financial crisis

As President-elect Barack Obama turns to the enormous challenges facing the nation, his first priority will be to set his priorities. Already, there are more urgent problems than any president could tackle successfully in a single term, and even more will almost certainly emerge. Moreover, he now will have to lead in ways he did not have to as candidate, by taking real and contentious actions. His historic, landslide election will give him greater, initial political capital than any president since Ronald Reagan. Even so, capital gets spent, and a president’s power and influence are finite, so he will have to choose precisely where he intends to focus all that capital, power and influence.

The lead items on his domestic agenda must be the nation’s financial and economic crisis. That will require, first, steps to slow housing foreclosures. He has pledged to initiate a 90-day moratorium on foreclosures, but that would be only a first, modest step. He also could also create a new fund to lend tide-over funds to homeowners facing foreclosure after the 90 days are up, and while Fannie Mae and Freddie Mac work out a responsible plan for them to renegotiate the terms and interest rates on the mortgages of homeowners in distress. He also can help banks get credit flowing again with a temporary, reduced tax rate on an estimated $700 billion in profits now held abroad by the foreign subsidiaries of American companies.

That step also could provide a measure of stimulus for an economy currently entering what is likely to be a long, nasty recession, and addressing the recession also must be one of President Obama’s first priorities. Tax rebates won’t work, since most Americans would most likely save any new checks rather than spend them. So Washington will have to jumpstart the nation’s additional spending, with a new spending package of $200 billion to $250 billion. And President Obama should focus most of it on the long-term investments he called for during the campaign, including grants to digitize health care records and provide access to computer training for current workers, and new supports to modernize the electricity grid and accelerate the development and spread of alternative energy. On top of that – and grants to cash-strapped states so they can avoid large cuts in their Medicaid programs and their workforces – the new president should focus the infrastructure piece of his stimulus on creating a national infrastructure financing bank and initiating new commitments for low-polluting light rail systems in major metropolitan areas.

The president will also hear demands and pleas for a new regulatory framework for the financial sector. That task is clearly a necessary and urgent one, but getting it right will be a long, complex process. His best move would be to create a national, expert commission with a mandate to figure it out over the next six months and report back to the nation.

The president’s serious priority-setting can only really begin once he addresses those emergencies – and it won’t be easy. The stimulus measures can be the first steps toward meeting his pledge to help build a more energy-efficient and climate-friendly economy. And since he will have to choose, the rest of that agenda should probably take lower priority than health care reform. One reason is that while the recession will cut energy prices and energy use with no help from Washington, for at least a time, it will only worsen out health care problems. The recession will further increase the numbers of people without coverage, perhaps by millions, without making a dent in the steady, sharp increases in health care costs that will continue to cut into jobs and wages. And any further delay will only make it all worse. It’s time to carry out his plans to make coverage much more nearly universal, and tie those extensions to a hard-nosed program of cost controls that will require hospitals and clinics to adopt the best practices of the country’s most cost efficient medical centers.

This will leave President Obama with plenty to tackle in the second half of his term. That can be the time to take further steps to help make America more climate friendly and energy efficient. It also has to be the time to build on the cost-control lessons from health care reform and finally address the serious and treacherous business of reforming Medicare and other entitlement spending for tens of millions of Baby Boomers.

And if President Obama can make real progress in these priority areas over his first term, it will almost certainly earn him an even bigger national landslide for a second term. 

One of the factors that has supposedly fueled the current financial crisis is the mark to market rule put in place by Sarbanes Oxley. Under this rule, financial firms must keep securities on their books at the market price. The idea behind mark to market was to provide greater transparency into a firm's real value by providing a close to real time snapshot of the value of its holdings. However, in a declining market, the mark to market rules have forced companies to write down the value of securities to the point where the firm itself may appear insolvent. At this point rating agencies have no choice but to downgrade ratings which may force firms to increase collateral on loans, trigger default covenants in loans and make firms unattractive borrowers. Accordingly, some have called in the current crisis for relief from mark to market rules which make an entire firm's solvency dependent on the vagaries of the market.

While there is something to the argument that mark to market accentuated the current crisis, as John Kay writes today in the Financial Times, problems with mark to market in a decline are nothing compared to mark to market in a rising market.

