Monthly Archives: April 2009

Debt revamps hindered by credit default swaps Dealscape

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Chrysler files bankruptcy.  Let’s be clear about who is responsible here.  It is the banks, bondholders, and Wall St. that created the derivatives and Credit Default Swap (CDS) monster.  Derivatives have already created the current economic depression (Bear Stearns, Lehman, Merrill, etc).  Now the presence of CDS’s distorts the normal workings of a market economy and prevents the proper functioning of institutions.  In times past, the threat of bankruptcy (itself a centuries-old institution) worked to make all stakeholders: labor, capital, and management work together through difficult and unforeseen times.  Now, no longer.  Now capital demands full compensation with no risk.  It demands sacrifice by all others, but not itself.  It kills the goose in order to get a larger share.

THE DEAL PIPELINE SNEAK PEEK: Credit default swaps are complicating efforts to work out bank, auto and other restructurings outside of bankruptcy.

As the holders of billions in credit default swaps against a bankruptcy of General Motors Corp. and Chrysler LLC, the automakers’ lenders have so far rejected the government negotiators’ demands to greatly reduce their claims on the car companies.

Emboldened by credit default swaps, bondholders in other restructurings have resisted efforts to reduce the amount of money they are owed or refused to accept offers to swap debt for equity in hopes of at least sweetening the deal after a bankruptcy filing. They also are fighting to reserve their right to CDS payoffs, bankruptcy experts and analysts said.

The prevalence of credit default swaps has been blamed for at least worsening the financial crisis. Now they are complicating efforts to clean up balance sheets, ease debt burdens and unwind the tangle of financial obligations between financial firms and their counterparties — critical steps in reviving the economy.

GM: Some Bondholders Want Bankruptcy – BusinessWeek

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Business Week catches up to Econproph from last month.

The barriers to getting a deal done with GM bondholders, and negotiating away enough of that debt to strike a deal and avoid a planned, government-assisted bankruptcy, remain very big, with five weeks to go before the deadline.

…And second, some of the bondholders own credit default swaps, which amount to an insurance policy against the debt and pay them in full if GM defaults. Those bondholders actually fare much better if GM goes into bankruptcy.

Using Anti-trust to remedy “too big to fail”

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Simon Johnson, along with Joseph Stiglitz, and Thomas Hoenig argued yesterday in hearings that we need to break-up “too big to fail” banks. I heartily agree.

But of course our argument, both in the Atlantic and more broadly, is not against finance per se. In fact, we’ve received some strong expressions of support from within the financial sector – just not particularly from firms that are Too Big To Fail – as well as from many in the risk-taking entrepreneurial sector. And here Thomas Hoenig – President of the Kansas City Fed, with long experience regulating, winding down, and generally overseeing banks; and very far from being a sensationalist – absolutely nailed it towards the end of yesterday’s hearing. My recollection of his exact wording is: whenever you have banks that are too big to fail, you will get oligarchs yes, he said oligarchs.

But, we need to realize more than an act of congress is needed.   Ideology, economic theory, and the lure of oligarchs can prevent enforcement of even a recently passed anti-trust law. Remember it was almost 2 decades after the Sherman Act was passed before it was really enforced.

If we start looking at anti-trust as a way to prevent “too big to fail banks” (which I whole-heartedly endorse doing), we will run into another ideological roadblock from our freshwater economic friends. In this crisis we have already encountered the freshwater economic views of New Classical & RBC macro theories. These theories started with the assumption that the macro econ is at a general equilibrium and the (surprise!) draw the conclusion that no generalized glut or similar disequilibrium is possible.

Anti-trust has been neutered since Reagan I. With the exception of the Microsoft case and some explicit price-fixing cases, anti-trust enforcement has stalled. Anything goes. Bigger is better has been the Justice dept philosophy. And the intellectual foundation for the abandonment of anti-trust has been “contestable markets” theory and game theory – the idea that no market power will be exercised for fear of encouraging new entrants. It’s a theory that holds that 2 or 3 firms will engage in the same degree of competition that a plethora of small and medium firms will. In much the same way that macro became infatuated with elegant DGE models regardless of their empirical emptiness or uselessness, oligopoly and monopoly theory in IO has become enamoured of elegant game theory formulations that offer clever expressions of intriguing hypothetical situations, but they offer little empirical content, testability, or practical policy guidance. Just as macro needs to go back and re-learn some of Keynes’ (and Fischer and Wicksell) messy, inelegant insights into real economies, IO will need to re-discover structure, conduct, and performance.

