Neel Kashkari Is the Zombie Master...

There were three theories about what made the Great Depression great, and how it could have been avoided by better policy.

• Milton Friedman: the Depression was Great because of a lack of liquidity, and if only the Federal Reserve had kept the money stock from falling everything would have been fine.
• DeLong-Summers: the Depression was Great because expectations of continued deflation became entrenched, and when those expectations were broken--by Roosevelt's New Deal--recovery began.
• Ben Bernanke: the Depression was Great because of the collapse of the banking system, and the resulting credit channel failures that robbed businesses seeking to expand of capital.

The past fifteen months have been a big strike against Friedman: Ben Bernanke has kept the economy liquid, and yet we are in a recession which may become a deep recession. The past fifteen months have been a strike against DeLong and Summers: no expectations of deflation have emerged, and yet here we are.

Bernanke's theory of the Depression is the only one standing (which doesn't mean that it is right, only that it may be right).

So what to do? We don't want to let the banking sector collapse into bankruptcy--Lehman Brothers was bad enough, and we don't want to replicate the Great Depression. But we also don't want to repeat Japan's mistakes of the 1990s, with zombie banks neither alive nor dead failing to do their job for the economy as they focused on getting back above water to create some value for shareholders and executives.

And here is my worry about the current plan to buy preferred rather than common stock of the banks. Preferred stock runs a risk of creating zombies--if shareholders and executives conclude that the preferred has all the equity value if they continue business as usual, then they will not continue business as usual but will instead start behaving like the Japanese banks of the 1990s. And we don't want that.

By mighty spells the Head Voodoo Priest Henry Paulson has raised the corpses of America's biggest banks from the graves to which the financial crisis was consigning them, but has he restored them to life, or just to zombiehood? Will they do their job for the economy, or will they begin wreaking destruction, all the while crying out: "BBRRAAIINNS! BBRRAAIINNSS!"

If so, it will be up to Neel "The Zombie Master" Kashkari to control them...

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Justin Lahart collects opinions. I tell you, I'm never going to ask Barry Eichengreen for an extension:

Barry Eichengreen, Berkeley: This is now, finally, the right move. Were it a student paper, I would give it give it an A- for quality but lower the final grade to a C for lateness. The minus on the A reflects the Treasury´s reluctance to opt for straight stock with voting rights as other governments have done. If we are going to entrust the banks with taxpayer funds as part of their equity, then the taxpayer should have a vote. This is especially a problem with the weakest institutions, where at some point management, unrestrained by representatives of the taxpayer on the board, will be gambling for survival using public money. What should be next, you ask. Let the new measures work. Apply some fiscal stimulus in the form of aid to state and local governments and targeted tax cuts. The stimulus will be needed.

Kenneth Rogoff, Harvard University: It wasn’t just the right move, it was the only move. Thanks goodness they didn’t dally for another week to finally figure it out. There are many challenges ahead. The recession is only just picking up steam, now. In the wake of the housing and credit bust, there is no way that the US is going to sustain consumption at 70% of GDP. Exports will fall as the rest of the world goes into recession. [On policy] surely the next Congress will pass a massive bailout for mortgage markets, especially if housing prices continue to fall. Last but not least, the latest Treasury plan begs the question of what a post-bubble payments system should look like, and how it should be regulated. Will future profits from retail banking all come from supplying convenience services for what essentially amount to deposits with the US government? Surely the regulations governing money market funds will have to be completely rewritten.

Doug Elmendorf, Brookings Institution: These new policies are huge steps in the right direction. However, the announcement alone will not be enough, just as other recent announcements like the TARP and the Fed’s CP facility failed to increase lending by banks. It’s crucial now that the money start to flow from the government through all of these channels.

Anil Kashyap, University of Chicago Graduate School of Business: [I] strongly think recapitalization is the deep problem. I would prefer giving the option to raise it privately first, and would like to make sure that they do not waste money on an insolvent firm (a la Japan in 1998). Guaranteeing the debt is important to buy time. Ideally the time would be used to make sure you are only helping solvent banks.... I think if they truly get the details right and succeed at recapitalizing the system, then intermediation will start returning to normal. My guess is that we still wind up with a recession but perhaps one that is much less onerous than if they not acted now.

