The Meltdown (Part II)
The easy answer to why the bailout hasn’t worked is it hasn’t been implemented yet. But its purpose was largely psychological – to boost confidence that the government is doing something big to clear out bad debts that have been clogging the system. That psychological boost should have happened as soon as the bailout was enacted.
Yet no one seems to believe that 700 billion dollars will make much difference. And today’s interest-rate cut, coordinated with the European Central Bank and Bank of England, may not, either. This isn’t a liquidity crisis. It’s a crisis of trust. Lenders don’t trust that borrowers will be able to repay, because they don’t think borrowers will be able to collect on what’s owed to them. Every major player is moving to safer ground – holding money, hoarding it, putting it under a giant global mattress.
Bad mortgage loans from the era of anything-goes credit standards started it. But now that America is tipping into deeper recession and unemployment is mounting, more bad loans are cropping up because more people can’t pay their bills. And as consumers pull in their belts, more businesses can’t pay their bills. Which means more layoffs, and more bad loans, and a global sell-off.
The Fed and other central banks can pour endless money into the system but the problem is no longer just on the supply side. It’s now also on the demand side. Which means the federal government, as spender of last resort, has to jump start the economy, as do other governments. Now’s the time to start rebuilding our crumbling infrastructure – roads, bridges, levees, public transit. And help cash-starved state and local governments invest in their schools.
It does make sense to help homeowners directly, as Barack Obama has said. But John McCain last night came up with the stupidist plan I've heard yet for doing so. He wants the government to buy mortgages from the banks at face value and then write down the principal for homeowners. This would be the biggest handout yet to the financial industry. Taxpayers would take all the losses, including the downside risks of additional defaults if houses drop further in value, while the banks would get off scott free.
Yet no one seems to believe that 700 billion dollars will make much difference. And today’s interest-rate cut, coordinated with the European Central Bank and Bank of England, may not, either. This isn’t a liquidity crisis. It’s a crisis of trust. Lenders don’t trust that borrowers will be able to repay, because they don’t think borrowers will be able to collect on what’s owed to them. Every major player is moving to safer ground – holding money, hoarding it, putting it under a giant global mattress.
Bad mortgage loans from the era of anything-goes credit standards started it. But now that America is tipping into deeper recession and unemployment is mounting, more bad loans are cropping up because more people can’t pay their bills. And as consumers pull in their belts, more businesses can’t pay their bills. Which means more layoffs, and more bad loans, and a global sell-off.
The Fed and other central banks can pour endless money into the system but the problem is no longer just on the supply side. It’s now also on the demand side. Which means the federal government, as spender of last resort, has to jump start the economy, as do other governments. Now’s the time to start rebuilding our crumbling infrastructure – roads, bridges, levees, public transit. And help cash-starved state and local governments invest in their schools.
It does make sense to help homeowners directly, as Barack Obama has said. But John McCain last night came up with the stupidist plan I've heard yet for doing so. He wants the government to buy mortgages from the banks at face value and then write down the principal for homeowners. This would be the biggest handout yet to the financial industry. Taxpayers would take all the losses, including the downside risks of additional defaults if houses drop further in value, while the banks would get off scott free.
posted by Robert Reich | 11:36 AM
60 Comments:
Capitalism doesn't work without TRUST, but unfortunately governments do.
Over 70% of the US GDP is based on consumption… Americans are out of cash and can’t get credit.. thus can’t consume.
Americans have lost $2 trillion in pension money, $2 trillion in home value, $2 trillion on a dumb-war (including support for 30,000 wounded Vets over the next 50 years), and we have a deficit of $11 trillion. We have less jobs, failing schools, less medical insurance, and now big inflation.
It sounds like you want to hand out hammers and shovels, so we can all start digging (literally) out of this mess.
Most Americans are unable to sell their houses and are trapped in this country.
Things could start looking like the days in New Orleans shortly after hurricane Katrina.
It's even worse than you suggested.
With one hand Paulson is going to over-pay for mortgage backed securities. Thus, we the people, own those securities.
With McCain's plan, we will be certain those securities lose a great deal of value.
It's insanity.
My wife and I talked about these plans last night.
We left it agreeing that because we bought much less house in 1999 than we qualified for, have a fixed interest loan, and have penny pinched all of these years to eliminate our debts, we probably won't qualify for a government bailout of any kind.
It's hard to get excited about all of the extravagant plans to create vast quantities of money and through it ever which way.
Something about McCain's plan to reduce income, while borrowing and spending vastly more money, doesn't sound right.
I can't live that way without consequences. I guess he doesn't know any better.
Don't forget the moral hazard part of John McCain's idea...stop making house payments, renegotiate your mortgage with the treasury, get a lower mortgage and better terms...resume making house payments.
Anonymous Matt
Matt, who do you reckon, will get the No-Bid Contract to manage this for the Treasury?
Professor Robert Reich: What Senator John McCain was talking about when he mentioned the home-owners' loans was a plan proposed by Professor Martin Feldstein in the Wall Street Journal. An early version of this plan appeared sometime in Spring 2008 in the same newspaper. This plan has now been updated last week.
Please check-out my blog: http://selvasblog.blogspot.com
Q1. Why isn't the financial crisis on Wall Street palpable on Main Street? Although financiers, journalists and politicians have been warning of a major financial crisis, as big as the Great Depression, since August 2007 (some economists have been warning for several years now), normal economic activity seems unaffected, or at least the common man does not seems to feel any impending doom. Why is this so?
A. To a large extent, the current financial crisis does not involve the working capital of the American economy. The funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term. Sure enough, the persistent gloomy predictions on the economy seen in the newspapers and television channels, throughout the year 2008, would have had a negative effect on the confidence of the consumers and the business entrepreneurs. This would have led to cutbacks in production plans, tightening of credit, mark-down of inventories and penny-pinching of family budgets. But, on the whole, the real economy has shown unexpected and prolonged resilience. No doubt the action of the US Federal Reserve Bank to pump over one trillion dollars into the economy for over-night and short-term lending has also eased the flow of money. But, the main reason for the disconnect between Main Street and Wall Street is that the financial crisis is concerned with the accumulated capital (as opposed to working capital) of the American economy.
The term accumulated capital refers to the capital held by (i) pension funds which hold the life-time savings of Americans, (ii) reserve funds which hold the accumulated profits of large corporations and private companies, (iii) mutual funds and money-market funds, which hold savings of individuals that are in excess of mandatory life-time savings like social security, and are more freely invested in the markets expecting a better return than from treasury bonds, (iv) endowment funds, held by private trusts, which are collected through charities and donations, (v) hedge funds and private equity, (vi) any other entity that holds capital that has accrued through the savings of individuals, or the profits of private organizations, or the surplus of state, local and federal governments, and is not needed as immediate investment for the day-to-day functioning of the economy.
To provide a perspective on accumulated capital, one may note that the financial wealth in the American economy is estimated to be $40 trillion (ref: Wall Street Journal Oct 1, 2008 article by Professor Edmund Phelps). Wikipedia states that the world-wide value of all pension funds are in excess of $20 trillion; mutual funds total more than $26 trillion. Please note that it is possible that some of the pension funds are invested in mutual funds. Also, I am not aware of what is the exact total sizes of pension funds, mutual funds and other constituents of accumulated capital within America per se, but I would assume that they add up at least to $10 trillion (which, I suppose, is included in the $40 trillion quoted above). In additions, hedge funds have about $1.5 trillion under their management totally, all of which is investments from individuals of high net worth.
Q2. Aren't saving for retirement, insurance and pension systems old phenomena? Why did they bring down Wall Street this time?
A. Yes, pension and insurance systems were already well-developed in the industrial economies of 19th century Europe. There are two major differences this time around. Demographically, the senior citizens of 19th century Europe retained close ties to the younger generations because of genetic, ethnic and racial homogeneity. As a result, the pension amounts received by the retired people were substantially supplemented by contributions from inter-generational and intra-family transfers of wealth. If we go back a hundred or more years, old people lived with their families and helped to bring up their grandchildren. Moreover, hereditary transfer of wealth was still as important as creation of new wealth in the industrial economies of the 19th century. These factors served as economic incentives for the working adult population to provide old-age care for their parents, which supplemented the parents' income from pension. The second difference is that the dichotomy between an empire and a democracy was far more prominent among the nations of 19th century Europe. People felt assured that the social infrastructure provided by an empire would safeguard their standard of living through their old age. Examples of the social infrastructure of an empire during 19th century Europe are the establishment of universal heath care, the administration of the pension and life insurance systems, and subsidized public transport and postal systems. As an aside, it may also be mentioned here that the development of the modern university was pioneered in Germany during the 19th century.
Thus the fundamental reason for the current financial crisis is the time value of money. To maintain the standard of living that people who are close to retirement or have already retired would expect, the income from their pensions have to be substantially larger, in view of the reasons discussed above, than what a senior citizen in 19th century Europe would have received, even after adjusting for inflation and GDP growth. This enhanced pension income would have to come from interest on investments, because the senior citizens who receive them could not possibly compensate for this income with active work. Thus the managers of pension funds found it imperative to look for high returns on their investments. At the same time, since these funds were so huge and so critical to the lives of many millions of people, their investment strategy had to exercise the utmost caution. Diversification served as the compromise in this situation. The managers of these huge funds would invest the major part of their portfolio safely, for example, in treasury securities. A smaller part would be put under the stewardship of the Wall Street firms for more risky investments in the expectation of high returns. Over a period of two or three decades, such unreasonable expectations on Wall Street to keep generating high returns on capital took its toll.
Q3. How exactly did unreasonable expectations bring down Wall Street?
A. When one refers to Wall Street, it is important to keep two types of people in mind. The first type is the senior executives who have gained their credentials through many years of involvement in the traditional roles of investment banking, beginning in the 1950s or later. The conventional wisdom among these people places a lot of importance on trust-worthiness, reputation, people-skills and management techniques as the path to career-success. Advising industrial firms in mergers & acquisitions, underwriting the issuance of company stocks and bonds to the public, helping the government finance a deficit through the purchase of treasury securities for their clients, and trading in securities on behalf of their clients were the main activities of Wall Street firms before the 90s. We note that all these activities required trust-worthiness primarily, and moreover they didn't require much of the firms' own capital. The second type is the smart, innovative PhDs who have arrived on Wall Street starting from the 1980s. These people have helped build the massive computational infrastructure on Wall Street along with the development of financial innovation. Their most valued skills are quantitative and they are quite tech-savvy. On the downside, many of the senior executives making up the first type have come to exercise a lot of political influence which could be illegitimate sometimes. For their part, the tech-savvy 'quants' of the second type have grown-up with post-modern, anti-heroic sensibilities that has no use for honor or reputation, as defined conventionally. However, in spite of their differing attitudes towards reputation and the 'word on the street', when it comes to compensation, both the types would like to cash in on their professional worth right away with large bonuses.
The advent of computers transformed the industrial economy into an information-based economy. This meant that smart people who could devise intelligent strategies to take quick advantage of the flow of information could expect to make large profits, especially from financial investments. Thus, starting in the early 80s, Wall Street investment banks began to make huge profits, aided by their large investments in computers and their new army of smart PhDs. Over the course of the 80s and 90s, the capital in the 'bulge-bracket' investment banks grew from a few tens of millions to one or two dozen billions dollars. The capital in the smaller investment banks and hedge funds on Wall Street produced similar returns. Thus Wall Street turned into a sleek and mean money-making machine. It was for its massive returns on capital that the managers of pension funds and other sources of accumulated capital had been turning steadily to Wall Street. The boom in the technology stocks during the 90s turned the trickle of capital to Wall Street from these fund-managers into a flood. Now, as history would have it, the technology sector went bust in 2000 with the NASDAQ composite index losing more than 60% of its value between 2000 and 2003. This drastic loss of wealth exposed an inability of modern finance theory to figure out how to determine the proper economic value of technological progress. There was a big question about how Wall Street could continue to churn out its massive profits. It was in this scenario, that the smart PhDs on Wall Street stumbled on the great innovation to direct the huge sources of accumulated capital in America and the rest of the world towards solving the long-term demographic incongruities in America. This was how Wall Street came to trade in mortgage-backed securities. In the process, they found a way to keep the money-machine that is Wall Street hum along smoothly for another 8 years.
