Government Ownership of Banks

I see that the federal government is now considering taking equity positions in banks.

This is not as crazy or unprecedented as it may sound.

The federal government owned shares in both the first Bank of the United States (1791-1811) and the second Bank of the United States (1816-1836). There is a nice article about this in the William and Mary Quarterly by Carl Lane.

Early state governments owned considerable amounts of state bank stock, some of which it purchased and some of which it received as a sort of tax or quid pro quo for granting an act of incorporation.

The benefit of stock ownership was that it provided the government with a nice revenue stream.

The cost of stock ownership was the conflict of interest it created. Pennsylvania and New York, for example, were stingy with new bank charters because they did not want to hurt the value of their stock portfolio or decrease their dividends by allowing competitors to enter. That, of course, hurt both depositors and borrowers.

By the 1830s/40s, national and state governments began to divest their bank and other corporate stocks because of such conflicts of interest.

On net, therefore, I think it would be better simply to adopt my plan (see below), or similar ones recently proffered by Glenn Hubbard, Robert Shiller, or Martin Feldstein. (McCain's plan is too vague to evaluate but note its similarities to mine.)

Another thing we might think of doing is walling off safe institutions -- those with minimal exposure to derivatives -- behind very strong government guarantees and letting the rest crash and burn. The billions could then be spent on unemployment and re-education benefits and we could end this nasty moral hazard problem once and for all.

The Wright Rescue Plan

Last Friday (see below), I posted some ideas about how to rescue the economy from recession. I alerted numerous individuals about the plan by email and also sought media attention for it, thus far to no avail (that I know of, anyway). During the course of email and blog comment discussions, it became clear to me that some readers had not grasped the plan's most important features. In this post, I will be more specific.

The heart of the plan is to give homeowners (including financial institutions that come to own homes via foreclosure) the option of refinancing with the Federal government at 7 percent for up to 50 years. The 7 percent will ensure that most Americans will not opt for the Federal refinance (re-fi) because most already have mortgages at a lower APR. The 50 years is to help lower the monthly payments of homeowners who got in over their heads.

The government will pay off the existing principal balance on the mortgage with Treasury bonds. Right now, the government can borrow at low yields. It is the only large economic agent at present that can with great certainty generate a positive spread between its assets (7% mortgages) and its liabilities (2-3% Treasury bonds).

The plan should provide immediate relief to the financial sector because it will effectively remove uncertainty about the value of mortgage-backed securities (and hence credit default swaps, etc.). Either:
a) borrowers will continue to pay their existing mortgages
or
b) borrowers will re-fi with the Federal government, thus removing the risk of their default from the financial system
or
c) borrowers will default, in which case the lenders can re-fi, which will replace the "toxic" asset on their balance sheet with a safe and liquid one (Treasuries).

With the uncertainty gone, the credit markets can again function and mortgage backed securities will rise in value and will begin trading again, ending the cycle of write downs that has caused the recent bankruptcies.

The Wright Rescue Plan is also much more politically astute than the administration plan because it offers aid to homeowners first. While the total amount of aid needed cannot be known with certainty, the plan is clearly not a "bailout" because the government will almost certainly profit from it (at least at today's gross spreads). The sums already appropriated to the Hope for Homeowners program may very well suffice. Finally, and I can not stress this point enough, the plan could be implemented without creating a new federal bureaucracy. The Treasury and IRS already know how much people earn, whether they have existing mortgages, and so forth. They also have the power to garner wages and track people across state lines, so defaults on the re-fi's should be low. If the government comes to own some homes through default, it alone can afford to hold them until the market turns or to re-purpose them. As noted in various posts below, governments have successfully run mortgage programs in the past.

The Philadelphia Fed's Money in Motion Exhibit and the Subprime Mortgage Crisis

Thanks to the Jewish holiday, I had the opportunity to take 5 children, including 3 of my own (yes, Alexander Hamilton Was Wright too) to spend the day in Philly. After the obligatory Duck tour, we checked out the Philly Fed's Money in Motion Exhibit. As a guest museum curator myself (for the Museum of American Finance), I appreciated the exhibits in a new way and the kids had a blast. (I suspect they think, wrongly of course, that they can reassemble the shredded money the Philly Fed hands out upon each visitor's exit. Hey, what else are you going to do with the stuff?)

