Friday, October 31, 2008

"the government also has given an implicit (now largely explicit) guarantee to the creditors of all the major banks."

Dean Baker asks a good question:

"Why Is an Implicit Guarantee to Fannie and Freddie More of an Issue than an Implicit Guarantee to Goldman Sachs and Citigroup?

Federal Reserve Board Chairman Ben Bernanke discussed alternative mechanisms for supporting the mortgage market other than the unlimited implicit guarantee that it had given to Fannie Mae and Freddie Mac.

While it is certainly reasonable to ask whether the government role in the mortgage market can be better structured, the government also has given an implicit (now largely explicit) guarantee to the creditors of all the major banks. Fannie Mae and Freddie Mac do not seem to hold any special status given current policy.

It would have been appropriate for the media to note the government's guarantee of debt at all major financial institutions (except Lehman Brothers) when discussing Bernanke's comments. Many readers might have been wrongly led to believe that the government's guarantee for Fannie and Freddie was the exception rather than the rule.

--Dean Baker

My main interest in this piece is that Dean Baker sees the implicit and explicit guarantees floating around our system. He might well disagree with me about whether they are a good thing or not, but at least he sees them and acknowledges them. As well, he does ask the right question that these guarantees raise: Why A and not B?

"Just to put the 17 bank failures this year into perspective, here are insured bank failures by year since the FDIC was founded:"

From Calculated Risk:

Just to put the 17 bank failures this year into perspective, here are insured bank failures by year since the FDIC was founded:

FDIC Bank Failures Click on graph for larger image in new window.

Of course the size of the failed banks, and the cost to the FDIC, also matter.

The failure today, Freedom Bank, was a small bank by asset size ($287 million). Still the size of the cost to the FDIC is pretty amazing compared to the size of the bank (cost estimated at between $80 million and $104 million). Many analysts expect over 100 bank failures. Dr. Roubini expects "hundreds of banks" to fail in the cycle. If so, we are just getting started.

Note: there are 8,451 FDIC insured banks as of Q3 2008."

Was this enough moral hazard? I'd like to see the record of banks that were saved.

"In light of the most recent data another fiscal boost is needed, and it had better be big."

Clive Crook also supports a stimulus:

"How big a boost? One leading policy economist -- also a noted scholar of the Depression and a level-headed man not given to exaggeration -- is Barry Eichengreen of the University of California (Berkeley). He has called for a further stimulus of 5 percent of national income: in other words, another $700 billion. "This means that the [budget] deficit may be closer to $2 trillion than $1 trillion next year," he points out. A $700 billion stimulus is at the high end of the numbers currently being suggested. Among economists, packages of $300 billion to $500 billion are more the norm, and proposals circulating on Capitol Hill are at the lower end of that range. A year ago, even these smaller sums would have been regarded as staggering.

I agree with Eichengreen. The economy is no longer on the edge of the precipice but tipping over into free fall. A second stimulus package of $500 billion or more -- to include spending on infrastructure and unemployment assistance as well as tax cuts -- is necessary. If you are going to do this, there is no point in half-measures. The government has to fill the space that terrified consumers are now vacating, and it is a very big space."

I agree. Here's my comment:

"If European governments and other countries introduce big fiscal plans of their own (as they should, in their own interests), the chances of a flight from the dollar would come down. Second, the package should ideally include commitments -- including postdated tax increases and reform of the budget process -- that would reassure investors that Washington will bring the deficit back under control once the crisis is over."

But this:

"Stumbling and Mumbling on a stimulus plan:

"This raises an obvious question. If government borrowing today merely means lower state spending or higher taxes tomorrow, why should it boost aggregate economic activity at all? Won’t it just cause tax-payers to save in anticipation of higher future taxes, or public sector workers to save in anticipation of redundancy?
This is, of course, the challenge of the Ricardian equivalence hypothesis. This says that fiscal policy is impotent, because people should save in anticipation of higher future taxes, which is what borrowing is."

Will people save in preparation of tax increases? Or losing a job?

"the UK is one of the few countries in which Ricardian equivalence is wrong. So perhaps fiscal policy might work.
How can this be?
It‘s not necessarily because people are short-sighted. It‘s because they are liquidity-constrained - they can’t save or borrow enough.
Put yourself in the shoes of a poorly-paid person. You might anticipate higher taxes in five years’ time. But what can you do about it? You’re struggling to pay rent and leccy bills today. You just can’t save as a precaution against future problems - you’ve enough on your plate making ends meet now."

Well, if people are poor enough, No. They can't. They need to live.

