Financial Markets Meltdown Presentation
Presented by Malcolm Robinson
Clichés become clichés because some abiding truth is reflected in them. For example, Joe Biden reminded us on Thursday night that “past is prologue.” What can we learn from the relatively recent past? A real estate bubble burst in Japan in the late 80’s; banks were saddled with bad debt and their stock market collapsed. The Japanese government seemed to be in denial and the Japanese economy limped in and out of recession throughout the 1990’s. A real estate bubble burst in Sweden in 1992; banks were saddled with bad debt. The Swedish government boldly attacked the problem and the Swedish economy recovered quickly. The Swedes spent 4% of their national output on their recovery plan; by way of comparison, $700 billion dollars in the US today is 5% of our GDP. In the 1980’s, due to bad loans, our savings and loan industry was in crisis. The government created the Resolution Trust Corporation which liquidated $394 billion of assets held by 747 insolvent savings and loans between 1989 and 1995 and helped strengthen the US economy.
My cliché of the moment is “don’t let the perfect be the enemy of the good.” How bad are things right now in the US? I suspect the US has been in something like a recession since the 4th quarter of 2007. The US has experienced 9 consecutive months of job losses, 159,000 jobs were estimated to have been lost in September alone. The headline unemployment rate is 6.1. The U6 unemployment rate, however, has risen from about 8% in 2007 to 11% in September of 2008. Private residential construction has been declining for the last 28 months. On top of these changes in the real economy, we must add a deepening paralysis in our financial markets. In the 2nd quarter of 2007, $300 billion moved through financial markets to the business sector. In 2008’s 2nd quarter, only $150 billion in loans were made. I expect 3rd quarter numbers will be smaller and 4th quarter numbers will be even smaller still. The Chronicle of Higher Education reported that over 1000 colleges may have trouble meeting their payroll and other expenses because of the financial crisis. The State of California may ask the government to lend it $7 billion dollars because of its inability to access short term credit markets. An interesting piece of trivia, the interest rate on 3 month Treasury Bills is around .05%; on September 17th, a few days after the collapse of Lehman Brothers, this interest rate was briefly negative! Individuals were willing to take a small loss in order to gain security. As other assets look progressively riskier, (Reserve Primary Fund lost 2/3 of its asset value due to Lehman Brothers failure. It was worth 97cents on each dollar it held) the demand for treasuries has been rising which drives up their price and drives down the interest rate.
If you want to have an economy with a growing number of jobs, if you want to make sure that more jobs don’t disappear, then we must somehow keep the flow of funds moving through the financial markets. It’s good the government has moved with speed to deal with the financial market crisis. Here is another cliché you’ve heard a lot lately: Main Street depends on Wall Street.
The heart of the problem is that banks need more capital. Why is capital so scarce? As best as I can understand it (and there is tremendously little in the way of data here—what does the Federal reserve and Fed Chairman Bernanke know and when did they know it?), the root of the problem is falling housing prices. Nationally, housing prices have declined by 20% from peak values and I believe housing prices will continue to decline through 2009 and maybe until the beginning of 2010. As adjustable rate mortgages reset, homeowners find it difficult to refinance as housing values declined. In the 1970’s and 80’s, this problem would have remained confined to the subprime sector, but not today. Why not?
Here, let me digress for a moment to teach you some economic theory. George Akerloff pioneered the analysis of information problems in markets and won a Nobel Prize for his work. Consider the market for used cars. If individuals can tell the difference between high and low quality cars then markets operate, buyers and sellers find each other and exchanges occur. If only the seller knows the quality of the used car, then buyers can’t differentiate between the two cars. I might suppose that the primary reason you want to sell your car is because it’s a “lemon”, there’s something wrong with it. As the price of used cars fall because people don’t trust cars are of high quality, more high quality cars get pulled from the market and the market gets dominated by low quality cars increasing the probability you’ll buy a lemon. Economist describe this as a market failure because trades between buyers and sellers that would have taken place and made both better off, never take place.
Howe does this relate to today’s financial markets? Today, mortgages are packaged into mortgage based securities and then repackaged into collateralized debt obligations. Financial Institutions hold a significant quantity of assets backed by mortgage payments. These derivative assets were often rated AAA even though the underlying mortgages were of poor quality (I recommend Roger Lowenstein’s NY Times Magazine piece “Triple A Failure”) which meant buyers felt they were likely to yield steady payments with low risk. This made the assets liquid. If an institution needed cash, it could quickly sell these assets; a buyer didn’t worry about the composition of the assets because the stream of payments was safe. When housing prices started to fall, however, buyers could no longer ascertain the nature of the seller. Are sellers selling a security because they need cash or are sellers trying to dump their worst performing asset? The market price then reflects the fact that buyers can’t differentiate between high and low quality assets – the market price, the fire sale price, reflects the belief that securities are of low quality.
The same problem arises for firms. Because of real estate losses, institutions are under capitalized. If lenders can’t tell the difference between troubled financial institutions and sound financial institutions, then no one will want to lend and credit flows slow to a trickle. Trades that would benefit buyers and sellers don’t occur.
This is the rationale for the government to step in and help solve the financial crisis. Some very smart people have pointed at that private markets work very well, thank you. Didn’t Warren Buffet just buy $5 billion worth of stock in Goldman Sadrs? But Buffet himself has said that he wouldn’t have acted now if he didn’t believe the Paulson plan would be enacted. Government action was the precondition for Buffet’s private action.
Does the government have a plan to halt foreclosures and end the drop in home prices? Does the government have a plan to directly recapitalize financial institutions? No and maybe. Secretary of the Treasury Paulson presented a 3 page plan to Congress which Senator Chris Dodd and Representative Barney Frank transformed into a bill they believed the Congress could pass. I don’t believe that the Swedish Solution of 1992 could have passed through today’s Congress given that there is an election in about a month. The Swedish government invested in their failing major banks and essentially took them over. It ran the banks for a few years and then sold them to private investors when they became profitable. It turns out that this plan is embedded deep in the language of the bill as an option or at least that’s what NPR reports.
What the bill passed by Congress primarily will do is remove assets from the banks balance sheets. The model is the RTC approach. How will this be done? No one knows yet. For example, what price will be paid for these assets? The devil, clearly, is in the details. The idea, however, is that once lenders can identify the true value of the financial institutions, then those institutions can recapitalize and begin the process of moving funds from savers to business.
There is no guarantee the plan will work.
For example, foreign nations that have happily parked excess funds in the US may no longer deem US capital markets to be a safe haven; they may relocate their funds elsewhere. But the Treasury and the Fed’s position is that, after piece meal attempts to shore up the US financial markets failed, something major is called for to forestall a Japanese economy-like lost decade that would take us to 2018.