The Bank Capital Mirage

The Bank Capital Mirage

via Paul Kedrosky's Infectious Greed de pk le 23/10/08

The following more or less supports what some have been saying for a while -– that major banks in the U.S. and the U.K. will end up being entirely nationalized before this crisis is over –- but it's still a striking way of looking at the data. The gist: Government recapitalization and other fund-raising has largely been in service of banks' prior subprime losses, while corporate and consumer loans are just starting to hit bank balance sheets. It won't take much to tip banks over into insolvency again.

[via Bloomberg]

Bailing Out Homeowners: What Does It Mean?

Bailing Out Homeowners: What Does It Mean?

via Beat the Press le 21/10/08

David Leonhardt has an interesting column in the NYT discussing ideas for bailing out homeowners. He could have gone much further in his analysis if he asked what bailing out homeowners means.

As everyone should know now, the basic problem is that tens of millions of people (urged on by bankers, financial advisers, economists, and politicians) bought homes at bubble inflated prices. The bubble is now bursting so tens of millions of people now live in homes that are worth substantially less than what they paid, and in most of these cases, much less than what they owe on their home.

In this context, "bailing out homeowners" can have three obvious meanings:

1) It can mean protecting homeowners and banks from the loss they incurred from the fall in their home's value;
2) It can mean protecting them as homeowners, by allowing them to get mortgage terms that allow them to stay in their homes; or
3) It can mean allowing them to stay in their homes as tenants, if they can't afford a mortgage workout at the current price.

It would be difficult to argue on either moral or economic grounds for the first type of bailout. Homeowners would not share any capital gains on their homes with the general public, nor would the banks share their profits. It is difficult to see why the taxpayers should be asked to pick up their losses.

Some prominent economists, like Alan Blinder (who is mentioned by Leonhardt) have argued for some sort of house price support program, which presumably would be comparable to a farm price support program, to try to keep house prices at bubble-inflated levels. However, such plans make much less sense economically than farm price support programs. (Blinder also called Alan Greenspan the greatest central banker of all-time back in 2005.) Hopefully, this sort of bailout for homeowners will not go far.

2) The second type of bailout focuses on workout arrangements that allow homeowners to stay in their home as homeowners. This approach centers on forcing the banks to eat most or all of the price decline associated with the bursting of the bubble. If the homeowner really can't absorb the loss, which will be true in many cases, then banks will have little alternative to eating the loss. Even if they foreclose, the bank will not be able to resell the home at a bubble-inflated price. In many cases, a workout involving a write down to current value will be the best route for the bank as well.

While the government can encourage such workouts, there is an inherent problem that if it makes workouts too easy, then people who can afford to eat some of the loss opt to instead pass the losses onto the banks. This becomes a concern for the public, and not just the banks, if the government then has to cough up money to keep the banks alive, as is the case at present.

3) The third type of bailout keeps people in their homes as tenants, but allows the bank to take ownership of the house. This bailout has the benefit of providing housing security to homeowners without giving them any real windfall. In other words, they have no real reason to lie about their economic condition to benefit from it. After all, they will still end up losing ownership of their home. (Actually, rather than become landlords, many banks may opt to do workouts, if throwing homeowners out on the street is not an option.)

This is also by far the most simple route to deal with administratively, since it can be put in place by just changing the foreclosure laws. It requires no new bureaucracy and no taxpayer dollars. The biggest obstacle is that the same financial advisers, economists, and politicians who blindly pushed homeownership even in the middle of a housing bubble still can't think about renting as a serious housing option.

One point on which it should be possible to agree is that we should want the bubble to deflate as quickly as possible. While many economists have hugely exaggerated the problem caused by deflation (who cares if prices are rising 0.5 percent a year or falling 0.5 percent a year?), there is a real problem associated with falling house prices. Declining house prices mean that the people who buy homes in the current market will see a loss on their home. If they can't absorb this loss, then the bank that makes the loan (or whoever holds it) will absorb the loss. Rather than a program of house price supports, the country would be best served by a crash the bubble policy.