"But what if we had a more progressive tax system, with taxes only levied upon those of us who can afford to save? We might well trim spending on fripperies to save more. We would then be in the world of Ricardian equivalence, in which public borrowing was offset by private saving."

So, people who can save will.


"My point is simple. What allows Darling’s fiscal policy to work is the fact that taxes fall upon people who can‘t save. If the poor were better off - and so able to save - or if taxes were more progressive, fiscal policy would be less powerful.
Personally, I’d prefer a world of greater equality and less powerful fiscal policy. But not everyone shares my preference."

I agree, but I'm not sure I accept the reasoning. For one thing, oddly, if the rich will save in anticipation of future taxes, why not tax them now, and obviate that problem. Another possibility would be to raise taxes until they don't want to save. One could also tax their savings. I'm not advocating any of these things, but there do seem possibilities to counter this effect where it exists."

And this:

"You might be interested in this about the Japanese stimulus plan from the FT:

"Although the handouts would increase household disposable income, given that there could be a consumption tax rise in three years, the plan was structured in a way that would encourage people to save, Mr Morita said."

Now, are we more like Britain or Japan? Easy, where saving is concerned. But you've already mentioned the tax cuts earlier this year, and the fact that a lot of it was saved. Now this, from the WSJ:

"Part of the reason that consumer cut back on spending in September is that Americans were putting more of their money into savings. That may not be good news for GDP growth in the short-term, but it’s a positive sign for the long-term stability of the economy.

In September, personal saving — disposable personal income less spending — was $140.3 billion, compared with $82.5 billion in August. That raised the savings rate to 1.3% from 0.8% in the previous month. The savings rate spiked from May to July on the back of the government’s stimulus payments, but averaged below 1% for a number of years. It was just 0.2% in April before the stimulus payments went out, and has been nearly flat for years, not rising more than 1.5% in any month since 2004. The rate was in double digits in the 1970s and early 80s, but began a steady decline to the historic lows reached in recent years."

So, I'm with you on the stimulus, and we should eventually work on the deficit and debt, but, for God's sake, don't announce that now.

As the WSJ reports:

"In a currency bloc governed by strict rules about how much debt national governments are supposed to hold, it doesn’t happen often that a central banker encourages governments to up spending. But radical times call for radical measures."

Let's be radical now, and conservative later.

"Maybe he leaned ( sic ) his lesson. "

Paul Krugman considers Douglas Holtz-Eakin:

Alas, Doug Holtz-Eakin

OK, so John McCain’s chief economic spokesman, who I thought did a good job at the CBO, issued a statement on the GDP report:"

Read the post.

Here's my comment. I could learn to spell:

I though that Holtz-Eakin did a good job at CBO, so I’m puzzled by his recent analysis. But consider this:

Wednesday, October 8, 2008
Douglas Holtz-Eakin Tells The Truth
Well, at least he’s honest: e.html?adxnnl=1&adxnnlx=1225490676-ECnJ9XGb5Agk1nXV0kOL Pg

“WASHINGTON — The homeowner assistance plan that Senator John McCain announced without detail in the presidential debate Tuesday night would allow millions of financially stretched Americans to refinance their mortgages with government help, but it would leave taxpayers to cover the losses, rather than the financial institutions that hold the original mortgages.

Mr. McCain said in the debate that the program would be expensive, and on Wednesday his chief economic adviser, Douglas Holtz-Eakin, acknowledged that the liability would be borne directly by taxpayers.”

It seems like an awful plan, but Holtz-Eakin stands up for it.

Maybe he leaned his lesson.

— Posted by Don the libertarian Democrat

Chairman Bagehot's Response

Chairman Bernanke gave a speech on "The Future of Mortgage Finance in the United States":

"The financial crisis that began in August 2007 has entered its second year. Its proximate cause was the end of the U.S. housing boom, which revealed serious deficiencies in the underwriting and credit rating of some mortgages, particularly subprime mortgages with adjustable interest rates. As subsequent events demonstrated, however, the boom in subprime mortgage lending was only a part of a much broader credit boom characterized by an underpricing of risk, excessive leverage, and the creation of complex and opaque financial instruments that proved fragile under stress. The unwinding of these developments is the source of the severe financial strain and tight credit that now damp economic growth."

The financial crisis was caused by the end of the housing boom. This boom showed problems in mortgages:
1) Poor underwriting ( True )
2) Poor credit ratings ( True )
3) Allowing subprime mortgages with variable interest ( True )

A good start. 3 obvious principles that investors forswore at their own peril.