Now, the smart PhDs that form the second type came up with a lot of innovations to carefully control the risk involved in turning a housing mortgage loan into a hierarchy of claims on payments, called tranches. For their part, the senior executives that form the first type, who had built up a reputation for trust-worthiness over several decades, could borrow money from the pension funds and other sources at leverage ratios of 25 to 30 -- far in excess of the reserve ratios expected from the commercial banks under the regulations of the Glass-Steagal act. This unlikely marriage of old wise-heads and smart innovators on Wall Street was sanctified by the Federal Reserve which kept interest rates low to avoid a slowdown in economic activity, given the tragedy of 9/11. However, from 2007 onwards, cracks in the marriage began to appear one by one, and it became apparent that the party had gone on too long. The smart PhDs had not take into account that the process of securitization separates the property rights on mortgaged homes from the investments on mortgage securities. The home-owner lives under the threat of foreclosure. So, his/her property rights are compromised. The security-owner bears liquidity risk and credit risk. So, his/her income is uncertain. It is plausible that left to themselves the smart PhDs would have, in due course of time, overcome their error by devising a market-based solution that would mutually alleviate the grievances of the home-owner and the security-owner. However, the Wall Street money-machine was on high-gear by then, and it was not designed to slowdown for any eventuality. The senior executives, who were more comfortable with people-to-people communications rather than arcane finance theory, ran to their long-established connections in the political establishment and the media. Moreover, these senior executives decided to play smart. They used the very same unreasonable expectations that society had placed on Wall Street as a bargaining chip to hold society to ransom. Their constant chants were "Bail-out Wall Street, for otherwise there is the 'systemic risk' of a financial meltdown". "It's going to be armageddon, so raise FDIC insurance to $ one million" (CNBC's Jim Cramer). "We're going to see a repeat of the Great Depression's bank runs". Unfortunately, the long sage of bail-outs starting with Bear Stearns in March 2008, then Fannie Mae, Freddie Mac and AIG in September 2008 and finally the $700 billion bill passed now have not stemmed the financial crisis, and the reputation of Wall Street is in tatters. Thus Wall Street was brought down by unreasonable expectations.
Q4. So what about the billions of losses due to mark-to-market accounting rule? Could these losses lead to financial meltdown? Also, why is de-leveraging cited as a reason for the huge losses? Why is re-capitalization of the banks necessary?
A. In view of the explanations above, it is far simpler to think of the situation as follows. The 'bulge-bracket' Wall Street investment banks (that have now been converted into bank-holding companies or have gone bankrupt) had about $20 to $30 billion of capital each. Wall Street was so used to annual returns of 20% or more on capital before the collapse of the technology sector in 2000. To maintain this high rate of return after 2000, the investment banks resorted to leverage ratios of 25 to 30 in their investments on mortgage securities. This means that each of them borrowed about $750 to $900 billion from the pension funds and other sources. The reader might ask what is the collateral for this borrowing? The investment banks would purchase mortgage securities with this borrowing and submit these same mortgage securities as collateral to the pension funds. The payments received from the home-owners on these mortgage securities would be used to first pay the interest on the borrowings from the pension funds, and the rest would be the profits of the investment bank. In view of the leverage ratio of 25 to 30, a net difference of only about 0.8% in the interest rate received from the home-owner and the interest rate paid to the pension funds would ensure a rate of return of 20% or more for the investment bank. However, the problem with this scheme is that the pension funds only had the trust-worthiness of the investment bankers and the mortgage securities as assurance against the money they lent out. Of course, they also had the enticement that only the Wall Street money-machine could provide them the rate of return adequate to keep up with their large pension payments to senior citizens.
With a fall in the house prices, there would be a corresponding fall in the mortgage securities due to the risk of foreclosures. Moreover, these mortgage securities were structured in such a way that foreclosures of mortgaged homes would be reflected in increasing degrees as one went lower down the tranches. Thus the lowest tranches would lose value very quickly in the event of a fall in house prices. So, the pension funds and mutual funds would need to assess the value of the mortgage securities in their accounting books periodically, say once every quarter, to safeguard their interests. For this, they would need refer to the market value of these securities (mark-to-market), and to request the investment bank to replenish the collateral, if there is a drop in the market value of the mortgage securities. Unfortunately, since the leverage was so high, an average drop of 3% in the market value of the mortgage securities could mean that after the pension fund's collateral was replenished, the whole amount of the capital of the investment bank ($20 to $30 billion) would have to be replaced. This was what led to the bankruptcy of some of the large investment banks. The story with smaller investment banks and the hedge funds is similar. Now, if the pension funds simply didn't insist on mark-to-market accounting, then the investment banks would receive regular payments on the mortgage securities from the home-owners. Over time, the pension funds would recover the full amount of their investment along with the rate of interest that the they had expected, with the only risk being that of foreclosures. There would be no risk that the prices of the mortgage securities would fall due to illiquidity in the markets. Thus financial meltdown would be avoided, with or without the existence of the Wall Street firms.
However, this argument turned out to be the Achilles' heel of the investment banks. Working in their old trust-based mentality, they thought they could ride through this financial crisis if they simply convinced their creditors to rescind the mark-to-market rule and give them more time. They didn't find it necessary to sell off the risky mortgage securities and cut their losses, nor were they seriously looking to raise new capital. And they were caught by surprise when the end came. For the same reasons cited above, the investment banks and hedge funds that survived found that their capital had been seriously eroded by this need to replenish their creditors' collateral. Hence the banks need to be re-capitalized. However, it is not clear that the government should do this re-capitalization through its $700 billion bill. Moreover, the surviving investment banks and hedge funds have realized that such high leverage ratios are not sustainable. So they would like to sell off the mortgage security and pay off some of their borrowings to the pension funds. But since they are all looking to sell off in the short-term, the prices of the mortgage securities are lower, which again requires further de-leveraging. This phenomenon is called the 'paradox of de-leveraging'. However, the real economy on Main Street need not wait for Wall Street to de-leverage. As I mentioned above, the financial meltdown would be avoided with or without the existence of the Wall Street firms. De-leveraging is solely Wall Street's problem, and it is highly unprofessional for Wall Street executives to keep sending out predictions of impending doom in the media.
Q5. Why have the markets for mortgage securities continued to remain illiquid?
A. The main reason that the markets for mortgage securities have been illiquid for a prolonged period of time is that the home-owner who is the only party with a credible and serious interest as a buyer of the mortgage securities has been shut out of the market. Instead of directly involving the home-owner, Wall Street has been peddling bizarre theories of risk management that has resulted in this huge mis-allocation of this $700 billion recently. By providing the information for a direct match-up of the home-owners on Main Street and the security-owners on Wall Street, the government could implement a low-cost eBay-type bidding system that would enable the home-owners to bid for the various tranches in the mortgage securities issued on their homes -- those tranches that the banks want to get rid of. This way the home-owners stand to benefit from a reduction in their debt obligations. The security-owners gets a floor on the prices of the mortgage securities and because of the decent prices, their capital gets replenished. Moreover, the home-owners' debt reduction can be structured in a way that encourages good behavior, and timely re-payment of the rest of the mortgage loan. This process would cost less than $1 billion for the government and achieves the objectives of liquidity and re-capitalization stated in the $700 billion bill. In addition, this direct match-up plan reduces foreclosures by reducing the home-owner's debt. Professor Martin Feldstein has also proposed a plan to reduce foreclosures. In his plan the government re-negotiates the home-owners' loans to provide debt reduction through low-interest loans, in return for enhanced claims on the home-owner. In my plan, the government's role is solely to provide reliable information.
Q6. What exactly is this great innovation of directing accumulated capital towards solving demographic problems that Wall Street has achieved?
A. Throughout history poor people have lived in subsistence conditions. Due to shorter life expectations than exist today, a poor man would have had to work for a living all his life. As mentioned above, the industrial economies of the 19th century Europe enabled the rise of a broad middle class with the means of hereditary wealth transfer and of supporting retired lifestyles. Contemporary times have raised the possibility that this access to wealth of a middle class standard could be further broadened to the whole of the population. Over the course of the 20th century, home-ownership had come to be a fundamental middle class aspiration throughout the world. In his "Lectures on Economic Growth", Professor Robert Lucas cites the travails of the characters in Sir V. S. Naipaul's "A House for Mr. Biswas" as the model for growth and development. Of course, I should also mention that Professor Lucas is more directly concerned with developing human capital rather than with home-ownership in his lectures quoted above.
Historically, massive accumulations of capital that are unrequited, have always been problematic. In addition, accumulation of capital has also resulted in the military-industrial complex. Professor Jeffry Frieden's "Global Capitalism: Its Fall and Rise in the Twentieth Century" is an excellent narration of how promises of global capitalism at the beginning of the 20th century quickly unraveled into the two World Wars. Thus matching the culturally and racially homogeneous retirement age population with the more diverse and younger home-owner population finds a gainful investment for the accumulated capital.
Q7. If Wall Street has been achieving all these great feats, where did it go wrong?
A. When concerns about the mortgage securities surfaced last year, many Wall Street investment firms claimed to be safe because they had not invested in sub-prime mortgages. This created a fear psychosis whence people began to consider these sub-prime mortgages as 'toxic'. The prime mortgage is one which meets the eligibility criterion for purchase by Fannie Mae and Freddie Mac. This includes a 20% down payment and good credit score. Those mortgages that don't meet this criterion were called sub-prime. Gradually, Fannie Mae and Freddie Mac also began to deal with these sub-prime mortgages. So, it didn't make sense to be denigrating sub-prime mortgages. Wall Street wasted a lot of time in late 2007 and early 2008 trying to discredit the sub-prime mortgages. In the modern economy, every single participant is beset with economic insecurity. So, the distinction between the prime and the sub-prime borrower, while it exists, is not really that great. Moreover, it is the sub-prime borrower who stands to gain the most by way of the development of human capital that Professor Lucas discusses in his "Lectures on Economic Growth". So, the sub-prime borrower would be the most willing, in the long-term, to highly value the inter-generational trade of wealth to support the senior citizens. Thus to discredit the sub-prime borrower has been the single major mistake that led to the financial crisis on Wall Street.
Q8. What are the lessons that can be drawn from the current financial crisis for government involvement?
A. Government's role is very important for avoiding crises, like the current one, in the future. The government should ensure that public transportation is available from home-owner colonies to their places of work. Most of the new single family homes are built in colonies of 100 or so, with whole neighbourhoods of new homes developed together. These new home colonies form suburban communities around cities and they are the symbols of affluence near towns. Because of their distance from the business districts, millions of these new home-owners drive their own cars to work. For example, it is not uncommon for software engineers and other professionals living near the Washington beltway to spend two or three hours on the road every working day, by way of commuting to work. Many of these new home colonies do not have frequent public transportation service. If the government would ensure that convenient and timely public transportation to their place of work is available, then this would save billions of dollars in oil expenses for America. Moreover, this way, the automobile would be seen as a luxury product, to be used in the evenings and in the weekends for entertainment, rather than as a necessity to get to work. This way the market for higher-end automobiles would benefit.
For people buying new homes, the government should ensure that they are fully informed about the economic and financial aspects of their investment. Equally importantly, they should not be overloaded with irrelevant, unreliable and unnecessary information. The best step would be ensure that the new home buyers are aware of the Case-Shiller Home Price Index. Currently this index is available only for 20 major American cities, and the data is collected for repeat sale homes, not new homes. But, being aware of this index is the best way new home-owners can be equipped for making financial decisions about their homes. The government should assist the managers of this price index financially so that they can gather empirical data for the prices of homes in all residential communities in America, not just on the 20 major cities. Apart from this, the government should ensure that low income people who are vulnerable to predatory lending are properly educated about the risks involved in sophisticated financial products, like adjustable rate mortgages.
Q9. What is the role of the Chairman of the US Federal Reserve Bank in finding a solution for this crisis?
A. As far as the Federal Reserve Bank is concerned, the most important and pressing need, at present, is for its Chairman, Professor Benjamin Bernanke to give a well-thought public speech that demonstrates that he understands the problems he is encountering in the markets. (I am still studying his speech given at National Association of Business Economists today. I would have more to say after I have studied his speech carefully). He has done a good job in injecting more than $1 trillion into the economy by way of short-term funds to provide liquidity. Moreover, I had given him high marks for his speech at Jackson Hole in August 22, 2008 in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008). It still seems that he is the only person in government who is thinking seriously about the current crisis. However, it appears that he has let himself be sidelined by the Secretary of the Treasury, Henry Paulson, who has exacerbated the crisis to global proportions through his Bazooka theory. The best service that Professor Bernanke can do for America is to recommend to the United States Congress that the spending of the $700 billion be postponed by three months.