Hyun Song Shin, Princeton University: It’s the right move in principle. The case for an equity injection is compelling. Think of it like this. If you buy bank assets with 700 billion dollars, you add this much balance sheet capacity to the banking system. On a leverage of 10 to 1, this is like injecting equity of 70 billion. But, if you inject 700 billion of equity, then on a leverage of 10 to 1, this is adding additional balance sheet capacity of 7 trillion. So, dollar for dollar, you get much more bang for the buck in adding further lending capacity to the banking system. Will the plan work? It depends how the equity is injected. The plan now is to buy preferred stock. This is a buffer against loss for the senior creditors, but it doesn’t add anything to the common stock. Preferred stock is a claim without control, which just drains cash from the bank (think of Warren Buffett’s 10% coupon on his preferred stock from Goldman). Preferred stock will make banks lend if the problem previously was risk of loss for the creditors. But if the problem is that the controlling shareholders (the common stockholders) are being cautious, then preferred stock will just make things worse in terms of willingness to lend. Injection of common stock will free up lending more effectively, but this is bad in terms of taxpayers getting their money back. That’s the dilemma. Do you want to protect the taxpayers’ stake, or to you want to free up lending?

Ricardo Reis, Columbia University: I think it is the right move. Not an action without problems, nor one that is desirable in general, but one to swallow given the circumstances. The root of the problems is lack of capital in the banks. If private capital doesn’t seem to be stepping in, so let it be public capital. That is, as long as it is for a good price and as long as it does the best job possible of giving the right incentives by: not rewarding current shareholders (pay little to nothing for their equity), not rewarding current management (fire them or cut their compensation drastically), and not rewarding the reckless creditors who financed them (using warrants and preferred stock that gives priority on the government being paid). What comes next depends on how markets behave in the next few days. Forecasting is usually tricky, but with the current market volatility any predictions for what will happen next are very hard.

Raghuram Rajan, University of Chicago Graduate School of Business: It has many of the elements we have been advocating. So I like it a lot better than the Treasury plan. I would worry about some details. First, while I have been in favor of recapitalizing the stronger banks so that they can lift the system, I would have preferred giving them the choice of getting government capital or raising private capital. I guess the benefit of the force feeding by the government is that the ones who do take it do not send a bad signal about their options. I am unclear how the amounts were determined. Second, a temporary guarantee of debts — e.g., for 3 to 6 months (is it for all banks) would have been preferable to a three year guarantee. Not sure how you restrict it to new debt only — I can just repay old debt and raise new debt. Third, you have to be careful that entities outside the well-protected system (e.g., small banks and insurance companies) do not face runs. It may be that the guarantee will have to be extended to more entities (not clear if FDIC will guarantee debt of all banks). Presumably, the regulators will also audit banks over the next few months to identify and resolve the weak ones. It would not be clever to offer a blanket guarantee for an indefinite period to weak banks. In this regard, supervisors will have to monitor the asset growth of guaranteed banks so as to make sure they are not gambling with taxpayer money. Presumably, also, there will be some scheme to recapitalize small and medium sized banks that are worth saving. Would like to see more private participation in those.

Markus Brunnermeier, Princeton: Overall, I like the move. It’s way better than starting a complicated reverse auction for a very heterogeneous set of troubled assets. Why? a) It recapitalizes banks directly, i.e. has a bigger bang for the buck (i.e. if you buy troubled assets standing in the books for $400bn at a inflated price of $700bn, you recapitalize banks only by $300 bn. If you inject new equity, you recapitalize the banks by the whole $ 700 bn. That makes a big difference.) b) it’s faster (since it is less complicated)! c) gives the taxpayer an upside potential as well. An alternative approach (with even more horsepower) would have been to force all banks to do a rights issue that is underwritten by the government. (Forcing all of them to do it, gets around the stigma of issuing stocks and associated stock price decline.) I am not sure whether there is still enough time left, though. There will be a wave of new regulation coming, especially from Europe. The US seems to have lost its moral authority (in terms of “how to regulate markets”). Let’s not pretend: The balance of power has shifted. Hence, it is important to think clearly and carefully how the new financial architecture should look like. I have some thoughts/outlines on my website (e.g. risk measures like Value at Risk that focus only at the risk of an individual bank have to replaced with CoVaR that measures domino effects etc..). We can talk more about if you want.

Brad DeLong, Berkeley: Yes, it is the right move–but nonvoting preferred stock scares me as giving too great incentives to gamble for resurrection; I would prefer voting common; it’s the devil, but a lesser one. What comes next? Big fiscal stimulus, I think. All those banks need expanding manufacturing businesses to lend to.

