Kabuki Financial Regulation

Posted: March 10, 2009 | Author: | Filed under: Equity Markets, Global Financial Crisis, No Obama, U.S. Economy | Tags: , , , , , , , | 3 Comments

kuniyoshi-kabuki-musicians

Much speculation has been made recently about the possible similarities between Japan’s lost decade and financial crisis during the 1990s and the current US Financial crisis.  It’s impossible to get through any graduate program in either finance or economics without spending time with the mounds of research the decade ignited.  Since many folks are talking and writing about this period in the popular business press and speculating on the chance of an L-shaped recovery similar to the one experienced by Japan, I thought I’d focus some on Japan’s Lost Decade.   There are some similarities but some important differences too.

About a month ago, The Economist asked if America’s crisis could rival Japan’s. Their answer was yes.  This article examines something we’ve looked at twice before. That would the IMF study of banking crises. Both the Nordic banking crisis and the Japanese banking crisis are including in the database and highlighted by the study.  The experience of these  rich country crashes have both been bandied about as possible road maps to financial system recovery.  Sweden nationalized its banks.  There was also the lesson from South Korea. This country recovered after two years. The there was Japan. It  let its banks languish. Japan became infamous for its decade of economic stagnation. Are we turning Japanese?

Japan’s property bubble burst in the 1980s and its run up prior to the bubble was smaller than ours.  Additionally, Japan has a high domestic savings rate.  America is the world’s largest debtor.

Judged by standard measures of banking distress, such as the amount of non-performing loans, America’s troubles are probably worse than those in any developed-country crash bar Japan’s. According to the IMF, non-performing loans in Sweden reached 13% of GDP at the peak of the crisis. In Japan they hit 35% of GDP. A recent estimate by Goldman Sachs suggests that American banks held some $5.7 trillion-worth of loans in “troubled” categories, such as subprime mortgages and commercial property. That is equivalent to almost 40% of GDP.

The authors of The Economist articles see both other differences too.

Japan’s central bank took too long to fight deflation; its fiscal stimulus was cut off too quickly with an ill-judged tax increase in 1997; and it did not begin to clean up and recapitalise its banks until 1998, almost a decade after the bubble had burst. But the history of bank failures suggests that Japan’s slump was not only the result of policy errors. Its problems were deeper-rooted than those in countries that recovered more quickly. Today’s mess in America is as big as Japan’s—and in some ways harder to fix.

Let’s look at the first statement about deflation.  We’re not experiencing deflation in all sectors.  The latest numbers from the BLS still show slight inflation.    However, we are looking at some tax increases in the near future.  Both Japan and the Roosevelt administration in 1937 instituted tax increases before both of these major financial crisis had be solved.  In 1937, it led to a second economic and financial market down turn. In 1997 Japan, it slowed down recovery.

Our dollar is strengthening as the financial crisis impacts the global economy.  Japan’s yen is similarly a strong world currency.  The dollar is still seen as a kabuki-dancersafe-haven asset.  However, Japan is a net exporter while the US is a net importer.  Japan is not a debtor nation, but a creditor nation.  Japan could still rely on exports to deliver some economic stimulus.  The US does not have that luxury.  However, while South Korea and Sweden’s currencies weakened and helped make their exports look cheap, Japan’s yen stayed somewhat strong.  This crippled Japan’s ability to fully use exports as stimulus making its recovery much longer than either those of South Korea or Sweden.  The dollar continues to strengthen which also makes any exports we send to the rest of the world relatively expensive.  It also continues our reliance on imports as they stay relatively cheap.

In some ways America’s macroeconomic environment is even trickier than Japan’s. America may have a big current-account deficit, but the dollar has strengthened in recent months. America’s reliance on foreign funding means the risk of a currency crash cannot be ruled out, however. That, in turn, places constraints on the pace at which policymakers can pile up public debt. And even if the dollar were to tumble, the global nature of the recession might mean it would yield few benefits.

I already mentioned that Japan’s households were historically good savers.  This meant only the Japanese corporations had to ‘deleverage’ or get rid of debt during the Japanese crisis.  I remember watching Japanese commercials at the time from the government extolling patriotic Japanese households to go spend like crazy at the same time the US government was telling Americans to consider saving.  Well, that trend is reversing.  Japanese households are beginning to decrease their savings rates, while Americans have rediscovered thrift.  This is also something we’ve talked about.  Here’s how that played in Japan and could play out differently here.

