0:50:30 … My brother’s a cardiologist, I should show him this as a cardiogram, you know, he would tell me the patient was long since dead. – Desmond Lachman
Doom Transcripts: Index & Guide
Housing Doom is pleased to present a complete unauthorized annotated transcript IV.C for the American Enterprise Institute’s October 2, 2008 event "What Lies Beyond the Credit Crunch? Part III".1 The event site has a variety of resources including a summary and both an audio and a video of the proceedings. There is an official transcript, but the link to it does not seem to be currently working.
Part of the importance of this seminar is that it occurred just over 2 weeks following the pivotal crisis of mid-September 2008. In contrast to reflections2 a year later, these guys are giving their raw thoughts in a period before the story-line got established.
Table of Contents
[link navigation works best when full article displayed]
- 0:00:00 – Dead Air
- 0:01:35 – Peter Wallison Intro
- 0:10:30 – Charles Calomiris presentation
- 0:23:02 – Kevin Hassett presentation
- 0:40:09 – Desmond Lachman presentation
- 0:53:40 – John Makin presentation
- 1:09:32 – Vincent Reinhart presentation
- 1:33:15 – Panel responses
- 1:37:40 – Q&A
- 1:38:02 – Tad Howard[ph] question
- 1:42:36 – David Brazil[ph] question
- 1:49:01 – Brian Beery[ph] question
- 1:49:28 Makin response
- 1:51:44 – Greg Wilson[ph] question
- 1:52:06 Makin, Lachman, Reinhart responses
- 1:52:53 – Justin Ailes question
- 1:55:25 – John Serrapere question
- 1:57:53 – Gillian Gattia[ph] question
- 2:01:18 – Sue Simon question
- 2:04:02 – Wallison brief wrap-up
- 2:04:38 (end)
…
[1 min 35 sec of dead air]
…
Peter Wallison: OK, I think we’ll get started. I’m Peter Wallison. I’m a Senior Fellow here at the American Enterprise Institute. I want to thank all of you for coming to what is the 3rd in a series, which we didn’t actually expect to be a series when we started it. But this is the 3rd in the series of learning from our learned economists here at AEI about what the future holds for the US financial system.
It’s been quite a ride. I’m sure all of you are as puzzeled as I am, but let’s hope we can get a little bit of enlightenment, maybe of consensus coming out of the economists this time, that we were not able to find in past conferences of this kind.
The remarkable thing, it seems to me, when we look at what is going on in the credit markets today, is the resilience, up to now, of what you might call the "real economy." When we started, back in, I think, the first of these was in December, the turmoil in the world’s financial institutions was serious, even at that point. Libor spreads were historically high, and there were widespread reports that financing was not available at that time for some activities. The international financial markets were reported to be simply shut down. And that was back in December.
In that long ago time, some of our economists predicted that the housing market was headed for an immense bust, which would cause a severe recession in the general economy. Others thought the housing decline would not be as severe, and in any case would not create much more than a mild recession.
What everyone was reasonably sure about was that by the spring of 2008, we would have much more data, and it would be easy to say at that time, with some confidence, where the real economy was going. So we scheduled another conference in April, anticipating a lot more consensus. For those of you who were here, you’ll know we didn’t get that consesus in April.
If anything, more data created more controversy. There was still a lot of uncertainty at that point about how serious the housing decline really was, and part of the controversy among our economists was what data to use. Bear Strearns had been rescued in mid-March, and the international financial system was still very fragile, but inter-bank lending was improving at that point, and Libor rates were well down from their previous high. The US economy was still not in recession, it seemed, and indeed in the 1st quarter it ended with slight growth.
Because there was still no consensus, we scheduled this conference. Again the thought was that by October, we would surely have enough data to produce clarity. Maybe, maybe not. Financial market conditions have gotten a lot worse, but it is still not clear that the economy as a whole is yet in a technical, [0:05:00] or other kind of recession.
Growth in the 2rd quarter was somewhat over 2 percent. That’s not good, to be sure, but it’s certainly not a recession. Unemployment is increasing, but up to now not at the rate of previous recessions.
Recently there have been indications that consumers and businesses are feeling a severe pinch. The Wall Street Journal’s headline this morning certainly indicated that. And consumer spending is down, manufacturing contracted substantially in August.
One thing the last 18 months has shown is that we don’t have a very good idea of the linkages between the real economy and the financial markets. The financial markets are in a state not seen since the Great Depression, maybe even worse. But the economy as a whole is certainly not in anything like that condition, and hasn’t been for 18 months, that the financial markets have been in unprecedented turmoil. (And I think that’s one of the reasons why the Paulson plan has stimulated so much opposition. People really still do not feel that it’s all worth spending $700 billion to address.)
I don’t think most economists would have thought it was possible that the financial markets could be at this level of distress without causing a serious, very serious recession at the very least. If the Paulson plan is rejected again, there are predictions that this will lead to a financial market meltdown and a serious world-wide recession. Perhaps even a depression.
At this point it’s not implausible that a really serious recession could occur. There has been a huge flight to quality, to government debt in most of the developed countries. And if the cash is in government bonds or notes, rather than in banks, it is easier to see how employers might not be able to meet payrolls and companies might not be able to get the credit to meet their obligations.
Cash moves through the banking system to where it is needed, but the system depends on banks to lend to one another. And by all accounts, this is not happening. The principle reason appears to be that they are not sure of the solvency of their bank counterparties, and one of the reasons for this, in my view, has been the requirement for mark-to-market valuation of assets when there is in fact no active market.
Now that’s very controversial, and some people here on the panel will certainly not agree with it, but I think it is a serious question, and I am happy to see that the SEC now seems to be in the process of reversing itself on the application of mark-to-market accounting.
Six months ago, the Agency put out a letter to all the CFOs of public companies and said only when actual market prices are not available is it appropriate for you to use unobservable inputs, which is the accounting word for market prices — um, for non-market prices, for models of various kind in pricing an asset or a liability.
Yesterday, in a clarification, they said, (actually the day before yesterday) they said actually the opposite. When an active market for a security does not exist, the use of management estimates, that incoporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable. If the SEC had said this in March, in my view, we might not be in this situation.
The Paulson plan to remove bad assets from bank balance sheets makes sense, at least to me, if the Treasury buys assets from the banks at a value that takes into account the cash flows that these values produce. And that is what the SEC is suggesting. This has a chance of restoring some market confidence that the banks are in fact solvent.
For purposes of this conference today, our economists might assume that the Paulson Plan is adopted, or that it is not. They can also assume that if it’s adopted, it just makes things worse. Whatever they assume, I’m looking forward, like you, to hearing what they think the real economy is going to do in the months ahead.
The way we will do this is the way we’ve done it in the past, and that is we’ll go alphabetically from Charlie Calomiris on my right all the way around to Vince on the [laughs] extreme right, and each of them will make their statements, and suggest their views, then we’ll have a discussion among them, and proceed from there. Hopefully to get time for your questions.
Charlie Calomiris is a Visiting Scholar at AEI, [0:10:00] and codirector of AEI’s program on financial market deregulation. He and I are codirectors of that.
He’s the Henry Kaufman Professor of Financial Institutions at Columbia Business School, and a research associate at the National Bureau of Economic Research. I won’t read all of the background of every one of our participants here. They are too extensive, and you can read them in the materials that we have available for you.
So we’ll start immediately with Charlie.
Charles Calomiris: Thanks, Peter, and thanks to all of you for coming. I guess I could start by saying, like the SEC, I’d like to clarify some of my remarks. Actually, I think I’ll try to be a little more consistent than the SEC [laughter] in its clarifications.
The last two times we met, I said that a deep recession, like those of the credit crunch of the late 1980s, early 1990s, or the 1930s, was unlikely to result in the current capital crunch and credit crunch, and that several quarters of sideways motion for the economy, or a shallow recession, were a lot more likely.
I argued that the capital crunch that began over a year ago was being mitigated by large amounts of capital being raised by banks, and by aggressive Fed and Treasury policy actions.
Also that housing price declines from the mid-2007 peak were being exaggerated by the flawed Case-Shiller index, and that empirical evidence that I did with a couple of co-authors indicates that the effects of foreclosures on house prices going forward were likely to be mild, in spite of the looming tsunami of foreclosures that we all see coming.
I think it’s noteworthy that the sideways motion of the economy that I talked about then has actually occurred. I agree with Peter, I think that one of the surprising things is how robust, how resilient the economy has been, despite all the things that have happened.
So far we’ve weathered the credit crunch pretty well, I would say. The US may have entered a recession already, but even if it has, and I believe it has, that would be my guess, so far it’s a mild one. It’s also noteworthy that banks have raised much more capital since our last meeting. According to Bloomberg, $434 billion of capital as of 3 days ago, since this crisis began. More than $40 billion was raised this month alone, partly in support of stabilizing acquisitions of weak banks.
Furthermore, lending in commercial banks, believe it or not, has continued to grow. These patterns are a sharp contrast to the 1930s or the 1988 to ‘91 period, when lending contracted substantially.
Most importantly, policy makers provided liquidity recently, and more than liquidity, to shore up banks. Whatever one thinks of those actions (I’m sure we’re going to talk about them a little bit) one thing is clear, at least an important on a forward looking basis. Most of the prior looming risk of the possibility of large financial institutions failing, I would say, has been resolved, one way or another.
Weak large banks, in the US at least, are pretty much gone. The assets of Lehman, now being picked apart by various entities — Bear, Merrill, WaMu and Wachovia — have been acquired, or are in the process of being acquired. Fannie and Freddie are in conservatorship, and supporting continuing growth in the supply of mortgage credit under government funding. Morgan and Goldman survived their mid-September bear runs and raised significant new capital, although Goldman and Morgan were briefly at risk on September 17 and 18, that risk has passed, especially in light of their capital raising, and the likely passage, and this is significant, of course, to my opinion, the very likely passage, in my view, of the Rescue Bill tomorrow.
The concentration of the risk of loan losses and derivatives losses in the few remaining big banks also means that we have a much more accurate picture of the distribution of losses among the largest 5 financial institutions. In other words, we’re not as confused about where the losses reside. If we only had one bank, we wouldn’t be confused at all. [laughter] We’re getting there.
None is currently at risk of failing, that is, Goldman, Morgan, JP Morgan, Citi, Bank of America.
Now total worldwide losses on subprime and alt-A — and this isn’t just my number, but I think it’s a reasonable consensus — will be no more than about $500 billion, just on the subprime and alt-A, and probably less than that. Add on other losses [0:15:00] from other markets, and I don’t think you can possibly, reasonably get to a total amount of write-downs, long-term losses, above $1 trillion. In fact I think it’s going to be substantially less.
Given that some of that is in the protected hands of Fannie and Freddie, let me remind you, as Peter and I recently wrote about, Fannie and Freddie own $1 trillion worth of the claims on the $2 trillion worth of subprime and alt-A outstanding mortgages.
And also, given the fact that banks retained earnings and capital offerings have raised huge amounts of capital to replace losses, so long as the current financial panic that began on September 17th subsides, and I recognize that’s a big "so long as," I would say this now seems quite likely, but so long as — to me anyway — given what I think is quite a good chance that we’re going to get legislation tomorrow, … So given this likelyhood, I would say it’s also likely that banks will again acquire some additional capital. Of course even this week we’ve seen Warren Buffett digging down into his pockets.
