Twofish's Blog

November 24, 2008

Notes on Citi

Filed under: Uncategorized — twofish @ 7:19 am

Some comments I put on Brad Delong’s web site.

Something that is also important is the time element. When things start going bad, how quickly do they start going bad. The danger is the classic bank run. Once your balance sheet starts going bad, people want their money which causes your losses to increase.

The in the case of Bear-Stearns and Lehman Brothers, this run unfolds very, very quickly. The stock in both companies plummeted within a week. The reason for this is that their business model involves borrowing short term to fund long term. If you have a bank run, the short term borrowing stops, and you are dead. In the case of Lehman and Bear-Stearns, things were happening on an hour-by-hour basis.

In the case of Citigroup, it has insured deposits and a liquidity line with the Federal Reserve. This means that when something bad happens, it falls apart much more slowly, and this gives you time to think about what to do. The thing that you have to be careful about is not to do anything that makes the problem worse. If you have a crisis of confidence, then saying or doing the wrong thing, just panics people even more. On the other hand, the other danger is that by doing nothing on the theory that doing something will panic people, you run the risk of looking as if you are out of touch and this panics people even more.

Also if you look at the systemic long-term problems at Citigroup there are two:

1) Citigroup has more employees maintaining the same amount of money as the mega-banks. The layoffs at Citi have been more than its competitors, because the pre-crisis employment numbers were higher.

2) The business model that Citigroup was advancing when it pushed for the passage of Gramm-Leach-Billey never quite gelled. The idea was that Citi would be your one stop financial services shop, but they never were able to quite to get this to work.


James Gary: The central thesis of the original post seems to be that the Citibank’s problems are due to “erroneous distributional assumptions in the risk models.” What specifically were these “erroneous assumptions?” Is there any quantitative way to describe them? Please advise.

The basic erroneous assumption involved calculating the probability that one mortgage will go bad if another goes bad. One way of thinking about it is that one way of calculate the chances that one window will break if another breaks is too look at historical window breakage rates, and think about how likely it is that one window break will cause other window to break.

The problem comes in is if you have a category five hurricane hit, then all of the windows will break at the same time. It’s worse if you are looking at a place in which a hurricane has never hit before. The two things that the risk models didn’t consider were

1) when one thing goes bad, everything will go bad, and

2) just because something has never happened before, doesn’t mean that it can’t happen. There were probably some meetings a few years ago where someone said “the only way we could get into trouble is if we have a repeat of 1929.” This is great, until you have a repeat of 1929.

This gets to a very deep philosophical problem which is causing lots of problems right now. You generally deal with the future by looking at the past, but if you are in a situation where you have something that isn’t quite like anything you’ve ever seen, what do you do? How do you predict the unpredictable or know the unknowable?

Finally there was one particularly bad assumption. In every CDO model I’ve seen, the assumption was that you’d be able to recover 40% of the value of the loan. This is partly because CDO models and CDO’s were originally designed around corporate bonds, and when a corporation goes under, there is a very well organized process for keep the corporation alive and settling losses, and 40% recovery isn’t an reasonable assumption if you are creating a security off of corporate bonds.

It turns out to be a very bad assumption for subprime mortgages. When a corporation goes bad, you still usually have a factory or some inventory that can be quickly sold, whereas when a house gets foreclosed, you end up with something that may be unsaleable. Also it’s bad because if you are creating a CDO off of a security of mortgages instead of mortgages themselves, you end up concentrating risk.


There is one more point that needs to be made, and what is why Citi started really having problems last week and not before that. After all, Citi’s balance sheets and it’s holdings of mortgages had been known for years. Why did everyone suddenly panic last week?

The reason for that is that it’s dawned on everyone that we may be in for a really bad recession. If it were the situation that all Citi had to do was to write down subprime, then there wouldn’t be a problem. What has people spooked is not the subprime (since we’ve known about that for months), but if we start getting 8-10% unemployment rates, then people will stop paying prime mortgages, credit cards, auto loans, and student loans. If all those go bad, then what had been great assets before now turn into duds.

