What's the Best Liberal Case Against Principal Reduction?

Aug 21, 2012Mike Konczal

Binyamin Appelbaum has an article in the New York Times about the administration’s terrible response to the housing crisis.

Binyamin Appelbaum has an article in the New York Times about the administration’s terrible response to the housing crisis. The administration “tried to finesse the cleanup of the housing crash, rejecting unpopular proposals for a broad bailout of homeowners facing foreclosure in favor of a limited aid program — and a bet that a recovering economy would take care of the rest.” This has several responses, including David Dayen at firedoglake, as well as Ezra Klein writing about the administration's response from a balance-sheet recession and housing point of view. That got a response from Dean Baker arguing that this balance-sheet recession point of view, and the subsequent focus on mortgage debt reduction, is a distraction from better policy.

With President Obama pushing for a wider refinancing plan and the debate over refinancing and principal reduction back in the headlines due to the book Bailout and the fight over the GSEs, it might be useful to formalize the best liberal case against principal reduction. It'll give us a set of arguments to wrestle with so that we can then work backwards toward better arguments. So what is the best case? I see three broad arguments.

1. Wealth Effect Means It Doesn't Matter

This is the approach Dean Baker takes, and I think it is influential among many liberal wonks. The housing crashed destroyed a lot of housing value, leaving us feeling poorer, which means we spend less. An important way to understand this argument is that if every house during the housing bubble was paid for with cash instead of a mortgage, and we had the same housing bubble and crash but no mortgage debt overhang, our recession and slow recovery would look virtually identical. Reducing housing debt in our situation won't help the economy as a whole (though it will help the individuals involved), because housing debt hanging on the economy isn't the drag.

Foreclosures are still bad in this argument (and Dean has been at the forefront of fighting against foreclosures), but they only need to be stopped in the sense that all bad things should be stopped; housing crisis policy will help some and hurt some, but it isn't a check on the recovery. It is not necessary and isn't effective in getting us back to full employment.

I think there are some empirical problems with this argument. The elasticities people are finding are an order of magnitude bigger than realistic expectations. Declines in housing prices are nonlinear against wealth distribution. Something else is in play. See this interview or this paper for more on these arguments. The administration seems to be moving in this balance-sheet direction. Let's say we reject this wealth effect argument -- should we change policy?

2. Fiscal and Monetary Uber Alles

Christina Romer would say no. She, like many, would argue that housing debt is probably a drag on demand, but we should respond to it with fiscal and monetary stimulus. She would stay out of the policy in the purple circle above, which is the mapping I use around here to approach how people think of the recession. Romer, from September 2011:

[One argument is that the] bubble and bust in house prices has left households burdened with too much debt. Until we deal with this problem — perhaps by providing principal relief to the 11 million households whose mortgages are larger than the current value of their homeswe’ll never get the economy going.

The premise of this argument is probably true: recent evidence suggests that high debt is holding back consumer demand. But it doesn’t follow that the government needs to directly lower debt burdens to stimulate job growth.

Recent research shows that government spending on infrastructure or other investments raises demand even in an economy beset by over-indebted consumers. Another effective approach is to aim tax cuts and government payments at households that would like to spend, but can’t borrow because of their debt loads (such as the poor and the unemployed).

History actually suggests that the “tackle housing first” crowd may have the direction of causation backwards. In the recovery from the Great Depression, economic growth, which raised incomes and asset prices, played a big role in lowering debt burdens. I strongly suspect that fiscal stimulus will be more cost effective at speeding deleveraging and recovery than government-paid policies aimed directly at reducing debt.

There's a general critique of the president's stimulus program that argues it was too focused on tax cuts instead of long-term investments, which have a better bang for the buck. The same critique can be used on spending money on principal reduction. It's money that by definition isn't spent (it was already spent), so you need second-order effects for it to go. We'd prefer just giving people money (tax cuts) over principal reduction in the same sense that we'd prefer infrastructure over tax cuts.

And one doesn't need to be a conservative worried about helping the "losers" or someone who is uncomfortable with the fairness of mortgage debt reduction to think there are better ways to spend this money. Consider having $250 billion dollars to spend, one benchmark put forward as the amount of money that could have been spent from TARP. You could hand it out in some manner to pay off underwater debts, perhaps a matching scheme with the banks. That wouldn't reduce overall mortgage debt that much because there is a lot of it.

Meanwhile, with $250 billion dollars, you could build 5,000 miles of high-speed rail. You could fund universal pre-K for a decade. You could take the 13 million people unemployed under the traditional unemployment measure and give them a basic income of almost $10,000 for two years. You could build infrastructure, create social goods designed to foster egalitarianism, or tackle poverty. These are all better investments for us to make, plus they build a better society and they get us to full employment faster. Tackling mortgage debt produces none of these benefits.

When Geithner's argued against principal reduction, saying that it would be "dramatically more expensive for the American taxpayer, harder to justify, [and] create much greater risk of unfairness," he followed it up by saying "The whole foreclosure crisis across the country now is really driven by what happened to unemployment and what happened to the income of Americans. The best things we can do now to help mitigate that risk is to help get the economy. growing again, bring unemployment down as quickly as we can, put people back to work." I view that as in line with Romer's argument.

By itself, I think this is correct. But one important response to that is that principal reduction can often pay for itself, especially in situations where a borrower is at risk. A lender will want a consistent, if lower, payment stream rather than to take ownership of an abandoned house in a depressed market. As Lew Ranieri said, "You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure." So it is good economics, especially in a distressed market. Another response is that few people propose just giving money away, but instead want to tie it to some sense of risk and reward, or reaccounting of the banks' balance sheets. So how does that play out?

