Credit Study by the Federal Reserve Says No Crunch

"[most businesses have] been able to obtain all or most of the credit they need. What they don't have are customers."

Read more about it here.

The Panic of '08: Recession Cause or Effect?

Copyright, The New York Times Company

The financial panics of last September and October will always be part of the story of this recession, just as bank failures are always part of the Great Depression story. But recent research questions the claim that the financial panics themselves contributed to their contemporaneous and severe employment downturns.

In his academic research, Ben S. Bernanke blamed part of the Great Depression of the 1930s on banking panics. And this time last year (at the height of the panic in the commercial-paper market) he was telling President Bush that if “we don’t act boldly, Mr. President, we could be in a depression greater than the Great Depression.” A lot of taxpayer money was spent based on this theory.

Some recent research supports an alternative view: that those financial panics did not cause depressions, but are merely symptoms of deeper economic forces.

The U.C.L.A. economics professor Lee Ohanian’s recent paper has looked at monthly data from the 1930s and finds that bank failures came well after manufacturing establishments had sharply dropped their work hours. Moreover, the banks failing during the initial panics were known to be weak. Whatever brought those weak 1930s banks down had already hit the manufacturing sector hard.

The timing was different in this recession — the largest employment drops seemed to come immediately after the financial panic — but a recent paper by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg of Northwestern argues that the coincidence is just as misleading. They argue that the changing global economy — with more employment of residents in developing countries like China — created a glut of savings in those countries, and was destined to reduce employment in developed countries regardless of whether there had been a financial panic.

The foreclosure crisis is not fully behind us, and the time may come again when it looks like “banks are in trouble.” When that time comes, will taxpayers still believe Mr. Bernanke’s theory that they are better off financing bailouts than letting a bank panic run its course?

NY Fed Timeline

I look at the NY Fed's Economic Data Release calendar almost every day.

Now I hear that they have developed an international financial crisis timeline.

Why Markets, Not the Treasury, Determine Bank Capital

Copyright, The New York Times Company

Bailout mania began with the Bush administration’s attempts to boost bank capitalization rates. The Obama administration’s reaction to bank stress-test results marks an important change by asking failing banks to raise their own capital rather than injecting another round of taxpayer funds. Yet neither administration has admitted to the public how difficult it is for the Treasury to have an impact on bank capitalization, because the market works to offset Treasury transactions in bank capital.

Bank capital refers to the excess value of banks’ assets over liabilities. Bank capital belongs to the bank shareholders, but provides a degree of insurance to the bank’s creditors –- its depositors and bond holders –- because their claims on bank assets (in the case of bankruptcy, for example) are senior to those of bank shareholders. Some economists also think that adequate bank capital is also essential for lending.

As the housing market crashed, so did the value of some of banks’ important assets: residential mortgages and mortgage-backed securities. This not only reduced the value of bank stocks, but heightened the risk that bank creditors might not be paid in full, because bank capitalization rates (the amount of bank capital per dollar of bank assets) were falling. Some thought that bank lending would suffer, too.

The Federal Reserve and the Bush administration let some banks fail, but ultimately desired to do something to replenish bank capital. They convinced Congress that they could do so, and had $700 billion (almost $7,000 for every United States household) earmarked for that purpose. Almost $300 billion of that amount had been awarded to banks between late October 2008 and Inauguration Day, in the form of Treasury purchases of newly issued bank stock.

Although the Federal Reserve and the Bush administration included quite a number of officials who once admired the power of free markets, none of them admitted to the taxpayers (whose money they requested) that the marketplace would largely, if not entirely, thwart their recapitalization efforts. The market would react to Treasury share purchases by reducing private holdings of bank capital, and react to Treasury share sales by increasing private holdings.

As noted above, bank capital belongs to the shareholders. Moreover, a variety of market mechanisms permit shareholders to increase or decrease bank capital. New shares can be issued in the private sector, or old shares bought back. Dividends can be increased, or decreased. Banks can merge with each other in cash deals, which decrease the combined capital of the merging banks and increase cash paid to shareholders.

Thus, bank capitalization rates are expected to suit shareholder interests, not the United States Treasury’s. Markets will neutralize Treasury transactions regardless of whether the Treasury reasonably desires banks to be more capitalized, because the bank capital belongs to the shareholders, even if the shareholders’ desired capitalization is “unreasonable” or “panicked.”

