Monday, September 29, 2008

Ted Spread Not Coming Down

If this sucker does not come down soon, we will be having a financial Armageddon.

Ted spread (=LIBOR 3M - T-bill 3M) since 2004, click to enlarge.

Sunday, September 28, 2008

Thomas Friedman: Real Engineering vs. Financial Engineering

Thomas Friedman wrote on NYT that "we need to get back to making stuff, based on real engineering not just financial engineering".

Green the Bailout

Many things make me weep about the current economic crisis, but none more than this brief economic history: In the 19th century, America had a railroad boom, bubble and bust. Some people made money; many lost money. But even when that bubble burst, it left America with an infrastructure of railroads that made transcontinental travel and shipping dramatically easier and cheaper.

The late 20th century saw an Internet boom, bubble and bust. Some people made money; many people lost money, but that dot-com bubble left us with an Internet highway system that helped Microsoft, I.B.M. and Google to spearhead the I.T. revolution.

The early 21st century saw a boom, bubble and now a bust around financial services. But I fear all it will leave behind are a bunch of empty Florida condos that never should have been built, used private jets that the wealthy can no longer afford and dead derivative contracts that no one can understand.

Worse, we borrowed the money for this bubble from China, and now we have to pay it back — with interest and without any lasting benefit.

Yes, this bailout is necessary. This is a credit crisis, and credit crises involve a breakdown in confidence that leads to no one lending to anyone. You don't fool around with a credit crisis. You have to overwhelm it with capital. Unfortunately, some people who don't deserve it will be rescued. But, more importantly, those who had nothing to do with it will be spared devastation. You have to save the system.

But that is not the point of this column. The point is, we don't just need a bailout. We need a buildup. We need to get back to making stuff, based on real engineering not just financial engineering. We need to get back to a world where people are able to realize the American Dream — a house with a yard — because they have built something with their hands, not because they got a "liar loan" from an underregulated bank with no money down and nothing to pay for two years. The American Dream is an aspiration, not an entitlement.

When I need reminding of the real foundations of the American Dream, I talk to my Indian-American immigrant friends who have come here to start new companies — friends like K.R. Sridhar, the founder of Bloom Energy. He e-mailed me a pep talk in the midst of this financial crisis — a note about the difference between surviving and thriving.

"Infants and the elderly who are disabled obsess about survival," said Sridhar. "As a nation, if we just focus on survival, the demise of our leadership is imminent. We are thrivers. Thrivers are constantly looking for new opportunities to seize and lead and be No. 1." That is what America is about.

But we have lost focus on that. Our economy is like a car, added Sridhar, and the financial institutions are the transmission system that keeps the wheels turning and the car moving forward. Real production of goods that create absolute value and jobs, though, are the engine.

"I cannot help but ponder about how quickly we are ready to act on fixing the transmission, by pumping in almost one trillion dollars in a fortnight," said Sridhar. "On the other hand, the engine, which is slowly dying, is not even getting an oil change or a tuneup with the same urgency, let alone a trillion dollars to get ourselves a new engine. Just imagine what a trillion-dollar investment would return to the economy, including the 'transmission,' if we committed at that level to green jobs and technologies."

Indeed, when this bailout is over, we need the next president — this one is wasted — to launch an E.T., energy technology, revolution with the same urgency as this bailout. Otherwise, all we will have done is bought ourselves a respite, but not a future. The exciting thing about the energy technology revolution is that it spans the whole economy — from green-collar construction jobs to high-tech solar panel designing jobs. It could lift so many boats.

In a green economy, we would rely less on credit from foreigners "and more on creativity from Americans," argued Van Jones, president of Green for All, and author of the forthcoming "The Green Collar Economy." "It's time to stop borrowing and start building. America's No. 1 resource is not oil or mortgages. Our No. 1 resource is our people. Let's put people back to work — retrofitting and repowering America. ... You can't base a national economy on credit cards. But you can base it on solar panels, wind turbines, smart biofuels and a massive program to weatherize every building and home in America."

The Bush team says that if this bailout is done right, it should make the government money. Great. Let's hope so, and let's commit right now that any bailout profits will be invested in infrastructure — smart transmission grids or mass transit — for a green revolution. Let's "green the bailout," as Jones says, and help ensure that the American Dream doesn't ever shrink back to just that — a dream.

Eichengreen: Fed Groping In the Dark

Barry Eichengreen, one of the most respected economic historians, says the Fed is still groping in the dark and 10% unemployment rate is not out of question (source: VOX).

A couple of months ago at lunch with a respected Fed watcher, I asked, "What are the odds are that US unemployment will reach 10% before the crisis is over?" "Zero," he responded, in an admirable display of confidence. Watchers tending to internalise the outlook of the watched, I took this as reflecting opinion within the US central bank. We may have been in the throes of the most serious credit crisis since the Great Depression, but nothing resembling the Depression itself, when US unemployment topped out at 25%, was even remotely possible. The Fed and Treasury were on the case. US economic fundamentals were strong. Comparisons with the 1930s were overdrawn.

The events of the last week have shattered such complacency. The 3 month treasury yield has fallen to "virtual zero" for the first time since the flight to safety following the outbreak of World War II. The Ted Spread, the difference between borrowing for 3 months on the interbank market and holding three month treasuries, ballooned at one point to five full percentage points. Interbank lending is dead in its tracks. The entire US investment banking industry has been vaporised.

And we are in for more turbulence. The Paulson Plan, whatever its final form, will not bring this upheaval to an early end. The consequences are clearly spreading from Wall Street to Main Street. The recent performance of nonfinancial stocks indicates that investors are well aware of the fact.

So comparisons with the Great Depression, which have been of academic interest but little practical relevance, take on new salience. Which ones have content, and which are mainly useful for headline writers? 

First, the Fed now, like the Fed in the 1930s, is very much groping in the dark. Every financial crisis is different, and this one is no exception. It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros. could safely be allowed to fail. It did not adequately understand the repercussions for other institutions of allowing a primary dealer to go under. It failed to fully appreciate the implications for AIG's credit default swaps. It failed to understand that its own actions were bringing us to the brink of financial Armageddon.

If there is a defence, it has been offered Rick Mishkin, the former Fed governor, who has asserted that the current shock to the financial system is even more complex than that of the Great Depression. There is something to his point. In the 1930s the shock to the financial system came from the fall in the general price level by a third and the consequent collapse of economic activity. The solution was correspondingly straightforward. Stabilise the price level, as FDR did by pumping up the money supply, and it was possible to stabilise the economy, in turn righting the banking system.

Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself. There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933.

In addition, the progress of securitisation complicates the process of unravelling the current mess. In the 1930s the Federal Home Owners Loan Corporation bought individual mortgages to cleanse bank balance sheets and provide home owners with relief. This time the federal agency responsible for cleaning up the financial system will have to buy residential mortgage backed securities, collateralised debt obligations, and all manner of sliced, diced and repackaged paper. Strengthening bank balance sheets and providing homeowners with relief will be infinitely more complex. Achieving the transparency needed to restore confidence in the system will be immensely more difficult.

That said, we are not going to see 25% unemployment rates like those of the Great Depression. Then it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them. This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover's in 1930. Where last time it took the Congress three years to grasp the need to recapitalise the banking system and provide mortgage relief, this time it will take only perhaps half as long. Ben Bernanke, Hank Paulson and Barney Frank are all aware of that earlier history and anxious to avoid repeating it.  

And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analogue for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the US economy, notwithstanding the admirable flexibility of its labour markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10%.

