Bigger questions: financial crisis and global economy

[Agent327]

For starters:


House passes Obama's $819B stimulus


The Associated Press
Published: January 29, 2009









WASHINGTON: The Democratic-controlled House of Representatives approved a historically huge $819 billion stimulus bill Wednesday night, offering an early legislative victory in Barack Obama's presidency even as he failed to win over Republican support.
Obama has been hammering economic themes, but despite his efforts at reaching across party lines he was unable to sway the opposition in the first test of his bipartisanship goals. The vote was 244-188, with Republicans unanimously opposed.
With unemployment at its highest level in a quarter-century, the banking industry wobbling despite the infusion of staggering sums of bailout money and states struggling with budget crises, Democrats said the legislation was desperately needed, while Republicans argued the bill was short on tax cuts and contained too much spending.
"This recovery plan will save or create more than three million new jobs over the next few years," the president said in a written statement released moments after the House voted. He later welcomed congressional leaders of both parties to the White House for drinks as he continued to lobby for the legislation.
Earlier, Obama declared, "We don't have a moment to spare" as congressional allies hastened to do his bidding in the face of the worst economic crisis since the Great Depression of the 1930s.




The increasingly troubled economy is the first major test of Obama's presidency. How he handles the volatile situation, and the effect of his stimulus package on the economy, could set the tone for his first year in office, if not his entire term.
The vote sent the bill to the Senate, where debate could begin as early as Monday on a companion measure already taking shape. Democratic leaders have pledged to have legislation ready for Obama's signature by mid-February.
Republican House leader Rep. John Boehner said the measure "won't create many jobs, but it will create plenty of programs and projects through slow-moving government spending." A Republican alternative, comprised almost entirely of tax cuts, was defeated, 266-170.
On the final vote, the Democratic legislation drew the support of all but 11 Democrats, while all Republicans opposed it.

The president had earlier said he understood skepticism about the size of the stimulus package, "which is why this recovery plan will include unprecedented measures that will allow the American people to hold my administration accountable." He said Americans would be able to follow the spending on a new Web site, http://www.recovery.gov.

Before the House vote, at his first Pentagon briefing as president, Obama heard the opinions of the four U.S. military service chiefs in a next step toward fulfilling his promise to withdraw all American combat troops from Iraq within 16 months.

The chiefs are among those in the Defense Department hierarchy who have expressed misgivings about the impact that long, repeated war tours in Iraq and Afghanistan have had on the U.S. military. The chairman and vice chairman of the Joint Chiefs of Staff, the president's senior uniformed military advisers, and Defense Secretary Robert Gates attended the briefing.

Emerging from the meeting, Obama said that his administration faces "difficult decisions" about Iraq and Afghanistan. But the new commander in chief offered no further details about his plans.

"We're going to have some difficult decisions that we're going to have to make surrounding Iraq and Afghanistan," Obama said.

Earlier, White House spokesman Robert Gibbs said Obama's process is deliberate as he moves toward changing the mission in Iraq.

Defense officials have said they can meet Obama's campaign pledge, but several have suggested that a fast withdrawal could upset the fragile security now in Iraq.

Much of Obama's briefing was expected to have centered on the fight in Afghanistan and how Obama's plans to add forces and resources there will depend in part on the success of the Iraq exit. The Pentagon is nearing an announcement of new troop deployments in Afghanistan, with forces arriving in numbers in the spring and summer.

Obama pledged during his campaign to remove all combat troops from Iraq by May 2010. However, he has said he would consult with military commanders first and adjust his timeline if sticking to it would risk the safety of U.S. troops remaining behind to train Iraqis and fight al-Qaida or cause backsliding in Iraqi stability.

Meanwhile, Obama moved a step closer to having a full Cabinet as the Senate confirmed retired Adm. Dennis Blair as the new national intelligence director — Obama's top intelligence adviser — and a Senate committee confirmed the nomination of Eric Holder as attorney general.

Holder, who would become the first African-American U.S. attorney general, testified during his hearings that waterboarding is torture and pledged to prosecute some Guantanamo Bay detainees in U.S. courts, forcefully breaking from the Bush administration's counterterrorism policies.

(From International Herald Tribune: http://www.iht.com/articles/ap/2009/01/29/america/NA-US-Obama.php)

 

[Agent327]

In Davos world leaders convene for an economic summit:

http://www.reuters.com/article/GCA-Davos2009/idUSTRE50M4BE20090129

and:

http://www.bloomberg.com/apps/news?pid=20601087&sid=amP_xjjX5T7Y&refer=home.

In addition the IMF predicts negative economic growth in the EU and the US Federal Reserve warns for a possible global economic slowdown:

http://www.bloomberg.com/apps/news?pid=20601103&sid=a4KPs.0wymUo&refer=us

 

[AL_DA_GREAT]

$ 819 000 000 000
Where is this money coming from? How come that throughout my life I have allways heard lack of money, lack of funds, but now their seems to be all the money in the world.

 

[AL_DA_GREAT]

$ 819 000 000 000
Where is this money coming from? How come that throughout my life I have allways heard lack of money, lack of funds, but now their seems to be all the money in the world.

 

[Cutlass]

$ 819 000 000 000
Where is this money coming from? How come that throughout my life I have allways heard lack of money, lack of funds, but now their seems to be all the money in the world.

It's being borrowed. In normal times there's a limit to most governments willingness to do so. This isn't normal times. And the Democrats in Congress are taking advantage of that fact. Possibly to too great of an extent.

 

[Agent327]

Since banks aren't willing to provide loans (even with interest rates as low as they are), basically the government (or an institution such as the IMF) is the only one left to supply funds for investment during times of crisis. Without government intervention financial crisis might deepen to a full-fledged economic crisis. (Which, BTW, certain economists argue is what should happen as the current recession is capitalism at work. People losing their job or livelihood might feel different though.)

 

[Agent327]

IMF prognosis shows an expected overall global economic growth of 0.5 %, the lowest rate since WW II, with even China's economic growth dropping to below 7%; The IMF does expect the global economy to pick up in 2010.