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Mortgaged Home, Sweet Mortgaged Home

Posted: February 18, 2009 | Author: | Filed under: Global Financial Crisis, Team Obama, U.S. Economy | Tags: , , , , , | 9 Comments

farm-1933-for-saleObama announced more details on his bailout plan that was focused more on borrowers instead of the lenders.  He released a four page fact sheet here.  There are three portions and The Economist does a pretty good job of summarizing them here.

First, the administration will increase the number of homeowners able to refinance at current, low mortgage rates. Borrowers whose mortgages are owned or guaranteed by Fannie Mae or Freddie Mac will be able to refinance a loan up to 105% of the home’s value (up from 80%, previously). This is expected to help about 4 to 5 million households who owe nearly as much or more than the value of their homes. This seems like a reasonable step to take, though as Calculated Risk notes, it’s a bit of a lottery. Those whose mortgages haven’t been purchased by Fannie or Freddie are basically out of luck.

The second part is the one that’s grabbed headlines; the president has dedicated $75 billion toward efforts to prevent foreclosures. Chief among these efforts is a plan to reduce monthly payments for troubled borrowers. For those spending greater than 38% of their income on mortgage payments, up to 43%, the government will ask lenders to reduce interest rates to bring payments down to the 38% level. The government will then match lender dollars, one-for-one, in bringing down interest payments until the borrower is only spending 31% of income. Both borrower and lender will be eligible for $1000 payments when payments are reworked, and if the planned payments are made. If it’s necessary to reduce principle, then Treasury will provide assistance with this, as well.

This portion of the plan has drawn criticism, since many homeowners with too-large payments are those who took on irresponsible loan structures or who simply purchased too much house—who behaved irresponsibly, in other words. Ideally, officials would no doubt prefer not to help such borrowers (just as they’d no doubt prefer to let bankers who’d made bad decisions go under). But frankly, that’s not a top concern of mine. Rather, I’m interested in whether or not this is the best way to use $75 billion to halt foreclosures.

The Economist has two concerns.  The first is that it may just delay foreclosure rather than solve it because:

… interest payments are being reduced first, and principle written down only as a last resort (such that many who take advantage of the programme will nonetheless remain underwater). Perhaps, but by trying to leave principle alone, the government is avoiding excessive transfers of wealth to borrowers. A shared-equity plan might have been better, but this will halt some foreclosures and incent homeowners to stay in their homes longer.

The second issue there are enough incentives in the bill to rework the payments.  On this point, they say:

Presumably, it’s already in the interest of lenders to reduce payments rather than foreclose, so it’s unclear whether $1000 is going to alter the balance. This, I think, is a more serious point. The housing plan passed last year to help rework problem mortgages seriously underperformed—where some 400,000 borrowers were deemed to be eligible, actual applications numbered in the tens.

The third portion of the plan seeks to “strengthen” Fannie and Freddie and to keep mortgage credit available and loan terms to ensure housing affordability.   The amount  scheduled for this is $200 billion.

David Leonhardt of the New York Times had this to say. His  blog thread concentrates on who is most likely to benefitfarm-foreclosure from the plan.  If you watched Obama’s speech, supposedly  the plan won’t help the ‘irresponsible’ speculator.  Leonhardt questions if the plan can successfully separate the homeowner is trouble by purchase motives.

But the lines aren’t quite as clear as Mr. Obama suggested. In fact, his plan will end up helping a fair number of people who bought homes that they should have known they would never be able to afford. The core of the plan gives banks a financial incentive to reduce many mortgage payments to no more than 31 percent of a borrower’s income.

Which homeowners will benefit from this reduction?

Certainly, some who took out a reasonable mortgage and later lost their job will be helped. But people who bought too much house — and banks that allowed people to do so, or even encouraged them to do so — will also benefit. As distasteful as this may be, it’s the only way to make a serious dent in foreclosures and, in the process, to help the financial system.

These same political calculations help explain the public emphasis that the White House is giving to the relatively modest steps it is taking to help underwater homeowners — those with a mortgage worth more than the value of their house — who can afford their monthly payments.

The actual details of the plan aren’t due out until March 4th when it goes into effect.  Market Watch had some interesting statistics for the plan today.  Here are the number of homeowners the plan itself says it will help.

The bill is supposed to help s many as 9 million households in fending off foreclosures:

  • Allows 4 million–5 million homeowners to refinance via government-sponsored mortgage giants Fannie Mae and Freddie Mac.
  • Establishes $75 billion fund to reduce homeowners’ monthly payments.
  • Develops uniform rules for loan modifications across the mortgage industry.
  • Bolsters Fannie and Freddie by buying more of their shares.
  • Allows Fannie and Freddie to hold $900 billion in mortgage-backed securities — a $50 billion increase