demandside

Plus Richard Posner, Idiot of the Week, and more

4.29.09 News

The Chrysler bankruptcy was reportedly triggered by the unwillingness of hedge funds to make a deal.  We wonder, and in fact, suspect, that the unwillingness was stimulated by the derivatives of credit default swaps.  As we reported last week, insurance provided by CDS’s makes bondholders less willing to deal in potential bankruptcy, since they get paid in full.

The bank’s stress tests were described by David Goldman as “The stress test snooze”

April 24th, 2009, he wrote on his Inner workings blog Inner workings blog http://blog.atimes.net/?p=926 Banks were modestly higher after the Federal Reserve’s non-release of non-information of non-tests on — I almost wrote non-banks, but they actually are banks, more or less. What began as a tail-covering public relations stunt by Geithner turned into a potential embarrassment for the administration, which wants to show that it is being tough, pre-emptive and responsible, but doesn’t really want to do anything to make waves. Why should he? This post is brief because there is not much more to say about banks for the interim. They will range trade. The big action is over. Happy weekend.

Also on April 24, Floyd Norris wrote in the New York Times Subprime Loans, Corporate-Style, Will Fuel Defaults

Correction Appended

The loans went to borrowers who might never before have been allowed to borrow. When they found repayment difficult, they were permitted to refinance their loans, generating fees for the lenders and postponing the ultimate reckoning. Then the credit markets turned and both the borrowers and lenders were in deep trouble.

So it went with the subprime mortgage crisis. And so it is now going with corporate loans and bonds. It appears that defaults on leveraged loans and corporate bonds will soon rise to levels not seen since the Great Depression.

If that does happen, a wave of corporate bankruptcies will deal another blow to the American economy, and present the Obama administration with more painful decisions about possible bailouts — bailouts that could be made directly or indirectly by persuading bailed-out banks to make loans that might not seem wise to the bankers.

One reason for the rise in defaults is that this is a severe recession. But it is not the principal one.

Calculations by Moody’s Investors Service show that as of the beginning of April, a record 27 percent of speculative-grade debt issuers had a rating on their senior debt ranging from Caa down to C. These are the lowest rungs of credit quality — rungs that once rendered a borrower ineligible for a loan.

The default rate on leveraged loans and speculative grade bonds is rising rapidly. “We expect the default rate to get to the range of 14 percent by the end of the year,” said Kenneth Emery, a senior vice president of Moody’s. That compares to peak default rates of 10 to 12 percent during the last two recessions, in 1991 and 2001.

…

How did we get into this mess? The story is remarkably similar to the tale of subprime mortgages. Lenders who were making money by putting the loans into pools became more and more eager to make loans, and less and less concerned about their quality.

The way the loan securitization market developed, the most profitable loans to make were those rated B or even B-minus, levels of debt below the old standard for most junk bonds. There was a market for some Caa paper, even though such loans historically often landed in default.

Borrowers who ran into problems could refinance their debt, creating new rounds of fees for the banks making the loans and obscuring the problems with credit. And with the economy booming, there were not that many problems anyway.

The secret to all this was the collateralized loan obligation, or C.L.O. As with mortgage securities, the rating agency models figured that 70 percent of the money that went into financing single-B rated loans could be financed with AAA-rated paper.

As time went on, the big banks making the leveraged loans became more and more competitive, figuring the secret to profits was in making the loans and securitizing them — not necessarily getting them paid back. It was financial alchemy, but the AAA-rated paper was popular with buyers like banks and insurance companies, whose capital rules treated such securities as virtually risk-free. They wanted more such paper, and the big banks obliged.

