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Financial Skeptic Bulletin, October 2008

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Old News ;-)

the US recession is only just beginning. Willem Buiter's, October 2008


Willem Buiter's Maverecon Better to be wise than lucky

The Fed wasted 425 basis points of cuts in the Federal Funds target rate since August 2007 trying to fight a liquidity crunch. And the US recession is only just beginning.

... ... ...

If the liquidity crisis coincides with or is merely the reflection of an underlying fundamental insolvency crisis, recapitalisation of systemically important highly leveraged institutions (HLIs) by the tax payer is called for.

... ... ...

In the US, the UK and the rest of the EU, the financial sector is undergoing both a fundamental solvency crisis (reflecting past reckless lending, investment and funding decisions) and a liquidity crisis. The liquidity crisis is, I would argue, more than just the reflection of an insolvency crisis. After all, (fear of) insolvency is neither necessary nor sufficient for illiquidity. Indeed, in the current phase of the crisis, when the authorities in some countries (Ireland is the most extreme example) have guaranteed most of or even all of the liabilities of the banking system, we can find ourselves in the interesting situation that banks are fundamentally insolvent but nevertheless liquid.

Roubini -- S&P500 May Decline Another 30%

Should in 2009 Roubini be considered as a bullish signal ? ;-) Right now he still probably on mark: he sees economy contracting and another 12 months of recession. Much more painful 2009 then 2008. He expects earnings to decline which represent downside risks. S&P500 can drop to 720 or even 600.

Rest Willem Buiter's Maverecon Better to be wise than lucky

The Fed wasted 425 basis points of cuts in the Federal Funds target rate since August 2007 trying to fight a liquidity crunch. And the US recession is only just beginning.

... ... ...

If the liquidity crisis coincides with or is merely the reflection of an underlying fundamental insolvency crisis, recapitalisation of systemically important highly leveraged institutions (HLIs) by the tax payer is called for.

... ... ...

In the US, the UK and the rest of the EU, the financial sector is undergoing both a fundamental solvency crisis (reflecting past reckless lending, investment and funding decisions) and a liquidity crisis. The liquidity crisis is, I would argue, more than just the reflection of an insolvency crisis. After all, (fear of) insolvency is neither necessary nor sufficient for illiquidity. Indeed, in the current phase of the crisis, when the authorities in some countries (Ireland is the most extreme example) have guaranteed most of or even all of the liabilities of the banking system, we can find ourselves in the interesting situation that banks are fundamentally insolvent but nevertheless liquid.

Roubini- S&P500 May Decline Another 30%

Should in 2009 Roubini be considered as a bullish signal ? ;-) Right now he still probably on mark: he sees economy contracting and another 12 months of recession. Much more painful 2009 then 2008. He expects earnings to decline which represent downside risks. S&P500 can drop to 720 or even 600.

Fed's Yellen: "Economy Contracting Significantly"

Q4 is going to be ugly.
by CalculatedRisk From San Francisco Fed President Dr. Janet Yellen: The Mortgage Meltdown, Financial Markets, and the Economy. Excerpt on the economic outlook:
[R]ecent data on the economy have been deeply worrisome. Data released this morning reveal that the economy contracted slightly in the third quarter. For the fourth quarter, it appears likely that the economy is contracting significantly. Mainly for this reason, inflationary risks have diminished greatly.
For consumers, the credit crunch is one of several negative factors accounting for the decline in spending in recent months. Consumer credit is costlier and harder to get: loan rates are up, loan terms are tougher, and increasing numbers of borrowers are being turned away entirely. This explains, in part, the exceptional weakness we have seen in auto sales. In addition, of course, employment has now declined for nine months in a row, and personal income, in inflation-adjusted terms, is virtually unchanged in extending credit to customers and other counterparties.

Nonresidential construction also is headed lower largely because of the financial crisis; the market for commercial mortgage-backed securities, a mainstay for financing large projects, has all but dried up.
Until recently, weakness in domestic final demand was offset by a major boost from exporting goods and services to our trading partners. Unfortunately, economic growth in the rest of the world has slowed noticeably. ... As a result, exports will not provide as much of an impetus to growth as they did earlier in the year.
emphasis added

"It appears likely that the economy is contracting significantly". Strong words from a Fed president. Q4 is going to be ugly.


steelhead writes:

From Jesse's Cafe Americain "30 October 2008
Even in a "Market Meltdown" and a "Once-In-A-Lifetime Financial Panic...."

...the Other People's Money (OPM) managers can still find time to paint the tape into the end of month.

When this coat dries, they *might* try to slip on one more layer of paint before the weekend, but if we break to the downside we would look for a complete retrace of this rally to retest the lows.

Why? Because it is based solely on speculation, market manipulation and experimentation by the Fed and Treasury. It is not based on anything organic to the economy, neither reform nor restructuring.

Wall Street corruption is one of the biggest impediments to an economic recovery. It has become an inefficient obstacle to capital allocation, price discovery, and real economic growth.

The US financial system represents a general systemic risk to the rest of the world because of the manipulation of the US dollar as reserve currency to serve the short term secular interests of a small but powerful financial elite."

Absolutely correct.

steelhead | 10.30.08 - 5:00 pm | #


Neuromancer writes:

Yes. Leverage is credit. De-leveraging is removing the credit.

Look, when a bank lends out at 40:1, as many German banks did, this means for every dollar of actual capital held by the bank (reserve deposits or whatever) they lend 40. They do this because the feel the risk is low and that they can make more money. Once banks relaize that this is pretty silly, they start taking back those 40:1 ratios down to 10:1. That loss of extended credit, hereby a factor of 4, is a quick and massive loss of credit in the system.

The fed then prints to cover that delveraging (effectively leveraging up the system) by putting in real reserves that can actually be used to realize real losses AND so that banks can still lend at (at least) 10:1. Without the fed, most big banks would simply have gone under and then. Well then, you have a Depression. The wave of business collapse would have been staggering.

In fact, it still may happen. The US has dumped $130b into AIG and it STILL may go under. The derivitce exposure to AIG must be staggering.

Neuromancer | 10.30.08 - 6:11 pm | #

Econbrowser Deflation risk

Inflation is the only real problem in fiat money regime...
Notwithstanding, I think Greg is raising a very valid point. Allowing the overall deflation in the U.S. in the 1930s and Japan in the 1990s was one quite fixable policy error. But perhaps modern macroeconomists have deluded ourselves into thinking that if this policy error had not been made, the whole episodes could have been avoided. How bad would the Great Depression have been if the price level had not fallen? Not as bad as it was, I'm convinced, but maybe still pretty bad.

I still like Brad DeLong's perspective on all this:

Is 2008 Our 1929? No. It is not. The most important reason it is not is that Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929....

They want to make their own, original, mistakes..


Whose Afraid Of Deflation?
In my last post, William Gross said this:

"They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past."

Via Greg Mankiw, who wasn't convinced, came the following:

"In a previous post, I expressed surprise that yields on inflation-indexed Treasury notes are rising. Readers have emailed me a variety of hypotheses, the most common of which is deflation. As one smart economist put it:

Here's one possible answer -- the credit crunch has precipitated a massive expansion of money demand -- a scramble for cash. Despite its best efforts, the Fed has not matched this with a sufficient expansion of money supply. As simple IS-LM would predict, this surge in money demand has raised real interest rates (indicating that monetary policy is perhaps still too tight).

Rising real rates on inflation-indexed bonds and falling rates on nominal bonds also tell us that markets expect this surge in money demand to result in near-zero inflation or even deflation in the years ahead. It's starting to look more and more like 1990s Japan, though hopefully for not as long."

From Michael A. Fletcher's story today in the Washington Post:

"The confluence of trends has some economists worried that the country could be headed for a debilitating cycle of deflation: a period in which weak consumer demand, falling prices and tight credit ignite a downward spiral of still weaker demand and still lower prices. Under this scenario, as some businesses are strangled, joblessness increases, feeding the cycle.

"It was just a few months ago that everyone was obsessed with inflation. Now it's deflation," said Bill Gross, co-chief investment officer at Pimco, an investment management company. "I think it's a possibility."


"Some economists note that a period of price adjustments does not necessarily signal the start of a deflationary spiral.

"Deflation is not the problem we should be worrying about," said Adam Lerrick, an economist at Carnegie Mellon University. "A drop in the level of prices for some goods must be distinguished from a continuous fall of prices. Oil is down to $90 from $140, but does anyone expect it will be $55 a year from now and $35 in 2010?"

Analysts said that a few months of price declines should not be a problem for the economy.

But if prices continue to fall across the board for a prolonged period, the declines will weigh heavily on businesses and consumers, particularly those juggling a lot of debt, which must be paid back even as money is harder to come by.

"For a few quarters, I say bring it on, but not for too much longer," Gross said of deflation. "Capitalism depends on mild inflation. Unless we get it, the dynamics of capitalism sort of move in reverse."
But then, there's this:

"In the United States, policymakers have been much quicker to respond to deflationary threats. Five years ago, as inflation approached 1 percent, spawning deflation concerns, Alan Greenspan, then the Federal Reserve chairman, cut the Fed's benchmark lending rate to 1 percent and the threat was never realized. It is an outcome that gives assurance to some economists.

"As long as governments print money and run deficits, you cannot have deflation," Lerrick said."

So, in the end, doesn't that mean inflation is the only real problem?

Posted by: Don the libertarian Democrat at October 29, 2008 08:32 AM


Of course, doing so is a huge mistake that just pushes the real crash out further.

If we don't have massive deflation soon, we're going to have continued stagflation: wages falling behind inflation in real cost of living (using Roosevelt's, not Reagan's, CPI). In fact, we've had that for 20 years now. The real cause behind falling house prices isn't just the subprime bubble and crash- it's that housing is now unobtanium for a large percentage of the US population when you take away con games like the subprime mortgage market.

Food & fuel are also now quite problematic- you can't afford to live 5 miles out in the country and have an inner-city minimum wage job, there's no way to get to work. Food prices are increasing fast enough that we're seeing charity organizations, last resort for the poor, running out of food in the food banks.

Yes, you're absolutely right that deflation is not to be feared, that the FED can control the deflationary rate. Yes you're right that deflation is not a reasonable forecast because of this. But we're coming very close to the point of the lack of deflation causing a civil war, it's already to the point where a lack of deflation is causing suicide. Is that what you really want?

Posted by: Ted Seeber at October 29, 2008 09:20 AM

naked capitalism Money Market Rates Still Improving, Albeit Slowly

Anonymous said...
BOE fin stability report
Chart 2.5 Share of corporate debt accounted for by businesses with interest payments greater than profits:
2001 = 30%
2002 = 30%

2007 = 27%
2008 = ?
2009 = ?
"I don't know why she swallowed a fly.."

doc holiday said...
Hot money is suddenly making me think Bernanke, helicopters and positive inflation, i.e., The Central Banks seem to be willing to allow currency exchange rates to fall with unified and collective "stealth" intervention, in the form of rate decrease. However, the deflationary ZIRP-like rate decreases which devalue currency seem to have an inverse function of increasing inflationary pressures. In this hyper-volatile roller coaster VIX ride, these engineer gurus want to take us back to the party days of summer where commodities were un-regulated and out of control in a whipsaw environment of speculative manipulation. The Fed rate cut at this point is obviously symbolic and meaningless for economic stimulation, but it does serve as a priming function to re-boot the speculative commodity bubble and open the door for hot money to get back into the business of stimulating volatility and maintaining global systemic instability.

IMHO, if the ZIRP-linked value of currencies connects the deflationary impacts of depreciation to lower yields, hot money will chase after commodity swaps that are based on nothing but speculation. Hence, we will see inflation increase during this recession and a return visit to stagflation with a nice taste of liquidity trap.

This does go back to the concept that tossing a trillion bucks at a hundred trillion is like sprinkling pennies in front of Buffett and watching him get flattened by a steamroller. While there may be some dancing in the streets today and a huge campaign to turbocharge the amplification of the music, the game of musical chairs and hot potato have yet to be played out.

I suggest re-reading some of The Helicopter Ben Bedtime Stories, of which there are many, and here is one example: "This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so."

Anonymous said...
While money rates appear to be improving, the devil is in the details. See this story recently posted on Bloomberg regarding Citi and CSFB charging Nestle, Nokia and others LIBOR + a % of CDS swap spread on their loans. Some bigger cos have managed to cap the rates, but this is a DANGEROUS trend!

CNN Money worries rob workers of sleep

Money worries rob workers of sleep, study shows

Nine of 10 American workers are losing sleep over financial worries, according to a survey released Monday by a company that helps workers deal with wellness issues.

Thirty percent of respondents reported worrying about the cost of living while 29 percent cited credit-card debt.

Keeping up with the rising cost of living and credit card debt were top concerns preventing people from falling asleep, according to the results from ComPsych Corporation, which surveyed employees of companies it serves. Thirty percent of respondents reported worrying about the cost of living while 29 percent cited credit-card debt.

How Credit Default Swap Settlements Are Draining Liquidity From Interbank Market

naked capitalism
This informative discussion that sheds further light on the stresses created by credit default swap settlements comes in the current issue of the Institutional Risk Analytics weekly, "In the Fog of Volatility, the Notional Becomes Payable":
Another example of the ongoing discontinuity in the markets comes in the linkage between the unwind of credit default swap ("CDS") positions written regarding Lehman Brothers, Fannie Mae and Freddie Mac, and dollar LIBOR rates in Europe.

The auction process begun by DTCC, by which holders of CDS on bankrupt Lehman Brothers settled in cash via the DTCC's facility, caused many tongues to wag as to the "net" amount providers of protection must pay to holders of CDS. Several members of the media called last week to ask if Don Donahue, CEO of DTCC, was speaking truth when he said that the net payments on Lehman contracts processed by the DTCC's warehouse were a mere $6 billion or so.

Of course Don Donahue is providing the straight skinny on the flow of transactions which have actually participated in the DTCC auction. But consider that other than holders of CDX and some holders of single name CDS not offended by the prospect of cash settlement, there remain a large number of total holders of CDS for Lehman who do not wish to take cash settlement and indeed are expecting to receive the underlying bonds.

Now the apparent non-event from the Lehman CDS auction is a source of media frustration. Wasn't there supposed to be a breakdown in the CDS markets, a dramatic failure event a la Lehman Brothers? But the merchants of doom should take heart.

The bad effect of the CDS market comes not merely from when there is market dysfunction and an individual counterparty fails. That happens often enough, but the prime broker-dealers clean up the mess quietly so as not to roil the markets. Remember, the dealer already owns the counterparty's collateral through the credit agreement, so there is no point forcing the issue with a messy and noisy bankruptcy. Right? This is why the media rarely hears of fails in CDS.

No, as with the repatriation of the Structured Investment Vehicles onto the balance sheets of C and other money center banks, the true significance of CDS comes when the markets function smoothly, as after a default event like Lehman. The trigger event putting a single name CDS contract in the money results in a liquidity-raising event for the seller of protection, who must fund the purchase of the debt at par less recovery value - whether or not the other party actually owns the debt!

This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers. But remember two things:

We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

As one veteran CDS trader told The IRA on Friday, "It's not that people can't fund, it is that people have got to fund these CDS positions. These banks don't have access to sufficient liquidity internally to fund, so they hit the London markets... The Fed and the other central banks must start to deal with the huge overhang of currently hidden funding needs from the CDS and other derivatives." Another market observer suggests this is precisely why the Fed and other central banks have been furiously putting reciprocal currently swap lines in place.

Then there is the situation with Fannie and Freddie paper, which is currently trading 200-300 over the curve despite the Paulson quasi-nationalization this past August. Some of the very same EU banks that are getting killed on Lehman paper are also taking delivery of GSE paper on CDS positions. In this case, the payout on the CDS is small since the GSE debt is money good, at least in nominal terms, thus the net recovery value is high. But the huge overhang of paper in the markets is making the in theory "AAA" rated GSEs trade like poor quality corporates.

In both cases, the normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks. But as retail and corporate default rates rise, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the real economy.:


Richard Kline said...
So if I follow Risk Analytics here, they are saying that in the Lehman settlement a significant share of CDS counterparties did _not_ in fact clear; instead, they have collateral in hock to primary dealers as pledge to their positions while they are currently frantically trying to raise the cash to actually pay out and get their collateral back. Counterparties were _not_ then fully hedged against their Lehman written swaps (and how could they all be covered, really?), but only fully pledged. The Lehman shoe dropped, then, but hit the footstool, bounced sideways, and has yet to land. Hmm.
ruetheday said...
Re: "OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers"

How is this possible if A) the contracts permit protection writers to request delivery of the insured bonds and B) protection writers actually are refusing cash settlement and demanding delivery of the bonds?

It seems to me that if those two conditions hold, there is no "multiplication of risk" stemming from the multiple of CDS written on specific issues.

Ban Of CDS Gets Some Traction

Moon of Alabama

While not driven by my recommendation to declare all Credit Default Swaps null and void the general idea seem to get a bit of traction.

At The Agonist Sean-Paul Kelly asks:

It seems to me that one of the most significant problems we face right now (and going into the future) is CDSs. What would happen if the Federal Government simply said: "they are all dead trades. if you sold protection you are off the hook, if you bought it, too bad"?

He points to a NYT piece which includes this:

Janet Tavakoli, a finance industry consultant who is president of Tavakoli Structured Finance, said the stock market's gyrations are a result of a severe lack of confidence in the very officials who are charged with cleaning up the nation's mess.
She also suggests that financial regulators impose a form of martial law, allowing them to rewrite derivatives contracts that bind counterparties to terms they may not even comprehend.

Chua Soon Hook who runs a profitable billion dollar fund for Asia Genesis Asset Management explained on Bloomberg TV how CDS are now used to raid leveraged companies and even countries.

Hedge funds and banks load up with cheap credit insurance via CDS for debt of a company or country. They then short that companies stock. With that, the stock value of the company sinks, the default likelihood of that company increases and the value of the CDS bought goes up. This gives the fund money to buy more credit insurance which, as other market participants watch the increasing default spreads, will again increase the default risk of the company and the value of the bought insurance and the value of the short.

Credit insurance can be written, bought and sold in unlimited number. A company's $1 billion total debt can be insured a 100 times and more. Even if the likelihood of a debt default increases only a tiny a bit, a big CDS position in a thinly traded market may dou very profitable deal. Chua suggests to immediately make the writing of any new CDS worldwide illegal.

A scheme similar to the above now gets some interest from New York State and federal prosecutors:

Prosecutors are looking at whether traders manipulated the largely unregulated market for credit-default swaps to drive down the price of financial shares over the last year, people briefed on the investigation said.

In an unregulated over-the-counter market there are no rules and manipulation will be very hard to prove.

It seems to me that a similar raid tactic is now used to profit from problems in some countries:

The cost of insuring Russian bonds against bankruptcy rocketed to extreme levels yesterday. Spreads on credit default swaps (CDS) reached 1,123, higher than Iceland's debt before it sought a rescue from the International Monetary Fund.

Russia has over $500 billion in foreign reserves. The high CDS spread is by all means totally out of whack with reality. But with a rumor here and there, I am sure it can be driven up even more and some holders of some CDS will profit a lot from that.

Like Chua I believe that these CDS make the crisis we are in much worse and create a lot of unnecessary damage in the real economy. If a company has to pay higher interests because of CDS bets against it, jobs get lost.

The markets that should reflect the real economy get out of whack because of unregulated instruments like CDS. The false sentiment they generated then influences the real economy. This is an example of Soros' reflexivity.

So here again the steps to get rid of these:

At the same time:

[Oct 27, 2008] Can the Public Sue the Media for Incredibly Awful Investment Advice?

I think not: freedom of the press... But to follow talking head is probably the worst investing strategy imaginable...
Last summer, when the market first took a swoon, the news media filled its air time and pages with the comments of financial analysts who said that people should hold their stock and that in fact the depressed prices made it a good time to buy. In fact, I dug up this BTP post which refers to BBC radio telling its listeners about the bargain basement stock prices that should encourage buying. That was back when the S&P was more than 50 percent higher than it is today.

As I pointed out at the time, a buy and hold strategy is not always best. It makes sense to look at fundamentals, most obviously the price to earnings ratio. When the ratio is very high, then there is a risk of large losses and less hope for a large sustained gain.

The media should have presented analysts making this obvious point. They rarely did. If the public took the investment advice that they receive through the media seriously, they have lost a huge amount of money in the last year as a result.

--Dean Baker

[Oct 27, 2008] Exclusive

Oct. 27 | Bloomberg

The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion.

The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.

``Securitization was based on the premise that a fool was born every minute,'' Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee on Oct. 21. ``Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''

Eager Adopters

European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros, according to the European Securitization Forum, a trade organization.

Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country's financial system into a hedge fund. All three banks have been nationalized by the government, leading Prime Minister Geir Haarde to advise citizens to switch from finance to fishing.

In Germany, one bank, Landesbank Sachsen Girozentrale, bought $26 billion worth of subprime-backed investments, putting the state of Saxony on the hook for $4.1 billion.

In Japan, Mizuho Financial Group Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.

Shadow Banking

The damage reaches all the way to Australia, where the town council of Wingecarribee, a municipality outside Sydney with a population of 42,000, bought $20 million of securities from Lehman Brothers Holdings Inc. Now, Lehman is in bankruptcy, the town council is in court and the securities are worth about 15 cents on the dollar.

Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.

Beginning about three years ago, investment banks revved the system's engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.

Powerful Technology

``It's a powerful technology that has been driven beyond the speed limit,'' said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey & Co. who wrote a 1988 book popularizing structured finance. ``For the last five years, instead of going 65 mph, they've been gunning it to 140 mph, 150 mph.''

Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost.

During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest.


The word ``securitization'' implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite get paid later and receive more interest.

Securitization's biggest innovation was off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special- purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.

With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.

``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''

Capture the Prize

Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston Inc. raced from bank to bank to convince issuers it was the wave of the future.

William Haley remembers a 10 a.m. meeting in 1987 at Imperial Thrift & Loan Association in Glendale, California. As Haley, at the time a 33-year-old Salomon banker, and his team walked into the conference room to make a pitch, the First Boston team was walking out.

``We exchanged some knowing looks and then tried to beat the pants off them,'' said Haley, who now works at RBS Greenwich Capital Markets Inc., a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group Plc. ``There was a fierce desire to capture the prize.''

First Boston

First Boston, housed in the same New York office tower as McKinsey, was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry Corp., a predecessor of Unisys Corp. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance Corp. in October 1986, the biggest corporate debt issue at the time.

Haley's project was a $50 million deal for Banc One Corp. called Certificates for Amortizing Revolving Debts, or CARDs. It was the first credit-card securitization and a blueprint for the $358 billion of such securities now outstanding. The transaction also gave the banks a way to securitize their own assets and get them off their balance sheets, which allowed the money to be lent all over again.

The strategy was detailed in Ocampo's 282-page book ``Securitization of Credit: Inside the New Technology of Finance,'' which he co-wrote with McKinsey consultant James Rosenthal. Ocampo, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.

McKinsey Book

The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn't embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.

``The McKinsey book helped with credibility with issuers,'' said Haley. ``It wasn't that easy in the beginning. Conferences now have thousands of people, but I remember once in Beverly Hills, I gave a speech and there were maybe 25 people in the audience. They were furiously taking notes, however.''

The new technology was spread around the world by the people who worked on the First Boston and Salomon teams. Salomon's group was led by Patricia Jehle, who later founded Bear Stearns's asset-backed unit. Another member, Michael Hutchins, started the first team at a European bank when he went to Zurich-based UBS AG in 1996. A third, Michael Normile, moved to Merrill Lynch & Co., where he ran its securities business, then switched to London-based HSBC Holdings Plc in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank NV.

Hard Sell

First Boston's team included Walid Chammah, 54, who went on to head debt and equity capital markets at Morgan Stanley and is now co-president of that firm. Joseph Donovan, the banker responsible for the GMAC relationship, went to Smith Barney in 1995, to Prudential Securities in 1998 and two years later took over the asset-backed group at Credit Suisse First Boston after Zurich-based Credit Suisse bought First Boston.

Donovan remembers traveling to Europe for First Boston in the early 1990s, trying to convince Volkswagen AG in Wolfsburg, Germany, and Renault SA outside Paris of the benefits of securitization. It was a hard sell. Europeans, he said, didn't take out auto loans.

``We tried over and over,'' Donovan recalled. ``We were trying to get more issuers, and there weren't any.''

50-Year Pedigree

By the time Donovan went to work for Credit Suisse in 2000, European attitudes had changed. Home-mortgage securitizations were especially appealing, he said, because European banks didn't need a ``50-year pedigree to compete.''

``You don't need a whole equity-research department and relationships with CEOs and CFOs,'' Donovan said. ``You basically needed good computers and distribution. You can always buy a Fannie, Freddie or Ginnie Mae pool. You just go online and buy it. You can't buy a Ford Motor Credit deal, because you have to know people.''

CSFB went from third in underwriting structured finance in 2000, behind Lehman and Salomon Smith Barney, to first in 2001, when it issued $96.3 billion in securities. Its market share increased 50 percent to 12.7 percent. The bank fell to fourth place in 2005, although its volume soared to $144.5 billion.

Exporting Debt

As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf.

``One of the things the United States exported overseas was a debt culture,'' Haley said.

While consumers were snapping up credit cards, Stephen Partridge-Hicks at Citibank in London were figuring out a way to sell the new bonds. Their solution: Alpha Finance Corp., the first off-balance-sheet structured investment vehicle, or SIV.

Alpha was created in 1988 as a way for Citibank, and later Citigroup Inc., to vertically integrate its business like an oil company. The raw material was found in a loan, refined into a security, then sold to a SIV at a profit.

Citigroup, formed in a merger of Citicorp and Travelers Group Inc., which owned asset-backed pioneer Salomon, also got a new product to sell: capital notes that boast returns of more than 20 percent a year. Owners of these notes receive all the excess return when borrowers pay their bills on time, though they are the last to be paid when times get hard.

Citi SIVs

In the beginning, SIVs were small and cautiouial paper and medium-term notes. The SIV could hold only debt rated A- or higher and didn't take any currency or interest-rate risk, according to a 1993 Fitch Ratings report.

Alpha was followed by a slew of SIVs with names such as Beta Corp. and Five Finance. By 2007, Citigroup's SIVs had $90 billion of assets, equal to the stock market value of PepsiCo Inc., making up about one-fourth of the entire SIV industry.

In 2003, the bank was sued by creditors of Enron Corp. for its role in setting up entities that enabled the Houston-based company to move assets off the balance sheet for Chief Executive Officer Jeffrey Skilling. Citigroup paid $1.66 billion in March to settle the lawsuit. Skilling, a former McKinsey consultant, was convicted of accounting fraud and is serving a 24-year prison sentence.

Mismatched Funding

Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day.

``What happened in 2005 was that because of subprime and some other changes, commercial paper and asset-backed securities offered a bigger spread than anything that had ever been in the market before,'' said Deborah Cunningham, chief investment officer of Federated Investors in Pittsburgh, who oversees $235 billion in commercial paper. ``It was hundreds of basis points, as opposed to 10 or 20 basis points before.''

SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007.

Huge Appetite

Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''

To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months.

Among conservative lenders, that rang an alarm: Bankers are taught to avoid such mismatched funding, in which a lender has to pay back money before the borrower has to pay the principal.

``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July.

Reserve Funds

Bent, chairman of New York-based Reserve Funds, said he didn't buy any asset-backed commercial paper until 2007, when the market froze in the wake of the collapse of the Bear Stearns hedge funds. That's when his Reserve Primary Fund began buying castoffs of asset-backed commercial paper at cut-rate prices from other funds.

Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since.

Reserve Primary Fund's implosion, and the subsequent seizing up of two Commonfund portfolios used by universities and endowments to hold cash, triggered a panic in U.S. money markets, cutting off this form of credit to industrial companies and banks. No one could be sure whether the banks held securitizations that had dropped in value, making them insolvent. That set off a series of bank takeovers and bailouts around the world, including a $64 billion capital injection by the U.K. government into that nation's financial institutions and 400 billion euros in loan guarantees pledged by Germany.

Absolute Disaster

``We've created an absolute disaster,'' said Nouriel Roubini, a New York University professor of economics, who predicted the failure of investment banks in a paper he wrote in February titled ``Twelve Steps to Financial Disaster.'' ``The reputation of the United States as a financial center and a leader has been tarnished significantly.''

Also tarnished, if not blackened, is the securitization business itself. Sales of European asset-backed securities, including bonds for car loans and credit cards, fell by 40 percent to 12.7 billion euros in the second quarter, and CDO sales fell by two-thirds to 10 billion euros. In the U.S., mortgage bonds issued by entities not affiliated with the government plummeted to $10.8 billion in the first half of the year, one-twentieth of the $241 billion sold in the same period in 2007.

Cioffi, Bosh

The authors of the 1988 McKinsey handbook on securitization have moved on. Rosenthal, who declined to be interviewed, became a managing director at Lehman and is now in charge of information technology at Morgan Stanley. Ocampo received a patent for risk-controlled investing and founded an institutional fund-management firm, Trajectory Asset Management. The firm doesn't have any structured-finance obligations.

Bear Stearns's Cioffi, 52, was indicted on charges of misleading investors by assuring them that his hedge funds were healthy when he knew they weren't. Cioffi, who now works out of his home in Tenafly, New Jersey, has pleaded not guilty. He declined to comment.

The Bank of New York's Bosh lost his job when his company was merged with Mellon Corp. in June 2007. He's still looking for work.

``You try to do the right thing,'' Bosh said in an interview this month. ``And this is what happens.''

(TOMORROW: A Lehman-Assisted Bank Overdose in Germany.)

[Oct 27, 2008] That emerging market exposure

The next leg of subprime crisis might be not Alt-A loans...

As the world faces up to the risk of emerging market failure, banks' current exposure - as estimated by the Bank of International Settlements (BIS) - is perhaps worth reiterating.

According to Ambrose Evans-Pritchard of the Telegraph, the BIS states that Western European banks hold almost all the exposure to the emerging markets:

They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles.

He quotes Morgan Stanley's currency guru Stephen Jen as saying an emerging market crash is a vastly underestimated risk, which threatens to become "the second epicentre of the global financial crisis".

The big emerging markets banking players are to be found in Austria, Switzerland, Sweden, UK and Spain, with exposure ranging from 50 per cent of GDP (Austria) to 23 per cent (Spain).

Conversely America's exposure is just small wafer of that at 4 per cent.

Meanwhile, among those European institutions already signalling distress on their emerging market exposure:

[Oct 26, 2008] Autumn Is Here. Now for the Fall...

Hat tip to Barry Ritholtz (comments to his article The Big Picture SPX Earnings & Multiples are well worth reading). If we assume eight times earning and $50 per share we will have estimate of ~400-500 for S&P 500. That's really presuppose Japanese type of recession. I hope this is not true...

Oct 25, 2008 | WSJ

"The financial system is undergoing a sea change that is forcing a global sell-down of assets. Even when this is complete, there is likely to be greater restraint when it comes to the use of borrowed money to juice returns.

... consensus estimates peg 2009 aggregate operating earnings for companies in the Standard & Poor's 500-stock index at about $94 a share, according to Thomson Reuters. That figure assumes earnings growth both this year and next.

If those estimates panned out, the S&P on Friday would have traded at what looks like a bargain multiple of about 9.3 times forward earnings.

... it is well above trough valuations of about eight times seen during the depths of the 1970s bear market, according to data from UBS. And the economic outlook, along with the unwinding of the credit bubble, means it is unlikely that earnings will increase this year or next. The better question is how far they will fall.

... Barry Ritholtz, director of research at Fusion IQ, for example, says he reckons that 2009 earnings could drop to about $50 a share. In that case, even a multiple of 14 times would bring the S&P to about 750 -- nearly 15% below current levels."

[Oct 26, 2008] Fire -- by Clay Bennett, Chattanooga Times Free press

Hat tip to Barry Ritholtz. Is that what they mean by the 'FIRE Economy'? You can probably assign particular Fed and Gov characters to four firemen poring water into the bank while all the streets around them are on fire.


Very wise words from Doug Noland:

Only today is it readily apparent what a mess the global pricing system had become. Think in terms of a net Trillion plus U.S. dollars inflating the world each year, of which a large part was recycled through Chinese and Asian purchases of U.S. securities (inflating domestic Credit systems and demand in the process). Think in terms of rapidly inflating economies with several billion consumers (Brazil, Russia, India, and China). Think in terms of the surge of inflation that forced thoughtful policymakers in economies such as Australia, New Zealand and elsewhere to significantly tighten monetary policy. Rising rates, however, only enticed more disruptive speculative finance flowing loosely from (low-yielding) Credit systems including the U.S., Japan, and Switzerland. Speculation could have been as simple as shorting a low-yielding security anyplace to finance a higher-returning asset anywhere. Or, why not structure a complex leveraged derivative transaction that, say, borrowed in a cheap currency (i.e. yen or swissy), played the upside of rising emerging equities markets, and at the same time had triggers to hedge underlying currency and/or market exposure. And the counterparty exposure for a lot hedges could be wrapped up in collateralized debt obligations (CDOs).

And later on he gives the money quote.

The notion that derivatives can be a reliable hedge has proven a fallacy.
One thing was missing in the cartoon; the bucket brigade of homeowners ignoring their houses and pouring their "water" into the source of the firemen's liquidity.

Posted by: AGG | Oct 25, 2008 7:21:31 PM

[Oct 26, 2008] More weak data, hedge-fund selling seen this week

Amid the credit market strains and hedge funds' deleveraging, economists are still adjusting their forecasts downward -- just last week, economists at both JPMorgan Chase & Co. and Citigroup Inc. lowered their U.S. estimate for fourth-quarter GDP to a drop of about 4 percent. According to JPMorgan's Lee, "valuations, in our view, will not define the bottom, but rather an abatement of risk aversion." So, with the economy and the markets in uncharted territory, waiting for the dire headlines to end and gauging investors' sentiment is in some ways more helpful than looking at historical charts and technical factors like price-to-earnings ratios.
Financial News - Yahoo! Finance

Even if stocks have seen their lowest levels, an upturn is not necessarily around the corner.

"When will that occur and what will spur it? Good economic news should, but who knows when that will happen," Detrick said. The Dow's recent range of about 8,200 to 8,600 prices in "a major recession, the biggest recession since the '30s. Hopefully it's wrong and this is a tremendous buying opportunity, but no one knows."

Economists are not optimistic about data this week on new home sales, durable goods orders, third-quarter gross domestic product, personal spending and income, and consumer confidence. All these reports are anticipated to show continued weakness -- GDP in particular, which is expected to come in negative.

Investors are also worried that this week's earnings reports from companies such as Kellogg Co., Kraft Foods Inc., Procter & Gamble Co., Visa Inc. and Colgate Palmolive Co. will reveal signs of an even weaker-than-expected consumer.

The Federal Reserve is expected to lower interest rates by at least a half-point to 1 percent this week. But the rate reduction is already priced into the market and unlikely to calm its restlessness.

One reason: The credit markets remain incredibly constricted, even in anticipation of another rate cut. Bank-to-bank lending rates are down from their highs earlier this month, but are still lofty by historical standards, suggesting that banks continue to hoard cash instead of lend.

This is a troubling sign for companies that rely on banks and the credit markets for borrowing. Demand has all but dried up for bonds issued by companies with less-than-ideal credit ratings -- a huge problem that has yet to be fully felt by the real economy.

"Every week credit markets remain dysfunctional is doing unknown damage to the macro economy," JPMorgan stock analyst Thomas J. Lee wrote in a research note Friday.

Another reason the market is likely headed for more turbulence is the enormous amount of deleveraging going on. When investors like hedge funds deleverage, it means they are getting out of debt and risky assets and building up their cash levels.

Some of the recent deleveraging is due to risk aversion, but some of it isn't even within the funds' control -- investors are asking for their money back, so the funds have to cash out other assets. Often, these assets are typical safe-haven investments like big-name industrial stocks and commodities, because they're the only things that can be sold in the current environment.

"Sectors that traditionally and intuitively should be defensive are really getting punished," Knepp said.

Knepp used the S&P 500's utilities group as an example; this should be a strong sector right now, but it's down about 35 percent year-to-date. Another favorite asset during times of crisis -- gold -- has fallen 20 percent since the beginning of October.

[Oct 26, 2008] Recession fears haunt markets


The U.S. Federal Reserve is widely expected to announce a 50 basis-point cut in overnight rates on Wednesday that would take them to 1 percent, the lowest level since June 2004, with some expecting an even deeper reduction to 0.75 percent.

