Economic Dreams - Economic Nightmares

Vampire's Lair or Plato's Cave?

I've spend a bunch of time on this blog trying to understand who played what roles in both the run up to, and the meltdown of the recent financial bubble. But I've not, until now covered Matt Taibbi's exposés, or "screeds" as some call them. [Note: I got 179,000 Google hits on "Matt Taibbi"+screed] Taibbi's, The Great American Bubble Machine, Rolling Stone (07/09/2009), libeled Goldman Sachs as a "great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

Ultimately in the court of public opinion, if not in the legal system, we have to come to grips with who among Wall Street players might have been playing the role of bloodmoney-sucking vampires, aided and/or least cheer-led by politicians, regulators, rating agencies, and the media.

However, since it proves too easy to charge others with crimes (or even moral turpitude), we need to introduce a notion that Gillian Tett talked about in Fool's Gold: that many were blind to realities that others readily saw. Some were blinded by their own institutions and subcultures. Some were simply blinded by greed and venality. All were (some still are) among those dwelling in modern-day versions of Plato's Cave (Wikipedia). To these we have to give a pass — I suppose — although we (and they) have lessons to learn about why we need whistleblowers, and why we all need to take responsibility to speak up when we think things seem not right.

In a recent update to his story, Why Isn't Wall Street in Jail?, Rolling Stone (3/3/2011), Taibbi leaves little doubt that a whole bunch of Wall Street players ought to be in jail for their roles in the meltdown of 2007-2009. See also Taibbi's recent interview with Amy Goodman at Democracy Now.

I don't disagree that many ought to be in jail. But "ought to" is easier than "will be." Too many laws (financial regulation, usury, etc.) were relaxed over the last decade or two, and too many people played too many games on both sides of the political aisle as well as on both sides of the regulatory game to make it easy to sort out bad-enough deeds — vampire deeds — to land very many people in jail.

No matter which court (public opinion or legal) we work with, how are we to decide whether folks were knowingly committing fraud? As noted earlier, the media and politicians too were seldom found on the peoples' side of the issue. Regulators and ratings agencies were either hoodwinked or captured. Those few who dared speak up lost their heads, figuratively speaking. Maybe instead we ought to handsomely reward whistleblowers.

Finally, how are we to determine deeds deemed bad enough to constitute fraud, when we know that both organizations and culture trap people into ideological and methodological traps from which few can escape. People become chained as prisoners, and blinded by circumstance in Plato's Cave, as Gillian Tett notes in the epilogue to Fool's Gold (2009):

[T]he financial world's lack of interest in wider social matters cuts to the very heart of what has gone wrong. What social anthropology teaches its adherents is that nothing in society ever exists in a vacuum or in isolation. Holistic analysis that tries to link different parts of a social structure is crucial, be that in respect to wedding rituals or trading floors. Anthropology also instills a sense of skepticism about official rhetoric. In most societies, elites try to maintain their power not simply by garnering wealth, but also by dominating the mainstream ideologies, in terms of both what is said and what is not discussed. Social "silences" serve to maintain power structures, in ways that participants often barely understand themselves let alone plan.

… In recent years, regulators, bankers, politicians, investors, and journalists have all failed to employ truly holistic thought—to our collective cost. Bankers have treated their mathematical models as if they were an infallible guide to the future, failing to see that they were based on a ridiculously limited set of data. A "silo" mentality has come to rule inside banks, leaving different departments competing for resources, with shockingly little wider vision or oversight. The regulators who were supposed to oversee the banks have mirrored that silo pattern, too, in their own fragmented practices. Most pernicious of all, financiers have come to regard banking as a silo in its own right, detached from the rest of society. They have become like the inhabitants of Plato's cave, who could see shadows of outside reality flickering on the walls but rarely encountered that reality themselves. The chain that linked a synthetic CDO [Collatorized Debt Obligation] of ABS [Asset Backed Securities], say, with a "real" person was so convoluted, it was almost impossible for anybody to fit it into a single cognitive map—be they anthropologist, economist, or credit whiz.

Yet the only thing that is more remarkable than this deadly state of affairs was that it went so unnoticed, for so long. [pp.252-3]

Let's leave final words to John Kenneth Galbraith, The Great Crash 1929:

One of the oldest puzzles in politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention it deserves is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

See also: In Plato's Cave, The Economist, 01/22/2009

[Endnote: By their own admission, neither Taibbi nor Tett got their stories perfectly right. But they came close enough. Their main storylines hold true. And if they don't I suspect I'll hear about it soon.]

Reinstate Glass-Steagall: Roubini says yes

I have been keeping an eye on various proposals to "reinstate" Glass-Steagall for quite some time. Sometime I ought to post a more comprehensive list as to who is in favor (and in what sense) and who is opposed. Clearly the folks at New Economic Perspectives (from Kansas City and Beyond) are so inclined. So too Nouriel Roubini, as reported by Tech Ticker, 4/11:

Roubini supports the 'Volcker Rule' which would force banks to stop proprietary trading. "Why should you use taxpayer money to essentially subsidize risky prop trading?," he asks.