The Federal Reserve would be well advised to restrict its actions solely to providing liquidity in the global financial system. In particular, changes in the Fed's interest rate are not advisable until a new government is sworn in. In this respect, one should note that one explanation for the persistent spread between the treasury yields and the inter-bank lending rates (TED spread) could be that the private banks, unlike the Fed, are not willing to lend money at real interest rates that are negative. This is a legitimate point, and it suggests that in fact it could be the Federal Reserve that has read the interest rate situation wrong. Then again, buying of commercial paper, as announced today (October 7) is ill-advised. More importantly, it is nearly a dereliction of duty to have approached the United States Congress for permission to spend $700 billion six weeks before a Presidential election. Professor Benjamin Bernanke had disassociated himself from this plan during his Congressional testimony, in fact, going to the extent of saying that he is just a college Professor, and has not worked on Wall Street and does not have any personal connections in the finance industry. The consensus among academic economists (as expressed by Professor Kenneth Rogoff) seems to be that the United States has a lot of money to spend, perhaps referring to the fact that countries in the rest of the world had their currencies seriously devalued in comparable situations like the East Asia crisis, the Russian crisis, Mexican crisis and the Latin American crisis. But, I should point out that $700 billion is about 5% of the annual GDP of the United States.
Q10. What is really ailing the American financial system? Doesn't the government need to intervene to salvage the situation?
A. The real problem is that the common man and the individual investor expect an honest and trust-worthy functioning of government. As I mentioned in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008), 'What the taxpayers (and the voters) within the United States, along with investors all over the world, most need to see, at this moment, is that there is a functioning legal (and legitimate) framework within which the financial markets play the role of enabling the process of economic decision-making towards optimal allocations of scarce resources'. At present, decision making at the government level has been taken over by vested interests. Both the Presidential candidates have promised to curtail the greed on Wall Street. The democrats have been complaining about executive compensation for many years now, and they have proposed government regulations of the finance industry in the future. The Republican candidate, Senator John McCain has openly called for the firing of the SEC Chairman Christopher Cox, and for prosecuting any fraudulent activities on Wall Street. This situation has given great jitters to Wall Street. So, the power mandarins on Wall Street have figured that they need to get the most they can before the current administration goes out of office at the end of the year. This seems to be the most credible explanation for their political activities of the last two months. However, I am no expert in political science, and I am just making my own conclusions based on my reading the news. The reader should consult a Political Science Professor on this question. My own point is that the government authorities have very little credibility, especially after the hilarious testimony to the US Congress two weeks ago. What is really ailing the American financial system, it seems to me, is a vacuum in the political leadership. Thus the role of the government in the current financial crisis should be minimized as much as possible until a new government is sworn in. The world runs on democratic principles much more than it does on fear of bazookas.
When are we we going to start to see serious numbers of people charged and arrested for wire fraud, conspiracy, etc.? Trust will not return to the markets until people are assured that those who cheated them are in jail, or, no longer work in the financial sector. And folks, that is a lot of people!
Let me again quickly run down the list of those eligible for arrest:
real estate agents and brokers (please arrest some of them; I won't mention names). They colluded to increase the price of homes to get fatter commissions;
appraisers who said homes were worth more than they actually were;
city and county bureaucrats who knew property appraisals were coming in too high but loved the increasing property tax revenues;
mortgage brokers and companies who offered liar loans (no documentation) and changed loan conditions at closing;
regular banks who started doing what mortgage companies did when they saw all the money being made;
Fannie & Freddie officials who bought all of the phony and unsupportable mortgage paper, knowing most of it was toxic;
Ditto for Wall St. banks, who sliced it up (securitized) into little pieces and sold them off to investors around the world;
Ditto for the insurance companies (i.e. AIG) who rated these investments AAA!;
Federal government-idiots, bought and paid for-most of them need to go to jail.
As you can see, since most of the financial and legislative system is criminally corrupt, no one of consequence is going to jail. Which means trust will not be restored anytime soon.
“But John McCain last night came up with the stupidest plan I've heard yet” Hey, McCain admitted economics isn’t his bag, “The issue of economics is not something I’ve understood as well as I should.” But he has Greenspan’s book. Where’s Phil Gramm when he needs him? Switzerland?
Doc:
We realize this is the Internet but you are a highly regarded college instructor, among all your other achievements. The word, term, is scot-free, not scott free.
Minor point I know, but if you can't spell "solutions" how can you prescribe them?
I think the rest of the world is waiting for the U.S. to fall. Then they will come together and stabilize global banking and their markets.
The world police (aka USA) won't be able to afford their military dominance and threats to control foreign commodities (aka oil, etc.).
The US needs to stop foreign investor runs on our markets, which is happening every day. We the American workers have been brain-washed into not touching our 401ks, but the rest of the world is seeking shelter from our FALL STREET.
It's Worse Than The Housing Bill Plan
The Curious Capitalist agrees with me about the McCain plan and gives more context:
"John McCain's announcement during the debate Tuesday night that he wants the government to spend $300 billion buying up mortgages and rewriting the terms was something of a landmark in the national discussion over what to do about our financial mess. Yeah, it was a half-baked proposal that made no acknowledgement of the fact that Barney Frank and Chris Dodd have already gotten a similar if far-less-bold and far less expensive plan enacted into law (without much help from either McCain or Obama, who missed both the April 10 the July 26 Senate votes on the bill). As the LA Times reports:...
According to the outline of McCain's newest proposal, the federal government would pay borrowers and lenders in full, regardless of how wise or fair the original transaction was. Lenders would be able to remove the bad mortgages from their balance sheets, and borrowers would be able to refinance into government-guaranteed loans. Mortgage holders would have to prove they lived in the home and had good credit at the time of the original loan. ...
By contrast, the housing bill passed by Congress over the summer, and which went into effect Oct. 1, required lenders to take a loss by writing down the principal on troubled mortgages to 85% of the house's current value. Borrowers with adequate incomes and credit records would then qualify for refinanced mortgages from new lenders.
Government funds were used only to help finance mortgage insurance for the new loans; cost estimate for taxpayers was roughly $20 billion."
This plan seems worse than the housing bill plan.
But notice this:
Is Paulson Considering The Swedish Plan?
Paul Krugman posted this before I got to it. Justin Fox at The Curious Capitalist is on a roll:
"Did anybody else notice that when Hank Paulson was describing in his press conference today what the Emergency Economic Stabilization Act enables Treasury to do, the first thing he listed was "to inject capital into financial institutions"?
That wasn't how Treasury initially advertised its Troubled Asset Relief Program. It was sold as a way to get the market for mortgage securities moving (or, to use the jargon, liquid). Lots of academic economists objected that liquidity wasn't the problem, it was insolvency. What Treasury needed to do was recapitalize financial institutions and take equity stakes in return...
But Congress went ahead and forced on Paulson a provision that said he had to get equity or senior debt from financial institutions in exchange for taking significant assets off their hands--effectively enabling backdoor recapitalizations. Yesterday Ben Bernanke hinted that a change in emphasis might be in the offing for the TARP. And today Paulson seemed to confirm it.
None of the people asking questions at the press conference really seemed to pick up on this, of course (&%%$# Washington journalists!). Along with Paulson's affirmation that the FDIC was going to use its "systemic risk" powers to protect depositors and unsecured creditors "as appropriate," I take it as one more sign that we're headed toward a Swedish solution of our banking crisis—recapitalization and temporary nationalization of much of the banking system. This is the right thing to do, I think. But I'm still a little bit confused as to why Paulson had to back into this instead of asking for it in the first place. Maybe because he thought President Bush would never sign a bill to nationalize the banks? Just a thought."
God I hope he's correct.
As for a stimulus:
My Team Wants A Stimulus Package
Ezra Klein says the following:
"It's cruel irony that turmoil caused by elites gaming the financial markets has managed to rip attention from the struggles of the broader economy."
Actually, a number of people have commented on the need for a stimulus package for the economy:
Lawrence Summers:
"Indeed, in the current circumstances the case for fiscal stimulus -- policy actions that increase short-term deficits -- is stronger than ever before in my professional lifetime. Unemployment is almost certain to increase -- probably to the highest levels in a generation. Monetary policy has little scope to stimulate the economy given how low interest rates already are and the problems in the financial system. Global experience with economic downturns caused by financial distress suggests that while they are of uncertain depth, they are almost always of long duration.
The economic point here can be made straightforwardly: The more people who are unemployed, the more desirable it is that government takes steps to put them back to work by investing in infrastructure or energy or simply by providing tax cuts that allow families to avoid cutting back on their spending."
Robert Reich:
"Wall Street and its creditors are not at the core of the American economy. Main Street and consumers are at the core. So even if the bailout bill keeps Wall Street going and prevents the sort of massive defaults that would freeze global credit markets, it does virtually nothing to help the vast majority of American consumers who are already at the end of their ropes -- who right now need extended unemployment insurance, affordable health coverage, and assistance in meeting their mortgage payments and fuel bills. And as long as Americans remain at the end of their ropes, the American economy will continue to decline.
So the real choice isn't between a lousy bailout bill or economic Armageddon. It's between taking prompt action to help average Americans or watching the nation fall into a deeper and deeper recession. Wall Street will be bailed out. The bigger question is whether Congress and the next administration do what's needed to rescue the rest of America, and the overall economy."
Paul Krugman:
"We also desperately need an economic stimulus plan to push back against the slump in spending and employment. And this time it had better be a serious plan that doesn’t rely on the magic of tax cuts, but instead spends money where it’s needed. (Aid to cash-strapped state and local governments, which are slashing spending at precisely the worst moment, is also a priority.) Yet it’s hard to imagine the Bush administration, in its final months, overseeing the creation of a new Works Progress Administration."
Robert Kuttner:
"Third, with the real economy now suffering real damage, the Wall Street rescue should be linked to a big stimulus package to pump money into the rest of the economy -- infrastructure spending, help to state and local governments, and extended unemployment benefits."
Sen. Obama:
"As soon as we pass this rescue plan, we need to move with the same sense of urgency to rescue families on Main Street who are struggling to pay their bills and keep their jobs. I’ve said it before and I’ll say it again: we need to pass an economic stimulus plan that will help folks cope with rising food and gas prices, save one million jobs by rebuilding our schools and roads, and help states and cities avoid budget cuts and tax increases. A plan that would extend expiring unemployment benefits for those Americans who’ve lost their jobs and cannot find new ones."
Sen. Obama also said the following:
"We cannot mortgage our children’s future on a mountain of debt. It’s time to put an end to the run-away spending and the record deficits – it’s not how you would run your family budget, and it must not be how Washington handles your tax dollars. It’s time to return to the fiscal responsibility and pay as you go budgeting that we had in the 1990s. Many in Congress have been fighting for these commonsense principles, and I will be a President who supports them and makes sure they succeed. That’s why I’m not going to stand here and simply tell you what I’m going to spend – I’m going to start by telling you how we’re going to save when I am President.
I will go through the entire federal budget, page by page, line by line, and eliminate the programs that don’t work and aren’t needed. We should start by ending a war in Iraq that is costing us $10 billion a month while the Iraqi government sits on a $79 billion surplus. We should stop sending $15 billion a year in overpayments to insurance companies for Medicare, and go after tens of billions of dollars in Medicare and Medicaid fraud. We need to stop sending three billion a year to banks that provide student loans the government could provide for less. And we can end the hundreds of millions a year in subsidies to agribusiness that can survive just fine without your tax dollars, and use some of the money to help struggling family farmers. That’s what I’ll do as President.
And we can’t stop there. We lose $100 billion every year because corporations set up mailboxes offshore so they can avoid paying a dime of taxes in America. In the Senate, I worked across the aisle to crack down on these schemes. And as President, I will shut down those offshore tax havens and all those corporate loopholes once and for all. You shouldn’t have to pay higher taxes because some big corporation cut corners to avoid paying theirs. All of us have a responsibility to pay our fair share. That’s accountability. And that’s what we’ll have when I’m President.
