Monday, September 22, 2008

Cash-for-trash or paradox of deleveraging

Deleverating is a money-term which means the reduction of financial instruments or borrowed capital previously used to increase the potential return of an investment. It is the opposite of leverage. The paradox discussed here refers to the fact that the US Treasury will be left holding worthless investments or investments which will potentially yield only poor returns in the future. The band-aid measures being discussed such as $700 billion bail-out to buy 'loan' instruments from troubled financial institutions because of ill-thought-out house mortgages are likely to result in the reduction in the value of the 'assets' themselves (that is, the mortgage loans (which are assets in the money-jargon) are of lesser worth than what appears as net present value of the asset).

The problem with capitalism is well articulated by the following quote from a professor:

“If you reduce their debt payments, they will start spending again,” said Mr. Roubini, a professor at New York University. “It’s not going to help us avoid a recession, but it could make it shorter.”

American citizens are encouraged to spend and spend again through a credit card payment system which promotes financial irresponsibility.

How can anyone be asked to cash the family jewels and keep spending, by borrowing in perpetuity?

Isn't there something called 'savings' to cope with the rainy-day for the family and to provide for future obligations of the family, for e.g., college tuition fees for the growing children?

The financial system has made a mockery of the concept of 'savings' and the concept of time in economics. Time is treated only as a discounting mechanism and not as a framework for responsible financial management of one's EARNINGS, earnings made the hard, old-fashioned way, through work.

We have seen how fetishism of money works. Money has become a commodity and the citizens are made to believe that the commodity is only to be spent and will be produced by the Treasury or the Central Bank by printing currencies.

This is problem number one with American capitalism, the cancer which has engulfed the world financial system: fetishism of money.

The second problem is the discounting of savings as a measure of financial responsibility of the wage-earner(s) of the family.

The dangers for India in this ongoing melt-down in USA is that Indian financial system -- together with other financial systems of other nations -- will be asked to bail out the beleaguered American financial system. In simple terms, America is looking for suckers. Business process outsourcing now takes a new fork: Money process outsourcing. Who cares if the Rupee is Rs. 60 to a dollar? If it can help 10 Janpath chamcha-s to merrily accumulate their monies, who cares for remedying the impoverishment of the poor Indian who has to bear the burden of inflation run amuck?


Cash-for-trash or paradox of deleveraging

$700bn rescue plan is ‘cash for trash’
By Paul Krugman

Some sceptics are calling Henry Paulson’s $700 billion rescue plan for the US financial system "cash for trash." Others are calling the proposed legislation the Authorisation for Use of Financial Force, after the Authorisation for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq.

There’s justice in the gibes. Everyone agrees that something major must be done. But Mr Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’ money on behalf of a plan that, as far as I can see, doesn’t make sense.

Some are saying that we should simply trust Mr Paulson, because he’s a smart guy who knows what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of the past year and a half — a period during which Mr Paulson repeatedly declared the financial crisis "contained," and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? He’s making it up as he goes along, just like the rest of us.

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.
2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.
3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.
4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse.
This vicious circle is what some call the "paradox of deleveraging."
The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?
Well, it might — might — break the vicious circle of deleveraging, the last step in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.
Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?
The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.
That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)
But Mr Paulson insists that he wants a "clean" plan. "Clean," in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr Paulson is also demanding dictatorial authority, plus immunity from review "by any court of law or any administrative agency," and this adds up to an unacceptable proposal.
I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.
But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.$700bn rescue plan is ‘cash for trash’

