Blame Canada?

Unlike the USA and most of western Europe in 2008-2009, Canada did not have a financial crisis. Quite a few columns and articles were written about the superior stability of Canada’s financial system, which is much more concentrated but is apparently much more tightly regulated and has captured far fewer politicians and regulators than its US counterpart. I meant to blog about that but never got around to it.

Which makes Krugman’s recent post about Canada‘s still-raging housing bubble fascinating reading. In brief: housing prices in Canada experienced much the same run-up as US housing prices in the mid-2000s but instead of plummeting after 2007, have kept on rising. They are now more than double their 1975 level, whereas US house prices peaked at about 190% of that level. Canadian household debt as a percentage of income also never stopped rising and is now slightly above the US ratio.

Does this mean Canada is headed for a financial crisis? Not necessarily. Canada’s financial sector still looks sedate compared to its high-flying, reckless US counterpart. But you can have a collapsing bubble and severe recession without a financial crisis. Canada did not escape the worldwide 2008 recession and has made a fair recovery, but it is not hard to see where the next big blow could come from. Dean Baker has emphasized that the recent US financial crisis depended far less on subprime borrowing, securitization, credit default swaps, and the other usual suspects and much more on the collapse of a multi-trillion-dollar housing bubble, and the loss of all that wealth and wealth-driven consumption. Not surprisingly, Baker liked Krugman’s post. He adds that the collapse of the housing bubble could be even worse in Canada because 30-year fixed-rate mortgages never took hold in Canada (as they did in the US during the New Deal). The standard mortgage in Canada has to be paid off or refinanced in five years, so when interest rates rise from their current record lows (1% is the current benchmark short-term rate in Canada), millions of homeowners could see their monthly payments shoot up. The scenario is similar to the expiration of low “teaser rates” on adjustable-rate mortgages (ARMs) in the US in 2006-2008, but could be even worse, as the five-year limit appears more common in Canada than ARMs were in America. Could large numbers of defaults on “underwater mortgages” (where amount owed exceeds market value of house) happen in Canada, too?

I love Canada, but if I were to move there today, I’d rent.

The ZIRP walk

Today’s news from the Fed is that they will continue their zero interest rate policy (ZIRP) until the unemployment rate falls to 6.5%. To be precise, the Federal Open Market Committee (FOMC) announced that they believe the current 0 – 0.25% range for the federal funds rate “will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

This replaces the Fed’s statement from six weeks ago, which was that they expected to continue the ZIRP “for a considerable time after the economic recovery strengthens” and said they thought the ZIRP would continue at least through mid-2015.

I think the new policy is better, first of all because it’s specific. Of course they’re going to raise rates when the economy’s better, but how do they define better? They just told us — 6.5% unemployment (it’s now 7.7%).

The new statement also is better because it’s a fairly clear policy rule, tied to an actual, observable number, as opposed to a prediction about when the ZIRP medicine will no longer be needed. Including a date like mid-2015 is problematic partly because predictions have a way of being wrong, but also because they have a way of creating bubbles. “Through mid-2015” was widely reported not as a prediction but as a fixed commitment by the Fed, which it wasn’t. If enough people in the financial community believe the Fed will keep rates low through mid-2015, there could be a problem. Because if they know that short-term interest rates will be low for the next three years, then they may be more likely to borrow massively in the short-term money market and invest it in longer-term risky assets while rolling over their short-term debts for the next three years. (Some people say we’re already in a stock-market bubble right now, thanks to today’s low interest rates.) Granted, “borrowing short and lending long” is what banks do, but usually it’s without the certainty of near-zero interest rates for the next three years.

Dean Baker on banks, bailouts, and reform

Naked Capitalism has an excellent two-part interview with Dean Baker, one of the Cassandras who spotted the housing bubble years before it burst and who has been a much-needed gadfly in the ointment of economic news reporting and the economics profession. Baker’s new book, The End of Loser Liberalism: Making Markets Progressive, is available for free download here, including in Kindle and Nook formats. Here are some highlights from the interview, conducted by Philip Pilkington. I’ve highlighted in boldface some lines I found particularly compelling:

PP: Moving on, in the book you make the claim that had the financial system been allowed to melt down we would not actually have ended up in another Great Depression. This is not to say that you don’t recognise that letting the financial system melt down would have caused a lot of problems – for banks, of course, but also for pension funds and the like – but you say that those in charge of the bailouts exaggerated the importance of the financial sector. Could you explain briefly what you mean by this? And what do you think should have been done at the time of the bailouts?

