Krugman on Geithner's plan: "Financial Policy Despair"

Nobel-winning economist Paul Krugman is none too pleased with the latest plan by the Obama Administration to address the financial crisis. From his New York Times column:

Right now, our economy is being dragged down by our dysfunctional financial system, which has been crippled by huge losses on mortgage-backed securities and other assets.

As economic historians can tell you, this is an old story, not that different from dozens of similar crises over the centuries. And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

That’s what Sweden did in the early 1990s. It’s also what we ourselves did after the savings and loan debacle of the Reagan years. And there’s no reason we can’t do the same thing now...

But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets...

But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

Ouch!

60 Minutes talks with President Obama about the economy, AIG and settling into his new job

They say that starting a new job is one of life's most stressing events -- and if you're Barack Obama and you're taking the helm of the United States as the world teeters on the edge of financial catastrophe? Gallows humor. Lots of it. From CBSNews.com:

By most accounts, this past week was one of the most difficult in the young presidency of Barack Obama. At the heart of it all was the public upheaval over $165 million in bonuses paid to employees of AIG, a company largely responsible for bringing the world's financial system to its knees and now being propped up by U.S. taxpayers. The bonuses touched off a cultural war between Wall Street and Main Street, both of whose support the president needs to help stabilize the economy.

After campaigning in California to drum up support for his $3.6 trillion budget, the president sat down with 60 Minutes in the Oval Office for a conversation about the AIG debacle, the economy, and getting the hang of the world's most difficult job.

Part I:


Watch CBS Videos Online

Part II:


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Has Obama's "Katrina" moment already arrived?

Apparently things move very fast in the Obama Administration, with some of his more virulent opponents already calling for his impeachment. But New York Times columnist Frank Rich suggests that the lack of communication on the financial crisis has quickly become Obama's own "Hurricane Katrina" moment. From his column:

A CHARMING visit with Jay Leno won’t fix it. A 90 percent tax on bankers’ bonuses won’t fix it. Firing Timothy Geithner won’t fix it. Unless and until Barack Obama addresses the full depth of Americans’ anger with his full arsenal of policy smarts and political gifts, his presidency and, worse, our economy will be paralyzed. It would be foolish to dismiss as hyperbole the stark warning delivered by Paulette Altmaier of Cupertino, Calif., in a letter to the editor published by The Times last week: “President Obama may not realize it yet, but his Katrina moment has arrived.”...

Six weeks ago I wrote in this space that the country’s surge of populist rage could devour the president’s best-laid plans, including the essential Act II of the bank rescue, if he didn’t get in front of it. The occasion then was the Tom Daschle firestorm. The White House seemed utterly blindsided by the public’s revulsion at the moneyed insiders’ culture illuminated by Daschle’s post-Senate career. Yet last week’s events suggest that the administration learned nothing from that brush with disaster. Otherwise it never would have used Lawrence Summers, the chief economic adviser, as a messenger just as the A.I.G. rage was reaching a full boil last weekend. Summers is so tone-deaf that he makes Geithner seem like Bobby Kennedy...

Click here for entire column.

When incentives backfire

During last Monday's presentation on the economy for the Orange County BIA, Chris Thornberg noted something about incentives that I had also seen echoed in an article for Fast Company magazine -- namely, that they often backfire when people only think about short-term goals.

As an example, one primary reason that a former employer of mine wasn't able to manage a specific division was because they didn't realize that since everyone was maniacally focused on individual monthly revenue instead of collaboration, not only did that prevent honest teamwork from forming, but ultimately let to the entire group's destruction. In the end, the efforts I made to strengthen the entire team through branding and promotion were usurped by those individuals who only saw incentives as a path to monthly riches, and thus in direct contrast to building a long-term organization. According to the Fast Company article, the world of sports is full of such examples -- as are real estate and finance:

Years ago, AT&T executives tried to encourage productivity by paying programmers based on the number of lines of code they produced. The result: programs of Proustian length.

Incentives are dangerous, and not just because people game them. They often yield collateral damage. Remember the tale of the Darwin Award winner who strapped a jet engine to his car, dreaming of a joyride for the ages, and then met his sorry end as a human flapjack on the side of a mountain? Incentives are like that jet engine. There's no question the engine will take you somewhere, fast, but it's not always clear where. Or what you're going to mow down on the way. Yet incentives are still the first resort of most managers, perhaps because they all think they're smart enough to create the perfect carrot...

To be fair, there are some contexts where one variable dominates. If you're employing a field sales rep who is selling a simple, self-contained product, then it probably makes sense to tie incentives to the sale. If you're traveling a long, straight road, the jet engine will get you there faster.

But chances are you don't live in a one-variable world. In your complicated, squishy, matrixed world, if you're dreaming up an incentive plan, you're almost certainly in the grips of a focusing illusion. You're trying to maximize or optimize or minimize something. And you may unwittingly find that when you maximize the length of your programmer's code, you end up minimizing your job tenure...

