Fisher quotes Deng Xiaoping
According to this BW article, titled "Forget Adam Smith, Whatever Works", Federal Reserve Bank of Dallas President Richard W. Fisher, in addressing the high and mighty of global finance in Washington during pivotal meetings of the Group of Seven and the International Monetary Fund, borrowed a Chinese proverb popularized by the late Chinese leader Deng Xiaoping: "No matter if it is a white cat or a black cat, as long as it can catch mice, it is a good cat."
Washington's partial nationalization of banks marks a fundamental shift in thinking about the relationship of the public and private sectors.
Read more about the future of capitalism.
Derivatives and Mass Financial Destruction
Complex financial products can be useful if regulated properly (source: wsj)
Proposals for a makeover of the financial system include reform of the credit derivatives market, which offers over $50 trillion of default insurance coverage. Do investors need that much insurance, or is this mainly a dangerous casino operating under the radar of regulators — until a major financial institution like AIG needs a bailout? What sort of reform is needed?
The seller of protection in a credit derivatives contract receives premiums from the buyer of protection until maturity, or until default of the named borrower. Contracts are negotiated over the counter, not on an exchange, so it is difficult to know how much insurance exists on each borrower, or to know who has insured whom, and for how much.
That privacy is not unusual in the normal course of business contracts. What is unusual is the size of the potential claims. There is a public interest in knowing that systemically important sellers of protection have not overdone it. If a large bank or insurance company does not have enough capital to cover settlement claims, then its failure, or the threat of it, can cause mayhem, as we have just seen.
The largest credit derivatives positions are held by big-bank credit derivatives dealers. Because they intermediate between buyers and sellers, dealers often have nearly offsetting positions. For example, according to J.P. Morgan's latest quarterly report, it had bought protection coverage on $5.2 trillion of debt principal, and sold protection on $5 trillion. The vast quantity of outstanding derivatives in the global market is therefore not a good gauge of the effective amount of insurance offered.
Of the $532 trillion notional amount of financial instruments covered by over-the-counter derivatives in June of this year — including credit derivatives, interest-rate swaps and equity derivatives — the International Swaps and Derivatives Association estimates potential exposures to counterparties of $2.7 trillion. These exposures are further reduced by collateral held against the potential failure of counterparties.
Of roughly $350 billion in credit derivative settlement claims that arose in Lehman's default, about $6 billion in actual settlement payments were scheduled for payment yesterday, after canceling offsetting claims. For illustration, suppose that Goldman Sachs had sold protection to the point that it owed $7 billion in Lehman settlement claims, and had purchased protection on which it was owed $7.5 billion. In this situation, Goldman would collect a net of $0.5 billion, unless a counterparty fails to pay. Suppose that one of Goldman's counterparties, say a hedge fund, had failed to pay Goldman a $100 million settlement claim. If Goldman had received the industry-average 65% collateralization from its counterparty, it would keep the collateral and be out $35 million. Goldman could then pursue additional recoveries as a claimant in the hedge fund's bankruptcy. The Depository Trust & Clearing Corporation, which keeps records of the majority of credit derivatives trades and settlements, reported yesterday that there were no payment failures on scheduled Lehman credit derivative settlements.
So far, the credit derivatives settlement process has worked smoothly through several large defaults, but the safety of the settlement process could be improved significantly. Because dealers lay off such large positions with each other, a large fraction of their exposures is unnecessary. For example, suppose that Bank A is exposed to Bank B for $1 billion, while B is exposed to C for $1 billion, and C is exposed to A for $1 billion, all on the same underlying named borrower. That circle of exposures is eliminated if all three banks clear their positions with the same central clearing counterparty. Because Bank A is long and short by the same amount, it would have no settlement payment to make or to receive from the clearing counterparty. Banks B and C would likewise have no potential loss. In practice, exposures would not be offset so neatly, but a large fraction of them would.
The Fed is pressing dealers to quickly establish clearing in credit derivatives. The dealers have expressed an interest in using their own clearing counterparty, the Chicago Clearing Corporation. Alternatively, they could clear credit derivatives with a new joint venture of the Chicago Mercantile Exchange and Citadel (a large hedge fund). Either way, regulators should ensure that a clearing counterparty is extremely well capitalized and has strong operational controls.
Unfortunately, the urgency to set up clearing for credit derivatives may lead us to miss the opportunity to reduce exposures even further by clearing credit derivatives along with other forms of over-the-counter derivatives, such as interest-rate swaps and equity derivatives, which represent similarly large amounts of risk transfer. Regulators should press dealers to clear more types of derivatives with the same clearing house.