Advance third-quarter U.S. economic growth data due on Thursday is expected to show a 0.5 percent contraction in gross domestic product after 2.8 percent growth the previous quarter.

"Increasingly, the signs point to a deep and synchronized global recession," JPMorgan economist Bruce Kasman said.

[Oct 25, 2008] Financial Crisis Again on the Border of a Meltdown

Moon of Alabama

Four days ago we mentioned the possibility of a U.S. default. Via naked capitalism we now learn that some folks in Taiwan take such talk seriously:

Regulators in Taiwan ordered insurers to limit their holdings of Freddie, Fannie, and Ginnie Mae paper. The stated reason was that they could not assess the credit risk and could not rely on published ratings. The explicit repudiation of rating agency ratings seems to be the first move of this type. and may be the beginning of a trend.

This statement either shows considerable ignorance or is an early warning of worries about the creditworthiness of the US government.
What calls this action into question, however, is that inclusion of Ginnie Mae on the list. Ginnies are full faith and credit obligations of the US government. If you are worried about the payment risk on Ginnies, then you are worried about the creditworthiness of the US government, period.

On Wednesday Roubini gave a talk at a London hedge fund show (video 45 min, report.) He is getting gloomier again. The major points:

The IMF has $100 to $250 billion it can lend to countries in need. This is now too little. As the NYT reports today, there are talks of 'western officials' to somehow enable the IMF to lend up to $1 trillion to emerging market countries (Brazil, South Africa, Turkey.) The piece does not say where that money would come from.

The Fed has now acknowledge a loss of $2.6 billion on the $29 billion of loans it took over in the Bear Stearns bailout. Those losses will grow. AIG got a $123 billion loan line from the Fed in its bailout. $90.3 billion of these have now been used by AIG to pay off bad bets on Credit Default Swaps. AIG will need more money.

As Roubini says politicians are running out of policy options. The only policy response that I can think of would make a real difference is to declare all credit default swaps null and void.

A finance professional from Shanghai was on Bloomberg TV yesterday and came close to that: Chua Says New Credit-Default Swaps Should Be Banned. He believes that CDS are now used to manipulate (short) some currencies and stock markets and threaten to bankrupt whole countries making the situation even worse than it already is. He may well be right.

With concern of U.S. solvency now being official, some CDS issuers and speculators may think about this and try a trick or two against the U.S. If Soros could break the Bank of England, could some savvy rich folks from Asia or the Gulf try a similar trick on a different country?

The Taiwanese regulators seem to think so.

Posted by b at 06:22 AM | Comments (31)

[Oct 25, 2008] There is no end in sight for this particular storm

Times Online

It is hard to recall a grislier day in the financial markets. We've experienced nastier economic shocks. We've seen bigger share market falls. We've witnessed uglier profit warnings. We've heard doomier pronouncements. But never quite so many squeezed into so few hours.

The GDP numbers were horrific. The British economy is shrinking at a far greater than predicted speed. The pound is collapsing at an astonishing rate, plumbing $1.55 at one point yesterday. Shares slid to new five-year lows.

The world economy no longer looks remotely immune to Europe's and America's woes. Shares in emerging markets, the regions supposed to soften the economic agony in the West, are down by 15 per cent on the week.

Even the most cautious officials have been rocked by the forces threatening the world's financial institutions. "This is . . . possibly the largest financial crisis of its kind in human history," says Charlie Bean, the Deputy Governor of the Bank of England, not a man prone to hyperbole.

The gloom has spread far beyond the world of banking and financial services. Sony, Air France-KLM, Samsung, Microsoft, Daimler, Fiat and Renault are among the groups to have sounded warning notes in the past 48 hours.

The cost of insuring against blue-chip companies defaulting on their bonds ballooned to a record high. The premiums paid on these insurance policies - credit default swaps – are regarded by many officials as the best measure of stress in financial markets, more important even than the wholesale interbank lending rates

[Oct 25, 2008] Martin Wolf - The world wakes from the wish-dream of decoupling

Yet the news is not all bad: inflationary pressures are abating fast. Even so, this hides more bad news. The broken financial system will weaken the transmission from monetary easing to the economy. This will make the coming slowdown last a long time. Even though decisive action has saved the financial system from its recent heart attack, the patient remains enfeebled.

[Oct 25, 2008]Greenspan finds a flaw

The Mess That Greenspan Made

"The role of government regulators leading up to the current financial crisis was the subject of yesterday's gathering of the House Committee on Oversight and Government Reform and, just in case you're a real glutton for punishment, our government has made the entire transcript available in .pdf form - all 201 pages of it. Your tax dollars at work..."

The key replies from the former Fed chairman were that he "found a flaw" in his ideology regarding how markets work, that he was "partially wrong" about derivatives, and that he "made a mistake" in trusting industries and individuals to self-regulate.

But, without a doubt, the big news was the fall from grace.

To wit, this opening exchange:
Henry Waxman: You were perhaps the leading proponent of deregulation of our financial markets, certainly you were the most influential voice for dergulation. You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements:
  • In 1994, you testified at a Congressional hearing on regulation of financial derivatives. You said there was nothing involved with federal regulations that make it superior to market regulations.
  • In 1997, you said there was no need for government regulation of "off-exchange" transactions.
  • In 2002, when the collapse of Enron led to the renewd Congressional efforts to regulate derivatives, you wrote the Senate, "We do not believe a public policy case exists to justify government intervention"
  • And earlier this year, you wrote in the Financial Times, bank loan officers, in my experience, know far more about the risks and working of their counterparties than do bank regulators.
And my question for you is simple: Were you wrong?

Alan Greenspan: Partially. Let's separate these problems into their component parts. I took a very strong position on the issue of derivatives and the efficacy of what they were doing for the economy as a whole...

Waxman: So, you don't think you were wrong in not wanting to regulate derivatives?

Greenspan: Well, it depends which derivatives we're talking about. Credit default swaps have serious problems associated with them...

Waxman: Let me interrupt you because we do have a limited amount of time.
Waxman: Dr. Greenspan, Paul Krugman the Princeton Professor or Economics who just won a Nobel Prize wrote a column in 2006 as the subprime mortgage crisis started to emerge. He said, "If anyone is to blame for the current situation, it is Mr. Greenspan who poo-pooed warnings about an emerging bubble and did nothing to crack down on irresponsible lending".

He obviously believes that you deserve some of the blame for our current conditions. Do you have any personal responsibility for these financial crises.

Greenspan: Let me give you a little history, chairman. There's been a considerable amount of discussion about my views on the subprime market in the year 2000. And indeed, one of our most distinguished governors at the time, Governor Gramlich, who regrettably is deceased but who was unquestionably one of the best governors I've had to deal with, came to my office and said he was having difficulty with the problem of what turned out to be a fairly major problem in predatory lending...

Waxman: He urged you to move with the powers that you had as chairman of the Fed as both the Treasury Department and HUD suggested that you put in place regulations that would curb these emerging abuses in subprime lending, but you didn't listen to the Treasury Department or Mr. Gramlich.

Do you think that was a mistake on your part?

Greenspan: Well, I question the facts of that. He and I had a conversation. I said to him I have my doubts whether that would be successful. But to understand the process by which decisions are made at the Fed it's important to understand...

Waxman: Dr. Greenspan, I'm going to interrupt you. The question I have for you is... You had an ideology ... You had the authority to prevent the lending practices that led to the subprime mortgage crisis, you were advised to do so by many others, and now our whole economy is paying the price. Do you feel that your ideology pushed you to make decisions that you wished you had not made.

Greenspan: Well, remember what an ideology is. It's a conceptual framwork for the way people deal with reality. Everyone has one. To exist, you need an ideology. The question is whether it is accurate or not. And what I'm saying to you is that I found a flaw - I don't know how significant or permanent it is - but I've been very distressed by that fact. But if I may, can I just answer the previous question?

Waxman: You found a flaw in the reality...

Greenspan: I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.

Waxman: In other words you found that your view of the world, your ideology, was not right. It was not working.

Greenspan: That's precisely the reason I was shocked because I was going for forty years or more with very considerable evidence that it was working exceptionally well.

But, just let me finish if I may...

Waxman: Well, the problem is that time is already expired.

[Oct 24, 2008] Another Buy In

Is he in too early ? Is he is trying to catch a falling knife ? As one reader commented: "Remember the Hysenberg uncertainty principle? When you start basing your actions on observation, the thing being observed changes behavior. Barry, I think you are log rolling off Niagara Falls. Try to be more careful and prudent. A lot of people trust you for advice and leadership. Don't get carried away."
The Big Picture
We put some more money to work this morning into the mess -- another 5% -- while I was somewhere over North Carolina, on the way to Tampa. we are now down to 55% cash, from a peak of 80%.

As I noted on October 10, we "scale in over time, in 10% increments, and recognize that the bottoming process can take several months to several quarters to complete. Hence, slowly buying in is the key."

I would expect that another whoosh down will lead us to put another 5-10% to work. I was disappointed to see we didn't get the 1000 point down capitulation. That's probably to pat, and widely expected/hoped for.


We have an entire industry of traders, money managers, institutional investors, etc. who are trained to buy anytime the market drops big. They are all looking for a "capitulation" event, with a spike of fear, because historically it has been profitable to do so. Now what we see is that any time the market opens down big, everybody gets excited and jumps in to buy.

As long as this occurs, we'll never truly see the selling climax that they're looking for. The bottom won't be in until all these traders jump in, and then get smoked when the market falls by another 20% or more. It happened during the depression. It will happen again. The bottom won't be in until NONE of these clowns wants to jump in and buy equities. That will be the final capitulation.


No, Barry is not insane for scaling in slow and easy. Recessions end, even bad ones. Stocks almost always bottom before the recession ends.

There are some massive amounts of equity dumping going on that are not, IMO, based on either the seller's opinion of company fundamentals, the seller's view of the stock technicals, or even the seller's fear of additional market losses.

Rather, the selling reflects the sellers need to raise cash. There is plenty of the other kind of selling, too, of course, but I think there is also a large temporary component to the selling.


We should have another down leg in here to new lows, but, if we are truly in a bear market (my view), it will be less dynamic that the spike low at Dow 7880. The liquidation on that decline will be from individual investors who were shocked at the recent selloff but didn't act.

In bull markets individual investors and institutions are the sellers in spikes because they lack conviction. In bear markets they hold until new lows finally discourage them. The bottom should be a "W" not a "V"

After that, a rally for a few months and then we start down again for a deeper leg


What's going to ignite this recovery? We haven't even gotten into all the job losses. Keep the powder dry friends...this ones got a long way to go. It aint your average Bear Boo-boo....


This is how capitulation works in real time.

The other option is to trade it away, then gain insight. Capitulation only occurs when you have been wrong for a long, long time. Quote for today "Cash will continue to outperform until stocks are no longer fashionable."

And boy will that take a long time. One reluctant convert at a time.


Cash is a position. It is NOT a Mega Bear or a Perma bull. When someone disagrees with you it is not name calling. Do a Google search for stock investing rules. You will find:

This is Investing 101 stuff, if you do not have any capital when the real trend becomes clear what then?

I do not know what that trend is going to be, and yes maybe it will be up.

love you all


For those of you looking for the bottom:
Yes, there were some people that made money during the 30s. It wasn't by looking for a bottom. It was by looking at those boring things like fundamentals. You know, like is there a market for the product the company makes?

For the next few years, the only buyer of market goods in quantities to increase a corporation's profit will be the government. The people are tapped out. It's depressing but it it's the real deal. There is no there, there.

We are going back to a low VIX and dividends as the main investment attraction. Yeah, it's boring but that's the way things are when liquidity is gone.


Those of you that who are so convinced we are going much lower with no rally in between whatsoever, would you be so kind as to explain,in simple terms, the basis for your calls?
1. Apart for financials, I think earnings have barely started to come down.

2. I think people are still focusing on dividends when dividends will be cut as the economy weakens and eps drop.

3. So if you cut future eps, multiples still too high.

4. Too much money sloshing around still. Too many investors salivating with every market drop.

5. True. Markets don't fall in a straight line to the trough. They do bounce around, but I've been in the business long enough to know myself. When I'm invested I spend too much time looking at my stock prices and not enough time doing my research. For the last 5 years, I've been doing my research and I know which prices stocks have to hit for me to pick them up. Now I'm working on the next 5 years.

Also, I know that I have trouble selling the sutff once it bounces up so I'm better waiting for the bottom. Then it falls again and I want to wait for the next leg up. Nope don't want to play that game.

Finally, I have a life. If I'm playing the trading game to catch every bounce from every bottom, it can't focus on anything else. And because I have a life, I tend to miss the bounce backs because I'm not necessarily on the trigger when it's time to sell.

There are many ways to make money and rule number 1 is to know yourself.


Thank you Dan !

I appreciate your arguments, and I really don't disagree with any of them very much. Mine is a trading call (when the easier thing to do would have been to stay mostly in cash).

But I love comments like yours -- healthy debate makes us all better trader/investors.

As to catman -- what we get paid to do isn't greed, its to be opportunistic. Its not greedy when you go to work and get paid -- my job description includes making money for clients when opportunities arise.

As to "the egotism of being right" -- thats more about preventing anonymous trolls (not you) from besmirching a professional reputation. I have no patience for those haters, and I happily delete and ban the same asshat posters again and again.


Yields for BAA-rated paper/bonds are high right now because demand for them is low. In Q1 1930, Baa paper waterfall'ed from a yield of 6% to nearly 13% Q2 1932. Yields for BAA-rated paper/bonds are high right now because demand for them is low.

Note that Moody has A and AA and AAA rated corporate bonds, which did NOT drop as much as the BAA.....This is a telling sign that the bond markets do NOT believe that the debt of these corporations are collectable per whatever period they sell for.

These are bond yields, on not the best rated, but still investment grade corporate bonds. It is the guys closer to the margin. Its not the worst of the worst, but given the fact many corporations don't have stellar ratings these days, you find there are quite a lot of them at or near the margin. Notice also the speed of this collapse. It happened within DAYS compared with the 30's MONTHS. The GDP collapse this implies will be much the same.

We're getting a different rhyme this time round from 1929. In '29 the crash in oct/nov wasn't due to the bonds leading the way. But the April 30 bear market taking away 86% of the DOW WAS led by this paper.

One more reason I fear the chances of a "rally" are gonna be interesting

Posted by: brion | Oct 24, 2008 6:16:22 PM


Scott F. -

Its the economy, silly. Earnings flat-out SUCK. The Alt-A and option ARMs haven't begun re-setting in earnest. We have Birth/Death model catastrophically tilting the unemployment numbers. We have massive demographic (Boomers) that has been socking away the lion share of their income into the market and they are about to begin withdraws, in earnest.

We have banks hoarding capital. We have a FED that has lost control of the one thing they actually control. We have credit card debt that is higher than many countries GDP. We are at a point where each dollar of new debt has a Net negative effect to the GDP.

We have hedge funds blowing up. The alphabet soup the FED has created is not working. Auto makers are a hair away from total implosion. The consumer is close to saying no mas, if they haven't already (see closing and consolidation in retail land).

I have more... shall we go on?

[Oct 24, 2008] Kotok Says Hedge Funds "Definitely" Causing Pushdown in Markets

Oct. 24, 2008 | Bloomberg

David Kotok, chief investment officer at Cumberland Advisors Inc., talks with Bloomberg's Tom Keene and Ken Prewitt about his outlook for the U.S. economy and financial markets, Federal Reserve monetary policy and his recent research.


[Oct 24, 2008] Executives Selling Shares to Meet Margin Calls

Another symptom of equity-market distress. And the New York Times also provides an interesting discussion of the behavioral implications of corporate officers borrowing against their holdings:

When executives own big stakes in the companies they run, investors can rest a little more easily at night, knowing those managers have the shareholders' best interests at heart.

Except when maybe they don't....

Already this month, there have been about $1 billion in sales by company insiders dumping stock to meet margin calls, as lenders' demands for the stock sales are known. According to Equilar, an executive compensation research firm in Redwood Shores, Calif., executives at three dozen companies have disclosed such sales since October....

Under Securities and Exchange Commission rules, executives are typically required to disclose insider sales within two days of making them and indicate why they were sold, including as a result of a margin call. But experts say there are no rules requiring that the public be told ahead of time that an executive has pledged stock in a margin loan or how the borrowed money is being used. It might be a loan to buy more shares of the company's stock - which would indicate a vote of confidence in the shares. Or it might be a loan to buy some other company's stock or something else altogether - possibly a sign that the executive thinks there are better places to invest.

"The disclosure rule is vague," said Ben Silverman, director of research at InsiderScore, which tracks the buying and selling of company insiders.

Over the last 25 years or so, investors have come to take on faith the need for executives to own significant amounts of company stock, as a way to make sure the interests of the people running a company are aligned with those of the shareholders. But the ability to use the shares as collateral for a loan may change that dynamic, said Charles M. Elson, a corporate governance expert at the University of Delaware.

"It may be at certain levels de-aligning," he said. Although individual circumstances may not require public disclosure of an executive's decision to pledge the stock, Mr. Elson said, he argues that the boards of directors should be told.

Paul Hodgson, a senior analyst at the Corporate Library, a governance research group, says it is too easy for investors to be misled when executives are not holding the stock outright. "The disclosure is a problem," Mr. Hodgson said. Most investors will look at the executives' holdings in the proxy statement, he said, and say, " 'They own a lot of stock - they are really committed.'


Mara said...
I have to counter this premise of "They own a lot of stock - they are really committed" since I've encountered that attitude in quite a few people. I'd say the real problem is that stock prices are decoupled from the overall company performance they are meant to reflect. It'd be more accure to say that the execs are committed to jacking the numbers so that the stock's doing well just in time for their options to be exercised. Then crashed when it's time to be gifted more shares.
As for the premise of the article, I agree that the disclosures are too few and too vague to be of help to the avg shareholder. I'm a big fan of cash accounting, no intangibles, no booking future sales ahead. I feel the CEOs job is to get the productivity of the company up, not to play accounting tricks. I'm not very popular with the MBAs at parties...
Lune said...
I agree with anon-6:34.

Merely borrowing against your stock holdings doesn't necessarily undercut your incentive, since you still want that stock to improve in value, and you will still be materially affected by future movements in the stock price.

But my understanding is that many, many CEOs and other executives with stocks execute hedges and other arrangements so that they can essentially "sell" their stocks (i.e. get cash based on current price, with no further gain or loss based on future movements in the share price) without actually selling them so as to avoid having to disclose , I'm not sure how the SEC can require reporting since most of these hedges are private arrangements.

dlr said...
Exactly. Pledging something as collateral doesn't decrease your exposure in any way. The real question is, are executives required to disclose short positions they hold in the company stock (or bonds)?

[Oct 24, 2008] Willem Buiter's Maverecon Credit crunch, effective supply failure and stagflation

And when commercial paper markets also dry up, as has been the case in the current credit crisis, not only SMEs (Small and medium enterprises --NNB) may run short of working capital. Large enterprises, which typically fund themselves through the commercial paper market, are also likely to find themselves off their notional output supply curves because credit is simply not available at any price.

... ... ...

It is likely that, with commodity prices falling globally (relatively and absolutely in most currencies), and with demand getting hammered, especially from the consumer demand side and increasingly from the fixed investment side also, inflation will be dropping sharply globally.

Where the working capital channel of monetary and credit transmission via the supply side are important, however, effective supply failures may, in the short run, reduce or even reverse the domestic inflationary effect of the credit crunch.

Monetary policy makers should, in my view, 'see through' this reduction in domestic disinflationary pressures caused by effective supply (constrained by credit availability) being below notional supply (what supply would be if credit markets were not subject to rationing but functioned normally).

It is the task of credit policy (and banking sector solvency restoring or solvency-boosting measures by the fiscal authorities) to eliminate the gap between effective supply and notional supply.

[Oct 23, 2008] Bianco Calls Fed Liquidity Efforts 'Hyper-Inflationary': Video

Posted by Barry Ritholtz on Thursday, October 23, 2008 | 02:30 AM

in Economy | Federal Reserve | Inflation | Video

Jim Bianco, president of Bianco Research LLC, talks about the Federal Reserve's move to provide up to $540 billion in loans to help relieve pressure on money-market mutual funds, credit market conditions and the outlook for the U.S. economy and stock market.

click for video

00:00 Fed move to buy money fund commercial paper
01:59 Commercial paper market; "shortage" of loans
04:36 U.S. credit markets, Fed liquidity efforts
06:59 Outlook for housing, mortgage markets
07:54 Potential second stimulus a "short-term fix"
09:27 Fannie and Freddie loan, mortgage rules
11:08 Bank lending practices, housing market
13:10 Fed liquidity efforts: impact on inflation
16:01 Outlook for U.S. dollar, stocks: strategy
Running time 19:47

Bianco Calls Fed Liquidity Efforts `Hyper-Inflationary'
Bloomberg, October 21, 2008 13:30 EDT

[Oct 23, 2008] Monetary despotism By Hossein Askari and Noureddine Krichene

Asia Times

$700 billion Troubled Assets Relief Plan (TARP) of US Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke. If recent bailouts and liquidity injection are added together, the price tag could easily amount to 70% of US gross domestic product in 2008.

Certainly, Western central banks have not injected this much in real gross domestic product, that is, in millions of tons of commodities (rice, corn, milk, oil, vegetables, clothing). If they had done so, their action would have been most beneficial. They have only created money out of nothing. Some call it legal robbery, others call legal counterfeiting.

Their action has amounted only to a redistribution of real GDP and real wealth among two groups: the winners (bankers, debtors) and the losers (workers, taxpayers, pensioners, creditors). How will this redistribution take place? The answer is forced inflation.

Bailouts schemes on such a scale have no precedent. They are the outcome of cheap money policy followed in the past decade and the sophisticated speculation, call it financial engineering or exotic finance, which developed complex derivatives, proliferating fictitious credit to gain abnormal returns.

The speculative exponentiation of fictitious assets on the top of each other has made most banks over leveraged in ratios of 1 to 40. In a credit system devoid of securitization, the credit multiplier is finite and cannot exceed six or seven. In a system with securitization, the credit multiplier is theoretically infinite and in practice could reach 50. Certainly, these giant bailouts have changed the rules of the game. Speculators, that is asset funds managers, are now secured by central banks; it is a case of if heads, they win; if tails, taxpayers loose.

The credit to be bailed out, or, if you will, the capital to be recapitalized, is not money that has been channeled to agriculture, industry, commerce, or infrastructure. These sectors rely on long-term capital, financed essentially through equities, or corporate, government or municipal bonds. All productive loans are fully performing and have negligible default.

All the bailouts by central banks and governments are purely for replacing losses of short-term speculative capital that has caused the present financial trauma. Only speculative capital causes financial instability; such was indeed the cause of the Great Depression, brought about by default on speculative loans in stock markets. The bailouts are primarily intended to write off bad debts, so that borrowers can walk free of their debt obligations and enjoy the wealth they had acquired earlier on.

Of course, in this new system of free lunch, everyone would like to become a borrower, as borrowing is the easiest way for acquiring free wealth in form of houses, cars, stocks, appliances and goods. Bailouts are meant to replenish liquidity of asset funds (such as hedge funds, equity funds and so forth) so their skilled managers can keep inventing complex products and earning high financial profits. Bailouts are also intended to buy intoxicated assets (identified in the alphabet soup of MBSs, CDSs, CDOs, and so on). Being free money, some of this money will be used for celebration and retreats in luxurious hotels.

The banking and political establishment would have us believe that these bailouts are meant to save the banking system and allow the economy to borrow, credit markets to unfreeze, and economic prosperity to prevail.

Academics, media and politicians have welcomed with applause the recapitalization of banks. Many have already declared victory, saying the worst is over and the crisis, thanks to this giant recapitalization, is fully resolved. Markets rebounded on the first day in a most spectacular way. Of course, and to be expected, the market then gave up more than its gain in the next two trading days. However, the biggest surprise was that banks unanimously rejected recapitalization but were forced to sign on. They wanted the TARP. This again shows that policy making is in a vacuum of factual data, sound economic analysis, and only follows political pressure or market hiccups.

Economic uncertainty has never been as high. Has the crisis been correctly tackled or has it only been made worse? In view of incredibly huge liquidity injection by major central banks, has money supply become out of control? In view of the incredibly huge bailouts and recapitalization by governments, how will the fiscal deficit will be financed? How long will the crisis last? Which sectors and countries will it affect? What will be its impact on growth and employment? What will be its fiscal and inflationary cost? Will inflation finally run out of control? How soon will another, and far bigger, come due once speculation resurges again? What will be the social consequences among workers?

Western central banks and political leaders, like ostriches, have decided to ignore these questions and perpetuate their misguided policies.

While precise answers to these crucial questions are not possible, it is quite irresponsible not to assess the implications of such monumental bailouts. Absent economic modeling, assessing the macroeconomic consequences of these gigantic bailouts over the short-and-medium-term can only be based on economic theory, extrapolation of recent trends, and empirical experience.

Many scenarios of economic and social chaos are possible, with intensity and duration that cannot easily be predicted. The most feared scenario would be forcefully maintaining unsustainable and overly expansionary fiscal and monetary policies that will rapidly erode real savings and investment, and ignite a runaway inflation and unemployment.

This scenario will be in essence similar to Bernanke's aggressive expansionary policy since August 2007, which set off speculation in commodities markets, triggering food riots and sending food and energy prices to levels that finally disrupted transport sectors, brought world economic growth to a remarkable slowdown and triggered rising unemployment.

Under this scenario, fiscal deficits will soar to unprecedented levels, public debt will rise rapidly, real savings and investment will decline, external deficits will widen, currency will depreciate, real incomes of workers will fall sharply, and real spending will sharply decline, causing unemployment to increase even more rapidly.

As under former Fed chairman Alan Greenspan's credit boom, overabundance of liquidity combined with negative real interest does not help productive sectors; it only fuels speculation by asset funds, Ponzi financing, and deteriorating creditworthiness. Speculators will take advantage again of real negative interest rates and abundant liquidity to re-engage in asset and commodities speculation.

On October 11, the Group of Seven leading industrialized nations stated in a communique that "Crisis Requires Urgent and Exceptional Action. We agree to: Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding. The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate."

However, in of spite their declaration, Western central banks continue to reject adamantly the most important tools for stabilizing monetary policy, and only want to perpetuate, at any cost for the economy, the unsustainable monetary policy that brought about the present financial and fiscal chaos.

It is not understood why Western central banks insist on a cheap money policy and on forcing negative real interest rates, despite the disastrous consequences. Bernanke wants to solve the financial crisis by still reducing the federal funds rate from its present 1.5%. What did he achieve with previous cuts? In an environment where many leading banks are overly leveraged and their assets are impaired, is 1.5% an equilibrium rate for interbank loans? Although the market mechanism is disrupted, could the equilibrium rate be 20% or 30% instead of 1.5%?

The only plausible explanation for such negative real interest rates and massive bailouts is to force speculative losses on taxpayers and workers. Banks are forced into a loss-making situation under the threat of nationalization.

The US and the European economies are recognized as the world's most advanced. Unfortunately, they have in the past decade suffered from central banking despotism. Greenspan ignored criticism for bailing out hedge funds such as LTCM as well as warnings regarding housing speculation. Bernanke and Paulson have only been aggravating financial instability and crippling economic growth.

An economy cannot operate optimally or grow with such immense price distortions or inflationary price pressure. The G-7 has to have a coordinated approach for reining in money supply, re-introducing money and credit targets, and totally freeing interest rates and housing prices. The faster an economy returns to equilibrium prices, the faster recovery will be. In a context of supply-oriented and employment-promoting strategy, credit has to be selectively oriented to productive sectors and much less to speculation. The health of each bank has to be dealt on a case-by-case basis and over a long span of time.

The credit crunch appeared only in speculative financing. If recapitalization is used to fuel speculative credit, then it will be too damaging for economic growth, as seen in the past year. The answer to the present crisis is how to reduce the speculative component of credit without reducing the circulating media (that is, protecting deposits) and how to reallocate credit to non-speculative and growth-generating sectors. These aspects have not been addressed by Western central banks.

It would appear that the Fed and the European central banks have not learned the real lessons of the Great Depression. But they had better start soon.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.

[Oct 23, 2008] Clusterfuck Nation by Jim Kunstler

It looks the the pressure of public discontnt requres opening a safe valve like some level of prosecution to banksters. Nothing serious and just as a self-preservation measure for the ruling elite...

It's fascinating to read the commentators in mainstream journals like The Financial Times and The Wall Street Journal all strenuously pretending that "the worst is over" (maybe... we hope... fingers crossed... hail Mary full of grace... et cetera). The cluelessness would be funny if it didn't involve a world-changing catastrophe. All nations that have reached the fork-and-spoon level of civilization are now engineering a vast network of cyber-cables that lead directly from their central bank computers to the Death Star that is hovering above world financial affairs like a giant cosmic vacuum cleaner, sucking up dollars, euros, zlotys, forints, krona, what-have-you. As fast as the keystrokes create currency-pixels, the little electron-denominated units of exchange are sucked out of the terrestrial economies into the black hole of money death. That's what the $700-billion bail-out (excuse me, "rescue plan") and all its associated ventures are about.

To switch metaphors, let's say that we are witnessing the two stages of a tsunami. The current disappearance of wealth in the form of debts repudiated, bets welshed on, contracts canceled, and Lehman Brothers-style sob stories played out is like the withdrawal of the sea. The poor curious little monkey-humans stand on the beach transfixed by the strangeness of the event as the water recedes and the sea floor is exposed and all kinds of exotic creatures are seen thrashing in the mud, while the skeletons of historic wrecks are exposed to view, and a great stench of organic decay wafts toward the strand. Then comes the second stage, the tidal wave itself -- which in this case will be horrific monetary inflation -- roaring back over the mud flats toward the land mass, crashing over the beach, and ripping apart all the hotels and houses and infrastructure there while it drowns the poor curious monkey-humans who were too enthralled by the weird spectacle to make for higher ground. The killer tidal wave washes away all the things they have labored to build for decades, all their poignant little effects and chattels, and the survivors are left keening amidst the wreckage as the sea once again returns to normal in its eternal cradle.

So, that's what I think we will get: an interval of deflationary depression followed by a destructive wave of inflation that will wipe out both constructed debt and constructed savings, scraping the financial landscape clean. There's no question that stage one is underway. But we can be sure the giant wave of money recklessly loaned into existence in just a few weeks time will wash back through the global economy leaving a swath of destruction.

And then what? The societies of the world will be faced with the task of rebuilding systems of fruitful activity, i.e., real economies based on productive behavior rather than the smoke-and-mirrors of Frankenstein-finance con games. In fact, excuse me while I switch metaphors again, because the Frankenstein story -- the New Prometheus -- is yet another apt narrative to inform us what we have done. We have "played" with financial fire and brought to life a monster now bent on killing us. One question that this metaphor-narrative raises is: when will the angry peasant mob storm the castle with their flaming brands and cries for blood from the makers of this monster? Rather soon, I think. Perhaps, in some countries (maybe the USA, if we're lucky), this will take the more orderly form of systematic prosecutions, bringing to justice persons who perpetrated swindles involving the alphabet soup of investment "products" that have gone bad in so many accounts (and ruined so many individuals, institutions, and governments).

I think it has already begun with the inquisitors summoning the shifty Dick Fuld of Lehman Brothers -- but there are hundreds of other characters like him out there, who scored untold millions of dollars in activities that were simply grand swindles. I wouldn't be surprised if, eventually, Treasury Secretary Hank Paulson found himself in the dock to answer how come, when he ran Goldman Sachs, there was a special unit in the company dedicated to short-selling the very mortgage-backed securities that another unit in the company was so busy pawning off to every pension fund on God's green earth

[Oct 22, 2008] Get Robert Shiller's Yale course for free online

The wisdom of Robert Shiller, described by the FT's Clive Crook as "one of the world's outstanding economic thinkers", is being brought to a wider audience.

Yale University, where he teaches, has just published online the 26 lectures that comprise Economics 252, his introductory course on financial markets. They can be viewed for free or downloaded as MP3 or video files. Transcripts are also available.

I've only had the time to dip into the lectures. Much has happened since they were filmed in the spring, so some of the content has inevitably been overtaken by events.

But if you look at lecture eight for instance – Human Foibles, Fraud, Manipulation and Regulation – there are lots of timeless insights into the psychological tics that influence investor behaviour (including one derived from a cruel experiment on pigeons).

Finally, if Prof Shiller's lectures don't appeal, you could always eavesdrop on a class discussion of Nabokov's Lolita or a course of 24 lectures on France since 1871.

Technology – it doesn't always make us more stupid.

October 22nd, 2008 in Business schools | Permalink

[Oct 22, 2008] Calpers Loses More than 20% Since June

Oct 22, 2008 | Calculated Risk

From the WSJ: U.S. Pension Benefit Guaranty Loses at Least $3 Billion

The U.S. Pension Benefit Guaranty Corporation [PBGC] lost at least $3 billion in stock investments in the 11 months through August ... It is likely that losses will be "substantially worse" after September results are reported, the committee said.
The committee says the losses came in the agency's "trust fund," which holds the assets of terminated plans that have been turned over to the PBGC.
And on Calpers:
[T]he California Public Employees' Retirement System ... said a decline of more than 20% in its assets since June 30 may lead to increased employer contributions to the fund of 2% to 4% starting in July 2010 and July 2011.
The PBGC problems might lead to a bailout and will likely lead to higher insurance premiums for pension plans. The Calpers problems are part of a larger looming pension deficit and retirement funding crisis.

At least retirees can rely on the equity in their homes ... (OK, sorry for the snark).

[Oct 22, 2008] America the Banana Republic by Christopher Hitchens

Hitchens is former neocon and the guy for who exaggerations are a way of life, but still there is some grains of truth in this rant.
October 9, 2008 |

In a statement on the huge state-sponsored salvage of private bankruptcy that was first proposed last September, a group of Republican lawmakers, employing one of the very rudest words in their party's thesaurus, described the proposed rescue of the busted finance and discredited credit sectors as "socialistic." There was a sort of half-truth to what they said. But they would have been very much nearer the mark-and rather more ironic and revealing at their own expense-if they had completed the sentence and described the actual situation as what it is: "socialism for the rich and free enterprise for the rest."

...but another term for the same system would be "banana republic."

... the chief principle of banana-ism is that of kleptocracy, whereby those in positions of influence use their time in office to maximize their own gains, always ensuring that any shortfall is made up by those unfortunates whose daily life involves earning money rather than making it. At all costs, therefore, the one principle that must not operate is the principle of accountability. In fact, if possible, even the similar-sounding term (deriving from the same root) of accountancy must be jettisoned as well. Just listen to Christopher Cox, chairman of the Securities and Exchange Commission, as he explained how the legal guardians of fair and honest play had made those principles go away. On September 26, he announced that "the last six months have made it abundantly clear that voluntary regulation does not work." Now listen to how he enlarges on this somewhat lame statement. It seems to him on reflection that "voluntary regulation"

was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the program and weakened its effectiveness.

Yes, I think one might say that. Indeed, the "perceived mandate" of a parole program that allowed those enrolled in it to take off their ankle bracelets at any time they chose to leave the house might also have been open to the charge that it was self-contradictory and wired for its own self-destruction. But in banana-republicland, like Alice's Wonderland, words tend to lose their meaning and to dissolve into the neutral, responsibility-free verbiage of a Cox.

And still, in so many words in the phrasing of the first bailout request to be placed before Congress, there appeared the brazen demand that, once passed, the "package" be subject to virtually no more Congressional supervision or oversight. This extraordinary proposal shows the utter contempt in which the deliberative bodies on Capitol Hill are held by the unelected and inscrutable financial panjandrums. But welcome to another aspect of banana-republicdom. In a banana republic, the members of the national legislature will be (a) largely for sale and (b) consulted only for ceremonial and rubber-stamp purposes some time after all the truly important decisions have already been made elsewhere.

I was very struck, as the liquefaction of a fantasy-based system proceeded, to read an observation by Professor Jeffrey A. Sonnenfeld, of the Yale School of Management. Referring to those who had demanded-successfully-to be indemnified by the customers and clients whose trust they had betrayed, the professor phrased it like this:

These are people who want to be rewarded as if they were entrepreneurs. But they aren't. They didn't have anything at risk.