However, the general problems are:
1) underpricing risk ( What caused this? )
2) excessive leverage ( True )
3) complex investments ( ? )
4) not transparent investments ( ? )

Okay. I think 1 and 3 and 4 go together, but that's me. Now he says this:

"To address these issues, we must consider both the part played by securitization in the mortgage market and the role of the government and government-sponsored entities in facilitating securitization."

Here I don't agree. I've already considered securitization with the help of Derivative Dribble.

Here's why they're worthwhile:

"The ability of financial intermediaries to sell the mortgages they originate into the broader capital market by means of the securitization process serves two important purposes: First, it provides originators much wider sources of funding than they could obtain through conventional sources, such as retail deposits; second, it substantially reduces the originator's exposure to interest rate, credit, prepayment, and other risks associated with holding mortgages to maturity, thereby reducing the overall costs of providing mortgage credit."

Okay. They give:
A: Originators more sources, e.g., retail deposits
B: Originators risk decreased on:
a: interest rates
b: credit
c: Prepayment
d: Holding mortgages to maturity
And these lower costs of providing mortgage credit.

This sounds good. The only things needed for using securitization properly are:
1) Ultimate investors invest in good quality mortgages and underwriters
2) All investors in process must be able to manage risk
3) Must be transparent, because hard to price

Here's the thing: These are all common sense and not complicated. I'm sorry, but this is investing 101.

He gives a bunch of remedies, but, I'm sorry, it wasn't the products. It was the investors. The question is why did these investors take these risks? So, all the remedies are last year's news to me. Go ahead and fool around with regulating these things. Good luck.

I believe that investments involving shifting risk to third parties or magnifying risk, often with complicated models, should be looked into or regulated, but the principles need to be broad to capture future innovations.

In any case, we need better investors, and having government guarantees makes that impossible.

Here's Beranke's conclusion:

Regardless of the organizational form, we must strive to design a housing financing system that ensures the successful funding and securitization of mortgages during times of financial stress but that does not create institutions that pose systemic risks to our financial markets and the economy. Government likely has a role to play in supporting mortgage securitization, at least during periods of high financial stress. But once government guarantees are involved, the problems of systemic risks and contingent taxpayer involvement must be dealt with clearly and credibly. Achieving the appropriate balance among these design challenges will be difficult, but it nevertheless must be high on the policy agenda for financial reform."

I agree that government has a role to play. I just gave one area above.
I agree that if government is guaranteeing these investments, they should be highly regulated and limited in risk in order to keep the risk to the taxpayer at small as possible.

Is there any better plan?

I believe that there is.
First, I accept what I call Bagehot's Principle: If the B of E exists, it will be the ultimate guarantor, and that must be taken into account. Given the Fed and our government, they are the ultimate guarantors and must be taken into account. And, following Bagehot, I would like to see the following:

A: Real moral hazard for banks or financial entities far short of a crisis. No propping up.
B: General supervision as I recommended above. Minimal, but effective.
C: Serious penalties if these businesses need government help. I recommend effectively taking them away from them,i.e., nationalization, which is why I favored a Swedish type plan, that would divest these nationalized entities back into private concerns as soon as possible. But such conditions as TARP are not nearly onerous enough.

These principles have been known since Bagehot, and, since him, we have known that a pure free market plan is not real, as long as certain financial and government entities exist. It's time we follow his advice.

"A $15 billion weekly outflow is rather large."

Brad Setser with some scary money flows from Russia:

"But about $15 billion reflects Russian intervention in the currency market, as well as the drain on Russia’s reserves associated with the loans Russia’s government is making to Russian banks and firms seeking foreign exchange to repay their foreign currency debts.

A $15 billion weekly outflow is rather large.

$15 billion is as much as the IMF committed to lend Russia back in 1998. And the IMF actually only disbursed a third of that total.

The most the IMF ever actually lent out to a single country in the past was roughly $30 billion (to Brazil, in 2002-03). At the current rate, Russia will run through that much in two weeks."

So, $15 billion, and the IMF has only ever loaned to one country $30 billion.

"But the pace of decline in Russia’s reserves is also evidence of the scale of the reversal in capital flows to emerging economies — and the pace of the current outflow.

More money is probably leaving Russia than is leaving other countries, as Russia has some uniquely Russian vulnerabilities that other emerging economies lack. But even if Russia is at one end of the distribution, it certainly isn’t atypical …


Here's my comment:

    October 31st, 2008 at 2:10 pm

  1. Is there any way to even estimate what the IMF might need to fulfill the two programs that they recently announced?

But nothing. Wow,

"THE ECONOMIST, as we've mentioned once or twice, has published its endorsement of Barack Obama"

Free Exchange asks if the Economist's endorsement of Sen. Obama was expected, because, if it wasn't, then it might be significant ( that's the logic, don't blame me ):

"So they can be important, but they're more important if they're unexpected, given the perceived bias of a publication. The question, then, is just what did you all expect?"