So I believe that we’re going to see the worst aspects of the credit crunch dissipating pretty quickly, and I think, believe it or not, we’re going to have a recession, and maybe even a protracted recession, but I don’t think it’s going to be a deep one, that is, I still don’t think we’re looking at a capital crunch and credit crunch that’s in any way similar in severity and loss to the 1930s or the late 1980s.
There’s little doubt in my mind that the Treasury’s about to capitalize and liquify US banks to ensure that the currently high credit spreads that we’re witnessing (today’s Libor, I think, may have set new records) is going to be reduced. I think credit growth, obviously, has been a big problem in the last 15 days. Credit growth is likely to resume if capital continues to grow. So I think that’s the story line of why this capital crunch has been so unusual compared to those two previous episodes.
House prices, I think, will continue to decline, but only slightly in the face of rising foreclosures. There’s a lot of pipeline that’s not coming out on the market, that’s going to provide support over the next year. That doesn’t mean that house prices are going to go up, probably until maybe 2011. But it doesn’t mean that they’re going to fall much either.
To me, employment is the bigger concern for consumption than house prices anyway, as we know in theory house prices shouldn’t have a very large effect on consumption. It seems very likely that consumption and investment aren’t going to do very well over the next several months. US labor markets, manufacturing and durable goods are all pointing in a southernly direction, and obviously the recession’s going global, in Europe, Asia and elsewhere.
But I would still say that so long as credit markets stabilize, and I think that they will, there’s still reason to believe that the recession will not be as bad as those prior episodes I mentioned.
At core, I would say the things to keep in mind are that panic episodes like the Panic of 1907, which I think what we’re experiencing right now is very reminiscent of, are not the same as episodes in which there are huge amounts of loss. We’re still looking, on the subprime market, we’re still looking at losses, while very large, nothing like those prior episodes.
I’ll save for the discussion, I hope, the details of a couple of other things I hope we’ll get to, which is … How should, assuming that the Treasury’s plan does pass, how should it be implemented? My own view is, and I’m very happy to see that the current legislation actually has this flexibility, that the Treasury should go in the direction of purchasing preferred stock in banks (and it can do that now under this legislation) rather than buy assets.
Buying assets puts the assets into government hands rather than private hands, buys them at prices that we have no idea whether they’re sensible or helpful, so I think this is the right way to go, and I would say that there’s an academic consensus, and maybe even a policymaker consensus forming around it.
Second thing I would say is, I don’t see why we don’t learn something from what Mexico did in the late 1990s. In the face of gridlock, where there was not a sufficient amount of efficient renegotiation of debt instruments, the Mexican government told creditors and debtors, "You have 6 months …" I think it was about 6 months "… to renegotiate your debt downward. Whatever writedowns you can agree on, the government will bear a share of." And what that did is it crowded in compromise, it crowded in [0:20:00] renegotiation and it reduced financial distress and uncertainty.
I think that we could do that to great effect right now, and I think the bill would be pretty small. And if the taxpayers were willing to bear, let’s say 10 or 20 percent of voluntary, privately determined renegotiations between creditors and debtors in the mortgage market, that that would probably be a very helpful thing, and it wouldn’t cost very much. … Thank-you.
Peter Wallison: Thanks, Charles. Charlie has to leave early, that’s still true, is it not, Charles?
Charles Calomiris: Unfortunately …
Peter Wallison:Well then in that case, let me just ask you a question which came up in what you said earlier, probably occurred to many of the people here, and that is, …
It appeared, at least it has been reported, that bank lending is at an end, it’s stopped. The market is basically not … banks are simply not lending to one another.
Now you said commercial lending has continued to grow. That seemed to me to be inconsistent. Maybe not, but you could explain it.
Charles Calomiris: I’m talking about the time frame of the last year and 3 months, so if you look at the weekly reporting banks, or the whole banking system in the US, C&I lending has continued to grown. It doesn’t look anything like the 1930s or the late 1980s.
[crosstalk]
Now wait, no but … It’s mid-September …
So I was just going to say, that’s not meant to be a statement about today, meaning September. In the last couple of weeks of September I think that that’s the kind … but during financial panics, which is I think what we’re in the middle of, of course we know that markets freeze up. Those Libor rates I was referring to are indicative of it. We have a complete seizing up of the financial system right now. I’m not trying to in any way understate the importance of that, but I’m saying it’s reminiscent of a panic situation.
Remember that during Panics in US history, the actual losses underlying the Panics were very small, but they could create enormous disruptions to the flow of credit, and that’s what we’re experiencing right now.
I don’t in any way want to minimize the sudden sort of seizing up that’s going on. I’m just saying what’s interesting is over the longer term …
Peter Wallison: … mmmmm ….
Charles Calomiris: … credit markets have continued to function. Although right now, we’re in the middle of something very different.
Peter Wallison: OK, thank-you. Our next learned economist is Kevin Hassett. Kevin is the Director of Economic Policy Studies here at AEI, and a Resident Scholar. He’s also a weekly columnist for Bloomberg. Before joining AEI, Kevin was the Senior Economist at the Board of Governors at the Federal Reserve of course, and an Associate Professor of Economics and Finance at Columbia Business School.
He’s got a much longer resumé in your materials, and I’ll leave it for you to take a look at it, but everyone knows Kevin anyway, so Kevin, go right ahead.
Kevin Hassett: Thanks, Peter. [slide3 1] You know, when I was a kid, the only movies that had lots of sequels were happy movies like "Herbie the Love Bug" (there were about 10 of them) and "Benji".
And then at some point kind of around the time I was in college it flipped. And all the movies with lots of sequels were horror movies like "Friday the 13th" (there’ve been, what, a dozen of them now?).
And I guess that this conference is starting to feel a little bit like, you know, "Nightmare on Wall Street III." (I wish it would have been a better title.)
If you look back at my remarks, one of the things that I’ve focused on, which is how I think about the world too, is I try to think to establish is with as much precision as possible where we are right now. And that helps think about … helps me think about where we might go, and sometimes can be really quite illuminating, because the first time that I presented, way back before we knew we would have sequels (I guess the box office was just so glorious that we had to keep doing it) was that everyone said that we were in a recession, and then I introduced the model that I think one should use in real time when addressing that question, and said, "We’re absolutely not in a recession." And we aren’t, you may recall.
And then in April, using the same model, I expressed my enormous discomfort that I was sort of living through one of those lessons that economists … lessons in humility that economists often are served, in that I’d written an article in the New York Times with my co-author, who’s writing a book on this with me here at AEI along with Jim Hamilton, on recessions, and we had extolled the virtues of our glorious model, that Marcelle had originally developed, for dating recessions in real time, and had told the [0:25:00] New York Times’ readers around November that, "We’ll let you know as soon as it happens."
And then more or less what occurred was that for most of the 1st half of the year, the model said, "Can’t tell." Basically it didn’t say we weren’t, it didn’t say we were.
And so to begin my remarks, what I wanted to do is update you on where we are with that, and I can announce with some certainty that recession probably began in June.
This is the … again this model, what it does is it assumes that there’s an underlying data-driving process for the economy that you could conceptualize as there being two urns: a good urn and a bad urn. And in the good urn GDP growth of about 3 percent is what God draws out of the urn on a ball and says, "3 percent," but there’s some noise: sometimes it’s 1 percent, sometimes it’s 4 1/2 percent.
And in the bad urn, God pulls out the ball and tells us what GDP growth’s going to be, the average is maybe about minus 1 percent, and there’s a lot of noise. Problem for the econometrician is to discern which urn God is picking from.
Originally, Jim Hamilton had a paper4 in Econometrica that (my guess is he might win the Nobel Prize for eventually, because it has had such a huge influence on the profession) that did it with quarterly GDP data only, subsequently, Marcelle Chauvet has advanced his work significantly by drawing on a whole bunch of monthly indicators, but using the same conceptual framework, and Marcelle got a model that in real time, or more-or-less real time, has called every post-War recession, and it’s never given a false signal, and it’s now saying that (this is updated with data through September 4th, but only for data through June, because of the vagaries of which data we believe when we’re willing to run it through the model) … [slide 2]
The probability clearly has gone up since then, although we don’t have enough data to report a formal probability. But if you look way to the right, the shaded area’s are recessions, the probability of recession tends to spike during a recession, not outside of that. These probabilities are smoothed, which is only useful information for the time series gurus amongst you.
But you can see that we spiked well above 50 percent in June, and are probably a good deal higher now.
This is what it looks like if we don’t smooth, [slide 3] which is just sort of interesting because you can see that there are very few blips. Essentially no blips this high, outside of a recession.
And so … yeah … recession started.
It’s actually kind of interesting in the sense that … it could be this is a fundamentally different kind of recession, and in the end the NBER will decide that they’re going to go back and say it began in December or something like that, but given almost first … almost 3 percent growth in the 2nd quarter and so on, I think that they’re going to be forced to say June as well, … So my guess is that they’ll say June.
If you’re an NBER handicapper that suggests that the formal announcement that we’ve had a recession will take place in … mmmmm …. in about in January, about in January, maybe December is when we can hear word from them.
And so we’re in a recession now, and from the point of view about thinking about where we are, it suggests that there’s a fundamental difference right now, which is that we’ve gone through this financial crisis for, as Peter mentioned, well over a year. And one of the things that has softened it has been the health on Main Street, the fact that the economy’s really doing OK.
Now if you don’t have a financial crisis driving you into a recession, and you have a recession because there’s a war in the Middle East, the price of oil spikes, "Boom!" you’re in recession, then a lot of times there’s financial distress — credit card companies aren’t getting paid, and banks start to go … you know, have troubles, even absent the kind of problems we’re going in now.
And so the concern would be, OK, the thing that’s made it so (even though we’ve had this financial distress for so long that it’s made it so that we’ve been OK) is now gone, and in fact the economy is going to be piling bad news on top of bad news, and how should that influence how we think the future is going to play out.
I can tell you that markets are more pessimistic about the future in ways that I’m about to quantify for you than they’ve been throughout recorded history, but I really only have the history to report the things I’m about to show you back to the ’70s. And so I can’t compare us to the Great Depression or to the 1900s, 1907, but right now markets are basically pricing in a scenario that if it comes to fruition [0:30:00] means that our way of life will fundamentally change. And I’ll show you what I mean by that.
Before I get to that, this is … my friend Mark Zandy at Economy dot Com likes to do a map [slide 4] of where we are in recession using employment data, and I think it’s kind of interesting that it’s starting to spread just about everywhere through August.
Now you’ve heard a lot of talk about the TED spread [slide 5] and I guess if we’re doing movies, if we had a bill, we could have "Bill and Ted." But (I guess nobody knows that movie) but [laughter] they had an "Excellent Adventure" and this would be the … the second one was "Bogus Journey," which could be what we’re doing right now.
But the TED spread, you know, everybody’s … people have been talking about it. I like to take these interest rate spreads and turn them into things that I can think about, and I’m kind of stupid, so I’ve got to make it a really simple thing. And what I did is I took the TED spread data and I said, "OK, well if markets are behaving so that the people who are deciding to buy this thing as opposed to that thing can expect to break even, then there’s an implied default probability in the TED spread."