More facts and figures in this article:



Grim Japan, U.S. figures show world crisis deepening

Fri Jan 30, 2009 1:37am EST


By Paul Tait


SINGAPORE (Reuters) - Japan sank deeper into recession with industrial output tumbling and inflation slipping to almost zero, while U.S. data later on Friday was also expected to mirror the worsening financial crisis.
Japan's industrial production fell a record 9.6 percent in December, with companies forced to cut output as demand for their cars, electronics and machinery waned, while annual core inflation slowed to a mere 0.2 percent.
Rising unemployment, slowing household spending and no improvement in the industrial outlook added to investors' fears that Japan was flirting with deflation and would post a horror GDP figure in February if exports do not bail it out.
"It is already a consensus view that core consumer inflation will turn negative soon, but we must watch if a worsening of the economy pushes Japan into a deflationary spiral even though the Bank of Japan sees no signs of that happening right now," said Tatsushi Shikano, senior economist at Mitsubishi UFJ Securities.
Economists expect February's figures to show Japan's economy shrinking at a double-digit annual rate.
The worsening economic conditions in Japan, and elsewhere, could prompt more drastic measures by central banks already seeking more inventive ways to support economies and relieve credit markets that are starving key companies of cash.
LITTLE APPETITE
Equally startling because it was so unexpected, Australian private sector credit shrank in December for the first time since 1992 as foreign banks cut lending to local companies.
Reserve Bank of Australia figures showed that total credit fell 0.3 percent in December, well below a forecast 0.5 percent rise, fuelling expectations the RBA would announce another hefty interest rate cut next week.
"Under pressure and facing a squeeze on margins, businesses are clearly not expanding and have little appetite for debt and growth," said Su-Lin Ong, senior economist at RBC Capital.
Other economists said the surprise figure strengthened the case for a second stimulus package in Australia, accelerated income tax cuts and increased government spending.
Across the Tasman Sea, the once-favored New Zealand dollar fell to another six-year low after the central bank said interest rates would likely have to be cut further, a day after the benchmark rate was cut by 1.5 percentage points.
"Lest there be any doubt, the tool box is by no means empty," central bank governor Alan Bollard told a business meeting.
The yen rose across the board, its reputation as a safe haven helping it overcome Japan's weak economic data.
But Japan's Nikkei Nikkei share average closed 3.1 percent lower after the bad industrial output and rising unemployment news. Wider Asian stocks were down 0.6 percent, the first daily drop in a week.

The falls followed similar declines on Wall Street after record monthly U.S. unemployment figures.
More bad news was expected in the United States on Friday.
Economists think the U.S. Commerce Department will report that gross domestic product, the broadest measure of economic activity, shrank at an annualized 5.4 percent in the fourth quarter.
Figures out on Thursday showed new U.S. single-family home sales fell 14.7 percent in December to an all-time low. The number of Americans receiving unemployment benefits jumped to a record 4.78 million in mid-January and first-time filings also rose.
"LOSERS' UNION"
New U.S. President Barack Obama had his first legislative win this week when the House of Representatives passed his $819 billion stimulus plan, which still faces an uncertain road before a hoped-for mid-February completion.
Markets also liked his administration's proposal for a "bad bank," or aggregator bank, to absorb toxic debts, but CNBC reported that negotiations over how such a bank would work hit a snag and that round-the-clock meetings were being held.
As more jobs and company wealth were lost, Obama railed against "shameful" Wall Street bonuses paid to executives at a time when taxpayer money was being used to shore up the crumbling financial system.
U.S. and Japanese companies were providing daily evidence of how deeply the global crisis was biting, costing governments trillions of dollars and threatening millions of jobs.
Toyota Motor Corp was likely to post an operating loss for the year to March 31 in excess of its latest forecast of 150 billion yen ($1.67 billion), a company source said, because of big production cuts planned in coming months.
In an unsourced report, the Nikkei business daily said Toyota's loss would hit 400 billion yen ($4.5 billion).
Toshiba Corp was in talks to merge part of its chip operations with NEC Corp's semiconductor unit as they battle slumping demand and prices, a source with knowledge of the negotiations said in Tokyo.
Toshiba had already warned it would post its biggest annual loss ever and its shares slid 17 percent on the possible chip unit merger, leading to a rating cut by Goldman Sachs.
"It's a losers' union," said SMBC Friend Securities manager Fumiyuki Nakanishi. "The domestic chip industry appears at the brink of death."
The picture in Europe was hardly any sunnier.
German unemployment rose almost twice as much as expected in January, euro zone economic sentiment hit a new low, while hundreds of thousands of French workers staged a nationwide strike demanding more was done to protect jobs and wages.

Reflecting the slowdown in world trade, the International Air Transport Association said air freight in December fell a "shocking" 22.6 percent from a year earlier.

(From http://www.reuters.com/article/GCA-Economy/idUSTRE50S0TL20090130)

 

[Agent327]

From BBC News on-line (this time with pictures):

Is the US heading for a depression?



By Steve Schifferes
Economics reporter, BBC News




The sharp contraction of the US economy accelerated in the last three months of 2008, with official figures showing GDP shrinking at an annualised rate of 3.8%.
With forecasters already predicting the worst US recession since World War II, how big a danger is there that the US economy will slip into a depression similar to the 1930s?
The latest figures paint a gloomy picture of the US economy.
Consumer spending, which makes up two-thirds of the economy, fell for the second quarter in a row, by 3.5%.

For all the talk of this being a consumer-led downturn, the credit crunch is hitting businesses even harder


Paul Ashworth, Capital Economics



US enters recession

This drop was led by a 22% drop in spending on durable goods like automobiles and washing machines.
The decline in motor vehicle production was so great that it alone contributed 2% to the fall in GDP.
Businesses hit
Businesses as well as consumers have been hit hard by the slowdown.
Exports, which had helped boost GDP earlier in the year, fell sharply, by 19.7%, as foreign markets for US products were hit by their own recessions.
US recession is a continuing disaster, President Obama says