The exhibit "Supervision Mission" was particularly fascinating and provides unintended insights on the subprime mortgage crisis. The exhibit is a computerized game where the visitor starts off as a trainee. After mastering a basic multiple choice test, the trainee becomes a loan officer who has to make decisions about whether or not to lend to various fictional applicants. It was great fun for the kids and even for me, until I started to get the "wrong" answers, invariably because I turned down loans that my electronic boss thought were "good business for the bank." One applicant wanted a $1 million loan on terms that would have had her repaying some $50,000 per month on expected income of like $20,000 per month. She had other collateral of $2 million but the collateral was not income earning. I turned the sucker down only to be chastised for it!

I managed to get promoted (I think everyone does, eventually) to the final level, investment manager. Here, again, my decisions (60% domestic loans, 15% foreign, 15% Treasuries, 10% cash) were chastised as too conservative. Apparently, they wanted primary reserves of less than 5 and secondary of less than 10.

If this is the sort of supervision the Fed gives its banks I have only two words to say:
No wonder!

Cause of, and Cure for, Hard Times (New York: 1818)

I'm writing a variety of things right now, including a book called Fubarnomics and a book chapter on corporate capitalism. To help with both, I pulled an old pamphlet out of my collection -- Cause of, and Cure for, Hard Times (New York: 1818) -- and was struck by the similarities with our financial struggles today. I received a photocopy of the pamphlet the hard way, via ILL, about a dozen years ago but if readers are interested it is on Google books and also available for purchase in a 2008 edition on Amazon.

A Simpler Plan

I missed a chance to be on CNN again (gosh darn it!) in order to do an hour long show on NPR Oregon with economist Brad DeLong. The show got me thinking about a simpler way to fix the current problem than doing reverse auctions of toxic assets. Simpler economically and politically.

Here it is:

Any American with a mortgage can trade it in for a government one for the same principal amount, at a fixed 7 percent interest per annum, for any term up to 50 years. In return, the government will pay off the existing mortgage with a Treasury bond with the same market value and maturity as the mortgage it is replacing. The lender can then hold the bond on its balance sheet until maturity, sell it in the market, use it as collateral for a loan, strip and sell the coupons, etc.

Because the government can at present borrow at far less than 7 percent, and because it can easily garnish wages using existing (tax) infrastructure, this will not be a bailout but rather a source of revenue which can be applied to pay down the national debt. (See my blog entry below about the colonial loan offices, which prove that governments can and have profited by providing mortgages to citizens.) The two keys are extending the term of the mortgage to the point that homeowners can afford to make the payment and making sure that borrowers don't default simply because they are "in the bucket" (have negative equity) by using the coercive power of the state. Anyone who prefers to default rather than take the government loan may do so, at which point the lienholders (new owners) may, if they wish, mortgage the property to the government for the amount they are owed. (Or they can resell or rent it, as they prefer.)

The plan is also much more palatable politically than the current administration plan, for several reasons:

a) as noted above, it is not a bailout, but rather the entry of a new lending competitor that can win borrowers away from current mortgage lenders due to its long time horizon and low cost of funds. This is a major point because NOBODY wants a bailout if one can be avoided;
b) it does not require the creation of a new government bureaucracy (like the Homeowners Loan Corporation of the Great Depression) because existing agencies and workers can handle the minimal work involved, so fiscal responsibility types (who I admire) can support it without hypocrisy;
c) helping financial services firms by eliminating their root problem (defaulted mortgages) is much more popular than directly bailing out "Wall Street fat cats," which is especially important in an election year;
d) since any American with a mortgage automatically qualifies, this proposal does not directely discriminate against fiscally careful Americans nor does it unduly reward the fiscally profligate.

Of course most of those who will take the government mortgages will be subprime borrowers paying greater than 7%, those who got caught with teaser rates, ARMs, etc., and those about to be foreclosed upon.

