TOPICS IN POLITICAL ECONOMY

COMMON SENSE AND STRAIGHT TALK IN THE NEW WHITE HOUSE?

Larry Summers, a former Treasury Secretary for Bill Clinton, apparently will be the economic policy chief in the Obama White House. I find this a reassuring piece of news. If Summers is going to set policy with respect to the failed government mortgage agencies, Fanny Mae and Freddy Mac, maybe we are going to see some serious, sensible reforms.  Consider his observations on the two agencies in his blog this past July:

One hopes that we are now witnessing the end of this particular experiment in creative capitalism: the government is moving to pick up the pieces of the mess the [agencies] have made and their shareholders are losing most of their money. . . the sense that the mission is virtuous is always a great club for beating down skeptics. When institutions have special responsibilities it is necessary that they be supported in competition to the detriment of market efficiency.

It is hard in this world to do well. It is hard to do good. When I hear a claim that an institution is going to do both, I reach for my wallet. You should too.

On the other hand,  maybe Summers, known for his sometimes abrasive manner as well as his straight talk, won’t last very long in his new job. Let's hope he has a reasonable tenure (as long as his stint as President of Harvard?).

BAILOUTS, "MORAL HAZARD," AND GENERAL MOTORS

If you want to know why General Motors (GM) is pleading for a Congressional bailout today, you need to know what happened in 1980.

That was the year that Chrysler, the #3 U.S. automaker, came close to going belly up.  After years of unsuccessfully struggling to adapt to a more competitive marketplace due to Japanese imports – and a growing presence in the U.S. of Japanese-owned manufacturing plants - it was bailed out with a $1.2 billion US government loan guarantee and a quasi-Chapter 11 bankruptcy proceeding.  (For a straightforward narrative of this saga as of 1983, see www.heritage.org/research/regulation/bg276.cfm.)

No matter that several years later the U.S. Treasury, as part of the package for Chrysler, was able to auction off Chrysler common stock warrants at a profit of $300 million.  Taxpayers at the time may have thought they came out ahead, but the bailout created a mega “moral hazard” precedent that GM managers, shareholders, workers, and affiliated politicians are frantically leveraging off of at this moment.  (And, of course, today Chrysler, still unreformed, is desperately trying to merge with one of the two other “big three.”)

“Too Big to Fail?”  For GM management and board members, the lesson of 1980 has been clear: if Chrysler was too big to fail then, certainly GM today is in the same class.  Truly serious downsizing, substantive labor contract re-negotiations, and a vast change in management culture can be avoided, since the U.S. government will be always be there to bail them out. This is an excellent illustration of what is call "moral hazard" by students of bailouts: precedents influence behavior of those who follow.

If Chrysler, and all its stakeholders, had been eliminated as an independent automaker in 1980, much as LTV, Bethlehem, and various other American steel companies disappeared into bankruptcy over the past ten years, chances are that GM management and workers would have “seen the light.”  They would have taken the necessary drastic and painful steps to get their house in order. This is what U.S. Steel did after Wilbur Ross and Lakshmi Mittal (two rank outsiders) established  their credibility with the steel workers’ union and  reorganized much of the faltering U.S. steel industry.

A bailout of General Motors today would be establishing another precedent that, in the long run, would rank as a major achievement in destroying American competitiveness in global markets.

WHO DO YOU TRUST? RATING AGENCIES OR CREDIT DEFAULT SWAPS?

As a source of sound analysis, the business pages of The New York Times on the current travails of the global financial system tend to be a travesty of responsible journalism.  In their unceasing crusade for more regulation, their writers’ crusade against credit default swaps (CDS) is “Exhibit A.”

Who Is a Better Predictor of Creditworthiness?  No matter that market-driven credit default swaps are far better predictors of defaults or "credit events" than Standard & Poor's and Moody's, whose ratings are inherently skewed by the fact that borrowers (not investors) pay for the rating.

Consider this blatantly wrong statement by senior writer Gretchen Morgenson in a recent article: credit default swaps are a “$55 trillion market at the heart of almost every big corporate failure and near-collapse of recent months.”

In fact, the demise of Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual and Countrywide Financial had nothing to do with credit default swaps – they simply borrowed too much and/or invested in excessively high risk mortgages. 

True, insurance giant AIG was crippled by rating agency downgrades that forced it to put up more cash than it could come up with against swaps that it had issued; but the problem was not swaps per se, but the toxic mortgages that underlay many of those transactions.

The Market is Working. For Morgenson, all the settlements to date of credit default swaps triggered by the demise of the firms cited above must have been disappointingly dull – everyone got paid without a fuss. The market worked just fine, thank you. 

As I have noted before and is demonstrated dramatically below in a chart from the latest issue of the Bank of England's October "Financial Stability Report," there are plenty of other derivatives which have demonstrated their usefulness in reducing interest rate, equity, commodity and foreign exchange risk. Most of these, like credit default swaps, are traded over the counter (OTC), although interest rate swaps are both exchange-traded and OTC. 

 

 

The editor of The Times' business section should red pencil wild, sweeping generalizations by their reporters, demand they pay more attention to hard facts and to spend less time making non-too subtle pitches for senseless regulation.

If you don't like the job that the credit rating agencies have been doing you should be pushing for an expansion of the CDS market, not trying to throttle it.