Economic Dreams - Economic Nightmares

Willem Buiter: Reigning in ‘Leverage’ to Restrain Asset and Credit Boom-busts

In a very good Financial Times post, Willem Buiter weighs in on "leverage", "asymmetry", and the very important need to create institutional means to disallow financial entities from capitalizing via leverage on the upside of credit booms while running for the protective cover of the government on the often sudden downsides.

Buiter has three recommendations, highlighted below, that ought to be vetted carefully as we work our way from the 'wilds' of our current deregulated escaped-from-regulation system into a relatively tamer future-world of once-again, reasonably 'structured finance'. In short, Butier recommends (shortening his commentary a wee bit): (1) common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements imposed on all large institutions whose leverage exceeds a given value, (2) minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions, and (3) all large leveraged institutions deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. To Butier:

Restraining asset and credit booms, Willem Buiter, ft.com, May 25, 2008: … [There is] a major asymmetry in the macroeconomic policy and financial stability framework. This asymmetry is not that interest rates respond more sharply to asset market price declines than to asset market price increases. Even if there were no 'Greenspan-Bernanke put', such asymmetry should be expected because asset price booms and busts are not symmetric. Asset price busts are sudden and involve sharp, very rapid asset price falls. Even the most extravagant asset price boom tends to be gradual in comparison. So an asymmetric response to an asymmetric phenomenon is justified. This does not mean that there has been no evidence of a 'Greenspan-Bernanke' put, of course. In fact I believe that phenomenon - excess sensitivity of the Federal Funds target rate to sudden declines in asset prices, and especially US stock prices - to be real, unfortunately.

Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.

Operationally, the asymmetry is that there exists a panoply of liquidity-and credit-enhancing measures that can be activated during an asset market bust and during a credit crunch, to enhance the availability of credit and to lower its cost, but no corresponding liquidity- and credit-restraining instrumentarium during a boom. When financial markets are disorderly, illiquid or have seized up completely, the lender of last resort and market maker of last resort can spring into action. …

Leverage is the key
These asymmetries have to be corrected through regulatory measures, effectively by across-the board credit controls. Every asset and credit boom in history has been characterised by rising leverage. The one we are now suffering the consequences of is no exception. Leverage is a simple concept which may be very difficult to measure, as those struggling to quantify the concept of embedded leverage will know. …

Traditional sources of leverage include borrowing, initial margin (some money up front - used in futures contracts) and no initial margin (no money up front - when exposure is achieved through derivatives).

I propose using simple measures of leverage, say a measure of gross exposure to book equity, as a metric for constraining capital insolvency risk (liabilities exceeding assets) of all large, highly leveraged institutions. Common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements would be imposed on all large institutions whose leverage, according to this simple metric, exceeds a given value. These capital adequacy requirements would be varied by the monetary authority in countercyclical fashion.

To address the second way financial entities can fail, what the CRMB calls liquidity insolvency, meaning they run out of cash and are unable to raise new funds, I propose that minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions. These liquidity requirements would also be tightened and loosened by the monetary authority in countercyclical fashion.

Finally, I would propose that all large leveraged institutions that are deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. … [emphasis mine]

NPR Does Subprime

If you want a very good lay person's edition of the Credit Bubble mess, listen to NPR's Global Pool of Money Got Too Hungry (audio, 13 min., All Things Considered, May 9): "Adam Davidson and This American Life's Alex Blumberg jointly report on how rising defaults on subprime mortgages in the U.S. have became a global financial crisis. This American Life host Ira Glass talks with Michele Noris".

NPR demystifies SEVs, CDOs, MBSs, "Liar Loans," and more. The narrative concludes: "… Nobody really questioned things. And why should they? Everybody was making money — right up to the day the bottom fell out."

An hour-long version — The Giant Pool of Money — airs this weekend on This American Life.

James Galbraith on the 'Collapse of Monetarism'

Hyman Minsky, John Kenneth Galbraith and John Maynard Keynes take center stage as James Galbraith throws down the gauntlet to contemporary mainstream economists. Speaking at the 25th Annual Milton Friedman Distinguished Lecture at Marietta College, Marietta, Ohio, Jamie Galbraith asks Fed Chair Ben Bernanke and a host of others to embrace the " intellectual victory of John Maynard Keynes, of John Kenneth Galbraith, of Hyman Minsky." — else to explain "why not". We will search and update on any "why nots" if and when they surface. To Galbraith:

The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus [PDF], by James K. Galbraith, March 31, 2008 : … I come to bury Milton [Friedman], not to praise him. But I would like to do so on the terrain that he favored, where he was strong, and over which he ruled for many decades. This is monetary policy, monetarism, the natural rate of unemployment and the priority of fighting inflation over fighting unemployment. It is here that Friedman had his largest practical impact and also his greatest intellectual success. It was on this battleground that he beat out the entire Keynesian establishment of the 1960s, stuck as they were on a stable Phillips Curve. It was here that he set the stage for the counter-revolution that has dominated academic macroeconomics for a generation, and that – far more important — also dominated and continues to influence the way in which most people think about monetary policy and the fight against inflation.

What was monetarism? Friedman famously defined it as the proposition that "inflation is everywhere and always a monetary phenomenon." This meant that money and prices were tied together. But more than that, Friedman believed that money was a policy variable — a quantity that the Central Bank could create or destroy at will. Create too much, there would be inflation. Create too little, and the economy might collapse. There followed from this that the right amount would generate the right result: stable prices at what Friedman came to call the natural rate of unemployment.

The intent and effect of this line of reasoning was to defend a core proposition about capitalism: that free and unfettered markets are intrinsically stable. In Friedman's gospels government is the lone serpent in Eden, while the task of policy is to stay out of the way. Just as this was the vulgar lesson of "Free to Choose" so it turns out it was also the deep lesson of the larger structure of Friedman's thought. Friedman and Schwartz's Monetary History for all its facts and statistics carried a simple message: the market did not fail; the government did.

Friedman succeeded because his work was complex enough to lend an aspect of scientific achievement to his ideas, and because the ideas played to the preconceptions of a particular circle. As Keynes wrote of Ricardo:"The completeness of [his] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely…to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority."

Friedman's success was similar to Ricardo's but not in all respects. Yes he also explained away injustice and supported authority. But the logical superstructure was not vast and consistent. Rather Friedman's argument was maddeningly simple, yet slippery. He would appeal to short run for some effects and to the long run for others, shifting between them as it suited him. … His money growth rules promised stable employment without inflation. Their promise was not austere, but happy. Ricardo was Scrooge. Friedman was more like the Pied Piper.

Butier Responds to Greenspan's Latest Attempt to Rewrite History

{Updated, April 9}
At maverecon Willem Butier counters Alan Greenspan's latest claim the he and the US Fed not be held responsible, in large part, for our current mess. Butier's eight policy "tragedies":

1. The Greenspan Fed (August 1987 - January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan's statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan's theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08.

Butier elaborates on each. We will bring forward only one, dealing with possibilities for moral hazard. But before we do, I just found Martin Wolf's counter-balancing position, Ft.com, April 8, still praising Greenspan, while fearing that over-zealous regulatory reform spaned by a Greenspan "blame game" will kill the "good" that free-er (my word, Wolf uses "free) market mechanisms bring. Whereas Butier lists eight "tragedies" of Fed policy/practice, Wolf highlights two: (1) regulators should have been "tougher", in subprime and elsewhere, and (2) monetary policy should have been tigher, not looser — to lean against prevailing winds of excess instead of leaning with them.

David Beckworth, via Macro and Other Musings, adds insight into why Butier's critique is on target:

… [T]he Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom. …

Back To Butier:

The Greenspan Fed: a tragedy of errors, Willem Butier, maverecon:Financial Times, April 8: Mr Greenspan's apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince. …

Everyone Hates Treasury Secretary Paulson's Reform Proposal

{Updated April 1, 2}

Ok. Some are cheering, if softly. But not among folks I read regularly. Clearly Robert Reich hates Secretary Paulson's self-proclaimed reform proposal, concluding: "Hank Paulson's discussion paper – it's not even meant to be enacted under the Bush Administration – is not broad, it's not an overhaul, and heaven forbid, if we're facing another Great Depression, it will do absolutely zilch to head it off."

