Banks Need More Capital -- Alan Greenspan, The Economist

GLOBAL financial intermediation is broken. That intricate and interdependent system directing the world’s saving into productive capital investment was severely weakened in August 2007. The disclosure that highly leveraged financial institutions were holding toxic securitised American subprime mortgages shocked market participants. For a year, banks struggled to respond to investor demands for larger capital cushions. But the effort fell short and in the wake of the Lehman Brothers default on September 15th 2008, the system cracked. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. The world faced a major financial crisis.

For decades, holders of the liabilities of banks in the United States had felt secure with the protection of a modest equity-capital cushion, allowing banks to lend freely. As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.”

Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

The three-month LIBOR/Overnight Index Swap (OIS) spread, a measure of market perceptions of potential bank insolvency and thus of extra capital needs, rose from a long-standing ten basis points in the summer of 2007 to 90 points by that autumn. Though elevated, the LIBOR/OIS spread appeared range-bound for about a year up to mid-September 2008. The Lehman default, however, drove LIBOR/OIS up markedly. It reached a riveting 364 basis points on October 10th.

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Greenspan Roundtable: Is $250 Billion Enough? -- Economists @ Free Exchange

Luigi Zingales:

Alan Greenspan is factually correct in his description of the current economic environment, but he is reticent in his analysis of the causes and wrong in his prescriptions. He is right that the global financial intermediation is broken because investors are concerned about the solvency of the banks. However, his analysis is incomplete because it does not explain why investors have become fearful. He seems to hint at irrational fear (“human nature being what it is”), but this is a convenient scapegoat. Investors are correctly fearful because they do not know the value of banks’ assets. When Lehman’s bond in bankruptcy fetches a little more than eight cents on the dollar and when Merrill Lynch sells its loans at 20 cents on the dollar, we do not have to revert to irrational fear to explain why investors require hefty premiums to lend to banks. Given that Citigroup had to be bailed out twice in less than 60 days, the problem is not that the market wants unrealistically high levels of capital: it wants reasonable levels of correctly measured capital.

Brad DeLong:

FOUR factors impose haircuts on the values of financial assets. The first is default: perhaps your counterparty simply will not be around when the financial asset you hold matures. The second is duration: even if you are certain that your counterparty will be around, and even if you are certain that you understand the situation, and even if you don't care about risk, you would still rather have your money now than at its maturity date in the future. The third factor is information: maybe you don't understand what you are buying, for if it is such a good deal for you to buy it at this price why is the seller so eager to sell the asset to you? The fourth is risk: even if your counterparty will be around and even if you don't care about getting your money now rather than later and even if you understand the security perfectly, you still are not sure how valuable the security will be to you in your particular situation when it matures.

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Why GM Deserves Support -- Rick Wagoner, Wall St. Journal

Much has been said about the impact of the credit crisis on U.S. auto makers, and whether or not the government should assist the industry during this extraordinary financial turmoil. In these discussions, many critics simply ignore the substantial changes that U.S. auto companies have already made -- changes much like those the critics are calling for as part of any aid package.

At General Motors, we have been responding to fierce competition here and abroad by transforming our business. Over the past decade, we have taken tough actions to cut costs, at the same time investing billions in fuel-efficient vehicles and new generations of advanced propulsion technologies.

On the cost-cutting side, we have been streamlining our U.S. operations while simultaneously improving quality and productivity. Since 2000, we have reduced our U.S. hourly workforce by 52%, from 133,000 to 64,000, through buyouts and other programs. During the same period, we have cut our U.S. salaried employment from 44,000 to fewer than 30,000, and reduced our U.S. executive ranks by 45%.

However, we know we cannot just slash our way to prosperity. We have closed the quality and productivity gaps with the imports, as confirmed by J.D. Power and Associates (the consumer ratings firm) and the Harbour Report (which benchmarks North American plant-floor performance). New GM product programs launched earlier this decade have produced award-winning cars and crossovers like the Saturn Aura, Cadillac CTS and Buick Enclave. And that is just the beginning.

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Let Detroit Go Bankrupt -- Mitt Romney, NY Times

IF General Motors, Ford and Chrysler get the bailout that their chief executives asked for yesterday, you can kiss the American automotive industry goodbye. It won’t go overnight, but its demise will be virtually guaranteed.

Without that bailout, Detroit will need to drastically restructure itself. With it, the automakers will stay the course — the suicidal course of declining market shares, insurmountable labor and retiree burdens, technology atrophy, product inferiority and never-ending job losses. Detroit needs a turnaround, not a check.

I love cars, American cars. I was born in Detroit, the son of an auto chief executive. In 1954, my dad, George Romney, was tapped to run American Motors when its president suddenly died. The company itself was on life support — banks were threatening to deal it a death blow. The stock collapsed. I watched Dad work to turn the company around — and years later at business school, they were still talking about it. From the lessons of that turnaround, and from my own experiences, I have several prescriptions for Detroit’s automakers.