So the TED spread, which is the spread between the interest rate, the Libor and the T-bill, that is paid by really the bluest of the world’s blue chip banks, Deutsche Bank, Bank of America and so on. If the interest rate difference is that big, then that means that the banks worry that each of them is not trustworthy, they’re going to go bankrupt.
So I asked myself, "What’s the bankruptcy probability, or default probability that’s implied in the TED spread?" And that’s the next chart. [slide 6] And so what this chart shows you is that right now the implied default probability from the TED spread. And this is a default where basically, you give money to, say, Deutsche Bank, and you just don’t get the money back. So this isn’t like they go into bankruptcy and then you get half of your … This is zero, OK? This is default.
And the probability of that is about 3 percent … It’s actually higher than that now, after today, and that’s over 3 months.
And so right now, Libor is about 15 banks or so? I should have counted before I came. 16? The 16 best financial institutions in the world, right now, the TED spread is telling us that they’re trading amonst each other as if they think that there’s a 3 percent chance that you’re going to lose everything if you give your money to that guy. If you compound that, presume that the spread were to stay here, then that means that there’s a more than 10 percent chance that over the next year that a typical thing would default.
And I can say that that’s very troubling, right? Because the odds … I mean, the governments would step in, you would think. And so for there to be a probability that high, it must mean that people are worried that the governments are going to lose the ability to save you, when the thing goes down.
That’s very troubling, but I can tell you that we’re talking Happy Days, the Shire at Bilbo’s birthday party, if you’re looking at the TED spread, if you compare that to the rest of the bond market.
And this [slide 7] is the same calculation for 10 year bonds right now, so it tells you the probability right now, priced into capital markets, that bonds of different types will default over the next 10 years.
And so you can see, for me one of the favorites is triple-A bonds. Right now, current market prices suggest that triple-A rated bonds, bonds that still have a triple-A rating as of last week, have a 40 percent chance, just about, of defaulting over the next 10 years.
For US financial institutions? The default probability is almost 70 percent? And for non-financial institutions it’s about 40 percent? And so what bond markets are telling us right now, if you’re Milton Friedman and you’re, … I guess Milton would have a story for this, so I don’t want to set him up as a Straw Man, but if you think that markets are perfectly efficient, then what they’re saying right now is that our lives are fundamentally going to change. We’re going to see defaults. 70 percent of our financial firms, 40 percent of non-financial firms, it’s going to be something unlike anything you’ve ever seen. That’s what’s priced in.
And so then the question is, is that a reasonable scenario? And for me, one thing I like to do when I’m thinking about what can happen, and what prices are, is just look at what’s happened in the past.
This chart [slide 8] shows the same default probabilities for some of those (I think I might have dropped a couple because I was running out of space), but the blue line is the worst actual default experience that we’ve ever had, and the red line is the average default. And now certainly we would expect to be above the average default experience, but we’re basically looking at [0:35:00] capital markets right now that, if we’re to interpret their prices as being rational, are saying that we’re going to have something like 10 times the worst thing that’s ever happened. (Data goes back to about late ’60s or early ’70s.)
So there’s a lot of bad times between then and now, but not every bad time. And so in that scenario then, we could say, "Well, how does the credit crisis end? … How does the credit crisis end?" And for me, I think that government policy, obviously it’s something that needs to be considered. But we have to remember that … I just showed you these bonds, but if we could take any bonds, we could take any debt anywhere in the world, it would have similar fundamentals, if we were to do these calculations. And so what we’re talking about is maybe a total value of world stuff that’s being priced at probabilities of default that are really almost implausibly, … yes implausibly high — is in the $10s and $10s of trillions. It’s not just mortgage debt, it’s everything, everything. Nobody wants to take risk, everybody wants cash.
And so, if you’re going to go in there and try to affect prices, then you have to remember that your talking $70 trillion worth of stuff, or $60 trillion worth of stuff is what you’re trying to affect.
And so you need to be kind of humble about what government alone is going to do.
So what would actually turn it would be: people would look at this and they would say, "OK, well the worst thing that’s ever happened is there wasn’t much default, and if 40 percent of triple-A bonds right now, over the next 10 years, default, then I break even relative to treasuries. That’s a bet I’m willing to take."
OK, if people start to think that way, that’s how this thing unwinds. The question is, "What can move them in that direction?"
For me, though, my problem is that you have to restore calm. It’s a Panic, as Charlie said, and to restore calm then, you need some good news, I would suppose. And the problem is that the economy is turning right now. And it’s visible, and the claims, as Charlie mentioned, you know, we kind of grew, it’s kind of not so bad. We haven’t really had a recessionary employment report yet, [slide 9] but the claims are at the level where we could expect the number that we get on Friday to maybe be minus 200,000 jobs, the kind of … like a recession employment report.
And if we look at everything else, like vehicle sales just went down, we found out today, [slide 10] and the home sales, they’re terrible. [slide 11] [slide 12] If I back out consumption right now from the data that we have for the current quarter, I get that it might be, if you’re an optimist, down 2 percent? If you’re a pessimist down 3 percent or so, which means that the 3rd quarter GDP, right now a lot of Wall Street consensus … I was noodling around, and I didn’t take an average, but I just looked at what a few different people were saying. They’re sort of saying minus 1/2 to minus 1, that would be a very happy outcome, relative to where we are in the data.
I think it’s possible that 3rd quarter GDP will be about as bad, a negative number as we’ve just seen in post-War recession history.
So we’re looking, with the start that we have, that a real negative quarter, and so we’ve got these prices that, really, they can’t make sense. They can’t make sense. Especially if you start to unwind the the fundamentals of the things that we’re talking about, like look at the balance sheets of US corporations, which are actually pretty darned good outside of the financial sector.
They can’t make sense, the Panic will end, but there’s not good economic news in the next 3 months to cause that to happen. And so it’s a time looking forward of great uncertainty and great volatility.
I think that in the end, once we start to climb out of the mess, that the climb could be very rapid, as Charlie said, because the prices are basically factoring in right now at today’s prices such terrible things, that even if you go from terrible to ridiculously bad, then there’s a huge celebration of markets.
And so there is an up side. But it’s going to be a very, very tough time, and it’s a significantly worse than it looked like it did in April. Thanks.
Peter Wallison: Thank-you Kevin. I don’t see anyone leaving to make an investment right now, [laughter] but …
voice: … they outlawed short selling … [laughter]
Peter Wallison: … Now for the bad news. Our next scholar is Desmond Lachman. Desmond joined AEI as a Resident Fellow after serving as a Managing Director and Chief Emerging Market Economic Strategist at Salomon Smith Barney. He’d previously been a Deputy in the International Monetary Fund’s Policy and Review Department, and was active in staff formulation of IMF policies.
He’s written on [0:40:00] topics such as economic policy, fund arrangements, monetary reform, import restrictions and exchange rates. Desmond …
Desmond Lachman: Thank-you, very much, Peter, for arranging this. [slide5 1] I really must compliment you on you foresight, in terms of the timing of this crisis, [laughter] that I’m sure that you saw the calamities that were going to afflict Lehman, AIG, Merrill Lynch, Fannie and Freddie and so on, and my recommendation for solving this crisis is that we don’t have any more of these seminars. [laughter]
I’m also deeply relieved that we’re not discussing whether or not we’re in a recession, and the discussion is now focusing on how long and how deep this recession is going to be. I was clearly the most pessimistic on this panel, and I’m going to say three words that are very difficult for most humans to say, and certain for economists to say — I was wrong. That this has turned out to be a whole lot worse [laughter] than we expected. And I think that it doesn’t serve any purpose to be in denial, to talk about the resilience of the economy, when the economy performs rather poorly with a $100 billion fiscal stimulus package that is now in the process of fading.
I think that really what we’ve seen right now is the worst economic and financial crisis that we’ve know for the last 80 years, [slide 2] and I would think that it’s pretty much baked in the cake that this is going to be the deepest and longest recession that we’ve had … I think that it certainly surpasses the … that in the 1980s. I wouldn’t go so far as to say that we go into Depression, that depends on policy mistakes, and I haven’t been too reassured by the performance of our policy makers to date, but I take comfort that Ben Bernanke, for all his sins, is an expert on The Depression and Japan, so presumably we won’t make those mistakes.
The reason for my pessimism is that there are two basic problems, in my view, that are underlying the crisis:
- one is the housing bust of tremendous proportions that we’re doing nothing about (we’re in the downward spiral);
- the second is that we’re in the process of a huge amount of deleveraging in the banking system, because there’s a shortage of capital, and I don’t see the Paulson plan as really addressing that.
Let me turn to, give a more detailed account of why I’m coming to this position.
The first point I would make is that when you look at the credit crisis, what you really have to do is see that this credit crisis is not occurring in isolation. [slide 3] Indeed, it’s occurring, as I mentioned, with … should I say? … just back up and say that both Paul Volcker and Greenspan are describing this as a once in a century, or once or twice in a century event, so you’re got a major credit crisis, but what you’ve also got is you’ve got a tremendous housing market bust, which I’m going to talk about in a moment, and that there’s nothing stopping house prices from continuing to fall at the same kind of pace that we’ve seen right now, which only compounds the banking problem, compounds the balance sheet position of the households.
But what we’ve also got is we’ve got asset prices declining in a generalized way, in that they haven’t occurred before. Not only do we have house prices declining, but we’ve got equity prices — you know equity prices, S&P 500’s fallen a mere 23 percent since the beginning of this year. We’ve got bond prices, corporate bonds blowing out to ridiculously high spreads.
So what you see is that asset prices have now fallen at the fastest rate that we’ve seen here in the last 30 or 40 years. [slide 4] My calculation is that we’ve just wiped out a mere 50 or 60 percentage points of GDP and household wealth, and I would boggle my mind if that doesn’t have a big impact on consumer spending going forward.
The other thing that I would just say is that there’s a minor problem that we’ve also had a commercial bubble in commercial real estate, [slide 5] and I would have thought that, as Lehman and AIG unwind, the property in this kind of environment, we’re going to get a bust there that’s only going to compound bank losses going forward. So the bank loss story, in my view, is a ongoing saga.
Now the previous speakers have spoken about the environment [slide 6] in which we are operating, the starting point isn’t too good; that [0:45:00] employment has fallen each of the last 8 months, [slide 7] which is an indication, as Kevin has indicates, that the recession has already started. Consumer sentiment is at something like a 28 year low, or so, [slide 8] and when we look at GDP numbers, [slide 9] if what Kevin says is right, that you’ve probably got flat or negative GDP in the 3rd quarter, it means the last 4 quarters, at best we’ve been doing something like 1 percent growth at a time, that I said, that we’d had a huge fiscal stimulus package, like $100 billion is like 3 points of GDP in a particular quarter, and what we see is, if you look at the red line, most of the growth that we have had has come from the export sector.
Meantime what’s occurred is the dollar has begun to appreciate, and what we see is Euroland is in recession, [slide 10] Japan’s in recession, so our export markets aren’t doing too hot. So, as I say, we’re starting from a very bad beginning point.