More dissent:
Not "Calculated Risk" or Paul Krugman.
Not Clive Crook
Not Willem Buiter
Not Barry Ritholtz or Michael Mandel

Last but not least:

Stephen Cecchetti, soon to be Economic Advisor to the Bank of International Settlements, in a 19 min. Bloomberg audio podcast with Tom Keene says "Paulson Proposal isn't right first move". Included are good insights into much-needed regulatory reform, particularly w/r/t leverage and the troubling phenomenon of investment banks, hedge funds etc. moving where-ever around the world to avoid any specific country's regulatory requirements.

A few tidbits from Crook:

The new Treasury blueprint for reforming financial regulation is not really a blueprint at all. (The full document is here; or see a Treasury summary of it here.) It says some sensible things and has some good ideas, but for the most part it is an agenda for discussion rather than a detailed plan. Given that the Treasury has been working on this thing at least since March 2007, it is surprisingly thin.

Moreover, it is concerned exclusively with the structure of the regulatory system. I think that getting this right is more important than Paul Krugman does—he calls this the Dilbert strategy—but Paul is surely right to complain that a better structure will get you only so far. It is a question of form and content. What the rules say matters more than which regulators are responsible for enforcing them, and the so-called blueprint does not go into that. …

At least there is some agreement that "Something should be done." Duh! AND: It's about time. But 'not yet', of course it's an election year! Next year the excuse will be something else.

Here is CNNMoney Good plan, bad plan - Reaction to Paulson, demonstrating that mainstream media will always find opposing views, no matter how far and wide the search.

Still, I'm a wee bit hopeful, as is Paul McCulley, that we may at least avoid a Depression and get some needed financial regulatory reform as well—but it will take time and much deliberation, and perchance more pain felt by stock and bond fund holders as well as by taxpapers in general. Here's Paul McCulley's latest perspective [PDF] on the general financial/economic landscape—not specifically on Paulson's proposal. I think McCulley nails it! What do others think?

Death Dance: Bear Stearns and Carlyle Capital Linked

I try not to lift others' posts in their entirety. But this time I'm going to make an exception, and just highlight points readers here may find especially important. Loretta Napoleoni wrote this piece too well to chop it up, and the tale told is too important to miss. It's a tale of greed, corruption in highest places and ultimately the beginning of the end this time around, hopefully, for those who have been looting our financial systems. To Napoleoni:

Bear Stearns and Carlyle Debacles Are a "Modern-Day Greek Tragedy", Loretta Napoleoni, Huffington Post, March 17 The collapse of Carlyle Capital and the temporary rescue of Bear Stearns may go down in history as the key events signaling the end of the 'roaring nineties' (which lasted into the 21st century), nearly two decades of easy money, cheap credit and soaring global debt. Exceptional events -- such as the Fed for the first time in 50 years throwing a monetary lifeline to a bank on the verge of bankruptcy -- constitute the choreography of the closing scenes of this financial catastrophe which so much resembles a modern-day Greek tragedy.

The victims, a hedge fund and a bank, systematically ignored the bad omens because they felt omnipotent. Only a few months ago, while the British government struggled to save Northern Rock, the London-based European chairman of Bear Stearns dismissed any future troubles linked to the sub-prime meltdown. The rescuers, the Federal Reserve and J.P. Morgan, are determined to perform against all odds, but unless a Deus ex Machina, which for the Greeks was an impossible, supernatural event, takes place, their efforts will be in vain. Even the chorus, i.e. the market, follows a well known script: in one moment howling for the unlucky fate of the actors, and in the next scheming against them.

For the ancient Greeks the roots of all tragedies lie in men's uncontrollable passions: love, hate, power and greed. Carlyle Capital's and Bear Stearns' destinies confirm this belief. Bear and Carlyle are deeply intertwined because they both jumped on the easy credit bandwagon to make money. In other words, greed motivated them. Both had reputations of being highly aggressive and competitive-ruthless, many in Wall Street would add. But these characteristics are common in globalized finance where the old fashioned rules of the game are ignored or simply forgotten. What brought down Carlyle Capital and crippled Bear Stearns was not their business behavior but the sub-prime house of cards they contributed to building. Their fall was an event that was bound to happen but that none of them was willing to consider. And in the best Greek tragedies, those who fall are given the chance to avoid disaster.

The script for this modern tragedy is a masterpiece of the power of illusion in the hands of those who believe to be gods, Tom Wolfe's 'Masters of the Universe.' Carlyle Capital was indeed half human and half superhuman. An offspring of the Carlyle Group, the "club of the powerful", whose members include former prime ministers such as John Major, presidents of the United States, Bush senior, and the Arab super rich, among whom are the bin Laden family, the fund used its amazing connections at the highest political and financial levels to gather cheap credit. Giants of global finance, Citigroup, Deutsche Bank, Bear Stearns, Lehman Brothers and UBS, got into financial scrums to become Carlyle Capital's lenders at phenomenal and ridiculous conditions: for each dollar in assets held by the fund, they lent $31 more. Carlyle Capital's leverage, the ability to raise money in the world market, was simply unique. When it went down it had $22 billion outstanding debt against assets of about half a billion.

Almost $2 billion came from Bear Stearns, a major player in the mortgage-backed securities s secondary market linked to the booming housing market. Over the years, Carlyle Capital had built a portfolio exclusively of such stocks. On paper it was a match made in heaven -- or better, in the Olympus of global finance. Advised by the members of the 'club of the powerful', the fund had bought triple-A mortgage-backed securities, implicitly guaranteed by the US treasury, issued by Fannie Mae and Freddie Mac, two of the most reputable institutions in the metamorphosis of the US housing debt into a global asset. Within the sub-prime secondary market, these stocks were among the most secure. And this is the unexpected twist of this tragedy: that the first ones to fall are those who had invested in 'secure' mortgages.

The game lasted as long as the housing market boomed. Carlyle Capital borrowed money from Bear Stearns money to buy mortgage-backed securities and used their increasing value to keep borrowing more and more. It was a win-win game. Each time the interest rate went down, borrowing became cheaper and housing demand went up while property prices rose. On paper(remember we are talking about a house of cards here) both partners were making money because one held and the other funded purchases of homes that were rising in value. For a decade the deflationary policy of the Federal Reserve fueled this mechanism. Hundreds of thousands of similar partnerships took place, creating a global web where every financial institution is linked to every other. Then one day the wheel of fortune turned, Americans could not meet their mortgage payments any longer. As prices of properties began to slide, paper assets of companies like Carlyle Capital and investment banks like Bear Stearns vanished. Inside the web of easy credit, people panicked and began calling on their loans. Carlyle Capital fell victim to its own lenders' demands for cash and Bear Stearns, one of Carlyle's lenders, may well share the same destiny for the same reason.

The last scene of this modern financial tragedy will be played out this week. Tickets are already on sale in the major financial centres, from Wall Street to the City of London. Book soon because we are expecting a full house!

Loretta Napoleoni is the author of the bestselling book Terry Inc.: Tracing the Money Behind Global Terrorism. She is an internationally recognized expert on money laundering and terror financing. Her current book is Rogue Economics: Capitalism's New Reality.

HT: Naked Capitalism

{Update:} On Carlyle Capital via The Ground Floor from Urban Land Institute:

Don't Feel Sorry For Carlyle

We're not being hard-hearted or gleeful about someone else's troubles. You know the expression: you live by the sword, you die by the sword. As reported in the European edition of the Wall Street Journal, March 14: "…Carlyle Capital would exploit the differences between the interest earned on its investment in mortgage securities and the costs of financing those investments. The secret to making money was borrowing massive sums. Carlyle Capital managed only $670 million in client money, but used borrowings to boost its portfolio of bonds to $21.7 billion, meaning it was 32 times leveraged." If some numbers we did on the back of an envelope are correct, if Carlyle's directional play had worked -- if the yield on its investments had followed the downward yield curve of U.S. Treasury securities -- to the tune of 0.50%, Carlyle would have made about three times its investment. Similarly, if interest rates went the wrong way, or if the prices of its securities portfolio did not follow and align with the yields on Treasuries, Carlyle would suffer huge losses. It appears that Carlyle became mired in the same trap as Long-Term Capital Management did in 1998 when the flight to quality turned into a flight to both quality and liquidity. Carlyle got caught by one of those "Black Swan" events -- totally unexpected and therefore totally devastating. They made a strategic bet, backed with it huge leverage, and suffered the unexpected consequences. In a letter to investors Carlyle Capital management noted: Carlyle Capital "believed this [its strategy] to be a creative and thoughtful approach and one that was time tested in the markets for these types of assets."

