Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- decreased at an annual rate of 0.3 percent in the third quarter of 2008, (that is, from the second quarter to the third quarter), according to advance estimates released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 2.8 percent.
The Bureau emphasized that the third-quarter "advance" estimates are based on source data that are incomplete or subject to further revision by the source agency (see the box on page 3). The third- quarter "preliminary" estimates, based on more comprehensive data, will be released on November 25,
2008.
The decrease in real GDP in the third quarter primarily reflected negative contributions from personal consumption expenditures (PCE), residential fixed investment, and equipment and software that were largely offset by positive contributions from federal government spending, exports, private
inventory investment, nonresidential structures, and state and local government spending. Imports, which are a subtraction in the calculation of GDP, decreased.
Most of the major components contributed to the downturn in real GDP growth in the third quarter. The largest contributors were a sharp downturn in PCE for nondurable goods, a smaller decrease in imports, a larger decrease in PCE for durable goods, and a deceleration in exports. Notable offsets were an upturn in inventory investment and an acceleration in federal government spending.
Final sales of computers contributed 0.06 percentage point to the third-quarter change in real GDP after contributing 0.17 percentage point to the second-quarter change. Motor vehicle output contributed 0.09 percentage point to the third-quarter change in real GDP after subtracting 1.01
percentage points from the second-quarter change.
Friday, October 31, 2008
Economists React: GDP Report Shape of Things to Come?
From the WSJ.
Economists and others weigh in on the 0.3% contraction in third-quarter GDP.
According to the BEA’s advance estimate, real GDP contracted at an annualized rate of 0.3% during the third quarter. Note that the advance estimate is subject to two rounds of revisions, which will almost surely yield a larger contraction in real GDP when all is said and done. Moreover, the third quarter offers a hint of what lies ahead for the U.S. economy, and we expect a significantly larger contraction in real GDP during the current quarter. –Richard F. Moody, Mission Residential
Consumption was grim, down 3.1%, while corporate capital spending dropped 5.5%. Housing investment plunged 19.1% but commercial structures continued to rise, up a hefty 7.9%. Still, the sector is slowing; expect an outright drop in the fourth quarter. This is the first of a run of negative GDP numbers; the economy is in recession. We tentatively expect GDP of -1% in the fourth quarter and first quarter of 2009. –Ian Shepherdson, High Frequency Economics
A shift should transpire. Consumers are getting relief at the pump and retailers and foreign exporters are ready to offer discounts. Net exports and business equipment will be drags. –Stephen Gallagher, Societe Generale
Despite a stronger dollar, net exports provided a substantial boost to GDP growth, adding 1.1% to the total number. Goods exports, much of which was likely the result of orders placed in a period of a weaker dollar, grew by 7.5%, while goods imports shrunk by 2.8% on energy costs which, judging by the average quarterly price of oil, decline by around 4.5%. There’s no reason to expect that export growth will provide any benefit in the fourth quarter, though the continued decline in oil, if it manages to sustain, should reduce imports rather sharply. –Guy LeBas, Janney Montgomery Scott
Output in the nonfarm business sector fell at a 1.7% annual rate (more steeply than GDP, which includes government expenditures), and we estimate that hours worked declined at a 2% annual rate, implying a sluggish 0.3% advance in productivity. –Alan Levenson, T. Rowe Price
The data imply that just about all sectors of the economy are in the process of a serious contraction with the capitulation of the consumer the primary catalyst behind what is clearly the first consumer driven recession in three decades. And what was behind that? A -8.7% decline in real disposable personal income in the third quarter in contrast with the 11.9% increase observed in the second quarter of 2008. The advance estimate of gross domestic product sets the stage for an operatic end to the recent business cycle in what looks to be a significant contraction in the fourth quarter in excess of 4.0% –Joseph Brusuelas, Merk Investments
The details of this report were worse than the headline growth figure might suggest, and the outlook for the fourth quarter and beyond is grim, dominated by a tapped-out consumer, ongoing weakness in housing, and an incipient downturn in capital spending that promises to gain momentum. Partly blunting the decline will be continued narrowing of the net export deficit and surging federal government spending. However, states and localities are busy slashing spending to try to balance budgets that are hemorrhaging red ink, so this will partly offset the federal government’s upward impetus. All in all, we look for a recession that is both longer and deeper than those in recent memory, lasting at least through 2009 and encompassing a string of negative GDP growth figures. –Joshua Shapiro, MFR Inc.
In other times, the inflation side of the report would have been troubling with core PCE prices up 2.5% year-over-year and chain GDP prices up 2.7% on the same basis — but the Fed has no inflation worries because of falling commodity prices and rising slack in labor and product markets (we are not sanguine about the long-term inflation consequences of the explosion in the Fed’s balance sheet, but now is not the time to worry about that). –RDQ Economics
Government statisticians cited a couple of special factors that influenced the economy during the quarter — hurricanes and the Boeing strike. However, based on underlying sales and shipments figures, we suspect that the impact associated with each of these factors was relatively minor. –David Greenlaw, Morgan Stanley
Compiled by Phil Izzo
Economists and others weigh in on the 0.3% contraction in third-quarter GDP.
According to the BEA’s advance estimate, real GDP contracted at an annualized rate of 0.3% during the third quarter. Note that the advance estimate is subject to two rounds of revisions, which will almost surely yield a larger contraction in real GDP when all is said and done. Moreover, the third quarter offers a hint of what lies ahead for the U.S. economy, and we expect a significantly larger contraction in real GDP during the current quarter. –Richard F. Moody, Mission Residential
Consumption was grim, down 3.1%, while corporate capital spending dropped 5.5%. Housing investment plunged 19.1% but commercial structures continued to rise, up a hefty 7.9%. Still, the sector is slowing; expect an outright drop in the fourth quarter. This is the first of a run of negative GDP numbers; the economy is in recession. We tentatively expect GDP of -1% in the fourth quarter and first quarter of 2009. –Ian Shepherdson, High Frequency Economics
A shift should transpire. Consumers are getting relief at the pump and retailers and foreign exporters are ready to offer discounts. Net exports and business equipment will be drags. –Stephen Gallagher, Societe Generale
Despite a stronger dollar, net exports provided a substantial boost to GDP growth, adding 1.1% to the total number. Goods exports, much of which was likely the result of orders placed in a period of a weaker dollar, grew by 7.5%, while goods imports shrunk by 2.8% on energy costs which, judging by the average quarterly price of oil, decline by around 4.5%. There’s no reason to expect that export growth will provide any benefit in the fourth quarter, though the continued decline in oil, if it manages to sustain, should reduce imports rather sharply. –Guy LeBas, Janney Montgomery Scott
Output in the nonfarm business sector fell at a 1.7% annual rate (more steeply than GDP, which includes government expenditures), and we estimate that hours worked declined at a 2% annual rate, implying a sluggish 0.3% advance in productivity. –Alan Levenson, T. Rowe Price
The data imply that just about all sectors of the economy are in the process of a serious contraction with the capitulation of the consumer the primary catalyst behind what is clearly the first consumer driven recession in three decades. And what was behind that? A -8.7% decline in real disposable personal income in the third quarter in contrast with the 11.9% increase observed in the second quarter of 2008. The advance estimate of gross domestic product sets the stage for an operatic end to the recent business cycle in what looks to be a significant contraction in the fourth quarter in excess of 4.0% –Joseph Brusuelas, Merk Investments
The details of this report were worse than the headline growth figure might suggest, and the outlook for the fourth quarter and beyond is grim, dominated by a tapped-out consumer, ongoing weakness in housing, and an incipient downturn in capital spending that promises to gain momentum. Partly blunting the decline will be continued narrowing of the net export deficit and surging federal government spending. However, states and localities are busy slashing spending to try to balance budgets that are hemorrhaging red ink, so this will partly offset the federal government’s upward impetus. All in all, we look for a recession that is both longer and deeper than those in recent memory, lasting at least through 2009 and encompassing a string of negative GDP growth figures. –Joshua Shapiro, MFR Inc.
In other times, the inflation side of the report would have been troubling with core PCE prices up 2.5% year-over-year and chain GDP prices up 2.7% on the same basis — but the Fed has no inflation worries because of falling commodity prices and rising slack in labor and product markets (we are not sanguine about the long-term inflation consequences of the explosion in the Fed’s balance sheet, but now is not the time to worry about that). –RDQ Economics
Government statisticians cited a couple of special factors that influenced the economy during the quarter — hurricanes and the Boeing strike. However, based on underlying sales and shipments figures, we suspect that the impact associated with each of these factors was relatively minor. –David Greenlaw, Morgan Stanley
Compiled by Phil Izzo
Wednesday, October 29, 2008
Fed Cuts Rate to 1% to Avert Prolonged Recession
The Fed cuts its benchmark rate to 1 percent and leaves open the possibility of further cuts. How low will the Fed go?
Fed Cuts Rate to 1% to Avert Prolonged Recession
The Federal Reserve cut its benchmark interest rate by half a percentage point to 1 percent, matching a half-century low, in an effort to avert the worst U.S. economic downturn in the postwar era.
``Downside risks to growth remain,'' the Federal Open Market Committee said today in a statement in Washington. ``Recent policy actions, including today's rate reduction, coordinated interest-rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth.''
Central bankers worldwide are trying to revive credit and stop a self-reinforcing downturn in consumer spending and bank lending from triggering a global recession. Today's decision follows the half-point reduction the Fed coordinated with the European Central Bank and four other central banks on Oct. 8. Borrowing costs were pared today in Norway and China.
The U.S. economy shrank at a 0.5 percent annual rate last quarter, the most since the 2001 recession, the Commerce Department's report on gross domestic product will probably show tomorrow. Economists expect the slump to persist in the fourth quarter, according to the median estimate.
`Economy Weakens'
``If the economy weakens further, it may open the door for another 25 or 50 basis points in December,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina.''
Plunging commodity prices, including a 54 decline in the cost of oil from a record in July, have eased inflation pressures.
``The committee expects inflation to moderate in coming quarters to levels consistent with price stability,'' the FOMC said in today's statement.
The vote was unanimous. The Fed also lowered the discount rate a half point to 1.25 percent.
While cutting the main rate during the past 13 months from 5.25 percent, Fed Chairman Ben S. Bernanke, 54, has created six loan programs channeling at least $700 billion in cash and collateral into money markets as of Oct. 22.
``This Federal Reserve has been extremely aggressive in terms of providing liquidity,'' Frederic Mishkin, a former Fed governor and now a Columbia University professor, said in a Bloomberg Television interview before the announcement.
Confidence Weakens
Still, consumer confidence tumbled this month to a record low, and orders for durable goods, excluding automobiles and aircraft, dropped for a second straight month in September, reports showed this week. Home prices in 20 U.S. cities declined 16.6 percent in August from a year earlier as foreclosures climbed, according to the S&P/Case-Shiller home price index. The Standard & Poor's 500 Stock Index is down 36 percent this year.
``The intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit,'' the Fed's statement said. ``The pace of economic activity appears to have slowed markedly.''
The credit crisis that began in August 2007 with rising foreclosure rates has led to the collapse or forced mergers of some of Wall Street's biggest firms. Lehman Brothers Holdings Inc. filed for bankruptcy last month, while the government seized control of American International Group Inc. and put Fannie Mae and Freddie Mac under conservatorship. Wachovia Corp. agreed this month to be acquired by Wells Fargo & Co.
Global financial institutions have reported $680 billion in writedowns and credit losses on home loans, mortgage-backed securities and related assets.
Funding Costs
The spread between the cost of overnight loans in New York and three-month dollar loans in London widened to 4.02 percent on Oct. 10 as investors fled risk following Lehman's Sept. 15 bankruptcy. The spread averaged 0.27 percentage point for all of last year. It has since fallen back to 2.5 percentage points.
Bernanke and U.S. Treasury Secretary Henry Paulson gained congressional approval this month for the use of taxpayer funds for a $700 billion bank rescue. The Treasury plans to use some of the funds in the Troubled Asset Relief Program to buy equity stakes in banks.
The Fed redoubled its aid this month, agreeing to finance the commercial paper issuance of General Electric Co. and other corporations and help money-market mutual funds raise cash to meet shareholder redemptions.
Fed's Balance Sheet
The central bank's new loan programs have expanded assets on its balance sheet by 104 percent during the past year to $1.804 trillion, or 12.6 percent of GDP.
Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac were 6.04 percent last week versus 6.07 percent on Jan. 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy is dim, economists said.
``We are in an environment where they lower rates, but then spreads widen so you get no net effect,'' Vincent Reinhart, former director of the Fed Board's Division of Monetary Affairs who is now a visiting scholar at the American Enterprise Institute in Washington, said before the decision. ``We are in a recession.''
Fed officials provided their forecasts for this year and the subsequent three years at the two-day meeting. The uncertainties surrounding the Fed's forecast are ``unusually large,'' and the economy may experience subpar growth ``for several quarters,'' Bernanke told the House Budget Committee on Oct. 20.
The economy ``looks terrible,'' Stephen Stanley, chief economist at RBS Greenwich Capital Markets Inc., said before the announcement. ``Consumer spending is going to be very negative in the fourth quarter, even with gasoline prices falling.''
Policy Tools
Now that their target rate is so low, Fed officials may have discussed alternative policy strategies such as the possibility of keeping rates low on short- and medium-term notes. Bernanke, as a Fed governor, was the top central bank official on research into ``non-traditional'' policy tools between 2002 and 2004, when the central bank last cut the benchmark lending rate to 1 percent.
The Fed has lost some control over the amount of reserves in the banking system because the total lending in some of its programs are driven by market demand. As a result, the federal funds rate has traded below its target every day since the Oct. 8 emergency rate cut.
The central bank raised the floor on the benchmark lending rate and said on Oct. 22 that interest on excess reserves would be equal to the federal funds rate minus 0.35 percentage point. The previous floor was 0.75 percentage point below the federal funds rate. Still, the move hasn't closed the gap between the target rate and the market rate.
To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net
Fed Cuts Rate to 1% to Avert Prolonged Recession
The Federal Reserve cut its benchmark interest rate by half a percentage point to 1 percent, matching a half-century low, in an effort to avert the worst U.S. economic downturn in the postwar era.
``Downside risks to growth remain,'' the Federal Open Market Committee said today in a statement in Washington. ``Recent policy actions, including today's rate reduction, coordinated interest-rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth.''
Central bankers worldwide are trying to revive credit and stop a self-reinforcing downturn in consumer spending and bank lending from triggering a global recession. Today's decision follows the half-point reduction the Fed coordinated with the European Central Bank and four other central banks on Oct. 8. Borrowing costs were pared today in Norway and China.
The U.S. economy shrank at a 0.5 percent annual rate last quarter, the most since the 2001 recession, the Commerce Department's report on gross domestic product will probably show tomorrow. Economists expect the slump to persist in the fourth quarter, according to the median estimate.
`Economy Weakens'
``If the economy weakens further, it may open the door for another 25 or 50 basis points in December,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina.''
