SECRETARIA DE ESTADO DE ECONOMÍA,

MINISTERIO SECRETARÍA GENERAL DE POLÍTICA ECONÓMICA DE ECONOMÍA Y ECONOMÍA INTERNACIONAL Y HACIENDA SUBDIRECCIÓN GENERAL DE ECONOMÍA INTERNACIONAL

CUADERNO DE DOCUMENTACION

Número 87-2º (alcance)

Anexo II

Alvaro Espina Vocal Asesor 20 Abril de 2009

BACKGROUND PAPERS (continuación):

68. U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages?, RGE Monitor… 251 69. Obama’s Ersatz Capitalism, by Joseph E. Stiglitz… 253 70. How Much Will U.S. Housing Prices Fall And How Long Will The Downturn Last?, RGE Monitor… 255 71. U.S. Housing Starts and New Home Sales Improve, Permits Still Weak: Is the Sector Stabilizing?, RGE Monitor… 256 72. A task fit for Herculean policymakers, by Gillian Tett… 258 73. Japan PM attacks Merkel’s complacency, Eurointelligence… 260 74. The Future of Investing: Evolution or Revolution?, by Bill Gross… 263 75. Playing Solitaire with a Deck of 51, with Number 52 on Offer, by Paul McCulley… 267 76. Reading Krugman, thefinancebuff.com… 272 77. Are ABX Derivatives Prices An Accurate Measure of Subprime RMBS and CDO Valuations?, RGE Monitor…274 78. America the Tarnished, by … 276 79. Obama’s Nobel Headache, by Evan Thomas… 278 80. The G20: expect nothing, hope for the best and prepare for the worst, by Willem Buiter… 283 81. Does Obama Have a Plan B?, by Adam S. Posen… 289 82. New home sales is this bottom?, calculatedrisk… 292 83. The Mega-Bear Quartet, calculatedrisk… 293 84. Forecast: Two-thirds of California banks to face Regulatory Action, Calculatedrisk…294 85. Q1 GDP will be Ugly, Calculatedrisk… 294 86. February PCE and Personal Saving Rate, Calculatedrisk… 296 87. Revisiting the Global Savings Glut Thesis, by Doug Noland… 298 88. We need a better cushion against risk, by Alan Greenspan… 302 89. Zapatero favours a new round of stimulus spending, Eurointelligence… 305 90. Battles Over Reform Plan Lie Ahead, by Edmund L. Andrews…307

62 91. As Oversight Plan Is Unveiled, Turf Battle Begins to Unfold Rival Regulators Argue for Right to Expanded Authority, by Zachary A. Goldfarb, Binyamin Appelbaum and Tomoeh Murakami Tse… 309 92. RTC All Over Again, Hedgefundnet... 311 93. Geithner to Propose Vast Expansion Of U.S. Oversight of Financial System, by Binyamin Appelbaum and David Cho… 312 94. Time For A New Insolvency Regime For Non-Banks And Bank Holding Companies?, RGE Monitor… 315 95. Blueprint for Regulatory Reform: Regulation By Activity For Everybody Rather Than By Institution?, RGE Monitor… 316 96. Will The Fed's PPPIP Get Credit Flowing Again?, RGE Monitor... 317 97. Details Of Geithner's Public-Private Partnership: Large Taxpayer Subsidies For Toxic Asset Investors, RGE Monitor… 319 98. Can Geithner's Toxic-A+sset Plan Work?. The Treasury Secretary's plan to rid banks of bad loans faces plenty of roadblocks. Only time will tell if it can succeed, by Jane Sasseen… 322 99. Commercial Real Estate Bust Has Started: Access To TALF Just In Time?, RGE Monitor… 324 100. Is the EU run by a madman?, Eurointelligence… 326 101. Geithner Affirms Dollar After Remarks Send It Tumbling, by Anahad O’Connor... 330 102. Las turbulencias de la economía hacen caer a tres gobiernos de Europa del Este, por Cristina Galindo… 332 103. En medio de la crisis: la sequía de crédito, por Miguel Boyer Salvador… 334 104. Economists React: ‘Has Housing Hit Bottom?’, Posted by Phil Izzo… 337 105. New Home Sales: Is this the bottom?, Calculatedrisk… 339 106. Los hedge funds vuelven al punto de mira de los reguladores Universia-Knowledge@Wharton... 342 107. Is it back to the Fifties?, by John Authers… 347 108. Regional Banks Are the Future, por Meredith Whitney… 352 109. Dissecting Bank Plan for a Way to Profit, by Graham Bowley and Mary Williams Walsh… 353 110. Chris Carroll Reassures Me that I Am Not Crazy..., by Brad Delong… 356

63 111. Treasury rewards waiting, By Christopher D. Carroll… 356 112. Geithner’s plan, FT Lex… 358 113. Will the Geithner Plan Work?, NYT Editors (4 opinions: Paul Krugman, Simon Johnson, Brad DeLong and Mark Thoma)… 359 114. Dear A.I.G., I Quit!, by Jake DeSantis… 365 115. China Proposes a Shift to the SDR: Is it ready for A Global Role?, RGE Monitor… 368 116. Funding the Fed: Precedents and Purposes for Issuing Federal Reserve Bills, RGE Monitor… 369 117. U.S. Plan Seeking Expanded Power in Seizing Firms, by Edmund L. Andrews and Eric Dash… 371 118. U.S. Seeks Expanded Power to Seize Firms Goal Is to Limit Risk to Broader Economy, by Binyamin Appelbaum and David Cho… 373 119. Reactions to the Geithner Plan, by Adam Posen… 375 120. Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed, by Willem Buiter… 376 121. The Treasury’s Financial Stability Plan: Solution or Stopgap?, by Adam S. Posen... 389 122. Geithner’s trillion dollar gamble, Eurointelligence… 391 123. Geithner plan arithmetic, by Paul Krugman… 393 124. Prices of most-traded risky loans recover, by Anousha Sakoui… 395 125. The threat posed by ballooning Federal reserves, by John Taylor… 396 126. Financial de-globalization, illustrated, by Brad Setser…398 127. Reorganising the banks: Focus on the liabilities, not the assets, by Jeremy Bulow and Paul Klemperer… 402 128. Global imbalances and the crisis: A solution in search of a problem, by Michael Dooley and Peter Garber… 407 129. Mistakes Beget Greater Mistakes, by Doug Noland… 411 130. A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations, by Adam S. Posen… 414 131. The new Geithner plan is a flop, by Luigi Zingales… 426 132. Exclusive: PIMCO to participate in U.S. toxic asset plan, Reuters… 428

64 133. Saving Capitalistic Banking From Itself , by Paul McCulley… 430 134. Managing the Bailout: He’d Do It for Nothing, by Edward Wyatt… 435 135. How Main Street Will Profit, by William H. Gross… 438 136. It's the Housing Market Deflation, by William H. Gross… 439 137. Why We Need a Housing Rescue, by William H. Gross… 440 138. William H. Gross — The King: “If Any One Man has put Bonds on the Map, it's Bill”, by Money Masters… 443 139. Guess Who Really Pays the Taxes, by Stephen Moore... 445

65 Apr 1, 2009 U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages? Overview: U.S. credit card defaults rise to 20 year-high. Analysts estimate credit card chargeoffs could climb to between 9 and 10% this year from 6 to 7% at the end of 2008. In that scenario, such losses could total $70 billion to $75 billion in 2009 (Reuters). Meanwhile, the $5trillion in outstanding credit card lines (of which $800bn is currently drawn upon) are being trimmed even for credit worthy borrowers with Meredith Whitney estimating that over $2 trillion of credit-card lines will be cut in 2009 and $2.7 trillion by the end of 2010. Research shows that unemployment is one of the most important drivers of credit card and auto loan loss rates. RGE (Kruettli) estimates that credit card charge-off rate could reach 13% (or $146bn) in the worst case scenario. o March 16 Reuters: losses particularly severe at American Express and Citigroup amid a deepening recession. AmEx, the largest U.S. charge card operator by sales volume, says net charge-off rate rose in February to 8.7% from 8.3% in January as job losses accelerated and the economy deteriorated. Citigroup -- one of the largest issuers of MasterCard cards -- default rate soared to 9.33 percent in February, from 6.95 percent a month earlier. o cont.: Positive surprises: JPMorgan Chase and Capital One reported higher credit card losses, but they were below analysts expectations. o BNP March 16: AAA ABS Benchmark Spreads Improve In View of $1000bn TALF liquidity program , Fixed Rated ABS Spreads Stay High. o Fitch March: In January, credit card delinquencies breached all-time highs for the second consecutive month according to the latest Fitch Credit Card Index results. At January month end, the 60 plus day delinquency rate was 4.04%. The results come amid an unending parade of troubling economic data from surging unemployment to steeper declines home and equity market values. o Moody's: January credit card charge-offs reached a record-high 7.74%, and with an increasing number of borrowers falling behind on their credit card payments charge-off rates will almost certainly increase in the coming months. The seasonal post-holiday rebound in payment rates did not materialize this January, leaving the payment rate index, which has been falling since early 2007, near a five-year low. The payment rate has been falling since early 2007. (research recap) o Meredith Whitney (via WSJ) March 10: Currently, there is roughly $5 trillion in credit-card lines outstanding in the U.S., and a little more than $800 billion is currently drawn upon. Just six months ago, I estimated that at least $2 trillion of available credit-card lines would be expunged from the system by the end of 2010. However, today, that estimate now looks optimistic, as available lines were reduced by nearly $500 billion in the fourth quarter of 2008 alone. My revised estimates are that

251 over $2 trillion of credit-card lines will be cut inside of 2009, and $2.7 trillion by the end of 2010.--> see Credit Card Reform: What Impact On Consumers? On Banks? On Investors? cont.: Currently five lenders dominate two thirds of the market. o SIFMA: Q4 2008 marked the first time ever that four of the major sectors (home equity, credit card, student loan, and equipment leases) had no issuance. o Graef (Deutsche Bank): Credit card debt grew strongly in absolute terms but was comparatively stable in relation to disposable income. In light of the virtually unchanged ratio of credit card debt to disposable incomes we cannot detect a credit card bubble-->we do not expect an above-average increase in credit card defaults, particularly in view of substantially lower credit card interest rates compared with earlier years. o White (NBER/UCSD): Ratio of consumer debt to median income increased to 4.5 in 2007 from 1 in 1980 compared to a ratio of 3 for mortgage debt/median income--> "high debt/misuse of credit cards" is the primary reason for increase in bankruptcy filings since the mid-1980s. o Wieting (Citigroup): Households shifted expensive credit card debt to less expensive, tax-deductible mortgage credit in the early/mid 2000s. Revolving credit grew at an average 4.3% year/year pace in 2002-2007 vs 12.4% for mortgage debt. As such, credit card delinquencies have been closer to “cyclical norms,” unlike housing. However, we believe the employment downturn will now drive cyclical delinquencies in cards too. Expect unemployment to rise to 8-10%. o Mathias Kruettli (RGE): Given that lending standards are being tightened across the board, a jump in the unemployment rate is likely to increase the default rate on credit card debt, which might lead to higher write-downs on the banks credit card portfolios. o cont.: The paper comes to the conclusion that write-downs in 2009 are likely to be significantly higher than in2008 (50 billion USD). In the worst case scenario the credit card receivable write-downs could be as high as 146billion USD in 2009. In the best case the write-downs will be around 64 billion USD. Currently, there are about $2.5T ABS receivables outstanding, incl. credit card, auto loan, HEL (SIFMA estim. of Q2 08) o Fitch, DBRS: report addresses the sensitivity of auto and credit card transactions to unemployment, one of the most important macroeconomic indicators for consumer finance. Results: - Changes in the unemployment rate are strongly correlated with changes in auto loan losses and credit card chargeoffs; - Auto loan and credit card ABS loss rates are expected to increase proportionately to the increases in unemployment rate; - Prime credit card chargeoffs are expected to increase on a 1:1 basis wrt unemployment. Accordingly, a 100% increase in the base unemployment rate, from 5% to 10%, would lead to a 100% increase in the prime credit card chargeoff index, from 6.18% (April 2008) to 12.36% over the next 12 months; - Subprime credit card chargeoffs and prime and subprime auto loan net losses are expected to increase at a rate closer to 1.2−1.3:1, meaning a 100% increase in unemployment could lead up to a 130% increase in losses; - Consumers are more likely to default on credit cards more immediately than they default on auto loans following shocks to the labor markets; - While, on average, the ‘BBB’ or ‘AAA’ bonds could withstand an unemployment rate of up to 11% or 20% respectively before a default occurs, downgrades during these stresses would be inevitable. http://www.rgemonitor.com/index.php?kwd=Search+Articles%2C+Blogs%2C+Archives+and+more...&option=com_search&task=search

252 Opinion

April 1, 2009 OP-ED CONTRIBUTOR Obama’s Ersatz Capitalism By JOSEPH E. STIGLITZ 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 , 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

253 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. http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1&th&emc=th

254 Apr 1, 2009 How Much Will U.S. Housing Prices Fall And How Long Will The Downturn Last? o The S&P/Case-Shiller 20-City Composite Index fell 19.0% y/y in January 2009, the fastest on record, as high inventories and foreclosures continued to drive down prices. All 20 cities covered in the survey showed a decrease in prices, with 9 of the 20 areas showing rates of annual decline of over 20% y/y.(S&P) o As of January 2009, average home prices are at similar levels to what they were in Q3 2003. From the peak in mid-2006, the 10-City Composite is down 30.2% and the 20-City Composite is down 29.1%.(S&P) o Q4 2008: The decline in the S&P/Case-Shiller U.S. National Home Price Index recorded an 18.2% decline in Q4 2008, largest in the series' history. This has increased from the annual declines of 16.6% and 15.1%, reported for the Q3 and Q2 2008, respectively. o Kiesel: U.S. housing prices, despite having fallen roughly 20% from their peak back in the second quarter of 2006, remain 10%–15% overvalued based on long-term historical measures such as price-to-income, price-to-rent and price-to-economic growth. In addition, total new and existing inventories of 4.7 million units are higher now than at the beginning of the year, and roughly 12 million homes are now in a negative equity position in which homeowners owe more on their mortgage than the home is worth. More challenging credit markets also mean fewer potential buyers. As a result, in terms of housing’s total peak-to-trough decline, a 30%–35% total decline from peak now looks possible o RGE Monitor: based on a range of indicators (real home price index by Shiller 2006, price rent ratio and price/income ratio) the fall in home prices from their peak will be in the 30- 40% range o CEPR: Nominal prices have now declined 19.5 percent from their peak two years ago, which implies a real decline of approximately 27 percent. This means that the bubble is approximately 60 percent deflated. This corresponds to a loss of more than $5 trillion in real housing wealth o OFHEO index fell 0.6% m/m in July and it is down 5.3% on a y/y basis. This is the sharpest decline for this cycle and on record o Fitch (via Calculated Risk): expecting home prices to decline by an average of 25 percent in real terms at the national level over the next five years, starting from the Q2 2008 o Wachovia:the S&P/Case-Shiller 10-city composite index will fall 28.6% on a peak-to- trough basis. OFHEO purchase only index will decline around 22% o IMF: the baseline scenario for the U.S. economy assumes a 14–22% drop in house prices during 2007–08

255 o PMI Group: U.S. home price declines will probably double to a national average of 20 percent by next year, with lower values most likely in metropolitan areas in California, Florida, Arizona and Nevada o Krugman: My preferred metric is the ratio of home prices to rental rates. By that measure, average home prices nationally got way too high. We'll probably basically retrace all that. So that's about a 25% decline in overall home prices (CNN) o Davis, Lehnert and Martin: prices would have to fall 15% over five years - assuming rents rose 4% a year - to bring rent/price ratio back to its long-term average o Goldman Sachs (Calculated Risk): Home prices to fall 15% w/o recession and 30% in case of a recession o Shiller: home prices to fall up to 50% in some areas

Apr 1, 2009 U.S. Housing Starts and New Home Sales Improve, Permits Still Weak: Is the Sector Stabilizing? Stabilization in the U.S. housing sector is not yet in sight: inventories and vacancies are still at a record high and continue to put downward pressure on home prices which continue to fall translating into trillions of real wealth losses for the engine of the economy: the U.S. consumer o Feb 2009: Starts rose unexpectedly by 22.2% m/m to an annual rate of 583,000, led by a surge in the multifamily component, but are down 47.3% y/y and 74% below their peak in January 2006. This first gain in eight months defies weak fundamentals and is likely to be due to seasonal factors. Building permits, a indicator of future construction rose slower at 3.0% m/m, indicating that starts might ease further in the future. Completions rose 2.3% m/m and were down 37.3% y/y. o Feb 2009: Existing home sales rose 5.1% to an annual rate of 4.72 million units in February from 4.49 million units in January, as cheaper credit and bargains on foreclosed properties attracted first time buyers. Distressed sales accounted for 45% of all sales, causing the national median home price to fall 15.5% y/y. The number of previously owned unsold homes on the market by the end of February represented 9.7 months’ worth supply at the current sales pace, up from 9.6 months in January. Resales of single-family homes rose 4.4% to an annual rate of 4.23 million in February. Sales of condos and co-ops rose 11.4% to an annual rate of 490,000 units. o Feb 2009: New home sales rose unexpectedly by 4.7%m/m in February to an annualized rate of 337,000. New sales are down 41.1% y/y and down 76.1% from the peak of July 2005. Lower mortgage rates and falling home prices caused the gain in sales in February.

256 The median sale price fell to $200,900, the lowest since December 2003 and is 17.7% below last February's level. o Feb 2009: Construction Spending fell 0.9% in February 2009 and by 10% y/y, led by declining residential construction. Housing construction fell faster in February by 4.3% from a 2.9% drop in January. Nonresidential spending rose marginally, up 0.3%, while government building projects rose by by 0.8% o NAHB builders’ sentiment index rose a single point to 9 in February – virtually unchanged from a record low of 8 in January o November new home sales plunge -35%; existing home sales -10.6%--> Ritholtz: Mortgage rates are the lowest in three years but tight lending standards mean that credit is hardly available for anyone but the best qualified buyers. o MBA: 1 in 10 Americans fell behind on mortgage payments or were in foreclosure in Q3 2008. The share of mortgages 30 days or more overdue and the share of loans already in foreclosure both jumped to all-time highs in a survey that goes back 29 years o Q3-08: Foreclosures boosted sales of single-family houses and condominiums to 5.04 mn at a seasonally adjusted annual rate, up 2.6% in Q2-08 o RealtyTrac: Foreclosure filings (incl. default notices, pending auctions, repossessions) rose 25% y/y to 279,561 in October o CBO: Under an optimistic scenario, starts will return to normal underlying levels by end of 2009; Under cyclical downturn scenario, return to underlying levels doesn't occur until early 2011; Under pessimistic scenario, return to underlying levels occurs in 2H 2012 o NAR: The Pending Home Sales Index a forward-looking indicator based on contracts signed in October 2008, slipped 0.7% to 88.9 from an upwardly revised reading of 89.5 in September, and is 1.0% below October 2007 when it was 89.8 o Toll Brothers cancellation rate running around 24.9% (CEPR) http://www.rgemonitor.com/80/Housing_Bubble_and_Bust?cluster_id=6077

257 A TASK FIT FOR HERCULEAN POLICYMAKERS

A task fit for Herculean policymakers By Gillian Tett in London Published: April 1 2009 22:49 | Last updated: April 1 2009 23:32 As global leaders gather in London on Thursday, they might be forgiven for feeling caught in a Sisyphean situation. Time and again over the past two years, bureaucrats and bankers have tried to halt the financial crisis by unveiling measures to write off toxic assets – and make the banks healthy again. Yet almost every time they have laboriously rolled the toxic asset boulder up the hill, it has come crashing down again. Never mind all those flashy forensic tests that bankers have promised, to measure the scale of the rot – or those trillions of dollars of taxpayers’ funds that have been spent to “clean up” the banks. As more toxic assets keep emerging, public confidence in the financial system keeps crumbling afresh. Little wonder. After all, the only thing more scary than the current scale of today’s banking woes is that, a full two years after subprime defaults got under way, policymakers and bankers alike remain confused about just how big the toxic rot really is, let alone when it might end. Will Thursday’s meeting provide any further clues? Don’t bet on it. After all, the issue of toxic assets – or “legacy assets”, as the Americans prefer to say – barely even features on the official agenda of the Group of 20 summit. Instead, the topics that are grabbing the limelight are initiatives on public spending, banking pay or regulatory reform, including an eye-catching row about tax havens. That is no accident. One dirty secret that hangs over Thursday’s meeting is that there is still precious little global consensus about how to tackle the toxic woes. Some countries (such as the US) are trying to persuade banks to sell their bad assets; others (such as the UK) are trying to “insure” the banks against losses instead. Meanwhile, several governments in continental Europe seem to be just holding their breath – and praying that the problem will magically disappear. “You won’t have a recovery until you cleanse the system [of toxic assets], but nobody wants to discuss it,” mutters one senior global policy official. “The Americans are hiding behind stimulus and the Europeans are hiding behind regulatory reform. But that misses the real issue.” To a certain extent, this reluctance to debate the issue reflects a desperate attempt to avoid telling taxpayers how much it might really cost to remove the toxic rot. The other big problem, though, is logistics. A decade ago, during Japan’s banking crisis, officials eventually managed to halt their woes by summoning senior bankers into a single (smoke-filled) room and imposing a common system to measure the rot.

258 It took them several attempts before they arrived at a credible number (and it was dramatically bigger than the first guess). But once they finally came up with a big sum, they recapitalised the banks – and rebuilt investor faith. However, the problem that now haunts western leaders is that it looks extremely hard to replicate the same smoke-filled room trick. After all, this is a global crisis involving banks in numerous different legal and accounting regimes that answer to different bosses. Moreover, the bad loan total is a moving target: as confidence crumbles in the banks, the economy is weakening – creating more bad loans. Even if global leaders could organise a single “count”, in other words, it would almost certainly be out of date by the time it was completed. Yet the rub is that until a credible number appears, it will be painfully hard to end the current banking mess. “The main thing we need now is to implement a sense of transparency where we can put a credible floor to the bank losses,” points out Mario Draghi, the Bank of Italy governor who chairs the influential Financial Stability Forum. Given that, Mr Draghi and others are now quietly hunting for fresh ideas. Thursday’s gathering will give the FSF an expanded role on the global stage – and Mr Draghi intends to use that wider mandate to push for more global consistency in measuring bad loans. More broadly, many policymakers hope – or pray – that if the meeting boosts investor confidence, it may eventually help to halt the slide in asset values, too. Yet the grim fact remains that, a full year after the International Monetary Fund first caused “shock” by predicting $1,000bn of credit losses, the IMF has now doubled that tally to $2,200bn. That is more than 20 times bigger than the US government’s first estimate of the likely credit losses, back in the summer of 2007. Yet the gossip is that the IMF estimate is poised to jump even higher soon. That is just one more reminder – if any were needed – that the G20 now needs to display some truly Herculean vision and strength. Copyright The Financial Times Limited 2009 http://www.ft.com/cms/s/0/b459b6a0-1f00-11de-a748-00144feabdc0.html

259 01.04.2009 JAPAN PM ATTACKS MERKEL’S COMPLACENCY

Japan’s PM Taro Aso said Angela Merkel did not understand the importance of fiscal policy duiring a slump. He made his pointed remarks in an interview with the FT. It is extremely unusual for a Japanese prime minister to criticise another head of government, which shows the scale of the irritation of the global community at Germany’s refusal to do more, considering that the country has been running extremely strong current account surpluses. Aso said: “the experience of the past 15 years, we know what is necessary, whilst countries like the US and European countries may be facing this sort of situation for the first time...I think there are countries that understand the importance of fiscal mobilisation and there are some other countries that do not – which is why, I believe, Germany has come up with their views.” Sarkozy threat to walk out of the meeting if there is no agreement is widely seen as a typical sign of Sarkozy grandstanding – especially so since the results are being negotiated well before the meeting starts. Le Monde politely calls it dramatising, while the FT makes the point that he is not going to walk out considering that the following day he will receive Nato leaders in Strasbourg. Martin Wolf says on current patterns, crisis will last forever In his FT column, Martin Wolf argues that the G20 will end up with some symbolic politics, but will not decide anything substantial to help the global economy now. He says Germany is behaving irresponsibly. He calculates that Germany, Japan and China have been running accumulated current account surplus of E629bn, which required off- setting deficits in other countries. But these deficits are coming down, and so are the surpluses. While the deficit countries are offsetting the fall in private sector through large deficits, the surplus countries, with the exception of Japan, refrain from massive fiscal boosts in the hope to be bailed out by a global recovery. Wolf concludes that this constellation means that there will be no exit from the crisis, since the deficit countries will not be able to deliver this recovery. He says at least part of the answer has to be changing the policies of surplus countries.

260 Adam Posen on Japan and the US In a brilliant comparative analysis, Adam Posen, writing in the Daily Beast, compares the experiences of various Japanese administrations in the 1990s with the present administration’s approach to bank rescue. The Geithner public-private partnership idea, too clever by half, has actually been tried in Japan, and failed. “I know that the very same self-limiting discussions took place at Okurasho, the Japanese Ministry of Finance circa 1995-1998. And they ended with the same result, a series of bank-recapitalization plans that tried to mobilize private-sector monies and overpay for distressed bank assets without forcing the banks to truly write off the losses. Even though the top Japanese technocrats at the ministry were even more insulated from a weak Diet than the congressionally unconfirmed advisers currently running economic policy for the Obama administration, they did worse. Whatever the political context, countries usually try to end banking crises on the cheap, with a limited public role at first, overpaying for distressed assets and failing to change banks’ behavior, only to have to go back in a couple of years later.” Wolfgang Munchau on the G20 In the first installment of a three part series on post-crisis global economic governance, Wolfgang Munchau says that the G-Groups were in the past useful to take ad hoc decisions – a stimulus in the 1970s, stabilisation of the dollar exchange rate in the 1980s –but the group is unsuited to the management of longer-term projects. The G20 is to large to be effective, too small to be representative, and too intergovernmental for the detailed work that is require to fix globalisation after the crisis. OECD calls on ECB to adopt quantitative easing Euro area inflation was down to 0.6% in March- now definitely undershooting the ECB’s price stability target. The FT reports that the OECD has warned that disinflationary pressures will continue, and has called on the ECB to cut interest rates, and adopt a policy of quantitative easing. German stimulus ineffective according to OECD The OECD has calculated what effect fiscal stimulus will have on GDP (not just how much their headline figure amounts to in GDP growth). For the 2009, the effect will be a meagre 0.5 % (on projections of a fall of GDP in the 5-7% range), which means there is effectively no meaning stimulus. The effect in the US is much better at 1.3% (and even better in relative terms considering that the US economy is not falling quite as fast. In our view, the discrepancy is almost entirely due to the lack of co-ordination in the euro area. The result is that stimulus is shifted towards long-term pork barrel projects, rather than short-term consumption). FT Deutschland writes that the stimulus effect for 2010 will remain small at 0.7%. German unemployment rises The jobs data in Germany are beginning to show the extent of the downturn. Unemployment in February rose even on even on a seasonally unadjustment basis, which means that companies are not hiring. The hardest hit are the young trainees, who are not taken over into full employment after the end of their traineeship, reports FT Deutschland. What seems to be happening is that companies remain massively overstaffed, due to the short-time working arrangement under which staff remain on the

261 payroll in exchange for government subsidies. Hence the complete collapse of new demand. Short-time work is hiding the underlying problem, and once those schemes run out, unemployment totals are likely to explode. More bank rescues likely in Spain El Pais leads its economic section with the story that more bank rescue packages are likely in Spain, follow the weekend rescue of Castille La Mancha, a savings bank. The governor of the Bank of Spain, Miguel Angel Ferandez said if the crisis extends (which it will), it would be necessary to reconstructure several more smaller or medium sized savings banks, and to divert more public funds into bank rescue operations. He said the large banks are ok under any circumstances. In a separate article, the paper quotes OECD chief economist Klaus Schmidt-Hebbel as saying that the Spanish banks are in a relatively strong position, much better than their counterparts in other EU countries. US house prices continue to fall The fall in US house continues, and has now reached a decline of about 30% from the peak. But perhaps more important, as this chart from Calculated Risk shows, it has still a long way to go. Without the support of a credit bubble, there is no reason to expect why house price should not return to the trend. Given or take a little, we are about half-way through – another year or two.

262 PIMCO Investment Outlook Bill Gross | April 2009 The Future of Investing: Evolution or

Revolution? The title of this Outlook, “The Future of Investing,” is a theme that will take the evolving years to resolve, let alone the next few days. Still, PIMCO is an organization that loves a challenge. All of us here today would agree that the answer to both questions will be highly dependent on the evolution of the global economy, and when it comes to those questions PIMCO has excelled because of its long-term secular outlook. It has paid dividends for our clients for over 30 years and it should do so now as well. The fact is, that the future of investing will depend on the long-term future of the global economy – its nominal growth rate and the distribution of that growth between public and private interests. And so we should start at the beginning, or perhaps at the top, of our top-down process – the future of the global economy. I. Future of the Global Economy The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern- day finance is being fast forwarded and reconstituted almost as we speak. 1. Delevering – The prior half-century of leveraging and the development of the amorphous was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated. 2. Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton

263 Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets. 3. Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot- com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years. With the top-down framework for future global economic growth in place, let’s take a look at PIMCO’s outlook for the future of investing – evolution or revolution. II. The Future of Investing Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. Those who believe that capitalism is and will remain a going concern and that risk taking – over the long run – will be rewarded, must recognize that those rewards spring from beginning prices and valuations that correctly anticipate the global economy’s future growth path and volatility. In terms of that old maxim “buy low – sell high,” this means at the minimum that an investor during this period of re-rating must “buy low.”

In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be

264 reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks.1 Home prices have declined a staggering 30% since their peak in late 2006, and have barely kept up with inflation for the last century according to Case-Shiller statistics. Commercial real estate when ultimately mark-to-market over the next several years will likely show similar results. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Government policies will also play an important role, especially insofar as they impact long-standing property rights and capital structures. What I have previously described as a CQ – a common sense quotient – may take precedence over IQ and quantitative analysis in future years. How much of a benefit, for instance, did the renowned risk modeling of some of our major competitors produce over the past several years in terms of their bond funds and derivative-related products as compared to PIMCO’s? We invite comparison, not only of our own risk models, but our collective common sense quotient. What then does common sense tell us about future asset returns? Let’s revisit our previous conclusions on the developing environment for some clues. They include: delevering, deglobalization, reregulation leading to slow global growth, a heightened risk aversion, a distrust of conventional investment model portfolios, and a greater emphasis on surviving as opposed to thriving. If valid, then an investor or an investment committee would likely stress the bird in the hand – as opposed to the one in the bush; stable and secure income – as opposed to uncertain capital gains; a government-regulated utility model – as opposed to innovative yet risky venture capital investments. At current price levels, to cite one example, the current income from corporate bonds is higher and certainly more secure than the dividend income from stocks.2 A return to an era reminiscent of the first half of the 20th century is not unimaginable where stocks were viewed as subordinated income producers with yields exceeding their senior bond companions on the liability ladder. But let me not go too far in suggesting that asset classes near the perimeter of risk have no future. They do if only because they eventually will be priced right. In fact, PIMCO intends to participate in the management of many of them, and as argued previously should be well and healthily positioned to do so. Our recent launch of a global multi-asset fund featuring tail-risk protection is just one example. The potential participation in TALF and other government-sponsored levered structures is another. Still, the tide seems to be going out and as Buffet suggests, all swimmers are being exposed, swimming suits or bare-bottomed naked.

There are a host of investment implications that one can subjectively conclude from this outgoing tide, although they have not been officially endorsed by our upcoming secular forum. It seems to me, though, that one has only to ask what investments were positively affected by the previous long-term cycle of levering, deregulation, and globalization in order to imagine which ones will do poorly as the trends reverse. A short list might read as follows: 1. The Dollar – As the center of structured finance and the shadow banking system, the

265 dollar was bolstered as it sold paper to the rest of the world. To date, its recent strength seems counterintuitive. Weakness may more accurately describe its future. 2. Credit – Lax regulation and increasing leverage squeezed risk premiums and spreads to historically overvalued levels. We are now moving in full reverse. 3. Equity – In addition to the previous conclusions, it is evident in retrospect that narrow risk premiums in credit markets facilitated narrow equity premiums in stocks if only because they seemed cheap by comparison and allowed corporations to borrow cheaply and buy back their own stock. 4. Emerging Market Globalization and lax lending standards re-rated emerging and developing country financial markets to unrealistic levels. Eastern Europe is likely the first to fall. Many of these trends, of course, have now reversed course, direction, and magnitude, and there will come a point where those low and lower prices, as well as the potential for successful policy healing, will favor what is now in disfavor. For now, however, let it be simplistically said that the trend is your friend and that the ad hoc, disjointed and anemic policy responses of government appear to be too little, too late. Investors should therefore favor stable income as opposed to speculative growth or the subordinate liability structures of most private market balance sheets. Shake hands with the government is and has been our motto although the contractual certainty of a government handshake may now be questioned in an increasingly number of marginal areas. Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free- enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies. Thus, while historians might describe these years as an evolution, for those of us living it day-by-day it most assuredly has the feel of a revolution. Much like Irving Fisher’s “permanently higher plateau” of prosperity that was quickly turned on its head in 1929, those who would forecast a “permanently lower valley” of despair might similarly be off the mark. Yet there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.

William H. Gross Managing Director

1 Source: Research Affiliates. 2 Source: Bloomberg. As of 3/30/09, the current yield on the Barclay’s investment-grade credit index is 7.11% and the current yield on the S&P 500 is 3.66%.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outloo k+April+2009+Evolution+or+Revolution+Bill+Gross.htm

266 Playing Solitaire with a Deck of 51, with Number 52 on Offer Paul McCulley: Global Central Bank Focus April 2009 http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/Global+Central+Ba nk+Focus+April+2009+Money+Marketeers+Solitaire+McCulley.htm Thank you, Dana, for that wonderfully kind introduction. It is a deep honor to be speaking before this august club for the fourth time. When I look at the list of speakers over the last 50 years, I am very humbled. As I’ve mentioned before when here, this forum is one of the very few for which I actually write a speech. Not that I actually deliver it the way I write it – that might be congenitally impossible for me! – but because I want to be held accountable, to be forced to both own and eat my own words. And to re-read them again and again, before speaking yet again. Looking Backward In May 2004,1 just before the Fed embarked on a tightening process from 1% Fed funds, my axe to grind was that the conventional wisdom of a constant neutral real Fed funds rate was wrong. Put more wonkishly, as I’m wont to do, I challenged the notion of a constant constant in the Taylor Rule. As all in our profession know, John Taylor conveniently assumed that if the active cyclical terms in his Rule – (1) the gap between actual inflation and targeted inflation and (2) the gap between actual and potential GDP (Gross Domestic Product) – drop out, because inflation is at target and GDP is at potential,2 then the real Fed funds rate should approximate the potential real growth rate of the economy, determined by demographically-driven labor force growth and productivity growth. That’s the constant term in the Taylor Rule, and John assumed it to be constant. I took issue with this concept of the constant in Taylor being constant on two key fronts, one a matter of theory and the other a matter of practicality. On the theoretical front, I have always made a distinction between cash and capital or, in the words of today, the difference between capital and liquidity. I’ve always believed in the capitalist notion of no risk, no reward. Thus, I’ve always struggled with the notion that government-guaranteed cash, or liquidity, if you prefer, should pay a positive after-tax real rate of return. Yes, I believe nominal cash yields should be high enough to offset the inflation rate, which is an implicit tax. And since we tax nominal returns, I have also always believed that the nominal cash yield should be high enough to not only offset the implicit inflation tax, but also the explicit tax on the inflation tax. But I’ve never believed that cash should generate a real after-tax return. Again, no risk, no reward. Cash always trades at par, at least in nominal terms, and that’s a very precious attribute. You can have it if you want it. But if you do, you should not get paid for it, but rather pay for it, in the form of forgoing any after-tax real return. If you want a positive after-tax real return, you gotta take some risk, summarized best, perhaps, by the possibility of your investment trading south of par. Which means that I did and do believe that a positive neutral after-tax real rate of interest does exist, even if it is not constant. But for me, unlike John, it’s the after-tax real rate of interest on high grade, long-term, private sector debt obligations. Back in May 2004, I posited that we should use the long-term swap rates as a proxy – the credit risk of the AA global banking system. (Note I said system, not any individual bank.)

267 That after-tax real rate of return should, I argued, be consistent with John Taylor’s assumption – widely embraced in our profession – that there is a functional connection between potential real growth rates and real interest rates. Thus, John and I were actually in the same analytical church, but we were sitting in very different pews, singing from a different hymn book. We both wanted to tie the neutral real rate to the potential real growth rate of the economy. But he focused on the overnight risk-free rate, which the Fed directly controls, while I focused on the long-term private sector rate, determined by the market. Translated, John was and is a Fed funds man while I was and am a financial conditions man. Which brings me to my practical beef with John: I don’t believe that the neutral rate – whichever one you choose – is constant, but rather time-varying, a function of changes in broad financial conditions. With my colleague, and good friend, Ramin Toloui, I wrote a lengthy essay on this issue this past February.3 No need to replow that plowed ground again tonight, except to say that the financial crisis over the last year proves my point in spades. Be that as it may, most of you thought I was singing way off key back in 2004. And truth be told, I felt that at the margin too, as I recognized my theoretical construct implied a very steep yield curve, an open invitation for entrepreneurial financial operators to lever to the eyeballs into the carry trade. Thus, I openly acknowledged that if the Fed were to embrace my notion of a neutral zero after-tax real rate on cash, then it would be necessary to put regulatory limits on the use of leverage by financial intermediaries. At that time, policy makers were doing just that with the GSEs (Government Sponsored Enterprises), putting limits on growth of their balance sheets. I was encouraged by this. But falsely so, as the next several years demonstrated painfully, with unbridled growth in the Shadow Banking System, a term I coined in August 2007 at Jackson Hole. Recall, Shadow Banks are levered-up intermediaries without access to either FDIC deposit insurance or the Fed’s discount window to protect against runs or stop runs. But since they don’t have access to those governmental safety nets, Shadow Banks do not have to operate under meaningful regulatory constraints, notably for leverage, only the friendly eyes of the ratings agencies. The bottom line is that the Shadow Banking System created explosive growth in leverage and liquidity risk outside the purview of the Fed. Or, as I said here last time in November 2007, again playing the wonk, Shadow Banking both (1) shifted the IS Curve to the right and also (2) made it steeper, or less elastic, if you will. In such a world, Fed rate hikes had little tempering effect on the demand for credit, or if you prefer, little tightening effect on financial conditions. And so it came to pass with the Fed hiking the nominal Fed funds rate to 5¼%, double that which I had forecast in May 2004, as financial conditions refused to tighten in sympathy with the Fed’s desire. I was proven spectacularly wrong. It was the Forward Minsky Journey, as I lectured here last time. And it ended in the Minsky Moment, defined as the moment when bubbly asset prices – made so by the application of ever-greater leverage – crack, kicking off the imperative for deleveraging, notably by the Shadow Banking System. We can quibble about the precise month of the Moment. I pick August 2007, but would not argue strenuously with you about three months either side of that date. Whatever moment you pick for the Moment, we have, ever since, been traveling the Reverse Minsky Journey, violently shifting the IS Curve back to the left, with an even steeper slope. This prospect implied, I argued 16 months ago, that the Fed would inevitably cut the Fed

268 funds rate dramatically, in more-than-mirror image of the hiking process, as financial conditions would refuse to ease in sympathy with the Fed’s intentions. In turn, I forecast that by the next time you invited me here again, the Fed funds rate would likely be at or below the 2½% level that I had so petulantly forecast back in May 2004. I also forecast that I might be contemplating buying a second home, after never having owned more than one. Looking Forward Which brings us to today, with the nominal Fed funds rate pinched against zero. I simply wasn’t bold enough in my forecast last time here. And while I haven’t bought a second home, I am indeed contemplating buying one. I’d like for it to be in a certain city a few hundred miles south of here, but that’s a decision above my power grade, even if below my pay grade. But I digress. What I want to discuss with you tonight is just how simple the solution to our current global economic and financial crisis is on paper, contrasting that to just how difficult and complex the solution is in reality. The present crisis, in textbook terms, is a case of the dual, mutually reinforcing maladies of the Paradox of Thrift and the Paradox of Leverage. In many respects, they are the same disease: what is rational at the individual citizen or firm level, notably to increase savings out of income or to delever balance sheets, becomes irrational at the community level. If everybody seeks to increase their savings by consuming less of their incomes, they will collectively fail, because consumption drives production which drives income, the fountain from which savings flow. Likewise, if everybody seeks to delever by selling assets and paying down debt, or by selling equity in themselves, they can’t, as the market for both assets and equity will go offer-only, no bid. Both of these maladies require that the sovereign go the other way, (1) dis-saving with even more passion than the private sector is attempting to increase savings, thereby maintaining nominal aggregate demand and thus, nominal national income; and (2) becoming the bid side for the levered private sector’s offer-only markets for assets and equity. It really is that simple, at least on paper, as Keynes and Minsky wisely taught. The problem with the desirable textbook solution is that it suffers from constrained political feasibility. Actually, dealing with the Paradox of Thrift is practically much easier, even if less critically important, than dealing with the Paradox of Deleveraging. While Congress may belly-ache and wrangle incessantly about the precise size and composition of fiscal stimulus packages, it is safe to say that but for a few wing nuts, we are all Keynesians now in the matter of cracking the Paradox of Thrift. In contrast there is limited political consensus for using the sovereign’s balance sheet and good credit to break the Paradox of Deleveraging. Put differently, while we may all now be Keynesians, we are not all Minskyians. What is ineluctably needed involves socializing the losses of a banking system – both conventional banking and shadow banking – after the spectacular winnings of the Forward Minsky Journey were privatized. It simply doesn’t sit well politically. In fact, it stinks to high heaven. Thus, to quote my partner Mohamed El-Erian, we must contemplate a scenario in which the economically desirable solution is not politically feasible, while that which is politically feasible may not necessarily be economically desirable. Last Sunday, on 60 Minutes, addressed this nasty reality directly when he said that perhaps the most severe risk we face is the lack of political will.

269 I applaud him, both for doing the interview, speaking directly to the American people, and for speaking the truth. But that doesn’t necessarily mean that the truth will set us free. As Kris Kristofferson wrote long ago, and Janis Joplin made famous, we cannot dismiss out of hand the proposition that freedom is just another word for nothing left to lose. I trust not. But the honest answer is that we honestly don’t know. We are living in a world of hysteresis, in which outcomes become path-dependent, where multiple outcomes are possible, where both policy input and economic/financial outcomes become hostage to serial correlation. How’s that for talking wonkish? Concluding Comment Seriously, let me conclude by once and again quoting Mohamed, who observes that what we are experiencing is not a crisis within the market-driven, democratic capitalist system of most of our careers, but rather a crisis of the system itself. This is not a spat within a marriage, but rather a test of the sustainability of the marriage itself. It’s playing solitaire with a deck of 51. Fortunately, the 52nd card is now on offer, if only policy makers are willing to seize it and play it: Competitive Quantitative Easing (mixed with Credit Easing, in some cases). Usually, when we think of competitive global policies, we think of them in a negative way, as in competitive hiking of tariffs or competitive currency depreciation. While different in execution, these two forms of competition are economically very similar, a competitive attempt to secure a larger piece of a too-small global aggregate nominal demand pie. In contrast, Competitive Quantitative Easing (QE) offers scope for growing the global aggregate demand pie, with an endogenous enforcement mechanism. How so? First, let’s consider what QE is all about. In an oversimplified nutshell, it involves a central bank voluntarily surrendering for a time its independence from the fiscal authority, taking the short-term policy rate to the zero neighborhood, thereby obviating any need to control growth in its balance sheet. For those of us in the room old enough to remember the jargon — and there are more than a few! — QE obviates any need for the central bank to keep “pressure on bank reserve positions,” so as to hit a positive target for its policy rate. It’s not quite that simple, I recognize, for central banks that are allowed to pay interest on excess reserves, as is now the case with the Fed. Conceptually, with the ability to pay interest on excess reserves, a central bank could “go QE” and still peg a positive policy rate. But that’s a technicality without great substance at the moment, notably with the Fed, whose target range for the Fed funds rate is 0–.25%. Close enough to zero for me! Thus, the Fed is practically unconstrained in how big it can grow its balance sheet. Which, in turn, sets the stage for the Fed to voluntarily work corporately with the fiscal authority — Congress and the Treasury — to monetize longer-dated Treasury securities, facilitating a huge expansion in Treasury debt issues at exceedingly low interest rates. Ordinarily, we would be aghast at such a prospect, as every bone in our bodies would scream that such an operation would, in the long run, be inflationary. And our bones would be right. The very reason for central bank independence within the government – but not of the government – is precisely to prevent the central bank from being the handmaiden of the fiscal authority, who inherently wants to spend more than it taxes, running deficits, overheating the economy in an inflationary way. But if and when the dominant macroeconomic problem is a huge output gap, borne of deficient aggregate demand, fattening the fat tail of deflation risk, the argument for strict central bank independence goes into temporary submission. Note, I said temporary, not

270 permanent. There is no more sure way, in the proverbial long run, to destroy the purchasing power of a currency than to let vote-seeking politicians have the keys to the fiat-money printing press. But there can be extraordinary and exigent circumstances when it does make sense for a central bank to work cooperatively, if not subordinately, with the fiscal authority to break capitalism’s inherent debt-deflation pathologies. Indeed, none other than Chairman Bernanke made the case forcefully in May 2003, speaking in Japan about Japan (my emphasis, not his): The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say “no” to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty. Thus, the Fed’s announcement just yesterday that the central bank would be buying up to $300 billion of Treasuries, primarily in the two- to ten-year maturity range, is fully consistent with both what Mr. Bernanke said six years ago and with evident debt-deflationary pathologies, both here in the and around the world. Indeed, what intrigues me the most right now is the concept of global Competitive QE, rather than competitive tariff hiking or competitive currency depreciation. If all countries, or most major countries anyway, “go QE,” then the global game changes from fighting for bigger slices of a too-small global nominal aggregate demand pie to actually correlated efforts to enlarge the nominal pie. Note I said “correlated” not “coordinated.” There need not necessarily be any explicit coordination between countries, because those that choose not to play will likely experience a rise in their real effective exchange rate, a deflationary impulse to their underutilized economies. Thus, there need not be an explicit enforcement mechanism to propel Competitive QE, merely individual countries acting in their own best interest. This is the best kind of cooperative behavior, explicitly because it need not be coordinated, but rather brought about by, you guessed it, Adam Smith’s invisible hand! To be sure, the ECB (European Central Bank) has difficulty with the concept of QE, in part because Euroland represents monetary union without political union and, thus, fiscal policy union. Put differently, if the ECB wants to be accommodative of more Keynesian fiscal policy stimulus, de facto monetizing it, what fiscal authority does the ECB call to cut the deal? It’s an open question, but my sense is that about ten big figures higher from here for the Euro, the ECB would find the answer! Thank you, again, for the great honor of being here tonight. Paul McCulley Managing Director [email protected]

271

Reading Krugman March 31, 2009 by TIE I think Paul Krugman has a blind spot. Yes, the Nobel Prize winning, Princeton University economist, and NY Times columnist Paul Krugman. I saw evidence of it in last week’s debate among economists over Treasury Secretary Geithner’s bank rescue plan, the so-called Public- Private Investment Program (PPIP). In brief, under PPIP private investors would receive non-recourse federal loans to buy toxic assets from banks. The goal is to increase lending so as to reduce unemployment. (Was that too brief? If so, the dots are connected in Brad DeLong’s clever FAQ, and well-crafted numerical examples can be found here and here.) The cynical won’t be surprised that the plan is similar to one pitched to the Treasury Department by institutional investors, or that some banks may be gaming the system. The plan is also similar to one proposed by Harvard Law Professor Lucian Bebchuk. While the White House press corps was not terribly interested in PPIP, it lit up the economics blogosphere. MIT’s Ricardo Caballero thinks the plan “is well-conceived and deserves to be supported.” Johns Hopkins economics professor Christopher Carroll finds savvy the way it induces private investors to price assets. NYU’s is cautiously optimistic. Many other sharp economists view the approach favorably, including Mark Thoma (Univ. of Oregon) and Brad DeLong (Berkeley). There is a list of equally impressive opponents. Jeffrey Sachs of Columbia University thinks PPIP provides a one-way bet: heads investors win, tails the government loses. Financial Times columnist Martin Wolf calls PPIP a “vulture fund relief scheme.” MIT Sloan School’s Simon Johnson worries in a well thought out LA Times opinion piece that without nationalization banks will not sell enough of their toxic assets. Finally, Paul Krugman is filled with despair over PPIP, calling it a “waste of taxpayer money.” He believes Obama is “squandering [the] credibility” he needs to win support for bank nationalization. (Krugman once worried that nationalization might be too expensive: Times change and opinions with them.) As the liberal economist of record, Krugman’s critique of PPIP received a lot of press much of it uncritical. I think a little more critical reading is warranted, that his cry for nationalization now misses something crucial. Namely, he has a blind spot for the political and implementation risks and challenges. As John Heilemann wrote in New York Magazine, “Getting the economics right may be devilishly difficult—but the politics are even trickier, and just as crucial.” One cannot be president and apolitical. Incentives and risks of governance compel Obama to think beyond economics even when considering economic issues. He is, no doubt, sensitive to his political capital, the issues over which to allocate it, and Congress’ appetite for alternatives to PPIP (like nationalization), among others. Brad DeLong points out that Obama does not easily achieve the 60 votes in the Senate he would need to take bolder action. (PPIP requires no additional congressional approval.) “Do we want to revive our economy, or do