The big problem in this story is that the folks who somehow could not see the largest housing bubble in the history of the world are still running economic policy. Unlike custodians and dishwashers, economists are not held accountable for their job performance. For this reason, we should expect many tough times ahead.

--Dean Baker

The Great Crash of China

The Great Crash of China

via Paul Kedrosky's Infectious Greed de pk le 19/10/08

I'll confess to being something of a (short-term only) sino-bear, so this piece from the Far Eastern Economic Review a few weeks ago on China's looming economy troubles perhaps over-fits my biases, but it's still worth reading. The gist: A combination of capital misallocation, non-performing loans, an over-rapid forced transition to high value-added manufacturing, a post Olympics malaise, a collapse in the domestic stock market, and a recession in its main export markets mean that China is going to hit the economic wall sooner and harder than its many supporters expect.

By the end of 2007 almost half of China's GDP growth was attributed to exports and government consumption, a dramatic reversal from 2003 when growth was dominated by investment and private consumption.

While savings rates have been traditionally high, immense wealth has been invested in the stock market and real estate. The Shanghai index lost two-thirds of its value since its peak in mid-October 2007 and the Hang Seng is down over 50% from its peak a year ago.

While fixed asset investment may be rising, one-third is continuing to pour into the real-estate sector (up 29% year-on-year) despite vacant commercial floor space in China rising by 6.1% at the end of July (the latest month for available statistics). Real estate prices are experiencing their slowest growth in 18 months and new home prices in Guangzhou and Shenzhen have actually declined. Meanwhile growth in new car sales, while still robust, is slowing.

Not surprisingly, consumer confidence, according to official Chinese statistics, is drifting downwards and Western ratings on Chinese commercial banks, the holders of unused commercial real estate, are being lowered. Those on the cusp of entering the middle class are faring poorly as tens of thousands of small and medium sized enterprises go bankrupt.

Guangdong Province alone, the heart of China's low-cost manufacturing base, has seen half of the shoe manufacturing industry close shop (over 2,200 factories) this year.

More here.

Perhaps unsurprisingly, this piece has sparked a great deal of (often emotional) debate, including here and here and here.

Charlie Munger: Leash and Collar Wall Street

Charlie Munger: Leash and Collar Wall Street

via naked capitalism de Yves Smith le 14/10/08

The backlash is starting to get serious. It is one thing for the man on the street to fulminate about the excesses of financiers. And even those who try to harness that anger find themselves checked. John McCain, who has said that he is going to fix the economy by (among other things) going after "Wall Street corruption" is having difficulty filling his New York fundraisers.

But it's when people in or close to the financial services start calling for reform that you know the tide is turning. In a Forbes interview, Jamie Dimon and Felix Rohatyn (storied top M&A banker for two generations, also led the restructuring of New York City's finances in its fiscal crisis) do an able job of singing from the reform hymnal. But Charles Munger, long-standing partner of Warren Buffett, calls for root and branch reform. If other prominent Main Street executives fall in with Munger, we might see the banking industry restored to its proper role, that of a support function to commerce.

From Forbes (hat tip reader Steve):

Even more radical is Berkshire Hathaway's vice chairman. Munger wants Wall Street balance sheets reduced by 70% and insists that the firms "be a market maker, a broker, an underwriter and a custodian of securities but not the hedge funds they have become." He wants to restrict leverage to 50% on every securities transaction except for the Treasury trading desk where "you're dealing with the safest securities around."

That 50% margin level, incidentally, is the maximum that ordinary investors can obtain from their broker when they purchase common stock. Before their respective demises, Bear Stearns and Lehman Brothers were leveraged to the tune of $30 of debt for every $1 of capital.

To rid Wall Street of its Las Vegas tone, Munger suggests leveling the options exchanges in Chicago and New York, and banning completely all derivatives contracts, a rather impossible vision but one that's true to his spirit. He's also furious with the accountants, in particular for letting Wachovia report actual profits on accrued interest from risky mortgages when, in fact, the interest wasn't paid but added to the principal amount due on the mortgages.

