Monday, July 18, 2011

More Fireworks.

Serious questions

While the previous posting, “It’s My Party, And I’ll Cry If I Want To,” focused on blame, economist being a serious lot (or at least they try to be), the focus now goes beyond blame. Blame is still there; it’s just accompanied by a lot of analysis.


The email included this article from FORTUNE, “Surprise! The Big Bad Bailout is Paying Off” By Allan Sloan, senior editor-at-large July 8, 2011 with this note: This article is from the July 25, 2011 issue of Fortune; additional reporting by Tory Newmyer. Since the article is available, the posting doesn’t quote it. The article is worth reading.


Thought you’d like to see this.
Don’t let the accounting get in the way of the economics.
I’ll certainly agree that the “bailout” is apparently producing more in-flow than out-flow, that the “bailout” was necessary to avert The Great Depression II, and avoiding the GD II “saved” a lot of money.

But many unanswered questions remain. First, why aren’t the masterminds that brought us to the economic abyss doing the Perp Walk? Second, the supposed financial Maginot Line embodied in the Dodd-Frank bill to prevent all this from happening again is being scuttled by politicians being bought by lobbyists. Third, the “Too Big to Fail” banks are now even bigger. And fourth, the $42 billion on the government’s new income statement is a pittance compared with the $14.0 trillion on its new balance sheet.

This is no different than a bank “restructuring” a loan to an underwater homeowner. The bank keeps the original loan on its books, enlarges the loan even more, and buys toxic assets from the homeowner. The bank’s balance sheet is now much bigger and much more risky. The homeowner, in the meantime, pays a little more in each installment when compared with the additional loan balance. And viola – the bank says “Yippee … we’re now making money!!”

Accounting is one thing; Economics is another. The sad truth is the true cost of our financial idiocy is actual output being way below potential output. These costs show up as unemployment, foreclosures, curtailed public services, bankruptcies, lower home values, ruined lives, and suicides. These economic costs are not counted in the accounting … and that’s why the “bailout” looks less costly than it really is.

Interesting article. Thanks.

Back in about 1872 Bagehot made a statement to the affect that during a financial panic a central bank should lend freely against good collateral at usurious rates and it would always make money. The Hedged Economist never doubted the loans in total would make money. [See the October 2, 2010 posting, “TARP: A success not being acknowledged.” The Hedged Economist thought the issue was important enough to justify leaving the posting up into November]

If The Hedged Economist had lots of money or could print it, it would have been glad to make some of the loans. But in a liquidity crisis, no one has money. There were specific loans that The Hedged Economist figured were write-offs from the start. That's politics. No big thing.

This blog’s TARP posting didn't try to figure a subsidy value of the loan guarantees. With few exceptions, The Hedged Economist doesn't like government loan guarantees as a policy. They move a liability of unknown size to the treasury. The preferred approach is the cut and dry of either making the loan or not. But, loan guarantees can make sense in a panic.

Three things about discussions of the bailout are of concern:

First, it's frightening to think that a substantial portion of the public still thinks a loan is a bailout. You'd think the deleveraging we're going through would teach the public otherwise.

Second, the number of people who think lenders are, or should be, doing the borrower a favor is fascinating and frightening.

Third, so many people are letting the search for who to blame distract them from solving the problem that it should worry anyone who wants to see the slowdown end. The focus on blame seems to originate from a sense of injustice about the disparity in the risk exposure inherent in loans. "The borrower is betting his or her future. The lender is just betting someone else’s money." But, blame doesn’t solve problems.

Any loan can involve agent issues. All consumer loans involve one agent (the lender) and one principal (the borrower). In that environment, it seems to me the quickest solution is through the principal -- as in educate the public. We’re trying to regulate the agent. It won’t work. Doesn’t matter who is to blame. The incentives for lenders and borrowers to find loopholes are too great.

All valid points.

On a slightly different slant, I want your opinion on this: If the Govt. helps out a “GM” or “AIG” and takes partial ownership, gets them turned around and sells their shares off at a profit, how is it any different than a Kirk Kerkorian-type leveraged buy-out?

