I am selling into the strength BIDU, GOOG, RIMM, TBT. But keeping my FXI, VT and AET.un
Time to unload
I am selling into today's strength. With the garbage stimulus plan and employment falling off a cliff. We are not at bottom yet. There is not much the Obama stimulus plan can do to turn the tide at the moment. Further, states are having budget problems, Eastern Europe is having credit problems (which will drag Western Europe down). Everyone needs money all of a sudden and only a few will be able to borrow. Some entities will be forced to raise bond rates to attract buyers (Spain) and this will further push and damage the already suffering economy.
Blind Men and the Elephant: On the Urgency of Asset Price Reflation
You've surely heard of the six blind men and the elephant. If we adapt the traditional story to our current financial and recessionary crisis, the key role-players become:
- The Fed, who figures that the money supply and interest rates are what matter, and proceeds to lower short-term rates all the way to zero percent, while starting open-market purchases of commercial paper and mortgage securities to reel in credit spreads;
- The Treasury, who decides that weak banks are the problem, and spends $350 billion of TARP funds recapitalizing banks and financial institutions, and deliberates over details of how to deploy the remaining $350 billion;
- The FDIC, who feels that confidence in the financial system matters most, and boosts deposit insurance limits to $250,000 to help prevent runs on the banks;
- Democrats in the House and Senate, who are sure that our problems will go away if the government spends more without worrying so much about the deficit, and quickly assemble a massive $900 billion stimulus package;
- Republicans, who are certain that only tax cuts matter, and refuse to support the Democrats' proposal; and
- President Obama, who believes that jobs and working together matter most, and pushes to get his stimulus package passed to jump-start creation of the 3 million jobs being forecast by his economic advisers, while reiterating his willingness to compromise for the sake of expediency.
You see, the publicly spoken solution to our economic crisis--which seems like it ought to go away if only interest rates were lower, if the banks had more capital, if depositors and consumers had more confidence, if the government were to spend more to stimulate demand, if we had lower business and personal taxes, or if we could replace lost jobs--is really missing one essential ingredient. The elephant that everyone is touching but not quite comprehending (or at least not openly acknowledging) is the pressing need for a reflation of assets, home prices in particular.
In what now seems like quaint history, our economic woes began with a "minor" subprime mortgage problem in the middle of 2007. Through an unfortunate combination of regulatory leniency, misplaced incentives, financial irresponsibility and sheer Wall Street greed, a sizable number of underqualified, overleveraged borrowers began to have difficulty paying their mortgages and, as home prices fell, found themselves "upside-down" with negative equity, holding mortgages exceeding the value of their homes. Mortgage problems quickly spread to other highly leveraged borrowers as well, and over the ensuing year and a half have precipitated a downward spiral of plummeting real estate and stock prices, loan defaults and foreclosures, deteriorating bank balance sheets, abnormally tight credit markets, depressed consumer demand, a rising number of layoffs, etc.
Some wisdom may be gleaned by going further back in history to the last time our economy faced a crisis of this magnitude. As described by Irving Fisher in 1933, the basic problem we are experiencing is over-indebtedness, which leads to price deflation, which in turn makes matters only worse:
"[I]n great booms and depressions [the] two dominant factors [are] over-indebtedness to start and deflation following soon after. . . .Indeed, it is curious that, although we all recognize our over-indebtedness and are suffering through painful dislocations because of it, no policymaker is placing front-and-center the glaring need for asset price reflation.
"Debt liquidation leads to distress selling and to . . . contraction of deposits and of their velocity . . . [which] causes . . . [a] fall in the level of prices, . . . [a] still greater fall in the net worths of businesses, precipitating bankruptcies and . . . [a] like fall in profits, which . . . leads . . . to . . . [a] reduction in output, in trade and in employment . . . to [p]essimism and loss of confidence, which in turn lead to . . . [h]oarding, . . . [all of which] cause . . . [c]omplicated disturbances in the rates of interest.
"[I]t is always economically possible to stop or prevent such a depression simply by reflating the price level [bold added] up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."
(Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1933, pp. 337-357)
In addition to the Fed's policy of keeping inflation moderate, which is a long-run strategy to stabilize the rate-of-change of prices, current crisis-oriented policy must target a short-run higher absolute price level, if we are to steer ourselves out of the mess we are in. Essentially, we need to re-create wealth by reflating asset prices, as quickly as possible, up to a high enough level to make our bad debt problem go away. When the relationship between home prices and indebtedness returns to a more manageable level comparable to where it was prior to the onset of our current crisis, we will find that those underwater mortgages are not so underwater anymore, that the banks are no longer on the verge of bankruptcy, that consumer confidence and retail sales are rising again, that companies are no longer laying off workers, and that our economy is finally on the road to recovery.
Two recent news items are relevant here:
- Senator Johnny Isakson has proposed a homebuyer tax credit, approved last night by voice vote in the Senate for amendment to the stimulus package being worked out. The measure "would offer new homebuyers a tax credit of up to $15,000 or 10 percent of the purchase price of a house that could be spread over two years." This tax credit would create increased demand among homebuyers and is fairly direct way of supporting home prices. In my opinion, the legislation should be amended to offer even more stimulus to the housing market and economy, by both a) raising the upper limit on the tax credit to $50,000, and b) allowing the amount of the credit to be carried forward indefinitely and applied to taxes owed until used in full by the taxpayer.
