Friday, October 31, 2008
I recently found yet another striking illustration of the stark contrast between U.S. and European legislative efforts to explore comparative (foreign) solutions.
When the U.S. Congress was considering the wholesale revision of the Bankruptcy Act in the early 1970s, the Bankruptcy Commission report contained a section on "Contemporary Bankruptcy Experiences in Other Nations." I was excited to see this early openness to comparative analysis . . . until I read the two-paragraph section. After a number of observations on how different the "legal, economic, and social conditions" are in the U.S. and elsewhere, and without saying anything about the approach(es) taken by foreign systems, the report concluded glibly "the bankruptcy experience of other countries is not a useful resource." [H.R. Doc. No. 93-137, Pt. I, at 66 (1973)] Sigh. Granted, at least in my area of interest (consumer bankruptcy), there wasn't much to compare in the early 1970s, but one might have expected a bit more effort from U.S. policymakers . . .
In contrast, when Denmark set out to consider adopting the first consumer insolvency law in Continental Europe, it took careful account of comparative lessons to be learned. Like the U.S. commission's report, the 1982 report of the Danish commission assigned to explore this issue contains a section on "Foreign Law." [Betænkning on Gældssanering, nr. 957 (1982)] This section, though, is not two paragraphs, and it doesn't dismiss all foreign legislation as "not a useful resource." Instead, it undertakes an impressively sophisticated analyis of consumer bankruptcy legislation and practice in England, Ireland, the U.S., Canada, and New Zealand (11 pages). Though the approaches of these "Anglo-American" systems was ultimately rejected as inconsistent with Danish-Continental legal philosophy and practice, at least they considered--quite carefully and sensitively--relevant foreign models.
Note that the language of all of the systems considered by the Danes was English. So there's one less excuse for the U.S. Commission's failure to consider these comparative models. But it gets better! Midway through the Danish report's comparative consideration of U.S. law, it directs the reader to consider a lengthy passage from the legislative history of the U.S. Bankruptcy Code, enacted a few years earlier. The entire page-and-a-half passage is reproduced in English! The message is clear and impressive: Any educated reader of this Danish report would read English well enough as to not require a translation of the legislative history of the U.S. law. Stunning. Granted, a country with a language not widely in use, like Danish, might be expected to take seriously the notion of English proficiency, but the contrast between the attitudes and abilities of the Danish and U.S. bankruptcy commissions is shocking.
Unlike in the early 1970s, U.S. legislators now have a wealth of comparative analysis of both legislation and practice in European bankruptcy systems, especially consumer bankruptcy. Doug Boshkoff pioneered this area of research with his 1982 empirical article on the discharge process in England (Limited, Conditional, and Suspended Discharges in Anglo-American Bankruptcy Proceedings, 131 U. Pa. L. Rev. 69 (1982)). The rapidly developing consumer insolvency systems in Continental Europe have also been explored in detail in recent years (see, e.g., here and here).
So when Congress returned to the drafting table to revise (many would say deform) the consumer bankruptcy law in 2005, did they consider comparative experience then? I searched in vain for any comparative reference in the legislative history of BAPCPA (the 2005 reform law's acronym). So is Congress afraid, or does it just not care . . . ?
Thursday, October 30, 2008
As if it weren't hard enough to get banks to offer workouts to overindebted consumers! While I find the premise of the following story hard to believe, apparently major credit card lenders want to forgive significant portions of credit card debt that borrowers can't currently repay, but the Office of the Comptroller of the Currentcy and the IRS have conspired to prevent this.
Currently, when overburdened debtors (or their counselors) call up asking for a workout, credit card lenders will generally only agree to reduce interest rates and penalties and perhaps extend repayment terms to reduce payments. I had always attributed this to avarice and irrational refusal to accept the economic reality that borrowers would repay more if only they were given a bit of a break. As it turns out, I might well have been wrong, as explained in this letter describing a new pilot program to expand credit card debt forgiveness. According to the Financial Services Roundtable (whom I don't trust, by the way) and the Consumer Federation of American (whom I emphatically do trust), lenders appreciate the economic reality point, but the OCC and IRS inhibit lenders from offering significant reductions of principal. They do this by (1) requiring OCC-regulated lenders to demand payment of reduced principal amounts (and book the loss) within three to six months maximum, which (2) triggers a requirement that lenders send a 1099-C "Cancellation of Debt" tax form to borrowers, which in some cases might require the recently forgiven debt to be recognized as taxable income to the hapless debtor [NOTE: most debtors in this position will have been insolvent before (and probably still after) the forgiveness, in which case the COD/forgiveness "income" is excludable from taxable income, see IRS Pub 4681].
For decades we've been trying to convince lenders to act more reasonably in extending workout terms to borrowers WAY over their heads in debt, and now this. Just when you solve one problem, the IRS and some other regulatory agency create another one.
Though the accounting principle in play here doesn't strike me as so intrusive as to have prevented realistic debt forgiveness by banks, I nonetheless hope the OCC and IRS go for this proposal to eliminate the problem, however slight. The FSR/CFA letter promises that "virtually all of the largest national credit card banks" have agreed to offer "significant reductions in the principal [credit card] debt owed" to see if collections increase (my bet: they will!). Speaking as a proud paternalistic supporter of government intervention, I really hope the OCC and IRS get out of the way on this one!
Update 11/12/08: The proposal was rejected in what seems to me like record time for government bureaucrats. Hmmm.
Wednesday, October 29, 2008
In Payment Systems class, we recently had our "why do students prefer to use debit cards" discussion. I'm continually amazed that, even after learning how much more practically and legally protected users of credit cards are (TILA and Reg Z) as compared to users of debit cards (EFTA and Reg E), students still express a strong preference for using debit cards. Note that my question relates only to the payment function of the card, not the (dangerous) credit function. I use credit cards for every possible payment, but I have not paid a penny of interest or fees since I was a poor judicial clerk years ago outfitting my first apartment (and I've received hundreds of dollars in rewards over the years to offset those early interest payments). I understand (and explain to my students) that card issuing banks are still making money from my use through interechange fees imposed on merchants, but I'm quite willing to pay marginally higher prices at the counter (though I doubt this happens) in exchange for the fabulous convenience and protections of credit card use.
