Tag: Finance

Some Questions about TARP’s Future

As I discussed the other day, using TARP to pay for new jobs programs faces some serious practical issues. First, the administration is limited in how it can deploy existing TARP funds. It should be straightforward to use more funds to support lending to small businesses (which TARP already does to some extent), but it would take great legal ingenuity to use it to fund infrastructure projects or aid to state and local governments.  Indeed, in an article titled “Use of Cash from TARP Hits Hurdle“, the Wall Street Journal reports that top Democrats have concluded that TARP money can’t be used for either of those ideas.

Second, legislative use of TARP money are limited by budget scoring rules, which currently would attribute only 50 cents of budget savings to each dollar by which TARP’s authority might be reduced. And even then, careful budgeteers would realize that such savings are make-believe if, as seems likely, any such limits would apply only to TARP authority that was unlikely to be used anyway.

In short, the rhetoric about using TARP to finance various proposals seems to have gotten ahead of reality.

The President’s speech at the Brookings Institution today provided some additional insight into the Administration’s plans for TARP, but some important questions still remain.

Here are the President’s three forward-looking statements about TARP (he also made some comments about TARP’s origin and history, but that’s a topic for another day):

I’m asking my Treasury Secretary to continue mobilizing the remaining TARP funds to facilitate lending to small businesses. …

[W]ith a fiscal crisis to match our economic crisis, we also must be prudent about how we fund [initiatives to accelerate the pace of private hiring].  So to help support these efforts, we are going to wind down the Troubled Asset Relief Program — or TARP — the fund created to stabilize the financial system so banks would lend again. …

TARP is expected to cost the taxpayers at least $200 billion less than what was anticipated just this past summer.  And the assistance to banks, once thought to cost taxpayers untold billions, is on track to actually reap billions in profits for the taxpaying public.  So this gives us a chance to pay down the deficit faster than we thought possible and to shift funds that would have gone to help the banks on Wall Street to help create jobs on Main Street.

If I am reading that right, the President would like to (a) continue Treasury’s existing effort to support small business lending through TARP, (b) wind down the TARP program, and (c) shift funds to other purposes. That leaves me with some important questions, including:

  • Does the administration plan to expand TARP’s small business lending support or just execute the one that’s already been announced? (NB: The President also endorsed several other steps to help small businesses, including easier access to SBA loans.)
  • Does “wind down the TARP program” mean that Secretary Geithner won’t use his authority to extend the program beyond December 31, 2009? If I were him I would sleep much better at night if I had some “dry powder” in an extended TARP, just in case we have another September-October of 2008. Such a replay seems highly unlikely (knock on wood), but if that exceedingly remote event did happen, I wouldn’t want to be the Treasury Secretary who went up to Capitol Hill to ask for a TARP II.

Deja Vu All Over Again?

Earlier this week, the Treasury released its quarterly update about its borrowing requirements and its strategy for meeting them. I haven’t had time to review all the documents, but I did skim through the minutes of the meeting of the Treasury Borrowing Advisory Committee (TBAC), which was held on November 3.

This pair of paragraphs particularly caught my attention (my emphasis added):

The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve’s exit strategy and the implications for the Treasury’s borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities. It was noted that the near-zero interest rates driven by current Federal Reserve policy was pushing many financial entities such as pension funds, insurance companies, and endowments further out on the yield curve into longer-dated, riskier asset classes to earn incremental yield. Treasury securities have benefitted from the resultant increase in demand, but riskier assets have benefitted even more. According to the member, the greater decline in the indices for investment grade and high-yield corporate debt relative to 10-year Treasuries and current coupon mortgages display this reach for yield. A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.

Yes, our old friend the reach for yield. Back in pre-crisis days, the reach for yield would often be viewed as evidence that the monetary transmission mechanism was working well, with low short-term rates providing a real boost to the economy. Now, however, we are all-too-familiar with the downside of the reach for yield: unsustainable booms in longer-term assets.

Is this deja vu all over again? I don’t know. But those paragraphs certainly didn’t make me feel more comfortable about our recovery.

P.S. I should also note that the TBAC endorsed greater reliance on Treasury Inflation Protected Securities (TIPS), as well as moving from 20-year TIPS to 30-year TIPS. These recommendations paralleled some similar ones released back in September by the GAO.

Counterintuitive Accounting: Ambac Edition

Earlier today, Ambac Financial Group (a big bond insurer) reported that it earned more than $2 billion in the third quarter, or $7.58 per share. As reported over at Marketwatch, these must be among the lowest quality earnings in accounting history:

Ambac Financial Group reported a $2.19 billion quarterly profit Wednesday as the company got a big accounting boost from deterioration in the perceived creditworthiness of its main bond insurance unit. …

Most the gain came as credit spreads widened on Ambac Assurance Corporation, the company’s main bond insurance subsidiary. When credit spreads widen, that implies investors are more concerned about a company not being able to meet its obligations. However, when this happens, it reduces some of the insurer’s liabilities. For example, if the insurer is deemed to be less capable of standing by its derivatives-based guarantees, the value of those liabilities falls. That results in a derivatives gain.

