The Irish Bailout

Posted in Economics, Financial Markets, Politics and Policy at 7:11 pm

More or less what was expected.  €85 billion at 5.8% interest.  €10 billion in immediate cash to re-capitalize the banks, another €25 billion line of credit for the banks, and €50 billion to meet state budgetary needs.  Oddly, the Irish government must contribute €17.5 billion, mostly from the state pension system.

Most interestingly, a vague “permanent resolution mechanism” for restructuring debt was announced that will go into effect sometime in 2013, and that “may” require bondholders to take losses at that point.  That’s their long term solution to the contagion problem?  Wow.


Wait, what? Belgium?

Posted in Economics, Financial Markets, Politics and Policy at 10:58 pm

It seems that a number of blogs have picked up on Belgium as a likely candidate for the next domino to fall – either immediately before or immediately after Portugal.

Let’s look at the facts here:

  • Belgium’s budget deficit is under 5% of GDP, below the Eurozone average
  • Belgium has a savings rate of 11.5%
  • Belgium is currently running a current account surplus, and has been for some time
  • Belgian GDP is growing around 2% per year
  • Belgian 10 yr bonds are trading at roughly 1% above German Bunds, a mere fraction of the spreads at which other Eurozone countries’ bonds are trading

So what is the case for a Belgian default?

It seems to be:

  • Belgian national debt is around 100% of GDP, third overall in the Eurozone, behind Greece and Italy
  • Belgium has failed to form a new government for the past 6 months, with a split between parties representing the Dutch and French speaking areas
  • Concerns over Belgian banks, which in reality are no shakier than those of other Eurpoean countries not consider to be on the domino list, certainly far less shaky than those of Ireland

National debt as a % of GDP is not an indicator of short term instability.  It’s only real relevance is with regard to debt service levels, and given Belgium’s current account surplus, savings rate, and GDP growth, this is a non-issue in the short to medium term.  The danger represented by lack of a government is completely overblown, and if there were a crisis, I’m fairly confident they’d pull together a government in short order.  The banks, again, really are in no more of a fragile state than those in the rest of Europe.

If, in fact, a “crisis” does develop in Belgium, I think it warrants stepping back and re-examining what’s really happening in Europe and whether the current approach to rectifying the problem is appropriate.

Ireland, then and now

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 6:17 pm

In 2007, Ireland ran a budget surplus of 0.051% of GDP.  That was the 5th straight annual budget surplus for Ireland.  In fact, from 1997-2007, Ireland ran an average 1.6% annual budget surplus.  Likewise, in 2007, Ireland’s total government debt was 25% of GDP.  This was not a country on the brink of a fiscal crisis.

Fast forward to the present.

Ireland is now running an annual budget deficit of around 32% of GDP and the national debt is 65.6% of GDP.

What happened?  Obviously the financial crisis led to a large falloff in tax revenue, along with an increase in countercyclical spending.  That’s not the main story, however.  What really happened is that Ireland experienced a banking crisis and the Irish government guaranteed its banks.  That is the prime driver behind the numbers and is the motivating factor behind the ongoing bailout talks.

Ireland is about to inflict an unconscionable amount of pain on its citizens through a combination of austerity programs while saddling them with an enormous amount of new debt in the form of the EU/IMF bailout.  Is this necessary?  This amounts to a naked transfer of wealth from ordinary Irish citizens to a handful of German, British, and French banks who are creditors of the failed Irish banks.  There’s no making the losses disappear, the only question is who realizes them.  It has been determined that the Irish government, and by extension, the citizens of Ireland, will realize the loss.  Why?  Why not the bondholders?


Some further thoughts on QE2

Posted in Economics, Financial Markets, Politics and Policy at 7:54 am

I’ll focus here on what I call “compositional effects” – how the composition of an action (in this case QE) can be more important than the absolute level of the action.

Bernanke has used the metaphor of “dropping money from a helicopter” in past discussions of monetary policy.  The implication is that the Fed could always prevent a deflationary spiral through the use of their “printing press”.  Let’s look at compositional effects as they apply to the helicopter metaphor.  In this case, what matters is who receives the newly created money, or, to extend the metaphor, the location of the helicopter when the drop begins.  Consider for a moment that the banking system is currently sitting on around $1 Trillion in excess reserves and the helicopter drop will simply funnel an additional $75 billion or so per month to these same banks.  Bernanke has effectively positioned the helicopter over a volcano before starting the drop.  When the drop is done, we’ll likely have $1.6 Trillion in excess reserves with very little net change in the real economy.  Perhaps a smaller drop, with the helicopter instead positioned over Main Street would have been a wiser move.