Students' explanations for their preference for debit cards make sense--they fear credit cards inherently (see Angie Littwin's fascinating paper on this subject), they fear the lack of external control on spending and the psychological effect of credit card use increasing spending, and they really fear the credit card issuing banks' game of imposing confusing interest calculations and hefty and spiraling fees for any minor deviation from the contract (overlimit, late payment, etc.).
The credit crisis has brought us one more explanation for why many payors might prefer debit cards: in an abrupt about-face from recent practice, card issuing banks are slashing access to consumer credit! Increasingly today for those with imperfect or underdeveloped credit histories, credit cards may not be an effective option for making all monthly payments, as credit limits may be insufficient to cover a month's payments (even if the payor has money in the bank--or will by month's end--to cover the charges).
It occurs to me that this might be a blessing in disguise. Perhaps the scaled-back credit limits can act as the external spending limit that my students fear. If people can discipline themselves to remain under their lower credit limit, they might develop better spending and budgeting habits that can carry over to the post-crisis time when credit becomes more freely available. I hope at least some people can use this period of tighter credit to begin using their credit cards as disciplined payment devices that offer really substantial protections against fraud and merchant machinations, not to mention real financial rewards (eventually) for those with good histories.
A friend of mine recently acquired a credit card with a reasonable limit. S/he has found that pulling out the card for every payment has disciplined her/him to control spending, at least for now, as s/he is now acutely aware that all purchases are mounting on one bill, which can (and should) be checked periodically (weekly?). That fat "balance" figure, though it is no different from what s/he used to spend monthly, makes an impression that a list of debits and a shrinking bank balance does not . . . and the credit card again offers better legal and practical protections in case of fraud or other transaction problems.
I'd really like to see credit card issuing banks hoisted by their own petard. Fine, you want to cut credit limits, well we'll respond by training people to use your product in a more constructive way for us, avoiding the traps you've set while taking advantage of the benefits for which merchants are now paying. This last part might change ultimately if the interchange fee war is decided in merchants' favor, but I'm not betting on that, and I'll change my practices when and if that happens. Vive la carte de crédit!
Update: For a discussion of people who use this strategy successfully, see here.
Tuesday, October 28, 2008
Much of the word out of the IMF sounds familiar. We must restore investor confidence in the financial markets. Without that, the economies struggle, both here in the United States and in countries like Hungary. There is also a similar vein in the actions underway across Europe to make sure that the banking systems are stable. So, our market ups and downs have an even greater impact abroad. Thankfully, in the end, it seems like world leaders have realized the inter-twined nature of the economies and are attempting quick action.
Hungary's bailout is $25.1 billion. Sure, we are talking about an entire country needing a bailout. Just the thought of country bailouts is imposing. This amount, though, pales by comparison to the $122.8 billion the Treasury has extended to AIG alone (see Explaining the Financial Crisis to Students). Keeping focus on the financial magnitude of government intervention, AIG is receiving close to five times what the whole country of Hungary will receive. To borrow a concept recently used by Jim Chen over at Moneylaw to refer to a greater magnitude of financial measurement, we might say "Now that's a lot of Smoots!" Of course, we might wonder if $25.1 billion will be enough for Hungary (or, whether AIG will stop at $122.8 billion).
Dominique Strauss-Khan, Managing Director of the IMF, spoke recently about the need of the IMF to be in a position to act quickly to respond to financial crises in emerging markets. It seems that the IMF's proactive stance was a wise route. One can hope that these early interventions by the IMF will help ease the ride of this financial crisis in developing countries. Time will tell in the end, just how much intervention will be needed in developing economies.
I have had it with the misleading rhetoric on comparisons of the McCain and Obama tax plans! Whatever your political persuasion, I hope most of us (about 99%) can agree that the "marginal tax rate" is just irrelevant, though this comparison continues to occupy center stage because it's an easy target.
A recent W$J piece (hat tip to Paul Caron at TaxProf Blog) compares . . . yet again . . . the McCain and Obama tax plans based on marginal rates; that is, the highest rate at which your LAST dollar of income will be taxed in our graduated (progressive) income tax system. One's first dollars of taxable income are taxed at 15% up to a limit, then 25% beyond that, then 28% beyong that, etc., until the highest "marginal rate" of tax on one's last dollar(s) is reached. Not suprisingly, the marginal income tax rate under McCain's plan is reported to be 35% (just as under current law, NOT rolling back the temporary Bush tax cuts from the former 39.6% rate), while the Obama plan's marginal rate is higher (the W$J suggests it's 41%, but this must represent a combination of the 39.6% reinstituted marginal rate plus losses of deductions and exemptions for high earners). So, the average person considering this issue might be concerned that an Obama administration would "spread the wealth around" by taking 5%-6% more tax from our last dollars--oh, my!
Here's the rub: how much do I have to earn, you ask, to break into the highest marginal tax "bracket"? The answer, in 2008, is $357,700 (either single or married filing jointly)! I don't know about you, but I'm FAR from having to worry about the highest marginal tax rate. I can't imagine that more than 1% of the U.S. population (even the U.S. taxpaying population) receives this much taxable income (remember--deductions, etc., allow particularly high earners with big deductible expenses to pay tax on only a fraction of their income).