Jeff Skilling at Enron supposedly broke open bottles of champagne upon receiving an SEC letter allowing Enron to make wide use of mark to market rules. The SEC ruling allowed Enron to book unrealized fluctuations in the value of securities as profits. As Kay notes, it gave Enron instant credit for the discounted present value of traders' ideas at the moment of inspiration--regardless of whether the ideas ultimately panned out. Under this logic, Sir Isaac Newton should have been a very rich man until the theory of relativity wiped him out. As Kay explains mark to mark during the bull market in housing and stocks that preceded the current financial crisis, helped bankers, prop traders, hedge funds and others make huge profits out of nothing.

Ultimately, behind the mark to market debacle is the central belief of our age: boundless, unlimited faith in markets. As Adam Smith discerned, markets are a wonderful way to allocate scarced goods relative to the alternative--some version of central planning. However, the same enthusiam cannot attach to the wide gyrations in market prices as money sloshes around the globe that clearly reflect not only animal spirits but old fashioned chaos, accentuated by human passions. The wild gyrations of the last few weeks are not guides to long term value. While instant prices are a tool in understanding value, they should not be the final word. Interestingly, even free market zealots like Newt Gingrich have come out in favor of suspending mark to market rules because of their impact in downturns. But as Kay points out, our real concern should be their impact in upturns.

It is time to re-examine the mark to market rule--and the idea behind it that market prices are infallible.

New York City -- Stuff happens, but in dissecting financial disasters, more often than not, it turns out that some singular event--usually regulatory--not mere chance, opened the gates to abuse.  In the S&L fiasco in the 1980s, one such event was the success by lobbyists in winning a rule change that allowed them to take unlimited brokered deposits, ie deposits not from you and me opening accounts, but through financial markets. From that point on, many banks bid for deposits with little thought of the interest rate, lent the money without oversight and, when markets turned downward, a disaster ultimately occured.

This time around, while there is still a sense that our current crisis just happened, the New York Times reports today that, once again, it was not an accident.  As revealed in the article, in 2004, in an obscure meeting held in the basement of the SEC building, Commissioners voted to approve a proposal by lobbyists of Wall Street's biggest firms, led by Goldman Sachs, to change the rules to allow the firms to increase their rates of leverage on equity up to 33 to 1. As long as their returns were greater than the cost of borrowing, this allowed them to juice their returns.  However, one or two bad investments at this leverage--for example in sub-prime loans--had the ability to go diastrously awry, wiping out the firm's entire equity.  This, in essence, is what has happened to the entire financial industry. It turns out there is a smoking gun in this crisis, a rule change secured by lobbyists--that had disastrous effects.

The Times goes on to report that in exchange for the unprecedented leverage, the firms promised to monitor their risk and the SEC set up an office to monitor risk as well.  Unfortunately, the office never became functional.  A software consultant and MBA who designed software used by banks to monitor risk was the lone dissenter in a letter to the SEC.  However, his letter and advice were ignored and the rule was approved unanimously.

Had the SEC followed through on the oversight it was supposed to perform, the consequences might not have been so dire.  But dergulation combined with abdication of all responsibility by the regulator, the SEC, provided fatal.  And we are now seeing the consequences. 

With news coming that the Senate has loaded up the bailout bill with a number of tax provisions, including an AMT patch and crucial tax credits for renewable energy, the House vote on the proposal, should it pass the Senate, looks to be a defining moment for pay-go.

Pay-go has been the largest stumbling block in extending renewable energy tax credits – a package so popular that it recently passed the Senate with a vote of 93 to 2. Now, a bipartisan agreement by Leaders Reid and McConnell to include these provisions in the bailout bill, which is predicted to pass the Senate tonight, will only be derailed if some in the House continue to insist on pay-go.

NDN has long argued that pay-go creates far too much arbitrary, artificial rigidity in the legislative and governing processes, and this bailout serves as a perfect example. Should a bipartisan bill designed to rescue the economy on the order of $700 billion fail due to a pay-go fight over far less costly tax provisions that are partially offset, the legacy of pay-go, a provision that doubtless has limited life to it anyway, will go from murky to downright laughable.

As the economy slides into recession, one can only hope that the popularity and job creation benefits of the tax credits, especially those for renewable energy, will garner enough votes to more than offset the votes lost from pay-go proponents.

Ann Coulter always has the special ability to infuriate me, yet somehow her post on Townhall.com last week still managed to surprise me. She blamed the morgage crisis and failing ecomony on affirmative action, stating that it took a Democratic Congress with a Democratic President for political correctness to ruin the financial industry. So to be fair, she really blames the Clinton administration and minorities.

