Robert Samuelson, (who in full disclosure was a former neighbor) writes in the Washington Post today blaming economists for misreading the current crisis, failing to give proper warning. Instead, they were “out to lunch”.

In my opinion, a more thoughtful, introspective, and productive piece on the same subject was written some SEVEN months ago by Martin Wolf of the Financial times.

Judge for yourself.

Yesterday’s news was not encouraging. Home value declines will continue to make families and home owners second guess their net worth. In a recession, this prompts only one reaction: saving.

The macro economic accounting identity states savings equals investment. This static steady theory is becoming a large force against fiscal stimulus, now awaiting Senate Approval.

Let’s review the facts. With the Fed meeting today, Fed Funds ended trading at 0.18% according to the Financial Times. As rates are not able to go below zero,  interest rates are essentially fixed. And bank reserves held at the Fed increase. There thus is no further mechanism to force private investment to equal savings.

As savings not offset by investment (which would lead to new jobs) and unemployment increase, taxes decline. If government expenditures just stayed the same, our federal deficit would have to increase, even without fiscal stimulus.

Faced with the choice of

• Large Federal Deficit
• Infrastructure Investments => New Jobs and a Large Federal Deficit

Its best to choose jobs, new infrastructure and a large federal deficit.

Today’s news was even less encouraging. That jobs are lost in record numbers makes valuing mortgage bonds, even if simply constructed, even harder. Yet mortgage bonds are not simply constructed, they are incredibly complex.

Job losses will not decelerate for a while. It will take time for fiscal stimulus to take effect. This makes the idea of the “bad bank” incredibly complex. Many like Reich still hold out hope for a solution that protects the tax payer. The economic reality makes it impossible that mortgage assets still on the books are worth anything close to what they were previously valued. To unclog lending, we -the taxpayer- must further take it on the chin.

Yet as the fiscal stimulus and bad bank solutions work through the economy (and slowly), we must ask ourselves: what kind of economy do we want to now create? Should the Financial Sector contribute 31% of GDP as it did in 2006?

Which should we value more? Financial engineering or mechanical engineering?

This is again why infrastructure investment as the stimulus for tomorrow’s economy is so important: The only way long term balance will be restored (and one could measure this by the current account balance) is to choose engineering over financial engineering. The more we build (not out of paper) at home, the more our economy will grow in a balanced, mature way for generations.

As Congress released the second round of TARP funding this past week, anxiety grew that its original purpose is failing: banks are not lending.

To discern why, we must think about the relationship between the TARP funding requirements and Federal Reserve Monetary Policy.

With banks taking write downs during the fall of 2008, its plausible to assume TARP funding was the only new source of capital - all remaining bank liabilities and assets were matched after write downs, tied to existing economic activity. The only source of capital for new economic activity was TARP funding, now $700 billion. To give comfort to this assumption, add up the market capitalization of the largest US banks - far smaller than TARP.

By law,  TARP funding is preferred equity on a bank balance sheet, with a 5% annual dividend. Add on administrative costs, and a loan just to break even needs approximately 6%, just to service the taxpayer requirements of TARP. Yet through Open Market Operations, the US Ten Year Treasury currently yields 2.34%, according to the Financial Times and the effective Fed Funds rate is 0.18%. TARP funding requirements place this large source of new capital no where near this historically low yield curve, completely at odds with Open Market Operations.

Two years ago, overnight treasuries traded at 5%. When the economy grows at 3% per year, an inflation at 2%, a business owner merely switches on the lights to pay back a 5% interest bearing loan. Yet in today’s environment, 5% is expensive. In today’s environment -a ZIRP interest rate environment - a recessionary environment - a deflationary environment,  those willing to accept north of 5% (6%) is a classic adverse selection problem: The smart businesses horde cash as new cash is too expensive. The businesses accepting such a loan may not be able to pay it back.

Faced with the prospect of new bad loans, it is no surprise banks are not lending. They would rather preserve capital to plug foreseen bad loans in the coming year. Further, to achieve 5%, M&A is a preferred method, scooping up the right loan packages at the right price.

A Solution:

This page has long argued TARP dividends should be a rolling average of the yield on treasury bills/notes - the opportunity cost of taxpayers funding the banks. If yields are low, economic activity is weak, keeping dividend payments manageable. If yields are higher, (assuming no runaway inflation) economic activity has increased as treasuries were sold for corporates, again making dividend payments manageable. We hope the new administration makes this change.

Robert Shiller, in his book The Subprime Solution offers a risk management tool for governments. It is a “Trill” and it pays a perpetual share of GDP.

As GDP increases, the instrument pays a higher coupon. During a recession, it pays less. Quite the floating instrument. Shiller assumes each share would pay roughly $15, believing perpetual GDP would average $15 trillion annually. (Hence the “Trill”). Each Trill would be worth roughly $300. This assumes the US Risk Free rate is 5%. The risk-less rate of the US economy is 5%.