That investors can benefit from a market for insurance against default risk does not seem controversial. The market premiums offered on credit derivatives also provide investors with "price discovery" of the financial health of corporations and sovereign states. (Although trading is private, samples of prices are disseminated by financial news services.)
There is a public interest in limiting the exposure of large, systemically important financial institutions, relative to their capital, whether from derivatives or from other forms of risk taking. We were supposed to have had such limits, but they were not effective, and will presumably be revisited by regulators soon.
Regulators should also have access to more detailed information on the potential exposures of large financial players to each other. But general public disclosure of specific derivatives trades seems unnecessary in most cases, can lower incentives to invest efficiently, and runs counter to our norms for privacy. We do nothing like this in other financial markets, such as those for common stocks, except when positions are large enough to suggest the potential control of public corporations. (Derivatives do not carry control rights.)
Public disclosure can nevertheless be a good disinfectant whenever sufficiently severe conflicts of interest lead to inefficient control of risk (moral hazard) or to unfair exploitation of counterparties. If a lender can largely insure itself against its borrower's default, it has lessened its interest in the financial health of the borrower, and may neglect to monitor the borrower. Default losses to the lender would be passed on to credit derivatives counterparties, who may not be aware of the conflict of interest.
When unconstrained by good regulations, derivatives can be financial weapons of mass destruction. Our new regulations should be smart and surgical.
Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.
Crisis Hits Ivory Tower
Crisis Shakes the Foundations of the Ivory Tower
The financial and economic tsunami that has ripped through Wall Street and the housing market is beginning to wash across the college green.
Higher education hasn't yet seen anything to compare with foreclosures and bank nationalizations in the private sector. But seized-up credit markets, shrinking endowment funds and a reduction in state subsidies are punishing universities from California to Vermont.
A campus construction boom is slowing, administrations are cutting jobs and faculty may be forced to pay more into their pension funds. The demise of a $9.3 billion investment fund used by 900 colleges has some schools scrambling to pay their bills.
It all brings a gloomy pall to what has been, until recently, a booming industry. Higher education has grown rapidly in the last half-century into a formidable slice of the economy. U.S. colleges and universities spend $334 billion annually, employ 3.4 million people and and enroll 17.5 million students.
The boom was powered by a growing stream of donations, strong returns on endowments, rising enrollments and tuition prices that climbed well above the rate of inflation — paid, more and more, by families who borrowed heavily to meet the bills.
All of these wealth generators for the Ivory Tower are facing threats in the current economic turmoil. The cratering stock market has already hit endowments. Falling markets typically take a toll on gifts, many of which are made, for tax reasons, in the form of appreciated stocks and bonds. Analysts and schools are predicting even bigger tuition increases than those seen so far. But this time, families may be in no position to meet the higher bills. Falling house prices have sapped their ability to use home-equity loans for tuition payments, and the credit crunch has forced many lenders to stop making student loans.
At a time when many political candidates — notably Democratic presidential nominee Barack Obama — are stressing the importance of access to college to the country's economic future, financial exigencies threaten to offset or overcome anything the government can do to promote more college attendance.
"This is the worst environment for colleges I can remember," says Mark Ruloff, a consultant at Watson Wyatt in Arlington, Va., who advises college endowments. With their ability to raise capital curtailed by the crisis, schools may be forced to sell their most liquid endowment assets at a time when the markets are not offering much, he predicts.
Molly Corbett Broad, president of the American Council on Education, which represents 1,600 colleges and universities, says public schools face the greatest challenge in a slumping economy because they get as much as three-quarters of their revenue from state taxpayers.
She says students could face double-digit tuition increases next year, up from the typical 4% to 6% level in recent years. Some university presidents privately confided to her that their institutions, which she declined to name, are even considering midyear tuition hikes. Ms. Broad adds that small private colleges without hefty endowments may have to consider merging with bigger rivals.
Some colleges are already feeling squeezed. As part of steep statewide budget cuts, the University of Massachusetts system this week said it would have to cut its budget by about $25 million, or 5%. The flagship Amherst campus froze hiring in all but the most critical positions. To avoid reductions in financial aid or increases in fees, the University of Massachusetts president, Jack M. Wilson, promised work force cuts and consolidations.
