Financial policy: Looking forward

May 11, 2009

Washington is turning its attention to the future, having put out most of the financial fires. The crisis seems to be over, but questions remain about how to manage under-capitalized banks and, especially, how to design a financial system for the future that is more robust to adverse shocks. With fiscal stimulus in place and no likelihood of more, financial policy by the Fed and the Treasury is the only active possibility for further action to offset the recession.

The current state of the economy

The stock market thinks that the economy is turning around, and the financial press greeted last Friday’s payroll report with a positive spin, for once. But the news is not good. Here’s payroll employment, compared to  the severe recession of 1981-82:



The good news is only the almost invisible inflection in the downward path of jobs.

Apart from the successful effort to prevent the collapse of the financial system, the primary financial action to offset the recession has been the Fed’s  adoption of an interest-rate target for interbank lending of essentially zero. Rates on short-term safe assets–Treasury obligations and private instruments enjoying explicit or implicit government guarantees–are close to zero. But, sadly, rates actually paid by most private decision makers are almost as high, or in some cases higher, than before the recession began. The Fed and Treasury’s policies to lower these rates have delivered fairly little so far. Here is the record:

interestRates paid by individuals–credit cards, pesonal loans, car loans, and mortgages–have fallen slightly, but by less than the decline in inflation, so the real rates are up a bit. Rates paid by corporations, measured here as BAA bond rates, have risen substantially in nominal terms and even more in real terms. Rates paid by state and local governments have also risen in slightly in nominal terms and more in real terms.

The notion that monetary policy has been highly expansionary–promoted by those looking only at safe government (Treasury) interest rates and at the volume of bank reserves–is plainly incorrect. Rather, higher interest rates are discouraging spending and production.

Monetary expansion

The Fed is attacking high interest rates by purchasing private debt. Higher demand for any class of debt will drive down the interest rate for that class. One of the important lessons of the past year has been that various interest rates do not all move together in times of severe financial stress (or at other times either). Thus, the Fed has not run out of options after it drives the Fed funds rate to zero. Unfortunately, the Fed is not able to expand its holdings of private securities efficiently. The efficient borrower is the Treasury, which floats short-term debt at very low rates in the world credit market. The buyers placing the highest value of Treasury debt outbid the others, so the debt finds its most desirable home. By contrast, the Fed borrows only from American banks. The Fed currently pays twice as high an interest rate on its borrowings as does the Treasury for its shortest-term borrowings (25 basis points for the Fed; 14 for the Treasury). The Fed displaces other asset holdings in  American bank portfolios, whereas the Treasury places its debt in many portfolios around the world. Earlier in the crisis, the Treasury did borrow and place the funds at the Fed’s disposal, providing the efficient approach to Fed expansion, but the Treasury has withdrawn most of those funds. It’s time for the Treasury to resume its past practice on a much larger scale and for the Fed to cut reserves back to more normal levels. The political obstacle to this move is the ceiling on the national debt, which fails to count reserves as part of the debt, so the government can circumvent the ceiling by creating reserves instead of issuing Treasury securities, at a somewhat higher cost.

Current policy for weak financial institutions

Economists are increasingly puzzled by the government’s treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government’s actions for Chrysler and General Motors follow the doctrine. In Chrysler’s case, bankruptcy converts the claims of debtholders into equity, making its new relationship with Fiat financially attractive to Fiat. General Motors may be able to continue as a stand-alone automaker if the claims of its debtholders, including the debt-like claims of retirees, become equity.

By contrast, the government’s current policy for all large financial institutions is to dribble taxpayers’ funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. The government injects funds into AIG, Citigroup, the Bank of America, and many other institutions to keep them just above water. The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the “lost decade.”

The celebrated stress tests, just completed, illustrate the current policy perfectly. The test asks if it is likely that a bank can sustain its current status through the end of 2010. “Sustain” means earn enough from operations and asset returns to cover losses that would occur under a pessimistic macro forecast. The Fed’s white paper describing the tests contains the following remarkable sentence: “While this approach [the stress test] likely captures the bulk of the losses that might be realized on these assets, it is important to note that it does not include the substantial losses that have already been taken.” (page 3) The stress test takes the current condition of the bank as the goal for the future. If the bank can just squeak through the next 20 months with enough profit from operations and margins of investment earnings over the cost of funds to offset increases in reserves for loan losses, then it passes the test. If the bank would have inadequate capital at the end of 2010 under the scenario, it flunks the test and needs more capital. Many large banks including Citigroup and the Bank of America flunked. They need to raise capital to be barely solvent at the end of next year. The test has nothing to do with ensuring that banks are heavily capitalized, ready to resume their normal roles in the economy.  The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. The government turned to stress tests, it appears,  out of discomfort with the answers the standard capital tests gave, based on seeing that properly measured capital was adequate in relation to obligations.

