Economic Dreams - Economic Nightmares

Krugman: Fed Lacks Tools to Deal with Crisis

Paul Krugman says Nouriel Roubini was right: We are in the worst financial crisis since the Great Depression. AND, The Fed probably lacks the tools to deal with it. Then Krugman muses, "Who ya gonna call?", The White House? Greenspan? To Krugman:

Who ya gonna call? Paul Krugman, March 17:

Um, on second thought

Nouriel is right: this is the worst financial crisis since the Great Depression, and the Fed, with the best will in the world, probably lacks the tools to deal with it. Broader action is necessary.

But then comes the question: who ya gonna call?

The Gang That Couldn't think Straight still holds the White House; no good ideas will come from that quarter. Worse, Incurious George would probably veto any sensible plan from Congress, even if said plan could get past a filibuster.

Hey, here's an idea! Let's create a nonpartisan expert commission, headed by Alan Gr …. oh, wait. He's part of the problem. In fact, is there any way we can repossess his book royalties?

Seriously, it's very hard to see who can take charge.

Things fall apart, and the center doesn't exist.

PS. Most of what I dig up and find "most interesting to share", I now distribute via Google Reader on my Econ Dreams - Nightmares sidebar.

Dean Baker: Don't Blame 'The War', entirely

Dean Baker tells us, "The public's wrath should be focused on the Fed, the regulators, the Wall Street crooks and the others responsible for letting a housing bubble wreck havoc on the economy. … There are plenty of good reasons to be opposed to the war, and its negative impact on the economy is one of them." Sure we've spent a trundle on W's War. But that ought not blind us to the graft on Wall Street and other Power Centers in the USA and around the world. More from Baker (emphasis added):

The war at home, Dean Baker, Guardian: comment is free, March 10: … The war is a drain on the economy, but it is not the cause of the recession. The recession is due to the collapse of the $8 trillion ($110,000 per homeowner) housing bubble.

It is understandable that people would look to the war as the villain in this story. After all, the war is costing around $180bn a year (approximately 1.2% of GDP). This is a substantial drain on the federal budget and the economy. This money could have gone to productive uses that would benefit people and make the economy stronger. …

[Don't forget that] the increase in borrowing associated with the war is actually not very large relative to the size of the economy. It can be expected to have a negative effect, but it is relatively modest and only begins to be felt over time. …

This is bad news, but it is not the recession that we are seeing now. This recession has a different group of villains. First and foremost on this list is Alan Greenspan, who at least ignored the housing bubble, if he didn't actively promote it. The list also includes regulators at both the state and federal level who tolerated abuses in the mortgage industry that were completely visible at the time they took place. And there is a long list of politicians and community leaders who encouraged low- and moderate-income families to buy homes in the middle of a housing bubble. And of course, there are the incompetent economic forecasters who could not see an $8tn [- that's 8 TRILLION -] housing bubble in front of their faces.

These are the people who deserve the blame for what is likely to be the most severe recession in the post-war period. The public's wrath should be focused on the Fed, the regulators, the Wall Street crooks and the others responsible for letting a housing bubble wreck havoc on the economy.

There are plenty of good reasons to be opposed to the war, and its negative impact on the economy is one of them. But we should not allow the war to be misused to allow some big-time villains to get off the hook. If we had better spent our money over the last five years, we would be better able to withstand the effects of the housing crash - just as a person who eats well and exercises can more quickly recover from a bout of pneumonia. But laziness and a bad diet were not the cause of pneumonia, and the war is not the cause of this recession.

Minsky Moment and Trillion Dollar Meltdown: What might Help?

George Magnus, UBS Senior Economic Advisor, widely credited for popularizing the "Minsky Moment" phrase a year ago, once-again invokes Hyman Minsky and suggests that we are likely facing a Trillion dollar financial meltdown when all eventually gets added up. And he says that "fixing the problem" goes way beyond simple Monetary Policy fixes. Legislative and regulatory fixes will need to accompany monetary policy fixes.

Magnus believes that Ben Bernanke sees the crisis in proper perspective and believes that the US Fed is doing what is necessary, although not sufficient to stem the worst outcomes from this crisis. Here is a link to three-part video (3 minutes per part, Feb 25) featuring Magnus as interviewed by Financial Times Gillian Tett. In part three, Magnus predicts a Credit Crisis Bailout (by the US Government and others) by October.

Meanwhile, US Treasury Secretary Henry Paulson is in full attack mode as to a Credit Bailout. And Allan Meltzer suggests (Feb 28) that, far from doing what appears proper and necessary, the Fed is repeating the mistakes of the 1970s.

Of the three, I think Magnus is more likely correct.

P.S. I'm wandering off for a few days skiing in the Utah mountains.

