Relevant and even prescient commentary on news, politics and the economy.

Everything Old is New Again

Back in the Good Old Days, Leveraged Buyouts (LBOs) all the rage. Not coincidentally, the phrase “underfunded pension liabilities” moved into the mainstream.

Long story short: when legislation is finally passed to make the “underfunded” portion a thing of the past (you can stop laughing any time), several large companies run by Captains of Industry—think Roger Smith and GM—complained that actually putting that funding on their balance sheet would cost One Billion dollars off their market cap. So they were given twenty (20) years to Make It Right.

And Everyone Lived Happily Ever After.

Apparently, until today:

Stung by outsize investment losses, some of the nation’s biggest companies are pushing Congress to roll back rules requiring them to put more money into their pension funds, just two years after President Bush signed a law meant to strengthen the pension system.

The total value of company pension funds is thought to have fallen by more than $250 billion since last winter. With cash now in short supply for companies, they are asking Congress to excuse them from having to replenish the required amounts.

Lawmakers from both parties seem receptive to the idea, and there was talk of adding a pension relief provision to the broad fiscal stimulus package Congress considered for this week’s lame-duck session. [emphasis mine]

The best line, of course, comes from an advocate of the Steal Short, Pauperize Long crowd:

“Congress needs to make the funding less volatile,” said Representative Earl Pomeroy, Democrat of North Dakota, who has long been outspoken on pension issues. “I believe that taking this step will save thousands of jobs without costing the Treasury anything.”

I believe in the Easter Bunny, the Tooth Fairy (not the Tom Noonan version), and the Reagan Revolution, too.

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The WSJ Editorial Page Talks, the Market Listens

Thursday morning editorial:

The voters may be full of hope about the looming Obama Presidency, but so far investors aren’t. No President-elect in the postwar era has been greeted with a more audible hiss from Wall Street. The Dow has lost 1,342 points, or about 14%, since the election, with the S&P 500 and Nasdaq hitting similar skids. The Dow fell another 4.7% yesterday.

Much of this is due to hedge fund deleveraging,* as well as dreadful corporate earnings reports and pessimism that the recession will be deeper than many had hoped.** We also don’t want to read too much into short-term market moves.*** But there’s little doubt that uncertainty, and some fear, over Barack Obama’s economic agenda is also contributing to the downdraft.****

What WSJ readers did on seeing that (via Google Finance):

And, lest you think I’m cherry-picking to avoid the broader markets, from the same source:

*This is from the paper that argued continually until October that the hedge funds were running perfectly.

**There might be a link there.

***Really?? So how do they explain the next sentence?

****This is on a par with deleveraging, lack of investment, lack of profits, lack of markets that clear, fading real estate values for the mall-stores, and the multiple recent retail bankruptcies (Circuit City, Ponderosa, Applebee’s, etc.)? Looking at the six-month graphic, it appears that the market hit a bottom on October 27th [Oct27 close: 8,175.77, more than 100 points below the level when the editorial was written], bought into the Obama rumor, and has been selling some gains on the Obama fact and the Fed easing and Hank Paulson’s admitting he has never known what he was doing.

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Is David Leonhardt pretending Henry Paulson did his job?

Or does he know better?

This year’s election coincided with an important moment in the financial crisis. The credit markets have stabilized in the last few weeks and even improved a bit. But the rest of the economy is deteriorating fairly rapidly. It’s now in danger of falling into a vicious spiral, in which spending cuts by consumers and businesses lead to further layoffs and then more spending cuts.

To prevent that from happening, the Obama administration will need to move quickly — before it takes office — to put together some emergency plans for the financial markets and the broader economy.[italics mine; emphasis his]

So Leonhardt’s first solution is “throw more money.” Or maybe—as with the common taters last night who pretended that the Republicans didn’t control the Presidency and both Houses of Congress for six years—he’s forgotten that this one was tried, with the same kleptocrat at the helm of the Treasury then as there is now, and will be until 20 January 2009.