Derivatives are simply not going away, but there are ways to restrict OTC derivatives (for instance, forbidding any institution that has access to the Fed window from buying or selling them or lending to any entity that has non-exchange traded derivatives on its books) which pose the greatest danger.

The article concluded on this cheery note:

One thing is sure: The abhorrent excessive compensation on Wall Street is bound to be severely reduced. If Wall Street firms can only be leveraged 10 to 1 instead of 30 to 1, then the excessive gains made on borrowed funds will be reduced by two-thirds. So the path to $5 million to $10 million annual payoffs will be more reasonable but still in the millions. Hamptons summer homes will be reduced in price. Private jets will be out of range for many. Applications to law school should go up. The buyside will have their choice of the brightest business school graduates. And forever more we'll all wonder what a meltdown would have been like with the attendant chaos.

There will be an international conference dealing with global finance that will place such restrictions in order to prevent such a close brush with Armageddon and systemic collapse ever again. It cannot be left to the free market.

Worst. Week. Ever.

pour le souvenir

Worst. Week. Ever.

via The Big Picture de Barry Ritholtz le 11/10/08

Well, if you were long, anyway. Those of you who were defensive, or in cash, or God-love-ya, short, had a pretty good week. (Feel free to hit the wish list anytime and buy yourself something nice!)

This is a headline you probably have never seen before:

>

>

I don't know if you will ever see more astonishing data for another 20 years:

International Trade Seizing Up Due to Banking Crisis (Updated)

Effrayant

International Trade Seizing Up Due to Banking Crisis (Updated)

via naked capitalism de Yves Smith le 09/10/08

I have been more than a tad concerned about near-paralysis in the money markets and imploding equity prices. But this e-mail, from a well connected international investor not prone to alarm or (normally) the use of capital letters says that the banking crisis is staring to bring international shipping to a halt.

By way of background, letters of credit of various sorts are essential for trade. For instance, imagine the difficulty if you are, say, a Chinese manufacturer who wants to sell his wares to buyers overseas. How can he be sure the goods he ships will ever be paid for? Imagine the considerable difficulty and cost of chasing a deadbeat in a foreign country. Letters of credit. issued by banks, assure payment. They can also serve to finance the shipment (ie, fund the inventory while it is in transit).

Not only are banks now leery of lending to each other for much longer than overnight, they are also starting to refuse to honor letters of credit from other banks. From the above-mentioned reader:

At the end of the day, if every counterparty is bad then you don't have a market and you don't have an economy. I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citi today for short term funding for his vessels, they won't give it to him. That means he can't ship goods, which means that within the next 2 weeks, physical shortages of commodities begins to show up. THE CENTRAL BANKS CAN'T LET THAT HAPPEN OR WE HAVE NO ECONOMY, LET ALONE A CREDIT SYSTEM.

We spoke later in the evening and said he had heard of another instance of a trade transaction failing, different parties entirely, this a shipment of coal, again due to the unwillingness of the seller's bank to accept an LC from the buyer.

Update 12:10 AM: Confirmation comes from the Financial Post, "Grain piles up in ports" (hat tip reader Vox Sanus):

The credit crisis is spilling over into the grain industry as international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.

Before cargoes can be loaded at port, buyers typically must produce proof they are good for the money. But more deals are falling through as sellers decide they don't trust the financial institution named in the buyer's letter of credit, analysts said.

"There's all kinds of stuff stacked up on docks right now that can't be shipped because people can't get letters of credit," said Bill Gary, president of Commodity Information Systems in Oklahoma City. "The problem is not demand, and it's not supply because we have plenty of supply. It's finding anyone who can come up with the credit to buy."

So far the problem is mostly being felt in U. S. and South American ports, but observers say it is only a matter of time before it hits Canada.

"We've got a nightmare in front of us and a lot of people are concerned it's going to get a lot worse," said Anthony Temple, a grain marketing expert based in Vancouver....

