CIT had friends, but not enough - and maybe this tells us something about the shifting political sands. The Financial Services Roundtable (top financial CEOs) came out in force, the House Committee on Small Business reportedly made worried noises, and Barney Frank sounded supportive. But the American Bankers Association (the broader mass of bankers) publicly stood on the sidelines and Senate Banking—and prominent senators—seemed otherwise engaged.
CIT's small and mid-size customers are important to the recovery. But the reckoning is that this business can be easily sold to someone else—after all, this is exactly what bankruptcy can get right in the U.S.
So the question became: is CIT too big—on its liabilities side—to fail? And if $80 billion financial firms are now "too big to fail," what does that imply for other potential bailout conversations and for our fiscal future?
In the final analysis, CIT wasn't even big enough to meet Secretary Geithner face-to-face—he's still out of the country.
The bottom line: we need fewer $800 billion firms and more $80 billion firms. If Goldman Sachs were broken into 10 independent pieces, we could all sleep much more soundly.
Also posted on Simon Johnson's blog, Baseline Scenario. Previous postings this week:
CIT Battle Lines (July 15)
The issue of the day is obviously CIT. It's hard to sort out the real news from clever PR/planted stories in this situation, but it looks like the FDIC is coming out strongly against being involved in a rescue package. Given Sheila Bair's successful political positioning and strong popular appeal, it's hard to see how—once dug in—the FDIC can be moved.
The lobbying frenzy has concentrated on CIT's role in financing small and medium-sized business; "the recession will be deeper if CIT fails" is the refrain. This is a weak argument—it would be straightforward to refinance this part of CIT's business without bailing out CIT's creditors, and definitely without keeping top CIT executives in place; this is the essence of "negotiated conservatorship," which is a proven model in the US.
More plausible is the concern that given Treasury's generous handouts to date for financial firms, if they are now tough on CIT's creditors, this will send a new signal about how they may treat other firms—and maybe raise fears of Hank Paulson-like flipflopping. Citigroup's CDS spread is still at worrying levels, and Treasury/National Economic Council watches this closely—for both organizational and personal reasons.
Essentially, by trying to refloat an undercapitalized banking system, Treasury has created pervasive financial vulnerabilities to CIT-sized shocks. These are now the basis for more bailouts and even great fiscal costs.
If CIT is determined to be "too big to fail" in today's context, this has far reaching implications. Instead of financial entities with assets of at least $500 billion creating systemic risk, we now have to worry about anyone who has not much more than $50 billion. This is a profound change—and a point that seems to have escaped the Financial Services Roundtable, which is pushing hard for a CIT rescue.
Mr. Geithner is travelling back from the Middle East today. Once he lands, I would guess that a bailout package will go through (on the weekend, if they can get that far) and creditors are unscathed. But I still suspect that there will be management change at CIT.
How the CIT deal impacts current Capitol Hill discussion on system risk and regulatory reform remains to be seen. The effects there could be more profound than expected.
Will CIT Go Bankrupt? (July 14)
CIT Group is apparently in trouble and now negotiating with Treasury, the Fed, and the FDIC for some sort of "bailout", e.g., in the form of a guarantee for its debt.
Traditionally, CIT provided vanilla loans to small and medium-sized business. "But under its current chief executive, Jeffrey M. Peek, a well-liked Wall Street veteran who lost out several years ago in a race to run Merrill Lynch, CIT made an ill-timed expansion into sub-prime mortgage and student lending" (NYT today).
What happens to CIT will help define exactly where we are with regard to "too big to fail."
At the end of 2008, CIT had total assets around $80bn, which was about 1/10th the size of Goldman (and about 1/25th the size of Citigroup) and puts it just outside the top 20 publicly traded financial services company. Presumably, it just missed the cut for inclusion in the government's recent "stress tests."
Its assets are between 2 and 3 times those of the largest "hedge funds"—although obviously what gets that label these days is somewhat arbitrary, and the leverage in any individual fund could mean system risks roughly of the same scale as for CIT.
CIT's bailout possibilities are now in the realm of political choice. The rest of the financial sector, including hedge funds and the American Bankers' Association (ABA), should be lobbying for it not to get bailed out—otherwise the bar for "too big to fail" will be lowered (by roughly an order of magnitude), and there will be many more voices arguing that even medium-sized banks/funds need to be broken up or otherwise severely constrained.
However, given that hedge funds have no discernible political strategy—other than to cry in public about impending European regulation—we should not expect any coherent response from that quarter. And the ABA mistakenly thinks they can take on all comers on all issues; their hubris does not lend itself to thinking through this particular part of the chess game. So both of these powerful forces are likely to sit on the fence.
The decision therefore largely comes down to the administration. On this front, the lack of strong connections between CIT's CEO and senior Treasury officials looks like a weakness. CIT seems to sit at the edge of the charmed circle, with regard to meetings, shared social engagements, and intellectual entanglements. This is a close call, but I think it is just on the outside of the circle—in the sense that with the overall financial market situation more stable, the GM bankruptcy well-managed relative to expectations, and other credit support programs still in place, the balance of official opinion will tilt against CIT.
So then it all comes down to political donations. At least in terms of what is in the public record, Mr. Peek has not been overly generous, but he did give money to John McCain—and not to any Democrats. If this is in fact the limit of his recent contributions, I think you know the outcome.
Waiting for the Big Push: Selling the Consumer Protection Agency For Financial Products (July 13)
In mid-March, the administration proposed that toxic assets could and would be safely removed from banks balance sheets. We were skeptical, and the PPIP now seems to have slipped into irrelevance (loans; securities). But the administration still put an impressive effort into persuading independent analysts, and broader public opinion, that they should do something clearly beneficial for banks. This was "all hands on deck," and it definitely had an impact on the debate, at least for a while.