Now let’s look at QE and inflation expectation through the lens of compositional effects.  Changes in inflation expectations have been put forward by numerous economists, including Paul Krugman, as the primary mechanism through which QE will stimulate the economy.  This makes sense if price level changes, or rather the expectation of future price level changes, are more or less homogenous throughout the economy.  What happens if they are not?  What happens if the primary effect of QE is to increase the prices of commodities (oil, food, metals, etc.) but not finished goods or labor?  This would result in a sort of reverse wealth effect for individuals (who could now consume less energy and food out of a constant income) and declining profitability for firms (who face rising input costs and constant output prices).  The net effect would be a decline in aggregate demand.  Compositional effects matter.


QE2 Is Here

Posted in Economics, Financial Markets, Politics and Policy at 2:28 pm

FOMC Press Release:


To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

$600 billion in longer-term Treasuries at a rate of around $75 billion per month.  This is roughly in line with expectations (consensus was for $500 billion – $1 trillion, at a rate of around $100 billion per month), though it’s at the lower end of the range.  Also, there had been talk about the Fed potentially purchasing MBS and other assets in addition to or instead of Treasuries and that did not materialize.

I’ll post more later.


First Citi, Now AIG

Posted in Economics, Financial Markets, Politics and Policy at 8:38 pm

The Treasury seems to be in an awful rush to convert the preferred shares it acquired in these companies as part of the bailouts into common shares.  This entails giving up a sizable dividend, giving up their place in the hierarchy of creditors should there be future financial problems at the firms, and exposing themselves to additional market risk as the value of the common shares fluctuate.

There are a number of scenarios under which this could make sense.

If the Treasury intended to sell the shares all at once, the dividends and creditor standing would largely be irrelevant.  They also wouldn’t be exposed to market risk over time, although the selling of such a large block at once would certainly depress the price enough to significantly reduce the amount of money they’d receive.  In any case, the Treasury has signaled that they do not intend to take this route and will slowly dispose of their common shares over an extended period.

Another scenario where this approach would be desirable would be if the Treasury expected a period of strong economic growth leading to strong profit growth for these companies followed by a significant appreciation in share price.  It’s hard to see how that could realistically be their near to mid term forecast, however.

That leaves largely political motivations.  The administration wants to end the noise about “government takeovers” coming from the Right.  The American people in general find the idea of bailouts distasteful.  The firms in question want to improve their PR images.  So on and so forth.  There are risks here though.  Prematurely paying back the government and having the government prematurely extricate themselves will leave the firms more exposed should the financial storm reappear.  It would also make it politically difficult for the government to engineer additional policy measures should that happen.


GSE Reform

Posted in Financial Markets, Politics and Policy at 6:36 am

There are two primary issues, orthogonal to one another, that need to be addressed:

  1. How should the GSEs be organized (public agency, private for-profit company, some sort of hybrid)?
  2. What functions should the GSEs perform?

I’ll address the second question first, as the answer will impact how we frame the solution to the first question.

Currently, the GSEs (Fannie and Freddie) engage in three separate activities:

  1. Purchasing whole mortgages from lending institutions and packaging them into MBS.
  2. Providing a guarantee on the MBS they create.
  3. Purchasing MBS (their own and private label) to hold in their portfolio.

They issue debt (agency bonds) to finance #1 and #3.

Function #3 should be eliminated.  It is this function that created most of the systemic risk and required taking the GSEs into conservatorship.  The GSEs were essentially operating a hedge fund here, and a highly leveraged one at that.  It makes no sense whatsoever to concentrate MBS holdings at any one or two firms to that degree, and that is the case regardless of whether we’re talking private companies or quasi-government enterprises.  That level of size, market risk, and leverage is hazardous anywhere.

Function #1 should probably also be eliminated.  It’s not particularly harmful, but there’s no reason why private firms cannot fulfill what it a relatively mundane function.

Function #2 should be kept.  Without some sort of guarantee, interest rates would be much higher, potentially several hundred basis points higher as Bill Gross of PIMCO noted yesterday, the mortgage market would be highly illiquid, and it would be prone to periodically locking up.

What do we end up with if we eliminate Functions #1 and #3 and keep #2?  We end up with Ginnie Mae.  That is exactly what Ginnie Mae does today – they provide guarantees and nothing else, they do no buy whole mortgages to create MBS nor do they hold any securities for their own portfolio.

Now we can address the first question – How should the GSEs be organized?  Onstensibly, prior to Fall 2008, they were private companies, however they had an implicit public guarantee, no matter how vehemently they denied it.  Thus, they were a sort of hybrid.  This was the worst of all possible worlds, and should not be repeated.  Somewhat better than this would be to structure them as purely private, for-profit corporations.  There are two problems with this approach – 1) the market will always perceive there to be some sort of implicit guarantee, regardless of what is said and 2) since their ultimate purpose is to perform a public policy function (enabling low-cost liquid mortgage markets), why create an inherent conflict (between shareholders and policy makers) from the start?  The best solution is to make them an explicit government agency.