“C.L.O.’s bought about two-thirds of corporate loans from 2004 to 2007,” said David Preston, a structured products analyst at Wachovia Securities. But there are now no new C.L.O.’s being created, and many of the old ones may soon be barred from reinvesting repayments in new loans — in part because so many existing loans are being downgraded by the rating agencies.It all sounds absurd now. But at the time, any bank that refused to lower standards on mortgage loans or on corporate loans risked plunging profits as all the business went to competitors. That might not have happened if regulators had been willing to step in, as some of them wanted to do. …

THE ARTICLE IS WORTH READING IN ITS ENTIRETY.  WE ABBREVIATE IT HERE FOR REASONS OF TIME.  BUT HERE ARE A COUPLE OF THE MORE INTERESTING PARAGRAPHS.

But Alan Greenspan, the chairman of the Federal Reserve when the credit party grew delirious, was the dominant regulator. He saw no need to interfere with markets. It might have been different if he had understood markets and the flaws that were leading to disaster. Instead, he worshipped markets.

Defaults are now rising because of the recession, but the news could get even worse. Unlike most mortgages, leveraged loans and junk bonds are not scheduled to be gradually paid off over the life of the loan. Instead, they come due and must be refinanced. Moody’s reports that leveraged companies need to refinance $26 billion in loans this year, $44 billion in 2010 and $120 billion in 2011. If credit markets remain tight, we could see lots of defaults even among companies that are doing well enough to make their interest payments.

…

And in California, Attorney General Jerry Brown

is making news ahead of his run for the Governor’s chair.

martin.zimmerman@

latimes.com

On the much-ballyhooed TALF program, Mark Thoma at Economist’s view reports,

The TALF program intended to increase auto loans, student loans, and credit card lending has a lot in common with the Geithner public private investment plan to remove toxic assets from bank balance sheets, including the valuable non-recourse loan feature. The fact that the TALF program is not living up to expectations - not even close - leads to questions about whether the Geithner plan will encounter similar problems.

Thoma cites a Washington Post article,

Federal Program to Boost Private Lending Struggles to Get Money to Consumers, by Neil Irwin,

In its first two months, the government’s signature initiative to support consumer lending has fallen well short of expectations, deploying only a fraction of the amount officials had hoped to extend to stimulate auto loans, student loans and credit card lending. …

Under [the Term Asset-Backed Securities Loan Facility, or] TALF, private investors … put up a relatively small amount of money to be matched with a larger loan from the Federal Reserve. The combined funds are then used to purchase newly created, highly rated securities, which in turn fund a wide range of consumer and business lending.

…

Officials envisioned TALF supporting tens of billions of dollars a month in new lending, saying it could eventually total $1 trillion. But in March, when it was launched, it backed only $4.7 billion in auto loans and credit cards. For April, it logged only $1.7 billion.

…

The Public-Private Investment Program, designed to buy loans and securities from banks, is structured similarly to TALF. …

Thoma says, ”

And the differences between the PPIP and TALF programs that I can think of, e.g. that the PPIP has toxic assets as part of the bargain, and some of the banks will need a bailout so the reassurances about executive pay, etc. can’t be made in these cases, are additional factors working against the PPIP’s success. Stimulus from the market

Demand side stimulus, Keynesian stimulus, traditionally is seen as deriving from government spending or tax cuts.  It is hard to find an economist or politician today who argues for no use of these.  Even the sacred tax cuts for the rich, established under the supply side prediction that they would lead to ever greater output, are now defended from the demand side.  That is, reversing these tax cuts will reduce much needed demand for products and services.

But demand side stimulus can come from the market as well, if the appropriate incentives are in place.

The supply side market stimulus is most often seen in state tax breaks to businesses to encourage them to site a factory or other facility in the neighborhood.  The theory goes that the new private facilities will produce jobs which will make the economy better.  But as Yogi Berra said, “In theory there is no difference between practice and theory.  In practice there is.”

All too often the new facilities undershoot their targets.  Some local businesses may be pleased, but rarely will it stop their complaining about the taxes which necessarily shift away from the newcomers and onto the current rate base.  And at bottom, studies have shown, there is a tendency for businesses to site according to more salient factors, then just game the local jurisdictions to cut their tax exposure.  More primary to business siting decisions, for example, are — one, two and three — market access, four, workforce availability, five transportation in and out, six educational facilities, and among the category of “also may be important” comes tax considerations.