Leonhardt then admits that Barack Obama knows more about economics than he does:

Throughout the campaign, whenever Mr. Obama was asked about the financial crisis, he liked to turn the conversation back to his long-term plans, by saying that they were meant to solve the very problems that had caused the crisis in the first place. Back in January, he predicted to me that the financial troubles would probably get significantly worse in 2008. They had their roots in middle-class income stagnation, which helped cause an explosion in debt, and the mortgage meltdown was likely to be just the beginning, he said then.[italics mine]

We then get the mealy-mouthed conditional that makes the NYT so Authoritative:

His prognosis was right — and the pundits now demanding that he give up major parts of his economic agenda in response to the financial crisis are, for the most part, wrong.[ibid.]

And, just so we’re clear, Leonhardt isn’t talking about much money:

There is at least one obvious area of potential compromise: Mr. Obama’s call for a $1,000 payroll-tax rebate for almost every family. That would cost the government about $65 billion. But a stimulus package should probably be a lot bigger than that — maybe $200 billion or so. And at this point, drafting it well matters more than passing it immediately.

So consumers might get to borrow $2 to pay themselves for every $7 they give to Hank Paulson’s buddies. But of course these monies will be poorly spent. Not the parenthetic:

That means starting work on new construction projects that government agencies have already deemed worthy but that lack financing. It also means sending money to state governments to close their budget shortfalls, in addition to softening the blow of the downturn by extending jobless benefits (as flawed as the unemployment insurance system is).

Meanwhile, giving AIG that money has been a great investment.

Leonhardt finally gets to a positive:

The two leading candidates for Mr. Obama’s Treasury secretary — Timothy Geithner and Lawrence Summers — seem likely to be more aggressive than Henry Paulson, the current secretary. Mr. Geithner, the president of the Federal Reserve Bank of New York, has at times lobbied for a more proactive approach to the current crisis. He favored direct equity injections into banks, for instance, before Mr. Paulson did.

As early as last December (2007), meanwhile, Mr. Summers criticized policy makers for being “behind the curve.”

“More aggressive” translates to “actually know what they are doing.”

What will this mean? Leonhardt glosses the ending:

Whatever he decides, it probably has to involve more money — which will make the government’s budget problems even worse. Some economists think next year’s deficit could potentially exceed $900 billion. Relative to the size of the economy, that would be the largest deficit since the years just after World War II.

A deficit like that will indeed force Mr. Obama to change his approach to the economy’s long-term problems, mainly by coming up with new ways to pay for his solutions. But that is tomorrow’s problem. Today’s are big enough as it is.

What this means is that apparatchiks like EconomistMom* will be whining about “the deficit” and the evil of “having to pay the increasing costs of social programs.” (If you wonder why we question your motives, look at your list of Senators and Conngresssmen who are determined to “do something about the spectre of future deficits”—a large portion of whom are the same people who pushed through the 2001 and 2003 raping and pillaging of the same people whose benefits you want to cut now. We question your motives because, by your own Revealed Preferences, you’re crooked.)

Leonhardt wants to placate them. Dean Baker, for one, knows that’s not possible, and pushes for a more optimal solution.

*If I were being fair to Diane Rogers (who advertises her Clinton Administration credentials whenever she can, so that we can believe she’s one of The Good Ones even as she shills for Pete Peterson and the entitlements-for-me-but-not-for-thee crowd), I would say she was hired to argue that neo-Hooverism is A Good Thing—but she made that bed and chooses to lie in it, so sympathy is not something I’m inclined to. Others here disagree. You can look it up.

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The House Republican Plan: A Bailout or Worse than No Plan

by Tom Bozzo

I want to recommend that readers make it to the end of Robert’s last post with respect to the disastrous economics of the House Republican (and maybe or maybe not McCain) “insurance” plan (or is that insurance “plan”?). I’ll risk maybe repeating Robert since it’s an important point: either the premiums are subsidized and the losses on the toxic assets end up being socialized by a means that looks less like a bailout for political reasons, or the premiums aren’t subsidized and the plan is maybe worse than nothing. The plan’s basic perversity is that it makes up-front demands on ailing financial institutions which, if they could afford in the first place, the free market fairy would have already solved the problem.