Roubini goes even further, saying Congress should reinstate Glass-Steagall which separated commercial banking from investment banking. "If Goldman Sachs wants to be a hedge fund, so be it, but there should be a level playing field," he argues. "Other hedge funds don't borrow at zero rate with the guarantee of the government."

For more on the "Volcker Rule", and financial reform: 5/13 CNN Money video featuring Senator Ted Kaufman, D-Del that is worth a look, and 5/11 link featuring Nouriel Roubini.

Paul Krugman's ideas seem to differ a bit, and seem to be where the Obama Administration is trying to lead Congress. Here's Krugman, Financial Reform 101, 4/1:

It's easy to see where concerns about banks that are "too big to fail" come from. In the face of financial crisis, the U.S. government provided cash and guarantees to financial institutions whose failure, it feared, might bring down the whole system. And the rescue operation was mainly focused on a handful of big players: A.I.G., Citigroup, Bank of America, and so on.

This rescue was necessary, but it put taxpayers on the hook for potentially large losses. And it also established a dangerous precedent: big financial institutions, we now know, will be bailed out in times of crisis. And this, it's argued, will encourage even riskier behavior in the future, since executives at big banks will know that it’s heads they win, tails taxpayers lose.

The solution, say people like Mr. Volcker, is to break big financial institutions into units that aren’t too big to fail, making future bailouts unnecessary and restoring market discipline.

It's a convincing-sounding argument, but I'm one of those people who doesn’t buy it.

Here's how I see it. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same. I don’t have any love for financial giants, but I just don’t believe that breaking them up solves the key problem.

So what's the alternative to breaking up big financial institutions? The answer, I'd argue, is to update and extend old-fashioned bank regulation.

And this is exactly what the Senate is now doing. Sort of. Economics of Contempt (EoC) is generally OK with regulatory reform that doesn't get too bizarre. On the other hand, EoC is particularly against the Sen. Blanche Lincoln's "Section 106" proposal as per derivatives. To EoC, 5/8:

Bloomberg has an excellent story on the origins of Blanche Lincoln's disastrous swaps proposal (the infamous "Section 106") — Bloomberg: How ‘Hard to Fathom’ Derivatives Rule Emerged in U.S. Senate. Short version:

The idea arose from a mix of policy debate, campaign politics and personal relationships -- and little consideration of the business or economic implications, according to interviews with Senate aides, administration officials and industry lobbyists.

Read the whole article. Oh by the way, Paul Volcker has now also come out against Section 106. Sheila Bair penned a letter to Lincoln sharply criticizing Section 106 last week, and the Fed circulated a memo on the Hill a couple weeks ago arguing that Section 106 should be deleted. …

The whole point is that Section 106 doesn't distinguish between prop trading and market-making. It bans banks from doing both. [Robert] Reich clearly has no clue what Lincoln's Section 106 proposal is even about — and yet he's already declared that failing to support it would be "pandering to Wall Street."

Look, this isn't difficult. Swaps are a critical part of modern banking. Just like normal commercial lending requires banks to serve as intermediaries between savers and borrowers, the swaps market also requires intermediaries (known as dealers, or market-makers). These intermediaries borrow short and lend (through swaps) long; they are susceptible to runs; and their disorderly failure can cause severe collateral damage to the real economy. Pretending that swap dealers aren't engaged in an important banking function by refusing to call them "banks" is not just delusional, it's also dangerous. And yet this is what Blanche Lincoln's Section 106 proposal aims to do.

Maybe Section 106 won't last long. According to one source, 5/12 "Reuters was reporting Monday that … Section 106, is going to get excised, perhaps this week."

American Oligarchs and their Minions, take 2

Last Friday, Bill Moyers sat down for an hour with Simon Johnson and James Kwak (authors of The Baseline Scenario and 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.) Watch it in two parts here. The topic of the day was (and will continue to be for the next month or so) financial regulation in the wake of financial meltdown. Among other arguments, Johnson and Kwak make the case for breaking up America's big banks  financial oligarchy. They, with Bill Moyers ever-thoughtful-guidance, help us better understand the the deeds, misdeeds, and too-often blind ideological missteps that brought us to the edge of the abyss, and that keep us in bondage to those who ought have been more concerned with our collective progress than with lining their own pockets with gold.

I continue to be somewhat agnostic on setting up a "size rule" for large financial institutions, but Johnson and Kwak have me leaning in their direction right now.  Here is a snip (from the transcript) arguing for breaking up the big banks:

SIMON JOHNSON: . . . [I say] to all my Republican friends: on Fannie Mae and Freddie Mac, you were right. They became too big to fail. They captured Congress. They were known as some of the most formidable financial lobbyists in the 1990s. They argued for the rights to take on these kinds of risks, okay?