September 20, 2008
Costly Financial Rescue Could Narrow Economic Options Later
WASHINGTON — The rescue plan being created by the Bush administration is like the financial crisis it is meant to end — complex, far-reaching and potentially rife with unpredictable consequences.
Among the dangers cited by economists on Friday, as word of the plan began circulating: an explosion in federal debt, higher financing costs, an escalating reliance on foreign capital, higher inflation and a further erosion of American economic sovereignty.
All of these dangers, these experts stress, are hypothetical — except for the cost, which by many estimates could exceed $1 trillion.
Taking on that much additional debt could narrow the economic options available to the next administration.
“The implications are that, at some point, you’re going to have to see higher taxes, lower expenditures or a combination of both,” said Carmen Reinhart, an economist at the University of Maryland.
Debt can also act as a drag on economic growth, she said, pointing to heavily indebted countries like Italy and Japan. And although public debt does not by itself fuel inflation, it can tempt governments to pursue an inflationary policy, as has happened regularly in Italy in recent years.
Not all of the potential consequences of the plan are negative. Nouriel Roubini, an economist known for his pessimistic views, said the rescue, if properly executed, could lift the economy by reducing the burden on households, particularly those afflicted by troubled mortgages.
“If you reduce their debt payments, they will start spending again,” said Mr. Roubini, a professor at New York University. “It’s not going to help us avoid a recession, but it could make it shorter.”
To finance the rescue effort, the United States will have to borrow even more from foreign investors. That has not been a problem in recent days, given the intense demand for Treasury bills, which are perceived as a safe haven by investors around the world.
But if the bailout does not quickly restore confidence in the American financial system, foreign investment could slow, which would drive up the cost of financing that debt, said Kenneth S. Rogoff, a professor of economics at Harvard.
So far, the dollar has shown remarkable resilience in foreign markets, suggesting, he said, that foreigners still have faith in the ability of the United States to get out of this crisis.
The concerns of foreign central banks over the fate of Fannie Mae and Freddie Mac, played a role in the Treasury department’s rescue of the mortgage finance giants. That influence is likely to grow, along with the debt they hold.
“The people with leverage are the Japanese, the Chinese and the oil-producing countries, who will want assurances that the debt they hold is worth something,” said Eugene Steuerle, a senior fellow at the Urban Institute who worked in the Treasury department during the Reagan administration.
Mr. Steuerle said he hoped that the additional burden would force policy makers to confront the country’s long-term budget imbalances. The last time this happened, he said, was in the early 1990s, after a much more modest government rescue effort in the aftermath of the 1987 market crash.
But first the Treasury department and the Federal Reserve must successfully carry out this plan. And the sheer scale and complexity of it left economists and other experts slack-jawed.
“It’s like doing a quintuple jump in figure skating,” said Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics and a Treasury department official during the Clinton administration. “It’s impressive if they can do it. It’s impressive even to try.”
Among the potential sources of tension is the Treasury’s ultimate decision on whether it will buy troubled mortgage-backed securities from non-American banks. European banks, like UBS, invested heavily in such securities.
“If Paribas has bought a mortgage-backed security, why can’t they present it to Treasury?” Mr. Truman said. “If the government is going to do it for the American banks, they should do it for everyone.”
But that could provoke a strongly negative reaction from lawmakers on Capitol Hill, who already protested that other countries should chip in for the $85 billion rescue of the insurance giant American International Group, because it has operations in those countries or has insured their banks.
“Are the taxpayers in the United States going to bail out all the banks in the world?” said Allan H. Meltzer, a historian of the Federal Reserve. “I just don’t know how this works out.”
Mr. Meltzer said he believed the plan would be politically viable only if participation was voluntary, and if the banks that received government aid were required to pay it back later. “We’re protecting private industry, not the public interest,” Mr. Meltzer said.
Beyond issues of fairness, he said the government could be overwhelmed by the task of identifying troubled securities, which are bundled together in complex packages, with varying degrees of risk. The challenge, he said, dwarfed that of theResolution Trust Corporation during the savings and loan crisis.
Perhaps the longest-term consequence of the plan is a wholesale reordering of the financial landscape. Economists said the government would almost certainly impose a raft of new regulations on banks.
“It’s hyperbole to say we’re abandoning the free-market system,” Mr. Rogoff said. “But we certainly seem to be entering a new uncharted territory of regulation.”

September 23, 2008
Stocks Fall as Rescue Plan Is Negotiated
This article was reported by David M. Herszenhorn, Stephen Labaton and Mark Landler, and written by Mr. Herszenhorn.
WASHINGTON — Senate and House Democratic leaders said on Monday that they had reached an agreement on their conditions for approving a $700 billion rescue plan for the financial system, including more oversight of the program and a requirement that the government do more to help troubled borrowers refinance their mortgages.
But even as Congressional Democrats and the administration began to narrow their differences, Democrats are bracing for a battle over efforts to limit the pay of executives whose firms seek help and over whether to grant bankruptcy judges authority to modify the mortgages of borrowers in danger of foreclosure.
Investors were skeptical. Concerns that the bailout plan may not move smoothly through Congress contributed to the anxiety in the markets that pushed the Dow Jones industrial average down more than 372 points and pushed crude oil up more than $16 a barrel.
President Bush on Monday morning urged legislators to resist the temptation to add provisions that, he said, “would undermine the effectiveness of the plan.” Still, Treasury officials indicated a willingness to negotiate.