And even here, the supply side stimulus is a zero sum game.  When one jurisdiction is chosen, the others are neglected.  If one community scores a Wal-Mart, businesses in all affected communities suffer.

But regardless of any of this, there are market-based measures that can stimulate from the demand side.

One is the forward commitment procurement process.  You may remember Dr. Jonathan Frost, featured repeatedly here on the podcast, advocating this technique.  Government simply commits to purchasing products in the future which meet the desired specifications.  Frost used the example of the British prison system’s procurement of a zero-waste mattress.

They described the attributes they wanted in a mattress.  In this case, not being flamable, usable as a weapon, and so on, and particularly including the attribute of producing no waste for the landfill.  The prospect was described by some as impossible.  Even if such a product could be produced, it would be prohibitively expensive.

In fact, they received over thirty responses to their proposal, and the one selected produced a mattress that actually — when disposal costs were included — was more economical than the previous version.

A more famous example cited by Frost is the mandate by the state of California for a halving of emissions from automobiles.  This was issued in the 1970s when the atmosphere of Southern California was nearly viscous with pollutants.  The premise was that autos could not be sold into the California market unless they met strict emission requirements.

Of course, the common response was that even if such a product could be produced, it would be prohibitively expensive.  The actual outcome, after billions in overwhelmingly private investment activity, was the catalytic converter and skies cleaner by far more than half.

The two salient features are the simplicity of the mandate — two paragraphs describing the product as to its emission effects — and the absence of government interference or micromanaging.  A great error of the ethanol debacle, for example, was to describe the technology, not the desired result.  Let the market do what it does best, innovate to the desired outcome

And here let us extend what is really a long digression.  One of Frost’s insights was the difference between R&D and innovation.  Research and development is always successful, he says, because you always discover something you didn’t know.  It is essentially an intense study.  Innovation is extremely difficult and often not successful.  You begin with an idea of the desired result and the process of innovation is essentially a creation of a path from here to there.

It is difficult, expensive, and as said often not successful.  The only reason to do it, Frost says, is because there is no other option.  That is the situation we have with global climate change.  There is no option other than solving the energy and transportation carbon problem.

End of digression.

The point we began with was that by mandating an emission level in order for automobiles to be sold into the California market, that state generated tens of billions of dollars in private investment and economic activity.  The same sort of opportunity could generate multiples of that number without a dime of public spending.

For example, if the national government mandated zero emission vehicles within ten years, and the mandate were credible, we would be looking at a complete turnover of the automobile fleet in addition to the investment in technology up front.  New plants, facilities, et cetera.  This is economic activity.  This is stimulus that produces jobs.

Would it be economically efficient?  Unless you believe that the destruction of the planet’s climate is economically efficient, the answer has to be yes.

And it overcomes a basic dynamic of depression, the collapsing consumption function.  We’ll go into this more deeply in another podcast, but the basic idea is that people are hoarding and cutting back spending in the face of economic uncertainty.  This restriction of spending is exacerbating the downturn.  Also discouraging spending from the monetary side is the collapse of credit markets, including pullbacks in credit cards, and you have a downward vector greater by perhaps a factor of three than the sum of the upward vectors of the stimulus and the various ad hoc measures being cobbled together by the Fed and Treasury.

Of course, a ten-year turnover over of the auto fleet is not realistic.  A workable plan would involve the mandate — the carrot of being able to sell cars — and penalties for gas guzzlers.  But this is another point on which Frost and I agree.  Taxes cap-and-trade schemes are not sufficient.  They will lead simply to expensive use of the same technologies.  The mandate, the necessity to innovate, is essential.