Now, the administration's major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public. And the skepticism—and outright opposition—comes from the banking sector.
How does the administration's effort compare, then vs. now?
As far as I can see, they are not pushing this new consumer protection/safety agency hard enough.
Some sources claim that Secretary Geithner is fully on board with the Agency, and certainly he has mentioned it in public. But there is no sign of the frenzied effort that accompanied efforts to launch the PPIP—when, for example, almost every economist in the administration seemed pressed into service to call potential critics and ask them to "give it a chance."
One symptom of this "effort gap" is that counter-arguments and disinformation about the proposed agency begin to gain the upper hand. One senior executive recently told me that this agency would have unprecedented powers to determine the decision of individual products—"something not even the FDA can do."
Of course, this is nonsense. The new agency would be powerful—and thus it is feared by the industry—and presumably it would be able to prevent sufficiently toxic products from being sold. Hopefully, it will also be able to require that all financial institutions also offer some vanilla products, to make consumers' choices easier. But the idea that an agency would design the details of all products for any sector is both implausible and a malicious rumor being spread by opponents (actually, it reminds me of the pushback from meatpackers, and others, early in the 20th century).
If Treasury is so supportive of this new Agency, now is the time to launch public, high profile, and clever counterattacks. By the time the legislation is being voted on, it will be too late.
And in this context, the administration should push hard on one of the great ironies here. Financial sector executives like to stress the importance of "consumer confidence," and they urge the government to take steps to restore this confidence (e.g., with a straight face, suggesting even more really cheap credit from the Fed to their favorite sector).
But the same people completely reject the idea that consumers will feel more confident about financial products if there is finally some serious consumer protection around those products. Whenever people learn—or just fear—that a particular food product is unsafe, they stop buying it. When the stock market ripped people off in the late 1920s, it took legislation with real teeth to rebuild investor confidence—take a look at, for example, the Securities Exchange Act of 1934. And the entire edifice of modern medicine is based on the idea that someone in government will make the call, right or wrong, on whether a compound can be regarded as a helpful drug—as opposed to colored water or something actually poisonous, which is what was sold as "patent medicine" 100-150 years ago.
If Treasury and the administration really want a Consumer Protection/Safety Agency for finance, they need to kick their support campaign into much higher gear immediately.
Larry Summers' New Model: Details, Contradictions and Odd Assumptions (July 11)
Larry Summers had "lunch with the FT" (p.3 in the Life and Arts section today)—although unfortunately the paper does not report when this happened; a week or two makes quite a difference these days.
Putting this next to his April speech to the IDB, Summers' view of the way forward has a few problems.
Summers says: "The American problem this time has more in common, at least qualitatively, with the Japanese post-bubble problem, where the issue was not reassuring foreigners but maintaining sufficient domestic demand to push the economy forward."
But Japan had a chronic current account surplus, which became bigger as firms saved more in order to pay down their debts during the 1990s. The Japanese government could finance its deficit domestically—and the country exported capital consistently. In contrast, with our well-established and large current account deficit and our eye-popping budget deficit, we rely much more on the confidence of foreigners—unless Summers is assuming that the increase in our private sector savings will be truly enormous.
As Summers says, quite accurately, the Asian and other crises of the late 1990s,
"… took the form of a foreign lack of confidence in a country that led to a mass withdrawal of funds and made reassuring foreigners the central priority. That's why interest rates often had to be increased."
Surely, we face some sort of hybrid Japan/emerging market crisis. Or perhaps we are heading towards blending Japan in the 1990s and the US in the 1970s, i.e., there has been a permanent shock (oil then v. financial sector now) to which we should adjust, and if we attempt to postpone that adjustment excessively through overly expansionary macro policies, we'll experience a great deal of inflation.
On Japan in the 1990s, Summers is famous for first arguing it was an aggregate demand problem and later coming to the view that the banks were undercapitalized and—without this—the economy could not sustain a recovery. His ideas on the US are likely to go through the same evolution.
It is also striking that he makes no mention of balance sheets problems, either for consumers or businesses—in Japan then or the US now. It sounds like he is getting ready to push for a second fiscal stimulus—actually, for him this would be the third stimulus, as he argued hard for the tax cut stimulus of early 2008.
Summers is almost certainly wrong when he says, "The very great enthusiasm for accumulating reserves that one saw globally is likely to be a smaller factor over the next decade than it has been in recent years." On the contrary, most emerging markets are glad they had more reserves than in the past and are now wondering about how to build up those reserves further. This may, of course, help the US sell some of its forthcoming government debt—but it doesn't reduce "global imbalances" or address the fact that we are on an unsustainable public debt and foreign debt path. Most of all, it lets us dig a deeper hole for ourselves and for the world economy.
More broadly, Summers continues to argue, at least implicitly, that we face a temporary shock or one-off aberration of some kind. He distinguishes sharply "fixing" the banking system and "getting the economy out of the rut" from long-run issues, "like fixing health-care, like having real energy policy, like reforming education." He apparently does not see much by way of connections between these two sets of issues.
But doesn't the economic and political power of our troubled banking system threaten our longer run opportunities? Aren't our nonfinancial reform options (e.g., on universal healthcare coverage) already limited by the doubling of government debt (towards 80% of GDP) we are undertaking as a direct consequence of financial sector misfeasance? And won't Medicare—and much else—be undermined by the behavior of "too big to fail" banks down the road?
Summers has commendably switched some of his rhetoric, so now he emphasizes nonfinancial technology development—presumably in the private sector—as the road to sustainable growth. And he rightly contrasts this with the financial engineering that brought us to this point. But does his model really offer the most plausible or appealing path from here to there?