3. Upsides and Downsides

One reason giving away money to pay off underwater debts is a bailout, and thus politically unpopular, is that there would be a disconnect between who absorbed the costs on the downside and who gains the potential value from the upside. If taxpayers just paid off mortgage debts, banks and homeowners would gain a windfall that isn't directly shared with taxpayers. One way to deal with this is either to force creditors to eat a cost upfront -- they absorb the downside and then can benefit from the upside. The other is for taxpayers to gain from the upside, usually through the mass purchase and/or refinancing of mortgages. Let's look at the first way.

Why aren't bank servicers doing writedowns? There's a mix of bad incentives and poor resources that result in bad practices. The administration hasn't been aggressive with using financial fraud, like the range of practices including robosigning and documentation fraud, to force reform here, instead focusing on removing legal liabilities from the banks. Maybe that task force will someday do something, but from my read even sympathetic observers think it was a wasted opportunity. 

But even if policy is centered on forcing servicers to clean up their fraud, there's a lot of creditor free-riding in ad hoc debt writedowns that becomes problematic. Is writing down first mortgages good policy even if junior mortgages, often held by the biggest banks, are untouched? If home equity lines of credit are acting as a last line of income maintenance and credit for households in this weak recovery, is it wise to push policy to extinguish them to adjust first mortgages? If you wipe out both, isn't that a giant transfer to other creditors like auto lenders, private student loans, and credit card companies? Should we be concerned about moral hazard from the debtor's side? You need some mechanism to coordinate and bind the collective behavior of creditors while preventing free riding and also bringing in impartial adjudication, which is a traditional function of bankruptcy. Bankruptcy reform was famously not pushed by the administration, and to me that was its biggest mistake.

The other approach to avoid a bailout is for the government to gain a share of the upside for taking on the downside. This is one reason writedowns for the GSEs make sense: we gain the upside, as we own the GSEs, and we're already on the hook for the downside, so the risk on the downside isn't a "bailout" but prudent policy.

When it comes to dealing with the broader housing market, a lot of the programs proposed, like revitalizing HOLC or Senator Merkley's plan on refinancing, would have taxpayers put up money but gain in the upside. Even the IMF is now encouraging the United States and other countries to investigate bringing back something like an HOLC. The two counter-arguments would be that HOLC still had a high redefault rate, a rate that would have a lot of people crying foul. The second is the problem of what to pay for the mortgages. Recent attempts to use eminent domain to purchase mortgages at below-market rate in order to compensate taxpayers for absorbing these risks in a terrible market also have a lot of people crying foul.

My general thought is that moral hazard can be a problem, but the misery and wasted lives of mass unemployment is a much bigger problem. That said, bankruptcy and these government programs eliminate most moral hazard concerns. Bankruptcy can be done in such a way to hit homeowners as well; for the government program you'd want people to be trying to take advantage of them. That's why so many people have been shocked that the administration hasn't pushed on either.

What I find interesting is that all these articles about what could have been done with housing take the way TARP played out as given. But starting a HOLC program, rebooting the broken servicing model, or otherwise writing down mortgage principal would have been significantly easier if the banks were put into a receivership in early 2009. TARP policy, which was to protect the banks' balance sheets at all costs, worked counter-productively, putting administration resistence to enacting even the lowest-hanging policy fruit. Receivership would have cost more upfront, but it would have been significantly easier to tackle these problems. There is a major debate to have on this topic.

 

Mike Konczal is a Fellow at the Roosevelt Institute. Follow or contact the Rortybomb blog:

  

Share This

Paul Ryan Really Doesn't Like Dodd-Frank

Aug 13, 2012Mike Konczal

Beyond thinking Dodd-Frank generally was a bad bill, he's voted against most of its individual pieces.

The entirety of Romney's plan for financial reform in the wake of the 2008 crisis is contained in the following sentence: "Repeal Dodd-Frank and replace with streamlined, modern regulatory framework." One might argue that this is vague enough to cause some of the dreaded economic policy uncertainty, but either way it is very unclear about what exactly financial regulation should involve.

Beyond thinking Dodd-Frank generally was a bad bill, he's voted against most of its individual pieces.

The entirety of Romney's plan for financial reform in the wake of the 2008 crisis is contained in the following sentence: "Repeal Dodd-Frank and replace with streamlined, modern regulatory framework." One might argue that this is vague enough to cause some of the dreaded economic policy uncertainty, but either way it is very unclear about what exactly financial regulation should involve.

This might change with Paul Ryan. Not only is Ryan well known for his wonky style, but he voted for TARP, the Wall Street bailout. He also went to the floor of the House and asked his fellow Republicans to vote for TARP. One would imagine he would think that the status quo is flawed if he had to vote for TARP to save the economy. Alas, Paul Ryan voted against the Dodd-Frank Wall Street Reform and Consumer Protection Act, the major financial regulatory response to the crisis.

(It might be worth noting that Public Citizen did an analysis that found that House members who voted for TARP and against Dodd-Frank, a club Paul Ryan belongs to and consists mostly of Republicans, received three times as much campaign money from the financial industry as those that voted the opposite in both cases. As Zach Carter pointed out in an analysis back in 2010, of the 60 Republican House members who voted for TARP and against Dodd-Frank, Paul Ryan received the ninth highest donation from the financial industry in 2010, with a haul of at least $531,500 for the year.)

So Paul Ryan is against Dodd-Frank as an overall bill. He also seeks to repeal it in his budget. But what does Ryan think of the individual parts of Dodd-Frank? One could be opposed to Dodd-Frank as a whole while still thinking individual parts are good ideas. In order to isolate that question, we can look at a series of Dodd-Frank amendments Ryan voted on, as well as subsequent actions and statements.