272 we want to punish the bankers?” DeLong asks, “I don’t agree that we can do both.” Matthew Yglesias elaborates, “Doing something…without an additional vote makes it more likely that they can ask Congress to cast those tough votes on the budget and on health care rather than on bank bailouts.” According to Obama aides, “Krugman’s suggestion that the government could take over the banking system is deeply impractical.” (Newsweek) Impractical politically but also because nationalization would require expertise and staff the Treasury Department does not yet possess. Therefore, like it or not, Geithner needs the banking industry’s cooperation to increase lending. He nearly lost it during the uproar over the AIG bonuses. He’d lose it for sure with a nationalization plan. If nationalizing banks is a political non-starter then attempting to do so would destroy the credibility Krugman feels Obama is squandering with PPIP. Therefore, right now PPIP may be the only step forward. After all, a bank balance sheet has only two sides: assets and liabilities. Nationalization works the latter, PPIP the former. My critique of Krugman is brash. He has a Nobel Prize while I have a Certificate of Appreciation from my employer. Yet it is hardly ever wise to consider an expert’s opinion thoughtlessly. Even experts can be poor sources of expertise. Even Nobel laureates make mistakes (like this or this). Whether you’re reading Krugman or TIE, it is not wise to reflexively trust what you read. You can take that to the bank. © The Incidental Economist (TIE) http://thefinancebuff.com/2009/03/reading-krugman.html

273 Mar 31, 2009 Are ABX Derivatives Prices An Accurate Measure of Subprime RMBS and CDO Valuations? Issue: Generally speaking, the less repackaged a security, the higher is the degree of cash- flow pass-through from underlying credits (e.g. pro-rata pass-throughs where each tranche receives the same share of the underlying cash-flow). The further up the repackaging chain, and the more mixed the collateral in a structure, the more the value of a security depends on credit enhancement, implied leverage of junior tranches, and market risk than on pass-through from underlying credits (see also Adrian/Shin) Moreover, CDOs were overvalued to start with based on their large undiversifiable systemic risk component in senior tranches resulting from cash flow prioritization--> current low valuations are more realistic (Coval et al., Harvard) o BIS (Fender/Scheicher): Declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007--> PPIP/TARP is a good program in that it brings back liquidity. o RGE: Markit index shows that as of December 2008 mark-to-market (MTM) losses for the entire 1.4 trillion subprime RMBS universe from 2005-2007 implied by the ABX derivatives index are $700bn (i.e. 50%) which is roughly consistent with expected credit losses on 2006/07 vintages calculated from a further 17% fall in house prices (and high oil prices) as estimated by Sherlund (2008). Shin/Hatzius (2008) and Hatzius (2008) show similar comparability between ABX and other loss estimates. o cont.: Moreover, cash flow shortfall from subprime loans in foreclosure plus serious delinquencies is 19% as of December 2008 according to OCC data--> subprime RMBS residuals and mezzanine tranches are wiped out at these levels (ie. first 20% of notional) and ABS CDOs comprised of mezzanine RMBS tranches are worthless and expected to remain that way. o Bank of England Financial Stability report: "Credit losses from the turmoil are unlikely to ever rise to levels implied by current market prices [e.g. ABX index] unless there is a significant deterioration in fundamentals, well beyond the slowdown currently anticipated. That is because prices are likely to reflect substantial discounts for illiquidity and uncertainty that have emerged as markets have adjusted but which should ease over time.” o Tett, auditors: If AAA RMBS and CDO securities are so obviously underpriced, why don't bargain hunters step in? Or the Bank of England itself? o Nov 18, FT: John Paulson who made a fortune shorting the subprime ABX index in 2007, told his investors he started to buying troubled MBS that dropped to record low

274 values after Hank Paulson dropped plans to buy up troubled assets but focus on recapitalizing banks instead (see Geithner's Financial Stability Plan) o Parisi-Capone (RGE): Merrill sells first 5% loss on $30.6bn portfolio to Lone Star for $1.7bn or around 5 cents on the dollar while retaining any losses above $1.7bn--> This is reminiscent of CDO structure where Lone Star buys equity/low mezzanine tranche for 5 cents on the dollar--> ABX.HE.BBB- trades at 5.5 cents on the dollar; latest available TABX equity tranche price at 5.25 cents on the dollar (Markit)--> Current ABS CDO market values consistent with ABX pricing. Merrill actually gained from transaction so there is no fire sale involved. o Daniel Gros: The non-recourse feature of U.S. mortgages translates in a de facto long put option for the mortgage owner and short put option for the lender. As long as house prices rise, the option is worthless but the more house prices fall, and the higher indebted the borrower, the higher the borrower's incentive to walk away (i.e. exercise the put)--> when the payout costs of this put option are taken into account, U.S. private-label mortgage assets are indeed nearly worthless. o BIS Joint Forum: There is little upside to CDOs of ABS or CDO^2 as there were not even enough subprime deals in H2 2007 to create a new ABX.HE 08-1 index (each ABX index vintage refers to 20 subprime RMBS deals closed in the prior six months.)--> TABX derivatives index that tracks CDOs is worthless including the most senior tranches. o BIS: The credit risk (i.e. probability of default PD and expected loss EL mappings) of corporate bonds and tranched securities such as RMBS and CDOs are not directly comparable [this is the rating agencies' mistake]--> tranched securities are inherently leveraged and will therefore experience larger value losses with changes in either PD or EL of underlying assets. Correlation complicates the picture further. Structured and tranched securities need own PD/EL matrices and rating scale, as acknowledged in Congress hearings. http://www.rgemonitor.com/691/Securitization,_Structured_Finance,_and_Derivatives?cluste r_id=9804

275 Opinion March 30, 2009 America the Tarnished By PAUL KRUGMAN Ten years ago the cover of Time magazine featured Robert Rubin, then Treasury secretary, Alan Greenspan, then chairman of the Federal Reserve, and , then deputy Treasury secretary. Time dubbed the three “the committee to save the world,” crediting them with leading the global financial system through a crisis that seemed terrifying at the time, although it was a small blip compared with what we’re going through now. All the men on that cover were Americans, but nobody considered that odd. After all, in 1999 the United States was the unquestioned leader of the global crisis response. That leadership role was only partly based on American wealth; it also, to an important degree, reflected America’s stature as a role model. The United States, everyone thought, was the country that knew how to do finance right. How times have changed. Never mind the fact that two members of the committee have since succumbed to the magazine cover curse, the plunge in reputation that so often follows lionization in the media. (Mr. Summers, now the head of the National Economic Council, is still going strong.) Far more important is the extent to which our claims of financial soundness — claims often invoked as we lectured other countries on the need to change their ways — have proved hollow. Indeed, these days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along. It’s painful now to read a lecture that Mr. Summers gave in early 2000, as the economic crisis of the 1990s was winding down. Discussing the causes of that crisis, Mr. Summers pointed to things that the crisis countries lacked — and that, by implication, the United States had. These things included “well-capitalized and supervised banks” and reliable, transparent corporate accounting. Oh well. One of the analysts Mr. Summers cited in that lecture, by the way, was the economist Simon Johnson. In an article in the current issue of The Atlantic, Mr. Johnson, who served as the chief economist at the I.M.F. and is now a professor at M.I.T., declares that America’s current difficulties are “shockingly reminiscent” of crises in places like Russia and Argentina — including the key role played by crony capitalists. In America as in the third world, he writes, “elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.” It’s no wonder, then, that an article in yesterday’s Times about the response President Obama will receive in Europe was titled “English-Speaking Capitalism on Trial.” Now, in fairness we have to say that the United States was far from being the only nation in which banks ran wild. Many European leaders are still in denial about the continent’s economic and financial troubles, which arguably run as deep as our own — although their

276 nations’ much stronger social safety nets mean that we’re likely to experience far more human suffering. Still, it’s a fact that the crisis has cost America much of its credibility, and with it much of its ability to lead. And that’s a very bad thing. Like many other economists, I’ve been revisiting the Great Depression, looking for lessons that might help us avoid a repeat performance. And one thing that stands out from the history of the early 1930s is the extent to which the world’s response to crisis was crippled by the inability of the world’s major economies to cooperate. The details of our current crisis are very different, but the need for cooperation is no less. President Obama got it exactly right last week when he declared: “All of us are going to have to take steps in order to lift the economy. We don’t want a situation in which some countries are making extraordinary efforts and other countries aren’t.” Yet that is exactly the situation we’re in. I don’t believe that even America’s economic efforts are adequate, but they’re far more than most other wealthy countries have been willing to undertake. And by rights this week’s G-20 summit ought to be an occasion for Mr. Obama to chide and chivy European leaders, in particular, into pulling their weight. But these days foreign leaders are in no mood to be lectured by American officials, even when — as in this case — the Americans are right. The financial crisis has had many costs. And one of those costs is the damage to America’s reputation, an asset we’ve lost just when we, and the world, need it most. http://www.nytimes.com/2009/03/30/opinion/30krugman.html?_r=1&th&emc=th

277

From the magazine issue dated Apr 6, 2009 Obama’s Nobel Headache Paul Krugman has emerged as Obama's toughest liberal critic. He's deeply skeptical of the bank bailout and pessimistic about the economy. Why the establishment worries he may be right. Evan Thomas Traditionally, punditry in Washington has been a cozy business. To get the inside scoop, big-time columnists sometimes befriend top policymakers and offer informal advice over lunch or drinks. Naturally, lines can blur. The most noted pundit of mid- 20th-century Washington, Walter Lippmann, was known to help a president write a speech—and then to write a newspaper column praising the speech. Paul Krugman has all the credentials of a ranking member of the East Coast liberal establishment: a column in The New York Times, a professorship at Princeton, a Nobel Prize in economics. He is the type you might expect to find holding forth at a Georgetown cocktail party or chumming around in the White House Mess of a Democratic administration. But in his published opinions, and perhaps in his very being, he is anti- establishment. Though he was a scourge of the Bush administration, he has been critical, if not hostile, to the Obama White House. In his twice-a-week column and his blog, Conscience of a Liberal, he criticizes the Obamaites for trying to prop up a financial system that he regards as essentially a dead man walking. In conversation, he portrays Treasury Secretary Tim Geithner and other top officials as, in effect, tools of Wall Street (a ridiculous charge, say Geithner defenders). These men and women have "no venality," Krugman hastened to say in an interview with NEWSWEEK. But they are suffering from "osmosis," from simply spending too much time around investment bankers and the like. In his Times column the day Geithner announced the details of the administration's bank-rescue plan, Krugman described his "despair" that 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." If you are of the establishment persuasion (and I am), reading Krugman makes you uneasy. You hope he's wrong, and you sense he's being a little harsh (especially about Geithner), but you have a creeping feeling that he knows something that others cannot, or will not, see. By definition, establishments believe in propping up the existing order. Members of the ruling class have a vested interest in keeping things pretty much the way they are. Safeguarding the status quo, protecting traditional institutions, can be healthy and useful, stabilizing and reassuring. But sometimes, beneath the pleasant murmur and tinkle of cocktails, the old guard cannot hear the sound of ice cracking. The in crowd of any age can be deceived by self- confidence, as Liaquat Ahamed has shown in "Lords of Finance," his new book about the folly

278 of central bankers before the Great Depression, and David Halberstam revealed in his Vietnam War classic, "The Best and the Brightest." Krugman may be exaggerating the decay of the financial system or the devotion of Obama's team to preserving it. But what if he's right, or part right? What if President Obama is squandering his only chance to step in and nationalize—well, maybe not nationalize, that loaded word—but restructure the banks before they collapse altogether? The Obama White House is careful not to provoke the wrath of Krugman any more than necessary. Treasury officials go out of their way to praise him by name (while also decrying the bank-rescue prescriptions of him and his ilk as "deeply impractical"). But the administration does not seek to cultivate him. Obama aides have invited commentators of all persuasions to the White House for some off-the-record stroking; in February, after Krugman's fellow Times op-ed columnist David Brooks wrote a critical column accusing Obama of overreaching, Brooks, a moderate Republican, was cajoled by three different aides and by the president himself, who just happened to drop by. But, says Krugman, "the White House has done very little by way of serious outreach. I've never met Obama. He pronounced my name wrong"—when, at a press conference, the president, with a slight note of irritation in his voice, invited Krugman (pronounced with an "oo," not an "uh" sound) to offer a better plan for fixing the banking system. It's possible that Krugman is a little wounded by this high-level disregard, and he said he felt sorry about criticizing officials whom he regards as friends, like White House Council of Economic Advisers chair Christina Romer. But he didn't seem all that sorry. Krugman is having his 15 minutes and enjoying it, although at moments, as I followed him around last week, he seemed a little overwhelmed. He is an unusual mix, at once nervous, shy, sweet and fiercely sure of himself. He enjoys his outsider's power: "No one has as big a megaphone as I have," he says. "Aside from the world going to hell, it's great." He is in much demand on the talk-show circuit: PBS's "The NewsHour" and "Charlie Rose" on Monday last week, ABC's "This Week With George Stephanopoulos" this past Sunday. Someone has even cut a rock video on YouTube: "Hey, Paul Krugman, why aren't you in the administration?" A singer croons, "Hey, Paul Krugman, where the hell are you, man? We need you on the front lines, not just writing for The New York Times." (And the cruel chorus: "All we hear [from Geithner] is blah, blah, blah.") Krugman is not likely to show up in an administration job in part because he has a noble—but not government-career-enhancing—history of speaking truth to power. With dry humor, he once told a friend the story of attending an economic summit in Little Rock after Bill Clinton was elected president in 1992. As the friend recounted the story to NEWSWEEK, "Clinton asked Paul, 'Can we have a balanced budget and health-care reform?'—essentially, can we have it all? And Paul said, 'No, you have to be disciplined. You have to make choices.' Then Paul says to me (deadpan), 'That was the wrong answer.' Then Clinton turns to Laura Tyson and asks the same questions, and she says, 'Yes, it's all possible, you have your cake and eat it too.' And then [Paul] says, 'That was the right answer'." (Tyson became chairman of Clinton's Council of Economic Advisers; she did not respond to requests to comment.) Krugman confirmed the story to NEWSWEEK WITH a smile. "I'm more tolerant now," he says. But at the time, he was bitter that he was kept out of the Clinton administration. Krugman has a bit of a reputation for settling scores. "He doesn't suffer fools. He doesn't like hauteur in any shape or form. He doesn't like to be f––ked with," says his friend and colleague Princeton history professor Sean Wilentz. "He's not a Jim Baker; he's not that kind of Princeton," says Wilentz, referring to the ur-establishment operator who was Reagan's secretary of the Treasury and George H.W. Bush's secretary of state. But Wilentz went on to

279 say that Krugman is "not a prima donna, he wears his fame lightly," and that Krugman is not resented among his academic colleagues, who can be a jealous lot. Krugman's fellow geniuses sometimes tease him or intentionally provoke his wrath. At an economic conference in Tokyo in 1994, Krugman spent so much time berating others that his friends purposely started telling him things that they knew weren't true, just to see him get riled up. "He fell for it every time," said a journalist who was there but asked not to be identified so she could speak candidly. "You'd think that eventually, he would say, 'Oh, come on, you're just jerking my chain'." Krugman says he doesn't recall the incident, but says it's "possible." Born of poor Russian-immigrant stock, raised in a small suburban house on middle-class Long Island, Krugman, 56, has never pretended to be in the cool crowd. Taunted in school as a nerd, he came home one day with a bloody nose—but told his parents to stay out of it, he would take care of himself. "He was so shy as a child that I'm shocked at the way he turned out," says his mother, Anita. Krugman says he found himself in the science fiction of Isaac Asimov, especially the "Foundation" series—"It was nerds saving civilization, quants who had a theory of society, people writing equations on a blackboard, saying, 'See, unless you follow this formula, the empire will fail and be followed by a thousand years of barbarism'." His Yale was "not George Bush's Yale," he says—no boola-boola, no frats or secret societies, rather "drinking coffee in the Economics Department lounge." Social science, he says, offered the promise of what he dreamed of in science fiction—"the beauty of pushing a button to solve problems. Sometimes there really are simple solutions: you really can have a grand idea." Searching for his own grand idea (his model and hero is ) Krugman became one of the top economists in the country before he turned 30. He took a job on the Council of Economic Advisers in the Reagan administration at the age of 29. His colleague and rival was another brilliant young economist named Larry Summers. The two share a kind of edgy braininess, but they took different career paths—Summers as an inside player, working his way up to become Treasury secretary under Clinton and president of Harvard, then Obama's chief economic adviser. Krugman preferred to stay in the world of ideas, as an "irresponsible academic," he puts it, half jokingly, teaching at Yale, MIT, Stanford and Princeton. In 1999 he almost turned down the extraordinary opportunity to become the economic op-ed columnist for The New York Times. He was afraid that if he became a mere popularizer he'd blow his shot at a Nobel Prize. Last October, he won his Nobel. Most economists interviewed by NEWSWEEK agreed that he richly deserved it for his pathbreaking work on global trade—his discovery that traditional theories of comparative advantage between nations often do not work in practice. He was stepping into the shower at a hotel when his cell phone rang with the news that he had achieved his life's ambition. At first, he thought the call might be a hoax. His wife Robin's reaction, once the initial thrill wore off, was, "Paul, you don't have time for this." He is, to be sure, insanely busy, producing two columns a week, teaching two courses and still writing books (his latest is "The Return of Depression Economics and the Crisis of 2008"). He posts to his blog as many as six times a day. Last Thursday morning, he was gleeful because he was able to thump a blogger who insisted, wrongly, that Keynes did not use much math in his work. In class that day, discussing global currency exchange with a score of undergraduates, he was gentle, bemused, a little absent-minded, occasionally cracking mordant jokes (on trade with China: "They give us poisoned products, we give them worthless paper"). He says he plans to reduce his teaching load a little, and his colleagues say his best academic work is behind him. "His academic career culminated with him winning the prize," says his Princeton colleague

280 and friend Gene Grossman. "He's not that engaged anymore with academic research. He has a public career now. That's what he views as his main avocation now—as a public intellectual." He has made enemies in the economics community. "He's become more and more outspoken. A lot of what he says is wrong and not considered," says Daniel Klein, professor of economics at George Mason University. A longtime mentor, MIT Nobel laureate , who taught Krugman as a grad student, remembers him as "very unassertive, mild-mannered. One thing he still has is a smile that plays around his face when he's talking, almost like he's looking at himself and thinking, 'What am I doing here?' " But, Solow added, "when he started writing his column, his personality adapted to it." Academic life, bolstered by book and lecture fees, has been lucrative and comfortable. Krugman and Robin (his second wife; he has no children) live in a lovely custom-built wood, stone and glass house by a brook in bucolic Princeton. Krugman pointed out that unlike some earlier Nobel Prize winners, he has not asked for a better parking place on campus. (He was not kidding.) Arriving at the Times just before Bush's election in 2000, he was soon writing about politics and national security as well as economics, sharply attacking the Bush administration for invading Iraq. Someone at the Times—Krugman won't say who—told him to tone it down a bit and stick to what he knew. "I made them nervous," he says. In 2005, Times ombudsman Daniel Okrent wrote, "Op-Ed columnist Paul Krugman has the disturbing habit of shaping, slicing and selectively citing numbers in a fashion that pleases his acolytes but leaves him open to substantive assaults." Krugman says that Okrent "caved" to the criticism of conservative ideologues who were out to get him. ("I tried to be an honest broker," says Okrent. "But when someone challenged Krugman on the facts, he tended to question the motivation and ignore the substance.") It's true that during the Bush era Krugman was the target of cranks and kooks, but it is also true that in areas outside his expertise he sometimes gets his facts wrong (his record has improved lately). Krugman is unrepentant about his Bush bashing. "I was more right in 2001 than anyone in the pundit class," he says. Ideologically, Krugman is a European Social Democrat. Brought up to worship the New Deal, he says, "I am not overflowing with human compassion. It's more of an intellectual thing. I don't buy that selfishness is always good. That doesn't fit the way the world works." Krugman is particularly passionate about the growing gap between rich and poor. Last week he raced down to Washington to testify on the subject before the House Appropriations Committee. In the 2008 election, Krugman first leaned toward populist John Edwards, then Hillary Clinton. "Obama offered a weak health-care plan," he explains, "and he had a postpartisan shtik, which I thought was naive." Krugman generally applauds Obama's efforts to tax the rich in his budget and try for massive health-care reform. On the all-important questions of the financial system, he says he has not given up on the White House's seeing the merits of his argument—that the government must guarantee the liabilities of all the nation's banks and nationalize the big "zombie" banks—and do it fast. "The public wants to trust Obama," Krugman says. "This is still Bush's crisis. But if they wait, Obama will be blamed for a fair share of the problem." Obama administration officials are dismissive of Krugman's arguments, although not on the record. One official made the point that pundits can have a 60 percent chance of being right— and just go for it. They have nothing to lose but readers, and Krugman's many fans have routinely forgiven his wrong calls. The government does not have the luxury of guessing wrong. If Obama miscalculates, he could truly crash the stock market and drive the economy into depression. Krugman's suggestion that the government could take over the banking system is deeply impractical, Obama aides say. Krugman points to the example of Sweden,

281 which nationalized its banks in the 1990s. But Sweden is tiny. The United States, with 8,000 banks, has a vastly more complex financial system. What's more, the federal government does not have anywhere near the manpower or resources to take over the banking system. Krugman swats away these arguments, though he acknowledges he's not a "detail" man. He believes he is fighting a philosophical battle against the plutocrats and money-changers. Although he thinks Geithner has been captured by Wall Street, he has hope for Summers. "I have a strong suspicion that if Larry was on the outside and I was on the inside, we'd be reversing roles," he says, but adds, "Well, not entirely. Larry has more faith in markets. I'm more of an interventionist." Last week Krugman and Summers were "playing phone tag." ("It doesn't necessarily mean that much," says Krugman. "We've known each other all our adult lives." Summers initiated the call; Krugman suspects he wanted to talk him through the administration's plan.) In Friday's column, Krugman tweaked Summers directly for his faith in markets, though he grudgingly gave the Obamaites credit for calling for extensive regulation of the financial world. Krugman thinks that Obama needs some kind of "wise man" to advise him and mentions Paul Volcker, the former Fed chairman who tamed inflation for Reagan and now heads an advisory panel for Obama. How about Krugman himself for that role? "I'm not a backroom kind of guy," he says, schlumped over in his Princeton office, which overflows with unopened mail. He describes himself as a "born pessimist" and a "natural rebel." But he adds, "What I have is a voice." That he does. With Pat Wingert, Daniel Stone, Michael Hirsh and Dina Fine Maron

March 28, 2009, 4:43 pm THE MAGAZINE COVER EFFECT By Paul Krugman I’ve long been a believer in the magazine cover indicator: when you see a corporate chieftain on the cover of a glossy magazine, short the stock. Or as I once put it (I’d actually forgotten I’d said that), “Whom the Gods would destroy, they first put on the cover of Business Week.” There’s even empirical evidence supporting the proposition that celebrity ruins the performance of previously good chief executives. Presumably the same effect applies to, say, economists. You have been warned.

282 ft.com/maverecon Willem Buiter's The G20: expect nothing, hope for the best and prepare for the worst MARCH 29, 2009 8:11PM The Group of Twenty (G20) meetings that start on April 2, ought to have started on April 1 instead. That way, when nothing but hot air emanates from the Docklands venue, at least the organisers of the event will be able to claim it was all an April fool’s joke. In the unlikely event that the assembled dignitaries get serious and decide to negotiate as if the well-being of mankind hung in the balance - as it does - I have a short agenda to propose. (1) A true commitment to maintain an open global trading environment The summit of finance ministers and central bankers from the (G20) in the English town of Horsham on 13-14 March 2009, concluded with a statement that contained the following sentence: “We commit to fight all forms of protectionism and maintain open trade and investment”. Let’s just hope they are more successful that they were for the past year and a half, or even since their mid-November 2008 meeting. The hypocrisy and mendaciousness of the G20 when it comes to protectionism are breathtaking. The World Bank published a Report on March 2, 2009, which shows that seventeen of the 19 developing and industrial nations (plus the EU) have introduced restrictive trade practices since pledging (again!) in mid-November to avoid protectionism. The G20 includes the Group of Seven industrialised countries — Britain, Canada, France, Germany, Italy, Japan and the United States — and 12 developing countries and emerging markets — Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, South Africa, Saudi Arabia, South Korea and Turkey — as well as the European Union. Since the financial crisis started in August 2007, officials in the countries monitored by the World Bank (including but not restricted to the G20 members) have proposed and/or implemented roughly 78 trade measures. Of these 66 involved trade restrictions and 12 trade liberalising measures; 47 trade-restricting measures were implemented. Scanning the World Bank study (I did not have access to the raw data), it is clear that all the G7 countries (and the EU) imposed protectionist measures. So did Argentina, Australia, Brazil, China, India, Indonesia, Russia and South Korea. There must be two more among the four G20 countries not named in the Report (Mexico, South Africa, Saudi Arabia and Turkey) that did impose trade restrictions — my guess would be Mexico and Turkey. To avoid screwing up the world economy any further, it is not enough to abstain from actions that violate WTO rules. Many WTO-compliant actions are deeply protectionist. The Buy American provisions in the American Recovery and Reinvestment Act of 2009 (Recovery Act) are an example: “SEC. 1605. USE OF AMERICAN IRON, STEEL, AND MANUFACTURED GOODS. (a) None of the funds appropriated or otherwise made available by this Act may be used for a project for the construction, alteration, maintenance, or repair of a public building or public work unless all of the iron, steel, and manufactured goods used in the project are produced in the United States.”

283 This is protectionism of the most blatant kind. Another example of WTO-compliant protectionism is ‘bound tariffs’, which are the maximum tariff rates that WTO members agree to. These can be high for developing countries. Raising the actual tariff level does not breach any WTO obligations as long as the new higher tariff level does not exceed the bound level. For instance, India has actual tariff rates for manufactured goods in the 10 percent to 12 percent range, but has bound rates in the 40 percent to 60 percent range. Another potentially WTO-compliant set of protectionist measures fall in the Anti-Dumping category - used extensively by the advanced industrial countries and by India. Every country whose banking sector has got into trouble to the extent that financial support actions had to be mounted, underwritten ultimately by the Treasury and the tax payer, has indulged in financial protectionism. Governments have extracted promises of additional lending from banks suckling at the public teat (the UK and the Netherlands are examples). It is clear that the expectation is that this lending will be to domestic enterprises and households. It is therefore not surprising that cross-border leverage in the banking sector is declining much faster than overall leverage. Much of this financial protectionism is the politically unavoidable consequence of the use of national fiscal resources to bail out banks and shadow banks. In (2c) below, I propose that to avoid financial protectionism from spreading beyond what we will have to live with because of the absence of supranational fiscal authorities or international fiscal burden sharing rules, permissible restrictions on cross- border banking activity be explicitly regulated with reference to macro-prudential stability criteria. (2) A true commitment to tackle the fiscal stimulus and macro-prudential financial regulation issues as part of an integrated package There is no point in the US and UK authorities clamouring for a larger global fiscal stimulus until it is recognised that the global financial system that grew up since about 1980 has collapsed and cannot be patched up, let alone reconstructed to re-capture its 2006 state of glory, with just a light trimming of a few excesses. There is a huge problem in the US and in the UK particularly caused by the inability/unwillingness of the authorities to recognise that we have to re-think 39 years of financial sector de-regulation. In the US, Larry Summers and Tim Geithner were major players, during the Clinton Presidency, in creating the financial structures that have now collapsed. In the UK, distortions and excesses were allowed or even encouraged to develop on an unprecedented scale under the stewardship of Gordon Brown as Chancellor of the Exchequer. Clearly, these developments had started earlier, under the governments of Margaret Thatcher and John Major, but the cult of light-touch regulation or even no-touch regulation (or self-regulation) reached its most extreme form when Gordon Brown was Chancellor of the Exchequer. It is unlikely that those who put together the faulty design are the right persons to clean up the mess after the collapse of the system, and to lead the construction of a new banking and financial system, domestically and globally. The theory that only those who screwed it up can sort it out has no evidence to support it, but continues to exercise a powerful influence. In the case of Long Term Capital Management, the geniuses who brought the to the edge of collapse were allowed to stay on (with an equity stake) to manage down the portfolio, something that could have been done by a handful of ABD graduate students in finance from any top university. Hank Paulson’s tenure at the US Treasury is widely judged to have been a failure.

284 It doesn’t really matter at this stage whether it is selective blindness (cognitive capture) or more conventional forms of capture that have made the officials in charge of the rescue of US financial intermediation as ineffective from the perspective of the macroeconomy and as attentive to the wishes and demands of the financial establishment as they have been since the crisis started. The result is a dysfunctional non-system that continues to enrich a few while failing to serve the many. Let me suggest the following as a minimal global regulatory reform agenda. (2a) All systemically important financial institutions and markets will have to be regulated according to the risks they pose to the financial system and the real economy. The legal form of these institutions is irrelevant. Failure to pursue the macro-prudential regulation of institutions, markets, trading platforms and other financial infrastructure according to the systemic risk they pose, and according to this risk alone, will result in another round of cross- legal-entity regulatory arbitrage, even within a given national regulatory jurisdiction. (2b) This regulation has to be done at the global level. Failure to do so will result in another round of cross-border regulatory arbitrage resulting in the kind of global soft-touch regulation that was at the root of many of the excesses that were allowed to sprout and propagate during the Great Financial Deregulation (1979-2007). (2c) There has to be an agreement to restrict the scope of systemically important cross-border banking and other financial activity to what can be effectively regulated and supervised, supported with central bank liquidity and bailed out fiscally. As an example, cross-border bank branches would be ruled out, except in a region like the Euro Area, where there is a supranational central bank, provided there is a single Euro-Area banking supervisor and regulator for cross-border banks and shadow banks, and provided the Euro Area creates either a supranational fiscal authority, a fund or a fiscal burden sharing rule for recapitalising cross-border banks (and the Eurosystem). There can be cross-border bank subsidiaries, but they would have to be independently capitalised, with independent, dedicated liquidity, managed at arm’s length from the parent and supervised and regulated by the host country. For centralised management by the parent and partial or full pooling of capital and liquidity of parent and subsidiaries, it is necessary that the parent and each of the subsidiaries (1) be regulated and supervised by the same regulator/supervisor; (2) have access to the lender-of-last-resort-and market-maker-of-last- resort-facilities of the same central bank; and (3) have the same fiscal authority, facility or arrangement as a back-stop source of capital and other financial support. (2d) There has to be international agreement on restricting the size and scope of financial institutions. Aggressive enforcement of anti-monopoly policy and the imposition of capital requirements that are increasing in the size of a bank (for given leverage and risk) would be two obvious tools for achieving this. (2e) Financial innovation (that is, the introduction of new instruments, services, products and institutions) should be regulated the way the FDA regulates pharmaceuticals. The required testing, evaluations, trials and pilot schemes should be regulated at the global level, to avoid innovation arbitrage. Economies of scale and scope in banking and shadow banking are limited. The reasons banks want to be huge and like to be involved in a wide range of financial services, products and activities are (1) the desire to exploit monopoly power; (2) the desire to shelter systemically unimportant but profitable activities under the umbrella of institutional support given to the

285 banks by the state because of their systemically important (narrow banking) activities; and (3) the attractions of exploiting conflict-of-interest situations. Once these financial regulatory issues are agreed, a global fiscal stimulus, modulated according to (1) national fiscal spare capacity and (2) the national sustainable current account imbalance. This means no further fiscal stimulus for the US, and preferably a reduction in what has already been announced. The US political system does not today permit a credible commitment to future tax increases or public spending cuts. The government deficits of 14 percent of GDP or more that are likely in the US even without any further discretionary stimulus are likely to be more than the markets are willing to tolerate and absorb, except at a much weaker external value of the US dollar and a much higher level of long-term Treasury bond rates. A country with fiscal credibility can promise virtue in the future in exchange for fiscal laxity now. That permits it to escape the painful consequences of the paradox of thrift: that an ex- ante desire to increase the national saving rate (say though fiscal tightening or a shift upwards in the private propensity to save) may, at least temporarily, depress economic activity to such an extent that ex-post savings will not rise very much if at all. For the US, I see no alternative to a painful restoration of external balance through a higher national saving rate. The UK’s position is not very different. On current policies, government deficits of more than 10 percent are likely for the next fiscal year. As with the US, such banana-Republic deficits are likely to spook the market. As with the US, the pro-cyclical behaviour of fiscal policy during the last boom will have done nothing to get the markets to believe that this time things will be different. China, Germany and even France, however can do more than they have so far indicated they will do. So can some other emerging markets, including Brazil. Only the virtuous can follow Keynesian policies. If they don’t, they not only are bad global citizens, they will also shoot themselves in the foot. Like all recessions, the current global recession is proximately an investment-driven recession. The recovery, when it comes, will be an investment-driven recovery. Those who point to large increases in private saving rates in the US and some other countries (including the UK) should recognise that household investment includes residential construction, spending on home-improvement and purchases of consumer durables, including cars, white goods, furniture and IT equipment. Investment can be internally financed, out of retained profits, as well as externally. When animal spirits re-awaken in the enterprise sector and firms want to invest again, retained profits will, after several years of deep recession, be low or negative. So external finance - its availability and cost - will be key to a sustained recovery. This holds even for the recovery of inventory investment and working capital investment. That is why reconstructing financial intermediation by creating a new banking system and a system of functional capital markets is so central. There will be no sustained recovery without it. 3. A true commitment to increase the resources of the IMF at least 10-fold and to change its governance to reflect the current distribution of economic power in the world. The IMF has approximately $250 billion worth of resources. With what it has already committed in Europe (Iceland, Latvia, Hungary, Ukraine and Romania, with Lithuania about to join the party), there is not enough left in the kitty to provide effective support to a couple

286 of large EMs. Doubling the resources to $500 billion would be a sad under-reaction to the severity of the crisis. To be a serious player in the global financial stability game, even if just in the EM and developing countries, the IMF needs an increase in its resources of about $2.25 trillion. Global capital markets are likely to remain impaired for years to come, not just for developing countries and emerging markets, but also for a large number of supposedly advance industrial countries. The need from IMF financing is BAAAAACK! It should be granted that increase through an increase in quotas (a massive new issue of SDRs) rather than through a series of bilateral loans from countries keen to buy influence. The increase in IMF resources should be accompanied by a revision in voting weights that reflects the current economic realities. That means a radical reduction in the shares of the European nations (ideally, they should be replaced by a single European Union Executive Director)), It also means a reduction in the voting weight of the US large enough to deprive it of its veto power in the organisation. It is clear that the US and the European nations have repeatedly muzzled the IMF when the organisation wanted to sound the alarm about financial in stability in the heartland of financial capitalism. That should no longer be possible. Tax havens and regulatory havens It is likely that the G20 will push further on the issue of tax havens. This certainly is the time. The aspect of tax havens that matters is not the tax rates on different sources of income or different kinds of wealth, but bank secrecy - the ability of natural and legal persons to hide assets and income from their domestic tax authorities. Bank secrecy serves tax avoidance, tax evasion and tax fraud. It assists tax evaders, tax frauds and other criminals to hide income, be it legitimate income or the proceeds from illegal activity, from the eyes of the authority. They should be closed down. The easiest way to achieve this is to make it illegal for any natural or legal person from a non-tax haven country to do business with or enter into transactions with any natural or legal person in a tax haven. That ought to do it. Tax haven, again, is defined not with respect to tax rates or tax bases, but with respect to bank secrecy, that is, with respect to the information shared by the country’s financial institutions with foreign tax authorities. That information sharing should be automatic and comprehensive. As regards regulatory havens, once common G20 standards for regulatory norms, rules and regulations has been set, countries that violate these standards would be black-listed. The obvious sanction is non-recognition of contracts drawn up in the regulatory haven jurisdiction and non-recognition of court decisions in these regulatory havens. That ought to do it. Bonuses Moral indignation is no substitute for thought. Structuring incentives to promote the long- term interests of all the stake holders in listed companies is both important and complicated. Where possible, the regulator should take into account the impact of internal incentive structures on the risk profile of the organisation when it comes to determine capital adequacy. Governance, however, is a matter in the first instance for shareholders and boards. Shareholders have been robbed blind. Now it is the turn of the tax payers. Boards have often been complicit or oblivious in these robberies. Corporate governance reform is obviously overdue. The insiders (agents), that is the management and employees, have had their day at the expense of the outsiders (principals), that is the shareholders and tax payers. In new corporate governance legislation, the same person should never combine the obviously conflicted responsibilities of Chairman of the Board and CEO. The fiduciary duties of the

287 Board to the shareholders and to the other stakeholders would be spelled out clearly. Civil and criminal law consequences should follow from wilful negligence. We clearly don’t want to have sectorally differentiated tax policies for bonuses or other forms of remuneration. Simple rules like taxing all income according to the same schedule, be it labour income, bonuses, interest, dividends or capital gains, would remove some obvious distortions. Further mitigation is likely to result from more progressive income taxation (including a higher top rate) in a much-changed political climate. Ceterum censeo Carthaginem esse delendam. http://blogs.ft.com/maverecon/2009/03/the-g20-expect-nothing-hope-for-the-best-and- prepare-for-the-worst/

288

Does Obama Have a Plan B? by Adam S. Posen, Peterson Institute for International Economics Op-ed in the Daily Beast March 29, 2009 It is so much harder when the financial crisis is in your own country. Timothy Geithner, Larry Summers, and a host of other economists—myself among them— spent the late 1990s yelling at Japanese and other Asian officials to clean up their banking crises. A typical conversation would end with the American adviser bursting with frustration: "Don't you understand? The money is gone. If you just wish for the banks' asset values to come back, any recovery will be short-lived and you will only get more losses in the end. We all know this from long experience." Then we would go to conferences and discuss what it was about Japanese (or Korean or Indonesian) political economy that prevented resolute action. So it is with some irony if not humility that we should approach Treasury Secretary Geithner's Public Private Investment Plan presented on March 23. A number of major American banks have lost huge amounts of money, and clearly have insufficient capital if they are not literally insolvent. Why else would they be pushing so hard to change the accounting rules to avoid showing what they really have on their books instead of raising private capital? Why else is the US government taking so long to perform "stress tests" and trying to get expectations of overpayment for some of the bad assets on the banks' books before the test results are out? In short, the US government is looking to shovel capital into the banks without sufficient conditions, hiding rather than confronting the actual situation. That is just like the Japanese government in their lost decade, or the US officials during the 1980s before they really tackled the savings-and-loan crisis. In those cases, the delay simply made the problem worse over time and in the end the government had to put more money into the troubled banks directly, taking over or shutting down the weakest of them. Whatever the political culture, it would seem we have not learned from experience. Or perhaps we cannot act on our learning. The universal barrier would appear to be the political difficulty of recapitalizing banks. That seems obvious, but the constraint it puts on good policy is enormous. That is why the Geithner plan is so complex and jury-rigged, to avoid the need for public requests for more money for banks. Unfortunately, it is unlikely to succeed absent additional public money and more-intrusive government action. The plan will buy some time and certainly some appreciation in bank share prices. Current shareholders will be getting a new lease on life with subsidies from taxpayers. For that reason alone, the plan certainly will cost

289 the taxpayer more in the end than a more direct recapitalization with public control would have. A year or two down the road, we will know for certain whether it worked. By then the banks will either return to normal pre-crisis lending or they will be both too distrusted and too distrustful even to borrow from each other again. As we have seen over the last 18 months, the latter is what near-insolvent banks do. When I was working with the US Council of Economic Advisers and the Japanese business federation Keidanren in 2001–02 encouraging the Japanese government to do finally what was needed, it was the commitment of public money with tough conditions on the banks that we pushed for, and it was the normalization of the interbank market and then of lending behavior that showed success. In essence, the U.S. Treasury’s plan to subsidize private investors’ purchases of the banks’ toxic assets is a too-clever-by-half mechanism to fix the banks while avoiding going to Congress for more upfront on-budget expenditures. One can imagine the discussions at the White House: We have a budget to pass, and cannot give up those goals to give the bankers still more. Figure out some way to do this off-budget. And so the Geithner plan hugely bribes private investors with taxpayer money, as Simon Johnson, Paul Krugman, Jeffrey Sachs, and I have all described, with one-way government insured bets. Yet the bets are contingent, they only pay when the taxpayer loses—and those losses first appear on the Fed or FDIC balance sheet, not subject to congressional approval. I know that the very same self-limiting discussions took place at Okurasho, the Japanese Ministry of Finance circa 1995-1998. And they ended with the same result, a series of bank- recapitalization plans that tried to mobilize private-sector monies and overpay for distressed bank assets without forcing the banks to truly write off the losses. Even though the top Japanese technocrats at the ministry were even more insulated from a weak Diet than the congressionally unconfirmed advisers currently running economic policy for the Obama administration, they did worse. Whatever the political context, countries usually try to end banking crises on the cheap, with a limited public role at first, overpaying for distressed assets and failing to change banks’ behavior, only to have to go back in a couple of years later.

I hope the Geithner plan, combined with the other financial measures under way, proves to be an exception to the rule and succeeds in stabilizing the U.S. banking system. It could remove some of the bad assets from the banks’ balance sheets and put some capital into the banks. Even in that best case, though, it is clear that the avoidance of on-budget costs makes it penny- wise, pound-foolish, for the U.S. taxpayer. It will likely cost the taxpayer more on net, between the subsidies given and the transfer of most upside gains to the private investors, and the overpayments to current bank shareholders for toxic assets. If the U.S. government steps in more aggressively to take full ownership and pays a low price for these assets, the taxpayer would stand to get the full upside, even though it would require more cash up front. That would still be better than the Japanese experience. But the pattern of these crises—Japan in the 1990s or the U.S. in the 1980s, and elsewhere around the world—leads me to believe that this partial fix will be temporary at best. The banks will still have the worst toxic assets on their books; their managers and shareholders’ incentives will not have changed. The banks will be playing with a fresh stack of public money with insufficient strings and probably insufficient capital. Then, 18 months or so down the road, the U.S. government will still have to put capital into the banks, because credit markets will break down again, with many banks again under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out.

290 Part of the problem is that some of these distressed assets are genuinely toxic. They cannot be consistently valued and priced by anyone because they are part of larger securitized packages and so purchasers cannot disentangle the underlying investments behind them. Under the Treasury plan, those toxic assets are not restructured, but sold as-is just because of the federal guarantee offered against losses. Restructuring these assets would require government supermajority ownership, which so far seems to be politically unpalatable. In which case, the FDIC will end up paying out on the insurance for overpriced assets. What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers Hashimoti, Obuchi, and Mori in 1995 and 1998: Rather than ask the legislature for straightforward recapitalization money, you have the political leadership preferring to risk overpaying current owners of toxic assets rather than forcing sales. For all of Japan’s supposed intervention in markets, its government still lacked the stomach for taking over banks, let alone closing them. In 1998, Japan did get a reformer, Hakuo Yanagisawa, the first financial-services minister independent of the Ministry of Finance. He got a bank recapitalization under way—but did so without putting enough conditions on the capital, hoping to mobilize private investment and limit the number of bank nationalizations. I remember a dinner with him in Tokyo shortly thereafter, where he spoke with conviction about the need to be tough with the irresponsible banks, and how he was politically independent enough to be tougher than the bureaucrats had been, since he was an elected official running a new agency. Three years later, the Japanese banking system failed again, imperiling the economy, while having accumulated billions more in non-performing loans. Only when Heizo Takenaka became the responsible minister in 2002 were Japanese banks forced to write down the value of the distressed assets before getting recapitalized. From that point forward, the Japanese economy began growing again, and within months, the worst of the Japanese banking crisis was resolved. In the meantime, a couple of Japanese governments had lost power, Yanagisawa had been replaced three times, and Japan suffered three more years of recession. Takenaka was a brave academic economist unafraid to cite lessons from the U.S. and abroad and took strength from the personal support of the new reformist Prime Minister Junichiro Koizumi. At least as importantly, though, the failure of the Japanese banking system had become so evident and imminent that politicians had no choice but to do the right thing with public capital injections and some bank closings. It is as easy to imagine the candidates for the Takenaka role in the U.S. today as it is tempting to hope that Geithner’s current plan will work, albeit at excessive taxpayer expense. But I fear that until Congress gets the message, a lasting resolution of the U.S. banking crisis will not occur—and it may take the failure of the current plan to get that message across, as it did in Japan and elsewhere. http://www.petersoninstitute.org/publications/opeds/oped.cfm?ResearchID=1170

291 http://www.calculatedriskblog.com/2009/03/new-home- sales-is-this-bottom.html WEDNESDAY, MARCH 29, 2009 From the Seattle Times: Washington's banks under stress (ht Lyle) Ailing financial giants such as Citigroup, Bank of America and AIG have drawn most of the attention as the worst banking crisis since the Great Depression grinds on. But several of Washington's community banks also are clearly straining under the weight of the crisis, a Seattle Times analysis shows. At least a dozen of the 52 Washington-based banks examined are carrying heavy loads of past-due loans, defaults and foreclosed properties relative to their financial resources. ... While banks big and small have been kneecapped by the collapse of the housing bubble, the crisis has played out differently for the big "money center" banks and the thousands of regional and community banks sprinkled across the country. The main problem for the big banks and investment firms has been exotic instruments such as collateralized mortgage obligations, structured investment vehicles and credit- default swaps — all tied, one way or another, to pools of residential mortgages that were bought, sold, sliced up and repackaged like so much salami. ... But at most community banks, residential mortgages were a relatively small part of their business. Instead, their troubles are tied directly to their heavy dependence on real-estate loans — mainly loans to local builders and developers. "Many community banks found that (construction and development loans) was an area in which they could compete effectively against the big banks," Frontier's Fahey said. At Frontier Bank, for example, construction and development loans made up 44.5 percent of all assets at year's end. City Bank had 53.3 percent of its assets in such loans, and at Seattle Bank (until recently Seattle Savings Bank), they constituted a full 54.2 percent of total assets.... Regulators can act to bring wobbly banks back into balance, short of seizing them outright. Four Washington banks — Horizon, Frontier, Westsound and Bank Reale of Pasco — are operating under FDIC "corrective action plans" that place tight restrictions on their lending practices, management and overall operations. But sometimes, such plans just delay the inevitable. Last year, for instance, the FDIC imposed corrective action plans on Pinnacle Bank and Silver Falls Bank, both of Oregon; in February, both were seized. This article makes a couple of key points that we've been discussing: many community and regional banks sidestepped the residential mortgage debacle, and focused on local commercial real estate (CRE) and construction & development (C&D) lending. Now, with rapidly increasing defaults on C&D and CRE loans, the high concentrations of CRE and C&D loans at these banks will lead to many bank failures. And unlike the "too big to fail" banks, these community banks will just be seized by the FDIC.

292 http://www.calculatedriskblog.com/2009/03/mega-bear-

quartet.html Saturday, March 28, 2009

The Mega-Bear Quartet

By popular request, here is a graph comparing four significant bear markets: the Dow during the Great Depression, the NASDAQ, the Nikkei, and the current S&P 500.

This graph is from Doug Short of dshort.com (financial planner): "The Mega-Bear Quartet and L-Shaped Recoveries". Note: updated today.

293 HTTP://WWW.CALCULATEDRISKBLOG.COM/20 09/03/FORECAST-TWO-THIRDS-OF- CALIFORNIA-BANKS.HTML Saturday, March 28, 2009

Forecast: Two-thirds of California banks to face Regulatory Action

From the LA Times: FDIC orders changes at six California banks [T]he Federal Deposit Insurance Corp. disclosed Friday that it had ordered six more California banks to clean up their acts in February after the agency examined their books and operations. ... The number of such regulatory actions has been increasing rapidly. ... By the end of 2009, two-thirds of the state's banks will be operating under cease-and- desist orders or other regulatory actions, Anaheim-based banking consultant Gary S. Findley predicts. ... Most banks targeted in such actions eventually tighten up operations and continue in business or merge with stronger institutions, but regulators are preparing for a major wave of failures. ... In addition to public cease-and-desist orders, banks are subject to a variety of regulatory sanctions, including so-called memorandums of understanding, which are informal directives to correct problems. Regulators don't release those memos, but banks sometimes disclose them to shareholders. So far 21 FDIC insured banks have failed this year, and 3 in California. There will probably be many more ... http://www.calculatedriskblog.com/2009/03/q1- gdp-will-be-ugly.html Friday, March 27, 2009

Q1 GDP will be Ugly

First, a quick market update ... This graph is from Doug Short of dshort.com (financial planner): "Four Bad Bears". Note that the Great Depression crash is based on the DOW; the three others are for the S&P 500. On Q1 GDP: Earlier today the BEA released the February Personal Income and Outlays report. This report suggests Personal Consumption Expenditures (PCE) will probably be slightly positive in Q1

294 (caveat: this is before the March releases and revisions). Since PCE is almost 70% of GDP, does this mean GDP will be OK in Q1? Nope.

I expect Q1 2009 GDP to be very negative, and possibly worse than in Q4 2008. Right now I'm looking at something like a 6% to 8% decline (annualized) in real GDP (there is significant uncertainty, especially with inventory and trade). The problem is the 30% of non-PCE GDP, especially private fixed investment. There will probably be a significant inventory correction too, and some decline in local and state government spending. But it is private fixed investment that will cliff dive. This includes residential investment, non-residential investment in structures, and investment in equipment and software. A little story ... Imagine ACME widget company with a steadily growing sales volume (say 5% per year). In the first half of 2008 their sales were running at 100 widgets per year, but in the 2nd half sales fell to a 95 widget per year rate. Not too bad. ACME's customers are telling the company that they expect to only buy 95 widgets this year, and 95 in 2010. Not good news, but still not too bad for ACME. But this is a disaster for companies that manufacturer widget making equipment. ACME was steadily buying new widget making equipment over the years, but now they have all the equipment they need for the next two years or longer. ACME sales fell 5%. But the widget equipment manufacturer's sales could fall to zero, except for replacements and repairs. And this is what we will see in Q1 2009. Real investment in equipment and software has declined for four straight quarters, including a 28.1% decline (annualized) in Q4. And I expect another huge decline in Q1. For non-residential investment in structures, the long awaited slump is here. I expect declining investment over a number of quarters (many of these projects are large and take a number of

295 quarters to complete, so the decline in investment could be spread out over a couple of years). And once again, residential investment has declined sharply in Q1 too. When you add it up, this looks like a significant investment slump in Q1. http://www.calculatedriskblog.com/2009/03/february-pce-and- personal-saving-rate.html Friday, March 27, 2009 February PCE and Personal Saving Rate The BEA released the Personal Income and Outlays report for February this morning. The report shows that PCE will probably make a positive contribution to GDP in Q1 2009. Each quarter I've been estimating PCE growth based on the Two Month method. This method is based on the first two months of each quarter and has provided a very close estimate for the actual quarterly PCE growth. Some background: The BEA releases Personal Consumption Expenditures monthly and quarterly, as part of the GDP report (also released separately quarterly). You can use the monthly series to exactly calculate the quarterly change in real PCE. The quarterly change is not calculated as the change from the last month of one quarter to the last month of the next. Instead, you have to average all three months of a quarter, and then take the change from the average of the three months of the preceding quarter. So, for Q1 2009, you would average real PCE for January, February, and March, then divide by the average for October, November and December. Of course you need to take this to the fourth power (for the annual rate) and subtract one. The March data isn't released until after the advance Q1 GDP report. But we can use the change from October to January, and the change from November to February (the Two Month Estimate) to approximate PCE growth for Q1. The two month method suggests real PCE growth in Q1 of 0.8% (annualized). Not much, but a significant improvement from the previous two quarters (declines of -3.8% and -4.3% in PCE). The following graph shows this calculation:

This graph shows real PCE for the last 12 months. The Y-axis doesn't start at zero to better show the change. The dashed red line shows the comparison between January and October. The dashed green line shows the comparison between February and November.