That's almost exactly right, except that they did have something at risk. What they put at risk, though, was other people's money and other people's property. How very agreeable it must be to sit at a table in a casino where nobody seems to lose, and to play with a big stack of chips furnished to you by other people, and to have the further assurance that, if anything should ever chance to go wrong, you yourself are guaranteed by the tax dollars of those whose money you are throwing about in the first place! It's enough to make a cat laugh. These members of the "business community" are indeed not buccaneering and risk-taking innovators. They are instead, to quote my old friend Nicholas von Hoffman about another era, those who were standing around with tubas in their arms on the day it began to rain money. And then, when the rain of gold stopped and the wind changed, they were the only ones who didn't feel the blast. Daniel Mudd and Richard Syron, the former bosses of Fannie Mae and Freddie Mac, have departed with $9.43 million in retirement benefits. I append no comment.

Another feature of a banana republic is the tendency for tribal and cultish elements to flourish at the expense of reason and good order. Did it not seem quite bizarre, as the first vote on the rescue of private greed by public money was being taken, that Congress should adjourn for a religious holiday-Rosh Hashanah-in a country where the majority of Jews are secular? What does this say, incidentally, about the separation of religion and government? And am I the only one who finds it distinctly weird to reflect that the last head of the Federal Reserve and the current head of the Treasury, Alan Greenspan and Hank "The Hammer" Paulson, should be respectively the votaries of the cults of Ayn Rand and Mary Baker Eddy, two of the battiest females ever to have infested the American scene? That Paulson should have gone down on one knee to Speaker Nancy Pelosi, as if prayer and beseechment might get the job done, strikes me as further evidence that sheer superstition and incantation have played their part in all this. Remember the scene at the end of Peter Pan, where the children are told that, if they don't shout out aloud that they all believe in fairies, then Tinker Bell's gonna fucking die? That's what the fall of 2008 was like, and quite a fall it was, at that.

And before we leave the theme of falls and collapses, I hope you read the findings of the Department of Transportation and the Federal Highway Administration that followed the plunge of Interstate 35W in Minneapolis into the Mississippi River last August. Sixteen states, after inspecting their own bridges, were compelled to close some, lower the weight limits of others, and make emergency repairs. Of the nation's 600,000 bridges, 12 percent were found to be structurally deficient. This is an almost perfect metaphor for Third World conditions: a money class fleeces the banking system while the very trunk of the national tree is permitted to rot and crash.

... ... ...

At a White House meeting with his financial wizards-and I mean the term in its literal sense-the same chief executive is reported to have whimpered, "This sucker could go down," or words to that effect. It's not difficult to imagine the scene. So add one more banana-republic feature to the profile: a president who is a figurehead one day and a despot the next, and who goes all wide-eyed and calls on witch doctors when the portents don't seem altogether reassuring.

Now ask yourself another question. Has anybody resigned, from either the public or the private sectors (overlapping so lavishly as they now do)? Has anybody even offered to resign? Have you heard anybody in authority apologize, as in: "So very sorry about your savings and pensions and homes and college funds, and I feel personally rotten about it"? Have you even heard the question being posed? O.K., then, has anybody been fired? Any regulator, any supervisor, any runaway would-be golden-parachute artist? Anyone responsible for smugly putting the word "derivative" like a virus into the system? To ask the question is to answer it. The most you can say is that some people have had to take a slightly early retirement, but a retirement very much sweetened by the wherewithal on which to retire. That doesn't quite count. These are the rules that apply in Zimbabwe or Equatorial Guinea or Venezuela, where the political big boys mimic what is said about our hedge funds and investment banks: the stupid mantra about being "too big to fail."

In a recent posting on The New York Times's Web site, Paul Krugman said that the United States was now reduced to the status of a banana republic with nuclear weapons. This is a variation on the old joke about the former Soviet Union ("Burkina Faso with rockets")...

[Oct 22, 2008] The Guys From 'Government Sachs' -

...Goldman's presence in the department and around the federal response to the financial crisis is so ubiquitous that other bankers and competitors have given the star-studded firm a new nickname: Government Sachs.

[Oct 21, 2008] Disappearing Stock-Market Earnings

Felix Salmon

Slide of the Day comes from John Mauldin, via Paul Kedrosky: he shows how estimates for the S&P 500's 2009 earnings have come down from $81.52 in March to just $48.52 now. That's a drop of 40% in seven months.

Here's a list of S&P 500 earnings since 1960; the last time they were below $50 was 2002. So it's probably perfectly reasonable that stock prices are back down to their 2002 levels as well.

[Oct 21, 2008] Robert Reich's Blog The Meltdown (Part IV)

October 20, 2008 | Robert Reich's Blog

Paulson is recapitalizing the banks -- giving them money directly rather than relying on reverse auctions -- largely because he's come to understand that the banks have taken on so much debt that the reverse auction system he told Congress he would use (designed to place a market value on these fancy-dance instruments) will leave too many banks insolvent.

But pouring money into these banks, expecting they'll turn around and lend to small businesses and Main Streets, is like pouring water into a dry sponge. Nothing will come out of it because Wall Street is so deep in debt that the banks are using the extra money to improve their balance sheets. They're hoarding it because their true balance sheets -- considering the off-balance sheet vehicles they created over the past several years -- are in such rotten shape.

In other words, taxpayers are financing a massive effort to save Wall Street's balance sheets from Wall Street's previous off-balance-sheet excesses. It won't work. It can't work. The entire effort is merely saving the asses of lots of executives and traders who got us into this mess in the first place, and whose asses should not be saved at taxpayer risk and expense.

What to do? Immediately require the Treasury to stop the broad Wall Street recapitalization, and require Wall Street to lend the money directly to Main Street. At the same time, force Wall Street to write down its true balance sheets: Let the executives and traders take the hit. Let their shareholders and even their creditors take the hit for Wall Street's colossal irresponsibility. This is the only true way to restore trust. It's also the only way to save Main Street's small businesses, homeowners, students, and everyone else.

[Oct 21, 2008] It Isn't Over Until the Fat Lady Sings

From reader comments: " interest rates cannot be properly determined anymore. They should be high (as Libor is pointing) to encourage lenders to lend to counterparties of doubtful worth (as they will be compensated for extra risk). This is what happens in the high street. But interest rates should also be low to prevent zombifcation of the housing market and an economic depression. Governments can't have it both ways. Low rates for the economy but high rates to compensate lenders for increased loan risk in this environment. It is getting impossible to see a controlled way out of the crisis."
naked capitalism

Big caveat: even though we have very strong opinions, we do not give investment advice. What we provide (aside from commentary) might be regarded as investment hazard warnings. You may nevertheless decide to go ahead after reading what we offer, but we hope you will proceed with caution. One thing most investors fail to realize (and we have made this mistake ourselves) is the warning from mathematician and market maven Benoit Mandelbrot: ""Markets are very, very risky – more risky than the standard theories assume."

The thought for today is that oversold does not necessarily mean undervalued. And a second thought is that the stock market increasingly seems to serve as a quick proxy for how the economy is doing, when it has a strong propensity to give false positives.

A lot of technically-oriented investors saw the market as oversold the week before last and got in, some of them taking some punishment but now sitting on very pretty short term gains. But for mere mortals, studies have repeatedly found that short-term traders do less well than those who take a longer-term horizon (like it or not, if you take a short-term focus, you are competing with folks who have better access to information than you do. And many of them probably have steelier nerves too). Even perennial bear Marc Faber, who has only 7-8% of his portfolio in stocks (and by the sound of it, not US ones either), thinks the market was primed for a technical rally but is not keen on the long-term prospects for the US economy:

``The governments in this world have no other option but to print money. That will lead down the road to inflation,'' Faber said. ``You don't need to be an economist graduated from Harvard to know we're already in a recession. They will just put white paint on a crumbling building....

``To rebuild economic health in the United States, you need a serious recession that will last several years,'' he said. ``The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine.''

So whether or not the market signal is correct, we don't see the credit/economic crisis as close to resolution. The fact that we averted a systemic meltdown is not the same as saying the powers that be found a cure. Consider the factors that have not changed in the last two weeks:
Housing has another 10-15% to fall (see here for a reminder), and that assumes no overshoot or second leg down due to a sharp increase in unemployment. And this won't happen quickly, either. Alt-A and option ARM resets continue at high levels through 2011 (in fact, 2009 is a bit of a lull, so we might have a false sense that the crisis here has passed midway through the year).

More banks are going to hit the wall, both midsized and large concerns. The stress on this front is far from over, even if we do not revisit the panic levels of the last month. Consider these observations from Chris Whalen of Institutional Risk Analytics, who has separately said that mid-sized and small banks will see a considerable amount of distress:

Rather than resolving the crisis, the government's plan to inject capital into big banks is "merely the appetizer and soup course" in what will ultimate be a multi-course meal, says Christopher Whalen..

So what does Whalen see as the main course? Greater government control, if not outright ownership, of the nation's biggest banks, including:

Citigroup, which Whalen says is the "riskiest" of the group because of its exposure to consumer loans.

Bank of America, which faces more Countrywide-related litigation and keeps more of its loans in house, meaning it has "whole loan" risk.

JPMorgan, which is heavily exposed to potential defaults by businesses and is what Whalen calls an "over-the-counter derivatives exchange with a bank attached."

Whalen, lauded for forecasting the banking crisis when most others were sanguine, believes the U.S. banking system is going to face $250 billion to $300 billion in additional loan losses in the coming 6 to 9 months. In anticipation of such heavy losses, banks are now diverting capital into loan loss reserves rather than seeking to make new loans.

The dollar has remained unexpectedly strong (that view is based on disgruntled sounds I have heard from various sources). Most expected continued dollar weakness, although a minority saw the euro taking a big hit before a dollar slide resumed. An orderly fall in the dollar would hopefully not discomfit our trade partners unduly, but a disorderly slide would.

As an aside, I was very surprised to see Bush announce a currency summit, which appears to be on for early November. First, it's a very big move for a lame duck president, and seems particularly odd at this particular juncture (the US is currently in a position of strength via having provided unlimited dollar swap lines to the EU and bailing out AIG, which saved Eu banks from massive writeoffs. One theory is that this is merely symbolic, particularly since not much beyond very general principals could be studied and pre-approved before the pow-wow. But a gathering of this sort, particularly if not well framed, has the potential to expose rifts. The political mavens I have pinged are at a bit of a loss as to what this was about, except perhaps a sop to Sarkozy, who has been very helpful to the US.

The big unresolved issue now is that even though we appear to have avoided a financial meltdown (even Nouriel Roubini thinks that risk has passed), we are still going to see considerable deleveraging, due primarily to the fact that lenders are in no mood to take risk, but compounded by the fact that consumers and businesses are feeling plenty shell-shocked.

We have noted before that even if the Fed gets Libor and the interbank risk measures associated with it down to less stressed levels, that does not mean we are back to status quo ante. First, rates could improve at diminished levels of activity. Second, even if banks do lend to each other, that does not mean that they are going to resume extending credit on anything other than very cautious terms to customers.

Remarkably, Anna Schwartz, who with Milton Friedman, was the author of the pathbreaking monetary study of the Depression that concluded the worst would have been averted had central banks injected more liquidity, said in an interview with the Wall Street Journal that the Fed was using the wrong remedy to this crisis, and was treating it as a liquidity crisis when it is in fact a solvency crisis. Indirectly, that bolsters the view that the relief in the interbank markets may be limited despite the extreme measures taken:

Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue....

. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them..." The only way to "get rid of them" is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson's original proposal to buy these assets from the banks was "a step in the right direction."

The problem with that idea was, and is, how to price "toxic" assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail."...
[H]e's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Anna Schwartz is arguing for something pretty close to the Swedish model: figure out how underwater various banks are. liquidate or sell the worst ones, recapitalize the ones that are impaired but are strong enough to pull through (the Swedes nationalized them; it might be possible to keep them private, but with with substantial government oversight and upside participation), and spin bad assets off into a Resolutions Trust type liquidation vehicle.

So not surprisingly, with an economy on the downturn, even if banks do decide to become freer with lending to their peers, evidence is mounting that they are not going to be as accommodating with their customers. From Andrew Ross Sorkin at the New York Times:

"Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital," Mr. Paulson said in a statement Monday. "And we expect them to do so, as increased confidence will lead to increased lending. This increased lending will benefit the U.S. economy and the American people."...

But Mr. Paulson is making a big assumption about confidence, because until the real economy recovers - which could take more than a year - lending to Main Street is unlikely to return rapidly to normal levels.

"It doesn't matter how much Hank Paulson gives us," said an influential senior official at a big bank that received money from the government, "no one is going to lend a nickel until the economy turns." The official added: "Who are we going to lend money to?" before repeating an old saw about banking: "Only people who don't need it."

From Robert Reich:
The Dow is see-sawing but the reality is that the Bailout of All Bailouts isn't working. Credit markets are largely still frozen. Despite all the money going directly to the big banks, despite all the government guarantees and loans and special tax breaks, despite the shot-gun weddings and bank mergers, despite the willingness of the Treasury and the Fed to do almost whatever the banks have asked, the reality is that credit is not flowing. It's not flowing to distressed homeowners. It's not flowing to small businesses. It's not flowing to would-be homeowners with good credit ratings. Students are having a harder time borrowing for their tuition. Auto loans are drying up.

Why? Because the underlying problem isn't a liquidity problem. As I've noted elsewhere, the problem is that lenders and investors don't trust they'll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years -- the derivatives, credit default swaps, collateralized debt instruments, and so on -- has undermined all notion of true value.

Roubini now foresees a deep recession of at least two years' duration. That does not appear to be part of the newfound stock market cheer. Given Roubini's success in calling this credit crisis, I'd be loath to take a long-term bet against him.


'studies have repeatedly found that short-term traders do less well than those who take a longer-term horizon'

I am a long term investor who started to put money in mutual funds since the late nineties. Sofar I have had no gain. And if I have to belief the doom sayers, I will not earn anything with stocks in the next 5-10 year. So what is exactly long term when 15-20 years does not give a good return? Recently I started to take a look at the history of the Dow index and this has learned me that this period is not unique: between 1965 and 1985 investors didn't earn anything either. In fact, the up trends are much shorter then the down or no net gain trends of the stock index. So I came to the conclusion that these studies of long term horizons must be based upon periods of above 25 years, but most people are not having the luxury waiting 25-30 years before getting a reasonable return. so all that talk about long term horizons is starting to sound pretty shallow to me. I think the stock market is increasingly a casino and long term investors have little to expect.

[Oct 21, 2008] Willem Buiter: "We are laying the foundations of the next systemic crisis"

naked capitalism

One of the reasons I am a fan of Willem Buiter is that he is bracingly candid about his likes and dislikes. And we happen to share a major dislike, namely, the conduct and policies of Henry Paulson.

Buiter lambasts Paulson's gift capital provided to nine large US banks. What is striking is that Buiter is genuinely outraged, seeing this as a very bad deal for the taxpayer and providing all the wrong incentives to the miscreants recipients.

I cannot recall seeing a single US commentator remotely as critical of this deal as Buiter (for the record, we have gone off the deep end more than once as far as Paulson is concerned, but not on this particular action). Why so little outrage when we are going to wind up living with the consequences of these costly handouts to an undeserving industry? AIG was put on a very short leash. Why do Goldman and Morgan Stanley deserve better?

From Buiter:

The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. This is surprising to me, because the complete or partial nationalisations of a number of US financial behemoths earlier in the year represented rather better value for money for the tax payer.

The nationalisation of Fannie, Freddie, AIG and pieces of the nine largest US banks (with more to come) was necessary to prevent a complete collapse of the house of cards we used to know as the American financial system.

Unfortunately, Treasury Secretary Hank Paulson's injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.

In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. By contrast, in the Netherlands, the injection of €10bn worth of subordinated debt into ING bank comes with a price tag that includes two government directors on the board and a government veto over all strategic decisions by the bank.

In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks' discretion, on terms that are highly attractive to the banks. The US tax payer is not only getting a lousy deal compared to private US investors like Buffett, (s)he is also doing much worse than the British tax payer in the UK version of Paulson's capital injection (£37 bn so far out of provisional budget of £50bn). The UK preference shares have a 12 percent yield and come with government-appointed board members.

Even in the cases of AIG, Fannie and Freddie, unsecured senior creditors did not have to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out of this exercise whole. There were no up-front haircuts, charges or mandatory debt-to-equity conversions.

That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending to elephantesquely large financial enterprises. Unless not only the existing shareholders of the banks benefiting from these capital injections but also the holders of the banks' unsecured debt (junior and senior) and all other creditors of the bank (with the possible exception of retail depositors up to some appropriate limit) are made to pay a painful penalty for investing in excessively risky if not outright dodgy ventures, we are laying the foundations of the next systemic crisis, even as we are struggling to escape from the current one.

[Oct 20, 2008] Engine of Recovery

Nouriel Roubini in his latest piece says that "the prospect of a decade-long L-shaped recession...cannot be ruled out."

Regardless of whether you believe him or not, I think we all would agree we are having problems.

What I would like discussed is: What is the engine--or fix--that will bring us out?


Stormy - "What is the engine--or fix--that will bring us out" of a "decade long long L-shaped recession"?

If we make the assumption that this will only be a recession as opposed to a national or global depression, that results in one answer. If one makes the assumption that a pending economic collapse broader than a recession is the probable outcome, perhaps that brings forth another answer.

I'm not convinced that we will only experience a protracted recession.

What will be the engine of recovery? I couldn't answer that until it is clear that the causes of the economic collapse have been checked and corrected, including regulatory reforms.

A future economic environment based on less credit availability, less risk (hopefully), more realty, and a general return to the basics of whatever (and the list is long) suggests to me that whatever recovery occurs will be long and difficult unless we observe a shell game whereby the cash infusions are so large that the previous economic game continues with minor hand slap corrections and minimal oversight protections. If that occurs, what difference does it make? None as far as I know.

I see no quick fix engine if we are to consider a path that returns economic performance to something other than the phony parade we have observed for two decades.

Ok, it won't be housing. It won't be easy credit. Perhaps infrastructure later on. But that probably requires more, credit at government levels.

You raise the right question. And I have no idea what will work this time. The face cards are gone from the deck.
Movie Guy | 10.19.08 - 3:49 pm | #


I totally buy into David Livingston's newly revealed view... ...

that under pricing labor is the root cause of most bubbles from the Great Depression to the the boom to the housing bubble. (Of course I do; under priced labor is my endless one-note complaint.) His thesis is startling simple and makes so much sense: he says that if business squeezes labor's pay way down it causes DEMAND TO DROP while providing business with excess loot with no healthy place to invest it -- don't need more factories while demand is stagnating or going down.

Enter under-regulated markets, especially if there is a going boom: there is a place to put all that excess cash -- as long as the tide is high and looks like it will stay up forever. Stupid investing and under-regulating are necessary but not sufficient conditions. The third necessary condition -- at least to grow the froth into a real, economy wrecking bubble -- is all that excess profit looking for a home.

Movie Guy's second Roubini extract included the following two proposals:

"- public provision of credit to the solvent parts of the corporate sector in order to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;

- a massive direct government fiscal stimulus that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower-income households and provision of grants to cash-strapped local governments"

These are the parts of Roubini's plan which aren't about saving existing banks and, for that very reason, they are the best of his proposals. I'm no expert on the New Deal, but so far as I'm aware recapitalisation of insolvent banks was never part of the Roosevelt agenda. Rather than trying to recapitalise existing banks, the New Deal policies went around them, so to speak, via direct Govt. expenditures. So far as I know (and I make no claim to special knowledge), the New Deal initiatives with regard to the banking industry were mostly regulatory, not aimed at resuscitation by artificial means. That seems to be a (maybe the) major difference between then and now.
gordon | 10.19.08 - 6:02 pm | #

[Oct 19, 2008] 101608_DoddOpeningStatement

Criminal negligence of Greenspan's Fed ?

It is clear that greed and avarice overcame sound judgment in the marketplace – causing some very smart people to act in very stupid ways. But what makes this scandal different from others is the abject failure of regulators to adequately police the markets.

Regulators exist to check the tendency to excess of the regulated. They are supposed to step in to maintain transparency, competition, and fairness in our economy. In this case, though, our nation's financial regulators willfully ignored abuses taking place on their beat, choosing to embrace the same faulty assumptions that fueled the excessive risk-taking in the marketplace. Instead of checking the tendency to excess, they permitted and in some ways even encouraged it. They abandoned sensible and appropriate regulation and supervision.

No one can say that the nation's financial regulators were not aware of the threats posed by reckless subprime lending to homeowners, communities, and indeed the entire country. That threat had already been recognized by Congress. In fact, the Congress had already taken strong steps to neutralize it. In 1994, then-President Clinton signed into law the Home Owners and Equity Protection Act. This law required – let me repeat, required – the Federal Reserve Board as the nation's chief financial regulator to "prohibit" unfair, deceptive, and evasive acts and practices in the mortgage lending market.

Despite this direct requirement, the Federal Reserve under its previous leadership decided to simply ignore the law. Not for days. Not for months. But for years.

Indeed, instead of enforcing the law by simply imposing the common-sense requirement that a mortgage loan be based on a borrower's ability to repay it, the Fed's leadership actually encouraged riskier mortgage products to be introduced into the marketplace.

....It occurred despite warnings from respected economists and others that the Fed and its sister agencies were playing with fire.

Witness Testimony

Honorable Arthur Levitt 101608_LEVITT BankingCommitteeTestimonyFINAL , Jr., Senior Advisor, The Carlyle Group

Honorable Eugene Ludwig 101608_LUDWIG EAL TESTIMONY , Chief Executive Officer, Promontory Financial Group

Honorable Jim Rokakis 101608_Rokakis Testimony , Treasurer, Cuyahoga County, Ohio

Honorable Marc H. Morial 101608_MORIAL Testimony , President and CEO, National Urban League

Mr. Eric Stein 101608_STEIN Testimony , Senior Vice President, Center for Responsible Lending

[Oct 19, 2008] After W., Le Deluge by Maureen Dowd

As for the greatest financial crime of the century an interesting question arises: who will be Greenspan on the deck of cards if the next administration decides to borrow a method that was used in the recent past -- a deck of cards with photos of 52 former Masters of the Universe... " ?
October 18, 2008 |

The best of times because W.'s long Reign of Error is about to end. The worst of times because, well, you know why.

In this season of darkness, as Charles Dickens described an earlier mob scene, I'm feeling as vengeful and bloodthirsty as Madame Defarge sharpening her knitting needles at the guillotine.

I even felt a little thrill go up my leg, as Chris Matthews would put it, when I heard that the Lehman Brothers C.E.O., Richard Fuld, got punched in the company gym after it was announced that the firm was going under.

I can't wait to see the tumbrels rumble up and down Wall Street picking up the heedless and greedy financial aristocracy that plundered and sundered free-market capitalism.

Just when we thought executives of A.I.G., the insurance giant bailed out by taxpayers for $123 billion, had been shamed into stopping their post-bailout Marie Antoinette spa treatments, luxury sports suites, Vegas and California posh resort retreats, we were dumbfounded to learn that some A.I.G. execs were cavorting at a lavish shooting party at a British country manor.

London's News of the World sent undercover reporters to hunt down the feckless financiers on their $86,000 partridge hunt as they tromped through the countryside in tweed knickers, and then later as they "slurped fine wine" and feasted on pigeon breast and halibut.

The paper reported that the A.I.G. revelers stayed at Plumber Manor - not the ancestral home of Joe the Plumber, a 17th-century country house in Dorset - and spent $17,500 for food and rooms. The private jet to get there cost another $17,500, and the limos added up to $8,000 more.

In an astonishing let-them-eat-cake moment, the A.I.G. big shot Sebastian Preil held court at the bar and told an undercover reporter, "The recession will go on until about 2011, but the shooting was great today and we are relaxing fine."

There were at least three New Yorkers bagging birds - Jeffrey Malkovsky, a senior director at A.I.G.'s Manhattan office, Hilary James, the general manager of the Bristol Plaza Hotel, and her friend, John Roberts, an A.I.G. adviser.

Who are these looters of our loot? The New York Times should follow up the excellent Portraits of Grief it did after 9/11 with Portraits of Greed.

Payback doesn't have to go as far as the French Revolution. The grifters shafting us don't have to shed blood, but they do have to give the money back. As far as these self-serving corporate con men and short-selling traders are concerned, off with their headsets.

John McCain wasted his last-chance debate Wednesday by trying to stir up faux class rage against Barack Obama with Joe the Unvetted Plumber instead of tapping into the real class rage the country feels over bailing out ungrateful financiers who gambled away the life savings of working people.

'Tis a far, far better thing that New York's attorney general, Andrew Cuomo, did when he demanded that A.I.G.'s former executives who were trying to abscond with many millions in severance payments, bonuses and golden parachutes surrender the swag. He set a good example for the feds, who slapped Mr. Fuld in the face with a subpoena.

Cuomo got A.I.G. to instantly reverse itself and cancel 160 conferences and other events that would have cost more than $8 million, as well as give up information on compensation, bonuses and other payments to determine whether they were fitting. (How could they be?)

"We stopped a $10 million severance payment to Stephen Bensinger, the chief financial officer," Cuomo told me Friday. "Just look at the words chief financial officer. There's a phenomenon when senior management sees the corporation deteriorating and they concoct a version of looting the company to take care of themselves."

Even Cuomo, who has been locked in battle with A.I.G. for a long time, was stunned when he learned of the British hunting folly. At first he thought it could not be true.

"That was our partridge hunting trip," he said. "The partridge paid the ultimate price, but the taxpayer came close."

He is using a state "claw back" law, which he says allows him to recover contracts and rescind payments if there was unjust compensation.

Great. Now can he find the $123 billion lost by A.I.G. that we now have to plug with taxpayers' money?

Let's hope that if Barack Obama becomes president, the first thing he does is keep his promise to make the junketeers come to Washington (preferably by bus or carpooling) and write the U.S. Treasury a check, after which he will fire them on the spot.

Heads must roll.

[Oct 19, 2008] How Long is the Way Out of the Hole by Christian E. Weller

Oct 13, 2008 | Credit Slips

The stock market just ended its worst week in history. This has sharply eroded families' financial security. Under rather optimistic expectations it would take about six years before families can hope to achieve the same level of financial security as they had at the end of 2007, before the latest round in the financial market crisis took shape.

Often observers will look at how long it took a stock price index after past crises to recover its previous nominal level. This approach has several problems, though. It understates the speed of recovery since it tends to ignore the fact that stock holders will also earn a dividend on their stocks and generally reinvest that dividend, especially if the money is invested in an index fund in a retirement account, such as a 401(k). It also tends to understate the speed of financial recovery for families since most families hold bonds in addition to stocks. So, the drop in stock prices overstates the actual drop in people's portfolios. Looking just at stock prices will, however, overstate the speed of recovery in financial security since it ignores that incomes also rise at the same time -- after all wealth exists primarily as an income replacement measure.

So, consider the following hypothetical scenario that better captures families' financial security. The primary figure to calculate is the ratio of wealth to income. A moderately risk adverse family will invest about 60% of its portfolio in stocks and 40% in bonds. Let's say somebody had $50,000 in wealth and an income of $50,000 at the end of 2007, or a wealth to income ratio of 100%. Since then, stock prices have fallen by 38.0%, dividends have averaged 1.6% of stock prices, bond interest rates amounted to an average of 4.3%, and wages grew by a total of 2.7% during this period. Combine all of this with a portfolio that is allocated 60% in stocks and 40% in bonds and the ratio of wealth to income amounted to 77.2% in September 2008. Financial security took a hit of 22.8% over the past nine months.

What could the future look like? Let's assume that stock gains will amount to 10% per year as a result of higher prices and dividend yields. At the same time, let's assume that interest rates on bonds will average 7% each year. At the same time, let's assume that wages will rise by 4% annually. All of these growth rates are before inflation. Put this all together and you will see that it will take a little under six years before the ratio of financial wealth to income will equal 100% again.

It could take much longer for families to recover their previous level of financial security, though. For instance, stock prices could continue to fall further or it could take some time before they start rising again. Also, families may take money out to pay bills or they may simply convert their money to cash to limit their losses. Further, some of their assets will be taken up by fees for financial services. All of these factors could substantially lengthen the time that it takes to reach prior levels of financial security.

On the other hand, the recovery in financial security could come more quickly. Most importantly, families may decide to save more, which is a little hard to imagine in the current economic environment.

No matter how families will react to the current crisis, it is important to realize that it will likely take years to recover the losses in families' financial security over just a few weeks.

[Oct 19, 2008] Wealth Destruction by the Numbers

Oct 13, 2008 | Credit Slips

Financial markets went into free fall in late September and early October. The third quarter of 2008 continued the wealth destruction that took place in the previous nine months. This wealth decline is large, broad, and quick.

The primary reason for wealth building is retirement. Many families nearing retirement, though, relied primarily on their homes for their retirement income. According to the Federal Reserve, only 62.9% of families between the ages of 55 and 64, had a retirement account, such as a 401(k) or IRA, in 2004. The typical holding in such accounts was $83,000 in 2004 dollars.

In comparison, 79.1% of such families owned their own house with a total typical value of $200,000. In other words, policymakers need to take a comprehensive view at restoring family wealth in an effort to strengthen retirement income security. Much of the policy attention has been on protecting housing wealth. Policy responses, though, need to match the problem, specifically by fostering a pension renaissance and by vastly improving existing retirement savings plans in addition to protecting housing wealth.

Calculations based on data from the Federal Reserve show that the decline in household wealth was very large. In inflation adjusted 2008 dollars, total household wealth fell by $4.5 trillion from September 2007, the last wealth peak, to June 2008. Included in this total wealth loss was a drop of home equity by $1 trillion. Also, total wealth in pension plans – traditional defined benefit pensions, pension plans for state and local government employees, pension plans for federal employees, and retirement savings plans, such as 401(k) plans – fell by $1.2 trillion during those nine months.

It is especially important to consider total wealth relative to disposable income. Total wealth is a store of future income that can be used to replace income, for instance, in the case of retirement. Relative to disposable income, wealth has also dropped sharply. Total wealth amounted to 517.4% of disposable income in the second quarter of 2008, the lowest level since September 2003. Also, financial wealth totaled 275.8% of disposable income in June 2008, which was also the lowest level since September 2003. More dramatically, though, home equity fell to 81.2% of disposable income in June 2008, the lowest level since December 1976.

The drop in household wealth was very fast. For instance, the decline in real total household wealth was an annualized average loss of 10.2% for the three quarters from September 2007 to June 2008. In comparison, during the first three quarters of the downturn in the early 2000s, from March 2000 to December 2000, the rate of decline averaged to an annualized 6.8% and for the entire wealth loss streak from March 2000 to September 2002 it averaged to 7.1%. That is, the current wealth loss is more than 40% faster than during the last period of wealth loss.

The loss in housing wealth was even more breathtaking. Home equity shrank at an annualized average rate of 17.8% from September 2007 to June 2008. This was the second highest drop in real home equity over a three quarter period on record and the largest such decline since the first three quarters of 1974.

Against this backdrop, it is tantamount for policymakers to focus not only on protecting housing wealth, but also help to build other forms of retirement wealth, e.g. by encouraging a pension renaissance and by vastly improving retirement savings plans, such as 401(k) plans.

[Oct 19, 2008] It's Still the Economy by Christian E. Weller

Oct 13, 2008 | Credit Slips

You can't be serious!

Federal Reserve chairman Ben Bernanke says what anybody with a passing interest in economics already knows -- that it will take time for the economy to turn the corner -- and the market tanks. The market seemed punch drunk on the massive stabilization packages -- $2.5 trillion and counting -- that the industrialized world was showering on failing financial institutions.

A mere 36 hours later, though, Wall Street realized that it cannot regain its strength without a healthy Main Street. It was a weakening labor market, following a bursting housing bubble, that contributed to the massive foreclosure wave and to the crisis.

No amount of tinkering with the stabilization package will detract from the fact that people and businesses need more income, not loans, to pay their bills and to invest in their future. It should be clear by now to everybody, even extremely myopic financial markets, that the next policy step lies in helping U.S. businesses and families back on their feet through a well designed second economic stimulus.

[Oct 19, 2008] Wall Street: A new Iraq War By Pepe Escobar

Oct 10, 2008 | Asia Times

The Wall Street US$810 billion - and counting - bailout is being interpreted by millions of angry Americans as no less than a class struggle weapon of mass destruction. It may cost US taxpayers over $2 trillion after real interest payments are added. Yes, this bailout is a second Iraq war.

Even the initial Bush/Paulson numbers - everyone remembers those $700 billion - came out of nowhere. As a US Treasury spokesman told Forbes magazine, "It's not based on any particular data point ... We just wanted to choose a really large number."

So Americans will soon be listening to the sound, not of music, but of over a trillion dollars of their future taxpayer earnings being sucked-up by Goldman Sachs, Citibank, Bank of America and JP Morgan Chase. The Bank of China will also collect. There's absolutely no guarantee any of these banks will put the money back into productive US investments.

The US Treasury - that is, Treasury Secretary and former Goldman Sachs CEO Hank Paulson - will print money like crazy, just like during the Latin American crisis of the 1980s. And who is the Treasury hiring to decide which banks and which debts to buy up? Wall Street experts.

So this is a new Iraq war in more ways than one. In Iraq, Washington subcontracted the war to private military outfits, like Blackwater. Now it's time for Wall Street to pull its own Blackwater.

Did the US Congress make at least an effort to appoint a group of independent experts to analyze the whole mess? No, it didn't. The bailout ballet was staged to perfection. Representative Marcy Kaptur, Democrat from Ohio, was one of the few to denounce the intimidation tactics and the fearmongering atmosphere on the House floor. Representative Brad Sherman, Democrat from California, warned that martial law would be imposed in the US if the bailout did not pass.

Let's assume, for the sake of argument, Americans would want to vote out all the politicians who supported the bailout. They simply can't. Because there are not enough third-party candidates - or progressives - to replace them; this is the realm of money politics, and they simply cannot compete with the Democratic or Republican machines. Not to mention that two-thirds of the Senate - which also approved the bailout - are not up for re-election.

The economists' man
The Economist magazine - the voice of the City of London - says that economists are mostly Barack Obama cheerleaders. But what was Obama doing before the bailout was approved? Both Obama - and McCain - were frantically calling House representatives to change their "no" vote into a "yes".

Were there other options apart from the biggest redistribution of wealth - this one towards the top, not the bottom - since the 1917 October Revolution in Russia? Of course there were. One of them was offered on the pages of the Washington Post by two respected Yale economists. [1] Essentially, it says "pay off all the delinquent mortgages".

John McCain, in a desperate Hail Mary pass trying to stop the bleeding in his campaign, came up with more or less the same proposal ("It's my idea, not Senator Obama's") at the presidential debate - stunning all the punditocracy.

But he didn't know how to sell it. He didn't explain where the funds - expected to be upwards of $300 billion - would come from, he didn't say that the bailed-out banks under Bush/Paulson could in fact buy up mortgages, and on top of it, he incurred the ire of large sections of his already irate "base".

The Obama campaign, caught off guard, responded the next day via Obama economic adviser Jason Furman: "The biggest beneficiaries of this plan will be the same financial institutions that got us into this mess, some of whom even committed fraud."

Obama, for his part, bought the bailout hook, line and sinker - and has been busy trying to justify it on the campaign trail. He may be leading the polls - even before the debate - but this has more to do, according to the Washington Post, with "negativity about the country's financial prospects" than an Obama plan B to deal with the financial crisis. Obama was never pro-active - he was reactive to the Bush/Paulson plan, which then became the Bush/Paulson/Pelosi/McCain/Obama bailout plan.

Obama could have called dozens of economists to educate him about the financial crises in Mexico in 1997, Brazil in 1999 and Argentina in 2001. He could have learned how Sweden dealt with its own crisis in 1989 - yes, they pay high taxes but have one of the highest standards of living in the world.

All this when Paulson - Mr Goldman Sachs himself - revealed that the first bad debts would be bought up only after the November 4 elections. So American voters won't even evaluate if the bailout worked (the markets, for their part, have already said "no") before they elect Obama or McCain and their new House representatives.

So there was no US national debate. Could it be because, according to the nonpartisan Center for Responsive Politics, those who voted "yes" had received 41% more money from the financial sector over their congressional careers than those who voted "no"? As the Center points out, "election after election, the finance, insurance and real estate sector has been the top campaign contributor in federal politics, giving more than $2 billion to federal candidates and political parties since 1989."

Whoever is elected, Obama or McCain, will inherit this supreme Bush administration-made toxic mess - which includes the biggest fiscal and foreign deficits in US history, a fiscal debt currently at 70% but bound to explode to about 90% of US GDP, and no control of monetary policy.

Both Obama and McCain, during the debate, have adamantly refused to admit that the US economy will get much worse before it gets better. McCain has already admitted, on the record, that he knows virtually nothing about the economy - his top economic adviser was uber-deregulator Phil Gramm, the eminence grise who said America is a "nation of whiners".