Consumer Protection: While the bill that became Dodd-Frank was going through the House, Ryan voted to scrap the Consumer Financial Protection Agency and replace it with a plan proposed by the Chamber of Commerce. Right before Dodd-Frank came up for a vote in the House, there was an amendment proposed by Rep. Walt Minnick (D-ID) to replace the CFPA with a council of existing regulators. According to reports from the time, this was modeled off suggestions from the Chamber of Commerce. The amendment failed, though Paul Ryan voted for it. Beyond concerns of accountability or funding of the CFPB, Paul Ryan would likely rather see the entire thing go.

Derivatives Regulation: Part of Dodd-Frank requires that derivative contracts trade through a clearinghouse. We don't have a clear vote from Ryan that shows what he thought of derivatives at the time, but he did vote against the Lynch amendment. Stephen Lynch (D-Mass) proposed a simple amendment stating that a financial firm can't own more than 20 percent of a derivatives clearinghouse to prevent conflicts of interest. Later, Ryan also voted to delay the implementation of derivative regulations for one year in June 2011, signaling he doesn't approve of the aggressive derivatives reforms people like Gensler are championing at the CFTC. This contrasts him sharply with someone like John Hunstman, who had very strong derivatives reform as part of his broad, serious financial reform ideas during the Republican primary.

Resolution Authority: Ryan voted for the repeal of resolution authority -- indeed, he sponsored the legsliation to repeal it. Resolution authority, or orderly liquidation authority, is a new set of legal abilities that allow the FDIC to take over and wind down a failing financial firm. When Barney Frank says that his bill actually has a death panel in it, he's referring to this part.

We can get a bit specific with why Ryan likely did this. In his Path to Prosperity, Ryan makes two points in argument against resolution authority. The first is that it "intensifies the problem of too-big-to-fail by giving large, interconnected financial institutions advantages that small firms will not enjoy." As Barney Frank and others point out, there's not evidence that banks are actively seeking to be designated as systemically risky. The general read is that business are going out of their way to avoid that designation, even restructuring away from risky activities. Which is the point.

The second critique is that "Federal Deposit Insurance Corporation (FDIC) now has the authority to access taxpayer dollars in order to bail out the creditors" and will presumably use it, preserving Too Big to Fail. Depending on who is talking, this usually refers to either the FDIC’s ability to provide “an immediate source of liquidity for an orderly liquidation, which allows continuation of essential functions and maintains asset values” or its ability to repay creditors.

Dodd-Frank requires that the FDIC's responsibilities include ensuring "that unsecured creditors bear losses in accordance with the priority of claim,” that shareholders receive nothing "until after all other claims and the Fund are fully paid" and that any losses remaining afterward that could impact Treasury are repaid through assesments on systemically risky financial institutions. In order to avoid situations like AIG, the FDIC is explicitly prohibited from taking "an equity interest in or become a shareholder of any covered financial company or any covered subsidiary" during resolution. Management has to be fired. Taxpayer money is recouped and bailouts avoided.

Title II is built to avoid looking like a bailout, self-consciously so. If the critique is about the powers to differentiate payments, those powers, as Douglas G. Baird and Edward R. Morrison noted about the powers, look like critical vendor orders or other parts of bankruptcy powers. By all accounts the FDIC rules are being written in this manner.

Bankruptcy: Speaking at a town hall, Ryan has seemingly proposed modifying the bankruptcy code, perhaps in line with plans from the Hoover Institute, in order to handle financial firms. (He also seemed to endorse the Volcker Rule in that town hall, but I haven't seen that from him anywhere else.) This would mean the FDIC would lose the special powers it has been given, which are believed to be important for resolution, including advance planning and living wills, debtor-in-possession financing and liquidity, making payments to creditors based on expected recoveries, keeping operations running, having graduated regulations based on size and riskiness, the ability to transfer qualified financial contracts without termination, and the ability to turn up or down regulations going into a potential resolution based on prompt corrective action. If that is the plan, and those powers are unnecessary to tackle TBTF, Ryan should spell it out more clearly.

At the same time, Ryan has proposed policies that were already in or based on Dodd-Frank. He has told CNBC and Ezra Klein that he was interested in using Luigi Zingales' approach to taking down a financial firm as outlined in a National Affairs article. This approach uses credit default swap measures, a financial derivative designed to gauge the risk of collapse, to judge when to take a financial firm into an orderly liquidation.

As I noted at the time, this is a form of resolution authority. It is specifically a form of prompt corrective action, which requires regulators to go ahead and collapse a firm based on market signals instead of regulator judgement. For it to work, you'd need legal powers to carry out a resolution, which Ryan has voted against, as well as sufficient regulation of dervatives to make sure the price signal is clear, which Ryan also voted against. And it seems to stand in contrast to the bankruptcy approach he has talked about elsewhere.

At this point there are some allusions to specifics in what Ryan talks about when it comes to taking down a large financial firm, though it often contradicts itself. But he hasn't offered anything specific on derivatives, consumer financial protection, insurance, securitization, ratings agencies, and the shadow-banking industry more broadly -- all of which would be up for grabs if Dodd-Frank was repealed under the Path to Prosperity.

Mike Konczal is a Fellow at the Roosevelt Institute. Follow or contact the Rortybomb blog:

  

Share This

A Year After S&P's Rating Downgrade, US Treasuries Trade 1% Lower

Aug 5, 2012Mike Konczal

On August 5th, 2011, one year ago today, S&P downgraded the United States from AAA to AA+. This was four days after Congress voted to raise the debt ceiling. S&P did this because they didn't like the politics of the debt ceiling, implicitly blaming the Republicans' aggressive threat of a default on the national debt to obtain their political goals.

