Thursday, April 2, 2009

“We could have known better that foreign investors were not prepared for Lehman to collapse.”

From Real Time Economics:

By David Wessel

In the first — and not likely to be the last — lengthy behind-the-scenes account from veterans of the Bush administration, Phillip Swagel, who was assistant Treasury secretary for economic policy from December 2006 until January 2009, offers his take in a 50-page essay to be presented later this week at the Brookings Panel on Economic Activity. Swagel, who has an economics Ph.D. from Harvard, will teach at Georgetown’s McDonough School of Business in the fall. Swagel says academic economists think the government has more power than it does. “A lesson for academics is any time the word ‘force’ is used as a verb (‘the policy should be to force banks to do X or Y’), the next sentence should set forward the section of the U.S. legal code that allows such… action.” (Read the full paper.)

Among his points:

  • The Treasury predicted in May 2007 that “we were nearing the worst of it in terms of foreclosure starts” and the problem would subside after a peak in 2008. “What we missed is that the regressions didn’t use information on the quality of the underwriting of subprime mortgages in 2005, 2006 and 2007,” Swagel said — Federal Deposit Insurance Corp. staff pointed that out at the time.
  • The ill-fated 2007 Treasury proposal to create a privately funded entity — called MLEC, or Master Liquidity Enhancement Conduit – to buy up toxic assets from the banks was developed by the Treasury’s Office of Domestic Finance and shared with market participants without involvement from other Treasury senior staff. “The MLEC episode looked to the world and to many within Treasury like a basketball player going up in the air to pass without an open teammate in mind — a rough and awkward situation,” he said. He notes, though, that some elements of MLEC are present in the Obama administration’s Public Private Investment Partnership plan to joint venture with big money investors to buy loans and securities “though with the (huge) advantage of being able to fund the purchases through low cost government financing and with taxpayers assuming much of the downside risk.”
  • On the housing front, the Paulson Treasury staff did develop, though it never proposed, a plan to offer a federal subsidy to lenders willing to lower interest rates to reduce monthly payments for at-risk borrowers. A similar plan eventually was embraced by the Obama administration. Federal Reserve staff wanted to do more than the Paulson Treasury to aid homeowners who were underwater — that is, with mortgages greater than the value of their homes. “Among the White House staff in particular, but also within Treasury… there was no desire to put public money on the line to prevent additional foreclosures,” Swagel said. “The cynical way of putting this was that spending public money on foreclosure avoidance would be asking taxpayers to subsidize people living in McMansions they could not afford with flat screen televisions paid out of their home equity line of credit.” Swagel argued that — at least in late 2007 and early 2008 — there wasn’t much congressional interest in voting to spend money on foreclosures. “There were constant calls for Treasury and the administration to do more on foreclosure prevention, but this was just rhetoric.” Housing policy, he added, was “essentially static” until Congress passed the $700-billion Troubled Asset Relief Program, and the FDIC offered ways to tap that fund to avoid foreclosures, proposals that the Treasury considered badly flawed.
  • Treasury staff had “distinctly mixed feelings” about Secretary Paulson’s move towards “hardening the heretofore-implicit” government guarantee of Fannie Mae and Freddie Mac’s debt in July 2007. “Treasury Departments across administrations had sought to remove the implicit guarantee, not to harden it….[M] any people expressed to me their misgivings about what looked like a bailout in which GSE bondholders and shareholders won and taxpayers . It was hard to disagree,” he said. Paulson soon shared those misgivings and immediately set Treasury staff to work on the next step, the August move to put the companies in conservatorship.
  • The surprises to the Treasury on Monday, September 15, after Lehman Brothers filed for bankruptcy, were two-fold: “the breaking of the buck by the Reserve Fund [a money market fund] and the reaction of foreign investors to the failure of Lehman.” Swagel says it was impossible for the Treasury to anticipate that the Reserve Fund had so much Lehman paper, but, “We could have known better that foreign investors were not prepared for Lehman to collapse.”
  • “Saving AIG was not what anyone wanted, but at the time it seemed the only possible course of action….There was little time to prepare for anything but pumping in [government] money — and at the time only the Fed had the ability to do so for AIG.”
  • Paulson, on Sept. 18, set out three principles for Treasury staff: (1) He wanted any policies to be readily understood by markets. (2) Actions should be decisive and overwhelming,” in contrast to the July Fannie and Freddie move. (3) “Actions must have the explicit endorsement of Congress,” as opposed to continued to rely exclusively on the Fed.
  • Paulson “truly meant” to the use the $700 billion in TARP money to buy assets from the banks, not to buy shares in the banks, because he saw it as “a fundamentally bad idea to have the government involved in the ownership of banks.” He changed is mind when markets deteriorated and “he well understood that directly adding capital to the banking system provided much greater leverage.” The initial plan was to offer a matching program under which Treasury would invest a dollar for every dollar private investors kicked in, but that didn’t prove possible. Swagel, responding to critic, argues that the terms of the capital had o be generous because “there is no authority in the U.S. to force a private institution to accept government capital.”
  • As late the last week in October 2008, Treasury staff were still planning to conduct “reverse auctions” to buy assets from the banks, but about then it became clear that “the economy had deteriorated and the tide of public opinion had begun to turn against the TARP, so much so that there were real doubts as the whether Congress would release the second stage of the TARP funds at all.” (Congress had insisted on doling out the $700 billion in two chunks.)
  • To get access to the money, Swagel says, the Treasury knew it needed “a well-developed set of programs” and needed “to be able to explain what it was doing…never our strength.” So a decision was made in late October and announced by Paulson on Nov. 12 to abandon asset purchases. “Paulson knew that canceling the auctions would make it seem as if he was switching course yet again… He was willing to take the criticism… to keep the resources available for more capital injections.” But the program to invest the second $350 billion in the banks was never developed as events — namely the woes of Citigroup and U.S. auto companies — got in the way.