In other words, bank shareholders will have whatever capitalization level they want to have, and if they don’t like the level foisted upon them by the Treasury, they can easily grind it back down to their preferred level. And they have done just this, again and again.

Although lawmakers acted surprised, it is more than coincidence that payouts to bank industry shareholders occurred at the end of 2008 as the United States Treasury was “injecting capital.” Banks paid dividends that were far greater than what was commensurate with their profitability.

Joe Nocera reported in The New York Times that JPMorgan Chase’s chief executive, Jamie Dimon, told his employees that the $25 billion they obtained from selling equity to the Treasury would help them acquire competitors.

These are all ways how Treasury bailout funds ended up with bank shareholders rather than adding to bank capital, as bailout advocates led taxpayers to believe.

Several banks are now trying to give back their taxpayer capital injections — i.e., they are asking Treasury to sell back their bank shares. (Perhaps they find the Treasury to be an extraordinarily meddlesome shareholder.)

If the Bush administration had been right that Treasury purchases of bank stock raise bank capital, shouldn’t Treasury sales reduce bank capital? Recent events suggest not. Bank cash going back to the Treasury will be largely offset by cash coming in from the private sector: an offset mirroring what we saw in the fall, when cash coming in from the “capital” injections was spent on dividends, cash mergers and the like.

That’s what’s happening at banks such as BB&T, which plans to pay back $3.1 billion to the Treasury. At the same time, BB&T will issue $1.5 billion in common stock and cut their dividend by $0.725 billion per year. In two years’ time, the combination of those two actions alone will raise $2.95 billion, almost entirely offsetting the cash going to Treasury as it sells back BB&T shares.

The Obama administration’s reactions to bank stress-test results are refreshingly cognizant that the marketplace, and not Treasury injections, will determine bank capitalization. When the latest stress tests find that a bank has too little capital, the Obama Treasury (unlike the Bush Treasury) is asking that bank to raise its own capital, rather than arranging for a Treasury “injection.”

The moral: Bank capital is determined by the market, not the amount spent by taxpayers on bank bailouts.

CORRECTION: A previous version said that National City shareholders got cash from the merger -- they did not receive much, but as PNC shareholders they continued to get a historically high dividend ($0.66 per share) through January 2009.

Flashback: Treasury Capital Crowds Out Private Capital at BB&T

Treasury "capital injections" just result in greater payments to bank industry shareholders. Some of the ways it could work is that a bank receiving TARP money would buy back its shares (or buy, for cash, shares of competitors), use the Treasury funds to forestall raising new capital that (thanks to the recession and housing crash) would have been necessary, or cut dividends.

The same argument implies that payments from a bank TO the Treasury would reduce payments from banks to bank industry shareholders (or increase payments from shareholders to the banking industry).

That's what's happening at BB&T. They plan to pay back $3.1 billion to the Treasury. At the same time, they will issue $1.5 billion in common stock and cut their dividend by $0.725 billion per year. In two year's time, the combination of those actions will raise $2.95 billion.

Why do Troubled Banks Pay Dividends?

A recent study documents how troubled banks continue to pay dividends.

Dividends are paid because the taxpayers are giving the banks more cash than the banks' shareholders' want to have in the banks. This is not Monday morning quarterbacking, but rather the prediction of economic theory that has been recognized for decades and was applied to the bank bailout this fall.

We Have the Tools

This blog is based on the premise that we have the tools (esp. the tools of supply and demand) to understand what has happened in the economy, and what will happen.

Professor Merton has the same view. Watch a video where he explains why:

• stock prices fell a lot in September, even without much change in the (already bad) housing fundamentals
• "complex securities" are not that complex (that is, undergrad econ tools can be used to understand them)
• even if the "complex securities" like CDS's are complex, they are no more complex than securities that have existed for centuries, such as equity in non-financial business firms.

Flashback: Treasury Capital Crowds out Private Capital

It is reported that Goldman Sachs will issue common stock to repay their TARP loan.

It is neither a coincidence nor a surprise that Goldman issues shares at the same time that they repay their TARP money. I explained last fall how Treasury "capital injections" just result in greater payments to bank industry shareholders. One (of many ways) it could work is that a bank receiving TARP money would either buy back its shares (or buy, for cash, shares of competitors), or use the Treasury funds to forestall raising new capital that (thanks to the recession and housing crash) would have been necessary.

The same argument implies that payments from a bank TO the Treasury would reduce payments from banks to bank industry shareholders (or increase payments from shareholders to the banking industry). That's what we see with Goldman's new issue.