Saturday, September 27, 2008

Fed Balance Sheet: then and now

I compare the most recent Fed balance sheet with the one in Feburary.  You will see a lot have changed.

(for all pictures below , please click to enlarge)

First, a review of the Fed balance sheet back in February (courtesy of Steve Cecchetti):

The Fed balance sheet now (as of Sept. 24, 2008, my own calculation):

Fed's balance sheet increased from $885 billion to $1,214 billion, a jump of 37%.  So far, we haven't seen much money-printing: the Fed reserve notes (the fiat money) just increased from $779 billion to $799 billion.  But the composition of Fed's asset holdings worsened, as highlighted in red.   The Fed put too much bank junks onto its balance sheet.

Below three extra graphs are taken out from Northern Trust research team, demonstrating the effect in a more dramatic fashion. 

Harvard Panel on Current Financial Crisis

Link to the webcast.

I also extracted Robert Merton, Greg Mankiw and Ken Rogoff's talk in texts below (source: Harvard Magazine, part I, part II):

McArthur University Professor Robert Merton, a 1997 Nobel laureate in economics for his work on options pricing and risk analysis, advanced the importance of "functional analysis of the financial system." (His experience with the system is both theoretical and actual; he was a principal in Long Term Capital Management, the extraordinarily leveraged investment firm whose collapse in 1998 nearly precipitated  a world financial crisis and necessitated a bailout negotiated by the Federal Reserve; see a review of books on that precursor of the current situation here).

Although current concerns focus on liquidity and the credit markets, Merton said, it was essential to note that as too-high housing prices deflated, perhaps $3 trillion to $4 trillion of actual wealth had been lost in the last year alone—and was unlikely to return. With each successive decline in the value of an asset held on a leveraged basis, he said, an owner's effective risk and effective leverage ramped up at an accelerating rate, underlining the destruction of the financial institutions that held the underlying failed mortgage loans and securities based on them. In addition, such deterioration prompts "feedback": for instance, banks and thrift institutions held Fannie Mae and Freddie Mac preferred stock as part of their presumably safest, most reliable capital; when the government took control of those institutions, the banks' and thrifts' capital absorbed immediate, large losses—instantly increasing their own leverage and decreasing their ability to make loans, worsening the underlying housing crisis.

Financial innovation and "engineering" are widely blamed for causing, or worsening, the current crisis, and in a sense, they have, Merton said. Innovations inherently involve the risk that some ideas will fail, and inherently outrun existing regulatory structures. But rather than clamping down so severely that financial innovation is choked off, he argued that regulation must allow for further, future innovation as an engine of growth, because the functional needs—consumers' need to finance their retirements, developing nations' ability to fund economic development—remain intact. Thus, he urged that the focus remain on the necessary financial functions, and not on saving any particular form of institution that currently meets those needs, or did until recently.

Jobs in finance, he told the anxious M.B.A.s, would be "tough" to come by. But the solution for society would not be to rid financial institutions of highly trained, innovation-oriented financial engineers. Rather, he insisted, management teams, boards of directors, and regulators needed much more such expertise in their own ranks so they could understand the products they were offering and acquiring—as they so apparently did not in the recent past.


Beren professor of economics N. Gregory Mankiw, who teaches the perennially popular Economics 10 introductory course and and is the author of the core introductory textbook in the field, said that "the basic problem facing the financial system is that lots of people made very big bets that housing prices could not fall 20 percent," despite evidence to the contrary in the Great Depression and more recently in Japan. The resulting losses wouldn't matter in classical economic theory, he said—taking risk entails absorbing loss—except that the simultaneous large bets undercut much of the financial system all at once, and that system, as readers of his textbook know, is vital for the economy as a whole. Federal Reserve chairman Ben S. Bernanke '75 (access his June Commencement address here) focused on just this problem in his examination of the role of bank failures in worsening the Great Depression, Mankiw noted.

How should one view the proposed $700-billion federal financing initiative, Mankiw asked. One theory, advanced by President George W. Bush the night before, was that financial institutions' damaged assets have value greater than their current price, and only the federal government has the resources to buy and hold them to maturity. Wall Street economists, Mankiw said, like that interpretation. Their (tenured) academic counterparts are skeptical: the Treasury, they say, will overpay, thus bailing out failed managers who don't deserve it; and/or the funds will be insufficient to recapitalize banks, given the real magnitude of the losses they face.

Academic economists' alternatives are three: let the market handle the situation (as hedge funds and private-equity funds step forward where they see attractive opportunities to invest fresh capital); have the government somehow take equity positions in troubled banks and other institutions, directly infusing them with capital but benefiting as they recover (much as investor Warren Buffett put $5 billion into Goldman Sachs, with the right to invest $5 billion more on favorable terms); or force banks to raise capital, no matter what (in the friendly manner, Mankiw suggested, of a Mafia enforcer dropping by for a chat with management).

As for the presidential candidates, Mankiw said, Barack Obama, J.D. '91, seemed to be saying that the market had run wild, inflicting on the public the downside of unfettered capitalism. Recalling his service from 2003 to 2005 as chair of the president's Council of Economic Advisers, Mankiw said that he had tried to rein in the government-sponsored Fannie Mae and Freddie Mac. Predecessors in the Clinton administration, he said, found the task impossible, too. This was a known "time bomb," he said, not a market problem. Nor was it simply a problem of lax underwriting standards for loans.

Of John McCain's emphasis on Wall Street "greed" and "corruption," Mankiw said, there was scant evidence that corruption was the problem. Many people made ill-advised bets, he said, but that was not criminal. And he suspected that greed would be a factor in the markets that any future administration would encounter.


Cabot professor of public policy Kenneth Rogoff, former chief economist and director of research for the International Monetary Fund, tried to put the "truly incredible" recent developments in some larger context.

The financial sector of the economy, he said, had become "bloated"—accounting for 7 to 8 percent of jobs (including insurance employees), but capturing 10 percent of wages and 30 percent of profits. Such evidently huge returns naturally attracted torrents of new investment, making the financial sector as a whole a bubble: "It is too big, it is not sustainable, it has to shrink" even beyond its already depleting ranks. The problem, he said, is not merely bad debts held by institutions, but "bad banks" themselves: the whole sector of financial enterprises begs to be restructured. (Rogoff noted that he had for several months forecast the collapse of at least one large investment bank, but even he was surprised at the near-collapse of nearly all the principal investment banks virtually overnight.)

Much as auto makers or steel companies in the past argued that they were basic to the economy and therefore required federal support, he said, today the "country is being ransomed by the financial sector" in the demand for the $700-billion bailout, which would have the effect of maintaining management salaries, bidding up the prices of stock and bond holdings in their companies' portfolios, and so on. Today, unlike during the Great Depression, Rogoff argued, the shrinkage of such institutions would be "not unproductive" for the economy as a whole. (As an aside, he noted that all those Harvard students who marched off to investment banking "will be freed to go into other activities.") Given the difficulties of conducting auctions to buy distressed assets with the government's largess without letting excess funds leak back into the financial sector, Rogoff was sympathetic with Warren's argument for focusing on the needs of homeowners.

In international perspective, he said, the United States "has been running spectacular deficits" for 15 years or more. The availability of foreign funds has enabled the country to keep interest rates low—maintaining abundant liquidity—but has exposed the fragility of the system if federal budget deficits balloon. In the present instance, he said, the issue becomes a question of whether Beijing wishes to lend the United States $700 billion to repair American financial institutions. Americans aren't immediately going to be the source of those funds, he noted: "We're supposed to keep consuming." In other words, the country is saying, "We borrowed too much, we screwed up, so we're going to fix it by borrowing more."

