Wednesday, 1 October 2008

What Paulson Should Have Said

I’ve criticized Treasury Secretary Paulson for poorly explaining and marketing his plan. Here’s the statement I believe he should have given before the Senate Banking Committee. I’ve also criticized the plan itself, but I’ll leave my suggestions for a better plan for another time.

Chairman Dodd, Senator Shelby, members of the committee, ladies and gentlemen:

I come before you today because the United States and the American people are facing three financial crises: a housing crisis as home prices continue to tumble; a mortgage crisis as defaults and foreclosures continue to rise; and a banking crisis as banks contract their lending in the wake of losses on mortgages and mortgage-related securities.

All three crises require the urgent attention of Congress and the Administration, and we are committed to working with you to address each of these crises. But while the housing and mortgage crises are both critically important, it is the banking crisis that now demands our immediate attention.

As mortgage defaults and foreclosures have increased, the values of the mortgages and mortgage-related assets held by banks have plummeted, and the attempt by the banks to shed these assets in the marketplace have resulted in further price declines. This downward spiral has depleted the capital positions of some banks to the point of insolvency. In some cases, the insolvent institutions have been allowed to fail, and in some instances they have been purchased by stronger institutions. But in either case, we’ve witnessed a loss to our nation’s financial infrastructure.

While the majority of financial institutions are not insolvent, many banks find that their capital positions no longer support the provision of new loans. As a result, credit has been contracting for corporations, small business, municipalities, and consumers.

No one can predict with certainty the eventual impact that this contraction will have on the economy and on the lives of the American people. But some very frightening scenarios have now become plausible.

If the commercial paper market were to freeze further, large corporations would be unable to meet their payroll obligations. Large retailers would be unable to hold inventory on their shelves. Airlines would be unable to purchase fuel ahead of peak periods. If bank lending were to contract further, small businesses would be unable to maintain working capital, forcing them out of business. New business creation would come to a standstill. Farmers would be unable to finance the purchase of seed and fertilizer.

Imagine the country with no paychecks, barren shelves, fallow fields, no air travel, and hundreds of thousands of small business failures. Unemployment would skyrocket. A deep recession would ensue. And some scenarios would be more accurately characterized by the word depression.

But in addressing this problem, we also have an opportunity. The current banking crisis is not the first our country has experienced, and we have learned valuable lessons from previous experience. In particular, Chairman Bernanke and I are proposing a good bank / bad bank approach to our current crisis, in which the troubled mortgage-related assets are placed in a government entity, leaving the private-sector banks with fewer problem assets and a real chance to recapitalize and to increase their lending activities to the levels required to support our economy.

I use the term opportunity to describe this proposal because the values of these assets have been driven to levels that appear very attractive based on realistic assessments regarding the likelihood of future repayments. Taxpayers have an opportunity to acquire these assets at prices that are very likely to produce handsome returns in the future.

The press has referred to these mortgage-related assets as being toxic, and you may be wondering why we propose that US taxpayers should make a tremendous investment in toxic assets. Simply put, we do not believe these assets are toxic at all. These assets are the IOUs of the American people. They may be sliced, diced, and repackaged, but in the end they are still the promised payments of the American people. As such, we strongly object to characterizing them as toxic.

It is true that many Americans are having difficulty in these troubled times making all their payments when they are due. As a result, some of these payments will arrive late, and some will not arrive at all. But the default assumptions consistent with the valuations of these troubled assets suggest that the nation will experience levels of default and recovery rates that are unprecedented.

If these securities are so attractive, why should we offer to buy them from the banks? To be clear, many banks are happy to hold these assets on their books, fully expecting the payments to be made and/or for the assets to recover much of the value lost in recent months. But in that case, the banks would be using their capital to support these assets rather than to support new lending.

Ladies and gentlemen, this is not a bailout for the banks. This is an opportunity for us to motivate the banks to lend new money to businesses and consumers rather than simply sitting on the loans they had made previously. The goal of our proposal is not to provide money to Wall Street but rather to enable credit for Main Street. Our banking system is the mechanism by which credit reaches businesses and consumers. If Wall Street is using its remaining capital to hold troubled mortgage assets on its books, it can’t use that capital to provide credit to Main Street. If we can motivate Wall Street to sell these troubled assets to a newly-created government entity, Wall Street can use its capital to provide credit to the business and consumer sectors, thereby supporting the economy.