Here's my comment:

I'm thinking that you don't think that you're very credible, otherwise, like the sensible people that you are, you would be worried that someone might actually listen to you.

I wouldn't want that on my conscience, and I doubt that you do either. Eccentrics like us need to keep our own counsel on really weighty matters. Don't you agree? That's what I was expecting.
10/31/2008 9:47 PM GST

"in Baghdad, home prices have nearly doubled since last year. "

Freakonomics on the Iraqi housing boom:

"So who buys a luxury home in northern Iraq? Government officials, oil executives, wealthy Kurds from abroad. But the homes are selling slowly, and only time will tell whether the subdivisions of Erbil can avoid the fate of this Seattle subdivision, which the American housing crisis has turned into a ghost town."

Here's my comment:

I live in Tacoma, and I don’t even know where this place Stevenson is.

Anyway, I think that this is like the Bay Area where housing prices are down in S.F. and the hub area, but in outlying areas like the far suburbs and Central Valley, they’re way, way down.

So, I suppose, it depends on where Erbil fits into this map. Is it a hub, or an outlying area? Baghdad prices might remain pretty high even after a downturn.

— Posted by Don the libertarian Democrat

"The poll seems to indicate that Mr. McCain persuaded all the wrong people."

Floyd Norris in the NY Times with a post about Sen. McCain's campaign:

"McCain’s Economy Problem

It’s been a tough year for Senator John McCain, the Republican presidential candidate. I’m not forecasting the election, but I think the New York Times/CBS poll released last night provided some evidence of how Mr. McCain’s efforts to zigzag through the election season have failed to have their desired effect."

That seems right:

"Mr. Obama did his own zigzagging. He sounded much more like a free trader in the general election than he did in the primaries. But that issue is not a big one this year. Instead of persuading both conservatives and moderates that he agreed with them, Mr. McCain may have alienated too many voters in both camps."

Here's my comment:

This is strange. I’m a Democrat now, but I became a Republican in 2000 to support McCain. I’m voting for Sen. Obama, even though he’s not my first pick on economics, for sure. I have to pray that he’s more to my taste than he appears. Having Sen. McCain be president wouldn’t have bothered me before this campaign began, but now I feel differently.

Also, Douglas Holtz-Eakin was pretty good at CBO, and he has seemed way off of his game.

So, on economics, it’s a wash, with a slight nod to Sen. Obama. But, on everything else, Sen. Obama is way better for my beliefs. I don’t know where Sen. McCain went, but somebody might want to check for pods.

— Don the libertarian Democrat

But That's My Own Petard! How Dare You!

I was going to do something with this story, but Yves Smith's take on Naked Capitalism is just too good:

Friday, October 31, 2008

Investment Banks Hoist on 2005 Bankruptcy Law Changes Petard

Listen to this article. Powered by
Investment banks? What investment banks, says the alert reader. They are all gone, either bought by big banks, dead, or forced to become them so as to be able to pull funds from the Federal Reserve more readily.

The Financial Times report that the changes to the bankruptcy law in 2005 may have played a role in the undoing of these firms. The danger for an investment bank, as the Bear Stearns case illustrated, is that counterparties can become nervous about having credit exposure and can start curtailing certain types of activities and close accounts that would be frozen in bankruptcy. Worse, if a firm is downgraded beyond a certain point, counterparties will stop trading with the troubled firm because exposure to that firm would get them downgraded. And an inability to trade is a death knell for a securities firm.

The irony is that carveouts in the 2005 bankruptcy reform bill intended to help investment banks appear to have worked in the opposite fashion. From the Financial Times:"

Read the post. Well played!

"Many economists are calling for another fiscal stimulus package.";And At Least One Idiot Blogger

Greg Mankiw on the horns of the stimulus dilemma. He decides to ride them both ( Watch out Greg, that could hurt ):

"If there is going to be another fiscal stimulus, there will likely be a division between those who want tax rebates to households and those who want to help states pay for extra infrastructure spending. I have a compromise, based on the grand U.S. tradition of federalism: Let each state decide."

He always comes up with reasonable solutions, but note:

"Marty thinks the tax rebates earlier this year did not do much to stimulate consumer spending. I think Marty is too quick in reaching this conclusion: Other scholars who have seriously analyzed the data disagree.'