He said a better strategy was required—but not at the expense of excessive regulation that would choke off innovation, one of the few flagships of American economic growth and strength in recent decades (a point also made by Merton at HBS on September 23, and again after Rogoff's presentation). After the bust of 2000-2001, Rogoff said, the technology sector regained its footing. Today, it is equally important not to overreact, so that a dynamic financial sector, corrected by "tough love," can resume its proper and important role in the economy and in future growth.

Friday, September 26, 2008

Get the auction right!

Laurence Ausubel and Peter Cramton, two Maryland economists specializing in auction theory, take on the reverse auction in Paulson's plan. and propose their own solutions (source: Economist Voice):

Thee Treasury proposes to invest $700 billion in mortgage-related securities to resolve the financial crisis, using market mechanisms such as reverse auctions to determine prices. A well-designed auction process can indeed be an effective tool for acquiring distressed assets at minimum cost to the taxpayer. However, a simplistic process could lead to higher cost and fewer securities purchased. It is critical for the auction process to be designed carefully.

The immediate crisis is one of illiquidity.  Banks hold a variety of mortgage-backed securities, some almost worthless while other retain considerable value. None can be sold, except at fire-sale prices. The Treasury proposes to restore liquidity by stepping in and purchasing these securities. But at what price?

A simple approach leads to overpayment

A simple but naïve approach would be to invite the holders of all mortgage-related securities to bid in a single reverse auction.  The Treasury sets an overall quantity of securities to be purchased. The auctioneer starts at a price of nearly 100 cents on the dollar. All holders of illiquid securities would presumably be happy to sell at nearly face value, so there would be excess supply. The auctioneer then progressively lowers the price—90 cents, 80 cents, etc.—and bidders indicate the securities that they are willing to sell at each lower price. Eventually, a price, perhaps 30 cents, is reached at which supply equals demand. The Treasury buys the securities offered at the clearing pricing, paying 30 cents on the dollar.

This simplistic approach is fatally flawed.  The Treasury pays 30 cents on the dollar, purchasing all mortgage-related securities worth less than 30 cents on the dollar. Perhaps, on average, the purchased securities are worth 15 cents on the dollar. The Treasury buys only the worst of the worst, intervening in a way that rewards the least deserving. And, as a result of overpaying drastically, the Treasury can mop up relatively few distressed securities with its limited budget.

In the simplistic approach, competition among different securities overshadows competition within securities and among bidders.  The auction merely identifies which securities are least valuable, rather than determining the securities' value. An auction that determines a real price for a given security needs to require multiple holders of the security to compete with one another. This can be achieved if the Treasury purchases only some, not all, of any given security.


A better approach

Thus, a better approach would be for the Treasury to instead conduct a separate auction for each security and limit itself to buying perhaps 50% of the aggregate face value. Again, the auction starts at a high price and works its way down. If the security clears at 30 cents on the dollar, this means that the holders value it at 30 cents on the dollar. (If the value were only 15 cents, then most holders would supply 100% of their securities to be purchased at 30 cents, and the price would be pushed lower.) The auction then works as intended. The price is reasonably close to value. The "winners" are the bidders who value the asset the least and value liquidity the most.

This auction has an important additional benefit. The "losers" are not left high and dry.  By determining the market clearing price, the auction increases liquidity for the remaining 50% of face value, as well as for related securities.  The auction has effectively aggregated market information about the security's value. This price information is the essential ingredient needed to restore the secondary market for mortgage backed securities.

Handling many securities is a straightforward extension. Different but related securities can be grouped together in the same auction and purchased simultaneously. Each security has its own price. The bidders indicate the quantity of each security they would like to sell at the specified prices. The price is reduced for any security with excess supply and the process repeats until a clearing price is found for each security.  Auctioning many related securities simultaneously gives the bidders some flexibility to adjust positions as the market gradually clears.  This improves price formation and enables bidders to better manage their liquidity needs. As a result, efficiency improves and taxpayer costs are further reduced.

For this auction design to work well, there needs to be sufficient competition. This should not be a problem for securities with diffuse ownership.  For securities with more concentrated ownership, various approaches are possible.  The Treasury could buy a smaller percentage of the face value. Alternatively, the Treasury could purchase the securities with the explicit understanding that the securities would be sold by auction some months or years in the future, after the liquidity crisis is over. To the extent that the securities are sold at a lower price, the holder would contractually owe the Treasury the difference, plus interest.

One sensible approach for the sequencing of auctions is to start with the best of the worst; that is, begin the auctioning with a group of securities that are among the least toxic. These will be easier for bidders to assess, and the auction can proceed more quickly. Then, subsequent auctions can move on to the increasingly problematic securities. In this way, the information revealed in the earlier auctions will facilitate the later auctions.

The basic auction approach suggested here is neither new nor untested. It was introduced over the last ten years and has been used successfully in many countries to auction tens of billions of dollars in electricity and gas contracts.  It is quite similar to the approach that has been used to auction more than $100 billion in mobile telephone spectrum worldwide.  It is a dynamic version of the approach that financial markets use for share repurchases.  If implemented correctly, each auction can be completed in less than one day.

Thus, the auction approach meets the three main requirements of the rescue plan:

1)   provide a quick and effective means for the Treasury to purchase mortgage-related assets and increase liquidity;

2) yield prices that are closely related to value; and

3) provide a transparent rules-based mechanism that treats different security holders consistently and leaves minimal scope for discretion or favoritism. 

Indeed, the second and third requirements may be decisive for obtaining broad political support. The main alternative to auctions put forward by the Treasury is to employ professional asset managers. To the extent that negotiations or other individualized trading arrangements are used, the public will be rightfully wary that favoritism may be exerted and that some security holders will be offered sweetheart deals. By contrast, a transparent auction process is readily subjected to oversight.  The Treasury appears to be embarking on the greatest public intervention into financial markets since the Great Depression. The ultimate success or failure of the intervention may depend on the fine details of the auction design. Let's get it right.

Thursday, September 25, 2008

Roach on Chinese Economy and Paulson's Rescue Plan

Stephen Roach, Chairman of Morgan Stanley Asia, talks about his assessment on the current condition of Chinese economy. (courtesy of Bloomberg).

Note: This is an audio clip about 20 mins.

Wednesday, September 24, 2008

Why Investment Bank Model Failed

This presentation, from Princeton economist Markus Brunnermeier, explains why investment bank model is so easy to fail during crisis and what should be done in the future. 

Buffet: Government $700 billion bailout could make money

CNBC interview on Warren Buffet right after his investment in Goldman Sachs.

(click to play)

Monday, September 22, 2008

Pimco's Mohamed El-Erian on the markets

El-Erian talks about implications of government plan, and the new banking model on Wall Street.

On government regulation:

Contrasting views on the dollar

Two contrasting views on dollar in lieu of last week's financial turmoil and government huge bailout plan.
First piece is from Ken Rogoff (source: FT), professor of economics at Harvard University and former chief economist of the International Monetary Fund.

America will need a $1,000bn bail-out

By Kenneth Rogoff

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America's flagship financial sector, the public and private sector's massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan's debt levels. It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday's $85bn bail-out of the insurance giant AIG.

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.

True, the US Treasury and the Federal Reserve have done an admirable job over the past week in forcing the private sector to bear a share of the burden. By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury's most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.

