Resurrect the Resolution Trust Corp. - Paul Volcker

You may remember that I mentioned Paul Volcker in class. He was Fed chairman before Alan Greenspan and was the key figure in bringing inflation under control in the early 1980s. This is his assessment of the current financial crisis and his recommendation for dealing with it.

WSJ September 17, 2008

Resurrect the Resolution Trust Corp.

By NICHOLAS F. BRADY, EUGENE A. LUDWIG and PAUL A. VOLCKER

We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse.

Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis.

Fannie Mae and Freddie Mac, the giants in the mortgage market, are overextended and now under new government protection. They are not in sufficiently robust shape to meet all the market's needs.

The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms. This paper, in turn, is unable to support huge quantities of structured financial instruments, levered as much as 30 times.

Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy that so far has held up reasonably well.

There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. There are precedents -- such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.

Such a stabilizing mechanism would accomplish four much-needed tasks:

- First, by buying paper that otherwise is effectively not trading, it would help restore liquidity to the marketplace and help markets to function more fluidly again.

- Second, by warehousing the troubled paper for a longer period than, for instance, the Fed's discount window typically should or could, it would allow for a more orderly liquidation of this paper, and the chance for much of it to recover a portion of its value.

- Third, by giving the agency the ability to manage mortgages with flexibility to keep people in their homes and businesses running, it should lessen the number of foreclosures. This, in turn, would help moderate the decline in real estate values and the deterioration of neighborhoods, thus supporting house prices that in fact lie at the heart of the crisis.

- Fourth, where necessary, like the RTC of the 1980s, this new mechanism can assist the Federal Deposit Insurance Corporation in resolving sick institutions that are so clogged with the troubled paper they cannot continue as independent entities. However, we would hope that purchasing the mortgage-related paper will minimize the need to provide emergency, short-term assistance to solvent banking institutions.

It is certainly the case that the new institution we are proposing will in the short run require serious money. That will involve a risk to the taxpayer; but the institution, administered by professionals, means that ultimate gains to the taxpayer are also possible.

Moreover, a failure to act boldly in the fashion we are suggesting would cost the taxpayer and the country far more. The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link. A deteriorating financial system, diminished economic activity, loss of jobs and loss of revenues to the government is enormously costly. And the cost to our citizens' well-being is incalculable.

Crisis times require stern measures. America has done well in the past to face up to economic turmoil, take strong measures, and put our problems behind us. RTC-like mechanisms have worked well in past crises. Now is the time to take a similarly forceful step.

The American economy still has enormous underlying strengths. What we need, and in part are proposing, is a road map to financial stability.

Mr. Brady was U.S. Treasury secretary from 1988-1993. Mr. Ludwig was U.S. comptroller of the currency from 1993 to 1998. Mr. Volcker was chairman of the Federal Reserve from 1979-1987.

The Wall Street Journal
OPINION
SEPTEMBER 16, 2008

The Resilience of American Finance

By JEREMY J. SIEGEL

The turmoil in the financial markets will reorganize the financial landscape. But this does not mean the financial industry will shrink dramatically. In fact the current crisis could well lead to an increase in the demand for financial services, as the world grapples with the need for new financial instruments, new risk management techniques, and the increasing complexity of the financial world.

Getty Images

There is no doubt that some of the most hallowed names in the industry, such as Bear Stearns, Merrill, Lehman and others will disappear as separate entities. Their demise was caused by bad risk management, and a failure to understand the high risks of an overheated real-estate market, the root cause of our current problems.

We can argue about who was responsible for the overleveraging of the financial industry and the poor to nonexistent credit standards that prevailed in real estate. Certainly the regulatory agencies, including the Federal Reserve, should have sounded a warning. But the lion's share of the blame must go to the heads of the financial firms that issued and held these flawed credit instruments and then, in many cases, "doubled down" by buying more when their price was falling.

