Where did you go, John Pierpont Morgan?

This entry was written by Eric Hart and posted on his behalf by fellow editorial board member Drew Thomas

The legislative debate over the government bailout plan has given Congressional Republicans an opportunity to vent their long-brewing frustration with the Bush administration. Led by Rep. John Boehner (R-OH), they have bucked the President’s plan to purchase distressed assets with taxpayer dollars. Their proposed alternative is to extend insurance coverage to all of the at-risk assets. That protection would in turn entice private investors to the table. Freed from much of the downside risk, investors with free capital would remove the distressed assets from the balance sheets of financial institutions, restoring the free flow of credit without putting taxpayer dollars at risk.

The severity of the situation has been trumpeted over recent days by the three-headed economic Cassandra of Treasury Secretary Hank Paulson, Fed Chief Ben Bernanke and SEC Chief Chris Cox. The fall of Troy goes something like this: After years of feverish growth, a speculative U.S. asset bubble bursts, resulting in rapid devaluation that slams the balance sheets of financial institutions. This causes a string of bank runs that crescendo into bank failures. Access to credit dries up, grinding the economy to a halt and throwing the nation into a recession. With domestic confidence shattered and a skeptical international community running for cover from the fallout, the U.S. recession devolves into a deep, prolonged depression.

Critics of the Republican’s proposed private sector solution point to historical parallels provided by the 1929 stock market crash. As stocks plummeted, Herbert Hoover convinced an all-star cast of Wall Street scions including J.D. Rockefeller to step in and buy stocks in an attempt to restore stability. The efforts failed and the crash went on unabated. Hoover’s further efforts to solve the crisis through private sector measures proved equally ineffective and the country eventually entered the Great Depression. If there is one person in today’s government who wishes to avoid a similar fate, it is noted Depression-era economic historian Ben Bernanke.

Yet that same discredited private-led approach was employed with some success during the crises of 1893 and 1907.. In the crisis of 1893, speculation in the rapidly expanding railroad industry led to a huge asset bubble. The collapse of the Philadelphia and Reading Railroad sparked a stock-market sell-off that turned into a bank run. By the end of the year, more than 600 banks had failed. Things got so bad that domestic and international investors began redeeming their paper dollars for gold specie, driving the U.S. Treasury below its reserve requirements in 1895. Through last ditch efforts of J.P. Morgan, the government was able to successfully float a $65 million bond issuance to a syndicate of U.S. investors and European banks. Twelve years later, a similar panic was averted when Morgan was able to assemble a syndicate private domestic investors to infuse capital into cash strapped banks.

So there is some historical precedent for a private-led bailout. There are some key differences, however. Unlike in 1893, today there are no market makers of J.P. Morgan’s stature. The closest analog in wealth and reputation is Warren Buffet. Yet at its height, the House of Morgan controlled $1.3B in assets, representing roughly 8% of the U.S. GDP in 1893. Today, Berkshire Hathaway controls only $273B in assets, a mere 2% of today’s GDP.

So financial salvation in today’s market would invariably require a group effort, but who would that group include? The remaining U.S. commercial banks? Unlikely. High-magnitude acquisitions like the BofA-Merrill Lynch and JPMorgan-WaMu mergers can only be repeated a few more times. Insurance companies? Regulators would probably object. No, most of the capital would need to come from private equity and hedge funds. The question is whether there enough capital to go around. Some quick back of the envelope math would suggest otherwise.

· In 2007, private equity funds raised roughly $300B in capital from investors. Let’s assume that they raise the same amount in 2008, and that half of that capital went to the purchase of distressed assets. Total capital raised = $150B

· Assets under management at Hedge Funds totaled $1.5 Trillion at the end of 2007. Let’s make an equally optimistic assumption that 25% of those assets could be reallocated to this effort. Total capital raised = $370B

That would still leave a shortfall of roughly $180B, which would need to be funded by the remaining domestic investor classes. This also assumes no restrictions on which kinds of funds were allowed to purchase the assets. Congress would undoubtedly enact various restrictions and qualifications to prevent malicious or unscrupulous investors from purchasing the assets, which would narrow the pool of available capital even further.

Another alternative would be to turn to the international markets. Given the size of the shortfall, any discussion of foreign investment would have to include sovereign wealth funds, which currently hold between $2-3 trillion in assets. But it is hard to comprehend political support for a plan that would gift-wrap American homes and hand them over to foreigners. Even if such a plan were approved, for sovereign wealth funds to buy any significant portion of the $700B would be unprecedented. In FY 2007 through Q12008, the total cross-border investments made by SWF’s were only $91 billion.

At the time of this writing, it appears that momentum is on the side of the Paulson-Bernanke-Cox camp, and that Congress will override the objections of House Republicans and fast-track a deal for the president to sign into law. If Republicans do manage to kill the plan to use government funds to buy distressed assets, it will be interesting to see who they manage to recruit to fill the $700B void.