As for Obama, these are some of the questions he is not answering at the moment:

  • How deep will the recession be?
  • Will the US invent another bubble to try to dribble the recession?
  • And, if that is the case, will that be an military-industrial complex bubble? Or a disaster-capitalism bubble?

    'A new world is coming into being'

    The McCain campaign strategy in the face of all this is simple: more sleaze, in the form of a barrage of unsubstantiated attacks on Obama on the campaign trail (he's a dangerous black man, maybe a Muslim, and maybe a terrorist) by the lipstick pitbull from Alaska, mooseburger-eating creationist hockey mom Sarah Palin, who seems to have better things to do than reading the Constitution, or picking up a dictionary, or stop winking, or ending her habit of misquoting people. In the words of a McCain strategist, "If we keep talking about the economic crisis, we're going to lose."

    And why don't they want to keep talking about the economy? Refer, for instance, to the new Obama campaign strategy - a 13-minute documentary posted on the net about the late 1980s Keating Five savings and loan scandal, a deregulation fiasco in which McCain had a starring role.

    Both campaigns are not even trying to really debate the pitfalls and the seriousness of it all. Remember that low-level functionary who came up with that sub-Hegelian concept of the "end of history" after the fall of the Soviet Union - one Francis Fukuyama? Even he is alarmed.

    Once again, it's up to those pesky Europeans to tell it like it is. Jean-Claude Milner, former president of the International College of Philosophy, puts it in stark terms. The European bourgeoisie worries about savings security. The American bourgeoisie worries about credit security. In Western Europe, credit is a means to acquire assets. In America, it's the opposite: an asset is a means to obtain credit. The whole thing works, as long as there's no depression.

    Then there are the enormous Pentagon budgets. They aren't solely dedicated to facilitate "preemptive wars"; they are above all a means of permanent support to the economy. So, American capitalism is in fact state capitalism - where the state is not an entrepreneur, or an owner, but a larger-than-life client. Therefore, this client must intervene in times of crisis. In Milner's lovely formulation, the US state is "the invisible hand behind the visible credit".

    Milner goes beyond the military-industrial complex. He identifies a "military-financial complex". That's how the snake bites its own tail: "Wall Street relies on credit. Credit relies on the absence of depression. The military budget makes a depression impossible." It's this idea of capitalism, based on credit and disconnected from natural resources, that is today on fire. And not only because of the subprime crisis. Miller stresses how the US Army is above all an economic tool, and much less a traditional army (which the neo-cons, drunk with power, imbued with the mission of bringing democracy to the Middle East).

    The other key factor is that owners of natural resources don't accept this financial capitalism disconnect anymore. The best example is Russia. That's also where al-Qaeda's logic fits in. Al-Qaeda reasoned that what causes the disconnect is financial capital. The symbol of financial capital is the Twin Towers. So the towers must be destroyed. Whether al-Qaeda is, or is not, a US-controlled cipher is beside the point; the fact is bin Laden and al-Zawahiri, in their writings, have always stressed their strategy of bleeding the empire through its overextended Achilles heel.

    Milner is somewhat apocalyptic. For him, if American financial capitalism collapsed, it would drag most developed and emerging markets. The other main protagonist left on stage would be Russian capitalism - which follows a completely different logic: excess of natural resources, and state control over how they reach the market.

    Another pesky European, John Gray, professor of European Thought at the London School of Economics, author of crucial books like Straw Dogs and Black Mass, and one of Europe's most brilliant intellectuals - of course, Bush, McCain, neo-cons, they all hate intellectuals - says the financial crisis is the American equivalent to the fall of the Soviet Union. As he wrote on the London Observer,

    Having created the conditions that produced history's biggest bubble, America's political leaders appear unable to grasp the magnitude of the dangers the country now faces. Mired in their rancorous culture wars and squabbling among themselves, they seem oblivious to the fact that American global leadership is fast ebbing away. A new world is coming into being almost unnoticed, where America is only one of several great powers, facing an uncertain future it can no longer shape.
    A new world, coming into being almost unnoticed. You betcha.

    1. The Trickle-Up Bailout, by By Jonathan G S Koppell and William N Goetzmann, Wednesday, October 1, 2008, Washington Post

    Pepe Escobar is the author of Globalistan: How the Globalized World is Dissolving into Liquid War (Nimble Books, 2008). He may be reached at

  • [Oct 18, 2008] Hedge fund squeeze wreaks havoc in equity markets By Louise Armitstead

    I'm surprised many 401K investors have substantial holdings of equities with this type of risk still in the financial system. 401K investors either didn't learn from dot-com collapse, or have very short memory. This is the world of reckless gamblers, not P/E computations.
    Oct 16, 2008 | Telegraph

    Prime brokers have this week hiked up the cost of trading for hedge funds.

    The move has pushed some funds closer to the brink and triggered yet more havoc in global stock markets.

    The bankers say that the wild swings in stock prices across the globe has radically increased their risk, forcing them to demand as much as five times more collateral from the hedge funds.

    The extra demand has left funds scrambling to find the extra cash or collateral, forcing many to sell other positions to fund their more important ones.

    One hedge fund said: "One of our positions is a blue chip firm for which we have normally put up just 5pc cash [while the bank funds the remaining position]. Yesterday we got a call saying we had to put up 50pc margin. We're already tight on the line and had to quickly sell stock to fund it. And this was just one position."

    A prime broker said: "The volatility in the market over the past few days has been extraordinary. Huge stocks have been swinging by 40pc a day – Morgan Stanley went down 85pc in one day. We can't handle this sort of risk without passing it on, even though we know it's causing more volatility."

    Another prime broker said: "We've had to hike the margins in times of stress before so this shouldn't have come as a surprise. The clever ones are already in cash so it hasn't affected them. The problem has been caused by those holding illiquid assets that they can't sell. This means their having to sell their better positions to get the cash together."

    The expense had added to the mounting squeeze being felt across the high-rolling hedge fund sector. Over the past month many hundreds of hedge funds have been caught up in the collapse of Lehman Brothers, one of the biggest prime brokers. The freezing of the assets and failure of trades at Lehman has forced many funds to cover their exposures elsewhere.

    A group of the largest US hedge funds has called on the Bank of England to intervene to free an estimated $65bn (£38bn) of Lehman's assets that are frozen in London.

    The funds, through the Managed Funds Association, said the scale of the problem was so great that it could undermine bank rescue plans as tens of billions of dollars would be kept out of the market and other funds would fail.

    The warnings come as hedge funds have been quietly shifting billions of dollars of assets out of London to the US, claiming that the US legal system provides greater protection.

    [Oct 19, 2008] F.B.I. Struggles to Handle Wave of Financial Fraud Cases - by Eric Lichtblau, David Johnston and Ron Nixon.

    September 11 was a really lucky moment for Wall street shenanigans. Suddenly nobody cared about their machinations. And with Greenspan blocking all attempt to regulate Wall street this is double luck.
    October 19, 2008 |

    The Federal Bureau of Investigation is struggling to find enough agents and resources to investigate criminal wrongdoing tied to the country's economic crisis, according to current and former bureau officials.

    The bureau slashed its criminal investigative work force to expand its national security role after the Sept. 11 attacks, shifting more than 1,800 agents, or nearly one-third of all agents in criminal programs, to terrorism and intelligence duties. Current and former officials say the cutbacks have left the bureau seriously exposed in investigating areas like white-collar crime, which has taken on urgent importance in recent weeks because of the nation's economic woes.

    The pressure on the F.B.I. has recently increased with the disclosure of criminal investigations into some of the largest players in the financial collapse, including Fannie Mae and Freddie Mac. The F.B.I. is planning to double the number of agents working financial crimes by reassigning several hundred agents amid a mood of national alarm. But some people inside and out of the Justice Department wonder where the agents will come from and whether they will be enough.

    So depleted are the ranks of the F.B.I.'s white-collar investigators that executives in the private sector say they have had difficulty attracting the bureau's attention in cases involving possible frauds of millions of dollars.

    Since 2004, F.B.I. officials have warned that mortgage fraud posed a looming threat, and the bureau has repeatedly asked the Bush administration for more money to replenish the ranks of agents handling nonterrorism investigations, according to records and interviews. But each year, the requests have been denied, with no new agents approved for financial crimes, as policy makers focused on counterterrorism.

    According to previously undisclosed internal F.B.I. data, the cutbacks have been particularly severe in staffing for investigations into white-collar crimes like mortgage fraud, with a loss of 625 agents, or 36 percent of its 2001 levels.

    Over all, the number of criminal cases that the F.B.I. has brought to federal prosecutors - including a wide range of crimes like drug trafficking and violent crime - dropped 26 percent in the last seven years, going from 11,029 cases to 8,187, Justice Department data showed.

    "Clearly, we have felt the effects of moving resources from criminal investigations to national security," said John Miller, an assistant director at the F.B.I. "In white-collar crime, while we initiated fewer cases over all, we targeted the areas where we could have the biggest impact. We focused on multimillion-dollar corporate fraud, where we could make arrests but also recover money for the fraud victims."

    But Justice Department data, which include cases from other agencies, like the Secret Service and Postal Service, illustrate the impact. Prosecutions of frauds against financial institutions dropped 48 percent from 2000 to 2007, insurance fraud cases plummeted 75 percent, and securities fraud cases dropped 17 percent.

    Statistics from a research group at Syracuse University, the Transactional Records Access Clearinghouse, using somewhat different methodology and looking only at the F.B.I., show an even steeper decline of nearly 50 percent in overall white-collar crime prosecutions in the same period.

    In addition to the investigations into Fannie Mae and Freddie Mac, the F.B.I. is carrying out investigations of American International Group and Lehman Brothers, and it has opened more than 1,500 other mortgage-related investigations. Some F.B.I. officials worry privately that the trillion-dollar federal bailout of the financial industry may itself become a problem because it contains inadequate controls to deter fraud.

    No one has suggested that a quicker response would have averted the mortgage meltdown, but some officials said a faster reaction might have deterred more of the early schemes that seized on loose federal lending regulations.

    "They were very late to the game," Representative Zoe Lofgren, a California Democrat who has quarreled with the F.B.I. over its financing priorities, said of the bureau's response to the mortgage crisis. "They were not on top of this, and they're just now starting to really do something."

    Republicans and Democrats in Congress are pushing for a more aggressive response by the F.B.I. Representatives Mark S. Kirk, an Illinois Republican who sits on the House appropriations committee, and Chris P. Carney, a Pennsylvania Democrat, called on Congress to triple the F.B.I.'s financing for financial crimes investigations.

    "To fix our system and prevent a repeat of the events we now see," they wrote in a letter this month to Robert S. Mueller III, the F.B.I. director, "we have got to set an example by bringing the full might of federal law enforcement against the people who illegally profited or destroyed companies at the expense of our country."

    In public, Mr. Mueller has said that the bureau is doing more with less, when it comes to criminal prosecutions. And Justice Department officials have repeatedly asserted the administration's commitment to fight violent and white-collar crime even as they have not provided the bureau additional resources.

    But current and former officials say Mr. Mueller has lost a behind-the-scenes battle with the Justice Department and the Office of Management and Budget to replenish the criminal ranks.

    Interviews and internal records show that F.B.I. officials realized the growing danger posed by financial fraud in the housing market beginning in 2003 and 2004 but were rebuffed by the Justice Department and the budget office in their efforts to acquire more resources.

    "The administration's top priority since the 9/11 attacks has been counterterrorism," Peter Carr, a Justice Department spokesman, said. "In part, that's reflected by a significant investment of resources at the F.B.I. to answer the call from Congress and the American public to become a domestic intelligence agency in addition to a law enforcement agency."

    From 2001 to 2007, the F.B.I. sought an increase of more than 1,100 agents for criminal investigations apart from national security. Instead, it suffered a decrease of 132 agents, according to internal F.B.I. figures obtained by The New York Times. During these years, the bureau asked for an increase of $800 million, but received only $50 million more. In the 2007 budget cycle, the F.B.I. obtained money for a total of one new agent for criminal investigations.

    In 2004, one senior F.B.I. official, Chris Swecker, warned publicly that a flood of fraudulent mortgage deals had the potential to become "an epidemic." Yet the next year, as public warnings about fraud in the subprime lending markets began to approach their height, the F.B.I. had the equivalent of only 15 full-time agents devoted to mortgage fraud out of a total of some 13,000 agents in the bureau.

    That number has grown to 177 agents, who have opened 1,522 cases. But the staffing level is still hundreds of agents below the levels seen in the 1980s during the savings and loan crisis.

    F.B.I. officials said they had had no choice but to make the cuts in the criminal division, which they said were necessary to expand the bureau's national security effort, particularly in the wake of criticism of the bureau's performance in failing to detect the Sept. 11 plot.

    In white-collar crime, they said the bureau has given up only lower-level cases of marginal significance that might have never been prosecuted anyway. They say they have focused the available criminal resources on public corruption and other difficult crime issues in which the F.B.I. can make a unique contribution.

    "We only had a finite number of white-collar crime agents available to address the threat that mortgage fraud posed," said Joseph Ford, who retired from the F.B.I. this year and once served as its chief financial officer.

    The Justice Department is relying more than ever on the state and local authorities to pick up the slack through joint task forces. And private investigators say that companies victimized by fraud are turning to them in increasing numbers because they are unable to attract much attention from the F.B.I. anymore.

    In some instances, private investigative and accounting firms are now collecting evidence, taking witness statements and even testifying before grand juries, in effect preparing courtroom-ready prosecutions they can take to the F.B.I. or local authorities.

    "Anytime you bring to the F.B.I. a case that is thoroughly investigated and reduce the amount of work for investigators, the likelihood is that they will take the case and present it for prosecution," said Alton Sizemore, a former F.B.I. agent who is a fraud examiner for Forensic Strategic Solutions in Birmingham, Ala.

    One American company facing extortion demands last year from a computer hacker used private investigators from the Kroll firm to do much of the legwork in the case as the F.B.I. monitored and directed the situation behind the scenes, said Daniel Karson, executive managing director for Kroll. The private investigators even went undercover and set up a sting operation that led them to Germany, where the authorities made an arrest.

    Mr. Karson said the F.B.I. no longer had the resources to take on such lower-level cases by itself. "When you come in with a garden variety, plain vanilla crime, you may have to stand in the queue," he said.

    Some critics question whether the shift indicates not just a lack of resources, but a lack of interest by the Bush administration.

    After the collapse of Enron in 2002, the Justice Department moved aggressively against corporate fraud - too aggressively, in the view of some people within the administration. It set up a national task force to tackle the problem, garnered hundreds of convictions at companies like WorldCom, Adelphia and Enron, and forced the closure of Arthur Andersen, the accounting firm, for its role in the Enron collapse.

    But several former law enforcement officials said in interviews that senior administration officials, particularly at the White House and the Treasury Department, had made clear to them that they were concerned the Justice Department and the F.B.I. were taking an antibusiness attitude that could chill corporate risk taking.

    Justice Department officials said political pressures had never influenced the way prosecutors approached corporate cases. But the department's approach has become noticeably more tempered in the last several years.

    This spring and summer, as public concerns about the subprime mortgage crisis were growing, Attorney General Michael B. Mukasey rejected repeated calls for the creation of a national task force like the one used after the Enron collapse. The attorney general likened the problem to "white-collar street-crime" that could best be handled by individual United States attorneys' offices.

    In the last four years, the Justice Department has scored fewer of the big-name prosecutions that marked President Bush's first term in office. Even when investigations have pointed to corporate wrongdoing, the Justice Department has agreed, in dozens of cases in the last four years, to "deferred prosecutions" that allowed companies to pay fines in order to avoid criminal prosecution.

    Paul J. McNulty, who served as deputy attorney general under Alberto R. Gonzales, said the complexity of white-collar investigations and the shortage of investigators had driven a decline in high-profile cases.

    "There's no question that the department has been stretched thin when it comes to resources generally, and that has affected white-collar enforcement in a variety of areas," Mr. McNulty said in an interview.

    "What happened is that the first years after the Enron collapse, there were some very high profile, noticeable cases - the low-hanging fruit - that gave Justice the opportunity to rack up some very big wins," he said. "Those cases played themselves out and it became tougher to find those big cases."

    [Oct 18, 2008] Capitalism Without Capital by Ron Paul

    Information Clearing House - ICH

    Not only is our nation on the verge of bankruptcy, but so are its people and private institutions. We are now repeatedly hearing about businesses "needing to access the credit market to make payroll." This is an unmistakable sign of more dire consequences ahead for the economy. If businesses must borrow just to make payroll, this is evidence of a severe undercapitalization that cannot be sustained, even for the short run.

    Couple these facts with items such as the explosion of the "payday loan" industry and the unmasking of the false sense of economic well-being is nearly complete. These payday loan companies use preferred access to easy credit to inject cash into the hands of the working poor. They are nearly always set up in lower-income neighborhoods. These people, who are struggling to buy food and pay rent, get addicted to the credit drug. Their standard of living is only further depressed by the interest payments on these loans that make them profitable to their providers. Thus, the recipients are left even less capable of paying for items such as food and housing in the long run, without using this credit again and again.

    These people are often the very ones being paid by businesses who "borrow to make payroll." This is the dark underbelly of the fiat money, borrow-and-spend economy this nation has been building. As the government takes over more and more functions of the economy many see the rise of socialism as an antidote to this failure of "capitalism." However, the fact remains that our economy has been increasingly running on debt, not capital. Capitalism does not exist without capital and debt is not, has never been and will never be a form of capital. Only now are we seeing the more dire implications of an economy without capital.


    Payday loan sharks are noumerous around military bases - especially Army bases. Soldiers are taking reenlistment bonuses to pay off the loan sharks. DISGUSTING.
    zaz | 10.16.08 - 5:58 pm | #

    I'm a transplant from Northern Indiana. I moved to Massachusetts in the middle 80's due to REAGANOMICS. I worked at U.S. Steel from the late 70's to the middle 80's. After the layoffs. I couldn't find a good paying job. My friend from high school had moved to Massachusetts. Sent me a Sunday Boston Globe. At the time? Over 136 pages of jobs! I moved out here. Found a good paying job. Now I worry about this lousy economy. In my early 50's.
    I blame ALL the politicians. And STUPID voters. I've voted all my life. Always, third party.
    When this country sinks? I'll walk away from EVERYTHING. I'm so pissed off about the last 30 years of this horrible government of ours, it not funny.
    The majority of American's deserve this nightmare. They are self centered bigots. No brains. No heart. Don't deserve liberty or justice.
    And please...Don't feed me your thoughts. Think about what you will do when the bread lines grow across the country.
    Metro Boston | 10.17.08 - 12:52 am | #

    America has outsourced its wealth, period. Call it a "reversal" of economies. China becomes the economic powerhouse ploughing out consumer goods and increasing the wealth of its population. America transforms into a Third World country and decreases the wealth of its population except for a select few.
    Simple, really.
    Anonymous | 10.17.08 - 1:34 am | #
    Well the oil price came down and that makes the way for cheap Chinese crap into the US market.

    Otherwise the US inflation would be terrible.
    gmathol | Homepage | 10.17.08 - 1:48 am | #

    Look, Ron Paul has done what he can. But why haven't some of you arrived at the obvious conclusion that; THERE IS NOTHING YOU CAN DO TO SAVE THE SYSTEM.

    The spreading of risk/debt through the derivatives has destroyed not only credibility, but quite simply has made them ALL worthless. The bankers know this. Which is why they hoard. The bankers need the massive debts of others to keep going. If people default they eat sand. That's why they won't want anyone to be saved by a "payout" or mortgage deal.

    To save the US worker has to earn. Salaries have been held down for 20 years. The outsourcing was only the latest in a long series to undercut the basic wages.

    The dark underbelly, is darker than you think. There are 967 million people starving on this planet and 25(? - at least!) million of those are in the US, and 16% of the EU (57.5 million by my calculation) have food problems.

    In a crisis the worst as well as the best in humans comes to the surface (as in Payroll sharks). But there is a long way to go yet before humanity has "compassion for his neighbour" shoved into it's collective brains.

    Just blowing off. Capitalism is going the same way as communism. For both of them they were bought down by absolute corruption of those who had the power.
    stonebird | 10.17.08 - 2:16 pm | #

    [Oct 16, 2008] "Hard Times Are Good Times at Pawnshops" (MSNBC):

    Quick cash a lure when it 'doesn't matter what your credit is like'

    At People's Pawn in Springfield, Mass., the collection of DVD players, televisions and other electronics just keeps getting bigger.

    As many as 200 a people a day come in to "sell all their stuff so they can get gas money," said Efren Rivera, who works at the shop. "Some people have to pay their mortgages."

    The story is similar at EZ Cash Pawn in West Palm Beach, Fla., where the shelves are so stacked with electronics, musical instruments, guns, fishing poles, scuba gear - you name it - that people are being turned away.

    "I have no choice," said Robert DeSantis, the shop's owner. "I have tools in the warehouse now - every single tool you can think about."

    With the economy in the tank and high energy prices eating away at Americans' paychecks, pawnshops are prospering.

    Unlike the bank, where tough times make it harder to get a loan, "with us, doesn't matter what your credit is like," said Todd Faircloth, owner of Georgia Loan and Pawn in Albany, Ga. "You can come in and borrow from us if you've got merchandise."

    Sometimes, pawning's a good option
    When you pawn an item, you are really taking out what financial professionals call a "secured non-recourse loan." Sometimes, according to Jean Chatzky, a financial columnist and author of "Pay It Down: From Debt to Wealth on $10 A Day," that loan might be your best option to cover an important bill.

    Pawnshop loans charge interest, anywhere from 5 percent to 20 percent a month, depending on the merchant's assessment of the merchandise and the reliability of the customer. At 20 percent, a $75 30-day loan repaid on time would cost the customer $15. By comparison, penalties for bounced checks and late credit card payments average double that.

    "Pawning can be a relatively less expensive option," Chatzky said - but only if you pay back the loan on time. If you don't, "you're going to pay another month's interest," plus a storage fee, she said.

    The National Pawnbrokers Association said 80 percent of customers reclaim their pawned property on time, providing a steady stream of interest income that increases as the economy worsens. With more people being driven in the doors by hard times, it's a good time to own pawnshops.

    The business has become so lucrative that First Cash Financial Services Inc. announced plans this month to shut its auto lending division so it could focus on its pawnbroker operations. The company, which operates more than 250 pawnshops and payday lending shops, said its pawnshop profits rose by 26 percent in the first quarter of the year, topped by a 39 percent rise in the second quarter.

    "Our core pawn business is tremendously profitable and continues to grow at record levels," said Rick Wessel, chief executive of the company, which expects to open 10 to 20 new U.S. stores by the end of the year.

    Likewise, Cash America International Inc., which operates more than 500 pawnshops in 21 states under the Cash America Pawn and SuperPawn brands, reported that second-quarter profits rose by 52 percent over the same quarter last year. It projected that profits would rise by another 13 percent to 20 percent over that when it reports third-quarter results later this month.

    "Higher loan demand continued our trend of increased revenue from pawn loans, and we experienced better-than-expected retail sales activity during the quarter," said Daniel Feehan, the company's president and chief executive.

    'Grills for bills'
    Those retail sales are another way pawnbrokers make money.

    Loans are typically made for about about half the value of an item. Whenever a customer defaults, the pawnbroker can offer shoppers a bargain while making a profit on the loan.

    "Pawnshops have always done consistently very well in a down market," said Randy Stormberg, owner of Bend Pawn and Trading Co. in Bend, Ore., who said business was up by 30 percent in his store. "They are there with merchandise at about half the price of new."

    Much of that merchandise is gold coins and jewelry. With the price of gold fluctuating between $800 and $900 an ounce, many pawnbrokers won't even bother to offer a gold item for sale; instead, they will have it melted down for its raw metal, Stormberg said.

    Pawnbrokers say they're getting a lot of unexpected items from people hoping to cash in on the boom in gold.

    Fort Myers Estate Jewelry and Pawn in Fort Myers, Fla., hit the headlines earlier this year when it reported that an unidentified athlete had pawned the gold medal he won at the 1980 Olympic Games. And across town at Larry's Pawn Shop, Ryan Champagne does a brisk business in "grills for bills" - gold teeth.

    "When somebody comes in, you don't want to be handling their teeth. So I grab a paper towel and just weigh it like anything else," Champagne said.

    A couple of years ago, it was unheard of for someone to come in offering his or her gold teeth for sale, but "now, it's a little more frequent than it was two years ago, there's no question about that," said DeSantis of EZ Cash in West Palm Beach.

    "I expect to see a lot more - a whole lot more," he said. "It's not getting better. It's getting worse."

    [Oct 18, 2008] Manufacturing, the Recovery, and What Lies Ahead By Stormy

    "Americans sold never to be repaid loans to the world to finance their consumption. It worked once, and in huge size, but it wont work twice." You need start to produce valuable goods...
    Angry Bear
    The big picture is always important. Today's report of the dramatic fall of the factory index is incredibly bad news, a significant part of the that big picture:
    The Federal Reserve Bank of Philadelphia's general economic index plunged to minus 37.5 this month, less than forecast and the lowest reading since October 1990, from 3.8 in September, the bank said today. Negative readings signal contraction. The index averaged 5.1 last year.
    How we respond to this fact has to be seen in a global context. We have watched one bubble burst; we are now about to confront the explosion of a negative bubble, a kind of black hole that we have been cultivating for some time: our manufacturing sector. The easy explanation is not always the correct one. Many will blame the present deep recession on just the financial crisis.

    That is not the full story.

    For over a decade, we have watched our manufacturing flee elsewhere; watched our largest companies outsource and offshore--with barely a peep from many economists. We have added jobs to government, health care, and service industries; manufacturing jobs have dwindled. Even many of our important service industries--in IT, medicine, and accounting--, we have outsourced, off-shored in the name of efficiency. Even Research and Development is leaving these shores.

    In short, the engine for our real recovery lies littered around us, rusted, broken, unattended, and ignored. I am not going to wage my usual complaint about the WTO or our trade policies, or push once again for fair, not free, trade. Nor will I complain that globalization was too rapid, too poorly structured. It is too late for all that. What's done is done.

    What I want to do is to adumbrate the directions in which the U.S. and the world seem to be going. Then I want to offer what I see as the only hope.

    The U.S. is in for a long downward slide. The fixes that are being proposed will be temporary, at best. To some extent, Europe and other developed countries will be tied to U.S. fortunes; many have sowed the same seeds that the U.S. has. But there is hope--and it may seem an unusual one to those who have understood me. That hope is China, hope that China moves as quickly as possible from an export platform to a more consumer based economy, hope that China is wise enough not to continue those policies that have drawn foreign company after company into its fold. (Those countries that can feed China's thirst for raw materials will do well.)

    The Short-term Fix

    Krugman clearly states how the U.S. will respond: "Lets Get Fiscal." Massive government spending will be the policy, regardless of U.S. indebtedness:

    Can we do otherwise? No. But understand this is our last fix.

    After it is over, we will have to pay the bill; we will have to return to that place where all ladders start. It will be a long climb. We will have to protect our people from predators, both at home and abroad; we will have to give them a safe place to work, free of medical worries, free of worries that an education is too expensive. We will have to construct policies that allow our people to compete fairly among the nations of the world. No more platitudes about being competitive; no more platitudes about freedom and democracy; no more celebrations that we are the best. Clearly, we are not gathering any laurels lately.

    Competitiveness is not just one man working hard; it is a society structured so that all hard work counts.

    Hard work, hard planning, hard thinking will be in order. We will have to see beyond one minute, one day, or one year. We will actually have to have some kind of vision for our future. Our government will be our collective instrument, not the whims and greed of a few important individuals. We may finally understand that democracy is hard, hard work, not the celebration of this or that personality. Then and only then will we begin that long climb upward.

    China: Policies and Growth

    With a population of over 1.3 billion people and with an impoverished third world economy, China's sudden entrance onto the world stage was an enormous counterweight to the industrialized nations. No country has ever had such an impact on the world, not even Japan as it climbed from the devastation of World War II. How is China doing now, a mere seven years after its entry into the WTO?

    While its growth will slow, China seems to be weathering the storm. How did China, a barely industrialized, impoverished nation achieve all this? Quite simply, it played perfectly its one great trump card: its 1.3 billion people. It then fashioned its playing field to exploit that advantage, by offering juicy inducements to foreign firms.
    1. It instituted a two-tier tax rate, giving the advantage to foreign firms. Foreign firms were taxed at 15%; indigenous firms, at 30%) In key industries, foreign firms were given a tax holiday if they promised to stay for ten years.
    2. It instituted no immediate provisions to protect its labor force from substandard working conditions, unscrupulous employers, or substandard pay.
    3. It used tax rebates to leverage exports on selected items. In short, no taxation for exported consumer goods. For a more complete discussion of how export tax rebates work, see data here and discussion here and here.
    4. It pegged its currency to the dollar in order to further leverage its exports.
    5. It ignored environmental degradation. (Most environmental regulations can be viewed as a hidden tax, advantaging companies that produce the pollution as well as those non-polluting companies who make use of the products that the polluting companies provide: Energy, for example.)
    6. It subsidized the cost of oil, thereby making energy cheaper for all.
    In short, China combined labor, tax, and environmental arbitrage together with its immense and impoverished population to build an unrivaled export platform, an export platform that fed the Western consumer with goods produced in many instances by foreign firms from industrialized nations. The next stage--already in motion--is to cultivate its own companies. Flushed now with cash, China is in an excellent position to do so.

    The Hope

    As I said above, the hope is that the world -- and China especially -- takes a breather and reconsiders how the game has been played. There is too much at stake. We simply cannot afford the kind of arbitrage to which I have pointed. It is too dangerous for all. We have to hope that China moves from being primarily an export platform to a consumer-based society. We have to hope that China vigorously begins to levy all those hidden environmental taxes, which in turn will raise the price of goods as well as clean the environment. We have to hope that China rapidly protects its labor force from predation, that it allows real bargaining between employer and employee. We have to hope that export rebates disappear entirely. We have to hope that China provides its people with the kind of social net that some more advanced countries provide. We have to see hope that China understands that an all-too rapid climb to becoming frontier nation can have disastrous global consequences. And when all of this is done, we have to hope that then--and only then, we are ready to compete fairly in the marketplace of ideas and products.

    Read More on "Manufacturing, the Recovery, and What Lies Ahead"

    [Oct 18, 2008] Finally, A Meaningful Improvement in the Money Markets

    naked capitalism

    Even though much has been made of itty bitty falls in Libor from very elevated levels, leaving Libor still at very elevated levels, we have a sign that the massive efforts of commercial banks to lubricate the money markets is finally having an effect. 30 day commercial paper rates eased meaningfully, although they still remain high.

    Note that 30 to 90 day CP are the most popular tenors; we need to see more improvement at the 30 day and longer maturities before we declare victory, but this is a move in the right direction.

    From Bloomberg:

    Rates for one-month commercial paper fell to a three-week low after central banks joined forces to pump cash into money markets and government backed loans.

    Average yields offered on the highest-rated commercial paper placed by dealers and due in 30 days fell 0.48 percentage point today to 3.45 percent, according to data compiled by Bloomberg. Rates fell 0.83 percentage point this week to the lowest since Sept. 26 from a nine-month high of 4.28 percent.

    ``The infusion of capital by the government into the banking system should improve balance sheet health greatly and gradually, make unsecured lenders more comfortable,'' Barclays Plc analysts Piyush Goyal and Kurush Mistry said yesterday in a report.

    printfaster said...

    It is not the commercial banks that are unsticking and buying CP, it is the Fed. Quoting also from Bloomberg:
    The Fed said last week it will create a special fund to buy commercial paper, seeking to unblock the financing that drives everyday commerce for American

    Even commercial paper is being nationalized. Perhaps the Fed will recognize sheets of toilet paper as foreign currency and buy them to inject more funds into the economy. We should be so lucky. All of the money is being sent to incompetent bank executives so they can hold on to their precious overpaid jobs

    Phil said...
    Taking a back seat to bailout
    Rules for governance, exec pay watered down in government plan.

    If you want to get sick read this article.

    Cash Mundy said...
    FairEconomist: your A2/P2 comment is interesting. I got curious and found out where the Fed Publishes this info, and a description of A2 vs. P2 paper at Calculated Risk.
    printfaster said...
    Phil, I don't even care about pay packages. I want them unpaid. Fired. Out. The banks are obsolete and do not provide the purpose for which they have been chartered, and that is to finance business activity. The whole financing industry for itself is a sham. It is finance for finance sake. It is financing billion dollar bonuses last year for Gunnie Sacks, which is what they executives should be wearing.

    When I think of how much money has gone into lower Manhattan, it makes one ill. That money needs to go back to main street to create industry which creates its own demand. Not the demand for financial products.


    doc holiday said...
    OT; this was nice, from a post in another part of The Universe, by someone named, Dr. Michael Yanakiev

    > Richard Dooling wrote in the New York Times: "Somehow the genius quants - the best and brightest geeks Wall Street firms could buy - fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and - poof! - created $62 trillion in imaginary wealth."

    Those algorithms were based on risk assessments that were seriously flawed, based only on the risk to the market at that moment, rather on cold, hard empirical data about a person's ability to pay and what would happen if a lot, rather than a few of them, stopped. As George Dyson (son of the quantum physicist Freeman) wrote in Edge last week: "The problem starts, as the current crisis demonstrates, when unregulated replication is applied to money itself. Highly complex computer-generated financial instruments (known as derivatives) are being produced, not from natural factors of production or other goods, but purely from other financial instruments." What is also becoming clear is that the financial markets are far more automated than ever before. There is a growing sense that much of this was made by machines, with the quants feeding the beast ever more intricate lines of code. Dooling has a growing conviction that we are now at the mercy of a financial system based on "arrangements so complex only machines can make". It seems we are at the mercy of the machine.

    Not a Great Depression, a Great Rebalancing

    Arete said...

    there was a concerted effort by Chase NY to lend 1 month cash (unsecured) in the market Friday. Citi bank joined in after the market started moving.

    To give you an idea of the magnitude of this, they started lending at approx. 5% (way above 1month usd libor note), and ended up lending at 3% (could have been lower after I left. The amounts involved were not trivial and it explains a lot of the movement in the eurodollar strip, the swap spreads and probably even the long end of the usd irs curve. I would guess Chase got a little persuasion to start lending out the cash, it wasn't coming from trader level in any case!

    So what.... well USD libors should collapse Monday. So what again... as one person said yesterday, "the panic to get out of panic trades has started".... and there are ALOT of panic trades out there that I think will all have to exit a very small door next week as sentiment comes back from the brink....

    [Oct 18, 2008] Some Curious Parallels with the 1930s

    naked capitalism

    The Hoover administration first tried to fix the problem without involving the government directly. Instead, the government merely facilitated the formation of the National Credit Corporation, a private central lending institution. Sound familiar? Remember the MLEF (Master Liquidity Enhancement Fund), a SIV of SIVs that Treasury tried to coordinate back in the fall of 2007, only to have the banks refuse to pitch in.

    Next, the Hoover administration (a lot of New Deal institutions were Hoover inventions) attempted to bolster bank capital through direct government loans through a government agency called the Reconstruction Finance Corporation. The loans didn't do the trick though. We tried some direct government lending support for faltering institutions: AIG, discount window lending to investment banks, government support for JPM purchase of Bear Stearns, FDIC guarantee of Citi's planned purchase of Wachovia. While this lending support might have helped prevent a worse crisis, it did not solve the current one.

    The Roosevelt administration then pushed through the Emergency Banking Act (cf. Emergency Economic Stabilization Act) that expanded the RFC's powers to include government purchase of preferred stock from banks. Banks didn't want to sell preferred to the RFC. It took RFC chair Jesse Jones telling the American Bankers Association that if they didn't get with the program and start lending again, the government would go into the direct loan business itself. The banks sold preferred to the RFC. I can only imagine what Secretary Paulson told the 9 bank CEOs would happen if they didn't sell to Treasury.

    In the end, the RFC bought lots and lots of preferred stock from banks. By 1935, nearly 1/3 of bank stock value was held by the RFC. The dividend on the preferred stock? Then, as in the current deal, it was 5%.

    The recapitalization of banks alone was not enough to get them to start lending, however. They didn't have enough credit-worthy borrowers. Government had to get into direct lending itself. Compare this with Secretary Paulson's declaration that the banks that received the forced equity injection from the Treasury had to deploy it. But also notice, that we've moved in the direction of government direct lending anyhow: the Fed is buying commercial paper (using a special deposit from the Treasury to do so) and FHA-insured refinancings as part of the hapless HOPE for Homeowners Act are equivalent to mortgage lending.