(As a note of political commentary, this isn’t the first Fifth Column insurance-like plan to come out of the House Republicans, some of you might recall the effort to get around the potential problem of inadequate ex post returns for privatized Social Security accounts by having the government guarantee private accounts’ returns. Alas, linkrot has taken away Rep. Paul Ryan’s summary page for the Ryan-Sununu Social Security Personal Savings Guarantee and Prosperity Act.)

Reportedly the Republican plan is vague on the nature of the insurance deal; apparently it would direct Treasury to design something. This should be a neat trick thanks to the adverse selection end of the insurance problem. Remember that for all of the fire directed from the right side of the fence at the GSEs and less financially able mortgage-holders, the GSE end of the sh*tpile has much lower (if increasing) default rates by a substantial margin, as you can see in the graphs in this Econbrowser post. In part, that’s because for their late efforts at self-destruction they were mostly involved in the relatively sensible end of the mortgage business.

To make a crude analogy, the problem is akin to being a term life insurer faced with a prospective customer who’s known to have had a cancer diagnosis but won’t (or to make the analogy a little better to the financial situation maybe can’t) let you see his full medical records. Assuming the customer’s spouse isn’t an extremely wealthy beer distributor, the problem isn’t that the customer doesn’t have a relatively urgent demand for insurance. Just based on the public information, the insurance would have to be sold, if it’s going to represent something other than a gift from the insurance company’s shareholders, at a much higher price than the customer would have paid had the insurance been sought back when cancer was mistakenly thought to have been vanquished. The insurance design trick is to avoid having the customer shake on the deal and then say “sucker,” not least because the customer may live to see the payout eliminating any element of poetical justice.

There may be things you can do to make pooling work like mandating participation (in which case the financially healthy subsidize the financially sick), but certainly we’re out of totally-free market territory already. And it doesn’t seem trivial to ensure full participation, since it’s necessary not jus to identify the universe of “financial institutions” but also the assets requiring insurance. So this may be administratively a lot more complex and in some ways intrusive than letting institutions volunteer assets under a mechanism that discourages them from dumping their lemons at non-lemon prices.

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David Leonhardt needs to retire, having abdicated responsibility

by Ken Houghton

I don’t believe David Leonhardt is an idiot, but that’s not based on the evidence at hand:

There are really only two [questions]: What steps are most likely to solve the immediate crisis? And how can the long-term cost to taxpayers be minimized?

Everything else — reducing executive pay on Wall Street, changing the bankruptcy laws, somehow slowing the descent of home prices — is either a detail or a distraction.

Let me say this slowly, so even a NYT reporter can understand it: If you are taking an equity stake in a firm, one factor is how much cash the firm will have on hand. Cash paid to executives is not cash on hand, nor can it be used to produce future capital, investments, and free cashflow, or even “the miracle of compound interest.” So executive pay is very much a factor in equity calculations.

Changing the bankruptcy laws is more tangential, but let’s again explain this slowly. Mortgage-backed securities are, well, backed by mortgages. Their value depends directly on those payments. If it becomes easier to workout a mortgage in bankruptcy court, the holders of those MBSes are liable to (1) receive a higher value and (2) know sooner how severely their securities are impaired. So changing the bankruptcy law will, again, make the value of the assets clearer sooner. Which is especially important if we’re all going to pretend that this thing is going away after two years.*

Slowing the descent of home prices—well, that’s a second-order effect, so I’ll agree with him there. Or at least let it ride.**

His next paragraph, however, is incomprehensible:

Usually, it would be easy enough to dismiss these sideshows as the inevitable gear-grinding of democracy. This is an extraordinary time, though. The credit markets are nearly dysfunctional, leaving the economy at risk of falling into a downturn unlike any most of us have lived through, and the government is about to commit billions of dollars after only a week of political debate. There’s no time to waste. [emphasis mine]

Let’s be clear: the government (meaning here the Executive Branch and the Federal Reserve, controlled and run by Republicans) has already committed billions of dollars over the past six months. Maybe $900,000,000,000. During the entire time of which, Mr. Paulson was (1) certain the crisis was over and (2) working on the idiocy plan that he presented.

Leonhardt’s very next sentence undermines his previous paragraph.