Overleveraging has been the cause of many past financial crises, and will undoubtedly be the cause of those in the future. It was the cause of the 1998 blowup of Long Term Capital Management, where the Fed also intervened to prevent a crisis. Then two years later the tech and Internet boom burst. If banks would have been allowed to buy on leverage these stocks during the bubble, they would have been in even more trouble than now.

But few were willing to admit that subprime real-estate loans could be as risky as stocks. It was just too profitable to issue these mortgages. So eyes were closed and the money kept pouring in. Groupthink prevailed. To paraphrase John Maynard Keynes, it is much easier for a man to fail conventionally than to stand against the crowd and speak the truth.

There is no doubt in my mind that if we didn't have a proactive Federal Reserve and deposit insurance, we would have been following the same course as we did in the 1930s, when the bursting of the stock bubble and fear of loan defaults led to thousands of bank failures and ushered in the Great Depression.

That will not happen this time. The rapid provisions of liquidity by the Fed will prevent any full scale downturn. In fact, I take it as a mark of confidence in our financial system that the Fed did not feel compelled to bail out Lehman Brothers as they did last March when they folded Bear Stearns into J.P. Morgan. Certainly politics played a role in this election year, as critics (and some Congressmen) criticized the government for bailing out the big boys, while letting homeowners twist in the wind.

Despite the recent turmoil, there is good evidence that the worst is over, especially for the commercial banks with access to Federal Reserve credit. Despite yesterday's severe sell-off, most are significantly higher than their July 15 low, and some such as Wells Fargo and UBS are up over 50%.

Nevertheless, the current crisis will change the financial landscape. Certainly Bear, Merrill, Lehman and others will disappear as separate corporate entitles. But other institutions, specifically the commercial banks that absorb these firms, and who have direct access to Federal Reserve credit, will become larger.

The demand for financial services will in no way disappear as the automobile pushed out the horse and buggy a century ago. Although unemployment on Wall Street will undoubtedly rise, many workers will be reabsorbed elsewhere in the industry. The current financial crisis calls out for new products and services as well as more, not less, information about what is safe and profitable in the future environment.

It is easy to be pessimistic about the future of financial services in the current climate. But objective facts indicate that the future demand for these services will be high. Looking beyond past losses, the demand for financial services, especially internationally, has been strong. The growth of the developing countries, combined with the aging in the developed countries, will lead to huge international capital flows that will be facilitated by new and existing financial intermediaries.

It is shocking that firms that withstood the Great Depression are now failing in what economists might not even call a recession. But their failure was not caused by lack of demand for their services. It was caused by management's unwillingness to understand and face the risks of the investments they made. The names of the players will change, but the future growth of the financial services industry is assured.

Mr. Siegel, a professor of finance at the University of Pennsylvania's Wharton School, is the author of "Stocks for the Long Run," now in its 4th edition from McGraw-Hill.

The Wall Street Journal
SEPTEMBER 16, 2008

Surviving the Panic

We're happy to report that the world didn't end yesterday, though sometimes it was hard to tell. A major Wall Street banking house filed for bankruptcy, the taxpayers didn't come to the rescue, and financial markets lurched but didn't crash. Amid the current panic, this is a salutary lesson that our fate is in our own hands and that a deeper downturn is far from inevitable.

The immediate priority is to calm markets and prevent a crash, and to do so it helps to recall how we got here. We are not living through some "crisis of capitalism," unless policy blunders make it so. Nor is this largely the fault of the Bush Administration, as Barack Obama claims, or of some lack of regulation, as John McCain asserts. These politically convenient riffs do nothing to reassure the public.

The current panic is the ugly aftermath of the credit mania that took flight in the middle years of this decade. As students of economic historian Charles Kindleberger know ("Panics, Manias, and Crashes"), financial manias throughout history have shared one trait: the excessive expansion of credit. This bubble was no different.

The Federal Reserve kept interest rates too low for too long, creating a subsidy for debt and a global commodity price spike. The excess liquidity and capital flows this spurred became the fuel for the wizards on Wall Street and in mortgage-finance who created new financial instruments that in turn fueled the housing bubble. As long as it lasted, nearly everyone inhaled the euphoria of rising asset prices and soaring profits. Normal risk assessment gave way to the excesses that always attend manias.

