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Will Bailout Work - Jean Kaplan

Will Bailout Work - Jean Kaplan

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Published by: hihik on Oct 13, 2008
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Jean Kaplan
October 7, 2008
Bailout plan: Will it work is not quite the right question. Will it prevent a recession? Clearly not. This boom hasbeen driven by something of a self perpetuating increase in asset prices fuelled by the availability of credit. Thisallowed people to become rich (on paper) and they behaved accordingly. Now that credit has tightened, assetprices are declining because people no longer have the credit to keep the prices afloat. As asset prices decline,people become poorer. The US consumer spent by borrowing (often against their house value). Now they will nolonger be able to do so and will modify consumption behavior accordingly. Reductions in consumption will causebusiness to become unprofitable and close, people will lose their jobs, and this will continue until a newequilibrium in the economy is found. Add to that a global economic slowdown, and it just means that theequilibrium will be at a lower point and will take longer to find. Right now this is a crisis in the banking system,but it is already spreading to the real economy. The severity of the impact on the real economy will bemagnified or limited by the magnitude and duration of the banking crisis. On a historic basis, US house pricesare still out of line with incomes -they need to come down to a sustainably affordable level, so this whole crash,in a sense, is a painful but desirable reallocation of capital in the economy.To go back to the fundamentals of how this happened: the GSEs (Fannie, Freddie) are charged with freeing upcapital in the mortgage system by buying up loans from regional banks that originate mortgages. They had verystrict mandates for what kind of loans they could buy (size of loan, documentation supporting loan, loan tovalue ratio, etc.) but these standards were loosened as part of a government initiative to extend homeownership and affordability. The originating bank keeps the loan if the loan does not conform, but is able toresell it to the GSEs when it does. When the loan is resold, the originating bank simply acts as a commissionedbroker, and is not as concerned about what happens to the loan after it is resold. Historically, loan to incomeratio in the US has been 2.5 to 3.5, which keeps the monthly payment value at around 30% of gross monthlyincome. In the 2004-2006timeframe, loan to income ratios rose to around 5, which brings it to60% of grossmonthly income. Furthermore, people were allowed to lever their purchases up even more by taking out loansthat have a 2-partinterest rate structure (people would want to do this because they would enjoy proportionallymore appreciation in a more highly leveraged transaction, while the bank can broker more and larger deals) -meaning that you are speculating either on an increase in your income, if you intend to stay in the home, or arespeculating on above-historical rate of price appreciation, if you intend to sell it back to the market at a higherprice, or you are speculating on Fed rates being likely to fall, allowing you to refinance at better rates andtherefore lower your monthly payments. Under the old regime of the GSEs, these loans could not have beenbought. But under the new mandate to increase homeownership, these loans could be bought, and they werethen resold to investment banks, who pooled them to diversify geographic risk, increased the leverage (throughsynthetic financial means), and resold them to domestic and international investors. The valuation inputs tothese securities are interest rates offered on mortgages, and historic rates of default. Interest rates affectrefinancing, which is the return of principal to investors, while default rates affect loss of principal on the
2securities. Using historical indicators allows you to price the securities, however, when economic conditionschange drastically, the securities become hard to value.This is the reason why we have the current crisis. Banks are holding a lot of these securities, and since nobodyknows what they are worth under the current economic conditions, banks don't want to lend to each other. Inprinciple, banks lend to each other just like people - you agree to lend money to your co-worker because youknow he has a decent salary and wears an expensive watch (has income and assets), in the worst case, if youmiscalculate his ability to repay you based on income, you can force him to sell the watch to obtain the moneyto return your loan. But what if the watch is a fake? If there is a concern that the watch is fake, the loan will notbe made.So, to answer the other question, will the TARP plan save the banking system? Likely, it will. The plan is theequivalent of having a third co-worker who will buy all watches priced as if they were near-new - regardless of whether or not they are fake or damaged. This co-worker also has lots of money - he has announced how muchhe received from his inheritance - so you know he can reasonably afford to buy maybe a third of the watches inthe company. Through this mechanism, banks can trade in pieces of themselves that cause the market to doubttheir net worth, and restore confidence, which gets banks lending to each other again. It becomes publicknowledge who has used this facility, though there are not enough funds for everyone holding the securities tomake use of it.In some sense, this is the US government taking responsibility for asocial experiment that has gone wrong andinfected banking systems allover the world. However, this is neither the cheapest nor the most expedient to goabout directly saving the banking system. Further more, it does not create the right incentives in the corporateworld. It is an endorsement of collective stupidity. What would be a better way? Creating an agency that willdirectly capitalize banks that are forced to seek its help at the expense of 1. wiping out all or most of the publicshareholders of the bank 2. converting the bank's unsecured debt to equity 3. reducing the performancecomponents of management's pay packages and 4. giving the government warrants on most of the bank'sequity. This punishes shareholders for investing in a bank with bad management, and for not replacing theboard of directors, punishes debt holders for irresponsible lending, punishes management for risky behavior,and gives the tax payers the upside when the companies recover, in return for their use of public funds. Thissolution can't help international banks, though - since the US will never directly recapitalize foreign banks, so theTARP plan has some advantages for international banking stability, in that sense. But the TARP works by buyingup the assets of the banks, and in order to be effective at recapitalizing the banks, it has to buy these assets atabove their current market values. Since no one knows what values will be realized on these securities if theyare held to maturity, it is highly unlikely, in my opinion, that any profit on these purchases will be realized, whichmeans that not all of the public moneys used to buy the securities will be returned to the taxpayer/US treasury.I think on balance this plan has a greater downside for the taxpayer than direct recapitalization of the banks,

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