And the Republicans were right. The Republicans called them on this. But now it's the big private banks that have the same incentive structure. That have bulked themselves up so big that you can't let them fail. That's what we saw in September 2008. Hank Paulson looked at his options. And they are all pretty awful. And I'm not a big fan of Hank Paulson, but I think the moment where he looked at it, he was right. That if you let JPMorgan Chase or Goldman Sachs fail, the consequences would have been devastating, because they're so big. It's a Fannie May and Freddie Mac structure come to Wall Street, come to the top guys on Wall Street. And our Republican colleagues and friends should recognize this, they should acknowledge it. And then we can all fix this together.

I also found this commentary on the hedge fund "Magnetar" particularly interesting. It foreshadows what may yet be revealed about many others in the financial industry:

JAMES KWAK: Magnetar is a hedge fund which means that other people gave them money to invest. And their job is to make as much money as possible. And these were the smart guys in the room. They saw that the system was broken. And they found a specific way to exploit it. And they knew that they could go for example, they could go to Wall Street banks and the banks would collaborate in making these extremely toxic securities. Because they knew what the bankers incentives were. They knew that the banker's incentives were to do the deal, to do the transaction, to get the fees up front. And they knew that there was nobody watching out for the investors. There was nobody watching out to make sure that securities they manufactured were actually good securities. But essentially what they were doing is they wanted to short the housing market. And they shorted the market in such a way that they actually made the problem worse, because what they did is they encouraged they tried to create these very toxic securities explicitly so that they could then short those securities. And that's why in a sense, they were they were shorting the American Dream. But what the real story of Magnetar, I think, is that they were exploiting a system that was deeply broken.

So, we like to think that the financial system we have in Wall Street are set up so that as people try to make lots of money they are they are indirectly helping the economy by making sure their capital goes where it's needed most. What the Magnetar story shows us that this is a casino, where you can make money you can make money exploiting the weaknesses in the casino. And it has nothing to do with the American Dream. It has nothing to do with making sure that capital goes to the places where it's needed most.

 Watch the rest of the story. I'll try to update this post as (or if) I see others commenting on on the Moyers, Johnson, Kwak tale.  American Oligarchs and their Minions, "Take One" is here.

Financial Regulation – Principles

This morning I am watching CSPAN's coverage of US Treasury Secretary Geithner at a House Committee on Financial Services hearing on financial regulation and systemic risk. Watch Geithner's opening statment here (via Yahoo! News).

Yesterday, over at Mother Jones Kevin Drum laid out some principles to guide new financial regulation. Drum suggested three and asked readers for more:

- Firmer Regulation Over Leverage, wherever and however it occurs. [To increase] capital adequacy ratios, … lead to similar oversight of hedge funds; ̷ overhaul how capital and assets are calculated; [regulate] effective leverage embedded in complex derivatives; [add] rules about off-balance-sheet vehicles; and so forth.

- Stronger Commitment to Act Countercyclically. …to force the Fed to keep an eye on asset inflation as well as goods inflation; a dedication to limiting credit expansion as well as credit destruction; capital adequacy rules that weren't merely stronger, but that tightened during expansions and loosened during contractions; and stronger down payment requirements for mortgage loans.

- A recognition that the global financial system could stand to have a little more sand in its gears. Something to slow it down just a little bit, … like a small transaction tax [Iverson here: e.g. a Tobin Tax (Wiki link) -- that could act in part as an insurance premium to tax payers against the risk that the tax payer will be required to bail them out]; exchange trading for credit derivatives; and stronger transparency rules.

Here is a combined "Eight Regulatory Principles" list, edited slightly:

• Firmer Regulation Over Leverage, (wherever and however it occurs, e.g. higher capital and margin (leverage) requirements that might be even higher for very large firms/entities that pose potential systemic risk)
• Stronger Commitment to Act Countercyclically (to lean against the wind during both "irrational exuberance" and "irrational pessimism", including adding "asset bubbles to diagostic toolkit)
• Better Control of Cross-border Capital Flows
• Better Firewalls Between Financial Businesses
• Holding Credit Rating Agencies and Auditors Accountable for their Judgments
• Making Financial Transactions as Transparent as Possible (like making them exchange traded, or having adequate clearing houses outside exchanges)
• Better Means to Discourage Speculative-runs-to-ruin (on corporations that show signs of relative weakness during market breakdowns)
• Reformed Incentives for Financial Executives, large in-house traders, etc. (e.g. require some bonuses to be paid in restricted stock that can only be liquidated in say 10 years.)
  

One of Drum's reader suggested three tactical moves. I'll add a fourth:

- Reinstate the Glass-Steagall Act in its final form (prior to repeal)
- Repeal the Gramm-Leach-Bliley Act
- Repeal Commodity Futures Modernization Act of 2000, which enabled unregulated market in credit default swaps, among other things
- Develop more flexibility in"Fair Value Accounting", mark-to-market accounting (e.g. to disallow entities to appear ever-more-wounded during bear raids)

From written testimony and verbal responses to questions, it looks to me like Geithner and Co. intend to cover most if not all the bases outlined in the principles above. But intentions must turn to action! We need to keep watch, as well as to add voice to make for better regulation, better action, and better oversight not only of government but of the private entities entrusted with our money.