Two observations follow from this. First, this talk of marginal rates is just silliness. Can we just agree that all of the extremely fortunate people who make (even combined-earnings couples) more than $350,000 of taxable income would prefer a McCain tax approach and leave it at that (though I see WAY more Obama signs in the yards of the rich suburb of River Forest, just north of where I live in Forest Park, outside Chicago)?! Marginal tax rates are utterly irrelevant for 99% of the population, and they show whom each candidate favors tax-wise: McCain favors high earners to offer incentives to produce jobs (trickle-down economics), while Obama favors middle-class earners and those who depend upon social programs (funded by wealth redistribution from the rich 1% to the not rich 99%). This is not news, it seems to me, and all the chatter about comparing tax plans is pointless. Far too much attention seems to be paid to the thin margin of "high-earner-not-rich-yet" (HENRY) people out there (and come on--if you make more than $300,000, you're wealthy in the mind of most Americans!!).
Second, the rate that matters is the effective rate; that is, the combined average rate applied to every dollar evenly. Effective rates vary greatly, too, but I would really like to see a more nuanced analysis of how the effective rate of the "average American" (or groups of them) would fare under McCain and Obama. I suspect effective rates would remain largely unchanged for all but the wealthy for McCain (that is, the Bush tax rollbacks would be made permanent, perhaps with a kicker cut for the wealthy), and effective rates for most people below the top tax bracket or two would go down under Obama (with tax shifted up to the higher earners).
I just can't imagine that the average U.S. voter really cares about this marginal tax rate issue--or at least, s/he wouldn't care if s/he realized how irrelevant the issue was for her/him. I would bet that the percentage of people who pay the marginal income tax rate is lower than the percent of U.S. voters who have lost a friend or relative in the war in Iraq, who are or know someone who has been victimized by immigration authorities or over-zealous federal prosecutors, or who are or know someone who has been wrongly convincted and is sitting on death row. The number and percent of people who pay marginal tax rates is clearly lower than the number and percent of voters who lack adequate health insurance and access to quality education. Aren't these issues far more important than marginal tax rates?
Update: Check out this cool CBO report on effective rates (its complexity suggests why we haven't seen more of this type of analysis).
Update 2 (10/29/08): Ask and ye shall receive! This CNNMoney story offers the sort of info I suggested would be more helpful . . . and it confirms my unsurprising speculation about how the candidates' tax plan effects would shake out (McCain blasting all taxes, with a big gift to the rich; Obama sticking it to the ultra-rich, favoring everyone else). For an even better discussion, see this paper by Citizens for Tax Justice.
Monday, October 27, 2008
Even very smart analysts seem to have a tough time understanding the most basic elements of the current crisis. The Economist for this week contains an "Economic Focus" section (Oct. 25th, p. 92) that discusses several plans for providing aid to homeowners to try to stem the tide of foreclosures and finally put an end to the basic problem at the heart of this financial mess. A key question is how to keep people in their homes and avoid mortgagees suffering 40% and higher losses on the increasingly depressed foreclosure market.
The premise of the introduction to the Economist's discussion is that declining house prices are getting in the way of this effort by undercutting mortgagors' (homeowners') incentive to work something out, keep making their payments, and stay put. While Alan White has convincingly and repeatedly pointed out that it is irrational resistance by lenders (and servicers) that is to blame here (see, e.g., here and here), not hesitancy by homeowners, the Economist perspective intrigued me . . . until I saw this catchy line: "Two features of housing finance make the crisis hard to resolve. The first is so-called 'no-recourse' home loans, which are standard in America (though not elsewhere)." [emphasis added] The second feature, by the way, is securitization and the problem of getting consensus from the pool investors for a workout, a problem that FDIC chairperson Sheila Bair seems to have largely disproved.
This observation from the non-U.S. Economist writers on American home finance seems to me patently false. Lesson for comparative researchers: if you discover that fundamental financing practices in a major region (like the U.S.) are different from "elsewhere," best check again. Non-recourse home mortgage loans (where the borrower is not legally indebted on the loan if the home value upon foreclosure does not retire the loan) are decidedly not standard in the U.S. (or anywhere else, so far as I know). While some states, like California and Arizona, make purchase-money loans for residential home mortgages non-recourse as a matter of law, these exceptional statutory impositions don't come close, it seems to me, to making non-recourse lending "standard" in the U.S.
Yes, many (but not all) U.S. home loans are secured by purchase-money residential mortgages, many (but not even most) of those loans are in California, and many (perhaps most) of the most troubled loans are in California, too, so the non-recourse issue has major relevance to the crisis. But let's not overdo it. Anecdotal evidence suggests that many of the troubled mortgages in California are investor properties--not residences--so these loans are most likely recourse in California, too. As for the practice of "jingle mail," where people just walk away from their hideously depressed-value homes and say "come get me" (or bettter yet, "ha, ha, you can't come get me") to the lender, I have yet to see any credible evidence that this is at all common, especially for residential mortgages (as opposed to investment units). It seems to me that, if the American Bankers' Association had hard, credible evidence of a high incidence of jingle mail, it would make serious political hay by sharing that evidence and decrying the sorry state of mortgagor morality in America. The fact that the ABA has remained mum on this issue (so far as I know) strongly suggests there's no "there" there.
So while ideas for getting folks to stay in their homes should be at the heart of a real solution to this crisis, such solutions should be neither explained in terms of nor based on the incorrect notion that most (or even many) home loans in the U.S. are non-recourse, and it's homeowners who need to be convinced to cooperate in workouts. If we can get lenders and servicers on board with the FDIC's IndyMac approach to mortgage modifications, we'll be moving in the right direction . . . and we don't need to worry about homeowners following.
Friday, October 24, 2008
In the end, the issue of assignee liability boils down to a bread and butter holder in due course/doctrine of bona fide purchase question. HDC status for secondary market assignees promotes liquidity to be sure. And, liquidity of subprime loans, that we certainly got. On the other hand, stripping of hdc status forces assignees/secondary market purchasers to exert more care over the practices of the origination market. As government turns to the reform stage of the crisis, one of the more interesting commercial paper questions will be whether to continue to insulate the secondary market from abuses at the origination level through application of principles of good faith purchase, or whether to move in the other direction, for example by extending the FTC HDC regulations to encompass all or a larger portion of mortgage loans.