As long as contestable markets and similar “the free market is self-regulating and self-limiting” ideology persists in Anti-trust division, even a new bill from Congress won’t help.

Macro: an awful mess today

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I was not alone.  Apparently Tim Harford of FT.com was also confused and disappointed while learning the modern macro models and theories.  I however figured it was a bunch of nonsense.  The assumptions made by modern macro models, particularly the Rational Expectations stuff of New Classical and New Keynesian theory are the problem.  By making assumptions that enable them to use their elegant math, they assume away any possibility of the model being useful.  The assumptions are not just “simplifying”, they are contra-reality.  It is as if I were to create a theory of flying in physics by first assuming that gravity cannot exist.  There’s a lot of work to be done in macro now to repair this failed research program.

I am struck by the soul-searching that has gripped the profession in the face of the economic crisis. The worry is not so much that macroeconomists did not forecast the problem – bad forecasts are more a sign of a complex world than intellectual bankruptcy – but that macroeconomics seems unable to provide answers. Sometimes it cannot even ask the right questions.

Willem Buiter, a former member of the UK’s Monetary Policy Committee who blogs for the FT, complains that macroeconomists have simply discarded the difficult stuff to make their models more elegant: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”

Mark Thoma offers additional insight at Economist’s View.

Krugman: Make Banking Boring

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If the real economy, the economy of making goods and services that improve people’s lives is to recover, we need to make banking boring again.  We need to focus on how to create goods, services, productive processes and real businesses.  These means giving up the gin, poker, and roulette games of high finance.  It will take real reform, but I am not optimistic of the chances for real reform.  (see here for why)  Today, Paul Krugman writes:

Much of the seeming success of the financial industry has now been revealed as an illusion. (Citigroup stock has lost more than 90 percent of its value since Mr. Weill congratulated himself.) Worse yet, the collapse of the financial house of cards has wreaked havoc with the rest of the economy, with world trade and industrial output actually falling faster than they did in the Great Depression. And the catastrophe has led to calls for much more regulation of the financial industry.

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come.

via Op-Ed Columnist – Making Banking Boring – NYTimes.com.

Mind the Wage Gap

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The real roots of the current crisis are structural changes in the American economy in the last generation.  We continued to fuel “prosperity” from increasing consumption of the middle and upper classes.  But, the during this period the middle class saw flat real incomes. To keep increasing our lifestyle, we had to borrow.  Why? Because while the middle class of the last 30 years has been increasingly productive, it has not shared the benefits of that productivity.   Read the full story at:   Mind the Wage Gap | The American Prospect.  An excerpt below the fold: Continue reading →

The definition of depression and recession

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A “recession” is actually well-defined.  A recession’s start and end are officially (in the US) declared by the National Bureau of Economic Research.   A “depression”, though is more subjective.  Personally I think we are now in a depression, but not one as big as the Great Depression –maybe we should call it the “little Depression” or “the newer depression”.

What is the difference between a recession and a depression?

THE word “depression” is popping up more often than at any time in the past 60 years, but what exactly does it mean? The popular rule of thumb for a recession is two consecutive quarters of falling GDP. America’s National Bureau of Economic Research has officially declared a recession based on a more rigorous analysis of a range of economic indicators. But there is no widely accepted definition of depression. So how severe does this current slump have to get before it warrants the “D” word?

A search on the internet suggests two principal criteria for distinguishing a depression from a recession: a decline in real GDP that exceeds 10%, or one that lasts more than three years. America’s Great Depression qualifies on both counts, with GDP falling by around 30% between 1929 and 1933. Output also fell by 13% during 1937 and 1938. The Great Depression was America’s deepest economic slump (excluding those related to wars), but at 43 months it was not the longest: that dubious honour goes to the one in 1873-79, which lasted 65 months.

via The definition of depression | Diagnosing depression | The Economist.