It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.

Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.

It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.

Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America's ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.


The second piece is from Morgan Stanley Currency Research team:
Nationalisation ≠ Currency Weakness
September 19, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

Conventional wisdom has it that, as a government fiscalises the contingent liabilities of nationalised banks, the currency of the country in question should depreciate.  More generally, banking crises are, very often, accompanied by balance of payments (or currency) crises.  The US, being a country with still out-sized 'twin deficits' (fiscal and external deficits), will likely see the dollar weaken because of the Treasury and the Fed's decision to effectively nationalise some of the large financial institutions, so the argument goes.  An inconvenient fact, however, is that nationalisation of banks, historically, did not tend to lead to further currency weakness.  In fact, very often the financial sector and the currency in question reach a trough just as the government takes steps to address the banking crisis.  Thus, currency weakness tends to precede, not follow nationalisation. 

Popular Thesis on Nationalisation and the Dollar

The notion that nationalisation of banks should lead to currency weakness is popular mainly because it is intuitive.  Since nationalisation of banks is 'not good news', and runs counter to the principles of capitalism and the free market, some have the visceral reaction to sell the currency in question. 

Further, as highlighted by Kaminsky and Reinhart (K&R) (see Graciela Kaminsky and Carmen Reinhart (1999), "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems", The American Economic Review 89: 3, June), there are many historical examples of 'twin crises', whereby banking crises and currency crises occurred simultaneously.  The more memorable examples include Argentina in the early 1980s, Sweden and Norway in the early 1990s, Japan in the late 1990s and Thailand in the late 1990s.  In fact, K&R found that, during 1980-1995, of the 23 banking crises, 18 were accompanied by balance-of-payments crises. 

This link between banking crises and currency crises is genuine, and the usual dynamics are well-summarised by ex-Governor of the Riksbank (Sweden's central bank) Mr. Bäckström (see What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience, Kansas City Fed Seminar in Jackson Hole, August 1997): "Credit market deregulation in 1985 … meant that the monetary conditions became more expansionary.  This coincided, moreover, with rising activity, relatively high inflation expectations, … (T)he freer credit market led to a rapidly growing stock of debt… The credit boom coincided with rising share and real estate prices… The expansion of credit was also associated with increased real economic demand.  Private financial savings dropped by as much as 7 percentage points of GDP and turned negative.  The economy became overheated and inflation accelerated.  Sizeable C/A deficits, accompanied by large outflows of … capital, led to a growing stock of private sector short-term debt in foreign currency".  This description applies quite well to the US right now.

Moreover, nationalisation of banks will increase the fiscal burden of the government.  For a country that already has a large fiscal deficit, this is clearly negative for the interest rate outlook.  For one that also has an external deficit, a large public borrowing need, ceteris paribus, should translate into a weaker currency, so the logic goes.  At the same time, the central bank may be tempted to 'monetise' the debt, or run a monetary stance that is easier than otherwise – again currency-negative.

The Inconvenient Historical Fact

While the arguments above may sound logical and compelling to many, the inconvenient fact is that the historical pattern of how currencies perform before and after nationalisation or bail-outs tells a very different story.  Averaged across five episodes of prominent banking crises, the nominal exchange rate tended to fall before nationalisation, but rise thereafter.  

The historical pattern suggests that financial markets tend to be forward-looking and try to price in the deterioration in the state of the banking system by selling down the currency and financial sector stocks, but the government is usually not compelled to act until conditions deteriorate significantly.  As a result, more often than not, government interventions have coincided with the lows in currency values.  In other words, even though K&R's observation that currency crises often occur simultaneously with banking crises is correct, there is no strong proof that nationalisation leads to further currency weakness. 

Other more visible examples are consistent with this link between banking crises and currency crises. The S&L Crisis and its bail-out spanned a protracted period of time.  The dollar index did continue to fall from 1986 – the beginning of the S&L Crisis – until 1989 or so.   (In 1986, the FSLIC (Federal Savings and Loan Insurance Corporation) – the deposit insurance scheme funded by the thrift industry but guaranteed by the government – first reported being insolvent (incidentally, the main reason why 1986 is remembered as the beginning of the S&L Crisis).  The RTC (Resolution Trust Corporation) was established in 1989, and by 2003, the RTC had 'resolved' US$394 billion worth of non-performing assets of US savings and loans.   (The total cost of the clean-up of the US S&L Crisis reached US$153 billion, in 'current' terms equivalent to some 2.6% of US GDP in 1991.  This translates to US$375 billion in 2008 dollar terms.)  The dollar index essentially moved sideways in the early 1990s.  The dollar did falter in 1994/95, but that was attributed more to the inflation scare than to the S&L Crisis.  Similarly, Japan's government did not explicitly address its banking crisis until 1998-99 and again in 2002-03.  After each episode, USD/JPY actually collapsed toward 100, i.e., JPY strengthened in the ensuing quarters.  Finally, in the case of Thailand, the banking crisis did indeed lead the currency crisis.  But bank bail-outs did not take place until 1998, and USD/THB drifted in the 36-42 range between 1998 and 2000 – significantly below the peak of 56 reached in January 1998. 

The case of the US at present is also illustrative.  Between the onset of the credit crisis in August 2007 and the collapse of Bear Stearns on March 16, 2008, EUR/USD rose from 1.35 to 1.58, and lingered around the latter level as the Fed and Treasury assisted other financial institutions in the subsequent months.  Since July, EUR/USD has collapsed from 1.60 to a low of 1.39 last week.  Even with recent dramatic events, there is no evidence that 'nationalisation = currency weakness'.  If anything, the dollar has held up remarkably well this week, despite several dollar-negative factors, including: (i) a higher probability of the Fed cutting the FFR than the ECB reducing the refi rate; (ii) a diluted Fed balance sheet, from the substitution of US Treasuries for other lower-rated securities; and (iii) large increases in the future fiscal burden of the US, from the contingent liabilities that are fiscalised.  In fact, the only dollar-positive factor this past week was lower oil prices.  EUR/USD seems to be drifting back toward 1.45, but we see this move as rather innocuous, given the severity of the financial stress in the US. 

In sum, banking crises are unambiguously bad for currencies, but nationalisation per se does not make the situation worse for currencies.  In fact, it often marks the low in the currencies. 

The US Fiscal Worries Over the Medium Term

Having said the above, the US does have quite a worrisome fiscal outlook in the years ahead, which may eventually have an impact on the dollar.  Setting aside the issue of the fiscal burden associated with the assistance the official sector has provided the financial sector, US expenditures may be too high and revenue buoyancy may be undermined by the weak equity and property markets. 

The Congressional Budget Office (CBO) released its budget update last week, and predicted that the US federal deficit will rise from US$161 billion (1.2% of GDP) in 2007 to US$407 billion (2.9%) in 2008.  This sharp deterioration in the fiscal balance reflects a simultaneous increase in spending and a decline in tax revenues.  (Total government spending will increase by US$226 billion, to close to US$3.0 trillion, reflecting both discretionary and mandatory spending.)    The CBO forecasts that deficits will remain above US$400 billion in each of the next two years. 

Investors will likely see it as key for the next Administration to control spending.  However, it is also important for investors to appreciate how sensitive US revenue collection is to GDP.  During 2001-02, for example, as the US economy fell into a brief recession, revenue collection plummeted from 21% of GDP to close to 16%.  Thus, the strength of the US economic recovery in the coming years will have important implications for the overall budget position.  These fundamental trends in revenue collection and 'core' spending are at least as important as the costs associated with nationalisation.  The performance of the dollar in the coming years will, therefore, be a function of how the US government deals with spending and how rapidly the US economy recovers, in our view. 

