March 16, 2009
Don’t Fall for Pundits’ Prattle that We’re All Keynesian Economists Now
By Wade Rousse
Before they learned the lessons of the Great Depression, Classical economists thought wages and interest rates would adjust on their own during economic downturns and guide the economy back to full employment in a relatively short amount of time. However, the 1930s undermined this line of thought, as the decade was characterized by very high unemployment rates.
Therefore, in an effort to explain the prolonged length of the Depression, English economist John Maynard Keynes developed a new theory. His key point was that businesses would produce the amount of goods and services they believed consumers, investors, governments, and foreigners would buy. But if this productivity level were below the economy’s capacity, a prolonged recession could follow. No natural economic forces would automatically guide the economy back to full employment. Hence, the theory goes, it’s the responsibility of the government to increase spending and return the economy to its potential growth rate.
But the popularity of this theory has diminished over time. First, it doesn’t explain the stagflation era of the 70s. Second, economies around the globe have been relatively stable in recent decades. In addition, many economists now believe that bad monetary policy contributed to the depth and duration of the Great Depression, when the money supply was allowed to shrink substantially. This is not the case in the current recession.
So it’s important to realize that modern macroeconomics continues to evolve. It is a combination of Keynesian views in the short run and Classical ones in the long run. Let’s not get carried away with the pundits who declare, “We are all Keynesians now.” Macroeconomics has moved beyond that.
Heart of Banking Crisis in a Non-Banking World
By Cindy Ivanac-Lillig
Banks’ balance sheets are in crisis. All proposed solutions point to different ways to get “toxic assets” off the balance sheets. Conventional wisdom seems to be these "toxic assets" are difficult to value or have no value. However, if we conclude we simply need to remove them from the balance sheet to have everything return to ‘normal,’ we may be disappointed.
The “toxic asset” conversation centers on mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS). Banks hold these securities on their balance sheets as financing vehicles for their businesses. It is similar to an individual holding a mutual fund. These securities used to be fairly liquid and provide some security during ‘normal’ business in the last few years. Banks would sell them when they needed more funds to lend or pay out. And when they had excess funds, they would buy them as investment vehicles.
At the moment, MBS and CMBS don’t have much of a secondary market (buyers and sellers), which is highly abnormal. This has left banks unable to finance their activities as easily as before. In addition, in ‘normal’ times, banks could make loans and then sell them to non-bank issuers of MBS and CMBS. This option is also not available to them at the moment.
These disruptions shed some light on how banks are financed. Both the issuance of MBS and CMBs, as well as the secondary market for them, lies in a non-bank world – the world of finance – and it has seized up. To illustrate how this impacts bank behavior, let’s look at the CMBS market. These are the securities created by pooling together commercial real estate loans. The underlying commercial real estate market did not show declining numbers until the last quarter of 2008. It currently has a default rate of less than 2%. However, the January 2009 FRB Senior Loan Officer Opinion Survey says, “80% of domestic banks reported that they had tightened lending standards for commercial real estate. 95% increased their loan-rate spreads….” (The numbers for residential lending were actually more favorable than that of commercial lending.) Because banks have assets that are difficult to sell and because they have few options in terms of selling a loan they initiate, they are choosing to give fewer loans. It isn’t only about the health of the underlying market.
The non-bank channels that finance banks have seized up, and this ironically may be the heart of our current ‘banking’ crisis. Removing bad assets alone will probably not result in resumption of ‘normal’ bank lending, but addressing securitization would go a long way. Perhaps when Fed Challenge team members are asked how the Fed should measure the results of its banking interventions, the leading indicators to consider should be non-banking ones, such as new issuance of mortgage backed securities. What do you think? Check out the TALF program, which squarely addresses the securitization issue. It’s set to launch on March 19.
March 6, 2009
What is a Bank Holding Company? And How Many is Too Many?
By Cindy Ivanac-Lillig
So, the larger than life investment bank Goldman Sachs has become a bank holding company (BHC). What does that mean exactly? Since the Fed supervises and regulates BHCs, does this mean the Fed will supervise all of Goldman Sachs’s business activity?
No. It is my understanding that the Fed will examine the parent company’s books as well as the operations of the commercial banking subsidiaries (whatever they may end up looking like), but the investment banking business will continue to be supervised by the SEC. BHCs are allowed to hold many subsidiary businesses involved in a wide array of financial services. But BHCs are generally not allowed to own any non-banking activities nor even have voting shares in non-bank related companies.
This all seems pretty hum-drum until you look up the original BHC act of 1956 and realize that what a Bank could do in 1956 is quite a bit different than what it can do today. In 1933, landmark banking legislation known as the Glass Steagall Act banned banks from offering investment, commercial banking and insurance services. This legislation lasted more than 60 years but was basically supplanted in 1999 by the Gramm-Leach-Biley Act, which allowed major financial/banking sector consolidations such as Travelers insurance group merging with Citibank, etc.
As a result, BHCs are now financial service conglomerates. And what we have learned very recently is that perhaps most any financial service company can tack on a small commercial banking arm and file paperwork to become a BHC. I guess my question to you is whether you think this a problem. Will our major insurance companies be next to file as BHCs?
We all know the benefits to being a BHC in this environment and having a permanent relationship with the Fed (access to funding), but who is next, and where should it stop from the Fed’s perspective?