So we really are looking at a bad cycle. If something bad happens to GM, you have unemployed workers defaulting on their auto loans and credit cards, which affects Citi, which then affects more companies, etc. etc.

What’s worse is that we were in a post-election gap in which there was no one that could get on television and say “we’re working on this and everything is going to be all right.”

The one piece of good news is that the “road to hell” happens week by week which gives you time to stop the spiral down. In the case of Lehman and Bear-Stearns, the “road to hell” was happening hour by hour.

November 23, 2008

Notes on fiscal stimulus

Filed under: china, finance — Tags: , — twofish @ 8:16 pm

Pettis: At the same time, Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus.

No they don’t. Right now short term Treasuries are near zero interest. The flight to liquidity and from risk means that there is no shortage of buyers for US debt. Everyone in the world wants Treasuries, so there is no need to focus on China as the main buyer of US debt, and one reason that a massive stimulus package is essential is to “push out” the massive purchases of US Treasuries. Without a fiscal stimulus the end state will be everyone having non-productive US Treasuries in their mattresses and no investment in anything that isn’t a US Treasury.

Also, to clarify the main source of disagreement between you and Setser on the one hand, and me and the other:

1) I don’t think that China is or was overproducing
2) I don’t think that the United States is or was overconsuming

The basic problem with the US economy was that the productivity gains of technology and globalization ended up in low interest rates rather than in increasing wages, and that there was massive misinvestment in non-productive goods rather than in productive ones. Less money for houses, more money for universities.

Had the US government spent more on public goods such as infrastructure, health and education this would have provided in increase in wages and interest rates, and would have reduced the amount of leveraging that took place.

The other missing piece here is productivity. If you take out a loan and spend it on inner city education or better subways, you end up boosting productivity which is going to help you pay back those loans.

Pettis: By the way the view that the Chinese authorities will have an easier time in this crisis than the US because “They have options, we don’t” is not, fortunately in my opinion, universally held among Chinese authorities.

Chinese authorities to have an easier time in one respect and that is the issue of “time” and “administrative bandwidth.” In politics, time is critical, and it helps a lot if you have time to argue and think about what is going on. If you aren’t faced with a crisis that has to be resolved in the next few hours, then this gives you time to think and debate about what happens next, and to rollback changes if they turn out to be wrong. If all you are doing to trying to deal with the next explosion, then you don’t have the time or energy to think and argue about long term consequences.

November 22, 2008

Notes on Chinese trade policy

Filed under: china, finance — Tags: , — twofish @ 7:17 am

  1. China can go fiscal while doing tax rebates. Personally, I don’t think that the tax rebates are going to do more than band-aid the situation since taxes on nothing are nothing.

    Pettis: Calling on the US government to engage in massive fiscal expansion to replace lost private demand is crazy. It means that we should continue the current game that has led us into so much trouble, but instead of having US over-consumption and rising debt at the private level we must have it at the public level.

    First the US government is the only entity that can generate the demand that is necessary and with all of the money that is going into treasuries it has a lot of free money that it should be doing.

    Second, the problem with what the US did from 2002-2008 was not that it expanded the economy. That was good, and it got us out of the 2002. The problem with what the US did was that this investment was in non-productive goods and that the benefit to the consumer was in the form of low interest loans rather than in higher wages. The US should try to generate demand by reducing consumption and having a massive effort to increase investment in roads, factories, health, education and anything else that will generate long term returns.

    Pettis: China needs to resolve this problem by expanding fiscally, not by stimulating exports.

    China doesn’t have a big enough economy to resolve global problems. It’s going to have a tough enough time fixing internal problems.

    Quote: The world has excess production and there is a need for the US to reduce its demand and increase its savings.

    *THIS* is the crazy part. We have overproduction and the solution is to reduce demand….. Hello???? If we have overproduction then we want to increase demand by any means possible.

  2. Pettis: It is amazing to me that people like Ferguson, who have been arguing correctly for years that US consumed too much and saved too little, are now terrified of the necessary adjustment, and are arguing that it should be stopped and even reversed.

    From my point of view the implication here is that they were wrong in the first place.

    Pettis: The process cannot be stopped – US savings are too low and will rise one way or the other.