Investment fared even worse.
Residential investment fell 23.6% as the glut of foreclosed properties reduced new home sales. Business investment was down 19.1%, led by a 27.8% drop in purchases of equipment and software.
Business inventories of unsold goods mounted. If the inventory build up - which is likely to be temporary - is excluded, GDP fell at an annualised rate of 5.1%.
"For all the talk of this being a consumer-led downturn, the credit crunch is hitting businesses even harder," said Paul Ashworth of Capital Economics.
Consumers save
The economic uncertainty does seem to be changing consumer behaviour. People are saving more in preparation for the coming downturn.
The personal savings rate rose to 2.9%, more than double the 1.2% rate in the previous quarter. Mr Ashworth predicts the savings rate will double again, to 5%.
Consumers are being hit by a triple whammy: rising unemployment, which could rise from 7% to 10% of the workforce by the end of the year; restricted access to credit; and falling asset values.
The fall in stock markets and house prices has reduced household wealth by 20%, from the middle of 2007. This alone has reduced consumption by around 1%, some economists estimate.
It may make sense for consumers to save instead of spend, but in an economy as reliant on consumer spending as the US, this does add to recessionary pressures.
How long?
The key question in whether this will turn from a recession to a depression is how long the slowdown will last.
FDR pledged a New Deal to combat the recession

In the 1930s, output declined for four years, with GDP cut by half while unemployment soared to one-quarter of the workforce.
Despite the New Deal, output did not recover to its 1929 level until World War II when there was a massive boost in government spending.
At the moment, most economic forecasters are predicting that the US slowdown will last around two years, with the economy returning to weak growth by 2010.
The National Bureau of Economic Research says the current economic slowdown actually began at the end of 2007 and is likely to be the longest post-war recession.
The non-partisan Congressional Budget Office (CBO) estimates a drop in real GDP for 2009 of 2.2%, followed by a rise of 1.5% in 2010, while the IMF predicts a fall of 1.6% this year, following by a recovery of 1.6% in 2010.
But economic forecasts have changed frequently in the past year. It is unclear what will happen after 2010, said the IMF's chief economist Oliver Blanchard.
Government rescue?
The only thing currently boosting the US economy is Federal government spending, which rose 5.8% in the quarter.
The government may have to help the millions who have lost their homes

But even if Mr Obama gets rapid approval for his $800bn stimulus plan - which has passed the House of Representatives and is currently being considered by the Senate - it will take some time for the money to be felt in the economy.
Only $170bn will be spent before 1 October 2009, representing just over 1% of US GDP, according to the Congressional Budget Office.
The bulk of spending (including tax cuts) would occur in 2010 ($354bn) and 2011 ($174bn).
Individual states may not be able to rapidly increase spending on infrastructure projects which make up a large part of the stimulus package.
It is also unclear how many jobs will be created: President Obama aims to create 3.5 million new jobs, but others say the stimulus package could create between 1.2 and 3.6 million more jobs.
Financial squeeze
Big US banking groups may need a bigger bail-out.

The other big uncertainty is whether the financial sector can be restored to health and at what cost.
There is now $2.2 trillion of toxic bank debt worldwide, the IMF says, $500bn more than it estimated a few months ago.
The collapse of financial markets in the autumn had a dramatic effect on consumer and business confidence.
There are plenty of reasons why growth might be even less than forecast, the IMF's Olivier Blanchard said, not least if banks have so many bad debts, they will further drag down the real economy.
The Obama administration still has $350bn left of the $700bn bailout for banks approved in October last year. It may need to ask for more.
If it gets the money it needs and if the money is spent promptly and wisely, the US might just escape with a relatively mild recession.
But given the extraordinary events of the past six months, most economists are still hedging their bets.






Meanwhile in Davos the Turkish PM Erdogan seemed more interesting in his home constituency than at the financial problems at hand...

 

[Verbose]

IMF prognosis shows an expected overall global economic growth of 0.5 %, the lowest rate since WW II, with even China's economic growth dropping to below 7%; The IMF does expect the global economy to pick up in 2010.

Does anyone really know what China's GDP growth actually is? The figure 7% from somewhere I find intriguing...

I believe the Chines rep. at Davios claimed that China would be at 8% GDP growth in 2009. No one really believes that, going by the comments I've read; it's just that 8% is the figure the Chinese govt. has put about as the figure necessary to maintain political stability. The expectation is that China will claim 8% growth whatever the hell is actually happening.

The Communist party has based its legitimacy on being able to provide stable and large economic growth. If there's a hic-up in the machinery the fear seems not to be so much that the dirt poor farmers will rise up and take the reins of power away from it, but rather that the new, powerful cadres of business men et al. will.

 

[Ayatollah So]

In addition the IMF predicts negative economic growth in the EU and the US Federal Reserve warns for a possible global economic slowdown:

Possible? POSSIBLE?!?! That's like a doctor happening upon a corpse swarmed with flies and pronouncing "I think the patient might possibly be ill".

As to whether stimulus works, the markets react favorably whenever large governments (like China for example) propose such plans. Those guys in their collective wisdom(?) know more about economics than I do - not that any of us, IMHO, really knows much.

Here comes another uncontrolled unscientific experiment for us to learn from, though - the only way macroeconomics ever gets done.

 

[Agent327]

Does anyone really know what China's GDP growth actually is? The figure 7% from somewhere I find intriguing...

I believe the Chines rep. at Davios claimed that China would be at 8% GDP growth in 2009.

The actual predicted IMF figure was 6.5-6.9, I believe. That's a relative slowdown from last year, when China's economic growth was still above 9% (as opposed to previous years, with double digit figures). Still, with an estimated global economic growth of 0.5% - and Western and Russian figures dropping below zero - even that "growth" has to be accounted for. The question is ofcourse if this year will show some signs of recovery or that the current recession will deepen - which will have global repercussions.

 

[kronic]

I had posted this link on Chinese growth before: http://fistfulofeuros.net/afoe/economics-and-demography/china-nears-recession-point-as-gdp-slumps/

The article claims, China isn't growing at all at the moment. It wouldn't be surprising at all given how much trade collapses all over the world.

 

[Godwynn]

Part of the United States' stimulus bill has an "American Only" provision where (in the House version it is only steel and iron, the Senate version has 100%) everything used in the projects must be from American companies, the machinery, the materials, all of it.

Hooray? Yikes?

 

[Integral]

Part of the United States' stimulus bill has an "American Only" provision where (in the House version it is only steel and iron, the Senate version has 100%) everything used in the projects must be from American companies, the machinery, the materials, all of it.

Hooray? Yikes?

I noticed that too. Yay protectionism! After all, it worked so well during the Depression.

...well, if they want to maximise the Keynesian multiplier, it makes sense to limit leakages out of the country.

