Economics/Finance

The British government has abandoned proposals for non-voting preference shares and is moving towards full-scale nationalisation of the banking sector. According to the London Times(h/t Felix Salmon) the latest proposals would leave the government owning 70 per cent of Royal Bank of Scotland and 50 per cent of Halifax. The London stockmarket is likely to be closed, and it seems unlikely that many banks will remain private by the time it reopens. Presumably, with Morgan Stanley and Goldman Sachs in deep strife, the US can’t be far behind, though Paulson is still talking nonsense about non-voting shares. Still, it’s only three weeks ago that he was opposing any kind of public equity, and only six weeks ago that he was claiming that there were no real problems.

As the Times says, no-one knows how much toxic sludge will turn up when the government finally gets access to the books, but it seems unlikely that most governments will be overwhelmed in the way that Iceland has been. The capacity of developed-country governments to raise additional revenue is huge, easily enough to cover trillions in bad debt over a few years. So, once the sector is nationalised it should be possible to get lending flowing again. And, the prospects for an orderly shutdown of the massively overgrown markets for derivatives like credit default swaps suddenly seem a lot better.

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A couple of days ago, I thought my call for full-scale nationalisation of the banking sector would remain beyond the pale of political acceptability for at least a week. I badly underestimated the pace at which events are moving. In today’s paper I read the following assessment:

Inevitably, the US, Britain and Europe are going to end up with nationalised banking systems in one form or another, and with governments guaranteeing not only their deposits but probably all their liabilities. The nationalisation will be a temporary emergency measure. But for some time at least the systemically important banks effectively are going to be public utilities and must be regulated accordingly.

This taxpayer rescue of banking systems opens up a new and potentially very important avenue for unfreezing bank lending and restoring the flow of credit. If governments effectively control the banks, what is to stop them from demanding that they start lending again?

The source is Alan Wood, probably Australia’s most consistently hardline free-market economics commentator, writing in the Murdoch-owned Australian.

To amplify Wood’s point, the time when the situation might have been salvaged by passive capital injections like the acquisition of preferred shares has passed. Only direct public control, combined with a commitment to salvage the financial system as a whole has any chance of success.

The Times tells the story of the failed efforts of one Brooksley E. Born, the chair of the Commodities Futures Trading Association in 1997, to attempt to impose greater regulation on derivatives. “She called for greater disclosure of trades and reserves to cushion against losses.” She was fiercely opposed in this by Alan Greenspan and Robert Rubin. [ed:spelling corrected]
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With the financial meltdown accelerating in the wake of the US bailout, and the recognition that many more failing banks will have to be nationalized, the British government is moving to get ahead of the game by offering equity injections across the board. But already this seems inadequate. Now that the taboo on nationalization has been broken, wouldn’t it make better sense to nationalize the whole sector? With full control, governments could then ensure the resumption of interbank lending at least among their own banks. This would provide a feasible basis for co-operative moves to re-establish international markets.

For this week at least, such an idea is beyond the range of political acceptability. But it’s striking to look back a month and realise that in that period the US government has become the main mortgage lender, the guarantor of the short term money market, the effective owner of the world’s largest insurance company, the potential future owner of much of the banking sector and now the purchaser of last resort for commercial paper. Since the reluctance of banks to buy commercial paper must reflect a significant probability of default, it seems inevitable that some of this commercial paper will end up being converted into claims on the assets of defaulting issuers, extending the scope of nationalisation beyond the finance sector and into business in general.

This kind of instalment-plan nationalisation seems to offer the worst of all worlds. At some point, a more systematic approach will have to be adopted, and given the rate at which markets are plummeting, the sooner that point comes the better. This isn’t the return of socialism, but it certainly looks like the end of the kind of financial capitalism that has prevailed for the last few decades.

The argument by talking point style that characterizes all sections of the political right in the US has been evident as usual in relation to the financial crisis, so I guess it’s time to play whack-a-mole yet again. The most prominent points I’ve seen are

* It’s all the fault of the Community Reinvestment Act, which forced banks to lend to low-income borrowers. Quite a few people have pointed out that many of the subprime loans weren’t required under CRA. More to the point, given that the market structures in the bubble made mortgages a fungible asset, the CRA was a nonbinding constraint. It’s clear that many more subprime loans were given out in the bubble years than were required under the Act and that the excess was greatest in the areas where the bubble was worst. The CRA had no effect at all under these conditions.

* If regulation were the problem, how come the hedge funds haven’t been affected? In fact, it was the failure of Bear Stearns hedge funds that signalled the spread of the crisis beyond the subprime mortgage market. And the main reason hedge funds haven’t yet been hit by the crisis of the past few weeks is that they don’t allow redemptions except at stated dates (for most of them it will be next Tuesday. Perhaps there won’t be a problem, but that’s not what the markets think. In any case, those making the claim seem to be unaware of the redemption restrictions.

Robert Waldmann of Angry Bear has a fascinating post exploring the possibility that sharp movements in the value of Lehman senior debt could be explained by the possibility that Lehman had sold Credit Default Swaps on itself. Since a CDS is insurance against the possibility of default on debt, this is a no-lose bet for Lehman. If the firm survives, they collect the premiums and pay nothing and, if it doesn’t the losses are borne by the creditors. And, as Waldmann points out, it’s not crazy to buy such a CDS, since it will retain some value in bankruptcy. If you’ve already sold a lot of Lehman CDS yourself, there’s a significant hedging benefit. So both parties benefit, and the losers are the existing bondholders. Waldmann has an interesting optimization exercise to show that optimal (for Lehman) use of the CDS option could explain the collapse in the value of Lehman bonds.

