Potentially, one of the most important short-term consequences of the stock market collapse is the impact on employer pension funds. On Wednesday, January 7, 2009 we were informed that pension funds in the U.S. are underfunded by about $400 million (according to a report by released by the Mercer consulting firm). Since this does not absolve companies of their pension obligations (and there are federal laws that require companies to boost pension fund contributions in the short run), corporate profits and divident payouts are likely to decrease. Many companies' credit ratings could also suffer as a result, leading to higher borrowing costs, lower business investment, and a slower pace of productivity growth.
Longer term, this development could lead to major changes in the US private sector pension system. Increasingly, the burden may fall to tax payers to cover shortfalls in pensions. In principle, private pension funds are insured through the federally chartered Pension benefit Guaranty Corporation. However, if the demands on this agency become too much, it may have to be bailed out. The result could be major changes in the way people save for retirement.
See "Stock Losses Leave Pensions Underfunded by $400 Billion," The Washington Post, January 7, 2008. http://www.washingtonpost.com/wp-dyn/content/article/2009/01/07/AR2009010701387.html
Friday, January 9, 2009
Saturday, January 3, 2009
So Much for Computer Models
The experts and their computer models indicated it was practically impossible. Yet, the supposedly remote possibility that credit default swaps (CDS) would wreck AIG was a virtual certainty when the company's management decided to take the plunge into selling contracts on securities backed by sub-prime mortgages.
A CDS is similar to insurance in that the buyer of the contract pays a premium to the seller (AIG) in exchange for protection against the default of the security or loan. AIG entered the business on the basis of the estimate that there would be a 99.85 percent chance of never having to pay out. This estimate was based on years of data collected on the ups and downs of corporate debt. According to the model, in order for AIG to suffer a major loss on these contracts by having to cover the defaults the economy would need to go into depression. In the short run, the company made hundreds of millions of dollars from the fees it collected on the contracts.
Of course, the problem with this is that mortgage-backed securities are not corporate bonds, no matter how highly rated they are. Add to this the fact that the rating agencies were not really doing their job, and the result was predictable: AIG would eventually receive demands for huge payouts it simply could not cover. The rest is bailout history.
For an excellent discussion of the bailout and how AIG got into this mess see the Washington Post series The Crash: What Went Wrong? http://www.washingtonpost.com/wp-srv/business/risk/index.html
A CDS is similar to insurance in that the buyer of the contract pays a premium to the seller (AIG) in exchange for protection against the default of the security or loan. AIG entered the business on the basis of the estimate that there would be a 99.85 percent chance of never having to pay out. This estimate was based on years of data collected on the ups and downs of corporate debt. According to the model, in order for AIG to suffer a major loss on these contracts by having to cover the defaults the economy would need to go into depression. In the short run, the company made hundreds of millions of dollars from the fees it collected on the contracts.
Of course, the problem with this is that mortgage-backed securities are not corporate bonds, no matter how highly rated they are. Add to this the fact that the rating agencies were not really doing their job, and the result was predictable: AIG would eventually receive demands for huge payouts it simply could not cover. The rest is bailout history.
For an excellent discussion of the bailout and how AIG got into this mess see the Washington Post series The Crash: What Went Wrong? http://www.washingtonpost.com/wp-srv/business/risk/index.html
Monday, December 29, 2008
State Governments Preventing a Quick Recovery?
There has been a lot of discussion in recent weeks of a need for a federal fiscal stimulus to offset the contraction in consumer spending and business investment. Currently, the incoming administration is considering new expenditures of nearly a trillion dollars, a sizable portion of which will be in the form of infrastructure investments. Yet, as Paul Krugman informed today in his column, state governments are doing just the opposite. They're cutting their budgets across the board, meaning that everything from medical care to road building is getting the axe. In the end, if a fiscal stimulus will help the recovery state spending cannot substantially offset new federal outlays.
Why would they being doing this at a time when peoples' incomes are falling and unemployment in increasing? Why would they anxiety in consumer's minds? The reason is that state governments are generally not allowed to borrow when taxex and other revenues decline. Borrowing is prohibited by state constitutions. So as less people work and spend and property values decline, the states take in less money and make up for it by cutting spending.
Juan Carlos Ginarte
See Krugman's column at http://www.nytimes.com/2008/12/29/opinion/29krugman.html?_r=1&ref=opinion
Why would they being doing this at a time when peoples' incomes are falling and unemployment in increasing? Why would they anxiety in consumer's minds? The reason is that state governments are generally not allowed to borrow when taxex and other revenues decline. Borrowing is prohibited by state constitutions. So as less people work and spend and property values decline, the states take in less money and make up for it by cutting spending.
Juan Carlos Ginarte
See Krugman's column at http://www.nytimes.com/2008/12/29/opinion/29krugman.html?_r=1&ref=opinion
Sunday, December 28, 2008
Mortgage Bailout Plans Have Benefited Few Homeowners
The Housing and Economic Recovery Act's Hope for Homeowners program and the Hope Now initiatives have to stem the foreclosure tide. Hope Now, a government-backed alliance of mortgage lenders has reportedly led to the modification of 2.2 million mortgages in 2008, but about half of these loans slipped back into delinquency in the first three months of the year. The main reason for this is lenders' refusal to reduce principal amounts or interest rates.
In the case of the Hope for Homeowners program, which was supposed to address deficiencies of Hope Now, the Department of Housing and Urban Development reports that only 312 applications have been submitted since the plan took effect on October 1, 2008.
The reason? The program made sense politically at the time since both "sides" of the mortgage equation were required to give something up. However, the program provides few economic incentives to participate. Under this plan, participating lenders were to sacrifice some of the principal value of homes while requiring borrowers to give up future profits and assume monthly of at least 31 percent of their incomes. Lenders are not required to participate, and neither are homeowners, so the poor results were not difficult to predict.
Meanwhile, as the number of foreclosures grows the stigma associated with simply "walking away" from the mortgage diminishes. And so far major banks appear not to be using federal bailout funds to help rescue homeowners. Add to this the weakening economy and rising unemployment and the result could be another major wave of foreclosures.
Two positive developments that could help homeowners are the decline in fuel prices and the decline in interest rates. Lower interest rates will favor borrowers with adjustable rate loans. Both developments will put more cash in household budgets that could be used to pay mortgages. But in the end the recession is likely to bring tens of thousands of more mortgages into default.
Juan Carlos Ginarte
In the case of the Hope for Homeowners program, which was supposed to address deficiencies of Hope Now, the Department of Housing and Urban Development reports that only 312 applications have been submitted since the plan took effect on October 1, 2008.
The reason? The program made sense politically at the time since both "sides" of the mortgage equation were required to give something up. However, the program provides few economic incentives to participate. Under this plan, participating lenders were to sacrifice some of the principal value of homes while requiring borrowers to give up future profits and assume monthly of at least 31 percent of their incomes. Lenders are not required to participate, and neither are homeowners, so the poor results were not difficult to predict.
Meanwhile, as the number of foreclosures grows the stigma associated with simply "walking away" from the mortgage diminishes. And so far major banks appear not to be using federal bailout funds to help rescue homeowners. Add to this the weakening economy and rising unemployment and the result could be another major wave of foreclosures.
Two positive developments that could help homeowners are the decline in fuel prices and the decline in interest rates. Lower interest rates will favor borrowers with adjustable rate loans. Both developments will put more cash in household budgets that could be used to pay mortgages. But in the end the recession is likely to bring tens of thousands of more mortgages into default.
Juan Carlos Ginarte
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