Unfavorable developments since the design of the stress test raise questions about its interpretation as the most pessimistic reasonable forecast. In the “more adverse” forecast that claimed that character, the unemployment rate is 8.9 percent for 2009 and 10.3 percent for 2010. The rate as of April 2009 was already 8.9 percent and almost certain to rise more during the coming months. The “more adverse” projection of 3.3 percent decline in real GDP in 2009 over 2008 is close to the current consensus. The figure for 2010 of 0.5 is below the consensus.

The market for bank debt tells an interesting story about the current policy (data are available to the public from FINRA’s TRACE database). Citigroup’s debt maturing in the next few years sells at par. The market believes the government’s pronouncement that it will keep Citigroup solvent in the near term. For longer maturities, the debt is deeply discounted. A large issue maturing in 2032, with a coupon rate of 6.625 percent, sold on May 8 for $65 per $100 of par value, to yield 10.8 percent. The market assigns a significant probability to default after the crisis clears up.

The effect of the government’s current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued,  had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. This policy is hugely expensive and stands in stark contrast to the losses that the government has expected investors in the debt of automakers to recognize. The Treasury has proposed legislation to empower the government to reorganize financial institutions but has not indicated that the new powers would focus on reorganizations that would recapitalize financial institutions without handing debtholders huge capital gains. The continuation of current policy would automatically give those capital gains. Holders of the Citigroup debt mentioned above would enjoy a large capital gain (from $65 to somewhere near $100) if investors came to believe that the government would keep dribbling funds into Citigroup to enable it to meet all its future obligations, including paying the interest and principal on that debt issue.

Because Congress, acting on behalf of the taxpayers, seems reluctant to vote new bailout funds for most financial institutions and is firmly opposed in the case of AIG, the government needs a better alternative for stabilizing weak institutions. There are much better uses for federal money than handing capital gains to debtholders.

We can easily describe the desirable policy in terms of goals, though implementation is more of a challenge. A primary goal is to avoid interference with the high-speed transactions of modern financial institutions. As the unwinding of Lehman Brothers shows, traditional bankruptcy can be a disorderly method for reorganizing modern financial institutions. The reorganization needs to start with a clear statement that the institution will meet its short-run obligations in full. In other words, some minimal amount of capital gains to claimants is involved in a practical reorganization. If an institution has substantial amounts of debt outstanding that is subordinated to all other claims, reorganization is fairly simple. The danger to the institution is that the subordinated claimants will put the institution into barnkruptcy at some future time when the institution fails to make required payments to those debtholders and that the bankruptcy will plunge the entire organization into Lehman-like chaos. To sidestep this danger, the reorganization alters the claims of the subordinated debtholders so that they cannot trigger a bankruptcy or so that the bankruptcy that they can trigger does not interfere with the activities of the institution.

The first approach is easy. It is the one that the government pushed on the debtholders of the automakers–convert debt to equity. With new powers granted by Congress, the government could figure out a conversion value  for a large amount of debt that gave the debtholders the same market value as equity as they currently enjoy. The debtholders would suffer no capital gain or loss. As the experience with automakers’ debt showed, it is virtually impossible to achieve such an exchange voluntarily, because both sides will play “chicken” until adult supervision intervenes. The compulsion of new law is necessary. Finding the conversion value is easier said than done, but is at least a well-posed question.

If a borderline institution lacks enough fully-subordinated debt to achieve an adequate level of capital by converting debt to equity, longer-term debt could be treated as if it were fully subordinated. Again, the debtholders could be given equity equal in value to the market value of the debt they gave up. In this case, the claimants subordinate to the converted debtholders would enjoy a captial gain, at the cost of the shareholders. One could imagine some kind of redistribution to deal with this inequity, but it is a complication. In the case of Citi, the claimants subordinated to the debt to be converted are mainly the foreign depositors.  Foreign depositors stand to absorb losses before the debt-holders do. Because the foreign deposits can be withdrawn on demand, even a hint of a policy that failed to deliver full value would trigger a run.  Averting the potential for a run in the midst of a bankruptcy, which would surely bring chaos, is the point of the reorganization.

