How Much Is the Environment Worth?

A really interesting article.

http://reason.com/news/show/132416.html

The Geithner Plan: A Primer

So, it's finally arrived: Tim Geithner delivered a new baby plan via The Wall Street Journal, presumably because last time he tried to give a speech all hell broke loose.

Some are cautiously optimistic, while others think it is dead on arrival.

So, what is the plan? I, here, will attempt to explain, as I understand it now.

We all know that there is a credit crisis. This is caused by bad assets (mostly bad mortgages) being spread throughout the financial sector in the form of securities. The problem? No one knows exactly where they are, since when they were securitized, they were all chopped up into little bits. Because they are who-knows-where, banks aren't willing to lend, since they don't know when the next shoe will drop and another investment of theirs will collapse. The entire credit system comes to a standstill.

Enter the Geithner plan:

1. Lend money, through TARP and the FDIC to investors (mostly hedge fund managers) for the purchase of bad (and potentially bad) assets. Lend 85% of the purchase, expect 15% to be paid by the investors. The 15% gives them a stake in the success of the enterprise.
2. Give management of a "Public-Private Investment Program" (P-PIP?) to the hedge funders.
3. At the same time, the Federal Reserve will join with the Treasury Department to expand the lending that they can.
   

OK--that seems simple enough. What the administration is hoping is that:

• First and foremost, the balancing sheets of banks will be cleared of crappy assets (I keep trying to get people to call them 'crapssets'). This (hopefully) will make them healthy and happy again, lending as carelessly as in days of yore, like 2006.
  
• The banks will make some money from the sale of the bad assets, though they will still take a significant loss. Currently, since no one is willing to buy them, the assets sit on the books at no cost (thanks to mark-to-market accounting). With the new P-PIP (what a lame acronym), there will be a separate market for bad assets, away from the banks' coffers.
• Hedge fund managers will invest in these bad assets, paying little for them (but more than zero), hoping to make a veritable fortune when (and if) they reach maturity.

In the end, it means that banks will be cleared of bad debt, taxpayers will be recouping a portion of any bad debt that survives to maturity, and--most importantly--the credit markets will start moving again.

However, as Paul Krugman notes in his New York Times editorial (linked above), Geithner is banking (pun definitely intended) on one thing that no one can guarantee, and that is that the bad assets (crapssets) will actually end up being worth more in the end, and not simply remain as the worthless sheets of paper they are now. Christina Romer thinks that the market will determine that the bad assets are undervalued. Krugman's point is that that assumption may not be true, and if it isn't true, there will be major consequences, since no one will pay for the assets, they will stay on the banks' books, and taxpayers will be out a few more billion dollars. Additionally, the Obama administration will be out of political capital, and a second try may not be possible. He says:

"The Obama administration is now completely wedded to the idea that there's nothing fundamentally wrong with the financial system -- that what we're facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.... What an awful mess."

We shall see what happens, since a large part depends on investors. Are they willing to buy into the idea that these crapssets are worth more than everyone thinks?

Unrelated: the New York Magazine has a great article on "Obama's Brain Trust" of economic advisers.

AIG Is Paying Out Its Bailout Money to Investment Banks?!?!??1!?!! Uh...That Was the Point.

In all the populist fervor surrounding the AIG debacle, one argument is being shuffled around the media. AIG, it seems, paid out their share of the bailout money to (*sarcastic gasp*) Goldman Sachs and JP Morgan and other investment banks! Frank Rich at the New York Times and Eliot Spitzer (reminder again: how did he leave office? Oh, yeah--in disgrace after cheating on his wife with hookers.) at Slate have both pushed this line of reasoning.

Uh, guys? Am I missing something? AIG paying out to these banks is the whole point of the bailout.

AIG, you see, is an insurance company. That means they sell insurance policies, and many of those policies were bought by major financial firms.

Finance, you see, is the business of risk management. We can see from the current debacle that financiers didn't manage their risk particularly well. Their firms are now hemorrhaging money. One reason for that is because even their safety nets have collapsed. AIG was one of the main safety nets.

When firms were chopping up subprime mortgages into little bits and selling them as securities, they were at least smart enough to try to insulate themselves from loss by buying insurance policies from providers like AIG. The problem with AIG is that it sold too many of these policies. Now, when everything is going to hell in a handbasket, the firms with the policies are calling them in. AIG ran out of money to pay. That is whey it needed a bailout.

(NB: I'm not discussing whether the bailout was a good or a bad idea, but only that the money was supposed to go to other firms.)

Imagine if suddenly, everyone with a car insurance policy got into a major wreck at the same time. State Farm, Geico, and all the other insurers would struggle to pay everyone back because there would be more demand for payment than actual cash available. Insurers like them bank on (and use actuaries for) figuring how much they should expect to be paying in any given time period. They use that to figure how much cash to have on-hand. AIG did the same thing but on a much, much larger scale. It just didn't expect the maelstrom.

So, what happens with the money from the bailout? When it is not being spent on executive bonuses, it is being paid out to the holders of policies. The government decided AIG couldn't fail--and this is something people don't tend to understand in this whole financial mess--because if it failed, the financial firms would have no safety net, and they would lose even more than they had already. Imagine you wrecked your car, but the insurance you had bought no longer applied because the insurer couldn't pay you. Suddenly, instead of being responsible for a few hundred dollars in repairs, you are liable for thousands. The government didn't want the same thing to happen in the financial world; banks couldn't pay the 'hundreds' (of billions), let alone the 'thousands', and bailing out the insurer costs way less than bailing out the policy holder.