296 Since PCE was weak in December, the March to December comparison will probably be positive too. This graph also show the declines in PCE in Q3 and Q4. For Q3, compare July through September with April through June. Notice the sharp decline in PCE. The same was true in Q4.

This suggests that PCE will make a positive contribution to GDP in Q1. Also interesting: Personal saving -- DPI less personal outlays -- was $450.7 billion in February, compared with $478.1 billion in January. Personal saving as a percentage of disposable personal income was 4.2 percent in February, compared with 4.4 percent in January. This is substantially above the near zero percent saved of recent years.

This graph shows the saving rate starting in 1959 (using a three month centered average for smoothing). Although this data may be revised significantly, this does suggest households are saving substantially more than during the last few years (when they saving rate was close to zero). This is a necessary but painful step ... and a rising saving rate will repair balance sheets, but also keep downward pressure on personal consumption. It is not much, but this is definitely a positive report.

297 March 27, 2009 Revisiting the Global Savings Glut Thesis by Doug Noland "The extraordinary risk-management discipline that developed out of the writings of the University of Chicago's Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators. But in August 2007, the risk- management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms' capital and risk positions." Alan Greenspan, March 27, 2009, Financial Times Alan Greenspan remains the master of cleverly obfuscating key facets of some of the most critical analysis of our time. The fact of the matter is that "the sophisticated mathematics and computer wizardry" fundamental to contemporary derivatives and risk management essentially rested on one central premise: that the Federal Reserve (and, more generally speaking, global policymakers) was there to backstop marketplace liquidity in the event of market tumult. More specific to the mushrooming derivatives marketplace, participants came to believe that the Fed had essentially guaranteed liquid and continuous markets. And the Bigger the Credit Bubble inflated the greater the belief that it was Too Big for the Fed To ever let Fail. It was clearly in the "enlightened self-interest" of operators of "Wall Street finance" and throughout the system to fully exploit this market prevision. With unimaginable wealth there for the taking, along with the perception of a Federal Reserve "backstop," why would anyone have kidded themselves that there was incentive to ensure individual institutions "maintained a sufficient buffer against insolvency"? By the end of boom cycle, market incentives had been completely debauched. The Greespan Fed pegged the cost of short-term finance (fixing an artificially low cost for speculative borrowings), while repeatedly intervening to avert financial crisis ("coins in the fusebox"). There is absolutely no way that total system Credit would have doubled this decade to almost $53 TN had the Activist Federal Reserve not so aggressively and repeatedly intervened in the markets. To be sure, the explosion of derivatives and attendant speculative leveraging was central to the historic dimensions of the Credit Bubble. Mr. Greenspan today made it through yet another article without using the word "Credit." "Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles..." "Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants." "Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself..." He might cannily dodge the topic, but Mr. Greenspan recognizes all too well that Credit has and always will be central to the functioning - and misfunctions - of free-market Capitalistic systems.

298 With respect to the past, present and future analyses, I believe the spotlight should be taken off asset prices. Such focus is misplaced and greatly muddies key issues. Much superior is an analytical framework that examines the underlying Credit excesses that fuel asset inflation and myriad other distortions. Ensure us a stable Credit system and the risk of runaway asset booms and busts disappears. Today's financial crisis - and financial crises generally - are defined by a sharp discontinuity of the flow of Credit. Major fluctuations in asset markets - on the upside and downside - are typically driven by changes in the quantity and directional flow of Credit. Central bankers should focus on stable finance and resist the powerful tempation to monkey with asset prices and markets. As common sense as this is, today's flawed conventional thinkng leaves most oblivious and poised for Mistakes to Beget Greater Mistakes. When it comes to flawed conventional thinking, few things get my blood pressure rising more than the "global savings glut" thesis. Two weeks ago from Alan Greenspan, via The Wall Street Journal: "...The presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005. That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis." It is difficult these days for me to accept that Greenspan, Bernanke and others are sticking to this misplaced view that a glut of global saving was predominantly responsible for the proliferation of U.S. and global Bubbles. The failure of our policymakers to understand and accept responsibility for the Bubble must not sit well internationally. Long-time readers might recall that I pilloried this analysis from day one. The issue was never some glut of "savings" but a historic glut of Credit and the resulting "global pool of speculative finance." In today's post-Bubble period, it should be indisputable that the acute financial and economic fragility exposed around the globe was the result of egregious lending, financial leveraging, and speculation. True savings would have worked to lessen fragility - instead of being the root cause of it. Unfortunately, there is somewhat of a chicken and egg issue that bedevils the debate. Greenspan and Bernanke have posited that China and others saved too much. This dynamic is said to have stoked excess demand for U.S. financial assets, pushing U.S. and global interest rates to artifically low levels. This, they expound, was the root cause of asset Bubbles at home and abroad. I take a quite opposing view, believing it is unequivocal that U.S. Credit excess and resulting over-consumption, trade deficits, and massive current account deficits were the underlying source of so-called global "savings." Again, if it had been "savings" driving the process, underlying system dynamics wouldn't have been so highly unstable and the end result would not have been unprecedented systemic fragility. Instead, the seemingly endless liquidity - so distorting of markets and economies round the world - was in

299 large part created through the process of unfettered speculative leveraging of securities and real estate. As is so often the case, we can look directly to the Fed's Z.1 "flow of funds" report for Credit Bubble clarification. Total (non-financial and financial) system Credit expanded $1.735 TN in 2000. As one would expect from aggessive monetary easing, total Credit growth accelerated to $2.016 TN in 2001, then to $2.385 TN in 2002, $2.786 TN in 2003, $3.126 TN in 2004, $3.553 TN in 2005, $4.025 TN in 2006 and finally to $4.395 TN in 2007. Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by mid-2003 (in the face of double-digit mortgage Credit growth and the rapid expansion of securitizations, hedge funds, and derivatives), where they remained until mid-2004. Fed funds didn't rise above 2% until December of 2004. Mr. Greenspan refers to Fed "tightening" in 2004, but Credit and financial conditions remained incredibly loose until the 2007 erruption of the Credit crisis. It is worth noting that our Current Account Deficit averaged about $120bn annually during the nineties. By 2003, it had surged more than four-fold to an unprecedented $523bn. Following the path of underlying Credit growth (and attendant home price inflation and consumption!), the Current Account Deficit inflated to $625bn in 2004, $729bn in 2005, $788bn in 2006, and $731bn in 2007. And examining the "Rest of World" (ROW) page from the Z.1 report, we see that ROW expanded U.S. financial asset holdings by $1.400 TN in 2004, $1.076 TN in 2005, $1.831 TN in 2006 and $1.686 TN in 2007. It is worth noting that ROW "net acquisition of financial assets" averaged $370bn during the nineties, or less than a quarter the level from the fateful years 2006 and 2007. The Z.1 details, on the one hand, the unprecedented underlying U.S. Credit growth behind our massive Current Account Deficits. ROW data, in particular, diagnoses the flooding of dollar balances to the rest of the world - and the "recycling" of these flows back to dollar instruments. This unmatched flow of finance devalued our currency, and in the process inflated commodities, foreign debt, equity and assets markets, and global Credit systems more generally. In somewhat simplistic terms, ultra-loose monetary conditions fed U.S. Credit excess, excessive financial leveraging and speculating, asset inflation, over-consumption, and enormous Current Account Deficits. And this unrelenting flow of dollar balances to the world inflated the value of many things priced in devalued dollars, thus exacerbating both global Credit and speculative excess. The path from the U.S. Credit Bubble to the Global Credit Bubble is even more evident in hindsight. Back in November of 2007 Mr. Greenspan made a particularly outrageous statement. "So long as the dollar weakness does not create inflation, which is a major concern around the globe for everyone who watches the exchange rate, then I think it's a market phenomenon, which aside from those who travel the world, has no real fundamental economic consequences." Similar to more recent comments on the "global savings glut," I can imagine such remarks really rankle our largest creditor, the Chinese. As we know, the Chinese were the major accumulator of U.S. financial assets during the Bubble years. They are these days sitting on an unfathomable $2.0 TN of foreign currency reserves and are increasingly outspoken when it comes to their concerns for the safety of their dollar holdings. There is obvious reason for the Chinese to question the reasonableness of continuing to trade goods for ever greater quantities of U.S. financial claims. Interestingly, Chinese policymakers are today comfortable making pointed comments. Policymakers around the world are likely in agreement on a key point but only the Chinese are willing to state it publicly: the chiefly dollar-based global monetary "system" is

300 dysfunctional and unsustainable. Mr. Greenpan may have actually convinced himself that dollar weakness has little relevance outside of inflation. And the inflationists may somehow believe that a massive inflation of government finance provides the solution to today's "deflationary" backdrop. Yet to much of the rest of the world - especially our legions of creditors - this must appear too close to lunacy. How can the dollar remain a respected store of value? Expect increasingly vocal calls for global monetary reform. "The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.' Zhou Xiaochuan, head of the People's Bank of China, March 23, 2009 http://www.safehaven.com/article-12948.htm

301

We need a better cushion against risk By Alan Greenspan Published: March 27 2009 02:00 | Last updated: March 27 2009 02:00 The extraordinary risk-management discipline that developed out of the writings of the University of Chicago's Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators. But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms' capital and risk positions. For generations, that premise appeared incontestable but, in the summer of 2007, it failed. It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk- product design were too much for even the most sophisticated market players to handle prudently. Even with the breakdown of selfregulation, the financial system would have held together had the second bulwark against crisis - our regulatory system - functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that "more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards". US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees. The UK's heavily praised Financial Services Authority was unable to anticipate and prevent the bank run that threatened Northern Rock. The Basel Committee, representing regulatory authorities from the world's major financial systems, promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers. The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong. What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate. But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation's savings into the most productive capital investments - those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism's great success over the generations.

302 New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly marketdistorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals. Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery. Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union. History also demonstrates that underpriced risk - the hallmark of bubbles - can persist for years. I feared "irrational exuberance" in 1996, but the dotcom bubble proceeded to inflate for another four years. Similarly, I opined in a federal open market committee meeting in 2002 that "it's hard to escape the conclusion that . . . our extraordinary housing boom . . . finan-ced by very large increases in mortgage debt, cannot continue indefinitely into the future". The housing bubble did continue to inflate into 2006. It has rarely been a problem of judging when risk is historically underpriced. Credit spreads are reliable guides. Anticipating the onset of crisis, however, appears out of our forecasting reach. Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it. Earlier this decade, for example, it was widely expected that the next crisis would be triggered by the large and persistent US current-account deficit precipitating a collapse of the US dollar. The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have arbitraged away the presumed dollar trigger of the "next" crisis. Instead, arguably, it was the excess securitisation of US subprime mortgages that unexpectedly set off the current solvency crisis. Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit. Mortgage-backed securities were sliced into collateralised debt obligations and then into CDOs squared. Speculative fever creates new avenues of excess until the house of cards collapses. What causes it finally to fall? Reality. An event shocks markets when it contradicts conventional wisdom of how the financial world is supposed to work. The uncertainty leads to a dramatic disengagement by the financial community that almost always requires sales and, hence, lower prices of goods and assets. We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear. I do not question that central banks can defuse any bubble. But it has been my experience that unless monetary policy crushes economic activity and, for example, breaks the back of rising profits or rents, policy actions to abort bubbles will fail. I know of no instance where incremental monetary policy has defused a bubble. I believe that recent risk spreads suggest that markets require perhaps 13 or 14 per cent capital (up from 10 per cent) before US banks are likely to lend freely again. Thus,

303 before we probe too deeply into what type of new regulatory structure is appropriate, we have to find ways to restore our now-broken system of financial intermediation. Restoring the US banking system is a key requirement of global rebalancing. The US Treasury's purchase of $250bn (€185bn, £173bn) of preferred stock of US commercial banks under the troubled asset relief programme (subsequent to the Lehman Brothers default) was measurably successful in reducing the risk of US bank insolvency. But, starting in mid- January 2009, without further investments from the US Treasury, the improvement has stalled. The restoration of normal bank lending by banks will require a very large capital infusion from private or public sources. Analysis of the US consolidated bank balance sheet suggests a potential loss of at least $1,000bn out of the more than $12,000bn of US commercial bank assets at original book value. Through the end of 2008, approximately $500bn had been written off, leaving an additional $500bn yet to be recognised. But funding the latter $500bn will not be enough to foster normal lending if investors in the liabilities of banks require, as I suspect, an additional 3-4 percentage points of cushion in their equity capital-to-asset ratios. The overall need appears to be north of $850bn. Some is being replenished by increased bank cash flow. A turnround of global equity prices could deliver a far larger part of those needs. Still, a deep hole must be filled, probably with sovereign US Treasury credits. It is too soon to evaluate the US Treasury's most recent public-private initiatives. Hopefully, they will succeed in removing much of the heavy burden of illiquid bank assets. We need a better cushion against risk, By Alan Greenspan , Published: March 27 2009 http://www.ft.com/cms/s/0/9b108250-1a6e-11de-9f91-0000779fd2ac.html

304 27.03.2009 ZAPATERO FAVOURS A NEW ROUND OF STIMULUS SPENDING

In an interview with the FT and other newspapers, Jose Luis Zapatero said he favoured a new programme of government spending, should a stimulus be needed later this year. He said he would back a fresh round of spending on renewable energy and biotechnology (not clear to us why and how this is can be cyclical, fast-acting stimulus, rather than a structural expense). He said such a new stimulus round would have to be smaller than existing ones, but better co-ordinated within the EU. Samuel Brittan on debt Samuel Brittan, in his FT column, draws some interesting historical parallels of periods when UK debt rose very fast, only to come down later with relative ease. He says the current fiscal expansion is not nearly on the scale as during the second world war, and that one was financed and repaid in the post-war economic boom. In times of fiscal expansion, there are always those who warn that the country would face bankruptcy. Geithner’s plans for regulation and supervision Tim Geithner yesterday outlined his plans for a regulatory overhaul, by forcing large financial institutions, including investment banks and hedge funds, to hold more capital. Geithner was weak on details, including how to determine which institution is systemically relevant, according to the FT. Hedge funds would have to register with the SEC, and large parts of the CDS market would be pushed into central clearing. The FT also noted that this proposals close the transatlantic gap on this issue. Papademous warns about vicious circle in credit Lucas Papademous warned about a vicious circle in which the financial crisis and the recession led to higher defaults, which led to reduced lending, which in turns makes the recession worse. He made his comments after the second monthly fall in the volume of credit in the euro area. On annual basis credit growth was only 4.2%. M1 was slightly higher – which some analysts got excited about – but this probably indicates mainly a rise in demand for sight deposits from outside the eurozone, and portfolio effects. M3 growth is down at 5.9%. The following is an interesting chart from Rebecca Wilder in Economonitor about the real money supply growth, showing how much the euro area is lagging behind the others.

305

Strauss Kahn sees growth recovery early 2010 if toxic assets are written off Dominique Strauss Kahn said on French television yesterday that he estimates economic growth to rebound in the first quarter of 2010 but only if the banking sector gets rid of its toxic assets (IMF estimates of remaining toxic assets to amount to $ 1.7 trillion), reports Le Monde. Stimulus packages alone will not do the trick and Europe as well the US are not doing enough. Prompted on French issues he said that the workers of the French production site of Continental had been deceived and called for pressure on Germany not to close the site. On rumours that he could become prime minister under Sarkozy DSK said “ce n’est pas serieux”. French bonus payments provoke fury E90m bonus payments to traders of Natixis provoke a row in France and make headlines in the newspapers, see e.g. Les Echos. The bank, a common subsidiary of Banques Populaires and Caisses d’Epargne, has cut 1250 jobs, lost E2.8bn in 2008 and is to receive E5bn government aid. Le Monde's article on Strauss Kahn mentions that the government is to announce a new regulation that excludes bonus payments to companies that received state aid. Solvency II takes final hurdle A committee by national governments and the European Parliament reached final agreement on the Solvency II regulation for the insurance industry, which includes some exemptions for France, where insurance companies will not have to use the strict capital adequacy rules for the valuation of equities in their pension investments. The French government had feared the loss of French companies as ankers of the French stock market, according to FT Deutschland

306 Economy

March 27, 2009 Battles Over Reform Plan Lie Ahead By EDMUND L. ANDREWS WASHINGTON — Outlining a far-reaching proposal on Thursday to rebuild the nation’s broken system of financial regulation, the Treasury secretary, Timothy F. Geithner, fired the opening salvo in what is likely to be a marathon battle. “Our system failed in fundamental ways,” Mr. Geithner told the House Financial Services Committee. “To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game.” On the surface, both the lawmakers who listened to the Treasury secretary and the financial industry’s lobbying groups made it sound as if they completely agreed with Mr. Geithner’s call for what he described as “better, smarter tougher regulation.” But in fact industry groups are already mobilizing to block restrictions they oppose and win new protections they have wanted for years. Even though Mr. Geithner carefully avoided specific details, laying out mostly broad principles for overhauling the system, financial industry groups are identifying issues they plan to pursue and lining up well-connected lobbyists and publicists to help make their cases. If history is any guide, Mr. Geithner’s proposals will start an equally intense battle among the regulatory agencies themselves — including the alphabet soup of banking regulators, the Securities and Exchange Commission and the Federal Reserve — to stay in business and enhance their authority. It took years to complete past efforts to overhaul regulation of the financial industry — replacing the Depression-era laws that separated commercial banks from investment banks, for example, and knocking down barriers between the telephone and cable television industries. And those efforts were in some ways easier than the task confronting President Obama and Congress today. Many of the past overhauls were really about deregulation, knocking down legal barriers that had prevented different segments of an industry from competing with each other. By contrast, Mr. Geithner’s plan marks the first attempt in decades to drastically tighten the restrictions on industry. It would create a new still-unidentified “systemic risk regulator” that would have the authority to scrutinize and second-guess the operations of bank holding companies like Citigroup or JPMorgan Chase, insurance conglomerates like the American International Group and other financial institutions that are deemed too big to fail. Hedge funds and private equity funds, which have been almost entirely unregulated, would have to register with the S.E.C. and tell it about their risk-management practices. Many financial derivative instruments, like credit-default swaps, would come under supervision for the first time. Mr. Geithner’s most specific proposal, which Democratic lawmakers hope to pass in the next few weeks, would allow the federal government to seize control of troubled institutions whose collapse or bankruptcy might jeopardize the broader financial system.

307 In the months ahead, Mr. Geithner said, he will unveil more detailed proposals to set up a new regime for tighter regulation of most segments of the financial services industry. He has also said the government should more actively regulate executive compensation, not just at companies that are receiving federal bailout money, but at all companies that might be providing incentives for excessive risk-taking. “The days of light-touch regulation are over,” said Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee. Mr. Frank said the financial and economic catastrophes of the last 18 months had created a new political consensus in favor of tighter financial supervision. Mr. Frank said he hoped to pass a bill “very soon” to give the federal government “resolution authority” to seize control, restructure and shut down troubled financial institutions. And he said he hoped to pass a much broader bill along the lines of Mr. Geithner’s plan by the end of this summer. But administration officials acknowledged that enacting broad financial reforms would provoke political battles that are almost certain to drag on for months, if not years. President Obama and his economic team are already trying to navigate between the deep popular anger over reckless financial practices and the pragmatic need to coax support from the financial industry for regulations they almost reflexively oppose. On Friday, Mr. Obama will meet with executives from the nation’s biggest financial institutions. Bank executives said they expected Mr. Obama to try to sell them on his ideas, and perhaps to encourage them to keep participating in the Treasury Department’s Troubled Asset Relief Program, or TARP. Goldman Sachs has signaled that it wants to return the government’s money that the Treasury loaned it under that program. On Thursday, most industry lobbying groups held their fire and reacted to Mr. Geithner’s proposals as if they agreed with him entirely. The Securities Industry and Financial Markets Association said on Thursday that it “has been advocating for many of the same reforms” and that it “looks forward” to developing specific legislation. The Private Equity Council, which represents firms like Kohlberg Kravis Roberts and the Carlyle Group, praised the Obama administration for its “plan to comprehensively address systemic risk.” The American Insurance Association declared that “we agree with Secretary Geithner” that the new rules should “encourage high standards and a race to the top.” But industry lobbying groups are pushing their own agenda. Edward L. Yingling, president of the American Bankers Association, said he hoped to use the meeting with Mr. Obama to make the case for relaxing mark-to-market rules, which require financial institutions to value their investment securities at current market prices. Banks have argued that the rules are hurting their financial positions. Many insurance companies, for their part, are hoping to free themselves from the oversight of 50 separate state insurance regulators. Lobbyists for the retailing and restaurant industry, meanwhile, are hoping to use the banner of financial reform to persuade Congress help reduce the fees that credit card companies charge for processing customer transactions. Edmund L. Andrews reported from Washington, and Louise Story from New York. David Stout contributed reporting from Washington, and Michael de la Merced and Zachery Kouwe from New York.

308

As Oversight Plan Is Unveiled, Turf Battle Begins to Unfold Rival Regulators Argue for Right to Expanded Authority By Zachary A. Goldfarb, Binyamin Appelbaum and Tomoeh Murakami Tse Washington Post Staff Writers Friday, March 27, 2009; D01 Even as Treasury Secretary Timothy F. Geithner yesterday was presenting to Congress his new blueprint for revamping financial oversight, federal regulators at the Securities and Exchange Commission and elsewhere were joining the battle over the creation and apportionment of any expanded powers. The Obama administration wants Congress to vastly expand federal oversight of previously unregulated financial markets such as trading in derivatives, and to impose more rigorous regulations and curbs on risk-taking by the largest financial companies, including major banks, insurers and hedge funds. SEC Chairman Mary L. Schapiro urged that her agency play a major role, telling the Senate Banking Committee that the SEC may soon ask for new authority to oversee financial firms and products, including hedge funds, derivatives and municipal bonds. At the same time, she warned that the administration's proposal to endow some federal agency with the authority to detect risks throughout the economy "could usurp" the work of the SEC and other regulators. Rival agencies -- including the Federal Reserve, Commodity Futures Trading Commission and banking regulators -- already are pushing similar arguments. Consumer advocates, meanwhile, say they are being ignored. Industry groups caution against a surfeit of new regulation. The administration is taking advantage of what Geithner described yesterday as an "opportunity" to enact regulations that before the financial crisis might have faced much more opposition. Notable by their absence, however, were proposals addressed at the causes of the crisis. There was no mention of increased regulation of the mortgage industry, for example, or of securitization, the process of bundling loans for sale to investors that funded much of the boom in lending. In part, the administration appears to be deferring to Congress. Rep. Brad Miller (D-N.C.) yesterday introduced legislation to create national regulations for mortgage lending. Rep. Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, opened the Geithner hearing with a speech about the need for increased regulation of securitization. The administration, by contrast, is focused first on creating a system for regulating the largest financial companies, limiting the risks they take and granting the government new powers to seize large firms before they collapse. In her testimony, Schapiro said she could endorse in principal the proposal to assign a single agency to regulate systemic risk but was concerned this could harm the effectiveness of the SEC. For example, a regulator that worries primarily about risks that one firm poses to the entire financial system might favor relaxing accounting standards in periods of crisis or

309 oppose stiff penalties for an already struggling financial company. Enforcing accounting standards and securities laws are the SEC's bread and butter. "We have to have equal attention on investor protection, and an independent agency like the SEC focuses on that," Schapiro said in an interview yesterday. Another area already being contested is Geithner's proposal to regulate derivatives, the exotic financial instruments such as credit-default swaps that have exacerbated the crisis. The SEC and CFTC are both trying to lay claim to overseeing this market. Schapiro yesterday cited the SEC's experience in regulating similar forms of trading as "a pretty compelling reason to be involved in their regulation." The CFTC released a statement asserting its own expertise and saying that it looked forward to contributing to the overhaul of derivatives regulation. Industry executives, fearful of regulatory overreach, are gearing up for marathon discussions with the administration and key members of Congress. "We want to achieve meaningful regulatory reform to make sure these products remain widely available, in a way that is cost effective," said Robert Pickel, chief executive of the International Swaps and Derivatives Association. The turf battle between agencies is mirrored on Capitol Hill, where House and Senate agriculture committees with authority over the CFTC do not want to cede authority to the financial services and banking committees that have oversight over the SEC. Yet another conflict is brewing over regulation of hedge funds. Geithner wants larger funds to register with the SEC. Schapiro wants all hedge funds to register with the agency. Geithner has also suggested that venture capital and private-equity firms register with the SEC. Schapiro hasn't expressed opposition to this but said that such companies may need to be subject to different rules than hedge funds. James Chanos, an outspoken hedge fund manager, said yesterday that while the industry is willing to accept some new regulations, Congress shouldn't be quick to treat them the same way as banks and other financial firms. "Hedge funds and their investors have generally absorbed the painful losses of the past year without any government cushion; the same certainly cannot be said of the major investment and commercial banks, insurance companies, and [Fannie Mae and Freddie Mac] that have had to run to the taxpayer to cushion against the losses caused by poor investment decisions, faulty risk management or fraud," he said. "Private equity can make a cogent argument that the problem was not of its own making," said an executive at a major private-equity firm who spoke on condition of anonymity because he expects to be part of the discussions with government officials in formulating details of the plan. "It poses no systemic risk. . . . The worst that can happen is the fund goes to zero. It doesn't suddenly turn into this black hole threatening to suck in everything around it." Perhaps Geithner's friendliest reception came from the House Financial Services Committee, whose members earlier this week had slammed the Treasury secretary for his role in the payment of bonuses to employees at American International Group. Staff writer Amit R. Paley contributed to this report. Tse reported from New York.

310

RTC All Over Again http://www.hedgefund.net/publicnews/default.aspx?story=9895# RTC All Over Again March 27, 2009 In September 2008, the Shadow predicted that a Resolution Trust Corp. (RTC)-type of entity would emerge to deal with the ill conceived, badly documented and unaffordable mortgages that are on the books of financial institutions. That day has arrived under Tim Geithner and the Obama Administration and has the potential, just as in the late 1980s and early 1990s, to generate enormous profits for entities that have the intestinal fortitude and work ethic to sift through the rubble to find properties that have value. The plan is intended to work something like this: A bank will auction a pool of mortgage assets to the highest private sector bidder, for which the FDIC will provide leverage directly to the buyer on a six to one debt-to-equity basis. So if a bidder wins a $100 million asset pool for say $84 million, the FDIC will provide guarantees of $72 million. Of the remaining $12 million of equity, the investor will provide $6 million and the U.S. Treasury will provide the balance of $6 million. Let us assume that the actual value of the assets after disposition is $50 million and that the total profit on the transaction is $2 million, which goes evenly to the equity holders. The investor made $1 million on a $6 million investment, or 16.7% return on capital. The assets are now off the banks’ books (making them stronger institutions) who actually sold $50 million worth of assets for $84 million (they gained $34 million), and the investor and the Treasury has turned a profit of $2 million. Who loses $36 million? The FDIC of course, who blindly will extend loans on assets worth perhaps far less than the debt used to acquire them. A friend of mine always recites a quote from Ronald Reagan during meetings when discussing mortgaged backed securities and it goes something like this: “What are the most feared words in America? ‘Hello, I’m from the Federal Government and I’m here to help.’” The point is well taken: if the government gets involved in any process that is normally handled by the private sector, you know that it will get screwed up somehow. No one seems to be accountable for any programs or behavior since it can be categorized as “the government.” How about using riot control tactics and singling out individuals. (“Mr. Geithner, you will be evaluated on this program” and perhaps have his pay tied to the success of the program.) Will this program of $1.2 trillion take enough of the impaired assets out of the mortgage marketplace to get the economy back on track and restore confidence with investors and consumers? Time will tell but it seems the government does not end up following through on a program before it becomes distracted and turns to some other issue. Experience tells us that fixing the underlying cause of a problem will alleviate the symptoms and not the other way around. As painful or as inequitable or as much of a boondoggle that this new program may turn out to be, it is at least an attempt to correct the problem. I am hoping against hope that the phrase “Hello, I’m from the Federal Government and I’m here to help” will take on new, positive meaning. The views expressed in this column do not necessarily reflect the views of Channel Capital Group. Inc.

311

Geithner to Propose Vast Expansion Of U.S. Oversight of Financial System By Binyamin Appelbaum and David Cho Washington Post Staff Writers Thursday, March 26, 2009; A01 Treasury Secretary Timothy F. Geithner plans to propose today a sweeping expansion of federal authority over the financial system, breaking from an era in which the government stood back from financial markets and allowed participants to decide how much risk to take in the pursuit of profit. The Obama administration's plan, described by several sources, would extend federal regulation for the first time to all trading in financial derivatives and to companies including large hedge funds and major insurers such as American International Group. The administration also will seek to impose uniform standards on all large financial firms, including banks, an unprecedented step that would place significant limits on the scope and risk of their activities. Most of these initiatives would require legislation. Geithner plans to make the case for the regulatory reform agenda in testimony before Congress this morning, and he is expected to introduce proposals to regulate the largest financial firms. In coming months, the administration plans to detail its strategy in three other areas: protecting consumers, eliminating flaws in existing regulations and enhancing international coordination. The testimony will not call for any existing federal agencies to be eliminated or combined, according to the sources, who spoke on condition of anonymity. The plan focuses on setting standards first, leaving for later any reshaping of the government's administrative structure. The nation's financial regulations are largely an accumulation of responses to financial crises. Federal bank regulation was a product of the Civil War. The Federal Reserve was created early in the 20th century to mitigate a long series of monetary crises. The Great Depression delivered deposit insurance and a federally sponsored mortgage market. In the midst of a modern economic upheaval, the Obama administration is pitching the most significant regulatory expansion since that time. An administration official said the goal is to set new rules of the road to restore faith in the financial system. In essence, the plan is a rebuke of raw capitalism and a reassertion that regulation is critical to the healthy function of financial markets and the steady flow of money to borrowers. The government also plans to push companies to pay employees based on their long- term performance, curtailing big paydays for short-term victories. Long-simmering anger about Wall Street pay practices erupted last week when the Obama administration disclosed that AIG had paid $165 million in bonuses to employees of its most troubled division, despite losing so much money that the government stepped in with more than $170 billion in emergency aid.

312 The administration's signature proposal is to vest a single federal agency with the power to police risk across the entire financial system. The agency would regulate the largest financial firms, including hedge funds and insurers not currently subject to federal regulation. It also would monitor financial markets for emergent dangers. Geithner plans to call for legislation that would define which financial firms are sufficiently large and important to be subjected to this increased regulation. Those firms would be required to hold relatively more capital in their reserves against losses than smaller firms, to demonstrate that they have access to adequate funding to support their operations, and to maintain constantly updated assessments of their exposure to financial risk. The designated agency would not replace existing regulators but would be granted the power to compel firms to comply with its directives. Geithner's testimony will not identify which agency should hold those powers, but sources familiar with the matter said that the Federal Reserve, widely viewed as the most obvious choice, is the administration's favored candidate. Geithner and other officials have said in recent weeks that such powers could have kept in check the excesses of AIG and other large financial companies. "The framework will significantly raise the prudential requirements, once we get through the crisis, that our largest and most interconnected financial firms must meet in order to ensure they do not pose risks to the system," Geithner said yesterday in a speech before the Council on Foreign Relations in New York. Hand in glove with this expanded oversight, the administration also is seeking the authority to seize these large firms if they totter toward failure. Under current law, the government can seize only banks. The administration yesterday detailed its proposed process, under which the Federal Reserve Board, along with any agency overseeing the troubled company, would recommend the need for a takeover. The Treasury secretary, in consultation with the president, then would authorize the action. The firm would be placed under the control of the Federal Deposit Insurance Corp. The government also would have the power to take intermediate steps to stabilize a firm, such as taking an ownership stake or providing loans. "Destabilizing dangers can come from financial institutions besides banks, but our current regulatory system provides few ways to deal with these risks," Geithner said yesterday. "Our plan will give the government the tools to limit the risk-taking at firms that could set off cascading damage." The administration compared the proposed process with the existing system under which banking regulators can take over failed banks and place them under FDIC control. One important difference is that the decision to seize a bank is made by agencies that have considerable autonomy and are intentionally shielded from the political process. Some legislators have raised concerns about providing such powers to the Treasury secretary, a member of the president's Cabinet. The cost of bank failures is carried by the industry, which pays assessments to the FDIC. The Treasury said it has not yet determined how to pay for takeovers under the proposed system. Possibilities include dunning taxpayers or collecting fees from all institutions the government considers possible candidates for seizure.

313 FDIC chairman Sheila C. Bair issued a statement that expressed support for an expansion of her agency's responsibilities. "Due to the FDIC's extensive experience with resolving failed institutions and the cyclical nature of resolution work, it would make sense on many levels for the FDIC to be given this authority working in close cooperation with the Treasury and the Federal Reserve Board of Governors," Bair said. The administration also wants to expand oversight of a broad category of unregulated investment firms including hedge funds, private-equity funds and venture capital funds, by requiring larger companies to register with the Securities and Exchange Commission. Firms also would have to provide financial information to help determine whether they are large enough to warrant additional regulation. Hedge funds were designed to offer high-risk investment strategies to wealthy investors, but their role quickly grew from one on the fringe of the system to a place near the center. Some government officials have sought increased regulation of the industry since the 1998 collapse of Long-Term Capital Management threatened the stability of the financial system. Geithner also plans to call for the SEC to impose tougher standards on money-market mutual funds, investment accounts that appeal to investors by aping the features of checking accounts while offering higher interest rates. He will not make specific suggestions. SEC chairman Mary Schapiro plans to testify today that the SEC supports both proposals. The administration's broad determination to regulate the totality of the financial markets also includes a plan to regulate the vast trade in derivatives, complex financial instruments that take their value from the performance of some other asset. Derivatives have become a basic tool of the financial markets, but trading in many variants is not regulated. Credit-default swaps, a major category of unregulated derivatives, played a major role in the collapse of AIG. Geithner plans to call for the entire industry to be placed under strict regulation, including supervision of dealers in derivatives, mandatory use of central clearinghouses to process trades and uniform trading rules to ensure an orderly marketplace. The Fed already is moving to improve the plumbing of the financial system, including of the derivatives trade. The administration wants to expand and formalize these efforts. Senior government officials view these highly technical arrangements as critical to the restoration of a healthy financial system. Staff writer Zachary A. Goldfarb contributed to this report.

314 Mar 26, 2009 Time For A New Insolvency Regime For Non- Banks And Bank Holding Companies? Overview: While banks have a receivership regime based on the FDIC taking over insolvent banks and working them out in a orderly way, bank holding companies and non bank financial institutions do not have such conservatorship/receivership regime outside of Chapter 11 or Chapter 7 bankruptcy. That is why the government had to bail out the creditors of Bear Stearns and AIG and that is why the collapse of Lehman was disorderly. We need now an orderly system to wind down systemically important financial institutions and bank holding companies as many assets and CDS and bonds of banks are at the holding company level rather than the bank level (Roubini)--> see Blueprint for Regulatory Reform: Should There Be A Super-Fed? o March 25 Geithner (via WSJ, CFR): The Treasury Department revealed key details of a draft bill it plans to send to Congress that would give regulators unprecedented emergency powers to wind down faltering nonbank firms such as insurer AIG. o cont.: Treasury said the draft bill would enable the federal government to seize troubled bank- and thrift-holding companies as well as firms that control broker- dealers and futures commission merchants. Under the bill, the Treasury secretary would have to make "triggering determination" before invoking resolution authority (akin to the so-called systemic risk exception under the FDIA). The secretary would have to find that the firm is in danger of becoming insolvent, that its insolvency would have serious adverse effects on the economy and financial stability, and that taking emergency action would avoid those adverse effects. o cont.: An Obama administration official confirmed that the legislative proposal would also give the government authority to shut down troubled hedge funds, which currently face minimal oversight. The government could potentially use the new "resolution authority" on any non-bank financial firm that is deemed to pose systemic risk, the official added. o March 10 Bernanke: Models do exist for resolution procedures including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008. o cont.: Any new regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization (see Financial Stability Forum report) o Bulow/Klemperer: Focus on liabilities of troubled institutions rather than on assets as with Geithner's pppip: 1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this. 2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge"

315 bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power. 3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank. 4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts. 5. Coordinating actions with other countries will reduce any risks. o Buiter: I propose that a special resolution regime for banks be designed in such a way that 1) it achieves any desired increase in the capital ratios of a bank entering the SRR (or any desired reduction in the leverage ratio) to the maximum possible exent through a mandatory debt-to-equity conversion. 2) Unsecured creditors would be first in line for a haircut (in reverse order of seniority). 3) Secured creditors would retain their claim to the collateral securing their loan or bond, but would share with the unsecured creditors the haircut in their claim on the bank. 4) New capital should only injected by the government if there either is not enough debt in the balance sheet or if the balance sheet of the bank is considered too small. 5) While it is conventional for existing equity holders to be wiped out before debt is converted into equity, I don’t consider this essential. Dilution may provide adequate punishment and incentives for future equity investment decisions. o cont.: The worst of all possible worlds would be the Irish (and now also Danish) approach where all creditors of the banks are guaranteed by the government (for a fee that undoubtedly will not cover the government’s opportunity cost) and the tax payer is left without any upside. Mar 26, 2009 Blueprint for Regulatory Reform: Regulation By Activity For Everybody Rather Than By Institution? o March 26 WaPo: Geithner will seek to impose uniform standards on all large financial firms, including banks, an unprecedented step that would place significant limits on the scope and risk of their activities. The administration also wants to extend federal regulation for the first time to all trading in financial derivatives and to companies including large hedge funds and major insurers such as AIG. o March 25: Roubini: Finally, Geithner and Bernanke (see respective testimonies at AIG hearing on March 24) have come to agree about the need for a new insolvency regime for systemically important financial institutions (bank holding companies and non bank financial institutions) in order to avoid another Lehman and expensive ad-hoc bailouts like AIG. A new conservatorship/receivership regime of insolvency could be similar to the one used to manage the orderly takeover of Fannie and Freddie. o March 10: Bernanke (via FTAlphaville): "Effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role." Bernanke's other suggestions for resolving systemic risk include: more supervision for financial institutions deemed ‘too big to fail’, tighter restrictions on the assets in which money market funds can invest, and, perhaps most significantly, modifying the accounting rules which cause pro-cyclicality for bank’s capital positions.

316 o March 6 Reuters: A top priority for lawmakers is to create a new regulator of systemic risk, a job that Barney Frank has previously said should go to the Federal Reserve. "Are any of you troubled with giving the Fed so much power?" asked Spencer Bachus, the top Republican on the full House Financial Services committee. Frank's Financial Services committee will explore legislation to prevent excessive leverage in the financial system, create a way for the government to unwind failed non-bank financial institutions, and prohibit 100 percent securitization of loans. o Baker/Wallison: Why expand the powers of an agency that sat idly by as the housing bubble took shape? o Gross (PIMCO): There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks. o Lewitt (HCM): There is too little, not too much regulation. To do: impose absolute leverage limit on all financial institutions incl. hedge funds; outlaw off-balance sheet entities; reinstitute downtick rule against short-sellers immediately. o Larry Summers: Raise bank capital requirements. o Barney Frank: Single regulator/greater power to Fed good idea. Regulators should also re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.

Will The Fed's PPPIP Get Credit Flowing Again? Mar 25, 2009 Overview: The Geithner plan rests on the premise that legacy assets that are being re- intermediated on banks' balance sheets thus clogging them up are fundamentally undervalued due to a liquidity premium rather than drastically reduced cash flow expectations. If such is the case, the substantial incentives and debt guarantees provided by the taxpayers to private asset managers should be enough to wake their interest in bidding for toxic assets at a reasonable value for sellers. Whether credit supply resumes depends on the true health of banks: fundamentally sound institutions will be able to take whatever writedown relative to the PPPIP established market price and get rid of the assets without the need of further recapitalization, others might need recapitalization in response to writedown (see i.e additional $750bn TARP 3 and 4 earmarked in Obama's budget subject to Congress approval as TARP 2 has only $150bn left), and weak banks won't have an incentive to sell at all in view of easing mark-to-market rules and if the writedown would wipe out their capital. o March 25 FT Guha/Guerrera: The government’s toxic assets plan will force banks such as Citigroup, Bank of America and Wells Fargo to take large writedowns on their loans, requiring them to raise more capital from taxpayers or investors, executives and analysts have warned. o March 25: ON Libor: 28bp - TED spread (3m LIBOR - T-bill): 104bp--> extreme flight to quality caused record repo fails; - 3m USD LIBOR - OIS: 98bp; - 3m EUR LIBOR - OIS: 82bp; - U.S. CDX IG spread: 184bp

317 - U.S. Crossover: 1673bp - EU iTraxx IG spread: 162bp; - EU iTraxx subfinancials: 904bp - CMBX, LCDX and ABX spreads/prices are all off their recent lows. o BNP March 24: We have seen equity, the iTraxx subordinated financials index and Tier 1 debt spreads all improve. But the rise in bank lower tier 2 debt spreads also appears to have been arrested in the last couple of days and iBoxx senior financials spreads have also been ticking slightly lower. Small improvements, but encouraging none-theless. o March 24 FT: The MBA revised its forecast for new loans upward by $800bn, predicting that aggressive Federal Reserve policies will drive the total loans originated to reach 2,780bn, the most since 2005. The revision was sparked by falling interest rates following last week’s Fed decision to purchase Treasury bonds and mortgage-backed securities which is expected to create a flurry of refinancing activity. o March 10 Bloomberg: “There is also a general concern over the demand for dollar-based funding in Europe,” said Meyrick Chapman, a fixed- income strategist in London at UBS AG. “Movement in cross- currency basis swaps signals that this demand has increased.” o Dec 19 WSJ: BBA made it clear that banks must not contribute LIBOR quotes for any government-guaranteed, or effectively secured, debt. The clarification is designed to help ensure the London interbank offered rates reflect the cost of unsecured borrowing between banks. o ECB via FT: ECB mulls an ECB-organized clearing house that would guarantee interbank lending, with the intention of overcoming mutual distrust between banks--> interbank guarantee would achieve in Europe what Credit Easing would do in U.S. with Fed buying non-financial debt because bank lending is relatively more important in Europe than market-based financing. o Dec 17 BNP analyst Jacq via Bloomberg: “There is no demand coming from the interbank market at all. Banks are borrowing straight from the Fed and hoarding that cash till they need some and then returning to the Fed. We don’t expect a return to normal conditions in the coming six months.” o Economist: Why isn't there any arbitrage between low funding cost and high lending revenue in term interbank market? One reason is that central banks require collateral against lending, and the type of assets that are suitable pledges are in short supply. o Mason: Reason for persistently high interbank spreads is not lack of confidence but forced re-intermediation of off-balance sheet items for which banks know all too well that there isn't enough capital (see: What is driving interbank spreads?) o Dec 6 RGE: The cost of protecting corporate bonds from default surged to records around the world as did corporate bond spreads themselves--> negative basis is back in AAA segment after Lehman's default, HY bond spreads in line with amount of low quality debt oustanding--> spreads are currently pricing in a default rate of 21%. Corporate downgrades are accelerating, real outlook worsens and deleveraging is likely to continue (see: Record Corporate Bond Spreads: A Buying Opportunity?) o Dec 19: George Magnus: 5 things to do after Minsky Moment: 1) European banks will need a further $100bn-$150bn of capital, while US banks, including regional banks, should quickly be allocated most of the unspent Tarp money of $350bn; 2) Equity-for- debt swaps will be required for companies with excessive debt; 3) British, German and

318 French programmes amount to a little over 1 per cent of their GDP, incl. much window- dressing. The forthcoming US programme, expected to be about $600-$700bn (or about 4 per cent of GDP), will compensate for much of the private sector’s withdrawal of spending and borrowing; 4) Quantitative easing helps to keep short-term rates near zero and could peg longer-term rates too--> risk of inflation can be dealt with later; 5) leadership. o Roubini: To make the Wall Street rescue sustainable Main Street must be helped as well. The US government will need to implement a clear plan to reduce the face value of mortgages for distressed home owners and avoid a tsunami of foreclosures (as in the Great Depression HOLC and in my HOME proposal). o cont.: A fiscal stimulus plan is essential to restore – on a sustained basis – the viability and solvency of many impaired financial institutions. If Main Street goes bust in the next six months rescuing in the short run Wall Street will still lead Wall Street to go bust again as the real economy implodes further. o cont.: To do: 1) the federal government should have a plan to immediately spend in infrastructures and in new green technologies; 2) also unemployment benefits should be sharply increased together with a 3) targeted tax rebates only for lower income households at risk; and 4) federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.). Details Of Geithner's Public-Private Partnership: Large Taxpayer Subsidies For Toxic Asset Investors Mar 25, 2009 Overview: Industry analysts estimate that the nation’s banks are holding at least $2 trillion in troubled assets mostly residential and commercial mortgages.(NYT) . Geithner's $500bn - $1 trillion Public-Private Partnership Investment Program plan in own words (WSJ): o “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." o "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." o "Third, private-sector purchasers will establish the value of the loans and securities purchased under the program through auctions, which will protect the government from overpaying for these assets." o Sample Investment Under the Legacy Loans Program: o Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.

319 o Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio. o Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages. o Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity. o Step 5: The Treasury would then provide 50% of the equity funding required on a side-by- side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6. o Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC. o Sample Investment Under the Legacy Securities Program: o Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program. o Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury. o Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund. o Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co- investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund. o Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities. o Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched. Reactions: o FT Alphaville: At the heart of this complex plan is liquidity, which Geithner has identified as both the problem and the answer. Increase liquidity and assets price will rise towards fair value, banks’ capital ratios will improve and they will start lending again. What if value of assets is low because of reduced cash flow expectations--> see also 'Fire- Sale' Vs. 'Hold-to-Maturity' Prices: Is The FASB Yielding To Pressure From The Industry? o Alea: The plan is good in theory as private investors have no incentive to overpay because they are in a first-loss position. However, there is likely to be a gap between the mtm value of the toxic assets and what a rational investor would pay, reducing or

320 eliminating the incentive for banks to participate. Only the truly cash-starved banks will jump. o Blog comments: private investors will take long positions in the selling banks’ stocks (or other long positions in derivatives) and will then have an incentive to grossly overpay for the securities in this program. They’ll gladly take some losses in this program to boost their other positions outside the program. o Krugman: Huge taxpayer subsidies to the private sector are involved: Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a non- recourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130 [in a competitive auction.] Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me. o cont.: Another way to say this is that by financing a large part of the purchase with a non- recourse loan , the government is in effect giving investors a put option to sweeten the deal. o John Mauldin (via TechTicker): I'm in the hedge fund business myself but as a taxpayer I don't believe Treasury should subsidize hedge funds.

Rationale: o Lucian Bebchuk (Harvard, via Forbes): If the underlying problem is at least partly one of liquidity, an effective plan for a public-private partnership in buying troubled assets can be designed. The key is to have competition at two levels. First, at the level of buying troubled assets, the government’s program should focus on establishing many competing funds that are privately managed and partly funded with private capital--and not creating one, large "aggregator bank" funded with public and private capital and engaging in purchasing troubled assets. Second, at the level of allocating government capital among the competing private funds, potential fund managers should compete for government capital under a market mechanism resulting in maximum participation of private capital and minimum costs to taxpayers.

321 News March 26, 2009, 5:00PM EST Can Geithner's Toxic-A+sset Plan Work? THE TREASURY SECRETARY'S PLAN TO RID BANKS OF BAD LOANS FACES PLENTY OF ROADBLOCKS. ONLY TIME WILL TELL IF IT CAN SUCCEED By Jane Sasseen The stock market enjoyed an explosive rally on Mar. 23 after Treasury Secretary Timothy F. Geithner at long last unveiled a detailed plan to team up with private investors to rid the banks of troubled mortgage assets. No mystery here: Bolstering major banks so they can start lending again is essential if the economy is going to recover. Will it work? It might, but that may require some sizable bank asset sales to come together by early summer, followed by a steady flow of deals through yearend to get the program off the ground. Geithner thinks he has the right mix of incentives in place to quickly ramp up the program. But it will take a sustained flow of deals to establish attractive prices for all manner of home loans and mortgage-backed securities, which have been devilishly tough for banks to unload since the credit crisis began back in late 2007. The Treasury's Public-Private Investment Program aims to create investment partnerships that will combine government cash with equity capital from private investors. Uncle Sam will then lend those partnerships money at below-market rates so they have more funds to buy up the banks' bad assets. By providing much of the funding—and limiting private investors' potential losses—Geithner hopes to spur competitive bidding that will establish realistic prices for the toxic assets and get them off the banks' balance sheets. "The goal is to provide liquidity to the market on reasonable terms," says Larry Summers, head of President Obama's National Economic Council. So far, private equity giant Blackstone Group (BX), bond mavens Pimco, and other investors have expressed interest in participating. Investors expect Treasury to line up a few high- profile deals by late May or June. William H. Gross, Pimco's co-chief investment officer, argues that if the government lends to the partnership at rates as low as 2%—which the market expects—investors could pay close to 60 cents on the dollar for the devalued assets with returns of around 15%. Sellers would still have to make concessions, but far smaller ones than if forced to sell at today's fire-sale prices. "Geithner's plan closes the gap significantly, but we'll still have to see if anything crosses the market," says Gross. With Treasury aiming to buy up to $1 trillion in bank assets, Gross wants to see a monthly deal flow of $150 billion in the second half. It will take that kind of volume to get a sustained lift in prices. "If this is working, you'll start to see housing and mortgage securities prices stabilize, and maybe even go up," says Steven D. Persky, managing partner of Dalton Investments. Money pros say it will be a month or even two before enough is known about the terms of the deal to decide if it's worth participating. Also, the backlash against AIG's (AIG) bonuses makes a partnership with Uncle Sam risky. "Until we see how the pricing mechanism works, the rates the government is offering, and the expected returns, [we won't know] where the deals are," says Robert A. Eisenbeis, the chief monetary economist for Cumberland Advisors.

