Topic: Finance, Banking & Monetary Policy

Out of the TARP, But Still on the Dole

While banks such as Goldman and J.P. Morgan have managed to find a way to re-pay the capital injections made under the TARP bailout, their reliance on public subsidies is far from over. The federal government, via a debt guarantee program run by the FDIC, is still putting considerable taxpayer funds at risk on behalf of the banking industry.  The Wall Street Journal estimates that banks participating in the FDIC debt guarantee program will save about $24 billion in reduced borrowing costs of the next three years. The Journal estimates that Goldman alone will save over $2 billion on its borrowing costs due to the FDIC’s guarantees.

One of the conditions imposed by the Treasury department for allowing banks to leave the TARP was that such banks be able to issue debt not guaranteed by the government.  Apparently this requirement did not apply to all of a firm’s debt issues.  These banks should be expected to issue all their debt without a government guarantee and be required to pay back any currently outstanding government guaranteed debt.

To add insult to injury, not only are banks reaping huge subsidies from the FDIC debt guarantee program, but the program itself is likely illegal.  The FDIC’s authority to take special actions on behalf of a failing ”systemically” important bank is limited to a bank-by-bank review.  The FDIC’s actions over the last several months to declare the entire banking system as systemically important is at best a fanciful reading of the law. 

The FDIC should immediately terminate this illegal program and end the continuing string of subsidies going to Wall Street banks, many of which are reporting enormous profits.

Would Summers Be Any Worse than Bernanke?

As I have argued elsewhere, Bernanke’s record as both a Fed governor and Chair suggest we be better off with a new Fed Chair come January 2010, when Bernanke’s term as Chair expires. Outside of those who believe the bailouts have saved capitalism, two very reasonable arguments are put forth for keeping Bernanke at the helm:  1) in a time of crisis, the markets need certainty and dislike change; and 2) the alternatives, such as Larry Summers, would be worse.  Both these points have real merit, however I believe in both cases the pros of change outweigh the cons of staying the course with Bernanke.  I will save the “certainty” debate for another time, for now, let’s ask ourselves:  Would Summers really be any worse than Bernanke?

Before I make the case for Summers, I do want to make clear, President Obama, and the country, would best be served by a “Carter picks Volcker” type moment.  Go outside the Administration, go beyond the usual circle of easy-money, new Keynesians.  The Fed lacks creditability in two (at least two) important areas: bailouts and inflation.  And one doesn’t even need to go outside of the Federal Reserve System to find candidates.  Topping my list would be Jeff Lacker (Richmond Fed), Gary Stern (Minn Fed) and Charles Plosser (Philly Fed).  Any of these three know the workings of the Fed, have the respect of the Fed staff, and have taken strong positions on both “too big to fail” and easy money.  In the case of Gary Stern, it would seem especially appropriate, as his early warnings (see his 2004 book on bank bailouts) were largely ignored and dismissed.  If we want to reward and promote those who got it right, these guys are at the top of the list.

But let’s reasonably suppose that Obama wants someone close, someone he personally knows and will stick with tradition by picking a member of his own administration.  Without going into any detail, picking Romer would offer little substantial difference with keeping Bernanke.  The case for Summers is essentially that here is one instance where his enormous ego would be an asset.  One easily gets the sense that when Summers sits next to President Obama, Summers is thinking to himself just how lucky the President is to be sitting next to Larry Summers.  One can call Summers lots of things, starstruck is not one of them.  Given what we now need most in a Fed Chair is true independence, from especially the Administration but also from Congress, Summers is the only qualified economist close to the President who displays even the slightest streak of independent thinking.  Bernanke, in contrast, has endlessly pandered to the Administration and to Congressional Democrats.  Summers has been willing on occasion to actually defend the sanctity of contract (remember the debates over the AIG bonuses), a rarity on the Left, and more than Bernanke was willing to say.  

So forced to choose between Bernanke and Summers, the need for an independent Fed Chair willing to take on the Administration and Congress, when appropriate, makes Summers a far better choice.  That said, here’s to encouraging Obama go outside his comfort zone and pick someone who has the will to remove excess liquidity from the system before the next bubble gets going.

For Financial Stability, Fix the Tax Code

There seems to be near universal agreement that the excessive use of debt among both corporations, particularly banks, and households contributed to the severity of the financial crisis.  However, other than the occasional refrain that banks should hold more capital, there has been little discussion over why corporations choose to be so highly leveraged in the first place.  But then such a discussion might lead us to the all too obvious answer – the federal government, via the tax code, encourages, even heavily subsidizes corporate leverage.

Cato scholar and banking analyst Bert Ely has estimated that the subsides for debt have historically resulted in an after tax cost of debt of 3 to 5 percent, compared to an after tax cost of equity of 12 to 15 percent.  With differences of this magnitude, it should not be surprising that financial companies and corporations in general become highly leveraged.

For corporations, this massive difference in cost between debt and equity financing results primary from the ability to deduct interest expenses on debt, while punishing equity due to the double-taxation of dividends along with taxing capital gains. 

If we are going to use the tax code to subsidize debt and tax equity, we shouldn’t act surprised when firms load up on the debt and reduce their use of equity – making financial crises all too frequent and severe.

