Finally Sorta Good Economic News

In today’s WSJ, Nouriel Roubini gives the best economic news I’ve heard in a while. It’s not what we normally think of as good news though, so let’s put the news in context. First understand that Roubini’s nickname is the “Dr Doom” and yet he has been very accurate in his predictions about the financial collapse.

David Ignatius, a Washington Post economics columnist, did a very useful thing recently, he documented why Roubini spotted trends others had missed. Here are the reasons:

The first involves standard number-crunching of the sort that economists routinely do — and that Roubini just did better and sooner. It’s his second answer that’s more interesting, because it goes to the heart of what we should take away from this crisis: Roubini decided to discard the assumption of market rationality that underlies most economics and to embrace the psychological insights of what’s known as “behavioral economics.”

I know this a huge deal, but have no idea what it means to how economics will be approached going forward, just that it will change. The good news is that even a guy like Roubini doesn’t advocate an alternative to capitalism. Here is how Roubini recently described his own feelings about proposing that banks be nationalized:

As free-market economists teaching at a business school [NYU Stern] in the heart of the world’s financial capital, we feel downright blasphemous proposing an all-out government takeover of the banking system. But the U.S. financial system has reached such a dangerous tipping point that little choice remains. And while Treasury Secretary Timothy Geithner’s recent plan to save it has many of the right elements, it’s basically too late.

Roubini’s Good News – Govt Program Which Exposes Failing Banks

On Nov 25th of last year, the FDIC started the Temporary Liquidity Guarantee Program, which backs all bank debt of less than three-year maturity with the full faith and credit of the U.S. government. In essence, they got to issue debt at government rates. The program worked.

The government’s motivation for this program is to get banks back in the lending game. But in an economic and financial crisis, we want healthy banks to lend to creditworthy institutions and individuals, not for unhealthy banks to play with the credit spreads. There proved to be a remarkable coincidence between the banks with the largest writedowns — one measure of sickness — and those accessing the FDIC program. Since Nov 2008, the following banks have borrowed a total of $203 billion:

BofA – $35.5 billion
GE Capital – $27 billion
Citigroup – $24 billion
J.P. Morgan – $19 billion
Morgan Stanley – $19 billion
Goldman Sachs – $15 billion
Numerous other banks – $64 billion

The Bad News

Those banks noted above are probably insolvent

Why Roubini Likes Geithner’s Plan

Treasury Secretary Tim Geithner’s plan — call it Bailout 2.0 — stops the madness.

Bailout 2.0 lacks details, but it is clear it won’t propose more bank freebies — no new loan guarantee programs or backstops of losses on their bad assets, or government capital infusions in the form of underpriced preferred shares. Now the banks will have to prove themselves via a “stress test” on their solvency to access new capital. It won’t be a pretty picture.

The government is now going to do it alongside private capital. These investors aren’t going to overpay, so that game is up as well.

Since Mr. Geithner’s plan has been unveiled, the stock prices of the financial sector are off about 19%. This is not necessarily a bad thing. The banks were expecting another handout.

While it was not his intention, the reality is that Mr. Geithner is going to confirm the insolvency of the financial system. Once we face this truth, there really isn’t much left to do but nationalize.

We are not talking about the government operating the banks for the long-term. But, as was done in Scandinavia in the early 1990s, we are talking about orderly clean up, then reselling the banks to private investors.

The good news is that much of the risk will be borne by the banks’ common and preferred shareholders and their long-term unsecured creditors — as opposed to by taxpayers. This makes sense since shareholders and creditors were the ones who bet on banks in the first place. We’ll also stop repeating the mistakes we made with Fannie and Freddie.

According to the Financial Times, Alan Greenspan agrees.

All articles referenced are copied in full at end of post.

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There’s Virtue In Geithner’s Vague Bank Plan. At least he doesn’t want to guarantee more bad debt.

FEBRUARY 18, 2009

By MATTHEW RICHARDSON and NOURIEL ROUBINI

On Jan. 27, Bank of America sold a whopping $6 billion of three-year notes at a yield of 2.2% — a good 3.5% less than what its other bonds of similar maturity were trading for. How did it manage this feat?

For a mere fee of 0.75%, BofA accessed the FDIC’s Temporary Liquidity Guarantee Program, which backs all bank debt of less than three-year maturity with the full faith and credit of the U.S. government. In essence, they got to issue debt at government rates.

Since the program started last Nov. 25, BofA has gone to the well 11 times for a total of $35.5 billion. Other banks have lined up 91 times for a staggering $168 billion. They include GE Capital ($27 billion), Citigroup ($24 billion), J.P. Morgan ($19 billion), Morgan Stanley ($19 billion), and Goldman Sachs ($15 billion).

Feelings about the liquidity guarantee program weren’t always so rosy. On Oct. 31, 2008, the law firm Sullivan & Cromwell wrote the FDIC on behalf of nine banks, arguing that the government program to back the bonds of financial firms did not provide strong-enough guarantees. The letter asked that the guarantee cover principal and interest payment obligations as they became due, backed by the full faith and credit of the U.S. government. The guarantee was included three weeks later when the final rule was issued. No prize for guessing which banks signed the letter.

There is, however, a remarkable coincidence between the banks with the largest writedowns — one measure of sickness — and those accessing the FDIC program.

It’s not as if we haven’t seen this before. On Sept. 7, 2008, the government put Fannie Mae and Freddie Mac into conservatorship. They were bankrupt because of an accumulated portfolio of $1.5 trillion worth of mortgage-backed securities, of which $225 billion was subprime mortgages and the other $1.275 trillion were illiquid prime mortgages.