 

[innonimatu]

Part of the United States' stimulus bill has an "American Only" provision where (in the House version it is only steel and iron, the Senate version has 100%) everything used in the projects must be from American companies, the machinery, the materials, all of it.

Hooray? Yikes?

Economic "globalization" is dead? Hooray!
That's the first step for people to reclaim control over economics back from the bankers and economists. No more excuses that "we must do as others do" or "it's what the free markets imposes", that kind of crap.
Economic organization is always a result of political choices. Sometimes this fact is hidden, and a small group of manipulators can organize things for their exclusive benefit. Eventually creating the crisis which interests all people again in the political nature of economics, and putting an end to those abuses.

It's being borrowed. In normal times there's a limit to most governments willingness to do so. This isn't normal times. And the Democrats in Congress are taking advantage of that fact. Possibly to too great of an extent.

It's not being borrowed, it's being created out of nothing. The current crisis is no mere "business cycle downturn" to be dealt with with keynesian policies. Those can't deal with a crisis on this scale: the financial system which should enable those policies has already broken down!

You can't borrow money that does not exist. As everyone is commenting, banks do not want to lend. And neither do any "investors", not are savings enough to support that kind of government spending. There's not enough money to absorb the government debt which will be created through 2009. The only solution will be to "print" - which now means create (out of nothing) new accounts with central banks, and have those central banks buy, directly on indirectly, the public debt created.

Guess what this will cause in the long run. It's default, slow and stealthy. Erase both debt and savings/assets, but do it slowly enough that those affected won't start some kind of revolution because they're feeling robbed - that's what governments are attempting. I doubt that they'll succeed. The attempts to counter the economic collapses so far are only setting the stage for a bigger, political one towards the end of the year or in 2010.

@Integral: You should be more careful when assessing the response to the Great Depression. It's easy to blame any particular measure for "making things worse". But with the system collapsing already, how do you prove that the particular measure you're talking about had a cause-effect relationship with the worsening of the situation?

 

[Integral]

@Integral: You should be more careful when assessing the response to the Great Depression. It's easy to blame any particular measure for "making things worse". But with the system collapsing already, how do you prove that the particular measure you're talking about had a cause-effect relationship with the worsening of the situation?

While it is obvously true that the Smoot-Hawley Tariff Act didn't cause the Depression, it is equally true that the Act didn't make things any better. World trade collapsed by as much as two-thirds by value after the passage of Smoot-Hawley. Further, (and this is a long-run, rather than short-run, observation and may not apply as strongly in the context of the recession) there is no evidence that increased protectionism systematically leads to increased growth rates.

Back to my main point, ostensibly this could be seen as a way to boost the so-called "Keynesian Multiplier", but increasing that multiplier is not a sufficient reason to revert to protectionism. I would be shocked if the stimulus package's effect would be demonstrably worse without "buy American" clauses. And with world trade collapsing considerably already, the last thing we need right now is another trade war.

Not that the stimulus will be very effective anyway. Most of the spending will not begin in earnest until mid-2010. The tax cut portion might have the benefit of being timely, but it is also one of the weakest parts of the bill. The other major proposal - aid to the states - is a good measure but will only be a stopgap.

 

[Agent327]

Obviously economy, being about choices, will always be political as well (originally the term used was political economy).

While it is obvously true that the Smoot-Hawley Tariff Act didn't cause the Depression, it is equally true that the Act didn't make things any better. World trade collapsed by as much as two-thirds by value after the passage of Smoot-Hawley. Further, (and this is a long-run, rather than short-run, observation and may not apply as strongly in the context of the recession) there is no evidence that increased protectionism systematically leads to increased growth rates.

Back to my main point, ostensibly this could be seen as a way to boost the so-called "Keynesian Multiplier", but increasing that multiplier is not a sufficient reason to revert to protectionism.

I think it's safe to say that protectionist policies actually deepened the 1930s crisis; so government stimulus would now be the best way to handle the current global recession. While there's plenty of talk of this, in practice governments more or less openly revert back to protectionist measures - which to me seems like a half-hearted tackling of the problems at hand.

As for globalization: this seems a long term process, initiated by labour specialization as such, i.e. it is a long term trend, stretching over centuries.

 

[Agent327]

From Forbes (and note also the last paragraph):


The Incredible Shrinking U.S. Job Market

Carl Gutierrez and Maurna Desmond, 02.08.09, 12:00 AM EST Employment situation likely to go from bad to worse in the short run.

U.S. joblessness is at its worst level in decades, and further deterioration is in the cards.
The Labor Department reported Friday that 598,000 private sector jobs were lost in January, pushing the unemployment rate to 7.6%, up from 7.2% in December. (See "U.S. Jobs Hemorrhage In '08.") Economists had expected only 540,000 jobs would be eliminated, with an unemployment rate to 7.5%.
The amount of Americans out of work will probably grow. The labor market lags behind economic output, and with the U.S. economy widely expected to contract in the first half of the year, the unemployment rate could reach 9.0%. Even with the best-case scenario of an economic turnaround in the second half of 2009, the labor market wouldn't see an improvement at least until the end of the year.
"It's going to get worse before it gets worse," said Doug Roberts, chief investment strategist for Channel Capital Research.com.
The massive jobless figure actually led to significant market gains Friday, as investors bet the shock would move Congress into passing President Barack Obama's economic stimulus package.
Mark King, chief investment officer for Bell Investment Advisors, said it would take a double-digit employment rate to provoke a decline in stocks, indicating that Wall Street has already built a lot of pessimism into stock prices.
U.S. Treasury bonds, on the other hand, fell sharply, as bond investors expected the data to lead to massive government debt issuance, an inevitable consequence of federal bailout and stimulus plans that investors seem to have overlooked until the past few weeks. The bellwether 10-year Treasury note's decline raised its yield to 2.99% from 2.90% on Thursday and up from 2.08% late last year.


In addition - or perhaps correction - to the IMF figure posted earlier for an expected global economic growth of 0.5%: this estimate is arrived at after a correction per national economy for local buying power (for instance a Chinese will have relatively large buying power in the Chinese economy). This results in a greater share for developing economies in the overall figure, making China the second largest economy. Measured in hard currency (US $) however, both China and India get a more realistic share in the global economy, resulting in an actual reduction of the world economy by 0.4% in 2009. That's the real news; a shrinking global economy hasn't occurred in a very long time.