My question: Why was ANYONE loaning money to Carlyle recently?

Fed's 'Historic Steps' into Uncharted Waters

Unless I'm mistaken, the Fed just took a first step toward Thomas Palley's suggested solution to our current mess:

Central Bank Offers Loans To Brokers … Historic Steps, Greg IP, WSJ, March 17: … It took a unanimous vote by the Fed's five governors yesterday to invoke a Depression-era clause in the Federal Reserve Act to waive the usual prohibition on Fed loans to nonbanks. A Fed official told reporters today's circumstances couldn't have been envisioned when the Fed was created, and noted newer central banks like Europe's have many of these powers. But these steps also take the central bank into uncharted territory with new and potentially troublesome risks.

Those risks include the possibility that with the credit crunch showing no sign of lifting, the Fed will be called on to lend to other troubled firms and end up a major creditor of Wall Street, even if at present the risk of any substantial loss appears small. Another risk is that while the Fed used a loophole yesterday in the Federal Reserve Act to expand its lending to nonbanks in "unusual and exigent" circumstances, it has in effect expanded the federal safety net with no political debate. However, the Fed sought and received agreement over the $30 billion loan from Treasury Secretary Henry Paulson, who informed President Bush.

Bigger Test

For now, though, the bigger test will be how the markets greet the initiatives today: with relief at the bold steps taken to shore up the financial system, or with alarm at how unstable the financial system had to be to invite such action.

Officials appear to hope the initiatives will restore enough confidence to markets to allow a smaller rather than larger rate cut tomorrow, but they acknowledge it will depend partly on how markets evolve over coming days.

On Wall Street, there is likely to be some relief that the Fed has finally opened the discount window to securities dealers, something they have long clamored for. The Fed has been reluctant because the move was outside its explicit mandate. "This is a five-vodka event," said a senior executive at one big brokerage firm that previously didn't have access to this funding source. "Liquidity is no longer an issue."

Federal Reserve Bank of New York President Timothy Geithner told reporters: "This is designed to help get liquidity to where it can help play an appropriate role in helping address the range of challenges" in the markets, especially in the mortgage-backed securities market.

Mr. Paulson said in a statement, "I appreciate the additional actions taken this evening by the Federal Reserve to enhance the stability, liquidity and orderliness of our markets."

For all their creativity, the Fed moves are also an acknowledgment that its previous steps have failed to stem the collapse in investor confidence, forcing it to abandon many of its original principles, such as not favoring particular firms or market sectors and sticking within its explicit statutory authority.

Last Tuesday, it announced what Wall Street called its most creative initiative yet: It lent up to $200 billion of its much-sought Treasurys to investment banks starting March 27 in return for a like amount of now-shunned mortgage backed securities for up to 28 days. The announcement led to a huge rally in stocks. But within days dealers were telling the Fed it didn't go far enough. They wanted longer term, more immediate funding against a broader range of collateral.

It also came too late to save Bear Stearns. On Thursday evening, Bear Stearns informed the Securities and Exchange Commission and Fed that it had experienced a dramatic loss of cash reserves and now saw no option other than to file for bankruptcy protection Friday morning. Fed officials at that point saw just two options. They could try to wall off the rest of the financial system. If the environment had been less tumultuous they might have chosen that option.

But in the current period they feared that a failure by Bear to make good on billions of dollars of contracts could severely dislocate critical markets, especially garden-variety repo loans -- overnight loans secured by various collateral that are the grease of the credit markets.

Too Interconnected

Officials grimly concluded that while Bear Stearns wasn't too big to fail, it was too interconnected to be allowed to fail in just one day. They spent Thursday night going over Bear's books and huddling with the SEC and Treasury. By Friday morning it had settled on its second option: a 28-day secured loan via J.P. Morgan to give time for a sale or wind up of the firm.…

'W' as Hoover?

A 'wild card' scenario, for sure. But what if the Bush Administration were to now retreat to its ideological roots — i.e. "markets rock, government sucks" — and pretend that market forces alone ought to bring us out of this credit crunch? Having contributed mightily to the stage-setting for the current crisis, the Administration might indeed catapult it into full-scale depression. Here is Gaius Marius' workup of this possibility:

the potential for real problems, gaius marius, Decline and Fall of Western Civilization, March 14: there's a canard in american political history that herbert hoover did nothing to alleviate the onset of the depression. such was the angle of attack from franklin roosevelt in 1932, and so successful was that campaign that its propaganda became embedded in american mythology.

it's not so, of course -- hoover was a very activist commerce secretary who took an active role in creating the credit excesses of the 1920s, and then an even greater activist stance in forestalling the bust. the new deal was his deal, by and large, carried out in grand scale by roosevelt as the depression wore on.

one can argue about the wisdom of government intervention in the aftermath of the bubble bursting, of course. but the original sin is in the creation of the bubble -- something that can only be done with government at minimum standing aside from its natural regulatory role, and indeed in this case was facilitated by manipulation of interest rates and the underwriting of massive credit backstops in the form of the GSEs.

many american conservatives are so totally divorced from reality on the issue so as to be dangerous. they generally have encouraged all manner of government facilitation of the credit bubble under the bush administration since 2000, but there remains underneath an ideological and utopian desire for non-interference. and now that long-building problems which arose with government complicity are surfacing, the animal desire to flee the problem (and all responsibility for creating it) is also surfacing -- in the form of belated laissez-faire.

moral hazard aside, an honest history of capitalism will reveal that every major crack-up since the tulip mania of the 1620s was addressed with government-taxpayer bailouts on some level. it is part of capitalism to do so -- the losses, once too great, are socialized, and this is the price paid for the long-term benefits of price-driven resource allocation. that this fact isn't part of the ideological mantra of capitalism as defined by the zealots and high priests is as meaningless as the fact that the doctors and philosophers of communism were disappointed by the impurity of the system in practice. and it is very important for in situ leadership to understand that ideological purity is a noose by which they will be hung if they insist.

what has happened in the united states is not good, but it is probably manageable IF government recapitalization of the banking system gets underway. however, the sort of public denial of deep-seated problems at the heart of the system that our executive leadership is apparently willing to forward -- beyond being yet another dimwitted escapade of a kind with that which led them to eschew the "reality-based community" over iraq -- can have massive ramifications if it results even in just a significant delay of action. once a deflationary credit unwind gets underway, it can be extremely difficult to stop. the key will be to support the banks well before that happens, and then to move into the credit markets with a measure of regulatory zeal longer-term to prevent the kind of credit underwriting lapses that characterized 2002-2007.

it seems almost comic that the tragic administration of george w. bush -- unsatisfied with trashing american soft power and cultural advantage, unsatisfied with plunging this nation into a fiscal and military morass in the middle east, unsatisfied with widening and hardening virtually every division in the american political landscape -- would take its infamous conflation of raging incompetence and ideological zeal to the final length of sealing the american economy in a tomb. and yet it might. if the administration draws a line against government recapitalization and tries to defend it, it will actually become what roosevelt once only painted the adminstration of herbert hoover as. and that would have the potential for real problems.

Lingering question: Did Herbert Hoover get a "bad rap" re: The Great Depression? That is, is Marius correct in this assertion: "hoover was a very activist commerce secretary who took an active role in creating the credit excesses of the 1920s, and then an even greater activist stance in forestalling the bust. the new deal was his deal, by and large"? See, by contrast, The Ordeal of Herbert Hoover.