The first thing to understand is that a bailout plan doesn’t have to cost anywhere close to $700 billion, so long as it’s designed well. [italics mine]

This is the plan that included absolute authority for the Secretary of the Treasury, and of which the Secretary of the Treasury said, “No, I’m not asking for absolute authority,” right? I would again invoke Daniel Davies’s Three Laws, but Leonhardt wants us to believe that this time will be different, if the plan is well-designed.***

Figuring out how much to pay for the assets is the first problem. The drop in house prices and rise in foreclosures have made it clear that these securities are worth considerably less than banks expected. But there is enormous uncertainty about how much less.

That’s why we have a market, no? (Clearly, the answer will be “no.”)

Based on the underlying fundamentals (like the current foreclosure rate and the one forecast for the future), many of the securities appear to be worth something on the order of 75 percent of their original value. But thanks to the fear now gripping the market — not necessarily an irrational fear, given that most forecasts have proven far too sunny over the last year — very, very few of those securities are trading hands. Among those that have, the sales price has been roughly 25 percent of the value. [I italicized, but he blocked it off in the first place; the bold is mine]

So the market has a price, but Mr. Leonhardt wants us to believe that these securities could be worth three times as much.

Assume I do. What should I be willing to pay for those securities? And what would I offer for them?

Now assume several of us believe that. What will be we do? Well, I’ll offer the current market price, Tom will offer 25.5, Robert will go 26, and pretty soon we’ll own all we want somewhere around 65.****

So where are the hedge funds and investment managers and new Vulture Funds? Who believes these securities are worth 75? Surely, they are willing to bid 25, 26, even 30. Mr. Leonhardt doesn’t tell us. In fact, the people who know the market best—Barack Obama’s classmate, Tom Marano, for instance—are retrenching, even after the first $900,000,000,000 in liquidity has been added.

Which price is the government going to pay?…[I]t probably can’t pay 25 cents. That might fail to fix the credit markets, because it would do relatively little to improve financial firms’ balance sheets. Firms might then remain unwilling to lend money to businesses and households, which is the whole problem the bailout is meant to solve.

Oh, wait. I thought that list of side considerations above were unimportant; now it turns out they’re “the whole problem the bailout is meant to solve.”

The most obvious solution is to pay more than 25 cents on the dollar and then demand something in return for the premium — namely, a stake in any firm that participates in the bailout. Congressional Democrats have been pushing for such a provision this week, and it’s one of the most important things they have done.

Well, that’s nice to know. Too bad it wasn’t in the original “well-designed” plan. I guess David Leonhardt believed Dick Fuld when he said he, er, gave at the office, too.

The government would then be accomplishing three things at once. First, it would take possession of the bad assets now causing a panic on Wall Street. Second, it would inject cash into the financial system and help shore up firms’ balance sheets (which some economists think is actually a bigger problem than the bad assets).

There’s a link to Krugman’s column on Monday omitted here. But let’s look at what Leonhardt has just done:

  1. He has admitted they are “bad assets,” while before they were just underpriced.
  2. He has declared that it would “inject cash into the financial system,” rather ignoring (again) the previous $900,000,000,000 than the Fed has “injected” in lieu of easing rates further.
  3. He has invoked “balance sheets,” for discussion of which I refer you to David Altig (h/t Felix)

But the best is yet to come.

And, third, it would go a long way toward minimizing the ultimate cost to taxpayers.

Overpayment is good because we’ll get more back. And I thought only Health Economics had an upward-sloping demand curve.

Why? The more that the government overpays for the assets, the larger the subsidy it’s providing to Wall Street — and the more it is pushing up the share prices of Wall Street firms. As Senator Jack Reed, Democrat of Rhode Island, notes, the equity stakes allow the government to recapture some of the subsidy down the road. It’s a self-correcting mechanism.

It’s a good thing Leonhardt opened his piece by noting that Congresscritters don’t know much about the financial markets, but, really, couldn’t we expect more from Economics writers?******

“Hey, Jack, if you pay me three times what this asset is worth in the market, I’ll give you an extra fifty cents six years from now.”
“Sounds like a great deal to me, Lloyd. And that writer in the Times thinks so too.”