Politicians told us that TARP money was actually going to be lent to bank customers, rather than paid to shareholders -- they were wrong.

For more examples, see my posts under the "bailout" label.

Waiting for the Subsidy

Copyright, The New York Times Company

Subsidies can have a perverse effect on activity if they are debated too long. The banking sector bailout is one example; the purchase of hybrid automobiles by Chicago cab drivers is another.

Hybrid automobiles can save gas, especially in urban driving conditions when the automobile is moving slowly or idling, when alternative power sources have a bigger advantage. A problem is that the purchase price of hybrid vehicles is often higher, and many are less spacious than the more ubiquitous sport utility vehicles.

A significant fraction of the taxicab fleet may be well suited for hybrids, because many of the miles driven are in urban conditions, and often the vehicles have only one passenger. Thus I have been surprised to notice so few hybrid taxis in Chicago, where less than 1 percent of cabs are hybrids.

In an admittedly unscientific survey, I watched for Toyota taxis with about 100,000 miles. I assumed that many drivers of Toyotas would be likely to buy a Toyota for their next taxi, and that the Prius — the company’s hybrid model — would get their consideration. I asked the drivers about buying a Prius.

The drivers told me about the Chicago City Council’s debates about transforming the city’s taxi fleet.

The council has debated mandating hybrid purchases. But the rumor among taxi drivers is that in addition, or perhaps instead, the city or other government agency will eventually subsidize the purchase of a hybrid.

Drivers have decided that they should not purchase a Prius or other hybrid until the subsidy arrived. Buying one now would mean over-paying.

Regardless of whether it is realistic to expect Chicago to someday subsidize purchases of hybrid taxis, the fact is that some cab drivers are considering the possibility. If taxi drivers consider future subsidies in their industry, then so must bank executives.

Last fall the public learned that banks were not selling many of their legacy mortgages and mortgage-backed securities, despite the impression that ownership of the assets were hindering the banks’ lending. A variety of theories have been put forward to explain this failure, and to suggest what the government might do to fix it.

But the lack of trade in mortgage-backed securities may have something in common with the lack of trade in hybrid Chicago taxicabs. The secondary market for legacy mortgages may have stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy. As I wrote last week, banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to eventually step in and help push the prices of the assets higher.

There would have been two preferable possibilities: for the government to come forth quickly with its subsidy, or make it clear from the beginning that no subsidy was coming. With both Chicago taxis and the secondary market for mortgages, the government did neither. Instead, it only fueled rumors that subsidies were on the way, and froze the same markets it intended to stimulate.

Encouraging the Sellers, Not the Buyers, of ‘Toxic Assets’

Copyright, The New York Times Company

Last week the Obama administration released what has become known as the “Geithner plan”: an administration policy to reorganize asset ownership in the banking sector. The plan may have its desired effect of loosening up the market for “legacy assets,” but probably not for the reasons the Obama administration has stated.

Banks own mortgages (either directly, or through ownership of mortgage-backed securities) whose values plummeted in 2008, because the mortgages are collateralized with real estates whose values crashed.

Conventional wisdom about the banking crisis says that bank lending to the wider economy cannot occur because banks have been unable to sell these assets, which adds to their difficulties in making new loans.

As United States Treasury Secretary Timothy Geithner says, a secondary market for mortgages “does not now exist” because there is a “lack of clarity about the value of these legacy assets [which makes] it difficult for some financial institutions to raise new private capital on their own."

I agree that (to a good approximation) a secondary market for legacy mortgages does not exist. But the biggest reason is not lack of clarity, but rather the lack of a viable government policy to deal with the banking crisis. Until now, perhaps.

But let’s stick with the conventional wisdom for a moment more. According to that wisdom, it does not help for the Treasury and the FDIC to subsidize and leverage the purchase of legacy mortgages from banks as Secretary Geithner proposes, because the plan does nothing to (a) create clarity in legacy asset value or (b) ensure that banks no longer have significant direct or indirect holdings of mortgages on their balance sheets.

As Professors Paul Krugman and Joseph Stiglitz have explained, the Geithner Plan does increase the value of legacy mortgages to its owners, because it subsidizes the purchase of them. But it does not increase the clarity of those values, and in fact reduces clarity.