Bottom Line

Banking crises are bad for currencies, but nationalisation per se does not necessarily make it worse for currencies.  In fact, it often marks the low in the currencies.   We believe this is the case for the dollar in the current episode.  What remains a lingering risk for the dollar over the medium term is the US fiscal position, unrelated to the costs of nationalisation.

Sunday, September 21, 2008

Gary Becker: Government intervention justified

Gary Becker reluctantly concluded that government interventions last week were justified.

The Crisis of Global Capitalism?

On Sunday of this past week Merrill Lynch agreed to sell itself to Bank America, on Monday Lehman Brothers, a venerable major Wall Street investment bank, went into the largest bankruptcy in American history, while Tuesday saw the federal government partial takeover of AIG insurance company, one of the largest business insurers in the world. Instead of calming financial markets, these moves helped precipitate a complete collapse on Wednesday and Thursday of the market for short-term capital. It became virtually impossible to borrow money, and carrying costs shot through the roof. The Libor, or London interbank, lending rate sharply increased, as banks worldwide were reluctant to lend money. The rate on American treasury bills, and on short-term interest rates in Japan, even became negative for a while, as investors desperately looked for a safe haven in short term government bills.

The Treasury" extended deposit insurance to money market funds-without the $100,000 limit on deposit insurance. The Fed also began to take lower grade commercial paper as collateral for loans to investment and commercial banks, and the Treasury encouraged Fannie Mae and Freddie Mac to continue to purchase mortgage backed securities.

Is this the final "Crisis of Global Capitalism"- to borrow the title of a book by George Soros written shortly after the Asian financial crisis of 1997-98? The crisis that kills capitalism has been said to happen during every major recession and financial crisis ever since Karl Marx prophesized the collapse of capitalism in the middle of the 19th century. Although I admit to having greatly underestimated the severity of this financial crisis, I am confident that sizable world economic growth will resume under a mainly capitalist world economy. Consider, for example, that in the decade after Soros' and others predictions of the collapse of global capitalism following the Asian crisis in the 1990s, both world GDP and world trade experienced unprecedented growth. The South Korean economy, for example, was pummeled during that crisis, but has had significant economic growth ever since. I expect robust world economic growth to resume once we are over the current severe financial difficulties.

Was the extent of the Treasury's and Fed's involvement in financial markets during the past several weeks justified? Certainly there was a widespread belief during this week among both government officials and participants in financial markets that short-term capital markets completely broke down. Not only Lehman, but also Goldman Sachs, Stanley Morgan, and other banks were also in serious trouble. Despite my deep concerns about having so much greater government control over financial transactions, I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy into a major depression.

Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments. Although the media has amde much of this possibility through headlines like "$750 billion bailout", that magnitude of loss is highly unlikely as long as the economy does not fall into a sustained major depression. I consider such a depression highly unlikely. Indeed, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many saving and loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, there may be a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvements were wise, but the likely losses to taxpayers are being greatly exaggerated.

Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.

The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.

Various other mistakes were made in government actions in financial markets during the past several weeks. Banning short sales during this week is an example of a perennial approach to difficulties in financial markets and elsewhere; namely, "shoot the messenger". Short sales did not cause the crisis, but reflect beliefs about how long the slide will continue. Trying to prevent these beliefs from being expressed suppresses useful information, and also creates serious problems for many hedge funds that use short sales to hedge other risks. Their ban can also cause greater panic in other markets.

Potential political risks of these actions are also looming. The two Freddies should before long be either closed down, or made completely private with no governmental insurance protection of their lending activities. Their heavy involvement in the mortgage backed securities markets were one cause of the excessive financing of home mortgages. I fear, however, that Congress will eventually recreate these companies in more or less their old form, with a mission to continue to artificially expand the market for mortgages.

New regulations of financial transactions are a certainty, but whether overall they will help rather than hinder the functioning of capital markets is far from clear. For example, Professor Shimizu of Hitotsubashi University has recently shown that the Bank of International Settlement (BIS) regulation on the required minimum ratio of bank capital to their assets was completely misleading in predicting which Japanese banks got into trouble during that country's financial crisis of the 1990s. Other misguided regulations, such as permanent restrictions on short sales, or discouragement of securitization of assets, will both reduce the efficiency of financial markets in the United States, and they will shift even larger amounts of financial transactions to London, Shanghai, Tokyo, Dubai, and other financial centers.

Finally, the magnitude of this crisis must be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25 percent unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. American GDP so far during this crisis has essentially not yet fallen, and unemployment has reached only about 61/2 percent. Both figures are likely to get considerably worse, but they will nowhere approach those of the 1930s.

These are exciting and troubling economic times for an economist-the general public can use less of both! Financial markets have been seriously wounded, and derivatives and other modern financial instruments have come under a dark cloud of suspicion. That suspicion is somewhat deserved since even major players in financial markets did not really understand what they were doing. Still, these instruments have usually been enormously valuable in lubricating asset markets, in furthering economic growth, and in creating economic value. Reforms may well be necessary, but we should be careful not to throttle the legitimate functions of these powerful instruments of modern finance.


A Professor and A Banker Changed American Capitalism

NYT reports how the rescue plan's main initiators, Bernanke and Paulson, came to the decision that will dramatically change American capitalism as we knew it.

Wednesday, September 17, 2008

TED Spread Spike

Ted spread reached its highest level since the crisis started summer 2007.

(courtesy of macroblog)

Monday, September 15, 2008

Rent Control in New York City

All price controls, including rent control, suppress the market mechanism and are prone to corruption (from WSJ):

Rent Control Is the Real New York Scandal


This week Charlie Rangel -- the New York Democrat and powerful chairman of the House Ways and Means Committee -- gave a news conference in Washington where he admitted failing to report on his taxes $75,000 in rental income from a villa he owns in the Dominican Republic.

[Cross Country]1

Just a few months ago Mr. Rangel admitted that he occupies four rent-stabilized apartments in a posh New York City building. It turns out that in a city with a very tight housing market, Mr. Rangel has wrangled himself a pretty good deal, thanks to rent-control laws that are ostensibly aimed at helping the poor and middle class.

But don't cluck too loudly at Mr. Rangel alone. Lots of well-connected New Yorkers have good deals.

New York City has had rent control laws since 1947, on grounds that they were necessary to protect people from rising rents. New York State expanded the regime in 1969, creating a rent stabilization program to cover apartments built after 1947 and before 1974 -- allowable rent increases are set by the City's Rent Guidelines Board.

The restrictions were loosened somewhat in 1971 and again in 1997 because of the realization that the system was benefiting wealthy renters. Under today's rules, landlords can move apartments renting for more than $2,000 a month with occupants making more than $175,000 a year onto the free market.

Today, there are 43,317 apartments where tenants (or their heirs) pay rents first frozen in 1947. There are another 1,043,677 units covered by rent stabilization. All told, about 70% of the city's rental apartments are either rent controlled or rent stabilized. And because the system has been in place for more than six decades, many residents see their below-market rents as an entitlement.

The regime has also incentivized builders to put up more luxury units -- a result met with policy gimmicks such as tax incentives for builders of affordable housing and landlords who keep units in rent stabilization.