As for the programs we do need, I will make them work better and cost less. I will create a High-Performance Team of experts that evaluates every agency and every office based on how well they’re serving the American taxpayer. I will save billions of dollars by cutting private contractors and improving management and oversight of the hundreds of billions of dollars our government spends on contracts. And I will finally end the abuse of no-bid contracts once and for all – the days of sweetheart deals for Halliburton will be over when I’m in the White House."
So, it's pretty clear that my team wants a stimulus package. From a libertarian Democrat point of view, we want to examine the effectiveness of the stimulus, and the budget ramifications of the stimulus.
Finally, I believe that one reason a stimulus package is not receiving much coverage right now is because it will have to wait for the next administration.
Don the libertarian Democrat
Weasel:
I actually like the lowering corporate taxes idea because we have already seen the stimulative effects of more favorable business environments in our country. More business friendly states like Texas and Arizona are growing like weeks whereas more regulatory and tax-heavy states like Massachusetts, Michigan, and New York are losing jobs by the day.
I always try to ask myself what I would do if I had the option. For example, I am a Red Sox fan and many of my compatriots were upset when Johnny Damon left Boston to play for the Yankees. But, I asked myself, "What would I do if I was Johnny Damon and had been offered millions more from New York with the realization that this is probably my last big contract?" I have to admit, despite the fact that we Boston fans aren't Yankee fans, I would have taken the money. And, Johnny didn't grow up a Boston fan, so it was probably an easier decision for him.
So, if I was setting up a business and could establish it here with 35% tax rates or in some other country with single digit or low double digit tax rates, I would do it as long as the incremental costs of doing business that way were less than $0.25 of every dollar of profit earned.
So, let's turn to Exxon/Mobil, which seems to be everyone's favorite target, despite the fact that they're not particularly profitable (net income is 10% of revenue). Biden and Obama say that McCain's plan would cost America $300 billion and that $4 billion of that would be from XOM.
XOM had $405 billion of revenue last year and around 81,000 employees, which works out to around $5 million of revenue per employee. Captal expenditures were $15 billion and operating expenses were $100 billion, which is about $1.5 million per employee.
So, let's say that XOM now got another $4 billion to play with...
One could argue that they would simply add that to the bottom line and give out big bonuses to the executives while still enriching the shareholder. But, I don't think they would do that because shareholder wealth maximizing companies seek multiple expansion through free cash flow growth. Simply passing the $4 billion to the bottom line would be a one-time free cash flow event. However, reinvesting those dollars could make them grow into something more and result in multiple expansion (a higher P/E ratio).
Assuming that XOM was able to transform that incremental $4 billion at the same return as its total business, then you're talking about 8,000 new jobs per year from XOM. Extrapolating that to the $300 billion gets you 600,000 incremental jobs per year.
Now that's all very quick, back of the envelope, but I think it does provide some insight into the thinking behind the proposal. And, please remember, this is not McCain's idea. He is just pimping it.
Some may see this as trickle down economics, but I don't think that it is the same as trying to give wealthy people tax breaks under the argument that their greater consumption will create more wealth for all (I don't buy that one as much, though I do think that the wealthy pay more than their fair share of taxes). I truly believe that shareholders would punish any company that simply tried to drop those dollars to the bottom line without seeking to productively reinvest them.
Anonymous Matt
Weasel:
No idea on your question. Probably some idiot second cousin of a highly placed pol.
AM
" He wants the government to buy mortgages from the banks at face value and then write down the principal for homeowners. This would be the biggest handout yet to the financial industry. Taxpayers would take all the losses, including the downside risks of additional defaults if houses drop further in value, while the banks would get off scott free."
You noticed that too? Seems our royalist republicans, think the serfs should bear the costs of the excesses of the royal family.
They are socialist, and advocate socialism for bankers and investors.
Who knew?
Matt,
In your $4 billion example showing job generation benefits assuming Exxon/Mobil reinvested it, I would agree if they reinvested it in Alternate Fuels ... where job generation is equally if not more promising.
I favor a windfall profits tax that is in effect nullified if the oil company reinvests the computed tax sum into new types of clean energy supplies. Of course, this would require disciplined Oversight of oil company Capital Budgets.
It is quite known that most oil firms invest a very small percentage of their annual Capital Budgets in Alternate Fuels today. An option would be to stimulate them to move towards a 4 year target of having at least 15% of their annual Capital Budgets going to development of energy sources other than fossil fuels.
Otherwise, the government should assess the oil firms a windfall profits tax and use funds to promote development of clean, safe non-fossil fuels. An added advantage here is that more flexible, entrepreneurial firms will probably manage the stimulus funds more effectively and innovatively than the bureaucratic oil firms.
Obama is right about paying as much attention to creative tax revenue generation as to cutting spending to help pay for the critical Investments needed in our economy ... especially in light of dramatic growth in our National Debt to $11.2 trillion range and rising each month.
John McCain's plan obviously doesn't work. With the jobs that have gone offshore, and otherwise lost in the United States, there will be no need for more than one bank, and only one micro-tiny mortgage company.
I can savor having the common sense not to vote for George W Bush for another few weeks.
I think trust needs to be coupled to "who is a liar?" Think back to everyone who got in turmoil over matt drudge and Rush Limbaugh running on and on about Bill Clinton lying under oath. The root of that problem was what goes on behind closed doors is nobody's business.
Ron Paul puts it a little better: what the main stream media presents to the American middle class is rarely what's important to their lives.
Now we have the American people unwilling or unable to recognize liars unless it's matt and Rush who point them out.
Honestly I believe it probably takes economic cataclysm to drive a wedge between the American middle class and Roger Ailes.
Plus, if he did that it would only make me madder that I didn't buy a house irresponsibly.
Anonymous Matt argues that giving XOM a $4B tax break will create 8,000 new jobs.
I'm no math whiz, but on my calculator, that works out to $500K per new job. That's seems a bit steep.
It was with great interest I heard your blog comments this evening on the radio (Marketplace I believe). Especially the comment about the government spending money into infrastructure. This is something I have been ranting about for years (and of course, no one pays attention to me LOL). Not only does it serve to move money through the market, but it gets back to the idea of a public works program, where people are put to work, given jobs that have some meaning, and earn an honest wage for honest work. From there, education will benefit as well, and health care, etc. I really believe that a 21st century public works program will be the catalyst that really launches us forward again, with sustained momentum.
The other interesting article I heard on NPR was about the CCC (Civilian Conservation Corps), and the structure it provided for many young men. Eventually, many of these men became our soldiers in WWII, and the training and discipline of the CCC made them the great force for freedom and democracy that they were. I think we will always have a need for a military presence (whether we like it or not), and having vast reserves of people trained and ready to provide assistance abroad (like the peace corps - Obama must be reading my mind!) will be fundamental to our success. Developing nations (and developed nations) don't want a military presence to remind them of their failures once the fighting is done. They need assistance building schools, agriculture, industry, and infrastructure - and this corps will have the experience from work here in the US.
Much easier to win the hearts and mind when the weapons are stowed out of sight (but within reach...).
First, would someone, anyone, please explain to me how spending MORE money on "education" will solve the broken public school problem. We already spend more per pupil than any other country.
Second, it is disingenuous, expected of course, for anyone to put blame on the idiot republicans or the idiot democrats. They are all idiots. Those who said year after year that this was coming were laughed at, scorned, dismissed e.g. Ron Paul. What has he not been right about, but I do not hear any one suggesting we might want to give him a hearing.
Third, when will we learn that college is not the answer for much of anything. College is an overpriced industry run mostly by liberals for liberals. They hand out these ridiculous degrees all the way up to ph.d and then demand that these "graduates" be employed at high wages. Get over it! The guy driving the 5000 gallon tanker delivering fuel is worth more to me than a neurosurgeon for goodness sakes.
There are no answers to this nightmare other than maybe time, heartache and even people dying from lack of something.
All we need is leadership??? BAH! You cannot lead this balkanized country full of people more concerned with ethnic identity than with the general welfare. Trust me, people are worried about their own hides, not their neighbor.
First, Obama has to win, then he can do whatever the lobbyists want him to do. I've asked before: how many banks have to collapse before the American Bankers Association runs out of lobbying money?
Even my life long Republican husband stated today he thinks George W. Bush's economic policies are a dismal failure.
also "stupidest" not "stupidist" plan. that is, unless you were referring to the nascent stupidism movement.
"My friends", we are on the first floor of the World Trade Center. Something bad has occurred above our level, but we don't know what to do. So here we sit wondering, waiting. What is going on? What is happening? When will someone tell us what to do? What are those "thunks" on the roof? Oh, those are falling bodies. Oh, when will someone do something. Oh, oh, oh....
And now you know the rest of the story.
THUNK! THUD! THUNK! Y'all wait right there, help is on the way.
Bravo!
I'm a big social democrat, but McCain's idea definitely was the worst idea I've heard so far: a huge expense, no equilibrium of prices, and no restoration of moral hazard. I'm not even sure what the criteria is for which houses fall under this plan and which don't...what's the rubric?
And on the same day as Sarkozy came up with a similar plan...I guess McCain is French now...I'm sure the conservative base loves that, LOL!
I guess she heard you:
http://www.washingtonpost.com/wp-dyn/content/article/2008/10/08/AR2008100803533.html?hpid=topnews
"House Speaker Nancy Pelosi said yesterday that she may call lawmakers back to Washington after the Nov. 4 elections to put together a new federal spending package worth as much as $150 billion in hopes of stimulating the nation's flagging economy.
"We have some very harsh decisions to make and some of them can't wait until January," Pelosi (D-Calif.) told reporters at a health clinic in Denver. "We may have to go back into session before the next Congress."
Don the libertarian Democrat
I want to talk for a few minutes with the people of the United States about banking -- with the comparatively few who understand the mechanics of banking but more particularly with the overwhelming majority who use banks for the making of deposits and the drawing of checks. I want to tell you what has been done in the last few days, why it was done, and what the next steps are going to be. I recognize that the many proclamations from State Capitols and from Washington, the legislation, the Treasury regulations, etc., couched for the most part in banking and legal terms should be explained for the benefit of the average citizen. I owe this in particular because of the fortitude and good temper with which everybody has accepted the inconvenience and hardships of the banking holiday. I know that when you understand what we in Washington have been about I shall continue to have your cooperation as fully as I have had your sympathy and help during the past week.
First of all let me state the simple fact that when you deposit money in a bank the bank does not put the money into a safe deposit vault. It invests your money in many different forms of credit-bonds, commercial paper, mortgages and many other kinds of loans. In other words, the bank puts your money to work to keep the wheels of industry and of agriculture turning around. A comparatively small part of the money you put into the bank is kept in currency -- an amount which in normal times is wholly sufficient to cover the cash needs of the average citizen. In other words the total amount of all the currency in the country is only a small fraction of the total deposits in all of the banks.
What, then, happened during the last few days of February and the first few days of March? Because of undermined confidence on the part of the public, there was a general rush by a large portion of our population to turn bank deposits into currency or gold. -- A rush so great that the soundest banks could not get enough currency to meet the demand. The reason for this was that on the spur of the moment it was, of course, impossible to sell perfectly sound assets of a bank and convert them into cash except at panic prices far below their real value.
By the afternoon of March 3 scarcely a bank in the country was open to do business. Proclamations temporarily closing them in whose or in part had been issued by the Governors in almost all the states.
It was then that I issued the proclamation providing for the nation-wide bank holiday, and this was the first step in the Government's reconstruction of our financial and economic fabric.
The second step was the legislation promptly and patriotically passed by the Congress confirming my proclamation and broadening my powers so that it became possible in view of the requirement of time to entend (sic) the holiday and lift the ban of that holiday gradually. This law also gave authority to develop a program of rehabilitation of our banking facilities. I want to tell our citizens in every part of the Nation that the national Congress -- Republicans and Democrats alike -- showed by this action a devotion to public welfare and a realization of the emergency and the necessity for speed that it is difficult to match in our history.
The third stage has been the series of regulations permitting the banks to continue their functions to take care of the distribution of food and household necessities and the payment of payrolls.