Once they are made an explicit government agency, however, another question arises.  Why have two additional agencies that are structured the same as Ginnie Mae and perform the exact same function?  Why not just expand Ginnie Mae?  This, I believe is the ultimate solution.  One government agency, providing mortgage guarantees and little else, subject to a specific set of restrictions on the underlying mortgages, for a specified fee.

The specific set of restrictions should be based on the GSE conforming loan standards that served the market well for many decades before the explosion of subprime: 20% down payments, LTV <= 80%, 28/36 DTI plus a FICO score (or substitute) somewhere in the low to mid 600′s as a minimum.  Approved mortgages should be standardized, with just a few options – 15 and 30 year fixed, and 3/1 and 5/1 ARMs (with perhaps slightly higher income requirements for the ARMs).

The fee (insurance premium) charged for the guarantee should be actuarily sound (balanced against claims over a moderately long horizon) and high enough to avoid underpricing of risk by the unscrupulous.

Let’s be absolutely clear.  This will, to a large degree, run counter to a policy of encouraging homeownership, particularly amongst the lower income strata.  At least in the short term it will.  I offer 2 arguments why this is a good idea:

  1. We don’t do low income potential home buyers any favors by putting them into houses they cannot afford and making foreclosure a near certainty.
  2. We don’t do low income potential home buyers any favors by artificially driving up the demand for houses, and thus increasing their prices.  Such policies, designed to make houses more affordable, run counter to their own purpose and make houses less affordable.

Government really ought to pursue the following two objectives with regard to the mortgage market, and these two objectives only:

  1. Ensuring that lenders are not discriminating against CREDIT WORTHY applicants on the basis of race, religion, ethnicity, sex, or geography.
  2. Ensuring that the mortgage market remains liquid and avoiding seizures (like what happened in late 2008 to early 2009) where credit worthy borrowers suddenly cannot find mortgage financing anywhere at any price.

This is the path forward.  It assumes a clean sheet of paper.  How we get from where we are today to the future, is a separate question, and a very difficult one.  The economy and the mortgage market are both fragile, and should not be disturbed excessively in the near term.  Implementation will have to involve a period of time when the current GSE portfolios are wound down simultaneously with the new system ramping up.


Quick Thoughts On QE2

Posted in Economics, Financial Markets, Politics and Policy at 8:57 am

Lots of talk out there on the Fed readying QE2 (a second iteration of Quantitative Easing).

It seems to me that QE2 would take one of two forms (or some combination thereof).

  1. The Fed starts buying 10yr and 30yr Treasuries in order to nudge down long term interest rates on mortgages and business loans.
  2. The Fed resumes its purchasing of MBS (it purchased $1.25 trillion late last year and early this year, but completed the program in the Spring).

The problem with #1 is that while it would lower long term rates to some degree, it would also flatten the yield curve.  A flatter yield curve means lower bank profits, and the banks are still in a somewhat precarious state, so this would likely mean less lending.  The problem with #2 is that the Fed’s ultimate goal is to make the mortgage origination and securitization markets self-sustaining (they’re currently on government life support) and additional purchases in this market would be contrary to that goal.

There are no easy answers here.  QE is great in theory, and it really SHOULD work.  Bernanke’s “helicopter speech” gets endless cites in the press.  The problem is that the Fed cannot, literally OR figuratively, drop money from helicopters.  Yet, in a sense, that is exactly what needs to happen – the new money created needs to be put into the hands of consumers and businesses, not kept as excess reserves by banks.  Unfortunately, the Fed has no legal authority to provide the new money to anyone other than banks.  However, the banking system is broken, and the new money being created is just sitting as excess reserves and not making it to the real economy.  A quandary indeed.


An Early Effect of FinReg

Posted in Financial Markets, Politics and Policy at 11:19 am

The business press has been making noise about FinReg holding up a Ford bond issue.  The legislation opens up the possibility of holding Credit Rating Agencies accountable for defective ratings.  As a result, the CRAs are refusing to allow bond issuers to disclose ratings in prospectuses.


In response, the SEC has issued a statement that it will temporarily allow bond sales to go on without ratings.  This decision should be made permanent.

The above article asks two good questions:

  • Why does anyone still care what the rating agencies say, anyway?
  • If rating agencies now won’t let their ratings be included in offering documents, what’s the point of having them in the first place?

The second question gets to the heart of the matter.  The business press is acting silly when they “blame” FinReg for the situation.


Fed Paper On Shadow Banking

Posted in Economics, Financial Markets at 7:40 am

The NY Fed has a new staff paper entitled, “Shadow Banking” available.

Shadow Banking – NY Fed

This is a phenomenal read that documents the rise of the shadow banking system in minute detail.

Note that what has been published is just Part 1 (~70 pages) of what will ultimately be a 4 part paper (~230 pages).  Essentially, this is the executive summary of the paper, though it is quite detailed for such.

I anxiously await the publication of the remaining parts.