Left Flank

The Nobel laureate talks both humorously and straightforwardly about his disagreements with Hank Paulson and Ben Bernanke (less bailout, more capitalization, don't let Lehman Brothers fail), and his wishlists for an Obama administration - nothing for John McCain.

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Oddly, instead of prepping myself for a dive off my roof, I'm taking cathartic relief from a consensus among smart talking heads and pundits, that humility is coursing through the media like a vaccination. No one knows if there is any precedent for this financial market crunch, and if so - or more likely, if not - what do we do? The big guy prayer - calling on the «leaders» to save us - took a swan dive now that consensus has it that allowing Lehman Brothers to tank was a bad plan.

That's because now - and blogging is a form of archiving - the plan is recapitalization.

American officials unveiled a three-part rescue programme on Tuesday October 14th. Under the first part, the Treasury will inject as much as $250 billion into American banks, with roughly half initially going to nine big institutions. The capital would come in the form of non-voting preferred stock. Under the second part, the Federal Deposit Insurance Corporation (FDIC) would guarantee unsecured borrowing by banks for maturities of up to three-and-a-half years, at a relatively modest cost of 75 basis points. That would include interbank loans. Under the third part, the FDIC would guarantee without limit small-business bank deposits that do not pay interest. Also on Tuesday the Federal Reserve gave more details of its previously-announced commercial paper backstop programme, which should ease borrowing for big nonbanks, such as GE Capital.

The plan is undoubtedly bold: it marks perhaps the largest foray by the American government into ownership of private enterprise since the second world war. But it would have looked much bolder a month ago. As it is, America has only caught up to where Germany, France and especially Britain (in that case, last week) had already reached. To a great extent, Hank Paulson, the treasury secretary and Ben Bernanke, the Federal Reserve chairman, are making up for what were, in retrospect, miscalculations in their earlier efforts.

The early evidence is reassuring. The historic stockmarket rally on Monday, though it petered out on Tuesday, will impress the retail audience of small investors and politicians. But the more important verdict is from the wholesale audience in the credit markets, which has been encouraging. Borrowing costs for big financial institutions plunged on Tuesday, as measured by credit-default swap spreads. Libor, the rate at which banks lend to each other, also dropped, although it remains stratospheric. «This is definitely the end as far as the systemic aspect to the credit system goes,» said Gregory Peters, head of fixed income at Morgan Stanley.

Even if true, that will not alleviate the downward pressure on the economy. Bank lending is still constrained by a lack of balance-sheet capacity: banks have been forced to boost loans to companies that are shut out of the commercial-paper market while setting aside more capital for future loan losses.

The new capital injections should help. In theory $250 billion of new capital leveraged by ten-to-one could support $2.5 trillion of assets in banking system, serious money when total loans to non-financial corporations, households and state and local governments in America stood at $27 trillion on June 30th. But it is unlikely to spur a big expansion in new loans. Much of the credit restraint comes from nonbanks such as the captive finance-arms of carmakers. Moreover, fewer householders can meet the stricter underwriting standards that now prevail because they have lost the equity in their home, or their jobs. «The combination of declining wealth and a sharp tightening of credit availability is likely to induce a substantial recession in consumer spending,» said Peter Hooper and Thomas Mayer of Deutsche Bank on Tuesday. They project zero growth for America in 2009 and outright contraction for every other G7 country apart from Canada.

The programme should overcome the errors that, with hindsight, hampered earlier efforts to tackle the crisis. The most prominent was the decision to let Lehman Brothers fail. That sparked a run on money-market funds which held Lehman paper, and forced deleveraging by customers and counterparties who had trading positions with Lehman. It dramatically raised in investors' minds the odds that other big banks could also fail, and those fears risked becoming self-fulfilling as their stock prices plunged, credit spreads exploded and lenders and depositors fled. The bank-loan guarantee and expanded deposit-insurance limits should eliminate that risk.

The authorities' second mistake was to treat the crisis as one principally of liquidity rather than solvency and thus to focus on solutions that did not directly rebuild capital in banks. The focus was understandable: in aggregate American banks are well capitalised and it is not clear how many would have voluntarily accepted public injections of equity. Fed officials had discussed ways the government could inject preferred equity into banks that also issued common stock as far back as June. But Mr Paulson worried that Congress would say no and in the process alarm markets more, according to some officials. A person close to the Treasury says that Mr Paulson and Mr Bernanke were in agreement on how to proceed. In any event, Mr Paulson made sure the bail-out law impliclity allowed such injections. But not until the law passed and panic ensued did he conclude it was necessary, and Britain's dramatic recapitalisation plan last week all but forced his hand.