 

[Agent327]

An insightful article on the causes of the current financial-economic crisis:

Volume 56, Number 2 · February 12, 2009

How We Were Ruined & What We Can Do

By Jeff Madrick

The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash

by Charles R. Morris

PublicAffairs, 194 pp., $22.95
Financial Shock: A 360° Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis

by Mark Zandi

FT Press, 270 pp., $24.99
The Reckoning

a series of articles by Gretchen Morgenson et al.

The New York Times, September 28–December 28, 2008
Some prominent figures in the financial markets insist that unchecked opportunism by financiers was not a root cause of the current credit crisis. Robert Rubin, the former Treasury secretary who has just resigned as a high-level adviser and director at Citigroup, told The Wall Street Journal in November that the near collapse of Citigroup, which was bailed out by the federal government, was caused by the "buckling" financial system, and not any mistakes made at his company. "No one anticipated this," said Rubin, who once ran the investment firm Goldman Sachs. Others such as Harvey Golub, former chairman of American Express, maintain that the fault lies principally with the federal government, which since the 1990s and even earlier has been actively promoting mortgages for low-income Americans. This, he argues, led to the unsustainable frenzy of sub-prime mortgages in the 2000s.
Charles Morris's informed and unusual book, The Trillion Dollar Meltdown, provides a decisive rebuttal to all such excuse-making and blame of "government." Morris makes it clear that it was an unquenchable thirst for easy profits that led commercial and investment banks in the US and around the world—as well as hedge funds, insurance companies, private equity firms, and other financial institutions—to take unjustifiable risks for their own gain, and in so doing jeopardize the future of the nation's credit system and now the economy itself. In fact, government-sponsored entities, Fannie Mae and Freddie Mac, did have a part in the crisis, but not because they were principally trying to help the poor buy homes. Rather, they were also trying to maximize their profits and justify large salaries and bonuses for their executives. They had been made into publicly traded companies in 1989.

