Time to Recapitalize Households

In the last few weeks we have seen dramatic shifts in the position of governments on the current financial crisis. In the UK, Gordon Brown has spearheaded direct government equity stakes in banks, and is pushing for long-run structural fixes.[1] Following similar moves elsewhere in Europe, the Bush administration has jumped on board as well. Markets have now factored in expected government support, in the form of debt forgiveness (i.e. tax payer bailouts) and equity injections. As such, we should not expect dramatic changes in market performance at the moment unless new information emerges.

As this drama unfolds, here has been a parallel debate in the context of the U.S. Presidential elections on what to do with bad mortgages. The McCain plan was a version of the Bush plan -- have taxpayers take over bad loans. This has been heavily criticized. Yet, they are correct that something needs to be done in the housing market. In the old days, with the FSLIC, if a Savings and Loan failed, the government would have been the one to ultimately step in and clear housing stocks. This did not end well last time, and it is not clear why the current analogue will be any better. Already we are seeing discussion of what to do about increasing foreclosure rates.[2]

Here is a crazy idea, instead of just buying up bad mortgages at face value -- Recapitalize Households. What I mean is the following.

1. in cases where households now owe more than their house is worth, but where they can make payments on a mortgage at the current value (i.e. a proper credit check), the government buys the mortgage from the current holder at the current value of the property -- NOT at the face value of the mortgage


2. The government takes an equity stake (up to perhaps 25%) in the property itself, shared with the homeowner and to be recovered at sale of the house.


3. Details can be worked out, but a logical set-up is that the government shares any future increase in property value with the homeowner. This provides an incentive to the homeowner to care for the value of the house, while providing relief from the drop in values. It also imposes part of the cost and responsibility on the owner.


4. The government uses its greater market power to borrow, and finances a new mortgage for actual equity at a better rate -- improving the cash-flow position of the household.


5. A provision is included to allow homeowners to trade more equity to the government, up to some limit, in exchange for cash now.
   
   

Such a program would have the following effects:

• banks would receive some relief as we reduce pressure from bad mortgages and they recover market value without all the risks of dumping a large stock of vacant housing


• homeowners can stay in their homes


• the government recapitalizes households (relieving cash-flow and solvency problems)


• households and banks both carry the costs of the bad loans


• government will recover costs as the housing market recovers

Given the stricter redrafting of bankruptcy laws in the U.S., something of the sort will be necessary to prevent a political firestorm if housing markets get much worse.

References

[1] "Gordon Brown's call for a new Bretton Woods gains traction ," 15 October 2008, The Telegraph.
http://www.telegraph.co.uk/finance/3201885/Gordon-Browns-call-for-a-new-Bretton-Woods-gains-traction.html

[2] Matthew Benjamin, McCain, Obama Promoting Populist Appeals on Rescue (Update2)," 14 October Bloomberg. http://www.bloomberg.com/apps/news?pid=20601070&sid=ahfMrINj__Mw&refer=home

Three Card Monty on the streets of New York, or "If this crisis is so different, why is it so familiar?"

In a recent New York Times editorial/blog, Paul Krugman argues that for the U.S. as a whole, there may be little net cost from the sub-prime bailout. [1] In the end, the cost to the U.S. taxpayer will depend on the people in charge acting responsibly and competently. We will witness massive transfers from the middle class taxpayer to Wall Street, but might not see comparable net costs to the U.S. There is a wide range of opinions and worries floating on the web about how competent and trustworthy the actors involved will really be. [2] At the same time, there is another player in the room, and he will lose massive sums of money. Indeed, in one way, we are looking at big losses for this other player no matter what happens in Washington. To explain what I mean, it helps to review history.