Enter the panic stage, or the great deleveraging that began some 13 months ago. Fear now trumps greed, while the short-seller and cash are kings. The core of our financial problem, as Treasury Secretary Hank Paulson said yesterday, is that these mortgage instruments are underpinned by real-estate assets whose value keeps declining. Until home prices stabilize, no one knows how large the losses will be. Thus no one is sure which financial companies are truly endangered, or how many.

Amid this turmoil and uncertainty, the challenge for policy makers is twofold: Protect the overall financial system from the fallout of individual bank failures, and protect the larger economy from recession caused by financial distress. They each require different policy levers.

On the finance side, there has already been much progress, albeit not enough. The banking system is reforming itself right before our eyes, without the advice of Congress or new regulation. The days of banks running with leverage at 30 or 40 to 1 are over. The companies that took those risks have either failed (Bear Stearns, Lehman) or been absorbed by others (Merrill Lynch, Countrywide). The SIVs, CDOs and other exotic creatures have been put back on balance sheets, losses have been taken, and new capital has been raised to absorb those losses. We are moving to a sturdier system.

On that score, Lehman's bankruptcy filing is another sign of progress. The Treasury and Fed have signaled they can say no. While Lehman's failure has spooked markets, the lesson that a storied investment house can fail without a federal rescue is its own crash course in risk management. The weekend decision by a group of major banks to establish a common fund to borrow against is also hopeful. The banks, which each anted up $7 billion to be part of this private lending fund, realize that acting in concert can serve their self-interest -- a lesson that J.P. Morgan would have applauded in the Panic of 1907.

Paul Volcker

And yet the financial system will remain fragile as long as asset values keep declining. More major bank failures are a certainty, including some very large ones. That means more Sunday soap operas like this month's, with all of the anxiety that inspires among the public. The longer these melodramas continue, the greater the risk of a recession.

Which leads us to suggest another Resolution Trust Corp. as one more tool to calm financial markets. The first RTC helped to buy, stabilize and liquidate troubled assets amid the savings and loan mess of the late 1980s. Then it blessedly went out of business. Former Fed Chairman Paul Volcker endorsed an RTC II yesterday in a speech in Naples, Florida, and we suspect the idea will gain more traction. He said he "reluctantly" embraced the idea for "dealing with the market breakdown, breaking the logjam of mortgages and other assets of uncertain value [and] restoring a sense of reasonable valuation and market confidence."

Yes, this would require a Congressional appropriation, and in that sense it would cost taxpayers. But by now it should be clear that some taxpayer money is going to be needed, if only to pay off insured depositors at failing banks. The Federal Deposit Insurance Corp. has already said it may need to borrow from its Treasury line of credit, and that's based on what could be optimistic estimates about home prices.

The taxpayer is also currently at risk through the Fed, which has become ever more creative with its use of the discount window. Its new lending facilities have been necessary amid this crisis, but they have also meant that the Fed is accepting ever-dodgier paper as collateral. Over the weekend it agreed to take non-investment grade paper. The danger is that all of this will put the Fed's own balance sheet at risk -- which would mean even bigger trouble. Better to put this bad mortgage paper on the Treasury side of the federal balance sheet.

Meanwhile, a new RTC would provide a buyer for securities for which there is no market, set a floor under the market, hold the securities until markets stabilize, and liquidate them in an orderly fashion, perhaps at a profit. Failed institutions and managers would not be bailed out. There's always a risk that the politicians will meddle, which is one reason for the Bush Administration to do this now so it can insist on enough political insulation.

As for the larger economy, the last 13 months are a guide to what not to do. The Fed recklessly cut interest rates, while Congress and the White House dropped "rebate" checks from helicopters. The rate cuts ignited another oil and commodity spike that walloped middle-class consumers, while the rebates did nothing to change incentives or lift investment.