'Weath Effect' in Reverse

Too good not to post:

Home Price Plunge Accelerates, Floyd Norris, NY Times, Feb. 26: The S.&P./Case-Shiller indexes for December, out this morning, show the following price changes for the fourth quarter of 2007, annualized:

San Diego -31.9%
Phoenix -30.1%
Los Angeles -30.0%
San Francisco -29.4%
Las Vegas -28.9%
Miami -25.7%
Detroit -24.5%
Denver -19.9%
Minneapolis -19.7%
Washington -18.5%
Tampa -17.7%
Atlanta -16.9%
Cleveland -16.8%
Dallas -14.0%
Boston -13.6%
Seattle -13.4%
Chicago -10.3%
Charlotte -9.2%
New York -8.5%
Portland -6.7%

The fourth quarter is normally the weakest of the year, and these figures may therefore overstate the decline. But it is nonetheless the first quarter ever — going back to the late 1980’s in most markets — that no market covered by these indexes showed a gain. This is a national plunge in real estate prices, brought on in part by a newly stringent mortgage market. Local factors — the strength of the local economy and the amount of speculation during the boom — help to explain variations, but the national factors are dominant.

It is also the worst quarter these indexes have seen for 17 of the 20 markets. …

The consumer confidence report came out today from the Conference Board. It should not be news that home price levels affect how consumers feel. The expectations index — based on how people expect things will be in six months — is down to 57.9. That is the lowest level for that index since January 1991. Then the United States was fighting in Iraq, mired in recession and led by a president named George Bush. …

Wall Street Melts As Bubbles Burst: Videos Worth Watching

If you haven't yet seen them, these three videos are interesting: Wall Street Meltdown, Here Comes Another Bubble, and Sub-Prime Meltdown. The first two are musical parodies, with pictorial and graphical highlights. The third is a short look at the subprime mess via Canadian The National Experience, Sept. '07 particularly focused on Cleveland Ohio's mess.

Wall Street Meltdown, Feb. '08

Here Comes Another Bubble, Oct. '07

Sub-Prime Meltdown, Sept. '07

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.

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. …

Banking Gone Bad: 'Privatizing gains and Socializing Losses'

Yves Smith at Naked Capitalism is one of the very best economic bloggers. She keeps the rest of us up to date on a daily basis. Today, I'm impressed with this particular find/commentary (snipped, in part):

Why banking is an accident waiting to happen", Nov28: Martin Wolf, the well respected lead economics editor of the Financial Times, turns to a favorite topic: why banks regularly get themselves in trouble. His answer: it's "a risk-loving industry guaranteed as a public utility." Privatizing gains and socializing losses, particularly if the employees share in that arrangement, is a formula for reckless behavior.

Wolf takes note of the persistent high profitability of the banking industry, in return on equity terms, and attributes it to formal and informal public guarantees (they allow banks to borrow more cheaply than otherwise) and undercapitalization relative to the risks assumed. But there is another way to look at bankings' relative profitability. Remember, ultimately, the banking industry provides services to the productive economy and individuals and extracts fees for those services. Its high profits represent a wealth transfer from the productive sector to what ought to be a support function.

Wolf briefly reviews some possible remedies …

Banks are wards of the state. The sooner the powers that be recognize that and treat them accordingly, the better off the rest of us will be.

From the Financial Times:

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation. …

Governments are not totally stupid. They guarantee banks because the latter provide a social utility: a safe haven for money, and a payment system. But governments also realise that they are providing incentives for banks to economise on capital and take on risk. So governments impose capital-adequacy ratios, rules on risk management and (if they are sensible) liquidity requirements, as well. Unfortunately, these institutions are not only complex, but are staffed by single-minded and talented people. They go round regulations, just as water flows round an obstruction.

The result of this ingenuity includes “special purpose vehicles”, hedge funds and even, in some respects, private equity funds. These are all, in varying ways, off-balance-sheet banks: ways to exploit the exceptionally profitable opportunities (and corresponding risks) created by high leverage and maturity transformation. Securitisation, to take a salient example, is a clever way to shift what would once have been bank loans on to the books of these quasi-banks, with the consequences we all now see. …

So what we have is a risk-loving industry guaranteed as a public utility. One result has been insufficient capital. That permits splendid returns in good times. But the capital may well prove inadequate in bad ones. The loss of capital could well lead to a tightening of credit in the years ahead.

If so, the structure and regulation of banking might have to be reconsidered, again. One possibility would be higher capital requirements. This would lower peak returns and so reduce the chances of subsequent negative returns. Mr Smithers and Prof Wood suggest a 40 per cent increase in capital for the UK. Other possibilities are measures to make regulation easier: narrow banking is an old favourite, although hard to make work. Henry Kaufman, a highly experienced observer of credit markets, suggests intense scrutiny of banks deemed “too big to fail”.