Thursday, October 23, 2008
Tis time, there must be a line of separation between honest Men & knaves, between respectable Stockholders and dealers in the funds, and mere unprincipled Gamblers.
Wednesday, October 22, 2008
Grandmothers beware . . .
Tuesday, October 21, 2008
- the Commercial Paper Funding Facility (CPFF), which on October 27, 2008 will begin funding purchases of highly rated, U.S.-dollar denominated, three-month, unsecured and asset-backed commercial paper issued by U.S. issuers, and
- the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), announced on September 19, 2008, which extends loans to banking organizations to purchase asset backed commercial paper from money market mutual funds.
Now, we also have the Money Market Investor Funding Facility (MMIFF), also rolling out on October 27, 2008! The AMLF, CPFF and the MMIFF are all intended to ease credit by making sure that there is liquidity in the short term debt markets. Yet, each program is targeted at a limited slice of short term debt. The MMIFF will be a Fed credit facility provided to certain private sector "special purpose vehicles" (PSPVs). The PSPVs can purchase eligible money market instrument. The Fed's term sheet provides for purchase of certificates of deposit, bank notes and commercial paper with a materity of ninety days or less. Purchases will be made using asset backed commercial paper or funding from the MMIFF. This program is intended to be short-term, with a termination date of April 30, 2009.
All of this should go to show the commitment of the Federal Reserve to backing up the short term credit markets. All of this might seem a collection of fancy programs. Ben Bernanke (I think correctly) is worried that any further problems with short term will cause more mischief in the markets if not attended to by the Federal Reserve. With company earnings reports for the third quarter being sluggish for many companies, problems with the short term credit that companies depend on would only make matters worse. Score 3 for the Fed on short term credit. And, if it doesn't do the trick here by April, the Fed left open the window to extend programs.
Bernanke is also calling for more stimulus programs. We'll see if they too are innovative. They very well may have to be in order for our economy to recover more quickly. Bernanke has been short on details about programs that might help, but expect wider based programs to be in the mix. Although Bernanke is not yet saying we are in a recession, the outlook is not rosy.
Without meaning at all to impugn theory or empiricism, it is wildly fun to take a long, close look at the Code in action.
Monday, October 20, 2008
What is/are others' favorite contribution(s) to commercial law scholarship?
We welcome Brooke's insights on Article 4 doctrine and other issues.
This financial crisis has been with us for more than a year. It was sparked by the end of the U.S. housing boom, which revealed the weaknesses and excesses that had occurred in subprime mortgage lending.
Of course, Bernanke goes on from there that the problems were much broader. Surprisingly, he takes on everything from the failures of Lehman and AIG to the on-going problems in the credit markets. This was the most detail and candor that I've seen come from Bernanke about where we are headed.
The speech is in two parts.
Friday, October 17, 2008
It sounds like the U.S. consumer needs some cheer-me-up news. At least as to commerce and finance, this week ends with some seriously good news.
As I suggested earlier (here and here), watching the Dow will likey produce unnecessary pessimism. The "destruction of wealth" that has caused much of the consumer pessimism mentioned in the Bloomberg story, linked above, represents temporary, paper losses. As the wildly volatile Dow this week has demonstrated, a big loss one day can be erased by a big gain the next. Admittedly, folks nearing retirement and those with equity investments locked up in 529 plans that they need to tap in the immediate future may well feel actual pain, but for most of us, we have too much access to information on stock market events that will ultimately have little impact on us. Indeed, remember: as the Bloomberg story mentions, 2/3 of the U.S. economy rests on consumer spending. We are the masters of our own destiny, in a sense. Irrational pessimism will lead us into a downward spiral of tighter spending and market contraction, so let's look on the bright side . . . (now where did I put that bright side . . .)
Oh, yes! Here it is: First, why are people not doing cartwheels in the streets now that oil futures have fallen by half in a few months, finishing today just over $70 a barrel. Gas prices have fallen in turn about 55 cents per gallon in just two weeks! If it weren't for a presidential election in a few weeks and the craziness on Wall Street, this would be front-page news, and consumers (and car dealers) would be giddy.
Even dearer to our hearts here on Commercial Law blog, the bank-to-bank and corporate "commercial paper" lending markets have really eased this week. Rates on one-month commercial paper (short-term loans by investors to corporations) have fallen to a three-week low. That's good news for big business, which employs many of the sour-puss consumers who responded to the Michigan consumer sentiment survey--cheer up! Similarly, LIBOR has continued its downward march. The overnight rate dropped precipitously to 1.67%, down from over 5% last Thursday. This is the lowest overnight rate in four years (!). The critical 3-month rate eased for the fith day in a row, ending at 4.42%. Though this is still abnormally high, the trend is clearly in the right direction. A close observer of the money markets remarked today "[a]n early and tentative judgment is that [world governments] have lubricated the gears and the [financial] engine is beginning to crank again." A lubricated lending machine will power recovery and (dare I say) expansion of small and big business alike. Hang on!
So think about this good news as you enjoy a wonderful fall weekend!
Thursday, October 16, 2008
Card companies have already responded to the financial crisis by cutting consumer credit lines. In an effort to assess consumer risk, American Express is and making on-going credit decisions based upon things where a consumer has their mortgage and what stores they shop at. With credit tightening, it would not be surprising for other companies to follow suit.
Sadly, the report does not contain good news in an already tough economy. With credit markets being tight, consumers that still have available credit lines may choose to use them. I see this as one more problem that the banks and consumers will have to confront in the future. Just like the home mortgages, banks knowingly issue credit card debt, which consumers use. Even with the Truth in Lending disclosures, I have concerns about the extent to which consumers understand all the workings of credit card special fees and mysterious increases in interest rates. As Steven Semeraro here blogged recently, the Credit Card Bill of Rights Act of 2008 is not likely to get further than passage in the House. While we're bailing out the banks now, there's been little discussion how the credit crisis and economic downturn will affect consumers and banks in terms of credit card default. We may be past some of the worst in terms of the panic in the financial markets and risk of widespread bank failures. Will the banks may next be asking the taxpayer to pay for heavy credit card write-offs that result from all of this mess? Let's hope not. I don't think my kids have another $100 billion to spare.