DB: The point here is that we know how to reflate an economy. Massive government spending will do it. It got us out of the Great Depression, although not until World War II created the political consensus for the level of spending that was necessary to actually do the job.

A financial collapse cannot condemn us to a decade of stagnation and high unemployment. That only comes about from a prolonged period of political failure. If we had allowed the banks to collapse in the financial panic of 2008 then we would [still?] have had the opportunity to pick up the pieces and get the economy back on track with a massive stimulus program.

Of course it was best to not let the banks collapse. However the bailout should have come with real conditions that would have ensured the financial system was fundamentally restructured. This would have included breaking up the too big to fail banks (on a clear timetable, not necessarily at that time), serious caps on compensation, a commitment to principal write-downs and other real conditions.

At that time the banks were desperate. Without a big dose of public money they would almost certainly have been insolvent, so they would have had little choice but to accept whatever conditions were imposed. As it was, they almost got President Obama thanking them for taking taxpayer dollars in the bailout.

PP: Any ideas about what could be done with the banks now? Or is the damage already done?

DB: We still need to reform and downsize the financial sector. We don’t have the same leverage over the banks as we did at the peak of the crisis when we could have slapped whatever conditions we wanted on the loans and guarantees they needed to stay alive, but Congress can still pass laws that will rein in the industry.

At the top of the list is a financial speculation tax. A modest tax on financial transactions will do much to reduce the rents in the industry and to eliminate or drastically reduce short-term trading that serves no productive purpose. It will also raise a ton of money.

The second thing is breaking up the too big to fail banks. There is no justification for allowing banks to be able to borrow at below market interest rates because they enjoy an implicit government guarantee.

The third item on my list would be re-instating a Glass-Steagall type separation between commercial and investment banking. The Volcker rule, which limits proprietary trading by banks with insured deposits, was a step in the right direction. However it looks as though the industry is using the rule-making process to turn the law into Swiss cheese. It is likely that most banks will be able to find loopholes that will allow them to do as much proprietary banking as they want.

Anyhow, these would be my top three reforms. Politically, all of them would be very tough sells right now. By contrast, at the peak of the crisis, the industry would have voluntarily agreed to the last two in order to get the money they needed to stay alive.

PP: You write in the book that the idea that the banks repaid all the money from TARP is misleading. Could you explain this, because this myth is very prevalent in the mainstream media?

DB: Yes, this is really kind of a joke. The banks got loans at way below market interest rates from the government, and we are supposed be grateful that they repaid the loans? The difference between the market interest rate and the rate they actually paid amounted to a huge subsidy. This is something that anyone with even a passing familiarity with business or economics would recognize, which is why it is so insulting when political figures go around yapping about how the money was repaid with interest.

To see this point, suppose the government gives me a 30-year mortgage at 1 percent interest. If I make all my payments and pay off the mortgage has the government made money? By the logic of the politicians claiming that we profited by the bailout, the answer is yes.

A serious assessment would look at what the market rate for these loans was at the time they were made. To take one example, just before we lent $5 billion to Goldman through TARP, Warren Buffet lent $5 billion himself. He got twice the interest and a much more generous deal on warrants. Plus he knows that it was likely that the government would bail out Goldman if it got in trouble.

Elizabeth Warren commissioned a study of the implicit subsidies in the bailouts when she was head of the TARP oversight panel. As I recall, it came to over $100 billion on just the first batch of TARP loans to the large banks. This didn’t count the value of later TARP lending, the much larger lending programs from the Fed, nor the extensive set of guarantees provided by the Fed, Treasury, and the FDIC.

All of these commitments involved enormous subsidies. In the business world firms pay huge amounts of money if they want their debt to be guaranteed. And everyone understands that a below market loan is essentially a gift. That is why it is so insulting when they try to imply that the public has profited from these loans.

You can make the argument that it was good policy to subsidize the financial industry to get through the crisis, but to pretend that we did not subsidize them is just dishonest.