Ignore the fact that Govt. prints the money and “KK” rounds up the leveraging. Assume that the Govt. profit allows the newly printed money to fully be destroyed.


First note that the assumption, print the money then retire it, screws up the accounting. Since one can’t calculate the cost of the capital, one never knows whether the turnaround made money. In TARP it is possible to argue the Government loans are a subsidized source of capital, but since interest was charged and there were comparable loans being made (Buffet’s loan to Goldman, for example), it is possible to make an estimate. However, it’s impossible to determine the exact subsidy value without estimating the value of the implied infinite liquidity associated with direct bailouts.

Even the Government includes a cost of capital, although they tend to use Government borrowing costs. They’re clearly too low for the risk involved. So, granted the cost of capital issue exists for all of the Government “bailouts,” it seems like less of an issue when liquidity is the focus than when it’s actually a quickie bankruptcy like the auto bailout. With AIG, The Hedged Economist has repeatedly admonished to follow the money flows. I’m sure the Government will claim a profit, but it may be the same fiction as they apply to the debt (where unfunded liabilities are ignored).

Given that caveat about the assumption, making your assumptions isn’t that big a stretch. Then the first big difference is inherent in all direct government interventions. Government is the only organization that has the ability to use force. The auto industry bailouts illustrate the difference. KK couldn’t force the unions or bondholders to accept his terms although he certainly tried. The bank loans, however, weren’t free of force. Setting aside terms, the big difference was that banks weren’t given the choice of whether to accept the loans. A discussion of why would be a good topic for a book. So, let’s just set why aside and note the use of force.

In many respects, it’s wise to view the Government in the same light as KK. They both act in their own self-interest. One difference between direct intervention and the private sector action answers your question earlier about why the big banks got bigger. Big Government needs big banks to collect big sums of deposits, the only real source of capital, in order to finance big deficits. However, as explained below, in that respect KK is different from banks.

Currently, I’m reading Allan H. Meltzer’s HISTORY OF THE FEDERAL RESERVE, Volume 2. It’s amazingly relevant. The discussion of the Fed / Treasury accord of the early 1950s seems relevant to the “bailouts” and “quantitative easing” debates; it is amazing it doesn’t get more play. The discussion of the debate around the “bills only” shift in the fifties illustrates the difficulty of disassociating monetary policy from more direct market intervention. For most of its history, the Fed has tried to use intermediaries (banks) to accomplish similar objectives.

In fact, going back farther in history, even during the Great Depression, the Treasury was the vehicle for direct capital allocation (e.g., reconstruction authorities even when they were called “banks,” FDIC, Fannie, etc.). The Fed just took on the role of financing the Treasury. With AIG and QE2, the Fed intervened directly. That may not matter to some, but it sure changes the role of the Fed.

Another Economist pointed out that the Fed has a long history of “rounding up banks” when it wanted to allocate capital to a specific organization. Long Term Capital Management is an example we’re all familiar with. During this crisis, Bear Stern via JP Morgan and, probably, Countrywide and Merrill Lynch via BofA are examples. Interestingly, pre 1930s the Fed’s thinking was monetary policy should focus on credit in the private sector rather than in Treasuries.

The difference between direct intervention and the round-up-some-banks approach is subtle; mainly it is the absence of the intermediary. The Fed isn’t elected; technically it is a creation of, but not a part of, Government. The Hedged Economist take is that by directly intervening, the Fed has sacrificed any coherent defense of its independence. So, the method matters. The Fed may have punched a tar baby that it will be stuck with forever.

As commented, in “It’s My Party, And I’ll Cry If I Want To,” if more people focused on their own self-interest as in “how to make oneself robust against the inevitable fact of uncertainty,” the asymmetric risk associated with consumer loans would not loom so large. Then, they might not feel that blame is worth the effort. More importantly, The Hedged Economist could focus on personal financial management without the drop in readers.

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