Plunging commodity prices, including a 54 decline in the cost of oil from a record in July, have eased inflation pressures.
``The committee expects inflation to moderate in coming quarters to levels consistent with price stability,'' the FOMC said in today's statement.
The vote was unanimous. The Fed also lowered the discount rate a half point to 1.25 percent.
While cutting the main rate during the past 13 months from 5.25 percent, Fed Chairman Ben S. Bernanke, 54, has created six loan programs channeling at least $700 billion in cash and collateral into money markets as of Oct. 22.
``This Federal Reserve has been extremely aggressive in terms of providing liquidity,'' Frederic Mishkin, a former Fed governor and now a Columbia University professor, said in a Bloomberg Television interview before the announcement.
Confidence Weakens
Still, consumer confidence tumbled this month to a record low, and orders for durable goods, excluding automobiles and aircraft, dropped for a second straight month in September, reports showed this week. Home prices in 20 U.S. cities declined 16.6 percent in August from a year earlier as foreclosures climbed, according to the S&P/Case-Shiller home price index. The Standard & Poor's 500 Stock Index is down 36 percent this year.
``The intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit,'' the Fed's statement said. ``The pace of economic activity appears to have slowed markedly.''
The credit crisis that began in August 2007 with rising foreclosure rates has led to the collapse or forced mergers of some of Wall Street's biggest firms. Lehman Brothers Holdings Inc. filed for bankruptcy last month, while the government seized control of American International Group Inc. and put Fannie Mae and Freddie Mac under conservatorship. Wachovia Corp. agreed this month to be acquired by Wells Fargo & Co.
Global financial institutions have reported $680 billion in writedowns and credit losses on home loans, mortgage-backed securities and related assets.
Funding Costs
The spread between the cost of overnight loans in New York and three-month dollar loans in London widened to 4.02 percent on Oct. 10 as investors fled risk following Lehman's Sept. 15 bankruptcy. The spread averaged 0.27 percentage point for all of last year. It has since fallen back to 2.5 percentage points.
Bernanke and U.S. Treasury Secretary Henry Paulson gained congressional approval this month for the use of taxpayer funds for a $700 billion bank rescue. The Treasury plans to use some of the funds in the Troubled Asset Relief Program to buy equity stakes in banks.
The Fed redoubled its aid this month, agreeing to finance the commercial paper issuance of General Electric Co. and other corporations and help money-market mutual funds raise cash to meet shareholder redemptions.
Fed's Balance Sheet
The central bank's new loan programs have expanded assets on its balance sheet by 104 percent during the past year to $1.804 trillion, or 12.6 percent of GDP.
Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac were 6.04 percent last week versus 6.07 percent on Jan. 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy is dim, economists said.
``We are in an environment where they lower rates, but then spreads widen so you get no net effect,'' Vincent Reinhart, former director of the Fed Board's Division of Monetary Affairs who is now a visiting scholar at the American Enterprise Institute in Washington, said before the decision. ``We are in a recession.''
Fed officials provided their forecasts for this year and the subsequent three years at the two-day meeting. The uncertainties surrounding the Fed's forecast are ``unusually large,'' and the economy may experience subpar growth ``for several quarters,'' Bernanke told the House Budget Committee on Oct. 20.
The economy ``looks terrible,'' Stephen Stanley, chief economist at RBS Greenwich Capital Markets Inc., said before the announcement. ``Consumer spending is going to be very negative in the fourth quarter, even with gasoline prices falling.''
Policy Tools
Now that their target rate is so low, Fed officials may have discussed alternative policy strategies such as the possibility of keeping rates low on short- and medium-term notes. Bernanke, as a Fed governor, was the top central bank official on research into ``non-traditional'' policy tools between 2002 and 2004, when the central bank last cut the benchmark lending rate to 1 percent.
The Fed has lost some control over the amount of reserves in the banking system because the total lending in some of its programs are driven by market demand. As a result, the federal funds rate has traded below its target every day since the Oct. 8 emergency rate cut.
The central bank raised the floor on the benchmark lending rate and said on Oct. 22 that interest on excess reserves would be equal to the federal funds rate minus 0.35 percentage point. The previous floor was 0.75 percentage point below the federal funds rate. Still, the move hasn't closed the gap between the target rate and the market rate.
To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net
Thursday, October 23, 2008
Commercial Paper Market Still Shrinking
The WSJ has a piece showing that the Commercial Paper market is still shrinking. See the chart below.
This view contrasts with that shared in a post on Krugman's blog that suggests that the money markets are unfreezing.
Scott commenting on Kruman's post writes "As recently as Friday, I heard three different people in the industry describe the LIBOR rate as “notional” or “fictional”, and state that everyone was still largely hoarding cash, even among the banks. The transactions are apparently not happening at a sufficient volume to clear the market, regardless of the offered rate. I’ll believe that the markets are thawing when I hear the ice crack. "
Seems to me that Scott heard right.
The big problem in the money market for the US seems to be the weak economy. WSJ states "What’s worrisome, though, is that the decline in short-term commercial paper issuance may not reflect as much on the clogged money markets as it does on economic weakness. "
This view contrasts with that shared in a post on Krugman's blog that suggests that the money markets are unfreezing.Scott commenting on Kruman's post writes "As recently as Friday, I heard three different people in the industry describe the LIBOR rate as “notional” or “fictional”, and state that everyone was still largely hoarding cash, even among the banks. The transactions are apparently not happening at a sufficient volume to clear the market, regardless of the offered rate. I’ll believe that the markets are thawing when I hear the ice crack. "
Seems to me that Scott heard right.
The big problem in the money market for the US seems to be the weak economy. WSJ states "What’s worrisome, though, is that the decline in short-term commercial paper issuance may not reflect as much on the clogged money markets as it does on economic weakness. "
Below is a National Debt Graph courtesy of zfacts.com.
Zfacts.com points out that the "gross national debt compared to GDP (how rich we are) reached its lowest level since 1931 as Reagan took office in 1981. It skyrocketed for 12 years through Bush I. Clinton reversed it at a peak of 67%. Bush II crossed that line on Sept. 22 and hit 69% on Sept 30. That's the highest it's been since 1955 (53 years ago)."
Democrats have done a better job at reducing the national debt when compared to Republicans.
Zfacts.com points out that the "gross national debt compared to GDP (how rich we are) reached its lowest level since 1931 as Reagan took office in 1981. It skyrocketed for 12 years through Bush I. Clinton reversed it at a peak of 67%. Bush II crossed that line on Sept. 22 and hit 69% on Sept 30. That's the highest it's been since 1955 (53 years ago)."
Democrats have done a better job at reducing the national debt when compared to Republicans.
The US tax payer is indeed getting a lousy deal for his $125 bn capital injection
Willem Buiter agrees with Uwe Reinhardt's article that suggests that the US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. I agree with both of them. Paulson's bailout gift is blatantly unfair to tax payers and the action creates a moral hazard problem that could destablize the US financial system someday in the future.
The US tax payer is indeed getting a lousy deal for his $125 bn capital injection
Uwe Reinhardt is absolutely correct. The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. This is surprising to me, because the complete or partial nationalisations of a number of US financial behemoths earlier in the year represented rather better value for money for the tax payer.
The nationalisation of Fannie, Freddie, AIG and pieces of the nine largest US banks (with more to come) was necessary to prevent a complete collapse of the house of cards we used to know as the American financial system.
Unfortunately, Treasury Secretary Hank Paulson’s injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.
In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. By contrast, in the Netherlands, the injection of €10bn worth of subordinated debt into ING bank comes with a price tag that includes two government directors on the board and a government veto over all strategic decisions by the bank.
In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks. The US tax payer is not only getting a lousy deal compared to private US investors like Buffett, (s)he is also doing much worse than the British tax payer in the UK version of Paulson’s capital injection (£37 bn so far out of provisional budget of £50bn). The UK preference shares have a 12 percent yield and come with government-appointed board members.
Even in the cases of AIG, Fannie and Freddie, unsecured senior creditors did not have to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out of this exercise whole. There were no up-front haircuts, charges or mandatory debt-to-equity conversions.
That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending to elephantesquely large financial enterprises. Unless not only the existing shareholders of the banks benefiting from these capital injections but also the holders of the banks’ unsecured debt (junior and senior) and all other creditors of the bank (with the possible exception of retail depositors up to some appropriate limit) are made to pay a painful penalty for investing in excessively risky if not outright dodgy ventures, we are laying the foundations of the next systemic crisis, even as we are struggling to escape from the current one.
The US tax payer is indeed getting a lousy deal for his $125 bn capital injection
Uwe Reinhardt is absolutely correct. The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. This is surprising to me, because the complete or partial nationalisations of a number of US financial behemoths earlier in the year represented rather better value for money for the tax payer.
The nationalisation of Fannie, Freddie, AIG and pieces of the nine largest US banks (with more to come) was necessary to prevent a complete collapse of the house of cards we used to know as the American financial system.
Unfortunately, Treasury Secretary Hank Paulson’s injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.
In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. By contrast, in the Netherlands, the injection of €10bn worth of subordinated debt into ING bank comes with a price tag that includes two government directors on the board and a government veto over all strategic decisions by the bank.
In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks. The US tax payer is not only getting a lousy deal compared to private US investors like Buffett, (s)he is also doing much worse than the British tax payer in the UK version of Paulson’s capital injection (£37 bn so far out of provisional budget of £50bn). The UK preference shares have a 12 percent yield and come with government-appointed board members.
Even in the cases of AIG, Fannie and Freddie, unsecured senior creditors did not have to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out of this exercise whole. There were no up-front haircuts, charges or mandatory debt-to-equity conversions.
That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending to elephantesquely large financial enterprises. Unless not only the existing shareholders of the banks benefiting from these capital injections but also the holders of the banks’ unsecured debt (junior and senior) and all other creditors of the bank (with the possible exception of retail depositors up to some appropriate limit) are made to pay a painful penalty for investing in excessively risky if not outright dodgy ventures, we are laying the foundations of the next systemic crisis, even as we are struggling to escape from the current one.
Monday, October 20, 2008
The Fund must be a global asset manager
Michael Bordo and Harold James argue that the IMF must be a global asset manager.
The Fund must be a global asset manager
The chaotic, costly and ineffective international response to the current financial disorder has prompted French president Nicolas Sarkozy, British prime minister Gordon Brown and German president Horst Köhler, a former head of the International Monetary Fund, to call for a new Bretton Woods conference to design a new global financial system.
This is the first big crisis since the Bretton Woods conference in 1944, when the IMF was created, when the Fund has stood on the sidelines. Yet the origins of the crisis lie in some of the areas where it has a direct mandate – in particular, the large current account imbalances – as well as in the areas where it has recently been extending its mandate to cover financial stability.
The core IMF function should be multilateral surveillance. But at present this often means just talking. This is quite different from past visions. The IMF originally supervised the rules of the system of the par value of currencies under the Bretton Woods order, which disintegrated in 1971. The effectiveness of multilateral surveillance as it developed in the 1960s was linked to the IMF’s presence as a significant financial intermediary. It is this role that needs to be rethought.
In the past, the ability to give powerful advice to the systemically important countries, such as the UK, was enhanced by the dependence of those countries on IMF resources. It was the financial power of the IMF that gave it its bite, and that power was enhanced by its borrowing – at first from the Group of 10 nations that constituted the General Arrangements to Borrow.
In the years after the collapse of Bretton Woods, the IMF reinvented itself as a vehicle for the management of the surpluses of the time. It borrowed from the new surplus countries, which as a consequence in part managed their new assets through the intermediation of the IMF. It was then able to lend to those countries that suffered shocks as a result of the increase in petroleum prices.
A very large financial actor can have a stabilising role. In the more distant past, market expectations were stabilised during panics by the counter-cyclical behaviour of very large private institutions. The multinational house of Rothschild made the first half of the 19th century stable. In the great panics of 1895-96 and 1907, the US economy was calmed by JPMorgan. At the time of the Great Depression in the 1930s, there was no house of equivalent power.
The IMF could be a powerful stabiliser in global markets if it managed a significant part of the reserve assets of the new surplus countries. It would be in a strong position to take bets against speculators, potentially in regard to speculative attacks on both countries and on financial institutions.
The stabilising action would benefit both the world economy and the interests of the owners of the reserve assets, which have (simply by the fact of the accumulation of the surpluses) a similar interest in world economic and financial stability. At the same time, the management of reserve assets by an internationally controlled asset manager would remove suspicions and doubts about the use of assets for strategic political purposes.
In order to carry out this new task, the IMF would need to regain the trust of its members. The rise in reserves in many Asian countries was a deliberate response to the 1997 Asia crisis, in which there was substantial disillusionment with the IMF. A precondition for acting as a global reserve manager would be governance reform in which the new surplus countries were able to exercise substantive influence through the IMF and feel secure that they were not being politically manipulated.
In particular, if the IMF were to be in a position of an asset manager that could shift assets from one market to another, it would need to be at greater distance from US influence and attempts at control: otherwise, it might be seen as a device for propping up the dollar or particular financial institutions for political economic reasons.
In a revised approach, votes in the IMF would be allocated or “bought” to a large extent through the assets held at the IMF. The proportion of votes determined in this way might be as high as 50 per cent, while the rest would be allocated in the traditional way. There is an analogy to this double determination of voting power in the US constitution, according to which all states have an equal share of Senate votes but very different numbers of seats in the House of Representatives, reflecting population differences.
Making a substantial part of Fund voting a reflection of the reserve positions held in the IMF would allow quick adjustments to new international realities. It would make the IMF more of a market institution, much like the ownership of joint-stock companies can change quickly and noiselessly.
A new version of the Fund could be a substantial contributor to stabilising market expectations. The IMF was conceived in 1944 in a world without major private capital flows, in which states would undertake all international transactions. Extending its mission to include some private sector rescues would be a recognition of the preponderant role markets now play. At the same time, the involvement of a rule-bound international agency would minimise the political poison associated with bank recapitalisations as well as currency interventions.
The Fund must be a global asset manager
The chaotic, costly and ineffective international response to the current financial disorder has prompted French president Nicolas Sarkozy, British prime minister Gordon Brown and German president Horst Köhler, a former head of the International Monetary Fund, to call for a new Bretton Woods conference to design a new global financial system.
This is the first big crisis since the Bretton Woods conference in 1944, when the IMF was created, when the Fund has stood on the sidelines. Yet the origins of the crisis lie in some of the areas where it has a direct mandate – in particular, the large current account imbalances – as well as in the areas where it has recently been extending its mandate to cover financial stability.
The core IMF function should be multilateral surveillance. But at present this often means just talking. This is quite different from past visions. The IMF originally supervised the rules of the system of the par value of currencies under the Bretton Woods order, which disintegrated in 1971. The effectiveness of multilateral surveillance as it developed in the 1960s was linked to the IMF’s presence as a significant financial intermediary. It is this role that needs to be rethought.
In the past, the ability to give powerful advice to the systemically important countries, such as the UK, was enhanced by the dependence of those countries on IMF resources. It was the financial power of the IMF that gave it its bite, and that power was enhanced by its borrowing – at first from the Group of 10 nations that constituted the General Arrangements to Borrow.