I simply think that we've already done what he asks, give tax rebates. Now we should try an infrastructure stimulus. Please don't hold me to its effectiveness as a stimulus. It just seems the best choice. Once again, I would target the stimulus to regions of high unemployment.

“It seems the increasing likelihood of a progressive White House is forcing the [UK] government to clean up its act"

Here's an interesting story in the FT:

"UK involvement in the Bush administration’s ‘war on terror’ was facing renewed scrutiny on Friday after it emerged that government lawyers had asked the attorney-general to investigate possible “criminal wrongdoing” by the security service MI5.

The Home Office confirmed its lawyers had referred evidence about the case of the last remaining detainee held at Guantánamo Bay since 2004 to Baroness Scotland, attorney-general. As an ‘independent law officer’ she is to consider what further action, if any, should be taken in the case.

According to the home office, Baroness Scotland will be looking at the the question of whether the police should investigate the latest claims of UK complicity in alleged rendition and torture.

Why is this coming out now?

"While admitting that MI5 and MI6 officers have been involved in questioning terror suspects who have been held by the US, the UK government has repeatedly denied that it has “outsourced” torture to third countries to obtain information for court use or use in counter-terrorism.

The UK has also denied that it has been complicit in the use by the US of so-called rendition – flying detainees to countries where bans on torture do not apply.

The home office refused to say what, if any, political motives lay behind the decision to subject the case to further scrutiny in a move that one Whitehall insider conceded could open a legal minefield if pursued through the UK legal system.

However, Edward Davey, the Liberal Democrats’ foreign affairs spokesman, linked the move to a greater degree of accountability coming into government on both sides of the Atlantic in anticipation of a new president in Washington."

In other words, they are worries about the Democrats coming to power and actually investigating these charges. Does this signal that there is something to be worried about?

“It seems the increasing likelihood of a progressive White House is forcing the [UK] government to clean up its act, on everything from Guantánamo Bay to Diego Garcia,” Mr Davey said. “But it is too little too late.”

“Under our…system the government undertakes enterprises only when private initiatives fail.”

James Suroweicki on The Balance Sheet:

"Reading “The Tradition of the New,” a collection of essays by Harold Rosenberg (the critic who coined the phrase “action painting”), I came across this line:

“Under our…system the government undertakes enterprises only when private initiatives fail.”

This is how, really, it’s always been in the U.S., to a greater or lesser degree. It’ll be interesting to see if this massive failure of private initiatives in the financial realm changes that. (If I had to bet, I’d say it won’t.)"

The problem is also that private enterprises know this and count on it. Failure is part of the risk, bailout is part of the calculation.

"Lawmakers unhappy with the plan are finding they can do little else but jawbone banks to lend"

Barney Frank agrees with me. From the WSJ:

"Frank Says Banks Should Just Use Government Funds for Lending

House Financial Services Committee Chairman Barney Frank asserted that a number of financial firms were “distorting” the financial rescue legislation by not using government capital exclusively to boost lending.

[Barney Frank]
“Any use of these funds for any purpose other than lending — for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc. — is a violation of the terms of the Act,” Frank (D., Mass.) said in a statement Friday.

But this:

“Maybe if we’d have 13 weeks instead of 13 days we would’ve written that bill with even more detail,” Senate Banking Committee Chairman Christopher Dodd (D., Conn.) said Thursday."

Come on. I saw this problem from the very beginning on my blog.

"However, they aren’t required to shut off dividends to shareholders. And there are no requirements that banks use the funds to lend, rather than bolster their balance sheets or make acquisitions. Indeed, Treasury supports banks using the funds to buy weaker rivals.

Lawmakers unhappy with the plan are finding they can do little else but jawbone banks to lend. The financial rescue legislation that granted Treasury authority for the bank capital program says little about the use of any government funds, other than placing some curbs on executive pay.

The House Financial Services Committee will hold oversight hearings on Nov. 12 and Nov. 18 on TARP. Frank warned, “It is very important if congressional and public support for this program is to continue that we receive assurances at those hearings that the money being advanced will be used only for relending and for no other purpose.” –Jessica Holzer"

Good work Jessica. How well does jawboning work? Why pass laws when we can jawbone? Holy mackerel.

``We will work with families who want to save their homes but are struggling to make their payments.''

Speaking of renegotiating mortgages. From Bloomberg:

"JPMorgan to Modify Mortgages to Limit Foreclosures (Update1)

By Elizabeth Hester

Oct. 31 (Bloomberg) -- JPMorgan Chase & Co., the largest U.S. bank by market value, plans to modify terms on $110 billion of mortgages and forgo foreclosure proceedings on all real-estate loans while the changes are implemented in the next 90 days.