This is the world in which Mr. Rangel lives. He uses three adjacent rent-stabilized apartments in Harlem's Lenox Terrace as his "primary" residence. He has a fourth apartment that he has used as an office and which he is giving up. He pays a total of $3,864 a month in rent, which is less than what he would pay for the same apartments on the open market.

His defense, that "They didn't give me anything. I'm paying the highest legal rent I can," is actually true. And that's precisely the problem. Rent control and rent stabilization have increasingly become a tool of the well-heeled and the well-connected. New York Gov. David Paterson, for example, also keeps a rent-stabilized apartment in the Lenox.

According to the New York City Rent Guidelines Board annual report, "Housing NYC: Rents, Markets and Trends," across the city there are 87,358 New York households reporting income of more than $100,000 a year which pay below-market rent thanks to the city's rent control and stabilization laws. A full 35% of all the city's apartments covered by the rent control regimes are rented by tenants who make more than $50,000 a year.

This system is destructive to the city's housing stock, because landlords who own rent-controlled apartments have less incentive to pay for repairs and upkeep. It also warps the housing market, and forces many new arrivals to occupy the least desirable apartments.

New York has a city-wide vacancy rate of just 3% -- and when good rent-stabilized apartments come on the market, you have to either know someone or pay someone (a broker, for example) to get it.

The result is that many renters who pay below-market rents are reluctant to move -- because it's too difficult to get as good a deal elsewhere in the city. Thus, economists Ed Glaeser and Erzo Luttmer estimate that 21% of the city's renters live in apartments that are bigger or smaller than they would otherwise occupy. The controlled rents certainly don't increase the number of affordable apartments.

Of course, to deal with the shortage of cheap apartments, lawmakers nearly always seem to favor more subsidized housing. Mayor Michael Bloomberg is now pushing a $7.5 billion Affordable Housing Plan that offers tax-exempt debt to anyone who builds "affordable housing." And he wants to expand the number of people who qualify for such units by including families earning up to $75,000 a year.

The Manhattan Institute's Nicole Gelinas points out that this will add 5.7 million New Yorkers to the eligibility lists, making it harder still to win the apartment lottery in New York.

There is a better way to address the lack of reasonably priced housing in the city. If Rep. Rangel, Gov. Paterson and all the other well-to-do New Yorkers lost their rent-controlled or rent-stabilized apartments, there would be a loud public outcry to loosen regulation and allow more new construction.

Ms. Norcross is a senior fellow at the Mercatus Center at George Mason University.

American Financial System, Shaken to Its Core

Lehman faltered, Merrill sold, American financial system was shaken to its core. Given what have already happened, what will happen next?  Can the financial system resuscitate itself, or more government bailouts to come?  What are the implications for the global financial infrastructure?  Time to think the unthinkables.
reports from NYT, WSJ.

China Cut Interest Rate

Facing global economic slowdown, and August's inflation falling to 4.9%, China's central bank cut its interest rate first time in six years (from wsj).

Sunday, September 14, 2008

Redefining Recession

Economist Magazine asks you to reconsider how to define recession. They think the current "two-quarter" rule is flawed.

A new yardstick for measuring slumps is long overdue

THERE has been a nasty outbreak of R-worditis. Newspapers are full of stories about which of the big economies will be first to dip into recession as a result of the credit crunch. The answer depends largely on what you mean by "recession". Most economists assume that it implies a fall in real GDP. But this has created a lot of confusion: the standard definition of recession needs rethinking.

In the second quarter of this year, America's GDP rose at a surprisingly robust annualised rate of 3.3%, while output in the euro area and Japan fell, and Britain's was flat. Many economists reckon that both Japan and the euro area could see a second quarter of decline in the three months to September. This, according to a widely used rule of thumb, would put them in recession, a fate which America has so far avoided. But on measures other than GDP, America has been the economic laggard over the past year.

The chart looks at several different ways to judge the severity of the economic slowdown since the start of the credit crunch in August 2007. On GDP growth, America has outperformed Europe and Japan. Unemployment, however, tells a very different tale. America's jobless rate hit 6.1% in August, up from 4.7% a year earlier, and within spitting distance of its peak of 6.3% during the previous recession after the dotcom bust. Other countries have so far published figures only for July, but their jobless rates have barely moved over the past year: Japan's has risen by only 0.2%, the euro area's has fallen slightly (though in absolute terms it is still a bit higher than America's). Another yardstick, GDP per head, takes account of the fact that America's population is rising rapidly, whereas Japan's has started to shrink. Since the third quarter of 2007 America's average income per person has barely increased; Japan's has enjoyed the biggest gain.


To the average person, a large rise in unemployment means a recession. By contrast, the economists' rule that a recession is defined by two consecutive quarters of falling GDP is silly. If an economy grows by 2% in one quarter and then contracts by 0.5% in each of the next two quarters, it is deemed to be in recession. But if GDP contracts by 2% in one quarter, rises by 0.5% in the next, then falls by 2% in the third, it escapes, even though the economy is obviously weaker. In fact, America's GDP did not decline for two consecutive quarters during the 2001 recession.

However, it is not just the "two-quarter" rule that is flawed; GDP figures themselves can be misleading. The first problem is that they are subject to large revisions. An analysis by Kevin Daly, an economist at Goldman Sachs, finds that since 1999, America's quarterly GDP growth has on average been revised down by an annualised 0.4 percentage points between the first and final estimates. In contrast, figures in the euro area and Britain have been revised up by an average of 0.5 percentage points. Indeed, there is good reason to believe that America's recent growth will be revised down. An alternative measure, gross domestic income (GDI), should, in theory, be identical to GDP. Yet real GDI has risen by a mere 0.1% since the third quarter of 2007, well below the 1% gain in GDP. A study by economists at the Federal Reserve found that GDI is often more reliable than GDP in spotting the start of a recession.

These are good reasons not to place too much weight on GDP in trying to spot recessions or when comparing slowdowns across economies. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), America's official arbiter of recessions, instead makes its judgments based on monthly data for industrial production, employment, real income, and wholesale and retail trade. It has not yet decided whether a recession has begun. But even the NBER's more sophisticated approach is too simplistic in that it defines a recession as an absolute decline in economic activity. This can cause problems when trying to compare the depth of downturns in different cycles or across different countries. Suppose country A has a long-term potential (trend) growth rate of 3% and country B one of only 1.5%, due to slower labour-force growth. Annual GDP growth of 2% will cause unemployment to rise in country A (making it feel like a recession), but to fall in country B. Likewise, if faster productivity growth pushes up a country's trend rate of growth, as it has in America since the mid-1990s, an economic downturn is less likely to cause an absolute drop in output.

This suggests that it makes more sense to define a recession as a period when growth falls significantly below its potential rate. The IMF estimates that America and Britain have faster trend growth rates than Japan or the euro area. The bottom-right chart shows that since the third quarter of last year, growth has been below trend in all four economies, but Britain, closely followed by America, has seen the biggest drop relative to potential.

But even if this is a better definition of recession, potential growth rates are devilishly hard to measure and revisions to GDP statistics are still a problem. One solution is to pay much more attention to unemployment numbers, which, though not perfect, are generally not subject to revision and are more timely. A rise in unemployment is a good signal that growth has fallen below potential. Better still, it matches the definition of recession that ordinary people use. During the past half-century, whenever America's unemployment rate has risen by half a percentage point or more the NBER has later (often much later) declared it a recession. European firms are slower at shedding jobs, so unemployment may be a lagging indicator. Even so, the jobless rate has usually started to rise a few months after the start of a recession.