Though, then again, we bailed the banks out, too.

What is Quantitative Easing?

So, maybe you read on the Drudge Report today that the Fed created $1 trillion 'out of thin air.'

Well, that's true--it did.

And here's how that happens.

h/t Greg Mankiw

Will Big Bird Soon Be in the Unemployment Office?

I was disheartened to read that the Sesame Workshop will be laying off 20% of its workforce. Apparently, in tough economic times, even fuzzy inner-city monsters can't quite handle the strain.

Maybe some of them can find a job at Wal-Mart; especially the multi-lingual ones.

In Which I Try to Comprehend the Collapse of Europe's Financial System

On Tuesday, my dad and I took a trip to the Chicago Auto Show. I can honestly say that it was the first time that I have seen the effects of the current economic debacle firsthand. Last year, I attended on a Wednesday. The place was packed with both people and cars. This time around, there were maybe half as many people as last year and about 75% the number of cars. It was amazing. The place felt like a ghosttown. America's GDP in the Fourth Quarter of 2008 dropped by 3.8%, which is pretty massive. In Europe, however, it is far, far worse.

The Telegraph of London reports that Western European banks have five times the exposure to bad assets as America and East Asia. Additionally, European banks (especially Austrian, German, and Swedish) have invested massively into Eastern Europe. That was a bad idea. Many of those nations aren't on the Euro, which means that if their loans were made in different currencies and that currency drops against the Euro, they either owe more (if the loans were made in the native currency for a stated amount of value in Euros) or the bank makes less (if the loans were made in the native currency and is now worth far less in real terms). Either way, the banks loose tons of money. Even more, because of mass demand dropoffs, especially in commoditites, Eastern European industries, which heretofore have been chugging along at mega-growth rates (sometimes in the teens), are suddenly contracting. Their loans cost more to them, are worth less to the bank, and are harder to pay off because of the losses in revenue. It's a complete mess. Add to it that Russia isn't busy buying debt or helping out non-Russian industries because it has spent the last few months using up 36% of its massive foreign currency reserves to keep the rouble from completely and utterly collapsing (it has lost 35% of its value thus far; the Russian stock market has dropped 70% in the past year).

All told, Europe's economy is in the crap-heap even more so than ours.

Germany, the industrial center of Europe, had 8.4% GDP decrease in the Fourth Quarter of 2008. We had 3.8%.

Methinks this is going to last for a long, long time.

The James Bond Market

So, the demand for 3-month treasury bills skyrocketed, pushing interest rates to their lowest since that whacked-out guy with the Charlie Chaplin stache was dancing across western Europe. What on earth does that mean? Well, fortunately for you (all three of you that happen to come upon this post), I have an economics degree. OK--fine--it's a math with specialization in economics degree, but whatever.

Here's the deal. U.S. Treasury securities (in common parlance, bonds) are issued by the U.S. government. They come in many variants, but here are the main three: Treasury bills (which mature in one year or less), Treasury notes (two to ten years), and Treasury bonds (ten to thirty years). There is also the inflation-adjusted bond, but that doesn't matter so much here. Now, bonds are sold by the government to raise money. They pay a certain (usually non-adjustable) interest rate over a period of time. At the end of that time, they mature and stop earning interest. You then present the bond to your local bank, and they cash it in for you using a handy chart provided by the feds (an exciting activity that I used to do as a local bank teller). If you cash it in early, you don't get the fully matured amount. Your grandparents probably own a lot of bonds or gave you a lot of bonds when you were growing up. They often earn good interest in the long run (assuming inflation stays low), and they can keep stupid teenagers from buying an iPod instead of paying for college or a house.

Well, then, what does this all mean, and why is it relevant in any way to the current financial situation? Good question. The Treasury likes to sell its securities. People like to buy them. Then, as enterprising entrepreneurs, they like to sell them on the open market. Right now, people want to play it safe with their money, which means that short-term bond rates have been pushed very low (as you can see here). It makes sense. More people want bonds because they are a safer investment than volatile stocks (still with me?). That means demand for bonds increases. Those with bonds, who also want safe investments, basically say to those who want to buy their bonds: "will you pay me this super-low rate for my safe investment? You won't make much, but it will be safe. How low are you willing to go for it?" Rates (the interest for the bond) drop. Bonds become less appealing. Demand levels out to a nice, comfy equilibrium.

That's how it works. But what are the practical effects? Treasury bonds are safe investments, remember? They are backed up by the government, which doesn't default (even when trillions of dollars in debt). The problem, however, is that by buying the government bonds, investors are moving away from company bonds (or company debt) and company stocks, since they don't trust the company on the return. For today's example, AIG got too involved in the suprime market; they insured homes against default (meaning that they agreed to pay the company with the insurance policy if the people holding their mortgages couldn't pay). Oops! Suddenly, people are defaulting on their (out of their means expensive) homes. The financiers are trying to cash in on their insurance policies. AIG doesn't have enough money on hand to cover it. What do they do? They try to sell bonds, asking investors to temporarily trust the company and give it money, which will be returned with interest in the future. Problem is, no one had trusted AIG to keep running and making money (at least in the short-term), so they said "no thanks, AIG. I'll go to a safer investment." Ta-da! Government bond demand goes up, interest rates are driven down. Effectively, investors would rather trust the government right now than the finance company.

So, in the end, what does it mean? It means that people want to run under the umbrella of the government because it keeps out all the rain. It means that people don't want to invest in companies because they perceive those companies as struggling. It means that I'm glad that I have no stake in any of these financial firms.