US homeowner bailout plan

President Obama announced the Homeowner Affordability and Stability Plan, which is expected to help as many as nine million American homeowners restructure or refinance their mortgages and thereby avert foreclosure, shore up housing prices, stabilize neighborhoods and slow a downward economic spiral. It could ultimately cost taxpayers as much as $275 billion.

It will have three major components
1. Low cost refinancing for upto 4 to 5 million responsible homeowners (those who are current on their payments, but who are paying high interest rates and cannot refinance because they do not have enough equity in their homes) to make their mortgages more affordable by reducing their interest payments. This will remove the current restriction on Fannie Mae and Freddie Mac that prohibits them from guaranteeing refinancing on mortgages valued at more than 80% of the home's value.
2. A $75 billion Homeowner Stability Initiative to reach upto 3 to 4 million at-risk homeowners and keep them in their homes. The government will offer incentives to lenders to alter the terms of loans to make them affordable for the troubled borrowers.
3. Supporting low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac through direct purchases of their debts as part of the quantitative easing measures announced in November 2008. This will substantially increase the credit available for newer mortgages.

More analysis on the Plan is available here, here and here. A nice NYT interactive graphic sums up the Plan.

Update 1
The Obama administration announced the full details of a $75 bn homeowner bailout plan, that seeks to help 4 m people avoid foreclsoures. People with mortgages as high as $729,750 could qualify for help, and there is no ceiling on how high their income can be as long as they are in danger of losing their homes. Interest rates on loans could go as low as 2% for some and many homeowners could see their mortgage payments drop by several hundred dollars a month, and some could save more than $1,000 a month.



Update 2
FAQ on Housing bailout plan here.

How much more to go before a turn around?

After the initial dilly-dallying, governments across the world have got their acts together in fighting the recession-turning-into-depression. The Obama administration has finally got both the $787 bn fiscal stimulus, enshrined in the ARRA 2009, and the revised version of the TARP, FSP, for the remaining $350 bn for bailing out banks, through. Governments across the world have also been busy responding with their respective versions of fiscal stimulus and financial market bailout programs. It now remains to get all this money under circulation. However, if the response of some of the prominent traditional bellwethers like equity market indices, bond market yields etc are any indication, none of these efforts have registered any significant impact with the market stakeholders.



The problem is that no one can, with any reasonable degree of certainty, prescribe policy responses that will lead us out of this mess. In fact, there is no magic macroeconomic policy prescription - fiscal, monetary, financial, or behavioural - that can restore normalcy in the financial markets and the economy. The only hope is to swiftly throw every policy response possible and that too in massive quantities, and then hope something or the other works.

Everything the US and others have tried till now - zero-bound monetary policy, quantitative easing, direct cash-infusions, fiscal stimulus etc - were tried by Japan in the past two decades, and in massive size. The Bush and now Obama administrations, and governments elsewhere, are implementing these policies with the same prevarication as the Japanese, understandable given the uncertainty surrounding their success and apprehensions about the popular backlash at the prospect of bailing out greedy bankers and investors. And like the Japanese in the nineties, the present day governments too are wary of the final plunge by taking direct equity positions or allowing banks to fail, leave alone extreme steps like "nationalization", to rein in the downward spiral.

It took Japan nearly two decades to emerge from its version of banking crisis induced economic recession - a real estate bubble burst in early nineties, leaving banks holding trillions of yen in loans that were virtually worthless, forcing a credit squeeze and economic recession. All of the proposals contemplated in the FSP announced by Treasury Secretary Tim Geithner, including leveraging private capital to create a market in distressed assets, were tried out, to little effect. From 1992 to 2005, Japanese banks wrote off about 96 trillion yen, or about 19% of the GDP. Real estate prices fell for 15 years in a row, equity markets declined by three-quarters, and the nation was trapped in a liquidity trap induced deflationary recession.



After meandering for nearly a decade with half-hearted equity injections and fiscal pum-priming, the financial markets started stabilizing from 2002, immediately in the aftermath of implementation of a massive and rigorous audit of the country’s top banks under the Takenaka Plan (Heizo Takenaka headed the government’s financial reform efforts), a move that forced out the full extent of bad loans to light. They also nationalized a major bank and allowed a few to fail. To that extent Geithner's stress tests are a step in the right direction.

