Topic: Finance, Banking & Monetary Policy

Oh C’mon, NYT!

C@L readers know that I’m a fan of the NY Times’s news and business reporting. If you want depth and detail (especially today, when papers increasingly read like Tweets), the NYT’s news coverage is about as good as it gets.

The opinion page, sadly, is another matter.

Case in point, last Friday’s lead editorial chastising Japan and Europe for not adopting large fiscal stimulus plans. The lede:

The world economy has plunged into what is likely to be the most brutal recession since the 1930s, yet policy makers in Europe and Japan seem to believe there are more important things for them to do than to try to dig the world, including themselves, out.

That’s actually OK — the editorial board is free to believe (and espouse) that massive fiscal stimulus is the best policy for dealing with the current recession. But to use an old saying, they’re entitled to their own opinion, but not their own facts. Ignoring that admonition, the ed led off its final graf with this howler:

In a recent speech, Christina Romer, another of President Obama’s economic advisers, pointed out some lessons [sic] from the Great Depression: fiscal stimulus works.

If you follow the economic history literature, this is a stunner; some of Romer’s most important academic work demonstrates the opposite, namely that fiscal stimulus did little to get the United States out of the Depression [$] and subsequent U.S. recessions [$]. Has she rejected her own findings?

I tracked down the speech transcript and found out that, nope, she hasn’t; in fact, she was explicit that “fiscal policy was not the key engine of recovery in the Depression.”

Romer did go on to say that she strongly supports the Obama stimulus plan, believing it will be effective and worthwhile. But this belief is rooted in one school of economic thought (or ideology, to borrow from NYT columnist Paul Krugman), not history. Whatever the merits of Romer’s belief, the NYT’s line about the Depression proving that “fiscal stimulus works” is just plain horseradish.

In recent years, the NYT editorial board has repeatedly chastised non-progressives, claiming they put ideology over objective fact. Will the ed board scold itself?

Are You Good for it, Ask the Chinese?

You might have trouble telling which country is the world’s superpower with the world’s largest economy, and which is the still relatively poor nation attempting to push its way onto the international stage.

Reports the New York Times:

The Chinese premier Wen Jiabao expressed concern on Friday about the safety of China’s $1 trillion investment in American government debt, the world’s largest such holding, and urged the Obama administration to provide assurances that its investment would keep its value in the face of a global financial crisis.

Speaking at a news conference at the end of the Chinese parliament’s annual session, Mr. Wen said he was “worried” about China’s holdings of Treasury bonds and other debt, and that China was watching United States economic developments closely.

President Obama and his new government have adopted a series of measures to deal with the financial crisis. We have expectations as to the effects of these measures,” Mr. Wen said. “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”

He called on the United States to “maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

Mr. Wen raised the concerns at a session in which he touted China’s comparatively healthy economy and said that his government would take whatever steps were needed to end the country’s economic slump. He also predicted that the world economy would improve in 2010.

The confident performance underscored the growing financial and geopolitical importance of China, one of the few countries to retain massive spending power despite slowing growth.

China has the world’s largest reserves of foreign exchange, estimated at $2 trillion, the product of years of double-digit growth.

Prime Minister Wen’s comments were conveniently timed, following a well-publicized naval game of chicken between a U.S. vessel and several Chinese boats in the South China Sea.  But the Chinese premier still has a point.  With the U.S. government stuck with unfunded liabilities in excess of $100 trillion even before it devoted trillions of dollars more to bail out just about anyone associated with the auto, housing, and financial industries, just how is Washington going to manage the new debt tsunami unleashed by the economic crunch?  Americans desperately want to know the answer to that question.

And, embarrassingly, so too do the Chinese.

Now He Tells Us!

President Barack Obama now says the economy isn’t as bad as we thought.  Reports the New York Daily News:

President Obama said Thursday the nation’s economic woes are not as dire as they seem and said his economic policies will get the country back on track.

“I don’t think things are ever as good as they say, or ever as bad as they say,” Obama told CEOs at a meeting of the Business Roundtable in Washington.

