So What is the Bailout (oops, 'Buy In,' sorry Nancy) Supposed to Do?

Last time I blogged about why credit matters to the economy, today I will try and explain in as simple terms as possible what Paulson's original idea is all about.

The background is now familiar. Investment banks and securities firms, eager to provide outlets for a huge pile of global money, started bundling together more and more suspect mortgages, sliced them up and created Mortgage Backed Securities (MBS) (see my old posts on the credit crisis). The huge demand for these securities caused even more suspect mortgage lending. This all fueled the housing bubble which finally popped. When the value of houses started crashing the performance of the MBS tanked. They tanked so badly that it soon become apparent that no one could really figure out how to value them. When that happened, the market for these securities basically disappeared. [It is worth noting that though MBS are not the only culprit, they are the main one] Suddenly a major part of the asset side of these banks (both investment and commercial - the difference is not that significant anymore) balance sheets lost all of their value both because of the drop in housing values on which they are based, but also because of they worry about valuing them appropriately made no one interested in buying them. Banks suddenly faced a solvency crisis and needed to raise liquidity. Normally you can do this by selling assets but as I just explained, there is no market for them. Alternatively you can borrow money and lend it out or invest it to try and raise new capital through profits, but now no banks want to lend to each other because they are all worried about default (and rightly so, look at Lehman Brothers, WaMu, etc.) So with banks facing insolvency and the usual channels to overcome this blocked we find ourselves teetering on the brink of total meltdown in the banking sector.

What the Treasury proposes to do is to try and address the second part of the asset pricing problem for the MBS. Namely, that no one wants to buy them because no one can figure out what they are worth (and their worth depends in large part on the future performance of the housing sector). The Treasury claims that they are not worthless (as the current market price suggests) but that 'hysteria' [my word] in the credit market is causing the current price to be much too low. Basically this is a problem of asymmetric information (not knowing the true worth) and coordination failure (not knowing what will happen to housing values which depends on the freeing of credit, which, in turn, depends on confidence returning to the banking sector). Treasury thinks that it can figure out the true worth of these MBS assets and pay that today. Doing so, they believe, will calm the hysteria and free up credit because essentially banks will take the Treasury money and put it right back into T-Bills which will shore up the balance sheet, return them to solvency and make the eligible to borrow and lend again -- which will eventually trickle down to the housing market. Once the hysteria is gone and housing markets have stabilized, the true value of the MBS will become clear and the Treasury can start selling them back - hopefully for as much or even more than they paid.

You can see the risk: if the hysteria about the MBS does not calm down (no one wants to touch them ever again) or if the injection of liquidity does not free up enough credit to turn the housing market around, the Treasury could be stuck with a huge amount of worthless MBS and will end up loosing $700 billion with nothing to show for it. This is why some economists claim is it better to buy equity in the banks because then if it doesn't work you at least have some tangible assets you can sell (like, e.g., WaMu's retail branches that apparently Chase coveted). [The rejoinder to this is that the government may find itself heavily invested in banking, will have a huge amount of complicated real and paper assets to deal with, and will go to even greater lengths to prevent failure.]

So the real cost of the plan, will depend on the sales price of the MBS in the future (and how far that future date is). It's a big risk, but meltdown is a risk an order of magnitude larger.

NB: Later I will try and comment on the DeFazio plan.

Why Credit Matters

Friend of the blog Jeff Alworth posed a challenge in the comments: can you explain what's at stake in the credit crisis for the average "person on the street." I started to write a response but it quickly turned into the now well-worn "credit dries up, housing market gets even worse, recession, unemployment, etc." and realized that I wasn't really helping. So I am going to try a new tack: explaining in simple terms (sorry, econ majors, bear with me) why credit matters so much to the economy.