Boston University's president sent faculty a letter late last month announcing that the school is imposing a freeze on new hires and new construction projects. The crisis, Robert A. Brown wrote, has "created unprecedented volatility for our students, their parents and the University."
The debt markets' breakdown comes at an inopportune time for colleges, which have been building gyms and dorms to attract top students. College construction soared to $15 billion in 2006 from $10 billion in 2001, according to College Planning and Management magazine. The figure slipped slightly to $14.5 billion in 2007 amid concerns about a weakening economy.
The state of Colorado has frozen hiring and state construction projects, including about $50 million worth at public universities, such as the renovation of an arts and science center at the University of Colorado at Boulder.
The Tennessee Board of Regents, which oversees the University of Memphis, five other universities and 13 community colleges, has been forced to cut $58 million since July.
Bob Adams, vice chancellor for business and finance, says the system, with 190,000 students, may have to increase tuition "fairly significantly" next year. Including tuition, room and board and other fees, students typically pay $12,500 annually.
The University of Memphis recently announced a voluntary employee buyout program. Mr. Adams says schools are also delaying equipment purchases, such as laboratory equipment, and library acquisitions, including books and subscriptions. He says he suspects that classes will get larger because of rising enrollments and shrinking staffs. "It may get to the point where we don't have the facilities to meet the demand," Mr. Adams says.
The University of California, Berkeley, faces $28 million in cuts or unavoidable cost increases for the academic year that began in July, according to Nathan Brostrom, vice-chancellor of administration. He says that rising health care costs will result in an 11% increase in the cost of providing medical and dental benefits to staff starting in 2009. Starting in July, Berkeley faculty and staff have been told to expect to make contributions to their pension funds for the first time since 1990 because slumping stock markets have eaten away the pension surplus.
Before the meltdown, richer colleges such as Harvard and Yale had responded to pressure from Washington and started to spend more of their endowments to lessen the tuition burden. Endowments have swelled in recent years, with 785 of the wealthiest holding more than $400 billion in assets as of 2007.
Now, Moody's Investors Service, the bond rater, is projecting endowment returns to be negative for the first time since 2002. In a report Thursday, the ratings agency estimates that college endowment losses averaged 5% to 7% in the year ended June 30. Since then, including spending and stock market losses, Moody's figures colleges experienced another 30% decline in cash and investments.
The crisis has even made colleges wary about where they keep their ready cash. Earlier this month, a fund that invests cash for about 900 colleges suddenly froze withdrawals. Schools, which can now withdraw about 40% of their money, may not be able to get all of it back until 2011.
Before Wachovia Corp., the fund's trustee, said it was terminating the fund, it held $9.3 billion in assets. The Commonfund Short-Term Fund, used like a checking account at many schools, invested in some mortgage-backed securities that now can't be sold for their full value.
At the University of Vermont, the finance chief secured a $50 million outside line of credit from a local bank to ensure he meets payroll and other monthly obligations — a move he made after learning the school cannot withdraw a chunk of the $79 million it held from a short-term cash fund until next year at the earliest.
Charlie Rose with Paul Krugman
Charlie Rose interview with 2008 Nobel Economics winner Paul Krugman.
Krugman: Why the crisis spread to emerging markets?
Paul Krugman writes on today's NY Times:
The really shocking thing, however, is the way the crisis is spreading to emerging markets — countries like Russia, Korea and Brazil.
These countries were at the core of the last global financial crisis, in the late 1990s (which seemed like a big deal at the time, but was a day at the beach compared with what we’re going through now). They responded to that experience by building up huge war chests of dollars and euros, which were supposed to protect them in the event of any future emergency. And not long ago everyone was talking about “decoupling,” the supposed ability of emerging market economies to keep growing even if the United States fell into recession. “Decoupling is no myth,” The Economist assured its readers back in March. “Indeed, it may yet save the world economy.”
That was then. Now the emerging markets are in big trouble. In fact, says Stephen Jen, the chief currency economist at Morgan Stanley, the “hard landing” in emerging markets may become the “second epicenter” of the global crisis. (U.S. financial markets were the first.)
What happened? In the 1990s, emerging market governments were vulnerable because they had made a habit of borrowing abroad; when the inflow of dollars dried up, they were pushed to the brink. Since then they have been careful to borrow mainly in domestic markets, while building up lots of dollar reserves. But all their caution was undone by the private sector’s obliviousness to risk.