Incidentally, the reforms Baker suggests are similar to those recently suggested by Rolling Stone‘s Matt Taibbi as a starting point for the Occupy Wall Street protesters. More on those later.

 

The world economy’s “Mingya!” moment?

“Italy Is Now the Biggest Story in the World,” says Kevin Drum. And he’s not talking about Joe Paterno (whose story I confess to having spent a lot more time following lately than Italy’s). But this is bad: another Eurozone country with a high debt/GDP ratio, soaring interest rates on its government debt, and no currency of its own that could depreciate to revive net exports, and no central bank of its own to expand the supply of credit. Just like Greece, except that Italy’s economy is about six times as large. It’s the fourth-largest economy in all of Europe, in fact.

For months people have been nervously watching Europe’s toxic cauldron of economic depression, austerity, sovereign debt crises, and bank funding problems (verging on crisis), and wondering if and when Europe’s problems might lead to a double-dip recession (or, as I’d call it, a recession within a depression, a la 1937). I wonder if someone else has already written the headline “Italy: Waiting for the Other Boot to Drop” yet.

P.S. If you’ve never heard the expression “Mingya!” then you obviously don’t live in Oswego. The Urban Dictionary will set you straight.

The big banks are still socializing the losses; or, Sympathy for the stockholder

The original bank bailout may have been repaid in full, but the big banks are still socializing the losses. This time, it’s among their shareholders. Brad DeLong offers some specifics:

‘Investors in Goldman Sachs have lost more than half their money since 2007 . . .

‘Investors in Morgan Stanley have lost more than three-quarters of their money since 2007 . . .

‘Investors in Citigroup have lost 93% of their money since 2007 . . .

‘Investors in Bank of America have lost 85% of their money since 2007 . . .

‘Investors in Bear Stearns, Lehman Brothers, and Merrill Lynch lost more than 90% if their investments as well . . .’

DeLong’s charts (click above link to see them) show that even after bank stocks started to rebound in fall 2009, the losses have still been huge.

One might think this is just a case of the rich getting poorer, but it’s not that simple. In fact, the distributional consequences seem to run the other way. The stockholders, most of whom are middle-class and upper-middle-class folks, are getting hammered. About half of the population owns stock (granted, the wealthy own most of it), so about half of The Other 99% own stock and are seeing their retirement portfolios shrink along with the rest of their savings. (If you own stock at all, you probably own a lot of big bank stock, because they are weighted heavily in index funds, other mutual funds, and pension funds.)

How has the reduced market value of these firms affected the executives and highest-paid employees at the big banks? Not much, apparently. While I don’t have precise data handy, there have been reports all through this Lesser Depression of huge payouts to bankers, including yesterday’s news of Morgan Stanley. It’s happening in England, too.

DeLong’s post includes some excellent comments about how the banks’ poor performance has affected their shareholders and their high-level employees so differently. There’s a technical term for it: looting.

P.S. The Wall Street Journal reports that bank losses have been huge of late. Goldman Sachs lost money in the second quarter of this year, and has had six straight year-over-year quarterly losses. Goldman’s stock is down 39% for the year, and Bank of America’s is down 50%. No mention of how (or whether) bonuses will be affected.

WTF, S&P???

How did I miss this one? Bloomberg News, on Aug. 31, reported that Standard & Poor’s is still giving its highest rating, AAA, to subprime-mortgage-backed securities:

Standard & Poor’s is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government….

More than 14,000 securitized bonds in the U.S. are rated AAA by S&P, backed by everything from houses and malls to auto- dealer loans and farm-equipment leases, according to data compiled by Bloomberg.

(Hat tip: Simon Johnson.)

The political economy of the financial crisis, in a picture

From Mother Jones, this is a picture of what the Senate would look like if its 100 seats went not to the current senators but to the interest groups that have been their largest donors over their careers. The green one, which would have 57 seats, is Finance, Insurance and Real Estate. Lawyers and Lobbyists would have 25 seats. No other group would have more than 5.

Gambling Is Going On in Here! (576 pp.)