Wednesday, October 15, 2008
The latest news about LIBOR seems to offer both hope for relief and, I'm afraid, a portent of impending doom. On the one hand, short-term credit markets seem to be coming back, thanks to the more-or-less coordinated efforts of major governments. The overnight dollar rate (the rate participating banks think they can borrow at overnight from each other in London) eased this morning to 2.14% down from 2.18% yesterday morning, and down from over 5% just last Thursday. Even the intermediate-term 3-month dollar LIBOR, the key rate for most observers, slid 9 basis points to 4.55% today, down from from 4.82% last Friday. All of this seems to suggest that the recovery effort has begun to succeed, though more water will have to flow under the bridge before we can announce a real recovery.
On the other hand, the key 3-month LIBOR rate has a long way to go back to normalcy. A month ago, it was only 2.82%. As I mentioned a few days ago, adjustable rate mortgages (ARMs), student loans, and many other types of private loans with floating interest rates are pegged to LIBOR, and those that are resetting these days may nearly double their interest rates for the remainder of the reset period. This strikes me as a perverse and unwarranted windfall for the banks holding these loans. I know, I know, those who play with adjustable rates must take the downs with the ups, but market fundamentals pushing rates higher makes sense to me; irrational panic pushing rates up--as an indirect result of these very banks' shenanigans years ago in the mortgage market--is just wrong.
My question is this: how often to most ARMs reset? If they reset quarterly, one quarter of pain might be bearable, but the reset will be dramatic (from about 2.8% to over 4.5%). If they reset annually, as I gather most student loans do, an entire year of astonomically hiked interest could produce yet another round of distress and anguish for the folks on Main Street--and, yet again, a windfall for those on Wall Street. That being said, 3-month LIBOR one year ago was nearly 5.25%, so maybe this won't be a catastrophe after all.
Update: See this fascinating chart that shows (1) 3-month LIBOR was quite high (in the 4.5-5.5% range) 1, 2, and 3 years ago, but (2) it stopped running parallel to the benchmark federal funds rate earlier this year, unexpectedly darting upward to join the Prime Rate recently, as we've discussed earlier. This seems to suggest that we'll know when something approaching "normal" credit market conditions have returned when 3-month LIBOR returns to a few basis points above the fed funds rate (now 1.5%, so 3-month LIBOR of, say, 1.75%).
I'm more and more pleased that I have a fixed rate mortgage these days.
Monday, October 13, 2008
Sunday, October 12, 2008
President Bush observed in his October 10th speech that the "fundamental problem" that began the financial crisis was the housing market decline, which caused banks holding mortgage assets to suffer serious losses. A simple start to things, but this is where things get complicated. The housing crisis itself would be a bad thing for the United States economy. But we have to add to this problem the credit default swaps (CDS), which Congress exempted from regulation in the Commodity Futures Modernization Act of 2000. Financial companies are always seeking to reduce the risk of default on credit instruments. For instance, this is the reason for mortgage life insurance and private mortgage insurance in home loans.
Imagine the owner of a corporate bond (i.e. Goldman Sachs) wants to manage risk without selling the underlying bond. The owner (buyer) purchases a CDS on the corporation by paying a fee to a seller (i.e. AIG) for the right to payoff of a loan in the event that the maker/corporation defaults. Apparently, there are some $62 trillion in CDS contracts outstanding worldwide. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's 2002 annual report Buffet commented:
"Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses--often huge in amount--in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."Well, it all seems to come down to whether the seller of the CDS has enough collateral to guarantee the CDS contracts. As we know now, the sellers of CDS did not have sufficient assets to back the contracts, leaving banks exposed when the market declines or the maker defaults. In the end, swaps are kind of like insurance, but not quite (or they would have been regulated). But imagine a large hurricane where property owners purchased insurance from insurance companies did not have enough assets to pay claims. The losses then would fall on those property owners who thought they purchased insurance.
Enter AIG, whose London Financial Products unit sold CDS contracts that declined in value. AIG's CDS contracts insure $441 billion worth of securities originally rated AAA, with$57.8 billion in securities backed by subprime loans. The decline in value led to the need for AIG to post additional collateral to its trading partners, which it could not do. Enter the Federal Reserve, who agreed to lend AIG $85 billion initially, followed by an additional $37.8 billion from the Federal Reserve. The Federal Reserve has received warrants for a large equity stake in AIG.
Back to the financial mess. To sum up:
- Banks that extend loans did not have enough assets to cover losses arising from default (including from the housing market).
- The sellers of the CDS contracts sold to the banks and others also did not have enough assets to cover losses. When the market changed, sellers like AIG could not post enough collateral on these contracts.
- After #1 and #2 occurred, the market declined precipitously. As all of this occurred, credit markets froze up as even banks became hesitant to lend even to other banks.
As John D. Rockefeller once said that "[t]hese are days when many are discouraged. . . . , depressions have come and gone. Prosperity has always returned and will again." Not that we are in a depression or will even enter one, but Rockefeller's optimism is good to remember.
Friday, October 10, 2008
We might speculate why, after action of the Federal Reserve, Department of Treasury, Securities and Exchange Commission, the FDIC the markets have not responded. And, after all, there have also been the speeches by Ben Bernanke (see Oct. 7 Remarks), Henry Paulson and President Bush on the economy. These speechmakers have intended their words to have a positive effect on the markets.
Yet, perhaps there is not confidence in the market due to a lack of confidence in the policy-makers to take appropriate action. This would include a broad public concern that the system will reward (or at least not punish) wrong-doers in this crisis. Lisa Fairfax, over at the Conglomerate discussed this problem in the context of AIG yesterday. It is no wonder that there is public concern that the Federal Reserve will bailout AIG, but no one will hold management accountable. I agree with Lisa's suggestion that the lack of confidence in our government to hold companies responsible for their share of the blame has contributed to a stalling of confidence in the markets. In order for the actions of the Federal Reserve, the Department of Treasury and others to have their desired effect on market confidence, it would seem that we might need more confidence in those same actors. At least, for now, that seems to be lacking.