In the years after the collapse of Bretton Woods, the IMF reinvented itself as a vehicle for the management of the surpluses of the time. It borrowed from the new surplus countries, which as a consequence in part managed their new assets through the intermediation of the IMF. It was then able to lend to those countries that suffered shocks as a result of the increase in petroleum prices.
A very large financial actor can have a stabilising role. In the more distant past, market expectations were stabilised during panics by the counter-cyclical behaviour of very large private institutions. The multinational house of Rothschild made the first half of the 19th century stable. In the great panics of 1895-96 and 1907, the US economy was calmed by JPMorgan. At the time of the Great Depression in the 1930s, there was no house of equivalent power.
The IMF could be a powerful stabiliser in global markets if it managed a significant part of the reserve assets of the new surplus countries. It would be in a strong position to take bets against speculators, potentially in regard to speculative attacks on both countries and on financial institutions.
The stabilising action would benefit both the world economy and the interests of the owners of the reserve assets, which have (simply by the fact of the accumulation of the surpluses) a similar interest in world economic and financial stability. At the same time, the management of reserve assets by an internationally controlled asset manager would remove suspicions and doubts about the use of assets for strategic political purposes.
In order to carry out this new task, the IMF would need to regain the trust of its members. The rise in reserves in many Asian countries was a deliberate response to the 1997 Asia crisis, in which there was substantial disillusionment with the IMF. A precondition for acting as a global reserve manager would be governance reform in which the new surplus countries were able to exercise substantive influence through the IMF and feel secure that they were not being politically manipulated.
In particular, if the IMF were to be in a position of an asset manager that could shift assets from one market to another, it would need to be at greater distance from US influence and attempts at control: otherwise, it might be seen as a device for propping up the dollar or particular financial institutions for political economic reasons.
In a revised approach, votes in the IMF would be allocated or “bought” to a large extent through the assets held at the IMF. The proportion of votes determined in this way might be as high as 50 per cent, while the rest would be allocated in the traditional way. There is an analogy to this double determination of voting power in the US constitution, according to which all states have an equal share of Senate votes but very different numbers of seats in the House of Representatives, reflecting population differences.
Making a substantial part of Fund voting a reflection of the reserve positions held in the IMF would allow quick adjustments to new international realities. It would make the IMF more of a market institution, much like the ownership of joint-stock companies can change quickly and noiselessly.
A new version of the Fund could be a substantial contributor to stabilising market expectations. The IMF was conceived in 1944 in a world without major private capital flows, in which states would undertake all international transactions. Extending its mission to include some private sector rescues would be a recognition of the preponderant role markets now play. At the same time, the involvement of a rule-bound international agency would minimise the political poison associated with bank recapitalisations as well as currency interventions.
Thursday, October 16, 2008
Clean coal
I got this in my e-mail box this money. It is from Brianna Cotter from Powervote.org
As I watched the final Presidential debate tonight, I was struck yet again by just how far political leadership is from popular support of clean, just energy. While "wind," "solar," "geothermal" and other great investments were mentioned two times each, I heard the nonexistent "clean coal" given even more credence by candidates specifically voicing their support at least three times. I heard about the building of 45 new nuclear power plants in one proposal. The hundreds of thousands of young people who are signing the Power Vote pledge want real solutions to climate change. We don't buy those "clean coal" and "safe nuclear" lies for a second. When candidates mention "off-shore drilling" again and again, we know that's not the answer. We want candidates that will stand up to the dirty energy industry and stand up for our future.
As I watched the final Presidential debate tonight, I was struck yet again by just how far political leadership is from popular support of clean, just energy. While "wind," "solar," "geothermal" and other great investments were mentioned two times each, I heard the nonexistent "clean coal" given even more credence by candidates specifically voicing their support at least three times. I heard about the building of 45 new nuclear power plants in one proposal. The hundreds of thousands of young people who are signing the Power Vote pledge want real solutions to climate change. We don't buy those "clean coal" and "safe nuclear" lies for a second. When candidates mention "off-shore drilling" again and again, we know that's not the answer. We want candidates that will stand up to the dirty energy industry and stand up for our future.
Wednesday, October 15, 2008
Bernanke at Economic Club of New York
Chairman Ben Bernanke spoke at the Economic Club of New York earlier today. He said government efforts to calm financial markets and stem the credit crisis probably won't result in an immediate economic rebound. Craig Torres reports on the speech here.
Tuesday, October 14, 2008
A Thumbs Up From Ivory Tower.
The WSJ has a collection of comments on the new Treasury plan from academic economists around the country. They are generally positive.
A Thumbs Up From the Ivory Tower
Academics and other outside economists were highly critical of the Treasury’s original rescue plan, arguing that taking over banks’ bad assets would do little to solve the problem. Right, left and center, they said that what was needed was a plan to recapitalize the banks – a plan like the Treasury plan has just announced. Here are initial reactions to the plan (some have been edited for length) from some leading economists.
Barry Eichengreen, Berkeley: This is now, finally, the right move. Were it a student paper, I would give it give it an A- for quality but lower the final grade to a C for lateness.
The minus on the A reflects the Treasury´s reluctance to opt for straight stock with voting rights as other governments have done. If we are going to entrust the banks with taxpayer funds as part of their equity, then the taxpayer should have a vote. This is especially a problem with the weakest institutions, where at some point management, unrestrained by representatives of the taxpayer on the board, will be gambling for survival using public money.
What should be next, you ask. Let the new measures work. Apply some fiscal stimulus in the form of aid to state and local governments and targeted tax cuts. The stimulus will be needed.
Kenneth Rogoff, Harvard University: It wasn’t just the right move, it was the only move. Thanks goodness they didn’t dally for another week to finally figure it out.
There are many challenges ahead. The recession is only just picking up steam, now. In the wake of the housing and credit bust, there is no way that the US is going to sustain consumption at 70% of GDP. Exports will fall as the rest of the world goes into recession.
[On policy] surely the next Congress will pass a massive bailout for mortgage markets, especially if housing prices continue to fall.
Last but not least, the latest Treasury plan begs the question of what a post-bubble payments system should look like, and how it should be regulated. Will future profits from retail banking all come from supplying convenience services for what essentially amount to deposits with the US government? Surely the regulations governing money market funds will have to be completely rewritten.
Doug Elmendorf, Brookings Institution: These new policies are huge steps in the right direction. However, the announcement alone will not be enough, just as other recent announcements like the TARP and the Fed’s CP facility failed to increase lending by banks. It’s crucial now that the money start to flow from the government through all of these channels.
Anil Kashyap, University of Chicago Graduate School of Business: [I] strongly think recapitalization is the deep problem. I would prefer giving the option to raise it privately first, and would like to make sure that they do not waste money on an insolvent firm (a la Japan in 1998).
Guaranteeing the debt is important to buy time. Ideally the time would be used to make sure you are only helping solvent banks…
I think if they truly get the details right and succeed at recapitalizing the system, then intermediation will start returning to normal. My guess is that we still wind up with a recession but perhaps one that is much less onerous than if they not acted now.
Hyun Song Shin, Princeton University: It’s the right move in principle. The case for an equity injection is compelling. Think of it like this. If you buy bank assets with 700 billion dollars, you add this much balance sheet capacity to the banking system. On a leverage of 10 to 1, this is like injecting equity of 70 billion. But, if you inject 700 billion of equity, then on a leverage of 10 to 1, this is adding additional balance sheet capacity of 7 trillion. So, dollar for dollar, you get much more bang for the buck in adding further lending capacity to the banking system.
Will the plan work? It depends how the equity is injected. The plan now is to buy preferred stock. This is a buffer against loss for the senior creditors, but it doesn’t add anything to the common stock. Preferred stock is a claim without control, which just drains cash from the bank (think of Warren Buffett’s 10% coupon on his preferred stock from Goldman). Preferred stock will make banks lend if the problem previously was risk of loss for the creditors. But if the problem is that the controlling shareholders (the common stockholders) are being cautious, then preferred stock will just make things worse in terms of willingness to lend.
Injection of common stock will free up lending more effectively, but this is bad in terms of taxpayers getting their money back. That’s the dilemma. Do you want to protect the taxpayers’ stake, or to you want to free up lending?
Ricardo Reis, Columbia University: I think it is the right move. Not an action without problems, nor one that is desirable in general, but one to swallow given the circumstances. The root of the problems is lack of capital in the banks. If private capital doesn’t seem to be stepping in, so let it be public capital. That is, as long as it is for a good price and as long as it does the best job possible of giving the right incentives by: not rewarding current shareholders (pay little to nothing for their equity), not rewarding current management (fire them or cut their compensation drastically), and not rewarding the reckless creditors who financed them (using warrants and preferred stock that gives priority on the government being paid).
What comes next depends on how markets behave in the next few days. Forecasting is usually tricky, but with the current market volatility any predictions for what will happen next are very hard.
Raghuram Rajan, University of Chicago Graduate School of Business: It has many of the elements we have been advocating. So I like it a lot better than the Treasury plan. I would worry about some details.
First, while I have been in favor of recapitalizing the stronger banks so that they can lift the system, I would have preferred giving them the choice of getting government capital or raising private capital. I guess the benefit of the force feeding by the government is that the ones who do take it do not send a bad signal about their options. I am unclear how the amounts were determined.
Second, a temporary guarantee of debts — e.g., for 3 to 6 months (is it for all banks) would have been preferable to a three year guarantee. Not sure how you restrict it to new debt only — I can just repay old debt and raise new debt.
Third, you have to be careful that entities outside the well-protected system (e.g., small banks and insurance companies) do not face runs. It may be that the guarantee will have to be extended to more entities (not clear if FDIC will guarantee debt of all banks).
Presumably, the regulators will also audit banks over the next few months to identify and resolve the weak ones. It would not be clever to offer a blanket guarantee for an indefinite period to weak banks. In this regard, supervisors will have to monitor the asset growth of guaranteed banks so as to make sure they are not gambling with taxpayer money. Presumably, also, there will be some scheme to recapitalize small and medium sized banks that are worth saving. Would like to see more private participation in those.
Markus Brunnermeier, Princeton: Overall, I like the move. It’s way better than starting a complicated reverse auction for a very heterogeneous set of troubled assets. Why?
a) It recapitalizes banks directly, i.e. has a bigger bang for the buck (i.e. if you buy troubled assets standing in the books for $400bn at a inflated price of $700bn, you recapitalize banks only by $300 bn. If you inject new equity, you recapitalize the banks by the whole $ 700 bn. That makes a big difference.)
b) it’s faster (since it is less complicated)!
c) gives the taxpayer an upside potential as well.
An alternative approach (with even more horsepower) would have been to force all banks to do a rights issue that is underwritten by the government. (Forcing all of them to do it, gets around the stigma of issuing stocks and associated stock price decline.) I am not sure whether there is still enough time left, though.
There will be a wave of new regulation coming, especially from Europe. The US seems to have lost its moral authority (in terms of “how to regulate markets”). Let’s not pretend: The balance of power has shifted. Hence, it is important to think clearly and carefully how the new financial architecture should look like. I have some thoughts/outlines on my website (e.g. risk measures like Value at Risk that focus only at the risk of an individual bank have to replaced with CoVaR that measures domino effects etc..). We can talk more about if you want.
Brad DeLong, Berkeley: Yes, it is the right move–but nonvoting preferred stock scares me as giving too great incentives to gamble for resurrection; I would prefer voting common; it’s the devil, but a lesser one.
What comes next? Big fiscal stimulus, I think. All those banks need expanding manufacturing businesses to lend to.
John Cochrane, University of Chicago Graduate School of Business: …grumble grumble, yes there are all sorts of warts on it, but at least this one will probably work, in the narrow sense that it can end the “crisis” or “credit crunch.”
Most of all, I think it will “work” well enough to put a stop to the escalating political panic and the contagion of bailouts. My biggest fears, and those of the markets I think, have been that some new “plan” comes along every two days which can wreck everything. …If I were in charge I would announce loudly “and we’re going to sit on our hands for a whole week no matter what happens to daily stock prices.”
But there are lots and lots of problems with it. Most obviously, now the government has stock in banks. Ok it’s preferred and nonvoting, but still, it is stock. And the government doesn’t need to vote its shares in order to profoundly influence how banks are run! There are lots of good practical reasons to fear government-run banking systems; governments inevitably use control over the banking system for political ends. Already ours has shown a wonderful track record in pushing Fannie Freddie and banks to make and hold bad subprime loans…
Of course, I would much rather do the same thing by marrying bank operations to new private capital rather than a government investment, and I see no reason what that is infeasible. There is lots of private capital sitting around. Pretty much by definition if the government is buying equity and private investors are not, it means the government is getting a bad deal, buying the assets at too high a price and thereby bailing out the existing share and debt holders….
So, the real questions arise going forward. What happens if the assets become worth even less? What happens if we discover that the bank really is insolvent, meaning the assets (mortgages) are worth less than the liabilities (debt)? A bank like that needs to fail, meaning the stock gets wiped out, the debt gets written down, and the operations married to new equity. Issuing a new class of stock now doesn’t help, it gets in the way. The point of equity is to be a “cushion” that can absorb losses if things get worse — which, for some banks, they surely will.
Bottom line, this needs to be a very temporary plan, with a much clearer path for how banks are going to be allowed to fail, to reorganize, to marry with private equity. Otherwise, this has become “no bank may ever fail again”, and part of a government-run banking system. That will quickly become sclerotic.
Charles Calomiris, Columbia Business School: Yes, these parts are the right move, and as you know, many economists including myself have been calling for them for weeks.
But the other aspects of TARP will likely be a mess to implement, especially asset purchases and asset work outs, and I predict that we will regret the stubborn insistence of the Treasury to waste resources on these plans that could be so much better put to use as capital injections.
Jeremy Stein, Harvard University: I think the plan is a strong step in the right direction. However, one item that was not addressed, and should be, is the continuation of dividend payments by the banks. Simply put, the government should force the banks to suspend all dividend payments. It makes absolutely no sense for the government to put money into the banks, only to see a significant fraction of it flow out again as dividends to shareholders, and in many cases, bank executives with large equity stakes. There is an obvious conflict of interest here: the value of the enterprises themselves, as well as social interest, are better served by the money being retained inside the banks, and being used to rebuild capital. But junior claimants who want to siphon off value from more senior creditors clearly want to move as much cash out the door to themselves as possible. Again, this should be stopped immediately. Bank CEOs may claim that cutting dividends will send a negative signal to the market, making future private issues more difficult. But of course, if the government simply compels them to cut dividends, there is no signal sent at all.
A Thumbs Up From the Ivory Tower
Academics and other outside economists were highly critical of the Treasury’s original rescue plan, arguing that taking over banks’ bad assets would do little to solve the problem. Right, left and center, they said that what was needed was a plan to recapitalize the banks – a plan like the Treasury plan has just announced. Here are initial reactions to the plan (some have been edited for length) from some leading economists.