Many economists like Paul Krugman have warned that we may be in for a long, long haul, and are looking at a Great Depression 2.0! Describing it a "balance sheet recession", Axel Leijonhufvud too feels that this recession is different from the regular troughs, and that "fiscal stimulus will not have much effect as long as the financial system is deleveraging".

He writes, "The financial crisis has put much of the banking system on the edge – or beyond - of insolvency. Large segments of the business sector are saddled with much short-term debt that is difficult or impossible to roll over in the current market. After years of near zero saving, American households are heavily indebted... the private sector as a whole is bent on reducing debt. Businesses will use depreciation charges and sell off inventories to do so. Households are trying once more to save. Less investment and more saving spell declining incomes. The cash flows supporting the servicing of debts are dwindling. The efforts by financial firms to deleverage... can trigger a rapid avalanche of defaults".

He also refers to a twin dilemma, "If government programs end up not being large enough to turn the recession around, we have to look forward to a deflationary period of indeterminate length. If they do succeed, however, severe inflationary pressures may surface quite quickly."

Nouriel Roubini paints the entire American banking system as "insolvent" and estimates that they need $1.4 trillion in new cash to return their capital levels to where they were before the crisis began, and this can be delivered effectively only by way of nationlization. He estimates that total losses on loans by American financial firms and the fall in the market value of the assets they hold will reach $3.6 trillion, up from his previous estimate of $2 trillion, of which banks will account for $1.7-1.8 trillion, the economy will contract from its peak by 5%, unemployment will touch 9% and real estate will fall another 20%.



Many other prominent opinion makers too feel that the Geithner plan is too little too late, and will only prolong the misery and increase the final costs. Without cleaning up the bad assets from the balance sheets of banks, it will not be possible to get banks restore their normal lending operations. There are increasing number of voices who now say that, like in Japan in 2002, Sweden in 1992 and the US itself in 1987-89, the government needs to aggressively intervene to weed out the weakest banks (translation - let them fail), pour capital into the surviving banks (translation - nationalize) and sell off their bad assets. And all this will need much more than the $350 bn left over under FSP, and could go well beyond another $ 1 trillion.

The experience of the Savings and Loan (S&L) crisis shows that a large number of banks failed and their assets were taken over and liquidated over a few years by the Resolution Trust Corporation (RTC). As the figure below shows, this time we are yet to reach those levels of failures. But if the S&L crisis is an indicator, as it looks increasingly likely, then the FDIC, which is responsible for taking over and liquidating the failing banks, may have to follow the example of the RTC.



Update 1
NYT has this article on how consumer spending has fallen in Japan, depriving the emabttled economy off one of its most important domestic engines for economic growth. As companies have cut costs, in order to bolster bottomlines, wages have been compressed and one-third of the labour force in the country have become temporary or non-traditional with no job security and fewer benefits.

Update 2
The Economist has this wrap up and an excellent graphic of how different countries have unleashed their fiscal fire-power. Dani Rodrik sums up the global fiscal stimulus plans here. An Excel sheet on the stimulus plans here.

Update 3
NYT has this article that examines three indicators - stock prices, home values, and consumer spending - as to whether the markets have bottomed out and recovery is on its way.

Update 4
The Economist has this report on the build-up to the London summit.

When do markets fail?

Robert Stavins puts in perspective the conditions under which markets work in a nicely written article. He writes,

"The 'first theorem of welfare economics' states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met... Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

So, the market by itself demonstrably does not solve all problems. Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule. Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources. Such government interventions will not necessarily make the world better off; that is, not all public policies will pass an efficiency test. But if undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency."

As Mark Thoma writes, the aforementioned applies to all markets. As the recent experiences show, market failures are commonplace and can wreak devastating havoc. Government intervention to push them in the right direction can improve the market's performance and make us better off.

Arms-length nationalization or bankruptcy?

After the initial opposition and debate, the voices supporting nationalization are getting louder. The latest to join in support is Alan Greenspan, once an ardent supporter of the fiction that modern financial markets are self-correcting.