Click here for full story.

An update on Mark Zandi's book "Financial Shock"

As one of my first freelance writing assignments for the real estate news syndicator Inman News, I'm going to be reviewing the book by Mark Zandi called Financial Shock: A 360º Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis.

Zandi, who is also widely quoted as an economic expert in the national press as well as a consultant to the McCain campaign, has been better known as Chief Economist and co-founder of Moody's Economy.com, so he's in a particularly good position to write the book, which provides a comprehensive overview of the sub-prime crisis, the related fall-out and, more importantly, some policy prescriptions for how to avoid similar mistakes in the future.

However, since his book was printed in July it missed out on some of the recent events, so I thought it was important to interview Dr. Zandi for any updates. Some money quotes:

On whether or not a government bailout is a wise move:

"It's guarding against the downside risks, which are quite considerable...If we don't down this path quickly, then the policy choices will get overwhelmed by the magnitude of the problem."

On what's next for the homebuilding industry:

"I would expect it to go through a very significant rationalization, and expect to see more failures, although the big, publicly traded builders are still in business and I don't think that's going to change."

On what else needs to be done to fix the housing market:

"Another write-down plan should be implemented and keep on trying to forestall foreclosures...It's a reasonable way to go to write down the first mortgage to the point that it becomes affordable and guarantee the part that's written down to the lender."

On the current economy:

"I think we've been in a recession for a year and will be through next summer -- about the worst we've experienced since the end of WWII, although perhaps not as bad as the 1982 downturn. I would expect unemployment rates to peak at 8% by early 2010."

"Dr. Doom" Roubini peers ahead

With an opinion piece published in the Toronto Globe & Mail entitled "Yes, Chicken Little, the sky is really falling," Dr. Noriel Roubini has some advice for a global financial system in crisis, and warns of what might happen if the right solutions are not applied (hat tip: Patrick.net):

The rich world's financial system is headed toward meltdown. Stock markets have been falling most days, money markets and credit markets have shut down as their interest-rate spreads skyrocket, and it is still too early to tell whether the raft of measures adopted by the U.S. and Europe will stem the bleeding on a sustained basis...

The delusion that economic contraction in the U.S. and other advanced economies would be short and shallow – a V-shaped, six-month recession – has been replaced by certainty that this will be a long and protracted U-shaped recession, possibly lasting at least two years in the U.S. and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown, the prospect of a decade-long L-shaped recession – such as the one experienced by Japan after the collapse of its real-estate and equity bubble – cannot be ruled out...

As we have seen in recent days, it will take a big change in economic policy and very radical, co-ordinated action among all economies to avoid disaster. This includes:

Another rapid round of interest-rate cuts of at least 150 basis points on average globally;
A temporary blanket guarantee of all deposits while insolvent financial institutions that must be shut are distinguished from distressed but solvent institutions that must be partially nationalized and given injections of public capital;
A rapid reduction of insolvent households' debt burden, preceded by a temporary freeze on all foreclosures;
Massive and unlimited provision of liquidity to solvent financial institutions;
Public provision of credit to the solvent parts of the corporate sector in order to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;
A massive direct government fiscal stimulus that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower-income households, and provision of grants to cash- strapped local governments;
An agreement between creditor countries running current-account surpluses and debtor countries running current-account deficits to maintain an orderly financing of deficits and a recycling of creditors' surpluses to avoid disorderly adjustment of such imbalances.

Anything short of these co-ordinated actions may lead to a market crash, a global financial meltdown and worldwide depression. The measures adopted by the U.S. and Europe are a start. Now they must finish the job.

Now you all go out and have a nice day, ya hear?

Bush Admin. announces partial nationalization of banking system

Ah, I love the smell of socialism in the morning, it smells like -- Europe. But is that necessarily a bad thing in order to save the banking system? From an L.A. Times story:

Bush administration officials today unveiled a dramatic partial nationalization of the U.S. financial system, a series of "unprecedented and aggressive steps" to pour at least $250 billion into the banking system and expand federal insurance protection in the largest government intervention since the 1930s...

The strategy closely resembles the path taken by Britain and the European Union, a route credited with reviving faltering stock markets there. The Dow Jones industrial average shot up more than 300 points shortly after it opened this morning, though the large gains later eased. Markets across Europe were soaring, as they did earlier in Asia.

Administration officials released the details of the massive government intervention, whose broad outlines began emerging Monday. They said the programs are intended to be temporary, lasting from one to five years with built-in expiration dates.

The centerpiece is a $250-billion infusion of cash into the banking system. Roughly half will go to nine large U.S. banks and financial institutions that agreed to participate after meetings with Paulson on Monday. Among them are Citigroup, Wells Fargo and Bank of America. The other half of the money will be made available to medium and smaller banks in the coming days.