- UCLA economics professor, Roger Farmer, proposes that "just as it sets the fed funds rate to control inflation, the Fed should set a stock market index to control unemployment." Targeting the price level of a stock market index, like the S&P 500 or even a broader index, would give the Fed a more direct handle on influencing performance of our economy. With our wealth as a society linked to the stock market, consumer psychology (which determines demand) is impacted more by a 10% drop in stock prices than by a substantial change in short-term interest rates. The Fed should continue to use all of the existing tools at its disposal--rate cuts, open-market operations and so on--and with an added mechanism for targeting for stock prices, policy objectives would become clearer and more effective, particularly in market environments like the present with standard interest rate easing already pinned to its zero percent lower limit.
Blind Men and the Elephant: On the Urgency of Asset Price Reflation
You've surely heard of the six blind men and the elephant. If we adapt the traditional story to our current financial and recessionary crisis, the key role-players become:
- The Fed, who figures that the money supply and interest rates are what matter, and proceeds to lower short-term rates all the way to zero percent, while starting open-market purchases of commercial paper and mortgage securities to reel in credit spreads;
- The Treasury, who decides that weak banks are the problem, and spends $350 billion of TARP funds recapitalizing banks and financial institutions, and deliberates over details of how to deploy the remaining $350 billion;
- The FDIC, who feels that confidence in the financial system matters most, and boosts deposit insurance limits to $250,000 to help prevent runs on the banks;
- Democrats in the House and Senate, who are sure that our problems will go away if the government spends more without worrying so much about the deficit, and quickly assemble a massive $900 billion stimulus package;
- Republicans, who are certain that only tax cuts matter, and refuse to support the Democrats' proposal; and
- President Obama, who believes that jobs and working together matter most, and pushes to get his stimulus package passed to jump-start creation of the 3 million jobs being forecast by his economic advisers, while reiterating his willingness to compromise for the sake of expediency.
You see, the publicly spoken solution to our economic crisis--which seems like it ought to go away if only interest rates were lower, if the banks had more capital, if depositors and consumers had more confidence, if the government were to spend more to stimulate demand, if we had lower business and personal taxes, or if we could replace lost jobs--is really missing one essential ingredient. The elephant that everyone is touching but not quite comprehending (or at least not openly acknowledging) is the pressing need for a reflation of assets, home prices in particular.
In what now seems like quaint history, our economic woes began with a "minor" subprime mortgage problem in the middle of 2007. Through an unfortunate combination of regulatory leniency, misplaced incentives, financial irresponsibility and sheer Wall Street greed, a sizable number of underqualified, overleveraged borrowers began to have difficulty paying their mortgages and, as home prices fell, found themselves "upside-down" with negative equity, holding mortgages exceeding the value of their homes. Mortgage problems quickly spread to other highly leveraged borrowers as well, and over the ensuing year and a half have precipitated a downward spiral of plummeting real estate and stock prices, loan defaults and foreclosures, deteriorating bank balance sheets, abnormally tight credit markets, depressed consumer demand, a rising number of layoffs, etc.
Some wisdom may be gleaned by going further back in history to the last time our economy faced a crisis of this magnitude. As described by Irving Fisher in 1933, the basic problem we are experiencing is over-indebtedness, which leads to price deflation, which in turn makes matters only worse:
"[I]n great booms and depressions [the] two dominant factors [are] over-indebtedness to start and deflation following soon after. . . .Indeed, it is curious that, although we all recognize our over-indebtedness and are suffering through painful dislocations because of it, no policymaker is placing front-and-center the glaring need for asset price reflation.
"Debt liquidation leads to distress selling and to . . . contraction of deposits and of their velocity . . . [which] causes . . . [a] fall in the level of prices, . . . [a] still greater fall in the net worths of businesses, precipitating bankruptcies and . . . [a] like fall in profits, which . . . leads . . . to . . . [a] reduction in output, in trade and in employment . . . to [p]essimism and loss of confidence, which in turn lead to . . . [h]oarding, . . . [all of which] cause . . . [c]omplicated disturbances in the rates of interest.
"[I]t is always economically possible to stop or prevent such a depression simply by reflating the price level [bold added] up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."
(Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1933, pp. 337-357)
In addition to the Fed's policy of keeping inflation moderate, which is a long-run strategy to stabilize the rate-of-change of prices, current crisis-oriented policy must target a short-run higher absolute price level, if we are to steer ourselves out of the mess we are in. Essentially, we need to re-create wealth by reflating asset prices, as quickly as possible, up to a high enough level to make our bad debt problem go away. When the relationship between home prices and indebtedness returns to a more manageable level comparable to where it was prior to the onset of our current crisis, we will find that those underwater mortgages are not so underwater anymore, that the banks are no longer on the verge of bankruptcy, that consumer confidence and retail sales are rising again, that companies are no longer laying off workers, and that our economy is finally on the road to recovery.
