of 1933, separating commercial banking from investment banking, made sense and why its repeal in 1999 did not. Since the repeal, most of the largest banks have combined commercial banking with investment banking and other financial services. Not surprisingly, the recent losses and valuation declines in the other businesses are inhibiting commercial lending now. Daniel Gros:

The resilience of "normal" banking operations to a recession or even a depression strengthens the case for a separation of commercial and investment banking activities. The classic banking operations of deposit-taking and lending tend to remain profitable even under stressed conditions. But this classic function of banking would not be such a cause of concern today if the investment banking arms of banks had not gotten into trouble by investing in "toxic" assets. At present, the authorities in both the US and Europe have little choice but to make up for the losses on "legacy" assets and wait for banks to earn back their capital. But to prevent future crises of this type, policymakers should make sure that losses from investment banking arms cannot impair commercial banking operations.

The financial crisis—from Bear Sterns, to Fannie and Freddie, to Lehman and AIG, to the panic in money market funds and commercial paper markets, to TARP and beyond—is described by 3 top Bush Treasury insiders in this 75 minute video. Some highlights:

"We were afraid of a complete and utter collapse of the global financial system."

Treasury had great difficulty getting political support for new intervention authorities because hardly anybody on Capitol Hill understood the first thing about credit markets. Only when constituents told members they were going to do layoffs and curtail operations due to a lack of credit, and when the stock market tanked the day the House rejected the TARP legislation, did the necessary votes finally appear. Further TARP-like legislation would have no chance in the current Congress under present circumstances.

The idea to buy assets, which was the reason Treasury said it wanted TARP, was abandoned because the conditions kept getting rapidly worse, it was found that putting an asset purchase program in place would take too long, the Europeans announced they were going to aid their troubled banks with capital injections forcing Treasury into a matching program for US banks, and at Treasury, "we believed the banking system was fundamentally undercapitalized." (As we saw, the capital injections could be accomplished in days, not months.)

The Treasury team, who worked around the clock for months, still could never get ahead of events and were in a constant state of improvisation and reaction. Paulson told his team at one point, "We're doing this with duct tape and fishing wire."

Lehman was not saved because there was no private buyer who could be encouraged with some Treasury money to take over all of Lehman, because there was a clear lack of authority for the US to guarantee all $600 billion of Lehman's debt, and because there was no third alternative. Contrary to the speculation that Treasury wanted to send a signal that players should solve their own problems because they would not be bailed out, Treasury worked desperately all summer to try to save Lehman.

Washington Mutual was seized and worked out "by the book," using authorities and procedures that were designed for failing banks and had been used many times before. Wachovia got special treatment (thrown into the arms of BofA) because—to the surprise of Treasury—the credit markets had reacted very, very badly to the WaMu seizure. In other words, the markets were telling Treasury that seizure of Wachovia would push the system much further toward collapse, whereas Treasury had seen no such signal before WaMu. It was an art, not a science.

Treasury was frustrated with the leadership of financial institutions because they refused to accept the reduced value of their assets and liquidate at market prices. There are still asset valuation problems, and banks are necessarily shrinking their balance sheets, both of which keep new lending tight. But it was not intended that the TARP capital injections be used much for new lending—the major purpose became to provide "a buffer against losses," and this was TARP's major, and important, achievement.

Paul Krugman, Matt Yglesias, and Brad DeLong are worrying that the Obama Administration does not have a clear and consistent narrative about its policies for the financial industry. They enumerate 5 possibilities:

1. We have to enrich undeserving banksters by driving up asset values because there is absolutely no other way to prevent the economy from getting much, much worse for everybody else.

2. Because government investments into the financial system are not infected by the recent "irrational pessimism" of the private sector, the government investments will stabilize the system in the short term and pay off handsomely later.

3. It is likely we will need to do more to rescue the economy—even dramatically more—but we can't get Congressional approval for more unless and until our current authority proves insufficient.