In exchange for the cash, the federal government will get preferred, nonvoting shares in the banks, with a fixed dividend of 5% for five years, increasing to 9% after that. The goal is to provide money to banks at a fairly low cost for five years to get credit flowing though the financial system...

Click here for full story.

Dow rises as Europe pledges billions to shore up banks

After last week's financial chaos, central bankers on both sides of the Atlantic have finally started planning in tandem to shore up the global banking system. From a New York Times story:

After a weekend of crisis talks on both sides of the Atlantic, European nations and the United States unveiled on Monday a staggering and coordinated series of multibillion-dollar rescue packages to shore up teetering banks and guarantee credit to free up lending between them...

Click here for full story.

Benanke warns of greater economic pain to come

Fed Chairman "Ray of Sunshine" Ben Bernanke warns that the current economic crisis will likely extend the downturn and make it more painful. At least he's being realistic! From an AP story:

Federal Reserve Chairman Ben Bernanke warned Tuesday that the financial crisis has not only darkened the country's current economic performance but also could prolong the pain.

The Fed chief's more gloomy assessment appeared to open the door wider to an interest rate cut on or before Oct. 28-29, the central bank's next meeting, to brace the wobbly economy...

All told, economic activity is likely to be "subdued" during the remainder of this year and into next year, Bernanke said. "The heightened financial turmoil that we have experienced of late may well lengthen the period of weak economic performance and further increase the risks to growth," he warned.

Consumers - major shapers of economic activity - have buckled under the weight of rising joblessness, shrinking paychecks, hard-to-get credit, declining net wealth and tanking home and stock values. All the strains are "now showing through more clearly to consumer spending," Bernanke said.

Inflation numbers are "very ugly right now," Bernanke acknowledged. Even so, he believed slowing growth in the United States and overseas will continue to damp prices for energy, food and other commodities, meaning a better inflation outlook ahead. Inflation will moderate "pretty significantly" over the next few quarters, he predicted...

Employers cut jobs in September at the fastest pace in more than five years, the government reported last week. Payrolls were slashed by 159,000 last month alone. It was the ninth straight month of job losses. A staggering 760,000 jobs have disappeared so far this year.

The financial and credit crises, which took a turn for the worst in September and continue to stubbornly persist, are likely to "increase the restraint on economic activity in the period ahead," Bernanke said.

Even households with good credit histories are now facing difficulties obtaining mortgages or home equity lines of credit, he noted. Banks are also reducing credit card limits and denial rates on auto loan applications are rising, he said.

Banks, too, are feeling the strain of a lockup in lending, particularly in the market for commercial paper.

To that end, the Fed on Tuesday announced a radical plan to buy massive amounts of this short-term debt in an effort to break through a credit clog that is imperiling the economy.

Office space starting to empty out

Given the current economic malaise, businesses aren't waiting to cut down on their office space expenses when they downsize. Factor in a long-term trend towards flex time and home offices, and is this a temporary blip or something more? From the Wall Street Journal:

Businesses are dumping office space at the fastest pace since the months after the Sept. 11 attacks, increasing the financial stress on commercial-real-estate owners and their lenders, many of them already ailing financial institutions. Nationwide, rents on office properties -- including landlord concessions and discounts -- were flat in the third quarter, the worst result for office-property owners since late 2004 -- when commercial real estate began to emerge from a prolonged slump, according to Reis Inc., a New York real-estate research firm...

The office market in suburban areas and smaller cities has been declining throughout the year. But now, with a recession looking inevitable, the pain is spreading to most large metropolitan areas. Previously immune cities such as San Francisco and Boston saw vacancy-rate increases in the third quarter. San Francisco's vacancy rate rose 0.6 percentage point to 9.9% in the quarter. Boston's rate rose 0.8 percentage point to 11.7%.

Of the 79 markets Reis tracks, vacancy rates increased in 66. Rents declined or were flat in 40...

Commercial real estate so far has fared much better than residential. Cash flows of most properties have stayed healthy and delinquency rates on commercial mortgages have remained low. Unlike the real-estate collapse of the early 1990s, the market also hasn't suffered from overdevelopment.

But the office sector has been suffering declining values from the shortage of financing. Now the problems are beginning to be compounded by declining rent, rising vacancies and mounting expenses for attracting and retaining tenants. This will add to the strain on financial institutions that already have been stuck with tens of billions of dollars of commercial-real-estate debt and securities. Many of them may choose to sell this troubled debt to the government if Congress passes the proposed bailout legislation.

Because real estate moves slowly, the financial turmoil of the past few weeks hasn't yet showed up in the numbers. Mr. Chandan predicted the bank failures and consolidations will be reflected in office space later this year and in 2009...

The worst-hit office markets continue to be the ones bearing the brunt of the housing crisis. Businesses tied to the housing industry, such as home builders, engineers and mortgage lenders, have evaporated, leaving behind acres of empty cubicles.

Blame the Community Reinvestment Act?