This is a half hour's work, so I reserve the right to modify details if I have erred conceptually.

Finally, if done just right this is an example of a Pareto improving policy, a concept I urged politicians earlier this month to consider more carefully before going for the partisan jugular.

Your Humble and Obedient Servant ...

I received this email several times today ...

and I think it might be spam:

REQUEST FOR AN URGENT BUSINESS RELATIONSHIP

DEAR AMERICAN:

I NEED TO ASK YOU TO SUPPORT AN URGENT SECRET BUSINESS RELATIONSHIP WITH A TRANSFER OF FUNDS OF GREAT MAGNITUDE.

I AM MINISTRY OF THE TREASURY OF THE REPUBLIC OF AMERICA. MY COUNTRY HAS HAD CRISIS THAT HAS CAUSED THE NEED FOR LARGE TRANSFER OF FUNDS OF 800 BILLION DOLLARS US. IF YOU WOULD ASSIST ME IN THIS TRANSFER, IT WOULD BE MOST PROFITABLE TO YOU.

I AM WORKING WITH MR. PHIL GRAM, LOBBYIST FOR UBS, WHO WILL BE MY REPLACEMENT AS MINISTRY OF THE TREASURY IN JANUARY. AS A SENATOR, YOU MAY KNOW HIM AS THE LEADER OF THE AMERICAN BANKING DEREGULATION MOVEMENT IN THE 1990S. THIS TRANSACTIN IS 100% SAFE.

THIS IS A MATTER OF GREAT URGENCY. WE NEED A BLANK CHECK. WE NEED THE FUNDS AS QUICKLY AS POSSIBLE. WE CANNOT DIRECTLY TRANSFER THESE FUNDS IN THE NAMES OF OUR CLOSE FRIENDS BECAUSE WE ARE CONSTANTLY UNDER SURVEILLANCE. MY FAMILY LAWYER ADVISED ME THAT I SHOULD LOOK FOR A RELIABLE AND TRUSTWORTHY PERSON WHO WILL ACT AS A NEXT OF KIN SO THE FUNDS CAN BE TRANSFERRED.

PLEASE REPLY WITH ALL OF YOUR BANK ACCOUNT, IRA AND COLLEGE FUND ACCOUNT NUMBERS AND THOSE OF YOUR CHILDREN AND GRANDCHILDREN TO WALLSTREETBAILOUT@TREASURY.GOV SO THAT WE MAY TRANSFER YOUR COMMISSION FOR THIS TRANSACTION. AFTER I RECEIVE THAT INFORMATION, I WILL RESPOND WITH DETAILED INFORMATION ABOUT SAFEGUARDS THAT WILL BE USED TO PROTECT THE FUNDS.

YOURS FAITHFULLY MINISTER OF TREASURY PAULSON 

An Easy Analogy

I first used a version of this analogy in Richmond on CBS 6's "Virginia This Morning," on 4 September 2008. It seemed to work well and some people seem flummoxed by the recent market disturbances so I thought I'd share it here.

The national debt is like a guy sitting in a boat called The Economy. When the national debt is small, the guy is skinny and there is plenty of distance between the boat and the waterline. If a wave (a crisis or shock) comes along, the boat may rock but it will stay afloat.

When the national debt is big, by contrast, picture a big dude -- South Park's Eric Cartman in the Kathy Lee Gifford episode, Marlon Brando near the end, or Jared before he found Subway sandwiches. Barely afloat on calm seas, the first big wave that comes along may swamp the poor little boat.

Now, because the boat is an analogy for the economy, we have to allow it to change size. Until recently, the boat was growing, albeit more slowly than the guy (debt). That gave advocates of the debt (of which there are too many, imho) reason for hope. But consider this: the boat has stopped growing and may actually shrink and at precisely the same time the guy is scarfing greasy donuts and washing them down with beer, and not even the light stuff.

Add on top of this the fact that a big wave may come along, perhaps a manmade one at that, and you can see why everyone is spooked.