Barry Eichengreen, Berkeley: This is now, finally, the right move. Were it a student paper, I would give it give it an A- for quality but lower the final grade to a C for lateness.
The minus on the A reflects the Treasury´s reluctance to opt for straight stock with voting rights as other governments have done. If we are going to entrust the banks with taxpayer funds as part of their equity, then the taxpayer should have a vote. This is especially a problem with the weakest institutions, where at some point management, unrestrained by representatives of the taxpayer on the board, will be gambling for survival using public money.
What should be next, you ask. Let the new measures work. Apply some fiscal stimulus in the form of aid to state and local governments and targeted tax cuts. The stimulus will be needed.
Kenneth Rogoff, Harvard University: It wasn’t just the right move, it was the only move. Thanks goodness they didn’t dally for another week to finally figure it out.
There are many challenges ahead. The recession is only just picking up steam, now. In the wake of the housing and credit bust, there is no way that the US is going to sustain consumption at 70% of GDP. Exports will fall as the rest of the world goes into recession.
[On policy] surely the next Congress will pass a massive bailout for mortgage markets, especially if housing prices continue to fall.
Last but not least, the latest Treasury plan begs the question of what a post-bubble payments system should look like, and how it should be regulated. Will future profits from retail banking all come from supplying convenience services for what essentially amount to deposits with the US government? Surely the regulations governing money market funds will have to be completely rewritten.
Doug Elmendorf, Brookings Institution: These new policies are huge steps in the right direction. However, the announcement alone will not be enough, just as other recent announcements like the TARP and the Fed’s CP facility failed to increase lending by banks. It’s crucial now that the money start to flow from the government through all of these channels.
Anil Kashyap, University of Chicago Graduate School of Business: [I] strongly think recapitalization is the deep problem. I would prefer giving the option to raise it privately first, and would like to make sure that they do not waste money on an insolvent firm (a la Japan in 1998).
Guaranteeing the debt is important to buy time. Ideally the time would be used to make sure you are only helping solvent banks…
I think if they truly get the details right and succeed at recapitalizing the system, then intermediation will start returning to normal. My guess is that we still wind up with a recession but perhaps one that is much less onerous than if they not acted now.
Hyun Song Shin, Princeton University: It’s the right move in principle. The case for an equity injection is compelling. Think of it like this. If you buy bank assets with 700 billion dollars, you add this much balance sheet capacity to the banking system. On a leverage of 10 to 1, this is like injecting equity of 70 billion. But, if you inject 700 billion of equity, then on a leverage of 10 to 1, this is adding additional balance sheet capacity of 7 trillion. So, dollar for dollar, you get much more bang for the buck in adding further lending capacity to the banking system.
Will the plan work? It depends how the equity is injected. The plan now is to buy preferred stock. This is a buffer against loss for the senior creditors, but it doesn’t add anything to the common stock. Preferred stock is a claim without control, which just drains cash from the bank (think of Warren Buffett’s 10% coupon on his preferred stock from Goldman). Preferred stock will make banks lend if the problem previously was risk of loss for the creditors. But if the problem is that the controlling shareholders (the common stockholders) are being cautious, then preferred stock will just make things worse in terms of willingness to lend.
Injection of common stock will free up lending more effectively, but this is bad in terms of taxpayers getting their money back. That’s the dilemma. Do you want to protect the taxpayers’ stake, or to you want to free up lending?
Ricardo Reis, Columbia University: I think it is the right move. Not an action without problems, nor one that is desirable in general, but one to swallow given the circumstances. The root of the problems is lack of capital in the banks. If private capital doesn’t seem to be stepping in, so let it be public capital. That is, as long as it is for a good price and as long as it does the best job possible of giving the right incentives by: not rewarding current shareholders (pay little to nothing for their equity), not rewarding current management (fire them or cut their compensation drastically), and not rewarding the reckless creditors who financed them (using warrants and preferred stock that gives priority on the government being paid).
What comes next depends on how markets behave in the next few days. Forecasting is usually tricky, but with the current market volatility any predictions for what will happen next are very hard.
Raghuram Rajan, University of Chicago Graduate School of Business: It has many of the elements we have been advocating. So I like it a lot better than the Treasury plan. I would worry about some details.
First, while I have been in favor of recapitalizing the stronger banks so that they can lift the system, I would have preferred giving them the choice of getting government capital or raising private capital. I guess the benefit of the force feeding by the government is that the ones who do take it do not send a bad signal about their options. I am unclear how the amounts were determined.
Second, a temporary guarantee of debts — e.g., for 3 to 6 months (is it for all banks) would have been preferable to a three year guarantee. Not sure how you restrict it to new debt only — I can just repay old debt and raise new debt.
Third, you have to be careful that entities outside the well-protected system (e.g., small banks and insurance companies) do not face runs. It may be that the guarantee will have to be extended to more entities (not clear if FDIC will guarantee debt of all banks).
Presumably, the regulators will also audit banks over the next few months to identify and resolve the weak ones. It would not be clever to offer a blanket guarantee for an indefinite period to weak banks. In this regard, supervisors will have to monitor the asset growth of guaranteed banks so as to make sure they are not gambling with taxpayer money. Presumably, also, there will be some scheme to recapitalize small and medium sized banks that are worth saving. Would like to see more private participation in those.
Markus Brunnermeier, Princeton: Overall, I like the move. It’s way better than starting a complicated reverse auction for a very heterogeneous set of troubled assets. Why?
a) It recapitalizes banks directly, i.e. has a bigger bang for the buck (i.e. if you buy troubled assets standing in the books for $400bn at a inflated price of $700bn, you recapitalize banks only by $300 bn. If you inject new equity, you recapitalize the banks by the whole $ 700 bn. That makes a big difference.)
b) it’s faster (since it is less complicated)!
c) gives the taxpayer an upside potential as well.
An alternative approach (with even more horsepower) would have been to force all banks to do a rights issue that is underwritten by the government. (Forcing all of them to do it, gets around the stigma of issuing stocks and associated stock price decline.) I am not sure whether there is still enough time left, though.
There will be a wave of new regulation coming, especially from Europe. The US seems to have lost its moral authority (in terms of “how to regulate markets”). Let’s not pretend: The balance of power has shifted. Hence, it is important to think clearly and carefully how the new financial architecture should look like. I have some thoughts/outlines on my website (e.g. risk measures like Value at Risk that focus only at the risk of an individual bank have to replaced with CoVaR that measures domino effects etc..). We can talk more about if you want.
Brad DeLong, Berkeley: Yes, it is the right move–but nonvoting preferred stock scares me as giving too great incentives to gamble for resurrection; I would prefer voting common; it’s the devil, but a lesser one.
What comes next? Big fiscal stimulus, I think. All those banks need expanding manufacturing businesses to lend to.
John Cochrane, University of Chicago Graduate School of Business: …grumble grumble, yes there are all sorts of warts on it, but at least this one will probably work, in the narrow sense that it can end the “crisis” or “credit crunch.”
Most of all, I think it will “work” well enough to put a stop to the escalating political panic and the contagion of bailouts. My biggest fears, and those of the markets I think, have been that some new “plan” comes along every two days which can wreck everything. …If I were in charge I would announce loudly “and we’re going to sit on our hands for a whole week no matter what happens to daily stock prices.”
But there are lots and lots of problems with it. Most obviously, now the government has stock in banks. Ok it’s preferred and nonvoting, but still, it is stock. And the government doesn’t need to vote its shares in order to profoundly influence how banks are run! There are lots of good practical reasons to fear government-run banking systems; governments inevitably use control over the banking system for political ends. Already ours has shown a wonderful track record in pushing Fannie Freddie and banks to make and hold bad subprime loans…
Of course, I would much rather do the same thing by marrying bank operations to new private capital rather than a government investment, and I see no reason what that is infeasible. There is lots of private capital sitting around. Pretty much by definition if the government is buying equity and private investors are not, it means the government is getting a bad deal, buying the assets at too high a price and thereby bailing out the existing share and debt holders….
So, the real questions arise going forward. What happens if the assets become worth even less? What happens if we discover that the bank really is insolvent, meaning the assets (mortgages) are worth less than the liabilities (debt)? A bank like that needs to fail, meaning the stock gets wiped out, the debt gets written down, and the operations married to new equity. Issuing a new class of stock now doesn’t help, it gets in the way. The point of equity is to be a “cushion” that can absorb losses if things get worse — which, for some banks, they surely will.
Bottom line, this needs to be a very temporary plan, with a much clearer path for how banks are going to be allowed to fail, to reorganize, to marry with private equity. Otherwise, this has become “no bank may ever fail again”, and part of a government-run banking system. That will quickly become sclerotic.
Charles Calomiris, Columbia Business School: Yes, these parts are the right move, and as you know, many economists including myself have been calling for them for weeks.
But the other aspects of TARP will likely be a mess to implement, especially asset purchases and asset work outs, and I predict that we will regret the stubborn insistence of the Treasury to waste resources on these plans that could be so much better put to use as capital injections.
Jeremy Stein, Harvard University: I think the plan is a strong step in the right direction. However, one item that was not addressed, and should be, is the continuation of dividend payments by the banks. Simply put, the government should force the banks to suspend all dividend payments. It makes absolutely no sense for the government to put money into the banks, only to see a significant fraction of it flow out again as dividends to shareholders, and in many cases, bank executives with large equity stakes. There is an obvious conflict of interest here: the value of the enterprises themselves, as well as social interest, are better served by the money being retained inside the banks, and being used to rebuild capital. But junior claimants who want to siphon off value from more senior creditors clearly want to move as much cash out the door to themselves as possible. Again, this should be stopped immediately. Bank CEOs may claim that cutting dividends will send a negative signal to the market, making future private issues more difficult. But of course, if the government simply compels them to cut dividends, there is no signal sent at all.
Monday, October 13, 2008
Krugman's autobiographical essay
Krugman writes "All in all, though, I've been very lucky. A lot of that luck has to do with the accidents that led me to stumble onto an intellectual style that has served me extremely well." From Krugman's autobiographical essay.
Iceland crisis: what does 'national bankruptcy' mean?
What does it mean when a country goes bankrupt?
Here is a lucid explanation.
Here is a lucid explanation.
Krugman Wins Economics Nobel
I was talking with a colleague last Friday and the talk gravitated to who is going to win this year’s Nobel Memorial Prize in Economic Science. I said I have a feeling Professor Peter Phillips of Yale University might win it for his work in time series analysis. It did dawn on me though that some economists have won the prize for related work, so naturally, we had to come up with a different name. We came up with Professor Paul Krugman of Princeton University. My response went like this, sure he will win the Nobel prize but I don’t think it will be this year. He is too young to win it. Was I wrong! Congratulations to Paul Krugman for winning this year’s Nobel Prize in Economics.
Sunday, October 12, 2008
Action plan - my foot
William Buiter is not happy about the current Action plan coming from the G7. I don't blame him. Here is his take on the Action plan:
Please read the following “Action Plan to Combat Crisis”, cribbed from the IMF’s website
Yesterday, October 10, the G-7 met and agreed the following plan of action:
Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.
Now that you have read this, please tell me: where is the beef? Where are the actions? Where are the decisive actions? Where are the internationally coordinated concrete measures and steps to be taken?
If by the time the markets open on Monday morning, this vague list of pious intentions has not been complemented with a rather longer list, by each of the G-7 and preferably by each of the G-20 nations, of specific actions and measures to suppport their key financial markets and institutions, including essential cooperative measures to stabilise border-crossing markets and institutions, then stocks will continue to plummet as they did last week. Some suggestions on what to do can be found in my previous posting on this blog. Even sitting alone in front of my laptop in my dressing gown, I came up with eight rather specific actions.
(1) Public guarantees of interbank lending between banks in different national jurisdictions. This could be implemented by national central banks acting as counterparty of last resort in the (unsecured) interbank markets.
(2) International agreement on limits on public guarantees for other bank liabilies and for liabilities of other highly leveraged institutions. This includes agreements on terms and conditions attached to such guarantees.
(3) International agreement on recapitalisation of banks with significant cross-border activities.
(4) Fiscal bail-outs of countries whose systemically important banks have a solvency gap that exceed the government’s fiscal capacity.
(5) International agreement on mandatory debt-to-equity conversions for banks and other highly leveraged institutions.
(6) International agreement on avoiding a moral hazard race to the bottom for deposit insurance through limits on deposit insurance (this is really as special case of (2)).
(7) International agreement on common access rules and common methods for valuing illiquid assets in different national TARP-like structures.
(8) International agreement to adhere rigorously to mark-to-market accounting and reporting principles and on common rules for relaxing regulatory requirements attached to marked-to-market valuations.
That wasn’t so hard! I know politics is difficult, but if the desire to succeed of the participants is commensurate with their egos, I know we can succeed.
Unless specific internationally agreed measures are agreed forthwith, we are likely to discover that, for the money that would have allowed the G-7 to nationalise the bulk of their banking systems at the end of last week, it will be possible to nationalise the bulk of all listed companies by the end of next week. The temporary nationalisation of the bulk of the G-7 banking sectors may by now have become unavoidable and indeed necessary, but I would hope that we can avoid the introduction of the other trappings of comprehensive state ownership of the means of production, distribution and exchange. Should economists begin to dust off their manuals on central planning?
I hope that at the Eurogroup + Gordon Brown meetings this weekend in Paris, more concrete steps will be agreed. Why not sneak in the American, Japanese and Canadian Treasury ministers and central bank governors as well, and just do the G-7 meeting of last Friday over again, this time properly?
Please read the following “Action Plan to Combat Crisis”, cribbed from the IMF’s website
Yesterday, October 10, the G-7 met and agreed the following plan of action:
Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.
Now that you have read this, please tell me: where is the beef? Where are the actions? Where are the decisive actions? Where are the internationally coordinated concrete measures and steps to be taken?
If by the time the markets open on Monday morning, this vague list of pious intentions has not been complemented with a rather longer list, by each of the G-7 and preferably by each of the G-20 nations, of specific actions and measures to suppport their key financial markets and institutions, including essential cooperative measures to stabilise border-crossing markets and institutions, then stocks will continue to plummet as they did last week. Some suggestions on what to do can be found in my previous posting on this blog. Even sitting alone in front of my laptop in my dressing gown, I came up with eight rather specific actions.
(1) Public guarantees of interbank lending between banks in different national jurisdictions. This could be implemented by national central banks acting as counterparty of last resort in the (unsecured) interbank markets.
(2) International agreement on limits on public guarantees for other bank liabilies and for liabilities of other highly leveraged institutions. This includes agreements on terms and conditions attached to such guarantees.
(3) International agreement on recapitalisation of banks with significant cross-border activities.
(4) Fiscal bail-outs of countries whose systemically important banks have a solvency gap that exceed the government’s fiscal capacity.
(5) International agreement on mandatory debt-to-equity conversions for banks and other highly leveraged institutions.
(6) International agreement on avoiding a moral hazard race to the bottom for deposit insurance through limits on deposit insurance (this is really as special case of (2)).