Within hours, Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, said he had reached a general agreement with the Treasury Department over mortgage aid and Congressional oversight.
But Mr. Bush may find that members of his own party are among the holdouts. Some conservative Republicans criticized the plan, raising the stakes for Treasury Secretary Henry M. Paulson Jr., who has been trying to persuade lawmakers and an increasingly frustrated American public that the rescue package was needed.
Newt Gingrich, the former House speaker, said he expected Republican lawmakers to oppose the plan in increasing numbers. “I think this is going to be a much bigger fight than he expected,” Mr. Gingrich said, referring to President Bush, who called again for swift action on Monday morning. “I think this bill is a long way from done,” Mr. Gingrich added.

Republican leaders who support the administration’s plan warned Democrats on Monday to exercise restraint and not slow the bailout package, even as they prepared for an aggressive internal campaign to rally Republican support.
“When there’s a fire in your kitchen threatening to burn down your home, you don’t want someone stopping the firefighters on the way and demanding they hand out smoke detectors first or lecturing you about the hazards of keeping paint in the basement,” Senator Mitch McConnell of Kentucky, the Republican leader, said in a speech on the Senate floor. “You want them to put out the fire before it burns down your home and everything you’ve saved for your whole life.”

Mr. McConnell added: “The same is true of our current economic situation. We know that there is a serious threat to our economy, and we know that we must take action to try and head off a serious blow to Main Street.”

The Senate Democrats’ proposals includes two bold provisions. One would grant the Treasury "contingent shares" of stock in any financial institution that wants to sell bad debt to the government; the other would grant bankruptcy judges the authority to modify the terms of primary mortgages, a step aimed at helping homeowners at risk of foreclosure.

The bankruptcy provision is staunchly opposed by the banking, lending and securities industries and by many Republicans in Congress, but Democrats insist that it is one of the few mechanisms to provide direct assistance to homeowners caught in the foreclosure crisis.

The contingent shares would give taxpayers an equity stake in companies seeking help through the rescue program, potentially allowing the government not only to recoup however much of the $700 billion it spends on bad debt, but also to profit should the financial firms prosper in years ahead. The legislation would require the value of the contingent shares to equal the value of the assets purchased by the government.
The 44-page Senate proposal, pulled together by Senator Christopher J. Dodd, Democrat of Connecticut and the chairman of the banking committee, would require the Treasury to run the rescue plan through a new "Office of Financial Stability" to be headed by an assistant treasury secretary. It would also establish an "Emergency Oversight Board" to monitor the bailout effort, made up of the Fed Chairman; the chairman of the Federal Deposit Insurance Corporation; the chairman of the Securities and Exchange Commission; and two non-government employees with "financial expertise" in the public and private sectors, one each appointed by the majority and minority leadership in Congress.
In addition, the Senate proposal would require monthly reports to Congress, rather than the biannual reports that would be required under the Bush administration’s proposal.

Amid continuing concerns over the deep global ramifications of the crisis, the finance ministers and central bank governors of the Group of Seven major industrial nations said on Monday that they were maintaining “heightened close cooperation.” In a joint statement, they pledged to take “whatever actions may be necessary, individually and collectively, to ensure the stability of the international financial system.”
The ministers and governors welcomed the “extraordinary” actions proposed by American officials to take illiquid assets off bank balance sheets, Reuters reported. But the statement made no other mention of any specific steps to be taken by the group’s member nations.

The Bush administration’s proposal could prove to be the largest government bailout of private industry in the nation’s history. It calls for nearly unfettered powers for the Treasury secretary in managing the bailout.
Though the jittery state of the financial markets put pressure on officials and legislators to move quickly, some lawmakers said they did not want to be rushed into approving extraordinary new powers for the Treasury secretary and the government without full consideration of the consequences.

Both presidential nominees, who face the prospect of inheriting an enormous program, said there had to be more oversight of the Treasury Department than the Bush administration had proposed.

Financial companies were already lobbying to broaden the plan. And the Bush administration did indeed widen the scope by allowing the government to buy out assets other than mortgage-related securities as well as making foreign companies eligible for government assistance.