What seems increasingly clear is that the combination of generous government guarantees with rampant profit-making in inadequately capitalised institutions is an accident waiting to happen – again and again and again. Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies. Since we cannot accept the latter, I suspect we will be forced to move towards the former. Little can be done now. But when the recovery begins, we must impose higher capital requirements.

Roubini's Nightmare

October Employment: Plus 166K or Minus 250K Jobs? Nouriel Roubini, Nov 02: … If you are interested in understanding where the economy is going you should [look not at the ambiguous Oct '07 "employment report", but ] rather look at the ongoing disaster in credit markets — with a severe and spreading credit crunch — that will get uglier in the next few months as financial institutions are forced to mark to market massive — still unrecorded — losses on trillions of mortgages and related MBS and CDO tranches. With the ABX index for BBB- now down to the 20s and even the AAA tranches now down from par to 79 there are hundreds of billions of losses that no financial institutions has even started to account for. When allegedly AAA tranches of CDO trade at 79 cents on the dollar you know you have a massive and severe financial nightmare ahead. So, instead of the NFP report look daily at what the ABX indices are telling you about what is happening the economy and the financial sector. [empahsis added]

One has to wonder whether this is really Roubini's nightmare or whether his real nightmare is that his bearish forecasts (which I've been following/echoing) won't come true and he will miss out on the rest of the upside from a "reflated" Bull Market.

For those are feeling a bit less Bearish than Roubini, here is a bit of confirming evidence (or soothing news) from Greg Mankiw:

The View from 1600 Pennsylvania Ave, Greg Mankiw, Nov 2: A friend in the White House emails me an economic update:

Today is Jobs Day. Here’s what you need to know about the October employment report:

• +166,000 net new jobs were added in October. This is almost twice what the markets expected.
• The unemployment rate is unchanged at 4.7%.
• The US economy has created 1.68 M net new jobs over the past year, and 8.3 M since the labor market turnaround in August 2003.
• We've had 50 months (4 years and 2 months) of continuous employment growth, a new record.
• Wages are up 1.2% over the past year, adjusting for inflation.

In other economic news, on Wednesday we got GDP data:

• GDP grew 3.9% in the 3rd quarter, well above market expectations of about 3%. This is the strongest quarterly GDP growth in 1½ years. Extra happy.
• We can see the effects of a strong labor market in the consumption numbers — people are working and their real incomes are climbing, so they're buying more stuff. Since consumption is about 70% of the economy, strong consumption growth is critical to continued GDP growth.
• Housing is still a drag — it knocked 1.1% off the third quarter growth number. This is bad but unsurprising. The silver lining is that there's no evidence the housing decline is spilling over into consumption.
• Business investment was solid. Investment in "equipment and software" grew at a 6% rate, the best in 1½ years.
• Exports continue to be strong, and they now make up 1 in 8 dollars of our GDP (12%). The rest of the world is growing, and they're buying our stuff.

This last point is a useful reminder — world economic growth is not a zero sum game. When other countries’ economies grow, they buy more US goods. That’s good for us. …

Later, Mankiw sprinkles a bit of gloom on the mix:

There are, however, some clouds going forward.

• It's probably going to take a while to work out of the housing downturn. We expect housing will continue to be a drag on GDP growth.
• Oil prices are nearing an all-time inflation-adjusted high (depending on how you measure inflation).
• The credit markets are still working through problems that first appeared in August.

Finally Mankiw ends, once again, on a happy note:

One of our favorite words when talking about the US economy is "flexible" — we have extremely flexible labor and capital markets. When bad things happen (e.g., a factory closing, wildfires, housing and credit market troubles), a flexible economy can adjust and recover quickly and with the smallest amount of pain. We're seeing the benefits of a flexible economy now.

When we look back some years hence, we will see whether the pessimist or the optimist prevailed. Or maybe even then the evidence will be so ambiguous that both will be declaring victory.

Can Structured Finance Survive?

That is this week's question from Prudent Bear's Doug Noland. As for me I have decided to take a "wait and see" attitude—since I don't have faith in anyone's ability to know the future— and since my long-term approach of living frugally, saving some small sums (in part by investing a bit in things I hope offer a bit of an "asset inflation" hedge), and staying debt free for the last 20 years will MAY allow us to weather whatever storms may be on the horizon. Too many others, however, ought to be rightfully much more worried than I am by Doug Noland and others' gloom and doom forecasts. Here is a shortened form of Noland's latest:

Structured Finance Under Duress, Doug Noland, Credit Bubble Bulletin, Oct 26: The market may be been perfectly content to brush it aside. It was … a brutal week for "contemporary finance." Merrill Lynch, a kingpin of structured Credit products, shocked the marketplace with a $7.9bn asset write-down — up significantly from the $4.5bn amount discussed just two weeks ago.… Street analysts have already warned of the possibility for an additional $4bn hit. Merrill is not alone.