In short, earnings skyrocketed because investors became even more doubtful about Ambac’s ability to pay its future liabilities. I see many benefits in mark-to-market accounting generally, but this treatment of liabilities is counterintuitive to say the least. There must be a better way.

Ambac shares closed at a lofty $1.50 per share, up 35% on the day. It’s not often that you encounter a stock that trades for less than one-fifth of its quarterly earnings …

Disclosure: I have no investments in Ambac or any bond insurer.

Booms, Busts, and the Leverage Cycle

Over the Wall Street Journal, Mark Whitehouse has a nice piece on John Geanakoplos, a finance guru in the worlds of both academia and Wall Street. Over the past ten years, he’s been exploring how leverage and the value of collateral can drive booms and busts in financial markets.

His research was sparked by the challenges his investment fund faced after the demise of Long-Term Capital Management in 1998:

A lender to the fund where Mr. Geanakoplos was a partner abruptly demanded more margin on a loan. The event, which nearly toppled the fund as the partners scrambled to raise cash by selling securities, drove home to Mr. Geanakoplos how margins could work two ways — stimulating asset buying as they go lower, but forcing fire sales as they rise.

In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them “natural buyers.”

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

“It was evident to me that there was a cycle going on, not just in my little market, but all over the world,” says Mr. Geanakoplos, who is still a partner at Ellington Capital. The “leverage cycle,” he called it.

Well worth a read.

The GM (er, Motors Liquidation) Anomaly

A few months ago, I wrote a series of posts about anomalies in the pricing of Citigroup common and preferred stock (see here for the final installment). At the time, Citi’s common stock traded at prices that appeared to be way too high relative to the preferred stock (which has since converted into common).

Limits on short-selling appeared to be the best explanation for that anomaly.

In today’s New York Times, Floyd Norris notes that the same thing is happening to shares of Motors Liquidation Company (symbol MTLQQ). Motors Liquidation is what remains of the bankrupt General Motors. It has no ownership in the new, post-bankruptcy GM and, a (see correction below). As far as I can tell, everyone believes that ML’s common stock is worthless. Yet, as Norris shows in an accompanying chart, the stock has persistently traded above $0.50 per share:

(One nit: I don’t think the top chart should be labeled “General Motors stock price …”; it should be “Motors Liquidation stock price …”)

Norris argues, correctly I think, that the difficulty of shorting ML common stock is why it trades at a positive price. Potential sellers have been unable to drive the price down where it belongs (close to zero) and, indeed, are occasionally forced to buy back shares to close their positions. Thus, the stock trades around $0.60 per share, and the number of shorted shares has been declining.

As a contrast, Norris points to Delta Airlines which went through bankruptcy back in 2006-7. In that case, short sellers increased their positions over time, and the stock price worked its way down to zero.

Correction (11/3/09): An astute reader points out that I was wrong to say that Motors Liquidation has no ownership position in the new GM. According to the investor FAQs for Motors Liquidation:

As part of the consideration for the acquisition of substantially all of the assets of the old General Motors Corporation, 10% equity in the new GM, as well as warrants for an additional 15%, will be provided to Motors Liquidation Company which is still in Chapter 11. Distribution of this equity to unsecured bondholders and other claim holders will be determined through the court process and will not occur until a plan of reorganization is submitted, accepted and implemented. It is too early to tell how long this may take.

If I am interpreting that correctly, it means that Motors Liquidation is, in essence, the conduit by which unsecured bondholders and other claim holders will eventually receive their equity stake in the new GM.

Another useful item on the Motors Liquidation web site is this warning to investors in common stock:

Management continues to remind investors of its strong belief that there will be no value for the common stockholders in the bankruptcy liquidation process, even under the most optimistic of scenarios. Stockholders of a company in chapter 11 generally receive value only if all claims of the company’s secured and unsecured creditors are fully satisfied. In this case, management strongly believes all such claims will not be fully satisfied, leading to its conclusion that the common stock will have no value.

Yuppie 911 and the Financial Crisis

If you make an activity safer, people will take more risk. The inventions of seat belts, air bags, and anti-lock brakes, for example, have all inspired people to drive more aggressively. And if you put drivers in SUVs, rather than regular cars, they are more likely to hit the road during a snow storm.

In recent days, several media outlets have noted a similar phenomenon: if you make it easier to call for help, more hikers will get themselves in trouble. As noted over at MSNBC (ht Tyler Cowen):

Technology has made calling for help instantaneous even in the most remote places. Because would-be adventurers can send GPS coordinates to rescuers with the touch of a button, some are exploring terrain they do not have the experience, knowledge or endurance to tackle.

Rescue officials are deciding whether to start keeping statistics on the problem, but the incidents have become so frequent that the head of California’s Search and Rescue operation has a name for the devices: Yuppie 911.

“Now you can go into the back country and take a risk you might not normally have taken,” says Matt Scharper, who coordinates a rescue every day in a state with wilderness so rugged even crashed planes can take decades to find. “With the Yuppie 911, you send a message to a satellite and the government pulls your butt out of something you shouldn’t have been in in the first place.”