(7) International agreement on common access rules and common methods for valuing illiquid assets in different national TARP-like structures.
(8) International agreement to adhere rigorously to mark-to-market accounting and reporting principles and on common rules for relaxing regulatory requirements attached to marked-to-market valuations.
That wasn’t so hard! I know politics is difficult, but if the desire to succeed of the participants is commensurate with their egos, I know we can succeed.
Unless specific internationally agreed measures are agreed forthwith, we are likely to discover that, for the money that would have allowed the G-7 to nationalise the bulk of their banking systems at the end of last week, it will be possible to nationalise the bulk of all listed companies by the end of next week. The temporary nationalisation of the bulk of the G-7 banking sectors may by now have become unavoidable and indeed necessary, but I would hope that we can avoid the introduction of the other trappings of comprehensive state ownership of the means of production, distribution and exchange. Should economists begin to dust off their manuals on central planning?
I hope that at the Eurogroup + Gordon Brown meetings this weekend in Paris, more concrete steps will be agreed. Why not sneak in the American, Japanese and Canadian Treasury ministers and central bank governors as well, and just do the G-7 meeting of last Friday over again, this time properly?
Saturday, October 11, 2008
The state of the US economy
FT shows which US States are suffering the most in the current economic and financial crisis. Analysisi is based on personal income, employment growth, foreclosures and real gross state product. Click here.
Thursday, October 9, 2008
Credit Default Swap Made Easy
Marketplace Senior Editor Paddy Hirsch goes to the whiteboard to make the complicated world of credit default swaps easier to understand.
National Debt Clock Runs Out of Digits
The clock has run out on the national debt.
Last month the national debt exceeded $10 trillion. The gross national debt as a percentage of the gross domestic product has now hit a 50-year high.
Last month the national debt exceeded $10 trillion. The gross national debt as a percentage of the gross domestic product has now hit a 50-year high.
Wednesday, October 8, 2008
Central Banks Coordinate Global Cut in Interest Rates
Central banks around the world cut short-term interest rates by up to half a percent on Wednesday after investors across Asia and Europe unleashed waves of sell orders onto already depressed stock exchanges.
Paul Krugman notes that for the US, we’re way past the point at which conventional monetary policy has much traction. So he does not expect much from the rate cut.
The trouble with rate cuts
The coordinated rate cut was the right thing to do. But I don’t expect much from it — because the relationship between Fed funds rates and the rates most businesses actually pay is very weak right now, thanks to the messed-up state of the financial system.
A quick illustration: in early July 2007, before the crisis, the target Fed funds rate was 5.25% and the rate on 30-day A2/P2 commercial paper — that is, CP issued by less-than-sterling borrowers — was 5.4%. On Monday of this week, the target Fed funds rate was 2%, down 325 basis points from pre-crisis levels, but the CP rate was 5.61% — up from pre-crisis levels.
So will this latest rate cut make any difference to borrowers? Maybe — but only to a few of them. We’re way past the point at which conventional monetary policy has much traction.
I wonder who are the few who will benefit from the rate cut.
Paul Krugman notes that for the US, we’re way past the point at which conventional monetary policy has much traction. So he does not expect much from the rate cut.
The trouble with rate cuts
The coordinated rate cut was the right thing to do. But I don’t expect much from it — because the relationship between Fed funds rates and the rates most businesses actually pay is very weak right now, thanks to the messed-up state of the financial system.
A quick illustration: in early July 2007, before the crisis, the target Fed funds rate was 5.25% and the rate on 30-day A2/P2 commercial paper — that is, CP issued by less-than-sterling borrowers — was 5.4%. On Monday of this week, the target Fed funds rate was 2%, down 325 basis points from pre-crisis levels, but the CP rate was 5.61% — up from pre-crisis levels.
So will this latest rate cut make any difference to borrowers? Maybe — but only to a few of them. We’re way past the point at which conventional monetary policy has much traction.
I wonder who are the few who will benefit from the rate cut.
GLOBAL FINANCIAL STABILITY REPORT
The IMF has this right. In their "Global Financial Stability Report" the Fund calls for a comprehensive approach to global credit turmoil, unlike the piecemeal approach that we have witnessed coming out of the US. They also stated that damage to real economy must be minimized and global regulatory system must be rethought.
World Economic Outlook- Global Economy Under Stress
IMF World Economic Outlook (WEO) - Financial Stress, Downturns, and Recoveries, October 2008 is out. You can find it here. The Executive Summary notes:
The world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930s. Global growth is projected to slow substantially in 2008, and a modest recovery would only begin later in 2009.
Inflation is high, driven by a surge in commodity
prices, but is expected to moderate. The situation is
exceptionally uncertain and subject to considerable
downside risks. The immediate policy challenge is to
stabilize financial conditions, while nursing economies
through a period of slow activity and keeping
inflation under control.
The world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930s. Global growth is projected to slow substantially in 2008, and a modest recovery would only begin later in 2009.
Inflation is high, driven by a surge in commodity
prices, but is expected to moderate. The situation is
exceptionally uncertain and subject to considerable
downside risks. The immediate policy challenge is to
stabilize financial conditions, while nursing economies
through a period of slow activity and keeping
inflation under control.
Monday, October 6, 2008
DataPoints: The Dismal Scientist Blog
DataPoints Blog home is here. It is mostly about macroeconomics.
The Challenge for Corporate Governance Posed by Financial Innovation
I stumbled on this article today and made me realize that the Fed was aware of the potential problem posed by some of the innovation associated with derivatives that has led to the current financial crisis. Sadly, there did not seem to be any tone of urgency in the speech. Furthemore, a direct link to a financial crisis of this magnitude was not made.
Written in Ocotber 2002, the title reads "The Challenge for Corporate Governance posed by Financial Innovation" and it is by Governor Susan S. Bies.
I appreciate the opportunity to speak with you today about corporate governance in the United States. The unfolding concerns in recent months have thrust the quality of accounting, auditing, and disclosure practices of major U.S. companies into the limelight. At the heart of these issues is the breakdown in professionalism of independent auditors. Auditors have been too focused on cross-selling new services to corporations, and have lost sight of the fact that their independent attestation to the quality of financial reporting is the core value that they bring to the market place. The customers of an audit engagement are investors and creditors. The absence of leadership within the profession to call for true reform will make regaining market confidence all the more difficult. The weight of regulatory reform rests on the SEC and the new Public Company Accounting Oversight Board and we should all support this new entity as it endeavors by enforcement to change the culture of an industry.
While I could focus on the issue of auditor independence, it has already received much attention. I want to instead talk about some broader, long-term issues affecting accounting and corporate governance that have not been the center of as much of the recent debate. Looking beyond the isolated cases of outright fraud, I believe a fundamental problem is this: As organizations have grown in size and scope, innovative financing techniques have made it more difficult for outside investors to understand a particular firm's risk profile and the performance of its various lines of business. Traditional accounting standards have not kept pace with the risk-management tools employed by sophisticated corporations. Thus, the disclosure of firms' risk-management positions and strategies is crucial to improve corporate transparency for market participants.
The second issue I want to focus on is that financial innovation has helped increase the importance of institutional investors, such as mutual funds and pension funds, in our equity markets. Because shareholders play a key role in corporate governance, the emergence of institutional investors as major holders of corporate equity also has implications for corporate governance.
As I shall discuss, a necessary response to the recent wave of financial innovation is a combination of enhanced transparency and market discipline applied by creditors, counterparties, and investors-including the institutional investors that now hold a large share of corporate equity. Together, these efforts should help lay a foundation for more effective corporate governance.
Financial Innovation and Risk ManagementThe last decades of the twentieth century were, without doubt, a period of dramatic change in financial engineering, financial innovation, and risk-management practices. Over this period, firms acquired effective new tools to manage financial risk, one of which was securitization. Many of the assets on a firm's balance sheet, such as receivables, can now be securitized--that is, grouped into pools and sold to outside investors. Securitization helps a firm manage the risk of a concentrated exposure by transferring some of that exposure outside the firm. By pooling a diverse set of assets and issuing marketable securities, firms obtain liquidity and reduce funding costs. Of course, moving assets off the balance sheet and into special-purpose entities, with the attendant creation of servicing rights and high-risk residual interests retained by firms, generates its own risks.
Several types of securitization have grown rapidly over the past decade. One of the fastest growing has been asset-backed commercial paper, which soared from only $16 billion outstanding at the end of 1989 to more than $700 billion as of the second quarter of this year. Commercial mortgage securitizations have also proliferated noticeably since the early 1990s. The dollar amount of outstanding securities backed by commercial and multifamily mortgages has risen from $36 billion at the end of 1989 to nearly $400 billion as of this past June. In addition, commercial banks and finance companies have moved business loans off their books through the development of collateralized debt obligations. Securitized business loans amounted to $125 billion in the second quarter of 2002, up from a relatively miniscule $2 billion in 1989.
Derivatives are another important tool that firms use to manage risk exposures. In the ordinary course of business, firms are exposed to credit risk and the risk of price fluctuations in currency, commodity, energy, and interest rate markets. For example, when an airline sells tickets months before a flight, the airline becomes exposed to fluctuations in the price of jet fuel. A higher price of jet fuel translates directly into lower profits and, perhaps, a greater risk of bankruptcy. Firms can now use derivatives--options, futures, forwards, and so on--to mitigate their exposure to some of these risks. The risk can be transferred to a counterparty that is more willing to bear it. In my example, the airline could buy a forward contract or a call option on jet fuel to hedge its risk and thereby increase its financial stability.
The use of derivatives, like securitizations, has been growing rapidly in recent years. The most recent statistics from the Bank for International Settlements indicated that the notional amount of over-the-counter derivatives outstanding totaled $111 trillion in December 2001, up from $80 trillion just three years earlier. For exchange-traded derivatives, notional amounts outstanding rose from $14 trillion to $24 trillion over the same period.
Complex Organizations Are OpaqueAs indicated by my brief discussion of securitization and derivatives, financial innovations have facilitated the separation and reallocation of risks to parties more willing and able to bear them. In the twenty-first century, businesses will use almost limitless configurations of products and services and sophisticated financial structures. A byproduct of these developments will be that outsiders will have ever more difficulty understanding the risk positions of many large, complex organizations; and traditional financial reporting--which provides a snapshot at a particular moment--will be even less meaningful than it is today.
The intended or unintended consequences of the opaqueness that comes with complexity raise serious issues for financial reporting and corporate governance. Effective governance requires investors and creditors to hold firms accountable for their decisions. But its prerequisite is having the information necessary to understand the risks that the firm is bearing and those it has transferred to others.
With sufficient, timely, accurate, and relevant information, market participants can evaluate a firm's risk profile and adjust the availability and pricing of funds to promote a better allocation of financial resources. Lenders and investors have an obvious interest in accurately assessing a firm's risk-management performance, the underlying trends in its earnings and cash flow, and its income-producing potential. In this regard, transparency is essential to providing market participants with the information they need to effect market discipline.
Sound, well-managed companies will benefit if enhanced disclosure enables them to obtain funds at risk premiums that more accurately reflect their lower risk profiles. This would be a positive. Without such disclosure, otherwise well-managed firms will be penalized if market participants cannot perceive their fundamental financial strength and sound risk-management practices. In recent months, I have been heartened to see that renewed market discipline does appear to be forcing companies to compete for investors' support by improving the transparency of corporate reporting.
Improving Accounting and Disclosure for Complex FirmsMost firms and market participants favor sound accounting standards and meaningful disclosure, but some companies have not been completely transparent in their application of accounting and disclosure standards to specific transactions. In these situations, financial reports have neither reflected nor been consistent with the way the business has actually been run, or the risks to which the business has actually been exposed.
In some of these cases, the company's external auditors appear to have forgotten the lessons they learned in Auditing 101. Auditors have focused on form over substance when looking at risk transfer activities, and they have failed to maintain the necessary independence from the client. But the issues run deeper than just a breakdown of basic auditing standards.
As a result of the recently recognized failures of accounting, auditing, and disclosure, the market was unable to appropriately discipline the risk-taking activities of these firms on a timely basis because outsiders lacked the information from financial statements or other disclosures to do so. As critical information became available--after the fact, as it virtually always will--the market reflected its concerns about underlying business practices and accounting through the declining values of equity and debt.
At this point, we do not have all of the facts about many of the situations involving alleged accounting and auditing problems, but a consensus is growing that changes should be made to some underlying accounting standards and to their application by companies and their auditors. Various groups are undertaking initiatives to correct the problems that have recently been identified. For example, the U.S. Financial Accounting Standards Board is considering how to improve the accounting standards for special-purpose entities. This is a direct response to the rapid growth of securitization and the opacity that securitization has introduced into financial reporting.
The Sarbanes-Oxley Act, which became law in July of this year, contains a number of provisions to improve accounting and disclosure. CEOs and CFOs are now required to certify that their financial reports fairly represent the financial condition of the company, not just that the reports comply with Generally Accepted Accounting Principles. Sarbanes-Oxley directs the Securities and Exchange Commission to issue new rules on the disclosure of off-balance-sheet transactions. It strengthens the role of corporate audit committees and requires that audit committees are comprised exclusively of independent directors. To bolster the independence of external auditors, Sarbanes-Oxley prohibits them from providing certain internal audit and other consulting services to their clients. Finally, it creates a new Public Company Accounting Oversight Board, independent of the accounting industry, to regulate audits of public companies. These are all changes for the better.
But improvements in accounting and auditing standards are also needed to address other problems that have been identified. In particular, it would be very helpful if fundamental principles and standards could be revised to emphasize that financial statements should clearly and faithfully represent the economic substance of business transactions. We need to insist on higher professional standards. We also need to move toward principles-based accounting standards rather than continue our reliance on rules-based accounting standards, since accounting rules tend to lag behind market innovation. Standards should ensure that companies give appropriate consideration to the substantive risks and rewards of ownership of their underlying assets in identifying whether risk exposures should be reflected in consolidated financial statements.
Besides applying sound accounting treatments, company managers must ensure that public disclosures clearly identify all significant risk exposures--whether on or off the balance sheet--and their impact on the firm's financial condition and performance, cash flow, and earnings potential. With regard to securitizations, derivatives, and other innovative risk-transfer instruments, traditional accounting disclosures of a company's balance sheet at a point in time may not be sufficient to convey the full impact of a company's financial prospects.
Equally important are disclosures about how risks are being managed and the underlying basis for values and other estimates that are included in financial reports. Unlike typical accounting reports, information generated by risk management tends to be oriented less to a point in time and more to a description of the risks. To take an example from the world of banking, where the discipline of risk management is relatively well developed, an accounting report might say that the fair value of a loan portfolio is $300 million and has dropped $10 million from the last report. However, the bank's internal risk report would show much more extensive information, such as the interest rate and credit quality of the assets and the range of values the portfolio would take under alternative future scenarios. The user of a risk-management report could determine whether changes in value were due to declining credit quality, rising interest rates, or sales or payoffs of loans.