Let me just turn to the housing story. [slide 11] If you look at Case-Shiller, [slide 12] what you see is you’ve already seen a decline. The last year it’s been about 16 percent, probably about 20 percent from the peak, and the red line there is what the futures market indicates. And I think that the futures market, this time, is correct. Not that I’ve got the greatest respect, having worked on Wall Street, I’m reminded of Fischer Black remark, when he came from MIT to work on Wall Street they asked him what had he learned, and his first thing that he said that he learned was that markets looked a lot better from the Charles River than they did from the Hudson. You know, I’ve found the same thing from the Potomac.
House prices are falling at the same time that inventories of unsold homes are rising to record levels. [slide 13] We’ve got something like a year’s supply of houses overhanging the market, and to make matters worse, as we’re getting very heavy negative equity positions in houses, [slide 14] means that people’s homes are worth a lot less than their mortgages, so people begin to walk away from homes, and, surprise, surprise, foreclosures are off the charts. [slide 15]
Forclosure procedures initiated are now running at a mere 3 million units [laughs] at an annualized rate a year. Where I come from that means that there’s more supply on the market, which isn’t too good for home prices. Not to mention that unemployment is rising, which doesn’t mean that there can be too many buyers, and mortgage lending has all but dried up, [slide 16] you know we’ve had a little fiasco with Fannie and Freddie, which means that you’re not getting lending from there, so the housing situation isn’t going to turn, that we’re going to see house prices continue to fall, and I think that that compounds the banks’ losses.
Let me just turn to the story with banks. As I said, my view is that the bank problem is one of a shortage of capital, which induces a process of deleveraging, [slide 17] but not everbody can deleverage at the same time, because as they deleverage at the same time, they just drive prices down further, which increases the losses, which means that they’ve got to deleverage a little bit more, so something has to come from the outside, something like a Sovereign Wealth Fund based in China, who wasn’t burnt, who would come up with more capital, which doesn’t look too likely, so I’m afraid it’s really the government, and you and I who are going to be having to foot this bill.
When I look at the bank story, this is a chart taken from a dated report from the IMF. [slide 18] At that stage what you had was you had something like losses recognized by the banks globally, $500 billion, but they only raised $350 billion in capital, so there was a $150 billion shortage, which, I think, would be compounded by falling asset prices, and also by the natural consequences of going into recession. You know, banks get losses and that makes their position worse.
This is an indication of bank lending, but this was done in July. [slide 19] I don’t know where we’ll be in September / October given the stress that’s occurred, but basically, banks are already restricting their lending very much. At the same time, that I should mention that’s what’s called the "Shadow Banking System" is all but dead. That something like 75 percent of capital now gets intermediated through the financial markets, nothings going on in financial markets, so we’re getting contraction of credit at the same time that the markets are frozen, means that credit’s not going to be available to households and companies, which must mean that you have a downturn.
Of course what this is doing [0:50:00] is the spreads are blowing out, [slide 20] that which what it means is that the Fed, much as it tries to cut the short-term interest rate the Federal Funds Rate, the rate at which people are borrowing now is much higher than it was before the whole crisis began, because spreads are widening, so monetary policy is pretty ineffective in this kind of environment.
Kevin has spoken about this chart. [slide 21] If ever there’s, … My brother’s a cardiologist, I should show him this as a cardiogram, you know, he would tell me the patient was long since dead. [laughter] but that I … This is really telling you that we’ve got a problem here of major proportions in the financial markets.
This chart is a little complicated to read, and this is dated. [slide 22] This is the numbers that Charlie was talking about, bank credit, all commercial banks. He’s right that if you look at it year-on-year, there’s not much of a problem, it doesn’t look too bad, but if you look at the last 3 months of available data, we haven’t had credit contracting at as rapid a pace in the last 50 years, and my expectation is, with what’s been going on in September, this chart is really going to look very ugly.
The reason that I think Paulson’s plan doesn’t work in its existing incarnation is that I don’t see it really addressing the capital shortage problem. [slide 23] I see it as being basically, as they so colorfully on Wall Street characterize the plan, it’s a "cash for trash" kind of plan. What I does is it helps in the deleveraging process, but unless they’re going to be paying a substantially higher amount than the assets are really worth, it doesn’t do anything for the capital position of the banks.
I think it’s a stupid plan for another reason, is that it’s not a particularly targeted plan, that it doesn’t distinguish between banks that have got a capital shortage problem and banks that don’t have a capital shortage problem. So I think that they could have designed this in a very much better way.
My expectation is that we’re not going to get to January 20, 2009 with another real financial market crisis, but in the event, whoever’s elected, I would think that they’ve got to do four things that … and they’ve got to do them simultaneously in a well thought out coherent kind of manner if we’ve got any chance of having this as being a major recession through 2009, [slide 24] and the four things are …
- they’ve got to stabilize the housing market;
- they’ve got to do something about the capital shortage of the banks;
- they’ve got to be more aggressive on monetary policy; and,
- they’ve got to be thinking about a second fiscal stimulus package.
On that happy note, I end.
Peter Wallison: Thank-you, all. Now we’ll get a lot of better news from John Makin. [laughs]
John is a Visiting Scholar at AEI. He’s still a Principal at Caxton Associates. John has been an advisor to numerous US government agencies and the Federal Reserve system as well as the Bank of Japan. He’s the author of numerous books and articles on financial, monetary and fiscal policy, and he writes AEI’s monthly Economic Outlook, which I assume you are all getting, and if you don’t get it, you should. John …
John Makin: Thank-you, Peter. Well let me start out on a light note. I always read the New York Post, because it is so eloquent [laughter] with regard to current events. And this is their cover, which has a Senator dressed as a piggy, to characterize the Senate version of the Paulson Plan bill. And it has some delicious details about some of the items that have been added to the bill by our Senators, who are deeply concerned about the fate of the Nation, including, and I’m glad to hear this, $128 million tax credit for land improvement by auto racing tracks. And since I’m a big fan, and I was always a big fan of other taxpayer subsidies, I’m just glad to see that the Senate is well focused on our welfare, but it’s business as usual in Washington.
I think the factual coverage here by Desmond of what’s happening to the economy is fully adequate, and as I’m sitting here and I’m listening to the different presentations I confess that I’m trying to identify with the audience, and try to explain to you why we have such different views [0:55:00] on the nature of the credit crisis and the economy. In order to discipline myself, I read the New York papers and the London papers and the Washington papers, and they come from different worlds. And so perhaps that’s some of it.
But I just wanted to describe the events that have occurred since Labor Day, and leave it to you to judge if the financial markets are still in pretty good shape.
Lehman Brothers has collapsed, leaving their counterparties with virtually valueless claims on the firm. Indy Mac, the California bank, experienced a run and is closed. washington Mutual was absorbed by JP Morgan in an innovative transaction. The massive insurance company AIG has collapsed, the Fed has given them an $85 billion loan in exchange for the company, or 80 percent of the company. Goldman and Morgan Stanley are now banks, so that they can get under the umbrella offered by the Fed. The investment banking industry is no more. Bear, Lehman, Morgan Stanley, Goldman, Merrill are all gone.
The … let’s see what else … oh yes … AIG gone, and then yesterday the best corporate credit in the United States, GE Capital, had to pay Warren Buffett 10 percent plus warrants, the effective cost of the money was about 15 percent, or perhaps higher, we haven’t got all the details; so that I would ask you if the best corporate credit in the country has to pay Warren Buffett hold-up rates in order to get financing, where he gets free warrants and a good piece of the upside, if you think the credit markets are in good shape, I invite you to try to get a loan. If you think the financial markets are in good shape, I invite you to take a glance at your 401(k) statement, which will reach you too soon, for the quarter that’s just ended. I’m guessing you will be down about 15 percent. And nationally that adds up to trillions of dollars of wealth losses.
The path of the economy, I would just remind you, in the 4th quarter of last year it grew at 0.2 percent (these are all annualized numbers), in the 1st quarter it grew at 0.9 percent, in the 2nd quarter it grew at 2.8 percent (that was just gold, just Goldman, they’re on my brain). As Desmond has pointed out, we’ve sent $150 billion out to the US economy, and that will do the trick anytime to get you a growth … it’s remarkable how weak domestic demand was in that environment, and that virtually all the growth was accounted for by net exports, and as Desmond has pointed out, the buyers of our exports are dropping rapidly.
So I just … I mean I can’t square the things that I see every day with what I would call sort of the sanguine view of capital markets and the economy that I’m hearing here. C&I loans are rising because companies are drawing their credit lines, much to the chagrin of the banks that have offered them, and wished they weren’t drawing them, but any company that has a credit line with a bank is going to draw it down, in order to raise capital, so they don’t have to go to Warren Buffett and pay up …
But we are … we’re in a serious problem, but let me try to explain how this happened, and then suggest how we might get out of it.
The alarm bell was the Bear Stearns collapse in March. Certainly that was a load alarm bell, there were others, but that was very dramatic. And what … the problem with the Bear Stearns collapse in March was that it generated a situation where banks, that were claiming that assets that they had on their balance sheets were worth more than they could sell them for in the market, had to start financing those assets. In other words, if you say I’ve got an asset, and I say it’s worth 100 units, and I’m not going to sell it to you, but I’m going to mark it on my books at 100, I then, if I’m not going to do it, then I … if I’m not going to sell it, then I have to finance it. And as the underlying situation, that is, the underlying value of the housing stock, to which most of these mortgages were tied, continued to drop in value, those who would normally finance the holding of those mortgaged backed securities became reluctant to do so, and gradually the financing … [1:00:00] dried up, and of course Lehman was one of the more highly leveraged investment banks, and so they hit the wall first.
But what’s important to recognize here is, I think, the pace of events. The pace of events in the last 30 days has been so fast that I literally have to write down all the events that have occurred. And I listed some of them for you here.
And under the surface there is a serious … I guess you’re not supposed to use the word financial Panic, but it looks like a financial Panic to me.
There are days on which, and part of it is the extreme lack of liquidity in this sector, and over the past two weeks there is no liquidity, banks will not lend to each other. That market is closed. I can assure you, I get a report every morning, that market is closed. Banks will not lend to each other.
And ever though the central banks don’t … lots … like hundreds of billions of dollars into that market, I think what we have is an interbank liquidity trap, because banks just hold on to the money that’s handed to them.
The other problem that we see, of course is there are signs of a run on the banking system, which are basically an attempt by households, and Milton Friedman documented this well in the Great Depression. You get a run out of currency … sorry, run out of bank money into currency.
So there was a day last week when the yield on 4-week T-bills was minus 1 basis point. That simply means that everyone wants to own claims on the government, and they’re [laughs] actually willing to pay the government a basis point to store their cash.
Yields on T-bills are still very low, and it’s a good measure of how nervous markets are, but you’re having … what you have is an incipient massive excess demand for government money, or currency, or T-bills, and an excess supply of bank money. So while we have the banking system is frozen, the credit markets are frozen, and households are beginning, or actually, not beginning to, have been running out of the banks. Part of the problem, of course, with an institution like Washington Mutual was that 40 percent, roughly 40 percent of the deposits were above the $100,000 FDIC limit, and so large depositors in Washington Mutual were rushing their funds out of Washington Mutual, because they had no protection.