322 Another problem: Bankers are already complaining that they could be forced into big writeoffs if the prices for troubled assets remain too low. If the banks refuse to sign on, the Treasury program will tank. That's one reason why Obama plans to meet with the CEOs of JPMorgan Chase (JPM), Citigroup (C), and other banks on Mar. 27. So it will be critical that the bidding process narrows the gap between what buyers will pay for the assets and what banks will sell them for. The market is in a deep freeze now, in part, because the two sides don't agree on the value of the tainted mortgage assets. Investors, who don't want to overpay, think most mortgage assets are worth only around 20 cents to 30 cents on the dollar. But many banks argue that plenty of good mortgages have been knocked down to rock- bottom prices and they want 70 cents to 80 cents on the dollar; accepting less would lead to more ruinous write-offs. And if, as expected, U.S. accounting rulemakers meeting on Apr. 2 make it easier for the banks to avoid such write-downs, the banks may be even less willing to sell at a loss. Administration officials make clear they expect the banks to take the haircut given the economic stakes. Those that do poorly on the so-called stress tests currently under way may have little choice but to cooperate. If they don't, expect another market mood swing, this time to one of despair. With Theo Francis Business Exchange: Read, save, and add content on BW's new Web 2.0 topic network Preventing the Next Crisis The Obama Administration has proposed giving Treasury the authority to reorganize financial giants if their collapse threatens the economy, a more expedient approach than relying on bankruptcy courts. New York University economist Nouriel Roubini, credited with predicting the current crisis, says that such authority is long overdue. To read Roubini's blog post, go to http://bx.businessweek.com/bailout/reference/ Sasseen is Washington bureau chief for BusinessWeek.

323 Mar 26, 2009 Commercial Real Estate Bust Has Started: Access To TALF Just In Time? Overview: The delinquency rate on about $700 billion in securitized loans backed by office buildings, hotels, stores and other investment property has more than doubled since September to 1.8% in March 2009. Foresight Analytics in Oakland, Calif., estimates the U.S. banking sector could suffer as much as $250 billion in commercial-real-estate losses in this downturn. The research firm projects that more than 700 banks could fail as a result of their exposure to commercial real estate.(Calculated Risk) o March 26: Soros: U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks. o March 23: Under Geithner's new PPIP for toxic legacy assets, the government expands the $1 trillion TALF secured lending facility -initially created by the government to restart the market for new car loans, student loans and credit-card debt- to include legacy AAA CMBS o Feb 5: MIT "With the index already having fallen 22 percent in the current downturn, it now seems likely that this down market will be at least as severe as that of the early 1990s for commercial property," o Dec 22 WSJ: According to research firm Foresight Analytics LCC, $530 billion of commercial mortgages will be coming due for refinancing in the next three years with about $160 billion maturing in the next year. Credit is practically nonexistent and cash flows from commercial property are siphoning off--> industry lobbies to be included in TALF. o Dec 22 Bloomberg: U.S. commercial properties at risk of default could triple to around 7% if rental income from office, retail and apartment buildings drops by even 5 percent, a likely possibility given the recession, according to research by New York-based real estate analysts at Reis Inc. o FT Alphaville: With CMBS, as opposed to RMBS, when trouble does hit, it is much more sudden and sharp. The delinquency rate might not be expected to smoothly move higher, it should jump. And it will do so when the real pain begins to bite in the economy. o Banks' exposure to real estate: - At the end of Q2, Deutsche Bank held $25.1 billion worth of commercial loans. Morgan Stanley held $22.1 billion and Citigroup had $19.1 billion. Lehman held largest exposure with $40bn worth of commercial real estate assets--> A large part of its portfolio is a high-risk loan known as bridge equity made with Archstone, a metropolitan apartment developer, and most of the rest are floating-rate loans, which are riskier, according to a person who reviewed the offering.

324 - CRE and CMBS exposures will likely exacerbate credit problems at U.S. banks but not as much as RMBS (except those banks specializing in commercial real estate); - default rates on CMBS collateral could increase toward the historical average of 80bp, roughly double or triple the lowest point of the credit cycle; - lax underwriting standards could increase rates on bank CRE loans further; - recent valuation declines in the CMBS market imply near-catastrophic and rather - unrealistic credit conditions; - CMBS troubles should not reach the 1980s levels. (Fitch and Interest Rate Roundup) o Fitch August 1: 50% of CMBS outstanding are 2006/2007 vintages--> Borrowers would default on an average of 17.2% of securitized commercial mortgages over 10 years if U.S. economy dips into recession with 0.2% contraction in growth, compared with current very low default rates of 4% (i.e. +330%). o OCC Dugan, Feb 08: One third of regional banks have commercial real estate exposure of at least 300% of equity. So far, non-current loans have increased in the construction&development category to around 5%; non-residential buildings, multifamily buildings, and real estate loans not secured by property are set to follow suit. o Fitch: Since '05, interest-only loans and loans with high loan-to-value ratios implying unrealistic future rent expectations http://www.rgemonitor.com/687

325 26.03.2009 IS THE EU RUN BY A MADMAN?

Speaking in the European Parliament, a mentally unbalanced Topalanek accuses Obama of going down the road to hell. The Czech EU presidency is now turning into the disaster we have always expected. A day after losing a vote of no confidence in his national parliament, the Czech premier took the stage at the European Parliament in Strasbourg to launch a diplomatically disastrous attack on US president Barrack Obama over his stimulus programme. He said the attempt to borrow trillions would pave the road to hell. (While conservative economists inside and outside the US may agree with that view, it is nevertheless a different matter for the acting president of the EU to make such a statement, as one would expect it to reflect official EU position, which it is not.) FT Deutschland said in its news story that the comments underline doubt the Czech EU presidency, which runs until June, could be successfully completed. Wolfgang Proissl of FT Deutschland also produced a nice anecdote in a separate article. When Topolanek said the US had to finance its stimulus through the issue of bonds, a translation error produce the news headline that the US would finance its stimulus through the export of bombs. Flabberghasted Czech officials told everybody that he said “bonds, not bombs”. Global trade shrinks 20% since October – Speed of decline greater than during Great Depression The best authority on real time global trade data is the Netherlands CPB Institute, which yesterday published its January trade data. Global trade are now down 20% since October. This is not annualised but actual. In other words, global trade volumes are down by a fifth compared to pre-crisis levels. FT Deutschland quotes a CPB staffer as saying this is faster than during the Great Depression (the estimates there range from 25- 35% during 1929 and 1932).

326 This is only the beginning Says a warning from a group named “bank bosses are criminals” issued after claiming responsibility for vandalising the home of former RBS chief Fred Goodwin. Goodwin was publicly criticised for receiving £700000 annual pension after his bank had to be bailed out by the government with a £20bn capital injection. FT Deutschland also reports about other incidents, such as the French 3M chief Luc Rousselet, who is taken hostage by his own staff over dismissals. In France, uprising social frustration is used by trade unions to mobilise for protest actions and led some commentators to compare the situation with the French revolution. But a contagion throughout the Western World seems still considered as unlikely since welfare systems are capable of buffering intense social tensions. German tax presents German finance minister Peer Steinbrueck wants a temporary tax break for companies to support them through the crisis reports the FT Deutschland. Parts of the tax reform last year could be reversed as the finance ministry now works on provisions that allows a loosening the limits for tax deductibility of interest payments (which is currently limited to 1m and could be extended to 3m). Also strict rules for firms that acquire other companies to offset their losses against own tax liabilities could be relaxed. Industrial confederations and Christian Democrats called for relaxation of both rules for weeks but met resistance from Steinbrueck, who now explains his U-turn by saying that he does not want to appear bull-headed. EU should help CEE A Le Monde editorial argues that the EU has no option to be indifferent to what happens in Central and Eastern Europe. They are emerging countries that our economies were happy to invest and outsource our production to in the past. Today, as the crisis proceeds, money and production are repatriated from the CEEs, causing their currencies to depreciate and provoking a political crisis in some countries. The other EU states are economically so interlinked with the CEE that a crisis there has serious repercussions for the centre. Also politically, it is impossible to simply leave those countries to their own destiny in a crisis that was not of their own making. In the coming years the CEE will need money but also political consideration. DSK: Question about new reserve currency legitimate In a hearing of the parliamentary finance committee in Paris, IMF president Dominique Strauss Kahn said that it is absolutely legitimate to discuss the possibility of a new international currency (Le Monde). This is not a new question but the current crisis renews the interest in this question. He also said that he does not consider that the dollar ceases to be an international reserve currency. Even the Chinese don’t think that. A new chief of the Economic and Financial Committee Thomas Wieser, state secretary in the Austrian finance minister is to be become the next head of the Economic and Financial Committee, the influential committee that prepares the eurogroup and Ecofin meetings of finance ministers. FT Deutschland has this story, and points out that it is unusually for a non-G7 representation to fulfil this role, but Germany’s Jorg Assmussen was considered as too inexperience to be entrusted with this

327 role. Wieser replaces Xavier Muscat, who will return to Paris as Sarkozy’s economic adviser.

US New Home Sales Bankers are now talking about the green shoots of recovery because a few indicators have turned. When it comes to the US housing market, a critical element in the crisis, our favourite source Calculated Risk tells us that the February upturn in new home sales should not be exaggerated, nor confused with an upturn in prices. Also the upturn is so small that it is hardly visible on the chart – an eyetest as Calculated Risks puts it. Still the blogger expects new homes sales to bottom out this year, which suggest that prices could bottom out next year. Here is the eyetest chart.

In defence of the Geithner plan Yesterday, we summerised four highly negative comments about the Geithner plan. For balance, we thought it appropriate to highlight a few of the positive comments. Brad DeLong The most comprehensive defence of the plan comes from Brad DeLong. He makes the point companies cannot currently finance expansion because asset prices are excessively low due to higher risk and information discounts. The idea is to boost asset prices to the companies can expand once again. If the government buys up $1 trillion of financial assets, the private sector has to hold $1 trillion less of risky and information-impacted assets. He estimates that one would have to take $4 trillion out of the market to move asset prices to unfreeze credit markets. So the plan is not sufficient. “But the Fed is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.”

328 Nouriel Roubini Nouriel Roubini says he sees light at the end of the tunnel, except that he does not know whether it’s daylight, or the light of an oncoming train. But he was positive on the Geithner plan: He told the New York Times he liked that the government was finally stepping up to clear the toxic assets off the bank’s balance sheet and that private capital would come in to make a market for it. “Having five people bid on a toxic asset, rather than a clueless government, will ensure that the government doesn’t overpay… People say, ‘the government is putting in 95 cents on the dollar, so why not put 100,’ to do it all by itself. It’s because private-sector participants have the incentive to get the best price.” Jeff Frankel, too, believes that the Geithner plan should be given a chance for similar reasons, as those of Roubini and DeLong. In the end, the argument boils down to the question how to judge the importance of the private sector component. Without it, the plan is similar to the TARP programmes, which most of these commentators have condemned as being ineffective. (¿es también cuestión de tiempo?)

329

Economy March 26, 2009 Geithner Affirms Dollar After Remarks Send It Tumbling By ANAHAD O’CONNOR Treasury Secretary Timothy F. Geithner on Wednesday said that the dollar would remain the world’s dominant reserve currency for some time to come, clarifying earlier remarks that sent the dollar tumbling. “The dollar remains the world’s dominant reserve currency,” Mr. Geithner said after a speech in Midtown Manhattan to the Council on Foreign Relations. “I think that’s likely to continue for a long period of time. Mr. Geithner’s comments came in response to a question regarding a proposal by Zhou Xiaochuan, the governor of the People’s Bank of China, that suggested a possible replacement for the dollar as a global reserve currency. The proposal called on the International Monetary Fund to increase the use of "Special Drawing Rights" — a basket of currencies made up of the euro, yen, pound and dollar that has served as a reserve asset. The dollar plunged earlier in the morning after Mr. Geithner, in response to another question, said China’s suggestion “deserves some consideration,” though he added that he had not read the proposal. The dollar rebounded later on Mr. Geithner’s clarification. Still Mr. Geitner said that the “evolution of the dollar’s role in the system depends really primarily on how effective we are in the United States in getting not just recovery back on track, our financial system repaired, but we get our fiscal position back to the point where people will judge it as sustainable over time.” “As a country,” he added, “we will do what’s necessary to make sure we’re sustaining confidence in our financial markets and in — and in the productive capacity of this economy and our long-term fundamentals.” In his speech before the group, Mr. Geithner pressed the case for expanding the government’s ability to take over and restructure ailing institutions that threaten the broader financial system. Mr. Geithner said that the government needed the expanded powers in order “to help ensure that this country is never again confronted with the untenable choice between meltdown and massive taxpayer bailouts.” “One of the key lessons of the current crisis is that destabilizing dangers can come from financial institutions besides banks,” Mr. Geithner said in his remarks, “but our current regulatory system provides few ways to deal with these risks.” Mr. Geithner focused his remarks on the Obama administration’s plan to free the nation’s financial institutions from the toxic mortgage-related securities that have poisoned the economy.

330 On Tuesday, Mr. Geithner, testifying before the House Financial Services Committee, proposed expanding the government’s power to give it more control over financial institutions, like insurance companies, that are in trouble and big enough to destabilize the broader financial system. With such authority, the administration argued, rather than having to spend $170 billion to bailout the American International Group, the government could have put the insurance company into receivership or conservatorship and regulators would have been able to unwind it slowly. Atop A.I.G. insurance companies “is an almost entirely unregulated business unit that took extraordinary risks to generate extraordinary profits,” Mr. Geithner said Wednesday. “And when this unit’s derivative contract losses pushed A.I.G. to the brink of failure last fall, the entire financial system was endangered.” “The legislation that I believe we need would help us deal with a similar case in the future,” he said. The proposal would extend power the government has long had over banks to insurance companies like A.I.G., investment banks, hedge funds, private equity firms and any other kind of financial institution considered “systemically” important. That would let the government for the first time take control of private equity firms like Carlyle or industrial finance giants like GE Capital should they falter. If Congress approves such a measure, it would represent one of the biggest permanent expansions of federal regulatory power in decades. But scores of questions remained about how the authority would actually work, and industry experts cautioned that it would only be one step in a broad overhaul of financial regulation that President Obama and Congress were beginning to map out. Mr. Geithner’s speech on Wednesday is sandwiched between hearings before the House Financial Services Committee. On Thursday, Mr. Geithner is scheduled to return before the committee. “Tomorrow, I will lay out the administration’s broad framework for dealing with the kind of systemic risk that A.I.G. posed,” Mr. Geithner said. “The framework will significantly raise the prudential requirements, once we get through the crisis, that our largest and most interconnected financial firms must meet in order to ensure they do not pose risks to the system.” “In the coming weeks, we will take additional steps, among them, proposing new and stronger rules to protect American consumers and investors against financial fraud and abuse.” He ended with a plea for cooperation. “The world needs to see America come together with a commitment that is commensurate with the deep gravity of the problem,” Mr. Geithner said. “The American people need confidence that the resources they are providing will be used wisely and in ways that will benefit them.”

331

Las turbulencias de la economía hacen caer a tres gobiernos de Europa del Este Las primeras señales de alarma política por la crisis de los mercados se dejan notar en Rumania, Hungría y República Checa CRISTINA GALINDO | Enviada especial - Varsovia - 25/03/2009 Primero fue Letonia, después Hungría y, ahora, le toca el turno a República Checa. La crisis económica está provocando la caída de los Gobiernos del Este de la Unión Europea (UE), acorralados por las turbulencias financieras y las protestas populares. Los elevados déficit públicos y las abultadas deudas externas de muchos de los países de la región no dejan margen a sus Ejecutivos, ya de por sí bastante inestables políticamente, para elevar el gasto y las inversiones y contrarrestar los efectos de la crisis. Los analistas ya comparan lo que está pasando en el Este europeo, muy dependiente de las inversiones extranjeras y de las exportaciones al Oeste, con las crisis sufridas en América Latina en los ochenta y en Asia en los noventa, cuando el Fondo Monetario Internacional (FMI) tenía que salir al rescate de esas economías, mientras sus Gobiernos caían uno tras otro. Rumania se ha convertido hoy en el tercer país de la zona que recibe ayuda de urgencia del Fondo, en colaboración con la UE y el Banco Mundial, en forma de préstamos por 20.000 millones de euros. Hungría ha recibido ayudas por otros 25.000 millones y la pequeña Letonia, por otros 10.000 millones. En la cumbre europea celebrada la semana pasada, la UE duplicó el límite máximo del mecanismo comunitario de ayuda financiera a las economías del Este hasta llegar a los 50.000 millones. Mientras algunos Gobiernos piden ayuda, sus rivales políticos piden elecciones adelantadas. "Lo que ha derrumbado al Gobierno checo no ha sido en realidad la crisis económica, sino que la oposición quiere ahora perjudicar de forma especial al partido de (el primer ministro Mirek) Topolanek de cara a las elecciones europeas de junio", afirma Jiri Pehe, director de la Universidad de Nueva York en Praga, y uno de los analistas más reputados del país, que además preside este semestre la Unión Europea. La corona checa caía este miércoles, un día después de que el partido del primer ministro, Mirek Topolanek, que llevaba meses gobernando en minoría, perdiera una moción de censura presentada por la oposición socialdemócrata por su gestión de la situación económica. La República Checa se enfrenta a la crisis con mayor solidez, en principio, pero si algo está demostrado este tsunami financiero es que nadie está a salvo de la recesión. "Creo que un equipo de expertos gobernará el país hasta las próximas elecciones, previstas para 2010; adelantar las elecciones en complicado", añade Pehe. Otra víctima es el primer ministro húngaro , en el ojo del huracán desde mucho antes del inicio de esta crisis porque su gestión no consiguió que el país creciera al ritmo de sus vecinos, ni en los buenos tiempos. Ahora, Ferenc Gyurcsany ha decidido dimitir porque considera que puede ser un obstáculo para la recuperación económica. Su partido, el socialista, tiene la minoría en el Parlamento, y tendrá que buscar un sucesor que convenza a los dos principales partidos de la oposición. El presidente del país, Laszlo Solyom, ha pedido hoy que se adelanten las elecciones, previstas para la primavera de 2010, para intentar evitar la bancarrota del país.

332 Pero el récord de la inestabilidad está en manos de Letonia, que acaba de formar su 15º Gobierno (una coalición de seis partidos) desde principios de los noventa. El república báltica, que creció un 50% entre 2004 y 2007, es el país del Este más afectado por la crisis: su producto interior bruto caerá un 12% este año y el paro amenaza con llegar al 50% de la población activa. Son las primeras señales de alarma. El tsunami financiero arrasa el Este y sus ciudadanos parecen cada día más indignados. El director gerente del FMI, Dominique Strauss-Kahn, ya advirtió de que la crisis amenaza con provocar disturbios sociales, que ya se han producido de forma considerable en Letonia, Lituania, Bulgaria, República Checa y Hungría.

333 OPINIÓN TRIBUNA: MIGUEL BOYER SALVADOR En medio de la crisis: la sequía de crédito MIGUEL BOYER SALVADOR 26/03/2009 Nos hallamos en un punto crucial de la crisis: la situación en la que la concesión de créditos se paraliza o, incluso, se contrae. Lo más tóxico para todos sería prolongar la contracción del crédito bancario El plan del Tesoro de EE UU tiene el mérito de poner manos a la obra En un estudio famoso de junio de 1983, Ben Bernanke -el actual presidente de la Fed- demostró que la Gran Depresión de 1929 no tuvo la profundidad y la duración desastrosa que conocemos por falta de liquidez, como era la tesis de Friedman, sino por la contracción del crédito bancario a los empresarios y a los particulares. Esto, según Bernanke, alargó la crisis en dos años más de lo que podía haber durado. En consecuencia, desde 1930 hasta 1933 y en cifras acumuladas, el PIB norteamericano cayó un 27% -lo mismo que el empleo y el consumo-, la inversión un 77% y la Bolsa un 82%. Quebró una cuarta parte de los bancos americanos y Roosevelt, apenas llegado a la presidencia, tuvo que declarar una "vacación bancaria" (suspensión del reembolso de los depósitos) en marzo de 1933, e inyectar inmediatamente 1.000 millones de dólares para recapitalizar a las entidades. Casi nadie piensa seriamente que la presente recesión puede alcanzar una caída de tal magnitud. Es evidente, sin embargo, que la dimensión de la crisis financiera y el efecto depresivo de la caída del valor de los activos mobiliarios e inmobiliarios sobre el consumo, la inversión y el empleo, deben tomarse con la mayor preocupación y combatirse con los instrumentos más potentes que nos dan la experiencia y la teoría económica. Para frenar la caída, y, luego, impulsar la demanda agregada -ahora casi en caída libre- se han puesto en juego medidas de política presupuestaria (gasto de inversión, reducción de algunos ingresos fiscales, ayudas a los sectores más dañados), enérgicamente en Estados Unidos, modestamente en Europa y, en particular, en España. Asimismo, los bancos centrales han ido aumentando la liquidez y bajando los tipos de interés. Entre los grandes bancos centrales -la Fed, el Banco de Inglaterra, el Banco de Japón- el Banco Central Europeo se ha destacado notablemente por su falta de agudeza y perspicacia en el análisis de la situación, subiendo los tipos de interés todavía en julio de 2008 y, declarando, ¡a mediados de septiembre pasado!, "que había unanimidad entre los gobernadores de su consejo en no bajar el tipo de interés". Es lamentable, porque las medidas monetarias tardan muchos meses en hacer todo su efecto y hay que utilizarlas lo antes posible. Afortunadamente, por el impacto de la caída del grande y centenario banco norteamericano Lehman Brothers y por los problemas que siguieron, el BCE se puso en marcha y ha resuelto en gran parte la falta de liquidez en Europa. Sin embargo, la liquidez abundante y los bajos tipos no resuelven el problema, crucial en esta fase de la crisis, que es el de facilitar y reactivar el crédito bancario. La interpretación de Bernanke sobre la tremenda responsabilidad del credit crunch en la profundización de la Depresión de 1929, es una advertencia que no debemos olvidar ni un momento.

334 Me parece tan importante que no he parado de recalcar -desde una entrevista en Abc el 26 de octubre de 2008, hasta otra en La Vanguardia el 8 de este mes- que es imprescindible y urgente aliviar a los bancos de una parte considerable de los activos dañados que figuran en su balance. El riesgo en que incurrieron aquéllos, con créditos dados en el pasado sobre garantías ahora devaluadas, crece con el tiempo y es una rémora que puede seguir paralizando el flujo necesario de nuevos préstamos. Las fórmulas para aliviar la "infección" de los activos tienen que descansar, ineluctablemente, en que el Estado asuma una parte de las pérdidas implícitas y sean cuales sean las soluciones adoptadas, sus defectos serán menos nocivos que un alargamiento del periodo de sequía de créditos, que sería lo más "tóxico" para toda la economía. Apenas enviadas las líneas anteriores a EL PAÍS, se ha conocido un plan del Tesoro de Estados Unidos para afrontar el fundamental problema de los activos "tóxicos" con un nuevo enfoque, tras los fracasados intentos del anterior secretario Paulson. Como el programa constituye una iniciativa de "manos a la obra", que parte de consideraciones semejantes a las que yo hacía en lo escrito, me ha parecido coherente añadir unos comentarios a la propuesta, conocida el martes pasado. En síntesis, el Programa (PPIP) consiste en asociar dinero proveniente de ingresos privados a otra cantidad, igual, aportada por el Tesoro Público, para dotar de fondos propios a un vehículo inversor, que comprará activos tóxicos de los bancos. Sobre esta base, la Corporación Federal de Aseguramiento de Depósitos otorgará préstamos al vehículo, en cantidad de seis veces lo aportado como fondos propios. El dinero movilizado así podrá llegar a 500.000 millones de dólares (extensibles a un billón de dólares). El procedimiento para la compra de activos será el de subasta, en la que el FDIC pujará por los activos que ofrezcan los bancos y, en el caso de que a éstos les convengan los precios, el vehículo los adquirirá. El método planteado por el secretario del Tesoro -Geithner- tiene importantes ventajas si es bien acogido por los inversores. Si no es así, no quedaría más solución que la asunción total del coste por el Estado. Por una parte, resolvería la cuestión del valor actual de los activos a comprar con un criterio de mercado, menos cuestionable que el de una transacción bilateral opaca entre banco y funcionarios de Gobierno. Por otro lado, elimina el intervencionismo político en los bancos -como ocurre con las recapitalizaciones vía acciones-, y reparte una parte (mínima, es cierto) del coste y del beneficio a los inversores privados. El PPIP parece haber sido bien recibido por Wall Street y por importantes inversionistas. Los que se han precipitado a poner el programa como "chupa de dómine" han sido el Nobel Stiglitz y el Nobel Krugman (novel, por cierto, en economía española, a pesar de sus viajes y de los buenos amigos que tiene aquí). El fondo de sus protestas es la indignación por una ayuda a los bancos, a costa de los contribuyentes. Es muy respetable, que Stiglitz y Krugman tengan siempre, como preocupación, la desigualdad entre la masa del pueblo americano y la clase alta, que se ha enriquecido notablemente en las últimas décadas. Pero me sorprende que olviden la inmensa miseria que la catástrofe bancaria y el crédito crash causaron en las clases más desfavorecidas de EE UU -y de Europa- entre 1929 y 1933. La prioridad ahora, es que no se repita tal desastre.

335 En EE UU hay una antipatía congénita de la mayoría de los ciudadanos por los bancos, según me explicó un Secretario del Tesoro, como corresponde a un pueblo de pequeños y medios empresarios. Me añadió que es casi imposible conseguir que el Congreso apruebe una ley que ayude o que parezca beneficiar a los bancos. Quizá por eso Geithner ha diseñado su plan de modo que no tenga que pasar por el cedazo parlamentario. Sería una enorme desgracia que un populismo demagógico e irresponsable y la repulsión que produce una ínfima -pero escandalosa- minoría de golfos financieros impidieran acortar y atenuar el sufrimiento que la crisis económica está infligiendo, principalmente a la población trabajadora.

Miguel Boyer Salvador es ex ministro de Economía y Hacienda.

336 WSJ Blogs Mar 25, 2009 1:35 PM

REAL TIME ECONOMICS ECONOMIC INSIGHT AND ANALYSIS FROM THE WALL STREET JOURNAL.

ECONOMISTS REACT: ‘HAS HOUSING HIT BOTTOM?’ Posted by Phil Izzo

Economists and others weigh in on the unexpected increase in new-home sales. Has housing hit bottom? It is much too soon to make this call. Recent housing numbers were influenced by weather. December and January were colder than normal in the Northeast and Midwest, and February was warmer than normal in the Northeast, and about normal in the Midwest. Temperature swings will swing the housing numbers, and the seasonal adjustment factors will augment these swings. On top of this, February was the eighth driest February in the 1895—2009 period, according to the National Climatic Data Center, the government agency within NOAA that monitors climate. Drier than normal weather during the winter months can also make the housing numbers spike. One key statistic pointing to “better-times-ahead,” however, bears watching. Last week, the Census Bureau reported that single-family housing permits (which are not influenced by weather as much as other housing numbers) increased 11.2% in February, but today, it revised this increase to 16.1%. Until we get another two positive readings on single-family housing permits, at best we can say that housing has likely hit an inflection point. An inflection means that the market is shrinking, but not in collapse. –Patrick Newport, IHS Global Insight Sales remain incredibly weak, but, as with the existing sales numbers, we are prepared to hazard the view that the post-Lehman meltdown is now over and the market is stabilizing. That’s not the same as a recovery, but it is better than continued declines in sales. –Ian Shepherdson, High Frequency Economics Overall, this report is better than we had anticipated, continuing a pattern of the February housing data exceeding expectations (recall that existing home sales bounced by 5% and housing starts climbed by 22%). To be sure, the improved data last month followed months of horrendous housing data, as activity fell off of a cliff following last fall’s financial upheaval. The pickup in February also came on the heels of an especially weak January performance, suggesting that the January-February swing may have reflected in part a weather effect. Still, the fact that starts, permits, and home sales rebounded in February despite still-challenging economic conditions suggests that, at the very least, the pace of decline in housing demand may be abating. It is clearly far too early to call a bottom in the housing market, especially given the deterioration in the labor market, but the February data have allayed some fears that the housing market would continue to freefall. –Omair Sharif, RBS Greenwich Capital Even with the number of homes available for sale down another 2.9%, a twenty-second consecutive decline to a seven-year low, the months” supply of unsold new homes only moderated to 12.2 months from the record high 12.9 months hit in January. Around 5 to 6 months of supply would be consistent with a balanced market, so inventories are still

337 completely out of hand heading into the crucial spring selling season. There’s little chance that the marginal bounce off the prior record low in single-family housing starts in February (the larger gain in overall starts was almost entirely in the volatile multi-family component) can be extended with inventories so bloated. –Ted Wieseman, Morgan Stanley New home sales in February staged their largest increase in over a year, increasing 4.7% to an annual rate of 337,000. Price concessions may be an important factor bringing buyers to the market last month; both median single-family home prices and average single-family home sales prices were down by record amounts in February. Almost half of homes sold last month were under $200,000; in the same month last year only 33% of homes sold were in this price range. –Michael Feroli, J.P. Morgan Chase The rebound in the number of U.S. new home sales may just be monthly volatility rather than a sign that housing activity has stabilized. New home sales fell by a huge 13.2% in January meaning that the 4.7% rise in February is nothing to get too excited about. Sales are still a frightening 75% below their peak. Admittedly, the figures do suggest that the rebound in February’s existing home sales (figures were released on Monday) was not solely due to a surge in sales of repossessed properties –Paul Dales, Capital Economics Federal Reserve Chairman Ben Bernanke talked about early signs of some “green shoots” appearing in the economy in his recent 60 Minutes interview. This week we are seeing some further positive notes in form of better-than-expected new and existing homes sales and durable goods orders for the month of February. These, and other positive, or even “less bad”, signs are a welcome change of tune following the severe economic downdrafts extending from autumn 2008 into early 2009. However, just as green shoots can get buried by springtime snows, the small upside surprises that we have seen may yet be overwhelmed by ongoing downward momentum in business investment, labor markets, durable goods consumption, and export markets. The U.S. economy remains many months away from stability and is even farther away from sustained growth. –Robert A. Dye, PNC Only a small rise in sales after 6 consecutive monthly declines cumulating to -36%. Sales of previously-owned homes appear to be bottoming (again! After Sep-Nov downdraft), and the Mortgage Bankers Association index of mortgage applications for home purchase has stabilized in recent weeks. Nonetheless, one month’s increase in sales in newly-built homes is not enough to call a trough in this series. –Alan Levenson, T. Rowe Price New-Home Sales Rise as Prices Fall Revisions Offset Durable-Goods Orders Climb MARCH 25, 2009, 2:06 P.M. ET WASHINGTON -- New-home sales climbed for the first time in seven months during February, another favorable sign for the housing sector, but the data also showed prices tumbled. Separately, durable-goods orders unexpectedly climbed during February, but demand in the prior month was revised down deeply, an adjustment countering the idea of a rebound in the slumping manufacturing sector. Sales of single-family homes increased by 4.7% to a seasonally adjusted annual rate of 337,000, the Commerce Department said Wednesday. January new-home sales plunged 13.2% to an annual rate to 322,000; originally, the government said January sales fell 10.2% to 309,000. http://online.wsj.com/article/SB123798406285137541.html

338 http://www.calculatedriskblog.com/2009/03/new- home-sales-is-this-bottom.html WEDNESDAY, MARCH 25, 2009 New Home Sales: Is this the bottom? Earlier today I posted some graphs of new home sales, inventory and months of supply. A few key points: Please do not confuse a bottom in new home sales with a bottom in existing home prices. Please see: Housing: Two Bottoms New home sales numbers are heavily revised and there is a large margin of error. Regarding the sales for February, the Census Bureau reported: This is 4.7 percent (±18.3%) above the revised January rate of 322,000, but is 41.1 percent (±7.9%) below the February 2008 estimate of 572,000. The "rebound" in February was very small, and this is the worst February since the Census Bureau started tracking new home sales in 1963.

This graph shows the February "rebound". You have to look closely - this is an eyesight test - and you will see the increase in sales (if you expand the graph). Not only was this the worst February in the Census Bureau records, but this was the 2nd worst month ever on a seasonally adjusted annual rate basis (only January was worse). Still, I believe there is a good chance new home sales will bottom in 2009. See Looking for the Sun. Because the data is heavily revised, we won't know until many months after the bottom occurs. Also, as Dr. Yellen noted earlier, we need to distinguish between growth rates and levels. Any bottom would be at a very grim level, and any recovery would probably be very sluggish because of the huge overhang of existing homes (especially distressed homes).

339 It is theoretically possible for new home sales to go to zero (very unlikely), and it is also possible that January was the bottom. We just don't know ... Anecdotally, I just spoke to two SoCal builders - both told me sales had picked up in the last week or so (March). Of course sales in SoCal have been close to zero, so this is like a few rain drops to a thirsty man lost in a desert - it seems like a flood! For a healthy market, the distressing gap between new and existing home sales will probably close.

For a number of years the ratio between new and existing home sales was pretty steady. After activity in the housing market peaked in 2005, the ratio changed. This change was caused by distressed sales - in many areas home builders cannot compete with REO sales, and this has pushed down new home sales while keeping existing home sales activity elevated. To close the gap, existing home sales need to fall or new home sales increase - or a combination of both. This will probably take several years ... If housing bottoms (or even if the decline in residential investment just slows), this will remove a significant drag on GDP growth. This would be a positive sign for the economy. The following table, from Business Cycle: Temporal Order, shows a simplified typical temporal order for emerging from a recession. When Recovery Typically Starts

Significantly Lags End of Lags End of Recession During Recession Recession

Residential Investment, Equipment &

Investment Software Investment, non-residential Structures PCE Unemployment(1)

340 There are a number of reasons why housing and personal consumption won't rebound quickly, but they will probably bottom soon. And that means the recession is moving to the lagging areas of the economy. But we know the first signs to watch: Residential Investment (RI) and PCE. (1) In recent recessions, unemployment significantly lagged the end of the recession. That is very likely this time too. Finally, even though some signs of a bottom might emerge (housing starts, new home sales, auto sales), it is worth repeating that any recovery will probably be very sluggish. Here are a few key reasons: house prices are still too high, there is too much housing inventory (especially distressed properties), households have too much debt and need to improve their balance sheets, the recession is global, and the Obama administration has chosen a less than optimal (and very expensive) approach to fixing the financial system.

Tp be Continued in: http://www.calculatedriskblog.com/2009/03/mauldin-on-housing.html

341

Boletín de Universia-Knowledge@Wharton http://www.wharton.universia.net 25 Marzo - 7 Abril, 2009 Los hedge funds vuelven al punto de mira de los reguladores Hasta el momento los fondos de inversión especulativos (hedge funds) han evitado la estricta regulación a la que están sometidos otros fondos. Pero tal vez dicha situación haya llegado a su fin a medida que la administración Obama y el Congreso buscan el modo de evitar otra crisis financiera. Aunque aún no está muy claro cuál ha sido el papel desempeñado por los fondos de inversión especulativos en la crisis actual, diversos profesores de Wharton creen que los malos resultados obtenidos por el sector, así como la demanda de mayor transparencia por parte de inversores y reguladores, provocarán grandes cambios en el modo en que operan estos secretos fondos de inversión. Es muy probable que la preocupación sobre los hedge funds haya aumentado tras la publicación el 18 de marzo en Wall Street Journal de un artículo en el que se informaba que la aseguradora AIG podría dedicar el dinero de los contribuyentes a fondos de inversión especulativos que apostaron por la caída del mercado inmobiliario. Tal y como se explicaba en dicho artículo, al mismo tiempo que el gobierno lucha para resucitar el mercado de la vivienda podría estar gastándose miles de millones de dólares en recompensar hedge funds que se beneficiaron de la caída del mismo. Hace tiempo que los numerosos detractores quieren que se tomen enérgicas medidas reguladoras en relación con los fondos de inversión especulativos, sosteniendo que tanto reguladores, inversores como el público en general saben muy poco sobre cómo las influencias de este sector sobre los mercados financieros. Pero hasta el momento el sector ha conseguido mantenerse a salvo de todo intento regulador, el más importante en el año 2005, cuando la Securities and Exchange Commission (SEC) propuso el registro obligatorio de los fondos en la agencia, así como una mayor supervisión. En 2006 un Juzgado Federal dictaminó que la SEC no tenía autoridad para imponer semejante medida. Pero cada vez son más numerosas las voces que claman regulación. El 29 de enero los senadores Carl Levin, demócrata de Michigan, y Charles E. Grassley, republicano de Iowa, introducían una propuesta de ley que otorgaría a la SEC autoridad para regular los hedge funds. Grassley sostiene que el clima político ha cambiado totalmente de dos años para acá, cuando se intentó aprobar una ley similar que no llegó a ninguna parte. Los burócratas de la administración Obama también apoyan una regulación más estricta, aunque nadie cuál será el grado de severidad. Según algunas noticias publicadas hace unas semanas, el plan general de esta administración para endurecer la regulación del sector financiero incluiría una mayor supervisión de los hedge funds por parte de la Reserva Federal. Reglas más estrictas también podría implicar mayor transparencia de los fondos. Es muy posible que una mayor regulación acabe limitando la capacidad de los hedge funds de endeudarse para sobrealimentar sus apuestas, o incluso frenando algunas inversiones de alto riesgo. La idea principal es asegurarse de que las actividades de estos fondos de inversión especulativos tengan consecuencias negativas únicamente sobre sus inversores, no sobre

342 pobres inocentes. Y parece ser que cualquier regulación se ira aprobando por etapas; inicialmente se mejorará la transparencia y luego se irán imponiendo nuevas normas a medida que se vayan detectando nuevos obstáculos. Según estimaciones del sector, 10.000 fondos de inversión especulativos controlan cerca de 1,5 billones de dólares en activos. Los hedge funds crecieron de manera espectacular en las últimas dos décadas a medida que los inversores buscaban rendimientos superiores a los del mercado, pero ahora cientos de fondos han perdido dinero y desaparecido, y los inversores pretenden recuperar su dinero en otros fondos. “El sector de los fondos de inversión especulativos está en estos momentos desvaneciéndose”, afirma Thomas Donaldson, profesor de Derecho y Ética Empresarial en Wharton. “Estamos viendo un sector cuya burbuja ha explotado”. “El año próximo veremos grandes cambios en la regulación”, añade el profesor de Finanzas de Wharton Richard Marston refiriéndose a la supervisión de todo el sector financiero, incluyendo los hedge funds. “No me importa en absoluto que los ricos de Palm Beach se queden desplumados… me importa que las empresas de Filadelfia sufran porque los fondos de inversión especulativos hayan desencadenado el pánico en los mercados financieros. Esta vez no lo han hecho. Fueron los bancos. Pero la próxima vez tal vez sean los hedge funds”. En 2008 el fondo de inversión especulativo promedio tuvo pérdidas del 20%. Si queremos ser optimistas, dichas pérdidas son sólo la mitad de las obtenidas por el mercado de valores de Estados Unidos. No obstante, resulta bastante molesto para inversores que tienen en mente el objetivo original de los hedge funds: ganar dinero incluso cuando el resto de mercados pierde. 2008 fue el segundo año con resultados negativos para los fondos de inversión especulativos; el primero fue 2002, con un 1,45% de pérdidas. El profesor de Finanzas de Wharton Marshal E. Blume señala que muchos hedge funds han desaparecido durante los últimos dos años después de haber sido virtualmente exterminados, y por tanto los resultados de los supervivientes dan una imagen mucho más positiva de la realidad. Según un estudio, cerca de 700 fondos desaparecieron en los tres primeros cuatrimestres de 2008, un incremento del 70% en comparación con el año previo. Algunas proyecciones hablan de la desaparición de 1.000 fondos al final del año, en otras palabras, el 10% del sector. “Existe un gran sesgo post-selección en los rendimientos de los hedge funds”, dice Blume. “Los fondos de inversión especulativos que fracasaron no están incluidos en esas cifras de resultados”. Errores garrafales de política Para ser justos, parte de las pérdidas de 2008 del sector de los fondos de inversión especulativos deberían ser atribuidas a errores garrafales de política federal en respuesta a la crisis bancaria, sostiene el profesor de Finanzas Richard J. Herring. Uno de esos errores garrafales ha sido, en su opinión, la decisión el pasado septiembre de permitir que Lehman Brothers se precipitase al vacío, lo cual hizo temer la llegada de más pérdidas e hizo caer el precio de los valores. Los hedge funds también se vieron perjudicados, señala Herring, por una prohibición el pasado otoño relacionada con las ventas en corto, esto es, apostar que los mercados van a caer, una práctica clave en la estrategia de inversión de muchos fondos. “Con la prohibición de vender en corto, la liquidez de varios mercados simplemente se evaporó”. Aunque posiblemente los hedge funds no sean los culpables directos de la actual crisis, hace tiempo que a muchos expertos les preocupa que estos fondos puedan desencadenar una crisis mundial. La primera alarma saltaba en 1998 con el colapso del hedge fund de Connecticut llamado “Long-Term Capital Management”, que había realizado complejas apuestas sobre el

343 precio de los bonos. Para evitar un tsunami financiero, la Reserva Federal organizó un grupo de grandes bancos para hacerse cargo de los activos de LTCM. “No eran altruistas”, dice Marston acerca de los bancos rescatadores. “Estaban salvando su propio pellejo. Es el motivo principal por el que los hedge funds deben supervisarse”. Aunque la legislación actual no obliga a la inscripción en la SEC de los fondos de inversión especulativos, muchos lo hacen porque sus inversores institucionales así lo solicitan. Las firmas registradas representan cerca del 70% de los activos de los hedge funds. Como únicamente están abiertos a gente pudiente e inversores institucionales, los hedge funds han disfrutado durante mucho tiempo de cierta excepcionalidad, no estando sujetos a los requisitos de transparencia o la regulación aplicable a los fondos de inversión, fondos que cotizan, rentas vitalicias u otras inversiones abiertas al público en general. Asimismo los fondos de inversión especulativos disponen de más opciones de inversión, como por ejemplo vender en corto, con apalancamiento o hacer apuestas sobre materias primas y derivados, estrategias en muchos casos no permitidas para el resto de fondos. La teoría es que los hedge funds se circunscriben a los inversores que pueden permitirse grandes riesgos. “No creo que deba haber una regulación que impida que inversores bien informados pierdan dinero”, dice Blume. Pero la actual crisis financiera ha dirigido el foco de atención hacia el riesgo sistémico, cuando todo el sistema financiero sufre las actividades de un pequeño grupo de jugadores, señala Blume. En los actuales mercados financieros, muy dinámicos, todo está conectado con todo lo demás. “Lo más preocupante es que grandes cantidades de capital pueden contribuir al riesgo sistémico y a recesiones sistémicas. Es un preocupación muy válida… los hedge funds disponen de enormes cantidades de dinero”. Si las apuestas de los fondos de inversión especulativos son capaces de enturbiar los mercados, pueden perjudicar a pobres inocentes. Marston señala que las donaciones de la universidad y los planes de pensiones se han convertido en grandes inversores en hedge funds, lo cual supone que cualquier fallo podría hacer daño a gente inocente. Marston citaba un estudio que muestra que la universidad estadounidense promedio había dedicado el 15% de su cartera de inversiones a “inversiones alternativas”, partida que incluye fondos de inversión especulativos otros fondos especialmente arriesgados. Tal y como explica Christopher C. Geczy, profesor adjunto de Finanzas de Wharton, los hedge funds pueden ser muy arriesgados para los inversores, pero no existe evidencia de que hayan desempeñado un papel protagonista en la actual crisis financiera. “A diferencia de lo que cree la gente, los hedge funds no han sido los causantes de esta crisis”, dice. Marston y Blume están de acuerdo. “No creo que los hedge funds hayan sido la causa de esta debacle actual”, señala Blume echándole más bien la culpa a la presión del gobierno para fomentar la propiedad de la vivienda, algo que a su vez fomentó hipotecas entre personas con poca capacidad crediticia. Dichas hipotecas fueron agrupadas en valores y estos valores vendidos a inversores de todo el mundo; el precio de dichos valores cayó al vacío cuando los propietarios empezaron a retrasarse en los pagos de sus mensualidades. “Los hedge funds compraron parte”, dice. “Si los hedge funds pierden dinero no hay problema. El problema es cuando los bancos pierden dinero”. En opinión de Marston, los bancos de inversión tienen mucha más parte de culpa en la actual crisis financiera. Insatisfechos con los beneficios obtenidos con sus actividades tradicionales – como fusiones y adquisiciones o suscripción de valores-, en los últimos años los bancos de inversión actuaron como sí ellos mismos fuesen fondos de inversión especulativos, realizando apuestas con apalancamiento muy complejas en sus propias cuentas, explica Marston.

344 Podría haber sido de gran utilidad que los reguladores hubiesen dispuesto de más información sobre las posiciones amasadas por los hedge funds, añade Blume, pero los reguladores sabían que los bancos estaban creando y vendiendo productos estructurados basados en hipotecas y otros préstamos arriesgados. “Si hubiesen tenido más información sobre los fondos de inversión especulativos, ¿habría cambiado algo? Probablemente no”. La actual estructura reguladora no trata muy bien el riesgo sistémico, señala Blume, principalmente porque la SEC, otras agencias gubernamentales y los propios entes reguladores del mercado de valores tradicionalmente se han centrado en proteger a los inversores individuales, no a supervisar el funcionamiento general de los mercados financieros. “Incluir en esta categoría a los hedge funds no contribuirá en absoluto a resolver el riesgo sistémico porque a la SEC no le preocupa este riesgo”, dice Blume. “Aquí es donde nos introducimos en nuevos terrenos. Por definición, si te preocupa el riesgo sistémico deberás asignar dicha misión a una organización, y en estos momentos no existe esa organización. Es más, habría que hacerlo a nivel mundial. Estados Unidos es poco propenso a ceder parte de su soberanía a favor de entes extranjeros… La actual estructura es por tanto inadecuada. No estoy seguro de hacia dónde nos dirigimos”. En Washington se están discutiendo varias ideas; desde simplemente fomentar la autoridad de los reguladores ya existentes hasta conceder poderes a la Reserva Federal en temas de regulación. Se habla incluso de crear una nueva “superagencia”. El diputado demócrata por Massachussets Barney Frank, que dirige el Financial Services Committee, quiere hacer a la Reserva Federal responsable de proteger la estabilidad del sistema financiero, con nuevos poderes para recabar información sobre hedge funds, aseguradoras, bancos de inversión y otros entes. Parece ser que la administración Obama quiere mostrar progresos reales en esta materia durante la reunión de abril del G-20. Los burócratas del gobierno han dado la bienvenida a las recomendaciones para una regulación más estricta propuestas en un informe del pasado año realizado por un comité internacional liderado por Paul A. Volker, ex presidente de la Reserva Federal que en la actualidad es asesor económico de Obama. El efecto Madoff Incluso sin una nueva regulación, es muy posible que el sector cambie. De hecho ya está cambiando: para retener a los inversores muchos fondos han recortado sus comisiones. Lo normal era un 2% sobre los activos gestionados y un 20% sobre los beneficios. “Cada vez hay más gente que habla de las altísimas comisiones que aplican estos fondos, algo de lo que Warren Buffet siempre ha hablado. Ahora estamos viendo cómo bajan… un par de fondos han renunciado al 20% sobre los beneficios. Algunos han bajado del 2 al 1% sobre los activos gestionados”. Los fondos también están sufriendo la presión de los inversores, contrarios a las actuales normas restrictivas para retirar dinero. De hecho, muchos fondos han endurecido dichas normas, cerrando toda puerta de salida, después de la crisis financiera que estimuló la desinversión. “Existe cierto malestar entre los inversores que ven como se ha cerrado la puerta de acceso a sus inversiones”, dice Marston. “Impedir que los inversores recuperen sus activos cuando muchos de ellos están desesperados por conseguir efectivo les alienará de manera permanente”. No obstante, permitir las desinversiones también crea problemas. Los fondos pueden quedar heridos de muerte, dificultando e incluso imposibilitando llevar a cabo estrategias de inversión complejas que requieran compromisos a largo plazo. Por último, también está la cuestión de cuáles son esas estrategias de inversión. Tradicionalmente los hedge funds han ofrecido a los inversores únicamente descripciones vagas, alegando que deben guardar el secreto sobre sus transacciones para mantener su

345 ventaja. “Dicho argumento, aunque fuerte, está cediendo lentamente a la apertura de cierta información, en especial para los inversores, para darles más confianza”, dice Donaldson. La demanda de mayor transparencia has sido fomentada por “el efecto Madoff”, eso es, una mayor desconfianza después de que saliese a la luz el pasado año el esquema Ponzi puesto en marcha por Bernard Madoff, con el que estafó unos 50.000 millones de dólares. Aunque la operación de Madoff nada ha tenido que ver con los fondos de inversión especulativos, se empleó el mismo tipo de secretismo que en los hedge funds, y se gestionó dinero para fondos de fondos, esto es, un subconjunto de hedge funds. Ahora muchos inversores quieren saber cómo se emplea su dinero y quién es el propietario de los valores que supuestamente forman parte del fondo, explica Donaldson. “Tiene sentido que haya algo más de transparencia ante la SEC y otras entidades reguladoras. También que exista el modo de atrapar a aquellos que estén haciendo un uso impropio del fondo”. No obstante, Donaldson advierte que las opciones de inversión de los fondos de inversión especulativos son tan variadas que será muy difícil regularlos de manera efectiva. Claramente estos son tiempos duros para los hedge funds. Pero no hay muchos expertos que piensen que el sector va a desaparecer. Los inversores siempre se sentirán atraídos por las promesas de grandes beneficios, y los fondos de inversión especulativos pueden emplear estrategias no permitidas a los fondos de inversión y otras inversiones. “Creo que los hedge funds van a ser evaluados más cuidadosamente por los inversores”, dice Blume, “pero no creo que el sector vaya a perder fuerza”.

IS IT BACK TO THE FIFTIES?