Corporate risk officers have developed other types of reports that provide information on the extent to which the total return in a particular line of business compensates for the line's comprehensive risk. On an enterprise basis, a reader of such a report can determine whether the growing lines of business have risk exposures that tend to offset those in other business lines -- thereby resulting in lower volatility for the earnings of the corporation as a whole.
Complex organizations should continue to improve their risk-management and reporting functions. When they are comfortable with the reliability and consistency of the information in these reports, they should begin disclosing this information to the market, perhaps in summary form, paying due attention to the need for keeping proprietary business data confidential. Not only would such disclosure provide more qualitative and quantitative information about the firm's current risk exposure to the market, it would help the market assess the quality of the risk oversight and risk appetite of the organization.
A sound risk-management system in a complex organization should continually monitor all relevant risks--including credit, market, liquidity, operational and reputation risks. Reputation risk, which recent events have shown can make or break a company, becomes especially hard to manage when off-balance-sheet activities conducted in a separate legal entity can affect the parent firm's reputation. For all these risks, disclosures consistent with the information used internally by risk managers could be very beneficial to market participants. Companies should ensure that they not only meet the letter of the standards that exist but also that their financial reports and other disclosures focus on what is really essential to help investors and other market participants understand their businesses.
In this regard, I believe that the Financial Accounting Standards Board has missed an opportunity in their recent exposure draft proposing changes to the accounting treatment of special-purpose entities, or SPEs. The exposure draft focuses on the choice of consolidating or not consolidating an SPE but says little about disclosure. If FASB's goal is to make the financial reporting of firms' dealings with SPEs more informative, disclosure of the effect of the SPE on the firm would be equally necessary. For example, if firms securitize receivables through commercial paper conduits, those receivables are no longer on the company's books under current accounting standards. Yet the aging of receivables is a key indicator that investors and lenders use to assess the quality of sales and operations. If the receivables move off the balance sheet, information about the aging of the receivables should continue to be part of the firm's disclosures. Further, the disclosures should include the firm's internal assessment of how its dealings with the SPE alter its risk exposures. I hope that as FASB debates this issue in upcoming weeks, due attention will be paid to the benefits of enhancing disclosure of SPEs.
I particularly want to emphasize that disclosure need not be in a standard accounting framework nor exactly the same for all organizations. Rather, we should all be insisting that each entity disclose the information its stakeholders need to evaluate the entity's risk profile. Companies should be less concerned about the vehicle of disclosure and more concerned with the substance of what information is made available to the public. And, we should keep in mind that disclosure without context may not be meaningful. These improvements in transparency are a necessary response to the recent corporate scandals and will help strengthen corporate governance in years to come.
Financial Innovations, Equity Holdings, and Shareholder ActivismJust as financial innovations spawned a variety of risk-management tools for businesses, they have also been responsible, in part, for changes in the structure of equity ownership. Along with advances in computer processing power that have facilitated the management of ever-larger portfolios, an increasing awareness among investors of the value of portfolio diversification has led to a dramatic secular rise in the share of equity that is held by institutional investors on behalf of households. According to the flow of funds accounts published by the Federal Reserve, the combined share of household equity managed by mutual funds, pension funds, and life insurance companies grew from only 3 percent in 1952 to over 50 percent at the end of 2001. Mutual funds held 16 percent of household equity at the end of last year, and public and private pension funds held about 10 and 20 percent, respectively. Life insurance companies held about 7 percent of household equity at that time, mainly through separate accounts that were, in effect, mutual funds with insurance wrappers.
These changes are indeed dramatic and motivate an important policy question: Should we be comforted or concerned that an increasing share of household equity is in the hands of institutional investors? A primary issue is whether institutional investors are more "active shareholders" than individual investors. That is, are institutional investors more likely than individual investors to actively monitor and influence both management actions and corporate governance mechanisms at the firms in which they invest? Shareholder activism may provide market discipline directly by preventing management from pursuing its own interests at the expense of shareholders. Shareholder activism may also pave the way for other forms of market discipline--such as corporate takeovers, share price changes, and funding cost changes--by eliminating management-takeover protections and by inducing greater transparency.
It is not clear whether institutional investors have more or less incentive to be activist shareholders than individual investors. On the one hand, because institutional investors make large investments in companies, they will have more bargaining power over company management than individual investors have, and they will derive more benefits from mitigating corporate malfeasance than individual investors will. Among institutional investors, pension funds and insurance companies are thought to benefit the most from shareholder activism because they tend to have relatively long-term investment horizons, while more actively managed mutual funds are thought to benefit the least.
On the other hand, index fund managers may have no interest in shareholder activism since they merely adjust their holdings when the mix of the index changes and only want to follow the index, not influence it. In addition, mutual funds and pension funds may have conflicts of interest that encourage passivity. Activism by a mutual fund complex or a pension fund manager could strain its relationships with corporate clients. For example, a fund manager bidding for the management of a firm's 401-K plan may be reluctant to vote against the Board of Directors' proxy recommendations.
In practice, institutional investors appear to have been relatively passive shareholders, in the sense that they have tended to initiate relatively few reform proposals. Prior to the past twenty years, most reform proposals were submitted by a handful of individuals and religious groups. Since the mid-1980s, some institutional investors--mainly large public pension funds and a few union funds--have stepped up to the plate and offered their own proposals, but corporate pension funds, mutual funds, and insurance companies have remained on the sidelines.
However, appearances can be misleading. Some institutional investors are active behind the scenes, keeping close contact with the management of the firms in their portfolios directly rather than through reform proposals. Moreover, passive institutional investors may still benefit shareholders as a whole by facilitating the building of shareholder coalitions that are initiated by others or by posing a possible threat to managers who might fail to act in the interest of shareholders.
Ultimately, the question of whether institutional investors mitigate corporate governance problems is an empirical one. Academic work in this area has not convincingly linked institutional holdings to firm performance, but some studies have shown that institutional shareholder activism does appear to be motivated by efforts to increase shareholder value, and other studies have confirmed that institutional activism is associated with a greater incidence of corporate governance events, such as shareholder lawsuits and corporate takeovers. Based on these findings, concluding that the rising share of household equity held by institutional investors is clearly good in terms of sound corporate governance would be premature. That said, it does seem reasonable to believe that there are benefits from institutional shareholder activism and that these benefits may help pave the way for market discipline in a broader sense.
Looking ahead, I am encouraged by signs that institutional investors are becoming more active shareholders. Mutual funds reportedly have been paying closer attention to proxy voting in response to recent corporate accounting scandals. Two of the largest fund complexes in the United States now publicize their proxy voting guidelines, and one of them reportedly maintains a full-time governance staff. I am further encouraged by the recent activity of shareholder rights organizations, such as the International Corporate Governance Network, and other informal groups, which galvanize institutional and private investors to promote corporate governance reform. Also, I am hopeful that changes in the regulatory environment will promote greater attention to corporate governance. As you are no doubt aware, less than two weeks ago the SEC proposed a rule calling for compulsory disclosure of mutual fund proxy voting records. Currently, mutual funds have no legal obligation to disclose proxy votes, and in practice, few do so.
As we go forward, even if transparency through corporate financial reports improves, shareholder activism will continue to be important in mitigating conflicts between management and shareholders. However, we must recognize that shareholder activism is not a substitute for disclosure. Neither activism nor the more common discipline device of selling the firm's debt and equity can work well without adequate disclosure. All forms of market discipline are built upon the solid foundation of accurate and complete disclosure.
Written in Ocotber 2002, the title reads "The Challenge for Corporate Governance posed by Financial Innovation" and it is by Governor Susan S. Bies.
I appreciate the opportunity to speak with you today about corporate governance in the United States. The unfolding concerns in recent months have thrust the quality of accounting, auditing, and disclosure practices of major U.S. companies into the limelight. At the heart of these issues is the breakdown in professionalism of independent auditors. Auditors have been too focused on cross-selling new services to corporations, and have lost sight of the fact that their independent attestation to the quality of financial reporting is the core value that they bring to the market place. The customers of an audit engagement are investors and creditors. The absence of leadership within the profession to call for true reform will make regaining market confidence all the more difficult. The weight of regulatory reform rests on the SEC and the new Public Company Accounting Oversight Board and we should all support this new entity as it endeavors by enforcement to change the culture of an industry.
While I could focus on the issue of auditor independence, it has already received much attention. I want to instead talk about some broader, long-term issues affecting accounting and corporate governance that have not been the center of as much of the recent debate. Looking beyond the isolated cases of outright fraud, I believe a fundamental problem is this: As organizations have grown in size and scope, innovative financing techniques have made it more difficult for outside investors to understand a particular firm's risk profile and the performance of its various lines of business. Traditional accounting standards have not kept pace with the risk-management tools employed by sophisticated corporations. Thus, the disclosure of firms' risk-management positions and strategies is crucial to improve corporate transparency for market participants.
The second issue I want to focus on is that financial innovation has helped increase the importance of institutional investors, such as mutual funds and pension funds, in our equity markets. Because shareholders play a key role in corporate governance, the emergence of institutional investors as major holders of corporate equity also has implications for corporate governance.
As I shall discuss, a necessary response to the recent wave of financial innovation is a combination of enhanced transparency and market discipline applied by creditors, counterparties, and investors-including the institutional investors that now hold a large share of corporate equity. Together, these efforts should help lay a foundation for more effective corporate governance.
Financial Innovation and Risk ManagementThe last decades of the twentieth century were, without doubt, a period of dramatic change in financial engineering, financial innovation, and risk-management practices. Over this period, firms acquired effective new tools to manage financial risk, one of which was securitization. Many of the assets on a firm's balance sheet, such as receivables, can now be securitized--that is, grouped into pools and sold to outside investors. Securitization helps a firm manage the risk of a concentrated exposure by transferring some of that exposure outside the firm. By pooling a diverse set of assets and issuing marketable securities, firms obtain liquidity and reduce funding costs. Of course, moving assets off the balance sheet and into special-purpose entities, with the attendant creation of servicing rights and high-risk residual interests retained by firms, generates its own risks.
Several types of securitization have grown rapidly over the past decade. One of the fastest growing has been asset-backed commercial paper, which soared from only $16 billion outstanding at the end of 1989 to more than $700 billion as of the second quarter of this year. Commercial mortgage securitizations have also proliferated noticeably since the early 1990s. The dollar amount of outstanding securities backed by commercial and multifamily mortgages has risen from $36 billion at the end of 1989 to nearly $400 billion as of this past June. In addition, commercial banks and finance companies have moved business loans off their books through the development of collateralized debt obligations. Securitized business loans amounted to $125 billion in the second quarter of 2002, up from a relatively miniscule $2 billion in 1989.
Derivatives are another important tool that firms use to manage risk exposures. In the ordinary course of business, firms are exposed to credit risk and the risk of price fluctuations in currency, commodity, energy, and interest rate markets. For example, when an airline sells tickets months before a flight, the airline becomes exposed to fluctuations in the price of jet fuel. A higher price of jet fuel translates directly into lower profits and, perhaps, a greater risk of bankruptcy. Firms can now use derivatives--options, futures, forwards, and so on--to mitigate their exposure to some of these risks. The risk can be transferred to a counterparty that is more willing to bear it. In my example, the airline could buy a forward contract or a call option on jet fuel to hedge its risk and thereby increase its financial stability.
The use of derivatives, like securitizations, has been growing rapidly in recent years. The most recent statistics from the Bank for International Settlements indicated that the notional amount of over-the-counter derivatives outstanding totaled $111 trillion in December 2001, up from $80 trillion just three years earlier. For exchange-traded derivatives, notional amounts outstanding rose from $14 trillion to $24 trillion over the same period.
Complex Organizations Are OpaqueAs indicated by my brief discussion of securitization and derivatives, financial innovations have facilitated the separation and reallocation of risks to parties more willing and able to bear them. In the twenty-first century, businesses will use almost limitless configurations of products and services and sophisticated financial structures. A byproduct of these developments will be that outsiders will have ever more difficulty understanding the risk positions of many large, complex organizations; and traditional financial reporting--which provides a snapshot at a particular moment--will be even less meaningful than it is today.
The intended or unintended consequences of the opaqueness that comes with complexity raise serious issues for financial reporting and corporate governance. Effective governance requires investors and creditors to hold firms accountable for their decisions. But its prerequisite is having the information necessary to understand the risks that the firm is bearing and those it has transferred to others.
With sufficient, timely, accurate, and relevant information, market participants can evaluate a firm's risk profile and adjust the availability and pricing of funds to promote a better allocation of financial resources. Lenders and investors have an obvious interest in accurately assessing a firm's risk-management performance, the underlying trends in its earnings and cash flow, and its income-producing potential. In this regard, transparency is essential to providing market participants with the information they need to effect market discipline.
Sound, well-managed companies will benefit if enhanced disclosure enables them to obtain funds at risk premiums that more accurately reflect their lower risk profiles. This would be a positive. Without such disclosure, otherwise well-managed firms will be penalized if market participants cannot perceive their fundamental financial strength and sound risk-management practices. In recent months, I have been heartened to see that renewed market discipline does appear to be forcing companies to compete for investors' support by improving the transparency of corporate reporting.
Improving Accounting and Disclosure for Complex FirmsMost firms and market participants favor sound accounting standards and meaningful disclosure, but some companies have not been completely transparent in their application of accounting and disclosure standards to specific transactions. In these situations, financial reports have neither reflected nor been consistent with the way the business has actually been run, or the risks to which the business has actually been exposed.
In some of these cases, the company's external auditors appear to have forgotten the lessons they learned in Auditing 101. Auditors have focused on form over substance when looking at risk transfer activities, and they have failed to maintain the necessary independence from the client. But the issues run deeper than just a breakdown of basic auditing standards.
As a result of the recently recognized failures of accounting, auditing, and disclosure, the market was unable to appropriately discipline the risk-taking activities of these firms on a timely basis because outsiders lacked the information from financial statements or other disclosures to do so. As critical information became available--after the fact, as it virtually always will--the market reflected its concerns about underlying business practices and accounting through the declining values of equity and debt.
At this point, we do not have all of the facts about many of the situations involving alleged accounting and auditing problems, but a consensus is growing that changes should be made to some underlying accounting standards and to their application by companies and their auditors. Various groups are undertaking initiatives to correct the problems that have recently been identified. For example, the U.S. Financial Accounting Standards Board is considering how to improve the accounting standards for special-purpose entities. This is a direct response to the rapid growth of securitization and the opacity that securitization has introduced into financial reporting.
The Sarbanes-Oxley Act, which became law in July of this year, contains a number of provisions to improve accounting and disclosure. CEOs and CFOs are now required to certify that their financial reports fairly represent the financial condition of the company, not just that the reports comply with Generally Accepted Accounting Principles. Sarbanes-Oxley directs the Securities and Exchange Commission to issue new rules on the disclosure of off-balance-sheet transactions. It strengthens the role of corporate audit committees and requires that audit committees are comprised exclusively of independent directors. To bolster the independence of external auditors, Sarbanes-Oxley prohibits them from providing certain internal audit and other consulting services to their clients. Finally, it creates a new Public Company Accounting Oversight Board, independent of the accounting industry, to regulate audits of public companies. These are all changes for the better.
