Republicans are growing increasingly concerned about the impact a bruising fight over raising the nation’s $14.29 trillion debt ceiling could have on U.S. financial markets.
House Speaker John Boehner (R-Ohio) has had conversations with top Wall Street executives, asking how close Congress could push to the debt limit deadline without sending interests rates soaring and causing stock prices to go lower, people familiar with the matter said. Boehner spokesman Michael Steel said Tuesday night that he was not aware of any such conversations.
Treasury Secretary Timothy Geithner has warned Congress that without new borrowing authority, the federal government could hit the statutory debt limit by May 16.
Treasury could then implement emergency measures to continuing making interest payments on existing debt until around July 8. After that, the U.S. risks going into default, an unthinkable idea to many economists and market participants who say such an event could drive scores of large banks into failure, send interest rates skyrocketing as foreign investors abandon U.S. securities and crush the already slow-going economic recovery.
Republicans and even some fiscally conservative Democrats want to use the debt limit fight as leverage to wring more significant spending cuts out of the White House. Politicians of all stripes are worried about how independents will react to a vote — or multiple stop-gap votes — to raise the debt ceiling. Many executives on Wall Street believe Washington is playing an enormously dangerous game with what is typically a non-controversial vote.
Sen. Chuck Schumer (D-N.Y.), who leads the Senate Democrats’ messaging efforts, expressed anger that Boehner was searching for leeway on the debt limit.
“The speaker seems to be testing out how far he can venture onto a frozen lake before the ice breaks. He should listen to business leaders who are telling him to watch his step. Messing around with the debt ceiling just to satisfy the tea party will lead to higher interest rates and an economic cataclysm.”
The Wall Street executives say even pushing close to the deadline — or talking about it — could have grave consequences in the marketplace.
“They don’t seem to understand that you can’t put everything back in the box. Once that fear of default is in the markets, it doesn’t just go away. We’ll be paying the price for years in higher rates,” said one executive.
Another said that “anyone interested in ‘testing’ the debt ceiling should understand the U.S. debt traded wider [with a higher yield] than Greek debt roughly five years ago. Then go ask CBO what happens to our deficits/public debt to GDP, if the 10-year [Treasury bond] goes from 3.5 percent to 5.5 percent to 7.5 percent.” The executive said such an increase would result in a downgrade of U.S. debt by ratings agencies and an end to the dollar as the standard global reserve currency.
By: Ben White, Politico, April 13, 2011
I don’t want to start a market panic here. I’ve no desire to be known for “The Klein Crash of 2011.” But it’s safe to say that much of Washington finds the low, low yields on Treasurys — which represent the market’s serene confidence that the U.S. can handle its debts — a little baffling. Senior government officials have told me they think Treasurys are probably a bit overpriced, which is a bit like the executives of GE privately wondering why investors are so sure they won’t go bankrupt. The investors might be right, but it’s not comforting to hear.
The market isn’t totally wrong, of course. The federal government probably won’t default on its debt. But it’s actually pretty hard to explain how we get the spending line and the revenues line to match each other. And we have a really dysfunctional political system. We’ll figure it out somehow. We always do. But our low borrowing costs are an advantage we want to preserve for as long as possible. That means keeping the market from realizing that partisan polarization mixed with our weird legislative system makes insane outcomes easily imaginable.
This is why a shutdown would be so dangerous. A last-minute deal tells the market that America is a country that dithers and procrastinates and anguishes but eventually makes the necessary decisions to avert terrible consequences. We can be trusted to follow through, even if only at the last minute. A shutdown tells the market that our political system has become so dysfunctional that we actually can’t be trusted.
Asger Lau Andersen, David Dreyer Lassen and Lasse Holbøll Westh Nielsen — remember them? — have looked into how the market treats late budgets in the states — and late budgets in the states, it should be noted, are considerably less public and psychologically disruptive than a shutdown of the federal government during a weak economy. The answer is: not kindly (pdf). “We estimate that a budget delay of 30 days has a long run impact on the yield spread between 2 and 10 basis points,” they conclude. To put that in context, economists estimated that if the Federal Reserve pumped $400 billion into the economy, it’d lower yield spreads by about 20 basis points, or two-tenths of a percent. And it actually gets worse than that: “Markets also punish late budgets much more harshly if they occur during times of fiscal stress.”
I think it’d be fair to characterize this as a time of fiscal stress, don’t you?
There are some reasons for optimism here. Markets seem to punish fiscal mismanagement more lightly if the state has access to lots of money, which usually means reserves. The federal government has access to lots of money — though through borrowing, not reserves — so it’s possible we’d get off lightly, too. If you look back to Treasury yields in 1995, you don’t see an obvious change, but (a) perhaps yields would have been lower without the shutdown and (b) the economy is a lot weaker today than it was in 1995. At any rate, do we really want to test this? And if so, how many times? The tea party types are already promising to oppose an increase in the debt ceiling in the absence of massive entitlement cuts. Sen. Marco Rubio says he’ll oppose lifting the debt ceiling unless it’s accompanied by “a plan for fundamental tax reform, an overhaul of our regulatory structure, a cut to discretionary spending, a balanced-budget amendment, and reforms to save Social Security, Medicare and Medicaid.” That’s quite a list of demands in order to avoid economic catastrophe.