In particular, we propose the American people invest seven hundred billion dollars to purchase assets backed by the promises of the American people. Specifically, in coming weeks the Treasury would hold fixed-rate tenders for banks to exchange mortgage-related assets for US Treasuries bills and notes. The rate of exchange would be based on mortgage models, using conservative but not unreasonable assumptions about the default and recovery rates for the assets underlying these securities. We anticipate that these prices would be somewhat greater than the values at which many banks currently have these assets on their books. In this case, banks could expect to make a small profit by participating in the program. And of course, even banks that did not participate in the program would enjoy mark-to-market gains in the values of assets they held. But then of course they would still have the assets on their books, and they would be unable to use their capital to make new loans.

On the other hand, we expect the transfer values for these securities to be significantly lower than their value assuming realistic rates of default and recovery, in which case the US taxpayer would enjoy a significant return on this investment, which would be returned to the Treasury general fund. If Congress saw fit, profits from this investment could be used to reduce future taxes or to fund future Social Security or Medicare obligations.

If we do nothing, the outcome is not certain, but the risks are clear. In short, we run the risk of severely curtailing economic activity, perhaps to an extent not seen since the Great Depression. But with this proposal, we have an opportunity to clear the channels by which credit reaches businesses and consumers, a prerequisite for a healthy economy. And we have an opportunity for the American people to invest in their own IOUs at prices that are likely to result in significant returns on this investment.

While I deeply regret our present circumstances, I am also encouraged that Treasury, the Federal Reserve, the Senate, and the House have an opportunity to take quick and decisive action to restore confidence, protect our financial infrastructure from further damage, and promote the provision of credit to businesses and consumers necessary for a healthy economy. I look forward to answering your questions about this proposal and to working with you in the coming days to ensure its timely and effective implementation.

Friday, 26 September 2008

Breaking the Paulson Plan

In today’s Wall Street Journal, Professors Diamond, Kaplan, Rajan, and Thaler published an op-ed piece titled, Fixing the Paulson Plan. Despite my considerable respect for this group (I completed my doctoral studies at Chicago), their recommendations are fundamentally flawed.

In their article, the professors start with some important observations. For example, the authors state, “the real concern about the financial sector is that it is undercapitalized, both because of the losses it has sustained and because of the growing risk aversion of lenders. Undercapitalized financial institutions are forced to try to reduce their assets, and, of course, this means they will make fewer loans, even to the healthy portions of the economy.” In fact, I expressed similar observations in my blog post, Batten Down the Hatches, on Wednesday of this week.

The professors also identify a problem with the Paulson plan that I believe is potentially fatal to its success. In their words, “it is not clear how that hypothetical [held-to-maturity] price will be established through competitive auctions.” This is not a detail to be glossed over now and addressed later. It is key to the entire issue. As I wrote in my earlier piece, a reverse auction, as suggested by the Treasury, has the potential to result in transfer prices that are lower than the values at which many banks currently have these securities marked, precipitating further writedowns and further reductions in bank capital.

Despite correctly diagnosing the problems with the banking sector and with the Paulson plan, the authors offer policy prescriptions that are unlikely to improve matters and may further exacerbate the situation. For example, the authors commend Senator Dodd’s suggestion that taxpayers receive contingent equity from the banks, equal to 125% of any losses the government subsequently realizes on transferred assets. So rather than being long the underlying assets, the banks would be short put options with 25% more downside exposure than they had previously. And of course the banks will have none of the upside.

Supporters of this proposal may argue that this arrangement would be beneficial to the banks as long as the government paid above the current market price for the assets. But presumably the strike prices for these put options would also be set at the above-market transfer price. In that case, the banks would immediately recognize a gain equal to the difference between the market price and the above-market transfer price. But unless this transfer could permanently increase the market price of the assets, the banks would be short put options whose intrinsic value was 125% of the difference between the market price and the above-market transfer price.

Perhaps the supporters of this plan are relying on these asset transfers having a permanent impact on their market prices, in which case there may be some economic benefit to the banks, despite the 125% put options. But if the original assets have proven difficult to value recently, the puts would be a nightmare to value, requiring not only current prices for the underlying assets but also assumptions about the volatility of the asset prices – and even the statistical distributions used to model the future asset prices – going forward. And since these options only increase the downside exposure of the banks, they won’t be able to ignore these accounting issues. Overall, the merit of the Dodd proposal appears doubtful.