Granted, nobody reads 576-page commission reports, but this newly released, two-year-in-the-making report by the Financial Crisis Inquiry Commission looks pretty good, based on the article about it in today’s NYT.  The article states:

‘The commission that investigated the crisis casts a wide net of blame, faulting two administrations, the Federal Reserve and other regulators for permitting a calamitous concoction: shoddy mortgage lending, the excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.

‘“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done,” the panel wrote in the report’s conclusions, which were read by The New York Times. “If we accept this notion, it will happen again.”’

Right on. And with testimony from more than 700 witnesses to inform those conclusions, there ought to be some good detail within the report.

The above conclusions might seem obvious, but acknowledging the obvious is something that politicians are not good at. And predictably, the commission was split among party lines.  The above excerpt is from the majority report. From the article:

‘Of the 10 commission members, the six appointed by Democrats endorsed the final report. Three Republican members have prepared a dissent focusing on a narrower set of causes; a fourth Republican, Peter J. Wallison, has his own dissent, calling policies to promote homeownership the major culprit. The panel was hobbled repeatedly by internal divisions and staff turnover.’

So much for feasible solutions. Even with a Democratic Congress, the financial reform bill we got last year was extremely watered down. Get ready for the next conflagration.

Financial reform bill: Better than nothing

This week the Senate passed a financial reform bill that’s at least a bit tougher than looked possible a couple weeks ago.  Paul Krugman has a concise rundown on it right here:

“What’s good? Resolution authority, which was sorely lacking last year; consumer protection; derivatives traded through clearinghouses; ratings reform, thanks to Al Franken; tighter capital standards for big players, although with too much discretion to regulators.

“What’s missing? Hard leverage limits; size caps; not much in the way of restoring Glass-Steagall. If you think that too big to fail is the core problem, it’s disappointing; if you think that shadow banking is the core, as I do, not too bad.”

Dean Baker has some additional words here on Al Franken’s credit-rating-agencies reform amendment, which would eliminate the huge grades-for-sale conflict of interest of having companies being rated pay the rating agency for their work.  Instead, the Securities and Exchange Commission will assign the rating agency for each new securities issue.

The Senate bill also includes a Consumer Financial Protection Agency, which will be technically independent, as reformers had been pushing for and industry had been furiously opposing.  However, the agency will be housed within the Federal Reserve, which reformers had opposed because of the Fed’s dismal track record on consumer protection over the past decade.  Supposedly the agency will not have to answer to the Fed’s leadership, but we’ll have to see how that works out in practice.  I have not yet seen any word on whether the fabulous Elizabeth Warren, the Harvard Law professor who had been advocating for this agency, would still be interested in heading it.

All told, the bill still leaves much to be desired — Simon Johnson and James Kwak at The Baseline Scenario decry its lack of hard capital requirements or bank size restrictions — but looks a whole lot better than nothing:

Too big, too bad, too late: Greenspan speaks

Simon Johnson has yet another fine post on the need to break up the biggest banks, for the sake of financial stability.  Unfortunately, he notes, it looks like it ain’t gonna happen, that the SAFE Banking Act sponsored by Sens. Sherrod Brown (D-OH) and Ted Kaufman (D-DE) won’t make it anywhere near the Senate floor.*

The post includes a remarkable quote by Alan Greenspan, who now seems to get it:

“For years the Federal Reserve had been concerned about the ever larger size of our financial institutions. Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. A decade ago, citing such evidence, I noted that ‘megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.’ Regrettably, we did little to address the problem.”

Now, Greenspan is a bit like the Bible, Shakespeare, or Adam Smith — comb through all his words and you can probably find something to support your position, whatever it is.  But it is striking that he acknowledges the lack of economies of scale brought by big banks and their potential for systemic damage.  His regret at not addressing the problem would be more constructive if he could find a concrete proposal to support, like Sen. Kaufman’s bill, for example.  (I’m reminded of the old quote A little knowledge that acts is worth infinitely more than much knowledge that is idle.)

* Update:  The Brown-Kaufman SAFE Banking Amendment did make it to the Senate floor on May 6, but it was voted down, 33-61.  The roll call vote is here.  About two-thirds of Democrats voted for it, along with three Republicans.  Among the Democrats voting No were Senate Banking Committee Chairman Christopher Dodd and New York’s Chuck Schumer and Kirsten Gillibrand.