Why Mortgage Modifications Aren’t Working

As covered in both today’s Wall Street Journal and Washington Post, the Obama administration has called 25 of the largest mortgage servicing companies to Washington to try to figure out why the Obama efforts to stem foreclosures has been a failure.

The reason such efforts, as well as those of the Bush Administration and the FDIC, have been a failure is that such efforts have grossly misdiagnosed the causes of mortgage defaults.  An implicit assumption behind former Treasury Secretary Paulson’s HOPE NOW, FDIC Chair Sheila Bair’s IndyMac model, and the Obama Administration’s current foreclosure efforts is that the current wave of foreclosures is almost exclusively the result of predatory lending practices and “exploding” adjustable rate mortgages, where large payment shocks upon the rate re-set cause mortgage payment to become “unaffordable.”

The simple truth is that the vast majority of mortgage defaults are being driven by the same factors that have always driven mortgage defaults:  generally a negative equity position on the part of the homeowner coupled with a life event that results in a substantial shock to their income, most often a job loss or reduction in earnings. Until both of these components, negative equity and a negative income shock are addressed, foreclosures will remain at highly elevated levels.

Sadly the Obama Administration is likely to use today’s meeting as simply an excuse to deflect blame from themselves onto “greedy” lenders.  Instead the Administration should be focusing on avenues for increasing employment and getting our economy growing again.  Then of course, this Administration has from the start been more focused on re-distributing wealth rather than creating it, which explains why it views mortgage modifications as simply a game of taking from lenders (in reality investors - like pension funds) and giving to delinquent homeowners.

Gallup Poll: Federal Reserve Makes the IRS Look Good

A recent Gallup Poll surveyed the public’s impression of how various federal agencies were doing their job.  Of the agencies evaluated, on the bottom was the Federal Reserve Board.  Only 30 percent of the respondents rated the Fed’s performance as either excellent or good.  I can understand now why Chairman Bernanke felt the need to take his act on the road.  Even the IRS managed to get 40 percent of respondents to see its job performance as excellent or good. A majority of the public, 57 percent, sees the Fed’s current performance as either poor or fair.

The result is not just driven by a general public disdain for federal agencies; over a majority of respondents thought such agencies as the Center for Disease Control, NASA and the FBI were doing an excellent or good job.

Nor is the result driven by public ignorance or indifference to the Fed; only a few years ago, back in 2003, 53 percent of Americans said the Federal Reserve was doing an excellent or good job and only 5% called its job performance poor.  But then, the Fed was also giving us negative real interest rates at that time as well.  Perhaps there’s a good reason to insulate the Fed from short-term public and political pressures.  Let’s hope Chairman Bernanke does not read these results as an excuse for repeating the Fed’s 2003 monetary policies.

Does the Left Know We Had a Housing Bubble?

Over the last week, speaking at a variety of events, I heard three different representatives of the Left; first a Democrat US Senator, then a senior member of the Obama Administration, and finally a “consumer” advocate, all repeat the same narrative:  all was fine in the housing market until predatory lenders forced hard-working honest families into foreclosure, which reduced house prices, bringing the economy to a crash.  That’s correct, apparently the Left believes we all would still be seeing double-digit home price appreciation if it wasn’t for those evil lenders.

Undoubtedly foreclosures, especially those that result in houses that remain vacant for a considerable amount of time, have an adverse impact on surrounding property values.  Many constitute a serious eye-sore and provide a haven for criminal activity.  But did foreclosures really drive down prices, or were foreclosures first driven by price declines resulting from a bursting housing bubble?  While causality is always difficult to establish with certainty, we do know that the rate of house price appreciation peaked and started declining about 18 months before the dramatic up-turn in mortgage delinquencies.  If one prefers a more rigorous test, economists at the Boston Fed have directly tested if prices first drove foreclosures or whether foreclosures drove prices.  Their results conclude that its was declining prices that matter, and that the price effect of foreclosures is minimal.

Why does any of this ultimately matter?  Because if we craft policies to avoid the adverse impacts of the next property bubble based upon a narrative of “consumer protection” – as is being pushed by the Obama Administration, we will do little to avoid the creation of the next housing bubble and its damaging aftermath.  Instead we should be focusing attention on those policies that contributed to the creation of the housing bubble: expansionary monetary policy and the Federal government’s blind pursuit of ever-expanding home-ownership rates at any cost.

What’s A Dollar Worth?

It’s not just Americans worried about the flood of dollars from the Fed.  The Chinese and now the Malaysians also are wondering if they should keep dealing in greenbacks.

Reports the Wall Street Journal:

Malaysia’s prime minister said China and his country are considering conducting their trade in Chinese yuan and Malaysian ringgit, joining a growing number of nations thinking of phasing out the dollar.

“We can consider whether we can use local currencies to facilitate trade financing between our two countries,” Malaysian Prime Minister Najib Abdul Razak told reporters at a briefing Wednesday after meeting with China’s premier, Wen Jiabao.

“What worries us is that the [U.S.] deficit is being financed by printing more money,” Mr. Najib said. “That is what is happening. The Treasury in the United States is printing more notes.”

The dollar won’t easily be displaced as the world’s principal reserve currency.  But Washington appears to be doing everything possible to hasten that day.

Perhaps Americans should consider keeping their wealth in yuan or even ringgits.  At least they might retain their value even as the Fed and Treasury attempt to inflate and spend the U.S. economy into oblivion.