So again I guess, being in the markets every day I know can blunt my perspective to some extent, but it certainly suggests to me that something really bad is happening. And I am concerned, … oh, I forgot to mention [laughs] that Fannie and Freddie are in conservatorship. … Nothing to it, nothing to it.
And actually, the nightmare that I had in April (and wrote about in the Wall Street Journal and … I guess I handed it out at the last session we had) was that we would be attempting a legislated solution to the problem in the midst of a financial Panic. Anyway, that pretty much describes what we’re doing. And that’s why I held up the piggy, because Congress in not equipped to deal with a situation like this. we’re asking the Congress to do things that they’re really not designed to do. And the Congress actually, I think, showed some wisdom when they rejected Secretary Paulson’s 3-page plan, which essentially said, "I’ll decide what to do, and by the way you can’t hold me legally responsible." I’m guessing that was unconstitutional, but we’ll leave that to the Judges to decide.
And so now that we have a financial Panic and we’re attempting a legislative solution — and I think, I don’t know, it will be interesting to see what people say — As I look at the Plan, I’m concerned that the Plan will pass and that the problems that I’ve been describing in the banking sector and the household sector will continue, and I’m glad to hear Charlie say that the idea that the Treasury may implement this by taking a stake in the banks with preferred shares …
Charles Calomiris: … I verified that the bill would allow it, …
John Makin: … right …
Charles Calomiris: … I haven’t verified that the Treasury is interested in it.
John Makin: … oh, OK, well we’ll grab at any straw here. I’ll take that as a hopeful sign. Because, again, we’ve seen the model. Warren Buffett’s a smart guy, and he worked it out, basically with Goldman and GE capital he said, "You want to … I’ll lend you some money, I’ll buy preferred stock, I want warrants, [1:05:00] I want the upside, and it’s going to cost you plenty, and if you want to call it in in 3 years, it’s going to cost you even more."
So Warren Buffett’s only risk in this is what I would call systemic risk. If GE Capital … (take care, Charlie …) if GE Capital is around next year, Warren Buffett will make a lot of money, and it probably will be.
The problem is that there aren’t too many … in other words it’s a good time to be a billionaire. [laughter] Always as good time to be, … but especially a good time to be a billionaire now. It’s the JP Morgan model in the Panic of 1907, the JP Morgan model over many panics, nicely documented in Ron Chernow’s book The House of Morgan, where if you’re a billionaire, or the equivalent thereof, this is a great time to step up to the plate and write contracts that will make you a lot of money. I do wish that the Treasury had consulted Warren Buffett on the framework for their proposal, because I think that it would have worked better.
So where we go from here is very difficult to say. I do agree with Kevin that the growth rate in the 3rd quarter will be somewhere between minus 2 and minus 3, but the downward momentum that we’re seeing from the numbers that are now coming out, both in terms of consumption and capital spending, and government spending, is not going to be bouncing up here either, it’s going to be contracting because tax revenues will contract rapidly, so I’m guessing we’ll see a bigger negative number in the 4th quarter, because what we’re seeing here is something that we didn’t want to see, which has caught the … it’s been articulated, the "adverse feedback loop," (Vincent’s very familiar with that) where the weakness in the credit market makes the economy weaker, and the weakness in the economy makes the credit market weaker.
So what to do? Well, I hope that we can redesign a program to inject capital into the banks on the terms that Warren Buffett has suggested, that is, that the taxpayers … the plan is set up so that the taxpayers who take the risk of putting capital up to purchase preferred shares issued by banks, and warrants thereon, get the upside, the upside should be earmarked for tax reductions. I’m a dreamer, but it certainly … that’s a better way to go.
On the monetary policy side, and I’ll leave Vincent to say more about this, I have been somewhat disappointed in the Fed’s passivity in response to this crisis. More action may be on the way. They certainly need some help from their brethren abroad in Europe, and they may get it, but we are probably at a stage where the Fed has to entertain the notion that if everybody wants to have currency, they’ll have to be able to get it. Because the way to stop a run on a bank — and we’ve had some — is to simply have anybody who wants to convert their bank money into currency able to do so. And once they’ve done it, and they see that the world is still standing and they’re not earning interest on it, while the bank’s earning interest, eventually the process is reversed.
Those are pretty radical measures, but I think we’re in a difficult situation.
Lastly, to see about the outlook for the economy, I think the Japanese model, the model from the Scandanavian countries around 1989 / 1990, suggests that it usually, after this kind of an episode where you have a credit crisis that causes the economy to get very weak and you have an adverse feedback loop operating, that growth keeps, the economy keeps falling for roughly 3 years after the peak in the bubble. So that would put us somewhere in 2010, when the economy starts to level out.
I’ll stop there. Thanks.
Peter Wallison: Thank-you very much, John. OK, our final economist is Vince Reinhart. Vince is a Resident Scholar here, at AEI, former Director of the Federal Reserve Board’s Division of Monetary Affairs, who has spent more than two decades working on domestic and international aspects of US monetary policy.
He’s worked on topics as varied as economic bubbles, and the conduct of monetary policy, auctions of US Treasury securities, alternative strategies for monetary policy and efficient communication of monetary policy decisions. … Vincent …
Vincent Reinhart: Thank-you, Peter. This is my opporunity for me to talk about what lies beyond the credit crunch. [slide6 1]
[laughter]
I secretly … I suspect that secretly the physicists in Switzerland fired up the world’s largest particle accelerator, [1:10:00] and did in fact create that mini Black Hole which they promised was a very low probability event, and that giant sucking sound that John and Desmond hear so clearly from markets is our future.
But instead, I’m going to be less pessimistic than them, which isn’t hard, but I would not consider myself an optimist. I’m going to build a principled case against less intervention than we had, but more than we do now. [slide 2]
But to do that I’d first like to talk about what went wrong, what would have been better, and then where are we now.
So the story thus far, [slide 3] which is basically a summary of the previous two panels we’ve had, is that the economy is absorbing an enormous economic drag associated with the correction of overbuilding in housing, and the associated house price declines.
That poses 3 direct drags. [slide 4]
First, there’s a drag on construction spending, as builders cope with bloated inventories. Declines in house prices associated with that excess supply of housing are lowering real wealth, and crimping household spending.
Well Charlie correctly pointed out that it is still the case in Chicago — Field Exams they ask to explain the case why house prices are not a part of wealth, you both own it … we own something that we effectively rent from ourselves to provide services. Actually, historically and statistically, it does appear the case that housing wealth is connected to household spending. And probably for a very good reason. The presence of housing wealth lifts the collateral constraint that we all face with housing equity. We can borrow against own future incomes. There’s less housing equity now, there’s less borrowing against future incomes.
And then third, some households seeing the value of their main asset, their home, go down, walk away from their main liability, their mortgage. That, of course produces the elevated defaults on mortgages. Here in the upper left panel of this exhibit, [slide 5] looking for cohorts of mortgages originated in the first part of this decade, 2005, 2006 and 2007.
Stunningly bad mortgages were made, in part as housing fundamentals slowed with the increases in interest rates and the slowing in income growth, but the industry tried to keep, as we — a metaphor we now owe importantly to Mr. Prince, the dance going by easing terms and standards on loans.
Credit markets are magnifying this economic loss. Mortgages serve as collatoral for security. It happens that those securities are complicated, often quite intentionally so. Investment bankers intentionally created complicated securities, because that was the product differentiation that provided above-market value to them.
If you look around in financial markets, those services that are commoditized bear no economic return. You get an average return. So mortgage-backed securities were intentionally complicated, and they’re held on entities with very opaque balance sheets. The net result is we’re seeing this withdrawal from markets for fear of weak counterparties. Each individual banker does the introspection of "I’m not actually sure of my own position, then the guy I potentially trade with must be in a similar position." And we’re also seeing an unwillingness of any of the stronger hands to partake in arbitrage that would better distribute liquidity.
So the mystery about that elevated Libor spread isn’t just, "Why are some banks so suspicious of their counterparties?" it’s also, "Why aren’t other banks going to the ECB or the Federal Reserve, borrowing funds at their discount window and relending in the market, where they could get so high returns?"
Short answer is, "Everybody’s conserving balance sheet right now." They don’t want to blow up their capital asset ratios.
The bottom line is financial firms need more capital. Up until now, the governemnt action has been ad hoc and inconsistent. In what ways? [slide 6]
Well, is it going to be Lehman or AIG?
And if there is a resolution, either outright done by the FDIC, or in encouragement from the government for a strong institution to take over a weak one. [1:15:00]
Will it be like WaMu, where a creditor, uninsured debt holders lost? Or will it be Wachovia, where all the liabilities were protected?
This inconsistent line has created 3 bad incentives over this year. It encourages the management of firms with capital deficiency to delay taking necessary actions.
My favorite example that I’m going to repeat it is Lehman. The week after the Federal Reserve opened its discount window to investment banks, Lehman issued a securitized product. It took the bits and pieces of mortgage securities that were lying on the cutting room floor, rolled them into a security that had no economic purpose other than it was now eligible for collatoral at the discount window.
If the idea of temporarily providing liquidity was to buy time for management to deal with the problems, creating a CDO-cubed by rolling together those securities evidenced that wasn’t working.
Now just so you know that investment bankers do have a sense of irony, does anyone know what those notes were called? … Freedom Notes. OK …
Second, government action has emboldened creditors and short-sellers to push for outcomes that raise debt values through credit enhancement and lower equity values.
Once you know the government playbook, once you’ve read it in terms of what happened to Bear, what they did with AIG, what they did with most firms, firms when they step in; if you have a perfect self-funding stategy. If you think a firm is going to be taken over by the government, you know the government will dilute the existing shareholders, and protect the debtholders. So you short the stock and use the proceeds to buy the debt.
And so it isn’t an accident that these funding runs ran together. Because once one firm fails, you look for the next weak antelope.
Together, the encouragement to bad behavior on the part of management, and speculation associated with knowing the government playbook, that deters the infusion of private capital. We have a hole somewhere on the order of … in excess of $1 trillion. We have seen capital come in, but government actions probably slowed that process.
Now, this really matters in financial markets, because bad policy can have a large effect. Because market behavior depends on the expectations of market participants. [slide 7]
And here’s a little tinker-toy model I always like to think about. Suppose your participation in an activity depends on your expectation that other people will participate in that activity. If you come to doubt they will participate, you’ll cut back your participation. And they will justifiably cut back their participation on the anticipation that you will cut back on yours.
That is, markets with an important roll for expectations can produce herding, can produce self-fulfilling prophecies, can produce multiple equilibriums. That means market outcomes are very sensitive to shifts in expectations, very sensitive to changes in cost.
Libor spreads don’t blow up in an afternoon and a half because everybody solved an information problem that says, "Oh it must be the case that balance sheets are more impaired." Everybody was heading for the exit at the same time.
But in that environment, a governmental action that provides even some reason to delay providing capital can have large consequences.
Now that’s where we are. Where could we have been, extending the physics metaphor to talk about an alternative universe? [slide 8] … Schrödinger’s Cat? and splitting paths?