346

Is it back to the Fifties? By John Authers Published: March 24 2009 20:12 | Last updated: March 24 2009 20:12 “My mother is 75,” said Jon Stewart, the US late-night comedian, at the end of his already famous interview with Jim Cramer, the television stock market pundit. “And she bought into the idea that long-term investing is the way to go. And guess what?” “It didn’t work,” replied Mr Cramer. The interview this month, in which Mr Stewart humiliated his guest, has earned a place in American cultural history. Mr Stewart was articulating a broad sense of betrayal among the populace that the faith all had been told to put in equities had been misplaced. That loss of faith spreads beyond retail investors. The crash has forced professional investors and academics to question the theoretical underpinnings of modern finance. The most basic assumptions of the investment industry, and the products they offer to the public, must be reconsidered from scratch. Indeed, the very reason for the industry to exist – a belief that experts make the smartest decisions on where people’s money will do best – is up for scrutiny as a result.

Mr Stewart was right about long-term investment, and not just for septuagenarians. US stocks have fallen more than 60 per cent in real terms since the market peaked in 2000. Anyone who started saving 40 years ago, when the postwar “baby boom” generation was just joining the workforce, has found that stocks have performed no better than 20-year government bonds since then, a forthcoming article by Robert Arnott for the Journal of Indexes shows. These people want to retire soon and the “cult of the equity” has let them down. To find a period that does produce an outperformance requires a span reaching back a lot further. The 2009 Credit Suisse Global Investment Returns Yearbook shows that since 1900 US stocks have averaged an annual real return of 6 per cent, compared with 2.1 per cent for bonds – while in the UK, equities have beaten gilts with a return of 5.1 per cent against 1.4 per cent. The problem is that they can perform worse than bonds for periods longer than a human working lifetime. Invest your tuppence wisely: a father pays out pocket money Further, recent experience challenges that basis of modern finance, circa 1955. The children of the “efficient markets hypothesis”, which in its strongest form holds that era, now at retirement age, are finding their holdings that prices of securities always reflect all known information. This are far short of what they implies that stocks will react to each new piece of information, yet expected without following any set trend – a description that cannot be applied to the events of the past 18 months. On these foundations, theorists worked out ways to measure risk, to put a price on options and other derivatives and to maximise returns for a given level of risk. This theory also showed that stocks would outperform in the long run. Stocks are riskier than asset classes such as government bonds (which have a state guarantee), corporate bonds

347 (which have a superior claim on a company’s resources) or cash. So the argument was that those who invested in them would in the long run be paid for taking this risk by receiving a higher return. That is now in question. “There’s no such thing as a risk that you get paid for taking. The whole point about risk is that you don’t know if you’re going to be paid for it or not,” says Robert Jaeger at BNY Mellon Asset Management. “What’s important about the current period is that now it’s true even for a very long period [that] people haven’t been paid for taking equity risks. These losses were taken by people who didn’t even think they were taking a risk.”

“It supposedly didn’t matter how long you waited. But the notion that the long run will bail you out no matter what stupid things you do in the short run I think is dead,” says Robert Arnott, who examines such performance in a forthcoming article for the Journal of Indexes. “And the notion that if you have the better asset class it doesn’t matter what you pay for it is on its deathbed.” Instead, the cult of the equity and the efficient markets hypothesis begin to look like phenomena born of the uniquely positive conditions in the middle of the last century. For decades until 1959, the yield paid out in dividends on stocks was higher than the yield paid out by bonds. This was to compensate investors for the extra risk involved in buying equities. In 1951, as the building blocks of the efficient-markets theory began to appear in academic journals, US stocks yielded as much as 7 per cent, compared with only 2 per cent on bonds. “The 1950s marked the start of a period of relative peace and prosperity. It came on the heels of a tumultuous 50 years that included two world wars and an economic depression. In

348 hindsight, the case for equities over bonds was especially compelling in the early 1950s,” says Robert Buckland, chief global equity strategist for Citigroup. So in 1959, the yield on stocks dipped below the yield on bonds – and stayed there for almost half a century until the two crossed once more last November. The theory changed to account for this and came to hold that bonds yielded more to recognise the superior long-term growth potential of equities. That growth potential made pension funds boost their allocations to equities. In the US, and later elsewhere, legislation gave individual investors more power over their retirement funds but also required them to take on the risks. As employers were no longer guaranteeing them a proportion of their final salary on retirement. Savers’ money went heavily into equities. Then came the bear market of this decade. If that bear market has damaged the case for stocks, the efficient markets hypothesis underlying it had been “dying a natural death for most of this decade”, according to Mr Arnott. In place of the standard assumption that all decisions are rational, behavioural economists began substituting findings from experimental psychology on how people actually make decisions. This helped to explain market crashes and bubbles, showed that investment decisions could be systematically irrational and led to attempts to create new models of how markets set prices. Efficient-markets theorists themselves moved away from the hardest version of the theory. They identified two anomalies: in the long run, small companies tend to outperform the larger, while cheap or “value” stocks (which have a low price in relation to their earnings or the book value on their balance sheet) outperform more expensive stocks. Burton Malkiel, a Princeton economics professor whose book, A Random Walk Down Wall Street, is the most famous statement of efficient-markets theory, suggests its strongest form is a straw man. “‘Efficient markets’ has never meant to me that the price is always right,” he says. “The price clearly isn’t right. We know markets overreact. They get irrationally exuberant and they get irrationally pessimistic.” But he says that the key implications remain intact. “What ‘efficient markets’ says is that there are no easy opportunities for riskless profit. There I still would hold that that part of the efficient markets is alive and well.” . . . Still, the search is on for a new theory to replace efficient markets. Perhaps most prominently, Andrew Lo, head of the Massachusetts Institute of Technology’s Financial Innovation Laboratory, has merged behavioural and efficient markets theory using Darwinian biology. In his “adaptive markets hypothesis”, markets behave efficiently during periods of calm. “Periods of extraordinary prosperity have behavioural effects – it gives us a false sense of security and therefore there is too much risk-taking. Eventually that kind of risk-taking is unsustainable and you get a burst of the bubble.” Once bubbles burst, Mr Lo’s theory predicts, a period of “punctuated equilibrium” will ensue, in which long-engrained behaviours no longer work. “We just had a meteorite hit us in financial markets. There will be destruction of species that have lasted a very long time. Out of the chaos will emerge new species.” Most clearly, the lightly regulated hedge fund industry – described by Mr Lo as the Galapagos of financial services – is suffering a shake-out. The sector as a whole suffered an average loss of 18.3 per cent last year, only its second losing year since 1990, according to Hedge Fund Research of Chicago. This prompted investors to pull $155bn (€115bn, £105bn) out of the funds. But the worst performing 10 per cent lost an average of 62 per cent, while

349 the top decile gained 40 per cent. The Darwinian process is well advanced: 1,471 hedge funds were liquidated last year, while only 659 new ones were launched, the lowest figure since 2000. The traditional mutual fund, in which managers run a portfolio of about 100 stocks and attempt to beat a benchmark index, may be another casualty. Last year, most equity mutual funds failed to beat their benchmark indices, even though their managers had the freedom to move into cash and to pick stocks. Mr Malkiel points out that of the 14 funds that had beaten the market in the nine years to 2008, only one did so last year. Both efficient-markets and behavioural economists say it is better just to match the index, with a tracking fund, and avoid the fees incurred in unsuccessful attempts to beat the market. Index funds have caught on over the last two decades and, recently, their growth has been driven by exchange-traded funds – index funds that can be bought and sold directly on an exchange. Mutual funds saw global net sales of $112bn last year but ETFs pulled in a net $268bn, according to Strategic Insight, a New York consultancy. Barclays Global Investors reckons there are plans to launch another 679 ETFs around the world. Index funds could become building blocks for new retirement savings products that may look much like the pensions that were the norm until confidence in equity investing took over. As it may be politically infeasible to continue to expect savers to bear all the investment risk, some benefits may have to be guaranteed. Mr Lo suggests that all these developments are consistent with a new world in which investments will largely be controlled by “herbivores” – funds that passively aim to match benchmark indices for a range of asset classes that goes beyond equities. This leaves room for a smaller group of “carnivores” to try to beat the market by exploiting inefficiencies and anomalies. Those carnivores will, moreover, be putting much less trust in theoretical models. As Mr Jaeger says: “Even with all those quantitative models, ultimately you have to make a decision. Ideally, what you are left with is people doing that somewhat old-fashioned kind of investing where you try to figure things out for yourself.” ‘I HAVEN’T OPENED A STATEMENT FOR MONTHS’ Christina Read is 61 and, at least on paper, has lost half her life’s savings in the past year, writes Deborah Brewster. “I started last year with about $400,000 – it’s down to I think about $200,000 now,” says the former dancer who now works as a nanny in Manhattan. For Ms Read, who is divorced with two college-age children, the loss means giving up her dream of a house in the country. “I had been thinking of an old farm, maybe in Nova Scotia. Now it is pretty much impossible.” But she is retaining the investments that have performed so poorly: “I will continue working, I have to keep money coming in now and, if the market doesn’t come back in the next 10 years, I will give up on having anything for myself – I will just leave it to my children.” It is this kind of stoicism that has the army of brokers, wealth managers, fund managers and product marketers who grew rich during the boom hoping individual investors will get back into the markets, and soon. Unless they do, the industry’s outlook will be dire. Retail investors, mainly through mutual funds, own a much larger part of the stock and bond markets than ever before. Bob Reynolds, chief executive of Putnam Investments, says: “It started out with 401(k)s [individual retirement accounts]. There are more mutual funds than stocks. We are an investor society.”

350 Will it stay that way? Ms Read may have sat tight but hers was not the only response to the world-shaking events. In the biggest ever exodus of money from professional management, Americans pulled a net $320bn (£218bn, €237bn) from mutual funds last year. They shifted into cash, ploughing a net $422bn into money market funds during the year. A net $212bn went into bank deposits – a figure that has since risen further, to $370bn for the 12 months to mid-March. Elbowing aside their advisers, some began trading their stocks themselves, sharply lifting retail trading volumes as they tried to take control of their investments. Others have done nothing, but for different reasons than Ms Read. Hearing the bad news, they have simply refused to open their financial statements. “I haven’t opened a statement since October,” says one Los Angeles-based business owner, who adds that his holdings were worth more than $3m at the end of 2007 but declines to estimate their value now. “I know it’s bad, but what can I do about it? There is no point in depressing myself. I need to focus on my business, which is going well. My investments are probably pretty much gone ... I had a lot of stocks – bank stocks, Bear Stearns, they’re gone. I see the statements come in the mail and I throw them right in the garbage.” George Gatch, chief executive of JPMorgan Funds, an arm of JPMorgan Chase, is working to re-engage with such investors. “We know how scared people are and we are trying to convince people to get back in, sit down and talk to their financial advisers,” he says. The 50,000 advisers with whom JPMorgan works are reporting that “it is very hard to get their clients to consider the steps they should take, to do a formal review of their portfolio ... There is a base of Americans that don’t want to look at their statements any more.” More than 90m Americans own stocks, through mutual funds and 401(k) plans. But Mr Reynolds adds: “There is a tremendous amount of cash on the sidelines today. Retail investors have close to $13,000bn sitting in money market funds and bank deposits. A year ago there was $7,000bn. That is billions that is just waiting to come back again.” In other words, retail investors have the wherewithal to get things working. The question is whether they will. “The demographics and people’s objectives haven’t changed because of the market,” says Mr Reynolds. But, like others, he sees a shift to more conservative investing. Independent financial advisers who work outside the big brokerage firms tend to be more pessimistic. “Once the money gets under the mattress, which it has, it takes a long time to pry it out again,” says one. If individual investors stay away, the consequences for the lucrative wealth management industry and its associated services and advisers are considerable. Wealth management is seen as a stable source of revenue for the Wall Street banks as they restructure themselves for a new era. For instance, Citigroup and Morgan Stanley are merging their wealth management operations, which will result in an army of more than 20,000 brokers to compete with Bank of America’s new “thundering herd”, previously part of Merrill Lynch. Jim McCaughan, chief executive of Principal Global Investors, an asset manager, says he does not see a shift away from using brokers or advisers: “Fear tends to lead people to want to talk to someone. They will go to the advisers and brokers: that is what has happened in past bear markets.” First, however, investors will need to start looking at their financial statements again.

351 WSJ Blogs March 24, 2009, 1:02 PM ET Regional Banks Are the Future The big-bank model isn’t going to last much longer, banking industry analyst Meredith Whitney said at the Journal’s Future of Finance Initiative, and said a more sustainable approach would be bigger regional banks.

Whitney, famous for foreseeing the troubles facing Citigroup, suggested that key parts of the big banking model made them susceptible to the types of problems that caused the financial crisis. One issue is the physical distance between loan originators and borrowers. Good lending results from a relationship with borrowers, and regional banks are in a better position to take advantage of those relationships. She added that five banks controlling two-thirds of mortgage origination and credit cards is fundamentally unbalanced. Instead, she suggested “supercharging” regional Meredith Whitney at the Journal’s Future of Finance Initiative. (Paul Morse) lenders. One possibility is that if stress tests help healthy banks and lead them to return TARP money, some of those funds could be transferred to local banks to encourage consolidation (on a smaller scale) in that sector. She also sees the potential for regional banks to take on business from nonblank lenders who were decimated by the subprime crisis. Regional lenders have grown angry at their larger counterparts, as evidenced by a conference in Phoenix last week. They are angry that the big players have given bankers a bad name. They cheered comments from Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. chief Sheila Bair about the need to clamp down on megabanks. However, not all smaller banks are created equal. While the majority of local banks are faring well and didn’t receive any TARP money, most of the 42 banks that have failed since the start of last year were community institutions.

352

Economy

March 25, 2009 Dissecting Bank Plan for a Way to Profit By GRAHAM BOWLEY and MARY WILLIAMS WALSH Up and down Wall Street, bankers and traders sharpened their pencils on Tuesday as they began the complex financial calculus of the latest bank rescue plan. Their goal: to find ways to profit from it. In skyscrapers across Manhattan, banking executives assessed how best to use the new Treasury proposal to sell billions of dollars of their troubled assets. Traders at giant investment houses and small hedge funds debated whether to buy them. And on a day when the Treasury secretary, Timothy F. Geithner, said he was seeking government authority to regulate or take control of nonbank financial institutions like insurance companies, insurance executives wondered whether they might use the program to ease their industry’s financial stress. “Even though they are called toxic assets, some of them are not toxic, and those are the ones that we are going to be ferreting out,” said Sherry Reeser, a spokeswoman for the California State Teachers’ Retirement System, which sees a buying opportunity in the so-called public- private investment program. But no one on or off Wall Street seemed any closer to answering the fundamental question hanging over these investments: What is this stuff really worth? Nor was there any consensus about an even more sobering question that confronts not only the financial industry but ordinary Americans: Will this be the plan that finally works? “It’s a wait-and-see attitude,” said Paul Graham, chief actuary of the American Council of Life Insurers. The proposal, which was announced officially on Monday, has provoked many responses and questions. Can banks that received government bailouts use taxpayer money to bid on toxic assets, in the hope of making a profit? Would that be bad, given that the point of the exercise is to stir up a bit of greed and animal spirits, the lack of which has been holding the economy back? Can banks sell some assets and then use the proceeds, leveraged by generous government financing, to buy more of the same? Might investment houses be tempted to overpay, if doing so buoys the value of their own investments? In the end, it will be the taxpayer who will be largely footing the bill. For the Obama administration, the challenge is to strike a balance between the potentially competing interests of investors and taxpayers. Some wonder if the proposal tips too far in favor of investors. Internet blogs were full of economists scratching their heads over how to game the plan and come out ahead of the government. Others, like Joseph E. Stiglitz, a Nobel Prize-winning

353 economist, in an interview with Reuters, called the program “very badly flawed” and said it offered “perverse incentives” that amounted “to robbery of the American people.” Despite such reservations, Goldman Sachs sent out a note to whip up investor interest in the government’s rescue plans, while BlackRock, the big money management firm, was considering the practicalities of starting, of all things, a mutual fund so everyday investors could buy into banks’ toxic assets. But Bert Ely, a prominent banking consultant, said investors would be cautious because many crucial details were still missing — the size and terms of loans they would receive from the Federal Deposit Insurance Corporation, for example, and the amount of equity they would be allowed to put in, and whether banks would be allowed to walk away if they did not like the price at auction. “Today we know a lot more than we did yesterday, right?” Mr. Ely said. “I am being facetious!” Many questioned the auction mechanism to sell toxic assets off from banks’ balance sheets. Price, most experts agree, is the biggest sticking point. The banks want to sell high. Potential investors want to buy low. Banking executives said that their institutions would not want to unload assets at fire-sale prices, a step that would compel banks to raise large amounts of additional capital. The gap is likely to be the widest for certain loans because of the way banks account for them. Because of the way they account for the assets on their books, Goldman Sachs and Morgan Stanley — Wall Street giants that converted themselves into banks last year in an effort to ride out the financial storm — may be more willing to sell assets than some commercial banks. Under accounting rules, banks must carry securities on their books at market prices. Most financial firms have already marked down these assets to prices that might be low enough to lure buyers. But banks need not carry ordinary loans at market value. Instead, they are allowed to hold them at their higher values until they are repaid. So, for many commercial banks, selling loans now, at distressed prices, would almost certainly lead to large losses. Such losses might raise questions about how some banks will fare in a so-called stress test that federal regulators are in the process of applying to about 20 lenders. “I don’t see how they are going to get the banks to sell,” said an executive at a large bank, who asked not to be named, given the delicate nature of the Treasury plan. “There are going to be substantial write-downs taken to get them off the books.” Federal regulators said privately that, in some cases, they might pressure banks to sell. Mr. Graham, of the American Council of Life Insurers, said pricing was also a crucial issue for insurance companies. Insurance companies have a long time horizon, he said, so they can hold impaired bonds through market downturns. For all the uncertainties, some big investors like BlackRock and Wilbur L. Ross Jr., a prominent figure in distressed investing, said they were willing to take the plunge. Pension funds also represent a large source of purchasing power, and Ms. Reeser, of the California State Teachers’ Retirement System, viewed the program positively. The fund, known as Calstrs, had already reduced the part of its portfolio dedicated to stocks by 5 percent, to free up money for this type of purchase, she said.

354 Institutional investors like insurance companies represent huge blocks of capital, and the success of the public-private investment program will depend in part on how eager they are to get involved as purchasers of the toxic assets. “Insurers account for 10 percent of all invested assets in the United States today,” said Robert P. Hartwig, president of the Insurance Information Institute. They would be interested in the program because of its partial government guarantee and their ability to find out what the structured assets consisted of, he said. “There is some significant upside potential here,” he said. “But you have to balance that against the fact that insurers are very conservative investors.” The problem, he said, is that companies have to maintain cash flows that match their payout obligations, and it was by no means clear that, in a pinch, they could get their cash out of the toxic assets. Eric Dash and Michael J. de la Merced contributed reporting.

355 Grasping Reality with Both Hands The Semi-Daily Journal of Economist Brad DeLong

Posted at 09:57 AM http://delong.typepad.com/sdj/ Chris Carroll Reassures Me that I Am Not Crazy... He, too, thinks that the Geithner Plan is a reasonable way for the Treasury to spend $100B of TARP money:

ft.com/economistsforum Treasury rewards waiting MARCH 24, 2009 11:56AM BY FT By Christopher D. Carroll Maybe it was worth the wait. Judging from preliminary details, the US Treasury’s plan to rescue the financial system is a lot savvier about the relationship between financial markets and the macroeconomy than are the usual-suspects: critics from both left and right who are already pouncing on the Geithner plan. Unlike the critics, the Treasury has absorbed the main lesson from the past 30 years of academic finance research: asset price movements mainly reflect changes in investors’ collective attitude toward risk. Perhaps the reason this insight has not penetrated, even among academic economists, much beyond the researchers responsible for documenting it, is that it has not been expressed in layman’s terms. Here’s a try: in the Wall Street contest between “fear” and “greed,” fear fluctuates much more than greed (in academic terms, movements in “risk tolerance” explain the bulk of movements in asset prices). Such extravagant movements in investors’ average degree of risk tolerance have proven impossible to reconcile with economists’ usual benchmark ways of understanding peoples’ attitudes toward risk. One response has been to try to reverse-engineer a “representative consumer” who would choose to behave in a way that matches the data, under the assumption that market prices are always a perfect and optimal representation of rational choice. Unfortunately, the reverse-engineered preferences look nothing like what we know of household behaviour from a vast literature that observes the choices households make in their daily lives (as documented in a variety of microeconomic datasets). The second response to the market’s remarkable fluctuations in risk attitudes is more in tune with Warren Buffett’s view, following his mentor Benjamin Graham, that market prices move much more than can be justified by the sober judgment of someone with a long horizon and stable preferences. Buffett has arrived at his current perch more by skepticism about the market than by unblinking faith in its wisdom. As Mr. Buffett has shown, patient investors who buy low and wait for underpriced assets to recover can do very well indeed. Which brings us back to the Treasury’s plan. The details flow from an overarching view that the markets for the “toxic assets” that are corroding banks’ balance sheets have shut down in

356 part because in those markets the degree of risk aversion has become not just problematic but pathological. The different parts of the plan reflect different approaches to trying to coax private investors back into the market by reducing their perceived degree of risk to levels that even a skittish risk-shy hedge fund manager might find tempting. The government and the private investor would be partners in a Buffett-like arrangement in which the assets would be held long enough that the investors can expect to receive payments that have justified the waiting. This motivation sounds suspiciously like some of the arguments for the ill-fated Paulson TARP plan from last autumn; but the problem with the Paulson plan was never fundamentally with the idea that there were problems in the market for toxic assets, but with the idea that the right way to fix that problem (and everything else wrong with the economy!) was simply to have the government drastically overpay to buy up the toxic assets from whoever was foolish enough to have ended up holding them. (Maybe this is not really what Secretary Paulson had in mind, but it seems the most sensible interpretation). Instead, the new plan from the Treasury gives private investors (who know more than Treasury about the likely payoffs of these securities) the pivotal role in competing to set the prices of the securities, via a competitive auction process. The private investors currently on the sidelines are not fools and have no incentive to lose money on the deal. In addition, there is no pretense now (as there was last autumn) that the resolution of the toxic assets problem is the sole remedy for our economic woes; it is part of a carefully conceived plan including the stimulus bill, the housing foreclosure mitigation plan, the TALF plan for reviving the market for securitised assets, the bank “stress tests” designed to triage the good banks, the salvageable banks, and the zombie banks; and a host of other measures designed to address other aspects of the crisis. Finally, the new plan’s principal goal, fostered in numerous ways, is to induce private investors to come off the sidelines and reengage with the markets, while the Paulson plan’s mechanisms for accomplishing that goal were either murky or nonexistent. When fuller details emerge, it would be useful if the economics profession and the financial community could have a mature conversation about whether the plan could be improved before it goes into operation. For example, it may be necessary to make any bank that participates agree to the sale of all their toxic assets, to prevent the kind of cherry picking that has contributed to the shutdown of these markets so far. And there is good reason to be very careful to minimize the possibility of “heads-I-win, tails-the-government-loses” kinds of bets. But broad-brush denunciations are unhelpful, whether they derive from preconceived prejudices of the left (which needs to recognise the important distinction between the greedy people who got us here and the wise captains of finance who can help us get out), or the right (which espouses a destructive ideology according to which all government action of any kind is a mistake). The rest of us should hope that even in the current fervid atmosphere, reasoned argument can win out over impassioned ideology.

Christopher D. Carroll is professor of economics at the Johns Hopkins University

357 LEX Finance & governance GEITHNER’S PLAN Geithner’s plan Published: March 23 2009 15:09 | Last updated: March 23 2009 18:34 After lambasting past announcements for being too broad brush, it is churlish to accuse Tim Geithner, US Treasury secretary, of obscuring his latest taxpayer-funded giveaway with excessive detail. In fact, the latest plan to cleanse the system of bad assets is appropriately nuanced. It is better crafted, using private involvement to lessen taxpayer risk. And there is the odd nice touch, like using a portion of fees to bolster deposit insurance funds. There are two main components to the latest plan, one targeting loans, the other securities. In the first, banks put loans up for sale to competing private sector bidders. The Federal Deposit Insurance Corporation guarantees debt of up to six times the equity in the winning fund. The Treasury takes up to 50 per cent of the equity, or about 7 per cent, of the fund. In the second part of the plan, the Treasury selects managers to run funds to buy real estate- backed securities, matching private investors dollar for dollar. Managers can top up with limited Treasury loans. The term asset-backed securities loan facility will also be expanded to finance purchases of legacy securities. Equity stakes give bidders an incentive not to overpay while competition between private funds should deter low-balling. But it is unclear that cheap leverage can close the gap between the prices at which banks will sell and investors will buy. The former depends on where banks’ assets are marked (and if they can sell without rendering themselves demonstrably insolvent.) But only one fifth of all assets are marked to market, says Credit Suisse, with ailing fundamentals yet to be recognised. The dross inevitably will be first on the block. After all, in the loan programme banks can choose what to sell and reject the result of the auction. This suggests price discovery only to the extent that prices are above banks’ marks. A tougher regulatory stick is needed to force banks to face reality. Instead, generous terms may help bridge the pricing gulf – further reason for investors fearful of a political backlash to stay clear.

358 Opinion Wednesday, March 25, 2009 March 24, 2009, 10:33 am WILL THE GEITHNER PLAN WORK? By The Editors

(Credit: Evan Vucci/Associated Press) Demonstrators standing behind Treasury Secretary Timothy Geithner before the start of a hearing of the House Financial Services Committee on Tuesday.

By offering private investors huge amounts of cheap financing at little risk to buy bad mortgage-related securities, along with an expansion of an existing federal program, the public-private plan unveiled by Treasury Secretary Timothy Geithner could buy up to $2 trillion in toxic assets now weighing down the banks. The market soared on high hopes that this will solve unfreeze credit and revive the crumbling economy. But is this plan sufficient to restore the banking system to health? We asked four economists — Paul Krugman, Simon Johnson, Brad DeLong and Mark Thoma — to tackle this question. • Paul Krugman, Op-Ed columnist, Princeton University • Simon Johnson, M.I.T. • Brad DeLong, U.C. Berkeley • Mark Thoma, University of Oregon

Perception vs. Reality

Paul Krugman, a Times Op-Ed columnist, is a professor of economics at Princeton University and winner of the 2008 Nobel economics prize. Well, the stock market loved the Geithner plan, which proves … nothing. Stock investors have no special knowledge here; they’re groping like everyone else. For what it’s worth, credit markets didn’t react much at all. But let’s back up and focus on the fundamentals.

359 In essence, the Geithner plan is the same as the Paulson plan from six months ago: buy up the toxic assets, and hope that this unfreezes the markets. Don’t be fooled by the apparent role of private enterprise: more than 90 percent of the funds will come from taxpayers. And the way the funds are structured provides a strong incentive for investors to overpay for assets (see my explanation on my blog). Subsidizing investor purchases of toxic assets has no real chance of turning things around. So can this work? Since the beginning of the crisis, there have been two views of what’s going on. View #1 is that we’re looking at an unnecessary panic. The housing bust, so the story goes, has spooked the public, and made people nervous about banks. In response, banks have pulled back, which has led to ridiculously low prices for assets, which makes banks look even weaker, forcing them to pull back even more. On this view what the market really needs is a slap in the face to calm it down. And if we can get the market in troubled assets going, people will see that things aren’t really that bad, and — as Larry Summers said on yesterday’s Newshour – the vicious circles will turn into virtuous circles. View #2 is that the banks really, truly messed up: they bet heavily on unrealistic beliefs about housing and consumer debt, and lost those bets. Confidence is low because people have become realistic. The Geithner plan can only work if view #1 is right. If view #2 is right – if the banks are really in deep trouble that goes beyond lack of confidence — subsidizing investor purchases of toxic assets, many of which aren’t even held by the most troubled banks, has no real chance of turning things around. As you can guess, I believe in view #2. We had vast excesses during the bubble years, and I don’t think we can fix the damage with the power of positive thinking plus a bit of financial engineering. But that’s where the issue lies.

A Partial Answer, Maybe

Simon Johnson is a professor at the M.I.T. Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and co-founder of the global crisis Web site BaselineScenario Secretary Geithner’s plan might work, in the sense of facilitating the removal of some “toxic” assets from the balance sheets of major banks. But it is unlikely to work, in the sense of restoring the banking system to health. There are already several trillions of troubled assets to deal with and this total may rise as we head deeper into recession. The Geithner plan needs to scale up in order to have real impact, but as it gets bigger the political backlash will grow. After less than 24 hours, the Internet already abounds with detailed and plausible proposals on how to take unreasonable advantage of the plan.

360 This kind of complex market-based scheme makes scams easy. After less than 24 hours, the Internet already abounds with detailed and plausible proposals regarding how to take unreasonable advantage of the plan, either if you are an independent hedge fund buying toxic assets or the employee of a bank selling the same or – ideally – someone with connections to both. Banks, hedge funds, insurance companies and the like are willing to stay involved only if this does not bring onerous additional government scrutiny. As scams become more apparent – and it only ever takes one or two prominent examples – controls will be tightened and private sector participation will fall off. Think of it this way. If the government offered you the chance to participate in a big new lottery at a cost of $10, you might be tempted. But what if the government wanted you to pay $1,000 and to have the I.R.S. camp at your house for a month to make sure everything you did was legal? The Geithner plan may prove to be part of the solution, but a relatively small part. If the economy continues to deteriorate, we urgently need a “resolution mechanism for large banks”; in plain English, the government will supervise their bankruptcy and had better figure out how to do this more effectively. We must learn the painful lessons of A.I.G. and create laws, put in place procedures, and hire people who can clean up massive financial messes. The magic of the market will likely not get us out of this morass; we need a new Resolution Trust Corporation-type structure and we need it fast.

Better Than Nothing

Brad DeLong is a professor of economics at University of California, Berkeley, and blogs at Grasping Reality with Both Hands. The purpose of the Geithner plan is to boost financial asset prices and so make it easier for businesses to obtain financing on terms that will allow them to expand and hire. The plan would take about $465 billion of government money, combine it with $35 billion of private- sector money, and use it to buy up risky financial assets. The sudden appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets other private investors will have to hold. And the sudden appearance of between five and 10 different government-sponsored funds that make public bids for assets will convey information to the markets about what models other people are using to try to value assets in this environment. That sharing of information will reduce risk — somewhat. We may need to take $4 trillion of risky assets out of the system to move asset prices to where they need to be. When assets are seen as less risky, their prices rise. And when there are fewer assets to be held their prices rise too: supply and demand. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

361 My guess, however, is that we would need to take $4 trillion of risky assets out of the supply currently held by private financial intermediaries to move financial asset prices to where they need to be. The Geithner plan offers only $500 billion. The Federal Reserve’s quantitative easing plan will add another $1 trillion. I should hasten to say that the administration thinks that information-sharing effects of the plan will do three times as much good in raising asset prices as the simple change in asset supply (I discount that entirely). So from their perspective the glass is 3/4 full. I think that 3/8 full is better than having no glass at all. Why isn’t the administration doing the entire job? My guess is that the Obama administration wants to avoid anything that requires legislative action. The legislative tacticians appear to think that after last week’s furor over the A.I.G. bonuses, doing more would require a Congressional coalition that is not there yet. The Geithner plan is one the administration can do on authority it already has.

How to Tell It’s Working

Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View. A bailout plan must do two things to be effective. It must remove toxic assets from bank balance sheets, and it must recapitalize banks in a politically acceptable manner. I believe the Geithner plan has a chance of doing both of these things, but it’s by no means a sure bet that it will. How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn’t induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization. If the price of these assets is increasing sufficiently fast, then the loans will be safe. The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program. Unfortunately, however, the loan terms make it unlikely that we’ll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble. In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will likely be

362 difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.

A Fix, But Maybe Not Permanent

Brad DeLong responds to Paul Krugman: Paul Krugman asks: Has the housing bust spooked investors, leading to ridiculously low prices for assets which makes banks look even weaker, which forces them to pull back even more, which leads to even more ridiculously low prices for assets. Or did the banks mess up by betting heavily on unrealistic beliefs about housing and consumer finance? The answer is: “Yes.” Both things are going on. And I suspect that in the end we will be driven down the road to some form of bank nationalization — and if that is where we are going Paul Krugman is correct to say that it is better to get there sooner rather than later. But unless Paul Krugman has 60 Senate votes in his back pocket, we cannot get there now. And the Geithner Plan seems to me to be legitimate and useful way to spend $100 billion of TARP money to improve — albeit not fix — the situation. It has the added benefit, I think, of laying the groundwork to convincing doubters of nationalization: “We tried alternatives like the Geithner Plan and they did not work” might well be an effective argument several months down the road.

Random Actions on Failing Banks

Mark Thoma responds to Simon Johnson: One of Simon Johnson’s points is very much worth emphasizing. When this crisis hit, we did not have the procedures in place for an orderly resolution for banks that were failing. Thus, because there were no well known procedures to follow, the actions that the government took when faced with a failing bank appeared ad hoc, almost random, because they were constructed on the fly to deal with problems at individual banks. The first thing we need to do is to change the regulatory structure so that banks cannot get too big and too interconnected to fail. When they are too big, their failure puts policymakers and the public in a position where there is no resolution that can confine the costs to those who were responsible for the problem. The dynamic is bad both ways: If the bank is allowed to fail, people who did nothing to cause the crisis are hurt. But if the bank is saved the people responsible are let off the hook at taxpayer expense, at least to some degree, and that brings up issues of both moral hazard and equity. But despite our best efforts, banks may become too large or too interconnected anyway, particularly if the interconnections are not transparent until trouble hits, and that’s where we need to do much, much better than we did in the present crisis. We need to have procedures available to resolve problems that are backed with a credible enforcement threat so that

363 everyone understands in advance exactly what will happen to institutions that are deemed insolvent. We simply cannot repeat the uncertainty generating ad hoc, case by case approach that was used in the present case.

A New Way to Handle Failing Banks

Brad DeLong responds to Mark Thoma: Mark Thoma is thinking about what to do with banks that fail… In the really old days, if you failed you failed: if you did not pay a debt, your creditor went to a court and got an order and the next thing you knew the sheriff was selling off the contents of your warehouse and your building on your front lawn for cash to be given to the creditor. Then came the rise of the large corporation, and the post-1869 deflation, and railroads with high fixed charges engaging in price wars; competitors began dropping like flies. The judges of New York said that it makes no sense to liquidate these enterprises — auctioning off their roadbed and their rolling stock — because, even bankrupt, they are worth much more as going concerns. So the judges made law: bankruptcy meant not a liquidation sale but rather a freezing of financial claims to the business while its operations went on. Then, under the supervision of a judge, the financial claims could be worked out and cuts administered. Later on we regularized this in legislation through the bankruptcy code: chapter 11. There was, however, a problem: how do you apply chapter 11 to finance? Letting operations continue while freezing financial claims is fine unless the operations are themselves financial claims. But we found a way. A commercial bank that goes bankrupt is seized by the FDIC. An investment bank or hedge fund going bankrupt was a stickier situation to be handled on a case-by-case basis, but it could still be handled if the cases occurred one at a time. Now we have a situation in which all our banks are merged investment-and-commercial organizations, so the FDIC cannot take them over cleanly, and in which all of them are blowing up or threatening to blow up at once. And so we need a new chapter of the bankruptcy code to deal with large financial institutions that become “bad banks.” I’d advise everyone to read Jeremy Bulow and Paul Klemperer, who have thought longer and harder about this than I have. A New Auction for Substitutes: Central Bank Liquidity Auctions, the U.S. TARP, and Variable Product-Mix Auctions, 2008, by Paul Klemperer. http://www.nuff.ox.ac.uk/users/klemperer/substsauc_NonConfidentialVersion.pdf Why Do Sellers (Usually) Prefer Auctions? Jeremy Bulow and Paul Klemperer∗ February, 2009 forthcoming, American Economic Review http://www.nuff.ox.ac.uk/users/klemperer/whysellersprefer.pdf

364 Opinion March 25, 2009 OP-ED CONTRIBUTOR

Dear A.I.G., I Quit! by Jake DeSantis 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 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

365 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.

366 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

367 Mar 24, 2009 China Proposes a Shift to the SDR: Is it Ready for A Global Role? o Zhou Xiaochun, the Chinese Central Bank governor proposed an overhaul of the global monetary system, suggesting that the U.S. dollar could eventually be replaced by the IMF's Special Drawing Right (SDR) as the world's main reserve currency. (via China Daily) PBoC vice governor, Hu Xiaolian, previously said China would consider buying bonds issued by the IMF to boost the institutions capital. These statements come as China has expressed increasing concern about the long-term value of its US assets o Zhou: The frequency and intensity of financial crises following the collapse of the Bretton Woods system suggests costs of the dollar-based system may have exceeded its benefits and that that the SDR could take on a key global role. Issuing countries of reserve currencies are constantly confronted with the Triffin dilemma, either failing to adequately meet the demand for global liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. Furthermore, member countries reserves could be instrusted to the IMF, pooling their reserves o According to Zhou: Necessary preconditions for a greater global role for the SDR - increase settlement between other currencies and SDR, promote its use in trade, create SDR denominated securities, expand currencies used in the SDR's basket, perhaps weighted by GDP o For China development of SDR bonds might allow it to diversify its holdings o Russian officials have also proposed shifting away from the U.S. dollar. A handful of countries, like Libya, peg to the SDR already o Foley: In the short term the costs to the US of losing its role as the reserve currency would be significant as it would lose seignorage benefits and ability to borrow in its own currency. In the longer term, the U.S. would benefit as it would regain some control over its currency. A central currency would make it harder for one country to get into so much debt to another and if the currency was increased along with global GDP it could provide a steady store of value. However: Obstacles include: Chinese RMB not ready to be included in the a basket as it is not fully convertible, China's role at the IMF is still limited (3% of IMF funds) o Johnson: China might be willing to provide more funds for the IMF if it receives increased votes. The US can do this - because they will keep their veto at the IMF, which is all they really want. The small Europeans may choke on this, but they increasingly feel the need for China’s commitment to the Fund. Alternatively China might try to keep the exchange rate off the table.

368 o Pettis: Zhou’s essay was not mentioned on either Xinhua or the People’s Daily. As the key of the reserve currency, the liquidity of SDR and other alternatives cannot match the US dollar. o Chinese Article IV consultation has been delayed for several years, reportedly on differences on the RMB and the results of the IMF's multilateral exchange rate surveillance. o Setser: China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. But China didn’t have to peg to the dollar and keep its peg to the dollar unchanged as the dollar fell from 2002 to 2005 o Prasad: G20 should create a reserve pool, offering participants a short-term credit line in case of a crisis. In exchange for this "coverage," each country would pay an entry fee of between $10 billion and $25 billion and an annual premium. http://www.rgemonitor.com/26/China?cluster_id=13652

Mar 24, 2009 Funding the Fed: Precedents and Purposes for Issuing Federal Reserve Bills

Federal Reserve is considering issuing its own interest-bearing bills. Mar 23, the Fed and Treasury put out a joint press release signaling increased likelihood that the Fed will ask Congress to give the Fed authority to issue bills and use Plosser's proposal for the Treasury to take some of the risk off the Fed balance sheet: "Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves." Foreign Precedents o Central bank bills may be a novelty in the U.S. but selling central bank debt to the public is nothing new in other countries o Countries such as Korea, China, Argentina have issued monetary stabilization bonds or bills (MSBs) as a way to control the money supply without using banks o In October, Switzerland introduced MSBs to have a way to withdraw liquidity as official interest rates near zero (when official interest rates cease to exist as a monetary tool) Why is the Fed considering issuing debt? o 1) The ability to issue interest-bearing bills would give the Fed another way to fund itself and achieve the desired positive overnight rate and further expand its balance sheet without clogging up bank balance sheets with excess reserves. The ability to issue

369 interest-bearing bills would leave both reserves and bills held by the public relatively unchanged (JPMorgan, not online) o 2) The Treasury is reaching its issuance limit (debt ceiling) and the Fed is reaching its floor on the amount of Treasuries left on its balance sheet (less than a billion dollars' worth). The Treasury is unwinding the Supplementary Financing Program and may be worried about its widening sovereign CDS spreads o 3) Issuing bills helps prepares an exit strategy from QE o 4) Paying interest on reserves hasn't worked to put a floor under the effective Fed Funds Rate (JPMorgan, not online) o 5) Fed officials are uncomfortable with the speed with which the monetary base (bank reserves plus currency in circulation) has expanded, either on their own account or because the public may see this as creating a huge inflation problem down the road. (Goldman Sachs, not online) o 6) Another possible motivation is to lay the financing groundwork for large-scale direct purchases of longer-term risky assets, such as private-label mortgages and corporate bonds (which would also require congressional approval). (Goldman Sachs, not online) o 7) The other major option for funding the Fed, exempting the Treasury Supplemental Financing Program from the debt ceiling, seems to have fallen out of the running as an alternative reserve management tool (JPMorgan, not online) http://www.rgemonitor.com/168/Global_Monetary_Policy?cluster_id=13345

370 Economy

March 25, 2009 U.S. Plan Seeking Expanded Power in Seizing Firms By EDMUND L. ANDREWS and ERIC DASH WASHINGTON — The Obama administration and the Federal Reserve, still smarting from the political furor over the bailout of American International Group, began a full-court press on Tuesday to expand the federal government’s power to seize control of troubled financial institutions deemed too big to fail. In his news conference on Tuesday night, President Obama said the government could have handled the A.I.G. bailout much more effectively if it had had the same power to seize large financial companies as it did to take over failed banks. “It is precisely because of the lack of this authority that the A.I.G. situation has gotten worse,” Mr. Obama said, predicting that “there is going to be strong support from the American people and from Congress to provide that authority.” Earlier on Tuesday, the Treasury secretary, Timothy F. Geithner, offered a proposal that would allow the government to take control, restructure and possibly close any kind of financial institution that was in trouble and big enough to destabilize the broader financial system. The federal government has long had the power to take over and close banks and other deposit-taking institutions whose deposits are insured by the government and subject to detailed regulation. But the Obama administration and the Fed would extend that authority to insurance companies like A.I.G., investment banks, hedge funds, private equity firms and any other kind of financial institution considered “systemically” important. That would let the government for the first time take control of private equity firms like Carlyle or industrial finance giants like GE Capital should they falter. The Treasury and the Fed each sent their own proposals to the House Financial Services Committee on Tuesday, and President Obama has asked Congressional leaders to put the legislation on a fast track. House Democrats said they planned to act quickly and hoped to bring a bill to the House floor within the next several weeks. If Congress approves such a measure, it would represent one of the biggest permanent expansions of federal regulatory power in decades. But scores of questions remained on Tuesday about how the authority would actually work, and industry experts cautioned that it would only be one step in a broad overhaul of financial regulation that President Obama and Congress were beginning to map out. Mr. Geithner, testifying before the House Financial Services Committee, said the government could have grappled more effectively with A.I.G. — an insurance conglomerate over which neither the Fed nor any other federal bank regulator had much authority — if the Treasury had already had broader authority to “resolve” troubled institutions.

371 “As we have seen with A.I.G., distress at large, interconnected, nondepository financial institutions can pose systemic risks just as the distress at banks can,” Mr. Geithner told lawmakers. “We will do what is necessary to stabilize the financial system, and with the help of Congress, develop the tools that we need to make our economy more resilient.” Ben S. Bernanke, chairman of the Federal Reserve, said that such powers would have allowed the government to scale back A.I.G.’s contracts to pay outsize bonuses and perhaps negotiate lower payments to the domestic and foreign banks that were among its creditors. “If a federal agency had had such tools on Sept. 16, they could have been used to put A.I.G. into conservatorship, unwind it slowly, protect policyholders and impose haircuts on creditors and counterparties,” Mr. Bernanke told lawmakers. But even as they made their case, administration officials left many of the big questions unanswered. Among them: what kinds of companies are “systemically important” and how does that get decided? What should be the government’s ultimate goal — to wind down the troubled company as quickly and smoothly as possible, or to rehabilitate it and return it to health? Under Mr. Geithner’s plan, the decision-making power would lie primarily with Treasury and the F.D.I.C., though the Treasury would have to consult with the White House and the Fed. But that idea could clash with plans to create a new, overarching “risk regulator” that would be responsible for monitoring risk across the financial system. Some lawmakers have proposed that the Fed, which is already at the heart of the financial system, should play that role. Other experts say the F.D.I.C. would be a more logical choice, taking advantage of its experience in taking over smaller banks. Supporters of this approach are concerned that the Fed will be overburdened with its regulatory duties and note that the Fed failed for years to exercise its authority to regulate dangerous mortgage practices. Jamie Dimon, the chief executive of JPMorgan Chase and an outspoken supporter for creating a systemic risk regulator, said it was hard to expand the government’s authority to seize troubled financial companies without also dealing with the regulatory issues. “You can’t take care of your heart and not your lungs,” he said in a telephone interview on Tuesday. “You need someone to look behind the corners and to say something like, ‘this company is too big or too risky.’ ” Mr. Dimon said that giving the government this power would have provided a process for dealing with failing institutions like Lehman Brothers, Bear Stearns, Wachovia and A.I.G. “You don’t want too big to fail,” he said. “You want a resolution process where the process doesn’t damage the whole system.” Representative Barney Frank, chairman of the House Financial Services Committee, plans to start drafting a bill in the next several days. Senator Christopher J. Dodd of Connecticut, chairman of the Senate Banking Committee, said Congress might consider putting the oversight authority in the hands of a task force, rather than consolidating it at the Fed. Mr. Dodd talked of establishing a council that includes the Fed, the F.D.I.C. and the Office of Comptroller of the Currency to avoid giving too much power to a single agency. “I for one would be sort of intrigued in looking at alternative ideas,” Mr. Dodd said. On Thursday, Mr. Geithner plans to outline his broader plan for overhauling the financial regulatory system.

372 On Friday, President Obama plans to meet at the White House with top executives from many of the nation’s largest financial institutions to discuss his financial stabilization effort. Administration officials have said their regulatory plan will create a broad role for the Fed as the lead risk regulator. The administration is also expected to propose tighter regulation for derivative financial products, like the credit-default swaps that caused most of A.I.G.’s problems, and to require that such instruments be traded in a more transparent manner on exchanges or through clearinghouses. Mr. Geithner made it clear on Tuesday that he would be pushing for tighter oversight of executive compensation, in part to make sure that financial incentives did not encourage reckless financial practices.

U.S. Seeks Expanded Power to Seize Firms Goal Is to Limit Risk to Broader Economy By Binyamin Appelbaum and David Cho Washington Post Staff Writers Tuesday, March 24, 2009; A01 The Obama administration is considering asking Congress to give the Treasury secretary unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy, according to an administration document. The government at present has the authority to seize only banks. Giving the Treasury secretary authority over a broader range of companies would mark a significant shift from the existing model of financial regulation, which relies on independent agencies that are shielded from the political process. The Treasury secretary, a member of the president's Cabinet, would exercise the new powers in consultation with the White House, the Federal Reserve and other regulators, according to the document. The administration plans to send legislation to Capitol Hill this week. Sources cautioned that the details, including the Treasury's role, are still in flux. Treasury Secretary Timothy F. Geithner is set to argue for the new powers at a hearing today on Capitol Hill about the furor over bonuses paid to executives at American International Group, which the government has propped up with about $180 billion in federal aid. Administration officials have said that the proposed authority would have allowed them to seize AIG last fall and wind down its operations at less cost to taxpayers. The administration's proposal contains two pieces. First, it would empower a government agency to take on the new role of systemic risk regulator with broad oversight of any and all financial firms whose failure could disrupt the broader economy. The Federal Reserve is widely considered to be the leading candidate for this assignment. But some critics warn that this could conflict with the Fed's other responsibilities, particularly its control over monetary policy. The government also would assume the authority to seize such firms if they totter toward failure.

373 Besides seizing a company outright, the document states, the Treasury Secretary could use a range of tools to prevent its collapse, such as guaranteeing losses, buying assets or taking a partial ownership stake. Such authority also would allow the government to break contracts, such as the agreements to pay $165 million in bonuses to employees of AIG's most troubled unit. The Treasury secretary could act only after consulting with the president and getting a recommendation from two-thirds of the Federal Reserve Board, according to the plan. Geithner plans to lay out the administration's broader strategy for overhauling financial regulation at another hearing on Thursday. The authority to seize non-bank financial firms has emerged as a priority for the administration after the failure of investment house Lehman Brothers, which was not a traditional bank, and the troubled rescue of AIG. "We're very late in doing this, but we've got to move quickly to try and do this because, again, it's a necessary thing for any government to have a broader range of tools for dealing with these kinds of things, so you can protect the economy from the kind of risks posed by institutions that get to the point where they're systemic," Geithner said last night at a forum held by the Wall Street Journal. The powers would parallel the government's existing authority over banks, which are exercised by banking regulatory agencies in conjunction with the Federal Deposit Insurance Corp. Geithner has cited that structure as the model for the government's plans.

374 25.03.2009 Reactions to the Geithner Plan Adam Posen Adam Posen has an interesting comment on the Geithner plan in which makes, among others, the following points. He says in terms of price discovery there is no new information for investors except the terms of the government guarantees and leverage terms, so that the price that will be discovered will reflect no more than that information. Also, he recalls the experience of Japanese financial services minister Hakuo Yanagisawa, who in 1998 got a bank recapitalisation scheme under way, but without sufficient conditions attached to the capital. The Japanese banking system failed again three year later. The Japanese banking crisis was only resolved when the banks were forced to write down their bad assets. Wolfgang Munchau Wolfgang Munchau says in his column in FT Deutschland that the Geithner plan is probably the single biggest policy error committed in this crisis, as it deliberately fails to address the problem of an undercapitalised banking sector. The programme is likely to succeed in its own limited terms – creating an artificial liquid market for bad assets – but this is not itself a solution to the problem. Moreover, it will take time to work, during which the economy will continue to deteriorate. Munchau advocates either outright nationalisation, or the setup of bad banks, good banks, but what Geithner proposes is another expensive scheme that will not do the job. Martin Wolf Martin Wolf says in his FT column that he is getting ever more worried. He is particularly worried about the politics of the Geithner plan. Even if it works, it is such a transfer of wealth from the taxpayer to the bank shareholders, that the public may get increasingly hostile to further bank rescues. He says this plan is not going to solve the problem of under- capitalised banks. The danger is that this scheme will, at best, achieve something not particularly important – making past loans more liquid – at the cost of making harder something that is essential – recapitalising banks. Jeffrey Sachs Jeffrey Sachs, writing in Vox, did some arithmetic and concludes that this plan is a massive transfer of wealth from the taxpayer to the bank shareholders. He has calcuated that investors have an incentive to bid $636bn for toxic assets worth $360bn, which means a transfers of $276bn from the taxpayer (via the Federal Deposit Insurance Corporation) to the bank shareholders. It is no surprise that stock prices were going up. Furthermore, Sachs advises Congress to block this scheme. Congress could use a 1990 Act, which would allow it to turn the off-balance sheet transfer into an appropriation. This means Geithner would have to ask Congress to get the $276bn, which is not going to happen.