Banks and traders also braced themselves for another tumultuous week in the markets. But early signs indicate that investors in Asia were reacting positively to the developments in Washington. Meanwhile, top Democrats and Republicans on Capitol Hill said on Sunday that they would act swiftly on the administration’s request, but not without setting their own conditions.

“We will not simply hand over a $700 billion blank check to Wall Street and hope for a better outcome,” House SpeakerNancy Pelosi said.

Top administration officials and senior lawmakers said that the markets could be devastated if Congress and the administration failed to reach agreement on the plan.
Mr. Paulson said he hoped that the government would recoup much of the cost of buying distressed mortgage-related assets. But he did not rule out that the initial cost of the bailout could rise beyond $700 billion, the limit set in the terse proposal sent by the Treasury to Congress on Saturday.

“That doesn’t mean we’ll go all the way there, or it doesn’t mean it will stop there and we won’t ask for more,” Mr. Paulson said Sunday on the CBS program, “Face the Nation.” “What we need is something that is big enough to get the job done. We’ll ask for what we think is a right amount to give us plenty of flexibility.”
David Stout, Carl Hulse and Brian Knowlton contributed reporting.

Auctions may be only option for US bailout
ReutersPosted online: Sep 22, 2008 at 1654 hrs
New York, September 22: : The US government may have little choice but to use an auction process to price up to $700 billion of toxic mortgage debt it is buying from financial institutions, even if the formula has its snags.
The Bush administration sent a proposal for the unprecedented bailout to US lawmakers this weekend to tackle the nation's worst financial disaster since the Great Depression.
The government has a tightrope to walk. It wants to buy assets cheaply enough to make sure taxpayers don't lose too much money, and perhaps even make money when markets stabilize, but at a high enough price to avoid hurting banks any more than necessary.
An auction process would make sense, because it would allow the banks with the best information about the securities to determine the price, said Peter Cramton, a professor of economics at University of Maryland who has set up auctions for governments globally. But competition among sellers would prevent banks from setting too high a price.
Cramton believes a "reverse descending clock auction" is ideal in this situation. Through that process, the government would announce a target for how much of a particular security it is seeking to buy in dollar terms, and an initial buying price.
Sellers would indicate how much they would sell at that initial price, and if there were too many sellers, the government would lower its price until the amount of securities that banks are willing to sell equals the government's target.
"I've conducted dozens of these auctions for assets valued at billions of dollars, and they are extremely effective in determining a competitive market price," Cramton said.
But there are drawbacks. A reverse descending clock auction would work best for securities held by multiple banks, but not as well for securities that are owned by just one or two institutions, Cramton said.
In that case, there would be less competition to sell. The price might be higher than the assets end up being worth, costing the government money.
Banks believe there are differences among their securities. For example, Merrill Lynch & Co Inc agreed in July to sell $30.6 billion of repackaged debt known as collateralized debt obligations at 22 cents on the dollar. That is well below where Citigroup Inc marked its securities in the second quarter. If Citi embraced Merrill's pricing levels, the bank could have another $7 billion of charges in the third quarter, Deutsche Bank analyst Mike Mayo estimated this summer.
And if auctions do attract a large number of sellers, competition may push prices down to low levels, forcing other banks to write down the value of their mortgage bonds to those prices.
Those write-downs could force banks to seek new capital, which has difficult to raise in the current environment. If raising capital proves too hard, more major banks could fail or get pushed into shotgun marriages, potentially worsening the financial crisis.
"Recognition (of losses) brings capital shortfalls into the open," wrote Jan Hatzius, an economist at Goldman Sachs, in a note on Saturday.
Also worrisome is the speed at which this auction will be set up, because of the complexity of the securities being sold.
"Nothing on this scale has ever been done before," said Eric Maskin, professor at the School of Social Science at the Institute for Advanced Study, who won a 2007 Nobel Prize for economics and has conducted extensive research into auctions.
But even with these concerns, such an auction can likely be done, and there may not be another choice, Maskin said.
Banks must purge bad assets before they can raise the new capital they need, or find other institutions willing to buy them. After the failure of Lehman Brothers Holdings Inc (last week, investors have grown increasingly suspicious of US financial institutions.
"You might not like the consequences of an auction, but it seems like the least of all evils," said Lawrence Ausubel, a professor of economics at University of Maryland.

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