So far, we have established that Paulson presented a plan that, if it had been well-designed, would be great. So who is at fault? Why, Congress, of course:

Instead of a laserlike focus on the big issues, though, Congress has been devoting a good chunk of energy to secondary matters. Some of the proposals, like changing bankruptcy rules to help some homeowners avoid foreclosure, are perfectly reasonable but just won’t do much to cure the credit markets. Others may not even meet that standard.

Let’s try this again. Homeowners who avoid foreclosure can, unlike those who don’t, pay their mortgage. Which monies flow to (wait for it) Mortgage-Backed Securities. Which then gain value and can be sold at a higher price. So, if you really want to reduce the cost of the bailout, keeping people out of foreclosure seems as if it would help. A lot more than seeing a stock price appreciate later, as was suggested in that well-designed plan by Chris Dodd, Barack Obama, and Congress.

And then Leonhardt just outright jumps the shark:

One of the fashionable ideas of the week, supported by both Democratic leaders in Congress and John McCain, is to limit the pay of top executives at any Wall Street firm that sells assets to the government.

Not even CNN fell for that one completely, despite their idiotic headline:

“Contrary to the lies told by the McCain campaign, it was John McCain who followed Sen. Obama’s lead in laying out principles that call for strict oversight and accountability, protecting taxpayers and cracking down on CEO pay. We only wish he had adopted those same principles over the last 26 years rather than cheerleading for the deregulation agenda that helped produce today’s crisis and repeatedly opposing limitations on the obscene compensation given to failed CEOs.”

And it doesn’t take a long use of The Google (well, I just went to Brad DeLong’s site) to find, from Sunday night:

Rescue requires mutual responsibility. As taxpayers are asked to take extraordinary steps to protect our financial system, it is only appropriate to expect those institutions that benefit to help protect American homeowners and the American economy. We cannot underwrite continued irresponsibility, where CEOs cash in and our regulators look the other way. We cannot abet and reward the unconscionable practices that triggered this crisis. We have to end them. [italic mine]

That’s rather clear, no? Not to Leonhardt, who tries one last time:

And in a frenzied week, any time spent on talking about C.E.O. pay is time not spent on designing the toughest possible bailout package.

Give you a hint, David. Pass a large portion of the firm’s revenues to Dick Fuld or Hank Greenberg or Vikram Pandit and there won’t be any effing stock appreciation for you to claim to have “reduced the cost” in the end. Even the Chamber of Commerce knows this.

*Brought to you by the administration that expected its Iraq Adventure to last six days, maybe six weeks at most.
**In the context, I’m inclined to argue, under that same “two year” timeframe, that they should want to accelerate the decline in prices. As a current seller, I object, though.
***For starters, it was designed to be initiated and run by a man who is unlikely to be in that same position six months from now. That this might be an elementary design flaw seems to have escaped Mr. Leonhardt.
****The extra ten is because we are not so stupid as Mr. Leonhardt, on whom someone pulled “75” out of his backside. No, we bid 65 because we know there is substantial uncertainty in that “75,” and we pulled “65” out of our backside.*****
*****Robert is now trying to figure out a correlation matrix for this.
******Ben Stein and Robert Samuelson always excepted.

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In Which I Fail Basic Budget Math

CNN does some he-said, she-said, but throws in some data:

The administration’s proposal also requests that Congress authorize an increase to the nation’s debt ceiling. Currently, it’s set to rise to $10.6 trillion for fiscal year 2009 – which runs from October 2008 through September 2009. But the proposal requests that limit be increased to $11.315 trillion to allow for the purchases of mortgage-backed assets. [emphasis mine]

Now, strangely, I have always heard that assets have a positive value. When I buy $100 worth of a stock—say, PWND—my Net Asset Value doesn’t change. The same should be true of buying a MBS worth $0.30 on the dollar.

So why would we need to increase the deficit ceiling by $700,000,000,000 if we’re buying assets worth $700,000,000,000?

The only reasonable conclusion is that we plan to pay $700,000,000,000 above market for the securities. No wonder it has to be “clean and quick.”