There's been a lot of noise lately on the culpability of the Community Reinvestment Act (CRA), which reportedly encouraged (some say forced) lenders to make subprime loans to those who couldn't afford it in the name of increasing homeownership.

So what is the CRA? First, from a Wikipedia entry:

The CRA was passed by the 95th United States Congress and signed into law by President Jimmy Carter in 1977 as a result of national grassroots pressure for affordable housing, and despite considerable opposition from the mainstream banking community.^[1] Only one banker, Ron Grzywinski from ShoreBank in Chicago, testified in favor of the act.^[2] The CRA mandates that each banking institution be evaluated to determine if it has met the credit needs of its entire community. That record is taken into account when the federal government considers an institution's application for deposit facilities, including mergers and acquisitions after the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 repealed restrictions on interstate banking.^[3] However, until 1995 the Act was laxly enforced and banks only were required to advertise in local minority newspapers or sit on the boards of local community groups.^[4] The CRA is enforced by the financial regulators (Federal Deposit Insurance Corporation ("FDIC"), Office of the Comptroller of the Currency ("OCC"), Office of Thrift Supervision ("OTS"), and the Federal Reserve System.^{[citation needed]} It also charged the Federal Reserve System to implement the CRA through ensuring banks and savings and loans met their CRA obligations.

So what's the controversy? Again, from Wikipedia:

Some economists and financial experts have wondered if the CRA was - or at least had become - irrelevant, because it was not needed to force banks to make profitable loans to a variety of lenders.^[11][12] Economist Howard Husock writes that a CRA-connected community group The Woodstock Institute found in a survey in the Chicago-area that even banks not subject to CRA tended to loan in a variety of neighborhoods. He also criticized as an "amateur delivery system" community groups' involvement in marketing loans.^[4] Federal Reserve chairman Ben Bernanke has stated that an underlying assumption of the CRA – that more lending is always better for local communities – is questionable.^[3]

Economist Stan Liebowitz notes that the Fannie Mae Foundation singled out Countrywide Financial as a "paragon" of a nondiscriminatory lender who works with community activists, following "the most flexible underwriting criteria permitted." The chief executive of Countrywide is said to have "bragged" that in order to approve minority applications, "lenders have had to stretch the rules a bit." Countrywide's commitment to low-income loans had grown to $600 billion by early 2003.^[13] On the other hand, Professor of Law Michael S. Barr stated in congressional testimony that a Federal Reserve survey showed that affected institutions considered CRA loans profitable and not overly risky.^[14]

Congressman Ron Paul has partially attributed the ongoing subprime mortgage crisis to legislation such as the Community Reinvestment Act.^[15] A Wall Street Journal editorial argued that the law compelled banks to make loans to poor borrowers who often could not repay them and that this contributed in part to the subprime crisis.

So what's the story? Are these charges true? An blog post in BusinessWeek says no:

Fresh off the false and politicized attack on Fannie Mae and Freddie Mac, today we’re hearing the know-nothings blame the subprime crisis on the Community Reinvestment Act — a 30-year-old law that was actually weakened by the Bush administration just as the worst lending wave began. This is even more ridiculous than blaming Freddie and Fannie...

Not surprisingly given the higher degree of supervision, loans made under the CRA program were made in a more responsible way than other subprime loans. CRA loans carried lower rates than other subprime loans and were less likely to end up securitized into the mortgage-backed securities that have caused so many losses, according to a recent study by the law firm Traiger & Hinckley (PDF file here).

Finally, keep in mind that the Bush administration has been weakening CRA enforcement and the law’s reach since the day it took office. The CRA was at its strongest in the 1990s, under the Clinton administration, a period when subprime loans performed quite well. It was only after the Bush administration cut back on CRA enforcement that problems arose, a timing issue which should stop those blaming the law dead in their tracks. The Federal Reserve, too, did nothing but encourage the wild west of lending in recent years. It wasn’t until the middle of 2007 that the Fed decided it was time to crack down on abusive pratices in the subprime lending market. Oops.

Better targets for blame in government circles might be the 2000 law which ensured that credit default swaps would remain unregulated, the SEC’s puzzling 2004 decision to allow the largest brokerage firms to borrow upwards of 30 times their capital and that same agency’s failure to oversee those brokerage firms in subsequent years as many gorged on subprime debt. (Barry Ritholtz had an excellent and more comprehensive survey of how Washington contributed to the crisis in this week’s Barron’s.)

There’s plenty more good reading on the CRA and the subprime crisis out in the blogosphere. Ellen Seidman, who headed the Office of Thrift Supervision in the late 90s, has written several fact-filled posts about the CRA controversey, including one just last week. University of Oregon professor and economist Mark Thoma has also defended the CRA on his blog. I also learned something from a post back in April by Robert Gordon, a senior fellow at the Center for American Progress...

Did Lehman's failure cause the global cash crunch?