Two recent news items are relevant here:
- Senator Johnny Isakson has proposed a homebuyer tax credit, approved last night by voice vote in the Senate for amendment to the stimulus package being worked out. The measure "would offer new homebuyers a tax credit of up to $15,000 or 10 percent of the purchase price of a house that could be spread over two years." This tax credit would create increased demand among homebuyers and is fairly direct way of supporting home prices. In my opinion, the legislation should be amended to offer even more stimulus to the housing market and economy, by both a) raising the upper limit on the tax credit to $50,000, and b) allowing the amount of the credit to be carried forward indefinitely and applied to taxes owed until used in full by the taxpayer.
- UCLA economics professor, Roger Farmer, proposes that "just as it sets the fed funds rate to control inflation, the Fed should set a stock market index to control unemployment." Targeting the price level of a stock market index, like the S&P 500 or even a broader index, would give the Fed a more direct handle on influencing performance of our economy. With our wealth as a society linked to the stock market, consumer psychology (which determines demand) is impacted more by a 10% drop in stock prices than by a substantial change in short-term interest rates. The Fed should continue to use all of the existing tools at its disposal--rate cuts, open-market operations and so on--and with an added mechanism for targeting for stock prices, policy objectives would become clearer and more effective, particularly in market environments like the present with standard interest rate easing already pinned to its zero percent lower limit.
New Investment Website
I, along with 7 other investment colleagues, are forming a new investment website which was launched last week. It is called: http://www.investorwalk.com/
Please refer to our new site for all my future blogs and articles, including my ten predictions for 2009. I will also post some public ones here from time to time. Thank you very much.
Please refer to our new site for all my future blogs and articles, including my ten predictions for 2009. I will also post some public ones here from time to time. Thank you very much.
Why Wall Street Needed Credit Default Swaps
This article was published at various websites in April 2008, the response and feedback have been overwhelming. I decided to re-post it here at my blog site.
We have all heard about CDOs (collateralized debt obligations) and probably about the insurance of CDOs through CDSs (credit default swaps), which transfer the credit risks of CDOs between two parties (financial institutions).
The CDS is a bet between two parties on whether or not a company or a financial product will default. It is third party speculation on the outcome of the CDO. The CDS provides insurance to cover a fixed income product in case of its default. If a company declares bankruptcy or a debt is downgraded, a claim is triggered.
Currently, the outstanding notional amount of all credit default swaps is about $65 trillion, more than half of the entire asset base of the global banking system. Why are financial institutions are so interested in them? Why have they created so many of them to make this market so big and out of control?
There are many incentives, some of them are larger, and some smaller. I will discuss the three major reasons.
Transference of Risk
First, credit default swaps are not normal insurance policies; each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly, after the original CDS contract is engaged, each of the original two parties will try to engage another party to further hedge their risk and earn a small spread. Pretty soon there are layers and layers of counterparties involved, with the total notional amount increasing several fold, until no one knows who they are really dealing with anymore.
You can't monitor this risk since you don't know your counterparty down the CDS chain, and whether they are able to pay in the event of a default. If you throw the counterparty risk out the window, you can always find a sucker to do the trade with you and earn a small spread.
This kind of entanglement has never been seen before in the usually highly-regulated insurance industry. This is why CDSs are traded on OTC (over the counter) derivative markets which bypass all government regulations.
This entanglement creates a chain reaction. If something happens - even a downgrade but not a default - the claim will trigger a domino effect of many claims cascading down through various parties. It will break at the weakest joint (counterparty), probably a highly leveraged hedge fund, and will ripple through all parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt, beyond the default risk of the CDO itself.
Let us use the analogy of new type of car insurance: Car insurance company A trades our car insurance policy costing us $1,000 per year (or $1,000 revenue for them) for another $1,100 similar policy from another company B, and pockets a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with the insurance company is always one on one.
However, imagine what happens if both parties trade the policy with a third party. If an accident occurs, company A will not want to pay us, since we engaged company C, and company C will not want to pay either, since it did not issue the original policy. And if company A pays us eventually, they will have to file a claim against company B, who will most likely deny such claim.
This is what happened to the insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines. To hedge this default risk, Bear purchased a protection contract from AON for $0.4M. To hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch on Wall St.? Think again!
You guessed it - the loan went bust as expected. Bear sued AON for $10M based on the first CDS contract. AON lost the case and paid. Of course, AON sued Societe Generale. Due to some legal technicalities, a different court and judge had a different opinion.
The judgment was that the first and second CDS contracts were two separate contracts. Legally, the resolution of first CDS lawsuit did not automatically grant the similar status to the second CDS. The first judgment can't be referenced in the second lawsuit. As a result, the risk can't automatically be transferred and offset each time.
AON lost the case, and the $0.1M "profit" turned into $10M loss in principal. It was an expensive lunch. This sets an important legal precedent for future CDS lawsuits. A small $10M default in the Philippines impacted three parties. Maybe this is an unexpected downside of globalization?
The market cap of GM is about $11Bn. However, based on estimates in the CDS market, there are about $1 trillion (notional amount) in CDSs betting on GM and their bonds. Any change in GM's situation will create a ripple effect in this $1Tn CDS community of GM.
There are obviously not $1Tn of GM assets to serve as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability, it will throw a monkey wrench in the whole community, as everyone is trying to unwind and get out at the same time. It becomes a "no way out situation."