Thursday, October 9, 2008
Letterman's Top Ten Ways to Make the Financial Crisis More Fun might make you laugh for a moment, though.
All of this raises the issues of who really is to blame here. That is, who is unfit and should be eliminated. Christine Hurt over at the Conglomerate explained that this is really a hard question to answer, not one that lends itself readily to soundbites and that there may not even be any "bad guys" after all. Or, the villain of my War of Wealth variety simply does not exist. I found this video:
One small silver lining of this crisis is that lots of terms with which I struggle with commercial law students are now splashed all over the front pages of financial and general news outlets. Perhaps the most important example is LIBOR.
The London Interbank Offered Rate is the interest rate at which a series of 16 banks are willing to lend to each other--overnight or for various longer intervals, like 3 months, and in a variety of currencies, most prominently U.S. Dollars and Euros. Bloomberg today has one of the clearest and most insightful discussions of LIBOR, its history, and the various ways it is being used to gauge the seize-up in the credit markets. Gavin Finch and Ben Sills offer a particularly lucid explanation of why the TED spread is a stark indication of how much banks distrust each other (or at least their ability to repay loans) and how that spread has really increased recently (spiking to levels far above what we saw in the 1987 crash and after the collapse of LTCM in 1998). The scariest passage:
Central bank efforts to tame Libor have had little impact because instead of lending the extra cash, banks are holding it on deposit with the ECB at a loss. [empahasis added] On Oct. 6, banks borrowed 13.6 billion euros from the [European Central Bank] at ... 5.25 percent. At the same time, they deposited 42.6 billion euros overnight at 3.25 percent.
This is just crazy! Can anyone say "irrational pessimism" (or, I guess, "negative/reverse arbitrage")? I hope these banks soon begin listening to Jean-Claude Trichet's exhortation for everyone to "keep their composure" and start acting like market players again.
Anyway, for those of us in the education industry, LIBOR is likely more important to our students than we might have realized. Many private student loans are pegged to 3-month U.S. Dollar LIBOR, and if these loans readjust before that index returns to "normal" levels, our students might face a crushing increase in current or expected student loan interest payments (much like poor Maureen McNally, mentioned in the Bloomberg story, whose LIBOR-pegged mortgage payments have jumped 50%, not to mention Danilo Coronacion, who oversees a $60 million debt with interest pegged to LIBOR).
At least overnight LIBOR rates (both $ and €) fell last night, so let's hope this trend continues and spreads to the longer maturities (especially the all-important 3-month rates).
Update: Further confirmation that LIBOR is the bellwether:
"Everyone's watching the Libor, looking for the credit market to thaw and it's not there yet,'' said Alec Young, a New York-based equity strategist at Standard & Poor's. "Until you get some convincing thawing in the credit markets, the threat of a global recession and a global profits recession remains and it's going to be difficult for stocks to build momentum.''
Wednesday, October 8, 2008
To make his point, Professor Speidel used the example of homeowners that have five year fixed price contracts for gas supply at $3 per BTU. After hurricanes disrupt the gas supply in the area, the market price of gas is $6 per BTU. The government, in an effort to bailout the suppliers, deletes the fixed price term out of the consumer contracts in the area. Professor Speidel argued that the occurrence of the hurricane in all likelihood did not make performance excusable due to the fixed price nature of the contracts. The supplier is excused nevertheless due to the government act. Thus, the consumer must pay the higher market price for the gas supply.
Explaining this outcome, Professor Speidel turns to U.C.C. § 2-615 and notes that the foreseeability factor is satisfied in the government act cases under the direct language of the Code, leaving only the impracticability component of the test, unless issues of risk allocation are present. Comment 10, though, explains that “governmental interference cannot excuse unless it truly ‘supervenes’ in such a manner as to be beyond the seller’s assumption of risk.” The Comments to the Restatement further explain:
With the trend toward greater governmental regulation, however, parties are increasingly aware of such risks, and a party may undertake a duty that is not discharged by such supervening governmental actions, as where governmental approval is required for his performance and he assumes the risk that approval will be denied. Such an agreement is usually interpreted as one to pay damages if performance is prevented rather than one to render a performance in violation of law.
Speidel's concern with the use of ordinary contract principles to allocate the risk of retrospective government acts helped shape my recent paper on Impracticability Under the U.C.C. for Wartime Contracts. Although Justice Souter noted in United States v. Winstar Corporation case the humdrum nature of basic procurement contracts, wartime sales contracts in Iraq have turned out to be less than routine due to the hazards created by insurgents. I have argued that the strict application of traditional doctrine must proceed with caution regarding wartime contracts as they arguably exhibit the same differential in bargaining power noted by Professor Speidel. As such, the traditional rules are applicable to wartime contracts as they are to regulatory ones, but one must exercise care in the allocation of risks. Not surprisingly, Professor Speidel’s proposition is consistent with the comments to the Code, directing reference to equitable principles where excuse or no excuse does not lead to a satisfactory result. U.C.C. § 2‑615 cmt. 6 (2001). Although Professor Speidel's work did not answer, nor was it intended by him to answer, the specific issues raised by extreme personal hazards faced by contractors during wartime, his words guided my thought process. Although I did not personally know Richard Speidel, his work has influenced my own. I would guess that there are many who share my perspective on the impact of Dick Speidel's work.
The War of Wealth was inspired by the Panic of 1893, which led to the "Long Depression." from 1873-1896. The panic was caused by a number of business failures and shaky financing which set off a series of bank failures. Sound familiar? As the state of the economy worsened, people withdrew their money from banks, causing runs. A credit crunch ensued. More than 15,000 companies and 500 banks failed during the crisis. Unemployment was high. Perhaps like Dazey's War of Wealth, a hero eventually arrives in the form of President McKinley and the Klondike gold rush. The economy plugs on for ten years of fast growth.