Financial 'Meltdown Moment': Thomas Palley Suggests a Solution

Everyone paying attention to our current financial mess seems to be scratching their head, wondering just what might get us out. Paul Krugman threw up his hands earlier today. Thomas Palley to the rescue! Palley suggests simply that the Federal Reserve "open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions." Sounds reasonable to me, but I only watch from the sidelines.

I suspect that such a move would have some banks trembling in their boots, since they would have to play on a more level playing field than they are used to. I'm sure that some libertarians will scream, perchance for good reasons, that this is getting us one step closer to dreaded big-brother land. It will be interesting to see if Palley's suggestion garners favorable response, and from whom. To Palley:

Meltdown Moment: What Must be Done: … In today's crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed's term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.

There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions. That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.

Such a change would level the playing field in financial markets and remove the unfair subsidy to banks. Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.

The Federal Reserve's current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change.

Multi-National Panel, as interpreted: Bumbling Banker Rubes Lost Billions

This one's important: Brad Steser calls the revelations Grim.

What Went Wrong…and Right, by Athenian Abroad: The Federal Reserve Bank of New York released an extremely interesting report today. Written by the Senior Supervisors Group (comprised of financial regulators from France, Germany, Switzerland, Britain and the United States), "Observations on Risk Management Practices During the Recent Market Turbulence" (pdf) analyzes the performance of eleven major banking and securities firms in the period prior to and during the subprime crisis.

In the pleasingly genteel language common to bank regulators the world around, the report delivers an unfailingly polite, yet devastating, critique of the "everyone was doing it" defense. Simply put, some institutions implemented responsible and sophisticated risk-management practices and successfully avoided the worst of the crisis. Others...well...others [messed] up. The report examines what worked, what failed, and why. …

In other words, all of these firms had sophisticated analytical capabilities, but only some actually chose to use them. Others didn't bother, preferring to rely on third-parties (like ratings agencies) and optimistic assumptions until it was too late. …

… [I]t wasn't just fecklessness that led firms to over-rely on ratings agencies, etc. It was a conscious decision at the executive level to ignore risk and pursue short-term profits. …

This is about as close as a multi-national panel of financial regulators will ever get to saying, "Bumbling rubes somehow got control of major banks...and lost billions!"

But the bottom line isn't simply that bumbling rubes lost billions; it is that some but not all of these institutions were mis-managed in this fashion. That is, there was nothing "inevitable" about the chain of events leading to the sub-prime meltdown, and the risks really were apparent to those who cared to look for them.

Hat Tip, Mark Thoma

Marc Faber Takes Fed to Task

Worth Watching: 15 Minutes with Marc Faber

Click for Video

Bloomberg News Video, March 5
Hat Tip: The Big Picture

Early this year I began to pay less attention to bearish views than for the past several years. Marc Faber is, of course, the king of the bears—but not the only bear I've drawn inspiration from. Most likely the fact that I'm now discounting hyper-bear rhetoric is a signal that investors should run for cover. Still, the US dollar plumbs new depths each day, and US exports surge providing some hope that we can indeed work our way out of our mess. Yes, US consumers are, on average, "in over their heads." And there are signs of US recession at every turn. And yes, the world is not highly decoupled from the US. Still, there are reasons to at least be hopeful. Just as there are reasons to believe that financial derivatives time bombs may still detonate.

Faber begins with a declaration that the US is already in a recession. Then follows with "gloom and doom", i.e. world markets being positioned for a bust, following 76 months of boom.

Faber follows up with a shot across the bow of the US Fed, and blames both Greenspan and Bernanke for the mess we are now in. So have I, in earlier musings. But Faber goes further and suggests that Bernanke will destroy the US dollar. I disagree. I believe that Bernanke and other major league central bankers are just trying to keep the world's currency markets solvent. Bernanke's next steps will be telling — or not — since if we are in a liquidity trap the Fed is pretty much impotent in any case.

Faber then goes on to talk about markets. Faber believes that Gold may go higher. But he really likes sugar. I'm not into commodity trading — or trading generally — so I'll leave that for what it may be. Besides, I missed this Gold rush early on, and will likely leave it alone now.

Faber also thinks Google, Apple, and RIM [Research in Motion LTD, (Nasdaq: GS:RIMM)] will all see at least a 50% reduction from their recent highs. Maybe. If so I might even take a bite of Google, as I did long ago with Apple (minor personal disclosure). {Update: Here is Fortune, Mar 7, on Apple v. RIM's Blackberry going forward.}

Faber also notes, importantly, that the US S&P 500 is not pricey in terms of Euros, indeed the S&P 500 is down 50% from its peak in 2000. Question is, What next for international currencies?

Faber believes that dollar devaluation will likely continue and we will see the imbalances work out there rather than in "asset declines in nominal terms measured in US dollars." China and India stock markets, by contrast may correct 30% to 40%. Finally, US Long Term Bonds, are, in Faber's opinion a "disaster waiting to happen", as are Long Term Treasuries.

Finally, Faber also says he hopes to see a major bank in the US fail, if only to see some discipline rebuilt into the US financial system. I want to see such discipline too, and suspect it will not be forthcoming short of more pain felt in the banking community that brought us to the brink of the abyss.

On Sheep and Greedy, Corrupt Shepherds

As I've watched the Securitization Mess unfold since last August, and opined about its inevitability prior, I have been awestruck by the silence from those who ought to have spoken loudly about the systemic corruption at work. I have been disgusted by the wanton greed from those who were knowingly profiteering from what inevitably would hurt those drawn into the deception. I have been dumbfounded by the blind faith of true believers in so-called "new economy" thinking, whether pundits, politicians, or CEOs. In all it brings to mind a couple of my favorite quotes:

Those who give no thought to that which is distant will find sorrow near at hand. Confucius (paraphrased)

People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity. Robert Heinlein (paraphrased)

As to why we don't learn from mistakes, we need not look further than what cognitive psychologists and decision theorists have been yarding together for years under headers like Self-deception Biases, Heuristic Simplification (information processing errors), Emotion/Affect Disorders, and Social Interaction Disorders.

As to the systemic nature of this Securitization Mess, I'll leave you with Doug Noland's recent words:

Confirmations, Doug Noland, Credit Bubble Bulletin, Feb. 22: … [T]he unfolding Credit Crisis has made a major leap toward the heart of the Credit system. I have no way of knowing to what degree widening spreads are being dictated by "technical" hedging-related trading dynamics, as opposed to fundamental issues with respect to the faltering U.S. economy; rapidly deteriorating corporate balance sheets; a highly susceptible leveraged speculating community; the vulnerable GSEs; a distressingly illiquid Credit market; and heightened systemic risk more generally. To be sure, a strong case can be made that the current backdrop is quite detrimental to a highly leveraged and speculative Credit system. The markets rallied late this afternoon — and perhaps they will rally further next week — on talk of a bailout for troubled Ambac. Unfortunately, there has been ample Confirmation that the Evolving Credit Crisis has quickly spiraled way beyond the "monolines."

Related: Flock Mentality, from Alea

P.S. I'm now pulling together recent "finds" from others on the sidebar of my blog. Or you can find them here, via Google Reader "Shared Items" (along with a feed).

Doug Noland: 'Breakdown of Wall Street Alchemy'

In his latest Credit Bubble Bulletin, Doug Noland concludes that "GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. … Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks. "

Although Noland's assessments continue to be bleak, I find them to be more 'on the mark' week-on-week than any other source I go to. Maybe I'm just hearing what I confirms my preconceived biases. Or maybe not? More from Noland (emphasis added):

The Breakdown of Wall Street Alchemy, Doug Noland, Feb 15: This week provided further confirmation of ongoing momentous Credit market developments. … Like the asset-backed commercial paper market that was popular with structured investment vehicles until last summer, auction-rate securities, a form of rolling short-term funding for long-term municipal commitments, have become fashionable in recent years."

"Auction-rate securities" has joined the beleaguered ranks of "subprime," "asset-backed commercial paper," "SIVs," and the "monolines" — financial structures that flourished during the prolonged Credit Bubble but no longer pass market muster in today's Post-Bubble Risk Revulsion Backdrop. This week's "unwinding" of the "auction-rate" market and the blowing out of Credit spreads should be seen as an escalation of the ongoing unwind of "Contemporary finance" and its many avenues of Risk Intermediation.