That said, you would generate a lot of investment and a substantial turnover of the fleet by higher carbon taxes.  Simply higher oil taxes.  The runup in oil prices between October 2007 and July 2008 brought to the fore a new generation of energy options and sold a lot of Toyota Priuses.  The retreat in oil prices carried many of these survival options out with them.

In this case, you generate new economic activity by making the status quo too expensive.

So those are market-based stimulus techniques that are economically efficient.

These could be combined with publicly sponsored stimulus in the form of infrastructure spending to create real progress, both in the short-term economic situation and in long-term security and stability.  Notice the publicly sponsored stimulus overcomes the problem of a declining consumption function by taxation.  This is forced consumption of public goods.  It is stimulative, but not necessarily a cut in taxes.

04.29.09 Forecast

Mark Thoma is coming close to the captured regulator position with regard to the Fed’s handling of the financial crisis.

http://economistsview.typepad.com/economistsview/2009/04/using-antitrust-law-to-break-up-banks-that-are-too-big-to-fail.html

http://economistsview.typepad.com/economistsview/2009/04/the-professionals-are-not-being-held-accountable.html

In a couple of posts linked on the web site, including his post entitled “The Professionals are not being Held Accountable” on Economist’s View, Thoma addresses this point.  In one he cites Michael Pomerleano

http://blogs.ft.com/economistsforum/2009/04/the-crisis-holding-the-professionals-to-account/

Viral V. Acharya and Rangarajan Sundaram.  The latter two point out: “The US recapitalization scheme … is … generous to the banks in that it imposes little direct discipline in the form of replacement of top management or curbs on executive pay, and secures no voting rights for the government“.

We seem to forget one of the successful lessons from the late 1980s savings and loan crisis in structuring positive and negative incentives: holding accountable the directors and officers, lawyers, accountants of the banks, investment banks and the rating agencies. … The Office of Thrift Supervision, which regulates the US’s thrifts, and its sister agency, the Resolution Trust Corp which was in charge of disposing of the assets of failed S&Ls, embarked on a deliberate deterrence strategy targeting lawyers, accountants, directors and officers of failed thrifts that aided and abetted the excesses leading to the S&L crisis. The intent was to discourage future abuses and recover some of the lost taxpayer funds. …

In the US, we are told that there are no culprits in the crisis. The attitude of the policy makers, regulators, bankers and traders involved in the crisis is virtually fatalistic, treating the crisis as an inevitable “force majeure”.

(Demand Side point:  According to Wikipedia, force majeure, literally superior force, refers often to a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as a war, strike, riot, crime, or an event described by the legal term “act of God” (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract. However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

Returning to Thoma, Pomerleano, Acharya and Sundaram.

All of them were observers and “no one saw it coming”. In short, the crisis is a Lemony Snicket’s “Series of Unfortunate Events”.

In reality the regulators that should have kept a close eye on the rapid growth of the shadow banking system were complacent, and the boards did not have the background in the industry and didn’t understand the risks. It is clear that the policy makers and regulators lack the moral authority to lead us out of the crisis. …

The US Treasury plans to rely on the same firms and people that were involved in leading to the crisis to get us out of it. … Clearly, nothing learned, nothing gained from the S&L crisis or the Swedish experience. Maybe this will change.

Saying it’s not your fault you crashed the ship into the rock because the rock was underwater and hidden - nobody could have seen it coming - loses its force when you are navigating in waters that are known to be rocky. Even if you have the latest sonar based upon fancy, innovative math that is supposed to detect the rock before you hit it, and even if regulators were supposed to clearly map and mark all danger, if you hit it anyway, there’s a reason why captains are expected to go down with - or at best be the last ones off - the ship. It ensures they’ll do all they can to avoid hitting it in the first place.

Unquote

This is getting very close to the Demand Side position that the Fed and other financial regulators are no different than examples throughout government where oversight bodies have become captives to the industries they are supposed to regulate.  The Fed’s continued insistence on rescuing the financial institutions rather than stabilizing the banking functions in new, smaller, credible institutions is the ultimate proof.

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