This bank holiday while resulting in many cases in great inconvenience is affording us the opportunity to supply the currency necessary to meet the situation. No sound bank is a dollar worse off than it was when it closed its doors last Monday. Neither is any bank which may turn out not to be in a position for immediate opening. The new law allows the twelve Federal Reserve banks to issue additional currency on good assets and thus the banks which reopen will be able to meet every legitimate call. The new currency is being sent out by the Bureau of Engraving and Printing in large volume to every part of the country. It is sound currency because it is backed by actual, good assets.
As a result we start tomorrow, Monday, with the opening of banks in the twelve Federal Reserve bank cities -- those banks which on first examination by the Treasury have already been found to be all right. This will be followed on Tuesday by the resumption of all their functions by banks already found to be sound in cities where there are recognized clearing houses. That means about 250 cities of the United States.
On Wednesday and succeeding days banks in smaller places all through the country will resume business, subject, of course, to the Government's physical ability to complete its survey. It is necessary that the reopening of banks be extended over a period in order to permit the banks to make applications for necessary loans, to obtain currency needed to meet their requirements and to enable the Government to make common sense checkups. Let me make it clear to you that if your bank does not open the first day you are by no means justified in believing that it will not open. A bank that opens on one of the subsequent days is in exactly the same status as the bank that opens tomorrow.
I know that many people are worrying about State banks not members of the Federal Reserve System. These banks can and will receive assistance from members banks and from the Reconstruction Finance Corporation. These state banks are following the same course as the national banks except that they get their licenses to resume business from the state authorities, and these authorities have been asked by the Secretary of the Treasury to permit their good banks to open up on the same schedule as the national banks. I am confident that the state banking departments will be as careful as the National Government in the policy relating to the opening of banks and will follow the same broad policy. It is possible that when the banks resume a very few people who have not recovered from their fear may again begin withdrawals. Let me make it clear that the banks will take care of all needs -- and it is my belief that hoarding during the past week has become an exceedingly unfashionable pastime. It needs no prophet to tell you that when the people find that they can get their money -- that they can get it when they want it for all legitimate purposes -- the phantom of fear will soon be laid. People will again be glad to have their money where it will be safely taken care of and where they can use it conveniently at any time. I can assure you that it is safer to keep your money in a reopened bank than under the mattress.
The success of our whole great national program depends, of course, upon the cooperation of the public -- on its intelligent support and use of a reliable system.
Remember that the essential accomplishment of the new legislation is that it makes it possible for banks more readily to convert their assets into cash than was the case before. More liberal provision has been made for banks to borrow on these assets at the Reserve Banks and more liberal provision has also been made for issuing currency on the security of those good assets. This currency is not fiat currency. It is issued only on adequate security -- and every good bank has an abundance of such security.
One more point before I close. There will be, of course, some banks unable to reopen without being reorganized. The new law allows the Government to assist in making these reorganizations quickly and effectively and even allows the Government to subscribe to at least a part of new capital which may be required.
I hope you can see from this elemental recital of what your government is doing that there is nothing complex, or radical in the process.
We had a bad banking situation. Some of our bankers had shown themselves either incompetent or dishonest in their handling of the people's funds. They had used the money entrusted to them in speculations and unwise loans. This was of course not true in the vast majority of our banks but it was true in enough of them to shock the people for a time into a sense of insecurity and to put them into a frame of mind where they did not differentiate, but seemed to assume that the acts of a comparative few had tainted them all. It was the Government's job to straighten out this situation and do it as quickly as possible -- and the job is being performed .
I do not promise you that every bank will be reopened or that individual losses will not be suffered, but there will be no losses that possibly could be avoided; and there would have been more and greater losses had we continued to drift. I can even promise you salvation for some at least of the sorely pressed banks. We shall be engaged not merely in reopening sound banks but in the creation of sound banks through reorganization. It has been wonderful to me to catch the note of confidence from all over the country. I can never be sufficiently grateful to the people for the loyal support they have given me in their acceptance of the judgment that has dictated our course, even though all of our processes may not have seemed clear to them.
After all there is an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people. Confidence and courage are the essentials of success in carrying out our plan. You people must have faith; you must not be stampeded by rumors or guesses. Let us unite in banishing fear. We have provided the machinery to restore our financial system; it is up to you to support and make it work.
It is your problem no less than it is mine. Together we cannot fail.
FDR Fireside Chat, March 12, 1933
http://www.mhric.org/fdr/chat1.html
I've really enjoyed reading your posts on the current situation. Your trenchant comments on McCain's plan are great; I'd like to see you elaborate them more (especially if he bothers to elaborate his plan in greater detail).
It seems to me one additional way to help homeowners is for the government to assist those who can afford to to upgrade their houses to maximum energy efficiency. This should also be done for any housing the government buys. It would help kick-start the home construction trades by doing these upgrades until they're back to building new houses. Eventually low cost / no cost loans like this this should be provided for all homes and small businesses down the road once we are back on our feet.
It's also crucial that any long term energy plan start by conserving and squeezing out every last photon of energy we use to bring overall requirements down. And it develops a market for renewable energy resources such as solar by starting to put them into place. Roads and bridges are important too, but the short term benefits might be recognized by the public at large when people begin cutting their energy bills by a third or more.
I was pleased to recently discover your blog. Your thoughts regarding this global meltdown give me solace. I hope to have opportunity to see your ideas drawn upon as a policy response forms around this crisis. We need you in the brain trust. Good leadership would go a long way toward rebuilding our trust. The timing of the election and the current lack of leadership could not be worse. It really compounds a bad situation. Let's hope we catch some luck.
I find it interesting to look back at the source of the problem.
Consumer belt tightening happens because they have less discretionary income. One of the initial causes of belt-tightening is the exporting of jobs overseas, which started earlier in this decade. That was the first domino that fell, hitting IT and manufacturing.
If you happened to be one of the people who purchased an adjustable mortgage prior to the initial rush to export jobs, you wouldn't feel the personal pinch until 3 to 5 years later. The the ARM holders start tightening their belts due to increased housing costs. At to that people who continue to lose their jobs to outsourcing, or have their income tied to consumer spending. More belt tightening and the loop repeats.
In a market driven by consumer spending, if you start cutting out the source of their money to spend (by eliminating jobs), eventually it hits the economy.
The economic hit would have come faster if there hadn't been free-flowing credit.
The lessons learned here are:
-- you can't expect the economy to keep expanding if the people you are counting on to expand the economy don't have discretionary income.
-- shedding on type of job (example manufacturing) to lower costs hurts the economy in the long run if there aren't replacement job (at equivalent salaries).
-- very few people look at the long run (business, gov't, and consumers). It's time to study history, make thoughtful projections and what-if scenarios, and make smart decisions for the long run.
Once those lessons are absorbed and applied, perhaps things will get better. I see a long decline, until everyone wises up. We need those FDR-type infrastructure programs, as Mr. Reich suggests, to get employment and personal incomes back on a steady pace.
I know the Limbaugh's of the world like to say, "Roosevelt is dead!". But guess what, Reagan is too. So, what are we going to learn from these two presidents and their economic policies?
Now that Reaganomics and quasi-laissez-faire capitalism have been thoroughly discredited as they should be having brought the world the greatest financial crisis in almost a century, now is the time for the US economy to be fundamentally restructured. Hopefully, this will happen if Obama and the Democrats win in the upcoming elections. There are three primary areas or sectors that need attention: (1) financial services, (2) health care and (3) the military-industrial complex. These three sectors provide the bulk of the jobs in the US economy and hence are large contributors to GDP. However, they need to be reduced. How, you say, can you reduce jobs in a recession throwing even more people out of work? Well it can be done if you provide jobs in other sectors, and the only entity (contrary to Reagan's mantra - "Government is the problem, not the solution") that can oversee this process is government.
Let's consider financial services first. More than any other sector, financial services is responsible for the world wide economic meltdown. They've ginned up exotic and sopisticated financial products that have resulted in a world wide Ponzi scheme presided over by nobody. They have been very successful in getting government out of our lives by repealing the Glass-Steagall Act that was largely responsible for getting us out of the Great Depression. Now since their campaign against FDR and his various acts and agencies has been shown to be the wrong approach, it's time to reinstate Glass-Steagall, reregulate the financial sector and diminish if not eliminate the exotic financial products like derivatives and credit default swaps that got us into this mess. It's clear that Bernanke and Paulson don't know what they're doing. They're just throwing money at the problem - a few hundred billion here and a few hundred billion there. Pretty soon it will add up to real money! :) Instead, it's time to rebuild the American economy from the ground up. All those Harvard MBAs that were counting on making a killing on Wall Steet will have to be disappointed because that component of GDP will have to diminsh. Those jobs should be eliminated as the financial sector is simplified, regulated and diminished. The financialization of America needs to come to an end, and the production of real goods and services needs to be started again.
The military-industrial complex which is responsible directly and indirectly for perhaps half the jobs in the US militarized economy needs to change. Look at all the job it provides! Look at all the GDP it generates! Here, more than anywhere else, is a sector that needs to be reduced and restructured. Budget outlays need to be slashed. Unfortunately, jobs need to be cut. This sector is the most wasteful on the planet. The US spends more on its military than the rest of the world combined and look where it has gotten us! The collapse of the Roman Empire was a mild recession compared to the mess the US is in right now. Here again the Federal budget that is taken away from the military-industrial complex can be redirected to other more positive sectors like infrastructure rebuilding, alternative energy production and environmentally sound construction projects. People's energies can be redirected to more wholesome spheres, and the real defense of the US can be made stronger and better than ever for half the money spent right now.
Jobs can be created in one sector while being destroyed in another. As long as a job is created in a more benign sector for every one destroyed, I would argue that progress is being made. The Hindus have gods of creation and gods of destruction, Shiva and Vishnu, and somehow these gods create a balance. Both creation and destruction are necessary. What we need is a balanced economy, and to get there some jobs have to be created and others destroyed. In this process greater unemployment and welfare benefits should be granted so that the poor suffer the least, contrary to the usual scenario in times of great change. Basic standards of living should be guaranteed and maintained with government support if necessary. The "least of these our brethren," the homeless, should be cared for and not treated with benign neglect as they are now. However, the wealthy may have to sacrifice their yachts and mansions. I advocate a wealth tax, a tax on assets over $10 million to provide funding and balance the budget. The wealthiest 400 families have added $680 billion to their assets in the last 8 years. Now it should be their turn to pay some of it back in return for the mess that they primarily have created and are responsible for.
You know there are other models in the world of societies that have been much more successful in providing a high quality of life for their citizens than the American model. I suggest we look elsewhere for some good ideas now that the USA is effectively bankrupt. And the last shoe has probably not fallen. So far the only thing that Bernanke and Paulson have proven they're good at is transferring private debt to public debt, but this only makes the problem worse in the long run because it puts the US government and, consequently, the US people as a whole in an even more precarious and unsustainable position. Dick Cheney said, "The American way of life is non-negotiable." But the American way of life has become the American way of death. The American way of life is a house built on sand in the midst of a tsunami. I know that better societal models do exist.
In my travels in Europe I noticed that the two biggest differences between the European way of life and the American way of life are the following. In Europe the average person lives in an apartment or condo, not a detached single family house on a lot, and Europeans are much more oriented to public transportation while Americans have a culture of the private automobile. Some American cities are trying to change that pattern. San Diego, for instance, has a redevelopment agency, the CCDC, which is in the process of encouraging high rise and mid-rise development near trolley stations and public transportation hubs so that people don't have to commute to McMansions in the suburbs. It makes a lot more sense. Meanwhile, the state of California is spending a small fortune on adding more freeway lanes and rebuilding overpasses and underpasses on the freeways. That money could be better spent on high speed rail transportation and enlarging the trolly and suburban commuter rail system. However, quasi-governmental oversight, brought to us by the CCDC, has been responsible for rebuilding downtown San Diego into a city with human dimensions that we can all be proud of from the trash heap it was 30 years ago. This took planning, guidance and the dedication of a few intelligent and committed people, and it has by and large been successful. Maybe it can be a model for the redevelopment of the US economy.
The American way of life is non-negotiable? Is this why we have to fight wars and try to dominate the rest of the world? If so, it's not worth it. May I suggest that there may be even better ways of life than the American way. Well realty is negotiating for us. We can either participate in the process and create a new and better American way of life or stand idly by and let the whole way of life collapse around us.
Links and more verbiage can be found on Will Blog For Food
Anonymous:
It's not $500k per job. It's 1 job per $5mm of revenue. And, you have to back into it from a return on invested capital assumption.