So let's start with the observation that healthy economies keep money circulating - the more it moves around the more it can be put to productive uses. Consider the simple, stylized example that often starts a money and banking course. A person saving for retirement wants to make sure there will be enough money available to them to live on in the future. So they start to stockpile cash in their mattress. At the same time, someone else has a great idea for a new business, one that could make a time saving device for all to benefit from and that would employ many people in its manufacture.  Problem is, this person does not have enough money to start making the devices but knows that if she could borrow it, her business would be successful enough to repay it many times over.  Could each person be made better off than the current stalemate of money in the mattress and insufficient funds to make the time-saving device?  Of course!  The saver could end up with more money to live on in retirement if they could loan it with interest and the borrower would happily pay interest in order to see her business get off the ground.  [NB: We economists call this a Pareto improving exchange as both parties are made better off and no one is worse off]

The problem is of course that the saver may never know the borrower exists, so even though they both would like to make this exchange, they cannot.  This is where banks and other financial intermediaries come in, they help facilitate the exchange. In fact, banks simply offer interest if you deposit money with them, they don't make you wait to be paired up with a borrower.  They go out and look for borrowers and charge them a higher rate than they pay to borrowers and the difference is how they make money.  And why not, it is a valuable service to both parties.  It is also a valuable service to society because now lots of entrepreneurs can find money to start up new businesses and these businesses employ workers, pay taxes and potentially make life better for the consumers of their products.  

But we still haven't left Bedford Falls where the building and loan collects locals deposits and lends them out as mortgages.  Now let's move to the bigger world of banking finance.  In the modern banking system banks on a daily basis have surpluses and shortages as money flows rapidly and hundreds of thousands of deposits and loans are accounted for.  The money that comes from savers now comes from around the world and is loaned out around the worlds too, though much of the worlds savings has been spent, recently, by US consumers.   To keep all of this money flowing to its most productive uses, banks regularly borrow and lend from and to each other.  And just like us little people, they too pay and charge interest rates.  And the problem right now is that this lending has essentially seized up, leaving banks high and dry when they are trying to raise some liquidity to lend in order to make some money to counter the quickly sinking assets they have on their balance sheet (largely mortgage backed securities).   Without this ability to raise capital, banks are in danger of collapsing (e.g. WaMu).  To see for yourself, look at the TED spread which is the difference in a measure of bank-to-bank interest rates and the rate in the T-Bill.  If you are a bank with some excess capital on your books and you want to earn money rather than having that money in your mattress (so to speak) you can invest it in the safest instrument around (the T-Bill) or you can lend it to another bank.  This second option is not as safe because there is a higher probability that you might not get paid back, and thus bank-to-bank interest rates are always a little bit higher - until now.  Now they have gone through the roof.  This is the purest snapshot of the trouble the credit market is in at the moment.

So it all maters to you.  In the wide world of banking, these intermediaries are like the fuel pump to an economy, constantly pumping the fuel (credit or other people's savings) to where it is most combustible, to the most productive uses. By so doing, it really keeps the engine of the economy running, it keeps existing businesses going, new businesses starting and consumers able to consume. So credit really is the fuel for the engine of an economy. In my work as a development economist, we often finger the credit markets (or lack thereof) as a major obstacle to growth in low income countries. 

What I would expect the 'person in the street' to see, if banks are allowed to fail is a drying up of credit for things like houses, education and consumer loans.  I expect to see a spike in unemployment, a further and perhaps much more dramatic fall in the residential housing market and a significant slowing of economic growth and probably negative growth for some time.  This all hurts.  Tax revenues will suffer, so state services will be diminished.  Jobs will be harder to come by and the ability to smooth consumption spending will be curtailed by the lack of credit.  

  

So it is not the big CEOs of these banks that will suffer if the banking system is allowed to collapse (they are incredibly wealthy already, they'll be fine), but the most vulnerable in society that will suffer.  I, for one, hope the bill is passed very soon.