Although the federal government defended its refusal to bail out Lehman Brothers, a story in the Wall Street Journal asserts that the consequences of that decision have been much more dire than predicted. That's the thing with predictions -- they're just GUESSES:

Two weeks ago, Wall Street titans and the government's most powerful economic stewards made a fateful choice: Rather than propping up another failing financial institution, they let 158-year-old Lehman Brothers Holdings Inc. collapse.

Now, the consequences of that decision look more dire than almost anyone imagined.

Lehman's bankruptcy filing in the early hours of Monday, Sept. 15, sparked a chain reaction that sent credit markets into disarray. It accelerated the downward spiral of giant U.S. insurer American International Group Inc. and precipitated losses for everyone from Norwegian pensioners to investors in the Reserve Primary Fund, a U.S. money-market mutual fund that was supposed to be as safe as cash. Within days, the chaos enveloped even Wall Street pillars Goldman Sachs Group Inc. and Morgan Stanley. Alarmed U.S. officials rushed to unveil a more systemic solution to the crisis, leading to Sunday's agreement with congressional leaders on a $700 billion financial-markets bailout plan...

In hindsight, some critics say the systemic crisis that has emerged since the Lehman collapse could have been avoided if the government had stepped in. Before Lehman, federal officials had dealt with a series of financial brushfires in a way designed to keep troubled institutions such as Fannie Mae, Freddie Mac and Bear Stearns Cos. in business. Judging them as too big to fail, officials committed billions of taxpayer dollars to prop them up. Not so Lehman.

"I don't understand why they didn't understand that the markets would be completely spooked by this failure," says Richard Portes, professor of economics at London Business School and president of the Centre for Economic Policy Research. Rather than showing the government's resolve, he says, letting Lehman fail only exacerbated the central problem that has afflicted markets since the financial crisis began more than a year ago: Nobody knows which financial firms will be able to make good on their debts...

The government's decision to let Lehman go marked a turning point in the way investors assess risk. When the Fed stepped in to engineer the takeover of Bear Stearns by J.P. Morgan Chase & Co. in March, Bear's shareholders lost most of their investments, but bondholders came out well. In the financial hierarchy of risk, this wasn't surprising, since bondholders have more contractual rights to get their money back than equity holders. But it created a false impression among investors that the government would step in to rescue bondholders when the next bank ran into trouble. By letting Lehman fail, the government had suddenly disabused the market of that notion.

The reaction was most evident in the massive credit-default-swap market, where the cost of insurance against bond defaults shot up Monday in its largest one-day rise ever. In the U.S., the average cost of five-year insurance on $10 million in debt rose to $194,000 from $152,000 Friday, according to the Markit CDX index.

When the cost of default insurance rises, that generates losses for sellers of insurance, such as banks, hedge funds and insurance companies. At the same time, those sellers must put up extra cash as collateral to guarantee they will be able to make good on their obligations. On Monday alone, sellers of insurance had to find some $140 billion to make such margin calls, estimates asset-management firm Bridgewater Associates. As investors scrambled to get the cash, they were forced to sell whatever they could -- a liquidation that hit financial markets around the world...

To make matters worse, actual trading in the CDS market declined to a trickle as players tried to assess how much of their money was tied up in Lehman. The bankruptcy meant that many hedge funds and banks that were on the profitable side of a trade with Lehman were now out of luck because they couldn't collect their money. Also, clients of Lehman's prime brokerage, which provides lending and trading services to hedge funds, would have to try to retrieve their money or their securities through the courts...

Spooked that other securities firms could fail, hedge funds rushed to buy default insurance on the firms with which they did business. But sellers were hesitant, prompting something akin to what happens if every homeowner in a neighborhood tries to buy homeowners insurance at exactly the same time. The moves dramatically drove up the cost of insurance on Morgan Stanley and Goldman Sachs debt in what became a dangerous spiral of fear about those firms.

At the same time, hedge funds began pulling their money out of the two firms. Over the next few days, for example, Morgan Stanley would lose about 10% of the assets in its prime-brokerage business...

To some, the government's decision to resort to a bailout represents a tacit admission: For all officials' desire to allow markets to punish the risk-taking that engendered the crisis, banks have the upper hand. "Lehman demonstrated that it's much harder than we thought to deal effectively with banks' misbehavior," says Charles Wyplosz, an economics professor at the Graduate Institute in Geneva. "You have to look the devil in the eyes and the eyes are pretty frightening."

JPMorganChaseWhooHoo?

Growing banking giant JPMorgan continued to grow today with the $1.9 billion purchase of the bank branches and deposits of the seized thrift Washington Mutual. Some of you may recall WaMu's recent "Whoo hoo" campaign, which a friend of mine at ad agency TBWA/Chiat/Day helped create, so I hope they've still got a client! The good news? The purchase means that the FDIC doesn't have to tap into its reserves. From an AP story via USAToday.com:

JPMorgan Chase (JPM) acquired the assets of Washington Mutual's (WM) banking operations Thursday after federal regulators seized the ailing thrift, the company's largest. The deal marks the second time in six months that JPMorgan Chase has taken over a financial institution crippled by bad mortgage bets.