“Things two years ago were not as good as we thought because there were a lot of underlying weaknesses in the economy,” he said. “They’re not as bad as we think they are now.”

Does this mean we can cancel the “stimulus” bill and reverse all those bail-outs that were promoted as necessary to save us from disaster?

Time to Think about the Gold Standard?

Back in 2007, presidential candidate Ron Paul generated a lot of talk, especially among libertarians, about monetary policy, the Federal Reserve, and the gold standard. As a longtime believer in sound money, I was surprised to discover how many smart young libertarians thought that talk of the gold standard was nutty. And perhaps more surprised to discover that they thought it was unnecessary now that the problem of central banking had been solved. As two of them wrote when I asked about their objections,

“The gold standard is the solution to no actual problem that is of concern to anyone. I think it’s a mistake to take a relatively professional and independent central bank for granted, but we have one. Inflation is low and predictable. The monetary climate is stable and amenable to savings and investment, etc.”

“What’s the beef with the Fed?  By my estimation, it’s been one of the most effective, restrained government agencies over the last twenty five years.  They’ve dramatically reduced the volatility of the business cycle while achieving low, reasonably constant inflation.” 

Well. How’s that confidence in central banking looking now? I’m reminded of Murray Rothbard’s comment in 1975 about what the era of Vietnam, Watergate, and stagflation had done to trust in government:

Twenty years ago, the historian Cecelia Kenyon, writing of the Anti-Federalist opponents of the adoption of the U.S. Constitution, chided them for being “men of little faith” – little faith, that is, in a strong central government. It is hard to think of anyone having such unexamined faith in government today.

Partly in response to such criticisms of the gold standard, in February 2008 Cato published a paper by Professor Lawrence H. White, “Is the Gold Standard Still the Gold Standard among Monetary Systems?” White argued:

The gold standard is not a flawless monetary system. Neither is the fiat money alternative. In light of historical evidence about the comparative magnitude of these flaws, however, the gold standard is a policy option that deserves serious consideration.

In a study covering many decades in a large sample of countries, Federal Reserve Bank economists found that “money growth and inflation are higher” under fiat standards than under gold and silver standards.

A gold standard does not guarantee perfect steadiness in the growth of the money supply, but historical comparison shows that it has provided more moderate and steadier money growth in practice than the present-day alternative, politically empowering a central banking committee to determine growth in the stock of fiat money. From the perspective of limiting money growth appropriately, the gold standard is far from a crazy idea.

And he quoted a devastating line from an essay (p. 104) by Peter Bernholz:

A study of about 30 currencies shows that there has not been a single case of a currency freely manipulated by its government or central bank since 1700 which enjoyed price stability for at least 30 years running.

In February 2008 White’s study didn’t get much attention. Most people still thought the Greenspan-Bernanke Fed was doing a great job, so why talk about alternatives to fiat money? But now, after the crash of 2008 and the growing realization that Dow 14000 was the product of a cheap-money boom that led to the inevitable bust, maybe it’s time to think about the gold standard or other constraints on politicized money creation.

Switzerland, Austria, and Luxembourg Defend Financial Privacy…and Get Support from the Czech Republic

The Birmingham Star reports on how Switzerland, Austria, and Luxembourg are defending their human rights policies of protecting financial privacy:

Switzerland, Luxembourg and Austria are fighting attempts to put them on blacklist for being tax havens and over-secretive in banking rules. Luxembourg officials hosted discussions with the Swiss and Austrian finance ministers over the weekend, resulting in a demand for involvement in talks on the issue prior to the G20 summit next month. Luxembourg treasury officials said the small European group wanted to be involved in the debates about bank secrecy which were currently being discussed in meetings to which they did not belong, such as the G20.