PS. In March 23 WSJ online, George Soros offers insight into "Means to Discourage Speculative-runs-to-ruin" by regulating Credit Default Swaps.

------------------------
Update, 3/19/2011: Today, in Stop Killing Messengers, I added two more:

• Protecting Rewarding Whistleblowers
• Hiring High-power Talent

Finally, I'll add that I really don't support reinstating Glass-Steagall, but instead creating a modern version of it.

Ten Trillion and Counting!

Tuesday, PBS Frontline will investigate what it means to add, in the next five years, 10 trillion dollars more debt to the American banking, political and social systems. See Ten Trillion and Counting. In the meantime we experience each day an ever-weakening US dollar, and ever-shrinking job/income picture for middle-class Americans, and an ever-more-anemic US consumption engine for the world economy.

What are to make of it?  One view, see Brad DeLong for example, paints this as a Keynesian economists dream.  DeLong see this as a chance to flood the world with money just in time to avert a total system collapse.  And then a chance to monitor the situation closely to ward off any hyperinflationary consequences that might accrue from the move. (Or maybe I'm putting words/ideas into DeLong's mouth?)

On the left, Paul Krugman sees the situation more darkly. Krugman believes that the Obama Administration, following the lead from the Fed (Ben Bernanke) and the Treasury (Tim Geithner)  continues to dither

…[I]f you think that the banks really, really have made lousy investments, this won't work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don’t have enough assets to cover their debts; that's the Swedish solution, it's what we eventually did with our own.

On the right, Doug Noland sees this as hopelessly misguided as well:

…Washington fiscal and monetary policies are completely out of control.  Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery.  I believe the principal objective should be to avoid bankrupting the country … our policymakers and pundits are operating from flawed analytical frameworks … completely oblivious to the risks associated with the current course of policymaking.

There is indeed great hope policymakers will succeed in preserving the current economic structure.  On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize.  The economy will be, it is anticipated, not far behind.  And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom — perhaps enough even to appear to stabilize the system.  But seeming "stabilization" will be in response to massive Washington stimulus and market intervention — and will be dependent upon ongoing massive government stimulus and intervention.  It's called a debt trap.  …Hyman Minsky would view it as the ultimate "Ponzi Finance."

… [O]ur highly inflated and distorted system requires $2.0 TN or so of Credit creation to hold implosion at bay.  It is my belief that this will ONLY be possible with Trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities.  Private sector Credit creation simply will not bounce back sufficiently to play much of a role.  Mortgage, consumer, and business Credit — in this post-Bubble environment — will not re-emerge as much of a force for getting total system Credit near this $2 TN bogey.  In this post-Bubble backdrop, only government finance has a sufficient inflationary bias to get Trillion-plus issuance.  But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an immediate erosion of confidence and a run on both government and private Credit instruments.  Also as I've written, once the government "printing press" gets revved up it's very difficult to slow it down.  This week currency markets finally took this threat seriously.

I don't know.  For some strange reason, given what I've written here on this blog the last few years, I am still pinning my hopes on Bernanke and Geithner.  I hate the idea of $10 trillion more debt, but I hope that it serves as a systems stabilization mechanism while the longer-term deals are worked out to reset our financial systems (see Ken Rogoff interview noted below.)

For those who want a very good refresher as to why we got into this mess, see Joseph Stiglitz, 'Capitalist Fools', Vanity Fair, Jan 2009  Here is a timeline of events, drawn from Stiglitz that ought to be (hope springs eternal) the subject of an upcoming Congressional hearing:

• 1987 - Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place … "Volcker … understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing, and he found him in a devotee of the objectivist philosopher and free-market zealot Ayn Rand. … Greenspan presided over not one but two financial bubbles. After the high-tech bubble popped, in 2000–2001, he helped inflate the housing bubble."
• 1993 – "When I [Stiglitz] was chairman of the Council of Economic Advisers, during the Clinton administration, I served on a committee of all the major federal financial regulators, a group that included Greenspan and Treasury Secretary Robert Rubin. Even then, it was clear that derivatives [credit-default swaps, and so forth] posed a danger. We didn't put it as memorably as Warren Buffett —who saw derivatives as 'financial weapons of mass destruction'—but we took his point. And yet, for all the risk, the deregulators in charge of the financial system—at the Fed, at the Securities and Exchange Commission, and elsewhere—decided to do nothing, worried that any action might interfere with "innovation" in the financial system.
• 1998 - Brooksley Born, head of the Commodity Futures Trading Commission called for derivatives regulation—"a concern that took on urgency after the Fed, in that same year, engineered the bailout of Long-Term Capital Management, a hedge fund whose trillion-dollar-plus failure threatened global financial markets. But Secretary of the Treasury Robert Rubin, his deputy, Larry Summers, and Greenspan were adamant—and successful—in their opposition."
• 1999 (November) - Congress repealed the Glass-Steagall Act. "Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest."
  … "The most important consequence of the repeal of Glass-Steagall was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking."
• 2001 (June) - "[W]ith a follow-on installment two years later, [President bush] and his advisers seemed to believe that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease—the modern-day equivalent of leeches."
  … "The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly—and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement."
• 2002 (July 30) - "[I]n the wake of a series of major scandals—notably the collapse of WorldCom and Enron—Congress passed the Sarbanes-Oxley Act. … "[I]n the negotiations over what became Sarbanes-Oxley a decision was made not to deal with what many, including the respected former head of the S.E.C. Arthur Levitt, believed to be a fundamental underlying problem: stock options. Stock options have been defended as providing healthy incentives toward good management, but in fact they are 'incentive pay' in name only. If a company does well, the C.E.O. gets great rewards in the form of stock options; if a company does poorly, the compensation is almost as substantial but is bestowed in other ways. This is bad enough. But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices.
  "The incentive structure of the rating agencies also proved perverse. Agencies such as Moody's and Standard & Poor's are paid by the very people they are supposed to grade. As a result, they’ve had every reason to give companies high ratings, in a financial version of what college professors know as grade inflation. The rating agencies, like the investment banks that were paying them, believed in financial alchemy—that F-rated toxic mortgages could be converted into products that were safe enough to be held by commercial banks and pension funds."
• 2004 (April) - the Securities and Exchange Commission "allowed big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process."
• 2008 (October 3) - The Bush administration's response to the crisis itself. "Both the administration and the Fed had long been driven by wishful thinking, hoping that the bad news was just a blip, and that a return to growth was just around the corner. As America's banks faced collapse, the administration veered from one course of action to another. Some institutions (Bear Stearns, A.I.G., Fannie Mae, Freddie Mac) were bailed out. Lehman Brothers was not. Some shareholders got something back. Others did not. The original proposal by Treasury Secretary Henry Paulson, a three-page document that would have provided $700 billion for the secretary to spend at his sole discretion, without oversight or judicial review, was an act of extraordinary arrogance. He sold the program as necessary to restore confidence. But it didn’t address the underlying reasons for the loss of confidence. The banks had made too many bad loans. There were big holes in their balance sheets. No one knew what was truth and what was fiction. The bailout package was like a massive transfusion to a patient suffering from internal bleeding—and nothing was being done about the source of the problem, namely all those foreclosures. Valuable time was wasted as Paulson pushed his own plan, 'cash for trash,' buying up the bad assets and putting the risk onto American taxpayers. When he finally abandoned it, providing banks with money they needed, he did it in a way that not only cheated America’s taxpayers but failed to ensure that the banks would use the money to re-start lending. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks.
  "The other problem not addressed involved the looming weaknesses in the economy. The economy had been sustained by excessive borrowing. That game was up."

If such a Congressional hearing were to happen, I'd like to see some name-economists, Administration supporters and detractors from left and right, as well as US government officials past and present, asked at each point along the timeline:What were you thinking? Why were you thinking it? And how would you now rethink it?

For perhaps the best insights as to where this may go, see the Ken Rogoff video interview on PBS NOW, Mar 14 (23 min)

Just Before the Dawn of a New Era?

I'm not the only "Perma Bear" who is now beginning to hope for another New Deal — by reregulating global finance and banning the wildcat speculation that has been the mainstay of particularly American-led investment banking and finance. No doubt there is still some tough sledding both on Wall Street and Mainstreets around the world. But at least central bankers around the world now know that the old order was indeed as unsustainable as many have been telling them that it was. Here's some of the latest from Doug Noland:

Hoping There's Hope, Doug Noland, Credit Bubble Bulletin, 10/09/2008: This is the first all-encompassing global dislocation of contemporary finance, impacting virtually all economies, markets and asset classes. The media is now all over the "Wall Street" and "banking" crisis. I am of the view, however, that the collapse of the hedge fund industry has moved to the forefront — that it is now at the epicenter of global market upheaval. To watch silver lose more than 20% of its value today in intraday trading; to see the collapse in energy prices; to see the entire commodities complex absolutely routed; to view global currency markets in complete disarray, with double-digit intraday drops in the Brazilian real and Mexican peso; to witness major currencies such as the Australian and Canadian dollars suffer precipitous declines; for benchmark Fannie Mae MBS yields to surge 62 bps in three days; to see Brazilian dollar bond yields jump almost 200 bps in four sessions; for global equities indices to suffer rapid double-digit drops throughout both the developed and "emerging" markets; to witness a 1,000 point intraday swing in the DJIA. All the favorite trades are blowing up, and the leveraged speculating community is in a panic de-leveraging.