The offer extends to customers of Washington Mutual Inc., the savings and loan JPMorgan agreed to buy last month, the New York-based bank said today in a statement. Loan modifications may include interest-rate or principal reductions. The bank said it will establish 24 regional counseling centers to provide face-to- face help in areas with high delinquency rates.

``We felt it is our responsibility to provide additional help to homeowners during these challenging times,'' said Charlie Scharf, chief executive officer of retail financial services at JPMorgan Chase. ``We will work with families who want to save their homes but are struggling to make their payments.''

Okay. Sounds good.
The help will be:
1) lower interest rates
2) principal reduction
In either case, lower payments should be possible.

"The JPMorgan program is expected to help 400,000 families with $70 billion in loans in the next two years, JPMorgan said. The company said an additional 250,000 families with $40 billion in mortgages have already been helped under existing loan- modification programs.

The programs are aimed only at homeowners who ``show a willingness to pay,'' the bank said. ``Customers should continue to make mortgage payments to reflect their intent to honor their commitments.''

JPMorgan said it will also donate or offer a ``substantial discount'' on 500 homes to community groups in order to stabilize local markets."

Okay. Good. Moral problem solved with willingness to pay, and no government intervention here. Although, I believe that they are part of TARP.

"the latest trial balloon of a plan being floated to rescue overextended mortgage borrowers"

Yves Smith also has some good points about the possible mortgage plan:

"Before we debate the merits (more accurately, the lack thereof) of the latest trial balloon of a plan being floated to rescue overextended mortgage borrowers, we need to consider a few not sufficiently discussed facts:
1. The problem is that banks are not making loan modifications as they did in the past. That is turn is due to securitization In the old days, including in the nasty (in the Southwest and Texas) housing bear market of the early 1990s, it was standard practice for banks to modify mortgages. That was not charity on the part of the bank but a cold-blooded economic calculation, that in the majority of cases, it would take a lower loss by changing mortgage terms than by foreclosing."

Read the rest.

Yves says that mortgage renegotiation used to be business as usual, so enough about the morality of it. It's in the lenders interest in some cases.

The problem now is:

1) Mortgages are held by people getting fees for holding them, and that means ( securitization:see my post on it here ) One note: This could make it easier to renegotiate since each of the holders hold many mortgages.
A. The don't like renegotiations, but prefer foreclosures, since they aren't paid for the first, but are paid for the second ( Makes sense: how about giving them a motive for doing this )
B. Unlike small banks, there's no banker with a relationship to the borrower to talk to. ( See this post on smaller banks )

However, foreclosures lower housing prices in whole area, which isn't a good thing. For another thing, it lowers property taxes, so the government might not like it. I guess there's a possible trade-off for the homeowner.

Also, Bankruptcy judges dealing in loans is a pretty fair option.

Here's my comment:

Don said...

I don't understand why this part of the problem, foreclosures, has taken so long to be dealt with unless the government is now afraid that they're going to have to deal with this problem at the other end otherwise,e.g.,AIG's CDS's.

As for the plan, the news keeps being there's going to be a plan. Why do they keep announcing this prior to unveiling an actual plan? There's going to be a plan. Good for you.

I just feel that I'm missing something. By the way, has anybody studied the effects on property taxes in the seriously hurt areas?

Don the libertarian Democrat

Here was my last comment:

Blogger Don said...

If foreclosures lower housing prices in the whole area, homeowners could petition for tax reductions. This would seem a clear problem for the expenses of local government.

Don the libertarian Democrat

October 31, 2008 11:42 AM

"we're not going to have enough water to farm,"

Via Yves Smith on Naked Capitalism, a story about water and farming in California, which is a crisis waiting to occur:

"SACRAMENTO, Calif. – California said Thursday that it plans to cut water deliveries to their second-lowest level ever next year, raising the prospect of rationing for cities and less planting by farmers.

The Department of Water Resources projects that it will deliver just 15 percent of the amount that local water agencies throughout California request every year.

Since the first State Water Project deliveries were made in 1962, the only time less water was promised was in 1993, but heavy precipitation that year ultimately allowed agencies to receive their full requests."

Here's the consequence for farming:

"Mike Young, a fourth-generation farmer in Kern County, called the projections disastrous.

"For the amount of acres we've got, we're not going to have enough water to farm," he said.

Young said he will be forced to fallow a fifth of his 5,000 acres. Water will go to his permanent crops — pistachio, almond and cherry trees — but most of his tomatoes and alfalfa will not get planted.

"We've got to start spending money on next year's crop now," Young said.