4. Receivership (opponents call it "nationalization") for the largest banks is impossible for feasibility, political, and/or ideological reasons.

5. The current approach of Public Private Investment Partnerships will cost the US government less in the long run than the receivership option.

These pundits wring their hands because the Obama Administration has not settled on a single narrative to the exclusion of all others. Krugman even compares the lack of a single focus to the shifting rationales that the Bush Administration used for tax cuts in 2001 and the invasion of Iraq. I note that there is no inherent inconsistency among the 5 narratives—they could all be true. Maybe the best way for the Administration to explain what it's doing is comprehensively instead of in sound bites.

Willem Buiter has a long and useful description here of credit default swaps, refutes the argument supporting them, and makes 6 arguments against them. He concludes:

The endless churning of contingent claims, including derivatives, when the purchaser has no identifiable insurable interest, turns financial intermediation into a market-mediated betting shop. Then the betting slips become bearer securities and are themselves traded, either OTC or on organised exchanges, and the derivative transactions volumes expand to dwarf the transactions in the markets for the underlying financial claims (let alone the markets for the underlying real resources). At that point, the betting tip of the financial tail of the real economy dog does all the wagging. It does not create value but redistributes it in a way that consumes real resources and exposes the real economy to unnecessary risk. It's time to tame the tiger.

The securitization of mortgages and other debt obligations gives senior tranche holders less risk of individual defaults, but increases the risk to a general economic downturn. Coval, Jurek, and Stafford demonstrate this in The Economics of Structured Finance a working paper published last week by the Harvard Business School. The paper contains exceptionally lucid descriptions of how structured finance works and uses simple examples to demonstrate the sources and magnitudes of under-appreciated systemic risks. It's 36 pages including charts and graphs and well worth the 1-2 hours it might take to understand it. Here's my summary of the essence. (Except as otherwise noted, all citations are to the PDF of the working paper.)

The main reason people buy investment grade bonds is that they want a very high degree of security that the promised income stream will not be interrupted even if there is a severe economic downturn causing a deep slump in the stock market. In other words, they want investments that are as weakly "correlated" as possible with general economic conditions because the values of other classes of investments, such as corporate stocks and commodities, are highly correlated with general economic conditions.

Rating agencies (Moody's, S&P, Fitch) developed methods to compare the creditworthiness of bond issuers against one another. For example, they tell us that this AA rated General Electric bond is less likely to default than that A+ rated utility bond and both are less likely to default than a certain A- rated municipal bond. "However, credit ratings, by design, only provide an assessment of the risks of that security's expected payoff, with no information regarding whether the security is particularly likely to default at the same time that there is a large decline in the stock market or that the economy is in a recession." At 18-19 (emphasis added).

When the rating agencies began to rate collateralized debt obligations ("CDOs"), they continued to ignore correlation of risk to general economic conditions. Regrettably, while pooling of mortgages and other debt obligations does reduce the risk to senior tranches of individual defaults, it increases the correlation to general economic conditions. As a result, a AAA rated CDO is more subject to systemic risk than a single AAA rated corporate or municipal bond. "[T]ranches written against highly diversified collateral pools have payoffs essentially identical to a derivative security written against a broad economic index." At 20. Consequently, much to the consternation of most of them, holders of CDOs had bet on the overall health of the economy, not on mortgage default rates in Tallahassee.

If this had been widely understood—it was not—buyers of AAA rated CDO tranches would have demanded higher yields than they did, and the business of "structured finance" would likely have been much smaller. However, the Basel I and II international banking agreements created additional impetus by providing that banks need to hold only half the reserves against AAA rated securities that they must hold against lower rated securities. At 26.