    If you have savings rates that are too low in an era of overcapacity, you can have the government print money and stuff it into people’s bank accounts. Boom. Instant savings. Take debt and print money to erase it. Boom. Instant equity. That’s actually more or less what the government has been doing.

    None of this makes sense in normal times, but if you have people without jobs, and factories that can produce stuff that aren’t producing it, and the only problem is lack of money, you can print it.

  3. One other thing is that I don’t think that trade policy is really going to make that much difference. You can issue as many tax rebates as you want, but if no one in the United States is buying then it’s not going to make much of a difference. Also, I don’t think that trade is going to be a major source of friction because what either China or the United States can do is constrained by WTO rules, and WTO provides a forum for everyone to coordinate policy.

    What is going to be more interesting is the complex interactions between trade, monetary and fiscal policy. For example, if China takes huge fiscal stimulus but the US does not, then you are going to see the RMB weaken, and this could produce a worse balance of trade with the United States unless China agrees to peg its currency to avoid devaluation. So if either China or the United States or Europe takes fiscal stimulus, this is going to require some coordination of trade and monetary policy with the other actors.

    The other thing is that very unexpected things have happened and will continue to happen and figuring out ways of reacting to them is going to make things very interesting.

November 6, 2008

Officials and the Chinese business cycle

Filed under: Uncategorized — Tags: , , — twofish @ 8:34 am

Victor Shih has written a wonderful book on the political economy of China when he points out that the business cycle in China corresponds to shaping power relationships between two groups of officials. One group consists of local officials that want more spending, and one group consists of central government finance officials that are more concerned about monetary stability. When the economy overheats, the monetary stability people come in and cool things down. When the economy goes into a slump, the local officials come in and start building things left and right. Also, you have to look at incentives, local officials love big infrastructure projects for the same reason Wall Street CEO’s love big complex financial instruments, you make lots of money personally off of them.

We agree that this is going on. He seems to think that this is a bad thing, and if the monetary hawks could stay in permanent control that we could abolish the business cycle. I disagree since I am a fan of Hyman Minsky and I don’t think the business cycle can be abolished and that the shift between these two groups of officials is that Chinese government reacting to the business cycle rather than causing it.

The other thing is that the notion that the financial system ought to be ideally independent of any government supervision is I think dead. It’s hard to fault Wen Jiabao calling up Chinese banks and says “LEND MONEY” when Paulson is basically trying to do the same thing, and the fact that Chinese banks are more willing to listen to Wen than American banks are to Paulson may not be such a bad thing.

Notes on the Chinese economy

Filed under: china, finance — Tags: , — twofish @ 8:23 am

China is largely a reprocessing plant, so as exports go down, imports of raw materials are also likely to go down, and that will blunt the impact on growth. The big worry, I’d imagine isn’t growth, but rather 1) employment and 2) local finances.

For 1), the Chinese government was generating massive numbers of jobs. The thing is that it was generating massive numbers of jobs at the same time it was closing down the old state owned enterprises and shedding large numbers of jobs. Looking at net employment numbers gives you a very misleading impression of what is going on, since the companies that are creating and losing jobs are the same ones, and the people who are getting and losing jobs aren’t the same people.

One thing that will help China this time is that there isn’t an overhang of people that need to be laid off from the state owned enterprises.

For 2), local government have been heavily relying on land sales to cover expenses, and I think you are likely to see a lot of defaults on local government owned companies and a general recentralization of Chinese finances.

For 1), China is planning a massive fiscal stimulus package in rural areas. Getting local government officials to spend money on infrastructure is rather easy to do.

There’s likely to be an increase in health and education spending, however, it’s more difficult to use health and education to do fiscal stimulus. One problem is that basic health and education is cheap and really doesn’t have that much of a stimulus effect. The other problem is that what do you do once you’ve stimulated the economy. It’s not as if you can (or should) fire doctors and teachers once the economy gets going.

One final point is that this is not the first time that China has had an economic down turn, and it’s in far better shape now than it was in the previous downturns. The basic reason is that productivity in China is still extremely low, so its still easy through capital spending to find ways of boosting productivity

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