Political Risk

In addition to the potential random and kick-em-when-they're-down shocks I discussed in yesterday's post, we also face tremendous political risk. 2008 is starting to look eerily similar to 1932 -- an unpopular Republican president in office, a pending election, and a financial crisis that won't go away. The threat before the election is that both parties will try to use the crisis to score political points. The threat after it, especially if the Democratic candidate wins as in 1932, is that the Republicans will sit on their hands while the minds of market participants race wondering what the incoming administration will do.

The good news is that the new president will be inaugurated in late January instead of early March. The bad news is that the world moves much faster now so late January is still a very long way away indeed. In early 1933, the payments system actually broke down just before FDR took office. You can't imagine what chaos that would cause today ... credit cards would stop working, ATMs would run dry, and Americans would learn the dirty little secret that their bank deposits are not convertible into Federal Reserve Notes on demand. Banks will exchange deposits for cash when it's convenient but they don't have to do it and in fact holding nothing close to enough vault cash to meet even a modest run. Let's hope it doesn't come to this but it would behoove policymakers to consider the possibility. We don't need a financial Katrina.

The Next Great Crisis

We're entering a dangerous period indeed. The government is currently planting the seeds of the next crisis. As I argued in One Nation Under Debt, we should never have allowed the debt to grow so large (2/3rds of GDP) in what was essentially peacetime. If the bailout doesn't go well and if the economy remains soft (and hence government receipts low), we could be looking at a national debt to GDP ratio of 100%. We could probably survive that, if nothing else bad happens. But guess what? The mere fact that we are down greatly increases the likelihood of getting whacked by additional negative shocks.

The probability of a natural catastrophe has not increased but our ability to respond effectively to one is impaired due to the difficulties at AIG (a major insurer) and in the capital markets more generally. At least two major recessions were exacerbated by natural catastrophes. The explosion of Mount Tambora in 1815 led to the "year without a summer" in 1816, disrupting agricultural markets in North America and Eurpe that culminated in the Panic of 1818/19. The Great San Francisco earthquake (1906) has been implicated in the Panic of 1907 because it created a massive flow of gold from British insurers to the West Coast, which induced the Bank of England to raise interest rates, which, in turn, burst an asset bubble.

Of course we don't know when or where the next major hurricane, earthquake, or volcanic eruption will occur. Nobody (I hope!) can cause one, and nobody can stop one, so such a shock will be random, dumb luck. Maybe one will hit us, maybe one won't. Such is not the case for manmade catastrophes. Terrorists must be salivating at the thought of hitting us hard while we are down. Hackers are undoubtedly gearing up to make attacks on technical network infrastructure that might fall into disarray during bankruptcies, quick forced mergers, and the like. And nation state enemies like North Korea and Russia are already beginning to behave badly. Another big shock might be all she wrote for the U.S. dollar.

I'm not being alarmist here, or if I am so is the Wall Street Journal which ran a short article yesterday (Septembe 20, 2008, B16) called "Stocks Gain -- So Does the National Debt." The article notes that the dollar could go either way at this point because "currency markets might see the fiscal cost [of the bailout] as a good trade-off against the bigger risk of letting the U.S. slip into a deep recession." That's right. But, as noted above, if the bailout does not go well, the national debt swells further, and we get whacked with another shock, the dollar could plummet again, to the point where the U.S. government may have to borrow in euro, sterling, yen, etc. At that point, we have to suffer very high interest rates and borrow only domestically or revert to emerging market status and borrow in other currencies, with all the attendant default risks.

Alexander Hamilton Was Wright

Yes, the Wall Street Journal correctly reported yesterday (September 20, A3 "Government Bailouts: A U.S. Tradition Dating to Hamilton") that I named one of my sons Alexander Hamilton Was Wright. I just couldn't resist the play on my last name, which sounds like "right" (correct) but actually means "maker" (as in wheelwright, cartwright, etc.) . So, yes, Hamilton was both correct and one of America's makers. For details, see Financial Founding Fathers (with David J. Cowen), The First Wall Street, and, of course, One Nation Under Debt. (Hamilton Unbound, by contrast, is actually a Hamiltonian interpretation of early U.S. history rather than a biography. It's a pun too.)