Consider an example, again from the conventional wisdom. Market participants are not sure whether a pool of mortgages will be worth $30 million or $50 million, and are concerned that the current owner knows a bit better and thus will offer for sale only the weakest of the weak. This $20 million worth of uncertainty, according to Secretary Geithner and the conventional wisdom, stops the secondary market from operating.

Thanks to the emergence of the Geithner plan’s subsidy and its leverage, the pool of legacy mortgages last week suddenly became worth $40 to $90 million (the Geithner subsidy raises private investors’ value of all types of bad mortgages, and its leverage increases the gap between the value of the best and the value of the worst). Yes, the legacy mortgages are worth more, but the profit of owning them is now less certain.

To make matters worse, the Geithner plan has no provision to stop banks from funding some of the ventures that will purchase the banks’ own legacy assets. The result may be bank ownership of mortgages that is less direct, but ownership nonetheless.

Thus, if the conventional wisdom is right, this plan will fail because it creates no clarity, and it does little to separate banking from legacy mortgage ownership.

But I believe that the conventional wisdom is highly exaggerated. Instead, the secondary market for legacy mortgages has stagnated largely because of the (ultimately correct) anticipation of a massive government subsidy. Banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to eventually step in and help push the prices of those assets higher.

We all witnessed last week the massive capital gains to banks that came with the unveiling of the Geithner plan. A bank would have been foolish to sell off its legacy mortgages during the fall or winter, before such a plan was unveiled and executed, because a fall or winter non-bank buyer of legacy mortgages would likely be ineligible for the ultimate subsidy.

Thus, the secondary market for legacy mortgages has failed so far due to the lack of a plan rather than a lack of clarity. In order to get the market operating again, the Geithner plan does not need to alleviate the market weakness improperly identified by its authors, but only needs to stay on the path to execution.

Will the Geithner-Summers plan solve an ownership externality?

Another hypothesis about the banking crisis is that there is an externality -- certain critical institutions harm the wider economy when they hold mortgage assets, but each in its decision to hold them considers only its own costs and benefits.

I guess the story is: a bank owner thinks a pool of mortgages is worth $10 million, but owning those mortgages makes the bank excessively cautious, which somehow harms the wider economy. So the wider economy would like to see the mortgages sold to an institution whose caution would be less harmful, even if the less harmful institution valued the pool at just $5 million. But the bank owner refuses to sell for less than $10 million, so the bank owner keeps the pool and its caution.

A simple subsidy will not solve the problem. Suppose that the government said that it would pay for $5 million of the purchase price. Then potential buyers whose ownership would be less harmful to the wider economy would be willing to pay $10 million ($5 million for the pool itself and another $5 million for the government subsidy). But the subsidy also increases the valuations of the institutions whose ownership of mortgages is harmful to the wider economy. So if the harmful owners placed the highest value on these assets without the subsidy, they would do the same with it.

Nothing about the Geithner-Summers plan gives an incentive to mortgage assets to be ultimately held by the "right" institution. It only gives money to banks and creates a flurry of transactional activity, without changing the real ownership pattern that supposed created the problem to be solved.

Will the Geithner-Summers plan solve the Lemons problem?

One hypothesis about the banking crisis is that a secondary market for mortgages "does not now exist" (quote from Mr. Geithner's oped introducing the plan) because there is a "lack of clarity about the value of these legacy assets [which makes] it difficult for some financial institutions to raise new private capital on their own." (quote from U.S. Treasury fact sheet).

I guess the story is: a bank owner thinks a pool of mortgages is worth $10 million, and therefore refuses to sell for less than that. Potential buyers of that pool think it is worth $5 million, and therefore refuses to buy for more than $5 million. The market does not exist because the sellers value the assets less than potential buyers do.

A simple subsidy will not solve the problem. Suppose that the government said that it would pay for $5 million of the purchase price. Then potential buyers would be willing to pay $10 million ($5 million for the pool itself and another $5 million for the government subsidy). The problem is that the bank owner (presumably aware of the subsidy) may not want to sell for less than $15 million. The reason is that he might be able to buy the pool from himself -- in which case he would pay $10 million for the asset (that's what he thinks it is worth) and another $5 million for the subsidy. So if he can sell to himself for $15 million, why should he sell to another buyer who will pay only $10 million?

You might say that the Treasury or FDIC would not allow a sham transaction like I just described. Well then you are saying that the Treasury or FDIC will micro manage things -- good luck with that!