On August 5th, 2011, one year ago today, S&P downgraded the United States from AAA to AA+. This was four days after Congress voted to raise the debt ceiling. S&P did this because they didn't like the politics of the debt ceiling, implicitly blaming the Republicans' aggressive threat of a default on the national debt to obtain their political goals. "The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed." And they did this because they wanted to nudge Congress to make big, Grand Bargain type changes. S&P was worried that, in the aftermath of the debt ceiling agreement, "new revenues have dropped down on the menu of policy options" and "only minor policy changes on Medicare and little change in other entitlements" would potentially be achieved in the near future.

Analysts at Treasury quickly noted, after reviewing the numbers, that S&P made a $2 trillion dollar mistake, which dramatically overstated the medium-term debt levels of the United States that were their economic justification. S&P stood by their downgrade while admitting the error.

The United States losing its AAA rating was a political shock. The verdict was quick from the center and the right - this would be incredibly harmful to the United States' ability to deal with its national debt. When S&P first brought up the possibility of the downgrade in July, the centrist think tank Third Way highlighted that "S&P estimates that a downgrade would increase the interest rates on U.S. treasuries by 50-basis points," and urged "Congress and the Administration [to] come together and pass a 'grand bargain' that will put us on a sustainable path and avoid a credit downgrade."

After the downgrade Mitt Romney noted that “America’s creditworthiness just became the latest casualty in President Obama’s failed record of leadership on the economy. Standard & Poor’s rating downgrade is a deeply troubling indicator of our country’s decline under President Obama."

Those are two empirical predictions. Did the downgrade increase interest rates on U.S. Treasuries 50-basis points? Would you go further and describe our creditworthiness itself as a casualty?

Here's FRED data on Treasury 10 years:

They are down a little over 1 full percentage point, from 2.58 percent to 1.51 percent. If you want to consider the baseline the 3 percent interest rates from right before the downgrade, or the 2 percent interest rates that happened afterwards, then rates are down either 1.5 or 0.5 percentage points. That's a major decline in the borrowing cost of the United States. One can't find the increase in rates in this market. Counterfactuals are difficult - perhaps S&P is correct, and 10-year Treasuries would be closer to 1 percent had there been no downgrade.

But that seems unlikely. Here's a previous link discussing ratings agencies' internal research finding that they consistently overstate the default risk of government debt. The ratings agencies can add value in thin markets with little history, or as a means of a coordinating research and action among market participants. But the United States' debt market is one of the most liquid, traded, researched and transparent markets in the world, and it seemed doubtful the ratings agencies were going to add much information with their downgrade. A year later the downgrade appeared to have been irrelevant to United States' borrowing costs. To the extent that they were relevant they signaled and reinforced a further move away from potential stimulus for the economy, which collapsed demand and drove even more money into government bonds and the interest rate down to 2 percent almost right away. But either way, low interest rates on US debt continues their downward march. Contrary to S&P, the financial markets are calling for a larger deficit, not a smaller one.

Follow or contact the Rortybomb blog:

  

Share This

Can We Start the Merkley Plan Now Using TARP (And Bypass a Dysfunctional Congress)?

Jul 30, 2012Mike Konczal

Senator Jeff Merkley (D-OR) has just released a new housing plan for dealing with the mortgage crisis by refinancing underwater mortgages titled "The 4% Mortgage: Rebuilding American Homeownership." This plan would create a Rebuilding American Homeownership (RAH) Trust, modeled after the HOLC plan in the Great Depression. It would buy out underwater mortgages for three years, then wind down while managing its mortgage portfolio.

Senator Jeff Merkley (D-OR) has just released a new housing plan for dealing with the mortgage crisis by refinancing underwater mortgages titled "The 4% Mortgage: Rebuilding American Homeownership." This plan would create a Rebuilding American Homeownership (RAH) Trust, modeled after the HOLC plan in the Great Depression. It would buy out underwater mortgages for three years, then wind down while managing its mortgage portfolio. Underwater mortgages would have three payment options, including a 15-year 4 percent interest rate plan to help rebuild equity, a 30-year 5 percent plan like a standard mortgage, and a two-part plan that splits the loan into a first mortgage equal to 95 percent of the home's current value and a "soft second" for the rest. Here are links to the summarythe full plan and a YouTube video introduction.

I think it is a great plan. Felix Salmon is also a "huge fan" of the plan and has a description of several of the positive features. Many will probably react to it like Matt Yglesias, who, after discussing the positive parts of the plan, notes that the "chances of Congress actually doing this are slim to none."

But what if this plan didn't need Congress? What if the Executive Branch could do this right now, on its own?

There is interest is moving forward. Senator Merkley told David Dayen that he was hoping that "pilot programs for RAH operating in several states between now and the end of the year." Treasury Secretary Timothy Geithner said that he'd be willing to try to "find legal authority and resources to -- to test [the RAH] on a pilot basis."

The report notes three potential homes for the plan: (1) FHA, (2) Federal Home Loan Banks system, or (3) the Federal Reserve. Of those, FHA seems like a potential place to launch the plan immediately. As the report mentions, "FHA already implements the FHA Short Refi program as one of the government's foreclosure prevention programs." What if the administration took the FHA Short Refi program and replaced it with what is needed to run the RAH? To launch this right away by replacing FHA Short Refi with the Merkley plan you'd need authority and cash, and FHA Short Refi has both.

Why does FHA Short Refi have the authority to implement this plan? FHA Short Refi plan is a part of TARP designed to deal with the housing crisis by modifying underwater mortgages. When Dodd-Frank passed in July 2010, special language was put in to limit the creation of new programs or initiatives under TARP. However, this project exists as part of that already-existing housing priority, and those programs can be modified. These programs are modified all the time to try to make them work better. HAMP, for instance, was modified earlier this year.