Actual exchanges of debt for equity are not needed to  recapitalize shaky institutions. Recall that the goal is to prevent bankruptcy from interfering with substantive business, not to prevent bankruptcy entirely. Reorganizing an institution so that the debtholders retain a debt claim is practical. If the institution suffers further losses in value which cause it to default on the debt, a bankruptcy will occur. Our earlier post described how to do this. In brief, the debtholders’ and existing shareholders’ claims are moved to a holding company (if they are not already in a holding company) which owns all of the equity in the operating institution. Some people, including us in our earlier post, called the holding company the “bad bank” and the operating entity the “good bank.” If the earnings of the operating institution are insufficient to meet the obligations to the debtholders at some future time, the holding company does a simple Chapter 7 bankruptcy in which the debtholders become the shareholders in the holding company, with no implications for the operating institution. This type of reoganization involves quite a few alterations in the contracts between the operating institution and its customers and counterparties, so it definitely requires the kinds of new powers that the Treasury has sought recently from Congress.

The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones, and that Congress should enact legislation promptly that would make these reorganizations possible. 

Reform for the longer run

Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government’s protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the statement of the Squam Lake Working Group, an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank.  As we discussed above, if the operations of the bank, paid as dividends to the holding company, could not meet the obligations to the debtholders, the holding company would go through a Chapter 7 bankruptcy and the bondholders would take over as shareholders.  The Squam Lake proposal would sidestep the bankruptcy by designing the debt to convert to equity on its own terms under adverse conditions.

The idea that banks should have large amounts of fully subordinated debt is hardly new. The only novelty in this line of thought is methods for protecting banks and similar institutions from breakdowns in high-speed financial transactions. And this novelty arises because our financial institutions have new moving parts they did not have even 25 years ago, and because it has been such a long time since our largest banks were so close to insolvent.  The regulatory structure has not kept up.

Under a requirement of substantial amounts of subordinated debt, bank deposits would become almost completely safe. Banks would be limited to financing their activities through deposits to the remaining fraction, 60 percent in our example above. For larger banks, this would not be a binding limitation.

The Fed Needs to Make a Policy Statement

April 13, 2009

More and more one hears the concern that the Fed has embarked on an expansionary policy that will result in high inflation once the economy returns to normal. John Taylor, a leading expert in this area, put the argument as follows, in recent Congressional testimony:

… the enormous increase in reserves is potentially inflationary. Many people ask me if it is inflationary, so I know it is on people’s minds. With the economy in a weak state and commodity and many other prices falling, inflation is not now a problem, but at some time the Federal Reserve will have to remove these reserves or we will have a large increase in inflation…Recall that increases in money growth affect inflation with a long lag. The question is whether the Fed will be able to reduce the reserves in time and whether people will expect the Fed to do so. If reserves get to the level [implicit in recent policy announcements] it will have to sell a huge amount of securities backed by consumer credit, mortgages, student loans, and auto loans. This will be difficult to do politically.

Chairman Bernanke responded to this view in January, but his answer–basically what we view as the correct one–received little attention and did not alleviate the misconception of incipient inflation that has spread widely since then.

A common way to express the concern is that the Fed has created huge amounts of money and that it will not be able to shrink the money supply in time to avert inflation as the economy recovers. This way of expressing the issue is completely confusing, because it equates reserves with money. The Fed now pays interest on reserves, so the connection of reserves to money is not mechanical but requires a modern analysis that includes the role of the interest rate on reserves. Though many central banks now pay interest on reserves, the extension of monetary theory to include that new factor has remained obscure. Only little-known academic studies such as “Controlling the Price Level” and “Optimal Fiduciary Monetary Systems” considered the issue.

Reserves are interest-bearing obligations of the Federal Government, enjoying the same safety and liquidity as Treasury bills. Reserves form the core of the payments system. Anybody can trade reserves dollar-for-dollar for currency by cashing a check, withdrawing from an ATM, or depositing currency in a bank account. Financial obligations stated in dollars can be met definitively by writing a check, which is an instruction to one bank to transfer reserves to another bank.

Banks must hold reserves of 10 percent of the amounts in their depositors’ checking accounts (required reserves), but this requirement is not binding today, as banks are holding vastly more than their required reserves.