But the crux of the Professors’ proposal involves two questionable strategies for achieving two laudable goals. In the words of the professors, the first goal is “to ‘liquefy’ certain moribund markets, thus allowing financial institutions to sell illiquid assets.”The second goal is simply “to raise capital levels in financial institutions.”

In pursuit of the first goal, the Professors suggest implementation of the Paulson proposal, in which “Treasury would buy assets through a reverse Dutch auction or some variant, but without any intent to overpay.” In their words, “the idea would be to jumpstart the market by establishing trading prices.” I’m certain the authors didn’t feel that this WSJ op-ed piece was an appropriate forum for discussing financial theory, but they offer no arguments whatsoever, persuasive or otherwise, for believing that liquidity can be re-established in these markets with a government “jumpstart.”

My own view is that a reverse auction, if successful, would allow the market to see the prices at which some institutions were willing to part with these assets. But it wouldn’t allow the market to see the prices at which other private institutions would be willing to purchase these assets. And if the gap between the willing sale prices and the willing purchase prices remained significant – as it appears currently – then the markets would remain illiquid, and this goal would not be achieved with a reverse auction. But on the other hand, some of these Professors are deservedly renowned as experts in modeling these sorts of issues, so it’s quite possible that they could offer some compelling arguments in support of their view. If that’s the case, they could contribute to the public debate by at least summarizing these arguments.

The most problematic proposal offered by these authors is in pursuit of their goal to raise capital levels in financial institutions. In particular, they suggest that government require all financial institutions, healthy and otherwise, to present plans to raise capital levels by 2% of their assets to preserve the stability of the financial system. They also suggest that the government could contribute up to half this amount in exchange for non-voting preferred equity in the event that an institution was having difficulty raising capital in the private market.

The main problem with this idea is immediately apparent simply by considering the supply and demand curves for bank capital. The demand for capital on the part of banks is an increasing function of their equity prices, whereas the supply curve for capital on the part of investors is a decreasing function of bank equity prices. As seen from numerous deals recently, the market for bank capital is currently very active relative to historical norms, and the market for bank capital appears to be clearing fairly well. The effect of this proposal would be to alter the demand curve for capital to have an inelastic segment at the quantity equal to 2% of assets.

Under this proposal, two scenarios are logically possible. First, the 2% floor could be below the current market-clearing quantity, in which case it would have no effect. Bank deals of the sort we’ve seen recently would continue to be arranged at prices determined by the intersection of these supply and demand curves. This proposal would do no harm, but neither would it accomplish anything positive.

The other scenario is that the 2% floor would be above the current market-clearing quantity. In this case, the inelastic segment of the demand curve would intersect the supply curve at a lower price than the current market price. In this case, a government mandate to raise capital would result in a decline in bank equity prices.

Given that the government has only recently introduced bans on the short sale of many hundreds of financial stocks, it would be highly questionable to impose a mandate on the banking sector that either would have no impact or would drive bank stocks to even lower prices.

Of course, the authors suggest that government could offer support for institutions that had difficulty raising the mandated capital via government purchases of up to half the required increase. But this raises other issues. For example, under what conditions would the government conclude that an institution was having difficulty raising capital? If there is no price at which private investors are willing to supply capital, then a government purchase of preferred shares appears futile. And if there is a price at which private investors are willing to supply capital, the government should allow the market to clear at that price. Government participation can alter the demand curve for capital by lowering the effective floor at which the demand curve must become inelastic, so government participation can increase the equity price. But in this plan government participation is only partial, and it only occurs in the context of a government mandate to raise capital. As a result, the net effect is either to lower the equity price or to have no impact whatsoever on either the price or the quantity of bank capital.

The authors suggest that the real benefit of a mandate is that it would remove the stigma associated with banks needing to raise capital. On this point, the Professors appear to be seriously out of touch with the current dynamics in the market. At the moment, there is no stigma associated with capital raising. Goldman Sachs recently raised considerable capital in a series of transactions for which they’ve been widely praised. Morgan Stanley also raised considerable capital recently. In fact, in the current environment, the ability to raise capital is seen as a sign of strength. There simply is no stigma to be overcome by a government mandate to raise capital.

I do believe the Professors make a useful contribution to the debate with their observations regarding the problems with the Paulson plan. But their proposals for fixing the Paulson plan appear to be poor policy prescriptions. The Dodd plan increases bank risk and decreases bank capital unless the asset transfers somehow permanently raise the market prices of the troubled assets – a proposition for which I see no basis. Their view that a reverse auction would somehow ‘’liquefy” the market isn’t supported by any arguments. And their proposal that government require banks to raise capital appears destined to lower bank stock prices – if it has any impact at all. Rather than fixing the Paulson plan, these proposals would appear merely to break it further.