New York Ciy--Felix Rohatyn used to remark, in telling the story of the New York City bailout,  that the Latin root of the word credit is credo, to believe.  When people believe they will get repaid they lend.  When they no longer believe, credit dries up.  This is what has happened in recent weeks as one financial institution after another has fallen victim to runs, most recently Washington Mutual.  In some cases, investors pulling their money were fellow firms as in the case of the runs on Bear Stearns and Lehman Brothers.  In these cases, some investors may have first shorted the stock, then pulled their money from the firm, news of which caused the stock to drop, and then covered the short to make sizable profits.  In the case of Wamu, ordinary savers pulled their deposits based on rumors of collapse.  While most of the discussion of the crisis has centered on bad loans, it is important to keep in mind that what has actually precipitated the collapse of the failed firms so far are runs on the bank. 

The air of desparation created by Hank Paulson with his emergency plan announced last Friday (after Goldman Sachs, his alma mater, was itself the victim of shortselling, dropping from 170 to 108 in about a week) and the desparate effort of President Bush and Ben Bernanke to sell the plan on the basis of fear, have, themselves, fueled the panic.

Had Treasury put forth a careful plan to deal with the mortgage crisis six months ago that included homeowner relief such as a proposal endorsed by Senator Clinton yesterday that has been floating around for some time to create a new Home Owner's Loan Corporation, similar to the one created in the 1930s to buy up bad mortgages and replace them with good ones and a mechanism to liquidate bad loans, this crisis might very well be over.

Instead, the release of a three page plan that gave sole authority for spending $700 billion to one man, the Treasury Secretary, and explictly barred judicial and other review, the clumsy effort to speed it into law, and exhortations by the sober stewards of our financial system, Mssrs. Paulson and Bernanke to pass this or else face doomsday, have if anything hastened doomsday.  At yesterday's White House meeting, the New York Times reported that Secretary Paulson actually got down on one knee to implore Speaker Pelosi to save the deal.

In finance, perception is a large portion of reality.  The crisis is navigable but only if our financial stewards take a deep breath, step back and provide a plan that addresses the real issues. 

What are the real issues?  They are twofold.  First, a number of large financial institutions have ended up holding large quantitites of depreciated paper that they acquired using leverage or borrowed money on their books.  They owe the money they used to buy the paper.  But the paper has declined in value.  They thus resemble homeowners that borrowed money to buy a house that has declined in value.  They may actually have negative equity.  What they need therefore is a capital infusion in the form of more equity--or equivalently for the government to buy the paper for more than its market value--what the Treasury plan proposes to do.  Overextended as they are, they are susceptible to runs--or investors taking back their money.

The second important issue is that millions of Americans are saddled with mortgages they can't afford.  The answer to this problem is what in commercial real estate is quite common and is called a workout.  Workouts amount to making a deal where the loans terms are modified so that the bank does better than it would through foreclosure but the borrower is able to make the payments.

The plan introduced to date is a form of creditor relief but offers no corresponding debtor relief.  It simply authorizes a transfer of funds from taxpayers to Wall Street.  As the New York Times said, it is shocking that so far, Secretary Paulson is unwilling to give bankruptcy judges the right to modify loan terms for mortgages when they have this right for other types of debt.  Missing from the deal is a meaningful plan to modify onerous loan terms to keep people in their homes.  A further deficiency of the deal is its extension to include any trouble assets such as credit card receivables as opposed to mortages, particularly in the absense of meaningful credit card reform.

There is time to resolve this crisis.  The Republicans who blocked the deal may well have done every one a favor by slowing down a proposal that does not go far enough to keep Americans in their homes.  There is time to develop good legislation but only if the principals stop their fear mongering and agree to something that works for Main Street as well as Wall Street.

(For a PDF version of this essay, click here)

Last Wednesday, Rob and Simon staked out early and important ground, making a forceful argument that of the many steps the government needs to take to address the worsening financial crisis, one of its top priorities must be to keep people in their homes. 

We at NDN are pleased to see how central this argument has become in the important debate taking place now in Washington and across the country. Building on this initial statement, Rob and Simon offer this new essay, which offers further analysis and additional recommendations:

Keep People in Their Homes

by Rob Shapiro and Simon Rosenberg

A decade of reckless deregulation, mismanaged regulation and equally reckless private mismanagement has now brought the American and global economies to a crisis point. Investment banks, hedge funds and other financial institutions have borrowed hundreds of billions of dollars to sink into securities widely recognized to entail extraordinary risk, passing that risk along to millions of Americans whose retirement plans, pension funds and money market accounts found their way into funds set up by such mismanaged financial titans as Lehman Brothers, Bear Stearns, Merrill Lynch and AIG.