There is no doubt that markets are in the midst of an unprecedented liquidation of positions across virtually all asset classes and a vicious unwind of a multitude of investment and trading strategies. The Massive Pool of Global Speculative Finance is being drained. Having watched the ballooning of the hedge fund industry over the past few years in absolute awe, I can say today that an industry collapse would entail the sale (voluntary and forced by the margin clerk) and unwind of literally Trillions of positions. Investors and speculators alike are desperate to flee risk. Having watched the ballooning of the hedge fund industry over the past few years in absolute awe, I can say today that an industry collapse would entail the sale (voluntary and forced by the margin clerk) and unwind of literally Trillions of positions. It has been history's most spectacular speculative Bubble and, especially over the past few years, it became very much global in nature and infiltrated virtually all asset classes. This Bubble is in a full-fledged collapse — entailing unprecedented liquidations — and it's taking global markets down with it. …

Perhaps things will stabilize once the hedge fund liquidations run their course. Treasury (TARP) purchases will commence soon. Fannie and Freddie will be aggressively expanding their market purchases. The Fed is now buying commercial paper, and the Fed and Treasury are working to resolve the dislocation in the "repo" market. Across the globe, governments are in full crisis management mode. There appears universal resolve to bolster financial sectors and stem the collapse. And there were actually some positive indications of stabilization in our Credit system late in the week.



I also hold out Hope that the Trillions of reserves held by global central bankers will provide some buffer to stem financial system collapse. In particular, I am Hoping that China, India, Russia, Brazil and the Middle East have today sufficient reserves to somehow avoid a '90s style financial and economic meltdown. I am Hoping that demand from China, India, Asia and Latin America will help offset inevitable economic downturns in the U.S. and Britain and, hopefully to a lesser extent, Europe. I am hoping that the collapse in energy and commodities prices is more a reflection of acute financial market dislocation rather than a harbinger of synchronized global economic upheaval. I am hoping there is more substance to the dollar’s rally than simply an unwind of bearish dollar bets. And I am hoping that with large capital infusions our deeply impaired banking system will retain the capacity to finance a much less robust but at least functioning U.S. economy. I really Hope everything is not as dire as it appears.

The Mess, Simplified: via TheDeal.com

Here is a simplified, grafic depiction of the mess that has emerged in the wake if the subprime trigger. From The Deal.com:

Chain of Fools
By Matt Miller
Published October 3, 2008 at 4:52 PM

The $700 billion bailout went down in flames at first. Now markets, investors, regulators and taxpayers are milling around trying to digest what to do next.

To understand the mind-boggling enormity of this mess, it's instructive to picture how we got here. Focusing on subprime mortgages or mortgage-backed securities ignores the dense network of links and connections that form an opaque system of derivatives and debt. "Any number of other high-yielding asset classes could have started the crisis," says Paul Mizen, an economics professor and director of the Centre for Finance and Credit Markets at the University of Nottingham School of Economics. "It so happened that the subprime market soured first."

Mizen was writing in the Federal Reserve Bank of St. Louis Review. The Deal decided to use Mizen's article -- "The credit crunch of 2007-2008: A discussion of the background, market reactions, and policy responses" -- as the basis for a graphic. This diagram -- admittedly simplified -- attempts to chart the chain of leveraged causation. It shows how a peak of $600 billion in subprime mortgages could metastasize into trillions of dollars of potentially toxic asset-backed securities, collateralized debt obligations and credit default swaps.

The rationale for such complexities is credit-risk transfer. The realities: securities and leverage so much bigger, more complicated and detached from actual assets that value itself became an abstraction. Writes Mizen: "Investors are far removed from the underlying assets both physically (due to the global market for these assets) and financially (since they often have little idea about the true quality and structure of the underlying assets several links back in the chain)."

Very simply, as the system seized up, no one knew what was held or what was its true value.

Our depiction begins with those subprime mortgages. These were issued by loan originators but usually sold off. According to an earlier Federal Reserve Bank of St. Louis study, about six in 10 subprime mortgages were securitized in 2003, the highest percentage ever.

Securitized subprime mortgages became part of a much larger pool called residential mortgage-backed securities. That includes the only slightly less risky Alt-A mortgages and the higher-grade conventional, jumbo and FHA/VA mortgages. At first RMBS were packaged by mortgage type, but, more recently, they were mixed and matched. FDIC-insured institutions alone held $1.2 trillion of these in 2006.

In turn, these mortgage-backed securities, which the credit agencies anointed with a AAA rating until June 2007, are part of a much bigger pool called asset-backed securities. That market totaled $10.7 trillion in 2006 and included commercial mortgage-backed securities, auto loans, credit cards and student loans.

At the next level, the underlying assets and their values begin to lose definition. Asset-backed securities are divided primarily into a debt-recovery pecking order into tranches -- senior, mezzanine and equity -- and then pooled. These are called collateralized debt obligations. A CDO can be backed by everything from corporate bonds to real estate investment trusts. A collateralized loan obligation is a CDO backed by bank loans. A pool of residential mortgage-backed securities is another way to construct a CDO. (CDOs are also divided between cash CDOs, or those backed by debt instruments yielding cash, and synthetic CDOs, which are backed by other credit derivatives.)

Before these pools are transformed into CDOs, some intermediate steps typically occur. CDO managers borrow from banks, which finance the acquisition of the asset-backed securities. The banks warehouse and reconstitute them.