375 vox Research-based policy analysis and commentary from leading economists Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 1 Willem Buiter 24 March 2009

In this first of a four-column series on fiscal aspects of central banking, Willem Buiter argues that the ECB’s lack of fiscal backing is both unusual among major central banks and a severe handicap – it is a factor in why the ECB is “fiddling while the Eurozone burns” by hesitating to undertake quantitative easing started by the Fed, Bank of England, and others. Editors’ note: This is the first of a four-part series of Vox columns culled from Willem Buiter’s recent post on his FT-sponsored blog, Maverecon. Introduction: Why central banks need fiscal backup Even operationally independent central banks are agents of the state. And like every natural or legal entity operating in a market economy, the central bank is subject to an (intertemporal) budget constraint. Some central banks are owned by the ministry of finance. The Bank of England, for instance, is owned 100% by the UK Treasury. The ECB is owned by the national central banks of the 27 EU member states. These 27 national central banks have a range of different ownership structures. The Federal Reserve System is not owned by anyone. Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. Ownership of a certain amount of stock is, by law, a condition of membership in the system. The stock may not be sold, traded, or pledged as security for a loan – dividends are, by law, fixed at 6% per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks). Even though central banks can “print money” or create money electronically by fiat, they are constrained in their financial operations by two factors. First, there is a limit to the amount of real resources that can be extracted through the issuance of nominal base money. The demand for real base money is a decreasing function of its opportunity cost – the short-term nominal rate of interest. Increasing the rate of monetary issuance will raise the actual and expected rates of inflation, putting upward pressure on the short-term nominal interest rate. Empirically, at sufficiently high rates of expected inflation, the demand for real base money declines more than proportionally with a further increase in the rate of inflation: there is a “seigniorage Laffer curve”. Hyperinflations, where the inflation tax rate increases without bound but the inflation tax base goes to zero even faster, are the most dramatic example of that. Unexpected inflation can raise inflation tax revenues. It can erode even more dramatically the real value of long-maturity nominal fixed-interest debt, private and public. But systematic surprises tend to be beyond the ken of the monetary authorities. There is therefore a strict limit to the monetary authority’s capacity to service foreign currency

376 debt or index-linked debt, if the only resources it has at its disposal are derived from seigniorage. Second, a central bank with a price stability mandate is likely to be constrained in its ability to extract more resources through seigniorage by the fact that, even when it operates on the upward-sloping segment of the seigniorage Laffer curve, the real resources it needs for financial survival may only be extracted at an inflation rate well above its target or tolerance level. In that case, the central bank needs additional resources from somewhere else to meet its price stability mandate. Although in principle the source of additional capital for the central bank could be charitable donations, in practice, the central bank gets re-capitalised by the Treasury. Behind every viable and credible central bank with a price stability mandate stands a fiscal authority – the only economic entity with non-inflationary long-term deep pockets. Fundamental problems arise when there is uncertainty about the fiscal backup of the central bank, as there is in the case of the ECB and the Eurosystem (Buiter 2008). Other, but equally fundamental problems, arise when the central bank – voluntarily or under political pressure – engages in risky financial transactions on behalf of the Treasury, but without a full guarantee from the Treasury for the losses it may incur as a result of these risky quasi-fiscal actions. This is the case of the Fed today. Why is the ECB so timid when it comes to taking direct credit risk? The ECB is fiddling while the Eurozone burns. Both the Bank of England and the Fed have started quantitative easing, that is, purchases of longer-dated government securities financed by increasing the monetary base, albeit on a modest scale, especially in the US. Japan, which pioneered quantitative easing, is at it again. Switzerland has engaged in a special kind of quantitative easing, involving not the purchase of Swiss government securities but the purchase of foreign exchange reserves. Such non-sterilised foreign exchange market intervention is a form of quantitative easing which is targeted specifically at the exchange rate. Sweden is about to join the club. Canada may not be far behind. The Bank of England’s £150 billion Asset Purchase Facility gives it the option of buying up to £50 billion worth of private securities and at least £100 billion worth of government securities. The Bank of England has announced that it aims, for the time being, at making £75 billion worth of asset purchases under the Asset Purchase Facility, most of them in the form of UK government bond purchases. The Fed has announced purchases of up to $300bn worth of US Treasury securities – a small number, but a start. Credit easing or qualitative easing – the outright purchase by the central bank of private securities – has been a part of the Fed arsenal since it started purchases of commercial paper in 2008. The recent announcement that it will double its mortgage-debt purchases to $1.45 trillion indicates the scale of its ambitions on the credit-easing front. The Bank of England is expected to start purchasing corporate securities soon. There is no sign, however, of any quantitative or credit easing by the ECB. When challenged on this, the ECB points to what it is doing. In particular, it makes available unlimited credit at maturities from one week to six months – against eligible collateral – at the official policy rate, now 1.5%. This is good, but not good enough. The maturity for which such credit is extended should be extended to one year, 18 months, and two years. The ECB also has a very liberal definition of eligible collateral – effectively anything that does not move (and a few things that do) is eligible as collateral, as long as it originates from within the Eurozone, is euro-denominated, and is rated at least BBB-. Indeed the Eurosystem has since the crisis started accepted increasing amounts of rubbish collateral, exposing it to serious private sector credit risk (default risk) on its collateralised lending and reverse

377 operations. For reverse transactions and collateralised lending, default risk is the risk that both the borrowing bank will default and that the collateral offered by the bank will go into default. The Eurosystem’s willingness to provided unlimited security at the official policy rate of 1.5% has flooded the system with short-term liquidity to such an extent that the unsecured overnight interbank rate is now close to the ECB’s deposit rate of 0.5% (the deposit rate is the rate at which banks can deposit funds overnight with the Eurosystem). The difference between the effective overnight interbank rates in the Eurozone, the UK and the US is therefore much smaller than the difference between the official policy rates (1.5%, 0.5%, and 0 to 0.25% respectively). Conclusion The ECB/Eurosystem is hobbled severely by the non-existence of a fiscal Europe, and specifically by the absence of a fiscal authority, fiscal facility, or fiscal arrangement that can recapitalise it should it suffer losses due to credit risk assumed as part of its monetary, liquidity, or credit-enhancing policies. It has the following policy options, provided it is willing to take additional credit risk: Extend the maximum maturity of the fixed-rate credit (against eligible collateral) from six months to up to two years. Engage in unsecured lending to banks, including acting as universal counterparty of last resort in the Eurozone interbank market. This is credit easing in a bank-mediated credit system – the natural counterpart to the outright purchases of private securities by the central bank in a market-mediated credit system. Engage in quantitative easing by purchasing a basket of the 16 Eurozone government debt instruments. Engage in market-mediated credit easing by purchasing private securities outright. For all these operations (including quantitative easing through the purchase of a portfolio of Eurozone sovereign securities), the ECB/Eurosystem ought to get a full, joint-and-several guarantee for the credit risk (default risk) involved from the 16 Eurozone national governments. Without such a guarantee, the ECB/Eurosystem can pursue its financial stability objectives only by risking its capacity to pursue its price stability mandate. The Fed has compromised its independence and ability to achieve price stability in the medium and long term. It has done so by taking huge amounts of private credit risk onto its balance sheet without a full Treasury guarantee or indemnity. The opaqueness of many of its arrangements, facilities, and operations undermines Congressional and wider public accountability for this vast commitment of public resources. The Fed should insist on a full Treasury indemnity for any private sector credit risk it assumes. It should also provide a full account of the ex ante and ex post quasi-fiscal subsidies and transfers it has paid to a range of mainly private counterparties. Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission. References: Buiter, Willem (2008). “Can Central Banks Go Broke?” CEPR Policy Insight No.24, 17 May 2008. http://www.voxeu.org/index.php?q=node/3333

378 Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 2

Willem Buiter 24 March 2009

The second of this four-column series on fiscal aspects of central banking discusses the institutional constraints on quantitative easing. It argues that the ECB can and should engage in quantitative easing since its independence gives it a credible non-inflationary exit strategy. The Fed, however, seems heading for a bout of inflation stemming from Congressional pressure. Buiter argues that the Bank of England’s situation lies between. Why has there not been quantitative easing in the Eurozone? Good question. No treaty-based obstacle There is no treaty-based obstacle to the ECB/Eurosystem buying Eurozone government securities in the secondary markets. Indeed, both the ECB and the 16 national central banks of the Eurosystem hold Eurozone government securities on their balance sheets. Article 101.1 of the Consolidated version of the Treaty Establishing the European Community reads as follows: “Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.” So, no ‘ways and means advances’ to national governments and no direct purchases by the Eurosystem of Eurozone government debt in the primary issue market, but nothing about the secondary market. Governments sell their debt to any party other than the Eurosystem, and the Eurosystem can buy any amount of this debt from these parties in the secondary government debt markets. There is the minor complication of deciding on how much of each of the 16 Eurozone governments’ debt to buy, but resolving that should take no more than five minutes. Obvious national government debt shares in some sovereign debt basket purchased by the Eurosystem would be the shares of these nations’ central banks in the capital of the ECB (normalised for the share of the 16 Eurozone member states in the total capital of the ECB, which is owned by all 27 EU member state national central banks). So why aren’t they doing this? Probably because of the intergenerational transmission of memories of Weimar in the case of some of the ECB Executive Board members and for some NCB governors, that is, because of the fear that “printing money” or its electronic counterpart will ultimately lead to the Zimbabwe-ification of the Eurozone. I am one of nature’s great pessimists, always ready to see a dark lining around a silver cloud, but the fear that unbridled monetisation of public debt and deficits in the Eurozone would tip the region into high inflation, or even hyperinflation, does not exactly keep me awake at night. The risk of deflation, on the other

379 hand, is serious. Time to wake up and smell the quantitative easing roses. There is a material risk that some Eurozone national governments could default Perhaps a reason for the reluctance of the Governing Council to start large-scale purchases of sovereign debt is that there is a material risk of default on the debt of some Eurozone national governments. The 20 March 2009 spreads of 10-year government bonds over Bunds were 2.76% for Ireland, 2.66% for Greece, 1.50% for Portugal, 1.27% for Italy and 1.04% for Spain. In addition, sovereign CDS spreads suggest that even the German government’s creditworthiness is not beyond doubt. Neither, of course, are the creditworthiness of the US and UK governments. Because there is a non-negligible risk that, without external support, one or more Eurozone national governments will default on their debt, it is reasonable for the EBC/Eurosystem to insist on a joint-and-several guarantee by all 16 Eurozone governments for any Eurozone government debt acquired by the ECB. Indeed, I would extend this requirement for a joint- and-several guarantee to any sovereign Eurozone debt accepted as collateral by the ECB in its reverse operations and collateralised loans. Such a joint-and-several guarantee does not exist at the moment – a reflection of the absence of a fiscal Europe and a fiscal Eurozone. More about that later. Need for an exit strategy to avoid inflation Finally, it is clear that any large-scale quantitative easing has to be reversed when the economy recovers and the demand for base money returns to levels that are not boosted by the extreme liquidity preference of a panic-stricken banking system. Without such a reversal of quantitative easing, unacceptable inflationary consequences are likely. If the reversibility, when needed, is not credible, longer-term inflationary expectations will rise and these inflation expectations, as well as possible inflation risk premia, can raise longer-term nominal and real interest rates. Credibility of the future reversibility of quantitative easing ought not to be an issue for the Eurozone. The ECB is the world’s most independent central bank. When it decides it wants to contract its balance sheet again – reverse the quantitative easing – it will simply dump the surplus-to-its-requirements government debt into the open market. The government debt becomes the problem of the respective Eurozone governments again. Either these governments are capable of generating the primary (non-interest) budget surpluses required to make the debt sustainable (and perceived as capable by the markets), or they will default on their sovereign debt. The option of forcing the central bank not to reverse the quantitative easing is not present in the Eurozone, because of the independence-on-steroids of the ECB. Short of sending a tank column to surround the Eurotower in Frankfurt and blast it into submission, the ECB cannot be forced to monetise government debt against its will. This is why, given obvious doubt about the ability and/or willingness of some Eurozone sovereigns to pursue and achieve long-term fiscal sustainability, default on the public debt is considered by the markets and by expert observers to be a distinct possibility for some Eurozone nations, but little if any likelihood is attached to the scenario where the ECB colludes in inflating away the real value of Eurozone government debt. The Fed exit strategy? Or will Congress tell them to inflate away the debt? I consider the opposite outcome to be more likely for the country with the least independent of the leading central banks – the US. The Fed has always acted like what it is: a creature of

380 Congress: “...the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute.” More recently, it has also consented to become an off-balance sheet and off-budget dependency of the US Treasury. If, as I consider likely, the US federal government will not be able to commit itself credibly to future tax increases or future public spending cuts of sufficient magnitude, US public debt will, during the next two or three years, build up to unsustainable levels. When faced with the choice between sovereign default and inflating away the real value of the public debt, there is little doubt about the alternative that will be chosen by the US Executive and the US Congress. The Fed will be instructed to inflate the public debt away. Either Ben Bernanke or a more pliable successor will implement these instructions. Double-digit inflation in the US at a horizon of 5 years or more It is surprising that even at a horizon of 5 years or more, the markets are not yet pricing in a distinct possibility of double-digit inflation in the US. The announcement of quantitative easing in the US did weaken the external value of the US dollar, but long-term sovereign interest rates fell for the maturities targeted by the Fed (two to 10 years) and did not rise materially for longer maturities. At some point, probably not too far into the future, the future inflation expectations effects of quantitative easing that is unlikely to be reversed when required to maintain price stability should overcome the immediate demand effect of the Fed’s quantitative easing on the prices of longer-term nominally denominated US sovereign debt instruments. The UK’s exit strategy The UK is somewhere between the Eurozone and the US as regards central bank independence and as regards the likelihood that current quantitative easing will be reversed in time to prevent inflation and inflationary expectations from escalating. The UK Treasury can take back the power to make monetary policy using the Reserve Powers granted in the Bank of England Act 1998. This only requires retroactive approval by Parliament. However, the degree of polarisation of the UK polity and of UK society in general is probably rather less than that of the US. In addition, because the UK political regime is an elected dictatorship, the UK Executive is subject to minimal checks and balances and may well be able to impose the future tax increases (I am less sure about future spending cuts) required to maintain government solvency without the need to inflate away much of the real burden of the public debt. Why no credit easing in the Eurozone? When asked this question, the members of the ECB’s Governing Council tend to reply that the Eurozone is much more dependent on banks than on capital markets for financial intermediation. This is in contrast to the US and the UK where the markets-mediated or transactions-oriented model of financial capitalism has achieved a much greater degree of prominence than in the Eurozone, where the relationships-oriented model of financial capitalism still rules the roost. It is true that banks are a more important source of funds for households and non-financial enterprises in the Eurozone than in the US or the UK. However, there is an analogue to outright purchases of private securities (the expression of credit easing in the transactions- oriented model) in the relationships-oriented model. This is unsecured lending by the ECB/Eurosystem to the banks. Unsecured lending by the central bank to the commercial banks is the straightforward expression of credit easing in the relationships-oriented or banking model of financial intermediation. There is an even more aggressive version of this,

381 which has the central bank lending directly and unsecured, to non-bank counterparties, bypassing the banks completely. The ECB/Eurosystem are not lending without collateral to the banks, let alone to non-bank counterparties (indeed the ECB/Eurosystem is not lending even with collateral to non-bank counterparties). The only valid reason for the ECB/Eurosystem not to make unsecured loans to the banks would be that the banking system is in such good shape, and that financial intermediation through the banks remains sufficiently functional, that unsecured lending is redundant. If that is indeed what the ECB/Eurosystem believe, they should go to the eye doctor. It is clear that even those Eurozone member states whose banks were by-and-large not involved directly in the financial excesses that brought us the financial collapse of the North Atlantic border-crossing banking and shadow-banking system are now gasping for financial air. The quality and size of banks’ balance sheets are declining swiftly, as the rapid contraction of real economic activity feeds back on the financial intermediaries. With both the demand for credit and the supply of credit collapsing, the ECB/Eurosystem may be deriving misplaced comfort from the fact that bank finance is not necessarily the binding constraint on economic activity. A dangerously shortsighted belief That would be dangerously shortsighted. First, there are always otherwise viable enterprises for which external finance is the binding constraint on production, employment, and investment, even when the surveys indicate that for most firms demand is the binding constraint. Second, if and when the recovery starts, non-financial enterprises will have to fund their expansion plans to a large extent from external sources – retained profits will be few and far between. Banks will be more likely to meet these demands from the non- financial enterprise sector if they can fund themselves unsecured through the Eurosystem. One particularly useful form of unsecured lending by the ECB/Eurosystem to the banks would be for the national central banks of the Eurosystem to become universal counterparties for inter-bank lending and borrowing.

Banca d’Italia example The Banca d’Italia has implemented such a scheme, the MIC, but only for banks with head- offices, subsidiaries, or branches in Italy, and for banks from other Eurozone jurisdictions that have reciprocal arrangements for Italian banks. This of course means a deplorable balkanisation of Eurozone monetary and liquidity management. Indeed, it undermines the essence of the Eurosystem as an institutional arrangement setting and implementing a common monetary policy for 16 Eurozone member states. It is surprising that the Banca d’Italia has been permitted to create such a distortion of the monetary and liquidity level playing field. But if a scheme like the MIC were to be implemented uniformly across the Eurozone, it would be a helpful measure, which would strengthen the Eurosystem rather than threaten to deconstruct it into a collection of imperfectly linked subsystems. http://www.voxeu.org/index.php?q=node/3334

382 Fiscal dimensions of central banking: the fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 3

Willem Buiter 25 March 2009

The third column in this series discusses the ECB’s lack of fiscal backing in detail and suggests three ways in which it might be provided by EU governments. An entirely valid reason for the ECB/Eurosystem to refuse to engage in either outright purchases of private securities or in unsecured lending to the banking sector (or to the non- financial enterprise sector directly), is that there is no ‘fiscal Eurozone’ – just as there is no fiscal EU. The absence of a fiscal Europe that matters here is a narrow one. I am not talking about the absence of a significant supranational fiscal authority in the EU (or in the Eurozone), with significant tax, spending, and borrowing powers – one capable of material system-wide fiscal stabilisation and cross-border redistribution. I am talking instead about two related fiscal vacuums. The first vacuum is that there is no single fiscal authority, facility, or arrangement that can recapitalise the ECB/Eurosystem when the Eurosystem makes capital losses that threaten its capacity to implement its price stability and financial stability mandates. The second related vacuum is that there is no single fiscal authority, facility, or arrangement that can recapitalise systemically important border-crossing financial institutions in the EU or provide them with other forms of financial support. When the Bank of England develops an unsustainable hole in its balance sheet, Mervyn King knows he only needs to call one person: Alistair Darling, the UK Chancellor of the Exchequer. If the Fed were to become dangerously decapitalised, Ben Bernanke also needs to call just one person, Timothy Geithner, the US Secretary of the Treasury.1 Whom does Jean-Claude Trichet call if the Eurosystem experiences a mission-threatening and mandate-threatening capital loss? Does he have to make 16 phone calls, one to each of the ministers of finance of the 16 Eurozone member states? Or 27 phone calls, one to each of the ministers of finance of the 27 EU member states whose national central banks are the shareholders of the ECB? I don’t know the answer, and I doubt whether Mr. Trichet does. This situation is intolerable. We need a fiscal Europe, at least at the level of the Eurozone, to fill the first vacuum. If we are to fill the second vacuum, we need a fiscal Europe at the EU level also. Three ways to fill the vacuum I see three alternatives. In decreasing order of desirability but increasing order of likelihood they are: (a) A supranational Eurozone-wide tax and borrowing authority, specifically dedicated to fiscal backing for the ECB/Eurosystem. This could be extended to include the provision of financial support to systemically important border-crossing financial institutions. In that case, the supranational fiscal authority would have to encompass all of the EU, not just the

383 Eurozone. This might require a two-tier authority, with a Eurozone-only tier to back up fiscally the ECB/Eurosystem, and a EU tier to financially back systemically important border-crossing financial institutions. (b) A Eurozone-wide fund, funded by the 16 Eurozone governments (in proportion, say, to their relative shares in the ECB’s capital), that the ECB/Eurosystem could draw on (subject to qualified majority support in the Eurogroup) if it were to suffer losses as a result of Eurozone-wide monetary policy, liquidity, and credit-easing operations. This fund could be capitalised by the 16 Eurozone national Treasuries, say in proportion to their shares in the ECB’s capital. Around €2.5 trillion to €3.0 trillion would be enough initially to cover the likely losses of the Eurosystem if the downturn is prolonged and deep and requires large- scale credit easing. As an interesting extra, the fund (let’s call it the Eurosystem Fund) could be allowed to borrow with its debt guaranteed joint-and-severally by the 16 Eurozone member states. This is permitted under Article 103.1 of the Treaty: “The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.” What gets the camel’s nose of a joint-and-several guarantee in the tent is the reference to “…mutual financial guarantees for the joint execution of a specific project.” What, after all, is a “specific project”? Anything can be a project. Certainly the creation of a special fund dedicated to the specific purpose of providing the ECB/Eurosystem with additional capital, should the need arise, would qualify as a specific project. You could even create the Eurosystem Fund as an activity of the European Investment Bank. According to the Treaty’s Article 267: “The task of the European Investment Bank shall be to contribute, by having recourse to the capital market and utilising its own resources, to the balanced and steady development of the common market in the interest of the Community. For this purpose the Bank shall, operating on a non profit making basis, grant loans and give guarantees which facilitate the financing of the following projects in all sectors of the economy: (a) projects for developing less-developed regions; (b) projects for modernising or converting undertakings or for developing fresh activities called for by the progressive establishment of the common market, where these projects are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States; (c) projects of common interest to several Member States which are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States.” The Eurosystem Fund would fit quite snugly into category (c) above. The European Investment Bank borrows on international capital markets under something practically

384 equivalent to a joint-and-several guarantee of the 27 EU member states. If joint-and-several borrowing by the Fund is considered a bridge too far, each of the 16 Eurozone member states could guarantee just a share of the losses of the Fund equal to its share in the ECB’s capital. A larger fund, separate from the Eurosystem Fund, could also be set up to provide financial support for border-crossing systemically important financial institutions for the EU as a whole. Let’s call it the Crippled Bank Fund. We certainly will need something like that to retain meaningful border-crossing banking activity in the EU. This crisis has reminded us that there is no such thing as a safe bank, even if the bank is sound in the sense that its assets, if held to maturity, could cover its liabilities. This crisis has also reminded us that there may no such thing as a sound bank any longer, but that is a separate story. To be viable, a bank needs to be scrutinised by a supervisor/regulator, have access to the short-term deep pockets of a central bank as lender of last resort and market maker of last resort, and have access to the long-term non-inflationary deep pockets of a Treasury. If we are to continue to have meaningful cross-border banking, we will need a European supervisor/regulator for border-crossing banks and a European fiscal authority or at least a European fiscal facility like the Crippled Bank Fund. (c) An ad hoc, hastily cobbled together fiscal burden sharing rule for the 16 Eurozone national governments to restore the capital adequacy of the ECB/Eurosystem. This may well be the best we can hope for in practice. The experience of the Fortis debacle makes me doubt whether it will work. When the three-country banking and insurance group Fortis (Belgium, the Netherlands and Luxembourg) was about to go under, the authorities of the three countries agreed a joint plan to save the institution as a border-crossing bank, with Belgium putting in 50% of the agreed funds, the Netherlands 40% and Luxembourg 10%. The agreement lasted less than a week. Fortis was broken up according to the national location of its activities, with the Dutch state buying 100% of Fortis Nederland and Belgium and Luxembourg doing the same for their local subsidiaries. This repatriation of cross- border banking will become a flood wave if more cross-border banks go under and country A’s tax payers refuse to stand behind the balance sheets of subsidiaries of their banks in countries B and C. Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission.

1 It is possible that no one in the US Treasury will pick up the phone, as none of the senior political appointments below Geithner are in place yet, but Geithner clearly would be the man to call. http://www.voxeu.org/index.php?q=node/3340

385

Fiscal dimensions of central banking: the fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 4 Willem Buiter 25 March 2009

The last column in this series on fiscal aspects of central banking reviews the differences in fiscal backing for the Bank of England, the US Federal Reserve, and the European Central Bank. The Bank of England When the Bank of England gets around to making outright private asset purchases, it will do so with an indemnity provided by Her Majesty’s Government to cover any losses arising from the use of the Facility. This is as it should be. In principle, a central bank should only take the credit risk of its sovereign – the state. If its monetary, liquidity, or credit-easing operations expose it to the credit risk of the private sector, it ought to do so with a full indemnity (guarantee for any losses) from the Treasury. The Bank of England has a full indemnity for outright purchases of private securities, but not for the private credit risk it assumes through repos and other forms of collateralised lending to banks where the collateral offered consists of private securities. I believe the UK Treasury should insure the Bank of England – for free – against all losses incurred as a result of the Bank of England taking private credit risk on its portfolio. The Fed The Fed does not have a full indemnity from the US Treasury even for its outright purchases of private securities. It has no guarantee or indemnity for private credit risk assumed as a result of its repo operations and collateralised lending. For the Fed’s potential $1 trillion exposure to private credit risk through the Term Asset- Backed Securities Loan Facility, for instance, the Treasury only guarantees $100 billion. They call it 10 times leverage. I call it the Fed being potentially in the hole for $900 billion. Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG, and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the Federal Deposit Insurance Corporation, and the US Treasury jointly. I consider this use of the Federal Reserve as an active (quasi-)fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US. There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – taxpayers’ money. As for the Fed’s independence (whatever independence remains), first, even if the central

386 bank prices the private securities it purchases appropriately (that is, there is no ex ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed. As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player or a debt collector. The ex post transfers or subsidies involved in writing down or writing off private assets are (quasi-)fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework. The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withhold. The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around $170 billion with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns’ balance sheet has been hidden in some SPV in Delaware. The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of taxpayers’ resources that it entails threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay. The ECB The ECB has no fiscal backup. There is no guarantee, insurance, or indemnity for any private credit risk it assumes. This huge error and omission in the design of the ECB and the Eurosystem threatens to make the ECB significantly less able than the Bank of England and the Fed to engage in unconventional monetary policy, including quantitative easing and credit easing. The exposure of central banks to private sector default risk applies, of course, not only to central banks making outright purchases of private securities. It applies equally to central banks that make loans to the private sector using private financial instruments as collateral. Repos are an example. The Eurosystem has taken private sector credit risk onto its balance sheet ever since it was created. It now accepts a vast collection of private securities as collateral in repos and at its discount window (just about anything issued in euro and in the Eurozone that is rated at least BBB-). The Eurosystem has already taken some significant marked-to-market losses on loans it made to eligible Eurozone counterparty banks against rubbish ABS collateral. In the autumn of 2008, five banks (Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks,

387 and Indover NL) defaulted on refinancing operations undertaken by the Eurosystem. The amount involved was just over €10 billion, and over €5 billion of provisions have been made against these impaired assets, because the mainly ABS dodgy collateral is, under current market conditions, worth rather less than €10 billion. Any losses incurred as a result of these defaults are, like all losses incurred by the Eurosystem in the pursuit of its monetary and liquidity operations, to be shared by all 16 national central banks in proportion to their shares in the ECB’s capital. But while the Eurosystem as a whole shares any losses incurred by its individual national central banks, there is no mechanism for recapitalising the Eurosystem as a whole. The ECB/Eurosystem is not yet hurting financially, however. The Eurosystem’s income from monetary policy operations was probably around €28.7 billion in 2008. A high degree of price stability and large denomination notes (including €500 and €200 notes, while the best the US can come up with is a $100 bill) make the euro the currency of choice for tax evaders, tax avoiders, money launderers, and other criminal elements everywhere. This makes for massive seigniorage revenue for the ECB and the Eurosystem. The combination of the obvious willingness of the ECB/Eurosystem to take serious private sector credit risk through collateralised lending to banks and its unwillingness to consider outright purchases of private securities or to engage in unsecured lending to the banking sector is difficult to rationalise. Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission http://www.voxeu.org/index.php?q=node/3341

388

REALTIME ECONOMIC ISSUES WATCH

GLOBAL FINANCIAL CRISIS

The Treasury’s Financial Stability Plan: Solution or Stopgap? by Adam S. Posen | March 23rd, 2009 | 05:55 pm I hope it works. The financial stability plan presented on March 23 by Treasury Secretary Timothy Geithner could be a part of the solution because it would remove some of the bad assets from the banks’ balance sheets and put some capital into the banks. The Treasury is clearly trying clever tactics to avoid going to Congress for more upfront on-budget expenditures to fix the banks. Even in the best case, though, I worry that the avoidance of upfont costs makes it penny- wise, pound-foolish, for the US taxpayer. The private sector investors get a subsidy from the government in terms of both leverage and insurance against asset declines, and the current bank shareholders get higher prices for their assets via these subsidies. It may well thus cost the taxpayer more on net, between these subsidies and the lost upside gains, than if the government had stepped in more aggressively to take full ownership and pay low prices for these assets, even if it costs less upfront. More worrisome, this partial fix might only be temporary. The banks will still have left the worst toxic assets on their books, their incentives will not have changed, and they will be playing with a fresh stack of public money with insufficient conditions and probably insufficient capital. Then, 18 months or so down the road, the US government would still have to put capital into the banks, because lending will have broken down again, and many banks will again be under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out. The explicit premise of this plan is that the real issue here is a market panic. Treasury is assuming that the private money managers on the sidelines are just sitting there because they are scared, and that the risks they fear (about the economy in general) are very unlikely to be realized, and that the banks’ investors need assurances to encourage them to buy. While markets do get things wrong, I think the panic is a misdiagnosis of the situation. Part of the problem is that some of these assets are genuinely toxic because they are part of larger securitized packages, and there is an inability to see what is behind them. Under this plan, those toxic assets are not restructured, because doing that would require government

389 supermajority ownership, which will not happen. So some will fail to find a market. In that case the FDIC will end up having to pay out on the insurance for overpriced assets. Another part of the problem is that the banks’ current management and shareholders have been unwilling to sell some of the assets for which there is a market at the prevailing low prices because they have been hoping for a government bailout. Bailout is what this plan may give them, with all the subsidies. Given the apparent deep motivation of the Treasury to minimize both on-budget costs and even temporary public ownership of anything, the Obama team is apparently willing to risk overpaying current owners of these assets rather than forcing sales. The Treasury plan is also supposed to lead to “price discovery” through the use of auctions and then resales. This sounds very nice, but since there is no new information for the private investors, except the government guarantee and leverage terms, what price will be discovered besides the worth of that subsidy? Nothing here transforms the worth of those assets. Who will be the eventual market for these assets unless that insurance and subsidy is transferred? If that is the real asset being sold, then why not have these investment firms sell derivative contracts stripping out and offering that insurance, based on the public guarantees? I am skeptical about the amount of price discovery that will occur in such a scenario. I and others have been arguing for a more direct government approach [pdf] not only to get the taxpayer the least cost in the end, though government should indeed be concerned with the long-term instead of temporary budget illusions. The main reason I argue for a more aggressively interventionist strategy—with clean lines between public and private ownership and more stringent pricing of bad assets—is that bolder intervention is the one proven way to resolve such a situation lastingly. Japan in 1998 had a reformer, Hakuo Yanagisawa, come in as Financial Services Minister, and he got a bank recapitalization underway—but he did so without putting on enough conditions on the capital, and three years later the Japanese banking system failed again. Only when Heizo Takenaka became the responsible Minister, and forced the banks to truly write down the value of the distressed assets before injecting capital, was the Japanese banking crisis resolved. Various Japanese government efforts to play with bad asset purchases before that only resulted in overpayments and the eventual accumulation of more bad assets. I hope that the current Treasury plan contributes to stabilizing the US banking system in a lasting way, even if it comes at excessive cost to the taxpayer and offers too much benefit to the private participants. But I also worry that in the end Treasury will have to just do this again with more public money for the same banks amidst renewed financial disruption a little later. http://www.petersoninstitute.org/realtime/?p=565

390 24.03.2009 GEITHNER’S TRILLION DOLLAR GAMBLE

Global stocks soared after US treasury secretary Tim Geithner announced his $1,000bn package to extricate toxic assets from the balance sheets of debilitated US banks. The dollar was also up against the euro and the yen. But while global equities rallied, many observers were still left sceptical or confused because of the lack of detail in Mr Geithner’s statement. We found the most succinct description and analysis how the schemes works, and why it is rip-off, coming from Colm McCarthy in the Irish Economy Blog. Essentially the Geithner plans creates a vehicle in which private equity accounts for 3%, public equity for 12%, and the rest is provided as debt by the public sector the (through the Federal Deposit Insurance Corporation, FDIC). McCarthy makes the point that the private guys do the bidding, and they get the debt on such preferential terms (non-recourse lending, interest rates close to T-bills), that they are bound to end up with a profit. The blogger Nemo (hat tip Felix Salmon) has produced an interesting post on how the Geithner Plan works in more detail, using a numerical example, which shows that from an investor’s point of view this is a Heads I Win Tails You Lose proposition. The only party that always loses, in all conceivable scenarios, is the tax payer. Paul Krugman came up with a similar calculation. The FT's editorial argues that Geithner’s plan assumes that buyers and sellers will agree on a price for bad assets if the government is willing to subsidise them enough. But this implies that assets are not trading today mainly because of a lack of liquidity. But no one knows whether the market malfunction is due more to long-term losses or short-term liquidity risk. A virtue of this plan is that it should help us find out. But this is a gamble, which could fail in two ways. (A short comment from us: We have noticed that the US blogging community is a lot more positive about the Geithner plan than the Paulson plan, even though they are essentially the same plan minus some insignificant details, such as who is in charge of the bidding process. So in our view the reactions to the Geithner plan are very a good metric of the partisanship in the US blogging community. Some bloggers like Krugman, Johnson and Naked Capitalism have remained consistent

391 throughout. Some of the others are merely telling us that they are Democrats, right or wrong.) ¿Opportunity? Projected fall in world trade The WTO expects world trade to fall by 9% this year. This would be the largest contraction since world war 2. After the oil price shock trade fell by 6.2%, the highest reduction to date. FT Deutschland reports that the RWI institute even forecasts a 12% fall. German growth forecasts revised downwards Bad news also for Germany, as the Ifo, DIW and RWI economic institutes revised downwards their growth forecasts, reports the FT Deutschland. Ifo institute forecasts a 6% fall under a worst case scenario, if e.g. world trade continue to contract on its current pace. The DIW forecasts a contraction of 4-5%, the RWI of 4.3%. The most pessimistic private sector forecast comes from Commerzbank, which is looking at 6-7%. The security implication of the crisis The German Foreign ministry sets up a special task force to evaluate the security risks resulting from the global financial and economic crisis. The Germans thereby follow the US counterpart by ranking the social and political repercussions of the crisis higher than that of a terrorist attack, reports the FT Deutschland. The scenarios include state defaults in politically unstable regions such as the Caucasus. Risk aversion recedes Prices on so called most-traded leveraged loans – loans to sub-investment grade companies – have recovered to the highest levels since October, reports the FT. Prices have been recovering since the start of this year after an onslaught of forced selling of loans by banks and hedge funds in the last quarter of 2008 pushed loan prices to record lows. However, Moody’s warned on Monday of rising loan defaults and said that recoveries for investors could deteriorate further during the course of 2009. IMF gloomy over UK’s public finances The IMF gets gloomy over Britain’s public finances , forecasting that the deficit will balloon to 11% of GDP in 2010, far more than the US (8.9%) or the G20 average (6.3%), reports the FT. Falling profits and rising job losses are taking a toll on public finances, £17bn more than expected in the pre budget report of November last year. In February total receipts were £40.7bn down from £45bn, expenditures £26.7bn higher than in the previous year John Taylor on inflation A good comment by John Taylor in the FT this morning. He says that the Fed’s monetary policy has boosted the size of reserve account from $8bn to $778bn by last week, which will go up to $3365bn by the end of this year, once all the announced programmes are implemented. There is no question that this will lead to inflation eventually, so the Fed will have to mob up some $3000bn, at a time when

392 the Treasury is loading up with debt. In the long-run, the Fed is sacrificing its independence, he concludes. The end of financial globalisation Brad Setser has an impressive post on financial de-globalisation. According to the latest US balance of payment data, the US has become a net lender to the rest of the world. Foreign investors have been withdrawing more credit from the US than they have been supplying. Setser concludes that Bretton Woods II has come to an end. As the US is still running a current account deficit, this can only be due to US withdrawals of funds from the rest of the world. Setser gets so excited about these data that he says: “Words cannot really capture the sheer violence of the swings in private capital flows that somehow produced a a rise (net) private demand for US financial assets”

March 23, 2009, 10:11 am Paul Krugman GEITHNER PLAN ARITHMETIC Leave on one side the question of whether the Geither plan is a good idea or not. One thing is clearly false in the way it’s being presented: administration officials keep saying that there’s no subsidy involved, that investors would share in the downside. That’s just wrong. Why? Because of the non-recourse loans, which reportedly will finance 85 percent of the asset purchases. Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me. Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy. And in this example it’s a large subsidy — 30 percent. The only way to argue that the subsidy is small is to claim that there’s very little chance that assets purchased under the scheme will lose as much as 15 percent of their purchase price. Given what’s happened over the past 2 years, is that a reasonable assertion? Update: Another way to say this is that by financing a large part of the purchase with a non- recourse loan, the government is in effect giving investors a put option to sweeten the deal.

March 23, 2009, 10:13 am INCOMMUNICADO, PROBABLY I’m working at home today, waiting for the Fios guy. Which means that I’m probably going to drop off the face of the earth for much of today.

393 March 24, 2009, 8:14 am LARRY, LARRY From The Hill: “I was surprised by Paul’s comments,” Summers told Bloomberg News on Monday. “He didn’t seem to recognize that this is one component of the plan, and I don’t know of any economist who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.” Futhermore, Summers accused Krugman of not actually recognizing what was announced today. “Paul has views on the state of the banking system. Certainly many observers don’t share those views,” Summers declared. “But more relevantly, that wasn’t what today’s announcement was about.” Summers added: “I didn’t understand his argument.” I’m fine with this. Larry is a first-rate economist with a job to do, and I wish him luck in it. He understands what I’m saying, of course, but he’s doing his best to support the official line. That line now goes like this: first, the Geithner put is just “one component of the plan” — although the other components are invisible to the rest of us, now that the stress test seems to have been downgraded to irrelevance. Second, rather than defending the large subsidy the plan creates for anyone who buys troubled assets, administration officials tout the virtues of markets in general, and say, hey, this creates a market, so it must be good. It’s a bit disappointing to see the Obama administration engaging in this sort of market- worship — hailing markets as a Good Thing in themselves, rather than as an often but not always useful means to an end. But I have reason to think that unlike the Bushies, they don’t really believe it; it’s just politics. Which is actually better than having genuine market fanatics running things, I guess.

394 PRICES OF MOST-TRADED RISKY LOANS RECOVER

Published: March 23 2009 18:05 | Last updated: March 23 2009 18:05 Prices of most-traded risky loans recover By Anousha Sakoui The prices of the most-traded risky loans have recovered to levels not seen since October as the fear of more assets being dumped on the market has receded. However, Moody’s warned on Monday of rising loan defaults and said that recoveries for investors could deteriorate further during the course of 2009. Last week, the prices of most-traded European leveraged loans – loans to sub-investment grade companies – rose for a second successive week, according to Standard & Poor’s LCD. Based on pricing from Markit, the average bid on a European risky loan rose to 70.69 basis points, up 17bp since March 12. Pricing for a broader composite of loans, which are less traded, has continued a downward decline, with the least liquid loans falling to 57.12bp, a record low. Prices on most-traded leveraged loans have been recovering since the start of this year after an onslaught of forced selling of loans by banks and hedge funds in the last quarter of 2008 pushed loan prices to record lows. Since then, the fear of forced loan sales has eased. (is a quarterly problem: June) One manager of a collateralised loan obligation – which pools leveraged loans and sells differently rated investment notes with varying risk profiles – said he believed loan prices could fall further as corporate earnings deteriorated. This year, rating agencies are forecasting that defaults will rise to a peak in the fourth quarter of 2009. Moody’s said on Monday that the default rate on bank loans to speculative-grade corporations had risen sharply in 2008 and recovery rates on leveraged loans dropped over the same period. It warned that this trend was likely to accelerate in 2009. While recovery rates fall and defaults rise, the complex and large debt loads put on companies in recent years will damp recoveries further. Sharon Ou, associate vice- president at Moody’s, said: “Given tight credit markets, a worldwide economic slump and a deteriorating issuer ratings mix, we expect default rates on leveraged loans will continue to climb in 2009 while recovery rates are expected to fall further.” Kenneth Emery, director at Moody’s, said: “The recent strong increase in loans’ share of total debt in issuers’ capital structures implies less protection for loan investors.”

395 THE THREAT POSED BY BALLOONING FEDERAL RESERVES

Published: March 23 2009 20:09 | Last updated: March 23 2009 20:09 The threat posed by ballooning Federal reserves By John Taylor An explosion of money is the main reason, but not the only one, to be concerned about last week’s surprise decision by the Federal Reserve to increase sharply its holdings of mortgage backed securities and to start purchasing longer term Treasury securities. First consider the monetary effects. When the Fed purchases public or private securities or makes loans to banks or to other private firms, it must finance them. The Fed can borrow the funds, or it can ask the Treasury to borrow the funds, or it can do it the old- fashioned way: create money. The Fed creates money in part by printing it but mostly by crediting banks with deposits at the Fed. Those deposits are called reserve balances and are the key component – along with currency – of base money or central bank money which ultimately brings about changes in broader money supply measures. These deposits or reserves have been exploding as the Fed has made loans and purchased securities. Six months ago reserves were $8bn, in a range appropriate for its interest rate target at the time. As of last week, reserves were nearly 100 times larger at $778bn, the result of creating money to finance loans to banks, investment banks, AIG, central banks and purchases of private securities. Before last week’s federal open market committee meeting, I projected these would increase to $2,215bn by the end of this year if the new Consumer and Business Loan Initiative of the Treasury were to be financed by money creation. With last week’s dramatic announcement, the Fed will have to increase reserves by another $1,150bn to $3,365bn by the end of the year if the securities purchases are financed by money creation. Quantitative easing or credit easing means that the growth rate of the quantity of money increases, but there is no monetary principle or empirical evidence supporting such an explosion. There is no question that this enormous increase from $8bn to $3,365bn will lead to higher inflation unless it is reversed. With the economy in a very weak state and commodity prices falling, inflation does not appear to be a problem now. The growth of reserves has led to an increase in the growth rate of the broader money aggregates, but less than proportionately because banks are still holding excess reserves. The Fed has expressed its concern about inflation with its new target-like longer term forecasts for inflation and by saying it will remove the reserves in due time. However, increases in money growth affect inflation with a long and variable lag. Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet. Making it more difficult are the extraordinary borrowing demands by the Treasury and the announcement of Treasury purchases by the Fed. Some argue that the unprecedented actions by the Fed are filling in for a lacklustre performance by the Congress and the administration, especially in light of the uproar over the AIG bonuses. But even if there are short-term benefits, they will be offset by the cost of lost independence of the Fed. What justification is there for an independent government agency to engage in such selective lending activities? The announcement by the Fed that it will

396 purchase long-term Treasuries is reminiscent of the period just before the Accord of 1951 when the Fed had little independence. The reason for these interventions is that the Fed wants to improve the flow of credit and lower interest rates for a wide range of borrowers. However, it is by no means clear that the interventions will be effective beyond a very short period, and they may be counterproductive. I found, for example, that the Term Auction Facility, set up to improve the functioning of the money market and drive down spreads on term interbank lending relative to overnight loans, had no noticeable impact on interest rate spreads. Such actions may have prolonged the crisis by not addressing the fundamental problems in the banks. These extraordinary measures have the potential to change permanently the role of the Fed in harmful ways. The success of monetary policy during the great moderation period of long expansions and mild recessions was not due to large discretionary interventions, but to following predictable policies and guidelines that worked. The writer, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

397

FINANCIAL DE-GLOBALIZATION, ILLUSTRATED Posted on Monday, March 23rd, 2009 By bsetser The financial world has changed — even if the scale of the change isn’t obvious in the financial sector’s 2008 bonuses.

Here is one indication of the scale of the change: the US government was — according to the latest US balance of payments data – a large net lender to the world. Yes, a net lender, not a net borrower. Foreign central banks are no longer providing the US with much new credit. Indeed, they withdrew $13.6 billion of credit from the US in the fourth quarter, as central banks’ agency sales ($96b) and the fall in their deposits in US banks (bank CDs fell by $80 billion) produced a net outflow despite record purchases of US treasuries ($179b, all short-term bills). And the US — through the Fed’s swap lines — provided a rather large sum of credit ($268 billion) to the rest of the world. For the year as a whole, the BEA data indicates the US government lent $534 billion to the rest of the world while foreign governments lent “only” $421 billion to the US. Judging from the data on net flows, Bretton Woods II has in some sense come to an end. The world’s central banks are no longer building up reserves and thus are no longer a net source of financing to the US. It just didn’t end in the way the critics of Bretton Woods II expected — on this, Dooley and Garber are right. The fall in official flows* was offset by a rise in (net) private inflows.

398 Then again, Bretton Woods II also didn’t anchor a stable international financial system in the way Dooley and Garber suggested either. Both private and official demand for US financial assets has collapsed. Gross inflows are close to zero.

How then can the US still run a large current account deficit if the rest of the world isn’t buying its financial assets? There is only one answer: Americans have pulled funds from the rest of the world (call it deleveraging, call it a reversal of the carry trade or call it a flight to safety) faster than foreigners have pulled funds from the US market. Words cannot really capture the sheer violence of the swings in private capital

399 flows that somehow produced a a rise (net) private demand for US financial assets. The modest change in net flows reflects an enormous contraction in gross flows. Look at the quarterly data — not a rolling four quarter sum — scaled to US GDP.** To put in in plain terms, Lehman’s collapse had a bigger impact on cross-border flows than 9.11. Compare q4 2008 to q3 2001. The enormous withdraw of private US lending to the world was offset, in part, by a surge in US official lending to the world. It was just the Fed, not the Treasury, that did all the heavy lifting.

For now, Dan Drezner doesn’t need to worry too much about the United States’ ability to be the world’s lender of last resort. A crisis may come when the US government cannot play a similar stabilizing role. But that crisis would be marked by a run out of the dollar — not a global scramble for dollars. The current crisis has constrained the United States’ ability to be the world’s importer of last resort, but not its ability to be the world’s lender of last resort. Not so long as the the world is scrambling to find dollars, the one currency the Fed can create. Here, my earlier concerns haven’t been born out. Still, it is hard to look at these charts and conclude all is well in the world. Cross-border financial flows rose to crazy heights during the credit boom. Thank the shadow financial system. Over the past year those flows have collapsed with stunning speed. Had the collapse in inflows and outflows not offset, there would now be talk of a sudden stop in capital flows to the US. But so long as the fall in demand for US assets is matched by a fall in US demand for foreign assets, a collapse in gross flows need not to lead to a collapse in net inflows. To date, the United States “sudden stop’ has manifest itself as a credit crisis not a currency crisis. The “great contraction” in private capital flows actually started in the summer of 2007. The pressure that led to Lehman’s failure — and the near-failure of a host of other financial institutions, not the least AIG — had been building for a while.