In the late 1970s and early 1980s, the Members of the OECD embarked on largescale deregulation of international investment flows. In Japan, the combination of high savings and foreign investment restrictions had led to an accumulated stock of domestic savings earning low returns. When the floodgates were opened, Japanese institutional investors poured into the United States. In a paper written at the time, a Japanese academic offered the following contemporary perspective:

"Since the basic change in Japan's law on foreign exchange controls in December 1980 toward deregulation Japanese banks, securities companies and institutional investors especially life insurance companies were gradually freed form rigid regulations on their overseas activities, and their management horizons and business activities were expanded on a world-wide scale. One of the new developments in Japan's foreign direct investment in the last few years is a sharp increase in investment in real estate business abroad, especially in the United States... Since around 1984 they are increasingly investing in real estate properties in the United States."[3]

Indeed, Japanese investment in real estate in the 1980s in the U.S. skyrocketed. An estimated $300 billion was poured into "high-profile properties like Rockefeller Center in New York and the Pebble Beach Golf Club in California."[4] Yet more was poured into U.S.-based financial institutions and instruments. As the subsequent Savings and Loan crisis rolled across the U.S. economic landscape, their holdings in commercial real estate alone lost roughly half their value. This coincided with a steep fall in the value of the dollar. The Japanese liquidated their positions at a fraction of original costs. Making a crude guesstimate, and assuming a 50% loss on their commercial property investments, they lost $150 billion by 1990 or roughly $230 billion in 2008 dollars. In other words, Japanese investors may have carried more than half the cost of the S&L crisis. The U.S. tax payer also paid a bit less than half, while on net for the U.S. much of this was just a net domestic transfer. From that point, of course, the Japanese went through a further real estate collapse of their own (Business Week estimated in 1998 that households may have suffered $250 billion in losses in Japan as real estate prices fell 70% from 1992 levels [5]).

So today, in 2008, we are looking at $700 billion set aside in reserves (so far) to clean up the U.S. exposure to sub-prime backed securities. More may be needed up front, but much will also be recovered over time as markets recover. Also, as Paul Krugman has stressed [1], much of these costs are essentially a domestic transfer. We are looking at a big debt for equity swap, where the shortfall is picked up by the U.S. taxpayer but a number of U.S. investors are saved in the process. To the extent we are saving U.S. shareholders and investors, these are "just" massive internal transfers. Unless this gets messier, and more expensive.

However..... rewind back to the 1980s, when Japanese institutional investors were badly burned by the U.S. real estate meltdown, and may have lost $250 billion or more in today's terms (with a worse hit adjusting for the ongoing exchange rate hit at the time). Today, we are looking at a sub-prime mess where half of the "stinky mortgages" (a phrase I steal from the sub-prime primer [6]) are held in the U.S., and the other half are overseas. Indeed, while the Chinese and Japanese may be holding massive amounts of U.S. Federal debt obligations, Europeans may own $250 billion in sub-prime junk, Japan may hold $200 billion, and China may hold $260 billion. Taiwan and Korea may hold another $50 billion. I say "may" because one problem here is continued lack of transperency, which has obviously contributed to the ongoign financial market jitters. ("Might it not be the case that we understood too little about the risks banks had taken on?"[7]) It is not clear what the foreign exposure actually is, and the estimates quoted here from 2007 may be low.[8]

So, the U.S. is apparently ready to bail out U.S. holders of sub-prime securities. This is only half the problem. To a large extent, the U.S. bailout involves internal transfers. At the same time however, we may want to use U.S. taxpayer costs as a money metric of the cost imposed on foreign investors, who will not be bailed out by the U.S. Congress and face very very real losses. Basically, much and perhaps most of the net financial cost of this crisis will fall on foreign investors. We are looking at the unwinding of an unintended real estate scam, where foreign investors lose several hundred billion dollars inside the U.S. financial system. In New York, Three Card Monty [9] is illegal. The city does, however, offer much more elaborate ways to see your money disappear.