Bill Gross at PIMCO did a simple calculation in January in his famous article "Pyramid Crumbling." The total amount of CDS contracts was $45 trillion at that time. The historical default rate is 1.25%, so $500Bn CDS contracts are likely to default. Assuming a recovery rate of 50%, the resulting loss is $250Bn alone.
In the case of CDOs created from sub-prime mortgages, Gross’ assumptions are too optimistic. The assumed default rate is far too low. His recovery rate assumption is probably also too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal maneuvers which can be implemented by homeowners (refer to my early articles on foreclosure). I expect to see real losses doubling his estimate, or approximately $500Bn in the sub-prime market.
Using CDS to Smooth Earnings
Second, and more importantly, besides the quick profit earned through a small spread, there is a big incentive to use credit default swaps to smooth earnings from quarter to quarter and to hide losses.
If a CDO is rated AAA by rating agency (almost as good as US Treasuries) why would Wall St. want to buy insurance for protection? At the same time, assume a AAA CDO enjoys a 50 basis point spread above US Treasury rates. It is almost as good as a free lunch. Why would Wall Street firms want to eat into the 50 bp spread (and their profit) to buy CDS insurance?
The answer lies in different accounting treatments. Wall Street firms are not stupid, and they are smart enough to know their CDOs are not US Treasuries, even if their structured product groups and sales people claim they are, with the backing of the rating agencies. It is similar to the promotion of internet stocks in late 1990s, when Wall Street put out a "strong buy" ratings on supposedly great internet companies with unbelievable growth stories, while their internal memos referred to them as "pieces of garbage".
Due to GAAP (generally accepted accounting principles) requirements, investment banks need to mark their CDO products to market if they do not carry CDS insurance. This creates a problem, since both interest rates and credit spreads fluctuate, making it harder to manage earnings. What happens if investors or regulators suddenly realize they are really a piece of garbage? They don't want earnings volatility and surprises, especially at the time when their bonuses are at stake. Banks want to defer paper losses due to write-downs until they actually sell their CDOs, which would mean real bonus reductions for executives and structured finance groups.
By purchasing CDS insurance, according to GAAP regulations, there is no need to mark-to-market, Investment banks need to declare losses only if the CDO is permanently damaged and a claim will have to be paid. No more quarter to quarter fear of marking to market.
This effectively transfers the price risk to a counterparty, who in turn dumps it to another party, and so forth. By the time it comes back full circle, no one needs to worry about marking to market and earning surprises. If a paper loss happens, they can point to the insurance and claim it is only temporary. Financial statements will not be impacted.
CDS provide a vehicle to allow participants to hide any losses to a point where they really can't hide them anymore. They act as an earnings smoother and, worse, they hide the actual risk of investment bank holdings from the public. This is a reason why so many strange things have happened on Wall Street over the last several years.
For example, for a AAA rated CDO with a 50 basis point spread, investment banks would buy insurance from a small second tier bond insurer (such as ACA) whose rating was only single A as a firm (now at junk triple C). If they believed a rating agency with AAA rating on this CDO, why would they want to cover it with a lower rated policy which eating into their profits?
In the example earlier, GM has an $11Bn market cap with $1Tn in CDS outstanding. Use home insurance as an analogy here. If your house is only worth $200k, why would there be policies on your home with a combined notional amount of $20 million?
Using CDS to Accelerate Earnings Recognition
The third and most important use of CDSs concerns the strong incentive to book the next ten years' profit today.
CDSs offer investment banks something called a “negative-basis trade,” which is another accounting loophole like the earnings smoothing discussed above. Using the same example of a CDO with a 50 basis point spread over US Treasures, banks will buy a CDS, costing 20 basis points. By doing so, even though they seem to make less profit (50 vs. 30 basis point spread), banks can book the difference in spread for the whole life of this CDO instantly, through the magic of a negative-basis trade.
If the life of the CDO is ten years, banks can book the whole ten years of phantom profits this year, even if the CDO defaults sometime in the future. This has obvious implications for the bonuses of the structured product groups at Wall Street firms.
Who cares whether this CDO defaults next year? Let’s realize the next ten years’ of bonuses today! There is a common secret at Wall Street - it doesn't matter whether a product is good or bad; the only thing that matters is how you structure it. As former Secretary of the Treasury, John Connally, said to European central bankers in the 1970s' "It might be our currency (the US dollar), but it is your problem." The same thing applies here. If a CDO defaults, investment bankers have already bumped up their stock price, cashed out their stock options and their vested shares, and collected their year end bonuses. Now it is the shareholders’ problem.
This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall Street has found out about this and is doing it. A firm owning a mortgage originator has a competitive advantage since it guarantees the source for the well. This is why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups could accelerate ten years of their firm's earnings and future bonuses.
Wall Street wants to package and collateralize everything from residential to commercial mortgages, from credit card to auto loan debt, resulting in a major shift and increase from traditional M&A fees to the so-called trading "profit" in recent years "earned" by investment banks.
How real were the past earnings reported by both Wall Street firms and hedge funds with large CDO profits? If managers can trade a minor reduction in profit (from 50 to 30 basis points) for an immediate bonus of 10 times (by accelerating ten years of earnings to the current year) what would they choose?