As Jason Kilborn reported, Congress approved the recent financial bailout. Yet, stocks were down to about 9605 at 2:30 p.m. today. Thinking about the numbers. The U.S. government has agreed to spend up to $700 billion. Washington Mutual Bank and Wachovia had about $1 trillion in assets together. Of course, we don't know how much of these assets are "troubled." We also don't know how many assets belonging to other banks are troubled and exactly which banks are on the FDIC's watch list. Bauer Financial Inc. gives banks "star" ratings based on information filed with the FDIC, with today's ratings being based on the June 30, 2008 filings. Wachovia Bank received a 3 Star rating for "adequate." Much has changed since mid-summer.
Last week, commenting on the proposed merger of Wachovia and Citigroup Inc., FDIC Chairman Sheila Blair commented:
"[o]n the whole, the commercial banking system in the United States remains well capitalized. This morning's decision was made under extraordinary circumstances with significant consultation among the regulators and Treasury."Federal Reserve Chair Ben Bernanke was more cautious in his comments about the bailout, saying:
"I applaud the action taken by the Congress. It demonstrates the government's commitment to do what it takes to support and strengthen our economy. The legislation is a critical step toward stabilizing our financial markets and ensuring an uninterrupted flow of credit to households and businesses."The Fed announced today that it will now pay interest on bank's required and excess reserve balances in an effort to encourage term lending. We'll have to wait and see what else develops as the government tries to stabilize markets.
I have my doubts about whether the bailout package will change things quickly toward greater stability. Like in 1893, there is a lot here to say about confidence in the markets. If today's market is any indicator, we (and banks) may be in for a rough ride. Andrew Gray, the Director of the Office of Public Affairs at the FDIC recently reminded us to "remember, no depositor has ever lost a penny of insured deposits, and never will." Consumers may lose elsewhere, but let's hope that Gray is correct on this small bit of good news. Not quite the hero of the War of Wealth variety, but it might have to do.
Tuesday, October 7, 2008
Finally, the sexy topic of commercial paper has made it onto the front page of the Wall Street Journal! No more hemming and hawing when our students ask for examples of commercial paper--here it is.
Ordinary people no longer use promissory notes as a payment/value device, endorsing notes from payee to payee (as used to be the case in the U.S. and elsewhere). Indeed, I doubt that most ordinary people ever put an endorsement on a check other than the restrictive "for deposit only." The whole notion of commercial paper and negotiation thus seems so artificial to our students, and I've had a hard time convincing myself that teaching the odd intricacies of this system is worth the effort (setting aside the bar examiners' idiotic continuation of testing on this anachronistic material).
Now, the main modern use of the term "commercial paper" has been thrust onto the public stage. Rather than taking short-term loans at the Prime Rate (5.0% or more currently) from a bank, large companies borrow from investors, like money market funds, by issuing promissory notes in exchange for loans, usually payable in 9 months or less, at rates much closer to the Fed's 2.0% target lending rate (thought rates have been elevated, in the 3.0% range, for nearly a month). While the investing market was awash in liquidity, this was a cheaper way to fund operations, leverage results, and have every last penny of a company's capital working at all times. When Reserve Primary Fund " broke the buck" on September 16 by admitting that losses on investments in Lehman Brothers (probably largely in its commerical paper) caused the value of its assets to fall below $1 for every $1 invested in the money market fund, public confidence in the stability and safety of money market funds was rattled, and other money market funds faced something close to a run on the bank as investors yanked money out. The commercial paper market dried up, as the primary investors in the market hoarded cash instead of investing in short-term loans to business, no matter how stable the borrower, because loans of longer than overnight would jeopardize the funds' ability to make funds available to investors who sought withdrawals--besides, who knew which company would be the next to make an ugly announcement about its financial stability and default on its short-term commercial paper loans. Again, in rides the Fed on its white horse, offering to buy commercial paper directly from companies and supply liquidity to this crucial corner of the market. What unprecedented move will we see next from the U.S. Treasury?!
Back to the classroom, though, I wonder if this "commercial paper" (1) actually satisfies the conditions for negotiability in Article 3, (2) actually changes hands more than once, from maker to payee, and (3) whether anyone in the system really cares, as these short-term loans are likely never subject to any payment dispute for which the maker-liability and holder-in-due-course rules would be relevant (they're enforceable payment contracts one way or another, one would think). Anyone have any direct knowledge on any of these points? My bet is that this paper (like the notes associated with home mortgage loans) is generally festooned with caveats and other requirements that violate the "extraneous undertaking" restriction in Article 3, removing the entire affair from the realm of negotiable instruments law. This makes me wonder whether we're really on a fool's errand in continuing to harp on these rules in Payment Systems, Commercial Paper, or whatever else the course might be called elsewhere.
Anyway, the fact that something called commercial paper has grabbed the headlines today makes me feel pretty cool in any event. Thanks, Ben and Hank!
Monday, October 6, 2008
contracts conference sought a leader to give a keynote address, we didn't hesitate to ask Dick. And he didn't disappoint. His address tracing many of the modern issues of contract law was thoughtful, poignant, and educational.
In short, Dick was a mentor, friend and supporter. And what is most impressive, our large family of contract and commercial law scholars can all say the same thing about Dick.
Friday, October 3, 2008
Now let's keep our eyes on the overnight and short-term money markets (especially the availability of longer-term "commercial paper") for some signs of relaxation, though this likely will not happen immediately (though see here for some early indications of a possible thaw). And let us not forget the 159,000 people who lost their jobs in September. The financial crisis may be on the wane, but the growing economic crisis remains. Let's hope relief from the former boosts relief to the latter.
Thursday, October 2, 2008
It feels good when smart people confirm that you're looking in the right place for answers. A propos of my post yesterday, a CNN story this afternoon explains the fall in the Dow today in terms of fears about more woes about tightening credit. The source is revealed!