Equally important, the Czech Republic is standing up for the sovereign right of jurisdictions to have strong human rights laws. The Finance Minister correctly explains that Switzerland’s laws should not be sacrificed on the altar of bigger government. The EU Business reports:

Czech Foreign Minister Karel Schwarzenberg defended Switzerland on Sunday against threats by EU member states to put it on a tax haven blacklist, saying sovereignty is “worth more” than lost taxes. “Certainly tax coffers here and there miss out on a couple of million euros… The independence of a country and the traditions of an independent, neutral Switzerland is however worth more than that,” Schwarzenberg said. “Why must one spoil that at all cost?” he added in an interview with the Swiss newspaper NZZ am Sonntag. The Czech Republic holds the rotating presidency of the European Union, and Switzerland has come under intense pressure in recent months over its banking secrecy laws.

Why Bank Stocks Rose on Bernanke’s Remarks

In a CNBC spot with Steve Liesman & Erin Burnett, I tried to explain why investors in bank stocks had good reason to be pleased with part of Fed Chairman Ben Bernanke’s speech.  Judging by the response of Steve and Erin, and others on CNBC over the following day,  I must not have been persuasive.

For clarification, I am quoting the exact language from Bernanke’s talk, with my emphasis added.

My main point is that Bernanke admitted that when it comes to the “financial crisis” of some big banks, this is largely an artifact of unduly harsh regulation being applied at the worst possible time:

There is some evidence that capital standards, accounting rules, and other regulations have made the financial sector excessively procyclical–that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, thereby intensifying cyclical changes.

For example, capital regulations require that banks’ capital ratios meet or exceed fixed minimum standards for the bank to be considered safe and sound by regulators. Because banks typically find raising capital to be difficult in economic downturns or periods of financial stress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment. We should review capital regulations to ensure that they are appropriately forward-looking…

Bernanke emphasized the regulators’ dangerous habit of raising capital requirements and loan loss reserves simply because of a strict mark-to-market misinterpretation of the “fair value” of mortgage-backed securities.

He noted that:

Determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency.

The key here is Bernanke’s criticism of the rigid use of Basel capital standards, not mark-to-market information per se (which would be harmless if it did not trigger foolish regulations). When combined with Barney Frank’s similar comments on the same day, it begins to look as though sensible economics might finally take priority over dubious bookkeeping.

Solve the Financial Crisis (and Make Some Serious Money)

Peter Van Doren and I have been puzzling over this very interesting NYT op-ed on home foreclosures by Yale economist John Geanakoplos and Boston University law professor Susan Koniak. If G&K’s story is right, then shouldn’t there be an opportunity for some clever financiers to help struggling homeowners keep their houses, help banks and other investors repair their balance sheets — and the financiers could help themselves to piles of cash in the process?

G&K argue that all three parties to a home mortgage — the homeowner, the lender, and the loan servicer who works as a go-between — currently face grim financial prospects:

  • Many homeowners are “underwater” — that is, they owe more on their mortgages than their homes are now worth. According to First American Core Logic, some 20% of mortgages were underwater as of December 2008. The percentage varies greatly from state to state, with 55% of mortgages underwater in Nevada, but only 7% in New York. The homeowners who are underwater include not just those who purchased with little down payment, but also many people who put down the traditional 20 percent when they bought in 2005 or 2006, at the peak of the real estate bubble. According to Case-Shiller index data, house prices nationwide have fallen 27% (as of December) from their May 2006 peak. Some local markets have experienced more dramatic declines, highlighted by Phoenix’s 46% slide. Rental prices are now far below many homeowners’ monthly mortgage payments, and lots of underwater homeowners will have to make payments for years before they have some equity stake in their homes. Many of those homeowners would rather default and risk foreclosure. G&K’s op-ed includes this figure showing that defaults increase dramatically as homeowners sink further and further underwater. Given their current options, default is rational.
  • The mortgage lender faces heavy losses if the home enters foreclosure. According to G&K, ”the subprime bond market now trades as if it expects only 25 percent back on a loan when there is a foreclosure.”
  • The servicer also is at risk. According to G&K, the servicer is obligated to continue paying the lender its monthly payment even if the borrower is in default. That obligation only lifts at foreclosure.