On numerous fronts, the markets and economy confront a Highly Problematic Breakdown in "Wall Street Alchemy" — the disintegration of key processes that had for some time transformed ever-increasing quantities of risky loans into perceived safe and liquid debt instruments that enjoyed insatiable demand in the marketplace. In the case of the “auction-rate securities,” it was a clever restyling of long-term and generally illiquid municipal debt (as well as student loans and other borrowings) into perceived liquid securities that could be easily sold at regularly recurring auctions (every one to a few weeks). With scores of flush corporate treasury departments and wealthy clients (managing huge Credit Bubble-induced cash-flows) keen to earn extra (after-tax) yield on "cash equivalents," the Wall Street firms had been diligent in ensuring (making markets for clients, when necessary) a highly liquid and enticing marketplace. Now, with the onset of Risk Revulsion and Acute Financial Sector Balance Sheet Pressures, investors are running for cover and Wall Street firms are shunning the use of their own capital to support this and other markets. Market liquidity has evaporated, confidence has been shattered, and we are witnessing yet another "run" on a previously popular risk market/asset class. The music has stopped for another game of musical chairs.

This week saw heightened systemic stress stampede toward the epicenter of the U.S. Credit system. It certainly didn't help that insurance behemoth AIG Group reported an almost $5bn writedown of its Credit default swap portfolio or that international securities dealer behemoth UBS reported massive losses on its U.S. Credit positions. Confidence was further shaken by huge losses reported by mortgage insurers, as well the twists and turns of the "monoline" bust turned apparent bailout. In the markets, various indices of investment grade Credits widened sharply to record levels. The key "dollar swap" (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November). The Breakdown of Wall Street Alchemy is now pushing the Credit Market Dislocation uncomfortably close to the core of our monetary system.

I'll return to financial aspects of this crisis, but I definitely feel the economic ramifications of the unfolding Credit Crisis are receiving short shrift in the media. This week saw parts of the municipal debt market grind to a virtual halt and the corporate debt market take another significant blow. Investment grade debt issuance has now slowed markedly after beginning the year at near record pace. At this point, the junk, CDO, ABS, "private-label" MBS, muni, and even investment grade debt markets are all somewhere between impaired, dislocated and completely dysfunctional. There is no mystery behind the recent string of abysmal economic reports.

The preliminary reading on February University of Michigan Consumer Confidence dropped 8.8 points to the lowest level since the 1992 recession. The Economic Conditions index sank and the Economic Outlook index plunged, while one-year Inflation Expectations rose from 3.4% to 3.7%. The Economic Outlook has sunk a remarkable 22 points since July. Falling national home prices are clearly wearing on confidence. This week, Dataquick reported that home sales throughout much of California have collapsed to more than 20-year lows, while home price declines accelerate. This is a huge unfolding issue/debacle for the MBS, agency, mortgage insurance, CDO, and Credit derivatives markets, not to mention the U.S. banking system and real economy. Countrywide Financial reported delinquencies on its $1.5 TN mortgage servicing portfolio had jumped to 7.47%, up from the year ago 4.32%. The New York "Empire" Manufacturing index sank to the lowest levels since April 2003.

The economy is now faltering badly and there is every reason to expect the downturn to gather pace — negative real interest rates compliments of the Fed and stimulus package compliments of the federal government notwithstanding. While fourth quarter data is not yet available, one can look to the first nine months of 2007 to gain important perspective. Despite the dislocation in the subprime mortgage market, Non-Financial Debt Growth accelerated from Q2's 7.2% to Q3's 8.9% (from the Fed’s Z.1 report). And while Household Debt Growth had slowed to a 6.9% pace, Business Borrowings accelerated to a blistering 11.9% annualized rate in the third quarter. This was the strongest corporate debt growth since the tech/telecom boom in the late nineties. Importantly, total (financial and non-financial) Corporate Debt expanded at an 11.1% rate during the first three quarters of 2007, followed by 9.3% growth in State & Local government borrowings. And while residential mortgage debt was slowing meaningfully, Commercial Mortgage Debt was expanding at an almost 13% rate.

Total (financial and non-financial) Credit expanded a seasonally-adjusted and annualized record $5.0 TN during the third quarter — as nominal GDP expanded at a 6% pace. While many trumpeted the "resiliency" of the U.S. economy in the face of mortgage and housing woes — more adept analysis would have focused on the massive Credit creation that had come to be required to sustain the Bubble Economy. Importantly, the faltering subprime market initially instigated only greater excesses throughout commercial real estate, municipal finance, M&A finance, and corporate lending more generally. The Credit Bubble was sustained at the great cost of heightened instability and weakened structures — especially throughout leveraged lending, state & local finance, and investment-grade corporate borrowings. Keep in mind that through the third quarter CDO issuance was actually running ahead of 2006's record pace. Until the fourth quarter, record Credit growth continued to fuel the finance-driven economy. This is all now coming home to roost.

Today, with bursting bubbles in corporate and municipal finance joining the mortgage bust, the U.S. Bubble economy has quickly fallen desperately short of sufficient Credit and liquidity. And the greater the Credit market dislocation and broad-based tightness of Credit, the bleaker become economic prospects and the more intense the Revulsion to Wall Street's Credit instruments. The days of free-flowing cheap finance for home buyers, state and local governments, LBO firms, commercial real estate speculators, college students, risky auto buyers, and high-risk Credit card holders are over — and they will not be returning for some time to come.

When I have previously underestimated the "resiliency" of the U.S. Credit Bubble and economy, it was in each instance a failure to appreciate the capability of Wall Street finance to expand to ever greater degrees of Bubble excess. Today, with "contemporary finance" mired in a historic collapse, I am confident that the Credit system is today only in a position to surprise on the downside. It is this framework that shapes my view of a rapidly escalating Credit crisis feeding an arduous economic adjustment period.

And while it could undoubtedly prod a highly speculative stock market, there is no resolution to the "monoline" dilemma that would meaningfully influence the trajectory of the unfolding Credit and economic bust. As we've been saying for awhile now, confidence in Wall Street finance has been irreparably shattered. Trust has been broken in "AAA" ratings, "mark-to-model," CDO structures, myriad risk models, Credit insurance, counter-party risk, and various instruments and vehicles for intermediating risk in the markets. Moreover, old fashioned lending will not come close to sufficing the demands of a highly imbalanced Bubble economy, especially with bankers nervous and retrenching. Again, we're witnessing nothing less than the Breakdown of Wall Street Alchemy — one that took a turn for the worst this week.

In a disconcerting development, recent market developments seem to confirm that the leveraged speculating community and the GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. Along with the "monolines" and mortgage insurers, the "Credit default swap market" and GSE mortgage Risk Intermediation were at the epicenter of the most egregious Systemic Risk Distortions and Accumulations. They are now quickly moving to the forefront of Current Acute Fragilities. Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks.

Not Your Father's Expansion - Or Recession

Max Wolff offers up a reasoned explanation of why we aren't going to get out of our mess easily, or soon. Soundbite: "Our recent economic performance was the offspring of financial innovation, low interest rates, massive consumer borrowing and asset price inflation. All is running in reverse now. The mechanics of the boom have become the engine of the bust." More:

Credit Crunch and Asset Deflation Recession, Max Fraad Wolff, Huffington Times, Feb. 12: … I believe that our post 2001 economic boom was uniquely and imprudently based on consumer credit and asset inflation. Equities rebounded and performed well- particularly outside the US -- since 2003. American home prices surged. All of this was based on consumer credit. Employment and personal earnings growth was weak across the last few years. Thus, it would not be shocking to see less profound earnings and employment downturn as recession begins. If you boom on house price inflation and consumer credit, you bust when they bust. They are busting now.

