Friday, September 26, 2008

Financial Meltdown: Part II - Bailing Out the Banks

As I write, Congress and the President are wrangling over what to include in a massive bailout package, intended to save Wall Street from itself. In Part I of this series, I provided what a friend termed the "antebellum" to this lovely financial conflagration. I'm going to assume you've all read that post, so you might want to read it before tackling this one. Part I details the domestic economic and regulatory causes of the current crisis, and can be found here. The current post is divided into two parts: an overview of the current situation and an assessment of what is needed to bail out the system. There is going to be a third part, discussing what to do to prevent a recurrence.

Overview: They Huffed, and Puffed, and Blew the House Down

Over the past few months, and especially in recent weeks, the entire operations of Wall Street have been turned upside down. Earlier this year, there were five major stand-alone investment firms on Wall Street. Earlier this month, the four largest still remained. Now there are none. Both major publicly guaranteed housing firms had to be nationalized by the government. Even normal mortgage institutions, protected by regulations governing loan-loss provisions, have required substantial assistance. The federal funds rate, in a time of upward pressure on inflation due to commodity prices, remains at a mere 2%. Given the speed of things, let's take stock of the principal damages. Here is a list of those companies requiring significant government intervention thus far.

Investment Banks: Smallest to Largest
Bear Stearns: Government brokered a buyout by JP Morgan Chase, valued at $10 per share. The government issued a $30 billion to JP Morgan Chase to support its purchase.
Lehman Brothers: Bankrupt, government unwilling to save, currently being scavanged by Barclay's PLC.
Merrill Lynch: Purchased by Bank of America to avoid insolvency.
Morgan Stanley: Announced it would become a "bank holding" company (like Citigroup), subject to stricter regulation.
Goldman Sachs: The giant investment firm, long the envy of Wall Street, also announced it would become a bank holding company, subject to stricter regulations. Warren Buffet has announced he will but $5 billion in preferred stock, and the company will issue another $5 billion in common stock to raise capital.

Other Institutions:
American International Group (AIG): Massive insurance company with over $1 trillion in assets. Government bailout of $85 billion for a 79.9% equity share in the company and ability to suspend dividends to common and preferred stock.
Fannie Mae/Freddie Mac: Federal takeover (79.9% equity) and bailout valued at $200 billion. Combined, the two institutions hold debt and mortgage-backed securities valued at around $5 trillion. The current agreement requires that "each GSE’s retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion."
Seventh-largest mortgage originator in the US, largest bank in Los Angeles area, with assets of around $32 billion (deposits valued at $19 billion). Taken over by FDIC, which guarentees deposits up to $100,000 (and 50% thereafter).
Washington Mutual: Largest Savings and Loan institution in the US, assets valued at over $300 billion. Worries persist about its financial health.

As far as I know, that covers all of the major problems in the past few months. Although, at the rate things are going, I might have missed one. In general, it might be an exaggeration to say that the financial sector is reverting to a pre-1929 conditions, but not by that much. The economy, despite media hyperbole, is not going to crash to Great Depression levels. The country should remain fairly well protected from that level of crash. Social security, Medicare, Medicaid, unemployment insurance, and the FDIC did not exist until the New Deal. Accounting standards and financial regulation through the SEC are also significantly stronger than before the Depression. Each of these measures affords some containment and security, a buffer against hard times.

However, if you will recall my previous post, one of the crucial post-1929 pieces of financial legislation was Glass-Steagall, which separated investment banks from mortgage banks. The repeal of that particular provision of Glass-Steagall in 1999 was a monumental mistake and opened the economy to systemic financial risk. The collapse, acquisition, or change of the investment banks into bank holding companies serves to exacerbate this problem, by and large. The increased concentration of capital into mega-banks concentrates management, distorts market incentives, and removes a layer of insulation from the financial markets. It connects personal deposits even more directly to risky investments taken on by the investment bankers. It also concentrates wealth in the hands of fewer institutions, meaning if one institution collapses, it in itself creates systemic risk. Imagine is Citigroup, with assets of over $2 trillion, were to go bankrupt! Perhaps the only ray of sunlight is that the bank holding companies are all subject to tighter regulation than normal investment banks, and access to deposits and the required loan-loss provisions can make the collapse of an institution more difficult.

Suffice it to say that the contagion has spread throughout the system, and no one has gone untouched. What is needed is a constructive solution with significant long-term components, based in an understanding of where the economy stands. What this means is that any bailout program needs to address long-term regulations as urgently as it needs to ensure short-term financial solvency. This trend could be disastrous if it continues.