Jim Beck, general manager of the Kern County Water Agency, noted that fewer plantings would yield fewer crops and a decrease in the number of farm hands hired.

"We're seeing a phenomenon in the Central Valley where growers who have been in the business of agriculture are laying off workers who have been with them for 20 or 30 years because they don't have the water," Beck said. "It's one thing to see brown lawns and shorter showers in urban areas. The real impact in the Central Valley is people are having to find new jobs."

Here's my comment on Yves blog:

Blogger Don said...

"Jim Beck, general manager of the Kern County Water Agency, noted that fewer plantings would yield fewer crops and a decrease in the number of farm hands hired."

This is a huge story. Thanks for flagging it. I'm from the Central Valley, and this problem has been coming for some time. What will the trade-off be between Agribusiness and Cities concerning water?

Also, the Central Valley is very GOP. This could effect politics in California.

In any case, the Central Valley's farming production is a very important issue. Danger ahead.

Don the libertarian Democrat

October 31, 2008 11:13 AM

"The crisis may ``knock some sense'' into private school"

From Bloomberg, British Public Schools prepare to live lean and pitch in:

"Students in U.K. Schools Grow Food Amid Credit Crisis (Update1)

By Jonathan Browning and Tom Biesheuvel

Oct. 31 (Bloomberg) -- Growing food is on the curriculum at Leaden Hall private school for girls in southwest England, and students can thank the credit crisis.

``Pupils are growing potatoes, tomatoes, runner beans and courgettes,'' said Diana Watkins, the head teacher of the school of 231 students, including 40 boarders, in the town of Salisbury. Planting took place in the spring, crops are tended by children and staff, and ``every patch of grass is being used,'' Watkins said.

The money-saving strategy at Leaden Hall, which charges about 13,500 pounds ($22,000) a year for boarders, underscores how some of Britain's most expensive schools are cutting back on everything from store-bought ingredients to new classrooms in their struggle to contain fees as the credit crisis bites."

I guess this is sensible. Rod Dreher would approve.

``There's a sense of a tidal wave coming towards us,'' said Anthony Seldon, the head of the college. ``We don't know if it is going to be a large one, an unpleasant one, or a massive one. We think many of our parents will be adversely affected. Some of them will be very significantly affected.''

You can tell things are bad when weather terms start being used to make the crisis more understandable, and weather terms have been becoming more and more popular recently.

"Capital projects will be among the first to go as bank loans become harder to obtain, said Sudhir Singh, the head of charities and education at Baker Tilly, the accounting firm that advises more than 120 independent schools in Britain."

What about raising tuition?

"Asking parents for extra money, beyond the school fees, isn't ``tactful'' when some of them may be facing unemployment, said Anning, who also chairs a regional group on education funding. Red Maids, in Bristol, southwest England, doesn't have boarders and charges about 9,000 pounds a year. "

That seems reasonable and decent. The British do see an upside:

"The crisis may ``knock some sense'' into private schools, said Martin Stephen, the head master at London's St. Paul's School, whose graduates include the poet John Milton. "

Maybe will get another "Paradise Lost" out this mess. Bottom line:

"Schools with budgets under pressure can either cut back on projects or reduce spending, according to Jonathan Cook, the general secretary of the Independent Schools' Bursars Association, which has more than 900 members. ``That is the type of debate we are just starting to enter.''

So, the response will be:

1) Cut spending, which includes projects
2) Grow your own food

But not:

1) Increase tuition or fees


1) Some sense will be knocked into some heads
2) Another Milton might appear

Thursday, October 30, 2008

"It might be worth reminding the banks that, should persuasion fail, public outrage will ensure that those drastic plans gather no dust."

The FT on the TARP and U.K. equivalent not leading to lending:

"Memo to bankers everywhere: Taxpayers did not rescue you because they love you. They rescued you because they need you. The rescues were intended to ensure the flow of credit to creditworthy businesses; yet that flow of credit seems to be slowing to a trickle. How should governments respond?

Let there be no mistake: government support for the banking sector was necessary. Without it, several large banks looked at risk of collapse, and the panic among banks and their creditors could have brought down the entire financial system. Yet just because the rescue was necessary, it was never guaranteed to be sufficient."

Again, I believe that this is a moral imperative. TARP was sold as a credit stimulus. Why aren't they lending?

"Naturally, many people are wondering why the UK Treasury – and the US Treasury, which faces a similar situation – is not doing more to force the banks to lend after their expensive rescue. It is easy to tell a tale of greedy banks and complaisant governments; but the true story is less of a pantomime and, sadly, more intractable.