References


[1] Paul Krugman, "Where Will the Money Come From?," NYTimes, September 30, 2008, 9:04 am.

http://krugman.blogs.nytimes.com/2008/09/30/where-will-the-money-come-from/

[2] Matt Stoler, "As the Senate Votes," Wed Oct 01, 2008 at 19:57

http://www.openleft.com/showDiary.do?diaryId=8743

[3] Ryutaro Komiya, "Japan's Foreign Direct Investment: Facts and Theoretical Considerations," University of Tokyo, October 1987.

http://www.e.u-tokyo.ac.jp/cirje/research/dp/87/f13/dp.pdf

[4] Terry Pristin, "COMMERCIAL REAL ESTATE; Echoes of the 80's: Japanese Return to U.S. Market," NYTimes January 26, 2005.

http://query.nytimes.com/gst/fullpage.html?res=950DE4D61F38F935A15752C0A9639C8B63&n=Top/Reference/Times%20Topics/Subjects/F/Foreign%20Investments

[5] Business Week, "JAPAN'S REAL CRISIS: Until its hidden debt mess is cleared up, no recovery is possible," 1998.

http://www.businessweek.com/1998/20/topstory.htm

[6] "Subprime Primer:How SubPrime Really Works," BigPicture, Friday, February 15, 2008 | 11:15 AM

http://bigpicture.typepad.com/comments/2008/02/how-subprime-re.html

[7] J.F. Francois, "Firewalls and Firestorms," The Random Economist blog, Sunday, October 28, 2007.

http://www.intereconomics.com/blogs/jff/2007/10/firewalls-and-firestorms.html

[8] Martin Hutchinson, "Where are the subprime bodies buried?" Money Morning, Tuesday, August 21st, 2007.

http://www.moneymorning.com/2007/08/21/subprime_bodies/

[9] Glenn Hester, "Three Card Monte from a Police Officer’s Perspective," threecardmonty.com.

http://www.threecardmonte.com/police_three_card_monte.html

Firewalls and Firestorms

This past Summer has seen the sub-prime lending crisis in the United States turn into a global liquidity crisis. Subsequent events illustrate two important things about financial globalziation. First, no financial crisis is really local. The U.S. crisis has sparked a bank run in the UK and has forced the German authorities to use tax payer money to support German banks in crisis. At the same time, because we are able to spread local shocks globally, the markets outside North America are absorbing some of the brunt of the U.S. crisis. In similar fashion, when we next have a crisis somewhere in Asia or Europe, the local impact will be less as global markets are better equipped to handle the shock than are local markets. This logic follows from the simple algebra of portfolio diversification and risk. And yet...

The current crisis also illustrates other, less sanguine, aspects of the emerging global financial architecture. One important aspect of modern banking is the blending of commercial banking services (managing the operating funds and transactions of businesses and households) with investment banking, speculation, and underwriting. For example, Germany's IKB Deutsche Industriebank AG had to receive financial support from the state-owned KfW development bank (along with other banks) because of its exposure to risks linked to the sub-prime crisis in the U.S. Its problems are linked to the bank's investment activities through Rhineland Funding. For those versed in the history of financial crises and regulation, this sounds uncomfortably like problems -- linked to investment activities of banks -- that preceded the crash of 1929. Indeed, in Europe it seems we are always facing banking scandals. It is clearly hard to bring perpetrators to task, and regulation is opaque and politically susceptible. This brings us to another aspect of the European side of the crisis -- an inherent instinct to distrust investors and hide information. Indeed, in a surreal twist on the logic of regulation, senior EU officials are calling for less transparency. To paraphrase Bank of England governor Mervyn King: "the European Market Abuse Directive was partly to blame for the crisis that hit Northern Rock by not allowing the Bank to act covertly." This follows similar statements by the European Commissioner Colin McCreevy (commissioner for the internal market). McCreevy is on record criticizing the UK for applying too much transparency. He said: “Unfortunately, in recent weeks, gold-plated transparency rules stood in the way of the quiet resolution of a problem before it became a crisis: The result was that transparency rules that were intended to underpin investor confidence, when put to the test, actually promoted investor panic." In other words, if we had been able to hide the problem from investors, we could have found a way to keep it quiet until the whole thing blew over. Elsewhere in the press it has been noted that "He said regulators would be wise to learn from the crisis and should adjust rules regarding transparency, saying it was often beneficial for issues affecting the stability of major financial institutions to be carried out behind closed doors." What?! Do recent scandals like Parmalat, Enron, and Bawag mean anything? Might it not be the case that we understood too little about the risks banks had taken on?