FHA Short Refi was designed to "enable lenders to provide additional refinancing options to homeowners who owe more than their home is worth." So it looks like it has the authority to act and change its mission structure from Short Refi to the Merkley plan, provided that Treasury's lawyers (I believe) approve of the changes.

FHA Short Refi also has moneyAccording to SIGTARP's quarterly report to Congress from July 2012, Treasury had allocated $8.1 billion for FHA Short Refinance.

How many mortgages have been modified under the FHA Short Refi program since it started? "As of June 30, 2012, there have been 1,437 refinancings under the program." Less than 1,500 mortgages in the country have gone through this program. How much money has been spent? "Treasury has pre-funded a reserve account with $50 million to pay future claims and spent $6.6 million on administrative expenses." Less than $57 million dollars. Given $8.1 billion dollars to spend on helping the housing market, less than 0.7 percent of it has been allocated, impacting less than 1,500 people.

That's a bit mind-boggling, but the failure of FHA Short Refi to either impact homeowners, help the economy or use its resources could be the genesis for the success of the RAH. FHA can provide the baseline funding for the part of the mortgage that isn't underwater, while the additional resources necessary to ensure the additional funding for the underwater part of the mortgage can come from this FHA Short Refi. That $8 billion could be used to insure the other part of the mortgages involved, which would then be sold off in a new bond. Amplified in this way, that $8 billion dollars could be used to backstop tens of billions of dollars of new mortgages.

At that point funding would end, but we'd have a sense if it was working or not. And if that $8 billion can insure $100 billion dollars worth of underwater debt, between 10 and 18 percent of underwater debt could be refinanced. If it is successful, there will both be a good empirical argument for continuing with additional funding and a political coalition of other underwater homeowners who would want to participate. If it is a failure, then it is a good opportunity to end it right there.

With that in mind, it might be useful to remind ourselves why this plan is important as an economic matter. Most of the recent research finds that underwater mortgage debt is strongly linked with weak consumption, high unemployment, and sluggish wage growth - our economy is stuck in a "balance-sheet recession." The blockage of prepayment has created a windfall for creditors in a weak economy with low interest rates; as Felix Salmon notes "the CBO is saying that if we paid off current bondholders at 100 cents on the dollar, they would lose as much as $15 billion...They’re basically taking unfair advantage of the fact that homeowners are locked into above-market mortgage rates" and can't prepay or refinance their mortgages.

Beyond creating a hangover effect on aggregate demand and basic unfairness, underwater mortgages also blunt the ability of monetary policy to do its full job. Even Federal Reserve Chairman Ben Bernanke believes this is happening. Here's Bernanke at a press conference from last November:

One area where monetary policy has been blunted, the effects have been blunted, has been the mortgage market where very tight credit standards have prevented many people from purchasing or refinancing their homes and therefore the low mortgage rates that we’ve achieved have not been as effective as we had hoped. So, monetary policy maybe is somewhat less powerful in the current context than it has been in the past but nevertheless it is affecting economic growth and job creation.

That’s Fed speak for underwater mortgage refinancing being a major boom to boosting demand, which helps the economy as a whole, even people who have no mortgage or debt but are stuck in a terrible jobs market. Given how interested the Federal Reserve is in this blocked channel for the efficiency of monetary policy, I hope they are considering how they can play a role in this.

All in all, Merkley has put together an excellent plan and I believe we have the means to do it. It provides new stimulus while amplifying already existing monetary stimulus, plus it contains a measure of fairness between creditors and everyone else. When can we start?

 

Follow or contact the Rortybomb blog:

  

Share This

A Big Banker’s Belated Apology

Jul 30, 2012Jeff Madrick

This op-ed originally appeared at NYTimes.com.

This op-ed originally appeared at NYTimes.com.

Last week, in a CNBC interviewSanford I. Weill, the former chairman of Citigroup, said that America should separate investment banking from commercial banking. This separation, of course, was the prime purpose of the Glass-Steagall Act of 1933, a piece of legislation that Mr. Weill and other bankers had successfully watered down, with Alan Greenspan’s support, before Mr. Weill helped engineer its official demise in 1999. Now, Mr. Weill, the creator of what was once the largest financial conglomerate in the world, suggests that Citigroup and others should be broken up. Banks can no longer “be too big to fail,” he told CNBC.

But what was most eye-catching was Mr. Weill’s claim that the conglomerate model “was right for that time.” Nothing could be further from the truth.

Mr. Weill’s original business concept — the justification of financial conglomeration — was to provide one-stop shopping to any and all customers. This could now include clients for investment banking, stock research, brokerage and insurance. Then, with the 1998 merger of his Travelers Group with Citicorp, it could include savers, business borrowers and credit card users, too. But few, even among his own executives, ever believed the strategy would work.

Rather, conglomeration bred conflicts of interest in Mr. Weill’s firms, and others — the very conflicts that the original Glass-Steagall Act was designed to prevent. This inevitably led to investment in and promotion of risky, poorly run and, in some cases, deceitful companies that brought us the high-technology and telecommunications bubble of the late 1990s.

Indeed, Mr. Weill’s Citigroup was a primary underwriter of and one of the two largest lenders to the oil and futures trading firm Enron, whose accounting charade resulted in what was in 2001 the biggest bankruptcy of its time. Citigroup was a major underwriter for the telecommunications giants Global Crossing and WorldCom, which would later go bankrupt as a result of flagrant accounting deceptions. There were many other, if less visible, debacles.

Read the full article here.

Share This

On Nickels, Bulldozers, JP Morgan's Now $5.8 Billion Dollar Loss, and the Volcker Rule

Jul 19, 2012Mike Konczal

One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular.

One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular. Like getting run over by a steamroller (another vehicle used for this metaphor), the losses are huge, painful, and immediate, yet they manage to continue coming.