In Russia, for example, banks and corporations rushed to borrow abroad, because dollar interest rates were lower than ruble rates. So while the Russian government was accumulating an impressive hoard of foreign exchange, Russian corporations and banks were running up equally impressive foreign debts. Now their credit lines have been cut off, and they’re in desperate straits.
Mankiw: Have we learned enough?
From today's NY Times.
But Have We Learned Enough?
LIKE most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.
But when Olivier Blanchard, the I.M.F.’s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was “nearly nil.” He added, “We’ve learned a few things in 80 years.”
Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?
The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.
In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.
But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)
According to the economic historian Christina D. Romer, a professor at the University of California, Berkeley, the great volatility of stock prices at the time also increased consumers’ feelings of uncertainty, inducing them to put off purchases until the uncertainty was resolved. Spending on consumer durable goods like autos dropped precipitously in 1930.
Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.
The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.
As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts.
Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy’s ability to channel financial resources toward their best use was seriously impaired.
Together, these forces proved cataclysmic. Unemployment, which had been 3 percent in 1929, rose to 25 percent in 1933. Even during the worst recession since then, in 1982, the United States economy did not experience half that level of unemployment.
Policy makers in the 1930s responded vigorously as the situation deteriorated. But like a doctor facing a patient with a new disease and strange symptoms, they often acted in ways that, with the benefit of hindsight, appeared counterproductive.
Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt‘s decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.
Less successful were various market interventions. According to a study by the economists Harold L. Cole and Lee E. Ohanian, both of the University of California, Los Angeles, and the Federal Reserve Bank of Minneapolis, President Roosevelt made things worse when he encouraged the formation of cartels through the National Industrial Recovery Act of 1933. Similarly, they argue, the National Labor Relations Act of 1935 strengthened organized labor but weakened the recovery by impeding market forces.
LOOKING back at these events, it’s hard to avoid seeing parallels to the current situation. Today, as then, uncertainty has consumers spooked. By some measures, stock market volatility in recent days has reached levels not seen since the 1930s. With volatility spiking, the University of Michigan‘s survey reading of consumer sentiment has been plunging.
Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.
The Fed and the Treasury Department, intent on avoiding the early policy inaction that let the Depression unfold, have been working hard to keep credit flowing. But the financial situation they face is, arguably, more difficult than that of the 1930s. Then, the problem was largely a crisis of confidence and a shortage of liquidity. Today, the problem may be more a shortage of solvency, which is harder to solve.
What’s next? Perhaps the most troubling study of the 1930s economy was written in 1988 by the economists Kathryn Dominguez, Ray Fair and Matthew Shapiro; it was called “Forecasting the Depression: Harvard Versus Yale.” (Mr. Fair is an economics professor at Yale; Ms. Dominguez and Mr. Shapiro are at the University of Michigan.)
The three researchers show that the leading economists at the time, at competing forecasting services run by Harvard and Yale, were caught completely by surprise by the severity and length of the Great Depression. What’s worse, despite many advances in the tools of economic analysis, modern economists armed with the data from the time would not have forecast much better. In other words, even if another Depression were around the corner, you shouldn’t expect much advance warning from the economics profession.
Let me be clear: Like Mr. Blanchard at the I.M.F., I am not predicting another Great Depression. We have indeed learned a lot over the last 80 years. But you should take that economic forecast, like all others, with more than a single grain of salt.
N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President Bush and advised Mitt Romney in his campaign for the Republican presidential nomination.
Sachs: "We need Nodic models"
Jeff Sachs crys out, "We need bigger government". Are we going to see a reversal of intellectual thinking? (audio source: Bloomberg)
Capital Flow and Crisis
Reinhart's write about capital in and out hot region and crises:
A pattern has often been repeated in the modern era of global finance. Global investors turn with interest toward the latest “foreign” market. Capital flows in volume into the “hot” financial market. The exchange rate tends to appreciate, asset prices to rally, and local commodity prices to boom. These favourable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weaknesses in the domestic banking sector even as those local institutions are courted by global financial institutions seeking entry into a hot market.
But tides also go out when the fancy of global investors shift and the “new paradigm” looks shop worn. Flows reverse or suddenly stop à la Calvo and asset prices give back their gains, often forcing a painful adjustment on the economy.
In a recent paper, we examined the macroeconomic adjustments surrounding episodes of sizable capital inflows in a large set of countries. Identifying these “capital flow bonanzas” turns out to be a useful organising device for understanding the swings in investor interest in foreign markets as reflected in asset price booms and crashes and for predicting sovereign defaults and other crises.