How bad is the housing scene? There was a 53% increase in the value of American homes as assets from 2002-2007. The price of all homes increased from $14 trillion to $21 trillion [PDF]. These are paper gains that rise and fall. Now they are falling and likely will decline by at least 15%, or over $3 trillion, before the end of 2009. Across the same period there was a 73% or $4.4 trillion increase in home mortgage debt. [PDF] This isn't going away. In fact, thanks to teaser intro rates and balloon options mortgages, it will rise. Consumer credit borrowing increased by $492 billion or 25%. We borrowed so much and so fast against our inflating homes that the average American went from owning 56% of their home in 2002 to owning 50% in 2007 [PDF]. As prices fall and debt levels remain the same, this percentage will fall further. Very soon the Average American family will own less than the half the value of their home!

From 2002-2007 there was a 55% -- $16 trillion -- increase in financial asset prices, from $29trillion to $45 trillion. [PDF] The prices of financial assets tend to be sensitive to corporate profits and credit conditions. Over the last 4-5 years corporate profits have risen sharply and are at 77 year highs as a percentage of national income. Corporate profit performance has been the mirror image of employee compensation. It has outperformed averages and surged to all time highs. Low interest rates and financial innovation allowed greater profitability and opportunity to corporations, particular those engaged in the booming credit and housing markets. Our recent economic performance was the offspring of financial innovation, low interest rates, massive consumer borrowing and asset price inflation. All is running in reverse now. The mechanics of the boom have become the engine of the bust.

This was not your father's expansion. It was not based on excellent overall economic growth. It was not based on salary and wage growth. There was only a 31%, $2.4 trillion, in disposable income over the last 6 years. Consumer debt increased by $2.4 trillion more than disposable personal income from 2002-2007. Housing and financial price inflation ran at many times the rate of income growth. Debt growth fueled consumer borrowing. A financial asset and housing boom based on easy money and financial innovation created a national economy dependent on assets and home price increases and further credit access. We are now faced with declining housing prices, falling asset prices and squeamish lenders fearful of overly indebted consumers. This is why I believe we are already in a recession or near recession. The near term future will be defined by significant economic weakness.

We don't see particular weakness in jobs and earnings because the recent recovery 2003-2007 was spectacularly weak in terms of job and income growth. The average wage and salary annual percentage gain across 55 years of expansions ran at about 3.8%. Our recent expansion has seen only 1.9% growth in wages and salaries. This is half the average annual wage and salary growth. That is how we reached the dubious low water mark for wages and salaries as a percentage of national income in 2006. In 2006 only 51.6% of national income went to wages and salaries, this is the lowest percentage since 1929 when data collection began. [PDF] We will have to wait to see weakness in the already limping areas of employment and earnings. I don't see how this bodes well for the near term future or acts to dispute our recessionary trajectory?

We are in the early to middle stages of asset price deflation and credit limitation. This is where we found growth and it will be where we find pain in the coming year. More important than the general forecast is the specific policy lesson that our inorganic and unusual recovery offers. It is unsafe, inequitable and fragile to build and base economic performance on asset price inflation and debt. This economic arrangement produces redistribution of wealth from debtors to creditors and creates a very delicate and poorly shared expansion. Sadly, the weakness that comes from the end of the boom falls heavily on the shoulders of those who gained little from the expansion. It must be with this in mind that we make policy and rebuild.

Financial Crisis: '20 Years in the Making'

Doug Noland tells us — preaching to the choir, since no one else will listen — that the stage for the mess now unfolding was built on a foundation laid over 20+ years by US Federal Reserve policy, cheerled by Wall Street finance. Noland says, "The unfolding financial and economic crisis has been more than 20 years in the making. It's a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For twenty years now the Fed has basically done everything that Wall Street requested and more." Here's more:

More than 20 Years in the Making, Doug Noland, Credit Bubble Bulletin, Jan. 25: … When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated an historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system Credit growth, and fight economic headwinds, the Greenspan Federal Reserve was more than content to garner outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Wall Street investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the GSEs never looked back — not for a second.

In the guise of "free markets," the Greenspan Fed sold their soul to unfettered and unregulated Wall Street-based Credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution, and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy’s speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling — alluring — seductive story.

But, as they say, "there's always a catch". In order for New Age Finance to work, the Fed had to make a seemingly simple — yet outrageously dangerous — promise of "liquid and continuous" markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative "insurance" — accommodating the markets' expanding appetite for hedging — required liquid markets whereby they could short securities to hedge their risk, as necessary. There were numerous debacles that should have alerted policymakers to some of New Age Finance's inherent flaws (1994's bond rout, Orange Co., Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron to name a few). Yet the bottom line was that the combination of the Fed's flexibility to aggressively cut rates on demand; ballooning GSE balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world's reserve currency all worked in powerful concert to sustain (until recently) the U.S. Credit Bubble — through thick and thin.

Despite his (inflationist) academic leanings and some regrettable ("Helicopter Ben") speeches as Fed governor, I do believe Dr. Bernanke aspired to adapt Fed policymaking. His preference was for a more "rules based" policy approach of setting rates through some flexible "inflation targeting" regime, while ending Greenspan’s penchant for kowtowing to the markets. Today, it all seems hopelessly naïve. Inflation is running above 4%, while the FOMC is compelled to quickly slash the funds rate to 3%. And never — I repeat, never — have the financial markets been more convinced that the Federal Reserve fixates on stock prices while is permissive when it comes to inflationary pressures. Today, the contrast to the ECB and other global central banks could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how they regain credibility as inflation fighters or supporters of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.

The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their "risk management" approach. Repeatedly, monetary policymaking was dictated by the Fed's focus on what it considered the possibility of adverse consequences from relatively low probability ("tail") developments in the Credit system and real economy. In other words, if the markets (certainly inclusive of "New Age" structured finance) were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through "activist" monetary easing was accepted outright as a patently more attractive proposition compared to the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative ("coin in the fuse box") policy approach is disastrous in Bubble environments.

The Fed's complete misconception of the true nature of contemporary "inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary — and greatly unappreciated — risks were part and parcel to the perpetuation of dangerous Credit Bubble Dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater Bubble-related distortions and fragilities — deeper structural impairment to both the financial system and real economy. In the end, the Fed's focus on mitigating "tail" risk guaranteed a much more certain and problematic "tail" — a rather fat one at that.

Fundamentally, the Greenspan/Bernanke "doctrine" totally misconstrued the various risks inherent in their strategy of disregarding Bubbles as they expanded — choosing instead the aggressive implementation of post-Bubble "mopping up" measures as necessary. They were almost as oblivious to the nature of escalating Bubble risk as they were to present-day complexities incident to implementing "mop up" reflationary policies. "Mopping up" the technology Bubble created a greatly more precarious Mortgage Finance Bubble. Aggressively "mopping up" after the mortgage/housing carnage in an age of a debased and vulnerable dollar, $90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global Bubbles, and a runaway Chinese boom is fraught with extraordinary risk. Furthermore, the Fed's previously most potent reflationary mechanism — Wall Street-backed finance — is today largely inoperable. …

It is also as ironic as it was predictable that Alan Greenspan — Ayn Rand "disciple" and free-market ideologue — championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our Nation’s financial and economic affairs since the New Deal. Articles berating contemporary Capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market Capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying Credit system. …

Jim Cramer's Rant: 'Fiction in Financials'

Normally I'm not one to recommend financial madman Jim Cramer's rants. But I'll make an exception today for: Cramer Rages on Banks: 'Where's the SEC?!'. The video feed (embedded in the CNBC post) is well-worth a few minutes of your time, even to endure a short ad at the beginning. The CNBC post begins, "Why isn't the Securities and Exchange Commission getting more involved in the whole banking sector writedown situation? Especially since the numbers are likely to get worse, not better? That's what Jim Cramer, CNBC's resident stock guru, wants to know." Then continues:

… "It's all fiction!" [Cramer] declared during a forceful exchange ….

"How can we have these levels of fiction in financials after Sarbanes-Oxley? How do people get away with this? How do they live with themselves?"

Cramer made his comments while reviewing results from Merrill. But his real consternation surrounded the insurers who cover banking investments. Some of those insurers haven't come clean about their liabilities, Cramer speculated. Eventually they will, and then the "fiction" will disappear, he said.