The “Risk” that is managed is during hard times, the government obviously owes less in debt service costs. In times of plenty, the government can afford to pay more. But in bad times, governments would have more cash on hand to handle a crisis (such as today).

The Pros.

• This instrument allows the market to truly estimate GDP growth. In some ways, the instrument is worth issuing simply to have a market view (a great view) of GDP growth.
• One now has the ability- with TIPS, Treasuries, and Trills- to estimate real GDP growth given  market views.
• Instead of perpetual Instruments, it could be more beneficial to issue “Trills” expiring annually, similar to TIPS and Treasuries. This way, one could have the market truly predicting GDP growth.

The Reasons for Pause:

• Reviewing the LM curve, as output grows, interest rates rise. As the economy falters, interest rates fall. Even in today’s crisis, this relationship holds true. The Trill’s desired hedge already exists. Further, this means the government has the ability to re-finance higher yielding paper in tougher times.
• The Hedge: Shiller’s main reason for the GDP indexed Trill is to provide government “room to spare” should a contraction occur. As GDP declines, so would tax receipts, lowering government revenue. It then is hard to argue the Government would have spare cash to attack a crisis.
• Other Financings: GDP, remember, is defined as Consumption + Investment + Government Expenditure + Net Exports. GDP could remain stable year on year, but Imports could still rise. In this example, Investment (Foreign Direct Investment) remains unchanged meaning the Current Account Deficit is in the form of domestic bonds and stocks, essentially payments to foreigners from US income. Trill payments could remain unchanged, but the country as a whole would pay more to maintain the same standard of living (in the short run).

Robert Shiller is one of our smartest thinkers on real property. Let’s work on the Trill as it has definite promise as a positive instrument for US Debt.

On a randomly selected May 16th, 2007, the Federal Funds rate was 5.25%. The effective rate (the rate bankers actually trade and negotiate at) was 5.29%. The actions taken by the Fed ensured its “target base rate” was the actual base rate for charged money. In short, this is our monetary system we take for granted, daily.

Before the credit crisis, how did the Fed ensure the spread between the target and effective rate stay so close to zero (if you know this, please skip down)?

• Banks are required to hold a certain amount of capital at the Federal Reserve. Prior to the crisis, a banking business model was to lend to outside parties. When lending exceeded required capital reserved at the Fed, banks had to borrow to repatriate to the Fed.
• The first choice of funds to borrow is capital held by other banks at the Federal Reserve.
• Should other banks charge too much for these funds, banks seeking capital could simply short treasuries.
• The Fed would mimicked this action,  buying and selling treasuries to ensure the market price for treasuries kept banks honest in pricing overnight lending.
• Sure enough, on May 16th, 2007, overnight LIBOR was 5.30%, one basis point from the effective rate and five basis points from the target rate.

Today, the story is quite different. The Federal Reserve’s target Federal Funds rate is 1.00%. The effective rate, (from the Financial Times), is 0.49%.

Two implications:

• Almost everyone surveyed, interviewed, and opining (including me) expects the Federal Reserve to slash the target rate from 1.00% to 0.50% in December. That decision is now moot.
• When the effective rate is nearly half the target rate and overnight LIBOR is 0.70%, in between the two rates, and yields on treasuries expiring on November 30th are 2.67%, there is a problem of illiquid markets, not responding correctly to simple centralized decisions attempting to steer the economy. To quote Senator Trent Lott, we are now “herding cats“.

How and why?

Reviewing the minutes from the last Federal Open Market Committee meeting and events of the “credit crisis” I find several issues:

• Randomly sampling daily market rates, the spread between target and effective rates was not large enough to be significant until after the bankruptcy of Lehman Brothers, on September 15th, 2008.
• By September 22nd, 2008, while the target rate was still 2.00%, the effective rate was 1.79%. By the end of that week, the effective rate was 1.21%. In short, capital required to be in the Fed was not going anywhere: thus the start of banks truly refusing to lend.
• So, the Fed on October 6th, 2008 started paying interest on held capital, attempting to establish a floor on effective rates. Most important, the Fed started to pay interest on excess cash held above any requirements.
• But by October 10th, 2008, the policy wasn’t working. While the Fed slashed rates from 2.00% to 1.50%, the effective rate was 0.90%.
• By October 21st, the effective rate hovered below the floor rate established by the Fed on October 6th, 0.73%.
• So, the Fed again in two different announcements, the latest on November 5th, raised the interest rates paid on excess balances. As of today, any excess capital receives the target rate.

We’re still in the same position and I highlight what is explained beautifully in a recent Financial Times article:

• Most of today’s spread is explained because our Government Sponsored Entities, Fannie Mae and Freddie Mac, hold reserves at the Fed. Yet they can not receive interest payments, and thus must lend their capital at the effective rate.
• As banks are queasy regarding their own reserve requirements, they do not want to borrow entity funds for opportunities.  This capital simply sits at the Federal Reserve, depressing the target rate.