John Cochrane, University of Chicago Graduate School of Business: …grumble grumble, yes there are all sorts of warts on it, but at least this one will probably work, in the narrow sense that it can end the “crisis” or “credit crunch.” Most of all, I think it will “work” well enough to put a stop to the escalating political panic and the contagion of bailouts. My biggest fears, and those of the markets I think, have been that some new “plan” comes along every two days which can wreck everything.... If I were in charge I would announce loudly “and we’re going to sit on our hands for a whole week no matter what happens to daily stock prices.” But there are lots and lots of problems with it. Most obviously, now the government has stock in banks. Ok it’s preferred and nonvoting, but still, it is stock. And the government doesn’t need to vote its shares in order to profoundly influence how banks are run! There are lots of good practical reasons to fear government-run banking systems; governments inevitably use control over the banking system for political ends. Already ours has shown a wonderful track record in pushing Fannie Freddie and banks to make and hold bad subprime loans.... Of course, I would much rather do the same thing by marrying bank operations to new private capital rather than a government investment, and I see no reason what that is infeasible. There is lots of private capital sitting around. Pretty much by definition if the government is buying equity and private investors are not, it means the government is getting a bad deal, buying the assets at too high a price and thereby bailing out the existing share and debt holders.... So, the real questions arise going forward. What happens if the assets become worth even less? What happens if we discover that the bank really is insolvent, meaning the assets (mortgages) are worth less than the liabilities (debt)? A bank like that needs to fail, meaning the stock gets wiped out, the debt gets written down, and the operations married to new equity. Issuing a new class of stock now doesn’t help, it gets in the way. The point of equity is to be a “cushion” that can absorb losses if things get worse — which, for some banks, they surely will. Bottom line, this needs to be a very temporary plan, with a much clearer path for how banks are going to be allowed to fail, to reorganize, to marry with private equity. Otherwise, this has become “no bank may ever fail again”, and part of a government-run banking system. That will quickly become sclerotic.

Charles Calomiris, Columbia Business School: Yes, these parts are the right move, and as you know, many economists including myself have been calling for them for weeks. But the other aspects of TARP will likely be a mess to implement, especially asset purchases and asset work outs, and I predict that we will regret the stubborn insistence of the Treasury to waste resources on these plans that could be so much better put to use as capital injections.

Jeremy Stein, Harvard University: I think the plan is a strong step in the right direction. However, one item that was not addressed, and should be, is the continuation of dividend payments by the banks. Simply put, the government should force the banks to suspend all dividend payments. It makes absolutely no sense for the government to put money into the banks, only to see a significant fraction of it flow out again as dividends to shareholders, and in many cases, bank executives with large equity stakes. There is an obvious conflict of interest here: the value of the enterprises themselves, as well as social interest, are better served by the money being retained inside the banks, and being used to rebuild capital. But junior claimants who want to siphon off value from more senior creditors clearly want to move as much cash out the door to themselves as possible. Again, this should be stopped immediately. Bank CEOs may claim that cutting dividends will send a negative signal to the market, making future private issues more difficult. But of course, if the government simply compels them to cut dividends, there is no signal sent at all.

Comments

[jim]

FIVE PERCENT! The perpetual preferred stock that Paulson is buying from the banks will pay 5%. Warren Buffet got 10%. The British Government is getting 12% on the preferred portion of their bailout.

Details. The devil is in the details. Before you praise the principle, check the details.

[Neal]

Does this mean that the whole idea of "buying crap at reverse auctions" is dead?

I can certainly see where the idea of handing out cash to Goldman Sachs and the other banks is more soul-satifying for the Goldman-Sachs employees (such as Paulson and Kashkari)that are currently on sabbatical from their Wall Street jobs, as opposed to buying bad assets at minimum price.

Even if it is right thing to do, the conflict of interest meter is "pegged"--don't you think?

[Robert Waldmann]

Now You tell me. Yaers ago you advised me to ask Eichengreen for an extension to give me time to correct a few (dozen) typos. Remember ?

[Tom Maguire]

Hmm, if you are worried about zombie banks, how do you feel about limits on executive compensation at these banks?

What sort of risk-taking appetite will a chief executive who is not allowed either bonuses or stock options have? Is that the sort of appetite (and incentive structure) that will get these banks out lending and taking risks again?

Or will we end up with de facto civil servants running their banks with a full focus on avoding any mistakes which could get them sacked from their modestly rewarding sinceure?

Just wondering!

[Not Really]

So we aren't even going to mention the gigantic orders for war material placed in the US by England, France, and Germany (a small amount by Japan too, although even less of that was delivered than Germany's orders) starting around 1937? It is fine to talk about these financial system transactions but it is hard to ignore what I have seen in the records of old manufacturing companies: things didn't really start humming again until 1938 and true recovery started with the truely large War Dept orders in 1940.

Not Really

[Rob]

I don't know, Tom, maybe like the rest of the world they'll do their jobs of fear getting fired?

