The Wachovia model

It appears that many Members of Congress who voted against the financial bill yesterday think they saved the taxpayers a lot of money. They need to think again. This is a case, to quote the old auto oil filter ad, of “pay me now or pay me later.” The cost to the American citizenry will be high — from direct costs of FDIC insurance payouts on failed banks and higher unemployment insurance to the indirect costs of what Steven Pearlstein warns may be “a decade of little or no economic growth.”
As Pearlstein notes, the action is already shifting from Treasury to the FDIC. The Wachovia deal is a case in point. The New York Times (“In the Wachovia Sale, the Banking Crisis Trickles Up”) describes the heart of the deal:

Citigroup will pay $1 a share, or about $2.2 billion, for Wachovia’s banking operations. Citigroup will assume the first $42 billion of losses from Wachovia’s riskiest mortgages and transfer to the Federal Insurance Deposit Corporation $12 billion in preferred stock and warrants. In exchange, the F.D.I.C. will absorb all losses above that level.

This action was precipitated by a different type of bank meltdown. As the Wall Street Journal (“Citi, U.S. Rescue Wachovia”) explains:

Wachovia’s motivating factor was not a run on the bank. While the bank and its regulators were nervous that depositors would start yanking their funds, it didn’t happen; the bank was fully liquid and hadn’t needed to borrow from the Fed.
The bigger problem was a prospective downgrade of Wachovia’s debt by Standard & Poor’s and Moody’s, which representatives of the two ratings agencies had informed Wachovia could occur by Monday. That had the potential to sow greater fear among Wachovia investors and customers, not to mention increasing the bank’s borrowing costs just as a batch of its debt was set to mature.

It was Wachovia’s portfolio of toxic assets that was the problem. Or should I say presumed portfolio, because without a market it is next to impossible to determine what these assets are really worth. Thus, it was not a liquidity problem, but a credibility problem.
That sets up a different type of rescue operation that the standard injection of liquidity everyone is talking about. As the Financial Times (“Citigroup avoids missteps of other bail-outs”) notes:

The Wachovia deal is notable because the government – in the form of the Federal Deposit Insurance Corporation – is taking much of the risk on Wachovia’s portfolio of toxic assets in return for a potential ownership stake in the combined bank.

In other words, the Citi-Wachovia deal accomplished the same end goal as the requested Troubled Asset Relief Program (TARP). Even the Wall Street Journal editorial board (“Pre-emptive Plumbing”) — a group I rarely agree with –liked the deal:

But the good news is that regulators are starting to take the initiative in forcing quick resolution at the most troubled banks, handing them off to stronger competitors and working creatively to contain the risk of contagion. It’s a far sight better than the political gamesmanship that still consumes the adolescents on Capitol Hill.

What worries me, however, is that this was a rescue in an ad-hoc rather than systematic manner. With the collapse of the Paulson plan, ad-hoc may be all we have. We are already well down that road, as the following graph from Wall Street Journal (“Bailout Plan Rejected, Forcing New Scramble to Solve Crisis”) illustrates:

So, pay now or pay later. And, as the auto mechanism in the ad implies, later is always more expensive.