As the old joke goes: when your neighbour loses his job, it is called an economic slowdown. When you lose your job, it is a recession. But when an economist loses his job, it becomes a depression. Economists who ignore the recent rise in unemployment deserve to lose their jobs.

Saturday, September 13, 2008

Charlie Rose with Bob Rubin and Larry Summers

Charlie worked out some really in-depth interviews lately.  This time is with former Clinton Administration Treasury Secretaries Robert Rubin and Larry Summers. The topic is financial crisis and the outlook.  Watch the interview here.

Thursday, September 11, 2008

Outlook for China's Banks

WSJ analyzes the outlook of China's big banks.  A related research on the financial repression in China by N. Lardy of Peterson Inst.

China's Banks Face Hurdles


Benefiting from rip-roaring economic growth and solid loan demand, China's banks have been the envy of their peers the world over. Now that economic growth has moderated, their outsize performance will be hard to sustain.

First-half profits at the nation's top four listed banks -- Bank of China, Industrial & Commercial Bank of China, Bank of Communications and China Construction Bank -- grew between 38% and 81%. Net interest margins continued to widen, and bad loan levels fell.

Nonperforming loans fell to 6.1% of outstanding loans at major Chinese banks by June's end, compared with 6.7% at the close of 2007, according to the country's banking regulator. In 2002, just before Beijing's last bank bailout, nonperforming loan levels were over 20%.

[Chinese banks]

Of course, that's history.

China's economic growth rate is slipping, taking corporate performance with it. Overall profit growth for 1,619 mainland-listed companies rose 16% in the first half, compared with a 49% rise in 2007, according to JPMorgan figures.

Evidence of a slowdown in the property sector has some worried. Real estate sales were down 20% on the year in July, for example.

As growth slows, the banks' outlook will depend largely on how disciplined they've been about managing credit risk. This hasn't been tested since the government's 2003 bad-loan bailout.

Loan growth since then -- of more than 13% in each of the last two years -- has given Chinese banks among the most unseasoned collective loan books in Asia. There's little data history for banks to stress-test their books effectively.

What can be said is there are few signs the banks have excessive exposure to deteriorating asset quality in one or another problematic sectors, whether real estate or export-focused manufacturers.

It's particularly true of the property sector. Commercial bank mortgage lending was around 11% of total loans at the end of 2007, while lending to property developers was 7% -- a total exposure of 18%. In the U.S., the comparable total figure was 53%, according to Goldman Sachs.

So even if this won't be anything like the crisis conditions afflicting Western peers, declining performance is likely.

Wednesday, September 10, 2008

Charlie Rose Interview on El-Erian, Roubini et al.

Charlie Rose interview with Floyd Norris, Mohamed El-Erian, Gretchen Morgenson and Nouriel Roubini on Fannie and Freddie bailout, and global economy.

Tuesday, September 09, 2008

Greenspan on F&F bailout

CNBC 3-part video interview in Fannie and Freddie bailout and his book "Age of Turbulence":
Part I     Part II    Part III

Why the Russian economy will falter?

Anders Aslund of Peterson Institute argues that Russian economy is destined to falter, and he gives 10 reasons for that:

Unfortunately, it is easy to compile 10 reasons why Russia is likely to have lower growth in the near future than it has had for the last nine years.

  1. Internationally, one of the greatest booms of all times is finally coming to an end. Demand is falling throughout the world, and soon Russia will also be hit. This factor alone has brought the Western world to stagnation.

  2. Russia's main problem is its enormous corruption. According to Transparency International, only Equatorial Guinea is richer than Russia and more corrupt. Since the main culprit behind Russia's aggravated corruption is Putin, no improvement is likely as long as he persists.

  3. Infrastructure, especially roads, has become an extraordinary bottleneck, and the sad fact is that Russia is unable to carry out major infrastructure projects. When Putin came to power in 2000, Russia had 754,000 kilometers of paved road. Incredibly, by 2006 this figure had increased by only 0.1 percent, and the little that is built costs at least three times as much as in the West. Public administration is simply too incompetent and corrupt to develop major projects.

  4. Renationalization is continuing and leading to a decline in economic efficiency. When Putin publicly attacked Mechel, investors presumed that he had decided to nationalize the company. Thus they rushed to dump their stock in Mechel, having seen what happened to Yukos, Russneft, United Heavy Machineries, and VSMP-Avisma, to name a few. In a note to investors, UBS explained diplomatically that an old paradigm of higher political risk has returned to Russia, so it has reduced its price targets by an average of 20 percent, or a market value of $300 billion. Unpredictable economic crime is bad for growth.

  5. The most successful transition countries have investment ratios exceeding 30 percent of GDP, as is also the case in East Asia. But in Russia, it is only 20 percent of GDP, and it is likely to fall in the current business environment. That means that bottlenecks will grow worse.

  6. An immediate consequence of Russia's transformation into a rogue state is that membership in the World Trade Organization is out of reach. World Bank and Economic Development Ministry assessments have put the value of WTO membership at 0.5 to 1 percentage points of additional growth per year for the next five years. Now, a similar deterioration is likely because of increased protectionism, especially in agriculture and finance.

  7. Minimal reforms in law enforcement, education, and health care have been undertaken, and no new attempt is likely. The malfunctioning public services will become an even greater drag on economic growth.

  8. Oil and commodity prices can only go down, and energy production is stagnant, which means that Russia's external accounts are bound to deteriorate quickly.

  9. Because Russia's banking system is dominated by five state banks, it is inefficient and unreliable, and the national cost of a poor banking system rises over time.

  10. Inflation is now 15 percent because of a poor exchange rate and monetary policies, though the current capital outflow may ease that problem.

In short, Russia is set for a sudden and sharp fall in its economic growth. It is difficult to assess the impact of each of these 10 factors, but they are all potent and negative. A sudden, zero growth would not be surprising, and leaders like Putin are not prepared to face reality. Russia's economic situation looks ugly. For how long can Russia afford such an expensive prime minister?


Monday, September 08, 2008

I found some new hope from WSJ

Since Murdoch took over WSJ, everyday I read more nonsense ads than real materials.  My favorite opinion section from economists of best kind got almost wiped out and it was replaced by partisan commentaries from nowhere.  Later, Greg Ip left WSJ for Economist Magazine, the intellectual level of WSJ got knocked down one more notch.  I have been thinking about cancelling WSJ paper edition. 
Well, in past couple of weeks, Jason Zweig who is responsible for writing The Intelligent Investor column offered me some new hope.  For the second time in a row, his stories on investing attracted my attention.  Thanks to him, I will postpone my cancellation and give the Journal some benefits of doubt.  
Today's story is about stock buybacks.  The traditional theory is that stock buybacks indicate that management thinks their stocks are cheap, so buyback signals to the market that "our stock is undervalued".  For this reason, after buyback, stock price often rises.  Knowing this effect, management often intentionally buys back stocks hoping to pop up their price.  So do stock buybacks always show management (the insider) knows more than the market?  Or the managment just don't get it? 

With Buybacks, Look Before You Leap

Repurchases Routinely Give Shares a Lift,
But the Effect Could Be Ephemeral

Buying high and selling low: That sounds dumb. But call it a "share repurchase program" (or stock buyback), and people get excited.

Stocks regularly jump up 3% to 6% on the announcement of a buyback, and it's easy to see why they should.

Done right, buybacks are a boon. They reduce the number of shares outstanding, spreading the company's future profits over a smaller base -- thus increasing earnings per share. Over time, firms that repurchase their shares have beaten the market by about three percentage points a year. Unlike dividends, buybacks generate no tax bills for ongoing shareholders.