Access to credit is key to the survival of maritime trade and insiders now say the supply is being severely restricted. More than 90% of the world's trade by volume goes by ship...

"The credit crisis has made banks nervous and the last thing on their minds is making fresh loans," Omar Nokta, an analyst at investment bank Dahlman Rose, said in an interview with Reuters.

While shipping has always been a cyclical industry whose fortunes rise and fall with the global economy, analysts said the current crisis over the drying up of credit is something they have never seen before.

Jason Myers, head of the Canadian Manufacturers and Exporters, said exporters across Canada are getting caught up in the turmoil as customers delay payments, forcing them to shoulder the cost.

"What some companies are saying is we can't pay you until our customer pays us, so it becomes a question of who bears the financial risk and the cost," Mr. Myers said. "We're hearing about it more and more."

What that means is that manufacturers are getting hit as revenue slows and longtime customers disappear from the order book altogether. As profits decline, investment in product development starts to fall, too, he said.

The Canadian Wheat Board, one of the world's biggest grain marketers, has yet to refuse a customer because of poor credit, according to a spokeswoman. "As of this moment we haven't run into that problem," said Maureen Fitzhenry,

Doing the right thing?

Il semblerait finalement que, via une footnote, le plan Paulson ne soit pas l'énorme gâchis/scandale que son objectif principal (attaquer le problème par la partie "actifs" du bilan plutôt que par la partie "passif") laissait présager.
En cela, l'exemple de l'Angleterre (injecttions massives de capital via des actions préférentielles)semble avoir été salutaire (difficile de prévoir à ce stade ce qu'il en adviendra), mais le consensus qui émerge aujourd'hui est que la solution "suédoise" (recapitalisation et dilution des actionnaires existants, au prix d'une nationalisation aprtielle) est la seule solution

Doing the right thing?

via Paul Krugman de Paul Krugman le 09/10/08

A tentative cheer: Paulson may have been dragged kicking and screaming into doing the right thing to rescue the financial system: Having tried without success to unlock frozen credit markets, the Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system, according to government [...]

Should Deregulation be Blamed?

La réponse est oui, mais le débat n'en est pas moins vif. J'aime bien le raccourci de JKG

Should Deregulation be Blamed?

via Economist's View de Mark Thoma le 06/10/08

Sebastion Mallaby says deregulation is not the cause of the financial crisis. Jamie Galbraith would disagree (more direct disagreement here and here):

Goodbye, Conservatives. Hello, Predators, by James K. Galbraith: Back in the Reagan days, Republicans talked economics. We had problems; they had solutions. Tight money would cure inflation. Low taxes would stimulate saving and hard work. Small government would "crowd in" investment; free trade would make us efficient. Smart people believed this, and they had Milton Friedman to back them up. I never thought they were right-but they were serious. They were coherent. And they argued with passion and conviction, which commanded respect.

But now, real economic conservatives have disappeared from the Republican stage. ... Bush is a bread-and-circuses reactionary with a clientele of lobbies. McCain gets his economic ideas from Phil Gramm, the ultimate architect of the Enron culture, of libertine speculation and financial disaster. ... This crowd deregulates and privatizes not because they think it might work out for the public... What they care about is putting their friends in charge.

Under Bush, oil and gas, drug companies and defense contractors, insurers and usurers, banks and big media control the government of the United States. John McCain..., as chair of the Senate commerce committee,... presided over Lobby Central; notoriously, his campaign is run by lobbyists ... and until last week his policy could be summed up in slogans: he was a "free market" man, a "deregulator." ... Bush and McCain are the predator state writ large...

On the morning that Lehman Bros. and Merrill Lynch fell,... the ... Dow Jones average fell 504 points... As stocks crashed, suddenly people remembered that modern markets cannot exist without a cop on the beat. Every important market out there, from fresh food and safe drugs to autos and air travel to housing and health care, depends on government to maintain trust, and without it, none of them would survive. Without regulation, predators take over, and when they do, trust eventually collapses. Every important market is in peril now, precisely because of the predators in power these past eight years. And none more immediately than finance.