A question of credibililty

I don’t know how the current financial crisis will work out after yesterday’s House vote. I suspect, as I mentioned yesterday, that nothing will happen until the level of pain from the credit market meltdown is apparent on Main Street. Right now, the connection between the bailout and daily life is not seen by most Americans. Until that connection is made (which, of course, will be after the pain becomes intense and possibly far too late to prevent the worst of the pain), the plan will be see as an unfair reward to economic greed.
Compounding the problem is the complete lack of credibility on the part of the Administration. The ugly truth is that American people (and even members of the President’s own party) simply don’t believe what the President and the Treasury Secretary are saying. And, sad to say, Secretary Paulson did himself no favors by starting out with a proposal that screamed of the Imperial Executive. I recognize that sometimes our legislation is far more complicated than it needs to be. But it was not the starkness of the 3 page Treasury position that got it into trouble. It was the explicit exemptions from any sort of oversight and accountability that grated so much.
One must be careful of drawing to much from historical analogies. But, as the saying goes, while history may not repeat, it often rhymes. In this case, that analogy is with 1932. I believe we may be in a similar situation as then — not for the economic parallel but for the political. By 1932, the Hoover Administration had lost all credibility in fighting the economic downturn we would later call the Great Depression. But that did not stop President Hoover from advocating his policies, even after the election. Arthur Schlesinger, Jr.’s great work The Crisis of the Old Order: The Age of Roosevelt describes the moment. For five months (back then the Inauguration was not until March), outgoing President Hoover tried to get incoming President Roosevelt to commit to some of his (Hoover’s) policies. Roosevelt steadfastly resisted until he had the reigns of government firmly in his grasp — thereby insuring the his response was his and his alone, not compromised by have to have the previous Administration either craft parts of it or completely implement it. Part of what Roosevelt understood was the necessity of creating a strong foundation of credibility to address the problem untainted by the past. A new beginning, as it were.
Such will be the task of the next Administration — either Obama or McCain. So I fear that the situation of governance, not simply the exigencies of politics, will prolong this crisis into January.
Things have changed since the days of FDR. In part, the Inauguration has been moved up two months. There is more of a sense that the incoming President can claim power (and is seen as responsible) immediately after the election. But it will still be a lame-duck President and a lame-duck Congress during those two months. And the credibility of a lame-duck is very weak.
Thus, I see no quick resolve to the underlying crisis of credibility. Until that crisis is resolved, we can’t even begin to approach the financial and economic crisis confronting our nation. While this may not be a repeat of 1932, the rhymes are pretty strong.

What next?

Now that the Congress (mostly GOP members) voted down the bailout, what happens next? I don’t know. But a friend of mine reminded me that tomorrow is the last day of the 3rd quarter. Lots of financial things happen at the end of a quarter.
According to news reports, the House will go out for the Jewish holidays and reconvene on Thursday. That will give time for both the leadership to work on a new plan and for Members to gauge the thinking of their constituencies. It remains to be seen whether they are greeted with a “Holy S–t” reaction to the vote – or an “Atta boy”. How much new pain emerges in the next few days may determine that response. And tomorrow’s end-of-quarter maneuvering will have a lot to do with that.

The heart of the matter

Here is what I think is the best description of the heart of the bailout plan — from Steve Lohr’s column in the New York Times Bailout Is Only One Step on a Long Road:

The rescue package, if successful, would make the recognition of losses and the inevitable winnowing of the banking system more an orderly retreat than a collapse. Yet that pruning of the banking industry must take place, economists say, and it is the government’s role to move it along instead of coddling the banks if the financial system is going to return to health.
Japan’s experience in the 1990s is a cautionary example of the peril of propping up banks after a real estate boom ends. The Japanese government helped keep many troubled banks afloat, hoping to avoid the pain of bank failures, only to extend the economic downturn as consumer spending and job growth fell.
The Japanese slump continued for many years, ending only a few years ago, a stretch of economic stagnation known as Japan’s lost decade.
“The lesson from Japan is that tough love for the banks is what’s needed,” said Kenneth Rogoff, an economist at Harvard. “In the current crisis, you do want to get rid of the bad assets from the banks, to get markets working again. But the key is going to be in the details of how the bailout works. You don’t want it to be a subsidy in disguise that keeps insolvent banks alive. That would just prolong the economic pain.”

As I’ve noted before, there is going to be a fair amount of blood on the floor before this is over. The legislation attempts to deal with some of the past bleeding by allowing banks to take a tax-deduction on their losses on Fannie/Freddie stock — Section 301 of the bill. (In the interest of complete disclosure, I own stock in a community bank that has had to write-off its investment in Fannie/Freddie). But clearly the work is only beginning.
So, to paraphrase Churchill, “while this may not be the beginning of the end, it may be the end of the beginning.”