The Geithner-Summers plan is more complicated than the simple subsidy described above. But my intuition is that even the complicated version misses the point that a subsidy raises every one's valuations of the item subsidized, rather than (as supposed needed) raising the valuations of some relative to the valuation others. Thus, the Geithner-Summers plan looks like giving taxpayer money to banks and creating a flurry of activity without really changing any of the fundamentals (reminiscent of what I wrote last fall about the Paulson plan).

Commenters: do you know of anyone who has worked out an explicit lemon's model and then added the Geithner-Summers plan to it?

Top Republicans say banks should be allowed to fail

reports the IHT. The first bank bailout was needless. If enough Senators recognize that a second bank bailout would also be needless, then we taxpayers may be lucky enough to stop at one bank bailout.

I believe that both of the Senators in the report voted for the first bank bailout. So maybe more politicians are adopting the opinion that bank bailouts waste tax dollars.

Still No Payroll Collapse

At the end of September, both Democrat and Republican politicans tried to scare us into believing that payroll spending would collapse.

The chart below (including the BEA's release this morning) shows that payroll spending has barely hiccuped, let alone collapsed, in the four months since those alarms were issued.

Although something is clearly awry in this economy, it is hard to show that a credit crunch is that important, given that trillions of dollars continue to flow from business to households in the form of wages and other personal income items.

cnnmoney survey of small business

Sorry, it does not fit the credit crunch stereotype.

Credit Crunch Hard to Find in the Investment Data

If the credit crunch were the big deal people say it is, then you would think it would be readily visible in the investment data.

It's impossible to see a credit crunch in the first two graphs -- investment looks like it does in a "run-of-the-mill" recession (recessions that needed no trillion-dollar-financial-sector bailout).

The last graph shows non-residential investment. As Luke Threinen and I have pointed out, non-residential investment has been unusually strong in this recession, at least through 2008 Q3. 2008 Q4 takes a dip down -- maybe that's an effect of a credit crunch -- but that dip has a number of precedents in previous recessions.

More Proof that Banks did not Need the Bailout

Bank of America received $45 billion bailout funds.

Bank of America spent $50 billion to acquire Merrill Lynch.

Bank of America CEO said told lawmakers this week that his company extended more than $115 billion in new credit to consumers and businesses during the fourth quarter.

Because 150 + 50 >> 45, it is clear that Bank of American could have survived AND loaned lots of money to customers without a bailout. Whether they would have bought Merrill is another story.

134 million floor

In October I predicted that employment would not drop below 134 million. It hasn't yet -- but it got close enough in January that I am skeptical that this prediction will turn out right.

Crunch Breeds New Banks

Yesterday that was a Wall Street Journal headline (hat tip to Bryan Cross at UBS).

Four months ago, that was a headline on this blog.

Nonexistent WMD V: Industrial production and Capacity Utilization

After Lehman failed and “credit markets froze” in the second half of September 2008, many people proclaimed that a second Great Depression would unfold. A few days ago, I explained how payrolls did not collapse as some had been predicting in late September and early October.

During the first days of October 2008, it was claimed that the frozen credit markets would especially paralyze businesses. Now that a couple of months have passed, let’s look at industrial production and capacity utilization (two measures of business activity that are available monthly) as measured by the Federal Reserve. The charts below show industrial production (measured as a index) and capacity utilization (measured as a percentage of full capacity) for each of the months of second half of 2008 (December data not yet available). Both fell in and again in September, and have remained higher than September in the months since.




The Lehman Brothers investment bank failed on September 15. The bank was deeply intertwined with other financial institutions – its failure to pay its obligations put its creditors at risk – and brought the credit crisis to its crescendo. By the end of the month, the intense financial chaos motivated Mr. Obama and others to warn that banks needed lots of money from taxpayers, or else businesses and consumers would get hammered. Because the bailout bill took time to pass, and then additional time for the Treasury to design and execute its $700 billion Capital Purchase Program (CPP), no bank received any money from the Treasury pursuant to the CPP until the last couple of days of October. Thus, if the warnings were right, business production should have suffered dramatically in October.

Industrial production and capacity utilization may put too much emphasis on manufacturing and thereby give a noisy picture of the overall economy, but we were promised disastrous results -- and thus results that would be obvious even in noisy data.

Politicians from both parties alarmed the American public at the end of September and in early October in order to justify spending $700 billion of taxpayer funds on a bailout of United States banks. I previously showed three measures of October and November activity that were by no means disastrous by comparison to previous months. Above are two more.