The Bottom Line:

• BANKS ARE NOT LENDING. If Banks were lending, there would be no need to pay interest on excess reserves.  That capital would be privately lent, to businesses large and small, old and new.

The Fed now has de-facto set a larger reserve requirement for banks, by paying interest on excess reserves. This is very dangerous.  That excess cash that should be in the market, growing our economy. (As I heard in business school again and again “putting capital to work”).

While overnight LIBOR has trended up since the Fed’s latest announcement (from 0.33% to 0.70% and most likely will continue up to 1.00%), the larger problem is this: For growth opportunities of the US Economy, the same target rate on a larger reserve pool of capital is equivalent to a higher rate on the official “reserve requirements”.

Therefore, when the Fed does cut rates to 50 basis points, what effect will it have?

Iceland’s current saga is not a pleasant one. Currently, all banks are nationalized and the government is receiving aid from the IMF. Further, the Bank of Iceland has been forced to raise key interest rates, forcing a recession.

Let’s go back to 2006. According to the IMF, Iceland’s current account deficit grew from 2.6% in 2005 to 4.23% of GDP. The inflation rate was 7% in 2006.

To be sure, credit was certainly cheap in 2006. So cheap that in late November, 2006 the Republic of Iceland issued a five year Euro denominated bond for one billion euros, with a coupon of 3.75% annualy. The yield when it was sold was 3.86% (3.86%!). In context, the bailout of Iceland from the IMF is worth 1.65 billion euros. For a country that two years later would be in default conditions, 2006 certainly was a cheap year.

What are the current issues with the bailout plan?

1. Banks will not dilute their equity to the government.
2. The US Congress wants bank equity and further, does not trust Hank Paulson to buy the best CDSs, CMOs, CLOs, and other toxic assets to make the bailout profitable for the taxpayer.
3. We are running out of time. If we do not get a deal done soon, imagine, just imagine what the butterfly spreads on LIBOR at the end of 2009 will look like as banks try desperately to shore up their capital at the close of earnings season.

So let’s act quickly and rationally, using a mechanism we currently operate every day.

Every time the Treasury sells debt to finance the US Government, it runs what is known as a Dutch Auction.

1. It announces how many billions of bonds it intends to sell
2. Everyone intending to buy the bonds bids
   a) An amount
   b) A yield on that amount
3. The Treasury fills its order selecting the best yields and amounts. (for full disclosure, once the Treasury has reached its amount, the highest yield becomes the single yield for all auctioned securities.)

This mechanism is a perfect solution for our current bailout. In short, here is how it would work.

1. The government auctions off a $500 Billion of Equity ($700 may be too much).
2. Registered banks and insurance companies submit anonymous bids of
   a) An amount of capital
   b) A percentage stake of equity stake in each company
3. The Treasury would fill its auction by selecting the best bargains for its dollars.

Once the auctions are awarded, the selected companies would be allowed to do the following:

1. Choose if the awarded money will be preferred equity or common equity
2. If it is preferred, the rate should be floating against current 10 year treasury rate. This should reflect the new marginal cost the taxpayer now incurs to finance the government.
3. If corporations choose to redeem the preferred shares they can buy back the shares at cost plus the current 10 year treasury yield times the share value. The funding would be used to immediately retire treasury debt.
4. If the shares are common, the government can choose to sell these equities at any time or participate in any buy-back plan.

The benefits are as follows:

1. The Taxpayer now owns a share of all banking and economic activity and better, is protected against government borrowing costs.
2. Banks, now with more capital, can write down their subprime assets.
3. In addition, with the participating option, banks need their subprime assets to perform only as well as the treasury rate times the equity they receive. Once they receive their required capital, they can write down their assets to perform as well as a marginal treasury rate.
4. Finally, no one needs to buy anything but equity in banks and insurance companies. If physicists, mathematicians can’t value these assets, let’s not even try. We could administer this auction by election day, move on, and stave off a recession.

Let’s end with a story.

Once, as a broke college student, I attended a church supper with a good friend. After supper was cleared, the entertainment turned to a lottery game, which worked the following way:

1. Everyone who wanted to participate bought a raffle ticket
2. Every round would consist of the Minister drawing a ticket from the bowl
3. If your raffle ticket was selected, you were eliminated from the game
4. Before the beginning of the new round, the remaining entrants could choose to end the game, but only unanimously, and then split the money.

Now, in the early rounds when there were roughly 100 people playing, no way would there be consensus to end the game. But sure enough, as the numbers dwindled down to six or seven, a decision to collude was reached. As a champion of that decision, I too walked away with $300, enough to pay my bills for that month of school.

One by one as the Government works toward a solution, banks are failing and being sold off at miniscule values to the equity holders, eliminated from the game. First it was IndyMac, then Bear Stearns, then Lehman, then AIG, then WaMu and finally yesterday, Wachovia (who by the way, only a week ago had its chairman on CNBC saying how great Wachovia was going to be when it emerged from this crisis).

Maybe they’ll now be few enough to collude in this fashion and take the money as equity, letting us all move on.