It would be wrong to conclude, however, that the new investment vehicles and intricate strategies for "securitization" that developed in the last thirty years had no value. Beginning in the late 1970s, the practice of packaging mortgages together and marketing them as so-called "collateralized debt obligations" was initially designed with the sensible aim of spreading the risk of making loans, particularly residential mortgages, by selling them to many kinds of investors throughout the US and eventually around the world. If many parties share the risk, this lowers the cost of borrowing and enables more people to buy homes and businesses to invest more in research, plants, and equipment. But over the last two decades, this innovative system was exploited to stunning excess. Charles Morris is one of the observers who, contrary to Rubin's claim that no one foresaw the current crisis, anticipated that the increasing gathering of mortgages into highly attractive investment devices had made the financial system dangerously vulnerable. A former banker himself, and author of several excellent books on finance over the past thirty years, Morris has described the intricacies of the American investment world as clearly as anyone. At the time of his latest book's publication at the start of 2008, it seemed far-fetched for him to say that the cost of the financial meltdown throughout the world was a trillion dollars. In fact, Morris may have underestimated the amount of financial damage. Estimates of losses by financial institutions now range between $1 trillion and $2 trillion.
Morris starts his account of the unwinding of the markets with the collapse of the housing market, as does Mark Zandi, a respected Wall Street economist, whose book Financial Shock is intelligent, useful, and a more recent if less detailed book on the crisis. But the crisis cannot be understood without looking back a couple of decades to the development and rapid spread of the investment technique on Wall Street of packaging loans, principally mortgages made by banks and savings and loan associations, into an investment vehicle in which pension funds, money managers, foreign governments, hedge funds, and others could invest. Securitizing residential mortgages in this way was especially appealing, in view of the size of the US mortgage market, which runs into the trillions of dollars.
There was a strong precedent. The Federal National Mortgage Association, or Fannie Mae, established in 1938, had been packaging federally insured mortgages since the 1970s and selling them to investors. It was joined by the Federal Home Loan Mortgage Corporation, Freddie Mac, started in 1970. The two government-sponsored organizations bought up many of the mortgages on the books of commercial banks and savings and loans, allowing them to write more such mortgages, thus making home ownership more widely available to Americans. Owning a home in America is an integral part of the nation's promise. Even in the revolutionary years a far higher proportion of colonialists owned property than in the Old World. And today no transaction is more favored by income tax advantages, including the deductibility of mortgage interest, than the purchase of a home. Home ownership is the principal source of the typical American's wealth.
But in the late 1970s, investment banks—Salomon Brothers in particular—discovered a profitable new source of business in these mortgage-backed securities and began packaging them in a way that made them more like conventional bonds, except that they paid higher interest. The most important breakthrough, says Morris, came in 1983, when an innovative banker at First Boston, Larry Fink, divided packages of mortgages into several different tiers of risk with appropriately graduated interest rates. These tiers are now called "tranches," the French word for "portion" or "slice." Fink's innovation attracted many more clients, including pension funds and major money market institutions, to invest in mortgage-backed securities, and eventually the private market accounted for substantially more such securities than did the government.
The first tier—or some 60 percent of all the investors in a mortgage-backed security—was to be paid interest and principal fully from the monthly cash flows of the mortgage holders and was therefore best protected. But these investors received the lowest interest rate. The more subordinate tiers were paid off after this senior tier received its payments, and thus earned higher interest because of the higher risk of nonpayment. The lowest tiers were the riskiest, the so-called toxic waste, which would get money last, and therefore lose money first if there were unanticipated defaults. But these investors were paid two to three percentage points more in interest to take the risk. This toxic waste was typically bought by hedge funds, the aggressive investment vehicles that took higher risks to earn higher returns for their investors, and often borrowed liberally to increase their returns on capital even further.
For the banks and mortgage brokers who wrote the mortgage loans, the financial advantage was significant. They could now sell the mortgages they wrote almost immediately to packagers, often investment banks, earning a quick and very handsome fee—one half to 1 percent of the value of the mortgage—in the process. By selling the mortgage loans, the banks did not have to maintain capital requirements for those loans, requirements that were imposed internationally by the Bank for International Settlements in the 1990s. The banks and mortgage brokers were then free to make still more loans with the cash they got back from selling the packaged mortgages and quickly to earn another round of fees.
Homeowners also benefited significantly from the securitization. In response to the demand for mortgages by pension funds, investment managers, banks, hedge funds, and others across the globe, mortgages were easily granted; banks and mortgage brokers lowered the interest rates on mortgages charged to home buyers in order to attract more customers. It was principally the investor appetite for the mortgage-based securities and the easy profits made by the banks and mortgage brokers that led to the mortgage-writing frenzy in the 2000s, not encouragement by the federal government to lend to low-income home buyers.
Securitization of mortgages was not all. In the 1990s, commercial and investment bankers expanded the market for new forms of insurance, called credit default swaps, which would supposedly guarantee holders of mortgage-backed securities against losses incurred by defaults. These were complex transactions involving derivatives—investment vehicles such as options or futures contracts based on traditional stocks, bonds, and averages or indices of stocks or bonds. Such insurance protection encouraged investors, including hedge funds and commercial and investment banks, to be still more bold in packaging and investing in mortgage-backed securities. Now that many of these mortgages have in fact defaulted, whether most of the insurance claims on them will be met is still an open question. AIG, the giant insurance company that was rescued by the federal government in September, for example, backed many of these insurance products and may not be able to meet its obligations.