[Don the libertarian Democrat]

http://www.nytimes.com/2008/10/15/business/economy/15bailout.html?hp

A Credit Stimulus Package
As I understand TARP, it is essentially a credit stimulus package. The first part was forcing 9 large banks to jointly participate because:

"Bringing together all nine executives and directing them to participate was a way to avoid stigmatizing any one bank that chose to accept the government investment."

I'm not so sure that this wasn't done to move the plan forward quickly and avoid negotiating with each bank, but I get the point, sort of.

Then, because each bank could use the money for something other than loans, the plan forces them to loan the money.

“The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” Mr. Paulson said, who offered some details of the plan along with the Federal Reserve chairman, Ben S. Bernanke, and the chairman of the Federal Deposit Insurance Corporation, Sheila C. Bair.

The problem here would seem to the quickness, intelligence, and risk of these loans.

"In a letter to Mr. Paulson on Monday, Mr. Schumer, chairman of the Joint Economic Committee, urged the Treasury to demand that banks receiving capital eliminate their dividends, restrict executive pay and stick to “safe and sustainable, rather than exotic, financial activities.”

I'm still not reassured.

[Peter K.]

John Cochrane, University of Chicago Graduate School of Business: …grumble grumble, yes there are all sorts of warts on it, but at least this one will probably work, in the narrow sense that it can end the “crisis” or “credit crunch.” Most of all, I think it will “work” well enough to put a stop to the escalating political panic and the contagion of bailouts. My biggest fears, and those of the markets I think, have been that some new “plan” comes along every two days which can wreck everything.... If I were in charge I would announce loudly “and we’re going to sit on our hands for a whole week no matter what happens to daily stock prices.”

When I read this I think 1) weren't unregulated markets the cause of this mess and the ensueing costly bailouts 2) isn't there a growing consensus that the collapse of Lehman brothers really got the ball rolling?

[Bernard Yomtov]

"What sort of risk-taking appetite will a chief executive who is not allowed either bonuses or stock options have? Is that the sort of appetite (and incentive structure) that will get these banks out lending and taking risks again?"

Is anyone proposing that there be no incentive compensation?

And isn't an excessive appetite for risk part of what got us here?

[kharris]

So the Bush administration pulled an economist out of a Ivy League hat, and somehow came up with the perfect guy for a job they never believed even needed to be done? This Bush adminstration? Not the grown up one?

[Neal]

Let the loans begin!!

Just a small matter--which person or enterprise is credit-worthy at this point in time?

Or if it is free money--who cares!?! And besides, the government is pushing to open the spigots!!

Oh wait, isn't that what happened last time...

[ogmb]

Why does Hank Paulson still have a job?

[Kaleberg]

None of this is reassuring. You guys sound like a debate on the comptine theology of Jupiter's left hand fifty years after Constantine. And this debate is taking place on Gazuto, a fantasy planet that I just made up.

To start with, the premise is wrong. The problem is the lag in wages with respect to productivity. The financial collapse is a symptom, and only a minor symptom, of the problem. How soon we recover depends on how soon we grasp that fact and act on it. It took nearly four years the last time.

If you want to understand how the financial corporations work, imagine that you are on the planet Earth. The people running these companies do what gets them the biggest paycheck. If putting the company into bankruptcy or selling nuclear weapons to Osama bin Laden gets them the extra $10M bonus, they'll do it without compunction. To them, money is like religion; it can justify anything. Congress and Paulson may sweat the details of their $700+B giveaway, but to these guys it is just niggling about their end of year bonus. Financial companies will only lend money if you make it worth their CEOs while. That is, if you get them more money personally. Any other attempt to manipulate their behavior, beside force of arms is futile.

If the government wants to extend credit to businesses, it should simply do so. It lends to banks, it lends to farmers, it lends to students, so cut out the middleman. These organizations made sense back when bookkeeping was expensive, but there is no need for them nowadays. It's not as if they know their customers or know the markets. They all subscribe to the same credit reporting outfits and research companies. Let them fail. More appropriate, more efficient institutions will arise to meet modern needs, but not until the field is cleared.

We are setting ourselves up for failure. We should use that $700+B for business loans and for increasing wages. Maybe on Gazuto the problem is failed financial institutions. Would that it were so simple here.

[tomrus]

I need to give a lecture on the financial crisis and the injection of public capital. Will anyone, no matter what there political stripe, object, if the first slide says "CLEARLY PRIVATE CAPITAL MARKETS DO NOT WORK?

[Tom Maguire]

"Is anyone proposing that there be no incentive compensation?