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The Safest Senator

When calling Congresscritters tomorrow, especially for those in NY State, please feel free to remind Senator Schumer’s office that he and Barack Obama were the two people [in contested elections] who finished with the widest margin of victory in 20062004 [h/t to my Loyal Reader and Kohole in comments]—about a 50% margin in both cases.

A few fewer dollars from Hank Paulson’s brethren four years from now aren’t going to cost him anything but bragging rights.

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Dean Baker Explains It All to You

UPDATE: Krugman comes to the same conclusions, more concisely. (That’s why he gets paid the big bucks.) And Brad DeLong has modified his original position to the point where it’s got a good chance of working going forward.

I started a “What is an Asset” post yesterday, which got sidetracked by Brad DeLong’s urging that the rewards for bad behavior be maintained while expecting a return to the “good” intertemporal equilibrium to be maintainable in the face of payoff-dominant strategies that, in his scenario, become equally risky and offer higher rewards.*

For those who want to see where the post would have gone, let us pull two comments from AnonCC to the fore:

“There are only a few problems, key of which is the title of this piece. Derivatives may have a value, but are they actually assets? Worse, if the Fed buys an asset, does it also have to buy all of the associated derivative contracts, one side of which may—by that simple—become worthless or become payable?”

This is precisely what really scares me about Paulson’s description of the bailout plan. Hybrid and synthetic CDOs (which cover most CDOs issued from 2006 on) are definitely not assets! These monsters are insurance companies that will be seen to be severely underfunded when insurers like MBIA, Ambac and AIG fail to pay on their reinsurance policies. If Treasury buys these insurance obligations, it will become a financial insurer for subprime.

(I should add that there are cash CDOs that are not insurance companies and can be fairly considered as assets. So all CDOs cannot be grouped in the same category.)

I think we’re talking hundreds of billions paid up front for the privilege of providing this insurance, and trillions out the back door to hedge funds and the remaining investment banks over the next decade.

Dean Baker takes the question of the bailout to an even more elementary level, having remembered that there is a market and therefore a “market value”:

The most obvious question: is how will paying market price for near worthless assets prevent the collapse of zombie institutions like Bear Stearns, Lehman Brothers and AIG? These institutions needed money. They won’t get it from selling mortgage backed securities, that are chock full of bad mortgages, at the market price. We already know this, because they already had the option to do so.

The Bush proposal to throw out hundreds of billions of taxpayer dollars to buy up this debt will do little if anything to prevent another round of collapsing banks. We will again see desperate weekends with Treasury and Fed honchos running around trying to save the next major basket case.

The other big question is: how will we get the banks to honestly describe the assets they throw into the auction?

Unless the Fed is planning to buy assets at above market value—that is, to directly subsidize those same bankers and firms with taxpayer dollars, with concomitantly to make those risky assets “less” risky in the market and still providing no route or incentive to return to the “good” equilibrium—the “bailout” as discussed with have no positive effect on the health of the firm(s).

So what Henry Paulson is proposing has to be a direct subsidy to have any effect.

As an isolated plan, it is a reward for bad behavior. Only if it were combined with those items for which we “don’t have time”—say, the plan suggested by Mark Thoma—could it possibly be an economically viable plan:

First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that. Administratively, it could come as an increased tax rate on profits and, if it helps politically, it could be earmarked for a particular cause. The government pays the firm a fair value for the assets plus an additional amount to help with recapitalization, and in return gets a claim on future profits for a period of time (I would also tie executive compensation directly to profits to help prevent gaming).

*As a result of this, and some unfelicitous phrasing, I am now in DeLong Coventry. I can live with that.

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An Economist Who Doesn’t Believe People Respond to Incentives

Ladies and gentlemen, Tyler (“So Right It Hurts“) Cowen presents the following, er, argument:

Excessive bank regulation is another danger. To be sure, the regulatory structure for financial institutions failed in the current crisis, and change is in order. But we shouldn’t reform in a way that will discourage bank lending and weaken the tie between savings and investment. Banks are already allergic to very risky mortgages — probably excessively so — and we shouldn’t overreact by punishing them for past mistakes. [emphasis mine]

Somewhere, an Economic Angel had its wings rent asunder.

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