    In the 1930s, the government had another major lever, however, to get credit markets going again in the 1930s. RFC preferred stock, unlike the preferred shares that Treasury is going to buy today, came with equal voting rights to common. The RFC exercised this to put its own managers in place at major financial institutions. The result was a distinctive type of state-capitalism. Arguably, Treasury might have done better to take preferred stock that would give it stronger control over bank management.

    Steve said...
    The problem is a little different this time: securitization didn't exist in the 1930's, LBO'd companies didn't employ millions of Americans, consumer spending wasn't even a third of today's 70% of GDP, the US was a net creditor, and US companies hadn't issued fraudulent paper worldwide. The government isn't going to replace the securitized markets where businesses raised debt for the last 10 years. How much are over-levered companies going to need over the next year to stay in business? --It won't be coming from the capital markets. The banks can't possibly take on balance sheet the leverage they have floated through the economy, and I don't believe the government can either.

    [Oct 18, 2008] The astonishing sign off of a wealthy fund manager in full

    The full text of the letter written by fund manager Andrew Lahde

    Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

    Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, "What I have learned about the hedge fund business is that I hate it." I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

    There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list those deserving thanks know who they are.

    I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they look forward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

    So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don't worry about my employees, they were always employed by Mr. Springer's company and only one (who has been well-rewarded) will lose his job.

    I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life -- where I had to compete for spaces in universities and graduate schools, jobs and assets under management -- with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

    On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it...

    ... ... ...

    With that I say good-bye and good luck.

    All the best,

    Andrew Lahde

    [Oct 17, 2008] More tarnish on the Greenspan legacy

    Friday, October 17, 2008

    Though former Fed chairman Alan Greenspan has been remarkably silent lately, perhaps no longer feeling the need to issue weekly "recession probability alerts" since it has become clear that we are now in the midst of one, his detractors have become more vocal.

    In fact, criticism of monetary policy over the last two decades seems to be gaining something of a critical mass in recent weeks, a development that is quite understandable given the earth-shattering events that have unfolded in financial markets.

    Even Ben Bernanke seems to be pointing a finger at his predecessor, though the current Fed chairman is certainly not without blame for the current mess as he has long been a proponent of the central bank's "hands off" approach toward asset bubbles, hedge funds, and all sorts of other late-20th century bright ideas that have caused so much trouble over the last year.

    This report in today's Wall Street Journal captures the new thinking at the Fed:

    The Federal Reserve and academics who give it advice are rethinking the proposition that the Fed cannot and should not try to prick financial bubbles.

    "[O]bviously, the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it," Fed Chairman Ben Bernanke said this week.

    The bursting of this decade's housing bubble, which was accompanied by a bubble of cheap credit, has wrought inestimable economic damage. The U.S. economy was faltering before the crisis in credit markets recently intensified, rattling financial markets and sending home prices down further. Even if the government's decision to take stakes in major banks works, it could take weeks for money to flow freely again.
    Obviously. Well, better late than never.

    Hopefully, this won't be a case of being too late.

    In today's American Banker can be found this story with a "Greenspan Mess" sighting right there in the title.

    [Note to financial writers: This kind of takes the thrill out of it for those of us who realized what was coming years ago and now spend a good deal of time on the lookout for others who are just catching on. Remember the rule: the two words must be within two paragraphs or one hundred words of each other.]
    Greenspan's Fingerprints All Over Enduring Mess

    In the fable "The Emperor's New Clothes," two make-believe weavers purport to spin a fine suit of clothes for the emperor, which is made of beautiful material that possesses the wonderful quality of being invisible to any man who is unfit for his office or unpardonably stupid. The potentate and his subjects acknowledge that the garments are very fine indeed. That is, until one little child sees the emperor marching in a procession, and says at last: "But he has nothing on at all" - and the grand swindle is exposed for all to see.

    The U.S. economy as well as economies around the world have been going through wrenching experiences lately, and much more is likely. Former Federal Reserve Chairman Alan Greenspan is the architect of the enormous economic "bubble" that has burst globally. No longer is he revered as a "potentate." His reputation is in tatters. Giulio Tremonti, Italy's Minister of Economy and Finance, has said: "Greenspan was considered a master. Now we must ask ourselves whether he is not, after [Osama] bin Laden, the man who hurt America the most." That speaks volumes.

    Greenspan let things get out of control, and the prices of U.S. homes rose to stratospheric levels. Americans and their counterparts abroad borrowed like drunken sailors because of their newfound wealth and net worths, and no one believed that the party would end. While borrowers were told to read the fine print about the risks of adjustable-rate mortgages and the like, few people worried about the future
    And to think that I actually attempted to change the name of this blog about 15 months ago, thinking that laying a good portion of the blame at The Maestro's feet had already become conventional wisdom.

    Bill Bonner at the Daily Reckoning steps in during the former Fed chairman's silence to pen A Letter from 'Alan Greenspan' About the Deterioration of the U.S. Economy, seeking to explain what might be going through the man's mind now that the financial world is collapsing along with his legacy.

    Some excerpts:
    This is not by any means the first thing I have written. I have written much over the years. But it was all written for a purpose, which only a few were able to discern. Most readers foolishly saw the cluttered mind of a dithering economist or the clumsy, stuttering pen of a professional bureaucrat. Many listening to my wandering speeches and twisting sentences thought that English was not my first language. They thought they detected a faint accent, like that of Henry Kissinger or Michael Caine. They mocked me as "incomprehensible" or "indecipherable." They watched what they thought was an obsequious bureaucrat squirm. They had no idea what I was really up to and what I can only now reveal.
    I had weaseled (why not be honest about it?) my way to the top post by knowing the right people and by making myself generally agreeable, and helpful, and by not saying anything anyone could disagree with. That was the original reason for what the press called "Greenspan speak." My private thoughts remained mine alone. All the public and the politicians got was gobbledygook, but for good reason.

    They would not have wanted to hear what I really thought. So, I did not tell them. For I knew well and good what generally happened when politicians and central bankers got their hands on soft money and a compliant central banker. I was not born yesterday. They use their control of the money to cheat people. It is as simple as that. (I explained this early on in my career; fortunately, no one bothered to read what I wrote. Otherwise, I never would have gotten the job.) If central banking were an honest mιtier, there would be no reason to have it at all. Private banks could do the job better.

    But people are ready to believe anything. Somehow, they think that a collection of rich financiers and power-mad politicians got together to create and run a central bank for the benefit of the people! Well, I've got news: it doesn't work that way.
    Go read the whole thing - Bill was in classic form when he wrote this but, in my view, he gives the former Fed chairman far too much credit.

    I've long thought it was more of a "childlike idealism", a severe character flaw common amongst economists, rather than a "knowing deception", as some believe, that caused the man to do what he did.

    Oh well, what's done is done.

    [Oct 16, 2008] NY Times: House Prices Far From Bottom

    Jamie Dimon: "If you are not fearful, you're crazy"

    From Vikas Bajaj at the NY Times provides an overview: Home Prices Seem Far From Bottom

    Home prices across much of the country are likely to fall through late 2009, economists say, and in some markets the trend could last even longer depending on the severity of the anticipated recession.

    In hard-hit areas like California, Florida and Arizona, the grim calculus is the same: More and more homes are going up for sale, but fewer and fewer people are willing or able to buy them.

    Yes, house prices are still too high.

    [Oct 16, 2008] Consumer Prices Flat in September

    "But inflation rates, particularly at the headline level, should fall further in coming months". That's bad for TIPS...
    naked capitalism
    The markets may take some cheer from the marked reversal in inflationary pressures, but the flip side is that the change points to deflationary forces starting to take hold. From the Wall Street Journal:
    U.S. consumer prices were flat in September, a government report showed, the latest indication that falling energy prices and the economic downturn are rapidly easing pressure on inflation.

    The figures, which included a slim gain in core prices excluding food and energy, should make it easier for Federal Reserve officials to lower official interest rates even further to address severe strains in financial markets

    ... ... ...

    The consumer price index was unchanged in September, the Labor Department said Thursday. It fell in August for the first time in almost two years. Excluding food and energy, the CPI advanced 0.1% last month. Both figures were 0.1 percentage point below Wall Street forecasts, according to a Dow Jones Newswires survey....

    Consumer prices rose 4.9% on a year-over-year basis, down from August and now well off the 17-year high of 5.6% reached in July. The core CPI grew a more modest 2.5% compared to September 2007, though that's still well above the Fed's long-term goal of 1.5% to 2%.

    But inflation rates, particularly at the headline level, should fall further in coming months. Oil prices tumbled again Wednesday, closing under $75 per barrel for the first time in more than one year. Leading consumer price indicators like import and producer prices each posted big drops in September for a second-straight month

    [Oct 16, 2008] Brad Setser Follow the Money " Blog Archive " An unlimited guarantee requires unlimited access to financing …

    [Oct 15, 2008] What Went Wrong By Anthony Faiola, Ellen Nakashima and Jill Drew Washington Post Staff Writers

    October 15, 2008 | Washington Post

    How did the world's markets come to the brink of collapse? Some say regulators failed. Others claim deregulation left them handcuffed. Who's right? Both are. This is the story of how Washington didn't catch up to Wall Street.

    A decade ago, long before the financial calamity now sweeping the world, the federal government's economic brain trust heard a clarion warning and declared in unison: You're wrong.

    The meeting of the President's Working Group on Financial Markets on an April day in 1998 brought together Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt Jr. -- all Wall Street legends, all opponents to varying degrees of tighter regulation of the financial system that had earned them wealth and power.

    Their adversary, although also a member of the Working Group, did not belong to their club. Brooksley E. Born, the 57-year-old head of the Commodity Futures Trading Commission, had earned a reputation as a steely, formidable litigator at a high-powered Washington law firm. She had grown used to being the only woman in a room full of men. She didn't like to be pushed around.

    Now, in the Treasury Department's stately, wood-paneled conference room, she was being pushed hard.

    Greenspan, Rubin and Levitt had reacted with alarm at Born's persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble -- deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time.

    Unlike the commodity futures regulated by Born's agency, many newer derivatives weren't traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street's top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what.

    Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them -- and if so, how.

    Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures. Born's agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market.

    At the April meeting, the trio's message was clear: Back off, Born.

    "You're not going to do anything, right?" Rubin asked her after they had laid out their concerns, according to one participant.

    Born made no commitment. Some in the room, including Rubin and Greenspan, came away with a sense that she had agreed to cool it, at least until lawyers could confer on the legal issues. But according to her staff, she was neither deterred nor chastened.

    "Once she took a position, she would defend that position and go down fighting. That's what happened here," said Geoffrey Aronow, a senior CFTC staff member at the time. "When someone pushed her, she was inclined to stand there and push back."

    Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today.

    The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all.

    In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas.

    "We knew it was a big deal [to attempt regulation] but the feeling was that something needed to be done," said Michael Greenberger, Born's director of trading and markets and a witness to the April 1998 standoff at Treasury. "The industry had been fighting regulation for years, and in the meantime, you saw them accumulate a huge amount of stuff and it was already causing dislocations in the economy. The government was being kept blind to it."

    Rubin, in an interview, said of Born's effort, "I do think it was a deterrent to moving forward. I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way. My recollection was, though I truly do not remember the specifics of the meeting, this was done in a more strident way."

    Rarely does one Washington regulator engage in such a public, pitched battle with other agencies. Born's failed effort is part of the larger story of what led to today's financial chaos, a bipartisan story of missed opportunities and philosophical shifts in which Washington stood impotent as the risk of Wall Street innovation swelled, according to more than 60 interviews as well as transcripts of meetings, congressional testimony and speeches. (Born declined to be interviewed.)

    Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system.

    A New Chain of Risk

    Futures contracts, one of the earliest forms of a derivative, have long been associated with big market failures. Harry Truman's father was financially wiped out by agriculture futures, and rampant manipulation by speculators contributed to the market collapses of 1929. Regulators have long known that new trading instruments have a way of giving reassurance of stability in good times and of exacerbating market downturns in bad.

    Futures -- essentially, a promise to deliver cash or something of value at a later time -- are traded on regulated exchanges such as the Chicago Mercantile Exchange, regulated by the CFTC. But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the "lack of basic information" allowed traders in derivatives "to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority."

    The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.

    By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy.

    The global derivatives market topped $530 trillion as of June 30 this year, including $55 trillion in the suddenly popular credit-default swaps; that $530 trillion represents all contracts outstanding. The total dollars at risk is much smaller, but still a hefty $2.7 trillion, according to an estimate by the International Swaps and Derivatives Association.

    To make sense of those figures, compare them to the value of the New York Stock Exchange: $30 trillion at the end of 2007, before the recent crash. When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay.

    Instead of dispersing risk, derivatives had amplified it.

    The Regulatory Rift

    Born, after 30 years in Washington, found herself on President Bill Clinton's short list for attorney general in 1992. The call never came. Approached about the CFTC job four years later, she took it, seeing a chance to make a public service mark, colleagues say.

    For several years before Born's arrival at the futures commission, Washington had been hearing warnings about derivatives. In 1993, Rep. Jim Leach (R-Iowa) issued a 902-page report that urged "regulations to protect against systemic risk" as well as supervision by the SEC or Treasury. Sen. Donald W. Riegle (D-Mich.), while acknowledging that swaps helped manage risk, saw "danger signs, on the horizon" in their rapid growth. He and Rep. Henry Gonzalez, a Texas Democrat, introduced separate bills in 1994 that went nowhere. Mary Schapiro, Born's predecessor, made her own run at the issue through enforcement actions.

    In an earlier decade, President Ronald Reagan had described the CFTC as his favorite agency because it was small and it had allowed the futures industry to grow and prosper. Born swept into the agency, the least known of the four major regulators with primary responsibility for overseeing the nation's financial markets, determined to enforce its rules and tackle hard issues.

    "One theory at the time was she was so disappointed not to be running Justice -- that she got this tiny agency as a consolation prize and was hell-bent to make it important. I'm not sure that was in her mind, but it was a point of criticism," said John Damgard, president of the Futures Industry Association. Damgard disagreed with Born's approach but said he respected her for fighting for her principles.

    Daniel Waldman, Born's law partner at Arnold and Porter and her general counsel at the futures commission, said Born let the industry know she meant business. "She got into a knock-down, drag-out fight with the Chicago Board of Trade over the delivery points for soybean contracts," he recalled. "She believed it was her obligation under the statute to review decisions by the exchanges. If they didn't meet agency requirements, she was going to say so, not look the other way."

    Born didn't back off on derivatives, either. On May 7, 1998, two weeks after her April showdown at Treasury, the commission issued a "concept release" soliciting public comment on derivatives and their risk.

    The response was swift and blistering. Within hours, Greenspan, Rubin and Levitt cited their "grave concerns" in an unusual joint statement. Deputy Treasury Secretary Lawrence Summers decried it before Congress as "casting a shadow of regulatory uncertainty over an otherwise thriving market."

    Wall Street howled. "The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association.

    Although Born said new rules would be prospective, Wall Street was afraid existing contracts could be challenged in court. "That meant anybody on a losing side of a trade could walk away," Brickell said.

    He spent months shuttling between New York and Washington, working on Congress to block CFTC action. "I remember getting on an overnight train and arriving at Rayburn by 5:30 a.m.," he said. "I watched the sun rise and then went to work on my testimony without a whole lot of sleep."

    Born, who testified before Congress at least 17 times, tried to counter the legal question by saying that regulation would apply only to new contracts, not existing ones. But she relentlessly reiterated her conviction that ignoring the risk of derivatives was dangerous.

    In June 1998, Leach, who had become chairman of the House Banking committee, thrust himself into the regulatory rift. He herded Born, Rubin and Greenspan into a small room near the committee's main venue at the Rayburn House Office Building, thinking he could mediate. "This is the most unusual meeting I've ever participated in," Leach recalled. "I have never in my life been in a setting where three senior members of the U.S. government reflected more tension. Secretary Rubin and Chairman Greenspan were in concert in expressing frustration with the CFTC leadership. . . . She felt, I'm confident, outnumbered with the two against one."

    Leach thought the futures commission lacked the professional bench to handle oversight. He pressed Born not to proceed until the Treasury and the Fed could agree which agency was best suited to the role. "I tried to take the perspective of, 'I hope we can work this out,' " he said. "Both sides -- neither side, gave in."

    Rubin said, in the recent interview, that he had his own qualms about derivatives, going back to his days as a managing partner at Goldman Sachs. He later wrote in a 2003 book that "derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements," forcing dealers to put up more capital to back the swaps. "But that will almost surely not happen, absent a crisis."

    Asked why he didn't suggest stricter capital requirements as an alternative in 1998, Rubin said, "There was no political reality of getting it done. We were so caught up with other issues that were so pressing. . . . the Asian financial crisis, the Brazilian financial crisis. We had a lot going on."

    Crisis and Ice Cream

    When the warring parties faced off next, in the Senate Agriculture committee's hearing room July 30, 1998, it was not a neutral battleground to air their differences. Chairman Richard G. Lugar, an Indiana Republican, wanted to extract a public promise from Born to cease her campaign. Otherwise, Congress would move forward on a Treasury-backed bill to slap a moratorium on further CFTC action.

    The committee had to switch to a larger room to accommodate the expected crowd of lobbyists representing banks, brokerage firms, futures exchanges, energy companies and agricultural interests, according to a Lugar aide. A dubious Lugar opened the hearing by telling Born: "It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth."

    Born would not yield. She portrayed her agency as under attack, saying the Fed, Treasury and SEC had already decided "that the CFTC's authority should instead be transferred to and divided among themselves."

    Greenspan shot back that CFTC regulation was superfluous; existing laws were enough. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," he said. "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."

    The stalemate persisted. Then, in September a crisis arose that gave credence to Born's concerns.

    Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-to-capital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don't know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript.

    Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world." She spoke of an "immediate and pressing need to address whether there are unacceptable regulatory gaps."

    The near collapse of Long Term Capital Management didn't change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market.

    The battle left Born politically isolated. In April 1999, the President's Working Group issued a report on the lessons of Long Term Capital's meltdown, her last as part of the group. The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change -- a recommendation that brokerages' unregulated affiliates be required to assess and report their financial risk to the government.

    Greenspan dissented on that recommendation.

    By May, Born had had enough. Although it was customary at the agency for others to organize an outgoing chairman's going-away bash, she personally sprang for an ice cream cart in the commission's beige-carpeted auditorium. On a June afternoon, employees listened to subdued, carefully worded farewells while serving themselves sundaes.

    In November, Greenspan, Rubin, Levitt and Born's replacement, William Rainer, submitted a Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States."

    Toward Self-Regulation

    Throughout much of 2000, lobbyists were flying in and out of congressional offices. With Born gone, they saw an opportunity to settle the regulatory issue and perhaps gain even more. They had a sympathetic ear in Texas Sen. Phil Gramm, the influential Republican chairman of the Senate Banking Committee, and a sympathetic bill: the 2000 Commodity Futures Modernization Act.

    Gramm opened a June 21 hearing with a call for "regulatory relief." Peering through his wire-rimmed glasses, he drawled: "I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws -- and I think you could say the same about regulation -- is like asking a man to wear the same clothes he wore when he was a boy."

    Greenspan and Rubin's successor at the Treasury, Larry Summers, still held sway on keeping the CFTC out of the swaps market. But Treasury officials saw an opportunity to push forward on a self-regulation idea from the Working Group's November 1999 report: an industry clearinghouse to hold pools of cash collected from financial firms to cover derivatives losses. But the report had also called for federal oversight to ensure that risk-management procedures were followed.

    The swaps industry generally supported the clearinghouse concept. One amended version of the bill made federal oversight optional. Treasury officials scrambled to act, and a provision introduced by Leach requiring oversight prevailed.

    The House passed the bill Oct. 19, but then the legislation stalled. Gramm was holding out for stronger language that would bar both the CFTC and the SEC from meddling in the swaps market. Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power.

    On the night of Dec. 15, with the nation still focused on the Supreme Court decision three days earlier that settled the 2000 presidential election in George W. Bush's favor, the act passed as a rider to an omnibus spending bill. The clearinghouse provision remained. At the time, it seemed like a breakthrough.

    A clearinghouse would have created layers of protections that don't exist today, said Craig Pirrong, a markets expert at the University of Houston. "An industry-backed pool of capital could have cushioned against losses while discouraging risky bets."

    But afterward, the clearinghouse idea sat dormant, with no one in the industry moving to put one in place.

    'An Absolute Siege'

    In 2004, the SEC pursued another voluntary system. This one, too, didn't work out quite as hoped.

    For years, Congress had allowed a huge gap in Wall Street oversight: the SEC had authority over the brokerage arms of investment banks such as Lehman Brothers and Bear Stearns, but were in the dark about deals made by the firms' holding companies and its unregulated affiliates. European regulators, demanding more transparency given the substantial overseas operations of U.S. firms, were threatening to put these holding companies under regulatory supervision if their American counterparts didn't do so first.

    For the SEC, this was deja vu. In 1999, the SEC had sought such authority over the holding companies and failed to get it. Late in the year, Congress passed the Gramm-Leach-Bliley Act, dismantling the walls separating commercial banks, investment banks and insurance companies since the Great Depression. But the act did not provide for any SEC oversight of investment bank holding companies. The momentum was all toward deregulation.

    "I remember saying at the time, people don't get it -- the level of missed opportunities to address some of these problems," said Annette Nazareth, then the SEC's head of market regulation. "It was an absolute siege on regulation."

    Five years later, the European regulators were forcing the issue again. Restricted by Gramm-Leach-Bliley, the SEC proposed a voluntary system, which the big investment banks opted to join. The holding companies would be permitted to follow their own computer models to assess how much risk they were taking; the SEC would get access to make sure the complex capital and risk-management models were up to the job.

    At an April 28 SEC meeting, commissioner Harvey Goldschmid expressed caution. "If anything goes wrong, it's going to be an awfully big mess," said Goldschmid, who voted for the program.

    Last month, the SEC's inspector general concluded that the program had failed in the case of Bear Stearns, which collapsed in March. SEC overseers had seen Bear Stearns's heavy focus on mortgage-backed securities and over-leveraging, but "did not take serious action to limit these risk factors," the inspector general's report said.

    SEC officials say the voluntary program limited what they could do. They checked to make sure Bear Stearns was adhering to its risk models but did not count on those models being fundamentally flawed.

    On Sept. 26, with the economic meltdown in full swing, SEC Chairman Christopher Cox shut down the program. Cox, a longtime champion of deregulation, said in a statement posted on the SEC's Web site, "the last six months have made it abundantly clear that voluntary regulation does not work."

    It was too late. All five brokerages in the program had either filed for bankruptcy, been absorbed or converted into commercial banks.

    Second Thoughts

    On Sept. 15, 2005, Federal Reserve Bank of New York president Timothy F. Geithner gathered senior executives and risk-management officers from 14 Wall Street firms in the Fed's 10th-floor conference room in lower Manhattan for another discussion about a voluntary mechanism. Also arrayed around the wood rectangular table, covered by green-felt tablecloths, were European market supervisors from Britain, Switzerland and Germany.

    E. Gerald Corrigan, managing director of Goldman Sachs and one of Geithner's predecessors at the New York Fed, had reported in July that the face value of credit-default swaps had soared ninefold in just three years. Without an automated, electronic system for tracking the trades or collateral to back them, the potential for systemic risk was increasing. "The growth of derivatives was exceeding the maturity of the operational infrastructure, so we thought we would try to narrow the gap," Geithner said in an interview.

    Talks have continued on a range of issues, including how to set up a clearinghouse with reserves in case of default -- the same concept in the 2000 legislation -- and what kind of government oversight would be allowed. But three years later, there is no system in place. Some major dealers have preferred to go it alone, and no one in the government told them they couldn't.

    With last month's death spiral of American International Group, the world's largest private insurance company until it was seized by the government, regulators saw their fears play out. AIG had sold $440 billion in credit-default swaps tied to mortgage securities that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its credit-default swap contracts to post billions in collateral that it didn't have. The government swooped in to prevent AIG's default, hoping to ward off another chain reaction in the already shaky financial system.

    The economic crisis has added momentum to the Fed's attempts to organize a voluntary clearinghouse. Geithner held two meetings last week with several firms and major dealers interested in setting up such a mechanism. Last week, the Chicago Mercantile Exchange announced it would team with Citadel Investment Group, a large hedge fund, to launch an electronic trading platform and clearinghouse for credit-default swaps. Other private companies and exchanges are working on their own systems, seeing opportunities for profit in becoming a shock absorber for the system.

    The crisis has prompted second thoughts. Goldschmid, the former SEC commissioner and the agency's general counsel under Levitt, looks back at the long history of missed opportunities and sighs: "In hindsight, there's no question that we would have been better off if we had been regulating derivatives -- and had a clearinghouse for it."

    Levitt, too, thinks about might-have-beens. "In fairness, while Summers and Rubin and I certainly gave in to this, we were not in the same camp as the Fed," he said. "The Fed was really adamantly opposed to any form of regulation whatsoever. I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets."

    Researchers Brady Dennis and Robert Thomason contributed.

    [Oct 15, 2008] Banks and "Innocent Fraud"

    naked capitalism

    John Kay, in "Banks got burned by their own 'innocent fraud'," argues that banks got themselves and the world at large in a heap of trouble via self delusion. Had the bets embodied in their products been presented in simpler terms, they would have recognized that they were bogus and bound to lose money. But the complicated structures blinded them to the fact that they were bound to end in tears.

    Kay draws the term "innocent fraud" from John Kenneth Galbraith and describes it as:

    the process that systematically benefits one group at the expense of another but generally falls short of outright criminality.
    I have trouble with the construct, and am always amazed how activities, if perpetrated by someone outside by the banking classes, are seen in a different light. The damage wrought by the credit crisis is truly colossal, but the fact that the perps (for the most part) thought the products worked and the benefits were shared makes them "innocent?" I don't buy that. Criminality is too low a standard for deeming behavior innocent of not.

    [Oct 15, 2008] Four consequences of US pension losses By Chrystia Freeland

    "What you might call the 401(k) effect has had two political consequences and, in the medium term, will probably have two even more powerful social ones. The first impact is a shift in the public's appetite for radical government action. The same constituents who besieged their members of Congress, calling on them to oppose a "Wall Street bail-out", are now demanding to know why the government has not acted more decisively. The second result has been a big shift in the polls in favour of Barack Obama, who seemed to be faltering a month ago but is now predicted to be heading for a landslide victory."

    October 12 2008 |

    Last week's dizzying rush of events and economic and market data threw up one number which can serve as your Rosetta Stone for understanding what impact the global financial crisis will have on American society: $2,000bn (€1,500bn, £1,200bn). That is the amount Americans have lost from defined-contribution 401(k) pensions over the past 15 months. Peter Orszag, director of the Congressional Budget Office, cited the figure in public testimony last Tuesday, so today the vanished retirement savings will be even greater.

    The hit to the 401(k)s – nearly triple the amount Hank Paulson asked for to rescue Wall Street and more than double the cost of the war in Iraq – most directly connects what had been a crisis of financial institutions and esoteric financial instruments with the lives, and old-age security, of millions of middle-class Americans.

    The credit crunch has been gnawing away at the world's financial sector for more than a year, but as recently as a fortnight ago – the date the House Republicans defied their own party and voted against Hank Paulson's bail-out plan – it still did not have much traction with Main Street America. That started to change even as members of Congress were casting their no ballots – because the US equity markets plunged in response. In the two subsequent weeks they have plummeted further, with the Dow closing 18.2 per cent, its sharpest drop ever.

    The Dow matters to the Joe Six-Packs of America because this is a society of shareholder capitalism. Until this month's sell-off, more than 60 per cent of Americans owned shares, up from just over 10 per cent in 1980. The result is a culture in which business television reporters are celebrities with photo spreads in Vanity Fair, Warren Buffett is a national hero, and the group Republican strategists call "the investor class" forms a majority of the population.

    In boom markets, that is a good thing. But it means that a market sell-off is felt beyond Wall Street. What you might call the 401(k) effect has had two political consequences and, in the medium term, will probably have two even more powerful social ones.

    1. The first impact is a shift in the public's appetite for radical government action. The same constituents who besieged their members of Congress, calling on them to oppose a "Wall Street bail-out", are now demanding to know why the government has not acted more decisively.
    2. The second result has been a big shift in the polls in favour of Barack Obama, who seemed to be faltering a month ago but is now predicted to be heading for a landslide victory. Months of a slowing economy, falling house values and petrol prices spiking above $4 a gallon were not enough decisively to shift the political debate to "the economy, stupid", the field on which the Democrats yearned to play. But the plunge in the Dow – computed with terrifying exactness in the 401(k) statements millions of Americans receive every month – has, and barring a war or a domestic scandal it will likely propel Senator Obama to the White House.
    3. The third, social consequence is not yet being felt, but it soon will be. The culture that gave us the term "retail therapy" seems about to rediscover the virtues of thrift. The assets that Americans measured to calculate their net worth – their homes and stock portfolios – have fallen sharply in value. And the personal credit they used to keep up with the Joneses in a society where so many people seemed to be getting so rich has dried up. One sign of the Zeitgeist: Gawker, the popular, waspish media blog (published by a friend and former FT colleague) this week offered recession-busting survival tips for hip New Yorkers, including buying lunch from street carts and cooking at home.
    4. The fourth consequence of the 401(k) effect hangs in the balance, and its resolution could affect not just the US but the rest of the world. Shareholder capitalism was a vital part of how America connected its most important political tenets – capitalism and democracy which, since the fall of the Berlin Wall, it has been exporting around the world with success. Now that the markets have turned on America's Main Street capitalists, the question is whether their faith will be shaken. Watching TV stock-pickers enthusiastically suggesting we now have a buying opportunity, it seems the answer, for now, is not yet.

    [Oct 14, 2008] Retirement Savers Lost $2 Trillion by Emily Brandon

    Retirement Savers Lost $2 Trillion October 8 | Yahoo (U.S.News & World Report)

    Stock market turmoil has wiped out roughly $2 trillion of Americans' retirement savings over the past 15 months, according to the Congressional Budget Office.

    The value of pension funds and retirement accounts dropped by roughly $1 trillion, or almost 10 percent, in the year ending June 30, the CBO told the House Education and Labor Committee Tuesday, citing Federal Reserve data. Since then, asset prices have dropped even further. The CBO says that retirement assets may have declined by as much as $2 trillion over the past 15 months.

    "To the extent households view balances in defined-contribution plans as part of their overall portfolio of wealth, a decline in those balances could lead people to reduce or delay purchases of goods and services," says Peter Orszag, director of the CBO. "It could also lead some workers to delay their retirement." The CBO says this multitrillion-dollar loss in retirement wealth could further slow the ailing economy.

    Individual 401(k) participants' average losses ranged from 7.2 percent to 11.2 percent in the first nine months of 2008, according to an Employee Benefit Research Institute analysis of 2.2 million participants. Over two thirds of the assets in 401(k)-style defined-contribution plans are invested in equities, either directly or through mutual funds. During the first nine months of 2008, stocks were down, with the S&P 500 index losing more than 19 percent. Fixed-income investments fared better, with the Lehman Aggregate index gaining 0.63 percent and three-month treasury bills gaining 1.54 percent.

    The recent market turmoil may be disproportionately affecting older Americans. Older employees generally have less of their money in stocks and stock funds than do younger workers, which shields them somewhat against catastrophic losses. But older workers' average account balances are markedly higher, so they have more to lose in a significant downturn and less time to recoup losses before retirement. "In the last few weeks, we've been confronted with older workers' and retirees' lives being turned upside down; their panic tops off an already existing state of chronic anxiety about retirement futures," says Teresa Ghilarducci, a professor of economic policy analysis at the New School for Social Research.

    Two potential solutions to retirement losses offered by the CBO are working longer to offset financial declines and sensibly allocating your assets to avoid bearing the risks associated with tumultuous markets as much as possible. For example, most workers should invest in diversified index funds rather than individual stocks.

    Here's another potential strategy to insulate yourself against stock market risks.

    [Oct 13, 2008] Fed Leads Unprecedented Push by Central Banks to Flood Market With Dollars

    "Someone described it as the incredible ebb tide before the tsunami. The dollars beach is dry, but soon they will all come back and cover the buildings."
    naked capitalism

    From Bloomberg:

    The Federal Reserve led an unprecedented push by central banks to flood the financial system with dollars, backing up government efforts to restore confidence and helping to drive down money-market rates.

    The ECB, the Bank of England and the Swiss central bank will auction unlimited dollar funds with maturities of seven days, 28 days and 84 days at a fixed interest rate, the Washington-based Fed said today. All of the previous dollar swap arrangements between the Fed and other central banks were capped.

    ``By providing unlimited dollar funds they are acting on the back of the G-7 plan to ensure the system is fully liquidized,'' said Lena Komileva, an economist at Tullett Prebon Plc in London. ``We're going to see even more liquidity provided and more aggressive rate cuts are coming.''

    Leaders of the world economy have redoubled efforts to unfreeze credit markets and avert the worst global recession in thirty years after last week's 20 percent slide in the MSCI World Index. Policy makers from the Group of Seven nations pledged at the weekend to take ``all necessary steps'' to stem a market panic and European governments are today announcing plans to avert a banking collapse across the region.

    The cost of borrowing in dollars for three months today fell to 4.75 percent from 4.82 percent, the highest this year. The rate for euros over the same timeframe declined to 5.32 percent from 5.38 percent.....

    ``Taken together, the latest moves increase the chances that we will begin to see some relaxation of the intense funding stresses,'' Dominic Wilson and other economists at Goldman Sachs Group Inc. wrote in a note today. ``This is because bank solvency risk should decline as the government offers protection.''

    As well as slashing interest rates in concert last week, global central banks are expanding their toolkits to push down money-market rates. The Fed on Oct. 7 said it will create a special fund to buy U.S. commercial paper and the ECB last week said it would offer financial firms unlimited euro funds. The Bank of England is scheduled to revamp its own money-market operations later this week.

    baychev said...
    One reader in another post linked an article in WSJ according to which European banks are big borrowers in USD commercial paper. If they can't roll over they have to liquidate their positions or borrow elsewhere, hence this new 'facility'.
    Anonymous said...
    Although I like this blog, and especially the discussions here, I'm getting more confused now. It sounds like the FED is just so powerful, with unlimited supply of dollars. Why do you people worry about a meltdown in the last few days? Is there any downside for FED to do this?
    fresno dan said...
    Trends can continue past sustainability - but eventually they can't continue. And that can happen suddenly. As some point everyone will realize that dollars are just pieces of paper, and the dollar will re-adjust, and in my view, dramatically.
    wintermute said...
    The worldwide shortage of dollars is indicative of a huge unwinding of dollar denominated assets and debt. Think of it as stage one in a process of obtaining liquid investments - cash. This is temporarily boosting the dollar.

    The big unknown is how long the foreign holdings will remain in dollars. It will be a wait-and-see whether the US economy handles the credit crisis better than others. If US country risk remains higher than other centers - stage two of the unwind begins and dollars are converted to other currencies or gold and commodities.

    printfaster said...
    Let's see if we can break down what is happening.

    Here is the equation for velocity of money:

    Velocity = GDP or economic activity
    Money supply

    Let's take a look at what happens when the US economy tanks, ie GDP sinks, then velocity goes down. Let's say credit collapses, cutting the money supply, then velocity starts going up, or to keep economic activity at the same level velocity goes up. We are seeing the demand for dollars because of credit collapse in an attempt to keep economic activity from tanking.

    If the Fed and treasury try to up the money supply in an attempt to keep velocity from running out of control (high velocity means running with a paycheck to buy essentials before the price goes up), then eventually the total value of that money decreases in terms of a reference, say gold.

    The need for money is being seen in the current drop of gold price (liquidation to find dollars), and rise in the dollar. As the effects of the fed and treasury work through, the results will be the devaluation of the dollar, until a rise in economic activity can compensate.

    The end result is severe monetary inflation, even though the current dynamics are for deflation.

    Someone described it as the incredible ebb tide before the tsunami. The dollars beach is dry, but soon they will all come back and cover the buildings.
    donna said...
    More like a bathtub than a tsunami. We're pouring in more money, but the drain is still open. Someone has to take the losses from the CDS mess, and the central banks are still trying to save all the players. But the money is simply gone, it doesn't exist and can't be monetized. They're trying to spread out the losses, but there still have to be losses.
    Anonymous said...
    What are the best indicators to forecast the potential for hyperinflation?

    There's no need to worry about hyper-inflation short term. Just small increases in long interest rates will set off another chain reaction of deleveraging, deflation and institutional failure.