If a CDO defaults next year and take a hedge fund under their high water mark, it's no a big deal. The fund already collected a 20% fee from the "profit" the year before. The manager can close the fund and open a new one, raising money probably from the same pool of investors. If you want to see a pyramid scheme, there is none more vivid than this.
How about those unbelievable earnings reported by Wall Street investment banks over the last several years?
Frankly and openly, early this decade, investment banks had repeatedly expressed their dissatisfaction about relying mainly on the traditional banking fees from M&A and IPOs. There was very little room for manipulation since they only got paid when a banking deal or IPO was completed. By discovering the CDO and CDS markets, they suddenly found their Holy Grail, with profit becoming more and more skewed toward the asset "structuring" (or manipulation?) and the trading side now representing the majority of their "earnings."
This kind of accounting abuse is not unusual. It happens in the option ARM (adjustable-rate mortgages) market too. Homeowners (borrowers) for the first year or two pay a teaser rate of 2%. However, in their financial statements, banks (lenders) report the full amount of interest, say 6%, as "profit," while they actually only collect 2%. The net 4% shortfall is added to the borrower's balance. Banks have nothing to lose, but homeowners see their balance increasing and home prices dropping.
WaMu reported $1.4B profit from this kind of ARM last year, while Countrywide earned approximately $600M from them in 2007. How much of those earnings were real? How much real cash have they actually collected or will collect? They would be lucky to collect one third, and the rest they may never see. ARM default rate jumped from 1.5% from last summer to 5% by end of 2007. There are two big waves of ARM rate resets coming - one this summer and another in October this year. By the end of this year, I forecast ARM default in double digits. The total outstanding ARM loans are estimated to be approximately $4-5 trillion. A 10% default will put $400Bn of loans in default.
There are many other accounting manipulations and abuses in the mortgage market. For example, when MBS (mortgage-backed securities) are sold to investors, banks will record the cash flow from interest and servicing rights over the whole life of this bond up front, as something called a "gain on sale". In another example, since mortgages classified as "loans held for sale" on the balance sheet must be marked to market, banks move them to another category called "loans held for investment," which has no such requirement. Only when banks believe their losses are not temporary, but permanent, must they mark to market. Banks can always argue the current real estate plummet is only temporary, if you think long term.
If you are using the last several years' earnings as a reference point, banks don't look very expensive today (setting aside the risk associated with all the off-balance items in their long footnotes). But do you think those trading profits will return in the future? I really doubt it.
Accounting and legal loopholes will get closed by new regulations, and the CDO market will dry up for the foreseeable future. Banks will not be able to return to their previous earning power without their trading "profit" from accounting loopholes. Even if the economy comes back soon with lots of M&A and IPO deals, which is very unlikely, the good old days of trading "profit" are likely gone forever.
I don't see why all the sovereign wealth funds (SWFs) are rushing to invest in Wall Street banks. There is not much upside - only a lot of downside. It is also very interesting to note the stated investment strategy of many SWFs is to seek a 5% stable annual return in very safe financial products.
SWFs are investing in financial institutions like Blackstone and investment banks which are anything but safe and stable. This totally contradicts their investment strategy. Nothing they have invested in can be regarded as safe and stable, let alone yielding a 5% annual return. Perhaps they will see a 5% fluctuation weekly if not daily.
No SWF has factored in currency risk, which may be 5% in US dollar terms, but could result in a negative 25% return in their own currency (if the US dollar depreciates 30% in the next several years, as I believe is likely). Their investments could not be further from their stated investment strategy, and this raises a credibility issue with regard to everything else SWFs have claimed.
Of the outstanding $45 trillion CDO credit default swaps at the end of last year, JP Morgan owned about $15 trillion, or one third of the whole market. This is may be the reason for the Bear Stearns' acquisition by JPM. Even though Bear Stearns' CDS position was “only” around $2.5 trillion, the default of Bear would bring a shock wave of counterparty risk across the whole CDS market and would inevitably expose JPM, with its huge CDS risk, to the global financial market. Who can afford to pay for this? Who has a large enough capital base to absorb such a loss, especially since these contracts are concentrated in only a few CDS derivative dealers like JPM? No one.
It always comes down to the deep pockets, as in any liability litigation, where litigators will skip all the smaller players but will jump on whoever has the deepest pockets and largest exposure and position. JPM currently seems to fit the picture. When such a time comes, all the other weaker and smaller players will try to dump their risk to JPM to unwind their positions. By buying Bear Stearns, JPM can postpone the CDS debacle for another year, but not forever. I expect JPM will eventually suffer very large losses in this area - bigger than one third of their market share. Bernanke and Paulson better get their helicopter and $500Bn of cash ready for their Wall Street friends.
Early this decade, Warren Buffett publicly turned against derivatives. "When Charlie [Munger] and I finished reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors. He said "Derivatives are financial weapons of mass destruction [WMD], carrying dangers that, while now latent, are potentially lethal."