400 And it is also striking, at least to me, that financial globalization collapsed of its own weight, not because of any political decision to throw sand into its gears. That may yet happen. The political reaction to the financial excesses of the past few years is just beginning. But the fall in financial flows to date largely reflects the unwinding of a a host of leveraged bets made by the City and the Street — not demands from Whitehall or Washington. Indeed, without government intervention, the collapse in cross-border flows would have been far larger. If the government hadn’t stepped in, a host of financial institutions would have collapsed, leading to an even sharper contraction in capital flows. That is something that often seems to be lost in the debate over financial protectionism. The data for the charts can be found here. • The BEA data understates official flows from mid 2007 to mid 2008, as it hasn’t been revised to reflect the results of the survey data. Even the revised BEA data understates the impact of central banks and sovereign funds as it doesn’t capture those funds that have been handed over to private fund managers, or the purchases of US securities by European banks with a large dollar balance sheet as a result of large central bank deposits. This isn’t an issue for the tail end of 2008 though. The fall off in official demand is real. Central banks were in aggregate selling off there reserves — as the IMF’s forthcoming COFER data will show. • ** A negative outflow is functionally the same as an inflow; a current account deficit can be financed by borrowing from the world (an inflow), selling equity to the world (an inflow) or by reducing your lending to the world (a negative outflow, and since outflows have a negative sign of the balance of payments data, a negative outflow generates a positive flow) and/ or selling your existing stock of foreign investments (a negative outflow). http://blogs.cfr.org/setser/2009/03/23/financial-de-globalization-illustrated/

401 vox Research-based policy analysis and commentary from leading economists Reorganising the banks: Focus on the liabilities, not the assets

Jeremy Bulow and Paul Klemperer 21 March 2009

Fixing the banks is an absolute priority in G7 nations. Doing this by buying toxic assets is costly, inefficient, and risky. Governments should focus on which liabilities, rather than which assets, they need to support. This column proposes creating “bridge” banks as a way of re- establishing a healthy banking system. Summary of the argument 1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this. 2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power. 3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank. 4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts. 5. Coordinating actions with other countries will reduce any risks. As we pour good money after bad in trying to save the banks, far too much time and attention has been focused on attempting to value or transfer or shore up the so-called “toxic” assets. This is natural enough, since they arguably caused the crisis, but it’s also wrong. Here’s why. Flaws of the current approach First, the toxic assets are very difficult to value. Many are held by only one or two owners so there is no real market even in good times. And even if a hedge fund buyer and a bank seller both thought that an asset was worth 50, the bank might demand 80 in the hopes of receiving that price in the next government bailout. Furthermore, the banks may be the “natural” owners of these assets. Say a bank makes a construction loan. Even if the loan sours, the bank may be the most knowledgeable party to hold and possibly renegotiate the loan. Second, purchasing or guaranteeing “toxic” assets creates other problems too. Putting aside the obvious inequity of paying bank creditors a “risk premium” for having invested in failed businesses, how can we ever again rely on market signals to allocate capital efficiently among banks if their capital structures are effectively guaranteed by the government? And under schemes like the recent Citigroup, RBS and Lloyds bailouts, banks’ incentives to manage the “insured” assets are drastically reduced, as the government bears up to 90% of any marginal losses. Lastly and perhaps most important, the obvious fiscal risks associated with the huge

402 incremental costs of current policies may undermine confidence far more than paying off creditors in full may temporarily boost it, however superficially attractive the latter approach may seem. Re-establishing a healthy banking system is crucial, but doing so through the purchase of toxic assets is costly, inefficient, and risky. How to reorganise the banks How then can we make banks healthy without separating the “bad assets”? The answer is, instead, to separate the “bad liabilities”.* Take Citigroup, for example. At the end of 2008 the bank had roughly $1.8 trillion in liabilities on its consolidated balance sheet, of which less than $800 billion were deposits. Say Citi’s assets were worth $1.5 trillion. A new (“bridge”) bank that included all the assets plus say $1 trillion of the old bank’s most senior liabilities would still be comfortably well capitalised, even if the asset values were overestimated. The original bank would be left with all the equity in the new bank, worth $500 billion, and the remaining $800 billion in liabilities. The original bank would still be insolvent, but that would not prevent the healthy new bank from operating efficiently and making good loans. If a risky original bank's marginal cost of funds is, say, 10% it will not be profitable for it to make new riskless loans at 7%, even if the market riskless rate is zero. By contrast, because the new bank is well capitalised, it can borrow on sensible terms if it has a profitable investment to fund.1 Giving the old bank an equity stake in the new bank is the best way to compensate the holders of old bank’s liabilities to the full liquidation value -- but not more than that value -- of their claims. It may also facilitate the reorganisation of the old bank if, as is likely, it goes into bankruptcy, since creating marketable equity in the new bank resolves the difficulty of valuing the old bank's assets, and avoids any need to sell the new bank on to a third-party – a transaction from which the government might be unlikely to get full value.2 The reorganisation could be managed under a regime like the UK’s Special Resolution Regime (SRR) or similar to that of the US Federal Deposit Insurance Corporation (FDIC)3 (there may be other possibilities too). The government’s role ends when the old bank has sold its shares or allocated them amongst its creditors. Who loses? Paying all creditors at least their liquidation claims is probably a pre-requisite for maintaining market confidence. It is anyway mandated by the Fifth Amendment in the US and by Human Rights legislation in Europe, and it is enshrined as the “no creditor worse off” principle in the recently-enacted UK Banking Act. So both the FDIC and the SRR assure the non-guaranteed creditors of the banks that they will be paid at least as much as they would receive under a liquidation of the institution, but not that they will get back every penny they are owed.4 Under a liquidation the junior creditors would suffer losses of $300 billion in our example (and the old bank’s shareholders would be wiped out), unless there were further government subsidies. A key virtue of isolating the junior liabilities rather than the troubled assets is that while the government may then choose to subsidise some of the junior creditors’ losses, it can more easily get off its current path towards subsidising them 100%. For example, in the U.S. system the order of priority for debts is the following: (1) administrative expense of liquidation; (2) secured claims up to the value of collateral; (3) domestic deposits (both insured and uninsured); (4) foreign deposits and other general

403 creditor claims; (5) subordinated creditor claims; and (6) equity investors. Recently issued subordinated debt has been guaranteed by the government, which would therefore take any loss on those securities in a reorganisation. (The UK prioritisation is a little different; in particular, it does not make domestic deposits senior to foreign deposits or other general creditors). For a large bank like Citi or Bank of America the first three categories would be placed in the new bank, and so would be fully protected. Foreign depositors should probably also be made whole. As when the Icelandic banks defaulted, countries will try to “ring fence” the operations within their borders if their deposits are not paid. Furthermore, not paying foreign deposits would lead to tit-for-tat behavior and might increase systemic risk. Making these depositors whole, and protecting domestic depositors in a jurisdiction like the UK that does not have depositor preference, may give them more than their liquidation values, so the government would have to either infuse the new bank with enough capital that the claims of the remaining creditors would be worth as much as in a no-intervention insolvency, or make a cash payment directly to the old bank. (The infusion to the new bank makes its equity more valuable and therefore raises the value of the claims of the “original bank” creditors in insolvency. The amount of the equity infusion or cash payment is easily calculable if the new bank’s stock is traded, as explained in this note.5) However, other general creditors (other than those with a government guarantee) including non-guaranteed bondholders and owners of credit default swaps that are not fully collateralised need not be paid in full. The government may, if it wishes, choose to pay these creditors more than they would receive in liquidation. (It can even buy their claims from the old bank at full value and place them in the new bank.) But because the old bank’s creditors’ leverage would be reduced to their financial claims, and they would not have the threat of bankrupting the new healthy bank were they not paid in full, this need only be done when not doing so would contribute to systemic risk. If there is still concern that the new bank is undercapitalised, the government can infuse more equity, but in contrast to the current situation the infusion would no longer have to be large enough to pay off the junior creditors. Finally, coordinating actions with other countries would resolve the concern that some have expressed that if one country alone fails to bail out a category of creditors, its institutions will find it hard to raise funding in the future. International coordination may also make it politically much easier to favour some groups of systemically-important creditors (especially foreign ones) over others. For some banks, particularly those whose liabilities are almost entirely deposits, this approach may save little money relative to the current bailouts. And, of course, if it is systemically important to make every creditor completely whole, then there is no saving at all. But if the authorities do not believe that any bank creditors can be asked to lose a penny then they should say so. We can then stop worrying about things like whether, if the government buys (or “insures”) the troubled assets from the banks the government pays fair price or an extra couple of hundred billion, since in this case any overpayment simply reduces the amount the government will ultimately have to pay to make good all the creditors, by an equal amount. If governments feel that they need to absorb more of the risk in the system, they should consider whether providing subsidies to bank creditors is the most effective use of their funds. Conclusion A plan that isolates the bad liabilities rather than the bad assets of the banks, and pays the

404 owners of those claims everything they legally deserve in liquidation but does not fully immunise them from losses, will achieve three major objectives. • It will help unfreeze the credit markets by creating healthy banks able to lend. • It will assure that depositors are paid in full, and all creditors are paid at least their entitlement. • It will make the bailout cheaper for the government, increasing its flexibility. Finally, as an additional benefit, paying creditors based on market values rather than government guarantees reduces moral hazard in bank finance, and increases the prospect of better monitoring by sophisticated private creditors in determining the future allocation of capital across financial institutions. There will be a lot more we will need to do to solve the financial crisis -- let's not make the bank bailouts more expensive than absolutely necessary.

* While presented in the form of a plan, what follows is intended to raise questions that deserve answers, rather than make definitive recommendations; some of this might require other legal means than those suggested here.

1. Why do undercapitalised banks have difficulty funding good, relatively safe loans? First, because any new capital raised is effectively bailing out the senior creditors. If any capital raise has to come primarily from junior creditors, as is likely since the supply of depositors’ funds is relatively fixed, the senior creditors benefit because there will be more collateral available to secure their claims. If the new funds are used for any new zero net present value investment, then any gain of the senior creditors must be matched by an equal loss for the junior creditors – regardless of the riskiness of the new investment. So an undercapitalised bank will need a higher return on even the riskiest investments, if the funding must come from issuing more equity or junior debt. Second, shareholders in a risky bank are biased against safe investments. Say that a bank that wished to borrow 80 pounds had to promise to return 100 – reflecting a 20% chance of not paying – even when the riskless interest rate is zero. Say that it could make a riskless investment with these funds that would pay off 90 – well above the riskless market rate (of zero). The sum of these two transactions would be a bad deal for the shareholders because they will receive 10 pounds less if the bank is able to pay all its obligations in full, and nothing otherwise. In addition, the probability that they will wind up with nothing will increase, because the risky assets the bank already holds will need a 10 pounds higher payoff to pay off the bank’s debts in full. 2. We have put all the assets, including the "toxic" assets, into the new bank, because this avoids the need to value or trade them (except to the extent that the market will estimate the value when putting a price on the new bank’s equity). A possible danger--depending in part

405 upon regulatory rules--is that the new bank might nevertheless feel under pressure to sell these assets to improve its regulatory capital position. In that case, the "bad assets" might be better left behind in the old bank if the old bank’s liquidation procedures did not create even greater pressures to sell rather than to run to maturity or renegotiate, etc., as appropriate. (A plan that credibly focuses the government’s bailout efforts on liabilities rather than assets should reduce the difficulties of trading the troubled assets, but it may still be inefficient to trade them.) 3. An important difficulty in the US is that the FDIC procedures cannot be applied at the bank holding company level (where some large US banks hold significant assets and liabilities) rather than at the bank level, and subsidies may also be required at the holding company level to curtail system risk. It is easy to imagine a situation where the operating banks are themselves insolvent and perhaps appropriate for a “bridge” bank reorganisation, while at the same time the holding company would be required to go through Chapter 11 of the bankruptcy code in the US. In this case the US government might perhaps provide Debtor in Possession financing to the holding company as it resolved its affairs. 4. In fact, the SRR guarantees only that creditors will get back what would have been their liquidation values in the absence of prior government assistance. So the benefits they gained from the recent government schemes to insure their assets could be discounted from their liquidation values to compute their guaranteed minima. Whether the benefits that some groups of creditors gained from earlier bailouts, including the Lloyds/HBOS merger, can also be "taken back" by the government is beyond our legal expertise. 5. Say for example, that a bank had liabilities in the amounts of L1 and L2, both equal priority, but the government wished to elevate the seniority of L1 by making it a debt of the new bank. If the new bank, with this liability, establishes an equity value of E and a debt value of L1, the value of the L2 claim becomes E, whereas its previous value as an equal priority claim was ((E+L1) times L2/(L1+L2)), so the amount of a fair cash payment to the old bank is the difference between these values, which equals (L2-E) times L1/(L1+L2). (This reflects the facts that the excess of liabilities over assets is (L2-E), and the owners of L1 originally bore share L1/(L1+L2) of these losses).

This article may be reproduced with appropriate attribution. See Copyright (below). http://www.voxeu.org/index.php?q=node/3320

406

vox Research-based policy analysis and commentary from leading economists Global imbalances and the crisis: A solution in search of a problem Michael Dooley Peter Garber 21 March 2009

This column argues that current account imbalances, easy US monetary policy, and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system. The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda: 1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US. 2. That the crisis was caused by easy monetary policy in the US. 3. That the crisis was caused by financial innovation. In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry. When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds1 that do not generate systemic risks. International capital flows One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.2 The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital

407 flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour. If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.3 At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices. We have not argued that a “savings glut” in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets. Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future. Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system. But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.4 The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.5 This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive. Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged “bad” behaviour. The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international

408 monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise? Easy money and financial innovation There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan’s critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants. Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis. The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers. Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books. Conclusions In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system. References Bernanke, Ben (2007) “Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11. BIS 78th Annual Report (2008).

409 Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) “The Revived Bretton Woods System,” International Journal of Finance and Economics, 9:307-313. Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) “Bretton Woods II Still Defines the International Monetary System,” NBER Working Paper 14731 (February). Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009. Economic Report of the President (2008) Economist (2009) When a Flow Becomes a Flood,” January 22. Paulson, Henry (2008) “Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update,” U.S. Treasury press release, November 12. Sester, Brad (2008) “Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations Notes 1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be. 2. See Paulson (2008), Dunaway (2009). 3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset’s price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices. 4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis. 5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior. http://www.voxeu.org/index.php?q=node/3314

410 CREDIT BUBBLE BULLETIN MISTAKES BEGET GREATER MISTAKES by Doug Noland

March 20, 2009 March 18 – Bloomberg (Kathleen Hays and Dakin Campbell): “Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve’s purchases of Treasuries and mortgage securities won’t be enough to awaken the economy. ‘We need more than that,’ Gross said… The Fed’s balance sheet ‘will probably have to grow to about $5 trillion or $6 trillion,’ he said.”

“The problem with discretionary central banking is that it virtually ensures that policy mistakes will be followed by only greater mistakes.” Here, I’m paraphrasing insight garnered from my study of central banking history. Naturally, debating the proper role of central bank interventions - in both the financial sector and real economy – becomes a much more passionate exercise following boom and bust cycles. The “Rules vs. Discretion” debate became especially heated during the Great Depression. It was understood at the time that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone. I believe the Bernanke Fed committed a historic mistake this week – compounding ongoing errors made by the Activist Greenspan/Bernanke Federal Reserve for more than 20 years now. I find it rather incredible that Discretionary Activist Central Banking is not held accountable – and that it is, instead, viewed as critical for a solution. Apparently, the inflation of Federal Reserve Credit to $2.0 TN was judged to have had too short of a half-life. So the Fed is now to balloon its liabilities to $3.0 TN, as it implements unprecedented market purchases of Treasuries, mortgage-backed securities, and agency and corporate debt securities. And what if $3.0 TN doesn’t go the trick? Well, why not the $5 or $6 TN Bill Gross is advocating? What’s the holdup? Washington fiscal and monetary policies are completely out of control. Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery. I believe the principal objective should be to avoid bankrupting the country. It is also my view that our policymakers and pundits are operating from flawed analytical frameworks and are, thus, completely oblivious to the risks associated with the current course of policymaking. Today’s consensus view holds that inflation is the primary risk emanating from aggressive fiscal and monetary stimulation. It is believed that this risk is minimal in our newfound deflationary backdrop. Moreover, if inflation does at some point rear its ugly head the Fed will simply extract “money” from the system and guide the economy back to “the promised land of price stability.” Wording this flawed view somewhat differently, inflation is not an issue - and our astute central bankers are well-placed to deal with inflation if it ever unexpectedly does become a problem. Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit

411 inflation (securities issuance), it is difficult for me to accept the shallowness of today’s analysis. In reality, the paramount risk today has very little to do with prospective rates of consumer price inflation. Instead, the critical issue is whether the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs. Additionally, what are the economic ramifications for ongoing market price distortions? The counterargument would be that Treasury and Fed stimulus are short-term in nature – necessary to revive the private-sector Credit system, asset markets and the real economy. That, once the economy is revived, fiscal deficits and Fed Credit will recede. I will try to briefly explain why I believe this is flawed and incredibly dangerous analysis. First of all, for some time now global financial markets and economies have operated alongside an unrestrained and rudderless global monetary “system” (note: not much talk these days of “Bretton Woods II”). There is no gold standard - no dollar standard – no standards. I have in the past referred to “Global Wildcat Finance,” and such language remains just as appropriate today. Finance has been created in tremendous overabundance – where the capacity for this “system” to expand finance/Credit in unlimited supplies has completely distorted the pricing for borrowings. As an example, while Total US Mortgage Credit growth jumped from $314bn in 1997 to about $1.4 TN by 2005, the cost of mortgage borrowings actually dropped. It didn’t seem to matter to anyone that supply and demand dynamics no longer impacted the price of finance. Yet such a dysfunctional marketplace (spurred by unrestrained Credit expansion) was fundamental in accommodating Wall Street’s self-destruction. Today, the markets will lend to the Treasury for three months at 21 bps, 2 years at 84 bps and 30 years at 371 bps. I would argue that this is a prime example of a dysfunctional market’s latest pricing distortion. As it did with the Mortgage Finance Bubble, the marketplace today readily accommodates the Government Finance Bubble. And while on the topic of mortgage finance, the Fed’s prodding has borrowing costs back below 5%. This cost of finance also grossly under-prices Credit and other risks. I would argue that market pricing for government and mortgage finance remains highly distorted – a pricing system maligned by government intervention on top of layers of previous government interventions. These contortions become only more egregious, and I warn that our system will not actually commence its adjustment and repair phase until some semblance of true market pricing returns to the marketplace. Yet policymaking has placed peddle to the metal in the exact opposite direction. The real economy must shift away from a finance and “services” structure – the system of “trading financial claims for things” – to a more balanced system where predominantly “things are traded for other things.” Such a transition is fundamental, as our system commences the unavoidable shift to an economy that operates on much less Credit of much greater quality. But for now, today’s Washington-induced distorted marketplace fosters government and mortgage Credit expansion – an ongoing massive inflation of non-productive Credit. I would argue this is tantamount to a continuation of Bubble Dynamics that have for years misallocated financial and real resources. In short, today’s flagrant market distortions will not spur the type of true economic wealth creation necessary to service and extinguish previous debts – not to mention the Trillions and Trillions more in the pipeline. Market confidence in the vast majority of private-sector Credit has been lost. This Bubble has burst, and the mania in “Wall Street finance” has run its course. The private sector’s capacity to issue trusted (“money-like”) liabilities has been greatly diminished. The hope is that

412 Treasury stimulus and Federal Reserve monetization will resuscitate private Credit creation; that confidence in these types of instruments will return. I would counter that once government interventions come to severely distort a marketplace it is a very arduous process to get the government out and private Credit back in (just look at the markets for mortgage and student loan finance!). This is a major, major issue. The marketplace today wants to buy what the government has issued or guaranteed (explicitly and implicitly). Market operators also want to buy what our government is going to buy. In particular, the market absolutely adores Treasuries, agency MBS, and GSE debt. There is no chance that such a system will effectively allocate resources. There is today no prospect that such a financial structure will spur the necessary economic overhaul. None. There is indeed great hope policymakers will succeed in preserving the current economic structure. On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize. The economy will be, it is anticipated, not far behind. And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom – perhaps enough even to appear to stabilize the system. But seeming “stabilization” will be in response to massive Washington stimulus and market intervention – and will be dependent upon ongoing massive government stimulus and intervention. It’s called a debt trap. The Great would view it as the ultimate “Ponzi Finance.” As I’ve argued on these pages, our highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay. It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities. Private sector Credit creation simply will not bounce back sufficiently to play much of a role. Mortgage, consumer, and business Credit – in this post-Bubble environment - will not re- emerge as much of a force for getting total system Credit near this $2 TN bogey. In this post- Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance. But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an immediate erosion of confidence and a run on both government and private Credit instruments. Also as I’ve written, once the government "printing press" gets revved up it’s very difficult to slow it down. This week currency markets finally took this threat seriously. http://www.prudentbear.com/index.php/home Conclusión: Es la Solución Bill Gross-PIMCO. Hay que parar a Geither, pero no porque su plan no vaya a funcionar. Probablemente funcionará, porque los precios de los activos de respaldo ya están próximos a su valor sostenible. Pero a la larga, la solución será peor porque la industria bancaria sumergida y corrupta será quien salve la situación, apoderándose del sistema. A no ser que Geither tenga otros cortafuegos preparados.

413 February 26, 2009 A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations | Apr 2, 2009 Testimony before the Joint Economic Committee of the US Congress hearing, “Restoring the Economy: Strategies for Short-term and Long-term Change” Chairwoman Maloney, members of the Committee, thank you very much for inviting me to testify today at this critical juncture in American economic policymaking. I am especially honored to be following the testimony of Paul Volcker, one of the greatest public servants this country has had in the economic sphere, to whose wisdom we all would do well to listen. Today, we face extreme financial fragility and, as a result serious, risks to our economy’s prospects for a sustainable recovery from its current troubles. Congress must grapple with difficult choices about America’s banks, and it must make those choices soon. Making the right choices now will require money upfront, large amounts of taxpayer money, and thus it is necessary as well as right for Congress to lead on this issue. But making the right policy choices now will restore US economic growth much sooner, at much lower cost, and on a sounder basis than trying to kick the trouble down the road or waiting for events to force the issue. Members of this committee are well familiar with such warnings, usually with respect to far-off economic problems. This time and this problem, however, are costing our citizens their jobs, homes, and hard-earned savings right here and now. And the correct policy response right now will make all the difference. Luckily, although the scale of the banking problem that we now face is unfamiliar to us, the kind of banking problem we face today is familiar, and in fact well understood. We have seen this before in the United States in the mid-1980s Savings and Loan crisis, in Japan’s post bubble Great Recession of the 1990s, in the Nordic countries from 1992–95, and many times in many other countries. It is reasonable to ask why these kinds of crises keep happening, and how to prevent them in future. I would be happy to discuss that, but that is of lesser importance to our current circumstances. It is also reasonable to ask why economists who did not foresee the current crisis can be trusted to give advice with great assurance now that the crisis has hit. I would say this is analogous to the doctor who does not foresee that his patient’s common cold will turn into pneumonia (or at least saw it as quite unlikely), but knows how to treat the pneumonia once it occurs. So today I would like to advise you on how to cure our financial pneumonia, rather than letting it runs its course, before it causes permanent damage or leads to the hospitalization of our economy. And the prescriptions I will give are based on many prior cases, particularly what worked to bring financial recovery in the United States in 1989 and in Japan in 2001, which are the crisis most similar to the current condition.[1] In brief, I would urge the Congress to have the US government: • Recognize that the money is gone from the banking system, and banks already are in a dangerous public-private hybrid state;

414 • Immediately evaluate the solvency and future viability of individual banks; • Rapidly sort the banks into those that can survive with limited additional capital and those that should be closed, merged, or nationalized; • Use government ownership and control of some banks to prepare for rapid resale to the private sector, while limiting any distortions from such temporary ownership; • Buy illiquid assets on the Resolution Trust Corporation (RTC) model, and avoid getting hung up on finding the “right price” for distressed assets or trying to get private investment up front, which will only delay matters and waste money; • When reselling and merging failed banks, do so with some limit on bank sizes; • And do all of this before the stimulus package’s benefits run out in mid-2010. This set of decisive actions is feasible and can be rapidly implemented, and follows a proven path to the resolution of banking crises. Implementing this program should spare us the fate of squandering additional national wealth and of postponing recovery for years that resulted from policy half- measures in Japan in the 1990s and in the United States in the 1980s. Similar policy frameworks were adopted and resolved those crises in the end, but only after delay cost dearly. Recognize That the Money Is Gone from the Banking System, and Banks Already Are in a Dangerous Public-Private Hybrid State There are statements in the press of late by bank managers and unnamed administration sources that some major banks currently under suspicion of insolvency actually have sufficient capital, or, slightly less dubiously, would have sufficient capital if only they were not forced to mark their assets to current low market values. These statements should be treated with extreme skepticism if not disdain. There are certainly some American banks that are either solvent, or sufficiently close to solvency that they can be returned to viability at little cost, despite the severe recession and market declines. But I agree with the vast majority of independent analysts and the obvious market verdict that sadly for many of our largest banking institutions solvency is but a far-off aspiration at present. And it is the present condition that matters. In the mid-1980s in the United States and most of the 1990s in Japan, bank supervisors engaged in regulatory forbearance, meaning they held off intervening in or closing banks with insufficient capital in the hope that time would restore asset values and heal the wounds. One can easily imagine the incentives for the bank supervisors, well documented in historical cases and the economic data, not to have a prominent bank fail on their watch. The problem, also evident in these historical cases and in the economic data, is that top management and shareholders of banks know that supervisors have this interest, and respond accordingly. The managers and shareholders do everything they can to avoid outright failing, which fits their own personal incentives. That self-preservation, not profit-maximization, strategy by the banks usually entails calling in or selling off good loans, so as to get cash for what is liquid, while rolling over loans to bad risks or holding on to impaired assets, so as to avoid taking obvious losses, and gambling that they will return to value. The result of this dynamic is to create the credit crunch of the sort we are seeing today, and this only adds to the eventual losses of the banks when these losses are finally recognized.[2] The economy as a whole, and nonfinancial small businesses in particular, suffer in order to spare the positions of current bank shareholders and top management (and, on the firing line, bank supervisors).

415 The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under Troubled Assets Relief Program (TARP), closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and the banks end up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch. These kinds of half-measures to keep banks open rather than disciplined are precisely what the Japanese Ministry of Finance engaged in from the time when their bubble burst in 1992 through to 1998, and over that period the cost to the Japanese economy from bad lending quadrupled from 5 percent to over 20 percent of Japanese GDP. In addition, this “convoy” system, as the Japanese officials called it, punished any better-capitalized and -managed banks that remained by making it difficult for them to distinguish themselves in the market; falsely pumping up the apparent viability of bad banks will do that. That in turn eroded the incentive of the better and more-viable banks to engage in good lending behavior versus self- preservation and angling for government protection. I believe, regrettably, that is what is happening now in the United States under the current half- measures. This is why further government intervention in the banking system, based on recognizing real losses and insolvencies is to be welcomed, not feared. So long as American banks have partial government guarantees and public funds to play with, but retain current shareholders and top management, they have perverse incentives and losses will mount. Think of Fannie Mae and Freddie Mac gambling with taxpayer dollars when having government guarantees but private claims on the profits and thus incentives for management and shareholder self-preservation. Hybrids are a good technology for autos; public-private hybrids are a terrible form for financial institutions. Thus, bending over backwards to keep all of the banking system in private hands without changing their management, while extending further government guarantees and investments is a recipe for disaster on the public’s accounts. Immediately Evaluate the Solvency and Future Viability of Individual Banks The first step to ending these perverse incentives, and getting us away from the destructive, undercapitalized, private-public hybrid banking system we now suffer under, is to get the books in order without hesitation about declaring banks insolvent based on current valuations. It was that kind of aggressive, intrusive, and published, honest evaluation by Japanese officials of their banks in 2002 that was the first policy step in finally ending their banking crisis. Treasury Secretary TimothyGeithner has acknowledged the need for evaluations, and will shortly be implementing “stress tests” on the 20 largest US banks. Unfortunately, it remains to be seen whether the supervisors and regulators sent in to make these evaluations will be sufficiently merciless in discounting the value of current assets. The administration has given conflicting signals on this point so far. Much of the opening rhetoric in the Secretary’s statements on the matter is tough, which I applaud. The statement that the stress tests will be implemented in a “forward-looking” manner, however, potentially opens the door to backsliding. We are in the midst of a very severe recession, and a huge asset price decline, when most things that could have gone wrong have gone wrong. So it seems reasonable that the current situation is about the most stress that banks’ balance sheets could be expected to come under. Why bother considering worse

416 situations, since all too many banks will fail the tests under the present stresses? In the United States in the 1980s with the Savings and Loans crisis, and in Japan in the 1990s with all their banks, forward-looking (by other names) assessments ended up being forms of forbearance. When the assessments took into account future periods when conditions would be calmer and asset values would be higher than they were during the crises, they gave the banks an unjustified reprieve. Granting such a self-defeating lifeline would also seem to be consistent with the administration’s repeated statements that they wish to keep the examined banks not only open and lending, but under continued private, and thus current, shareholder and management control. If this is the case, and I hope I am worrying unduly, it would be a grievous mistake. The fact that bank shares for many suspect banks have stopped dropping with the announcement of these programs, however, is another signal that many believe the stress tests will be beneficial to current bank shareholders. This stabilization, if not bump, in bank share prices cannot be based on a belief that the suspect banks will be revealed by the stress tests to be in truly better shape than the market believed them to be in until now, for then the private money sitting on the sidelines would be moving to acquire the (in that case) undervalued banks. Another red herring, which I also fear indicates reluctance to do what is needed, are the occasional statements that the process will take several weeks or more, and will be difficult to implement given staffing constraints and the complexity of banks’ balance sheets. There is no shortage of unemployed financial analysts looking for consulting work, and there is no need to be all that caught up in getting precisely the “right” price on various distressed assets (as I will explain). The implementation difficulties of such evaluations are surmountable, as they were in other countries, such as Japan, which had a new, unproven Financial Services Agency in place when it got tough in 2002, and here at home when the first Bush administration took on the S&L crisis in 1989–91. Furthermore, what have the bank supervisors of the FDIC, the Federal Reserve Bank of New York, et al. been doing for the last several years if not getting some sense of these banks’ balance sheets? The Treasury cannot make public claims that the banks’ balance sheets will be revealed to be better than expected, based on supervisory information, at the same time that it claims that making the evaluations of the balance sheets will be daunting. So, strict, immediate evaluations of bank balance sheets are agreed upon at least in form. Regrettably, there is some risk that the forward-looking stress tests may indeed be yet another transfer of taxpayer dollars to current bank shareholders. The people’s representatives in Congress should not stand for this. If it turns out that congressional insistence on tough love for the banks merely stiffens the spine of the Treasury, FDIC, and Federal Reserve to do what they intended to do anyway, so much the better. Their apparent reluctance to pull the trigger on tough evaluations may be based on fears in the administration that such forced write-offs would require the unpopular steps of another injection of public funds and/or a round of closures, either way involving some government ownership of those banks. Those fears can be forestalled through your committee clearly stating that this kind of tough evaluation is in the public interest, and the benefits outweigh the costs. You and your colleagues can and should make the stress tests work. Rapidly Sort the Banks into Those That Can Survive with Limited Additional Capital and Those That Should Be Closed, Merged, or Temporarily Nationalized Banks think with their capital. As discussed, when their capital is too low, the incentives for their top management and shareholders are perverted and run contrary to the public interest. Simply giving capital to all the banks that are judged to need some, however, is a mistake. It

417 spends taxpayer money we do not need to spend, and it rewards bad behavior by treating all banks equally, no matter how much capital they squandered. It is better to triage the banks quickly into categories by their viability on the basis of capitalization.[3] This is what the Swedish government did rapidly with great success in 1992, when their banking crisis hit, and is what the Japanese government got around to finally doing in 2002, when their banking resolution became serious. The capitalization criteria should not be simply whether the net position after strict balance sheet evaluation is above or below zero, i.e., solvency. As we learnt during the Savings and Loan crisis, and as therefore reflected in the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which allows supervisors to take over banks that have capital ratios of 2 percent, by the time you get to zero it is too late (of course, right now, the problem is that capital ratios will already be well below zero for many of the largest banks). So the three categories should be: 1. Banks with clearly positive capital that only need a topping-off to return to health and healthy behaviors; 2. Banks with low or slightly negative capital where removal of limited bad assets could restore viability; 3. And banks with clearly negative capital and large, difficult to unwind, portfolios of bad assets. The first category should receive their capital topping-off from public fund injections through preferred shares or other loans of liquid nonvoting capital. This format, combined with a clean bill of health from credible inspections, should lead to rapid repayment of these banks’ public funds. Yes, this is what was tried in the early days of the crisis and TARP; that did not work because it was wishful thinking at best to do so for all the major banks indiscriminately before credible balance sheet evaluations were completed. But for those banks within striking distance of solidly positive capital ratios, this is the right way to go. The second category of banks likely includes many of the mid- to large-size, but not the largest-size, banks in our system. These are banks that cannot get back to clearly positive capitalization once their bad assets are fairly written off, but whose balance sheets can be rapidly cleaned up by bad asset sales and whose capital needs are not overwhelming. Banks in this category are usually sold off, in part or whole, to other banks, or are merged with stronger banks combined with some injection of public capital. As part of this process, current top management is usually replaced (perhaps“naturally” in a merger process), and current shareholders’ equity is diluted (though discounted purchases of bank components, public minority ownership of some common equity, or both). It is the third category that grabs the political attention and that unfortunately is likely to include some of our most systemically important banks. Clearly insolvent banks with no rapid way to sell off their assets at a discount would be unwound in an orderly fashion under FDICIA, but in essence liquidated over time if they were small and did not present a systemic risk. That has already happened during this cycle to a few American institutions, such as IndyMac, and even in Japan’s lost decade, some minor institutions (like Hokkaido Tokushokku bank, Japan’s 19th or 20th largest in 1998 when it was allowed to fail) were wrapped up in this fashion, despite the general reluctance to close banks. Obviously, the issue is what to do about systemically important large institutions with difficult to unwind balance sheets. And this is the category for which temporary nationalization of the insolvent banks is the right answer.

418 In short, nationalization is only relevant for a part of the banking system under crisis, even for only a part of the technically insolvent banks, but it is necessary for the most systemically important banks that are insolvent. These banks must be kept in operation and have their positions and bad assets unwound in deliberate fashion. They also must have top management replaced and current shareholders wiped out. This is because the amount of capital required to restore them back to functionality is so large, and the process of restructuring their balance sheets so complex, with both having the potential to influence markets for other banks’ equity and asset prices, that only the government can do it. There will likely be private buyers a plenty for such a bank when the recapitalization and unwinding process is complete, but not before the restructuring begins. In a corporate takeover that requires significant restructuring of the acquired company, new private owners will always demand majority voting control and removal of current top management, who are accountable for the accumulated problems. The American taxpayer would be ill-served to receive anything less for putting in the vast amount of money needed to restructure and recapitalize these failed private entities. And the American taxpayer, just like any acquirer of distressed assets, deserves to reap the upside from their eventual resale. That basic logic is why failed banks that are too systemically important to shut down should be nationalized temporarily. That is what the Japanese government ended up doing with Long Term Credit Bank and Nippon Credit Bank, two of Japan’s systemically most important banks at the start of the 1990s, and thus banks that could not simply be shut down. Use Government Ownership and Control of Some Banks to Prepare for Rapid Resale to the Private Sector, While Limiting Any Distortions from Such Temporary Ownership Nationalization of some banks is solely the damage-limiting option under the current crisis circumstances. It beats the alternative of taxpayer handouts to the banks without sufficient conditionality, leaving financial fragility undiminished. Nationalization has its costs, however, beyond the upfront money provided and risks assumed by the government. No one in their right mind wants the United States or any government owning banks for any longer than absolutely necessary.[4] The Mitterand government nationalized French banks in the early 1980s as a matter of socialistideology, not necessity, intending to keep the banks in the public sector, and that was a huge mistake. The resultant misallocation of capital interfered with innovation and discipline in the French economy, and reduced the annual rate of growth in productivity and GDP by three or four tenths of a percent, which compounded over several years makes a huge difference.[5] But that was an unneeded governmental takeover of viable banks kept in place for a long period. The key is that government control is kept temporary, with sell-offs of distressed assets and viable bank units back to the private sector to commence as soon as possible, some of which can begin almost immediately. The historical record suggests that this kind of turnaround is not so difficult to achieve. That is what was seen with what became Shinsei bank in Japan (purchased by American investors after Long- Term Credit Bank was nationalized and cleaned up) as well as with the top five banks in Sweden in 1992–95. In both Japan and Sweden, most nationalized banks were reprivatized within two years, and all within three. And in all these cases there were private buyers when the governments were ready to reprivatize the banks, something that did not exist for these failing institutions before the government undertook restructuring. As is well known, in these cases the responsible government made back at least 80 percent of their costs, in the Swedish case turning significant profits for the taxpayers.

419 Furthermore, these banks continued most of their day-to-day operations during the nationalization period, retaining most personnel except top management. Given government majority ownership, it is possible to set up independent management, just as boards representing owners, public or private, always delegate to managers of complex organizations. New managers could be easily brought in from the among the many bank executives who specialized in traditional lending and banking and who ended up on the outs when American banks emphasized and other bonus- based securities businesses in recent years. The new managers could even be incentivized properly, the way we should consider incentivizing all bank managers: with long-term stock options instead of annual bonuses (some combination of public-service motivations, very high upside potential, and facing unemployment would yield sufficient numbers). Of course, there will be some pressures for politically driven lending, but transparency arrangements could go a long way to limiting that, and it is difficult to imagine that remaining shareholders and top management of banks in the current public-private hybrid situation would not have every (destructive) incentive to politically pander in hopes of keeping their job and their stake. The difference in efficiency and politicization of lending between the current situation and full nationalization of some banks will not be all that great, which is what was seen with the zombie banks in Japan in the late 1990s, and our Savings and Loans in the mid- to late-1980s—just pandering to politically connected borrowers in order to stay open as private concerns. Importantly, the existence of nationalized banks in banking systems that still had private banks operating as well did not lead to excessive pressures on their private competitors, let alone significant shifts of business or deposits away from those private banks. This can be seen today in the United Kingdom, where the government’s large ownership stakes in some major banks such as RBS and HBOS has not led to closures of or runs on the remaining private banks; in Switzerland, where the de facto public takeover and guarantee of UBS has not noticeably harmed the still private Credit Suisse; and in Germany and France, where private banking firms have continued to operate despite theongoing presences of Credit Lyonnais and the Sparkassen as government subsidized and part-owned entities. Again, nationalization is not cost free, for over time such public ownership arrangements do eat away at the private banks’ profitability and proper allocation of credit, which in turn hurts productivity and income growth. But additional inaction today regarding the fragile US banks leaving current management in charge has the prospect of rapidly adding several full- percentage points of GDP to the total of bad loans and losses in just the span of months, which is a much higher cost. It also risks a failure of a major financial institution without warning, before the government can respond, which would have large negative repercussions in the current environment: Nationalization wins out on the stability criteria as well, versus our status quo, in the short-run. Japan in 1998 demonstrated the unfortunate lesson that half- measures that stop short of nationalization backfire, when it gave the private banks more capital, only to find them running out of money and having accumulated further bad assets when a new, more actively reformist government took power three years later. Buy Illiquid Assets on the RTC Model, and Avoid Getting Hung up on Finding the “Right Price” for Distressed Assets or Trying to Get Private Investment up Front, Which Will Only Delay Matters and Waste Money To complete the full restructuring of the nationalized banks, or for that matter even the more- minor capital topping-off of the viable banks, when starting from honest evaluations of balance sheets, someone has to get the bad assets off of the banks’ books. The utility of so doing is widely recognized. The Treasury has proposed setting up a complicated not-bad but

420 aggregator public-private entity to serve this purpose. As with the stress tests, if the current US Treasury only says such things to sugar coat a tougher, less passive intent in practice, so much the better. The American government should be benefitting the taxpayer by paying as conservatively low a price as possible for our banking system’s distressed assets, and if that means having to increase the capital injections on one hand to make up for the write-offs from low prices on the other, in terms of net public outlay it is little different, but more of the future claims on the bad assets’ value is kept in US taxpayers’ hands. As Alan Greenspan has observed, if we nationalize the banks, we do not need to worry about the pricing.[6] The Treasury’s proposal for creating a complex, public-private aggregator bank instead of a wholly publicly owned, simple, RTC-like bad bank is motivated by two aspirations: to mobilize “smart money” currently sitting on the sidelines to share the upfront costs of buying the bad assets; and to generate price discovery about what the bad assets are really worth, particularly for illiquid assets for which there is no market. These are well-motivated aspirations, but in my opinion penny wise and pound foolish with taxpayer funds at best, and simply unattainable at worst. It is worth noting that there is no historical precedent for making such an attempt for price discovery and costs sharing with the accumulated bad assets. Simple, publicly owned, RTC-like entities sufficed in the Swedish and Japanese cases, and of course in the US Savings and Loan case that set the precedent. A new and clever approach always could be an improvement in theory, but this particular one seems to share with the reverse auction ideas of the initial TARP proposal a desire to be too clever by half. It is just as arbitrary to set prices for the bad assets by deciding how much guarantee or subsidy the private investors receive from the government to induce them to get back into the game as it would be to go into the banks and just pay what the markets are offering, which would be zero right now.

There will not be any price discovery through private-sector means by undertaking such a program because the only difference between these assets, unwanted now and then, is the value of the government guarantee (subsidy) on offer. Private investors are obviously not buying the distressed assets now, which they could do at the current low price, so the price will be set by the amount of the US government’s transfer to these private buyers. At best, this gets the toxic assets off of the various banks’ balance sheets, but at a far higher eventual cost to the taxpayer than would arise if the government purchased them outright and recouped the entire upside when there is eventual restructuring of and then real demand for these assets later. It is again Congress’ role to stand up for the American taxpayer, to say to the administration that they should not fear having to put up more money upfront if in the end it will save the taxpayer significant money to do so now. At worst, employing such a complicated scheme trying to hold restructuring up until meaningful prices somehow emerge (when the only change in the assets is a government subsidy with purchase) leads to a worse outcome. Uncertainty hangs over our banking system for longer, with all the noted perverse incentives for good and bad banks that induces. Possibility of a disorderly, outright bank failure persists, since the illiquid assets are not rapidly moved off of the balance sheets of some of the most vulnerable banks. The US government ends up overpaying for some assets in terms of guarantees and subsidies versus simply buying them at today’s low values, but only manages to sell the more liquid and attractive upside assets to the voluntary private participants. In short, the US taxpayer gets left with the lower future return lemons, while paying for the privilege of having private investors get the assets with the most upside potential. Eventually, there has to be a wholly public, RTC-type bad bank anyway, but now only for the worst remaining parts of the portfolio.

421 A wholly public, simple, RTC-type bad bank approach not only avoids these risks, but offers an advantage that the public-private hybrid (again a bad idea) aggregator bank does not. In fact, the additional complexity, and thus toxicity or illiquidity, of today’s securitized assets versus what our original RTC or Japan’s or Sweden’s faced is an additional argument for having them all be bought by the US government outright: If the US government buys most or all of entire classes of currently illiquid assets from the banks, it would have a supermajority or 100 percent stake in most of the securitized assets that have been at the core of our problems in this area. That would make it feasible to reassemble sliced and diced securities, going back to the underlying investments, such as mortgages. This would detoxify most of these assets, making them attractive for resale by unlocking their underlying value, removing the source of their illiquidity, and thus offering the possibility of significant upside benefit entirely for the US taxpayer when sold back to the private sector. It would be an actual value- added transformation, not just an attempt to game the pricing. In theory, a set of private-sector investors or public-private partnership also could do this kind of reassembly voluntarily, but in practice the coordination problems are insurmountable, as seen in the complete lack of a market for these assets at present. The use of the word “toxic” to describe these assets leads to an apt and valid analogy: Just as the EPA can go to a Superfund site, one on which no one can currently live and no private entity is willing or able to clean up, it can literally detoxify that real estate by changing its underlying nature, and then have it come back on the market at a good value. The Treasury and FDIC can do the same with these currently toxic securities, if the US government has ownership and puts up the funding and effort to do the clean-up. Without a wholly public RTC initially owning the supermajorities, such a literal detoxification of the assets is impossible. And without that kind of fundamental change in the nature of the bad assets on the banks’ books, it is difficult to see any reason for private smart money to buy them except to pick up a sufficiently large government subsidy. A hedge fund, sovereign wealth fund, or private equity firm with cash is not staying out of these markets for distressed assets at present just because the priceshave not yet “fallen enough”; such investors are staying out because the assets are indeed toxic with indeterminate prices. When Reselling and Merging Failed Banks, Do So with Some Limit on Bank Sizes One aspect of the financial crisis so far is that it has put pressure on banks and supervisors to increase concentration in the US banking system. When the government, for understandable reasons, will treat bigger banks as systemically important, and thus subject to bailouts and guarantees, it advantages them over smaller banks in the eyes of some potential depositors and borrowers. In addition, in each successive wave of banking fragility we have had up until now, US bank supervisors have tended to encourage stronger banks to merge with or buy up weaker banks, which is indeed in line with the standard, crisis-response best practice I outlined above, but also has contributed to greater concentration of the US banking system into fewer, bigger businesses. The deregulation of interstate branching has also played a role. In each case, concentration was a side effect of well-motivated policies, and never became a major problem on its own terms; obviously many smaller and community banks continue to do business just fine. We now approach a situation, however, where the US government will have capital stakes in a large portion of the US banking system, biased toward larger investments in the bigger institutions, and where there will be additional instances after triaging the banking system that seem to require mergers. Given the structural leverage over the US banking system inherent in upcoming decisions, and the sheer scale of the potential upcoming further consolidation, it is time to consciously put a limit on this process. As Paul Volcker has pointed out in the

422 recent G-30 Report that if we get into trouble with banks being simultaneously too big to manage their portfolio risks and too big to be allowed to fail, we probably should not have banks that big.[7] This is not a matter of the normal antitrust consumer protection against monopoly, since these developments have largely benefitted consumers on the usual pricing and choice criteria, but of other public interests at stake. Economically speaking, there is no clear logic to encouraging banks to be as big as possible. Years and years of empirical research by well-trained economists in the United States and abroad has been unable to establish any robust evidence of economies of scale or of scope in banking services. In other words, banks do not perform their key functions more efficiently or cheaply when they produce them in greater volume, and banks do not gain profitable synergies by expanding their range of services and products.[8] There was another reasonable theory that larger banks might be able to diversify their risks across a broader and more varied portfolio than smaller banks, and thus be more stable. The developments of the last two years in the United States, the United Kingdom, Switzerland, and elsewhere, as well as those seen in Japan’s highly concentrated banking system in the 1990s, however, reject that hypothesis rather dramatically, as do more-formal econometric studies. Finally, some people concerned with US economic competitiveness have argued that larger banks confer advantages, either because they allow for easier, large-scale funding of US export industries, or because they allow US banks to compete better for market share in global finance, and thus exportfinancial services. Unlike the previous two testable hypotheses, which were confronted with rigorous data analysis, these competitiveness claims have not been seriously studied. But the major threat to financing for American nonfinancial companies is market disruption caused by systemic bank failures, not limits on the credit available to them in normal times, and the export of financial services has been no more in the US national interest than picking any other single “strategic industry,” a thoroughly discredited practice.[9] So the Treasury, FDIC, and Federal Reserve should show some regard for excessive bank size and concentration in the US banking system when they are required to make decisions about banking structure upon returning parts of the system to fully private control. They cannot duck this, for even a nondecision to go with the likely outcomes of other priorities would result in defaulting to greater bank concentration at the end of the process. Unfortunately, unlike with regard to other aspects of the banking-crisis resolution framework I have outlined, there is no well-established practice for how to deal with this issue. I would suggest that two guidelines be employed: First, when any of the fully nationalized banks, which are likely to include among them some of the largest of current US banks, are brought back to market from public ownership, they should be broken up, either along functional or geographic lines. This has the additional advantage of allowing some parts of the temporarily nationalized banks to return to private hands sooner, and the return of investment to the US taxpayer also to arrive sooner. There will be some component operating units of the largest failed banks whose own sub-balance sheets can be cleaned up rather quickly. Second, preference should be given to mergers of equals for the publicly recapitalized but not nationalized banks that normally would be encouraged by regulators to be merged or taken over by other banks. Since this group of banks is likely to be of a smaller average size than the nationalized group, this should be feasible. While it remains for Congress to pass regulation to determine the rules of how the US banking system should be structured in the future, I believe that current law does give our bank supervisors enough authority and discretion over mergers of banks, especially for those involving a distressed

423 institution, that these guidelines can be followed when the bank clean-up moves forward in the near term, as it must. Do All of This Before the Stimulus Package’s Benefits Run Out Implementing the preceding framework for resolving the US banking crisis will restore financial stability as quickly as possible and at the lowest cost possible (though still high) to American taxpayers.[10] The experience of other countries, notably of Japan in the 1990s, but also of the United States itself in the 1980s, is highly relevant to today’s dangerous situation. Those historical examplesshow not only the right way to resolve our banking problems, but also that the rapidity and sustainability with which the US economy will recover from its present financial crisis is directly dependent upon our willingness to tackle these problems aggressively, including in some instances temporarily nationalizing banks. When the US government engaged in regulatory forbearance with undercapitalized S&L’s in the mid-1980s and when the Japanese government similarly pandered to its bankers and dawdled through the entire 1990s, the losses grew larger and the problems persisted. When the US government truly took on the Savings and Loan crisis in 1989–91 and when the Japanese government truly confronted its banking crisis in 2001–03 following this framework, the financial uncertainty was lifted and growth was restored. The only thing that makes the United States different from other countries facing banking crises has nothing to do with the nature of our banking problems. What is special about the United States in this context is the fortunate fact that we as a nation are rich enough, with enough faith in our currency, to be able to engage in fiscal stimulus to soften the blow to the real economy while the bank clean-up is done. Emerging markets and even most smaller advanced economies generally have to engage in austerity programs, further cutting growth, at the same time that they tackle their banking crises in order to be able to pay for the clean- up. This gives us a window of opportunity, but the clock is ticking. If we can resolve the US banking crisis in the next 18 months before the stimulus program’s impact on the economy runs out, the private sector will be ready to pick up the baton from the public sector, demand will grow, and recovery will be sustained. And following the common framework I have set out, it would be feasible to resolve most of our financial problems, if not return the entire banking system back to private ownership, within that time frame if we start right now. If we fail to move aggressively enough on our banking problems, this window will close because even the United States cannot afford to engage in deficit spending indefinitely, as President Obama rightly explained to Congress and the nation on Tuesday night. In that case, when the fiscal stimulus runs out, the private sector will be unable to grow strongly on its own, because the banking problems will prevent it from doing so. Japan showed us that fiscal stimulus indeed works in the short-term, but growth cannot be restored to a self- sustaining path without resolution of an economy’s banking problems. I ask the members of this Committee to carefully scrutinize and oversee the proposed programs of the US Treasury for banking crisis resolution. If those programs live up to their associated rhetoric, and are thus tough enough on the current shareholders and top management of our undercapitalized banks, we can in 2011 be like Japan in 2003, at the beginning of a long and much-needed economic recovery. If unneeded complexity of the bad- bank construct, excessive reliance on and generosity to private capital, and unjustified reluctance to temporarily nationalize some US banks turn the proposed bank clean-up programs into only half-measures, then we will be like Japan in 1998, squandering national wealth and leaving our economy in continuing decline, only to have to take the full measures a few years down the road when in even greater debt. I am hopeful that the Obama administration, with strong congressional oversight, will do what it is need in time.