So what does this have to do with the financial crisis? Well, it’s not merely that the government has been forced to save financial firms from things that they shouldn’t have been doing in the first place.

The broader idea is that people take more risks when they feel more comfortable. In the pre-crisis days, it appeared that business cycle fluctuations had gotten smaller. Because of this “Great Moderation”, firms and investors felt that they faced smaller macroeconomic risks when taking on new investments. Improvements in risk management had a similar effect, as firms and investors got better at managing pesky things like interest rate risk. These advances made it appear that risks were smaller and more manageable and, as a result, firms and investors felt more comfortable taking on more leverage and larger investment risks.

P.S. For additional coverage of Yuppie 911, see NPR.

IMF: The Lasting Effects of Financial Crises

Earlier this week, the IMF released a key chapter from the upcoming World Economic Outlook: Chapter 4: What’s the Damage? Medium-Term Output Dynamics After Financial Crises. As noted in the much pithier summary, the report concludes that:

The global financial crisis is likely to leave long-lasting scars on the world economy, but governments can act to stimulate a quicker revival and counter output losses … . The study finds that banking crises typically have a long-lasting impact on the level of output, although growth eventually recovers. Lower employment, investment, and productivity all contribute to sustained output losses.

Those conclusions are based on their review of financial crises around the world since the early 1970s. As shown in the following graph, the key finding is that after a financial crisis economic output remains below trend for years:

The blue line shows, for example, that in the average country, output seven years after the crisis was about 10% below what would it would have been if the pre-crisis growth rate had continued.

The dotted red lines, however, highlight the enormous range of outcomes. At least one-quarter of the countries eventually had output that was above the level implied by the earlier trend; while another quarter eventually fell at least 25% below the prior trend.

The study slices and dices this result in numerous ways, trying to identify the factors that lead to better or worse outcomes. Some are bad news for the United States.

Continue reading “IMF: The Lasting Effects of Financial Crises”

Lessons from the Fall of Lehman

As you have undoubtedly noticed, this week marks the one-year anniversary of the fall of Lehman Brothers–the moment at which the financial crisis became a severe economic crisis.

I did an interview on Fox Business on Tuesday to discuss some of the lessons learned. (My wife’s comment  on the interview: “You need to straighten your collar next time.”)

Going in, I had two basic points I wanted to make:

  • First, the fall of Lehman Brothers was the moment that the abstract threat of “systemic risk” became tangible to many policy makers and the public. As we progressed from propping up Bear Stearns to taking over Fannie Mae and Freddie Mac, many observers began to suffer from policy fatigue, and, in some circles, there was concern that the scale of the government actions might be disproportionate to the alleged, but little-seen, risk of a systemic crisis. That changed when Lehman fell, and the dominoes started toppling.
  • Second, we still have our work cut out for us. The major items on our to do list include:

(1) Taking steps to avoid such enormous shocks in the future (e.g., by increasing capital requirements and reducing allowed leverage for financial firms).

(2) Fixing the problem of too-big-to-fail (or, if you prefer, too-interconnected-to-fail). Unfortunately, this problem has worsened, in many ways, since the crisis began. Some gigantic firms have grown even larger. And the necessary interventions to prop up the financial sector have reinforced the idea that the government will prevent these firms from failing in the future.

(3) Disentangling the government from private firms, so that it can again act as a referee, not as a player. That will take time given the enormous investment portfolio that the government has amassed in financial firms and the auto companies. It is heartening, however, that even Citigroup is beginning to ponder how to raise outside capital and reduce the government stake.

The Simple Economics of Student Loan Crises

Yesterday, my students heard my second lecture on supply and demand. You know, the one in which we examined how government policies like rent control and the minimum wage can affect market outcomes. Those are important examples, and I dutifully discussed both of them. But I must admit they also feel a smidgen stale – how many millions of students have seen a lecture on rent control and the minimum wage?

To spice things up, I threw in a third example of government intervention: the market for guaranteed student loans. As I mentioned a few weeks ago, the government has a major program in which it provides guarantees for private student loans. Under the program, lenders are protected against the risk of future defaults by the student borrowers. In return for providing these loans, the lenders receive interest payments that are limited by a formula that is specified in law. (These payments are determined completely separately from the amounts that are charged to students which, for simplicity, I will ignore in what follows.)

This program is currently the focus of a major political battle: the Obama administration has proposed eliminating the program and replacing it with direct loans from the government (which currently account for a much smaller portion of the market). But I didn’t get into that larger debate in class. Instead, the reason I focused on this program is that it has experienced two crises in recent years:

  • In 2006 and 2007, the crisis was kickbacks. In their enthusiasm to win more business, private lenders were offering “inducements” to schools and student loan officers in order to get preferred access to students who wanted loans.
  • In 2008, the crisis was a lack of lending. In large part because of the financial crisis, private lenders had no enthusiasm whatsoever for making loans. As a result, there was a real risk that students might not be able to get loans.

As I told my students, I think both of these crises had the same root cause: the fact that the government, rather than market forces, determined how much lenders were paid for making guaranteed student loans. In both cases, the government got the payment levels wrong, and the crises followed soon thereafter.

Continue reading “The Simple Economics of Student Loan Crises”

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