Thirdly, the plan marks a move away from ad hoc interventions towards a comprehensive solution. In contrast to earlier rescues for AIG, Bear Stearns, Fannie Mae and Freddie Mac, the recapitalisations announced on Tuesday are designed to encourage new private capital infusions, rather than punish shareholders. Under the terms announced on Tuesday, the Treasury will receive preferred stock on the same terms as other preferred shareholders and warrants for common stock equal to 15% of the preferred stock, convertible at the trailing 20-day average stock price when the preferred stock is issued. The preferred stock will pay a 5% dividend for the first five years, and 9% thereafter. Those are hardly onerous: they are less than the 10% yield Morgan Stanley will pay Mitsubishi UFJ Financial Group and that Goldman Sachs will pay Warren Buffett for their preferred-stock investments. The banks can buy back the Treasury's stake after three years, sooner if they issue sufficient stock of their own.

Yet, even for all its customary optimism, The Economist is not immune to the bogeyman.

Aggressive as these actions are, they may not be the last. As the world falls into recession, loan losses will mount and banks may need yet more capital. Some emerging markets may be on the brink of another crisis on the scale of 1997-98. After 14 months, the defining characteristic of this financial crisis has been its tendency to change shape and return in ever more virulent form. But if the corner really has been turned, then attention in America will turn to the consequences of the bail-out, in particular: how will future administrations handle the responsibilities and temptations that come with being a big financial stakeholder?

Comparing the Japanese debacle in the 90s with the 2007-8 mutation, Joshua Kurlantzick rains further on the recapitalization prayer.

Koizumi's strategies were actually based on lessons learned after America's savings and loan crisis, when nearly half of the country's S&Ls went out of business and the rest were forced to adapt their business models. «A central lesson to remember from the U.S. [S&L] experience is that ... in the end, the principal use of public funds was to put institutions out of business,» notes economist Benjamin Friedman in a study comparing the S&L crisis to Japan in the '90s. Today, public funds are being used to do the opposite--to keep companies in business regardless of whether they change their practices, meaning that, as in Japan, the government might have to intervene again in a few years. Japan was able to afford repeated infusions of state cash in part because it was an export powerhouse. But, in the United States, which already boasts $10 trillion in public debt and regular trade deficits, another round of bailouts would be truly catastrophic. It could doom the entire U.S. economy throughout the next president's term. A «lost decade,» you might say.

Finally, Megan McArdle and Dan Drezner agree to remain skeptical and embrace their utter dearth of fortune-telling skills.

So, is there clear answer? Yes, according to Michael E. Lewitt, the dismal science is our savior.

...the stock market has the patience of a flea. The government's Herculean intervention into the markets will do what they are supposed to do--lead U.S. banks to start making loans again and reignite economic growth. But U.S. stock markets continue to be driven by «hot money»--failing to see money market rates plunge immediately, they conclude that these key lending rates won't drop at all. This is short-sighted and self-defeating. The government's actions will take some time to work, but they will work. The laws of economics were not repealed on the upside--that is why the markets crashed. But these laws were also not repealed on the downside, which is why these radical steps will work sooner rather than later.

Do less, but be firm and forceful when you do DO it? I'm very glad now I studied more political science than economics: it's axiomatic that the worst will happen, not, as the dismal science has it, that we can approach perfect equilibrium. At least I didn't waste my tuition money.

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Fundamentally, I'm skeptical about what the US Congress, Hank Paulson, and Ben Bernanke think they're doing (actually, for the same public choice reasons Will Wilkinson offers in his diavlog) with the compromise legislation awaiting floor votes in both chambers. I also resent the Bush administration's apocalyptic pronouncements as a tired reprise of post-September 11 doom and gloom. I continue to look for any expert who can reasonably explain the fiasco and give me a decent recommendation.

Cue Arnold Kling as he «blasts the Paulson plan as essentially corrupt». This just one small segment of a longer primer on this road to financial perdition. The advantage of Kling's plan is, that the government will have pennies to spare on relief, and not on pumping up stock prices. I'm also trying to avoid that huddling predisposition victims get when the tiger approaches, when a minute before each person knew the bad guy was luring the beast to them. I don't want just to trust Congress because I'm momentarily scared I have no other choice.

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Leaving aside the deregulation rant, it's odd to hear Krugman calling for turmoil.