When the Fed pays interest on reserves at a rate well below market rates–in particular, well below the Fed funds rate governing borrowing and lending among banks–banks economize on reserves. If the margin between the Fed funds rate and the reserve rate is large, say several percentage points, banks will hold only required reserves. In this case, standard old-fashioned monetary theory applies, taught to generations of freshman principles students as the “multiple expansion of deposits.”  Suppose we start with deposits of $100 billion and reserves of $10 billion, so banks hold no reserves in excess of requirements. Then the Fed creates another $1 billion of reserves. Banks will expand their activities to try to avoid holding excess reserves, which are undesirable because they pay interest far below market rates. The economy expands as a result, depositors hold more in their checking accounts–$110 billion to be precise–and banks no longer hold excess reserves. The economic expansion is a combination of more real activity and higher prices. An expansion of reserves raises the rate of inflation over some period, generally thought to run from about a year after the expansion to around four years.

This conventional analysis always applied when the Fed paid zero interest on reserves and market rates were in the range of 5 percent or more. Banks used sharp-pencil policies to avoid holding excess reserves. Manipulation of the quantity of reserves gave the Fed powerful and direct and direct control over economic activity and inflation.

When reserve interest rates and the Fed funds interest rate are close to each other, the situation is quite different. Banks are happy to hold excess reserves which pay just as much as could be earned on other safe investments. Expansion of reserves results mainly in expansion of excess reserves and has little effect on bank lending. Rather than stimulating economic activity and raising the volume of bank deposits, an expansion of reserves just adds to banks’  holdings of reserves. The Fed loses its control over economic activity. In particular, expansion of reserves is not inflationary when the reserve rate and Fed funds rate are the same. There is no risk of excess inflation in today’s economy.

Equality of the reserve rate and the funds rate comes about in two ways. One is for the funds rate to fall toward the reserve rate. Prior to October 2008, the reserve rate was always zero. Thus, as the funds rate approaches zero, the mechanical connection between reserves and economic activity vanishes. This limitation on the Fed’s ability to stimulate the economy has long been known.

The second way the two rates could become equal is for the reserve rate to rise to the level of the funds rate (or even a bit above, as it has since October). Note that both factors have operated in recent months. When the Fed started to pay interest on reserves in October, it set the rate at 0.75 percent or 75 basis points. The current rate is 25 basis points.

Raising the reserve interest rate is a contractionary measure.  A higher interest rate on reserves makes banks more likely to hold reserves rather than increasing lending. The Fed’s decision to raise the reserve rate from zero to 75 basis points just as the economy entered a sharp contraction in activity is utterly inexplicable. Fortunately, the Fed lowered the reserve rate subsequently, but the continuation of a positive reserve rate in today’s economy is equally inexplicable.  Some economists have proposed that the Fed charge banks for holding reserves, an expansionary policy worth considering. With the Fed funds rate at around 15 basis points, it would take a charge to restore the differential that drives banks to lend rather than hold reserves. Were the Fed to charge for reserves, they would become the hot potatoes that they were in the past, when the reserve rate was zero and the Fed funds rate 4 or 5 percent. Banks would expand lending to try not to hold the hot potatoes and the economy would expand. There is no basis for the claim that the Fed has lost its ability to steer the economy. (However, the Fed would have to go to Congress to get this power, as it did to get the power to pay positive interest on reserves.)

The basic point emerging from the analysis of the role of the reserve interest rate is simple: The margin between the Fed funds rate and the reserve rate is a potent new tool for stabilizing the economy. When the Fed wants to expand, it should raise the margin. In today’s economy, this would call for a negative reserve rate, that is, a charge to banks for holding reserves. When the time comes to move to a tighter policy, the Fed should lower the margin. At that time, the Fed would raise the reserve rate for two reason: first to reduce the margin and second to follow increases in market interest rates that will occur in a recovery.

So the question John Taylor posed–how can the Fed control inflation in coming years when it is committed to have a large volume of reserves outstanding to finance its purchases of illiquid assets?–has a simple and effective answer: The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.