We could have gotten back to basics. The hurdles that … and let me first say, I am not always opposed to government intervention. I think we had … the government had to protect the debt of Fannie and Freddie. Because that wasn’t the mistake, the mistake was allowing Fannie and Freddie to exist with an implicit guarantee for the prior decades. It wasn’t a bailout of Fannie and Freddie, it was honoring a commitment that had been made [1:20:00] on … sub rosa. And it would be a worse thing to deny that commitment than accept the moral hazard. Moral hazard was already there.
So, governments sometimes do have to act. There are, there can be market failures, there can be coordination problems, there can be periods in which, becauses of the self-referencing nature of markets, you’ve got to shift … you’ve got to nudge markets from the bad outcome to the good outcome.
But I think it’s important to pass over four hurdles, four questions [slide 9] to ask before you do that:
- first, how sophisticated are the investors in the firm? that is the idea[ph];
- how sophisticated are the creditors? (For instance, in this particular case of Fannie and Freddie, I’d argue that an important class of creditors to Fannie and Freddie were unsophisticated in the sense of their reading of … well to be fair[ph], reading the political landscape, but unsophisticated in their belief that it really was government guaranteed, and therefore we had to honor it);
- third, how long has everybody had to learn about the firm? and,
- how interconnected is the firm?
And those are the questions we should ask each time, in a crisis, when we’re asking to expose the public purse.
Having asked those questions, if intervention is needed, the authorities, wherever possible, should refinance the part of the balance sheet that has systemic implications. [slide 10] If Bear Stearns had systemic implications, it wasn’t the entire firm, it was this portion of the portfolio probably related to Credit Default Swaps — of course its derivatives position generally.
You see, you can act inappropriately in either way, you can protect too much of the firm Bear Stearns by not looking just at what parts are systemically important, or you can protect too little of a firm like Lehman, by not protecting the parts that are systemically important.
This would allow the rest of the institution to be resolved by the market, and as a consequence, authorities don’t have to make a determination about the underlying values of the firm.
Above all, you shouldn’t use instruments designed to provide liquidity as a substitute for capital. And the fundamental problem we’ve been making is the government has been misdiagnosing the problem as a liquidity one for a captial one. That means we’ve been using the wrong instruments of policy — lending, not capital infusion. And we’ve been using the wrong agents for those actions. The nation’s central bank rather than the fiscal authority.
We don’t, however, live in that alternative universe, [slide 11] and crisis management is all about where you are in the field at this point in time. And we’re already in a position now, driven by previous actions.
The good news about TARP, and somebody’s got to say good news about the pending legislation, is the government is finally recognizing that capital’s required. [slide 12] I think it correctly places the action with the fiscal authority rather than the central bank. And I would also argue that communication in that need has been inconsistent and unhelpful, to talk about this plan as potentially profitable. Doesn’t send an appropriate … doesn’t convey an appropriate diagnosis is the problem.
And I agree that asset purchases are inefficient relative to other alternatives. I don’t think that there’s any question about that, for many reasons. You’re trying to move a very large market, it is an indirect. There’s a question of what price we can actually is critical with how everything works.
And I can imagine a well constructed scheme that would have direct capital infusions, firm by firm, or offering insurance with government resources. The problem with the insurance scheme in the legislation — in variance with the legislation — is it assumes that an industry on net deficient in capital can somehow insure itself. If there was enough capital to solve the problem, then they don’t have to insure each other.
In some sense it reminds me a lot about the internet bubble, in which everybody was going to profit by selling space on their web page to other firms [1:25:00] who were selling space on their own web page. There has to be real money. And the legislation provides for real money.
There are also … imagine governmental assisted mortgage relief as solving the balance sheet problem by moving that very large housing market to ultimately support the underlying assets, the house, which protects the collateral, which then protects the mortgage securities.
You have to understand some limitations about government. [slide 13] Action — government action has a couple of very important inherent limitations, and the first is, officials are extremely bad at maintaining boundaries on programs. The perimeter of support expands. It tends to be bigger in legislation than it needs to be, and over time it grows.
I think, if the problem is the systemic strains in finacial markets, we can list on one page the number of firms that would need capital infusions. I’m also pretty sure that every single financial institution in the United States has had their sheet hurt by what happened in housing markets, and if Congress were to institute, institution by institution relief, I’m also fairly certain, it wouldn’t be that one page list, it would be the tens of thousands of financial firms.
Second, any firm by firm program where you are making decisions on capital infusion, or house by house programs where you’re providing mortgage relief, to be done right requires infrastructure; the HOLC, the Depression era construct from 1935, at it’s peak, employed 20,000 people, and touched 1 in 10 homeowner, and lasted until 1955. It’s also the case that such firm by firm negotiation puts the government officials at a decided information disadvantage relative to the private sector, they’re always going to bring better MBAs and lawyers to the table, they’re going to bring more of them, they’re going to show the worst assets.
Asset purchases in the market don’t need much infrastructure. The Treasury can start doing it the day … the morning after they get the authorization.
They also don’t make distinctions among who’s helped, so you can make the argument that the incidence is fairer, than in the individual firms. It is true that reverse auctions of individual mortgages are more complicated, but the fact is, the government does have experience in conducting auctions. Peter read my brief bio at the beginning, and what I worked on in the early part of the ’90s was the Treasury’s experiment in single-price auctions, after Salomon Brothers admitted cheating at Treasury auctions.
The government actually runs some very complicated auctions, including the auctions of spectrum rights, which was a band of the spectrum by area code of the country, in which it was an iterative auction where the entire market, the entire country market would clear each time.
And true, when you get to the level of individual mortgages, or pools of mortgages, or complicated securities, that information disadvantage, the asymmetry, where the government doesn’t know as much as the private sector, is there, but that’s the place to control through the issuance of warrants. If in a reverse auction, each claim to a pool of mortgages presented to the government had a warrant stapled to it, the upside on the equity price compensates for the downside associated with the information asymmetry.
TARP also gives considerable discretion to the Sectretary. If you’re an optimist like John, you say, "Maybe it will be used appropriately." You could look at the record up to today of the officials we are giving that authority, but the authority is broad, and it does include, basically, a blanket systemic risk exception, that the Secretary could buy anything that he, with consultation with the Chairman of the Federal Reserve, views as important for addressing [1:30:00] systemic problems. And consultation of the Secretary with the Chairman of the Federal Reserve, as we’ve seen in the last year, is not a real high hurdle.
So TARP does do some important things.
The legislation, by the way, also makes it more likely that the Federal Reserve will continue to keep its balance sheet at risk. [slide 14] Why? Included in the legislation is the provision that Federal Reserve can pay interest on reserves. What thay means is the Federal Reserve, once exercising that authority, will be able to expand its balance sheet without pushing the overnight rate to zero. It will push it to the floor established by the depository.
That supports unlimited expansion of the Federal Reserve’s balance sheet. It basically supports what we used to consider as unusual policy actions — expansions of the existing facilities, expansion of swap lines, potentially more aggressive purchases of assets generally.
Now there’s good news there, because Peter at the outset asked the question, "What happens if the legislation doesn’t pass?" Well, what’s going to happen is Congress will go home, but the crisis managers will not. The Treasury does have its authority under the July housing bill to buy mortgage-backed securities of Fannie and Freddie. The Treasury can abuse the notion of conservatorship and have those two firms that are currently being run by the government expand its own outright holdings of whole mortgages or private label securities, all within its ability, and within the scope of the July legislation.
And the Federal Reserve can expand its balance sheet up if the Treasury is willing to over-issue Treasury securities, as it has in the last few weeks. And the Federal Reserve does have a policy rate set at 2. It can go down, and when it goes to zero there is no constraint on the size of the Fed reserve balance sheet.
I think that the landscape, as many people have mentioned, the landscape of financial markets has changed very much in a short period. This will one day be over, and perhaps in version 12 or 13 of this sequel we’ll be talking about the cleanup legislation required to solve the problem. We’re going to have to think very hard, among other things, about what do we expect of the central bank? What role should the Federal Reserve have, given that, through experimentation, it has significantly expanded the number of its policy tools. In the future we’re going to have to ask the question, "Do we want the Federal Reserve to keep using those?"
Peter Wallison Thanks, Vince. Well we’ve come to the point where the members of the panel can talk to one another, and then we’ll got to questions from the audience. Do you guys want to say anything about … yeah, they’ve been waiting a long time, that’s right.
But I have one question that I do want to ask, and that is, Vince: The structurer of TARP, I think, is really fascinating and interesting to me. The idea that the Secretary came up with was to buy assets. I can’t help thinking that what his underlying view was, was that the assets currently in these banks were undervalued. Otherwise it makes absolutely no sense, because if you’re going to buy the assets at a market price, which is very low, you just make the banks insolvent.
So what do you think he had in mind, and why did he structure it this way, rather than as, for example, a capital investment?
Vincent Reinhart: I personally think the folks at the Treasury came with the idea of, in these auctions, initially with the view that they would be the broker and not the principal. That is, they would be facilitating the financial market clearing by organizing these auctions for them. But I think that’s background. … Why they do what they have, they did.
There’s 3 prices to think about. There is the price currently in the market. There is the price of these securities at normal tolerance for risk in normal market functioning. And presumably the Treasury is going to pick a price [1:35:00] somewhere in between. So that it provides balance sheet relief by increasing the prices of the assets sitting on these firms’ balance sheets, but with enough below the prices of normal times, so that that will provide at least the opportunity for some profit.
Importantly, the third price you should think about is the price that makes all financial firms solvent. That is well above the price associated with normal market fuctioning and tolerance toward risk. Why? Because that price includes, basically compensates for, the economic loss associated with mortgage defaults. That’s real. And it would be inappropriate to try to raise prices so high.
What’s that mean? It means that you should think about this bill as being an industry consolitation vehicle. The strong institutions will get their balance sheets liquified because they can put their troubled assets to TARP. The weaker institutions will have a harder time, because of mark-to-market hiding their losses, and can then therefore be taken over by the strong ones, and their troubled assets liquified.
Peter Wallison: Do you think the idea was to cause a lot of defaults?
Vincent Reinhart: I think the idea was to facilitate industry consolidation. … Charlie’s not here, but an interesting factoid is, Chairman Bernanke’s 2nd most cited paper on the Great Depression is actually one that compares the business cycle in the United States and Canada in the 1930s. And the contraction activity was much more gradual [in Canada]. The reason? Canada didn’t have bank failures, because Canada had a consolidated banking system.
Desmond Lachman: Could I just ask Vince, is there a long-run risk, getting beyond the crisis, that what we’re going to have is a banking system that essentially has 3 big banks, you know, not sufficient competition.
Vincent Reinhart: I think it’s a very serious risk, and essentially we’ll wind up with several large banks, all of them too big and too interconnected to fail.
I was on a program with … a panel with Paul Volcker two weeks ago. And he said, well, for solace he went back to "The Wealth of Nations" to see what Adam Smith would think of all this. And he had … there’s a chapter, true enough, on the Scottish banking system in the inherent risks in banking. And Adam Smith’s solution is, we’ve got to make sure that banks stay small. … **sigh**
Peter Wallison: OK, it’s your turn to ask questions. And what I’d like you to do, we have a microphone somewhere … The mic people are all up and ready. I’d like you to identify youself and then ask your question. And please ask a question, not just make a statement. A short statement is OK … as background, in the back … over there? …
Tad Howard[ph]: My name is Tad Howard[ph]. Peter, back when you were with Donald Regan at Treasury 25 years ago, every Friday morning we’d get alphabet soup of Ms on the money supply. What is going on in the money supply right now? I have my own fears, but I haven’t heard any announcements on money supply.