While some of Fannie and Freddie’s portfolios were hedged against interest rate movements using interest rate swaps, the subprime portion was an outright bet on default rates of low quality mortgages. How much cushion did they have? Only $1 of capital for every $25 of debt. What type of crazy creditor would lend to them? Almost anyone, because the debt had the implicit, now explicit, guarantee of the U.S. government.

With the economic dangers we now face, do we really want to go down this road again?

We don’t, and that’s why, for all the criticism, Treasury Secretary Tim Geithner’s plan — call it Bailout 2.0 — does have a silver lining. It stops the madness.

Yes, Bailout 2.0 lacks details, but it is clear it won’t propose more bank freebies — no new loan guarantee programs or backstops of losses on their bad assets, or government capital infusions in the form of underpriced preferred shares. Now the banks will have to prove themselves via a “stress test” on their solvency to access new capital. It won’t be a pretty picture.

And by the way, if banks want Uncle Sam to buy all those “toxic” assets, the government is now going to do it alongside private capital. These investors aren’t going to overpay, so that game is up as well.

Since Mr. Geithner’s plan has been unveiled, the stock prices of the financial sector are off about 19%. This is not necessarily a bad thing. The banks were expecting another handout.

While it was not his intention, the reality is that Mr. Geithner is going to confirm the insolvency of the financial system. Once we face this truth, there really isn’t much left to do but nationalize.

We are not talking about the government operating the banks for the long-term. But, as was done in Scandinavia in the early 1990s, we are talking about orderly clean up, then reselling the banks to private investors.

The good news is that much of the risk will be borne by the banks’ common and preferred shareholders and their long-term unsecured creditors — as opposed to by taxpayers. This makes sense since shareholders and creditors were the ones who bet on banks in the first place. We’ll also stop repeating the mistakes we made with Fannie and Freddie.

Messrs. Richardson and Roubini are professors who have contributed to the NYU Stern School of Business book, “Restoring Financial Stability: How to Repair a Failed System,” forthcoming by John Wiley & Sons.
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The Death of ‘Rational Man’

By David Ignatius

Sunday, February 8, 2009; B07

What allowed some people to see the financial crash coming while so many others missed its gathering force? I put that question recently to Nouriel Roubini, who has come to be known as “Dr. Doom” because of his insistent warnings starting in 2006 that we were heading into a global firestorm.

Roubini gave two kinds of answers. The first involves standard number-crunching of the sort that economists routinely do — and that Roubini just did better and sooner. It’s his second answer that’s more interesting, because it goes to the heart of what we should take away from this crisis: Roubini decided to discard the assumption of market rationality that underlies most economics and to embrace the psychological insights of what’s known as “behavioral economics.”

First, the standard analytical explanation: Roubini said that he studied a chart in economist Robert J. Shiller’s book “Irrational Exuberance.” It showed that U.S. housing prices, adjusted for inflation, had remained essentially flat for a century, until the mid-1990s, when they began to shoot up. What’s more, Roubini saw that the most recent housing correction in the late 1980s had a severe effect on the financial system — leading ultimately to the collapse of the savings and loan industry.

So Roubini knew two things: Housing prices wouldn’t keep going up forever, and when they went down, they would take a big piece of the financial system with them. From then on, it was a matter of watching the data.

But everyone else had those same numbers. Why did Roubini act? The answer is that he decided to trust his gut, which told him there was trouble ahead, rather than Wall Street’s “wisdom of the crowd,” which — as reflected in stock prices — said everything was rosy. He concluded that the markets were not pricing in the degree of risk that was actually present in housing.

“The rational man theory of economics has not worked,” Roubini said last month at a session of the World Economic Forum at Davos. That’s why he and other prominent economists are paying more attention to behavioral economics, which starts from the premise that economic decisions, like other aspects of human behavior, are influenced by irrational psychological factors.

The most compelling rebuttal of the rational model, paradoxically, was delivered by the ultimate rationalist, Alan Greenspan. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders,” the former Fed chairman told Congress last October.

That’s why Greenspan didn’t see it coming, argues Daniel Kahneman, a Princeton professor who is often described as the father of behavioral economics. His rational-actor model wouldn’t let him.

Let me put in a plug here for the godfather of behavioral economics, John Maynard Keynes. His 1936 “General Theory” is often interpreted simplistically as a call for fixing recessions by boosting demand with government spending. But at a deeper level, Keynes was analyzing the role of psychological factors, such as greed and fear, in economic decisions. He understood that markets freeze when people panic and start hoarding cash. (“Extreme liquidity preference,” he called it.) Conversely, economies start to roar when investors feel a surge of what Keynes called “animal spirits.”

One of the most powerful ideas I heard at Davos was the idea of “pre-mortem” analysis, which was first proposed by psychologist Gary Klein and has been taken up by Kahneman.

A pre-mortem analysis can provide a real “stress test” to conventional thinking. Let’s say that a company or government agency has decided on a plan of action. But before implementing it, the boss asks people to assume that five years from now, the plan has failed — and then to write a brief explanation of why it didn’t work. This approach stands a chance of bringing to the surface problems that the decision makers had overlooked — the “black swans,” to use former trader Nassim Nicholas Taleb’s phrase, that people assumed wouldn’t happen in the near future because they hadn’t occurred in the recent past.

One more take-away from this year’s Davos forum was a Japanese proverb cited by one speaker: “An inch ahead is darkness.” Recognizing the inherent unpredictability of economic life — the darkness that’s just ahead — should make us wary. But it can also make us smart.

The writer is co-host of PostGlobal, an online discussion of international issues. His e-mail address is davidignatius@washpost.com.
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