I believe what he was referring to at that time were not CDSs, but other derivatives such as interest rate swaps. The day will come when investors become aware of the OTC CDS scheme, which has no footnote in annual reports, no market, is not regulated, leaves no trace whatsoever, has no clearing house, and where everything depends on the credit and liquidity of the weakest player in the CDS chain. If an interest rate swap can be called a WMD by Warren Buffett, I can't come up with a name for the CDS. Just as Paul Volcker said last week, the current crisis is "the mother of all crises." The CDS is the mother of the current credit crisis.
The CDS is a Wall Street vehicle used to manipulate loopholes in accounting and legal regulations in order to move and hide losses, to record future profits today, to manipulate, realize and increase reported earnings in today's financial statements to accelerate bonus payments, all done with the help of willing and eager accomplices, in both bond insurers and rating agencies.
At the same time, it is the same old game of quick profits, phantom earnings, rip-offs, manipulation, distortion and cover-up, played on Wall Street since its inception. Only this time it is greatly exacerbated by the financial deregulations enacted during the Greenspan era.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
We have all heard about CDOs (collateralized debt obligations) and probably about the insurance of CDOs through CDSs (credit default swaps), which transfer the credit risks of CDOs between two parties (financial institutions).
The CDS is a bet between two parties on whether or not a company or a financial product will default. It is third party speculation on the outcome of the CDO. The CDS provides insurance to cover a fixed income product in case of its default. If a company declares bankruptcy or a debt is downgraded, a claim is triggered.
Currently, the outstanding notional amount of all credit default swaps is about $65 trillion, more than half of the entire asset base of the global banking system. Why are financial institutions are so interested in them? Why have they created so many of them to make this market so big and out of control?
There are many incentives, some of them are larger, and some smaller. I will discuss the three major reasons.
Transference of Risk
First, credit default swaps are not normal insurance policies; each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly, after the original CDS contract is engaged, each of the original two parties will try to engage another party to further hedge their risk and earn a small spread. Pretty soon there are layers and layers of counterparties involved, with the total notional amount increasing several fold, until no one knows who they are really dealing with anymore.
You can't monitor this risk since you don't know your counterparty down the CDS chain, and whether they are able to pay in the event of a default. If you throw the counterparty risk out the window, you can always find a sucker to do the trade with you and earn a small spread.
This kind of entanglement has never been seen before in the usually highly-regulated insurance industry. This is why CDSs are traded on OTC (over the counter) derivative markets which bypass all government regulations.
This entanglement creates a chain reaction. If something happens - even a downgrade but not a default - the claim will trigger a domino effect of many claims cascading down through various parties. It will break at the weakest joint (counterparty), probably a highly leveraged hedge fund, and will ripple through all parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt, beyond the default risk of the CDO itself.
Let us use the analogy of new type of car insurance: Car insurance company A trades our car insurance policy costing us $1,000 per year (or $1,000 revenue for them) for another $1,100 similar policy from another company B, and pockets a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with the insurance company is always one on one.
However, imagine what happens if both parties trade the policy with a third party. If an accident occurs, company A will not want to pay us, since we engaged company C, and company C will not want to pay either, since it did not issue the original policy. And if company A pays us eventually, they will have to file a claim against company B, who will most likely deny such claim.
This is what happened to the insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines. To hedge this default risk, Bear purchased a protection contract from AON for $0.4M. To hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch on Wall St.? Think again!
You guessed it - the loan went bust as expected. Bear sued AON for $10M based on the first CDS contract. AON lost the case and paid. Of course, AON sued Societe Generale. Due to some legal technicalities, a different court and judge had a different opinion.
The judgment was that the first and second CDS contracts were two separate contracts. Legally, the resolution of first CDS lawsuit did not automatically grant the similar status to the second CDS. The first judgment can't be referenced in the second lawsuit. As a result, the risk can't automatically be transferred and offset each time.
AON lost the case, and the $0.1M "profit" turned into $10M loss in principal. It was an expensive lunch. This sets an important legal precedent for future CDS lawsuits. A small $10M default in the Philippines impacted three parties. Maybe this is an unexpected downside of globalization?
The market cap of GM is about $11Bn. However, based on estimates in the CDS market, there are about $1 trillion (notional amount) in CDSs betting on GM and their bonds. Any change in GM's situation will create a ripple effect in this $1Tn CDS community of GM.
There are obviously not $1Tn of GM assets to serve as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability, it will throw a monkey wrench in the whole community, as everyone is trying to unwind and get out at the same time. It becomes a "no way out situation."
Bill Gross at PIMCO did a simple calculation in January in his famous article "Pyramid Crumbling." The total amount of CDS contracts was $45 trillion at that time. The historical default rate is 1.25%, so $500Bn CDS contracts are likely to default. Assuming a recovery rate of 50%, the resulting loss is $250Bn alone.
In the case of CDOs created from sub-prime mortgages, Gross’ assumptions are too optimistic. The assumed default rate is far too low. His recovery rate assumption is probably also too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal maneuvers which can be implemented by homeowners (refer to my early articles on foreclosure). I expect to see real losses doubling his estimate, or approximately $500Bn in the sub-prime market.
Using CDS to Smooth Earnings
Second, and more importantly, besides the quick profit earned through a small spread, there is a big incentive to use credit default swaps to smooth earnings from quarter to quarter and to hide losses.