The deal will cost JPMorgan Chase $1.9 billion. The Federal Deposit Insurance Corp., which insures bank deposits, said it would not have to dip into the insurance fund as a result of the seizure.

Good news! Only $700 billion!

More details continue to emerge from Treasury Secretary Paulson's proposed bail-out of distressed mortgages from various financial institutions. Whereas some pundits are predicting a cost of up to $1 trillion or more, this initial request is for $700 billion, thereby putting to rest any administration hopes of invading Iran! From a Wall Street Journal story:

The federal government is asking Congress for $700 billion to buy up distressed assets as part of its plan to help halt the worst financial crisis since the 1930s.

The Treasury Department sent Congress legislative language last night asking for broad authority to buy assets from U.S. financial institutions. The request is just two-and-a-half pages and contains a broad outline of how this new entity would function. The government wanted to keep the plan simple, in part because it wants the flexibility to adjust what its doing as market conditions change, a person familiar with the matter said.

Among the things the government is asking for is the authority to hire asset managers to oversee the buying of assets. The bare-bones request may irk Congress, which is already expressing concerns about the plan. It could present an opportunity for Congress to stack the bill with other provisions, such as more housing relief.

The proposal would give the Treasury secretary significant leeway in buying, selling and holding residential or commercial mortgages, as well as "any securities, obligations or other instruments that are based on or related to such mortgages."

The only limitation would be that purchases couldn't exceed $700 billion outstanding at any one time. That figure compares with the $515 billion President George W. Bush included in his fiscal 2009 base budget request for the Department of Defense. The plan also calls for an increase in the public debt limit, boosting it to $11.3 trillion...

House and Senate lawmakers, working hand-in-hand with the Bush administration, are expected to work throughout the weekend on finalizing the details of the plan. Congressional leaders have targeted a vote on the comprehensive plan for the coming week, though that will depend on the ability of the White House and Congress to agree on a final product.

The proposal would expire after two years but would allow the government to hold the assets purchased from financial firms -- which must be headquartered in the U.S. -- for as long as is deemed necessary by the Treasury. Any assets purchased through the program would have to be tied to mortgages originated before Sept. 17 of this year.

The plan offered to Congress also gives the Treasury legal immunity from any lawsuits. "Decisions by the secretary pursuant to the authority are non-reviewable … and may not be reviewed by any court of law or any administrative agency," the proposal says...

The most ambitious part of the government plan is to create a new entity to purchase impaired assets from financial firms. The process could work as a type of reverse auction, in which the government would buy from the institution that sells its assets for the lowest bid.

However, the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets. The Treasury department, which hasn't commented on specifics about the plan, is expected to propose issuing debt in $50 billion tranches to fund the purchases.

"I am convinced that this bold approach will cost American families far less than the alternative -- a continuing series of financial-institution failures and frozen credit markets unable to fund economic expansion," Mr. Paulson said at a morning press conference...

In another bid to provide liquidity, The Fed Friday, said it would buy short-term debt issued by Fannie Mae, Freddie Mac and Federal Home Loan Banks through primary dealers. The Fed said it would buy up to $69 billion of these securities, called discount notes, to ease the crunch in the market.

The SEC ban on short selling of some financial stocks -- an attempt to stem some of the worst stock-market slides in years -- is effective immediately and will last 10 days, but could be extended for up to 30 days.

No, not another RTC-type bailout. Perhaps another "RFC," updated from the 1930s.

Despite the constant parade of "no bailout!" exclamations accompanying email signatures on blog comments and the efforts by certain members of the blogosphere to energize an anti-bailout crowd, it seems that the housing/mortgage/financial crisis is spinning out of control to the point that some point of bailout seems necessary (something unhappily predicted by this blog back in late 2007). How might it look? A story in the Wall Street Journal reviews:

The federal government is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s, embracing the need for a comprehensive approach to the financial crisis after a series of ad hoc rescues.

At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies, said people familiar with the matter, a device that echoes similar moves taken in past financial crises. The size of the entity could reach hundreds of billions of dollars, one person said.

Another proposal would be the creation of federal insurance for investors in money-market mutual funds, coverage akin to the insurance that currently safeguards bank deposits. The move is designed to stem an outflow of funds as consumers start to worry about even the safest of investments, a sign of how the crisis is spreading to Main Street. There is $3.4 trillion in money-market funds outstanding.

In addition, the Securities and Exchange Commission is set to propose a temporary ban on short-selling. It's not clear how broadly the ban might extend, but it could apply only to financial stocks...