Paulson is writing his own account of the crisis, which he hopes to publish before year-end.

A spokeswoman for Paulson said he was traveling and couldn’t be reached for comment. In a recent interview with The Wall Street Journal and Dow Jones News Wires, Paulson said figuring out how to stretch the government funds was always a key challenge of managing the TARP. “It was clear to us that as much money as $700 billion is, it wasn’t enough by itself to directly purchase enough illiquid assets,” he said."

Me:

I found the paper fascinating. A few points:
“The Fed can lend,
however, against collateral to its satisfaction, so in principle the Fed could have lent
against Lehman’s unencumbered assets—essentially what it did with AIG. This would
not have saved the Lehman—indeed, it would have concentrated losses on the rest of the
firm—but it is possible that such lending could have provided time for a more orderly
dissolution of the firm (indeed, there are estimates that the disorderly bankruptcy reduced
the recovery value of the firm by billions of dollars). The feeling at Treasury, however,
was that Lehman’s management had been given abundant warning that no federal
assistance was in the offing, and market participants were aware of this and had time to
prepare. It was almost as if Lehman management was in a game of chicken and
determined not to swerve.”
1) The point is that saving Lehman would have allowed a more orderly unwinding, and, yes, the added losses were substantial.
2) Lehman assumed an implicit guarantee on a bailout, and acted as though they did. This should have been known, as later bailouts have shown that this was a widely understood part of the underlying basis of the financial system; namely, implicit government guarantees.
“The events together led to a run on money market
mutual funds, and this in turn caused commercial paper markets to freeze. If left
unstopped, this would have led issuers of commercial paper to turn to their backup lines
of credit—meaning that banks would have needed to massively fund these lines
simultaneously under circumstances that were never contemplated and then hoard capital
against those lines. As discussed by Ivashina and Scharfstein (2008), banks in the fall of
2008 did fund these lines as companies drew on them as a precautionary measure, but this
played out over time rather than all at once.
From the Treasury perspective, there appeared to be a broad run on the financial system.”
Yes, a Calling Run resulted, the beginning of Fisher’s Debt-Deflation Spiral. Since Bears had supposedly been saved to forestall a Calling Run, why the decision not to intervene here?
I have more points, but I’ll take up no more space.

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