The irony of all this comes clear if you consider why we’re afraid of deficits in the first place. If the market comes to believe our debt is too large for our political system to pay back, they’ll become more skittish about buying government debt, and that’ll send interest rates higher and the economy lower. But if we have a series of shutdowns while we argue over how much to cut and how fast, our paralysis will convince the market we can’t get our act together in time to pay off our debts and they’ll send interest rates skyrocketing anyway. We’ll have caused exactly what we sought to prevent, and done it now, when the economy is weak, rather than later, when the economy is stronger. As I said at the beginning of this piece, I’d sure hate to be known for causing an economic crash. How about you, Congress?
By: Ezra Klein, The Washington Post, March 30, 2011
Nostalgia is running high on Wall Street for the days when junk mortgage underwriting and opaque derivatives trading juiced bank profits. As regulators continue to devise the machinery of the Dodd-Frank regulatory reform law, major financial institutions are working overtime in Washington to bring the good times back again.
Unfortunately for taxpayers, some of these efforts are gaining traction, particularly regarding the regulation of derivatives and mortgages.
As you may recall, Dodd-Frank was supposed to shed light on derivatives trading so that the risks and costs of these instruments would be clear to regulators and market participants. To this end, the law required derivatives to be cleared and traded on exchanges or through other approved facilities. But Dodd-Frank contained a big loophole: the Treasury secretary can exempt foreign-exchange swaps from the regulation.
Currency trading is enormous: on average, about $4 trillion of these contracts change hands each day. Major banks are huge in this market. According to the Comptroller of the Currency, trading in foreign-exchange contracts generated revenue of $9 billion in 2010 at the nation’s top five banks. That’s more than was produced by any other type of derivative.
No one was shocked when the banks began pushing the Treasury to exempt these swaps from regulatory scrutiny. From last November through January, Treasury officials met to discuss foreign-exchange swaps with 34 representatives of large financial institutions, the Treasury’s Web site shows.
A spokesman for Timothy F. Geithner, the Treasury secretary, said last week that Mr. Geithner had not made up his mind on this matter. If Mr. Geithner sides with the banks, he will have bought into their argument that foreign-exchange swaps are different from other derivatives, that this market performed ably during the financial crisis and does not need additional oversight.
Others disagree. Testifying before the House Financial Services Committee in October 2009, Gary Gensler, the chairman of the Commodity Futures Trading Commission, said: “Any exception for foreign-currency forwards should not allow for evasion of the goal of bringing all interest rate and currency swaps under regulation to protect the investing public.”
Dennis Kelleher, the president of Better Markets, a nonprofit organization that promotes the public’s interest in capital markets, said he was dubious of the contention that the market for foreign-exchange contracts performed well during the turmoil of 2008. Mr. Kelleher said that the only reason this market did not seize up like others was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008.
“We suggested that Treasury hire truly independent experts to look at the data and provide the secretary with advice on whether or not the FX market performed well in the crisis and whether the exemption should be granted,” he said.
The analysis could be done within 60 days, he said. The Treasury told him it was confident that it had all the information it needed. “Their response was, ‘Thank you,’ ” he said.
Big financial institutions are also eager to return to the days of lax mortgage lending, judging from two initiatives being discussed in Washington. Both are intended to get the home loan market moving again — and to buoy falling home prices.
One relates to how regulators define a “qualified residential mortgage,” a term of art in the Dodd-Frank law. Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.
What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators.
The board of the Federal Deposit Insurance Corporation will hold an open meeting on Tuesday to discuss qualified mortgages and the risk-retention rule. Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.
The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured.
But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans. Lengthy litigation between the parties is under way but has by no means concluded.
Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington.
The final front in the mortgage battle involves a plan to restart Wall Street’s securitization machine with instruments known as covered bonds. Here, too, the big banks and the housing-financial complex are arguing that if private investors are to return to the mortgage market, we must create a new instrument that will let the good times roll again.
Covered bonds are pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets. The bank that issues the bonds, meanwhile, retains the credit risk. If losses arise, the bank that issued the covered bonds must offset the loss with its own capital. That could push troubled banks closer to the edge.
If an asset in the pool defaults, a separate entity would be required to remove the assets from the bank’s control. The assets would then be out of reach of the F.D.I.C. should the bank fail and the agency step in as receiver. The investors who bought the covered bonds would have first call on the assets, ahead of the F.D.I.C.
This structure would wind up bestowing a new form of government backing to the major banks issuing the bonds, raising the potential for losses at the F.D.I.C. insurance fund, which protects savers’ deposits.
Equally troubling, the covered bond structure favored by the banks would let the pools invest in risky assets such as home equity lines of credit. These loans have been among the worst-performing assets out there. Covered bonds issued overseas, by contrast, typically consist solely of high-quality loans.
“The industry is trying to do an end run around the F.D.I.C.,” said Christopher Whalen, publisher of the Institutional Risk Analyst. “This proposal is about restarting the Wall Street assembly line for selling toxic waste to investors.”
Clearly, the battle for the safety and soundness of the nation’s financial markets is far from won. The issues are complex and confounding — by design, in many cases — and financial institutions have armies of advocates in Washington. The taxpayers do not, which makes monitoring of these crucial proceedings all the more essential.
By: Gretchen Morgenson, The New York Times, March 26, 2011