The banking sector and its related industries are all too chummy, Cramer accused. That led the numbers related to mortgage investments -- investments that are currently souring -- to break from reality.

"I think the financial guys all belong to the same club and they got to protect each other," he said.

Worse, those executives behind the current credit crunch are unlikely to get any punishment for their mistakes and disingenuousness about their numbers, Cramer opined.

"I'm fed up with it. The American people should be fed up with it. And the SEC should be fed up with it," Cramer said.

"This is what the SEC is supposed to protect us from," he added. …

P.S. Cramer takes aim too at so-called "mortgage insurers".

Hat Tip: Paul Kedrosky, Infectious Greed.

Deconstructing 'Recession 2008?'

I spent an hour yesterday listening to three economists (Brad DeLong, Mike Mandel, and William Beach) discuss our current plight. I found their insights compelling. Areas of agreement, included:

• Don't look to the US Government for effective Fiscal Policy Help — particularly in an election year
• Don't look to the Fed to ease much pain since they are pretty much helpless in the face of a faltering US housing market (See Krugman too)
• Best we can do is to see both borrowers and lenders share the pain, with some pain (how much?) shared by the rest of us

The forum was hosted by Dave Iverson (a different, more erudite Dave Iverson) and aired on KQED, NPR, San Francisco. It's well worth an hour of your time, if only to get better acquainted with Brad DeLong's longer-than-a-post reflections (but skip the questions and answers). From Delong's Grasping Reality…

KQED | Forum: Recession 2008? [Jan. 11]

http://www.kqed.org/.stream/anon/radio/forum/2008/01/2008-01-11a-forum.mp3

Host: Dave Iverson

Guests:

• Brad DeLong, professor of economics at UC Berkeley
• Mike Mandel, chief economist for BusinessWeek
• William Beach, senior economist and director at the Center for Data Analysis at the Heritage Foundation

The Darker Side: Mortgage Crisis Morphs into Broader Corporate Debt Crisis

As markets continue their 2008 stumble, Doug Noland probes the depths of the darker side of things that may yet unfold (from his Credit Bubble Bulletin perch):

Mortgage Crisis to Corporate Debt Crisis, Doug Noland, Jan 11 The financial system fell under intense stress Wednesday. The epicenter of the crisis was in the "Credit default swap," or CDS market, and "contagion" fears were building quite a head of steam. …

This week brought back memories of the 2002 Debt Crisis. Weighed down by the telecom debt collapse, Enron, and other frauds, intensifying Corporate Debt problems late in the year were at risk of smothering the consumer sector. The nexus at the time was the auto finance subsidiaries and Household International. Consumer finance Corporate Debt spreads were widening significantly, and Household, in particular, was facing a liquidity crisis in early November. The failure of a major financial institution at that juncture would have created a major systemic issue.

… [O]n November 14 HSBC agreed to buy (bailout) Household International. A week later, FOMC governor Bernanke gave his now (in)famous "Deflation: Making sure 'it' doesn't happen here" speech. With rates at 1.0% (until June 2004!), the Fed was now publicly discussing "electronic printing presses," "helicopters" and other "unconventional measures." Wall Street was trumpeting "deflation" risk. Sure enough, the crisis was soon resolved and Wall Street was emboldened to perpetuate history's greatest Credit inflation and Mortgage fiasco.

The tables have been turned these days, with the Mortgage Crisis now evolving into a full-fledged Corporate Debt Crisis. The key nexus this time around has been Wall Street "structured finance," especially as it relates to the major Mortgage lenders (certainly including Countrywide, Rescap/GMAC, and Washington Mutual) and the “financial guarantors (in particular, MBIA and Ambac). The unfolding Mortgage implosion has destroyed the value of innumerable "structured products;" has annihilated legions of mortgage companies; has impaired scores of major lenders; has severely battered general market confidence; and this week was in the process of taking down a few huge mortgage companies. Institutions with enormous liabilities to the "money," "repo," securitization, and derivative markets — not to mention large borrowings from the FHLB system — were in serious jeopardy. The risk of a domino implosion in the Credit default market and the "financial guarantor" industry had become a very real possibility. System Risk Intermediation was in peril.

The Fed responded with what the market has interpreted as a promise of aggressive rate cuts, while Bank of America has apparently for now resolved the Countrywide debt issue. Citigroup's stock rallied on rumors of a major new investment from Prince Alwaleed and others. Washington Mutual's stock price rallied sharply on rumors of merger talks with JPMorgan. Countrywide's stock surged as CDS prices collapsed, a dynamic sure to have caused considerable grief to those shorting the stock to hedge against default protection written.

Curiously, the general market took little comfort from developments. A case can be made that the rally in CDS and financial stocks was destabilizing for much of the leveraged speculating community (including "market neutral" and "quants") keen to short financial stocks against (now sinking) technology shares. Overall, the market was hammered, while MBIA and Ambac CDS prices barely budged from record levels. Friday's market was one of those that surely caused havoc for numerous sophisticated trading strategies. And it is worth noting that an index of Junk bond spreads to Treasuries actually widened an additional 4 basis points to 603 bps, rising this week above 600 for the first time since — not coincidently — the 2002 Debt Crisis.

But the general environment is nothing like 2002, and I don't expect Fed words and actions — in concert with financial bailouts — to have similar effects. For one, 13% household mortgage debt growth in 2002 provided powerful financial and economic stimulus that will not be forthcoming in 2008. With consumer Credit relatively stable, 2002's Corporate Debt Crisis was not a serious systemic issue. Moreover, "Wall Street finance" was in an aggressive expansionary mode and the global banking community was developing quite a hankering to participate in the U.S. Credit Bubble. The economy was emerging from a shallow recession.

The world is a much different place today. The Mortgage Finance Bubble is a bust, Wall Street finance is imploding, and foreign financial institutions are keen to cut and run from the business of providing U.S. Credit. Countrywide's mortgage problems will be absorbed — along with so many other risks — by our own highly vulnerable domestic banking system. Worse yet, the economy is quickly succumbing to recessionary forces. With a high degree of confidence we can proclaim that the Mortgage Crisis has now evolved into a Corporate Debt Crisis — and this crisis will not be resolved anytime soon — by rates, by helicopters, or by bailouts.

Unlike 2002, today's Credit crisis is systemic. Consumer and financial sector fragilities — the heart of our Credit system — are now impaired to the point of imperiling the capacity of the Credit system to finance business spending and intermediate corporate lending risk. To be sure, prospects for a faltering U.S. consumer sector, massive financial sector Credit losses, and an imminent economic downturn have quite negative ramifications for business lending and valuations. In particular, unfolding dislocation in the CDS and Credit "insurance" markets will severely restrict Credit Availability for small, medium and large firms — especially those less than top-tier borrowers.

I'll go further and suggest that a severe tightening of Financial Conditions has abruptly made many business borrowing plans unviable; many a balance sheet and debt load untenable; and vast numbers of business strategies — crafted in altogether different financial and economic times — much less viable. Some companies will make the necessary adjustments and many will not. The unfolding backdrop definitely makes a lot of stock buyback plans imprudent and growth strategies highly risky. The aggressive risk-taking business manager — having previously capitalized on the protracted boom — will now be at a similar handicap to that which afflicted the zealous home buyer and lender.

For those searching for explanations behind the stock market's dismal start to the New Year, I suggest contemplating the many serious ramifications of the Mortgage Crisis having now evolved into an Incurable Corporate Debt Crisis. This week, the Bursting Credit Bubble passed another significant inflection point — one perhaps subtle but with major economic consequences.

