Everything Finance

NPR had a very good program about the MBS meltdown that kicked off the financial crisis.

Home prices are rising according to the S&P/Case-Shiller Home Price Index.

The New York Federal Reserve Bank has a very nice timeline of the financial market and policy response of the last two years

The State of California’s tax revenues fall far short of its spending and the legislature and governor are unable to close the gap, due in part to the large number of constitutionally-imposed constraints and in part to all the usual hurdles to forging agreement among a diverse group of human being (here is the NY Times article). So the State is planning to start issuing i.o.u.’s to pay its creditors. Further, these i.o.u.’s may pay interest (they did in 1992).  How should we think of and value these new assets?

Ravi Jagannathan and John Boyd advocate for identifying all firms that perform critical banking functions and regulate them as banks. They also advocate on a size constraint to avert a catastrophic event from happening. 

Continental suggests in lawsuit that some pilots got fake divorces to cash out of their pensions early. What does this teach us about “runs”?

According to a recent ABC News story, Continental Airlines is currently suing nine of its (now mostly former) pilots alleging that they faked divorces to fraudulently gain early access to pension benefits prior to retirement. In particular, by getting divorced, federal laws on defined benefit pensions plans (ERISA) allow spouses of the beneficiary to cash out a share of these benefits immediately. In the case of Continental, these early payoffs reached as high as $900K.

Recent commentators have suggested that house prices have a ways yet to fall, and that these further declines will lead to a further collapse in US output, potentially lengthening and deepening an already severe global downturn.  But while this US recession was kicked off by the sub-prime crisis, even the large declines in housing wealth that we have seen are not enough by themselves to explain the severity of the current downturn.  Let me explain why.

A host of commentators are arguing that the current U.S. slowdown – the most severe in a quarter century – is far from over and in fact destined to get much worse.  The argument usually invokes a parallel with the Japanese recession of 1990.  In Japan in 1990, real estate prices fell sharply after rapid increases over the previous decade, the stock market fell dramatically, and most large banks became either insolvent or very short on capital – all similar to what the US has experienced.  And Japan subsequently went through a great-depression style slowdown in economic growth from which they have still not fully recovered.

The Fed announced Tuesday that previously issued (legacy) commercial mortgage-backed securities (CMBS) will become eligible collateral for the Term Asset-Backed Securities Loan Facility (TALF). This comes less than three weeks after announcing that only newly issued CMBS would become TALF-eligible.

The American Recovery and Reinvestment Act, signed into law on February 17, 2009, provides for a one-time economic recovery payment of $250 to be disbursed this May to people who receive Social Security, Supplemental Security Income, or Railroad Retirement and Veterans benefits. Anyone eligible for one of these benefits at any time during the months of November 2008, December 2008 or January 2009, is eligible for the one-time payment.

The Federal Reserve Bank of New York has a fascinating and user-friendly way of presenting their data on mortgage financing, delinquencies, foreclosures and so forth across the nation for different types of mortgages.

One of the central questions in the current crisis is why the financial system seems so slow and/or unable to renegotiate debt contracts that seem likely to default.

The Chinese economy is slowing rapidly. The latest estimates show declines of several percent in official Chinese growth rates, which might be indicative of an actual recession. The Chinese government, like many around the world, is responding with a large economic stimulus plan. Official estimates are that the plan will cost roughly 14 percent of one year of China’s GDP, or well more than double the relative size of the proposed plan in the U.S. While some of the proposed stimulus spending may be worth doing anyway, the idea of a stimulus plan is to spend and build more than is worth doing in an economic slowdown. In the rush to stimulate the economy, there will surely be some waste and investments undertaken that in retrospect may be worthless.

On the Need for Truth in Borrowing Legislation

One of the great successes of financial regulation in the US is the Truth in Lending Act, passed in 1968, which protects borrowers from predatory lending. In the new financial architecture that will emerge following the current crisis, it is now obvious that we also need truth in borrowing legislation to protect banks and other financial institutions (if we still have any) from predatory borrowing by consumers.

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Many pundits and policymakers think that asset prices have deviated from “fundamental values” and that this deviation is part of the problem affecting financial institutions.  For example, if mortgage and credit assets, which banks hold in plenty, are currently priced below “fundamental values,” then banks will be assessed larger losses than they otherwise would. This in turn can lead to concerns of banks defaulting, etc. In other words, the dysfunctionality of asset markets is part of the problem in the current financial crisis.

All firms are bound to make mistakes and those mistakes will be bigger the bigger the firms involved. When big firms also happen to be financial institutions, especially banks, everyone in the economy will pay for their errors. That is because financial institutions are intricately connected with every aspect of the economy and they can and will bring an economy to a grinding halt if they cease to function. If banks and other intermediaries suffer badly enough, economic activity freezes and the entire economy suffers also.  This is what economists call a “negative externality” and the Great Depression was a great example of what that means in practical terms. It is why banks have always been more heavily regulated than other firms, and why they should be treated the same today. Big banks present special problems and they require special handling.

The Bush administration is working on a plan to help homeowners at risk of default.

This would be the second time this year that legislators intervene to help homeowners; in July, President Bush already signed legislation to help borrowers to refinance at more affordable rates. For an academic analysis of that legislation and the way it impacted taxpayers, homeowners, and the financial industry, see a recent paper by Mian, Sufi and Trebbi. Mian and coauthors argue that special interest campaign contributions from the financial services industry and local constituencies predict Congressional voting patterns when it comes to recent government interventions.

After threatening a financial meltdown in case his plan was not approved, and announcing that “the right way was not to going around using guarantees or injecting capital in the system (that is the Japanese solution),”  the Secretary of Treasury Hank Paulson has made a 180 degree turn and opted for plan B.  Plan B is an equity infusion into the banking system and a system of guarantees. This infusion amounts to $250 billion, effectively leaving very little money left for plan A to be implemented, at least in the short run. Advocates of plan B fundamentally believed that the problem of the financial system was a problem of undercapitalization. According to this camp, the problem is much bigger than originally acknowledged. They argued that, while there was a liquidity problem in the market, the fundamental weakness was due to the lack of enough capital in financial institutions. Dollar for dollar, you get more bang for the buck with the recapitalization. While there is some truth in this latter argument, the devil is in the details—if we want to ask whether plan B addresses the crisis appropriately, we should look at its details.

This week the Federal Reserve announced the creation of the Commercial Paper Funding Facility.  The facility allows the Fed to purchase 3-month commercial paper directly from issuers.  Why is it doing this, and how much will this cost taxpayers?

The U.S. Treasury’s proposed bailout plan raises a number of serious questions, many of which have been well articulated by politicians and pundits. Many of the plan’s merits, however, have been shrouded by confusion.  Is the taxpayer losing $700bn to Wall Street?  Is the Treasury paying fair value for assets?  How will the bailout help Main Street?  In fact, there are a number of merits to this proposal which all stem from markets currently being extremely illiquid.