    What happens to the remnants of the residential and commercial real estate markets when prime mortgage rates go up to, say, 8.5%? And at a time when real incomes are falling and lending standards are being torques down?

    Like the man said last night, sell this pop.

    LJR said...
    It is becoming quite clear why Japan allowed all that bad debt to stay on the books. And this was BEFORE the wholesale abuse of Credit Default Swaps.

    My question is whether the world governments are going to stand behind the CDS that come with the banks they recapitalize. If so they simply can't let the market discovery mechanism work and mark to model will rule the day.

    Japan could survive because the bad loans weren't protected by swaps. Not the case this time. Either the government has to "simulate" an income stream for bad loans or let the swaps pay off. Am I missing something here?

    Anonymous said...
    More like a bathtub than a tsunami. We're pouring in more money, but the drain is still open.

    The cycle of a stopped up flushing toilet is far closer to the truth.

    Everyone's stale nostrums, worn-out cliches and false historical analogies are failing. The scene changes like a kaleidoscope daily. That's the neat part of truly revolutionary times. What was too radical to consider last week is already overcome by events next week.

    Now, when this week's Ancient Regime rescue plan peters out in a week or a month, what next?

    This is not a mass failure of financial systems. It's a mass failure of financiers.

    Soros's sock puppet Obama promises "real change", unlike Goldman Sachs dominated Bush/McCain. And what's his latest bold change? A pathetic copy from FDR's playbook: Bank holiday - foreclosure holiday.

    Obama's a #2 alright. But he's not FDR II. He's Gorbachev II.

    [Oct 13, 2008 ] Daily Kos State of the Nation by Devilstower

    I think that corruption was on both sides republican and democratic so obvious bias toward republicans should be taken with a grain of salt ;-). Still the compete absence of checks and balances is really astonishing.
    Sep 21, 2008 | dailykos

    "Once is happenstance. Twice is coincidence. Three times is Enemy Action."
    -- Auric Goldfinger

    James Bond's wealthy nemesis may have had an obsession with gold, but he judged, quite correctly, that if people keep putting your plans awry, that was likely their intent.

    In 1982, the same year John McCain entered the Senate, a bill was put forward that would substantially deregulate the Savings and Loan industry. The Garn-St. Germain Depository Institutions Act was an initiative of the Reagan administration, and was largely authored by lobbyists for the S&L industry -- including John McCain's warm-up speaker at the convention, Fred Thompson. The official description of the bill was "An act to revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans." Considering where things stand in 2008, that may sound dubious. It should.

    Seven years later, the S&L industry was collapsing. What was the cause? Garn-St. Germain handed the S&Ls a greatly expanded range of capabilities, allowing them to go head to head with full service banks, but it didn't give them the bank's regulations. Left to operate in an anarchistic gray area, S&Ls chased profits, indulged in amazing extravagances, and cranked out enough cheap mortgages to fuel a real estate boom. They also experimented with lots of complex, creative -- and risky -- investments, even though they didn't have the economic models to really determine the worth of the things they were buying. The result was a mountain of bad debts and worthless "assets." Does any of that sound eerily (or nauseatingly) familiar?

    It wasn't a foregone conclusion. In 1985, three years after the deregulation of the S&Ls, the chairman of the Federal Home Loan Bank Board saw that the situation was already looking shaky, with the potential to become much worse. He instituted a rule to limit the amounts and types of investments S&Ls could carry on their books in an effort to head off disaster. However, many savings and loans -- among them Lincoln Savings & Loan Association of Irvine, CA, which was headed by a fellow named Charles Keating -- promptly ignored these rules.

    Now enters a familiar cast of characters. First to pop up was the universally beloved Fed-chief-to-be, Alan Greenspan. Greenspan argued against the loan board's new rules, and persuaded Reagan to appoint one of Keating's pals to the board to blunt the requirements. A quintet of senators, among them John McCain, began having meetings with both the management at Lincoln and the regulators at the loan board. ] Alan Greenspan also helped out with a letter to the regulators, asking that Lincoln be exempt from the new rules. With their help of Greenspan and their pet senators, Lincoln was able to stay in business an additional two years, at the end of which they failed -- taking the life savings of 21,000, mostly elderly, investors with them.

    How involved was John McCain? McCain and Keating had known each other since 1981 and had become fast friends. Of all the "Keating Five," it was McCain who moved into the life of the Lincoln S&L chief. The two men vacationed together multiple times, with the whole McCain clan (babysitter included) heading out for Keating's private Caribbean property on Keating's private jet. McCain didn't think to actually report these trips, or pay for them, until the investigators were breathing down his neck. And McCain took his payment in the form of more than just vacations. Keating and other members of Lincoln's parent company padded McCain's pockets with $112,000 in campaign contributions.

    In John McCain's biography, he called his meetings with Keating and regulators "the worst mistake of my life," though from the text you'd think this was a spur of the moment decision, not something that McCain did repeatedly over a space of years. Still, you might think that a "worst mistake" would stay fresh in his memory.

    It certainly didn't fade quickly for the country. Following the S&L crisis, the Resolution Trust Company was formed to swallow up the debt of Lincoln and 746 other S&Ls gone wild, and taxpayers were left with the $125 billion bill. The resulting budget deficit forced cutbacks in other programs. The artificial real estate boom collapsed and housing starts fell to their lowest levels in decades. Finally, the whole nation settled in for a period nasty enough that three years later someone could still campaign around the idea "It's the economy, stupid."

    Even so, by 1999 Phil Gramm -- who had entered the Senate two years after McCain and quickly become the economic guru of the Keating Five maverick -- put forward the Gramm-Leach-Bliley Act. This Act passed out of the Senate on a party line vote with 100% Republican support, including that of John McCain. (To be fair, the bill eventually passed again with a wide margin following revisions in the House.)

    This act repealed part of the Glass-Steagall Act. This may sound like a bunch of Congressperson soup, but the gist of it is that Glass-Steagall was put in place in 1933 to control the rampant speculation that had helped cause the collapse of banking at the outset of the depression, and to prevent such consolidation of the banks that the nation had all its eggs in one fiscal basket.

    Gramm-Leach-Bliley reversed those rules, allowing not only more bank mergers, but for banks to become directly involved in the stock market, bonds, and insurance. Remember the bit about how S&Ls failed because they didn't have the regulations that protected banks? After Gramm-Leach-Bliley, banks didn't have that protection either.

    Gramm wasn't done. The next year he was back with the Commodity Futures Modernization Act, which was slipped into a "must pass" spending bill on the last day of the 106th Congress. This Act greatly expanded the scope of futures trading, created new vehicles for speculation, and sheltered several investments from regulation.

    As with both Gramm-Leach-Bliley and Garn-St. Germain, large parts of this bill were written by industry lobbyists. This famously included the "Enron Loophole" that exempted energy trading from regulation and was written by (big suprise) Enron Lobbyists working with Gramm. Not coincidentally, Senator Gramm, the second largest recipient of campaign contributions from Enron, was also key to legislating the deregulation of California's energy commodity trading.

    Thanks to this fortunate trifecta of Gramm-crafted legislation, Enron was able to create "EnronOnline" and trade electricity in California with absolutely no oversight or transparency. They quickly worked out how to game the system. Previously, there had been only one Stage 3 rolling blackout in the history of California. Within months, the system had been manipulated by traders to generate 38 such blackouts and wholesale electrical prices had gone up more than 3000%. Despite production capacity equal to four times the demand during winter, energy traders even engineered a blackout in mid-January.

    During the confusion of these deliberate "shortages" and "price spikes," the California administration of Gray Davis -- blind to speculator manipulations because of the walls erected by Gramm's legislation -- was forced to sign energy contracts at enormous rates. There was little choice, because most of California's public utilities were on the brink of bankruptcy from the rising wholesale prices.

    In a single year, Gramm's legislation allowed speculators to bring the state to its knees. Enron alone looted California of $11 billion. The manipulations of the energy market were also a major factor in Davis getting the hook, helped usher the governator into power, and they still have repercussions in California's budget battles today. By the end of that year, the depth of Enron's deception could no longer be hidden, and the whole company came crashing down in the largest bankruptcy in history -- at the time. This brought more billions lost in mutual funds and pension funds across the country, and played a major role in the economic downturn of 2001.

    But that was only the second act. The combination of Gramm-Leach-Bliley and the Commodity Futures Modernization Act was a toxic cocktail whose total damage was greater than the sum of its parts.

    The first Act promoted bank buyouts and mergers that reached such an insane pitch that the average consumer could only keep up by tracking the changing names on their checks and credit cards. Mercantile buys Ameribanc and Mark Twain. Firstar buys Federated and First Colonial. US Bancorp buys Mercantile and Firstar. And, because it allowed brokerages and insurance companies to mingle with banks, the Act cemented a trend that was already (and illegally) underway in which all those terms had become rather quaint. Is Wachovia a savings bank, an investment bank, a brokerage, or an insurance provider? The answer is "yes."

    In allowing financial institutions to grow to Godzilla-sized proportions, Gramm-Leach-Bliley helped ensure that we would have financial entities that were "too big to fail." Rather than choosing to enforce rules that kept these institutions apart, the deregulators chose to create monster bankeragasurances whose downfall (and existence) was enough to threaten the whole system.

    But if Gramm-Leach-Bliley removed the limits on size and scope, these new institutions still needed fuel. With many financial transactions operating on razor thin margins, and increasing automation sapping the profits from trading of all sorts, they needed a new way to generate the funds required to swallow their brethren in the merged fiscal corporation pond. For that, the Commodity Futures Modernization Act was a godsend.

    Among those instruments which the CFMA sheltered from regulatory scrutiny was something called the "credit default swap." A kind of insurance one bank could exchange with another, credit default swaps supposedly made it safe for banks to take on ever riskier forms of debt. The Act didn't invent these swaps, though they were relatively new. Instead, by placing them in a state where they were not only unregulated but almost perfectly opaque, credit default swaps were turned into the perfect vehicle to fuel a Wall Street revolution. No one had any idea what these things were actually worth, they were traded "over the counter" without being administered by any exchange, and even the SEC could monitor their existence only indirectly.

    Who would cheer for a new kind of financial instrument that was difficult to understand, invisible to regulators, and impossible for even the whizziest of Wall Street whiz kids to value? Guess.

    More recently, instruments that are more complex and less transparent--such as credit default swaps, collateralized debt obligations, and credit-linked notes--have been developed and their use has grown very rapidly in recent years. The result? Improved credit-risk management together with more and better risk-management tools appear to have significantly reduced loan concentrations in telecommunications and, indeed, other areas and the associated stress on banks and other financial institutions.

    --Alan Greenspan, 2002

    Get that? Greenspan loved credit default swaps. He opined again and again that such instruments would be the salvation of the industry by spreading around risks. To the mighty Greenspan, both their complexity and their lack of transparency were good things, since swaps would only be handled by the big boys who knew how to play with fire.

    When questioned about his support of Gramm's legislation, John McCain called his friend (and by then, campaign co-chair) Gramm "one of the smartest people in the world on the economy" and pointed out that Greenspan also favored the acts Gramm and his coalition of lobbyists had authored. If both Gramm and Greenspan were on his side, McCain couldn't possibly be in the wrong.

    Except, of course, that he could.

    From the beginning, there were plenty of people in the financial community whose opinion of these unregulated credit swaps was not as rosy as that of Gramm, Greenspan, and McCain. Chief among those speaking in opposition was SEC Chairman, Arthur Levitt. Levitt argued that what the industry needed was more transparency, especially when it came to complex instruments like default swaps, and he testified to this before Gramm's Senate Banking Committee,.

    "In my judgment, the risk of this regulatory approach is simply unacceptable for America's investors."
    --Arthur Levitt, 1999

    Gramm paid no attention.

    Credit default swaps did allow the banks to share risks. So much so, that banks raced each other in an effort to find more risks. They made it possible for the down payment on homes to become 3%, 1%, 0%. Skip the credit check, avoid the employment requirements, damn the torpedoes, full speed ahead! We've got a credit default swap, we can do anything!

    The encouragement and "safety" that credit default swaps provided made the sub-prime mortgage market possible. Just as with the deregulation of S&Ls in the 1980s, the market was suddenly flooded with easy credit. The result was a real estate boom, soaring home prices, and a plague of "Flip that House!" shows on cable.

    As the banks piled up crappy mortgages, they heaped on ever more of the credit default swaps -- and they still had no idea how to value the things. Worse, they began to trade the swaps themselves as if they were an investment, treating them like something worth holding instead of a big bundle of cartoon bombs whose fuses were already lit. Since very few loans were falling into default at the time, owning a default swap seemed like a way to collect fees without ever paying out. Banks wanted more, and more, and more.

    A secondary market for trading swaps exploded into existence, and swaps were traded with absolutely no consideration for the nature or quality of the underlying investment. Swaps changed hands a dozen or more times, growing in "value" as they went. Worse still, no one regulated who could buy a swap, so it was (and is) perfectly possible for a company to acquire swaps that theoretically cover billions of dollars in loans, even if that company doesn't have a red cent on hand to cover those swaps should the loans default.

    How big did this market become? Here's business correspondent Bob Moon and host Kai Ryssdal on American Public Media's Marketplace from back in the spring.

    BOB MOON: OK, I'm about to unload some numbers on you here, so I'll speak slowly so you can follow this.

    The value of the entire U.S. Treasuries market: $4.5 trillion.

    The value of the entire mortgage market: $7 trillion.

    The size of the U.S. stock market: $22 trillion.

    OK, you ready?

    The size of the credit default swap market last year: $45 trillion.

    KAI RYSSDAL: That's a lot of money, Bob.

    As in three times the whole US gross domestic product, Bob. And the truth is that Moon probably underestimated. The unregulated and poorly reported credit default swaps may have actually passed $70 trillion last year, or about $5 trillion more than the GDP of the entire world.

    So, are you starting to get an idea of just how big a genie Phil Gramm and his pals unleashed?

    With some regularity over the last eight years, fiscal whistle blowers have tried to raise their hands and register a protest. Um, sirs? Is it altogether a good idea to run up debts exceeding all the assets it's even possible to hold? But so long as no one actually had to pay off on the swaps, the party went on. Even usually conservative (in the fiscal sense) companies like AIG started to worry that they were being left behind and leapt headlong into the swap pool.

    Shortly after Greenspan's departure in 2006, the Federal Reserve took the unusual step of issued a joint statement along with the SEC to warn about the risks associated with credit default swaps. But by that point, the damage was already severe. If swaps lost their value, most of those who had played the game would find their giant firms abruptly valued in pocket change. The only solution was to cover the problem with still more swaps and keep moving.

    Then a funny thing happened. After years in which banks had handed out loans willy-nilly, guarded by the indestructible swap, people and companies started to really default on those loans. Credit slowed, home prices fell, and the whole snake started to eat itself tail first. Suddenly, credit default swaps were not sources of limitless cash. It turns out that an insurance policy -- even a secret, unregulated policy -- is occasionally expected to pay. Speculators started to look at the paper they were holding and for the first time realized it could all be worthless. Worse, it could (and did) represent a massive debt; one that no one had the funds to cover.

    When Bear Stearns fell apart last March, it was only suspected that a big part of the effort in saving the giant investment bank was keeping their holdings in credit default swaps from unraveling and spreading to other institutions. Naturally, part of solving this problem involved creating a new credit default swap to cover Bear Stearn's potential debt. But the all-purpose swap was starting to lose its power. Shortly after Bear Stearns went belly up, AIG reported the largest quarterly loss in the company's history, taking a $11 billion hit on revaluing its holdings of swaps. The party was definitely coming to a close.

    When AIG finally collapsed this week, there was no doubt about the primary cause of its failure. The previously well grounded company had "gotten itself involved with something called credit default swaps." Point of irony alert: Arthur Levitt now serves on the AIG board... or at least he did until the government had to take over most of AIG to salvage the company from the very idiocy Levitt had warned of in 1999.

    This week, the Bush administration announced the beginnings of a plan to salvage what remains of the financial markets. At first glance, it appears that the plan will consist mainly of creating a kind of "garbage pit," a fund or group of funds -- cousins of the Resolution Trust that was created during the S&L crisis -- into which those people who have dabbled in bad debts can toss their problems. Only this time the cost to the taxpayers is at least $700 billion... and a big bite out of representative democracy.

    The expansion of unregulated Savings and Loans in the 1980s brought on the collapse of that industry, a crippling of the economy, and left taxpayers holding the bag. Maybe that was only happenstance. Those pushing for the Garn-St. Germain Depository Institutions Act may not have known what they were doing.

    The deregulation of the California electricity market, along with the protections provided to Enron through Phil Gramm's lobbyist-written legislation brought blackouts, fiscal and political chaos, and left taxpayers holding the bag. But the people who engineered that event -- people like Gramm and Greenspan -- had already seen what happened with the S&Ls. They should have known better. Still, perhaps that was only coincidence.

    The sub-prime mortgage crisis that has not only come so close to utterly destroying the markets, but has ruined the value of many people's homes and left millions with mortgages they can't pay, was also the outcome of the deregulation created by these men. The very predictable outcome. When taxpayers are left holding the bag for $1 trillion this time around, it's hard to believe it's any sort of accident.

    This is enemy action. This is a bullet deliberately fired into the economy by men willing to exercise their ideology regardless of the cost to taxpayers. Men who have every expectation that they can plunder the system again and again, while the public picks up the tab. John McCain may not have had his finger directly on the trigger, but he was there. He assisted. These were his personal friends and philosophical comrades. He may not be the high priest, but he has been a loyal acolyte in the cult of deregulation.

    It may come as a surprise to the champions of deregulation, but nobody likes regulation. The restrictions that were placed on banks, S&Ls, and other institutions in the 1930s weren't put there because someone thought it would be fun. They were put in place because they addressed problems that had just been clearly and painfully revealed. They were put in place because they were necessary.

    It's bad enough if John McCain didn't know that. It's far worse if he did.

    [Oct 13, 2008 ] Readers Journal-A 70 Trillion Dollar Counterfeiting Ring

    Now we go to the 70 trillion dollar credit default swap market of last year. If only 1 to 2 percent "service fee" were charged in these transactions (which are based on illusory assets), we're talking nearly three-quarters to one-and-a-half trillion dollars in real term fees being siphoned off (i.e. hijacked from) the global economy for no productive, but merely parasitic, purpose. If these fees are attached to phony assets, as I have propounded, than that means a net loss of, say, a trillion dollars of capital taken right out of the system. No wonder we have a liquidity crisis.

    [Oct 12, 2008 ] The Financial Crisis: Why Were Warnings Ignored?--Posner

    When Becker and I blogged on the financial crisis last Sunday, the bailout had just been announced. The reaction of the stock markets and of senior government officials here and abroad suggests that the premise of the bailout--that the financial crisis is a liquidity crisis that can be resolved by the government's buying the assets of troubled banks at prices equal to the value the assets would have if there were a market for them (that is, if there were adequate liquidity to enable transactions)--was mistaken. The crisis appears to be one of solvency rather than (or perhaps along with) one of liquidity; banks, along with insurers of bonds and other securities, are undercapitalized and so, as I suggested last week, require a capital infusion rather than just a purchase of frozen assets.

    All of which merely underscores the enormous cloud of uncertainty that has enveloped the crisis and left economists struggling to understand the causes, magnitude, future course, and cures of what is shaping up as the biggest economic bust since the Great Depression of 1929 to 1933. Last week's stock market crash may also reflect doubts about the government's competence to deal effectively with the crisis. There is a sense that its reluctance to take an equity stake in the banks reflects a doctrinaire hostility to public ownership.

    But here is the biggest mystery of all: why was the crisis not foreseen? An article on the front page of the business section of yesterday's New York Times attributes that blindness to "insanity," more precisely to a psychological inability to give proper weight to past events, so that if there is prosperity currently it is assumed that it will last forever. This explanation is implausible--often people fail to adjust to change because they expect the future to repeat the past--and unhelpful, especially when one remembers that the academic specialty of Federal Reserve Board chairman Bernanke is the Great Depression.

    We can get more help in answering the question of unpreparedness, or neglect of warning signs, from the literature on surprise attacks, notably Roberta Wohlstetter's great book Pearl Harbor: Warning and Decision (1962). As she explains, there were many warnings in 1941 that Japan was going to attack Western possessions in Southeast Asia, such as the Dutch East Indies (now Indonesia); and an attack on the U.S. fleet in Hawaii, known to be within range of Japan's large carrier fleet, would be a logical measure for protecting the eastern flank of a Japanese attack on the Dutch East Indies, Burma, or Malaya. Among the factors that caused the warnings to be disregarded are factors that may also have been decisive in the neglect of the advance warnings of the financial crisis now upon us: priors (preconceptions), the cost and difficulty of taking effective defensive measures against an uncertain danger, and the absence of a mechanism for aggregating and analyzing warning information from many sources. Most informed observers in 1941 thought that Japan would not attack the United States because it was too weak to have a reasonable chance of prevailing; they did not understand Japanese culture, which placed a higher value on honor than on national survival. Securing all possible targets of Japanese aggression against attack would have been immensely costly and a big diversion from our preparations for war against Germany, deemed inevitable. And there was no Central Intelligence Agency or other institution for aggregating and analyzing attack warnings.

    Much the same is true of the warning signs of the current financial crisis. Reputable business leaders and economists had been warning for years that our financial institutions were excessively leveraged. In mid-August of this year the New York Times Magazine published an article foolishly entitled "Dr. Doom" about a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini, who for years had been predicting with uncanny accuracy what has happened. In September of 2006--two years ago--he had "announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac." By August of this year, when the Times article was published, Roubini's predictions had come true, yet he continued to be ignored. Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics. Bernanke had repeatedly stated that it was unlikely that the mortgage defaults that accelerated after the housing bubble burst in mid-2006 would spill over to the financial system or the broader, nonfinancial economy. In May of 2007, for example, he said: "Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market." It has been more than two years since the housing bubble burst. One might have thought that that was enough time to enable the experts to discover that our financial system was in serious trouble.

    Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks. Borrowing and then lending the borrowed funds is inherently risky, because you have fixed liabilities but (unless you invest in risk-free assets such as short-term Treasury Bills) risky assets. But it was believed that the risks of borrowing had been reduced and therefore that leverage (the ratio of borrowing to capital) could be increased without increasing risk. Bayesian decision theory teaches that when evidence bearing on a decision is weak, prior beliefs will influence the decision maker's ultimate decision.

    Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble--and then Congress or the Administration would have been blamed for the fall in home values and the increase in defaults and foreclosures. In addition, it is very difficult to receive praise, and indeed to avoid criticism, for preventing a bad thing from happening unless the probability of the bad thing is known. For if something unlikely to happen doesn't happen (as by definition will usually be the outcome), no one is impressed; but people are impressed by the costs of preventing that thing that probably wouldn't have happened anyway. This is why Cassandras--prophets of doom--are so disliked. It usually is infeasible as a practical matter to respond to their warnings--but if the prophesied disaster hits, those who could have taken but did not take preventive action in response to the warnings are blamed for the disaster even if their forbearance was the right decision on the basis of what they knew.

    The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown. The cost of a disaster has to be discounted (multiplied) by the probability that it will occur in order to decide how much money should be devoted to reducing that probability. No one knew the probability of a financial crisis such as we are experiencing. Even Roubini did not (as far as I know) attempt to quantify that probability.

    Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk. Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks and other financial institutions and of regulatory bodies, and among academic economists, financial consultants, accountants, actuaries, rating agencies, and business journalists. But there was no financial counterpart to the CIA to aggregate and analyze the information--to assemble a meaningful mosaic from the scattered pieces. Much of the relevant information was proprietary, and even regulatory agencies lacked access to it. Companies do not like to broadcast bad news, and speculators planning to sell a company's stock short do not announce their intentions, as that would drive the stock price down, prematurely from their standpoint.

    In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.

    Of all the puzzles about the failure to foresee the financial crisis, the biggest is the failure of foresight of professors of finance and of macroeconomics, with a few exceptions such as Roubini. Some of the media commentary has attributed this to economics professors' being overly reliant on abstract mathematical models of the economy. In fact professors of finance, who are found mainly in business schools rather than in economics departments, tend to be deeply involved in the real world of financial markets. They are not armchair theoreticians. They are involved in the financial markets as consultants, investors, and sometimes money managers. Their students typically have worked in business for several years before starting business school, and they therefore bring with them to the business school up-to-date knowledge of business practices. So why weren't there more Roubinis? I do not know. And why, if not more Roubinis, not more financial economists who took the warning signs sufficiently seriously to investigate the soundness of the financial system? I do not know that either.

    [Oct 12, 2008] IMF warns that markets could collapse by another 20% - Times Online

    The world is on the brink of financial meltdown, the head of the International Monetary Fund (IMF) said last night. His bleak warning came as finance ministers tried to calm the frenzy in markets that saw share prices crash by more than 20% last week.

    Separately, the IMF's chief economist predicted that shares could slump by another 20% before stabilising. G7 finance ministers pledged to take all necessary steps to support the banking system and stave off an economic slump.

    Dominique Strauss-Kahn, the head of the IMF, warned that the measures so far "have not yet achieved the goal of stabilising markets and bolstering confidence".

    He said: "Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown." Countries would need to take further measures, including interest rate cuts and steps to bolster the banks.

    [Oct 12, 2008] From the Archive - Op-Classic, 1990 - Gloom at the Stock Exchange. By Henry Kaufman

    In case of 1990 crisis the collapse of the USSR and dollarization of former "socialist camp" territories saved the USA. Newly independent countries absorbed tremendous amount of dollars like water. That's why the Greenspan Fed managed to maintained a 1.75% Fed fund for 33 months (December 2001 to September 2004) without negative consequences at all. Repeating the same trick -- keeping rate at 1% from 2002 (accounting scandals) till June 2004 -- was a complete disaster. New markets created new demand that was the real basis of a stock boom of 1994-2000. This time there is not USSR to collapse. Some of them are bankrupt (Ukraine, Baltic countries) some have reserves (Russia, and some 'stans") but they cannot serve as "consumer of last resort" for bailing out the US this time. Like Andrew Leonard noted in his Salon aprticle Alan Greenspan on the mortgage crisis I didn't do it! "capitalism triumphed all over the world, and then proceeded to eat itself. "
    February 23, 1990 |

    Every week, the Opinion section presents an essay from The Times's archive by a columnist or contributor that we hope sheds light on current news or provides a window on the past.

    In 1990, in the wake of the collapse of Drexel Burnham Lambert and the failure of savings and loan associations, the economist Henry Kaufman foresaw an unhappy new era in which we would have to pay for Wall Street's recklessness.

    Wall Street Heads For Darker Days

    The demise of Drexel Burnham Lambert Inc. has been portrayed as the end of an era, and in many ways it is. But it also marks the beginning of a new, darker era in which Wall Street and the nation will pay a heavy price for the excesses of the last decade.

    Drexel Burnham's collapse is symptomatic of a deeper problem: the abuse of the American credit system. The consequences of this abuse now abound.

    Hundreds of savings and loan associations will have to be closed down, costing taxpayers hundreds of billions of dollars. Many other financial institutions have been significantly weakened by poor-quality loans and investments. The credit quality of American corporations is at its lowest point since the Great Depression, despite seven years of economic expansion.

    The abuse of the credit system began more than a decade ago, through a series of events and developments that loosened the structure of the financial system. That fostered a highly aggressive financial entrepreneurship that severely impaired the remaining code of prudent financial conduct.

    The credit system suffered further from the Government's willingness to allow deregulation to proceed in the absence of adequate new safeguards, improved official financial supervision and stricter rules of financial conduct. Instead, from Main Street to Wall Street, excesses multiplied through the employment of novel financial techniques and liberalized credit standards that were unthinkable even two decades ago.

    Hardly anyone in authority stopped to question the implications for the financial system. The facile rhetoric was that the ''marketplace'' would discipline the wrongdoers in our financial system.

    But relying on the market to discipline financial institutions is generally unacceptable. It is too blunt a weapon for financial institutions, which are thinly capitalized and closely linked through myriads of transactions with other institutions.

    Financial institutions are the holders and, therefore, the guardians of our savings and temporary funds, a unique public responsibility. Truly letting the marketplace discipline the financial system would mean acquiescing in an avalanche of potential failures - including many salvageable financial institutions and many of their customers.

    The excesses of financial entrepreneurship have been abetted by a kind of ''hollowing out'' of the financial regulatory system. Because of piecemeal legislation, official supervision and regulation is highly fragmented. That has meant heavy and inefficient overlapping authority in some areas and enormous regulatory gaps in other areas.

    Specifically, the two agencies with responsibility for the securities industry, the Securities and Exchange Commission and the Federal Reserve Board, hold opposite - and probably irreconcilable - theories of financial regulation and supervision.

    In a nutshell, the Fed believes that the holding-company parent and all affiliates of a bank or securities firm ought to be supervised on a consolidated basis. The S.E.C.'s legal authority is narrowly focused on the broker/ dealer operation of a securities firm.

    Thus, under the terms of its mandate from the S.E.C., the New York Stock Exchange must concentrate its surveillance on the broker/dealer. It has little authority to go into other affiliates of the broker/dealer's parent, even if they are involved in financial activities.

    This regulatory fragmentation, and the loopholes it provides, has not been lost on Wall Street. The leading securities houses have all sought to increase their financial leverage by forming elaborate holding companies. To this end, they use creative, though permissible, accounting techniques to hide from public view their gross asset and liability structures.

    Thus, the end of Drexel Burnham does not mean the end of the unwinding of the financial recklessness of the past decade. Continued slow economic growth or a business recession will bring forth failures that are still hidden in the financial fabric.

    For many firms in the securities industry, the franchise that they once had will not be recaptured. Wall Street's special role as adviser and investment banker to business and to other financial institutions is waning rapidly. The foundations of this role were based on trust. That trust has been shattered by conflicts of interest that were created when many securities firms rushed to participate in hostile takeovers and direct acquisitions of nonfinancial businesses.

    In the wake of the Drexel failure, the task of rebuilding a strong financial base for our corporations and financial institutions will require tax inducements, the strengthening and centralization of official financial supervision and the establishment of standards to hold corporate directors accountable for objective evaluations of corporate management performance.

    Under such a stiffened regulatory approach, Wall Street firms would probably be confronted with more stringent capital requirements and closer supervision of all the activities under their holding companies. With the loss of much of their franchise, the number and size of securities firms will eventually shrink. Many will become parts of banks or other financial institutions.

    Already, there are voices here and there in the securities industry calling for an end to Glass-Steagall, the Depression-era law that required banking and securities to remain separate businesses. This may signal that a merger with a commercial bank might be a preferred way out of the troubled position that many Wall Street firms now face.

    Outside Wall Street, few will mourn this outcome, especially in view of the excesses of the recent past. But however understandable that reaction may be, there will be an indirect economic consequence that we all will have to shoulder.

    In the more concentrated U.S. financial structure of tomorrow, conflicts of interest will flourish. This will invite governmental intrusion, less innovation and, ultimately, a more inefficient allocation of capital.

    [Oct 11, 2008] Soros Lambasts Paulson, Call for Intervention

    Soros understood the coming credit default swaps fiasco is coming six month before it occurred. And those guys in Fed and Treasury with all their research staff and facilities did nothing to prevent it... As one reader noted: 'Once upon a time, there was something called "The Peter Principle"....'
    April 3, 2008 | naked capitalism

    George Soros, in today's Financial Times, joins a long list of critics of the Paulson financial services reform plan, although even to dignify its bureaucratic legerdemain with the label "reform" is singularly misleading.

    Soros departs from his peers in sketching out where he thinks regulators went wrong and offers two specific proposals, I am particularly keen about his idea of moving credit default swaps to an exhange; as I've discussed before, that is one of the cleanest and most sensible options available, and it would be viable in a large, active market like CDS.

    From the Financial Times:

    The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

    Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants' biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

    Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed's decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

    The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

    The Bush administration has resisted using taxpayers' money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers' money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.


    Anonymous said...
    "You lose all the advantages of derivative."
    The problem: The CDS market, as played today, has very little real value ? An insurance policy that can't pay off when the S**t hits the fan is not an insurance policy, it is a scam.

    Just like a mortgage that can't pay.

    Andrew Teasdale said...
    I have felt for a long time that an OTC market merely places the risk above the banking system.
    An exchange is the only way to diversify, price and manage risk. It will also reduce "transaction" returns since one of the reasons for OTC contracts are the higher returns on creating them.

    I would also recommend that all derivative contracts be ultimately exchange traded. A competitive capitalist system depends on pricing competition and transparency.

    The financial institutions have forgotten that they are the medium through which the capitalist system operates and not the end itself.

    The explosive development of OTC derivative markets since 2000 has corrupted the financial system that supports capitalism.

    Andrew Teasdale

    The TAMRIS Consultancy

    By the way, this really is a great blog

    Dave Raithel said...
    Michael Greenberger was interviewed by Terry Gross earlier today (my time.)

    Interesting history on Phil Gramm's legislation to legalize what let UBS lose all that money. Interesting observations on Paulson's irrelevant regulation reshuffle. Interesting claim that "we'd" be better off if "Las Vegas" ran things given the current rules...

    Once upon a time, there was something called "The Peter Principle"....

    Soros- "Paulson must go. His entire mode of operation is the ...

    Soros: "Paulson must go. His entire mode of operation is the problem"


    H. L. Mencken - Wikiquote When a candidate for public office faces the voters he does not face men of sense; he faces a mob of men whose chief distinguishing mark is the fact that they are quite incapable of weighing ideas, or even of comprehending any save the most elemental - men whose whole thinking is done in terms of emotion, and whose dominant emotion is dread of what they cannot understand. So confronted, the candidate must either bark with the pack or be lost... All the odds are on the man who is, intrinsically, the most devious and mediocre - the man who can most adeptly disperse the notion that his mind is a virtual vacuum. The Presidency tends, year by year, to go to such men. As democracy is perfected, the office represents, more and more closely, the inner soul of the people. We move toward a lofty ideal. On some great and glorious day the plain folks of the land will reach their heart's desire at last, and the White House will be adorned by a downright moron.

    [Oct 12, 2008] PAULSON: The Fox Guarding the Henhouse - Sen. Bernie Sanders (I-VT)

    As GlobalPundit noted "Translation: Paulson was one of the architects of the crisis! Paulson also benefited personally from the casino economy he helped engineer. After creating billions of dollars in bizarre financial products that are now nearly worthless, he left Goldman Sachs with a personal fortune of over $700 million."
    Bernie Sanders on the Senate Bill

    by Dollars & Sense

    Bernie Sanders, the Socialist senator from Vermont, joined 24 others in voting against the bailout bill Wednesday night. He had earlier submitted an amendment that would have established a five-year, 10 percent surtax on families with incomes of more than $1 million year and individuals earning over $500,00 to raise $300 billion to help bankroll the bailout. The amendment was set aside in a voice vote.

    In a statement on his web page, Sanders noted

    "This bill does not deal with the absurdity of having the fox guarding the hen house. Maybe I'm the only person in America who thinks so, but I have a hard time understanding why we are giving $700 billion to the Secretary of the Treasury, the former CEO of Goldman Sachs, who along with other financial institutions, actually got us into this problem. Now, maybe I'm the only person in America who thinks that's a little bit weird, but that is what I think."

    [Oct 12, 2008] A final obituary for the 401k

    The Mess That Greenspan Made

    Some are calling this the "death knell" for 401k plans or, as is the case below, the "final obituary" for these plans as an entire generation comes to grips with the reality of being a stock investor in the middle of a stock bear market.

    This Wall Street Journal article($) that also conveniently appears at Yahoo! Finance has all the details:

    The market downturn has wreaked havoc on workers' retirement savings and raised more questions about 401(k) plans, which were already under intense scrutiny.

    This year through Thursday, the average 401(k) account balance dropped roughly 19% to 25%, depending on the participant's age and tenure with the plan, according to Employee Benefit Research Institute.
    IMAGEThe downturn comes at a time when regulators and lawmakers were already taking a hard look at 401(k) plans. Major pension legislation passed in 2006 encouraged employers to automatically enroll workers in 401(k)s to help get retirement savings on track.
    Some retirement-plan experts see current market conditions dealing a decisive blow to 401(k)s. Teresa Ghilarducci, professor of economic policy at the New School for Social Research, calls the downturn "a final obituary" for these plans. She adds, "Even with all the financial education in the world, [workers] can't control how old they'll be when there's a financial downturn."

    There's a bit more detail in the WSJ story about the dire consequences of poor choices made by plan participants and this report in the Washington Post is worth a look as well (actually, the WaPo article is quite good and comes with a photo of a distraught Homer Simpson doll on the floor of a stock exchange).