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system - if institutions need to be rescued like banks, they should be regulated like banks - why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for «orderly liquidation» of failing investment banks. Well, that was six months ago. Where's the mechanism?

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Lawrence H. White disposes of the deregulation rant.

On campus this afternoon I overheard the following remark by a non-economist, trying to explain to another non-economist the Lehman failure and today's stock market decline: «It's a combination of deregulation and greed. Boy, if you deregulate enough, the greed will follow.»

If I had butted in, I would have made two points. (1) If an unusually large number of airplanes crash during a given week, do you blame gravity? No. Greed, like gravity, is a constant. It can't explain why the number of crashes is higher than usual. (2) What deregulation have we had in the last decade? Please tell me. On the contrary, we've had a strengthening of the Community Reinvestment Act, which has encouraged banks to make mortgage loans to borrowers who previously would have been rejected as non-creditworthy. And we've had the imposition of Basel II capital requirements, which have encouraged banks to game the accounting system through quasi-off-balance-sheet vehicles, unhelpfully reducing balance sheet transparency.

And, Megan McArdle takes aim at Senator Barack Obama's jugular.

This was not some criminal activity that the Bush administration should have been investigating more thoroughly; it was a thorough, massive, systemic mispricing of the risk attendant on lending to people with bad credit. (These are, mind you, the same people that five years ago the Democrats wanted to help enjoy the many booms of homeownership.) Lehman, Bear, Merrill and so forth did not sneakily lend these people money in the hope of putting one over on the American taxpayer while ruining their shareholders and getting the senior executives fired. They got it wrong. Badly wrong. So did everyone else.

What, specifically, should the Bush administration have done, Senator? Don't tell me they should have beefed up SEC enforcement, since this is not a criminal problem (aside from minor lies by Bear execs after the damage was already done). Perhaps he should not have reappointed Greenspan, or appointed Ben Bernanke? Both moves were widely hailed at the time. Moreover, to believe that a Democrat could have done better is to assert that a Democratic president would have found a Fed chair who would pay less attention to unemployment, or a bank regulator who would have tried harder to prevent low-income people from buying homes. Where is this noble creature? And why didn't Barack Obama push for him at the time?

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Now, this might be too optimistic!

Last March, Mr. Paulson convinced Fed Chair Ben Bernanke to cross a line when we bailed out Bear Stearns. Maybe that will cost $30 b. The Fannie Mae and Freddie Mac bailouts are difficult to cost out, but it will be at least $200 b. or $300 b. and maybe more. Last weekend, Mr. Paulson drew the line at putting taxpayer money into Lehman Brothers or AIG. Finally, there is some shared sacrifice. Now lets be willing to cut federal spending and to raise federal taxes enough in the next few years to keep from passing these burdens on to our children.

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Don't overreact, Lehman Brothers and Merrill Lynch are not that big a deal!

1) Why is the U.S. government taking a hands-off approach with Lehman when it was quick to bail out Bear?
2) What will the aftermath of Lehman's collapse look like, and what will it mean for global markets?

The answer to the first question, experts say, relates mostly to nitty-gritty market mechanics. The Financial Times reported last week that Bear Stearns, despite being a smaller firm, in fact posed a greater risk to financial stability than did Lehman. The reasons for this included Bear's deep involvement in the credit default swap market, its prime brokerage business, and its role in the financial clearing system.

A more basic factor also comes into play, and helps answer question #2 as well as question #1. Since Bear's collapse, a variety of reforms have been made that alter how the Treasury and the Federal Reserve operate. The FT's Peter Thal Larsen noted in a video analysis before Lehman's collapse that the six months following Bear Stearns allowed global markets to factor in the idea of a large bank collapsing, so the impact of losing Lehman is potentially less devastating than the shock of Bear's rapid demise. Even so, the news of Lehman's bankruptcy shook global markets on September 15, sending equities worldwide falling sharply (WSJ), particularly in the financial sector. The collapse also spotlights the high level of insecurity among other major U.S. financial institutions. Washington Mutual has been hobbled of late (Forbes) by loan defaults, and on September 15 the insurance giant AIG required emergency government authorization to loan itself $20 billion (NYT) in order to stabilize its operations. Above and beyond lingering concerns over liquidity and mortgage-backed debt, the collapse of Lehman could create new problems for financial firms. Analysts say unwinding all the financial contracts tied to the bank in an orderly manner will be no small task.

A six months learning curve?

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