Fed Currency-Swap Lines – Liquidity for the World

In a press release on September 18, the Federal Open Market Committee announced a $180 billion expansion of the swap lines with foreign central banks, including Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank. The line has resulted in a decline in the inter-bank overnight lending rate amidst uncertainty of the assets in the counter-party bank. The Federal Reserve Bank of Atlanta provides detail on the swap mechanics.

What does this mean for the US Dollar? Empirically it may be difficult to disaggregate the increased liquidity for US Dollars in foreign markets and the impact on exchange rates from the other, more newsworthy, actions by the US Treasury. European markets saw a substantial decline in the overnight LIBOR (3.843% vs. 5.031%). In this case, many financial institutions did not have access to US Dollar overnight lending and the ECB first auction resulted in substantial demand ($101 billion for the $40 billion offer). The demand was not as strong at the BofE or the Swiss Bank as the central banks have varying collateral standards. Injection liquidity into the market is often an inflationary move, but in this instance it may prove to counterbalance a deflationary Wall Street characterized by tight lending practices, shrinking balance sheets, and cash hording.

Roughly twelve months ago, Former Governor Frederic S. Mishkin noted in his speech, “Systemic Risk and the International Lender of Last Resort”, that the lender of last resort was to provide the following: “(1) restore confidence in the financial system by quickly providing liquidity, (2) limit moral hazard by encouraging adequate prudential supervision, and (3) act as a lender of last resort infrequently.” While the speech was focused more heavily on emerging market economies, it does point out that the injection of liquidity will come with increased regulatory scrutiny (point 2) in order to restore the confidence of market participants (point 1). We all need to hope the injections come infrequently (point 3) and Wall Street, Bay Street, and City of London return to order soon.

UPDATE: At 1:00am EDT September 24 the Fed announced an additional $30 billion of swap lines have been established with the Reserve Bank of Australia, the Danmarks Nationalbank, the Norges Bank (Norway), and the Sveriges Riksbank (Sweden). The Fed will provide up to $10B to each Australia and Sweden and up to $5B each to Denmark and Norway.

What Is Environmental Economics?

So in an effort to figure out how environmental issues falls within the scope of an economics blog, please see this excellent overview of the complicated relationship between our environment and modern economics.

The entry outlines the four major problems that occur when applying basic economic principle to the environment: market failure, presence of externalities, common property & non-exclusion, and the existence of public goods.

Most rational people know that these problems exist when you're trying to apply economics to environmental issues, but the problem in most of these situations is the simple fact that valuing the outcomes of certain choices on the environment is an indeterminate science. One of the blog's editors likes to refer to a favorite graph of his that actually attempts to draw a correlation between average temperature and the number of pirates that exist in the world. Shockingly, the regression has a great R-squared!!! This is clearly meant to be a joke, but many people look at the data behind the hypothesis on global warming and draw the conclusion that the evidence is just not there to support it.

All humor aside, these issues are fairly serious, and looking at them in a logical manner without attempting to inject partisan politics is important. These issues may indeed seem secondary when we are faced with a financial system that looked to be on the brink of collapse, but these issues are very important in the long run.

And with that, let me say that I'm looking forward to exploring these topics with you.

Sliding down the slippery slope

The slippery slope is getting particularly slippery in Washington, D.C., especially with an election around the corner. Congress is considering a bailout of the automotive industry, with $25B of government loans up for grabs. Thanks to (unavoidable?) bailouts of Fannie Mae, Freddie Mac, and AIG, Detroit's Big 3 are feeling particularly confident in their ability to secure the loans . Both John McCain and Barack Obama have come out in support of this policy, despite McCain's (and George W. Bush's) previous opposition to a bailout. This support certainly makes sense if you are trying to win Michigan or Ohio (with 18 and 21 electoral college votes, respectively), but does it make sense economically? Perhaps not.

First, there is the sheer cost: the $25B have to come from somewhere, and the government is already straining with a large deficit. Second, there is reputational risk to consider. Is the U.S. as firmly commited to free markets as it urges other countries to be?

An appropriate rebuttal asks why Wall Street (Bear, Fannie, Freddie, AIG, et al) deserves bailouts while Detroit does not? One good reason is that the large financial institutions are being bailed out due to their effect on the rest of the economy. The effect of a Fannie/Freddie/AIG bankruptcy would have far more wide-ranging effects than the failure of a U.S. automaker.

Not only are automakers less intertwined with the rest of the economy, but Detroit is also looking for a better deal than Wall Street. Detroit wants loans without warrants attached, as they were in the Fannie/Freddie and AIG bailouts. And in return, Detroit promises to begin building more competitive products. More importantly than building better cars, Detroit promises to have disproportionate influence on the election in Michigan and Ohio... and it seems that fact is likely to be the deciding factor.

Let's hope the government gets an appropriate deal for taxpayers in the process, one that includes warrants, and, possibly, new commitments to CAFE standards.