We hope the Fed heeds this lesson and holds firm on rates today. Yesterday it injected $70 billion in liquidity to stabilize the fed fund rate at its peg of 2%, as it should in a crisis. But that money can be withdrawn over time as the crisis eases. Meanwhile, a more cautious monetary policy overall will help the dollar, which in turn will mean lower oil prices and more capital flows to the U.S.

What the economy really needs is a big pro-growth tax cut, the kind that will restore confidence and risk-taking. This is an opportunity for both candidates, but especially for Mr. McCain. Instead of focusing on an extension of the Bush tax cuts, the Arizonan should offer his own tax cut to revive capital markets and prevent a recession. Democrats will claim he's helping "the rich," but our guess is that every American who owns a 401(k) will figure he's one of those "rich."

One great lesson of past panics is that they needn't become crashes, if policy makers make the right decisions. Thirteen months into this crisis, the best choices are the same as they were last August: energetic emergency plumbing to protect the financial system, steady monetary policy to defend the dollar, and a tax cut to spur growth. It's also the kind of agenda -- and leadership -- that could win an election.

Hurricane Ike: Get Ready For Soaring Gasoline Prices

Hurricane Ike: Get Ready For Soaring Gasoline Prices

Posted By Keith Johnson On September 12, 2008 @ 12:51 pm In Gulf of Mexico, Gasoline, Refining | 24 Comments

Hurricane Ike is bearing down on the Texas coast like an eerie reminder of the deadly 1900 storm that mauled Galveston, and represents a perfect-storm scenario of possible damage to vulnerable refining, chemical, and shipping industries.

As Ike’s Category-2 winds start pounding one-quarter of America’s oil-refining capacity, what’s the likely outcome in terms of gasoline prices and shortages? Reuters quotes one breathless meteorologist:

“Hurricane Ike is a gigantic Category 2 monster and is likely to generate a massive and particularly destructive storm surge at key refinery centers,” said Jim Rouiller, meteorologist with private weather forecaster Planalytics. “Close to 20 percent of the U.S. refining capability could be lost for a long period of time.”

But what’s a “long period of time”? The folks at The Oil Drum have been trying to divine how Ike’s storm surges and inland flooding could affect Texas’ refining capacity. In a nutshell, it doesn’t look good—with some outages potentially lasting the rest of the year:

The key question is refinery damage…Current models are showing that there will be at least 1 MMBBL offline for 30 days, with the potential for 5 MMBBL offline at 30 days and 4 MMBBL at 60 days, 1 to 2 MMBBL out through the end of the year. That would certainly cause
significant shortages of refined products (eg gasoline).

You don’t have to tell Houston drivers. On their way out of town, many have already run into long gasoline lines—and some service stations have already run out of fuel, thanks to the early refinery shutdowns prompted by Ike’s arrival.

If Americans thought $99 oil meant the end of $4 gasoline, Ike might just make them think again.

Plan Skirts Housing's Biggest Troubles

Rescue Won't Fix Falling Home Prices, Rising Foreclosures

By MICHAEL CORKERY
September 8, 2008; Page A14

The government takeover of Fannie Mae and Freddie Mac likely will help ease mortgage rates for home buyers, say economists, home builders and housing experts. But it won't cure the housing market's biggest ailments: falling home prices and rising foreclosures.

"This is another marginal step in the right direction," says Richard DeKaser, an economist at National City Corp., a large Cleveland bank. "But it doesn't resolve the glut of homes on the market or remove pressure on prices."

The housing market is stuck in a vicious cycle. It started with an oversupply of homes that eventually caused prices to plummet. Falling prices led to waves of foreclosures, as homeowners ran into problems refinancing their mortgages or selling their houses. Banks are reluctant to lend when home values keep sinking and defaults are rising, curbing housing demand further and fueling more price drops and defaults.