The innovation agenda

Yesterday morning I was at the Information Technology and Innovation Foundation (ITIF) conference on Innovation Economics for the Next Administration. A lot of great discussion – much of which was based on two papers on the ITIF website: An Innovation Economics Agenda for the Next Administration and Economic Doctrines and Policy Differences: Why Washington Can’t Agree on Economic Policies.
The National Journal’s Tech Daily summarizes:

One study describes how three traditional economics doctrines – conservative neo-classical (supply-side), liberal neo-classical (Rubinomics), and neo-Keynesianism – have dominated thinking in Washington. It explains how innovation economics, which is based on an explicit effort to understand and model how technological advances occur, should be the path of the future. A companion report argues that putting innovation at the center of U.S. economic policies can spur economic growth and raise standards of living.
ITIF offers eight policy ideas to drive innovation-led economic growth:
1) Significantly expand the federal research and development tax credit
2) Create a national innovation foundation
3) Allow foreign students receiving graduate degrees to get a green card
4) Reform the patent system to drive innovation
5) Let companies expense new investments in IT in the first year
6) Establish a federal chief information officer
7) Implement a national broadband strategy
8) Implement an innovation-based national trade policy

Bottom line of the conference was that innovation is a key part of our economic strategy – but that policymakers need help in both understanding it and making the political case. In that regard, I was especially struck by the comment of Mike Mandel (of BusinessWeek) early in the morning that the US has failed in innovation — not that we haven’t created new stuff, but that we have failed to turn innovation into job creation. Invented here; produced over there. That seems to be the problem.
Re-establishing the connection between innovation and employment/incomes needs to be a major part of the new strategy. It is also part of the problem discussed at the New America Foundation forum a couple of days ago of reconnecting the link between productivity and wages (see earlier posting).
Rather than try to capture the entire discussion, I want to cherry pick a couple of ideas. One was the issue of measurement of innovation. As Mike pointed out, we do a good job of measuring consumption, but not innovation. Professor Richard Lipsey made the excellent follow on point that even when we think we are capturing innovation — in the form of total factor productivity — we aren’t because we can’t separate out the innovation (I would say intangibles) embedded in out machinery and products.
The second point had to do with patents. Michael Katz made the useful distinction between stronger patents and broader patents. In the current debate, we tend to confuse the two. A patent that has more coverage (broader) is automatically assumed to be stronger, especially by the more-is-better crowd, since it extends patent rights. I think that we need to strengthen patents rights by making patents better, not broader. As Jonathan Baker pointed out, the recent trends in broadening of patent rights played almost no role in the rise of Silicon Valley, for example (as the broadening came after the creation of the innovations, not before). Other mechanisms of appropriability — such as first mover advantage, speed to market, and tacit knowledge — were far more important.
The importance of these other mechanisms should our focus — if we are to truly understand the innovation process in the I-Cubed Economy.

Get ready for even worse economic news

To add to all the drama, the latest numbers on the housing market are not good: sales of new houses down 11.5% in August. But that is not the worst part, as the Wall Street Journal explains:

The data show that the housing market was weakening even before the latest flare-up in credit markets — which will likely depress activity further as potential buyers face more difficulty getting loans.
“Given the freezing up of the credit market, we do anticipate that the September and October data will be frightening,” said Joseph Brusuelas, chief economist at Merk Investments in Palo Alto, Calif.

So get ready for more bad economic news in the future.

Price discovery

In a posting yesterday, I noted how the key to the Paulson/Bernanke financial plan was price discovery (and how that is important in monetization of intangible assets as well). Today there have been a number of comments on price discovery. Here are a few.
Floyd Norris in the New York Times notes:

And how would that price be determined? Mr. Bernanke thought “auctions and other mechanisms could be devised that would give the market good information on what the hold-to-maturity price was for a large class of mortgage-related assets.” That strikes me as dubious at best. Auctions of disparate securities with one eager buyer and sellers of varying desperation may show something, but it is unlikely to be the “hold-to-maturity value.”
To estimate such a price, you need to make assumptions on how many defaults are likely, and how severe the losses will be, for each group of mortgages that was securitized. The correct answer will depend in large part on how long house prices fall, and how severe the recession is. If you think you know all that, then you can make a good estimate of value.
The nature of securitizations is that the losses arrive in lumps. A given security might meet all its payments if the mortgage pool backing it suffered losses of 5 percent, and be wiped out if the losses reached 6 percent. Change your assumption a little, and the value may change a lot.
But coming up with any kind of fair value was not the real objective. Instead, the goal was to recapitalize the banking system by placing a floor under the prices of securities that never should have been issued.