I assumed that their ROIC in this example was equal to their net profit margin, which makes it a conservative estimate because the way you really do ROIC is on an after tax operating basis. In this case, taxes would be lower, which would drive more ROIC, implying even greater revenues and thus more jobs at 1 job per $5mm of revenue.
As I said, it was a very rough calculation intended only to show the thinking behind the proposal.
The real argument is whether or not you believe that companies would invest the excess cash created by a lower tax rate. Some say they would and some say they wouldn't. I believe they would because my experience is that the primary motivation of management is multiple expansion. They would tell you that this is because they love the shareholder, but in reality is how they can generate massive financial upside for themselves.
Frank has an interesting take on this, though I don't agree because I don't favor having the government tell companies where to invest their capital dollars. I believe that corporations should seek to invest their capital where they can drive the most return. That said, I don't read his views and my views on this as being that far apart.
Anonymous Matt
Matt,
Curious as to why lowered corporate taxes would create jobs now, when the last eight years have plainly shown that lowering corporate taxes did not create jobs in the US?
One definition of insanity is doing the same thing but expecting different results.
psu77
All I can say is that I hope you, Mr. Secretary, will be in Obama's cabinet. While President Bush was contemplating the privatization of social security, you made a remark about not turning people's savings into a casino. You couldn't have been more right. Also, I can't agree with you enough that we must invest in our infrastructure. All this bla, bla patriotism by the right and with no results to show for it. Let's walk with grace and just get things done. We (us Americans) don't have to prove that we love our country. At any rate, keep up the good work. You are one of the premier intellectuals of our time!!
After Obama wins, I hope he assembles cabinet positions that use a committees, rather then risking the judgement of one individual.
e.g. Sec of Treas: Warren Buffet, Ron Paul, etc.
e.g. Sec of Foreign Affairs:
Collin Powell, Bill Clinton, Jimmy Carter, etc.
e.g. Sec of Labor:
Robert Reich, Dennis Kacinich, etc.
_Dr. Reich, you keep pushing a national infrastructure rebuilding program, funded by increased Federal deficit spending, but this will merely pour more vast sums of taxpayer indebted money into a handfull of corporations which dominate the infrastructure industry. This isn't 1954 where new roads, built by vast numbers of semi skilled and unskilled laborers, created increased demand for more automobiles, more vacation business and second homes, more tourist activities, motels, hotels, etc, ,etc., etc.
Like most current government interventions, the bulk of the money will flow to a wealthy few already very rich folks and the average Americans will just get the bills.
Silverfox...
I agree with your assumption, unless a plan is developed like the Civilian Conservation Corp in the 1930's.
The infrastructure companies would need to be American based and use only US citizens.
I can imagine a Halliburton coming in to run this and hiring 2 million illegal aliens (doesn't that sound like a plan the Republicans would propose??)
Bush has outsourced most of the Iraq war to contractors that have ties to Cheney et al. buddies.
The extended Bush family is making millions off of the Iraq war.
Matt:
C'mon! Your talking like a highly paid business executive.
XOM is a poor choice for an example. They have been making outlandish profits over the last 8 years and they have decreased employment not increased it. They have spent the majority of their unfathomable profits in repurchasing their own stock and it's doubtful they would do anything else but that with another $4 billion.
So, let's turn to Exxon/Mobil, which seems to be everyone's favorite target, despite the fact that they're not particularly profitable (net income is 10% of revenue). (emphasis added)
Doubt you have looked closely but I have been railing on here for months that XOM's stated profit margin is bogus. The gasoline taxes they collect for the government are categorized as excise taxes and thus are included in gross revenues and then deducted as costs of goods. They are applied consistent with excise taxes but are more truly similar to trust taxes in that the taxes are collected for the various government entities and are passed through to them. As you know accounting is not always the vehicle of truth.
What this treatment does is inflates gross revenues but via the deduction is profit neutral. You know the calulation for profit margins. What would their profit margins be if they deducted the taxes from both revenues and costs. Profits would be unchanged but profit margins would skyrocket, very probably doubling.
Look closely and you will see that while gross revenues of XOM have increased 115% since 1999, after tax profits have risen 413%. While those profit margins have risen sharply XOM's R&D expenditures have risen 29%; Capital and Exploration expenditures rose by only 57%; Average Capital Employed by only 54%; Total Assets are up by 68%; Total Debt is down by 50%; and Cash Dividends are only up by 30%. Given their profit performance and their stock repurchases one would expect much higher dividend payouts but they can assuage their stockholders by repurchasing stock and driving stock prices higher with better EPS. Meanwhile the CEO of XOM received an 18.6% increase in his earnings last year. Wanna bet on the wage increase percentage of the rank and file?
If we analyze their reinvestments in expansion, as opposed to retiring stock, there is little evidence that another $4 billion in tax savings will be invested in providing more oil and lower prices for that oil and gas. The interesting dichotomy is that more exploration, leading to greater supplies, will lower prices which will lower profits. What option would you pursue?
In an industry whose profits are predicated on prices and those prices are set, significantly, by sources outside the actual production market, and bear no relationship to increased production/delivery costs, then attempting to cast them on a per employee basis is meaningless, if not folly. That kind of analysis leads you to assumptions that have no foundation in reality. Attempting to extrapolate some euphoric job creation numbers from an increase in profits in most industries, other than hugely labor intensive ones, is an exercise in futility if not witchcraft.
Now you, in typical conservative fashion, harp on the 35% corporate tax rate. You and I both know that few corporations, if any, pay taxes at this rate. Our tax laws allow a variety of alternative treatments for certain expenditure classes as well as tax credits for others. If you want to analyze or pose comparative tax advantages of one country or state versus another then you have to use effective tax rates, those actually paid, rather than stacking up one tax rate structure against another.
You also overly simplify corporate relocation decisions. Granted local tax rates and laws are a consideration, but generally far more important are land values and availability, proximity to interstate highways, varying depending on the nature of your distribution, labor supply, especially skilled labor, climate, a big factor, infrastruture and for many industries proximity to colleges and universities.
The grand scale of industrial relocation that has taken place over the last 40 years from northern and midwestern states to southern and southwestern states has been greatly dependent on more favorable weather conditions. The unspoken rationale is often selecting those states where union influences are minimal. The vast growth in North Carolina in recent years has been influenced by the generally negative attitude of workers toward unions along with weather conditions and infrastructure.
The other question you leave begged, especially on a country to country analysis is what are the other taxes in place in addition to income taxes. Ireland, often held out as a tax haven, has a Value Added tax as well as a number of other types of taxes affecting both businesses and individuals. In most European countries the price of oil and gas is much higher than in the US. This is not due to higher distribution costs but because fuel taxes are much higher in those countries.
Your arguments and premises appear far closer to those of a politician or pundit than those of a CEO and especially not those of a wise, experienced accountant. If you want to sell me something, give me facts, give me meat, don't wave pretty pictures and give me simplistic analyses. Most of us reading and blogging here are not John Q. Public.
Psu:
When did corporate taxes get lowered? They were 35% when I was in business school during the Clinton administration and they are 35% now.
Anonymous Matt
This is a CONSUMER based economy folks. When we cease to consume, the economy crumbles. Hear that noise outside, that is the crumbling sound. No consumption, no economy---period. What is the advice we are hearing---stop buying.
Jobs to rebuild infrastructure? Nonsense! Infrastructure for what? Cars and trucks? The age of cheap fuel is gone. There is no quick technology to change that no matter if T Boone buys all the TV time. We are many years away from changing our petrol dependence.
These ideas of government programs like the CCC are absurd. To do what? Walk the roads and pick up trash? Name some projects that lend themselves to mass collections of people living in barracks particularly in our culture of disharmony and violence.
There is a chance that many farmers may not be able to borrow the money to plant a spring crop. We are talking fundamentals of survival of the state. Get real!
For the person who champions Europe's situation, it is true. They have wonderful transportation systems: trains, canals, rivers. You can also drive across old Europe in a matter of hours. You cannot do that in the USA. We have done away with many rail beds across the country. We will not rebuild our railroads.
I would suggest anyone look up how to grow a "Victory Garden".
Problem is, no one has the political backbone to come out & say the truth…that all those bad loans required a lender and also a borrower. Terms of those loans were legally disclosed & agreed upon. Dr. Reich, you speak as though the banks purposely set out to wreak havoc, and are the sole scapegoats for all our problems. To make that argument requires a very low opinion of the intelligence of the “common man”… to believe he was simply a victim of all this. There are actually many people around who did not go out & borrow money foolishly. Now, its those conservative people who are doing the bail outs. I’m not talking about rich people; I’m talking about average people that have been trying to live conservatively & try to get ahead. Some of us own a few shares of those banks you are denigrating. When will someone speak up for us!? As conservative owners, savers & investors, we are not too happy that those bank customers overspent, & then walked away from their obligations, while we were living within our means. So banks accept their mistakes, & their stock prices have gone down to reflect their losses. But to claim banks portentously conspired to harm the economy and are solely at fault is absurd. Now, we savers are expected to pay for this mess. They made poor investments, i.e. bad loans, & the values of those banks have diminished to reflect that fact. Dr. Reich, the owners of the banks are the stockholders – small stockholders exist too, and I can tell you that they have not gotten “off scot-free. I am getting sick & tired of the continual bashing of business for all our problems.
I remember the good ole days of the housing boom & hearing and reading about how every average Joe was investing in housing because everyone else was getting rich at it. It was O. K. to buy a bigger house because its price would surly rise anyway. Borrowers were greedy & it was obvious. Many people knew better, though. And by the way, everyone was real grateful for getting loans back then…no one was complaining. Yet, now we don’ here too much blame placed on these folks or saying how greedy they were. Oh no! As a matter of fact, it has become oh so politically important to bail these “victimized” people out.
We better get back to personal responsibility & stop trying to blame everyone else.
I’m as sympathetic for suffering people as anyone, but it seems like we need to be careful not to construct policies that create moral hazards…not to reward bad behavior & punish saving. That is a very real danger going forward. Dr. Reich, you and others propose to go after the profits of oil companies (i.e. oil company investors) simply because you consider them too high, i.e. “windfall”. What will be next, taxing people with large IRAs, because they have gotten too large?
I know my point of view will be unpopular on this particular blog, but there are actually many people who share my opinion, just not many who will publicly express it.
Art:
How much, exactly are the excise taxes here? Your math is right, I'm just wondering about the materiality of the margin rate change.
Also, what is wrong with share repurchase? It's an efficient way to return money to shareholders. Those shareholders could then do something else with that money. Investible dollars are investible dollars as far as I am concerned.
You're right that I simplified the corporate relocation thing and that there a lot more factors to consider. Please note, however, that I said "more favorable business environments," which include many factors, including those you mentioned.
I also simplified the corporate tax issue. Rest assured, I am familiar with many strategies for avoiding U.S. taxes. I and others of my ilk spend a lot of time on that issue because it is profitable for us to do so.
The simple fact is that those areas (be they Southern and Western states or other countries) that offer more favorable business environments--taxes, labor access, weather, whatever--will attract more investment dollars. It stands to reason that a more favorable U.S. business environment would result in greater investment here and result in more jobs here.
I know that you disagree with this and that I'm not going to change your mind, but maybe someone else will come over to my side.
I don't think it matters for this election, though. It's over.
AM
I'm glad you said what you did about McCain's plan. Those who bought homes they had no reasonable hope of owning should not be rewarded. I can see working out lower interest rates for those who bought a home and then the interest on a variable suddenly went too high for them to afford. But the idea that we should reward irresponsible buyers is as bad as bailing out Wall Street for its recklessness. I am no economic expert but it seems to me sometimes things have to crash when they weren't built on solid ground and perhaps we have to take this as such a time. Delaying it won't stop it from eventually happening. And I say that as one who has something at stake in all of this, but it won't do any good to pretend nothing is wrong. I hope we can go down and back up but not if we do dumb things as a government
Matt, you reasoning is seductive. But it depends on a giant 'IF' that never seems to happen.
'IF' a corporation behaved in the community's best interest..., then your plan is reasonable.
The problem is that a corporation behaves in it's own best interest. If those best interests aren't in creating jobs from tax breaks, then the it won't do it, and the stockholders will support them, so long as marketing tells them that their plan to move the money overseas (or whatever) will boost profits..