The administration had been taking a patchwork approach to the financial crisis, putting out fires as they ignited. The new moves represent an effort to take a more systematic approach, after a spiral of bad debts, credit downgrades and tumbling stocks brought down venerable names from investment bank Lehman Brothers Holdings Inc. to insurance giant American International Group Inc. Banks have grown unwilling to lend to one another, a sign of extreme stress, because financial markets work only when institutions have faith in each other's ability to meet their obligations.

Word of the plan came the same day as the Federal Reserve and other major central banks offered hundreds of billions of dollars in loans to commercial banks to alleviate a deepening freeze in the world's credit markets. That step appeared to have moderate impact on lending among banks. Meanwhile, a wave of redemptions continued hitting money-market funds, causing a second large fund to shut to investors...

The flurry of moves under discussion may bring the markets some breathing room, but it isn't clear whether they will amount to a long-term solution to the complex financial problems sweeping the market...

Treasury Department officials have studied a structure to buy up distressed assets for weeks, but have been reluctant to ask Congress for such authority unless they were certain it could get approved. The intensified market turmoil may have changed that political calculus, even with less than two months left until the November elections.

A big question still to be answered is how the government will value the assets it takes onto its books. One possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. Financial companies would likely take big losses...

Exactly how such an entity might be structured isn't yet clear. The possible plan isn't expected to mirror the Resolution Trust Corp., which was used from 1989 to 1995 during the savings and loan crisis to hold and sell off the assets of failed banks. Rather, a new entity might purchase assets at a steep discount from solvent financial institutions and eventually sell them back into the market.

The program may look more like the Reconstruction Finance Corporation, a Depression-era relief program formed in 1932 by President Hoover that tried to inject liquidity into the market by giving loans to banks and other businesses.

According to a top congressional aide, the Treasury department wants authority to either control the program or have it be a separate division of the government...

Thursday, Republican nominee Sen. John McCain sought a broad expansion of government regulation over financial institutions, including the formation of a body to both assume distressed mortgages and help failing investment banks.

Saying the government cannot "wait until the system fails," Sen. McCain called for the creation of an entity that would essentially help companies sell off bad loans and other impaired assets. It is unclear how the body, dubbed the Mortgage and Financial Institutions trust, would operate, including whether or not institutions would seek help or whether the government would intervene on its own behalf.

His rival, Democratic Sen. Barack Obama of Illinois was less specific about what steps he would take, offering broader outlines of policy proposals that included a "Homeowner and Financial Support Act." The measure, which would inject capital and liquidity in the financial system, is designed to provide a more coordinated response than "the daily improvisations that have characterized policy-making over the last year."

Can't wait for those debates!

Worst financial crisis since the 1930s?

Although it's unlikely that we'd see the same type of market unraveling that led to the Great Depression, the degree of the crisis is leading many to claim that it's the worst since the 1930s. Although the U.S. now has policies in place to avoid another Depression, the road ahead is still uncharted. From a Wall Street Journal article:

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners...

The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes...

Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.

Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.

"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."...

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied...

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets...

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace...

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market...

This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact...

The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago...

Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.

But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending...

One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."

At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.

In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible...

But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.

Financial crisis to prolong housing slump

As the housing and mortgage crisis continues to create more destruction on Wall Street, it's not surprising to hear that this only means bad news for the nation's builders, most notably through tighter requirements for business loans and mortgages for buyers. From a BuilderOnline.com story:

Builders who think the financial meltdown happening on Wall Street this week won't affect them should think again.

The capital to run their businesses—acquisition, development, and construction (ADC)—is likely to become less available and more expensive. The mortgages that consumers require to purchase a new home will become even harder to get, despite the recent federal takeover of mortgage finance firms Fannie Mae and Freddie Mac. And the number of jobs that Americans need to qualify for and pay those home loans will continue to shrink if banks are reluctant to give businesses the credit they need to expand and hire more workers...

"What is different today [from past housing downturns] is that you have an overall market problem—it's not isolated to any one geographic area or several geographic areas. It's almost a systemic problem," John Bittner, a partner at Grant Thornton, told BUILDER this week. "What you are seeing now is a much more protracted decline in the housing market because of the situation in the financial markets."...

Bittner, like others, foresees credit becoming even more difficult to get for builders in the months to come. "Credit will only be available to those with the most pristine of balance sheets, and if it's available, it won't be cheap," he predicted to BUILDER. "And the restrictions and covenants placed on the loans will be considerable."

Such a situation does not bode well for builders, who have been fighting for survival and cash flow for months. In a market where firms such as WCI, Woodside Homes, Neumann Homes, Kimball Hill Homes, and others are going bankrupt, what home building companies have such clean balance sheets? "That's the problem," Bittner said. "Very few of them have. They're long in land, and they have a significant amount of debt on their balance sheet. The larger publicly traded home builders, the smaller privately owned home builders with $100 million to $500 million in revenue—they all bought into [the boom] when times were good. Very few, if any, have the balance sheet to go out and get credit these days."...