I recently posted a link to an in-depth analysis by CEPR. What follows is my take on how we should modify financial governance in the wake of the current crisis. My take on long-term regulation is somewhat similar to Dean Baker at CEPR, but I do disagree with him on how to handle the current bailout. Also, his article is a bit technical and geared towards those with a significant background in economics and finance; I will try to make mine more accessible.

Bailing Out the Banks, but Not the Bankers

Given the sheer magnitude of the current situation, the primary focus of a bailout should be on efficiently flushing the toxic assets from the financial system. It is tempting to quail at the size of the Bush Administration’s proposal, but a full-fledged purge is exactly what the current situation requires. Japan in the 1990s attempted a succession of small stimulus plans and rescue packages, yet the economy remained in the doldrums for a decade, and the banks have only recently become profitable again. On the other hand, following the advice of the IMF, South Korea allowed the banking sector to collapse following the burst of the East Asian real estate bubble in 1997-8, and the economy underwent a severe contraction. In fact, the one country that survived the crisis with the least pain was Malaysia, which made sudden and decisive use of capital controls to prevent the flight of foreign portfolio investment (currently a problem for the US, as well).

In practice, this means that we need to put concerns about the national debt on hold until the financial system recovers. It is tempting to assume that debt, as debt, is a bad thing for the economy. However, government debt is not the same thing as your personal credit card debt. What matters is the cost of meeting debt-service obligations, and whether the debt-creating expenditures create more growth than debt-service. In the case of rescuing the US financial system, it is almost certainly money well spent. Additionally, talk of US debt problems are somewhat overblown. Government debt, by itself, has virtually zero correlation with the health of the economy. Consider that Japan has the 2nd-highest debt-to-GDP ratio and remains at the center of innovation. A number of countries that have low debt-to-GDP ratios remain underdeveloped (see the CIA World Factbook). Keeping this in mind, a $700 billion bailout is only 5% of the USA’s $14 trillion GDP. Even if all that money is not repaid, this takes out debt-to-GDP ratio from 61% to 66% - hardly a dire increase. The United States is not likely to run out of creditors, as we are the main anchor of the global financial system, and 5% of GDP is certainly a reasonable price tag for the targeted removal of toxic assets from the financial system.

If we look around, we can also see a lot of recrimination and blame. This is tempting, but somewhat counterproductive. Certainly, we need to strictly limit “golden parachute” payoffs to the executives that ran their companies into the ground. Just as certainly, these limits will likely not be as strict as the CEOs deserve (if you make a company bankrupt, I don’t personally think you deserve anything). However, we should not attempt to blame the shareholders and wait until companies absolutely need rescuing to do anything. Dean Baker suggested that shareholders need to be punished – but most shareholders are not board members, most are people who invested their retirement savings in a 401(k) mutual fund that then invested in these companies. Even if they did invest on their own, given the faulty risk ratings on many of these assets, and a lack of insider info, they could not be expected to know that profits would not continue – particularly since this bubble has been 5-10 years in the making, and most financial analysis only goes back to ten year averages (at most). Perhaps board members deserve to take a loss, but we should not punish innocent investors for making a decision based on the information that was available to them before the bubble burst.

It might be thought that I’m coddling Wall Street, despite my claims that executive compensation needs to be limited. What I have in mind is a two-step process; the limitations on Wall Street come in the form of regulations intended to prevent a recurrence of this disaster.

There are two things that need to be addressed in making this bailout effective and efficient, without unduly burdening the government or rewarding institutions and executives who ran themselves into the ground. Here I take two cues from Dean Baker. First, given the corruption and incestuous nature of the private risk appraisal industry, preventing gaming of the proposed auction process is a real problem. One way to avoid this is to make executives personally liable for the misreporting of auctioned assets - allowing them to be sued for assets that underperform (e.g. default more often than) their risk rating (outside a statistical margin of error, say +/- 5%). Faced with potential lawsuits, executives would think twice about misrepresenting risk to the US Treasury. Second, the government should not be responsible for repaying loans to companies that it bails out, if those loans were made within the financial quarter preceding the bailout. The creditors who made those loans, for instance to Bear Stearns or Lehman Brothers, had access to their books and knew their financial situation when they agreed to make the loans – they should be forced to suffer the consequences. This should prevent creditors from making last-minute high-return loans risk-free in expectation of government bailouts should default occur.

Sorry for the length – it’s been a complicated couple of months on Wall Street. Part III of this series will address long-term regulations to prevent a reoccurrence of this mess.