By the late 1990s, America's credit system had changed radically. Enormous numbers of loans were held, not on the balance sheets of commercial banks or thrift institutions, which are regulated by the federal government, but in a rapidly growing "shadow" banking system of hedge funds and other unregulated investors in New York, London, and around the world. This shadow banking system in effect made the loans, but unlike commercial banks, which have reserve and capital requirements legally imposed upon them for activities on their balance sheets, and are also subject to Federal Reserve scrutiny, its capacity to borrow was by and large unrestricted. By the 1990s, securitizers, often investment banks and even commercial banks, were packaging not only residential mortgages but also equipment loans, commercial mortgages, credit card debt, and even student loans—known in general as collateralized debt obligations (CDOs)—and the shadow banking system was buying them. Morris writes that 80 percent of all lending by 2006 occurred in unregulated sectors of the economy, compared to only 25 percent in the mid-1980s.
The mortgages traveled such a long distance from institution to investor that no one was in personal touch with the actual mortgage holder any longer. Now, the likelihood of defaults was assessed not by someone who tracked a specific mortgage holder but by complex, computer-generated statistical models of the entire portfolio of mortgages. Like all such models, no matter how mathematically intricate, they required an estimate about the future based on the past—an estimate that was inherently incapable of adequately taking into account the consequences of a historically rare and therefore seemingly unlikely crash in housing prices.
In addition, the ratings agencies used these statistical models to award ratings to the mortgage-backed obligations sold to investors. The ratings agencies were paid by the commercial and investment banks, who sold the packages of mortgages according to their rating, and who invariably benefited more the higher the rating. The agencies now have much to answer for.
The recession of 2000 and the World Trade Center attacks of September 11 led the Federal Reserve under Alan Greenspan to cut its target interest rate, the federal funds rate, from 6.5 percent at the end of 2000 to 1 percent in 2003, the lowest since the 1960s. For major institutions borrowing was now almost free, but there was no commensurate increase in the federal scrutiny of the loans being made, a power the Federal Reserve had but that Greenspan foreswore. And investment banks, hedge funds, and even commercial banks through off-balance-sheet subsidiaries known as structured investment vehicles borrowed aggressively to invest in the mortgage-backed securities—sometimes their borrowings amounted to thirty or forty times capital. The structured investment vehicles, typically domiciled in the Cayman Islands, enabled the banks to avoid higher capital requirements placed on balance sheet loans and closer scrutiny by the Federal Reserve and other federal watchdogs.
Because the short-term interest rates most affected by the reduced federal funds rate were so low, investors, including commercial banks, borrowed money in the form of short-term commercial paper, and invested it in the longer-term mortgages, adopting exactly the highly dangerous strategy that led to savings and loan bankruptcies in the late 1980s. Commercial paper consists of loans businesses make to one another with their temporarily excess cash. If rates suddenly went up on the commercial paper, profit margins on the long-term investment, whose rates stayed the same, would disappear, and they did. Not to have taken account of this result was a crucial and unambiguous example of irresponsibility by executives at banks like Citigroup.
The new financial structure might have worked out nevertheless had the loans been as safe as widely believed. It turned out that they were not. The investors had failed to scrutinize them. By 2006, Zandi points out, more than $1.1 trillion of the $3 trillion in mortgages written were either subprime—mortgages to individuals with questionable ability to pay—or so-called Alt-A loans—made to people without verifying their income.
Most remarkable, perhaps, the frenzied subprime lending occurred after the housing market had already climbed to unthinkable heights. On average, the prices of homes had been rising since the early 1980s, but between 2000 and 2005, they leaped by 50 per-cent despite low inflation. Yale economist Robert Shiller estimated that it was the largest housing boom in American history. Of course, the easy mortgage availability and low rates fueled the rising market.
Some mortgage brokers claim that the subprime mortgage holders were simply irresponsible, buying houses they couldn't afford. In fact, bankers and mortgage brokers promoted enticing loans, the most important of which was the adjustable rate mortgage, or ARM, in order to lower mortgage payments temporarily to levels that might seem well within the means of lower-income buyers. The initial interest rate on an ARM was about 3 percent, or even lower, but it would be automatically reset higher in two years. Surveys showed that many mortgage holders did not understand the terms. Remarkably, Alan Greenspan publicly suggested that if borrowers failed to take advantage of the ARMs, they could lose "tens of thousands of dollars" on their mortgage payments.
But Zandi makes clear that the mortgage writers believed house prices would continue to rise, enabling the owners to refinance their mortgages at a value higher than the original mortgage and at more advantageous terms. A rapidly growing proportion of the subprime loans in this period were also made to speculative investors who bought several houses at a time and "flipped" them to profit from the rapidly rising prices.
The housing market at last began to falter in the spring of 2006. At first, home prices moved downward and then the rate of defaults by homeowners began to escalate. The following year, the rates on many ARMs were reset upward, adding an average of $350 to monthly payments, and doubling defaults to an annual rate of 1.6 million by the end of 2007. That year, as housing prices fell and defaults rose, the ratings agencies started downgrading some of the mortgage-backed holdings on the books of investment banks, hedge funds, and the subsidiaries of commercial banks. Their values began to fall in the market. In addition, other packages of debt obligations based on consumer debt or equipment purchases were looking less reliable.
As the mortgage-backed obligations began to look less sound, the commercial paper buyers demanded higher rates, squeezing profits, and forcing the investors to sell more of these obligations, pushing their values down further. Eventually, many of the commercial paper lenders refused to lend their short-term money to the investors at all.
What made matters worse is that when the values of these securities fall, the banks and other investors are obliged to write down the investment on their books —a widely practiced accounting rule, established by the Financial Accounting Standards Board and encouraged by regulators, known as mark-to-market. This produced losses that reduced capital and the ability to make new loans. Meantime, lenders to these investors also typically require that investors put up more money as the value of the investment falls—in order to meet what is known as the margin requirement. This, too, resulted in more selling.
When two hedge funds at Bear Stearns, with substantial investments in mortgage-backed securities, had to unload investments to meet their margin requirements in 2007, it generated such enormous losses that the old-line brokerage firm, in order to avoid outright bankruptcy, had to sell itself at fire sale prices to J.P. Morgan in early 2008, in a deal engineered by the Federal Reserve. The Bear Stearns losses in 2007 were the first concrete signs of looming catastrophe. Others were soon to come. Losses were being announced publicly at America's leading investment and commercial banks as well as foreign banks like the Royal Bank of Scotland and Switzerland's UBS.[1]