Above all, share repurchases prevent cash from burning a hole in management's pocket. Long ago, Benjamin Graham pointed out a paradox: The better a company's executives are at managing its businesses, the worse they are likely to be at managing its cash. Great businesses produce piles of wampum -- and, to management, idle cash is the devil's workshop.

Three decades ago, with oil skyrocketing and profits gushing in, energy companies squandered billions of dollars on one bone-headed diversification after another. Mobil bought Montgomery Ward, the dying retailer. Arco acquired Anaconda Copper just before metal prices collapsed. Exxon even got the bright idea of manufacturing typewriters.

In the latest oil boom, the energy giants have favored buybacks over misbegotten empire building. So far in 2008, ConocoPhillips has spent $5 billion buying back stock; Chevron, $3.6 billion. From the end of 2004 through this June 30, says analyst Howard Silverblatt of Standard & Poor's, Exxon Mobil has soaked up an astounding $102.2 billion worth of its own shares.

Big oil is not alone. All told, the companies in the Standard & Poor's 500-stock index have bought back shares valued at more than a half-trillion dollars' worth of their shares in the past year.

Unfortunately, firms don't always buy stock back when it is cheap. In fact, you would have an easier time teaching a platypus to play the clavichord than getting a manager to admit his stock is overpriced. Every three months, Duke University economist John Graham surveys hundreds of chief financial officers. During the week of March 13, 2000, the absolute peak of the market bubble, 82% of finance chiefs said their shares were cheap, with only 3.4% saying their stock was "overvalued." More recently, buybacks hit their all-time quarterly high of $171.9 billion in September 2007, just before the Dow crested at 14000.

[Investor illustration]

Mistimed buybacks can be deadly. In 2006 and 2007, Washington Mutual spent $6.5 billion on buybacks. In January 2007, with the stock at 43.73 per share, chief executive Kerry Killinger called the repurchase program "a superior use of capital." Also in 2006 and 2007, Wachovia sank $5.7 billion into buybacks at an average price of more than 54. Citigroup spent $8.3 billion to repurchase stock in 2006 and 2007 at share prices of about 50. In April 2008, all three banks were so capital-starved that they had to raise cash by selling shares for a fraction of what they had recently paid for them -- WaMu at 8.75, Wachovia at 24, Citi at 25.27 a share.

Another warning: Contrary to popular belief, buying back stock isn't like canceling a postage stamp. Rather than being "retired," most repurchased shares sit in the corporate treasury -- and they can be yanked back out for just about any reason.

Look again at Exxon Mobil, which has repurchased 2.8 billion shares, carried on its books at their cost of $131 billion. But their current market value is $229 billion. If ExxonMobil decided to get into, say, the soap and diaper business, it could buy all of Procter & Gamble, the fifth-biggest stock in America, and have $10 billion in stock left over.

No, I don't believe Exxon Mobil is about to do anything that dumb. But less canny outfits could -- and will. Buy into a company that doesn't retire shares after it repurchases them and you are playing with fire.

Back in 1999 and 2000, tech companies wildly overpaid to buy back stock, while stodgier firms like Philip Morris repurchased shares dirt cheap. A buyback probably makes sense if the stock is less than its average price/earnings ratio of the past five years.

Finally, the historical outperformance of buybacks comes from an era when not everybody was doing them. From now on, long-term returns are bound to be lower. Before you invest, ask whether the stock would look cheap even without the buyback. It's hard enough to avoid buying high and selling low on your own account. Why run the risk that someone else will do it for you?



President Cycle and Stock Market Performance

Contrary to the common belief that Republican presidents are good for the stock market, there is really not much evidence to it.  Jason Zweig of WSJ tells you why and suggests you don't put real money betting on it, even on Democrats.

If You Bet on the Election,
Don't Use Real Money

Theories about Picking Stocks
Based on the "Presidential Cycle"
Don't Hold Up to Scrutiny

Every four years, as the clatter of the presidential campaign reaches a crescendo, Wall Street adds its voice to the din. Financial pundits spew forth one nostrum after another, often contradictory, never documented with evidence and always tailor-made to spur investors into making more trades. If you haven't yet heard "The stock market prefers Republicans," you will soon hear "The stock market prefers Democrats" or "Gridlock is good for investors."

Now that we know it's McCain and Palin against Obama and Biden, let me tell you three things about the "presidential cycle" in stock returns. There's not much to it, most of what you hear about it is wrong and there's no reliable way to make money on it.

From 1926 through the end of August, according to data from the market researchers at Ibbotson Associates in Chicago, the Standard & Poor's 500-stock index has done distinctly better under Democratic presidents (9.2% annually after inflation) than under Republicans (4.6%). While large stocks fared well in Democratic administrations, small stocks have skyrocketed, returning 16.5% a year after inflation, versus just 2.2% annually under Republicans. On the other hand, bonds have done much better in Republican than Democratic administrations (4.8% versus negative 0.4% annually, after inflation).

[Intelligent Investor]
Heath Hinegardner

Why do stocks do better under Democratic presidents? Robert Johnson, a former finance professor who now helps run the CFA Institute (which trains financial analysts world-wide), has studied the phenomenon and found an explanation that has nothing do with party. In years when the Fed tightens the money supply by raising interest rates, the market does poorly; when the Fed eases by cutting rates, the market does well. Rate cuts are most common in the third year of presidential administration -- helping explain why stocks have a significant tendency to do roughly twice as well in Year 3 of presidential terms as in years 1, 2 or 4.

Once you account for the market impact of the Fed's actions, the apparent predictive power of the presidential cycle evaporates; if you don't know whether the Fed will have to raise or lower interest rates, it doesn't matter which party is in power.

What about the nearly universal belief that "gridlock is good"?

Some pundits base that claim on numbers dating back to 1901. Dig into the data, however, and you discover that the gains from gridlock come entirely from a single year: 1919, when Woodrow Wilson, a Democrat, had to cope with a Republican House and Senate (and his own failing health). But it's absurd to give gridlock the credit for the Dow's 30.5% rise that year. Instead, it was the end of World War I, in the final weeks of 1918, that propelled the market to one of its best years ever.

The Stock Trader's Almanac, a popular reference book on Wall Street, reports that since 1949, the Dow has gone up by an annual average of 19.5% when the White House was Democratic and Congress was Republican. But that form of gridlock has occurred in just six of those 60 years, all under Bill Clinton, and in only 10 years in the past century. Such a thin slice of history is no basis for an investing strategy.

Overall, gridlock isn't good for investors. Since 1926, the S&P 500 has gained an average of 6.3%, after inflation, whenever one party controlled the White House and the other held the majority in both houses of Congress. That's less than the 6.8% annual average for the period as a whole.

What, then, should you do? The big margin of outperformance by small stocks under Democratic administrations might be worth betting on if you think Obama will win. But I wouldn't bet big on small-caps; they've beaten large stocks by such a wide margin lately that they are hardly a steal.

This time around, the credit crisis has made banks so reluctant to lend and borrowers so shaky that the Fed's recent rate-cutting push has hit the economy with all the impact of a piece of overcooked fettuccine. If the Fed has been rendered at least temporarily ineffectual, whoever is elected president may be forced to boost government spending in order to kick-start the economy. About all we can confidently say, then, is that this is unlikely to be a good time to add a lot of bonds to your portfolio.

Sometimes the most important thing for an investor to know is what not to do. Vote with your ballot; do not vote with your portfolio.