How should the Fed pick the level of the reserve interest rate? The policy for the reserve rate should be basically the same as the successful policy for the Fed funds rate that delivered exceptional stability to the economy from the mid-1980s until the current crisis. During that period, the Fed set the funds rate adaptively–when the economy seemed headed for overheating and excess inflation, it raised the funds rate to cool the economy off. When the economy stumbled, as in 2001 and in 2008, the Fed cut the funds rate to low levels. The resulting record on inflation was outstanding–the inflation rate remained in a tight band centered on about 2.5 percent.  One of the best ways to judge the performance of the Fed is to look at the consensus forecast for inflation over the coming two years. For the past 20 years, the forecast was right on 2 to 3 percent with few exceptions. Today the consensus is for too little inflation–only 1.2 percent in 2009 and 2010 and 1.7 percent in 2011. So inflation forecasts call for expansion. Once the forecast rises to around 2.5 percent for the coming two years, the Fed should raise the reserve interest rate and reduce the volume of reserves (to the extent permitted by the liquidty of its portfolio at that time) as needed to keep the forecast at around 2.5 percent. The Fed can pick a combination of a higher reserve rate and a lower volume of reserves to cool the economy sufficiently to keep inflation on tdarget.

The Fed needs to issue a pronouncement along the following lines to assure the public that there is no need for concern about inflation after the receovery and to reaffirm its historical commitment to stable and low inflation:

The Federal Reserve is fully committed to a policy of stable and low inflation. Though the Fed has not adopted a quantitative target for a specific measure of inflation, its actual performance over the period from 1987 through 2007 is indicative of its goal for the future. The Fed will continue its efforts to expand the economy this year, when inflation appears to be well below its normal range. Its past and planned expansionary policies during the current period of extreme stress will result in a large expansion of reserves. The Fed will use its authority to pay interest on reserves as needed to prevent excessive inflation as the economy recovers.

 Even the St. Louis Fed has missed the point that reserve interest policy can take care of an overhang of reserves. An article in its Review that discusses interest on reserves nonetheless concludes.

The key is that the Fed will have to drain reserves when the economy begins to recover if it is to prevent a rapid acceleration of inflation. That necessity drives the current discussion of exit strategies.

The (incorrect) logic suggested by this sentence is that as long as the Fed has a high volume of reserves outstanding, they must be held by the banking system and thus the monetary base must be large and inflationary. It misses the point that banks can be coaxed into just the right demand for excess reserves to ensure the desired inflation rate, by paying the right interest rate on reserves. The exit strategy from the Fed’s holdings of illiquid asssets need not be constrained by concerns about inflation, becuase reserve-rate policy can take care of inflation.

The author responds:

I like your website and this article, though, I think I was misrepresented (but not too badly). 

I understood the point made by Woodward and Hall when I wrote the article on recent changes in the monetary base. To quote, “The difficulty of maintaining price stability will depend on the size the balance sheet reaches before the crisis ends, the quality of the assets in the portfolio, and the policy followed to manage the interest rate paid on reserves.” (Italics added, page 57) The article is correct in that I chose to downplay this aspect of policy. For a model of the suggested policy, I recommend “Divorcing Money from Monetary Policy,” by Todd Keister, Antoine Martin and James McAndrews at the New York Fed.

It is not necessarily true that the Fed alone (that is, without further appropriations from Congress) could raise the interest rate on excess reserves high enough to prevent inflation. It is relatively easy to imagine situations in which the interest cost paid on reserves would absorb most or all of the Fed’s income. Such conditions might include an inverted yield curve, reduced income from the GSEs, and/or a rising portfolio of nonperforming assets from bank rescue operations.

Employment decline compared to Depression

March 7, 2009

The March payroll employment data showed that the decline in employment from the peak in December 2007 is now larger in percentage terms than the decline in the worst recession since 1960, in 1981-82. The plot below shows, however, that the decline is small in comparison to the Depression. The government did not collect monthly employment data during the Depression, so we have fitted a smooth curve through the annual data. The peak before the Depression was in August 1929, according to the NBER.


The right way to create a good bank and a bad bank

February 23, 2009

Policymakers continue to struggle to figure out how to turn a troubled bank into a good bank and a bad bank. Under the good-bank/bad-bank policy, the good bank will operate free from concerns about troubled assets, because these assets will be held by the fully independent bad bank. Most discussions of the separation of a bank in this way presume that the government must inject a lot of new capital to create a well-capitalized good bank together with a still-solvent bad bank. The math seems simple–the troubled bank has almost no capital, so if the capital has to be split between the two banks, a well-capitalized bank will need new capital.

But this math is incomplete. We can create a good bank with a big cushion of capital while keeping the bad bank as solvent as the existing integrated bank. The key idea–from Jeremy Bulow–is that the bad bank owns all of the equity in the good bank.