Investors and economists feared that a collapse of Fannie and Freddie would greatly exacerbate the downward spiral by essentially freezing the mortgage market. "The government's move takes that serious disruption to the financial market off the table," says Mark Zandi, chief economist at Moody's Economy.com.

Mr. Zandi says that while the takeover of the mortgage giants won't immediately stop the home-price slide, it should limit price declines to 5% to 10% over the next year, rather than the doomsday scenario of additional declines of 15% to 20% that some economists were predicting if Fannie and Freddie failed or pulled back dramatically....

Mounting Woes Left Officials With Little Room to Maneuver

By DEBORAH SOLOMON, SUDEEP REDDY and SUSANNE CRAIG
September 8, 2008; Page A1

WASHINGTON -- In the end, Fannie Mae and Freddie Mac had no choice.

Summoned to separate meetings on Friday with Treasury Secretary Henry Paulson and other top officials, the two mortgage giants were told they could either agree to a government takeover or one would be foisted upon them.

"We have the grounds to do this on an involuntary basis, and we will go that course if needed," Mr. Paulson told senior executives at the two companies, who had little idea such a move was coming, according to three people familiar with the meetings.

There was no dramatic trigger, nor was there fear of imminent collapse. Instead, the sweeping government intervention stemmed from a growing realization by Treasury and Federal Reserve officials that the two companies couldn't survive in their present forms, and that any collapse would be devastating to the economy.

The decision was hashed out over weeks of meetings. They included a conclave of Federal Reserve officials during their annual retreat at Jackson Hole, Wyo.; a mid-August polling of bond-market players by Morgan Stanley bankers advising Treasury; and a marathon session over the Labor Day weekend, fueled in part by Diet Coke and Coke Zero.

Dozens of bankers and lawyers were involved in the process. One junior banker joked that the round-the-clock schedule was tougher than prison -- at least there, you got three square meals a day.

In the end, Mr. Paulson, Federal Reserve Chairman Ben Bernanke and James Lockhart, head of the companies' regulator, the Federal Housing Finance Agency, concluded that the two companies had lost the confidence of the markets and couldn't survive as currently structured. No one could say how much money from the Treasury, either via a loan or an equity investment, would be enough to get them through the housing mess. Hence, the need for the government to step in and stabilize what has become a vital cog for the housing and mortgage market.

This account of the government's dramatic decision is based on interviews with government, Wall Street and company officials and others.....

U.S. Seizes Mortgage Giants

U.S. Seizes Mortgage Giants
Government Ousts CEOs of Fannie, Freddie; Promises Up to $200 Billion in Capital
By JAMES R. HAGERTY, RUTH SIMON and DAMIAN PALETTA
September 8, 2008;

In its most dramatic market intervention in years, the U.S. government seized two of the nation's largest financial companies, taking direct responsibility for firms that provide funding for around three-quarters of new home mortgages.

Treasury Secretary Henry Paulson announced plans Sunday to take control of troubled mortgage giants Fannie Mae and Freddie Mac and replace the companies' chief executives....

With that, the U.S. mortgage crisis entered a new and uncharted phase, potentially saddling American taxpayers with billions of dollars in losses from home loans made by the private sector. Bush administration officials argued that the cost of doing nothing would be far greater because of the toll on the economy of falling home prices and defaults in the $11 trillion U.S. mortgage market....

By taking this action, the government has seized control of the vast bulk of the secondary market for home mortgages and will have a more direct responsibility than ever for solving the housing crisis. The intervention also marks the failure of the public-private experiment that was created to boost home ownership among Americans. Fannie and Freddie were created by Congress to help prop up the housing market, and investors have long believed the government would bail the companies out in a crisis. But the companies have long been owned by private shareholders seeking to maximize profits.


The move is also likely to nudge down mortgage rates for consumers, who are facing the worst housing bust since the 1930s. Despite steep interest-rate cuts by the Federal Reserve, the cost of a typical 30-year fixed-rate mortgage has remained well over 6% for most of the past year....

Without government support for the mortgage market, home prices would fall much further, exposing the country as a whole to greater economic strain...