The metaphoric bulldozer continues to crush JP Morgan's balance sheet in light of its disastrous credit derivatives trading (remember that?). The losses were originally supposed to be around $2 billion dollars. The losses have now tripled to $5.8 billion dollar, as reported last week in their quarterly losses. According to the New York Times a few weeks ago, some estimate that it will be more like $8 or $9 billion. $9 billion is a lot more than the original $2 billion. And it is a significantly more than the handful of nickles they were looking to pick up if the strategy had worked.

It's worth looking at this in light of the Volcker Rule. There's an argument that this kind of propritary trading is entirely fine and good for the economy, but it does not need to be done by institutions that have taxpayer money on the line or function as a systemically important part of the financial infrastructure of the economy. It will be both well provided and well compensated on its own through hedge funds and smaller players in the financial markets. If anything, taxpayer subsidizes could crowd out smaller players, distorting the way that the financial market works.

But there's also the question of what to do if a large, systemically risky firm fails. Here the Dodd-Frank policy regime involves prompt corrective action to begin prepping a firm that looks like it will fail for failure, much like how the FDIC currently does with commercial banks. This system works better if there is adequate time and if there are no gigantic surprises.

Contrast that with Bear Sterns and its hedge funds. Bear Sterns put up $40 million of its own money into two internal hedge funds between 2004 and 2006, and in June 2007, Bear had to bail out these two funds with a line of credit worth $3.2 billion dollars. $40 million dollars upfront got crushed under the steamroller to the tune of $3 billion. Such a large loss absorbed so quickly put significant pressures on the firm; it later collapsed.

Given this asymmetric payout, prop trading makes a certain type of failure more likely - one that is quick, out of nowhere, and large. This type of collapse strains our system for resolving large, systematically risky financial firms. This system is what we need in order for financial firms to collapse in a fair way, one that allocates losses to those who gained the most while also preventing huge spillovers to third parties. The Volcker Rule is an essential part of this.

Share This

Four Issues with Miles Kimball's “Federal Lines of Credit” Policy Proposal

Jul 18, 2012Mike Konczal

Economics professor Miles Kimball has a new blog, Confessions of a Supply-Side Liberal. In one of his first posts, he outlines a plan for stimulus that he calls “Federal Lines of Credit” (FLOC).

Economics professor Miles Kimball has a new blog, Confessions of a Supply-Side Liberal. In one of his first posts, he outlines a plan for stimulus that he calls “Federal Lines of Credit” (FLOC). It's presented in a longer policy paper, “Getting the Biggest Bang for the Buck in Fiscal Policy." This has gotten interest across the political spectrum. Bill Greider has written about it in The Nation, as has Reihan Salam in the National Review.

What's the idea? Under normal fiscal stimulus policy in a recession, we often send people checks so that they'll spend money and boost aggregate demand. Let's say we are going to, as a result of this current recession, send everyone $200. Kimball writes, "What if instead of giving each taxpayer a $200 tax rebate, each taxpayer is mailed a government-issued credit card with a $2,000 line of credit?" What's the advantage here, especially over, say, giving people $2,000? "[B]ecause taxpayers have to pay back whatever they borrow in their monthly withholding taxes, the cost to the government in the end—and therefore the ultimate addition to the national debt—should be smaller. Since the main thing holding back the size of fiscal stimulus in our current situation has been concerns about adding to the national debt, getting more stimulus per dollar added to the national debt is getting more bang for the buck."

Let's kick the tires of this policy. There's a lot to like about the proposal, particularly how it could be used after a recession is over to provide high-quality government services to the under-banked or those who find financial services yet another way in which it is expensive to be poor (modified, it turns right into Steve Waldman's Treasury Express idea). It's not clear whether this is meant to supplement or replace normal demand-based fiscal policy - at one point he proposes it could balance out a "relatively-quickly-phased-in austerity program."

As a supplement it has promise, but I think there are some major problems with this proposal, which can be grouped under four categories.

I: Isn't deleveraging the issue? Is this a solution looking for a problem? From the policy description, you'd think that a big is credit access holding the economy in check.

But taking a look at the latest Federal Reserve credit market growth by sector, you can see that credit demand has collapsed in this recession. Consumer credit drops throughout the beginning of the recession, particularly in 2009. This is true even for consumer credit by itself, which rebounds in 2011. It's not clear that these lines of credit would be used to expand demand at the macro-level; likely, given what we see, it would be used to replace other, higher-interest forms of debt (see III), a giant transfer of credit risk from credit card companies to taxpayers. But certainly some people will benefit, so let's examine why this policy is supposed to work.

II: This policy is like giving a Rorschach test to a vigilante. No, not that vigilante. I mean the bond vigilantes. Because to assume this plan would work, you need to make some curious assumptions about how bond vigilantes think, as it increases the debt by a significant amount.

Let's say our country has a balanced budget with a debt-to-GDP ratio of 50 percent and we hit a recession while at the zero-bound. As a result of less tax revenue coming in and more automatic stabilizers going out, debt-to-GDP will be 60 percent at the end of the year. We want to stimulate the economy further using fiscal stimulus.

Let's say our default is that we take three percent of GDP, divide it among the population, and mail it out. At the end of the year, the debt-to-GDP ratio will be 63 percent (I am ignoring that fiscal stimulus at the zero-bound can be largely self-financing for this example).

In Kimball's FLOC, we instead take 9 percent of GDP, divide it evenly among the population, and mail out lines of credit that add up to that 9 percent of GDP. Let's also say that perfect forecasting tells us that within the year, 6 percent of it will be utilized as a loan not yet paid back, and 3 percent is still available as credit.