Peter Wallison: I’m not the one to ask about that now, we haven’t had that meeting in a while. Vince?
Vincent Reinhart: So the answer is that, yeah, the Federal Reserve’s balance sheet, for most of this year, didn’t really expand all that much. It’s only in the last 4 weeks, with the Treasury over-issuing debt securities in order to fund Federal Reserve balance sheet that you have this huge expansion of Federal Reserve credit. Actually it’s the last chart.
If you want to think about what’s happening in the money, let’s go to the narrowest concept, that would be reserves, which is the mirror image of reserve bank credit. It’s been growing pretty slowly over the last year, exploded over the last couple of weeks with the Treasury’s over-issuance.
Monetary aggregates have been growing at a moderate pace, in fact that’s what gives solace to some people that the economy won’t [indistinguishable]
Kevin Hassett: But we had the stickler, Des and I were talking, about this. The problem though is, that you’re not getting the money multiplier because they’re not lending. …
Vincent Reinhart: … oh sure …
Kevin Hassett: … and so the farther down in the Ms you go, the more reasonable is to assume it’s contracting.
John Makin: What do you think is happening to demand for money? and the composition of the demand for money?
Vincent Reinhart: Sure, the demand for currency is soaring, and the demand for bank money is collapsing, sure.
Kevin Hassett: …and so the aggregates can be a little misleading. here.
Vincent Reinhart: Sure, and this is not a time you would look at the monetary
[crosstalk]
John Makin: I have a technical question. Is it legal for the Treasury [1:40:00] to raise money for the Fed, to essentially lend money to the Fed? I thought the Treasury could only raise money for the finance of government purchases.
Vincent Reinhart: So the ability, the authority to borrow is in the Constitution. It’s given to the Congress, and it’s delegated to the Treasury through the Debt Ceiling.
John Makin: … right …
Vincent Reinhart: The Secretary can raise funds up to the Debt Ceiling.
What they’re technically doing is they are selling more Treasury Debt than required to fund the government from day to day, and building up the cash balance at the Federal Reserve.
John Makin: … right …
Vincent Reinhart: So in that respect they would argue they are not lending money to the Fed, they are just building up their cash balance. And in fact the Treasury in its debt management does have the ability to vary its cash balance.
Typically it keeps most of those funds with the private sec- … with private banks, but in this particular case, they’ve moved it to the Fed.
Peter Wallison: The Constitution says that you can’t withdraw money from the Treasury for spending purposes except through an appropriation, and what they are doing is simply borrowing, and depositing with the bank of the government, which is the Federal Reserve. They look at it as simply a deposit with the government bank. So it’s not really an expenditure.
Vincent Reinhart: And the Federal Reserve is the fiscal agent of the Treasury, and the Federal Reserve in the Federal Reserve Act is prohibited from borrowing.
Desmond Lachman: Do you know, I think that the monetary and credit aggregates would be a good idea to tell you where inflation might be going. My view is that this concern about inflation right now is totally misplaced. That it’s not simply that the monetary aggregates and credit aggregates are decelerating at a rapid rate, but it’s also that we’ve just had a huge commodity bust, so that oil, which used to be at $145 / $150 a barrel, is now at $95. All commodities are falling by something like 20 percent, so if we look forward, it really puzzles me that anybody can seriously, in these kind of circumstances, be concerned about inflation as a threat.
Peter Wallison: OK, additional, right here? And we have one … two … three / four, OK.
David Brazil[ph]: David Brazil[ph], Treasury, but have nothing to do with TARP. My question: I came here today trying to figure out why Bernanke and Paulson sort of chose the Treasury as the vehicle rather than the Fed Reserve as the vehicle as to inject what I see as a liquidity operation. And I was wondering if anyone on the panel could … and then after hearing Kevin’s talk, I figured [Treasury Secretary] Hank [Paulson] just decided he’s going to make a lot of money on this deal. But, would you have some insight as to why they went this way rather than, let’s say, very aggressive use of the discount window, á la AIG and so forth.
Desmond Lachman: My view would be that, finally, late in this game, they’ve figured out that it’s not a liquidity problem, but a solvency problem, and that a solvency problem is better addressed by Treasury rather than by the Fed just opening up its Discount Window.
Peter Wallison: Yeah, Actually it’s like that old line about — if your only tool is a hammer, everything looks like a nail. And the only tools we have had, in general, are liquidity tools through the Fed. And this was not a liquidity problem, it is doubt about the solvency of banks. … Do you want to just follow up with that, very quickly? Because we have others.
David Brazil[ph]: And that 2nd question has to do with that distinction between a liquidity problem and a capital infusion problem. If you inject enough liquidity into the system, won’t that lead to private investment eventually into equities as they see that you cannot … you stay on cash, cash earns nothing. I can turn that into a money-making enterprise, then, by buying equities.
Peter Wallison: Well wait a minute, if you inject liquidity and it’s a loan, you haven’t improved capital at all. The only way that liquidity, in the sense you’re talking about, improves the capital position, is if it isn’t a loan, it’s a capital infusion that doesn’t have to be paid back.
[crosstalk]
David Brazil[ph]: But what you have to do is you have to change expectations. People are not going to jump back into the markets until they’ve hit bottom, or they think they’ve hit bottom. And, … you think [1:45:00] things are undervalued right now, but I’m not going to jump in and buy anything that’s undervalued, if I think that it’s going to be more undervalued tomorrow. So I’m going to wait until I’m
Kevin Hassett: … Dave’s intuition is similar to what what Vincent referred to in the sense that there’s this puzzle — Why aren’t they taking the free money and then investing in the Libor and loans that would make … Because then if they did make a lot of short term profit on that, then it would help.
[crosstalk]
John Makin: But there was an exception to that pattern that’s consistent with what you were suggesting, and an exception to the pattern, Vincent, that you were suggesting, which is — I thought that the JP Morgan / WaMu deal was the, what I would call the incipient asphyxiation model, where JP Morgan waited until WaMu was virtually ready to expire, and then was able to write off all of WaMu’s liabilities, save those of depositors, and have the FDIC take over some of the bad assets, which kind of … a little bit different from the pattern you [Reinhart?] were suggesting.
It’s kind of a dangerous pattern. If you’re going to say to someone, "Well I’m going to strangle you, but just before you expire, I’ll let go and give you some oxygen." That was a … I was having dinner when that happened. It was breathtaking, and it was a change … it was a break in the pattern, don’t you think? And … I was a little surprised in the case of Wachovia, where the pattern was not repeated, because there was … And I think Vincent was kind of referring to this … the perverse incentives that came out of the WaMu deal were: if you see a bank in trouble, dump … Maybe they were trying to say, "Dump the stock and the bonds." [laughs] I … Just get out! And deposit the money in the bank, and then you’ll get saved.
But I think to reinforce Vincent’s important point, the pattern of these things has been ad hoc and reactive, and so the market can’t figure out — What are we doing here? — Every case seems to be different. In the case of AIG, the Fed says, "OK, we’ll lend you $85 billion, give us the company." In the case of WaMu we let JPM do it. In the case of General Electric or Goldman, we let Warren Buffett do it. And we’re just sort of extemporizing here with remarkable viruosity, I would say, in Warren Buffett’s case, but not necessarily in the government’s case.
And I think Charlie’s comments kind of brought home to me that we don’t know what the Treasury will do, because the legislation apparently gives the Secretary a great deal of depre- (uh … depression!) discretion.
And so that pattern continues that markets are in the position, or anybody who’s involved in this is in the position wondering, "What will we do with the next institution that’s in trouble?"
Just a relevant update here. I have just seen that there’s a group of Republicans who’ve proposed slashing the package to $250 billion, which, again … This just illustrates my fear of taking a … The problem with the Finance Ministry approach is that if you need real money, you have to go to the Congress, and you have to give them time to think about it. And … and … we … we [laughs] … We’re sort of saying, "We don’t have time, so don’t think about it." and the Congress says, "Oh yeah? Well we might think about it." So we’re in a difficult situation here.
Peter Wallison: Congress thinking is something difficult to imagine. [laughter] OK, over at the wall? Over here? Greg, could you … Oh, all right. First there, then Greg, then here. … and in the back.
Brian Beery[ph]: Brian Beery[ph], I report for EuroPolitics. I’m just wondering. Looking beyond the United States, of course in Europe you said there are a lot of banks that need recapitalizing, that’s happening moments ago, the nationalizing of banks in Benelux countries, etc. Just have you any views on … Are they taking the right approach in Europe, or are they completely going in the wrong way?
John Makin: The European approach, let’s say, is less transparent, than the American approach? And it seems that the kind of dreaded problem has come up, that has destabilized the approach. That is, the Irish government has taken the step of guaranteeing bank liabilities of Irish banks, and so in Mayfair we have wealthy Brits lining up to put their money into Irish banks. [laughter]
And of course [1:50:00] what we may get out of this is a deposit guarantee contest, where actually the US could be a big winner, because, with the deposit guarantee, we could probably attract lots of money, and it would force other countries’ banks to do the same thing.
I don’t … As I say the European case is not transparent. The central bank in Europe, the ECB, has thus far suggested that they’re more concerned about inflation than the slowdown in growth, although the language appears to have changed a bit today.
The number of failing institutions in Europe seems to be rising, and the capital impediments that European banks have experienced has to be as large as the US banks. It’s an international banking system.
The other problem that Europe has that’s a little bit unique is the too-big-to-save problem, which emerged in Belgium this week with Fortis. A very large bank in a very small country presents an awkward problem, because the government is not large enough to believably rescue that bank. And what you wonder about is if the Belgian government, which suggested in some a little bit opaque way that they would guarantee Fortis deposits (it wasn’t clear whether they were guaranteeing the deposits of Belgian citizens only, or everybody’s deposits in Fortis).
So it’s getting … I would say that the problems that are acute here are spreading rapidly to Europe, and I’m hoping that the central banks are working on that, but Vince, maybe you …
Peter Wallison OK, …
Greg Wilson[ph] Greg Wilson[ph] with a small consulting firm of the same name. Thank-you for a very sobering set of presentations. A quick question: Forget whether TARP passes or not on Friday. Would we be better off with a new and improved version of the RFC to inject capital into the banking system, given where we are, given all the issues that each one of you have … ?
Desmond Lachman: Yeah, I would say "yes," because that would be addressing what the problem is rather than simply a liquidity problem.
Vince Reinhart: I think I would opt for a well designed capital infusion package. I don’t know the institution that actually would do that well, and so it’s … express some concerns. I also think you could conceive of an insurance scheme that would also, with the government funds provide a mechanism to give the needed protection and attract capital.
Peter Wallison Next? Back there? … right there.
Justin Ailes: I’m Justin Ailes with the American Land Title Association. My members like real estate transactions [undeciferable] … appreciate all of the bad news going like this in the charts, and the good news going like this in the charts, but any predictions on stability and when the bell curves will … ?