With the economy reeling, consumers rethinking their spending, and banks reducing their own financial exposure by lending less money, builders will likely start feeling the pain of the overall economic tumult as well as the effects of the ongoing housing downturn.

Why another Great Depression is unlikely

With the housing bubble blogosphere abuzz lately with posts and comments predicting another Great Depression, L.A. Times writer Michael A. Hiltzik provides an excellent overview of how things are different this time around:

Dysfunctional capital markets, frantic central banks, stressed-out consumers, fear and uncertainty -- all are alarming echoes of the global economic cataclysm of the 1930s.

Which raises the inevitable question: Could another Great Depression be lurking over the horizon?...

On the surface, there are disquieting parallels between economic conditions in the early 1930s and those of today. There is the popping of enormous asset bubbles -- stocks then, housing now.

And, as in the Great Depression, the financial system is in disarray. It was symbolized back then by the failure of thousands of banks, mostly small, local outfits -- 2,300 in 1931 alone.The parallel today is the crippling ofonetime giantssuch as Bear Stearns Cos., Countrywide Financial Corp. and Ameriquest Mortgage Co.

Many economists believe that the U.S. will find it almost impossible to avert a recession, if one has not started already. Housing remains mired in a deep slump,with some analysts projecting that Southern California home values could plunge 40% from their peaks last year.The Commerce Department reported this week that new residential building permits nationwide plummeted 36.5% in February from a year earlier.

Then, like now, stock prices were highly volatile. The S&P 500 index, which fell more than 56% from 1928 through 1940, nevertheless recorded four up years in that span, including a 46.5% gain in 1933....

BUT

But there are vast differences between the 1930s and today. U.S. unemployment reached 25% during the Depression; last month it was reported at 4.8%. The international industrial economy was a shambles in the '30s. Today it is coming off a global boom....

Economists and historians say the most important difference between today's economic environment and the old days is the government's role.

"There's a perception now that you don't stand around at the central bank and whack people with a ruler for making bad decisions," said Robert Brusca, chief economist at New York-based Fact and Opinion Economics. "Instead, you do something."

Nothing demonstrates that as vividly as the Fed's orchestration of the takeover of Bear Stearns by JPMorgan Chase & Co. over the weekend. The deal staved off a possible Bear bankruptcy, which the central bank feared might traumatize financial systems worldwide.

The resolution drew a stark contrast with the Fed's role in the 1930 collapse of the Bank of the United States, a New York institution largely serving Jewish immigrants. The failure was then the largest in U.S. history, and the Fed's inability to arrange a rescue by Wall Street banks -- including J.P. Morgan & Co., the predecessor to the "white knight" in the Bear Stearns case -- caused a cataclysmic loss of confidence in the entire national banking system. That fueled a panic that historians regard as a key cause of the Depression.

The Fed's relative powerlessness in 1930 led directly to New Deal reforms that vastly expanded its authority. Some of the agency's new powers, such as its ability to lend directly to brokers and investment banks, were seldom or never used until the current crisis.

Fed Chairman Ben S. Bernanke, an expert in the central bank's Depression-era history, is also knowledgeable about the instruments at its disposal in a crisis...

But as Fed Vice Chairman Donald L. Kohn conceded in testimony before a Senate committee this month, the most serious challenges generally arise not from scenarios that can be forecast but from the unforeseen.

Alluding, in effect, to the tendency of regulated industries to burst at their weakest seams, Kohn blamed "the most sophisticated banks" for allowing credit rating agencies such as Moody's and Standard & Poor's to paper over the unsoundness of mortgage securities on their books.

The agencies bestowed lofty AAA ratings on some extremely complex mortgage bundles even though their inherent risks were not understood. The banks and firms that packaged the securities and hawked them to clients simply accepted the rating agencies' conclusions, which were often favorable to the packagers. The dubious valuations of many of these securities are at the core of the credit crisis roiling the financial markets today...

There are also limits to what monetary policy -- the Fed's responsibility -- can achieve on its own to forestall a drastic economic downturn. The Franklin D. Roosevelt administration not only reformed the Fed but also experimented with stimulative fiscal policy, such as unemployment relief.

New Deal programs aimed at staving off a wave of home foreclosures may be especially relevant today. Among the most important was the Home Owners Loan Corp., or HOLC, which is one of several models for homeowner relief being considered by Congress.

HOLC took over 1 million mortgages in default starting in 1933, worked to keep the owners in their homes and made new loans to strapped mortgage holders. When the agency was finally liquidated in 1951, it even returned a small profit to the U.S. Treasury.

So what next?

The Fed's recent actions were "a temporary palliative" to the fundamental problem in the economy, which is the rapid fall in home prices and its ripple effect on mortgage bonds and other securities, said Barry Eichengreen, a professor of economics and political science at UC Berkeley. "You have to reorganize the system, but the discussion about that has only begun."