 

[Agent327]

Part 2:

An excellent series this fall in The New York Times, called "The Reckoning," has provided fascinating insights into the reckless decision-making in some financial firms in the years just preceding the crisis. One of the reporters for the series, Gretchen Morgenson, describes how Merrill Lynch made twelve major acquisitions of mortgage and real estate companies between 2005 and early 2007 in order to take advantage of the boom, packaging the mortgages into mortgage-backed obligations themselves and selling them off or investing in them.
Merrill earned record profits in 2006 and set another record in the first quarter of 2007. But a common view outside the firm, Morgenson found, was that the Merrill executives did not understand the risks they were taking—or were perhaps deliberately looking the other way. Investors on all sides of these transactions were making a fortune. By the summer of 2007, with defaults rising and the value of the mortgage-backed obligations falling, the magic powder quickly turned to dust, and that October, Merrill reported a $2.3 billion loss. Stanley O'Neal, the chief executive, was forced to leave, as were other executives. But O'Neal took with him a $160 million severance package. Under O'Neal's successor, John Thain, former head of the New York Stock Exchange, Merrill sold itself to Bank of America in September 2008, during the same week in which the prestigious firm Lehman Brothers collapsed and AIG was bailed out by the federal government.
The Times series tells similar stories about the management of Citigroup, which tripled its issues of CDOs between 2003 and 2005, under the leadership of Charles Prince and, reportedly, the encouragement of Rubin. As late as the fall of 2007, reporters Eric Dash and Julie Creswell found, Prince was assured by the bond executives that the company would not suffer serious losses. Little attention was paid to risk taking. Less than a year later, total losses at Citigroup exceeded $65 billion and the bank was forced to seek federal help to stay in business. But Charles Prince, like Stanley O'Neal, walked away rich from Citigroup when he was replaced in 2007.
The Federal Reserve, which since 2006 has been led by Ben Bernanke, a former Princeton professor, only started cutting interest rates in the fall of 2007. In fairness to Bernanke, he was bold in light of the widespread opposition to such a cut. Many economists were worried at the time that rate cuts would reinforce an improbable resurgence of inflation.
One problem was that the Fed did not have adequate information about these markets because derivatives were not traded openly and the latest CDOs, including mortgage-backed obligations, were mostly on the books of the shadow banking system. It was a serious lapse of judgment, not to mention responsibility, on the part of the Federal Reserve under Greenspan and the Securities and Exchange Commission under Christopher Cox to fail to seek more comprehensive information far earlier about the surge of lending.
After the Federal Reserve stepped in to avoid a Bear Stearns bankruptcy in the spring of 2008, Treasury Secretary Henry Paulson continued to reassure the public that the mortgage crisis was contained. But only after Lehman was allowed to go bankrupt in mid- September, followed by the collapse of AIG and other financial institutions, did he at last demand the controversial $700 billion bailout fund from Con-gress and eventually proceed to supply capital to banks with part of it.
But even with the new capital, the banks were not lending appreciably more; nor, without specific stipulations guaranteeing their loans, should anyone have expected them to do so. The values of even more solid mortgage-backed obligations based on prime mortgages were falling and eating up the new capital.
Bernanke then cut the funds rate sharply again, lowering it in all to 1 percent from more than 5 percent in mid-2007, but with falling housing prices, credit largely unavailable, and declining consumer confidence, a serious recession was not to be averted. The Fed has taken other bold actions by buying or guaranteeing assets held by institutions. But as of this writing, defaults on mortgages are still running high, and all kinds of consumer and business loans are now under similar threat.
At the end of 2007, the administration and Congress pieced together a first stimulus plan composed of government spending and business tax breaks. It was not enough. The rebate checks eventually doled out to most American consumers were swallowed by the rapidly rising price of gasoline in the spring and summer of 2008. Congress talked about a second stimulus plan but it failed to act, partly because the administration offered no support. In 2008 job losses reached 2.6 million, and by December President-elect Obama was discussing an "economic recovery" package of more than three quarters of a trillion dollars, unthinkable only three months earlier.
The Obama team has not yet announced its thinking about how to reregulate the financial community once the economy is righted again. The team of economists headed by Lawrence Summers, the former Treasury secretary (1999–2001), were, after all, themselves supporters of financial deregulation in the 1990s when most of them were members of the Clinton administration. As the Times's series notes, Rubin, who preceded Summers as Treasury secretary (1995–1999), Summers, then his deputy, and Greenspan opposed regulating derivatives. In 1999, Rubin and Summers supported the repeal of the Glass-Steagall Act, the New Deal restriction separating investment and commercial banking.
In fact, with the blessings of the Clinton administration and Greenspan, commercial banks were already engaging in many of the more aggressive activities of investment banks; and investment banks, along with hedge funds, private equity firms, and other institutions, as we have seen, were making the loans once the province of commercial banks through purchases and packaging of mortgage-backed obligations. The Bush administration took deregulation further, essentially eliminating, for example, limits placed on borrowing by major investment banks.
One principle should dominate future regulation—the shadow banking system should be brought under the same regulatory oversight as commercial banking. In sum, these firms must maintain minimum capital requirements against the loans they make and mortgage-backed obligations and other CDOs they buy, just as commercial banks do. The structured investment vehicles commercial banks use to avoid such capital and other requirements should be disallowed. A federal agency, most desirably the Federal Reserve, should have the authority and obligation to examine the books of investment banks, hedge funds, and other participants in the shadow banking system to determine the quality of their investments and to set the standards by which capital is deemed adequate. Derivatives should be required to be listed on an exchange, where information about them and their prices is openly visible to market participants and federal authorities.
Rules are not enough, however. Greenspan had been given the authority to examine the quality of mortgage lending by Congress in the 1990s, but simply did not use it, pleading free-market principles. The SEC under Bush appointee Cox could have examined the books of investment banks, but again mostly did not bother. Congress will have to talk louder and exercise stronger authority.
Any regulation should also take account of the incentives for managers to take company risk for personal benefit. The ability to take immediate profits from fees on risky loans infected the financial industry and eventually the entire economy, and made possible disproportionately large annual bonuses. These incentives were among the main causes of the irresponsibility on Wall Street. The best way to prevent that from occurring is to base the bonuses and compensation of financial executives on the long-term profitability of the investment firms for which they work.
But the first order of business is to right the economy, and so far there has been only modest success at preventing matters from getting worse, for all the seeming activity by the Fed and Treasury. The number of lost jobs is rising sharply, consumption and manufacturing output are falling at record rates, house prices keep sliding, and large firms, like Linens 'n Things, have closed their doors. The major auto companies have only just won a reprieve with a loan from the federal government. What makes this recession more precarious than the steep 1982 recession is that a further fall in incomes will bring another round of intense credit contraction, as more home owners default, including prime borrowers. Now, many corporate borrowers are also one or two steps away from defaulting.
The broad outline of a rescue plan should be clear. It requires a two-pronged approach. First, the credit system must be unfrozen and loans must flow again, including mortgages. Second, demand for goods and services must be restored to slow the downward spiral of the economy, which is now well underway.
Restoring the health of the credit system, while some slight progress has been made, is not being managed well. The Treasury has given about half of the $700 billion bailout money approved by Congress to the banks as capital injections. But as noted, the banks largely have not used these funds to revive the credit markets. In fact, Paulson's original idea to buy some of the banks' assets that could not be sold or even priced, which was strongly criticized, was clumsy and expensive but was based on a sensible principle. If the banks are given capital, and it just falls down a hole because the banks' assets keep losing value, little good is done. The value of the assets have to be stabilized.
The recent bailout of Citigroup, which guarantees 90 percent of a portion of the bank's investments for a fee to be paid by the bank, was more practical if too generous to Citibank. A better proposal, offered by the Barnard College economist Perry Mehrling, is to have the federal government either insure or even buy the better assets of the banks, which have fallen irrationally in value along with the so-called toxic assets. At a reasonable cost, the federal government could then stop some of the bleeding and the capital could be put to work to make new loans, including writing new mortgages, and perhaps slow the fall in house prices.[2]
But if defaults continue at their current pace, the value of mortgage-debt obligations will remain under constant downward pressure, as will bank capital. The Bush Treasury has done little about this, leaving the task to modest measures taken by Fannie Mae and the Federal Deposit Insurance Corporation and purchases of assets by the Fed. There is no easy or cheap way to guarantee the bad loans, but ways must be found to slow the default rate. It is of some concern that as of this writing we have not heard more from the Obama transition team specifically on this issue.
Another necessary component for reviving the credit system involves the self-destructive accounting rules and loan covenants that are making the crisis worse than it need be. The losses required to be taken under mark-to-market accounting, and the consequent reduction in capital, reinforce the fall in asset values. Similarly, current ratings requirements force the financial institution to sell investments to raise capital. Federal authorities should imaginatively reassess these arrangements to adjust them, even if only temporarily, to minimize the crisis. International capital requirements should also quickly be relaxed.
The second major part of a rescue plan involves the so-called real economy. If fearful Americans start saving as much of their income as they did even in the early 1990s—a savings rate of 5 or 6 percent compared to nearly zero in 2007—the economy will lose $750 billion to $1 trillion in buying power. The stunning losses of stock market and housing wealth—which in the last year total well more than $10 trillion—could cause consumers to spend several hundred billion dollars less than was expected. Such a loss in demand will drive employment and profits way down. Moreover, with the federal funds rate already so low, the Federal Reserve's ability to stimulate the economy by lowering interest rates is now limited.[3] Thus, additional federal government spending of as much as $750 billion a year is by no means an exaggeration of what may be needed.
Here Obama has moved intelligently if cautiously in projecting a large spending package, probably amounting to as much as $800 billion over two years. He will invest part of the money in infrastructure and in clean energy, with emphasis on measures to protect against global warming. Such longer-term investment will create domestic jobs and is likely, if managed well, to stimulate higher productivity. The package will also include expanded unemployment benefits, aid to the states, and perhaps, to win political support, substantial tax cuts. Again, however, the hole in the economy may be still larger than Obama anticipates, and he may have to address the possibility of a further stimulus in six months or so.
This is, as many economists now concur, the worst economic crisis since the Great Depression. Financial market participants created a financial bubble of tragic proportions in pursuit of personal gain. But the deeper cause was a determination among people with political and economic power to minimize the use of government to oversee the financial markets and to guard against natural excess. If solutions are to be found, the nation requires robust and pragmatic use of government, free of laissez-faire cant and undue influence from the vested interests that have irresponsibly controlled the economy for too long.
—January 14, 2009
Notes

[1]The US commercial banks were booking huge losses in their off-the-balance-sheet structured investment vehicles. It turned out the banks were "warehousing" some of these obligations on the books as well when they couldn't sell them, and are now taking big losses there also.
[2]Toward the end of December, the Federal Reserve announced that it would accept some of these investments in return for reserves, a useful attempt to stabilize these markets.
[3]The Fed has other options, including buying long-term bonds, which could help reduce mortgage rates and prevent some defaults.


Quoted from the New York Review of Books: http://www.nybooks.com/articles/22280

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