The Bush-Paulson bailout exposed the predator state in detail. Deregulation and desupervision were the origin of this crisis: the 1999 Gramm-Leach-Bliley Act repealing Glass-Steagall, and the Gramm-authored loophole legitimating credit default swaps in 2000. Bush's financial regulators brought chainsaws to press conferences, a clear signal to sub-prime hustlers that "anything goes." "Liar's loans," "neutron loans" and "toxic waste" became financial terms of art. ...

It seems unlikely that John McCain, the regulation-wrecker, will become, overnight, the man who would turn vice to virtue on Wall Street. But even suppose he were serious. Who would trust him? No one with money on the line.

This is McCain's deeper problem. If he is elected, under his leadership, trust cannot be restored. ... Restoring trust requires a government of trustworthy people. Team McCain doesn't have any, and some, especially Gramm, inspire the opposite. It wouldn't matter what their policies were or pretended to be. Nothing they attempted would work.

The ... choice in this election is well-defined. One party believes that the government serves no public purpose. The other believes that it must. One party has turned the government over to lobbies, to cronies and to big donors. The other is beginning to realize that a real government must be rebuilt. One party would keep the same crowd in office; the other would have to begin by clearing them out. No one can say there is no difference between the parties this year, and the basic issue in this election is really just as simple as that.

I thought the best part of Sebastian Mallaby's article came when he provided this link: "There's a vigorous argument about whether Calomiris's number is too high." As to his main argument, "that deregulation is the wrong scapegoat," I don't think it was deregulation of any particular sector that caused the problems we are having in credit markets, I think it was lack of effective regulation of the shadow banking sector in general (i.e. the regulations that did exist in the shadow banking sector were not directed at the right issues, thus, it's possible to believe, as I do, that some of the deregulation was warranted while still believing that needed regulation was missing). The shadow banking sector should be under the same regulatory umbrella that traditional banks are subject to, and extended the same sorts or privileges within the Federal Reserve system in return (deposit insurance of some type, and lender of last resort functions in return for regulatory restrictions). There is no guarantee this would have stopped the credit crisis from developing, but I don't think the conclusion we should draw from the present experience is that these markets weren't free enough. Hopefully, we can use what we've learned as the crisis has unfolded and also use what we've learned from regulating the traditional banking sector to devise a regulatory structure that will improve the stability of credit markets.

Skill-Based or Bubble-Based Wage Differentials?

La remise en cause de toutes les théories foireuses qui ont été ressassées ces dernières années pour justifier l'injustifiable a commencé. Exemple, le "high-skill wage differential"...

Skill-Based or Bubble-Based Wage Differentials?

via Economist's View de Mark Thoma le 07/10/08

Arindrajit Dube says there's a paper he wishes to write once the data become available:

Does Mispricing of Financial Assets lead to Mispricing of Human Capital?

Over the late twentieth century, the financial sector grew rapidly, and attracted higher skilled workers at an increasing rate. Existing work attributes this to growth in financial sector productivity, which raised the marginal product of higher skilled workers. In this paper, we investigate the role of mispricing of financial assets (from asset bubbles) in artificially increasing returns to skill in the economy in the context of a two sector general equilibrium model. A speculative bubble arises from heterogeneous beliefs due to overconfidence and short-sales constraints, and investors perceive an option to resell the stock to others with even greater valuations. If the financial sector is relatively more intensive in the use of skilled workers, this can lead to an inefficiently large portion of these workers going to finance, and an inefficiently high skill-wage differential. Using data from the United States over the 1980 to 2012 period, we show that (1) the growth in asset bubbles were particularly important in increasing the perceived marginal product of higher-skilled workers; and (2) with the sharp retrenchment of the financial sector following the 2008 financial crisis, perceived marginal products and wages of higher skilled workers fell substantially. Our evidence shows that a large part of the "skill biased technical change" identified by earlier researchers actually represents a mispricing of human capital due to inefficiencies in the financial market.