If a CDO is rated AAA by rating agency (almost as good as US Treasuries) why would Wall St. want to buy insurance for protection? At the same time, assume a AAA CDO enjoys a 50 basis point spread above US Treasury rates. It is almost as good as a free lunch. Why would Wall Street firms want to eat into the 50 bp spread (and their profit) to buy CDS insurance?
The answer lies in different accounting treatments. Wall Street firms are not stupid, and they are smart enough to know their CDOs are not US Treasuries, even if their structured product groups and sales people claim they are, with the backing of the rating agencies. It is similar to the promotion of internet stocks in late 1990s, when Wall Street put out a "strong buy" ratings on supposedly great internet companies with unbelievable growth stories, while their internal memos referred to them as "pieces of garbage".
Due to GAAP (generally accepted accounting principles) requirements, investment banks need to mark their CDO products to market if they do not carry CDS insurance. This creates a problem, since both interest rates and credit spreads fluctuate, making it harder to manage earnings. What happens if investors or regulators suddenly realize they are really a piece of garbage? They don't want earnings volatility and surprises, especially at the time when their bonuses are at stake. Banks want to defer paper losses due to write-downs until they actually sell their CDOs, which would mean real bonus reductions for executives and structured finance groups.
By purchasing CDS insurance, according to GAAP regulations, there is no need to mark-to-market, Investment banks need to declare losses only if the CDO is permanently damaged and a claim will have to be paid. No more quarter to quarter fear of marking to market.
This effectively transfers the price risk to a counterparty, who in turn dumps it to another party, and so forth. By the time it comes back full circle, no one needs to worry about marking to market and earning surprises. If a paper loss happens, they can point to the insurance and claim it is only temporary. Financial statements will not be impacted.
CDS provide a vehicle to allow participants to hide any losses to a point where they really can't hide them anymore. They act as an earnings smoother and, worse, they hide the actual risk of investment bank holdings from the public. This is a reason why so many strange things have happened on Wall Street over the last several years.
For example, for a AAA rated CDO with a 50 basis point spread, investment banks would buy insurance from a small second tier bond insurer (such as ACA) whose rating was only single A as a firm (now at junk triple C). If they believed a rating agency with AAA rating on this CDO, why would they want to cover it with a lower rated policy which eating into their profits?
In the example earlier, GM has an $11Bn market cap with $1Tn in CDS outstanding. Use home insurance as an analogy here. If your house is only worth $200k, why would there be policies on your home with a combined notional amount of $20 million?
Using CDS to Accelerate Earnings Recognition
The third and most important use of CDSs concerns the strong incentive to book the next ten years' profit today.
CDSs offer investment banks something called a “negative-basis trade,” which is another accounting loophole like the earnings smoothing discussed above. Using the same example of a CDO with a 50 basis point spread over US Treasures, banks will buy a CDS, costing 20 basis points. By doing so, even though they seem to make less profit (50 vs. 30 basis point spread), banks can book the difference in spread for the whole life of this CDO instantly, through the magic of a negative-basis trade.
If the life of the CDO is ten years, banks can book the whole ten years of phantom profits this year, even if the CDO defaults sometime in the future. This has obvious implications for the bonuses of the structured product groups at Wall Street firms.
Who cares whether this CDO defaults next year? Let’s realize the next ten years’ of bonuses today! There is a common secret at Wall Street - it doesn't matter whether a product is good or bad; the only thing that matters is how you structure it. As former Secretary of the Treasury, John Connally, said to European central bankers in the 1970s' "It might be our currency (the US dollar), but it is your problem." The same thing applies here. If a CDO defaults, investment bankers have already bumped up their stock price, cashed out their stock options and their vested shares, and collected their year end bonuses. Now it is the shareholders’ problem.
This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall Street has found out about this and is doing it. A firm owning a mortgage originator has a competitive advantage since it guarantees the source for the well. This is why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups could accelerate ten years of their firm's earnings and future bonuses.
Wall Street wants to package and collateralize everything from residential to commercial mortgages, from credit card to auto loan debt, resulting in a major shift and increase from traditional M&A fees to the so-called trading "profit" in recent years "earned" by investment banks.
How real were the past earnings reported by both Wall Street firms and hedge funds with large CDO profits? If managers can trade a minor reduction in profit (from 50 to 30 basis points) for an immediate bonus of 10 times (by accelerating ten years of earnings to the current year) what would they choose?
If a CDO defaults next year and take a hedge fund under their high water mark, it's no a big deal. The fund already collected a 20% fee from the "profit" the year before. The manager can close the fund and open a new one, raising money probably from the same pool of investors. If you want to see a pyramid scheme, there is none more vivid than this.
How about those unbelievable earnings reported by Wall Street investment banks over the last several years?
Frankly and openly, early this decade, investment banks had repeatedly expressed their dissatisfaction about relying mainly on the traditional banking fees from M&A and IPOs. There was very little room for manipulation since they only got paid when a banking deal or IPO was completed. By discovering the CDO and CDS markets, they suddenly found their Holy Grail, with profit becoming more and more skewed toward the asset "structuring" (or manipulation?) and the trading side now representing the majority of their "earnings."