Meanwhile, managers get sales orders for these CDOs, which are typically acquired by conduits or special investment vehicles, off-balance-sheet, bankruptcy-remote entities. Those are often funded by asset-backed commercial paper, or ABCP, short-term loans, which are in turn sold to banks.

According to the research group Celent LLC, the CDO market in 2006 totaled $2 trillion.

The creation of CDOs isn't the end of the game. CDOs themselves can be divided and combined in various fashions, then sold off. These funds-of-CDO-funds are called CDO squared. That process can be repeated with CDO squared, creating CDO cubed.

Leverage fueled the acquisition of these instruments at every level. The result: A 20% drop in value could easily wipe out an investment. "Investors had concentrated risks by leveraging their holdings of mortgages in securitized assets, so their losses were multiplied," Mizen says.

To mitigate the risk of failure, creditors and holders of these securities bought credit default swaps, a kind of insurance policy originally crafted for corporate debt. An enormous market evolved in the swaps themselves; it more than doubled from June 2005 to the end of 2007. At the start of this year, according to Moody's Investors Service, the notional value of contracts outstanding stood at $62.2 trillion, while replacement value eclipsed $2 trillion.

The disassembly of these various securities could take years. Evisceration of the institutions has already begun. Of the six biggest issuers in 2006 of asset-backed securities, including mortgage-backed securities and CDOs, only two -- GMAC LLC and Royal Bank of Scotland Group plc -- remain in business. Countrywide Financial Corp., Lehman Brothers Holdings Inc., Bear Stearns Cos. and Washington Mutual Inc. are history. [Iverson note: Some hyperlinks to institutions and related emphasis in original omitted here]

HT: Paul Kedrosky

Another Frightening Show About the Economy: NPR Edition

If you want to get really scared/mad about our current financial mess, take an hour and listen to last Friday's version of Chicago Public Radio's This American Experience, titled Another Frightening Show About the Economy.

Act One: The Day the Market Died
Act Two: Out of the Hedges and into the Woods
Act Three: Swap Cops
Act Four: What's Next

A few quick notes:

Act One helps us better understand how the very boring arena of Commercial Paper recently caught the attention of high government officials when the arena suddenly dried up, threatening businesses small and large, state governments, and more.

Act two delves deep into Credit Default Swaps and might be subtitled: How 'Insurance' morphed into 'Speculation' on a massive, unprecendented scale. If you want to get a good feel for these arcane instruments, listen closely. A Snip: "If bad mortgages got the financial system sick, [Credit Default Swaps] helped spread the sickness into an epidemic."

Act Three helps us better understand Regulation (or the lack of it). For example, Why were CDSs not regulated, say, way back in 1998 when Michael Greenberger, then with the U.S. Commodities Futures Trading Division, and others tried to get such regulation? Many in the Clinton Administration and Congress argued, according to Greenburger, "These products are entered into by very sophisticated financial institutions … you and I couldn't buy them … and these people are very, very smart and it is a mistake to let government get in the way." In Dec. 2000, Congress passed a law — as a little-discussed 262 page rider to an Omnibus Appropriations Bill — that credit default swaps and things like them could not be regulated. So it went! So it goes… Nobody was even trying to restrain the investors, turned 'speculators.'

Greenburger concludes, "… The idea that you can have $60 Trillion in a financial market which is more than all the stock sold anywhere in the world and not have any oversight whatsoever is self-evidently absurd, and we are seeing the end result of that today."

Act Four give us some insight into the Bailout Bill as it was, and as it transformed into Law.

And if that whets your appetite, listen/read to Michael Greenberger's Sept. 17 Was Adult Supervision Needed on Wall Street?, also from NPR.

HT: Calculated Risk

60 Minutes Does the Shadow Financial System

Last Night 60 Minutes aired an enlightening 12 min. spot on the Shadow Financial System — in which James Grant blames Wall Street investment houses, in the main, for the mess that not only bought the investment banks to the brink of ruin, but also all but wrecked (so far!) the worlds financial systems. It reminds me of an old line from Sci Fi author Robert Heinlein, paraphrasing, "People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity."

As for mistakes, I agree with some of the 60 minutes interviewees that what happened at the top of the investment banks, and among some of their top traders, was likely more the stuff of outright graft and corruption than the stuff of mistakes. The big mistakes were made by the Fed, by the SEC, the so-called rating agencies, and others — in Congress and several Administrations who failed to see not only the bubbles they were blowing (Nasdaq, the housing bubble, and others around the world), but failed to regulate — were indeed actively deregulating — the financial markets. And not all the government players should be left out of the graft and corruption charges. Blame too a distracted American public more interested in watching "Reality" TV, sports and other amusements, than in watching what was happening to their government, to thier retirement funds, and so on.