What's the government's debt-to-GDP ratio at the end of the year in Kimball's example? I'm not sure how he'd account for it. I imagine it should be 69 percent (60 + 9). Perhaps it is 66 percent (60 + 6)? Either way, it is more than the 63 percent of just giving people money. His plan requires a larger debt-to-GDP ratio. If his accounting ends up with just 60 percent, I'm not sure I understand how he is doing it.

Now Kimball will say that bond vigilantes will be happy with this. Why? Because there's a built-in plan for repaying it. "[T]he fact that much of the money would ultimately be repaid would dramatically reduce the ultimate addition to the national debt...(though at a relatively attractive ratio of additional aggregate demand to addition to national debt)."

If we are guessing as to what the bond vigilantes want, it is clear they want more U.S. government debt. Ten-year Treasuries are selling at 1.5 percent, while real interest rates are negative! But for the purposes of the FOLC, we need a few assumptions about what the bond vigilantes think, which aren't clear.

First (i) it assumes that the bond market will only care about the government's long-run debt ratio instead of the short-term. I think that's correct. But much of the bond vigilante argument is predicated on the opposite, that no matter what the long-term is, the capital markets will freak on short-term deficits.

It also assumes (ii) that the repayments of these FOLC will be made easier through debt collection than just collecting the equivalent amount of money through taxation. I see no reason why that's the case, and many reasons to believe the opposite.

III: This policy will involve trying to get blood from a turnip. I very much distrust it when economists waive away bankruptcy protection. Especially for experimental, controversial debts that have never been tried in known human history.

As the paper admits, this is a machine for generating adverse selection, as the people most likely to use it are people whose credit access is cut due to the recession. High-risk users will likely transfer their balances from higher rate credit cards to their FOLC (either explicitly or implicitly over time if barred) - transferring a nice chunk of credit risk from the financial industry to taxpayers.

It's also not clear what happens a few years later when consumers start to pay off the FOLC. Could that trigger another recession, especially if the creditor (the United States) doesn't increase spending to compensate?

The issue isn't whether or not the government will be able to collect these debts at some point. It has a long time-horizon, the ability to jail debtors and use bail to pay debts, the ability to seize income, old-age pensions and a wide variety of income, and the more general ability to deploy its monopoly on violence. The question is whether this will be smoother, easier, and more predictable than just collecting the money in taxes. We have a really smooth system for collecting taxes, one at least as good as whatever debt collection agencies are out there. If that is the case, there's no reason to believe that this will satisfy the bond vigilantes or bring down our debt-to-GDP ratio in a more satisfactory way.

IV: Since we've very quickly gotten to the idea that we'll need to jettison legal protections under bankruptcy for this plan to work, it is important to emphasize that this policy is the opposite of social insurance.

I don't see a macroeconomic difference between the government borrowing 3 percent of GDP and giving it away and collecting it through taxes later versus the government borrowing 3 percent of GDP, loaning it to individuals, and collecting it later through debt collectors except in the efficiency and the distribution.

The distributional consequences of this proposal aren't addressed, but they are quite radical. Normally taxes in this country are progressive. Some people call for a flat tax. This proposal would be the equivalent of the most regressive taxation, a head tax. And it also undermines the whole idea of social insurance.

Let's assume the poorest would be the people most likely to use this to boost or maintain their spending. I think that's largely fair - certainly the top 10 percent are less likely to use this (they'll prefer to use high-end credit cards that give them money back). This means that as the bottom 50 percent of Americans borrow and pay it off themselves, they would bear all the burden for macroeconomic stability through fiscal policy. Given that the top 1 percent captured 93 percent of the income growth in the first year of this recovery, that's a pretty major transfer of wealth. One nice thing about tax policy, especially progressive tax policy, is that those who benefit the most from the economy provide more of the resources. This would be the opposite of that, especially in the context of a ""relatively-quickly-phased-in austerity program."

Efficiency is also relevant - as the economy grows, the debt-to-GDP ratio declines, making the debt easier to bear. The most likely borrowers under FOLC, the bottom 50 percent, have seen stagnant or declining wages overall, especially in recessions. A growing economy would keep their wages from falling in the medium term, but this is still a problematic issue - their income is not more likely to grow to balance out the payment burdens than if we did this at a national level, like normal tax policy.

The policy also ignores social insurance's role in macroeconomic stability, and that's insurance against low incomes. Making sure incomes don't fall below a certain threshold when times are tough makes good macroeconomic sense and also happens to be quite humane. This is not that. As friend-of-the-blog JW Mason said, when discussing this proposal, the FOLC is like "if your fire insurance simply consisted of a right to borrow money to rebuild your house if it burned down."

What else am I missing about this proposal?

Share This

Washington Monthly on the Future of Savings

Jul 18, 2012Mike Konczal

The latest issue of Washington Monthly has several fascinating pieces on the future of savings. John Gravois has a piece on where the Consumer Financial Protection Bureau currently stands. Barry C.

The latest issue of Washington Monthly has several fascinating pieces on the future of savings. John Gravois has a piece on where the Consumer Financial Protection Bureau currently stands. Barry C. Lynn and Lina Khan have a piece on the collapse on American business start-ups. My colleague Mark Schmitt has a piece on the idea of government savings accounts, a piece which is also fascinating as a history of a policy idea. Reid Cramer of the New America Foundation has a great list summarizing some of the policies at the forefront of the movement to build savings and assets, which include universal childhood savings accounts, autoIRAs, addressing the unbanked and, a favorite around here, the Save to Win program that puts a lottery in a savings account.