But improvements in accounting and auditing standards are also needed to address other problems that have been identified. In particular, it would be very helpful if fundamental principles and standards could be revised to emphasize that financial statements should clearly and faithfully represent the economic substance of business transactions. We need to insist on higher professional standards. We also need to move toward principles-based accounting standards rather than continue our reliance on rules-based accounting standards, since accounting rules tend to lag behind market innovation. Standards should ensure that companies give appropriate consideration to the substantive risks and rewards of ownership of their underlying assets in identifying whether risk exposures should be reflected in consolidated financial statements.
Besides applying sound accounting treatments, company managers must ensure that public disclosures clearly identify all significant risk exposures--whether on or off the balance sheet--and their impact on the firm's financial condition and performance, cash flow, and earnings potential. With regard to securitizations, derivatives, and other innovative risk-transfer instruments, traditional accounting disclosures of a company's balance sheet at a point in time may not be sufficient to convey the full impact of a company's financial prospects.
Equally important are disclosures about how risks are being managed and the underlying basis for values and other estimates that are included in financial reports. Unlike typical accounting reports, information generated by risk management tends to be oriented less to a point in time and more to a description of the risks. To take an example from the world of banking, where the discipline of risk management is relatively well developed, an accounting report might say that the fair value of a loan portfolio is $300 million and has dropped $10 million from the last report. However, the bank's internal risk report would show much more extensive information, such as the interest rate and credit quality of the assets and the range of values the portfolio would take under alternative future scenarios. The user of a risk-management report could determine whether changes in value were due to declining credit quality, rising interest rates, or sales or payoffs of loans.
Corporate risk officers have developed other types of reports that provide information on the extent to which the total return in a particular line of business compensates for the line's comprehensive risk. On an enterprise basis, a reader of such a report can determine whether the growing lines of business have risk exposures that tend to offset those in other business lines -- thereby resulting in lower volatility for the earnings of the corporation as a whole.
Complex organizations should continue to improve their risk-management and reporting functions. When they are comfortable with the reliability and consistency of the information in these reports, they should begin disclosing this information to the market, perhaps in summary form, paying due attention to the need for keeping proprietary business data confidential. Not only would such disclosure provide more qualitative and quantitative information about the firm's current risk exposure to the market, it would help the market assess the quality of the risk oversight and risk appetite of the organization.
A sound risk-management system in a complex organization should continually monitor all relevant risks--including credit, market, liquidity, operational and reputation risks. Reputation risk, which recent events have shown can make or break a company, becomes especially hard to manage when off-balance-sheet activities conducted in a separate legal entity can affect the parent firm's reputation. For all these risks, disclosures consistent with the information used internally by risk managers could be very beneficial to market participants. Companies should ensure that they not only meet the letter of the standards that exist but also that their financial reports and other disclosures focus on what is really essential to help investors and other market participants understand their businesses.
In this regard, I believe that the Financial Accounting Standards Board has missed an opportunity in their recent exposure draft proposing changes to the accounting treatment of special-purpose entities, or SPEs. The exposure draft focuses on the choice of consolidating or not consolidating an SPE but says little about disclosure. If FASB's goal is to make the financial reporting of firms' dealings with SPEs more informative, disclosure of the effect of the SPE on the firm would be equally necessary. For example, if firms securitize receivables through commercial paper conduits, those receivables are no longer on the company's books under current accounting standards. Yet the aging of receivables is a key indicator that investors and lenders use to assess the quality of sales and operations. If the receivables move off the balance sheet, information about the aging of the receivables should continue to be part of the firm's disclosures. Further, the disclosures should include the firm's internal assessment of how its dealings with the SPE alter its risk exposures. I hope that as FASB debates this issue in upcoming weeks, due attention will be paid to the benefits of enhancing disclosure of SPEs.
I particularly want to emphasize that disclosure need not be in a standard accounting framework nor exactly the same for all organizations. Rather, we should all be insisting that each entity disclose the information its stakeholders need to evaluate the entity's risk profile. Companies should be less concerned about the vehicle of disclosure and more concerned with the substance of what information is made available to the public. And, we should keep in mind that disclosure without context may not be meaningful. These improvements in transparency are a necessary response to the recent corporate scandals and will help strengthen corporate governance in years to come.
Financial Innovations, Equity Holdings, and Shareholder ActivismJust as financial innovations spawned a variety of risk-management tools for businesses, they have also been responsible, in part, for changes in the structure of equity ownership. Along with advances in computer processing power that have facilitated the management of ever-larger portfolios, an increasing awareness among investors of the value of portfolio diversification has led to a dramatic secular rise in the share of equity that is held by institutional investors on behalf of households. According to the flow of funds accounts published by the Federal Reserve, the combined share of household equity managed by mutual funds, pension funds, and life insurance companies grew from only 3 percent in 1952 to over 50 percent at the end of 2001. Mutual funds held 16 percent of household equity at the end of last year, and public and private pension funds held about 10 and 20 percent, respectively. Life insurance companies held about 7 percent of household equity at that time, mainly through separate accounts that were, in effect, mutual funds with insurance wrappers.
These changes are indeed dramatic and motivate an important policy question: Should we be comforted or concerned that an increasing share of household equity is in the hands of institutional investors? A primary issue is whether institutional investors are more "active shareholders" than individual investors. That is, are institutional investors more likely than individual investors to actively monitor and influence both management actions and corporate governance mechanisms at the firms in which they invest? Shareholder activism may provide market discipline directly by preventing management from pursuing its own interests at the expense of shareholders. Shareholder activism may also pave the way for other forms of market discipline--such as corporate takeovers, share price changes, and funding cost changes--by eliminating management-takeover protections and by inducing greater transparency.
It is not clear whether institutional investors have more or less incentive to be activist shareholders than individual investors. On the one hand, because institutional investors make large investments in companies, they will have more bargaining power over company management than individual investors have, and they will derive more benefits from mitigating corporate malfeasance than individual investors will. Among institutional investors, pension funds and insurance companies are thought to benefit the most from shareholder activism because they tend to have relatively long-term investment horizons, while more actively managed mutual funds are thought to benefit the least.
On the other hand, index fund managers may have no interest in shareholder activism since they merely adjust their holdings when the mix of the index changes and only want to follow the index, not influence it. In addition, mutual funds and pension funds may have conflicts of interest that encourage passivity. Activism by a mutual fund complex or a pension fund manager could strain its relationships with corporate clients. For example, a fund manager bidding for the management of a firm's 401-K plan may be reluctant to vote against the Board of Directors' proxy recommendations.
In practice, institutional investors appear to have been relatively passive shareholders, in the sense that they have tended to initiate relatively few reform proposals. Prior to the past twenty years, most reform proposals were submitted by a handful of individuals and religious groups. Since the mid-1980s, some institutional investors--mainly large public pension funds and a few union funds--have stepped up to the plate and offered their own proposals, but corporate pension funds, mutual funds, and insurance companies have remained on the sidelines.
However, appearances can be misleading. Some institutional investors are active behind the scenes, keeping close contact with the management of the firms in their portfolios directly rather than through reform proposals. Moreover, passive institutional investors may still benefit shareholders as a whole by facilitating the building of shareholder coalitions that are initiated by others or by posing a possible threat to managers who might fail to act in the interest of shareholders.
Ultimately, the question of whether institutional investors mitigate corporate governance problems is an empirical one. Academic work in this area has not convincingly linked institutional holdings to firm performance, but some studies have shown that institutional shareholder activism does appear to be motivated by efforts to increase shareholder value, and other studies have confirmed that institutional activism is associated with a greater incidence of corporate governance events, such as shareholder lawsuits and corporate takeovers. Based on these findings, concluding that the rising share of household equity held by institutional investors is clearly good in terms of sound corporate governance would be premature. That said, it does seem reasonable to believe that there are benefits from institutional shareholder activism and that these benefits may help pave the way for market discipline in a broader sense.
Looking ahead, I am encouraged by signs that institutional investors are becoming more active shareholders. Mutual funds reportedly have been paying closer attention to proxy voting in response to recent corporate accounting scandals. Two of the largest fund complexes in the United States now publicize their proxy voting guidelines, and one of them reportedly maintains a full-time governance staff. I am further encouraged by the recent activity of shareholder rights organizations, such as the International Corporate Governance Network, and other informal groups, which galvanize institutional and private investors to promote corporate governance reform. Also, I am hopeful that changes in the regulatory environment will promote greater attention to corporate governance. As you are no doubt aware, less than two weeks ago the SEC proposed a rule calling for compulsory disclosure of mutual fund proxy voting records. Currently, mutual funds have no legal obligation to disclose proxy votes, and in practice, few do so.
As we go forward, even if transparency through corporate financial reports improves, shareholder activism will continue to be important in mitigating conflicts between management and shareholders. However, we must recognize that shareholder activism is not a substitute for disclosure. Neither activism nor the more common discipline device of selling the firm's debt and equity can work well without adequate disclosure. All forms of market discipline are built upon the solid foundation of accurate and complete disclosure.
Saturday, October 4, 2008
Paulson, Bernanke Statements on Bailout Bill Passage
Now that Congress has passed the financial rescue plan, we are reminded that the plan is necessary to stablilize our financial system and protect the economic security of all Americans.
Treasury Secretary Henry Paulson released the following statement after Congress’s passage of the financial rescue package.
By acting this week, Congress has proven that our Nation’s leaders are capable of coming together at a time of crisis, even at a critical stage of the political calendar, to do what is necessary to stabilize our financial system and protect the economic security of all Americans.
The American people will appreciate the leadership of their elected representatives and senators who took bold action to help stem a severe credit crunch that threatens to cost many jobs and undermine access to credit for working Americans.
This bill contains a broad set of tools that can be deployed to strengthen financial institutions, large and small, that serve businesses and families. Our financial institutions are varied – from large banks headquartered in New York, to regional banks that serve multi-state areas, to community banks and credit unions that are vital to the lives of our citizens and their towns and communities. Each institution has its own unique benefits, and their collective strength makes our financial system more resilient, and more innovative. The challenges our institutions face are just as varied – from holding illiquid mortgage backed securities, to illiquid whole loans, to raising needed capital, to simply facing a crisis of confidence. This diversity of institutions and challenges requires that we deploy the tools in this rescue package, in combination with the tools the Fed, the Treasury, the FDIC and other bank regulators already have, in a variety of ways that addresses each of these needs and restores the ability of our financial system to fuel our broader economy.
There is no one-size-fits-all solution to alleviating the stress in our financial system. Each situation will be different and we must implement these new programs with a strategy that allows us to adapt to changing circumstances and conditions, and attract private capital. The broad authorities in this legislation, when combined with existing regulatory authorities and resources, gives us the ability to protect and recapitalize our financial system as we work through the stresses in our credit markets.
We will move rapidly to implement the new authorities, but we will also move methodically. In the coming days we will work with the Federal Reserve and the FDIC to develop strategies that deploy these tools in an expedited and methodical way to maximize effectiveness in strengthening the financial system, so it can continue to play its necessary and vital role supporting the U.S. economy and American jobs. Transparency throughout this process will be important, and I look forward to providing regular updates as we move ahead to implement this strategy.
Fed Chairman Ben Bernanke released the following statement following Congress’s passage of the financial rescue package.
I applaud the action taken by the Congress. It demonstrates the government’s commitment to do what it takes to support and strengthen our economy. The legislation is a critical step toward stabilizing our financial markets and ensuring an uninterrupted flow of credit to households and businesses.
The Federal Reserve will continue to work closely with the Treasury as it undertakes these new initiatives. We will continue to use all of the powers at our disposal to mitigate credit market disruptions and to foster a strong, vibrant economy.
Treasury Secretary Henry Paulson released the following statement after Congress’s passage of the financial rescue package.
By acting this week, Congress has proven that our Nation’s leaders are capable of coming together at a time of crisis, even at a critical stage of the political calendar, to do what is necessary to stabilize our financial system and protect the economic security of all Americans.
The American people will appreciate the leadership of their elected representatives and senators who took bold action to help stem a severe credit crunch that threatens to cost many jobs and undermine access to credit for working Americans.
This bill contains a broad set of tools that can be deployed to strengthen financial institutions, large and small, that serve businesses and families. Our financial institutions are varied – from large banks headquartered in New York, to regional banks that serve multi-state areas, to community banks and credit unions that are vital to the lives of our citizens and their towns and communities. Each institution has its own unique benefits, and their collective strength makes our financial system more resilient, and more innovative. The challenges our institutions face are just as varied – from holding illiquid mortgage backed securities, to illiquid whole loans, to raising needed capital, to simply facing a crisis of confidence. This diversity of institutions and challenges requires that we deploy the tools in this rescue package, in combination with the tools the Fed, the Treasury, the FDIC and other bank regulators already have, in a variety of ways that addresses each of these needs and restores the ability of our financial system to fuel our broader economy.
There is no one-size-fits-all solution to alleviating the stress in our financial system. Each situation will be different and we must implement these new programs with a strategy that allows us to adapt to changing circumstances and conditions, and attract private capital. The broad authorities in this legislation, when combined with existing regulatory authorities and resources, gives us the ability to protect and recapitalize our financial system as we work through the stresses in our credit markets.
We will move rapidly to implement the new authorities, but we will also move methodically. In the coming days we will work with the Federal Reserve and the FDIC to develop strategies that deploy these tools in an expedited and methodical way to maximize effectiveness in strengthening the financial system, so it can continue to play its necessary and vital role supporting the U.S. economy and American jobs. Transparency throughout this process will be important, and I look forward to providing regular updates as we move ahead to implement this strategy.
Fed Chairman Ben Bernanke released the following statement following Congress’s passage of the financial rescue package.
I applaud the action taken by the Congress. It demonstrates the government’s commitment to do what it takes to support and strengthen our economy. The legislation is a critical step toward stabilizing our financial markets and ensuring an uninterrupted flow of credit to households and businesses.
The Federal Reserve will continue to work closely with the Treasury as it undertakes these new initiatives. We will continue to use all of the powers at our disposal to mitigate credit market disruptions and to foster a strong, vibrant economy.
Friday, October 3, 2008
Why are real rates rising?
Greg Mankiw asks why are real rate rising. He shows a graph of 5-Year Treasure Inflation Index Security and notes that given the widespread fear in financial markets, we ought to see a flight to quality, with the resulting effect that the price of safe assets will be up and their yields down. This is what we see in short term Treasury Bills but not in the yield on 5-year inflation adjusted government bonds. His graph obviously shows that the yields have been rising but a look at the 5 year Treasury Constant Maturity Rate will show that rates are indeed falling. See below.
Wednesday, October 1, 2008
Pricing toxic assets
It now seems that the TARP will pass, given the Senate’s strong backing. There are still questions though on whether TARP will do much in the way of easing credit crunch. Will the banks located away from Wall Street still refuse to make loans. They might just hoard cash, afraid of being insolvent. There is also the other aspect of what the toxic assets are worth. Daniel Gros suggests they close to being worthless.