Incidentally, my big concern is if $700 Billion is enough.  I think that the probability that the US will take a big loss on these assets goes down the bigger is the bailout.  That's because the US is hoping that this temporary hysteria in the credit market is what has collapsed the price of these mortgage backed securities, not that they really are worthless.  The likelihood that these will return to a reasonable price is greater the greater is the bailout (the healthier the banks become and the more money is put back into housing - the fundamental asset behind these securities).  

Fingers are crossed for tomorrow... 

Payday Loans Redux

A new staff report by the Federal Reserve Bank of New York seems to confirm my fears about the regulation of payday lenders. As an economist, I believe that things like payday loan businesses arise due to some missing market, and to simply shut down that market does not address the original lacuna that caused it to arise. As payday borrowers are mostly lower income individuals, eliminating payday loans could end up making them worse off. Payday loans, as much as they seem usurious to us, seemed to be providing essential liquidity to a population that has a limited access to credit. Preliminary results are that credit troubles have worsened in areas where payday lenders were prohibited.

Payday Loans

Here is a topic which is a good example of the occasional enormous chasm that divides economists from non-economists and makes 'normal' people think that we just don't 'get it.' The argument for the regulation of the payday loan industry in Oregon (which, among other things, limits the amount of interest that can be charged at 36%) seems overwhelming: these businesses are praying on the poor and vulnerable and indenturing them into debt servitude, furthering their misery and contributing to their poverty. Yet, I don't buy it and I worry that the poor and vulnerable will be made worse off with such regulation, not better.

Let's begin the analysis with the root problem: access to credit for the poor and/or those with poor or no credit histories. This is a considerable hardship because credit provides flexibility when dealing with limited and often transitory income. Access to credit can also be a key to escaping poverty by allowing investments in productive assets (like education) that can increase future incomes. This is what I would call the disease.

Here is a symptom: Because credit at (for lack of a better term) mainstream financial institutions is inaccessible, a host of businesses have cropped up to provide credit to this population. They have been criticised for having exorbitantly high interest rates and short repayment periods. The subtext to this critique is that they are abnormally profiting from other's misfortune. Given as evidence of the scale of the problem are the vast numbers of payday loan shops. But these critiques strike me as completely misguided. The fact that there are many payday loan shops suggests to me that the industry is highly competitive, and therefore that the interest rates they charge are reflective mostly of the costs of doing business in small-scale loans and high delinquency rates. So the proposed cure will cause firms to exit the industry - worsening the disease by further limiting access to credit to the poor. For those that remain and are limited to 36% interest, they will impose more stringent requirements to limit their credit to only the least risky of their clients - again limiting access to credit for the poor.

So I find this a totally misguided policy. I think that payday loans are a problem, but that the problem is with access to credit for this population. What government could do that would be more appropriate perhaps is to mandate that banks, credit unions and thrifts extend credit to this population. To do so these institutions would end up charging more for credit for all and thus this would be a type of transfer from the relatively well to do to the relatively less fortunate. But it would be aimed at the disease and not the symptom.

Finally, one argument that really bothers me (and I am perhaps typical of economists) is that these payday lenders are predatory because borrowers are naive and don't understand what they are getting into when they borrow money. I find this incredibly patronizing - basically "the poor are dumb." While it is true that education and socio-economic status are highly correlated, intelligence is not. And even if people (in general) are not too savvy about understanding the implications of these loans, they tend to be very small and short and one experience is likely enough for borrowers to learn (unlike, say, sub-prime mortgages). It would be one thing if these lenders were accused of fraud (like, say, some sub-prime lenders) and I would be in favor of any sanction against such practices, but the argument is not fraud, but the failure to comprehend. But you don't have to just take my word for it, the issue of whether payday loans are really predatory has been studied very carefully by economists at the fed who find that, in fact, the population of payday loan customers looks very similar to customers of mainstream financial institutions in their delinquency rates and that the payday loan industry appears to be quite competitive.

So, in my view, here is a policy that just gets it wrong - it attacks a symptom, not a disease and is likely to hurt the very people it intends to help.