Watch it:

Watch CBS Videos Online

A Trillion Here, A Trillion There

Rumor has it that former US Congressman Everett Dirksen once quipped "… a billion here, a billion there, and pretty soon you are talking about some real money." In the last few years we've upped the ante. Now it's a trillion here, a trillion there — on the Wall Street Bailout, on the Iraq War, for instance. It looks like the NeoCons have at least insured that the government will be squeezed in times to come. Their dark dream of Starving the Beast, however, is not a short-term outcome though. Looks like the US government is getting ever-more-powerful by the day and by the year, in both military and financial arenas. Or maybe that was their real dream after all. Sad but likely true: Too few NeoCons will go to jail. Too many of the rest of us will suffer.

Here is Gretchen Morgenson's take on the latest phase of the mess in today's NY Times, subtitled Fixing Others' Mistakes:

…Treasury Secretary Henry M. Paulson Jr. [Paulson] has called the fund the "troubled asset relief program." I'll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis). [Iverson note: Yesterday, Willem Buiter called it a TAD: Toxic Asset Dump ].

And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren't visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.

So what's a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very
minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.

Such is our lot today: They break it. We own it. …

For background, here is yesterday's NY Times look at Hank Paulson and Ben Bernanke's recent takeover of the US financial system: A Professor and a Banker Bury Old Dogma on Markets .

Today Paul Krugman tells us that he isn't sure that the TARP isn't instead just the perverbial 'wool pulled over our eyes':

Thinking the Bailout Through: … Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that's the real plan, Congress has every right to balk.

So what should be done? Well, let's think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn't the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let's not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Yves Smith hates the Paulson/Bernanke plan too, and tries to help us better understand why:

Why You Should Hate the Treasury Bailout Proposal …First, let's focus on the aspect that should get the proposal dinged (or renegotiated) regardless of any possible merit, namely, that it gives the Treasury imperial power with respect to a simply huge amount of funds. $700 billion is comparable to the hard cost of the Iraq war, bigger than the annual Pentagon budget. And mind you, $700 billion is not the maximum that the Treasury may spend, it's the ceiling on the outstandings at any one time. It's a balance sheet number, not an expenditure limit.

But here is the truly offensive section of an overreaching piece of legislation:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure. The measure already gives the Treasury the authority not simply to buy dud mortgage paper but other assets as it deems fit. There is no accountability beyond a report (contents undefined) to Congress three months into the program and semiannually thereafter. The Treasury could via incompetence or venality grossly overpay for assets and advisory services, and fail to exclude consultants with conflicts of interest, and there would be no recourse. Given the truly appalling track record of this Administration in its outsourcing, this is not an idle worry.

But far worse is the precedent it sets. This Administration has worked hard to escape any constraints on its actions, not to pursue noble causes, but to curtail civil liberties: Guantanamo, rendition, torture, warrantless wiretaps. It has used the threat of unseen terrorists and a seemingly perpetual war on radical Muslim to justify gutting the Constitution. The Supreme Court, which has been supine on many fronts, has finally started to push back, but would it challenge a bill that sweeps aside judicial review? …

And Robert Reich said on Thursday that The Bailout of All Bailouts leaves too much room for future Wall Street shenanigans, for future "moral hazard."

… A better idea would be for the Fed and Treasury to organize a giant workout of Wall Street — essentially, a reorganization under bankruptcy, for whatever firms wanted to join in. Equity would be eliminated, along with most preferred stock, creditors would be paid off to the extent possible. And then the participants would start over with clean balance sheets that reflected new, agreed-upon rules for full disclosure, along with minimum capitalization. Everyone would know where they stood. Bad debts would be eliminated. Taxpayers wouldn't get left holding the bag. And there would be no "moral hazard" incentive for future financial wizards to take giant risks with other taxpayers' money.

Today Reich lays out five conditions that ought to be placed on any Bailout:

What Wall Street Should Be Required to Do, to Get A Blank Check From Taxpayers … 1. The government (i.e. taxpayers) gets an equity stake in every Wall Street financial company proportional to the amount of bad debt that company shoves onto the public. So when and if Wall Street shares rise, taxpayers are rewarded for accepting so much risk.

2. Wall Street executives and directors of Wall Street firms relinquish their current stock options and this year’s other forms of compensation, and agree to future compensation linked to a rolling five-year average of firm profitability. Why should taxpayers feather their already amply-feathered nests?

3. All Wall Street executives immediately cease making campaign contributions to any candidate for public office in this election cycle or next, all Wall Street PACs be closed, and Wall Street lobbyists curtail their activities unless specifically asked for information by policymakers. Why should taxpayers finance Wall Street’s outsized political power – especially when that power is being exercised to get favorable terms from taxpayers?

4. Wall Street firms agree to comply with new regulations over disclosure, capital requirements, conflicts of interest, and market manipulation. The regulations will emerge in ninety days from a bi-partisan working group, to be convened immediately. After all, inadequate regulation and lack of oversight got us into this mess.

5. Wall Street agrees to give bankruptcy judges the authority to modify the terms of primary mortgages, so homeowners have a fighting chance to keep their homes. …

I can't wait to see what the next few weeks/months bring. "Interesting Times" indeed! Looks like a good time for me to resume this blog…