Thinking about this, I’m more and more convinced that Warren Buffett’s description of derivatives as financial weapons of mass destruction applies in spades to CDSs.

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Pancho: So what does political philosophy have to say about the banking crisis?

Lefty: Excuse me?

Pancho: Well, millions ruined, pensions and savings binned, an appeal to taxpayers to save the banks? It all seems rather, um, well _distributive_… I’d have thought you could give us some policy advice?

Lefty: Well I don’t really do that kind of thing, I do ideal theory.

Pancho: What’s that when it’s at home?

Lefty: I’m mainly concerned with devising optimal principles of social regulation under conditions of strict compliance, this is far too messy for me …

Pancho: Go on, have a go!

Lefty: OK well, since you insist …. Luck egalitarianism might be a good starting point.

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For the (numerous) PG Wodehouse fans at CT, here’s a link to the first episode of Marcy Kahan’s dramatisation of Psmith in the City. It’s excellent: Kahan captures the feel of the text, without making it too wordy or quaint. And timely too (though I doubt there are many people currently in the City or on Wall Street who are starting work at 10, clocking off at 5, and feeling oppressed by such barbaric work hours).

One thing that really puzzles me about the great bailout plan is the almost universal acceptance that Paulson should be the one to run it, at least until the next Administration. More generally, I’m surprised by the kid-glove treatment he’s been getting in public discussion, even from people highly critical of the plan.

Let’s stipulate that he’s a smart guy. He wouldn’t have risen to the top in Wall Street if he wasn’t. And, of course, if having smart guys running the show was sufficient to ensure good outcomes, Wall Street wouldn’t be in its current mess.

Looking back at the record, plenty of people have observed that, at least in his public statements, Paulson repeatedly underestimated the severity of the crisis. And there’s nothing in the ad hoc shifts between cash infusions, bailouts and bankruptcies to suggest that he has much more of an understanding of what’s going on than anyone else. As Paul Krugman has said, he’s making it up as he goes along, just like the rest of us.

But the bailout plan is something else. The possibility of a meltdown like this has been talked about, increasingly seriously, for the last couple of years. Yet Paulson responds with a three page document saying “I need $700 billion, no questions asked”. Wasn’t there a contingency plan? Or worse still, was this the contingency plan?

Either way, Paulson should be sacked forthwith.

As currently proposed this bailout seems like an almost comically bad idea. I encourage all our US readers to get on the phone to their representatives and start bitching Monday morning. I am also very interested to hear what knowledgeable people such as our own dsquared think.

At a time when anyone on the cutting edge is talking quadrillions, it seems a bit petty to worry about a $50 billion component of the latest bailout (only $500 per US household!). Modest as it is, the insurance scheme offered to money market funds by the US Treasury provides the opportunity to explain a little bit more about the theory of insurance.

By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.

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Two days after the US authorities made much of standing firm against calls for a bailout of Lehman, the Fed has announced an $85 billion rescue of insurance company (and large-scale counterparty in all kinds of derivative markets) AIG. There’s none of the ambiguity surrounding Fannie and Freddie in this deal. AIG is not a federally regulated entity, and the insurance subsidiaries are regulated at the state level to ensure their ability to pay out on claims. This is, purely and simply, a case of a speculative financial enterprise that’s too big to fail.

Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation, starting with the derivative markets where AIG got into so much trouble, notably those for credit default swaps (CDS). Along with winding up the affairs of AIG, Lehman and others, the authorities will need to oversee an orderly unwinding of the transactions in these markets which they are now effectively guaranteeing. More generally, it’s time for a partial or complete reversal of the financialisation of the economy that took place after the breakdown of the Bretton Woods system back in the 1970s.

BTW, if you have cash parked in a money market fund, you might want to read this. (Insert disclaimer about financial advice)

UpdateBrad Setser has the same reaction.

Finally and “long overdue”:https://crookedtimber.org/2008/05/20/care-talk-blog/, here is my book review of Valuing Children, Nancy Folbre’s latest book. The overall goal of this book is to show how and why children matter for economic life, to provide estimates of the economic value of family (nonmarket) childcare and parental expenditures in the USA, and to raise critical questions about the size and kinds of public spending on children in the USA.

Folbre formulates four questions which she sets out to answer: (1) Why should we care about spending on the children? (2) How much money and time do parents devote to children? (3) How much money do taxpayers spend on children? And (4) who should pay for the kids (in other words, which share of the costs of children should be borne by parents and by the government)?
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Now that Lehman Bros and Merrill Lynch are gone, attention is turning to insurance company AIG. When the first big failure, that of Bear Stearns was coming up, the initial offer of $2 a share suggested that the company was worth less than the building it operated it (the deal was subsequently sweetened, courtesy of the US taxpayer[1]). Looking at AIG, this WSJ story says that, as of last quarter, assets exceeded liabilities by $78 billion, a number that has almost certainly declined since then, given that the $1 trillion asset book includes lots of toxic sludge. But the story also notes that the company’s aircraft leasing subsidiary (where did they get this?) owns planes worth more than $50 billion. So, it looks clear that, apart from the planes, AIG is worth little, nothing or (most likely) a large negative value.

Update Commenters object, correctly, that it isn’t legit to value the planes without taking account of the associated debt. However, after today’s debacles, it doesn’t matter too much. AIG is toast, the only question being whether the Fed will treat it as another Bear or another Lehman. Next cabs off the rank appear to be Washington Mutual and Wachovia, taking the FDIC with them. I even saw GE mentioned somewhere, but it seems too soon for that.

[1] Despite the tough talk and the refusal to bail out Lehman, the Fed has given yet further ground to the banks this time around, agreeing to lend public money against subprime trash.