It may be time to revisit the logic and working of the old U.S. system that was underpinned by the Glass-Steagall Act. Following the Great Crash that opened the show for the Great Depression, the U.S. Congress introduced a system of financial firewalls. Some were geographic, with a deliberate segmentation of regional financial markets. Others related to areas of operation. Basic commercial banking had to be kept separate from investment banking. This was accompanied by Federal guarantees of commercial bank deposits. The cost of this guarantee was regulation. With financial innovation, and the ability of investment firms to offer bank-like services (like money market accounts), this system was eventually dismantled, ending with repeal of Glass-Steagall in 1999. This was accompanied by a wave of financial mergers in the U.S. that, many believe, did promote greater efficiency in the financial services sector. The geographic fragmentation of U.S. banks did lead to small and capital-weak institutions unable to weather the liquidity crisis set off in 1929. And there are benefits to bigger banks. Yet, in light of present events one might wonder about the merits of segmentation of commercial and investment services... We again find ourselves in a world where banks are blending investment and basic banking activities. The result is that institutions that are important to the working of the basic monetary system underpinning the economy are threatened by financial cross-obligations in their investment arms. At the same time, it is not clear that incentives and rules are structured properly for full transparency about risks undertaken.

There are arguments for letting banks collapse in the current crisis, to send the "right signal" to the market that management (and investors) are responsible for their decisions. In the absence of explicit government guarantees, it is the role of investors, management, and rating agencies to sort out risk and communicate information. However, it is clear that we live under a second-best set of political constraints. It is not possible to let major banks go under, along with corporate and private savings. Instead there will be bailouts. Witness Northern Rock , IKB Deutsche Industriebank AG, and BAWAG. Whether is is explicit (like the deposit insurance scheme in the US) or implicit (like repeated bailouts in the EU), we live in a world where political constraints mean risk-taking behavior by bank management is underwritten by the public purse. We may wish it was otherwise. We may be able to argue that theoretically the world would be better if this were not so. However, the reality of populist politics in the industrial world means it is not possible let such institutions fail. If we admit that a mix of implicit and explicit guarantees is unavoidable, then we need to rethink regulation. This includes capital requirements under Basel II, but it also means more. We need to revisit the concept of firewalls between the basic liquidity services of financial institutions, and their more adventurous investment activities. It is encouraging that the chairman of the Basel Committee on Banking Supervision Nout Wellink is skeptical of US bank plans to fix the current problem with conduits (junk bonds?) with an "uber-conduit" or superconduit. Wellink's comments are diplomatic. Comments on the blogosphere are less diplomatic. (For example "I'll be the first to admit I'm not a financial expert. But engaging in even more of the same behavior? Sounds like trying to solve a gambling problem by gambling your way out.") Also, notwithstanding the opinions of Messrs. McCreevy and King, we need more transparency, not less. We also need to at least consider modern versions of the 20th Century's financial firewalls. We can then let the investment industry be as innovative as it likes (within the law) while maintaining a more stable though admittedly less exciting sub-sector for basic transaction services.

Further reading:

[1] "Understanding How Glass-Steagall Act Impacts Investment Banking and the Role of Commercial Banks," Brain Bank.

[2] "Suspend Rock shares – it’s a false market," The Sunday Times online, October 28, 2007.

[3] "Credit Crisis Spreading New Jitters in Europe," The New York Times online, October 26, 2007.

[4] "European Commissioner McCreevy blames UK gold-plating for Northern Rock debacle," MoneyMarketing, Paul Mcmillan - 26-Oct-2007.

[5] "Boom and Bust in Early America," in Money, Greed, and Risk: Why Financial Crises and Crashes Happen By CHARLES R. MORRIS, Times Business online (Chapter 1). This provides a good read on earlier times. The present crisis is nothing new. To quote: "The secret of successful banking, reported a New York practitioner of the banker's dark arts in 1836, was to issue notes with 'a real furioso plate, one that will take with all creation—flaming with cupids, locomotives, rural scenery, and Hercules kicking the world over.'"

[6] "Super Conduit to the rescue!" Salon.com letters to the editor, 16 October 2007.