First, their huge disadvantage in costs relative to foreign brands must be eliminated. That means new labor agreements to align pay and benefits to match those of workers at competitors like BMW, Honda, Nissan and Toyota. Furthermore, retiree benefits must be reduced so that the total burden per auto for domestic makers is not higher than that of foreign producers.

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Why The British May Decide To Love The Euro -- Wolfgang Münchau, FT

Let me start with a disclaimer. I was never a strong advocate of British membership of Europe’s economic and monetary union, though I was, and still am, a big fan of Emu itself. I always felt the economic arguments made by euro advocates in the UK were vastly exaggerated and counterproductive. Judged from a narrow economic perspective, which is how the British looked at this, they were right to stay out during the euro’s first 10 years. The tangible economic benefits that came with an independent monetary policy outweighed the much less tangible economic benefits of membership.

But that was then and this is now. A financial crisis, a house price crash and a recession later, the arguments are still fundamentally the same, but the cost-benefit analysis produces a different result. The advantage of monetary independence, while somewhat greater than zero, will be more than compensated by the following four factors.

The first relates to long-term economic costs. In the good old times of financial exuberance, global real interest rates were low and successive bubbles kept the credit-devouring beast of the British economy going. Even assuming that financial balance sheets will be back in good shape in 2010 or 2011, I would not expect a return to the credit-binge era. We have probably entered a secular bear market in equities. There will be no immediate appetite for another housing bubble and the regulatory framework will be conservative, to put it mildly.

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Eurozone Membership Is Still No Answer for UK -- Martin Wolf, FT

Is this the time for the British to swallow their pride, admit they made a mistake and beg to enter the eurozone? A growing number of people argue it is. They are wrong.

The reason for having a floating exchange rate is that it should float. In an uncertain world, an economy needs mechanisms of adjustment. The exchange rate is the most powerful such mechanism. Only exceptionally flexible or exceptionally open economies cope well with big shocks without any exchange rate flexibility.

The UK is now suffering relatively severely (and so “asymmetrically”) from six large negative shocks.

First, the UK is experiencing a rapid fall in house prices that seems likely to continue for a long time.

Second, UK households have high levels of indebtedness. According to the European Commission, only Denmark and Ireland have higher levels of indebtedness relative to gross household disposable income, inside the European Union, though Spain, Portugal and Sweden come close.

Third, the credit crisis has damaged the financial sector and so credit supply extremely severely.

Fourth, the UK relies heavily on the now contracting financial sector for supply of well-paid jobs.

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How to Ground The Street --
Eliot Spitzer, Washington Post

President-elect Barack Obama will soon face the extraordinary task of saving capitalism from its own excesses, much as Franklin D. Roosevelt had to do 76 years ago. Up until this point in the crisis, policymakers have appropriately applied the rules of triage -- Band-Aids and tourniquets, then radical surgery -- to keep the global financial system alive. Capital infusions, bailouts, mega-mergers, government guarantees of unimaginable proportions -- all have been sought and supported by officials and corporate chief executives who had until now opposed any government participation in the marketplace. But put aside for the moment the ideological cartwheel we have seen and look at the big picture: The rules of modern capitalism have been re-written before our eyes.

The new president's team must soon get to the root causes of the mistakes that have brought us to the economic precipice. Yes, we have all derided the explosion of leverage, the failure to regulate derivatives, the flood of subprime lending that was bound to default and the excesses of CEO compensation. But these are all mere manifestations of three deeper structural problems that require greater attention: misconceptions about what a "free market" really is, a continuing breakdown in corporate governance and an antiquated and incoherent federal financial regulatory framework.

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Spitzer as Victim -- Editorial, WSJ

Shame is fleeting in modern America, so it was probably inevitable that Eliot Spitzer would seek to return as an arbiter of everyone else's moral behavior. But even we have to admit to being a little surprised by the rapidity and audacity of his attempted self-rehabilitation, courtesy of an op-ed in Sunday's Washington Post. This guy makes Bill Lerach seem remorseful.

APLittle more than a week has passed since federal prosecutors declined to bring charges against Mr. Spitzer for soliciting prostitutes while Governor and before that while the chief law enforcement officer (Attorney General) of New York. The U.S. Attorney thus exercised more prosecutorial restraint than Mr. Spitzer ever showed to his targets as he sought to build his political career.

Spared a criminal charge, Mr. Spitzer is now re-emerging to offer advice on how to reregulate Wall Street and to assert that he was right all along about everything (save the call girls). The man who forced new management on Marsh & McLennan and AIG, to the great detriment of their shareholders, now points to AIG's failure as evidence of his success...

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