We illustrate with data from Citicorp (in billions of dollars):

citiThe left column shows Citicorp’s balance sheet roughly marked to market. The company’s value in the stock market of $11 billion is $76 billion less than reported book equity value. We deduct that amount from the reported value of long-term assets, which is where the troubled real-estate related assets are most likely to reside.

The other two columns show the balance sheets of the new good bank and bad bank. The good bank will continue to operate under the Citi brands as a well-capitalized operating entity. The bad bank will be a financial fund with no operating functions.  The good bank gets the short-terms assets and the “other” assets because many of these are related to its operating activities. It gets the better half of the long-term assets, taken to have book value, while the bad bank gets the poor half, where the impairment has already occurred and suspicions of further price declines persist. The bad bank holds the valuable equity in the good bank to the tune of $427 billion.

The deposits remain as liabilities of the good bank. Because the good bank is heavily capitalized, the deposits are safe. Most are uninsured, so the creation of the good bank eliminates the danger of a run on the bank by those depositors. All of the debt goes to the bad bank. The holders of the debt were never promised a government guarantee. The shareholders in Citicorp become the shareholders in the bad bank. They are indirectly shareholders in the good bank as well, because the bad bank owns the good bank.

The bad bank is thinly capitalized. In fact, it has exactly the same amount of capital that Citi had in the first place. With further declines in the values of the troubled assets, the bad bank may become insolvent. In that case, the bondholders will need to negotiate diminished values or the bad bank will need to be reorganized. In either case, the shareholders will lose all their value, just as they would have lost that value had Citi not been divided and there had been no further bailout from the government. The bondholders will lose part of their value, because there is no reason or justification for bailing them out.

The key property of this approach is that neither the shareholders nor the bondholders suffer any impairment of their existing intrinsic values. At present, the shareholders own an out-of-the-money call option on the assets. The bondholders own the assets subject to the shareholders’ call. Their combined value declines by the amount of any further decline in the value of the troubled assets. As claimants on the bad bank, they would be in the same situation, sharing the same decline in value, with the losses of bad-bank shareholders equal to the losses of Citi’s shareholders absent the separation and the same for the bondholders.

The adoption of the proposed good- and bad-bank separation would result in capital losses for the shareholders and bondholders, because the new policy would eliminate the benefit that they might receive from further bailout money from the government. The potential reorganization of the bad bank made necessary by future insolvency would not create any kind of financial emergency, so there would be no reason for the government to bail out the bad bank. There is no reason not to inflict the capital losses on the shareholders and bondholders, as they represent the capitalization of possible bad policies and are unrelated to the assets that the shareholders and bondholders actually own.

Now one might wonder, given that the intrinsic claims of neither the bond holders nor the equity holders has changed, why bother?  Pundits talk about the toxic assets in the banking system as if somehow they were infectious, and the good assets would become infected by the bad assets. One envisions the mold on one piece of cheese taking up residence on an adjacent piece in the frig. Or that somehow if the bad, hard-to-value, assets were moved somewhere else, both sets of assets would be easier to value and the banking system somehow more sound.  We don’t think the bad assets are infectious. Nor do we think this re-arrangement increases or changes values or facilitates the valuations of the assets behind the banking system.  What the change does do is make ever-so-clear what the priorities are in an insolvency.  Note that in this re-arrangement, the debt claims, including the short-term commercial paper, are direct liabilities of the bad bank.  If the bad bank cannot re-fund its commercial paper one morning, the bad bank must be re-organized.  Some of its claims must be turned into equity.  This is the standard sort of Chapter 11 re-organization.

Thus, what this re-organization of the ownership claims does is show how easy and orderly a garden-variety Chapter 11 reorganization of a large bank could be, and how unnecessary it is to throw additional public money into insolvent institutions.  And thinking about public money in insolvent institutions, consider that Citi’s present market cap of $11 billion (as of the close on Friday, 20 Feb 2009) includes the Treasury’s (that is, the public’s) investment of $50 billion in preferred stock (10/28/2008 and 12/31/08), and asset guarantees (1/16/09) are unambiguously underwater.

At the most practical level, the advantage of the good-bank/bad-bank separation is to prevent the emergency that would occur if a large bank threatened insolvency. For Citibank, which has large amounts of uninsured deposits, which would remain in the good bank, the first symptom would be a run on the bank by those depositors. At that time, the pressure for offsetting the emergency by an injection of public money would be overwhelming. By contrast, no run would occur on the heavily capitalized good bank in our example. Reorganization could proceed peacefully while the good bank went about its banking business. The claims of the shareholders and bondholders, which are inferior to those of the depositors, can be sorted out without interfering with the operation of the bank.