Wednesday, 24 September 2008

Batten down the hatches

In addition to dealing with the financial tsunami engulfing the banking system, Paulson now has to contend with a surly, mutinous crew. During yesterday’s hearing, Senators characterized Paulson’s plan for buying distressed assets as “half-baked” and a concept rather than a plan. And for good reason. A plan would contain clearly-articulated goals, strategies, and tactics. Paulson’s proposal contains a broadly-stated goal, but the strategies in pursuit of that goal appear misguided, as Paulson appears to have misdiagnosed the problem. And his proposal is virtually devoid of tactics to support his strategy. Given the reception he received in the Senate, his plan appears unlikely to come to fruition as proposed.

Let’s start with the goals. In his prepared statement yesterday, Paulson expressed his goal “…to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families' financial well-being, the viability of businesses both small and large, and the very health of our economy.” I would argue that there’s little reason for the government to care about financial institution failures except to the extent it cares about job losses, tax receipts, or the financial infrastructure supporting the economy, but the goal of well-functioning credit markets certainly is laudable.

But then Paulson goes awry in his diagnosis of the problem facing the financial sector. As he states in his prepared remarks, the “…root cause is the housing correction which has resulted in illiquid mortgage-related assets that are choking off the flow of credit which is so vitally important to our economy.” The analogy here appears to be one of pipes carrying the flow of credit that have become blocked by illiquid assets. According to Paulson, the decline in house prices has caused these securities to become illiquid, and now they’re clogging the pipes. If we could simply remove the illiquid securities from the pipes, the flow of credit could continue unimpeded.

This is a serious misdiagnosis of the problems facing the financial system. It is not the illiquidity of mortgage assets that is creating the problem. Rather, it’s their price declines.

These mortgage securities are financial assets whose underlying claims to real assets are the claims on houses. As house prices have declined, the values of the mortgage securities have declined. As expectations of further declines spread, owners of these mortgages began selling, often at distressed prices. After a while, the market prices for these securities came to reflect the psychology of market participants more than they reflected the fundamentals of the housing market. And as this psychology deteriorated further and became less predictable, many investors decided there was no price at which they were willing to buy these assets. Meanwhile, many mortgage holders anticipated that the market values of these assets would increase to more closely reflect more realistic expectations regarding default rates and recovery values. With buyers and sellers holding such different views of the market, the market became illiquid.

The commercial and investment banks holding many of these mortgages have been required to mark these securities to their market prices, which are considerably lower than their purchase prices in most cases and which are increasingly difficult to determine given the relative illiquidity of these markets. Of course, this process has caused banks to record large losses. And these losses, even if only on paper, have caused reported bank capital to decline considerably. And here is the problem. Many banks no longer have sufficient capital to support their business. Banks either need to obtain more capital or they need to shrink their business. Banks won’t resume typical lending activities until their risk-to-capital ratios return to more comfortable levels. But their efforts to reduce risk are causing further declines in asset prices, which are causing further declines in bank capital.

Paulson’s diagnosis is that mortgage securities have become illiquid and are now blocking the credit pipes. As a result, his prescription is to remove the illiquid securities from the credit pipes so a reasonable flow of credit will be restored. It’s true that the removal of the mortgage securities from the banking sector can help reduce the risks on bank balance sheets. But it’s also true that this process has the potential to further deplete bank capital. For example, if a reverse auction is used to enact the transfer of the securities from banks to the Treasury, as the Treasury envisions, it’s likely that banks will be forced to record further losses on these securities, resulting in a further erosion of bank capital. In this case, it’s possible that the risk-to-capital ratios would deteriorate even further, simply exacerbating the problem. Even after transferring mortgage assets to Treasury, banks may have to sell even more assets in an attempt to reduce risks to a level commensurate with their lower capital levels.

For this process to improve the situation, the transfer of assets will have to be enacted at prices that are higher than the prices at which they’re currently marked, so the banks can record gains on the sales, resulting in an increase in capital.

In his prepared remarks, Paulson was silent on the mechanism to be used to enact the asset transfers. But in a fact sheet released over the weekend, Treasury stated, “The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions.” Without significant collusion, a reverse auction is likely to lead to lower prices and a further deterioration in bank capital.