The following observations are the most salient, and I can't improve upon CNN's clear explanation, so I'll quote it here (with a hat tip to Alexandra Twin, CNNmoney senior writer):
Several measures of bank nervousness hit record levels Wednesday, with banks still wary despite the prospect of the bailout gaining passage.
"What all these measures are telling us is that banks aren't willing to lend to anyone," said [Ron] Kiddoo [chief investment officer at Cozad Asset Management]. "It shows you that the credit crunch is spreading to Main Street."
The 3-month Libor--the rate banks charge each other to borrow for three months--rose to 4.21% from 4.15% Wednesday, a more than 9-month high, according to Bloomberg.
The difference between the 3-month Libor and the Overnight Index Swaps rallied to an all-time high of 2.6%. The Libor-OIS spread measures how much cash is available for lending between banks and is used by banks to determine rates. The bigger the spread, the less cash is available.
The TED spread, which is the difference between 3-month Libor and what the Treasury pays for a 3-month loan, briefly hit an all-time high of 3.61%, before pulling back a bit.
When banks are relatively confident, they charge each other rates that aren't much higher than the U.S. government. When the spread widens, that indicates increased jitters.
Once again, I certainly hope (a) the House Republicans put ideology aside, get on board with their Senate colleagues, and pass the rescue bill, and (b) Treasury's actions pursuant to the new authority quickly dispel the "jitters" that the credit markets are suffering.
By the way, Ted Seto's brilliantly concise explanation of the roots of and solutions for this crisis are a must read (hat tip to Paul Caron). Thank goodness for really smart people like Ted who generously guide the rest of us to an understanding of these complex issues!
Update: For an even better story on this issue, see here (thanks again to CNN and David Goldman!).
Update no. 2 (10/3/08): And things just keep getting worse, despite anticipation of House passage of the rescue bill this afternoon, according to the latest from CNN Money and David Goldman:
The 3-month Libor rate . . . rose to 4.33%, up from 4.21% on Thursday, its highest level since January. . . .
The difference between that measure and the Overnight Index Swaps rate rose to an all-time record 2.73 percentage points, up from 2.55 points Thursday, according to data reported by Bloomberg.com. . . . Friday marked the sixth-straight record for the indicator, showing that banks are hoarding cash rather than lending to one another.
Historically, the typical Libor-OIS spread is about 0.11 percentage points, but it has averaged 1.66 points since the crisis began on Wall Street in mid-September, according to Merrill Lynch economist Drew Matus.
Another credit market indicator, the "TED spread," rose to yet another record high of 3.68 percentage points. The higher the spread, the more likely banks are to avoid risk. The TED spread was only 1.04 points on Sept. 5.
Wednesday, October 1, 2008
- Pete Linzer
I've been looking in the wrong places for indications of improvements in our current financial mess. The Dow is not a good indicator because it only indirectly reflects the real problem: uncertainty as to the value of mortgages and MBS held by banks and other investors, and the effect of that uncertainty on lending markets. What we should be looking for is a sustained improvement at the source--lending markets themselves. When liqudity begins to flow again, beginning with bank-to-bank lending, then prime corporate lending, then small business and consumer lending, hopefully on more realistic and careful terms than before, we'll have a good indicator that we've succeeded (it seems to me).
These markets get much less press than the simple Dow Jones Industrial Average and are generally more difficult to understand, particularly with all the high-flying jargon that bond and money market traders use to express their ultra-cool and sophisticated understanding of finance. John Jansen's bond market blog is a great example of an extremely insightful and helpful source for this info that uses language so opaque as to barely qualify as communication (at least for non-cognoscenti like me). Thanks to a mention from Jonah Gelbach on Prawfsblawg, which led to a comment by Felix Salmon on Portfolio.com, I found Jansen's cut-to-the-quick blog, which despite its difficult language offers the info we really need to gauge a recovery/success.
Contrary to the comforting news on the Dow from Wall Street yesterday, lending markets are still seized up, and things don't appear to be getting much better. We should care that equity traders believe the bailout will succeed, but only because this indirectly suggests that they believe that lending will loosen up, financing for business will return, and the economy will get back on track rather than grinding to a painful halt with repercussions all the way down to Main Street.
Better to go to the source, it seems to me. What do banks (lenders) think? The news on that front yesterday was nothing short of terrifying. The London Interbank Offered Rate (LIBOR) for overnight dollar loans climbed on Tuesday to a record 6.88%. This is the rate that banks charge each other to lend money (overnight)--if a bank has to pay nearly 7% to get a loan, imagine what a corporation, let alone an individual would have to pay to cajole a loan out of these banks! Luckily, the huge spike on Tuesday (the last day of the third quarter) was largely a result of artificial funding constraints caused by the final day of the quarter, and the rate fell over 3% (!) the next day to 3.79%. This is stomach-churning volatility! Money markets that normally hover within half a point of the Federal Funds rate (2.0%) opened at more than triple that figure, between 6.5% and 7% on Tuesday. The lending markets are not as sanguine about the proposed bailout or economic fundamentals as Wall Street traders apparently are.
When the volatility and scary inflated rates in these markets settle down, we'll be able to breathe more easily. The Dow's ups and downs are not a great gauge, it seems, when the real problem is a lack of liquidity (caused in large part by a lack of certainty with respect to mortgage and MBS value). Find the source of the liquid, and see if the faucet has turned on. Only when banks get comfortable lending to each other again can we have any hope of a sustained recovery. What John Q Public needs to understand in evaluating the "bailout" is that its purpose (I believe and hope) is to offer banks certainty with respect to the value of mortgages and MBS, and therefore comfort to turn on the lending faucet. This is a liquidity recovery program--"bailout" is an inaccurate label and, it turns out, very poor choice of wording for political purposes!
I don't know if the Paulson plan will produce this result, but I now feel more comfortable about where to look to find out if it was successful.