Also hit by sinking CDO fundamentals, Credit insurer Ambac Financial reported a third-quarter loss of $361 million — it's first-ever quarter of negative earnings. The company posted a $743 million markdown on its derivative exposures, "primarily the result of unfavorable market pricing of collateralized debt obligations." Credit insurance compatriot MBIA also reported its first loss ($36.6 million), on the back of a $352 million "mark-to-market" write-down of its "structured Credit derivatives portfolio." …

MBIA and Ambac combine for about $1.9 Trillion of "net debt service outstanding" — the amount of debt securities and Credit instruments they have guaranteed, at least in part, to make scheduled payments in the event of default. Throw in the Trillions of Credit insurance written by the mortgage guarantors and you’re talking real "money." Importantly, the marketplace is beginning to question the long-term viability of the Credit insurance industry, placing many Trillions of dollars of debt securities in potential market limbo.

With recent developments — including the monstrous write-down from Merrill Lynch, the implosion in the mortgage insurers, and the losses reported by the "financial guarantors" — in mind, I'll revisit an excerpt from a January article by the Financial Times' Gillian Tett: "…Total issuance of CDOs…reached $503bn worldwide last year, 64% up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005. These startling numbers will certainly not shake the world outside investment banking. For, as I noted in last week's column, the CDO explosion is occurring in a relatively opaque part of the financial system, beyond the sight — let alone control — of ordinary household investors, or politicians."

Subprime and the SIVs are peanuts these days in comparison to the gigantic global CDO and Credit derivatives markets. CDOs may lack transparency, trade infrequently, and operate outside of market pricing ("mark-to-model"). Nonetheless, CDO exposure now permeates the entire global financial system — exposure that regrettably mushroomed in the midst of the most reckless end-of-cycle mortgage excesses imaginable. Rumors this week had major insurance companies suffering huge CDO losses. To what extent the big insurance "conglomerates" have exposure to CDOs and other Credit derivatives is unclear today, but there is no doubt that the global leveraged speculating community is knee deep in the stuff. Importantly, as goes the U.S. mortgage market, so goes the CDOs. I'm not optimistic.

I don't want to place undue weight on one month's data, but the California statewide median home price sank $58,140 over the month of September (down 4.7% y-o-y to $530,830). This was by far the largest monthly decline on record and the first year-over-year fall "in more than 10 years." September California sales were down 39% from a year earlier. Weakness was statewide ….;

We've definitely reached a critical point worthy of the question: Can "structured finance," as we know it, survive the California and U.S. mortgage/housing busts? I don’t believe so. For one, the historic nature of the Credit Bubble virtually ensures the collapse of the Credit insurance "industry" (companies, markets, and derivative counter-parties). The mortgage insurers are now in the fight for their lives, while the "financial guarantors" today face an implosion of their "structured Credit" insurance business. Worse yet, major problems in municipal finance (certainly including California state and municipalities) are festering and will emerge when the economy sinks into recession. It is worth noting that California revenues were $777 million short of expectations during the first fiscal quarter ….

Returning to the vulnerable CDO market, some key dynamics are in play. With California now at the brink, uncertain but huge losses are in the pipeline for jumbo, "alt-A," and "option-ARM" mortgages — loans that were for the most part thought sound only weeks ago. The market began to revalue the top-rated CDO tranches this week, a process that should only accelerate. "AAA" is not going to mean much. If things unfold as I expect, a full-fledged run from California mortgage exposure could be in the offing. And as the dimensions of this debacle come into clearer market view, the viability of the Credit insurers will be cast further in doubt … with ramifications for Trillions of securities and derivatives. General Credit Availability would suffer mightily.

With global equities markets in melt-up mode, it might seem absurd to warn that a troubling global financial crisis is poised to worsen. But Structured Finance is Under Duress. The entire daisy-chain of liquidity agreements, securitization structures, Credit insurance and guarantees, derivatives counterparty exposures and, even, the GSEs is increasingly suspect. Trust has been broken and market confidence is not far behind.

The big global equities and commodities surge over the past few months certainly has been instrumental in counteracting what would have surely been a problematic "run" from the leveraged speculating community. How long this spectacle can divert attention from the unfolding mortgage/CDO/"structured finance" debacle is an open question. I can't think of a period when it has been more critical for stocks to rise — and rise they have. Yet I suspect recent developments will now encourage the more sophisticated players to begin reining in exposure.

The nightmare scenario - where the market abruptly comes to recognize that the leveraged speculating is hopelessly stuck in illiquid CDO, ABS, MBS, derivative and equities positions - doesn’t seem all that outrageous or distant this week. [emphasis added]