424

[1] I draw on a wide range of research by me and others. A good overview is given in Japan’s Financial Crisis and Its Parallels with US Experience, 2001, eds. Ryoichi Mikitani and Adam Posen, Washington: Peterson Institute for International Economics. [2] Arguably, repeated forbearance of this kind when major American banks previously made poor decisions about emerging-market lending and regional real-estate booms also contributed to getting us into the terrible situation of today, by encouraging the largest banks to believe that they would always be bailed out without having to take the worst losses. [3] We are already sorting banks on the basis of systemic risk by virtue of stress testing the largest, and thus probably most systemically important, banks first. No one worries about closing small banks, usually. [4] I have been on the record attacking state ownership and subsidization of banks in Europe for years. See, for example, Adam S. Posen, 2003, Is Germany Turning Japanese? Peterson Institute for International Economics Working Paper 03-5, a condensed version of which was published in the National Interest under the title “Frog in a pot,” Spring, 2003). That is completely different from temporary back nationalization. [5] There is a vast and empirically robust literature on the effect of differing financial systems on economic growth, led by the contributions of Jerry Caprio, Stijn Claessens, and Ross Levine, along with their numerous coauthors, from whom I take this simplified estimate. [6] Quoted in the Financial Times, February 18, 2009. [7] Federal Reserve Bank of Minneapolis President Gary Stern has been calling attention to this potential problem for some years now. More recently, my PIIE colleague William Cline has written about it as well. [8] In some trivial sense, back office consolidation of certain types of processing of transactions could yield economies of scale, but even attempts to find evidence for these have proven unsuccessful, perhaps because so many of those services are available on an outsourced and comptetitive basis these days. [9] Some top US economic officials during the 1990s and earlier this decade sincerely believed that financial liberalization was in the economic self-interest of developing countries and thus was in the foreign policy interest of the United States. That is probably valid, and I am broadly sympathetic to that view, subject to some important cautions raised by Dani Rodrik, , and others. But some of these officials then took that to mean that promoting the export of financial services by US financial institutions and the opening of foreign markets to US financial institutions’ investments and sales were in the US foreign policy, as well as export, interest. This was an unnecessary step, and one that is backfiring on the US reputation now that our financial “model” and aggressive advocacy thereof are being blamed (excessively, but not entirely unfairly) for the current global crisis. [10] See, for example, what I recommended for Japan in 2001, which was largely and successfully implemented by Japanese financial services minister Heizo Takenaka in 2002–03 (“Japan 2001: Decisive Action or Financial Panic,” available at: http://www.iie.com/publications/pb/pb.cfm?ResearchID=72). Many current, senior US economic officials, such as Treasury Secretary Geithner and NEC Chair Summers, advocated the same for Japan and for the Asian countries during the 1997–98 financial crisis there.

425 The new Geithner plan is a flop BY LUIGI ZINGALES Wednesday, March 25th 2009, 4:00 AM On Monday, the market rallied 7% at the announcement of Treasury Secretary's Timothy Geithner's plan to deal with banks' toxic assets. Should taxpayers celebrate as well? The answer is a resounding no. Geithner's plan is just a more risky and cagey version of the original plan by his predecessor, Henry Paulson: to buy toxic assets. Not only is it as likely to fail as his predecessor's, but it is also likely to create major political unrest. The premise underlying both plans was that banks were facing a temporary liquidity problem: Many mortgages and related securities allegedly were trading below their long-term values, making banks appear insolvent. According to this view, it would be enough to inject liquidity into this market to make valuation return to its "fundamental" level, restoring the health of banks. Hence the idea to pump the government's money into this market to fix the problem. As banks know well, however, no debtor on the verge of bankruptcy would ever admit to being insolvent; he will always perceive his own problem as a temporary liquidity one. The credibility of this position depends on the duration of the "liquidity" problem and on the existence of legitimate reasons to think that the long-term value has not dropped. When Paulson first asked Congress for money from the Troubled Assets Relief Program, several indexes of subprime, residential, mortgage-backed securities were trading around $65 a share. Now they are trading around $30. With delinquency approaching 12% and house prices down almost 30% and falling, these losses seem more than temporary illiquidity. Even Citigroup analysts, when they judge other banks, estimate losses on subprime loans at 25% to 40% and losses on credit cards at 26% to 38%. In other words, these problems are about as temporary as General Motors' ones. In the automakers' case, the government has used a tough-love approach, asking all the various stakeholders (including the bondholders) to make concessions. For the banks, on the other hand, Geithner has asked for concessions from no one. In fact, he has even grandfathered the managers' bonuses, while offering taxpayers' money to make bondholders and shareholders whole. It's no surprise the market rallied. It loves to be rescued at taxpayers' expense. And it's no wonder that hedge funds endorsed the plan; they love the subsidy Geithner is providing. Between the money lent by the Federal Deposit Insurance Corp. and the money invested by the Treasury, hedge funds can buy assets for $100 - when they invest only $7. In this way, they retain 50% of the upside and only $7 of the downside. To them, it is almost free. The irony of the plan is that it seems to replicate the same excesses that brought the crisis - carrying enormous economic and political risk. So, what happens now? The worst-case scenario is that the assets are really worth what the currently illiquid market thinks they are worth. In this case, the Treasury, but in particularly the FDIC, will face enormous losses. Had Paulson applied this strategy in late September, the Treasury would now be facing losses equal to 47%. On a trillion- dollar investment, we are talking about $470 billion in losses. The best-case scenario is that the value of the toxic assets bounces back so that the government recovers all its money and the hedge funds become filthy-rich. Even in this happy scenario, however, there is a very serious political problem: How would taxpayers

426 react when they find out that those who reap the biggest benefits of this program are the very same people who created this mess to begin with? Because let's realize this now: The most savvy buyers of toxic assets will certainly be those who created them. If you think that the revelation of AIG lavish bonuses has shown all the rage of the American people, think again. When former subprime lenders will become the new billionaires, we run the risk of a populist revolution. Zingales is a professor at the University of Chicago Booth School of Business. http://faculty.chicagobooth.edu/luigi.zingales/research/papers/geithner_plan_flop.pdf

427

Exclusive: PIMCO to participate in U.S. toxic asset plan Mon Mar 23, 2009 11:03pm EDT By Jennifer Ablan NEW YORK (Reuters) - Bill Gross, the influential manager of the world's largest bond fund, gave the Obama administration's financial stability effort a much-needed endorsement on Monday, saying PIMCO will participate in the public-private plan. "This is perhaps the first win-win-win policy to be put on the table and it should be welcomed enthusiastically," the founder and co-chief investment officer of PIMCO told Reuters. Gross' Pacific Investment Management Co oversees roughly $800 billion. He manages PIMCO's flagship Total Return fund, which currently has $139 billion in assets. "We intend to participate and do our part to serve clients as well as promote economic recovery," he said, adding PIMCO will both buy toxic assets and manage some of them. Another influential money manager, BlackRock Inc, told Reuters on Sunday that it too intends to be involved as one of the investment managers in the public-private investment fund. A Kohlberg Kravis Roberts & Co executive said on Monday the private equity firm would be "happy and willing" to partner with the government if an investment deal to buy assets made sense. The U.S. Treasury Department on Monday rolled out detailed plans for persuading private investors to help rid banks of up to $1 trillion in toxic assets that are seen as a roadblock to economic recovery. Generous government financing will underpin the Public-Private Investment Program, which the Treasury will launch with $75 billion to $100 billion from its $700 billion bailout fund approved by Congress last fall. "From PIMCO's perspective, we are intrigued by the potential double-digit returns as well as the opportunity to share them with not only clients but the American taxpayer," Gross said. Gross's endorsement is important after the lack of big investor interest in the debut of the Federal Reserve's consumer lending program last week. The Fed's Term Asset-Backed Securities Loan Facility, or TALF, received only $4.7 billion in requests for loans out of $200 billion on offer, heightening fears that big money managers will also shun the government's toxic-asset plan. TSUNAMI OF DISTRUST AFTER AIG Gross' vote of confidence also comes after last week's political furor surrounding the American International Group Inc bonus payment debacle and the anti-Wall Street mood, which raised the risks for private capital firms thinking about partnering with the Treasury. Congress is moving to clamp down on companies receiving financial bailout money by severely taxing bonus payments. There is concern that any financial firm getting involved in the toxic asset plan could face retroactive limits on compensation or profits.

428 "There's a sense of having gone too far and that there's fear that anyone that participates in this or any other government program would be subject to increased scrutiny and standards that didn't exist in the past ... I couldn't discourage that thinking," Gross told Reuters Financial Television. "I would point to Secretary (Timothy) Geithner's guarantee and promise as well as that from (Federal Reserve Chairman) Ben Bernanke that basically they want to maintain and ultimately produce a thriving private sector and the limitations that may be placed on AIG connections, I guess, won't exist in this particular program. So PIMCO has no fear of that, so to speak." He said the Treasury's public-private partnership plan has "an objective of liquefying relatively frozen portions of the credit market and promoting the extension of new loans in the U.S. economy." Gross added: "To succeed, it will require participation from both willing buyers as well as sellers, in addition to the substantial government assistance being provided in the proposed policy package." (Additional reporting by Daniel Burns, Chris Sanders and Megan Davies; Editing by Dan Grebler)

429

Global Central Bank Focus

McCulley | February 16 2009

Saving Capitalistic Banking From Itself

At its core, capitalism is all about risk taking. One form of risk taking is leverage. Indeed, without leverage, capitalism could not prosper. Usually, we think of this imperative in terms of entrepreneurs being able to lever their equity so as to grow. And indeed, this is the case. But more elementally, economies – both capitalist and socialist – require leverage because savers for very logical reasons do not want to have one hundred percent of their stock of wealth in equity investments. Rather, they logically want a portion of their portfolios in a fixed-commitment instrument that is senior to equity. And savers want some portion of that fixed-commitment allocation in literal money, defined as a government-guaranteed obligation that always trades at par. If you have any doubt about this, put your hands into your pockets and you will find just such an instrument. It’s called currency, a zero-interest, perpetual liability of the Federal Reserve, itself a levered entity, capitalized by its Congressionally-legislated monopoly over the creation of money. As a practical matter, of course, you don’t hold all of your always-trades-at-par liquidity in currency. You most likely have a demand deposit, also known as a checking account, as well as shares in a money market mutual fund, which is putatively supposed to always trade “at the buck.” You probably also have some longer-dated bank deposits, such as certificates of deposits, or CDs, which don’t necessarily trade at par in real time, but are guaranteed to do so at maturity. The Nature of Fractional Reserve Banking The public’s demand for at-par liquidity inherently creates the raw material for leverage in the economy. Indeed, from time immemorial, fractional reserve banking has been built on the simple proposition that the public’s collective ex ante demand for at-par liquidity is greater than the public’s collective ex post demand for such liquidity. Accordingly, the genius of banking1, if you want to call it that, has always been simple: A bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is de jure of finite maturity, as short as one day in the case of demand deposits. Thus, the business of banking is inherently about maturity and credit quality transformation:

1 “The Paradox of Deleveraging Will Be Broken,” Global Central Bank Focus, November 2008. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/Global+Central+Bank+Foc us+11-08+McCulley+Paradox+of+Deleveraging+Will+Be+Broken.htm

430 banks can hold assets that are longer and riskier than their liabilities, because their deposit liabilities are sticky. Depositors sleep well knowing that they can always get their money at par, but because they do, they don’t actually ask for their money, affording bankers the opportunity to redeploy that money into longer, riskier, higher-yielding assets that don’t have to trade at par. Enter the Government A key reason that depositors sleep well at night is the fact that since 1913 here in the United States, banks have had access to the Federal Reserve’s discount window, where assets can be posted for loans to redeem flighty depositors. A second sleep-well governmental safety net was introduced in 1933: deposit insurance, in which the federal government insures that deposits – up to a limit – will always trade at par, regardless of how foolish bankers may be on the other side of their balance sheets. Thus, the genius of modern day banking, again if you want to call it that, has always been about exploiting the positive spread between the public’s ex ante and ex post demand for liquidity at par, in the context of levering the two safety nets – the central bank’s discount window and deposit insurance underwritten by taxpayers – which provide comfort to depositors that they can always get their money at par, even if their bankers are foolish lenders and investors. Yes, I know that sounds harsh. But it really is how the banking world works. In turn, banks can be very profitable enterprises, because the yield on their risky assets is greater than the yield on their less-risky liabilities. And that net interest margin can be particularly sweet when recomputed as a return on equity, given that banks are very levered institutions (recall, banks must hold only 8% of liabilities in the form of Tier 1 capital). Put differently, equity investors in banks can lose only 8% of a bank’s footings, but they earn the net interest margin on 100% of those footings, so long as they don’t make so many dodgy loans and investments, destroying capital, that the providers of the two government safety nets cut them off. Thus, it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets. That’s why banks are regulated. Conceptually, as is the case in socialist countries, banks could be – and usually are – simply owned by the government, the ultimate form of regulation. Such an arrangement has the benefit of the taxpayer sharing in the upside, not just the downside. Such an arrangement also has the cost of putting the government in the lending and investing business, with little regard

2 “Comments Before the Money Marketeers Club, Minsky and Neutral:Forward and in Reverse,” Global Central Bank Focus, December 2007. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2007/GCBF+Dec+2007.htm 3 “The Paradox of Deleveraging,” Global Central Bank Focus, July 2008. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCBF+July+2008.htm 4 “All In,” Global Central Bank Focus, December 2008/January 2009. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+Mc Culley+All+In.htm

431 for the pursuit of profit, picking winners and losers on the basis of political clout. Thus, capitalist economies usually want their banking systems owned by the private sector, where loans and investments are made on commercial terms, in the pursuit of profit. But also in the context of prudential regulation, so as to minimize the downside to taxpayers of the moral hazard inherent in the two safety nets for depositors. The Mae West Doctrine But as is the wont of capitalists, they love levering the sovereign’s safety nets with minimal prudential regulation. This does not make them immoral, merely capitalists. And over the last decade or so, the way for bankers to maximally lever the inherent banking model has been to become non-bank bankers, or as I dubbed them a couple years ago, shadow bankers. The way to do this has been to run levered-up lending and investment institutions – be they investment banks, conduits, structured investment vehicles, hedge funds, et al – by raising funding in the non-deposit markets, notably: unsecured debt, especially interbank borrowings and commercial paper; and secured borrowings, notably reverse repo and asset-backed commercial paper. And usually – but not always! – such shadow banks relied on conventional banks with access to the central bank’s discount window as backstop liquidity providers. Structured accordingly, without explicit access or use of the government’s safety nets, shadow banks essentially avoided regulation, notably on the amount of leverage they could use, the size of their liquidity buffers and the type of lending and investing they could do. To be sure, Shadow Banking needed some seal of approval, so that providers of short-dated funding could convince themselves that their claims were de facto “just as good” as deposits at banks with access to the government’s liquidity safety nets. Conveniently, the rating agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval. And it was all grand while ever-larger application of leverage put upward pressure on asset prices. There is nothing like a bull market to make geniuses out of levered dunces. Call it the Mae West Doctrine, where if a little fun is good and more is better, then way too much is just about right.

Also call it the Forward Minsky Journey,2 where stability begets ever riskier debt arrangements, until they have produced a bubble in asset prices. And then the bubble bursts, in something called a Minsky Moment, followed by a Reverse Minsky Journey, characterized by ever-tighter terms and conditions on the availability of credit, inducing asset price deflation

432 and its fellow traveler, debt price deflation. This dynamic is inherently self-feeding, begetting the Paradox of Deleveraging,3 where private sector bankers – conventional bankers and shadow bankers alike – all move to the offer side of both asset markets and bank capital markets, trying to reduce their leverage ratios by selling assets and paying off debt, and/or issuing more equity. But by definition, if everybody tries to do it at the same time, as has been the case over the last 18 months or so, it simply can’t be done. What is needed is for the government to take the other side of the trade, effectively becoming the bid side, (1) buying assets, (2) guaranteeing assets, (3) providing cheap funding for assets, and (4) buying bank equity securities (of both conventional banks and shadow banks that are permitted to become conventional banks after the fact). Government Goes All In4 And indeed, all four of these techniques have been put into play since the fateful decision to let Lehman Brothers fall into disorderly bankruptcy. Put more bluntly, the hybrid character of banking – always a joint venture between private capital and governmental liquidity safety nets – is morphing more and more towards government-sponsored banking. Yes, I know that is harsh, but sometimes the truth is harsh. Capitalism and banking may not be divorced, but certainly are engaged in some form of trial separation. The Treasury, the FDIC and the Fed – the big three – are caught in the middle, serving both as mediators as well as deep pockets to the estranged parties. It’s not wholesale nationalization. And it’s not likely to become that. But only because the big three are committed to doing whatever it takes to prevent that outcome. Along the way, the big three would also like – need! – to restart the engines of credit creation, so as to pull the economy out of its gaping hole of insufficient aggregate demand for goods and services, also known as a recession. Will it work? Judging from the markets’ collective reaction to Treasury Secretary Geithner’s announcement last week of the new administration triage plans, there is room for doubt. I do not, however, take one-week swings in the markets as indicative as to where this game will end. And a key reason is actually the special powers of the Fed and the FDIC, which can lever the taxpayer monies that Congress provides for the Treasury. As evidenced in recent months, the Fed has two incredibly powerful tools: • Section 13(3) of the Federal Reserve Act of 1932, which permits the Fed, upon declaration of “unusual and exigent circumstances” to lend to anybody against collateral it deems adequate, and • Total freedom to expand its balance sheet, essentially creating liabilities against itself that trade at par – also called printing money – so long as the Fed is willing to surrender control over the Fed funds rate, letting it trade at zero, or thereabouts. The Fed has used both of these tools vigorously in recent months, expanding its lending programs mightily, to both conventional banks and shadow banks (i.e., investment banks who have re-chartered as banks, as well as primary dealers), while also doubling the size of its balance sheet, as it let the Fed funds rate fall to effectively zero. The FDIC also has an incredibly powerful tool: the so-called Systemic Risk Exception under the FDIC Improvement Act of 1991, which allows the FDIC to forgo using the “lowest cost” solution to dealing with troubled banks if using such a solution “would have serious adverse effects on economic conditions or financial stability” and if bypassing the least cost method would “avoid or mitigate such adverse effects.”

433 It’s actually not an easy clause for the FDIC to invoke, unlike Section 13(3) for the Fed, which can be invoked simply by a supermajority of the Board of Governors. For the FDIC, the Systemic Risk Exception must be deemed necessary by two-thirds of both the Board of Directors of the FDIC and the Fed’s Board of Governors, as well as by the Secretary of the Treasury, who must first consult and get agreement from the President of the United States. But where there is a will, there is a way, and the FDIC is now living firmly in the land of the Systemic Risk Exception, legally allowed to guarantee unsecured debt of banks as well as to put itself at risk in guaranteeing banks’ dodgy assets. Bottom Line The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week. And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF). The formula? Take a small dollop of the Treasury’s free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press. That’s the formula for the TALF, to provide leverage, with no recourse after a haircut, to restart the securitization markets. The same formula applies for the P-PIF, with the addition of FDIC stop out loss protection for dodgy bank assets that private sector players might buy. With such goodies, such players, it is hoped, will be able to pay a sufficiently high price for those assets to avoid bankrupting the seller bank. Unfortunately, Secretary Geithner hasn’t laid out the precise parameters of how to mix these three ingredients, which is driving the markets up the wall. But make no mistake, these are the ingredients, along with continued direct capital infusions into banks where necessary. Uncle Sam has the ability to substitute itself – not himself or herself! – for the broken conventional bank system, levering up and risking up as the conventional banking system does the exact opposite. Yes, there will be subsidies involved, sometimes huge ones. And yes, the process will seem arbitrary and capricious at times, reeking of inequities. Such is the nature of government rescue schemes for broken banking systems, while maintaining them as privately owned. You might not like it. I don’t like it, because regulators should never have let bankers, both conventional bankers and shadow bankers, run amok. But they did. So it’s now time to hold the nose and do what must be done, however stinky it smells, not because it’s pleasant but because it is necessary. Only with the full force of the sovereign’s balance sheet can the Paradox of Deleveraging be broken. Paul McCulley, Managing Director, February 16, 2009 [email protected] http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/GCB+February+20 09+McCulley+Saving+Capitalistic+Banking.htm

434 Economy

September 25, 2008 Managing the Bailout: He’d Do It for Nothing By EDWARD WYATT NEWPORT BEACH, Calif. — One of the chief concerns about the Treasury Department’s $700 billion bailout plan is that the same Wall Street firms that helped create the crisis could make a killing cleaning it up. William H. Gross, the manager of the country’s largest bond mutual fund, has a solution: he is offering to sort through the toxic assets — free. “We have a large and brilliant staff that can analyze and has analyzed subprime mortgages that can help the Treasury out,” Mr. Gross, the co-chief investment officer for the Pacific Investment Management Company, said in an interview at the company’s headquarters here. He added, “And I’d even be willing to say that if the Treasury wanted to use our help, it would come, you know, free and clear.” Mr. Gross explained his offer as a philanthropic one. With Pimco’s $830 billion under management, “we make fees aplenty,” he said. That could be considered an understatement. Pimco is a behemoth in credit markets, and Mr. Gross talks about them with a confidence that reflects his ability to maneuver in them. But maneuvering is becoming a lot harder these days. After breathing an initial sigh of relief when the Treasury plan was first announced, credit markets are again showing signs of stress. Mr. Gross pointed it out on Tuesday morning, standing on Pimco’s trading floor as Henry M. Paulson Jr., the Treasury secretary, and Ben S. Bernanke, the Federal Reserve chairman, testified before a Senate committee. “Today’s the worst day yet and nobody knows it,” he said. “Everybody is squirreling away cash. Even the big banks are refusing to lend money.” Bid-ask spreads on bonds in almost every sector of the debt markets stretched to a full point or more. “It’s not a pretty situation today, much worse than last week,” Mr. Gross said. “Those who just look at the stock market wouldn’t know it,” he added, because the Dow Jones industrial average was down only 126 points at the time. “But the credit markets are doing a pretty good job of freezing up.” Despite his proposal to offer his talents, gratis, some investment managers say the government should be wary of giving authority for the auction of mortgage securities to anyone in the private sector, particularly someone with as dominant a position in the bond market as Mr. Gross. Luis Maizel, a senior managing director of LM Capital Group in San Diego, said the government should instead turn to someone like a former official of the Federal Home Loan Bank Board, which is now defunct, or the Federal Reserve. “They should start with somebody who doesn’t have a conflict,” Mr. Maizel said. “Bill Gross is a good friend of mine, but if you put this in Bill’s hands, Pimco is going to come out great and I don’t know that the government will.”

435 Mr. Gross says that all he wants in return for helping the Treasury Department is for Pimco “to be recognized for the way we’ve seen this crisis coming, and for the way we’ve talked about what’s required.” For more than a year, Mr. Gross, whose investment expertise has earned him a net worth estimated at more than $1 billion, according to Forbes, has indeed played the role of the financial markets’ Cassandra. Beginning in July 2007, he warned that the would become far worse before it would improve. Other sectors of the financial markets, he predicted, also could seize up if the Federal Reserve and the Treasury did not do something to help keep the markets liquid. But Mr. Gross and Pimco also attracted criticism when it became clear that the Pimco Total Return fund earned more than $1.7 billion on the day the federal government bailed out Fannie Mae and Freddie Mac. Mr. Gross had been advocating such a move for more than a year, at the same time that he was moving more than 60 percent of his fund’s assets into government-agency bonds. The shift in investment strategy began in earnest shortly after Pimco hired Alan Greenspan, the former Federal Reserve chairman, as an adviser last year. Mr. Gross said there was nothing wrong with that advocacy because Pimco had no official role in formulating the plan to rescue Fannie Mae and Freddie Mac. “We had a role on CNBC,” he said, “in that every time we were asked, or I guess every time that The New York Times would call, they would say, ‘What are you doing?’ and we would say: ‘Well, we want safe, agency-guaranteed mortgages. We don’t want to take a lot of risks in subprime space.’ ” With the current liquidity crisis touching virtually every sector, any firm in a position to advise the Treasury on its rescue plan would have potential conflicts of interest, Mr. Gross said. “There’s fewer of them here than anywhere else,” he added. “Simply because we saw the crisis coming and we don’t have much of this paper.” The calm of the Pimco trading floor is perhaps a reflection of that reality. Even in the midst of the Wall Street tumult, it is less cacophonous pit than library, the low murmur of conversation among portfolio managers drowned out only by the clacking keyboards. Mr. Gross, a lanky 64-year-old who practices yoga and sometimes speaks so softly that colleagues lean toward him, drifted around the room on Tuesday, an unknotted pale blue Hermès tie draped around his neck, his gray and brown hair extending down over his ears, reminiscent more of the 1970s than today. Pimco’s headquarters sit on a bluff overlooking the Pacific Ocean. On a clear day, the view extends westward beyond Catalina Island, which sparkles like a jewel in the midday sun. The windows on the Pimco trading floor, where Mr. Gross spends most of his time, however, face in the opposite direction — toward Wall Street and Washington, two arenas where Mr. Gross and his firm carry outsize influence. Mr. Gross, who talks regularly with Mr. Paulson, believes the bailout plan should grant broader relief for homeowners and others weighed down by unmanageable debt. He says foreign banks should be allowed to take part in the program, but he argues against any measures that would try to restrict executive compensation — a move that Mr. Paulson tentatively backed Wednesday.

436 “I don’t even know if it’s legal,” Mr. Gross said of attempts to limit executive pay. “And so I think that complicates the situation. That’s not to defend those that are making big checks, but I don’t think it should be attached to this.” Mr. Gross is also skeptical of proposals to have the Treasury take ownership stakes in banks that sell troubled assets to the government. Buying a pool of subprime mortgages is not like buying part of a company, he said. The Treasury would own something — the mortgages themselves, which, if it pays the right amount for those loans, could earn it a yearly return of 12 to 13 percent when they are resolved. “All the capital gains will accrue to the Treasury,” he said. “There’s tons of equity here. It’s just that it’s very difficult for American taxpayers to understand.” The key, of course, is price, which is where an adviser to the Treasury would come in. Mr. Gross says much of the opposition to the plan stems from a misunderstanding that the Treasury would buy troubled mortgage bonds at face value. On the contrary, Mr. Gross said, he would advise the Treasury to pay closer to 60 or 65 cents on the dollar for the mortgage bonds. “If the price is right, the Treasury’s going to make money,” Mr. Gross said. “They made money on Chrysler. They can make money on this,” he said, referring to the federal bailout of the carmaker in 1979 and 1980. Still, when asked how he saw the broader economy here and abroad over the next year, Mr. Gross responded simply, “Not pretty.” “There will definitely be a prolonged period of either slow growth or recession for 12 to 18 to 24 months,” he said. “We’re not going to get out of this easily or scot-free. It’s just gone too far to now turn around quickly and to move into a positive growth mode.” In the meantime, a surge in regulation of the financial sector will be unleashed, probably an inevitable result of the problems and rescues of recent months. “Twelve to 24 months down the road, all of these high-flying investment banks and banks will be reregulated and downsized,” Mr. Gross said. “They won’t become arms of the government, but they will be supervised and held on a tight leash.” The greater regulation should draw investors back to the market and away from what seems to be their current financial strategy — stuffing their cash in mattresses. Even Mr. Gross admits that he has been, at times, reluctant to commit. “We were offered this morning a six-month sizable piece of Morgan Stanley,” he said on Tuesday. “Here’s the surviving investment bank that just last night got equitized or bailed out by a Japanese bank. We were offered a sizable piece of a six-month Morgan Stanley obligation at a yield of 25 percent, O.K.?” Pimco did not buy the bonds, “because we thought we could get it even cheaper,” Mr. Gross said, adding that thinking of that kind was at the heart of today’s market paralysis. “That’s where the fear builds in and makes for totally illiquid markets,” he said. “Where no one trusts anybody; no one trusts any price.” http://www.nytimes.com/2008/09/25/business/economy/25pimco.html

437

How Main Street Will Profit By William H. Gross Wednesday, September 24, 2008; A23 Capitalism is a delicate balance between production and finance. Today, our seemingly guaranteed living standard is threatened, much like it has been in previous recessions or, some would say, the Depression. Finance has run amok because of oversecuritization, poor regulation and the excessively exuberant spirits of investors; the delicate balance has once again been disrupted; production, and with it jobs and our national standard of living, is declining. If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest -- a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit. That, of course, has been the attempted remedy over the past 12 months. But recent events have made it apparent that this downturn differs from recessions past. Today's housing bubble, unlike that of the stock market's before it, was financed with excessive and poorly regulated mortgage debt, and as housing prices began to tumble from the peak, the delinquencies and foreclosures have led to a downward spiral of debt liquidation that in turn led to even lower prices and more foreclosures. And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that. In effect, the Treasury will have the fate of the American taxpayer in its hands. The Resolution Trust Corp., created in the late 1980s to deal with the savings and loan crisis, dealt with previously purchased real estate, which was flushed into government hands with a "best efforts" future liquidation. Today, the purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below "par" or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth. Politicians afraid of parallels to legislation that enabled the Iraq war are raising concerns about a rush to judgment, but the need for speed is clear. In this case, there really are weapons of mass destruction -- financial derivatives -- that threaten to destroy our system from within. Move quickly, Washington, with appropriate safeguards.

438 The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic. Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance -- between private incentive and government oversight. The writer is chief investment officer and founder of the investment management firm PIMCO. http://www.washingtonpost.com/wp-dyn/content/article/2008/09/23/AR2008092302322.html

It's the Housing Market Deflation By William H. Gross Thursday, January 31, 2008; A21 It seems to me that the U.S. economy requires a new orthodoxy, a redirection from consumption toward the stabilization of the housing market and an emphasis on infrastructure. America's economy is faltering because of an exhaustion of free-market capitalism that has mutated in recent years to something resembling a pyramid scheme. Our levered, derivative-based financial system, seemingly so ascendant after the dot-com madness that preceded it, has met its match with the and poorly structured, opaque mortgage-backed securities of today's marketplace. The result has been a dangerous deflation in America's most important asset class -- housing. Preventing home prices from declining even further is job No. 1 for monetary and fiscal authorities. So far, only Fed Chairman Ben Bernanke seems to appreciate the necessity for timely, creative solutions. The Fed has cut interest rates twice in eight days, by one-half of a percentage point yesterday and by three-quarters of a percentage point at an unscheduled meeting last week, and implemented a revised discount window framework in the form of its newly created Term Auction Facility. This "TAF" is designed to lower risk spreads in the high-quality end of the credit markets, and so far it is succeeding. Yet monetary policy has its limits. It cannot make bad assets turn good, nor can it be expected to lower mortgage rates to a level necessary to engender the buying power that would clear the tracts of unoccupied homes and place a floor under the deflating prices feared by American homeowners. The adjustable-rate mortgage, so dependent on lower short-term yields, is all but dead these days, thanks to increased regulatory scrutiny and the inevitability of future lawsuits. The heavy lifting, then, must be done by the 30-year mortgage, rates for which need to come down at least an additional percentage point before it can stop housing's deflation. With inflation higher than it was during the halcyon days of 2003-04, such a reduction is not likely even if Bernanke were to drop the Fed's target interest rate to its previous floor of 1 percent. So we do need a fiscal helping hand, and one that is timely and targeted, but current stimulus legislation appears to be aimed in the wrong direction. Granted, a measure that President Bush

439 and House leaders agreed to and that the House approved this week has a provision to allow Fannie Mae and Freddie Mac to back larger mortgages. But that would do little to help those Americans who purchased homes over the past five years and whose monthly mortgage payments are now substantially higher, as well as those people who are being forced out of their homes entirely. Granted, the bipartisan plan would put money into the hands of consumers, helping them pay overdue debt and regain some lost ground from bill collectors. The Senate's proposal to increase food stamp benefits may be helpful as well. But the big problem with the proposed "stimulus" is that it is really directed toward consumption, not toward the housing deflation that threatens the U.S. economy. Our economic problem today resembles the Japanese property market crisis of the 1990s. What's needed is not just $600 checks that will flow into Wal-Mart (and then to the Chinese) but an expanded Federal Housing Administration program offering below- market, 30-year mortgage refinancings with minimal down payments, which the private market and Bernanke cannot provide. Republican orthodoxy seems so intent on curtailing the past abuses of Fannie Mae and Freddie Mac that some politicians are looking past a government agency solution in their own back yard. Housing and our finance-based market mania got us into this mess. Housing and government-based financial solutions must begin to get us out of it. Ultimately, America's economy will require more than a $150 billion shot in the arm to resolve its slow-growth predicament. One hopes that Americans will come to recognize that a better direction for our economy will be neither tax-based nor consumption-oriented. We have followed that path to our detriment in recent years. If government is ascendant vis-¿-vis the hegemony of the private market, then it must invest more wisely than its economic partner has. For now, however, to be effective, the right temporary fix requires additional focus on where the damage lies -- and that is centered on our housing market deflation. The writer is founder and chief investment officer of PIMCO, the world's largest bond mutual fund. http://www.washingtonpost.com/wp- dyn/content/article/2008/01/30/AR2008013003211_pf.html

Why We Need a Housing Rescue By William H. Gross Friday, August 24, 2007; A15 During times of market turmoil, it helps to get down to basics. Goodness knows it's not easy to understand the maze of financial structures that appear to be unwinding. They were created by wizards of complexity: youthful financial engineers trained to exploit cheap money and leverage and who have, until the past few weeks, never known the sting of the market's lash. My explanation of how the subprime crisis crossed the borders of mortgage finance to swiftly infect global capital markets is perhaps unsophisticated. What Federal Reserve Chairman Ben Bernanke, Treasury Secretary Hank Paulson and a host of other sophisticates should have known is that the bond and stock market problem is not unlike the game "Where's Waldo?" -- Waldo being the bad loans and defaulting subprime paper of the

440 U.S. mortgage market. While market analysts can guesstimate how many Waldos might appear over the next few years -- $100 billion to $200 billion worth is a reasonable estimate -- no one knows where they are hidden. There really are no comprehensive data on how many subprimes rest in individual institutional portfolios. Regulators have been absent, and releasing information has been left to individual institutions. Many, including pension funds and insurance companies, argue that accounting rules allow them to value subprime derivatives for what they cost. Defaulting exposure therefore can hibernate for months before its true value is revealed. The significance of proper disclosure is the key to the current crisis. Financial institutions lend trillions of dollars, euros, pounds and yen to and among each other. The Fed lends to banks, which lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to hedge funds, and so on. The food chain is not one of predator feasting on prey but a symbiotic credit extension, always for profit but never without trust that the money will be repaid upon contractual demand. When the trust breaks down, money is figuratively stuffed into Wall Street and London mattresses as opposed to extended to the increasingly desperate hedge funds and other financial conduits. These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile as more and more financial institutions reach their risk limits at the same time. The past few weeks have exposed a giant crack in modern financial architecture, created by the youthful wizards and endorsed as a diversifying positive by central bankers present and past. While the newborn derivatives may hedge individual, institutional and sector risk, they cannot hedge liquidity risk. In fact, the inherent leverage that accompanies derivative creation may foster systemic risk when information is unavailable or delayed. Only the central banks can solve this, with their own liquidity infusions and perhaps a series of rate cuts. Should markets be stabilized, policymakers must then decide what to do about the housing market. Seventy percent of American households are homeowners. Granted, a dose of market discipline in the form of lower prices might be healthy, but forecasters are projecting more than 2 million defaults before this cycle is complete. The resulting impact on housing prices is likely to be close to a 10 percent decline. Such an asset deflation has not been seen in the United States since the Great Depression. Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 2 to 3 percentage points by the Fed would not avert an increase in interest rates of adjustable-rate mortgages; nor would they guarantee that the private mortgage market -- flush with fears of depreciating collateral -- would follow along in terms of 30-year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits. Such a move would also more than likely weaken the dollar -- even produce a run -- which would threaten the long-term reserve status of greenbacks and the ongoing prosperity of the U.S. hegemon. The ultimate solution must not emanate from the Fed but from the White House. Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners must be thrown to the wolves today? If we can bail out Chrysler, why can't we support American homeowners? Critics warn of a "moral hazard." If we bail out homeowners this time, they claim, it will just encourage another round of speculation in the future. But there's never been a problem in

441 terms of national housing price bubbles until recently. Home prices have been the most consistent, least bubbly asset aside from Treasury bills for the past 50 years. Only in the past few years, when regulation has broken down, when the Fed has failed to exercise appropriate supervision, have we seen "no-doc" and "liar" loans and "100 percent plus" loans. If you enforce regulation, you'll have no problem with moral hazard. This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hardworking Americans. Those who would still have them eat Wall Street cake (as a Wall Street Journal editorial suggested, saying they should get used to renting once again) should look at it this way: your stocks and risk-oriented leveraged investments will spring to life anew. Republican officeholders would win a new constituency of voters for generations. Get with it, Mr. President. This is your moment to one-up Barney Frank and the Democrats. Create a Reconstruction Mortgage Corporation. Or, at the least, modify the existing FHA program, long discarded as ineffective. Bail 'em out -- and prevent a destructive housing deflation that Ben Bernanke cannot avert. After all, you're the Decider, aren't you? The writer is founder and chief investment officer of PIMCO, the world's largest bond mutual fund. This column was adapted from his September investors outlook newsletter. http://www.washingtonpost.com/wp-dyn/content/article/2007/08/23/AR2007082301834.html

442

WILLIAM H. GROSS — THE KING “If Any One Man has put Bonds on the Map, it's Bill”

William H. Gross Bill Gross is widely recognized as the King of Bonds due to his ability to outperform the major bond indices, in all markets. His talent has become legendary. He is certainly the highest paid fund manager in the world, which is hardly surprising when you consider that he manages America's largest bond fund ($128 billion in assets, June 2008) and under his lead it consistently chalks up outstanding results. (Up 7.75% p.a. since he took the helm in '87.) When it comes to navigating turbulent seas, Bill has few rivals. He can make money as readily in bull markets as in bear with impeccable judgment and an unerring eye. Some say he can even walk on water. His secret? For a start, Bill is more aggressive than most bond managers. In his own words: "I've always said that a good institutional bond manager has to be one-third mathematician, one-third horse trader, and one-third economist." Most likely it is simply his passion to beat the odds. Born in Middletown, Ohio, he was raised there and California and as a young man, while recovering from an auto accident in Duke Hospital (NC), he read a book on beating the odds in gambling and discovered his true calling. He promptly headed to Las Vegas where he generated the money he needed to attend business school. Vegas taught Bill that with new ideas, patience and hard work he could beat the system! He has never looked back. Bill gained a BA in psychology at Duke University, Durham (NC) in 1966 and an MBA at UCLA in 1971 before founding Pacific Investment Management Co, LLC. From Bill's point of view there's no difference between gambling and money management. "The goal is to spread risk and avoid becoming emotional while staying focused on the odds." His investment philosophy is no secret at all. Bill respects secular trends rather than short-term interest rate movements, using diversity to temper risks, and aims for performance consistency by avoiding extreme swings in either maturity or duration. He relies more on interest rate and sector bets than individual bond selection. From this position he aims to beat the market. And he succeeds. He also aims to provide clients with the highest standard of excellence in asset management, emphasizing service, value, stability and vision. His own genius and PIMCO's huge analysis resource base help him get both of these right more often than not.

443 Today, Bill practices yoga, writes about investing (2 books and numerous newsletters and articles) and always believes in bonds. William H. Gross is founder and chief investment officer with Pacific Investment Management Company. ($829 billion assets under management - June 2008) In 1993 he was recognized as the most influential authority on the bond market in the United States. Gross and his team have three times been awarded Morningstar's "Fixed-Income Manager of the Year" award. (1998, 2000, and 2007) Bill is a Chartered Financial Analyst and a member of the Los Angeles Society of Financial Analysts. The fund we are investing in to gain access to Money Master Bill Gross is:

Fund Name: PIMCO Total Return

Fund Symbol: PTRAX

Fund Summary:

PIMCO Total Return fund invests in a diversified portfolio of fixed income securities - normally for 3-5 years - utilizing interest rate volatility, yield curve movements, and credit trends. Taken together, these sessions set the basic portfolio parameters, including duration, yield-curve positioning, sector weightings and credit quality. Bottom-up strategies, including credit analysis, quantitative research and individual issue selection, are then meshed with the top-down strategies to add value. We may at times use futures to replicate bond positions The fund may invest all assets in derivative instruments and up to 20% of fund assets may be invested in securities denominated in foreign currencies.

Pacific Investment Management Company LLC (PIMCO)

• More than 1,000 employees including 258 investment professionals. • Founded in 1971 and based in Newport Beach, California. • PIMCO is one of the world's leading fixed-income fund-management companies with more than $829 billion of assets under management; led by William Gross, noted bond manager. • Clients include more than half of the 100 largest U.S. corporations • Includes America's largest bond fund, PIMCO Total Return Fund, with $128 billion AUM as of June 30, 2008. • The company is majority owned by Munich-based Allianz Group, a leading global insurance company with over $1 trillion in assets and represented in 70 countries around the globe. * Notes: The 10-year average return shown for PTRAX is for the 10-year period 01/01/98 - 12/31/07. The average was calculated by adding the results for the 10 consecutive calendar years shown and dividing that result by 10. The 10-year average return and 10 individual annual performance results are shown with all dividends and gains reinvested and are net of all fund fees. All fund expenses have already been deducted from the percentage results shown. http://www.moneymasters.com/default.aspx?page=GrossWilliam

444

AMERICAN.COM A MAGAZINE OF IDEAS Guess Who Really Pays the Taxes By Stephen Moore From the November/December 2007 Issue Yes, income in America is skewed toward the rich. But taxes are skewed far, far more. The top 5 percent pay well over half the income taxes. STEPHEN MOORE has the numbers.

1. Are income taxes fair? That depends on who is offering the opinion. Democratic candidates for president certainly don’t think so. John Edwards has said, “It’s time to restore fairness to a tax code that has been driven badly out of whack.” Hillary Clinton laments that “middle-class and working families are paying a much higher percentage of their income [in taxes].” Over the past seven years, however, Americans in general think taxes have become more fair, not less. The Gallup Organization found in an April poll that 60 percent of respondents believe the income taxes that they themselves pay are fair, compared with 37 percent who believe the taxes they pay are unfair. In 1997, the figures were 51 percent fair and 43 percent unfair. 2. What income group pays the most federal income taxes today? The latest data show that a big portion of the federal income tax burden is shouldered by a small group of the very richest Americans. The wealthiest 1 percent of the population earn 19 percent of the income but pay 37 percent of the income tax. The top 10 percent pay 68 percent of the tab. Meanwhile, the bottom 50 percent—those below the median income level—now earn 13 percent of the income but pay just 3 percent of the taxes. These are proportions of the income tax alone and don’t include payroll taxes for Social Security and Medicare.

3. But didn’t the Bush tax cuts favor the rich? The New York Times reported recently that the average family in America with an income of $10 million or more received a half-million-dollar tax cut, while the middle class got crumbs

445 (less than $100 shaved off their tax bill). If we examine the taxes paid in a static world—that is, if we assume that there was no change in behavior and economic performance as a result of the tax code—then these numbers are meaningful. Most of the tax cuts went to the super wealthy. But Americans did respond to the tax cuts. There was more investment, more hiring by businesses, and a stronger stock market. When we compare the taxes paid under the old system with those paid after the Bush tax cuts, the rich are now actually paying a higher proportion of income taxes. The latest IRS data show an increase of more than $100 billion in tax payments from the wealthy by 2005 alone. The number of tax filers who claimed taxable income of more than $1 million increased from approximately 180,000 in 2003 to over 300,000 in 2005. The total taxes paid by these millionaire households rose by about 80 percent in two years, from $132 billion to $236 billion.

4. But haven’t the tax cuts put more of the burden on the backs of the middle class and the poor? No. I examined the Treasury Department analysis of how much the rich would have paid without the Bush tax cuts and how much they actually did pay. The rich are now paying more than they would have paid, not less, after the Bush investment tax cuts. For example, the Treasury’s estimate was that the top 1 percent of earners would pay 31 percent of taxes if the Bush cuts did not go into effect; with the cuts, they actually paid 37 percent. Similarly, the share of the top 10 percent of earners was estimated at 63 percent without the cuts; they actually paid 68 percent. 5. What has happened to tax rates in America over the last several decades? They’ve fallen. In the early 1960s, the highest marginal income tax rate was a stunning 91 percent. That top rate fell to 70 percent after the Kennedy-Johnson tax cuts and remained there until 1981. Then Ronald Reagan slashed it to 50 percent and ultimately to 28 percent after the 1986 Tax Reform Act. Although the federal tax rate fell by more than half, total tax receipts in the 1980s doubled from $517 billion in 1981 to $1,030 billion in 1990. The top tax rate rose slightly under George H. W. Bush and then moved to 39.6 percent under Bill

446 Clinton. But under George W. Bush it fell again to 35 percent. So what’s striking is that, even as tax rates have fallen by half over the past quarter-century, taxes paid by the wealthy have increased. Lower tax rates have made the tax system more progressive, not less so. In 1980, for example, the top 5 percent of income earners paid only 37 percent of all income taxes. Today, the top 1 percent pay that proportion, and the top 5 percent pay a whopping 57 percent. 6. What is the economic logic behind these lower tax rates? As legend has it, the famous “Laffer Curve” was first drawn by economist Arthur Laffer in 1974 on a cocktail napkin at a small dinner meeting attended by the late Wall Street Journal editor Robert Bartley and such high-powered policymakers as Richard Cheney and Donald Rumsfeld. Laffer showed how two different rates—one high and one low—could produce the same revenues, since the higher rate would discourage work and investment. The Laffer Curve helped launch Reaganomics here at home and ignited a frenzy of tax cutting around the globe that continues to this day. It’s also one of the simplest concepts in economics: lowering the tax rate on production, work, investment, and risk-taking will spur more of these activities and will often produce more tax revenue rather than less. Since the Reagan tax cuts, the United States has created some 40 million new jobs—more than all of Europe and Japan combined. 7. Are lower tax rates responsible for the big budget deficits of recent decades? There is no correlation between tax rates and deficits in recent U.S. history. The spike in the federal deficit in the 1980s was caused by massive spending increases. The Congressional Budget Office reports that, since the 2003 tax cuts, federal revenues have grown by $745 billion—the largest real increase in history over such a short time period. Individual and corporate income tax receipts have jumped by 30 percent in the two years since the tax cuts.

8. Do the rich pay more taxes because they are earning more of the income in America? Yes. There’s no doubt that the share of total income earned by the wealthy has increased steadily over the past 25 years. Since 1980, the share of income earned by the richest 1 percent has more than doubled, from 9 percent to 19 percent. The share of the income going to the poorest income quintile has declined. Income disparities, in absolute dollars, have grown substantially.

447 What is significant is that for the top 5 percent and 10 percent of earners, the ratio of taxes paid compared with income earned has risen. For example, in 1980, the top 10 percent earned 32 percent of the income and paid 44 percent of the taxes—a ratio of 1.4. In 2004, this group earned more of the income (44 percent) but paid a lot more of the taxes (68 percent)—a ratio of 1.6. In other words, progressivity—in terms of share of total taxes paid—has risen. On the other hand, for the top 1 percent of earners, progressivity has declined from a ratio of 2.2 in 1980 to 1.9 in 2004. 9. Have gains by the rich come at the expense of a declining living standard for the middle class? No. If Bill Gates suddenly took his tens of billions of dollars and moved to France, income distribution in America would temporarily appear more equitable, even though no one would be better off. Median family income in America between 1980 and 2004 grew by 17 percent. The middle class (defined as those between the 40th and the 60th percentiles of income) isn’t falling behind or “disappearing.” It is getting richer. The lower income bound for the middle class has risen by about $12,000 (after inflation) since 1967. The upper income bound for the middle class is now roughly $68,000—some $23,000 higher than in 1967. Thus, a family in the 60th percentile has 50 percent more buying power than 30 years ago. To paraphrase John F. Kennedy, this has been a “rising tide” expansion, with most (though not all) boats lifted. 10. Does the tax distribution look a lot different if we factor in other federal taxes, such as the payroll tax? It’s true that the distribution of taxes is somewhat more equally divided when payroll taxes are accounted for—but the change is surprisingly small. Payroll taxes of 15 percent are charged on the first dollar of income earned by a worker, and most of the tax is capped at an income of just below $100,000. The Tax Policy Center, run by the Urban Institute and the Brookings Institution, recently studied payroll and income taxes paid by each income group. The richest 1 percent pay 27.5 percent of the combined burden, the top 20 percent pay 72 percent, and the bottom 20 percent pay just 0.4 percent. One reason that the disparity in tax shares is so large is that Americans in the bottom quintile who have jobs get reimbursed for some or all of their 15 percent payroll tax through the earned-income tax credit (EITC), a fairly efficient poverty-abatement program. 11. How do tax rates in the United States compare with tax rates abroad? Overall, taxes are between 10 percent and 20 percent lower in the United States than they are in most other industrial nations. This gives America a competitive edge in world markets. But America’s lead in low tax rates is shrinking. For example, the United States now has the second-highest corporate income tax in the developed world, after Japan. Our personal income tax rate is still low by historical standards. But in recent years many European and Pacific Rim nations have been slashing income taxes—there are now ten Eastern European nations with flat-tax rates between 12 percent and 25 percent—while the political pressure in Washington, D.C., is to raise them. 12. Do tax cuts on investment income, such as George W. Bush’s reductions in tax rates on capital gains and dividends, primarily benefit wealthy stockowners? The New York Times reported that America’s millionaires raked in 43 percent of the investment tax cut benefits in 2003. It’s true that lower tax rates have been a huge boon to shareholders—but most of them are not rich. The latest polls show that 52 percent of Americans own stock and thus benefit directly from lower capital gains and dividend taxes. Reduced tax rates on dividends also triggered a huge jump in the number of companies paying out dividends. As the National Bureau of Economic Research put it, “The surge in

448 regular dividend payments after the 2003 reform is unprecedented in recent years.” Dividend income is up nearly 50 percent since the 2003 tax cut.

The same phenomenon occurred with the capital gains tax, which is essentially a voluntary tax because asset owners can avoid it by simply holding onto their stock, home, or business. This “lock-in” effect, as it is called, can be economically inefficient, since owners have a tax incentive to keep poor investments, rather than drawing out the cash and putting it into assets that are more productive. When the capital gains tax is cut, people unlock their assets and reinvest in other enterprises. The 1997 tax reform, passed under President Clinton, reduced the capital gains tax rate from 28 percent to 20 percent, and taxable capital gains nearly doubled over the next three years. The 2003 reform brought the rate down to 15 percent, and between 2002 and 2005 there was a 154 percent increase in capital gains reported as income. This explosion in realized gains cannot be explained only by the rise in the stock market, which averaged just 13 percent annually between 2003 and 2005. Capital gains tax receipts also far outpaced the revenues that the government’s static models predicted. Between 2003 and 2007, actual tax receipts exceeded expectations by $207 billion. Stephen Moore is senior economics writer for the Wall Street Journal editorial board and a contributor to CNBC TV. He was the founder of the Club for Growth and has served as a fiscal policy analyst at the Cato Institute and the Heritage Foundation. His latest book is “Bullish on Bush: How George Bush’s Ownership Society Will Make America Stronger” (Madison Books).

Image credit: chart illustrations by MacNeill & MacIntosh. http://www.american.com/archive/2007/november-december-magazine-contents/guess-who- really-pays-the-taxes

449