Though I understand the college textbook theory about the power that stockholders have over a corporation, I've rarely seen it take effect in real life. Stockholders are human beings and can be herded and manipulated by slick marketing efforts. A corporation that isn't going bankrupt, has little to fear in working against their best interests, so long as their PR folks are good liars.
A corporation will do no more than it has to in R&D and reinvestment. If such efforts don't give it a clear competitive edge, then the bean counters will see it as a waste, and it won't happen. In the case of the oil industry, no corporation is willing to waste money in projects that are shown to have a poor return. To do so, will weaken them in the face of their competition.
The US once, long ago, had a policy of using tax dollars to fund pure research. The corporatization of public research, has ended that tradition. Though whole industries benefited immensely from pure research, such as advances in the semi-conductor field from super-collider research, individual corporations saw that they needed to continually spend money to stay ahead, in case their competition got a bigger market share by passing them up.
Take out the pure research factor, and innovation can slow, while marketing can become the focus. This is cheaper than implementing untested applications to new theories in the hi-tech world.
This is the spin we see in 'innovation', which is nothing more than repackaging existing ideas. Innovation can be as simple as changing the color of packaging, or adding a radio chip to a cell phone. Neither is an application of newly invented technologies.
Alternative energies don't add up in the BTUs. McCain's plan for new nukes for instance, is a non-starter. It takes about 50 nuke plants to produce the same energy as 1% of the oil we consume in the US. To get back to 2% energy growth, we'd have to put 100 nuke plants online every year. Scale that to wind farms or solar farms, and the size of the infrastructure needed, increases quickly.
The oil industry employs some smart people that can count BTUs and do math. They know the score. They will only invest in alternative energy or transportation, as a marketing ploy. And thus, it won't get funding of a size that matters.
Only a return to open public, taxpayer funded research can bring together the people and resources needed to take any of these technologies to a higher level. This is why the real exciting stuff in these fields isn't happening in the US. It's happening in countries that invest more into their future than into military exploits.
A corporation's purpose is to acquire money. A corporation will seek the cheapest way to acquire it. If you desire that corporations produce a beneficial impact in a community, state or nation, then you must structure the laws so that every corporation can only make money, while producing the desired impact. If every corporation is held to the same standards they will contribute to the community and seek maximum profits. But it's only fair if they all must follow the same rules. Then real competition can drive the industry.
Our system increasingly favors those corporations that can grow so large that they can cheat, steal and use the legal machine to destroy smaller competitors. The stockholders don't invest in them because they are good for the nation, but because the harm that they do, leads to profits. If the destroy community conscious competitors, then the stockholders will see that reinvestment in the community loses money in the short run. They'll withdraw support for the weaker corporation, playing by different rules.
In my own city, IBM and Xerox cut a sweetheart deal to move in. They got a ten year stay on taxes, while the city paid for much of the construction of their offices, and utility work such as new water mains, sewage and roads.
When the ten years was up, they left town, and went to another town offering a free ride.
For two decades, those office buildings stood empty. The city and residents suffered to pay the losses in revenue, increased expenses and the huge layoffs.
The stockholders were elated that IBM and XEROX screwed our community. It was a smart business move. But it wasn't good for the city, the county, state or in the long run, the country.
This plan, would've worked out, 'IF' IBM and XEROX were planning to play by the rules. And that brings me back to the big 'IF' in your proposition. The 'IF' never seems to occur in the real world unless laws make them happen, and the laws have teeth.
I've brought up the idea of playing monopoly. It's fun well structured game, so long as everyone follows the rules. What if some players got special rules. They got to roll twice every turn for instance? Or a government lender subsidized half their purchase prices? Would it still be a fun game? What are the odds that other players could win anything?
What if some players didn't even have rules? What if they could just take the money out of the bank as if it were their own?
Or finally, what if the game has no rules? Whomever grabs the cash and titles fastest, wins?
We have a system now where the largest entities don't have to follow the regulations or the laws. They make up their own rules. Giving them cash prices or massive tax breaks won't make anything better.
I agree with some observations above...
I do not want to bailout homeowners that should not have been homeowners (zero down, interest only, 4000 sqr ft homes, ...). Basically, these were the renters that got a loan under preditory practices.
Basically, these renters will not really lose anything (since they had no down payment). They were playing the leverage game just like wall street. Thye got into a $500k asset waiting for values to go up, then they refinance and spend the profit.
Banks can put the home on the asset side of their balance sheet.
Over time, the banks can sell the home under market conditions.
They leverage players need to pay for their losses... many took there winnings already.
Americans are already pay for this mess with falling home and portfolio values.
It will take me another 5 - 10 years to recoup my net worth.
I've paid enough !!!
On John McCain's "stupid" plan - I understood him to say that the government would buy the loans at the value of the underlying asset (the "true" value of the previously overvalued house). The homeowner would then renegotiate to make mortgage payments on a loan more nearly tied to what it should be.
If this is what the plan is supposed to be, it seems like a pretty good idea to me. Banks loose out on the excess they, their value estimators and other "experts" thought the house was worth.
Bobby and Betty bought a nicer house than they could really afford. But their bank accepted that the $80,000 house was worth $100,000 and let Bobby and Betty move in, after loaning them $80K for a mortgage and $20K for a home equity loan. Now, since no one can afford to buy a house, prices are dropping and the house is recognized as being worth $80K today. Rather than continue to try to pay for a house they had no business buying in the first place, the couple declares bankruptcy, walks away and the bank is stuck with an empty house, probably in a neighborhood filled with similar couples. It doesn't take long for the values in the neighborhood (those of the homes and maybe even those of the people who live there) decline. I saw this happen in my neighborhood, temporarily, after a couple lost the home they couldn't afford sat empty for 2 years.
With the plan as I interpreted it, the US government buys the house for what it is worth (we'll need to train some new estimators since the ones we have are obviously morons) and then renegotiates the mortgage schedule with Bobby and Betty on the $80K house. The bank is off "scott-free" (or scot-free, i.d.k.) and must declare a loss of $20K. This will hit the bank as it will reduce earnings (and the fat executive bonus, if the board is doing it's job)
It seems to me that such a plan would punish the moron who barely finished B-school, yet ended up as a foolishly overpaid executive. It would help stabilize the price of homes as Uncle Sam steps in to buy homes. It would keep the homeowners dry and warm and still hold them responsible for their actions (dumb buyers are also guilty here, though deserve less punishment than the professional idiots). And in the long run, Uncle Sam would generate a predictable revenue stream, maybe even make a modest return on the investment, which should be directly applied to rewarding those who bought a house a little cheaper than the one their broker/banker and their friends, the Jones's said they should get. Use the money to help them send their kid to college.
Doug
Matt:
I have tried many times to dig out the total value of the excise taxes but can't find where Exxon or the others break them out. A cursory review of state gas tax revenues would suggest we are talking billions here. Likely tens of billions between state and federal collections. If only $50 billion Exxon's 2007 profit margins would jump to 11.9%. Not astronomical but in 1999, not a down year for gas prices, their profit margins were only 4.3%.
One finds it difficult to suggest that stock repurchases are in toto a bad thing. To some extent it depends on the motivation for the repurchases. If the billions Exxon spent on repurchases were paid out in dividends the shareholders would still benefit, both from the cash flow and the share price rise. Not that they are in grave danger of a problem but reducing the number of voting shares outstanding does give those insiders who hold onto their shares a much stronger control over future decisions.
We also should be aware that companies who engage in stock repurchases, do so with a well planned methodology so as to avoid meteoric price rises. Fairness might be considered but no company wants to repurchase shares at unsustainable prices. I once owned a couple of hundred shares of a company who offered a buyback at $7.50 a share. Given the recent history of their share price it was not an unreasonable offer. Since my basis was $8/share I decided to pass and hold on. Took a few years but the stock eventually shot up to $122/share. I missed the top, but later, in trying to chase the price, I ended up getting out at $66/share. Not a bad gain even if it took a few years.
The oil industry is not an industry that is selling widgets or perfumes. We're talking about a vital, critical industry, wielding significant power over our whole economy and focusing only on shareholder welfare is not a prudent approach for the rest of our economy. Your view is vastly different than that which Frank and I take, which is that shareholder value should not be paramount in the priority structure of such an important industry. He and I feel that across the private sector the principal focus should be on employees and customers with shareholders coming in, at best, third. Maybe even the environment and the long term general welfare of the country should usurp shareholder values.
It is this reliance on stock prices that cause many CEOs to focus on short term views. Tying CEO/Executive pay to stock price performance seems a no-brainer but it directs attention to maximizing profits in the short run with the assumption that there will always be future opportunities to further profits in the long run. Though seemingly true, there will be until. Tell that story to Bear Stearns stockholders or Lehman Bros. or the many others whose investments are in financial services companies.
You, as all conservatives, want to stress taxes as the driver for locating a business. I left it out, inadvertently, but whether state to state or country to country, labor costs and regulations are far greater impetuses than tax impacts. In this day and age it is possible for a corporation to shift its headquarters overseas, to cheaper taxing countries, while the executives remain in the US and through video conferencing, phone, email, and travel, maintain control over offshore operations. This may cause taxes as a criteria for location to rise but is there no loyalty to country? Is the Quixotic quest for greater profits more important than the general welfare? If execs were required to move along with their operations you can bet that there would still be a lot more jobs in the US.
Reducing the tax rates here will not offset the lower costs of labor and lesser regulation elsewhere, so we will not see a rush back to US shores of jobs and opportunities. Tax laws and rates that are punitive might prove the better solution; the WTO notwithstanding.
If the ultimate goal is more money and more stuff then your analysis brings the best results. Is that what it's all about? Is that how we continue to be the world's shining example? Current events would suggest not.
It is an old economic adage that when a high priced labor economy faces competition from cheaper labor, the high priced labor must come down. If that's true then, business friendly, requires undoing much that has been attained over the past 100 years. If your home value is suffering now, just wait until wages tumble from competition. In the pending turmoil of such an event, unskilled labor wages will not be the only ones that decline. You know that if you're hard pressed to reduce labor costs you seldom stop at the lower paid employees.
You are to be admired for the hard work and success you have achieved. If you think that those opportunities were available to all other Americans, then your excellent education did little to overcome your naivete.
By the way, my math is almost always right. It is how I made my living for 40+ years.
weaseldog:
Though I agree with much of your analysis, go easy on the bean counters. We are, after all, generally just the messengers.
Ok, Art, I'll start using the more PC term, Accountants. :)
It's an accountant's job to help a corporation make more money and reduce costs. An accountant that doesn't do this well, won't stay employed in a large corporation long. They'll be fired or like in the case of the accountant and CEO at one firm I worked at, they'll be arrested in the Caribbean.
Accountants are necessary. We need them.
weasldog:
Many thanks for your acknowledgement of the veracity and necessity for we of the green eye shades.
Though true we are often the harbingers of doom for those CEOs with grandiose ideas while at the same time being passive missives for the idiocy that pretends to leadership, but most of us try to maintain an objectivity of total welfare even if, at times, sequestered in the recesses of our minds.
Creativity has crept into the profession but we oldtimers tend to remain true to the mundane messenger role. I can tell you what happened and possibly why but it would be presumptuous of me to second guess the unfailing wisdom of a CEO. At least if I wanted to keep my job.
Why isn't anyone talking about providing subsidies for new mortgages?
Home values are supposed to decline between 18% - 30% over the next 2 years. What incentive does anyone have to buy a house with that expectation of decline? The current securities will also decline by this same value.
Home values need a floor. That's what this entire collapse is based on.
The DOW dumped 678.91 points today.
Will there be panic tomorrow?
Anonymous Doug,
Some of prior posts here have touched on the differences in the McCain homeowner bailout plan and Congress´s recently approved plan. I will try to recapitulate with a simple illsutration.
I.McCain´s Plan
McCain's government buyout plan
is not about buying back a home mortgage based on "the true value of a previously overvalued house."
Under McCain's plan, the government would be buying up (toxic) home mortgages at their Face Value and then renegotiating new mortgages with borrowers based on current lower market values. In effect, the government would be paying borrowers and lenders in full without any consideration of how fair or intelligent the original mortgage deal was. Bad debts are removed from lenders' balance sheets and borrowers are given opportunity to refinance a smaller mortgage that comes with a government guarantee.
For example, assume an original inflated 100% mortgage of $200,000.