It gets worse. There developed a practice of securitizing the mezzanine tranches of CDOs into CDO-squareds, thereby creating additional AAA rated bonds. At 17. Coval et al. show mathematically that any tiny underestimate of default rates or correlation of performance among the underlying obligations is hugely magnified in CDO-squareds. At 15. According to Moody's, CDO-squareds accounted for 55% of the notional value of all CDOs issued in 2006! At 17. It seems shocking that a AAA tranche from a CDO-squared is much more likely to default in a recession than a AAA tranche from a CDO, but that seems irrefutable.

There is some evidence that Wall Street executives realized it would end one day, but in the meantime, they had little incentive to move to the sidelines. In July 2007, the then-CEO of Citigroup, Chuck Prince, acknowledged that the cheap credit-fueled buy-out boom would eventually end, but that in the meantime, his firm would continue to participate in structured finance activities (as reported in Nakamoto and Wighton, 2007): "When the music stops, in terms of liquidity, things will get complicated. As long as the music is playing, you've got to get up and dance. We're still dancing."

At 26. See also Risk management means taking the risks your competitors take.

John C. Bogle, legendary founder of Vanguard Group, adds institutional money managers to the list of those whose failures contributed to the current financial crisis, reports Gretchen Morgenson whose NYT piece is the source of all facts and quotations below.

Professional money management firms like Fidelity, Vanguard, and Putnam today control 70 percent of the shares of large public companies, by making investment decisions on behalf of pension plans, IRAs, 401(k)s, and mutual funds. This gives them enormous potential power over board structure and governance, director elections, executive compensation, stock options proxy proposals, dividend policies, and other matters of concern to shareholders at the companies they own, but they rarely exercise any of this power. Their passivity enables managements to ignore the interests of shareholders and exploit their positions for their own gain.

But that isn't all. Despite the Investment Company Act of 1940 requirement that "mutual funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers," money managers routinely abuse their positions of trust by exploiting investors.

Consider fees. Charges levied on mutual fund investors are much higher than those that the identical firms exact on pension clients, for example. The three largest money managers, Mr. Bogle pointed out, charged an average fee rate of 0.08 percent to pension customers. This compares with 0.61 percent charged to fund shareholders.

Money managers also haven't done the kind of due diligence that might have protected their investors from titanic losses. "How could so many highly skilled, highly paid securities analysts and researchers have failed to question the toxic-filled, leveraged balance sheets of Citigroup and other leading banks and investment banks?" Mr. Bogle asked.

. . . .

Some money management firms are publicly traded themselves, and Mr. Bogle says that those firms offer an added layer of deep and serious conflicts because executives running them try to serve two masters: their shareholders and their fund clients.

. . . .

In the face of all this, Mr. Bogle suggests that we force our agents to relearn what being a fiduciary means. A fiduciary, these managers seem to have forgotten, acts for the sole benefit and interest of another. We need to replace the agency society with a fiduciary society, he argues.

Update on Tuesday, April 21, 2009 at 01:45PM by Skeptic

Bogle addresses the issues again in this Wall Street Journal opinion piece.

The six months report of the Congressional Oversight Panel for TARP is out. It describes the basic strategic options for fixing sick banks. Here's what it says about the strategy adopted by Treasury for TARP:

One key assumption that underlies Treasury's approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.

If its assumptions are correct, Treasury's current approach may prove a reasonable response to the current crisis. Current prices may, in fact, prove not to be explainable without the liquidity factor. Even in areas of the country where home prices have declined precipitously, the collateral behind mortgage-related assets still retains substantial value. In a liquid market, even under-collateralized assets should not be trading at pennies on the dollar. Prices are being partially subjected to a downward self-reinforcing cycle. It is this notion of a liquidity discount that supports the potential of future gain for taxpayers and makes transactions under the CAP and the PPIP viable mechanisms for recovery of asset values while recouping a gain for taxpayers.

On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth. The actions undertaken by Treasury, the Federal Reserve Board and the FDIC are unprecedented. But if the economic crisis is deeper than anticipated, it is possible that Treasury will need to take very different actions in order to restore financial stability.