Much thinking about bank policy takes an old-fashioned point of view by assuming that a bank finances all of its assets through deposits. The good-bank/bad-bank separation has no advantage in that traditional setting. But for a bank that is mostly financed by non-deposit borrowing, moving the non-deposit liabilities to the bad bank has an advantage in dealing with insolvency.

Employment crosses the line

February 7, 2009

With the January figure, payroll employment has crossed the line of the worst previous recession, the one beginning in July 1981, rescaled to the size of today’s labor force. One more bad month and the current recession will become the worst on record, apart from the Great Depression.


The Fed contracts

February 4, 2009

The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments. The Fed’s acquisition of large amounts of Fannie and Freddie’s debt was a notable success of that strategy, as it lowered their borrowing rates and thus lowered mortgage rates. But, as the graph below shows, the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holdings of higher-yielding investments. The line labed “Other assets” measures that type of investment. So far, no explanation for the Fed’s announcements of moving in an expansionary direction while actually contracting.


Venture Capital in the Recession

February 2, 2009


While plant and equipment spending for the entire economy was down in the fourth quarter, it only fell by 4.4 percent from its level in the fourth quarter of 2007.  By contrast, venture capital investment was down by 31 percent.  In the fourth quarter of 2007, $8.1 billion was invested in 850 venture deals.  In the fourth quarter of 2008, $5.6 billion was invested in 790 deals. The number of deals is not abnormally small—over the last five years, the fourth quarter has seen 750 deals on average, but the total invested is down a lot from last year.


This bodes ill for the 2000 vintage of venture capital.  Compare and contrast two vintages of venture:  1992 and 2000.  First note that we look at venture vintage years a bit differently from how other analysts look at them.  Others look at the year a venture fund originated.  Our vintages represent a set of companies that got their first round of venture funding in a given year.  In our analysis, the 1992 vintage year is all companies who received a first round of venture funding in 1992. 


1992 was a good year and a typical year for venture capital. By our reckoning, 1995 was the best year.  Reason is that the companies were mature enough to exit (go public or be acquired) at a time when the stock market was high.  Here’s the evolution of that 1992 vintage: 



To produce this chart, we add up all the investments made in the 1992 vintage companies, both in 1992 and all subsequent years.  We benchmark that total at 100 to make years easy to compare.  The blue line shows the total capital to be invested in the companies, and it declines over time as investments are made.  The red line shows the value of portfolio companies that are in venture portfolios, only from the 1992 vintage.  The black line shows cumulative distributions to investors from acquisitions and IPOs.  (This chart does not follow companies after they go public.  We figure there are already enough folks tracking public companies.)   Then there is the purple “total” line, the sum of capital that will be invested, value carried in private companies, and distributions to investors. Notice how the total line slopes upward most steeply in the early years, typically years 3-6, as the best investments exit.  The best exits are among the earliest, it seems for no more profound reason than the best ideas are evidently the best fairly early.  As time passes, the additional exits are middling.  Chances are, after 7 or 8 years, that if a company has not done something great for its investors as yet, it is not going to. This is a bit less true for the life science sector of venture than for information technology. But then, life science is the less risky sector of venture capital by every metric.

 Note how the rising tide of the stock market raised all values in 2000. For venture capital 2000 was an extraordinary year, as $95 billion was invested in venture companies during that year (vs. $30 billion in 2008).  But the prices paid for investments in that year were high.  Here’s the vintage year evolution for 2000: 



For 2000, distributions (from IPOs and acquisitions) are still below the amount invested. The “total” value line (purple) is above 100 near its end only because of the value at which portfolio companies are being carried.  With the recent blow to asset prices, these must fall.  Thus, it looks like 2000 will be the first year that venture capital as a whole will fail to return capital to investors. 


Note that these figures are before  the general partners’ take (a percent of invested funds and a fraction of capital gains), and are thus gross results, not net results to investors.  They are compiled from the database at Sand Hill Econometrics,built from data from Thomson, DowJones VentureOne, and a lot of our own research to fill in holes for valuations, shutdowns, and acquisition values.  We believe that this data comprise very close to the universe of venture-funded companies from 1989 to the present.