Great Depression 2010

August data on consumption spending was extremely weak and has me thinking about Willem Buiter’s prediction of Great depression 2010s. See his scenario below. I do not think we are heading for a depression but I do think things will get worse before they get better. August data from the Commerce department showed Personal consumption was unchanged compared with July. July spending rose 0.1%. Today’s report on unemployment rates, has the rate higher in August than a year earlier in 354 of the 369 metropolitan areas, lower in 13 areas, andunchanged in 2 areas. Among the 310 metropolitan areas forwhich nonfarm payroll data were available in August, 161areas reported over-the-year increases in employment, 142 reported decreases, and 7 had no change. The national unemployment rate in August was 6.1 percent, not seasonally adjusted, up from 4.6 percent a year earlier.

Willem Buiter writes:
What is likely to happen next? With a bit of luck, the House will be frightened by its own audacity and will reverse itself. If a substantively similar bill (or a better bill that addresses not just the problem of valuing toxic assets and getting them off the banks’ books, but also the problem of recapitalising the US banking sector) is passed in the next day or so, the damage can remain limited. If the markets fear that the nays have thrown their toys out of the pram for the long term, the following scenario is quite likely:
The US stock market tanks. Bank shares collapse, as do the valuations of all highly leveraged financial institutions. Weaker versions of this occur in Europe, in Japan and in the emerging markets.
CDS spreads for banks explode, as will those of all highly leveraged financial institutions. Credits spreads generally take on loan-shark proportions, even for reputable borrowers. Again the rest of the world will experience a slightly milder version of this.
No US bank will lend to any other US bank or any other highly leveraged institution. The same will happen elsewhere. Remaining sources of external finance for banks, other than the facilities created by the central banks and the Treasuries, will dry up.
Banks and other highly leveraged institutions will try to unload assets at fire-sale prices in illiquid markets. Even assets not viewed as toxic before will become unsaleable at any price.
The interaction of a growing lack of funding liquidity and increasing market illiquidity will destroy the banks’ business models.
Banks will stop providing credit to households and to non-financial enterprises.
Banks will collapse, both through balance sheet insolvency and through liquidity insolvency. No bank will be safe, not even the household names for whom the crisis has thus far brought more opportunities than disasters.
Other highly leveraged financial institutions collapse on a large scale.
Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.
Consumer demand and investment demand collapse. Unemployment shoots up.
The government suspends all trading in financial stocks until further notice.
The government nationalises all US banks and other highly leveraged financial institutions. The shareholders get nothing up front and have to wait for an eventual re-privatisation or liquididation to find out whether they are left with anything at all. Holders of bank debt get a sizeable haircut ‘up front’ on the face value of the debt and have part of the remainder converted into equity that shares the fate of the old equity.
We have the Great Depression of the 2010s.

Troubled Assets Relief Program Vote Fails

The lower House of Congress has just voted against the bailout package, and that news has sent the market spiraling downwards. CNN interviewed a trader who said that the bailout plan should be approved in its current form, so that the market can be calmed. He sees the DOW erasing more than 1000 points if not approved. While this revised version is an improvement over the earlier version in terms of cost to tax payers, accountability and implementation it is by no means a perfect rescue plan. The current plan does not get at the heart of the cause of the current crisis, it is a cure for a different problem.

Brad DeLong writes: Bring Congress Back into Session After the Election...
...and go for the Swedish plan: nationalize the insolvent large financial institutions: dare Bush to veto that after the election.
Vote Count:
Democrats: 141 Yea, 94 Nay Republican: 66 Yea, 132 Nay.
This Republican Party needs to be burned, razed to the ground, and the furrows sown with salt...

Payback provision in US bail-out plan

FT is reporting that a tentative deal has been reached authorizing the government to buy up to $700bn of troubled assets from financial institutions. The deal envisages historic restrictions on executive pay for banks involved in the programme and it opens the door for the government to take equity warrants in those institutions. The equity warrants idea is interesting since it is a good way of protecting taxpayers.

Here is what Patrick Honohan said in a comment to a post on “The price of salvation” :
Let the banks sell the assets for their current book value (they will hardly accept much less), but provide a warrant to purchase shares in the bank which can be exercised by the Government in several years time at a price – and here’s the key – which depends inversely on the value of the toxic debt at that future date. The future date needs to be set far enough into the future for the market in these kinds of assets to have settled down and their price less imponderable
If the banks prove to be right about the valuation, the warrant will end up too costly to exercise. If the banks are wrong and the assets end up worth far less than they are now recorded in the banks’ books, then the Government will hold an equity stake compensating it in the end for the losses it has taken on the assets.
Bank shareholders will not like the prospect of dilution if the assets really are more toxic than they have acknowledged. But they can limit their dilution exposure by accepting a lower price for the toxic assets.
There’s scope for many refinements of this scheme, including variations in the pricing and maturity of the warrants, and whether they should be for common or preferred shares. This flexibility should facilitate arriving at a deal which is both politically viable and sufficiently attractive to the bank shareholders.