The Financial Times also notes the problems with this approach:

Furthermore, it is debateable how much information will be created by the price-discovery process in the government auctions.
Since each security is so different, investors may regard marks based on these government prices as meaningless.
For the plan really to work the government will have to devise an effective new vocabulary for standardising mortgage- backed securities.
This may sound simple but it has eluded the private sector for more than a year now.

I understand, but disagree. I think the Wall Street Journal gets it right:

Economists and market experts agreed that a government purchase of distressed assets would help reveal the extent of losses at financial institutions, a necessary step before the financial sector can rebuild itself.
Many financial firms are holding assets on their books at unrealistic prices, in part to avoid taking necessary write-downs that accounting rules require when an asset becomes impaired. Because the market has frozen for these assets, companies have been able to avoid reflecting their real value on their books.
. . .
With Treasury buying these assets in the open market, every institution, whether or not they participate in the program, would have to reflect market prices on their books.
“The market for many of these mortgage-related assets is so illiquid that there’s very little price information out there,” says Matthew Slaughter, an associate dean at Dartmouth’s Tuck School of Business. “Once the government begins buying assets it will help the firms themselves, their investors, and their counterparties better understand their current balance sheets.”

As Arthur Levitt and Lynn Turner argue in their op-ed (How to Restore Trust In Wall Street –

There is a direct line from the implosion of Enron to the fall of Lehman Brothers — and that’s an inability for investors to get sound financial information necessary for making sound investment decisions.

But, of course, simply restoring trust may not be enough. Paul Krugman argues that equity sharing provides the necessary compliment:

Why is that so important? The fundamental problem with our financial system is that the fallout from the housing bust has left financial institutions with too little capital. When he finally deigned to offer an explanation of his plan, Mr. Paulson argued that he could solve this problem through “price discovery” — that once taxpayer funds had created a market for mortgage-related toxic waste, everyone would realize that the toxic waste is actually worth much more than it currently sells for, solving the capital problem. Never say never, I guess — but you don’t want to bet $700 billion on wishful thinking.
The odds are, instead, that the U.S. government will end up having to do what governments always do in financial crises: use taxpayers’ money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably have done this by buying toxic waste for much more than it was worth — and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that’s what the equity sharing is about.

Bottom line: I continue to believe that price discovery is an important part of the process. But it is one that will leave a lot of blood on the floor before it is over (as everyone finally writes down these assets). Thus, the Paulson/Bernanke plan is just the start. The next President and the next Congress will have a lot more work to do.

Using auctions to price hard-to-price assets

Here is good description of how an auction for hard-to-price assets might work — from
Economists Look at Ways to Structure Auctions –

Auction experts say the best solution would be for the government to bring experienced buyers into the auction process so it wouldn’t be the sole buyer. Absent that, there are techniques the government could use to force sellers to disclose what they believe the appropriate prices are, said University of Maryland economist Lawrence Ausubel.
He said he thinks the government should hold an auction in which it announces its intention to buy some of the amount outstanding of a security — perhaps half. It would then start the process by setting a relatively high price for a security at which presumably all the firms that hold it would want to sell all they own. Then the government would set the price progressively lower until the holders, either by dropping out or reducing their bid sizes, were willing, overall, to sell no more than half of what they own.
The “winners” of the auction would get to sell, but the losers, who were unwilling to sell cheaply, would benefit as well, because the price the government paid in the auction would help establish what a reasonable price for the security is, helping to re-establish the market for such securities. “Once the government establishes some liquidity, the private market may finish the job,” said Mr. Ausubel.

Key is price setting. In essence, this is what the OceanTomo IP auctions have been doing for patents. The systemic benefits from these auctions extend far beyond simply serving as a clearinghouse for IP transactions (as important as that is). The auctions give the rest of the market a starting point for private transactions by providing price data. That is not to say that negotiations don’t take place without price data. But once a generally accepted reference point has been established, the negotiations run a lot smoother and with less transaction costs.
So, Mr. Ausubel is exactly right. Set up a way to get some generally accepted price points and the market will start to work again. After all, a major cause of illiquidity is the lack of confidence – and that lack of confidence is due to uncertainty – on both price and the ability of your counterparty to fulfill their obligations. Reduce the price uncertainty and you can help reduce the illiquidity.