Kevin Hassett: If you want to do numerical gestimate and use history as a guide, then you could look at past recessions. This recession will be different, because it’s not being led by investment, but by consumption, so it should last longer. So that means, if you want to be an optimist that you should probably pick a recession length that’s closer to one of the longer ones, like maybe 18 months is the longest, I guess, as of … you could say, 14 months / 15 months, you know, might be optimistic from you. And I’m guessing that’s … And then you’ve got to run things out if we go for almost till next summer before we start expanding again.
There will be some tough times, but that’s probably … I mean I guess better things could happen, because prices are so crazy right now that maybe there’ll just be a massive and rapid reversal. But that seems like a very hopeful thing.
Desmond Lachman: I guess, I imagine you’re talking about the housing market; you’re wanting to know when that bottoms. A point that I would make is that in the same way as the housing market overshot away from fundamentals on the way up, in the absence of intervention, we could very well have a dynamic in which housing prices shoot … undershoot what the fundamental levels are. I’m particularly concerned about the dynamic that we’re in, where lower house prices lead to higher foreclosures, which in turn lead to lower house prices, [1:55:00] because through the negative equity side. And that’s why I think that it’s crucial that one has to stabilize the housing market if you have any hope of containing the damage in the financial markets.
Peter Wallison: Here in front … no, no, in front first.
John Serrapere: Thank-you for addressing these issues. I just wanted to ask, given that the … My name’s John Serrapere from Arrow Insights, a research firm. Given the protracted danger of the expectation of this decline, that evidence that … credit default swaps were involved with Bear Stearns’ and AIG’s problems, and there’s some speculation of possibly GE Capital. And given that some analysts are now looking at Standard & Poor’s default rates may be going from 15 to even 20 percent, which is astronomical, wouldn’t there be a greater concern of credit default swap blowups, you know, being the elephant in the room? … Again, another unknown?
But I would think that that may be something that would be on the radar screen if we had a protracted recession and greater defaults.
Kevin Hassett: Well, they’re already really pricy for one thing, so there’s already a very pessimistic scenario priced into these markets. That’s the one hopeful sign.
John Makin: I think one of the things that’s difficult about pricing now is that usually these instruments are priced on a bottoms-up basis on an institution-by-institution basis. But right now, when you have an overlying systemic risk, I think that distorts the pricing, and may not be very well incorporated into some of the formulae for this pricing.
For example, again, the GE deal that Buffett did yesterday, essentially you have somebody with a great deal of capital being paid very well to take systemic risk. And he wins if GE Capital is still around next year. He loses if the systemic collapse comes and they’re not.
So I think that is … I’ve noticed this with equity, our equity analysts. They’re used to looking at a company and saying, "Well, their earnings are good, and this is good, and this then this industry and blah-blah-blah … ." But what the valuations … and the valuations are screaming "Buy!" right now for many equities. The reason that they’re not being bought is the systemic risk, which is not … which is in the offer price, but not in the standard valuation formulae.
Gillian Gattia[ph]: Gillian Gattia[ph]. We’ve known for a long time that the situation was very serious. We’ve had these panels. My question is — Why was Congress and the Administration not preparing to deal with it? Why did it have to come up with an emergency plan at the last minute?
Kevin Hassett: This is something that I’ve studied from the point of view of tax policies so it’s a little bit different, but if you go through the history of tax policy then a huge fraction, I forget the exact numbers (I didn’t think we’d be talking about it today) … A huge fraction of tax bills occur after the NBER declares a recession.
And so the problem with that historically has been they tend to call a recession after it’s over. And so, here, they actually, with tax policy and stuff, started early. And we’re ahead of the curve. But I think that with regard to financial regulation, they’ve been behind the curve, but as bad as things have been, Congress has been better, although we could argue whether we like the form of the stimulus plan, but they’ve actually been better in terms of the timing this time.
But usually it’s so hard to move this in our government that they only move when a crisis is occurring …
John Makin: … but I think we credit our very own Desmond Lachman for scaring them into passing [laughter] the stimulus package in a timely manner last April or March, whenever they did it.
Peter Wallison: Anyone else? Vince, did you want to add to this? …
Vincent Reinhart: I mean, the political ecomony of the last year is such that it may very well have been the case that it wasn’t until it was a crisis that Congress was willing to act. And that what I view as the inconsistent, ad hoc policy was basically designed to get the government through this year in the hope that the next President and the next Administration would act, or that events would be so compelling that the Congress would act. [2:00:00]
Then the discouraging … It’s bad enough to think we sort of backed into where we are now, the fact that it was a design principle is quite discouraging.
John Makin: Just to reinforce. In 1932, before … just as we were going from the Hoover to the Roosevelt Administration, you had a parallel situation where the Hoover Administration on the way out was desperately trying to deal with the situation and the new Administration was not eager or prepared to act.
So if you look at the Freedman and Schwatz’ monetary history treatment of 1932 / 33, you get a sense of what was going on.
Desmond Lachman: I would look at something very much more fundamental that is going on that it was basically a huge misdiagnosis of the nature of this recession. That this isn’t the regular kind of a recession, this is dealing with an asset price bust, and a financial crisis. And essentially what both Treasury and Fed have been doing is dealing with this as if it’s a normal thing, that this is only a liquidity problem.
I think when history is written I don’t think either the Federal Reserve or the Treasury are going to come out of this looking too good.
Peter Wallison: OK, one last question, right here …
Sue Simon: Sue Simon, Capital Insights Group. I just have a question about the toxic securities and toxic debt that the government may be trying to auction off or whatever. Are we — have we gotten rid of some of it already with all the bankruptcies and the moving … or have we just moved it around and some of it’s under the control of the Fed and some of it’s being backed in theory by the government, or is some of it just disappeared in the Lehman bankruptcy? We’ve really gotten rid of some of it? or is it just all kind of out there somewheres still to be bought? … Just been moved around.
John Makin: Well, a little bit of each, I think. The mortgage-backed securities and the derivative securities that are combinations thereof are still largely on the balance sheets of banks. Where you have a failed institution like Lehman or Bear, their value has been largely written down. When you eliminate … When you put the institution into bankruptcy, essentially the value of the claims is lost, because the institution has more liabilities than assets, so they’re gone.
So they’re partly gone, they’re partly sitting on the balance sheets of banks all around the world, and I’m not quite sure, … I mean, I’d be curious to ask, for example, the Fed took $29 billion of Bear’s more toxic assets onto their balance sheet. I haven’t had an update on what they’re worth today, but I doubt if it’s $29 billion.
So to some extent, the holders are seeing that their value go down. That said, it’s very difficult to establish their value. But …
Desmond Lachman: I don’t know why John’s talking about $29 billion. In my understanding … that there was $500 billion in repurchase operations that the Fed has accepted — mortgage-backed securities. So that the Fed used to have a balance sheet where it was $800 billion treasuries. If you look [laughs] at the balance sheet right now, it’s not going to look too good.
John Makin: … I was just saying about Bear[ph] …
Desmond Lachman: … right.
Vincent Reinhart So the argument there is that they don’t own them outright, it’s collateral and it’s the loans that they own.
Desmond Lachman: … at the moment.
Vincent Reinhart … and clearly Maiden Lane, that’s the Special Investment Vehicle to hold the Bear Stearns assets is another place where the government is exposed to loss.
A much bigger one, however, is Fannie and Freddie, which is, as Peter and Charlie have pointed out, have very large positions, and are now in the hands of the US government.
Peter Wallison: OK, well I want to thank all of you for coming. I’m sure you’ve learned a tremendous [laughs] amount, maybe hasn’t induced you to party tonight … but in any event, thank-you for coming, and I want to thank our panel for a terrific program. [applause] [2:04:38]
[1]: "What Lies Beyond the Credit Crunch? Part III", AEI event site, October 2, 2008.
[2]: "Have we learned nothing from the economic catastrophe of 12 months ago?", New Statesman, September 10, 2009.
“BAB" is not the only sign that the City is on the verge of a return to pre-crash recklessness and excess. How about a “Re-Remic", which rhymes ominously with epidemic and stands for "resecuritisation of real-estate mortgage investment conduits"? These are, to all intents and purposes, repackaged and renamed collateralised debt obligations, the fiendishly complicated investment tools that helped cause the crash in the first place. The Financial Times has called Re-Remics "mutton dressed as lamb" – but that has not prevented them becoming increasingly popular as a way for banks to sell off bonds backed by commercial properties.
[3]: "What Lies Beyond the Credit Crunch: Part III" (PDF slide deck), by Kevin Hassett, AEI, October 2, 2008.
- Title
- Probabilities of Recession up to June 2008 – smoothed
- Probabilities of Recession up to June 2008 – filtered and smoothed
- States in Recession
- TED Spread 1985-2008
- Implied Default Probabilities from TED Spread 1985-2008
- Implied 10-Year Cumulative Default Rates by Bond Type
- 10 Year Cumulative Default Rates: Implied vs. Historical Worst and Averate Rates
- Weekly Jobless Claims
- Vehicle Sales
- Existing Home Sales- Through August
- New Home Sales – Through August
[4]: Hamilton, James D. (1989), A new approach to the economic analysis of nonstationary time series and the business cycle, Econometrica 57:357-384.
[5]: "Credit Crisis Seminar III" (PDF slide deck), by Desmond Lachman, AEI, October 2, 2009.
- Title
- The End of the Beginning
- A Confluence of Negative Shocks
- Change in U.S. Housing Prices, Stocks, and Bonds
- Commercial Real Estate Price Index- United States
- The U.S. Faces a Difficult Economic Environment
- Nonfarm Employment Change
- Consumer Sentiment Survey
- US Quarterly Economic Growth – 2007-2008
- Euroland Economic Growth Cooling – % change quarter ago
- The Housing Market Shows no Signs of Stabilizing
- House Prices – Case-Shiller House Price Indices (June 2006-100)
- U.S. Housing Starts and Months Supply of Existing Homes
- Falling Prices Leave Homeowners with Negative House Equity
- Foreclosures Surge… First mortgage loan defaults
- FRB Sr Loan Survey: Res Mortgages: Net Share, Banks Tightening
- De-leveraging is Intensifying the Credit Crisis
- Bank Writedowns and Capital Raised
- Federal Reserve Senior Loan Officer Survey for Commercial and Industrial Lending
- Spreads vs. 10-Year Treasuries- United States (ppts)
- U.S. Ted Spread
- Bank Credit: All Commerical Banks
- Paulson’s Plan will not work
- Economic Policy Priorities for Next Administration
[6]: "What lies beyond the credit crunch?: Part III" (PDF slide deck), by Vincent Reinhart, AEI, October 2, 2008.
- Title
- Build a principled case against less intervention than we had but more now
- The story thus far . . .
- The economy is absorbing the economic drag associated with the correction of overbuilding in housing and house price declines.
- Credit markets are magnifying the economic loss
- Up until now, government action has been ad hoc and inconsistent . . .
- Bad policy can have a large effect because financial market behavior depends on expectations of participants
- A digression on an alternative universe . . .
- Getting back to basics:
- If intervention is needed, the authorities should . . .
- We do not live in that alternative universe…
- With TARP, the government is finally recognizing that capital is required
- But TARP has some merits
- Recognize that the Federal Reserve will likely continue to keep its balance sheet at risk
