Is the UK once again the economic sick man? Or is it, as Alistair Darling, chancellor of the exchequer, argued in his Budget speech on Wednesday, just one of a number of hard-hit high-income countries? The answers to these questions are: yes and yes. The explanation for this ambiguity is that the fiscal deterioration is extraordinary, but the economic collapse is not. Continue reading "Is the UK once again the economic sick man?"

Spring has arrived and policymakers see “green shoots”. Barack Obama’s economic adviser, Lawrence Summers, says the “sense of freefall” in the US economy should end in a few months. The president himself spies “glimmers of hope”. Ben Bernanke, chairman of the Federal Reserve, said last week “recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding and consumer spending, including sales of new motor vehicles”. Continue reading "Why the ‘green shoots’ of recovery could yet wither"

By Michael Pomerleano

My education (Harvard Business School and economics department) and professional experience prime me to advocate finance’s role in the growth of economies. Politically, I am moderate and not a flaming liberal. However, the conduct of professionals in the financial crisis leads me to reassess these beliefs. I am not alone. Continue reading "The crisis: holding the professionals to account"

By Rebel A. Cole

The financial crisis has thrown the US economy into a deep and lingering recession. Most analysts agree that delinquent mortgages are at the heart of the crisis, and that opaque mortgage-related securities have spread their toxicity to other sectors of the credit markets. Continue reading "Tackling delinquent residential mortgages"

By Michael Pomerleano

The Obama administration program to address the fragility of the banking system is based on a two major initiatives. First, it has proposed the Geithner- Summers Plan to buy subprime securitized assets from the banks. The toxic assets plan deals with less that 40 percent of the balance sheet of the banks that is in marketable securities. It does not deal with the 60 percent of the balance sheets of US banks that are loans and are not marked to market. Further, it will take six months to get the program in motion. The plan elicited deserved criticism from reputable analysts, including Paul Krugman in his NYT column. As Krugman points out in his column this plan is the third variant of an old plan to lift the value of toxic assets. The plan meets Einstein’s definition of madness: continuing to do the same thing, hoping for a different outcome. Jeff Sachs (FT, March 23), Joseph Stiglitz (NYT, April 1) and Peyton Young (FT, April 1) added their concerns that the plan nationalizes losses and privatizes profits.

The second part of the administration program is the now famous stress test of the nation’s largest banks. The other dimensions of the Geithner plan are the loan-purchase program run by the FDIC, the Treasury securities-purchase component of the PPIP is supplemented by the expanded Fed TALF program, and the various programs aimed at lowering rates in the conforming mortgage market.

This article argues that The Obama administration is in denial regarding the problems in the financial system. The losses in the banking system are not an “unknown unknown”. As shown below, the stress test calculations can be conducted by any informed analyst, and the losses are known with a reasonable degree with approximation. The stress test is simply a “smoke screen” designed to postpone the inevitable moment when the administration has to deal with the well known and severe problems in the banking system. Continue reading "Geithner and Summers need to address the banking problems square-on"

By Michael Pomerleano

In an article this month, “Promising signs of progress in the ‘Bad Bank’ Plan” I wrote that the approach sketched out by Tim Geithner, US Treasury secretary, deserved consideration and support from the policymaking and financial communities for the following reasons:

1) This design ensures that troubled assets are worked out in the private sector. The government bureaucracy has neither the expertise nor the motivation to make decisive decisions on the resolution of troubled assets.

2) The proposed approach secures private equity capital, while providing government working capital. The programme further ensures that the incentives of the managers are aligned with the public interest since the managers’ own money is at risk.

3) The programme creates capacity and competition in the private sector to deal with the enormous impaired assets problem.

However, the programme presented by the Treasury on Monday is a disappointment. The programme is exceedingly generous to the private sector. The Treasury is acting as a rock bottom “discount” hedge fund; it offers assets to the private sector for a minimal amount of equity capital (the private sector is asked to contribute 3-5 per cent equity, with the Federal Deposit Insurance Corporation and the US Treasury shouldering the rest), and non-recourse financing at subsidised government interest rates.

The programme ends up as an enormous wealth transfer to Wall Street. We can make an educated guess on the value of the transfer. The value of the investment (as distinct from the equity participation) for the private sector can be represented as a call on the $1 trillion of assets.  We can calculate the premium for the hypothetical call.  The assets are highly volatile, and as known from option theory, the higher the volatility, the higher the value of the option.

On top of that, unless there is a stated expiry for the assets (which there isn’t), a “reasonable” term to maturity is two or three years, considered a very long option. Obviously the longer the call, the higher is the option value.  Finally, option theory is only really valid provided that the associated hedging strategy is available.

Otherwise the options are costlier. It seems fairly safe to say that there might be limited but not complete hedging strategies to offset the risk(s) the private sector takes on via this (implicit) call in the ABX markets. The value of the “implicit call” is high - and an estimate in the range of 15-20 per cent is reasonable. However, the private sector is asked to contribute 3-5 per cent equity. Without any appropriation the government is transferring to the private sector the option balance of 15-17 per cent. The prospective beneficiaries are the banks, the hedge funds or the mortgagees. Who is going to benefit? My guess is that the hedge fund industry will be the biggest winner.

Is The Summers-Geithner toxic asset plan viable? Maybe, but it has serious drawbacks. I am not sure the largesse is warranted.  It would have been desirable to see a far more robust risk sharing programme. Finally, the programme is not a “magic bullet”: it will take time to implement and will only partially address the soundness of the banking system.

Michael Pomerleano is advisor on financial stability to the Bank of Israel, on external service from the World Bank

By Michael Pomerleano, Harald Scheule, and Andrew Sheng

The US Treasury just announced a Financial Stability Plan (revamped Tarp) to help purge banks of their bad bets by partnering with the private sector to buy troubled assets. The basic idea is to lend government money (US Federal Reserve) or guarantee borrowings (Federal Deposit Insurance Corporation) at a suitable spread over Libor to anyone- e.g., hedge funds and pension funds - who wants to buy toxic assets from the banks.  Continue reading "Is Tarp II enough?"

By Laurence Kotlikoff and Perry Mehrling

As we advocated two months back (Bagehot plus RFC: The Right Financial Fix), Uncle Sam is finally starting to sell systematic risk insurance on high-grade securities in exchange for preferred stock. This is a critical function for the US government; Uncle Sam is the only player capable of hedging systemic risk because he’s the only player capable of taking actions that keep the overall economic system on the right course.

Continue reading "Finally, system-risk insurance"