Even some of the shrillest initial opponents of nationalization are now switching sides, albeit grudgingly and with some semantical gymnastics. Alex Tabarrok of Marginal Revolution feels that nationalization may now be "very likely" and even "desirable", but prefers to use the term "bankruptcy" instead to describe the process. He argues for a bankruptcy takeover wherein the "government steps in, removes current management, pays off the depositors, reorganizes and then sells the banks to recoup its losses". This, he says, is the capitalist solution to bank failure, since the presence of deposit insurance effectively makes government the guarantor of all the liabilities of a bank and a government takeover would be the capitalist way to punish the owners of the failed banks.

Andrew Rosenfield draws attention to the crucial distinction between a normal firm and a bank, "Banks are rather special firms; they are so highly leveraged that their operations heighten the possibility of contagion and "systemic" risk. As a result, the government itself provides insurance against imperilment and failure to certain investors - depositors and buyers of special debt instruments called certificates of deposit issued directly by a bank (but not the debt issued by a bank holding company) to prevent runs and build trust. In return, banks are not subject to the general bankruptcy statute. Instead, the government enjoys special contractual control rights that allow it to simply and swiftly take over banks it regulates whenever they become imperiled. Those rights include "receivership," which gives the government license to treat bank failures economically and expeditiously."

Both Rosenfield and Tabarrok make the case for separating ownership from day-to-day management of the banks so taken over. They write that the government should install a new CEO of its choice, along with senior executive management, then provide the bank with fresh financial capital, and let it undergo the required restructuring process. They also feel that this arms-length takeover and management should preferably be done through the FDIC.

In any case, whether it be bankruptcy or arms-length nationalization, the result is same - government takes over the institution, seizes all assets, removes the existing management, restructures it and then runs it for some time before exiting its stake.

Update 1
James Baker feels that America may be following Japan's unsuccessfull example of trying to keep "zombie banks" on life support, and thereby risk losing a "lost decade". He therefore prefers nation alization in another name - "a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible"!

He suggests that all banks be subjected to stress tests under the worst case scenarios and then divided into three groups - the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds.

He writes, "The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment. After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations."

He also feels that the FDIC or an institution like the Resolution Trust Corporation can manage the transition. And all the decisions should be taken in one go, so as to avoid bank runs.

Why duty cuts are a waste of money?

I just can't make sense of this fetish with lowering excise duties, sales tax, CENVAT etc. Industry groups have been aggressively lobbying for lower indirect taxes, on the grounds that it will stem the slow down in consumer demand. They are wrong and the government is also wrong to follow suit, more so given the limited fiscal space available. Scarce resources should not be allowed to go down the drain and should be deployed as to deliver the biggest possible bang for the buck.

The purpose of any fiscal stimulus measure is to boost aggregate demand, as directly as possible, by getting additional money into the hands of economic actors and then making them spend it immediately, thereby setting in motion a virtuous cycle of multipliers leading to economic growth. If in the process, the bottom lines of companies improves, as it will, so be it. But the reverse - increased corporate bottomlines will lead to more growth and thereby increased aggregate demand - is not always true.

Consider this example. All assumptions are made to simplify the scenario. A product Stimulant costs Rs 100, and it is taxed at 20%, amounting to Rs 20. Assume that Stimulant is sold at Rs 120 in the market (the actual market price, depends on the incidence of taxation, as shown in the graph, and is slightly less). Assume also that its manufacturing profit is Rs 25.

Now, as part of the fiscal stimulus package, the government reduces duties by half, thereby lowering taxes to 10%. Stimulant now gets priced anywhere between Rs 110-120 (the lower range indicates complete pass through, and the upper range is without pass through), depending upon various factors like its price elasticity of demand and other market specific reasons. Now assume that the market is balanced and competitive and the gains are equally shared between the manufacturer and the consumer. At a price of Rs 115, the producer profit (I) goes up by Rs 5 to Rs 30, consumer surplus (C) increases by Rs 5, and the government (G) loses Rs 10 in tax revenues.

Now assume that the manufacturer spends Rs 2 (even this is too liberal as we shall see) from out of the Rs 5 he gains on new investments. He uses the remaining Rs 3 to pay off his increased debt service burden or save it to build up reserves for the darker days ahead. Therefore (with all simplifying assumptions), on the net the economy gains Rs 2 + Rs 5 (assuming that the consumer spends all his incremental surplus), or Rs 7, while losing Rs 10 in revenues. Taking into account the multiplier and all, this is likely to be even less, since the consumer is not likely to spend all the Rs 5 saved by way of lower prices. We therefore have a sitaution where the economy gains less than a rupee for every rupee spent! Stimulating the sales of Stimulant is clearly not the way forward.