Catching up on Financial 'Interesting Times'

Let's begin with Paul Krugman's Dec 14 Authors@Google Series video on how we got into our current financial mess and some "mysteries" on how we might get out of it this side (or the other side) of a 'hard landing.' In this very good hour with Krugman, he covers the previous Long Term Capital Management induced mess, the Nasdaq "tech bubble", the housing bubble, the Fed, "financial innovation", and more. Good insights for we who don't spend 24/7 dealing with matters financial:

Krugman believes that the housing mess is with us for about the next six years, guessing, based on early '90s S. California housing bust, with an average 30% price drop (in "real" dollars) from "bubbleicious" peaks. In a blog post today, Unknown Housing Territory, Dec 19, Krugman gives us more:

… The bubbles in the most bubbleicious areas were bigger than anything we've ever seen — and there's every reason to think that the required fall in prices in those areas will be much bigger than anything we've seen since the Great Depression. …

In the video, Krugman admits being surprised by the enormous impacts of the housing and related credit crunch have on the "financial system". He highlights how the Fed has been 'behind the curve' on dealing with this latest crisis, naïvely believing that the same medicine that 'solved' the LTCM mess years ago would suffice here. Since that medicine didn't work this time, Krugman gives us glimpses of the newer approaches central bankers are trying to put into play.

One Highlight: Glassman's law, as a correlary to Stein's law (also from Bubble Denial, Dec 10 on Krugman's blog):

… [B]ack in 2005, when I started writing about the housing bubble — it didn't take much to see that something was way out of whack.

So how come the housing crisis has come as such a surprise to so many people?
Part of it was the usual bubble psychology. Economists like to cite Stein's Law: "If something cannot go on forever, it will stop." I think it needs to be paired with another law — let's call it Glassman's Law — along the lines of "If something unsustainable goes on for a while, there will be people claiming it can go on forever."

According to Krugman, everybody looks to the 1998 'fix' for the Long Term Capital Management debacle as a model for this episode. Problem is, that strategy doesn't seem to be working this time. The 'fix' as applied last August, seemed to work for awhile, but 'trouble' is now welling up again. So the Fed and other Central Bankers are now trying hard to funnel short- to medium-term liquidity into the system.

Krugman is hoping this latest, belated effort from central bankers will work, although he suggests there are no 'quick fixes' to this mess — adding that we still don't even know the size and extent of the mess. "Steve Cechetti is hopeful but has his doubts", says James Hamilton in his Monetary Policy Using the Asset Side of the Fed's Balance Sheet, Dec 16. Whatever you read from these extended hyperlinks, don't miss Cechetti's The Art of Crisis Management: Auctions and Swaps, Dec 16.

Noruiel Roubini is even less sure that even this latest easing will help , although he has been advising central bank "easing" for some time. See Roubini: First, Central Banks Are Getting Desperate in Dealing with the Liquidity Crunch …, Dec 18, and second, Why Monetary Policy Easing is Warranted Even in the Current Insolvency Crisis, Dec 15

Finally, Michael Shedlock (as an interesting member of the Libertarian Right) is apoplectic, not only at what he considers continuing mis-steps by the Fed, but also since Roubini, whom he admires as a forecaster, doesn't buy Shedlock's particular brand of 'free market fundamentalism': asking for the Fed to be abolished and for a return to the gold standard and private banking. See Shedlock's Missing the Boat on Monetary Easing, Dec 18.

Quite a bunch of interesting stuff out and about! Mostly I just sit back and read from the really good commentators I track on my sidebar (and my Google Reader). I don't pretend to be in the same league as they are on matters of finance and geopolitics. But I do like to try to sort out some of it, second hand. Ocasionally I even help others in their own sorting, and that makes this little hobby of mine worthwhile.

Happy Holidays to those who are celebrating such during this season.

Noland Debunks Greenspan's "No particular regrets" remarks

While I'm not yet ready to throw verbal rocks at Ben Bernanke, I certainly share Doug Noland's disdain for Alan Greenspan's behavior during the last decade and more. Here, with a few highlights, is Noland's latest view or where we stand and how we got here—cheerled by the US Fed:

No Regrets, Doug Noland, Credit Bubble Bulletin, Nov 23: November 23 – Bloomberg (Robin Wigglesworth and Craig Stirling): "Former Federal Reserve Chairman Alan Greenspan said he has 'no particular regrets' about his time at the central bank, adding that the deepening U.S. housing-market slump isn't result of his policies. 'Markets are becoming aware of the fact that the decline in house prices is not stopping,' Greenspan said… I have no particular regrets. The housing bubble is not a reflection of what we did, as it is a global phenomenon.'"

November 18 – Bloomberg (Anthony Massucci): "Former Federal Reserve Chairman Alan Greenspan said the dollar's decline hasn’t affected the global economy and is a 'market phenomenon.' 'So long as the dollar weakness does not create inflation, which is a major concern around the globe for everyone who watches the exchange rate, then I think it's a market phenomenon, which aside from those who travel the world, has no real fundamental economic consequences'…"

I don't know which of the two above quotes this week from Alan Greenspan I find more astounding. They are somehow equally despicable. The Greenspan Fed's fingerprints are all over the housing Bubble — at home and abroad. And they're everywhere when it comes to heightened global dollar and currency market tumult. Our much revered former Fed Chairman is making a fool of himself, a spectacle not all too supportive of confidence in our policymakers, Credit system, or currency.

Whether he will admit it or not, mortgage Credit inflation was central to the Federal Reserve's post-tech Bubble reflationary strategy. It really was a "Great Experiment" in inflationist monetary policy and, predictably, it failed miserably. The Fed and some notable Wall Street "strategists" feigned a system-wide "price level" that the Fed was obligated to adeptly manipulate to ensure that that evil “deflation” was not allowed to take root. What a crock. The risk was, then as it is now, U.S. Credit Collapse — and certainly not a somewhat deflating price level. Accommodating history’s most reckless Credit expansion over the past six years then ensured that the risk of collapse grew significantly greater while countermeasures turned increasingly unavailing.

I'll assume that the Fed simply lost control of mortgage Credit excesses. And as the risk of a devastating housing bust escalated, the Greenspan/Bernanke Fed became more ideologically intransigent in their opposition to pricking asset Bubbles. In this regard, Dr. Bernanke was Greenspan’s ideal surrogate. Unfortunately, we’re about to experience the consequences of the fundamentally flawed policy of ignoring Bubbles while they are inflating, choosing instead to wait for post-Bubble "mop up" duties. It was Greenspan himself decades ago that placed responsibility for the Great Depression on the Fed for repeatedly inserting "Coins In the Fusebox" during the Roaring Twenties. How differently would the world look today had the Fed not cut rates to 1% and left them at ultra-low levels for several years? How different would it be if the GSEs had kept their power dry, retaining financial resources to assist the mortgage market during this downturn instead of shooting all their bullets and more perpetuating the fateful Mortgage Finance Bubble? How differently would it be today if the dollar were fundamentally strong, instead of a currency carelessly debased to perpetuate an Economic Bubble?

As gatekeeper for the world's reserve Credit system and currency, to pass off our unfolding housing and financial messes as "global phenomena" would be laughable if it weren't so serious. "No particular regrets" Somewhere along the line the Federal Reserve lost sight of its fundamental mandate and responsibility — to protect the soundness and stability of our financial system and economy. Doubling our entire stock of mortgage debt in just over six years is certainly not consistent with price stability, financial stability, or economic stability — no matter what the reading on "core" CPI. And $800bn Current Account Deficits are an abomination and talk of a global "savings glut" shameful economics.

Moreover, it was our Credit system that led the world in the proliferation of securitizations, derivatives, leveraged speculation, Credit guarantees/insurance and highly tangled debt structures. And throughout his 18-year reign, Mr. Greenspan was the most vocal proponent of "Wall Street finance." He was the head cheerleader for securities-based risk intermediation, derivatives, dynamic hedging strategies, leveraged speculation and, generally, Credit Bubble Turned Global Financial Fiasco. If he were any kind of statesman, he would today at least be willing to admit where mistake were made.

U.S. mortgage excesses blighted the world. Credit systems around the globe adopted Wall Street securitization and derivatives practices, while incorporating uniform "risk management" strategies. Wall Street cut loose leveraged speculation to overrun financial systems around the world, while our Current Account Deficits were often "Recycled" back to high-yielding "structured products." And while not commonly recognized, U.S. mortgage Credit excesses and attendant Current Account Deficits concurrently debased the dollar while unleashing Credit systems globally. A complete lack of discipline — evolving into outright recklessness — at the "Core" nurtured rampant Credit and spe