On the other hand, Chairman Bernanke yesterday gave the impression that he envisioned that this process would lead at some point to these securities being marked at prices more closely reflecting their ‘hold-to-maturity’ value rather than their fire-sale prices. If this could be accomplished, it has the potential to significantly improve the situation. But given yesterday’s reception in the Senate, it appears unlikely that Paulson will be given license to transfer these assets at these higher hold-to-maturity values, particularly in the middle of election season.

If Congress is unwilling to approve the transfer of assets at hold-to-maturity prices, Paulson’s plan is very unlikely to achieve its goals. Many in Congress and most market participants appear to be aware of this. Perhaps even Paulson is aware of this. Perhaps he believes Congress needs to consider and reject this proposal before they will consider more draconian proposals.

In particular, I can think of two proposals that might help improve the risk-to-capital ratios in the banking sector. The first is a simple capital injection by Treasury, most likely in return for preferred stock. Congress would only approve this if it were done on terms that would severely dilute existing shareholders, but if done in sufficient size it probably would be successful at restoring the flow of credit. Second, Congress could suspend mark-to-market accounting for banks. In this case, banks could report their mortgage holdings at prices that more closely reflect Bernanke’s hold-to-maturity values, resulting in reported profits and capital increases. The stock market would be unlikely to react well to this approach, but the resulting reduction in risk-to-capital ratios very likely would lead to a restoration in a reasonable flow of credit.

I suspect there is a reasonable chance that Congress will allow the Treasury to purchase distressed assets -- though on substantially different terms than those proposed by Paulson. In particular, Congress appears reluctant to approve the entire USD 700 bln requested by Treasury. But there also appears to be a reasonable chance that this plan won’t be approved at all. In particular, I suspect there will be counterproposals suggested involving both direct capital injections and the suspension of mark-to-market accounting.

While the eventual result of this political process in unclear, it is clear that Congress and the Treasury are not going to proceed in a straight line toward a quick implementation of the Paulson proposal. As a result, we’re likely to see some resurgence of the storm that hit the banking sector and the credit markets last week. While it’s unlikely we’ll see conditions on the order of last week’s tsunami, I suspect we’re in for some serious turbulence in the coming weeks. In particular, look for renewed elevation in credit default spreads, lower equity prices, a continued scramble for T-bills, elevated swap spreads, lower oil prices, and continued expectations of near-term rate cuts by the Fed.

Wednesday, 30 July 2008

Rogoff Misdiagnoses the Problem

In his FT article of July 30, ‘The World Cannot Grow Its Way Out of This Slowdown’, Kenneth Rogoff makes some curious arguments. In particular, he identifies excessive demand for commodities and the excessive supply of financial services as the two main problems facing the global economy. And in response he advocates more restrictive fiscal and monetary policies and a greater willingness to allow financial services firms to fail.

Rogoff cites the large increase in commodity prices as prima facie evidence that the global economy is still growing too quickly and hence that commodity demand is excessive. However, one need only consider the oil price increases from 1974-1980 and the price of gold in 1980 to see that commodity price increases do not constitute prima facie evidence of even trend growth.

Rogoff chides central bankers in dollar bloc countries for having “slavishly mimicked expansionary US monetary policy.” While the Bank of Canada has lowered its lending rate in recent months, the Reserve Bank of Australia and the Reserve Bank of New Zealand have significantly tightened policy over this period. Perhaps Rogoff is also referring to Asian countries with managed currencies, such as China? If so, this characterization still appears misleading, as China has been increasing its rediscount rate and has significantly increased its required reserve ratio in recent years. The overall impression is that policy is relatively stimulative in markets operating below capacity and relatively restrictive in markets that appear to be operating above capacity, just as one would expect in a world still dominated by the Phillips curve paradigm.

Rogoff also chides regulators for preventing the failure of firms in the financial services sector, apparently ignoring the considerable consolidation occurring in the sector. The recent acquisitions of Bear Stearns and Countrywide serve as examples of ongoing consolidation, as does the recent acquisition of ABN AMRO, the largest such transaction to date. Regulators may be subject to criticism for failing to provide adequate regulation in certain instances but not for failing to allow consolidation and removal of capacity in the sector.

In short, I believe Rogoff has misdiagnosed the problem. The demand for commodities and the supply of financial services are the consequences of the profound changes that have taken place across the globe. They are not the causes of the current turmoil, and his prescriptions are unlikely to help ease the turmoil or set the stage for a more supportive environment in the future.