The figure below explains the movement of prices in a competitive market as the 20% tax is first imposed and then lowered to 10%. In more uncompetitive or distorted markets, as in India where price signals are not efficient and pass-through is constrained, the effective tax reduction is much lower, thereby keeping the consumer prices higher than expected. The proportion in which the tax gets distributed between the consumer and the supplier depends on the respective elasticities of demand or slopes of the curves. If price elasticity of demand is higher, as is the case for essentials and those with no substitutes, the incidence of the tax burden is higher on the consumers.



And on top of all these, duty cuts are difficult to roll back. The corporate lobby groups will ensure that these cuts end up being permanent. We therefore end up with back door corporate welfare. The government will have to make up the lost revenues by taxing elsewhere.

Standard economic theory says that GDP is the sum of consumption (C), investment (I), government spending (G), and net exports (NX). In uncertain times, I will always remain subdued given the rational expectations that imposes psychological blocks on committing investments. The deep uncertainty surrounding the global economy makes investments even more difficult to commit. I can at best accelerate a growth process set in motion by government spending and private consumption!

C is an important driver of the economic engine in such times, especially in the Indian context now. The issue is how do we stimulate C? As the aforementioned illustration shows, tax cuts are an ineffective way to stimulate C. And recent experience with duty cuts on steel, drugs, and a variety of other products shows that the benefits of duty cuts rarely ever gets passed on to the consumer and even when passed on, the share is disproportionately lower.

A more effective way to encourage consumption of say automobiles, consumer durables, and homes, is by offering more direct assistance like temporarily, say for three months, lowering interest rates on hire purchase schemes for them. Banks can be incentivized to lower rates on such lending by lowering provisioning requirements on loans made to these sectors anf offering guranatees etc, conditional on their actually lowering rates. Such incentives should be for a limited period of say, three months, so as to force consumers out into the market.

Similarly, fiscal support to prop up exports too may achieve little. The Government announced the extension of a 2% interest subsidy till September 30, on interest on pre-shipment and post-shipment credit for employment-oriented sector exports such as textiles, carpets, leather, gems and jewellery, marine products and other small and medium enterprises. In a depressed global economy, exports have declined because consumers outside have lost their apetite for the product. In such cicumstances, no amount of props, especially small token interventions like interest subsidy, can help Indian exporters increase sales. Such fiscal support then clearly becomes a handout to the specific exporter.

In view of all the aforementioned, direct government spending, G, is clearly the most effective way to spend scarce resources to deliver the biggest bankg for the buck. By bringing out the idle resources and excess capacity, both of which are growing, to use, the government spending will stimulate the economy as no other intervention can.

Update 1
And, predictably, the government has made duty cuts the center-piece of its third round of fiscal stimulus, the so-called election stimulus! The cost, Rs 30,000 Cr in revenues foregone. Will somebody, three months down the line, calculate how much of this has been passed down to the consumers?



As Businessline says, in any case, these cuts are just a drop in the ocean, too little to make any impact on the consumer's expectations.

Budget statistics

The best indicator of the fiscal stimulus is the abrupt increase in expenditures in 2008-09 from the original budget estimates



Another measure of the stimulus operative is the sharp increase in transfer to states. Interestingly this has grown considerably during the tenure of the present government.



Tax revenues have grown nicely over the past few years, and direct taxes form more than half all the taxes.



But taxes as a share of GDP is still very low and needs to go up substantially to reach the levels of even China. With GDP growing at near double digit rates, the tax buoyancy has to be truly spectacular for it to increase as a share of GDP.



Despite all talk of private investments in infrastructure and PPP, the private sector remains a very small player.

Fiscal deficit will rise - is there a choice?

The economic downturn has caught the government on the back-foot from both sides - declining revenues and rising expenditures (and here and here) - on fiscal expansion.





Classical economic theory tells us that counter-cyclical policies, that run up deficits during slowdowns and balances them during the up-turns, are critical to stimulate the economy at times of weakness. So given the economic crisis facing the global economy and the need for fiscal stimulus, widening deficits are inevitable. India's mistake was that we forgot to build-up a cushion during the good times.