A key issue for the $700 billion bail out plan now being finalised is the pricing of the ‘toxic assets’ the US Treasury should buy. The main target of the Paulson plan is the market for securities based on low quality mortgages (sub prime and ‘Alt A’ mortgages). This subclass of the general universe of RMBS (residential mortgage-based securities) has become illiquid. How should these securities be priced? In the few market transactions still taking place their value has often been less than 50 cents to the dollar of face value. But it is difficult to establish a reliable market price. Are there any other ways to assess their value?
This column discusses a simple way to thinking the valuation of mortgages and the establishment on fair prices for these securities. Preliminary calculations suggest that the value of securities based on lower quality mortgages might indeed be very low.
How to estimate the value of residential mortgage-based securities
The starting point is a key feature of the US mortgage market, namely that most loans are de facto or de jure ‘no recourse’. This means that the debtor cannot be held personally liable for the mortgage even if, after a foreclosure, the bank receives only a fraction of the total mortgage outstanding from the sale of the house.
With a ‘no recourse’ mortgage, the debtor effectively receives a virtual put option to ‘sell’ to the mortgage-issuer the house at the amount of the loan still outstanding. Mortgage lenders are ‘short’ this option, but this is not recognised in the balance sheets. In most cases, the balance sheets of the banks report mortgages at face value – at least for all those mortgages on which payments are still ongoing.
All RMBS, especially all securities based on low quality mortgages, should also take this put option into account in their pricing. It appears that this had not been done when these securities were issued. In particular it appears that the ratings agencies neglected this point completely when evaluating the complex products build on bundles of mortgages. A key input in banks balance sheets and the pricing of RMBS should thus have been a valuation of the put option given to US households.
Given certain basic data, it is actually fairly straightforward to calculate the value of the put option in a standard ‘no recourse’ mortgage.
The following calculations are for a mortgage of $100, which has an implicit put with a strike price equal to the loan to value ratio (LTV) because this is the amount for which the owner of the house can ‘sell’ his house to the bank. Most of the key inputs needed for the pricing of this option are in fact relatively straightforward. In the following it is assumed that mortgages run for 10 years, and that the riskless interest rate is 2% and the interest rate on mortgages is 6%.
It is more difficult, however, to put a number on a key input in the value of any option, namely the (expected) volatility in the price of the underlying asset. Recent data might be misleading, since prices had been steadily increasing until 2006, but then started to decline precipitously. Over a longer horizon the standard deviation of the Case Shiller index has been around 5% per year, but over the last few years the volatility has greatly increased. The figure is about 10%, if one looks only at the years since the start of the bubble (2002/3). The following will concentrate on the low volatility case (5% standard deviation). It turns out, however, that this parameter is not as significant as one might first think. Under the high volatility case (10 % standard deviation) the losses would be under most circumstances only moderately higher.
Applying the usual Black-Scholes formula to a typical subprime loan with an LTV ratio of 100% yields the result that the value of the put option embedded in the ‘no recourse’ feature is 26.8% of the loan, even in the low volatility case. For a conforming loan (a loan that could be insured by Fannie or Freddie) with a loan to value ratio of 80%, the value of the put option would still be close to 14% (still in the low volatility case). This implies that all sub prime loans (and other mortgages with a high LTV) were worth much less than their face value from the beginning. It is evident that the risk of a mortgage going into negative equity territory diminishes sharply with the loan to value ratio. For example, with an LTV of 60% the put option is worth only 2.8%.
In reality it is not the case that all mortgages with negative equity (where the present value of mortgage payments is higher than the value of home) go immediately into default since a default on a mortgage (and a subsequent foreclosure) still has a cost to the household in terms of a poor credit record, some legal costs, etc. This fact could be taken into account by just adjusting the strike price by the implicit cost of a worse credit history, etc, maybe by around 10%. However, a foreclosure usually leads to rather substantial costs for the bank, which can be a multiple of the amount of negative equity that is calculated by using standard house prices indices. A sheriff sale often fetches a much lower price than a normal sale in which the time pressure is not that great. The loss to the mortgage lender is often far in excess of 10% of the value of the home. These two effects thus tend to offset each other and the second might even be larger. It is thus likely that the value of the option as calculated here does appropriately reflect the risk for banks, and might even constitute a slight under estimation.
Given the high value of the put option on mortgages with high LTV ratios (i.e. especially subprime) it is not surprising that the value of the securities build on these mortgages should be rather low. The first loss tranches (e.g. first 10 % loss) are obviously worthless when the put option is worth already close to 28 %. Taking this put option feature properly into account shows why all except the ‘super senior’ tranches of an RMBS based on sub prime mortgages can easily fall in value below 50 cents to the dollar.
How much are the assets still on the banks’ balance sheets worth?
Another implication of the approach proposed here concerns the ‘fair value’ accounting of the $3.6 thousand billion of mortgages still on the balance sheets of US banks. The value of the put option granted to US mortgage debtors should reflect approximately the amount of capital the US banking system would need in order to cover itself against further fluctuations in house prices.
Little is known about the quality of the mortgages that are still on the balance sheets of US banks. It must be assumed that most of them are not conforming to the standards (limits on LTV, documentation, size, etc.) set by the (now) state-owned mortgage financing institutions Fannie Mae and Freddie Mac, since banks could make substantial savings on regulatory capital by re-financing conforming loans. It is thus likely that the mortgages still on the balance sheets of US banks are either jumbo loans (Fannie and Freddie refinance-only mortgages of up to around $400 thousand) or lower quality ones. Assuming a realistic distribution of loan to value ratios, the average value of the put option embedded in all mortgages would be around 9.5% in the low volatility case and 12.7% in the high volatility case (10% standard deviation for house prices). Given that the overall stock of mortgages still outstanding on the balance sheets of commercial banks is around $3.6 thousand billion, this implies that the US banking system would need between $340 and $460 billion just to cover itself against the variability in house prices. Under ‘fair value’ accounting, this is the amount of losses the US would have to book today if they recognised the put option as being implicit in the ‘no recourse’ mortgages on their books.
The total stock of mortgages outstanding in the US is about $10 thousand billion. However, the market value of these mortgages (whether still on banks’ balance sheets or securitised and embedded in RMBS) is in reality lower by $1-1.2 thousand billion, if one takes into account the value of the put option granted to US households.
Why was the value of this option not recognised earlier? One simple reason might be that as long as the housing bubble lasted it was generally assumed that house prices could only go up, as they had over the 1990s. The average annual increase in house prices had been about 5% in the 15 years to 2006. If that number is projected into the future the value of a put option even on a sub prime mortgage with an LTV of 100% would have been below 5%, as compared to the 26.8% mentioned above, if one uses the standard assumption that the price of the underlying (house prices) follows a random walk without drift. Viewed from the perspective of ever-increasing house prices, the risk of negative equity seemed minor. Expectations about house prices have now changed completely, however. If one were to assume that house prices will decline by 3% annually over the next decade, the value of the put option would be even higher than calculated so far. For a sub prime mortgage with an LTV of 100% the value of the put option would be over 40% of the mortgage, and even for a conforming loan (80% LTV) the put option would still be worth 30 cents to the dollar. The value of the put options on which the US banking system is short would then be above $900 billion, and the total losses on all US mortgages could amount to over $2 thousand billion.
If expectations of future house price declines are now appropriate, the value of all the securities built on sub prime mortgages might be close to zero. It remains to be seen what pricing, and thus what underlying hypothesis is going to be used for the $700 billion rescue plan.
Editors’ note: this first appeared as CEPS Commentary, 23 September 2008 and CEPS retains the copyright.
A key issue for the $700 billion bail out plan now being finalised is the pricing of the ‘toxic assets’ the US Treasury should buy. The main target of the Paulson plan is the market for securities based on low quality mortgages (sub prime and ‘Alt A’ mortgages). This subclass of the general universe of RMBS (residential mortgage-based securities) has become illiquid. How should these securities be priced? In the few market transactions still taking place their value has often been less than 50 cents to the dollar of face value. But it is difficult to establish a reliable market price. Are there any other ways to assess their value?
This column discusses a simple way to thinking the valuation of mortgages and the establishment on fair prices for these securities. Preliminary calculations suggest that the value of securities based on lower quality mortgages might indeed be very low.
How to estimate the value of residential mortgage-based securities
The starting point is a key feature of the US mortgage market, namely that most loans are de facto or de jure ‘no recourse’. This means that the debtor cannot be held personally liable for the mortgage even if, after a foreclosure, the bank receives only a fraction of the total mortgage outstanding from the sale of the house.
With a ‘no recourse’ mortgage, the debtor effectively receives a virtual put option to ‘sell’ to the mortgage-issuer the house at the amount of the loan still outstanding. Mortgage lenders are ‘short’ this option, but this is not recognised in the balance sheets. In most cases, the balance sheets of the banks report mortgages at face value – at least for all those mortgages on which payments are still ongoing.
All RMBS, especially all securities based on low quality mortgages, should also take this put option into account in their pricing. It appears that this had not been done when these securities were issued. In particular it appears that the ratings agencies neglected this point completely when evaluating the complex products build on bundles of mortgages. A key input in banks balance sheets and the pricing of RMBS should thus have been a valuation of the put option given to US households.
Given certain basic data, it is actually fairly straightforward to calculate the value of the put option in a standard ‘no recourse’ mortgage.
The following calculations are for a mortgage of $100, which has an implicit put with a strike price equal to the loan to value ratio (LTV) because this is the amount for which the owner of the house can ‘sell’ his house to the bank. Most of the key inputs needed for the pricing of this option are in fact relatively straightforward. In the following it is assumed that mortgages run for 10 years, and that the riskless interest rate is 2% and the interest rate on mortgages is 6%.
It is more difficult, however, to put a number on a key input in the value of any option, namely the (expected) volatility in the price of the underlying asset. Recent data might be misleading, since prices had been steadily increasing until 2006, but then started to decline precipitously. Over a longer horizon the standard deviation of the Case Shiller index has been around 5% per year, but over the last few years the volatility has greatly increased. The figure is about 10%, if one looks only at the years since the start of the bubble (2002/3). The following will concentrate on the low volatility case (5% standard deviation). It turns out, however, that this parameter is not as significant as one might first think. Under the high volatility case (10 % standard deviation) the losses would be under most circumstances only moderately higher.
Applying the usual Black-Scholes formula to a typical subprime loan with an LTV ratio of 100% yields the result that the value of the put option embedded in the ‘no recourse’ feature is 26.8% of the loan, even in the low volatility case. For a conforming loan (a loan that could be insured by Fannie or Freddie) with a loan to value ratio of 80%, the value of the put option would still be close to 14% (still in the low volatility case). This implies that all sub prime loans (and other mortgages with a high LTV) were worth much less than their face value from the beginning. It is evident that the risk of a mortgage going into negative equity territory diminishes sharply with the loan to value ratio. For example, with an LTV of 60% the put option is worth only 2.8%.
In reality it is not the case that all mortgages with negative equity (where the present value of mortgage payments is higher than the value of home) go immediately into default since a default on a mortgage (and a subsequent foreclosure) still has a cost to the household in terms of a poor credit record, some legal costs, etc. This fact could be taken into account by just adjusting the strike price by the implicit cost of a worse credit history, etc, maybe by around 10%. However, a foreclosure usually leads to rather substantial costs for the bank, which can be a multiple of the amount of negative equity that is calculated by using standard house prices indices. A sheriff sale often fetches a much lower price than a normal sale in which the time pressure is not that great. The loss to the mortgage lender is often far in excess of 10% of the value of the home. These two effects thus tend to offset each other and the second might even be larger. It is thus likely that the value of the option as calculated here does appropriately reflect the risk for banks, and might even constitute a slight under estimation.
Given the high value of the put option on mortgages with high LTV ratios (i.e. especially subprime) it is not surprising that the value of the securities build on these mortgages should be rather low. The first loss tranches (e.g. first 10 % loss) are obviously worthless when the put option is worth already close to 28 %. Taking this put option feature properly into account shows why all except the ‘super senior’ tranches of an RMBS based on sub prime mortgages can easily fall in value below 50 cents to the dollar.
How much are the assets still on the banks’ balance sheets worth?
Another implication of the approach proposed here concerns the ‘fair value’ accounting of the $3.6 thousand billion of mortgages still on the balance sheets of US banks. The value of the put option granted to US mortgage debtors should reflect approximately the amount of capital the US banking system would need in order to cover itself against further fluctuations in house prices.
Little is known about the quality of the mortgages that are still on the balance sheets of US banks. It must be assumed that most of them are not conforming to the standards (limits on LTV, documentation, size, etc.) set by the (now) state-owned mortgage financing institutions Fannie Mae and Freddie Mac, since banks could make substantial savings on regulatory capital by re-financing conforming loans. It is thus likely that the mortgages still on the balance sheets of US banks are either jumbo loans (Fannie and Freddie refinance-only mortgages of up to around $400 thousand) or lower quality ones. Assuming a realistic distribution of loan to value ratios, the average value of the put option embedded in all mortgages would be around 9.5% in the low volatility case and 12.7% in the high volatility case (10% standard deviation for house prices). Given that the overall stock of mortgages still outstanding on the balance sheets of commercial banks is around $3.6 thousand billion, this implies that the US banking system would need between $340 and $460 billion just to cover itself against the variability in house prices. Under ‘fair value’ accounting, this is the amount of losses the US would have to book today if they recognised the put option as being implicit in the ‘no recourse’ mortgages on their books.
The total stock of mortgages outstanding in the US is about $10 thousand billion. However, the market value of these mortgages (whether still on banks’ balance sheets or securitised and embedded in RMBS) is in reality lower by $1-1.2 thousand billion, if one takes into account the value of the put option granted to US households.
Why was the value of this option not recognised earlier? One simple reason might be that as long as the housing bubble lasted it was generally assumed that house prices could only go up, as they had over the 1990s. The average annual increase in house prices had been about 5% in the 15 years to 2006. If that number is projected into the future the value of a put option even on a sub prime mortgage with an LTV of 100% would have been below 5%, as compared to the 26.8% mentioned above, if one uses the standard assumption that the price of the underlying (house prices) follows a random walk without drift. Viewed from the perspective of ever-increasing house prices, the risk of negative equity seemed minor. Expectations about house prices have now changed completely, however. If one were to assume that house prices will decline by 3% annually over the next decade, the value of the put option would be even higher than calculated so far. For a sub prime mortgage with an LTV of 100% the value of the put option would be over 40% of the mortgage, and even for a conforming loan (80% LTV) the put option would still be worth 30 cents to the dollar. The value of the put options on which the US banking system is short would then be above $900 billion, and the total losses on all US mortgages could amount to over $2 thousand billion.
If expectations of future house price declines are now appropriate, the value of all the securities built on sub prime mortgages might be close to zero. It remains to be seen what pricing, and thus what underlying hypothesis is going to be used for the $700 billion rescue plan.
Editors’ note: this first appeared as CEPS Commentary, 23 September 2008 and CEPS retains the copyright.
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