Because of the servicer’s obligation, the servicer has strong incentive to push for quick foreclosure. However, the homeowner and the mortgage lender would likely benefit from a loan modification — even a significant write-down of principal — because that would keep the homeowner in his house and it would deliver a better return to the lender than the 75% loss from foreclosure. G&K thus argue that government, instead of continuing to bail out the banking industry and struggling homeowners (and putting taxpayers on the hook for hundreds of billions of dollars), should simply require that the lenders write down the mortgage principal.

But is government action needed? Couldn’t some private actors accomplish the same thing — and make some serious scratch in the process?

A financial wizard with sufficient backing could approach a troubled lender and offer, say, 50% of the original loan amount in order to take some of the toxic mortgages off the lender’s hands. Now, the lender won’t be happy with selling at a 50% loss, but that certainly beats a 75% loss, so the lender would grudgingly agree. The financial wizard would then approach the homeowner and offer to write down the mortgage principal to, say, 60% on condition that the homeowner purchase mortgage insurance. The homeowner should jump at the offer because it would put him back above water, purchasing a home that’s worth more than its debt. Finally, the financial wizard would get the servicer to release its control over the loan, because the servicer would want to be freed from the risk of having to cover the payments to the lender. The financial wizard would then pocket a cool 10% of the original mortgage’s value.

That is not chump change. G&K estimate some 8 million homes could be foreclosed upon in the coming years. Assume the original mortgage on each of those houses is $199,025 (95% of the median sale price of new U.S. homes in January 2004, about halfway up the bubble); that 10% would represent almost $160 billion.

Of course, if the bank proves recalcitrant and demands more than 50%, or the homeowner demands a write-down of more than 40% or he’ll walk away, that would cut into the profits. And the financial wizard would have to cover his costs and possible risk premiums. Still, at least in theory, there would seem to be a significant pile of money on the table.

So why isn’t this happening? Are there no money-loving financial wizards out there?

To some extent, they are. Last week, the NYT reported that some former Countrywide executives have formed a firm called PennyMac that, with financial backing from hedge funds and other investors, purchases toxic mortgages from insolvent banks at low prices, modifies the loans to increase homeowners’ likelihood of making payments, and profits from the rekindled mortgage revenue stream. In the particular case reported in the NYT, PennyMac paid 38 cents on the dollar. But PennyMac seems like very small potatoes compared to the $160 billion that may be on the table. And the banks were forced to sell the loans because they had been taken over by the FDIC.

So why aren’t there more firms doing what PennyMac is doing, or following the strategy that Peter and I have laid out above? And why aren’t banks lining up to offload their toxic mortgages (or to do the write-downs themselves and pocket the 10%)? Peter and I can think of three possible reasons:

  1. As G&K note in their op-ed, banks and other investors who’re currently saddled with toxic assets may be waiting for some form of government rescue that would enable them to recoup far more than the 50% or so that would be offered by our financial wizards.
  2. Banks are keeping bad mortgages on their books at values much higher than the 25 to 40 cents on the dollar observed in the rare sales of troubled assets, and so the banks are unwilling to sell the assets for 50 cents on the dollar. (Remember that PennyMac is purchasing assets from banks that have been taken over by the FDIC — in other words, these are forced sales.) The banks (and their managers) may strongly prefer to keep the assets on their books rather than sell them at a 50% loss.
  3. The transaction costs involved in this scheme (e.g., analyzing the toxic assets to determine which ones to buy, negotiating with the delinquent and at-risk homeowners) are prohibitively large.

Government can address (1) by committing not to bail out the investors. Unfortunately, it’s unclear how reliable that commitment would be, especially given government actions so far in this financial crisis.

Fixing (2) is difficult. Accounting rules could be changed to force the banks to lower their book values for bad mortgages, but it would be difficult to get that accounting change passed quickly. Besides, some accounting experts argue that, in stressful times, accounting rules should have more wiggle room rather than less.

As for (3), the PennyMac guys claim that the work is difficult. But c’mon, there could be a $160 billion payday for the guys who can figure it out.

So, come on you money-loving financial wizards: your country needs you!