Under McCain's plan, the lender would be paid $200,000 and the borrower would be allowed to refinance the mortgage based on current market value, say $170,000.
What happens? The banks are fully bailed out at original face value of mortgage; the government takes an immediate loss of $30,000 with possible added losses if market values still go down or borrower defaults. The ones who made reckless mortgages, the lending banks, are fully bailed out.
Congress´s Plan
Compare this to Congress's plan which was approved October 1. This bill requires lenders to take an upfront LOSS by writing down the mortgage principal on troubled mortgages to 85% of a house's CURRENT market value.
For example, assume same original inflated 100% mortgage of $200,000.
Let´s also assume the current assessed market value of the home is $170,000.
So, the government would pay lender 85% of the house´s current market value, or .85 x $170,000 =$144,500, reflecting a 28% discount of original mortgage´s face value. The government then negotiates a new mortgage for homeowner reflecting a 20% discount of original mortgage, or a mortgage for $160,000 (at market interest rate and amortization terms).
What happens? The bank, not the government absorbs an upfront loss of $55,500 while the government has far less risk of possible further falls in home values or default by the borrower.
CONCLUSION: The McCain plan rewards both bad lending and borrowing practices and is thus very costly to taxpayers.
Congress´s plan shifts high share of responsibility for troubled mortgage situation to the bank by requiring an effective upfront 28% write down of $55,500 to $144,500. It rewards borrower with a more affordable mortgage of $160,000, reflecting a 20% drop in the original inflated mortgage.
I stand open to corrections here, but I think the above closely represents the principal differences. McCain´s plan is clearly mush more costly and risky than the Barney Frank and Chris Dodd plan.
Lastly, McCain´s plan does not reflect Harvard Prof. Martin Feldstein´s as some seem to believe.
weaseldog:
Are you kidding? I'm thinking about buying.
The solution is clear to me, I just don't understand why Congress claims to be so clueless and powerless - they HAD to vote on something? – ANYTHING? - because they didn't have time to think it through to do something better? If you don't have time to do something right the first time, when are you going to get the time to do it over? Millions of us begged them not to do anything yet, to take the time to do it right. They were so panicked, though they heard our roar, they couldn't listen to reason. Now, they have started hearings and I'm hearing them say time and again, "We don't have jurisdiction over . . ." This is impossible. Congress has to have jurisdiction over everything - their job is oversight and responsibility - the buck does stop with them. It HAS to stop there, but they are all so frightened of the consequences of their own dereliction of duty over all these years, they have thrown all sanity to the wind. They have shredded the constitution repeatedly - there is no provision for bail outs - they are to provide for the COMMON good, not just for the wealthiest of us all. They have ignored contract law. These two legal traditions are the very foundations of an informed, responsible and free society and the best time proven tools for just and rational solutions. We are in this mess because the banking and finance industry have been allowed by using the crime of usury with the blessing of Congress to suck up into their hands most the wealth of much of the world. They have successfully lobbied congress for every advantage over us until almost all the money is in their hands and made sure no wealth will trickle down. The Fed is no better. They are issuing all these commercial lines of credit to generate inventory, but who's going to go shopping and buy any of this inventory when the consumer is broke? There is no money for inventory because we have already stopped shopping. I have no discretionary income and have not had for several years. We must face the fact that the consumer has suffered severe injustice at the hands of congress thereby becoming so financially overburdened with loss of wages that do not keep pace with the cost of housing, health costs that are totally unbearable and now escalated gas and food prices that, not only can we not afford to be consumers, we cannot afford any more credit. It's a "no brainer!" Christmas shopping in 2008 will be the easiest consuming to give up. We, the people, must have our debts forgiven. We have paid the banks many times over whatever we bought actually cost and they have made more profits than any mafia don money-changer ever dreamed he could. Forgive us our debts, pay us an honest wage, and get rid of the health insurance fraud schemers. Then we will have an economically just and viable society. We deserve no less.
We do not need to buy foreclosed properties. We need to re-instate the buyers, in the cases of those who lived in the homes they were purchasing. According to the prudent man rule, which the courts have employed since 1830, the lender is responsible for determining whether the borrower can repay the debt. The lender is given all the opportunity required to make sure the borrower is qualified. If he did not, or if the lender did not disclose to the buyer the material terms of the contract, they never had a meeting of the minds and the contract may be unenforceable and the lender may not collect on his debt and may even have to fore go return of his property. There is a legal basis to allow those people back in their homes or stay in them if this is the case and let the loans be recast in an amount appropriate to their real income. Once that is done, we will know what the bottom of the housing market is and we will know how much the values need to be adjusted. It's not like people are lined up to buy houses and not getting to have a roof over their head because they have the money to burn on houses that aren't worth what people were willing to pay for them when we had a falsely propped up economy. Once we start to recover, there will be homes available for any new buyers that will be more qualified than ever. Although, we better get on it, because those new homes that have been left standing and never sold are going to be deteriorating quickly.
Matt,
I guess I should have said effective tax rates.
While the 35% rate stayed current, cororate taxes versus GDP has been in a steady decline.
PSU77
Treating the disease, not the symptoms: a comparison of solutions to buying defaulting loans of any type.
While I’m personally a staunch Obama supporter, the proposal made by John McCain during the second debate regarding the purchase of underwater mortgages has some merit. There have been a variety of proposals for this line of attack, including recently by Martin Feldstein in the WSJ. I have also proposed a plan, outlined below. Following my plan is a précis of Feldsteins plan, followed by a comparison of both. There is great merit in a strategy of treating the disease and not the symptoms:
Some pertinent data points;
• Number of families who now hold a subprime mortgage: 7.2 million1
• Proportion of subprime mortgages in default: 14.44 percent2
• Proportion of subprime mortgages made from 2004 to 2006 that come with “exploding” adjustable interest rates: 89-93%
• Proportion of completed foreclosures attributable to adjustable rate loans out of all loans made in 2006 and bundled in subprime mortgage backed securities: 93%
• Number of subprime mortgages set for an interest-rate reset in 2007 and 2008: 1.8 million Valued at: $450 billion
There are 7.2 million subprime mortgages out there worth 1.3 trillion, of which possibly 70% of them have exploding rate mortgages, which means about 5 million have exploding rates. Exploding rate mortgages account for 93% of the bad mortgages, which means that possibly 4.5 million of these will go bad, or 63% of the total, at a value of $820 billion and an average value of $180,000. If the ARMs reset from 7% to 12%, the increase in monthly payments is about $590 per month. $590 per month times the total of 5 million is about 3 billion dollars per month. Therefore, $700 billion would pay for 233 months, or nearly 20 years of payments… and this without renegotiating the loans so that maybe they just go to… say… 9% with the government picking up the difference. The holders of all the CDO’s would then be able to value them, mark them back to market, solve their balance sheet problems… financial problems solved. From the housing markets point of view, it would relieve the pressure of the foreclosure spiral forcing down prices more than ‘normal’, and provide years for the economy to recover and housing to rebound. Furthermore, any homeowner who availed himself of the help would give up all or a part of the appreciation of the property over time, penalizing them for getting jammed up, but not penalizing the guy who is paying his mortgage and playing by the rules.
If the sub-prime ARMS were renegotiated down to 9%, the monthly payments the government would be liable for would be an average of $225 per house per month, or $1.1 billion annually. The $700 billion under those circumstances would be good for 636 months, or 53 years…
So in review, the proposal is to:
Have the government guarantee payment of the loan by taking over the payment of the amount above the ‘teaser’ rate, leaving the existing mortgagee paying the original rate while the government pays the difference.
Renegotiate that ARM rate down so the difference is smaller.
In exchange for this, the original mortgagee gives up rights to appreciation in the future, penalizing him for a bad decision, not rewarding him for it.
Benefits of the action:
Stabilization of the housing market by ending foreclosures
Small relative rescue price for the government, as the payments are monthly, not lump sum.
Homeowners who can’t pay are saved and penalized, while homeowners who can are not penalized.
The market in all mortgage related securities will be reestablished, as payment is now guaranteed, allowing all holders of all financial products based on the mortgages to have confidence in their value.
Market liquidity and company balance sheets will be reestablished through the market itself.
This would be a much cheaper and more effective way to solve the problem… renegotiate the exploding rate, paying the difference and profiting from the increase in asset value over time.
The following is the proposal advanced by Feldstein in the WSJ:
The Problem Is Still Falling House Prices
The bailout bill doesn't get at the root of the credit crunch.
By MARTIN FELDSTEIN
A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.
...
We need a firewall to break the downward spiral of house prices. Here's how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government's cost of funds and could be as low as 2%.
...
Consider a homeowner who has a mortgage equal to 90% of the value of his home. The 15% decline in the value of his house that may be needed to bring it back to its prebubble level would shift that homeowner into negative equity. Further price declines would make default attractive. But the 20% mortgage replacement loan would take the loan-to-value ratio to 72% from 90%, making it unlikely that prices would fall far enough to push him into negative equity. An interest saving that could be as large as $3,000 a year would provide a strong incentive to accept the mortgage-replacement loan, even if the individual thinks that he might temporarily have a moderate level of negative equity.
Below is a comparison of the advantages of the two plans point by point:
• No budget busting huge amounts of capital required in any one year, but rather nominal amounts in any particular year.
o Feldstein’s plan would require huge outlays of capital, a trillion dollars by his own estimate, in order to protect the 5,000,000 threatened mortgages, which is a totally unnecessary budget buster
• No need to try and ‘untangle’ all of the bundled, sold, sliced and diced mortgages… they will be paid.
o A benefit of both plans.
• Slows the fall in house values, shoring up all real estate assets both residential and commercial
o A benefit of both plans
• Doesn’t penalize those who ‘play by the rules’
o The Feldstein plan rewards those who for what ever reason can’t make their payments by making them eligible for a very cheap very long term loan. This penalizes those who are paying and is unfair on it’s face.
• Allows Mark to Market rule to continue to be used
o A benefit of both plans
• By establishing a value for all the mortgage-related assets, the markets in them will restart, liquidity problem solved.
o This is less clear under Feldstein’s plan, as there still could be defaults. Payment is left to the original mortgagee, and what if they decided to take that $80,000 and pay off some other more pressing bill. Because of that threat, the trillions of dollars in derivatives would not be as secure and thus would not be as valuable. They may be as liquid, but at a risk induced lower price… not a good thing.
• Moral hazard: companies that participated in selling the bubble take a hit for their reckless behavior through the discount in the ARM through the revaluing downwards of their assets.
o Feldstein’s plan does not recognize the need to lower the ARM (more appropriately an ERM – exploding rate mortgage) increases through a blanket one time renegotiation with all holders. This is equivalent to what happens when someone secures a better deal rescuing a company than the deal originally offered to the original stock holders… such is life.
• The program could be expanded to include anyone who was threatened with foreclosure due to ARMs… not just sub-prime, but Alt-A, etc.
o A benefit of both plans.
• No bankruptcy interventions necessary.
o A benefit of both plans.
In sum, there is merit in the strategy advanced by McCain… however, his methodology is poor and can be greatly improved upon.
Businesses, investors and consumers aren't just buying stuff. Some really do need to buy investments to protect their nest eggs for the mid- or long-term or to make contracts within the financial sector. But how? Credit default swaps are lurking in banks, bank holding companies, erstwhile investment firms, mutual funds, insurance companies and who knows where else. Disclosures about them are obscure to the point of being material misrepresentations. For example, I found CDS's being called "inline insurance products."
There will be no confidence in the financial markets until the market for credit derivatives is regulated and disclosed in uniform terminology. That's the only way any business, investor or consumer will know how much their investments or contracts are at risk. For now, those risks are buried so deep that those of us in the public markets have no realistic tool for assessing them.
And won't disclosure cause more panic sell-offs? And if you can answer that question, please explain to me the social utility of allowing credit default swaps to be traded by non-parties to the underlying transaction. We outlaw bookmaking outside certain sports books. Why are CDS's any different, when "investors" are betting on defaults on bonds the investors do not own? I appreciate the utility of allowing hedges as a way of softening untoward credit risk. I see no legitimate use of capital in CDS's for non-parties - - it is speculation, pure and simple.
I don't want to do business with speculators, and I'll bet I'm in the majority. My money isn't going anywhere unless I'm 100% sure it isn't at risk for someone else's gambling debts.
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