For those interested in more, New America had a series of panels on the events which you can find here. The previous paradigm of an "Ownership Society" has collapsed. It seems unlikely that, with 401(k) programs looking insufficient to cover retirements, that we are going to privatize Social Security in the near future. And using housing equity in a bubble as a quick source of savings has turned out to be both a giant problem and no longer available. Given that the current recession is a crisis of over-leveraged households, having more stable and sufficient ways of saving and buiding wealth isn't just a matter that impacts individuals, but one that impacts the country as a whole. This needs to be at the front of the policy agenda and this issue will catch you up to the debate.

Share This

A Shameful Few Weeks Begs the Question: Where’s Government?

Jul 17, 2012Jeff Madrick

With the recent crises in the financial world, it's clearer than ever that we need government to step up and address our problems.

With the recent crises in the financial world, it's clearer than ever that we need government to step up and address our problems.

There are certain periods in our history during which one can only sit back and wonder what the limits of astonishment really are. A couple of years since Dodd-Frank first passed, we have come through a period of such disrepute for business that one wonders why the working class has not risen as one — except, of course, because it is exhausted with efforts at reform that seem so futile. We have uncovered many disreputable and perhaps fraudulent business activities, but they essentially represent a failure of government. 

Facebook's initial public offering collapsed in price, leaving small investors holding the bag. Brokers took care of their big customers far better than their small ones. Where was the SEC?

New insider trading convictions, most recently of the widely respected Goldman Sachs director Rajan Gupta, show how rampant trading on insider information really is. The $6 billion losses at JPMorgan Chase by a department that was supposed to neutralize risk showed that trading risk is too profitable to be foregone voluntarily.

And now we find out that LIBOR is incontrovertibly rigged. Some may not realize that Barclays, which agreed to pay a $450 million fine, signed a Statement of Facts that admitted its traders rigged this key rate to make profits on positions, and collaborated with bankers/traders at other banks. Now we find out that Treasury Secretary Tim Geithner, while president of the New York Fed, was worried and even wrote British regulators about this. That’s nice. But why didn't government — and Tim Geithner himself — actually do something about it? Are government regulators that feckless?

Of course, there was a certain political advantage in a LIBOR that could be fudged. LIBOR is the rate at which banks lend to each other. It should be nearly riskless, and is therefore used as such in many transactions. LIBOR was the basis, in fact, for up to 100 percent of subprime mortgages. It is often a key input into complex pricing models for securities like derivatives and collateralized debt obligations.     

It could be that the Bank of England looked the other way when some bankers, including Barclays's, lied and said they were paying a lower interest rate than they were in order to make it seem their credit was good. Especially in the fall of 2008, after Lehman’s collapse, governments wanted to calm the waters. Did the Fed also tolerate fudging the numbers?

Why wouldn’t they? The Treasury puts a better face on matters all the time, as does the White House, no matter who is president. PR is an integral part of government. Has the practice in this age of greed slid off onto regulatory agencies? Surely Ben Bernanke was overly optimistic about controlling any impending subprime wreckage in 2007 because he knew it was better to err on the side of Pollyanish hopes that risk precipitating a crisis. What better way to underplay a crisis than to let the banks do it for you?

But for all these remarkable events — and government failures — most disturbing is the ongoing demands for austerity that even President Obama himself makes. The president wants to extend tax cuts for all except those who make $250,000 or more. But he cannot make the case without saying we have to get our fiscal house in order. The nation is likely to need stimulus. But Obama bought into the budget balancing process so early on by appointing Bowles and Simpson to come up with a solution that there is no effective opposition to impending obtuse budget policies in late 2012 and 2013. The classic case is made by the CEO of Honeywell on the front page of the Financial Times. Seeking to blame Republicans and Democrats alike, the esteemed chairman and member of the Bowles-Simpson Commission claims that business has no confidence until this is resolved.

The truth is more simple. Uncertainly surrounds the possibility that the Republicans will hold up the government again, claiming they demand budget cutting. And Mitt Romney promises to do far more damage. There is no contest between the two, and let’s keep in mind that Obamacare, and even Dodd-Frank, contain very good measures that Romney would try to overturn.  

As we end a bad few weeks and start a period of remedying the damage, let’s keep in mind that America’s fiscal problems in the near run are highly exaggerated. But even down the road, the problem is not what we spend, but the tax cuts we have been giving ourselves for 30 years. I will begin to believe the sincerity of arch deficit hawks when they argue for tax hikes, not only cuts in Medicare and Social Security. And so should the chairman of Honeywell and others of influence like him.

The myths of austerity economics are paralyzing the government and keeping the nation from getting its house in order. How may times can one say it? Not often enough, apparently.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

Share This

Jeff Madrick: Banks and Regulators Should Be Held Accountable for LIBOR

Jul 12, 2012

Roosevelt Institute Senior Fellow and Rediscovering Government director Jeff Madrick appeared on Viewpoint with Eliot Spitzer this week along with Financial Times correspondent Tracy Alloway to discuss who should bear the blame for the growing LIBOR scandal.

Roosevelt Institute Senior Fellow and Rediscovering Government director Jeff Madrick appeared on Viewpoint with Eliot Spitzer this week along with Financial Times correspondent Tracy Alloway to discuss who should bear the blame for the growing LIBOR scandal. Responding to evidence that Fed officials knew the banks were up to no good, Jeff says in the clip below that "this culture of manipulation and acceptance of manipulation I think went very deep throughout Wall Street." 

Jeff says that given these revelations, "any idea any longer that one can trust bankers or investment bankers or mortgage brokers to do the right thing and set the right rate rather than make a very easy buck should be out the window." In the online exclusive below, he adds that "the idea they let this happen should anger people on top of all the other financial crisis we've had... They should be demanding some form of justice." But he notes that banks shouldn't be the only ones sharing the blame -- there's plenty to go around for regulators "if it turns out they really fully understood it was going on, and I think they understood enough that was going on that they should be held responsible."

Share This

Pages