Through it all, the White House, Treasury and Federal Reserve have practiced their own reckless regulatory mismanagement, allowing the gradual accretion of the biggest financial house of cards in history. Now it has caught up with them and the rest of us, and those who let it happen are asking taxpayers to spend hundreds of billions of dollars to clean up this mess.

This crisis is far from over, and its effects are still spreading. We need a broad plan that will actually work to restore financial and economic stability. But those who have had little or no hand in it - America's taxpayers and most Members of Congress - should not be steamrolled into giving a blank check to those in the Administration who failed to head off this crisis. There are three primary reasons this plan is the wrong solution to the problem.

First, the check they want us to write is unlike any ever written before during financial crises. When Washington last took over the failing assets of private institutions, during the savings and loan bailout, taxpayers first took over the institutions themselves and then sold the assets, while the regulation of the remaining S&Ls was tightened and reformed to preclude another round of the same problems down the road. This time, Congress is being told that it must use taxpayers' money to buy up the degraded assets of hundreds of financial institutions while they continue operating as private entities and without any guarantee of regulatory changes that will prevent it from happening the next time. That's a bad bargain and terrible policy.

Second, it's doubtful that the plan will even work in its own terms. If the Paulson Treasury plans to buy the deteriorating securities at their current, low market values, it may help the institutions holding them to avoid further deterioration, but it won't reduce the losses they've already taken. Consequently, this bailout cannot actually lead us out of the crisis - unless the Treasury plans to pay these institutions above-market prices for the tanking securities they now hold, which would produce the largest direct transfer of money from taxpayers to shareholders and executives ever seen.

Third, the plan does not address the forces which continue to drive this crisis. At the base of the pyramid scheme that has infected our financial markets - underneath the credit default swaps and collateralized debt obligations created with borrowed money to "guarantee" mortgage-backed securities created with more borrowed money, in a housing market swollen by a historic bubble - lies the only real assets in the picture, the mortgaged homes of tens of millions of Americans. On that critical score, the Administration plan offers nothing

The only way to stop the cascading financial crisis consuming not only investment banks, investment funds, mortgage lenders and insurance companies, but also pieces of most Americans' retirement security, is to stabilize the housing market from which all of the rest arises. The Treasury and the Administration propose to use taxpayers to bail out the institutions which speculated in the securities based on that market. Given the system's current precarious position, a bail out of some kind cannot be avoided. But our government owes at least as much attention to homeowners facing foreclosure. If the Treasury and Fed had been willing to spend $85 billion on loans to strapped homeowners, as they did to AIG last week, the crisis might never have crested into the conditions that now require a system-wide bailout.

These mortgages are at the root of the crisis. It's their mounting defaults driving down the overall housing market which has brought venerable banks like Lehman Brothers and Bear Stearns. Before Congress leaves this week or next, it should enact legislation that either provides a mechanism for direct loans to people to avoid foreclosure or allows them to renegotiate their mortgages. This single step will keep untold numbers of people in their homes, help stabilize the housing market, help contain the crisis at one of its critical origins, and thereby help shore up the financial system. Paired with a program to provide more liquidity to financial institutions and an orderly way to write down their failing holdings, this step could finally take us past this crisis.

Even so, only a small share of the costs of this historic mismanagement are apparent today. This financial shock, on top of the housing and energy shocks that preceded it, have almost certainly pushed our economy into recession. That will further reduce the value of the assets held by tens of millions of American through their pension funds, retirement accounts, money market and mutual fund investments. The squeeze will be hardest on the rising numbers of Americans who will also lose their jobs. The need to help these people and millions of others keep their homes is urgent, then, for a host of economic and social reasons.

When Congress returns in December or next year, it will find itself with far fewer resources to finance badly-needed new initiatives in health care, climate change and tax policy. One urgent order of business, however, will be entirely within its capacity: adopt and apply strict and appropriate transparency, capital and other regulatory standards to all financial institutions. And the politicians who hailed the hands-off attitude that enabled this crisis to fester and break out, and who now blame greed instead of their own negligence, must be held accountable.