And isn't an excessive appetite for risk part of what got us here? "

Well, a misguided sense of risk, certainly. That said, Goldman sachs famously wound down its exposure to mortgage backed securities a year ago and still got caught up in the wash.

As to who is proposing what about incentive compensation - you tell me. This is from Chuck Schumer in the Times:

" In a letter to Mr. Paulson on Monday, Mr. Schumer, chairman of the Joint Economic Committee, urged the Treasury to demand that banks receiving capital eliminate their dividends, restrict executive pay and stick to “safe and sustainable, rather than exotic, financial activities.”

“I don’t think making this as easy as possible for the financial institutions is the way to go,” Mr. Schumer said in a call with reporters. “You need some carrots but you also need some sticks.”"

How much of a restriction on executive pay, and for how long? Incentive bonuses capped at $500,000 won't even be enough to make these guys laugh out loud.

If the restrictions are only for a few years (or until the company retires the government preferred), people may wait it out, figuring that historically these top spots were quite lucrative and will be again.

If the chairman of Goldman or Citi will never make more than the Secretary of the Treasury, these guys will quit to work for hedge funds, private equity, money managers, college endowments, insurance companies - basically, somewhere else in finance.

Maybe that's fine (hard to be a fan of these guys just now). But if it is, how can we also be worried about "zombie banks" that take no risks and make no creative loans? What chairman is going to sweat out a loan to General Motors, or to T Boone Pickens windmill farm, if he has no upside and will get sacked if the loan goes south?

[Sam Taylor]

Tom-

I don't know anyone who does not favor incentive compensation to executives for real results that benefit shareholders of publicly held corporations...or disincentives for results that do not benefit shareholders. The problem is that there are none of the latter and the former are gamed. Do you have a problem with sending the gamers (aka "cheaters") to the hedge funds?

[MattYoung]

Why not try attributing the cause of the Great Depression to a technology shock, like radio, for example, with its ability to transmit prices nearly instantaneously.

[Vito]

What about fourth explanation of the Great Depression - namely negative productivity growth shock... It would explain why the government intervention is ineffective or can't completely prevent significant recession. Asset price must come down to reflect future slower growth.

[stubydoo]

Friedman's theory has not been discredited at all by events of the last 15 months. Unemployment is what - 6.1%. Events so far are still consistent with a theory that we only have any kind of downturn at all because we had a little bit of an old fashioned bubble in housing, along with some nutty efforts to keep that bubble inflated. In this theory, the extra liquidity provided by Bernanke has been a rip-roaring success.

Not that I'm guaranteeing that Friedman was right.

[MattYoung]

Doing a little research on radio in the 1920s, let me report.

By 1924, commercial radio had arrived, including the pricing and product description of future product deliveries. Radio started by transmitting farm prices in 1921.

By 1926, radio listeners knew about the future before the banks. Hence, individuals would have been empowered to plan their own uses for money, banks would be playing catch-up.

[Bram Cohen]

Your classification of explanations of the great depression is interesting. The explanation I was taught in intro to macroeconomics in 1994 was that what kept the great depression going was that it became a better investment to literally keep your money under your mattress than to actually invest it in anything, and this was a self-enforcing liquidity trap, and what we should have done to get out of it was have an inflationary rather than a deflationary money policy (or maybe I'm mixing in some later Krugman writings on Japan). This whole theory all seemed to be attributed to Keynes.

Your very brief summary of Bernanke's opinion seems to be that people didn't keep money under their mattress because that was the best available investment, but simply because without a banking system you just plain can't make investments. Is that correct? It would seem to be a plausible theory, but without a sustained recession without deflation or a recovery from a sever recession with no inflation, it's hard to tell.

Is it true that we aren't experiencing deflation now? Oil has fallen dramatically, as has shipping, and it may only be a matter of time before that trickles into everything else, and certainly those are big deals in and of themselves.

As for your comment about zombie banks, it's very strange to be hearing about such situations outside of venture capital, but these are strange times indeed. It's unclear on whether the banks might really be zombies after this investment - it depends on just how insolvent they are right now. Generally speaking, there are two ways out of a situation where the common isn't worth anything. Either there's an M&A which wipes out common outright, or there's a recapitalization which redoes everything with common only having a small slice. The former is the one which can't really happen if the preferred only has non-voting shares.

The thing which puzzles me is how hardcore everyone is about liquidity preferences. If the first batch of money merely went, say, 75% to preferred, instead of the 100% that it does today, that would cause a lot less heartache stress for everyone involved. Such a severe misalignment of incentives is not generally speaking a good thing.