    The 2006 legislation that resulted in automatic enrollment wasn't such a bad idea, but legislators may rue they day they made the default option stocks instead of stable value funds or money market funds.

    I suppose this is all just part of the "ownership society" that has been in the process of tumbling down all around us over the last year or two.

    The whole concept of having individuals manage their own retirement accounts always seemed to be fundamentally flawed except in rare cases where individuals choose to spend about half of their waking hours reading and writing about these things.

    Even then you don't always get the results you desire

    [Oct 12, 2008] Whom Are We Saving? Oh, yeah, Rich Dudes. I forgot

    Well, we have seen one three-page plan: "Give me the money, honey. I know what do to. Just don't hold me responsible." Then we saw another longer plan: "Give me the money, honey. I will try to follow its fuzzy outline, but I want to be able to adapt to circumstances." Now we see another: "Well, maybe we should buy some shares. You know, be owners--but not influential owners. We can't tread on any rich toes, gouty from all those sweets."
    Angry Bear

    I wonder whom we are saving here?

    Treasury officials began canvassing banks and investment firms about the possibility of having the government buy stakes in them. The new bailout law gave the Treasury the authority to buy up almost any kind of asset it wanted, including stock or preferred shares in banks.

    Industry executives quickly told Mr. Paulson that they liked the idea, though they warned that the Treasury should not try to squeeze out existing shareholders. They also begged Mr. Paulson not to impose tough restrictions on executive pay and golden-parachute deals for executives who are fired.

    Mr. Paulson heeded those pleas. In his remarks on Friday, he carefully noted that the government would acquire only "nonvoting" shares in companies. And officials said the law lets the Treasury write most of its own restrictions on executive pay, and those restrictions can be lenient if they are applied to a set of fairly healthy companies.

    Well, we have seen one three-page plan: "Give me the money, honey. I know what do to. Just don't hold me responsible."

    Then we saw another longer plan: "Give me the money, honey. I will try to follow its fuzzy outline, but I want to be able to adapt to circumstances."

    Now we see another: "Well, maybe we should buy some shares. You know, be owners--but not influential owners. We can't tread on any rich toes, gouty from all those sweets."

    Damn, Paulson thinks he is playing Hamlet, here. Cut to the chase, Hank. Either you know what you are doing or move aside.

    Well, I want a voting share! And, since the largest shareholders are most probably the biggest crooks, I want to crowd them out. Let's buy enough shares to control the firms, to nationalize them, with no prospect of selling them back at a discount to some rich dude that is looking to make a future killing.

    As majority stockholder, my first vote is to fire the CEOs. Fire them the old fashion way. Let them take only personal mementoes--you know, the picture signed by Bush or Reagan or Cheney. And I want security watching in case they try to snatch something--or they make a move towards their computers. Security guards will escort them to the street.

    I want banks to serve the public not private interest.

    [Oct 11, 2008] Bill Moyers Journal Market Fundamentalism and the Madness of Crowds

    This week on the JOURNAL, Bill Moyers spoke with prominent investor and political activist George Soros about the economic crisis and its underlying causes.

    Soros attributed much of the current downturn to an erroneous faith in the market to govern itself:

    "There has been some kind of an ideological excess: namely, market fundamentalism for the last 25 or so years… It's that markets will correct themselves, that you should leave it to the markets, and there is no need for government intervention in financial affairs. Letting markets run rampant, and that doesn't work…

    Sometimes we get carried away. You know, in the Middle Ages people were religious. And so they had tremendous discussions about how many angels can dance on the eye of a needle. Now, if you believe that angels can dance then that's a legitimate question. And this is exactly what has happened here. You thought that you could slice and dice and engage in this kind of financial engineering. And it became very, very sophisticated and got carried away."

    In his famed MEMOIRS OF EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CROWDS, 19th century historian Charles Mackay chronicled numerous economic disasters caused by irrational human behavior, including the tulip mania in 17th century Holland. Mackay wrote:

    "In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first. … Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper…

    Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

    [Oct 11, 2008] How How to Save the U.S. Economy by Richard C. Cook

    The cause of the financial failure is that the producing and consumer economy is "maxed out" and is unable to repay existing loans much less new ones. This is because purchasing power in the U.S. has collapsed.

    Purchasing power has collapsed not only because we have outsourced our industry abroad and allowed our infrastructure to crumble, but also because of structural defects identified decades ago by C.H. Douglas and John Maynard Keynes. These defects occur due to the need for retained earnings (i.e. savings) to overcome the Law of Diminishing Returns. This leads to insufficient aggregate demand; i.e., the gap between prices and purchasing power that is endemic in an industrial economy.

    The problem is not the collapse of the stock market which simply reflects the deflation of the bubble economy. The problem is the oncoming recession/depression caused by the absence of an economic engine to generate new producing power.

    [Oct 11, 2008] Lehman Brothers demise triggers huge default

    Times Online

    Lehman's corporate debt default promises to increase the stress across global credit markets. Sean Egan, of the Egan-Jones ratings agency, said: "This is a killer. Lehman said a month ago that it was in terrific shape and now you can't even get ten cents on the dollar for its debt.

    "It underscores the deep structural flaws in our financial system, knocks confidence in the financial markets and raises the cost of capital. It also demonstrates that we are experiencing not only a crisis of confidence, but a [real] crisis."

    About 350 banks and investors are thought to have insured an estimated $400 billion of Lehman's debt through complex derivatives, known as credit default swaps. These include Pacific Investment Management, the manager of the world's largest bond fund, Citadel, the US hedge fund, and American International Group, the insurer that the US Government recently bailed out with two loans totalling about $123 billion.

    The Times has learnt that the US Treasury has been overwhelmed with requests from executives of other beleaguered sectors who are seeking a similar bailout scheme for themselves. It is thought that representatives from the US car and airline industries have approached the Government for assistance. It is understood that Mr Paulson does not believe that it is his job to help them. Rather, he is intent on addressing the root problems of the financial crisis

    [Oct 11, 2008] Was Bush's statement today the equivalent of a "Hoover Moment"

    Mish's Global Economic Trend Analysis

    Was Bush's statement today the equivalent of a "Hoover Moment"?

    "The fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis."

    Herbert Hoover, statement to the press, Oct. 25, 1929.

    Mike "Mish" Shedlock
    Click Here To Scroll Thru My Recent Post List

    [Oct 10, 2008] What would Jim Rogers do?

    It's very clearly a crush, a liquidation when people sell everything regardless of valuation. I looking at total, absolute panic. But there is not bottom, until people start to say there will be no bottom. Agricultural commodities still will enjoy almost the same demand, so in roger view they are relatively inexpensive. He would buy index but he is unsure as demand for metal will weaken further. He is buying gold. Plans that are coming from Washington and other capitals are hugely inflationary, and in six month or a year that should be visible. Bernanke and Paulson lost credibility so large part of market collapse is crisis of confidence.
    The Mess That Greenspan Made What would Jim Rogers do (interview by Bloomberg )
    This discussion really strikes at the heart of the current dilemma - do you try to lessen the impact of the current meltdown in an attempt to insure you'll avoid another Great Depression, or, do you just let markets do what they want to do and then pick up the pieces and start over?

    Slower with less pain or fast and painful? Obviously, Rogers favors the latter:

    I would tell you what has always worked throughout history and I'll tell you what has always not worked.

    The Japanese tried this in the 90s, they kept putting band-aids on and they wouldn't let people fail. You remember the term "zombie" companies, "zombie" banks? Well it's eighteen years later and the Japanese stock market is still down over 75 percent. They talk about the 90s as a lost decade.

    America tried it in the 70s - they wouldn't let anybody fail. We had one of the worst economic decades in American history - high interest rates, high inflation, a collapsing currency. It didn't work.

    Korea in the 90s, took a hit. They had a horrible two or three years but, since then, they've been one of the most rapidly growing economies in the world. The Russians took a horrible hit - since then, they've been one of the most rapidly growing economies in the world.

    This is not politics, this is not philosophy. I'm telling you what has worked throughout history and what has not worked throughout history.

    Look it up.

    When asked about letting banks collapse one by one, this reply came:
    Let 'em fail two by two or three by three. I mean, what is this? Banks have been failing since the beginning of time and they're probably going to fail again until the end of time.

    The way it's always worked successfully has been, let the incompetent fail and the competent people - banks, mainly in this case - take over the incompetent banks and everybody starts over.

    Yeah, you have a very bad year or two but we've had the worst excesses in the credit market we've had in world history. Never before in world history have people been able to buy a house with no money down, and many of them bought four or five houses with no money down and no jobs, and then the bankers were saying, "This is fun, let's do it with car loans, student loans, credit card loans".

    We've had horrible excesses -this has to be cleaned out.

    He also noted that the current recession is going to be the worst since World War II.

    The video is in high demand at the moment, so good luck getting it to play.

    [Oct 10, 2009] Blogger naked capitalism - Post a Comment

    Anonymous said...
    Dear Yves

    I've been studying the "credit default swaps" market for some time. It is said that there are $58 trillion of these outstanding. Though some are off setting many may be built on leverage and unreserved.

    What will happen as a result of the Lehman auction today and similar events is that those solid institutions that underwrote CDS contracts which they than turned around and hedged with an off-setting CDO will still be obligated contractually for the CDO they underwrote while losing their protection to a bankrupt counter-party. They will than have unhedged exposure and may be taken down by the same bankruptcy or another depending on whom they underwrote. A few major bankruptcies will take down the whole $58 trillion edifice like a "house of cards."

    The only way to resolve this is for the U.S. government to declare "force majeure" and annul these contracts. Parties will be relatively little scathed financially as they will lose only the premium flow and un-callable protection where they have underlying securities to protect.

    An Economist
    Steve Sposato

    Kady said...
    @Steve Sposato. I agree with you, with one proviso. It seems clear to me that the govt should step in and allow only those w/ actual ownership of the bonds to settle up (I believe part of the problem is that people were buying default protection against bonds that they did not in fact own, correct?) For those who do not own bonds, they can be made whole (premium paid back) but should in no way be allowed to get full $.9025 on the dollar. This should cut down significantly the exposure of those who underwrote the Lehman CDOs.

    This is just ridiculous.

    Owe Jessen said...
    @ Sposato: The problem of your proposal is that the banks who used CDS for "regulatory arbitrage" - read circumventing regulatory requirements - would be even more undercapitalized than they are right now.

    October 10, 2008 1:05 PM

    fresno dan said...
    First, I'll grant I'm none too bright. Now that is out of the way, why do I hear the CEO of Lehman complaining why he wasn't saved. Should he have been backstopped until recovery was only 1 cent on the dollar (O, right, the economy was magically suppose to return to 4.5% growth per annum and Lehman could have leveraged to 130)

    October 10, 2008 1:09 PM

    doc holiday said...
    Just before the collapse of Lehman Brothers, executives at Neuberger Berman sent e-mail memos suggesting, among other things, that the Lehman Brothers' top people forgo multi-million dollar bonuses to "send a strong message to both employees and investors that management is not shirking accountability for recent performance."
    Lehman Brothers Investment Management Director George Herbert Walker IV, second cousin to U. S. President George Walker Bush, dismissed the proposal, going so far as to actually apologize to other members of the Lehman Brothers executive committee for the idea of bonus reduction having been suggested. He wrote, "Sorry team. I am not sure what's in the water at Neuberger Berman. I'm embarrassed and I apologize.

    [Oct 10, 2009] Your Money - Switching to Cash May Feel Safe, but Risks Remain -

    How NYT can print such a crap. This is just a regular investment guru baloney. In reality, if you own stocks or commodities you should never allow profits run too high ;-). It is attempts to make a killing that cost us so dearly. I doubt about the wisdom of letting your 401K account shrink more then 5% At this point one need to sitting in cash especially if this is a baby boomer. Also missing a couple of bad days compensates for missing a couple of good days. Often overcompensates as 5% a day moves are more probably down then up.

    At some point, stocks will indeed fall enough that investors will remove the money from their mattresses and put it to work, causing prices to rise significantly. But, as Bonnie A. Hughes, a certified financial planner with the Enrichment Group in Miami, put it to me, there won't be an e-mail message or news release that goes out when this is about to happen. It will be evident only afterward, on the few days when the market surges.

    And it gets worse for those who think they won't have any trouble investing in stocks again later. Medium- or long-term investors who are considering a big move into cash right now are probably making an emotional decision, at least in part. For those who follow through, the same instincts will probably hurt when trying to figure out when to reinvest in stocks.

    "The emotional forces that drove them out of the market aren't likely to let them back in 'until things are better,' " Dan Danford of the Family Investment Center in St. Joseph, Mo., said in an e-mail message. "And for most people, things won't feel better again until the market has already moved back up." In fact, he added, plenty of people may not allow themselves to get back in until the market has already risen significantly.

    [Oct 10, 2009] Radical Measures May Be In The Wings - Financials US News Story -

    Even before details of the latest measures began to trickle out, there was heightened concern about the health of big institutions and the need for direct government support.

    " I don't wish to spread alarm on the line people but the big issue confronting the market is I'm afraid the health and sustainability of Morgan Stanley and Goldman Sachs " Hugh Hendry, Partner and CIO at Eclectica, told CNBC early Friday.

    [Oct 10, 2009] Early Boomers and the Economic Mess

    October 03, 2008 | Robert Reich's Blog
    The economic meltdown is hurting everyone. But if you're an early baby boomer over the age of 55, you may be in particularly big trouble. In an economic crisis, many employers lay off older workers first because their seniority makes them more expensive. And studies document that older workers who lose their jobs face more difficulties finding new ones.

    That's not the biggest problem you face. The house you've been living in for twenty-five or thirty years and were planning to cash in for retirement is worth far less now than the last time you looked. So is that 401-k plan you were counting on.

    And you don't have enough time before retirement to make up for these losses -- certainly not enough time to reap the gains you expected between now and then. If the economic crisis is as bad as some predict, housing prices and share values might not bounce back for five years or more. Japan's meltdown took ten years to correct.

    We early boomers – and note I said "we," because, sadly, I'm one of you – once had all the advantages. We entered the housing market in the 1970s and 80s, when houses were still cheap, and reaped the gains when late boomers came into the market and pushed prices up. We also got the plumb jobs because we were first into the post-industrial economy, before the boomers who followed us. And many of us got into the stock market early on, and rode that great wave.

    So maybe now we're paying the price for our good fortune then. But that doesn't make this any less painful.

    One saving grace. At least the Bushies didn't have the votes to privatize Social Security. Had they got their way -- and were we now completely reliant on the stock market for our retirements -- we early boomers would be in, as the President's father used to say, deep doo doo.

    Blogger Robert Reich's Blog - Post a Comment

    consultant said...

    When are we we going to start to see serious numbers of people charged and arrested for wire fraud, conspiracy, etc.? Trust will not return to the markets until people are assured that those who cheated them are in jail, or, no longer work in the financial sector. And folks, that is a lot of people!

    Let me again quickly run down the list of those eligible for arrest:

    As you can see, since most of the financial and legislative system is criminally corrupt, no one of consequence is going to jail. Which means trust will not be restored anytime soon.

    Robert Reich's Blog

    The Meltdown (Part III) What does it mean that the Dow closed below 10,000 today -- returning to levels first seen nearly a decade ago, in early 1999? Many interpret it to mean that the stock market is finally reacting to the credit crisis. A more accurate assessment is that it's finally catching up to the consumer crisis.

    After the market closed today, Bank of America announced a significant deterioration in people's ability to repay credit-card and other consumer debt.

    The central fact is this: consumers in the real economy are coming to the end of their capacities to keep spending. They can't take on any more debt. And with the costs of energy, food, and health insurance all soaring, they're doing the only thing they can. They're pulling in their belts. They're leaving the malls. They're not buying a new car or TV or anything else they can do without.

    For years, regardless of the business cycle, American consumers were the Energizer Bunnies of the world economy. Their spending kept it going. But now the Energizer Bunnies have turned into scared rabbits, and they're going back into their holes.

    Yes, we need better regulation of Wall Street in order to avoid the sort of bubbles and distrust that have generated a credit crisis. But even more than that, we need to get money back into the pockets of average American consumers -- including major investments in infrastructure, affordable health care, and a more progressive tax code.

    [Oct 09, 2008 ] The IMF's Outlook: Worried

    "In other words, we are all Wall Street now..." Recovery in 2009 ?

    From Chapter 1 of the IMF World Economic Outlook, released yesterday:

    The world economy is now entering a major downturn in the face of the most dangerous shock in mature financial markets since the 1930s. Against an exceptionally uncertain background, global growth projections for 2009 have been marked down to 3 percent, the slowest pace since 2002, and the outlook is subject to considerable downside risks. The major advanced economies are already in or close to recession, and, although a recovery is projected to take hold progressively in 2009, the pickup is likely to be unusually gradual, held back by continued financial market deleveraging. In this context, elevated rates of headline inflation should recede quickly, provided oil prices stay at or below current levels.

    The emerging and developing economies are also slowing, in many cases to rates well below trend, although some still face significant inflation pressure even with more stable commodity prices. The immediate policy challenge is to stabilize global financial markets, while nursing economies through a global downturn and keeping inflation under control.

    Over a longer horizon, policymakers will be looking to rebuild firm underpinnings for financial intermediation and will be considering how to reduce procyclical tendencies in the global economy and strengthen supply demand responses in commodity markets.

    ...A worrying aspect of this latest bout of turbulence is that there are now increasing signs that market strains are starting to fall more heavily on the nonfinancial corporate sector and on emerging markets. If sustained, such strains could well foreshadow a more severe macroeconomic impact of the financial crisis than previously anticipated.

    ... ... ...

    The recent surge in borrowing costs for nonfinancial firms has taken place against the backdrop of a gradual worsening of their risk profiles over the course of the financial crisis. The market-based measures of default risk and leverage ratios have risen across the credit spectrum in both the United States and Europe -- not only for low-grade bonds, as would be expected during a slowdown, but for high-grade bonds too (middle panel of second figure). For high-grade corporate bonds in the United States, for example, the probability of default has doubled since June 2007, although it remains below the levels experienced in 2004, in part owing to strong corporate balance sheets, particularly, ample internal funds.

    [Oct 8, 2008] The Big Picture

    What about hedge funds and other products of excessive deregulation ?

    To repeat my prior arguments, the proximate cause of the Housing crisis were

    1) Ultra-low rates; and

    2) Abdication of traditional lending standards, thanks to

    3) originators ability to resell mortgages for securitization purposes, and hence,

    4) not have to worry about loan defaults.

    The credit crisis was caused by

    1) the above securitized mortgage paper, that was

    2) rated triple AAA by Moody's and Standard & Poors, which then

    3) Which was then "insured" by credit default swaps (CDS) -- the unreserved for, shadow insurance products 4) whose exemption was made possible by the Commodities Futures Modernization Act. That legislation exempted these derivatives from any supervision or regulation.

    The lack of reserve requirements is why there is now $62 trillion in CDS, many of which will never pay their counter parties the promised insurance.

    If you are going to blame Fannie/Freddie/CRA, or George Bush or Barney Frank, you are missing the big picture.

    [Oct 8, 2008] russian-stock-market-collapse

    It is important to understand that the USA risks are wider the domestic. What if American financial institution will be declared persona non grata in some or many countries ? That effect can be much stronger then generally transitory boycott of American goods after the Iraq invasion...

    naked capitalism

    doc holiday said...

    I'm providing various unsubstantiated information from the internet below -- please do your own DD. Nonetheless, IMHO, world leaders will wake up in a few weeks and suspend derivative trading on a global basis, but I assume it will take a much larger event, like a country club closing, or maybe a few countries going under, or seeing Buffett on CNBC freaking out about his declining fortune, as he screams for help.

    • FYI: The size of the world stock market is estimated at about $60.9 trillion USD at the end of 2007. The world derivatives market has been estimated at about $480 trillion face or nominal value, 12 times the size of the entire world economy.
    • Libor, set by 16 banks in a daily survey by the British Bankers' Association at about noon in London, determines rates on $360 trillion of financial products worldwide, from home loans to derivatives.
    • The equity sell-off has eviscerated some $4.6 trillion of global stock market wealth in the past three weeks alone, according to the market capitalization loss on MSCI's main world equity index. Over the last 12 months, that figure is more than $12.4 trillion, of which some $7 trillion comes from the United States.
    • Fannie and Freddie already own or guarantee more than 40 percent of the $12 trillion in U.S. home loans.
    • Total Global GDP is about $50 Trillion
    • The market for Derivatives like Credit Default Swaps is over $60 Trillion
    • US Treasury Debt/deficit maybe $12 Trillion
    • Iraq War, maybe $3 Trillion
    • Global Government Bailout Packages closing in on $1 Trillion.

    This is new world order stuff folks and American backed derivatives are going to be viewed as financial terrorist weapons of mass destruction. IMHO, we will see American securities banned and suspended in many countries that will reorganize and kick out global entities that are connected to accounting fraud. If we don't re-engineer Wall Street immediately, this systemic collapse will change the course of the world within one year

    [Oct 8, 2008] Wolfgang Munchau: Policy Errors Risk Turning Credit Crunch Into Depression

    naked capitalism

    Wolfgang Munchau in EuroIntelligence argues against conventional wisdom, which is that modern policy tools and institutional arrangements will keep the credit crisis from morphing into a depression. He contends that the policy errors, the result of political considerations, have been substantial. He also says that Treasury Secretary Henry Paulson devised the badly-flawed Troubled Assets Repurchase Program to benefit Goldman. Although this is a widely-held view, few financial commentators have been willing to say so in writing. He also discusses how EU member nations are wasting firepower rescuing institutions for competitive reasons when they should have been allowed to fail.

    Thomas Palley is even more critical of US policy, arguing that it has focused on the traditional banking system, and has failed to address the escalating crisis in the shadow, or in his usage, the parallel banking system. Key sections:

    The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years....

    In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.

    Though the parallel banking system engaged in riskier lending than the traditional banking system, those differences were a matter of degree. Traditional banks like Washington Mutual, Wachovia, and Citigroup have also all lost huge sums. However, the traditional banking system is more protected for two reasons.

    First, traditional banks are significantly funded by customer deposits...Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans...

    From EuroIntelligence (hat tip reader Saboor):

    .... ... ...

    Financial crises do not automatically produce recessions or depressions. Only bad policy cab turn a crisis into a catastrophe. The 1930 Great Depression could have been avoided if governments had not pursued pro-cyclical policies, and most important, if central banks had not allowed deflation. We have learned from those mistakes, but are committing new and possibly bigger ones. Government is our one and only safety net. It could, if it wanted to, provide basic financial services, that could easily fulfil three economic functions that are attributed to finance: to provide liquidity, to share risk, and to allow agents in the economy to make inter-temporal choices. You don't need CDOs and CDSs for that. A network of central bank branch offices, in combinations with a relatively small number of national, or nationalised banks, could temporarily offer the vast bulk of all financial service of wider economic relevance. The way to go is to shrink the financial system and nationalise the systemically important financial institutions. I have heard there are about 45-50 in the euro area though this is not a precise guess, and subject to change over time. After the financial sector is stabilised, it is time to rebuilt the system, to allow the government later re-privatise its assets, ideally subject to different incentive structures than those that have led to this crisis. In theory, governments could even make money on it. I doubt it. But at the very least, governments can minimise losses.

    But if you squander valuable resources on second-rate institutions such as Hypo Real Estate, for the wrong reasons, your freedom of manoeuvre will be constrained at the moment you need it the most...

    [Oct 7, 2008] Retirement accounts have lost $2 trillion so far Financial News - First the took away pensions. Now they take away those meager sums that people saved.

    Yahoo! Finance

    Americans' retirement plans have lost as much as $2 trillion in the past 15 months -- about 20 percent of their value -- Congress' top budget analyst estimated Tuesday as lawmakers began investigating how turmoil in the financial industry is whittling away workers' nest eggs.

    ... ... ...

    "Unlike Wall Street executives, America's families don't have a golden parachute to fall back on," said Rep. George Miller, D-Calif., the panel chairman. "It's clear that their retirement security may be one of the greatest casualties of this financial crisis."

    ... ... ...

    Some experts argue that the hefty tax subsidies that Congress has put in place in recent decades for 401(k) and other worker-contribution accounts have made people's retirement income less secure by shifting risks, decisions and costs from employers to people who often know little about investing.

    "They are fatally flawed," Teresa Ghilarducci, an economist at the New School for Social Research, said of the tax-advantaged plans. "They're too risky, and it's not good policy to have workers run their own retirement plan. They want government help."

    Common mistakes workers make include overinvesting in a single stock -- often their company's -- and participating in funds that carry large fees or involve excessive risk, the witnesses said.

    ... ... ...

    The current market turmoil adds to an already difficult retirement savings picture for Americans, who are increasingly shouldering the burden of managing and funding their own company-sponsored retirement savings plans as firms eliminate traditional pensions.

    Even before the recent downturn, older Americans were on track to continue working longer. Twenty-nine percent of people in their late 60s were working in 2006, up from 18 percent in 1985, according to the Bureau of Labor Statistics. Over the next decade, the number of workers who are 55 and older is expected to increase at more than five times the rate of the overall work force, the BLS reported.

    Falling home values and now the decimation of much of their savings could plunge older Americans into period of austerity not seen in decades, Miller said: "The fear factor is huge, and they don't see the availability of resources to them to get well."

    [Oct 7, 2008] Lessons From Modern Economic Crises (Not for the Fainthearted)

    The rule of thumb for 401K investors is that in housing crisis equity prices will drop 50% and the equity price bust can last ten or more quarters
    October 7, 2008 | naked capitalism

    Now that the world is in the throes of the mother of all financial messes, economists are scrambling to develop expertise. Carmine Reinhart and Kenneth Rogoff recently had this beat largely to themselves. but in the last two weeks, the IMF came out with a stud of 124 modern banking crises.

    The latest addition to this growing body of knowledge comes from Stijn Claessens, M. Ayhan Kose,and Marco E. Terrones at VoxEU.

    While we will excerpt the paper at greater length below, here is the key paragraph:

    The episodes of credit crunches and housing busts are often long and deep. For example, a credit crunch episode typically lasts two and a half years and is associated with nearly a 20 percent decline in real credit. A housing bust tend to last even longer: four and a half years with a 30 percent fall in real house prices. And an equity price bust lasts some 10 quarters and when it is over, the real value of equities has dropped to half.

    [Oct 7, 2008] IMF says rapid and decisive global action needed to stem crisis -

    October 7, 2008 | Times Online

    The IMF's call came as it issued a startling new estimate that the total losses inflicted on US banks by the continuing crisis could balloon to $1.4 trillion (£798 billion). This was up from its previous estimate in April of $1 trillion in losses, and compared with $760 billion written off by American and global banks up to the end of September.

    ... ... ...

    "The global disappearance of trust in counterparties and widespread cash hoarding that has surfaced recently has made it inevitable that, if a resolution plan is to achieve an orderly deleveraging process that limits the damage to the financial system and the economy, the authorities will need to play a major role in it," it said.

    It gave a strong warning that a global strategy from the authorities, rather than piecemeal national measures, was needed. "Actions to stabilise the global financial system should be coordinated across countries and, in particular, across major financial centres," it said.

    [Oct 6, 2008] "One Hell of a Job," Brownie By Stormy

    October 06, 2008 | Angry Bear

    The old world order is not just slipping away; it is running out the door. Or, to change the metaphor, the structures of the old order are falling so fast that is difficult to keep track of the debris on the streets.

    While the CEO of Lehmann Brothers, that "gorilla of greed," Dick Fuld, has a small point when he says that the crisis is not just a crisis of Wall Street, he certainly has been part of the capitalistic gang that has driven the U.S. over the cliff, dragging many other countries with it.

    Yes, the fashioners of globalization have done a hell of a job, Brownie. The rich got really rich, but they simply could not keep the party going indefinitely, these great scions of capitalism. Today's offerings that spell out parts of the crises are from here and India. Both are worth reading in their entirety.

    M R Venkatesh spells out how China could wreck the U.S. economy, as if it needed more help, simply by selling some of their U.S. dollar denominated holdings.

    the recent bailout package being approved in the US Congress needs to be viewed in the context of the spurt in the accumulation of forex reserves of China by about $500 billion in the last six months to about $2 trillion in aggregate.

    Why is China engaged in this exercise? What could be its implications on the on going global financial crisis? Could China trip the bailout package announced by the US last week? Crucially what are the implications for the existing global order?

    What is intriguing in the Chinese forex reserve build-up is that both trade surplus and foreign direct investment account only for a part of this gargantuan pile.

    Be nice to China.

    William M Tab in The Monthly Review sees Four Crises of the Contemporary World Capitalist System:

    the financial crisis, the loss of relative power by the United States, the rise of other centers of accumulation, and resource depletion and ecological crisis.

    The Washington Consensus has been discredited, and although the damage it causes continues, it has not achieved Washington's goals. There has been a uniting of much of the world into a coalition of the unwilling. If serious left-wing governments took power in many countries of the South, there could be dramatic reconstruction of the global political economy.

    During the Bush presidency, the United States lost one in five manufacturing jobs and that too is part of financialization and globalization. Wages have been pushed down, pension benefits curtailed, health care burdens shifted onto workers and their families, employees made to work part-time or fired and hired back as "temporary" workers, and so on-all in order to meet profit targets and to finance the huge debts companies are burdened with as a result of widespread borrowing to finance takeovers. More people are working part-time or as temporary workers and are pessimistic about the prospects of their children. They see their government captured by the corporations and the wealthy.

    We are now witnessing the loss of what Charles DeGaulle once called the "exorbitant privilege" of the United States, derived from its role as issuer of the international currency. George Soros, speaking to the World Economic Forum in January of 2008, suggested, "It's basically the end of a sixty-year period of continuing credit expansion based on the dollar as the reserve currency."11 The advantage the United States has enjoyed by being able to borrow in its own currency has been undercut by abuse, outsized current account deficits, and the buildup of dollars in foreign hands. This has progressed to the point where the money creation and lower U.S. interest rates implemented by the Federal Reserve to stave off financial collapse have driven down the currency's value and encouraged further flight from the dollar.

    There is one other piece I thought I might include, but it does require extensive comment: The Financial Development Report (January 2008) from the World Economic Forum. Suffice it to say that its conclusions were:
    On the basis of this holistic view, this year the United States scores top honors in the rankings closely followed by the United Kingdom. The collective strength of financial intermediaries and markets in these countries, spanning banks, investment banks, insurance companies, equity markets, and bond markets is unparalleled.
    The circle has been squared at last. I do understand that placing just its conclusions before you is a bit unfair, but I am feeling particularly nasty today. Parts of the report are truly superb; others are just latrine filler.

    [Oct 6, 2008] Brics slump as investors flee emerging markets - Times Online

    The Bric stock markets crumbled yesterday as investors in emerging market stocks - including Brazil, Russia, India and China - suffered their worst one-day losses in history.

    Exchanges in Russia and Brazil halted trading as their benchmark indices plummeted 18 and 10 per cent respectively. India's Sensex index lost nearly 6per cent as foreign investors fled amid fears that a serious global downturn beckons. China's CSI 300 Index lost more than 5per cent, to extend its losses for the year to 60 per cent. Last night the MSCI Emerging Markets Index, which tracks bourses from Chile to Jordan, was down more than 8.2 per cent, leaving it poised for its biggest one-day slide on record.

    "Foreign funds are panicking," Deven Choksey, of KR Choksey, the Bombay brokerage, said. The Indian slump has been driven by the exodus of nearly $10 billion (£5.7billion) of overseas money this year as investors seek sanctuary in US Treasury bonds.

    As the markets opened yesterday, sentiment soured in the wake of an early Asian sell-off amid a toxic blend of high borrowing costs and lower commodity prices, traders said. Across the Bric nations, commodity and financial stocks led losers as oil dipped beneath $90 a barrel and fears grew that the global crisis would claim more victims outside the United States.

    Related Links

    Sberbank, Russia's biggest bank, dropped as much as 22 per cent. Gazprom, the country's biggest company, which holds its gas export monopoly, plummeted by 19per cent.

    Russia is seen as particularly vulnerable because investors have borrowed heavily to pump money into the market and now face unanswerable margin calls. Investors gave little heed to the Kremlin's pledge to pump $150 billion into the economy through loans and tax breaks.

    [Oct 6, 2008] Europe demands US 'take responsibility' for financial crisis - Times Online

    The European Commission delivered an unusually sharp rebuke to the United States yesterday over its failure to endorse its $700 billion (£394 billion) rescue package for the stricken financial services industry.

    Twenty-four hours before the Commission tables draft pan-European legislation to toughen up capital requirements for banks, Johannes Laitenberger, its spokesman, said: "The turmoil we are facing has originated in the United States. It has become a global problem. The US has a special responsibility in this situation . . . we expect that the decision will go through soon. The US must take its responsibility in this situation, must show statesmanship for the sake of its own country and for the sake of the world."

    The Commission's unusual decision to deliver the statement, unprompted, reflected the degree of frustration in Brussels at the failure of the US to take measures to calm financial markets. The organisation contrasted the paralysis in Washington with the action that British, French, German, Irish, Dutch, Belgian and Luxembourg authorities had taken over the previous 48 hours to try to shore up confidence in the banking sector.

    "The last hours have shown that European authorities are assuming their responsibilities. This again shows that public authorities in Europe can live up to the task of preserving financial stability and protect savings," Mr Laitenberger said.

    [Oct 5, 2008] Nick Rowe on What Caused the Financial Crisis

    This Nick is just a primitive neo-classical apologist, but some comments are really interesting...
    Economist's View

    Opening Salvo: Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.

    Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.

    What is a bubble? Everybody talks about the house price bubble, but nobody defines what it means.


    Benoit says...

    premise one: In the long term, a well diversified global portfolio always has positive growth.

    premise two: Maximizing returns is achieved by leveraging as much as possible those investments in sectors that are guaranteed to grow.

    conclusion: profit!

    Nothing can go wrong right?... right???


    Ryberg says...

    This is not anywhere near as difficult as you are making it.

    Understand first what a Ponzi scheme is. It is like a chain letter (which the US Postal Service made illegal many years ago). A schemer assures you positive returns if you "invest" today. Tomorrow the schemer gets 10 more "investors" and pays you off. You are now convinced that the schemer has a great "investment" so you plow your money back in along with 100 more "investors". The 10 "investors" are paid off so handsomely that they "reinvest" with a 1000 more "investors". It works wonderfully as long as more "investors" enter than are being paid off. And with "reinvestments", that can happen for a long time. Even decades and whole generations. Eventually, however, there will not be enough new "investors" to cover the promised returns to existing "investors". When word gets out that the promised returns can't be paid, at least some "investors" will want their money back, making it even harder for the scheme to work. This is when the Ponzi scheme can collapse.

    Note there are no goods or services that need to be exchanged and there is no requirement for capital investment capable of producing future goods so principles of economics do not apply. Forget about g and r. We are talking about gullible people getting duped by unprincipled people.

    So who are these gullible and unprincipled people? Look in the mirror.

    Why did real estate prices rise? Because people could borrow money to buy it. We didn't ask if it was worth the money because we knew its price would continue rising so we could always get our money back. We were told that real estate always increased in value so this was a safe "investment". If we bought just like the thousands of others who were buying we could make money without having to produce anything. Capital gains without real capital is the essence of a Ponzi scheme.

    Now let the financial engineers from Wall Street Investment Management banks enter into the game and we have a Ponzi scheme on steroids. They introduced financial derivatives and derivatives on derivatives. They didn't produce anything tangible but they did grow exponentially. Now that is one heck of a balloon. A bank might take $1 of capital and lend it out 10 times in mortgages. But a hedge fund could borrow a million dollars of Treasury Bonds and buy $25-50 million of mortgages from the banks, thus increasing their capital and enabling them to issue another 100 mortgages each. Hedge funds make huge amounts of money on the spread between the short term Treasurys and the long term mortgages. Banks make large (not huge) amounts of money on the origination of mortgages. And "investors" have proof that rising real estate prices will always reward them so they take to flipping real estate.

    Unfortunately, all Ponzi schemes end badly. Some "investors" find that even their minimal payments are more than they can sustain in the real economy so they default. When enough default, the prices of the real estate stop rising. More importantly, mortgages get written down to at least the falling price of the underlying property. But the mortages were leveraged several times by the hedge funds and banks. So a small decrease in loan asset prices causes large decreases in financial institution capital.

    This is how leverage works. Ponzi on the upside and crash on the down side.