This kind of accounting abuse is not unusual. It happens in the option ARM (adjustable-rate mortgages) market too. Homeowners (borrowers) for the first year or two pay a teaser rate of 2%. However, in their financial statements, banks (lenders) report the full amount of interest, say 6%, as "profit," while they actually only collect 2%. The net 4% shortfall is added to the borrower's balance. Banks have nothing to lose, but homeowners see their balance increasing and home prices dropping.
WaMu reported $1.4B profit from this kind of ARM last year, while Countrywide earned approximately $600M from them in 2007. How much of those earnings were real? How much real cash have they actually collected or will collect? They would be lucky to collect one third, and the rest they may never see. ARM default rate jumped from 1.5% from last summer to 5% by end of 2007. There are two big waves of ARM rate resets coming - one this summer and another in October this year. By the end of this year, I forecast ARM default in double digits. The total outstanding ARM loans are estimated to be approximately $4-5 trillion. A 10% default will put $400Bn of loans in default.
There are many other accounting manipulations and abuses in the mortgage market. For example, when MBS (mortgage-backed securities) are sold to investors, banks will record the cash flow from interest and servicing rights over the whole life of this bond up front, as something called a "gain on sale". In another example, since mortgages classified as "loans held for sale" on the balance sheet must be marked to market, banks move them to another category called "loans held for investment," which has no such requirement. Only when banks believe their losses are not temporary, but permanent, must they mark to market. Banks can always argue the current real estate plummet is only temporary, if you think long term.
If you are using the last several years' earnings as a reference point, banks don't look very expensive today (setting aside the risk associated with all the off-balance items in their long footnotes). But do you think those trading profits will return in the future? I really doubt it.
Accounting and legal loopholes will get closed by new regulations, and the CDO market will dry up for the foreseeable future. Banks will not be able to return to their previous earning power without their trading "profit" from accounting loopholes. Even if the economy comes back soon with lots of M&A and IPO deals, which is very unlikely, the good old days of trading "profit" are likely gone forever.
I don't see why all the sovereign wealth funds (SWFs) are rushing to invest in Wall Street banks. There is not much upside - only a lot of downside. It is also very interesting to note the stated investment strategy of many SWFs is to seek a 5% stable annual return in very safe financial products.
SWFs are investing in financial institutions like Blackstone and investment banks which are anything but safe and stable. This totally contradicts their investment strategy. Nothing they have invested in can be regarded as safe and stable, let alone yielding a 5% annual return. Perhaps they will see a 5% fluctuation weekly if not daily.
No SWF has factored in currency risk, which may be 5% in US dollar terms, but could result in a negative 25% return in their own currency (if the US dollar depreciates 30% in the next several years, as I believe is likely). Their investments could not be further from their stated investment strategy, and this raises a credibility issue with regard to everything else SWFs have claimed.
Of the outstanding $45 trillion CDO credit default swaps at the end of last year, JP Morgan owned about $15 trillion, or one third of the whole market. This is may be the reason for the Bear Stearns' acquisition by JPM. Even though Bear Stearns' CDS position was “only” around $2.5 trillion, the default of Bear would bring a shock wave of counterparty risk across the whole CDS market and would inevitably expose JPM, with its huge CDS risk, to the global financial market. Who can afford to pay for this? Who has a large enough capital base to absorb such a loss, especially since these contracts are concentrated in only a few CDS derivative dealers like JPM? No one.
It always comes down to the deep pockets, as in any liability litigation, where litigators will skip all the smaller players but will jump on whoever has the deepest pockets and largest exposure and position. JPM currently seems to fit the picture. When such a time comes, all the other weaker and smaller players will try to dump their risk to JPM to unwind their positions. By buying Bear Stearns, JPM can postpone the CDS debacle for another year, but not forever. I expect JPM will eventually suffer very large losses in this area - bigger than one third of their market share. Bernanke and Paulson better get their helicopter and $500Bn of cash ready for their Wall Street friends.
Early this decade, Warren Buffett publicly turned against derivatives. "When Charlie [Munger] and I finished reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors. He said "Derivatives are financial weapons of mass destruction [WMD], carrying dangers that, while now latent, are potentially lethal."
I believe what he was referring to at that time were not CDSs, but other derivatives such as interest rate swaps. The day will come when investors become aware of the OTC CDS scheme, which has no footnote in annual reports, no market, is not regulated, leaves no trace whatsoever, has no clearing house, and where everything depends on the credit and liquidity of the weakest player in the CDS chain. If an interest rate swap can be called a WMD by Warren Buffett, I can't come up with a name for the CDS. Just as Paul Volcker said last week, the current crisis is "the mother of all crises." The CDS is the mother of the current credit crisis.
The CDS is a Wall Street vehicle used to manipulate loopholes in accounting and legal regulations in order to move and hide losses, to record future profits today, to manipulate, realize and increase reported earnings in today's financial statements to accelerate bonus payments, all done with the help of willing and eager accomplices, in both bond insurers and rating agencies.
At the same time, it is the same old game of quick profits, phantom earnings, rip-offs, manipulation, distortion and cover-up, played on Wall Street since its inception. Only this time it is greatly exacerbated by the financial deregulations enacted during the Greenspan era.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Needed: A Large Drop of Helicopter Money
During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Needed: A Large Drop of Helicopter Money
During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
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