    There is no need for any real economic growth. Unfortunately, if there is some economic growth, financial engineers can persuade us (and our government) that all we need to do is restore confidence (in this scheme) and create another $700 billion in debt. The hair of the dog that bit you... And economists can mask the Ponzi balloon by talking about g and r.

    The United States has become a giant Ponzi scheme driven by exponentially growing debt, especially debt dreivatives, that is disconnected from any real economy. The sooner this cancer is removed, the sooner real economic forces can operate properly.


    RW says...

    What Ryburg and jamzo said: By all means read your grandparents books, your parents books too (show some respect), but don't skip Hyman Minsky whatever you do.

    Add Georg Soros' "The New Paradigm for Financial Markets" to supplement Minsky and you'll probably understand this catastrophe a lot better than Nick Rowe and most members of his audience.


    dd says...

    Nice Chart here:

    Notice the trickle up profits and the trickle down debt.

    [Oct 5, 2008] Wells Fargo- the FDIC didn't blink, so Paulson intervened

    Angry Bear

    ...Marcy Gordon of BusinessWeek (h/t Mark Thoma) sets the record straight:

    On Tuesday, the Internal Revenue Service issued guidance boosting banks' ability to offset the losses from loans and other bad debts held by other banks they acquire. The guidance allows banks to take larger tax write-offs against future profits....

    Before the IRS ruling this week, there were limits on the amount of certain losses that an acquiring bank could write off against post-combination profits. Now those limits have been suspended, said Jeff Harte, an analyst at Sandler O'Neill.

    With banks suffering billions in losses from soured mortgage-related assets, the IRS move "potentially increases buyers' ability to realize tax benefits from bank acquisitions," Harte wrote in a note issued Friday. The change "could spur significant bank industry consolidation," he said.

    "We suspect that the new IRS guidance allowed Wells Fargo to place a higher bid for Wachovia today than it might have been willing to a few days ago," Harte said.

    And who was responsible for the IRS announcement? Mark Sunshine, guest-blogging at the NYT Economix blog, suggests it was Secretary of the Treasury Paulson:
    But Mr. Paulson's fiscal-stimulus work didn't end with the bailout bill.

    With hardly anyone noticing, on Wednesday he pushed through very technical and obscure changes to tax regulations that provide a "tax subsidy" for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson's tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the "free markets work without government help" don't understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

    Couldn't have said that last better myself.

    [Oct 5, 2008] Financial Crisis Now Germany takes hot seat as Europe falls into the abyss - Telegraph

    "Unregulated free-market capitalism may be said to have killed itself by greed, vanity and excess, all amply evident before and at the death-scene". Also suffering is the American national foreign affairs ideology...

    During the past week, we have tipped over the edge, into the middle of the abyss. Systemic collapse is in full train. The Netherlands has just rushed through a second, more sweeping nationalisation of Fortis. Ireland and Greece have had to rescue all their banks. Iceland is facing an Argentine denouement.

    The US commercial paper market is closed. It shrank $95bn last week, and has lost $208bn in three weeks. The interbank lending market has seized up. There are almost no bids. It is a ghost market. Healthy companies cannot roll over debt. Some will have to sack staff today to stave off default.

    As the unflappable Warren Buffett puts it, the credit freeze is "sucking blood" out of the economy. "In my adult lifetime, I don't think I've ever seen people as fearful," he said.

    We are fast approaching the point of no return. The only way out of this calamitous descent is "shock and awe" on a global scale, and even that may not be enough.

    Drastic rate cuts would be a good start. Central bankers still paralysed by a misplaced fear of inflation – whether in Europe, Britain, or the US – have become a public menace and should be held to severe account by our democracies. The imminent and massive danger is now self-feeding debt deflation.

    The lesson of the 1930s is that any country trying to reflate in isolation will be punished. The crisis will ricochet from one economy to another until every one is crippled. We are seeing it play again in this drama as our leaders fail to rise above their narrow, parochial agendas.

    [Oct 4, 2008] End of an Era on Wall Street - Goodbye to All That -

    That sad thing is that it's 401K investors who are now paying for $5000 bottles of champagne and lavish life style of financial nova riches. Financial Enron has its own puppets and puppeteers. I think leading figures that led us to this debacle should investigated and if found guilty prosecuted to the full extent of the law. The list should definitely include Mr. Greenspan...

    "It's the beginning of the end of the era of infatuation with the free market," said Steve Fraser, author of "Wall Street: America's Dream Palace," and a historian. "It's the end of the era where Wall Street carries high degrees of power and prestige. And it's the end of the era of conspicuous displays of wealth. We are entering a new chapter in our history."

    To be sure, living large and flaunting it are unlikely to exit the American stage, infused as they are in the country's mojo. But with Congress having approved a $700 billion banking bailout, historians, economists and pundits are also busily debating the ways in which Wall Street's demise will filter into the popular culture.

    It's an era that traces its roots back more than two decades, when suspendered titans first became fodder for books and movies. It's an era when eager young traders wearing khakis and toting laptops became dot-com millionaires overnight. And it is an era that roared into hyperdrive during the credit boom of the last decade, when M.B.A.'s and mathematicians raked in millions by trading and betting on ever more exotic securities.

    Over all, the past quarter-century has redefined the notion of wealth. In 1982, the first year of the Forbes 400 list, it took about $159 million in today's dollars to make the list; this year, the minimum price of entry was $1.3 billion.

    As finance jockeyed with technology as economic bellwethers, job hunters, fortune seekers and the news media hopped along for the ride. CNBC became must-see TV on trading floors and in hair salons, while people gobbled up stories about private yachts, pricey jets and lavish parties, each one bigger and grander than the last.

    Finance made enormous and important strides in these years - new ways to parse risk, more opportunities for businesses and individuals to bankroll dreams - but for the average onlooker the industry seemed to be one endless party.

    In 1989, tongues wagged when the 50th birthday celebration for the financier Saul Steinberg featured live models posing as Old Masters paintings. That bash was outdone last year, when Stephen A. Schwarzman, head of the private equity firm Blackstone, feted guests at a 60th birthday party boasting an estimated price tag of $5 million, video tributes and the singer Rod Stewart.

    "The money was big in the '80s, compared to the '50s, '60s and '70s. Now it's stunning," said Oliver Stone, who directed the 1987 film "Wall Street" and is the son of a stockbroker. "I thought the '80s would have been an end to a cycle. I thought there would be a bust. But that's not what happened."

    Now, with jobs, fortunes and investment banks lost, a cultural linchpin seems to be slipping away.

    "This feels very similar, historically, to 1929 and the emotions that filled the air in the months and years that followed the crash," Mr. Fraser said. "There is a sense of extraordinary shock and astonishment, which is followed by a sense of rage, outrage and anger directed at the centers of finance."

    A WALL STREET hotshot was in a real-estate quandary, and he wanted Barbara Corcoran to help him sort things out.

    "This is a finance guy making a ton of money and he was trying to decide whether he should sell the country home in Connecticut, the apartment here in the city or the 8,000-square-foot dream home in Oregon that he just finished," recalled Ms. Corcoran, who has spent years selling high-end luxury properties to New York's elite.

    ... ... ...

    "Money was worshiped and continues to be worshiped," Mr. Stone added. "Maybe that will change now."

    Adoration of riches is hardly new, however. In the mid- to late 19th century, the Gilded Age - a term Mark Twain coined in 1873 - offered equally ostentatious displays of wealth and a broadening gulf between rich and poor.

    "In the Gilded Age, they built great, enormous palazzos in Newport that they lived in for six weeks a year," said the historian John Steele Gordon, whose book, "An Empire of Wealth," chronicles that era. "During the last 25 years, it's certainly been a gilded age in the sense that enormous fortunes have been built up in an unprecedented way."

    ... ... ...

    DESPITE these gains in the middle class, though, the truly wealthy have pulled away from the pack. Not since the late 1920s, just before the 1929 market crash, has there been such a concentration of income among individuals and families in very upper reaches of the income spectrum, according to researchers at the University of California, Berkeley, and the Paris School of Economics.

    Some say that anger over the yawning wealth divide found traction in the highly charged and polarizing debate in Congress over the bailout bill.

    Mr. Fraser, the historian, says that anger is informed by the de-industrialization of the American economy in recent decades. Factory closings and the loss of manufacturing jobs that paid decent, middle-class wages coincided with the heady expansion of the financial sector, where compensation soared.

    [Oct 4, 2008] The Road Ahead--Some Thoughts By Stormy

    Now is not a good time. In fact, the credit crunch may affect areas important to moving ahead: from funding renewable energy sources to rebuilding infrastructure, from a stable local tax base to the creation of jobs through business investment--to say nothing of mitigating the growing effects of pollution and global warming. One side effect has been the creation of ever-larger entities in almost every area--perhaps a dangerous development--as smaller firms in almost every area are gobbled up. Increasingly, the national government, along with these huge firms, will play a larger and larger role. And how much can a government do, especially one that is seriously in debt?

    Taking each of these areas separately, I see considerable difficulties.

    Funding Renewable energy sources: Cash rich, large utilities will be in the best position.

    Even if utilities do have to borrow, they can do so cheaply as government-regulated businesses with guaranteed rates of return which can pass on costs to consumers, said analyst Pavel Mulchanov at Raymond James & Associates in Houston.
    Europe may be better off than the U.S. in terms of renewables:
    On Monday, US lawmakers said they could run out of time to extend a wind power production tax credit (PTC) and a solar power investment credit (ITC), which have been powerful spurs for installations, in time for a Dec. 31 expiry deadline.
    What certainly will happen is that smaller firms, often the genesis for new ideas, will be absorbed. Start-up companies will be unable to find the necessary cash to get a foothold. Our choices for the kinds of renewables we pursue may increasingly be in the hands of larger and larger entities.

    How these larger firms choose to allocate investment resources will be important. Will they make wise decisions or be simply governed by short-term returns?

    Rebuilding infrastructure: As houses decrease in value, local tax bases will decrease, putting increasing strains on state governments. Once again, the national government will be asked to help, even as its tax base is slowly strangled. While national investment in infrastructure may create some jobs, without a better trade position, there will be little hope that infrastructure in the long run will be enough. Countries that are cash rich and that have good export markets will be better weathering the coming storm, as long as they export items that are essential.

    Creation of jobs through business development: Most firms will head for the trenches. If we are worried about "float loans," imagine the attitude towards actual investment. Even when the stock market boomed and the bubble grew, actual business investment inside the U.S. was mediocre. Firms saw better returns in emerging markets that offered cheap labor and tax subsidies. The chances of those firms returning to the U.S. are small--unless, of course, labor here becomes cheap enough--or the cost of transportation becomes prohibitive.

    Pollution and global warming: If the argument for meeting these twin demons head-on was that it would adversely affect the bottom line, that argument now, regardless of how foolish, is even more persuasive. Pollution grows apace.

    The Gulf of Mexico may just be a glimpse into the future of coastal waters around the world, if this is the case. Already, dead zones have been identified across the globe, from the Scandinavian fjords to the South China Sea to the U.S.'s Chesapeake Bay.

    [Oct 3, 2008] Fear and loathing after the credit crisis by John Willman

    Historical events change behaviour and attitudes. The two world wars, the Great Depression of the 1930s and the 9/11 terrorist attacks on the US each shaped the way a generation thought and acted. The financial crisis will be no different.

    Exactly how attitudes will change is not easy to forecast, however. As Niels Bohr, the Danish physicist, once observed, prediction is never easy – particularly about the future. But already some elements of the changed social landscape are emerging.

    One is a deep scepticism – loathing, even – of the financial wizards who got the world's markets into this mess. When the House of Representatives voted down Hank Paulson's $700bn bank rescue package on Monday, they did so because they feared the wrath of the voters.

    Main Street faced economic ruin with the credit markets closed for business, but those who inhabit it were determined to block any measure that appeared to shore up Wall Street. New York had the feeling of a war zone, said one executive, as angry demonstrators jeered at shell-shocked bankers in the financial district.

    The two archbishops at the head of the Church of England also caught the British public mood with their attacks on the City of London last week. Rowan Williams, archbishop of Canterbury and head of the Anglican church, said it was right to ban short selling, while John Sentamu, archbishop of York, called traders who cashed in on falling prices "bank robbers and asset strippers".

    "We have all gone to this temple called money," Dr Sentamu said in an interview. "We have all worshipped at it. No one is guiltless."

    ... ... ...

    Bankers, in any case, have never been popular. In London and New York, they bid up the price of homes, forcing ordinary mortals to commute from ever more distant suburbs. And the arrogance and hubris of a group who felt themselves to be masters of the universe means they are winning no more sympathy in these straitened times that Sherman McCoy did when he fell from grace in Tom Wolfe's Bonfire of the Vanities.

    ... ... ...

    Savers are also becoming more risk-averse – understandably, given the runs on banks around the world. Soaring gold purchases are one symptom, but so are transfers of funds between savings institutions in search of a safe home for savings.

    [Oct 3, 2008] Recapitalise the banking system By George Soros

    October 1 2008 |
    The emergency legislation currently before Congress was ill-conceived – or more accurately, not conceived at all. As Congress tried to improve what Treasury originally requested, an amalgam plan has emerged that consists of Treasury's original Troubled Asset Relief Programme (Tarp) and a quite different capital infusion programme in which the government invests and stabilises weakened banks and profits from the economy's eventual improvement. The capital infusion approach will cost tax payers less in future years, and may even make money for them.

    Two weeks ago the Treasury did not have a plan ready – that is why it had to ask for total discretion in spending the money. But the general idea was to bring relief to the banking system by relieving banks of their toxic securities and parking them in a government-owned fund so that they would not be dumped on the market at distressed prices. With the value of their investments stabilised, banks would then be able to raise equity capital.

    The idea was fraught with difficulties. The toxic securities in question are not homogenous and in any auction process the sellers are liable to dump the dregs on to the government fund. Moreover, the scheme addresses only one half of the underlying problem – the lack of credit availability. It does very little to enable house owners to meet their mortgage obligations and it does not address the foreclosure problem. With house prices not yet at the bottom, if the government bids up the price of mortgage backed securities, the taxpayers are liable to loose; but if the government does not pay up, the banking system does not experience much relief and cannot attract equity capital from the private sector.

    A scheme so heavily favoring Wall Street over Main Street was politically unacceptable. It was tweaked by the Democrats, who hold the upper hand, so that it penalizes the financial institutions that seek to take advantage of it. The Republicans did not want to be left behind and imposed a requirement that the tendered securities should be insured against loss at the expense of the tendering institution. The rescue package as it is now constituted is an amalgam of multiple approaches. There is now a real danger that the asset purchase programmed will not be fully utilized because of the onerous conditions attached to it.

    Different focus

    'Tarp's adverse consequences could be mitigated by using taxpayers' funds more effectively. If Tarp invested in preference shares with warrants attached, private investors, including me, would jump at the opportunity'

    Nevertheless, a rescue package was desperately needed and, in spite of its shortcomings, it would change the course of events. As late as last Monday, September 22, Treasury secretary Hank Paulson hoped to avoid using taxpayers' money; that is why he allowed Lehman Brothers to fail. Tarp establishes the principle that public funds are needed and if the present programme does not work, other programmes will be instituted. We will have crossed the Rubicon.

    Since Tarp was ill-conceived, it is liable to arouse a negative response from America's creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers' funds more effectively.

    Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve - effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

    This is how it would work. The Treasury secretary would rely on bank examiners rather than delegate implementation of Tarp to Wall Street firms. The bank examiners would establish how much additional equity capital each bank needs in order to be properly capitalised according to existing capital requirements. If managements could not raise equity from the private sector they could turn to Tarp.

    Tarp would invest in preference shares with warrants attached. The preference shares would carry a low coupon (say 5 per cent) so that banks would find it profitable to continue lending, but shareholders would pay a heavy price because they would be diluted by the warrants; they would be given the right, however, to subscribe on Tarp's terms. The rights would be tradeable and the secretary of the Treasury would be instructed to set the terms so that the rights would have a positive value.

    Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.

    A revised emergency legislation could also provide more help to homeowners. It could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated, based on the Treasury's cost of borrowing. Mortgage service companies could be prohibited from charging fees on foreclosures, but they could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.

    Banks deemed to be insolvent would not be eligible for recapitalization by the capital infusion programme, but would be taken over by the Federal Deposit Insurance Corporation. The FDIC would be recapitalised by $200bn as a temporary measure. FDIC, in turn could remove the $100,000 limit on insured deposits. A revision of the emergency legislation along these lines would be more equitable, have a better chance of success, and cost taxpayers less in the long run.

    The writer is chairman of Soros Fund Management

    [Oct 3, 2008] Goldman Sachs Forecasts "Deeper" Recession

    I doubt the it will take less then three years, at least. I think that 401K investors underestimate the gravity of the problem. financial bubble collapsed with Lehman.
    Calculated Risk

    Goldman is now forecasting Q3 2008 real GDP growth at 0.0%, with PCE at minus 2.5% (annualized as reported by BEA). This is similar to my two month estimate for PCE, see Estimating PCE Growth for Q3 2008. Both PCE and investment will be negative in Q3, but net exports, private inventories and government spending will probably all show positive growth in Q3. So GDP may be close to zero.

    A major change in the Goldman outlook is the increase in the unemployment rate to 8% in 2009 (their previous forecast was for unemployment reaching 7% in 2009).

    One of the features of recent recessions is that the unemployment rate kept rising for 18 months to two years after the recession officially ended. This suggests that the peak unemployment rate (for this cycle) might not happen until 2011, even if the recession ends in late 2009 - scary. I'll have some more thoughts on unemployment soon.

    Note that this is the headline unemployment number. Other measures of unemployment are much higher: See Krugman: The track record

    [Oct 3, 2008] The Reckoning - Agency's '04 Rule Let Banks Pile Up New Debt By STEPHEN LABATON

    ...decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency's failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

    On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

    They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

    The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.

    A lone dissenter - a software consultant and expert on risk management - weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.

    One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told - those with assets greater than $5 billion.

    "We've said these are the big guys," Mr. Goldschmid said, provoking nervous laughter, "but that means if anything goes wrong, it's going to be an awfully big mess."

    Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation's corporate laws after a wave of accounting scandals. "Do we feel secure if there are these drops in capital we really will have investor protection?" Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks' balance sheets.

    Annette L. Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.

    "I'm very happy to support it," said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: "And I keep my fingers crossed for the future."

    The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.

    After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

    With that, the five big independent investment firms were unleashed.

    In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms' own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

    Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio - a measurement of how much the firm was borrowing compared to its total assets - rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.

    The 2004 decision for the first time gave the S.E.C. a window on the banks' increasingly risky investments in mortgage-related securities.

    But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority.

    [Oct 3, 2008] Asia Times Online Asian news and current affairs

    ...The great financial alchemy of transforming endless risky loans into perceived safe and liquid "money"-like instruments has run its historic course.

    And with risky loans - household, financial sector, business, municipal and speculator - having come to play such a prominent role in the nature of spending and "output", the near elimination of risky lending will prove a momentous financial and economic development. The US bubble economy is today in dire straits.

    We've reached the point where it has become difficult to secure new borrowing unless one is of quite sound credit standing. This is the case for individuals seeking to buy automobiles and homes; to afford myriad discretionary and luxury goods and services; to finance educations; or to make the types of big ticket purchases that had been bolstering our bubble economy. Lenders are now moving aggressively to cut home equity and credit card lines. And, importantly, recent developments have significantly tightened credit availability for businesses of all sizes. Securitization markets have been largely shut down for awhile now. Now acute stress has incapacitated the money markets.

    Unless some dramatic development reverses the current course, it will not be long before a self-reinforcing cycle of company payroll and spending cutbacks takes hold. At the same time, the municipal bond market is in disarray. The economic impact from major cutbacks in state and local government spending will be significant. Today's finance-related economic headwinds are Cat-4 (and gaining) Hurricane Systemic Credit Seizure, compared with last year's Tropical Storm Subprime. Federal Reserve-dictated interest rates are extremely low - and the Fed and global central bankers have injected unfathomable amounts of liquidity - yet credit conditions have turned the tightest they've been in decades.
    The Lehman Brothers bankruptcy marked a major inflection point in the confidence of contemporary "money". It was a decisive blow against trust in various money market instruments - the very foundation of our monetary system. "Money" has now tightened significantly for virtually all players that had previously enjoyed cheap short-term financings. This list certainly includes the hedge fund community.

    The Lehman bankruptcy also marked a major inflection point in confidence for the various "daisy chain" players involved in intermediating risky loans into contemporary "money". The market was convinced Lehman was "too big to fail". Its failure inflicted thousands of market participants with losses - from investors in the Reserve Primary money fund caught with short-term Lehman paper to holders of Lehman's long-term bonds. Investors all over the world were impacted. The hedge fund community suffered mightily. The status of hundreds of billions of derivatives and counterparty obligations was suddenly up in the air or in the hands of the bankruptcy court. And, importantly, huge losses were suffered in the credit default swap marketplace - the marrow of one of history's most spectacular speculative manias.

    Trying to add a bit of simplicity to the complexity of a credit market breakdown, I'll say the Lehman collapse marked a critical inflection point in at least five major respects:

    • First, the crisis of confidence jumped the "firebreak" from risk assets to contemporary "money," shattering trust in various facets of contemporary finance that was forged over decades.
    • Second, it required the marketplace to reexamine exposures to various direct and indirect counterparty risks, a terminal blow for derivatives markets.
    • Third, it pushed the credit default swap marketplace into full-fledged dislocation and instigated a long-overdue regulator onslaught.
    • Fourth, it decisively burst the "leveraged speculating community"/hedge fund bubble. This has ushered in another round of problematic de-leveraging and accelerated the reversal of Ponzi finance dynamics.
    • Fifth, it instilled global fear with respect to the risks of participating in the inter-bank lending market with American institutions.

    Basically, the Lehman collapse marked the end of Wall Street risk intermediation as a significant component of system financial intermediation. Going forward, credit growth will be chiefly generated by the banking system, supported by various forms of government backing (Federal Reserve, Federal Deposit Insurance Corporation, Washington bailouts/recapitalizations, and so forth), the now government-operated government-sponsired enterprises (GSEs), and various forms of federal government debt issuance.

    Importantly, this new financial structure will ensure minimal risky lending as well as significantly reduced risk-taking. And from a global perspective, I believe newfound fears of lending to the American financial sector marks the beginning of the end of our economy's capacity for trading new financial claims for imports of energy and goods.

    Over time the changed financial landscape will have a profound impact on the underlying economic structure. Our economy will have no alternative than to get by on less credit, less risk intermediation, and fewer imports. In the near-term, the effects will be a rapid and pronounced slowdown of our economy's "output". And while we'll only know over time, I'd bet this new financial structure will allocate much less finance to entrepreneurial activities, productive endeavors and the asset markets - while at the same time providing ample (government-directed) purchasing power to ensure stubborn consumer price inflation.

    [Oct 3, 2008] Anthony Bolton Why now's the time to buy


    Today, he remains cautious about the timing and shape of the recovery ahead.

    He said: "Because of the credit overhang, it will be a protracted and slow upturn; I am not looking for a fast recovery. The current bear market started 15 months ago – which is longer than most bear markets have lasted – and the first sectors to suffer were financials and consumer cyclicals – such as retail and media stocks – and I expect these sectors to lead the upturn.

    "The Lloyds TSB takeover of HBOS should go through and will go through. Their share prices today will be seen as anomalies with the benefit of hindsight.

    "But I expect lots more regulation of the financial system, banks in particular, and taxes will have to go up to pay for their rescue."

    He is scathing about some directors' failure to accept responsibility for destroying household name institutions: "Where they have lost a huge amount of value for shareholders, there has got to be a question about whether the management should remain. When the rewards are there for shareholders, we expect directors to be paid well – but when they are not there, we don't expect them to continue to be remunerated in that way."

    Pressed on the specific example of Sir Fred Goodwin, the chief executive of Royal Bank of Scotland, who received substantial bonuses after the £47bn takeover of ABN Amro – now regarded by some critics as a deal too far – Mr Bolton said: "Knowing one of the non-executives recently appointed at RBS, I would be surprised if he went there and expected things to remain the same.

    "I agree with Charlie Munger, Warren Buffett's partner, who said that when the ship hits the rocks, the captain loses his job. I think that's a good general principle."

    [Oct 3, 2008] Henry Paulson's ploy may not stop credit crunch spreading

    Times Online

    The next question is, will it be enough? Frankly, the odds are not good. There are plenty of signs that the credit crunch has spread out of finance into the real economy. Another 159,000 off US non-farm payrolls in September is just one. If corporations, encouraged to take on too much debt in good times by those same banks, now find their access to credit limited, they will seek to reduce borrowings, delay investment and lay off workers. Those workers, and everyone else worried about their jobs and houses, will stop spending.

    Those corporations see falling sales, whether of consumer goods or of their components – note the abrupt fall-off in demand reported this week by Wolfson, which makes chips for iPhones, for example – and lay off more workers. Meanwhile, more entrepreneurial smaller firms, which have traditionally provided much of the impetus for economic growth, are even more constrained by their bankers. This is how it goes, down and down in an endless spiral.

    At the end of that spiral there are two futures. One is Gφtterdδmmerung, a financial catastrophe that does indeed bear comparison with the aftermath of 1929 – and please, disregard anyone who claims we are there, or anywhere near there, yet.

    The other is a sadder, shabbier world perhaps more comparable to Britain in the 1950s, where luxuries were just that, mostly inaccessible, a step up the housing ladder meant years of penury ahead and credit was almost unheard of. Worry if you work in finance, estate agency, retail or other vulnerable areas, or if you are unable to trade out of your debts on your existing salary.


    The bailout much like throwing a cocktail party to celebrate AA members one year without a drink will not work. Those in charge of making this bailout necessary will not change. Giving the alcohol to these addicted fools will only serve to further push world economies even lower.

    Richard Williams, oklahoma city, usa

    [Oct 3, 2008] Another Reason for Cash Hoarding: Big Credit Default Swaps Market Test Imminent

    Most observers have taken as a given that the increased disinclination of banks to lend to each other is counterparty risk, that is, the fear the money they lend out won't come back, or at least on the initially promised timetable (bankruptcy proceedings take time and usually lead to losses by unsecured creditors). Some wags have said that financial firms are unwilling to provide loans to each other because they know how bad their own books are, and won't want to be exposed to anyone in that shape.

    But it turns out there may be a specific reason that the banks are hanging on to cash for dear life. Reader Glen pointed to a Financial Times piece that discusses the upcoming settlement of credit default swap payouts triggered by recent defaults. The banks apparently lack a good estimate of their exposures (settlement prices are to be set by auction). And banks that don't have enough to meet their obligations may fail. And more failures would trigger more credit default swap settlements, which could trigger more failures...

    In other words, this process could take down an institution or two, and in a downside scenario, could lead to a cascading credit- default-swaps-induced failures, the financial equivalent of a firestorm. The FT article also pointed out that there could be banks that show large gains, but in these fragile markets, the costs of concentrated losses are vastly greater than the benefit of concentrated gains. Note also that the Fannie and Freddie settlements should in theory not be problematic (there should be no losses on the underlying bonds), but with exposure that large, there are worries about failure to settlement due to documentation or procedural irregularities.

    From the Financial Times (hat tip reader Glen):

    The $54,000bn credit derivatives market faces its biggest test this month as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.

    Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.


    Anonymous said...

    I am a little confused as to what needs to be determined by auction. I had though the CDS terms were clear-cut: you pay me x basis points; in the event of a default I pay you the nominal face value and you deliver the physical bond. What am I missing?

    Jesse said...

    This strikes me as a good reason for the extreme haste in proposing the 700 Bn bailout.

    Finally a date of an event to justify the rush.

    Yves Smith said...

    You don't have to deliver the bond. In Delphi, the amount of CDS outstanding was a significant multiple of the amount of cash bonds. From a recent post:

    In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

    Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of "protocols" – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called "auction system". The auction is designed to be robust and free of the risk of manipulation.

    In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% - 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi's senior unsecured obligation equating to a 0-10% recovery band ....

    doc holiday on mental leave said...

    This is the shit Paulson is in a Fuc-ing rush to buy -- before the market in Japan opens Monday -- because taxpayers really need to bail out this crap ASAP (before the world falls apart) -- and of course, someday, this stuff will gain in value -- but I swear to God, I see no reason as to why that isn't just some dumbass theory from a retarded speculator running from a casino at the speed of light! There is no where on Earth that this shit can run to and there is no future space or time where it will have value, and that includes Hell, where Paulson will return to with this worthless material that has no place on Earth to go!!!!!

    Furthermore, we should reward these cleaver speculators and let them run away while we taxpayers reload their bazookas with more play money, so they can get back to keeping America running like a Swiss watch!

    albrt said...

    Just one of the many reasons why anybody who ever referred to unregulated swaps as "insurance" should be in jail for fraud.

    Insurers only insure insurable interests (which would mean in this case you need to have an interest in the bond). Insurers who pay a claim are subrogated to the interests of the insured (which would mean they have a right to collect if the loss doesn't turn out as badly as the original claim).

    So the person who actually bought the swap as "insurance" ends up with a payout determined by a market process that assumes the swap holders were just speculators who suffered no actual loss, and asks the speculators how small of a windfall they are willing to take in settlement.

    FairEconomist said...

    In the current market conditions, it seems inevitable the bonds will go for less that "fair value'. Maybe not so much for Fannie and Freddie, since they're almost government bonds, but certainly for Lehman and Wamu. Between Lehman and Wamu there are going to be almost 1 trillion in losses. If their bonds are overinsured by speculators I don't see how the financial system can handle it. I wonder how much CDS is out there for them, and I'll bet there's no way to find out.

    [Oct 3, 2008] Newsweek Perspectives

    If money isn't loosened up, this sucker could go down.

    President George W. Bush, watching nervously as negotiations on the federal bailout plan hit partisan snags after he'd asked for congressional bipartisanship

    [Oct 3, 2008] - Columnists - Martin Wolf - Congress decides it is worth risking depression

    Winston Churchill, Roosevelt's partner, said: "The United States invariably does the right thing, after having exhausted every other alternative."

    [Oct 2, 2008] Why propping up banks will not rescue a debauched financial system - Telegraph

    ... the hard-sell of President Bush and the US Treasury Secretary felt too much like the pressure patter of a door-to-door hawker. Their message was crude: "Trust us. You are in a terrible place. Only we can get you out of this mess. No need to check the details. Hurry now, or it will be too late. Here's a pen. There's the dotted line. Just sign."

    But with the President's ratings so low, few would let him leave the House with anything more than small change. Congress asked, not unreasonably: "If you guys know so much about banking, how come we are in such trouble?"

    Having spent most of the year telling America, contrary to mounting evidence, that the US economy was just dandy, Mr Bush's credibility is threadbare. When making statements, he's beginning to look as if he doesn't even believe himself. As for Mr Paulson, his long association with the jackpot culture of Goldman Sachs is, in the eyes of many outsiders, a gilded millstone.

    Predictably, the refuseniks have been pilloried as ill-informed nihilists. They have been lambasted for failing to understand the consequences of their actions. They are, according to the Big Bail-out Brigade, condemning the rest of us to be buried alive in the rubble of a disintegrating banking system.

    Try a different take. Yes, the West's financial infrastructure is in severe distress. Yes, more banks are going to crumble. Yes, there will be a recession. But allocating $700bn (it would almost certainly turn out to be more) to a clean-up programme for toxic assets, in effect socialising the poison of private greed, has no merit other than to delay the inevitable. No amount of federal cash can rewind the X-rated horror video.

    There is a conspiracy of bankers and politicians whose self-interest is masquerading as sophisticated policy. They want us to believe that they have the keys to salvation. I have not seen a scrap of evidence to confirm this.

    There will, of course, be a renewed effort in Washington to push through a package of national deliverance. Concessions will be made. The US taxpayer will be offered improved terms. And, having made their point, having stood up for "traditional American values", some of the naysayers in the House of Representatives will cross over, enabling a deal to be done. Their consciences will be salved, but the crisis will not be solved.

    ... ... ...

    This, perhaps, will surprise you, but traditional banking – collecting retail deposits and making loans to ordinary customers – is barely profitable. Compared with the potential gains from a day at the currency-swap races, or a night in the derivatives casino, current accounts are cold potatoes. That is why bonus-hungry executives, at what we used to think of as boring banks, were so keen to spin the red-hot wheel of fortune.

    [Oct 1, 2008] Credit Card Debt: Next Big Hit to Banks?

    Reality does not care about models. or, for a change, Paulson and Bernanke stupid expectations...

    Given how overextended consumers are, and how banks have been cutting back on the cheapest piggybank, home equity loans, by slashing those credit lines, and the reports of rising delinquencies from even conservative lenders like American Express, one would think we'd also be hearing more about serious increased in credit card losses.

    But under the new bankruptcy code, if you do no qualify for Chapter 7 bankruptcy (crudely, if you are above the average income in your state), it is easier to walk from your mortgage than your credit card debt. So credit card issuers may be showing lower losses than they otherwise might because other lenders are taking the hit,

    That may be about to change. From MarketWatch:

    Credit-card debt is on the brink of imploding and will be the next storm to hit the fragile finance industry, an investment research firm predicted this week.

    According to Innovest StrategicValue Advisors, banks will charge off $18.6 billion in delinquent credit-card accounts in the first quarter of 2009 and $96 billion in all of 2009, more than double the research firm's forecast for all of this year.

    Innovest projects that amount would be high enough to damage some of the biggest card issuers.

    Credit-card charge-offs are "defying gravity" when compared with the problems in the mortgage market, according to Gregory Larkin, senior banking analyst for Innovest. But that will change as they catch up with mortgage charge-offs, which have spiked eightfold since the third quarter of 2007.

    "If history is any indicator, there should be an equivalent surge of credit-card charge-offs very soon," he said, though he concedes that an eightfold increase would be very aggressive.

    Comparatively, charge-offs reached $4.2 billion in the first quarter of this year and $3.2 billion in the same period a year before, according to the Federal Reserve, which only reports non-securitized debt. Innovest's projections include all credit-card debt, which the firm believes is double what the Federal Reserve reports. For all of 2007, charge-offs tallied $26.6 billion, according to Innovest's calculations, and the firm estimates they will reach $41.5 billion at the end of this year.

    [Oct 1, 2008] Marc Faber Disses the Bailout Plan, Likes the Dollar

    Being able to admit his mistakes is a really rare thing in investment community. so Mark Faber is an exception from the rule.

    We have a certain fondness for Marc Faber: he knows financial history, he is refreshingly direct, not attached to conventional thinking, and has a record of generally good investment calls (and admits to his mistakes).

    Reader Dean provided us his latest newsletter, plus a story covering recent interviews (no, Dean is not his PR agent, just a disciple). Some excerpts, first from the BusinessIntelligence article:

    "Most of the investment community are focusing on the financial crisis," Faber told TV newswire last night.

    "But what they should be focusing on is that earnings will continue to disappoint for a long time, and that global growth is going to go down substantially. Most economies already today are in recession."

    ...falling house prices are not the problem. It is the huge leverage that is the problem. If your house is 100% self-financed (no mortgage outstanding) a rise or a decline in the value of your house has no direct economic or financial impact. In short, my view is that the bail-out plan is not addressing the cause of the problem, which is excessive leverage.

    ...the Paulson bailout plan is a government bailout of the previously failed government bailout which was a bailout of the previously failed government bailout etc… Each bailout had its own unintended consequences which the next bailout tried to address. Greenspan bailed out the economy after the stock market bubble popped with 1% interest rates which sowed the seeds for the credit bubble. In order to bail us out, Bernanke slashed interest rates to 2% and a dramatic rise in commodity prices ensued. When that bailout didn't work, he instituted a bailout of the investment banks with the initiation of the TSLF and PDCF credit facilities for investment banks. That slowed down the deleveraging process as it gave the investment banks a false sense of security. I highlight Dick Fuld's comments soon after it began where he said it takes the liquidity issue off the table. The lack of dramatic deleveraging brought us to last week's panic in GS and MS, a failed LEH and a shotgun wedding for MER which led us to the Paulson bailout. The unintended consequence of this bailout will be a much lower US$ and selloff in the US bond market which will leave us with higher interest rates and higher mortgage rates throw's the intentions of the Paulson plan out the window. Who will bailout this bailout"?'s a plan for Washington DC, tell the banks to stop paying dividends to their shareholders. I went back and looked at just 20 of the top banks, including GS, MS and MER and saw that they are paying out $40 Billion per year out in dividends. The lending rule of thumb is $1 of capital can service $10 of lending. That is $400 Billion in lending capacity that can get freed up. That is more than half of the Paulson bailout plan and it costs the taxpayer ZERO.




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