The fundamental question is why banks are reluctant to lend. One possibility is pure fear: the banks lent too much before, destroying their reputations and tens of billions of pounds of their shareholders’ wealth, and now are erring on the side of caution.

A second possibility is that banks face a co-ordination problem. No bank wants to be the only one extending overdrafts and rolling over loans, but each might be emboldened if others did likewise."

1) Shell-shocked from previous lending

2) No bank wants to take the lead

Possibility three:

"The trouble is that, while fear and lack of co-ordination are partial explanations for the drying up of credit to businesses, they are not the whole story. It seems likely that many of the loans banks unwisely made in the good times are now intrinsically unprofitable. They were predicated on cheap credit, ample risk appetite and a growing economy. Now that banks cannot borrow cheaply or raise capital, those loans cannot be rolled over without losing money."

3) The banks are still insolvent

What to do?

"The UK government could step in directly and order the banks to lend to small and medium-sized businesses, effectively nationalising the whole sector and taking both the credit decisions and the credit risk. That may yet be necessary – but only a hopeless optimist would expect that story to end happily. Loans would become political, the government taking responsibility for who survived and who went under. This remains the last resort.

The government could also encourage banks to lend by lowering the price of the capital and credit insurance offered to them. Taxpayers would be paying to subsidise loans to businesses. Some of those businesses would be saved, and so too might other businesses that depend on them. Yet much of the money would go to businesses that need no subsidy, or businesses that are beyond saving. There is no simple answer and the problem is made yet worse by the fact that one bankruptcy can cause an avalanche of others with little warning."

1) Nationalize or manage banks

2) Give banks more subsidies

"Meanwhile, the government should stick to persuasion and leave more drastic plans on the shelf. It might be worth reminding the banks that, should persuasion fail, public outrage will ensure that those drastic plans gather no dust."

I was for nationalizing to precisely avoid this costly farce, not because I liked it.


This editorial was about Britain, yet it applies to us as well.

"in a move that could deepen the political backlash over its use of taxpayers’ money."

AIG just keeps amazing me. From the FT:

AIG has raised funds from a new Federal Reserve lending facility to repay part of a $123bn Fed loan that is keeping the stricken US insurer alive, in a move that could deepen the political backlash over its use of taxpayers’ money.

AIG said on Thursday that it had tapped a Fed lending window designed to kick-start the flagging market for commercial paper and used some of the proceeds to pay back part of the government loan.

The decision to use one government facility to repay another could raise eyebrows among Washington politicians, who have attacked AIG for paying for a corporate retreat and for spending money on lobbying following the federal bail-out.

So, there borrowing from one part of the government to pay off and avoid the punitive interest in the previous loan:

"Analysts said that AIG might have used the commercial paper facility to pay back the loan because the interest rates charged were lower. The government demanded a punitive rate of 8.5 per cent over the London Interbank Borrowing Rate on its $85bn two-year loan, while the Fed is charges interest of around 2-3 per cent for three-month commercial paper.

In a regulatory filing, AIG said that, under Fed rules, it can only raise a maximum of $21bn from the commercial paper window and adding the proceeds would be used for corporate purposes as well as repaying part of the loan.

The news came as Hank Greenberg, AIG’s former chief executive and a large shareholder, was Thursday night preparing to send a letter to Edward Liddy, AIG’s current chief, urging him to ask the government to guarantee all its credit default swap collateral. In Mr Greenberg’s view, the move would enable AIG to quickly repay the government loan."


1) Paying off 8.5% loan with 2/3% loan

2) Get government to guarantee all their CDS's

I thought that we already had.

"the challenge of the Ricardian equivalence hypothesis. This says that fiscal policy is impotent"

Stumbling and Mumbling on a stimulus plan:

"This raises an obvious question. If government borrowing today merely means lower state spending or higher taxes tomorrow, why should it boost aggregate economic activity at all? Won’t it just cause tax-payers to save in anticipation of higher future taxes, or public sector workers to save in anticipation of redundancy?
This is, of course, the challenge of the Ricardian equivalence hypothesis. This says that fiscal policy is impotent, because people should save in anticipation of higher future taxes, which is what borrowing is."

Will people save in preparation of tax increases? Or losing a job?

"the UK is one of the few countries in which Ricardian equivalence is wrong. So perhaps fiscal policy might work.
How can this be?
It‘s not necessarily because people are short-sighted. It‘s because they are liquidity-constrained - they can’t save or borrow enough.
Put yourself in the shoes of a poorly-paid person. You might anticipate higher taxes in five years’ time. But what can you do about it? You’re struggling to pay rent and leccy bills today. You just can’t save as a precaution against future problems - you’ve enough on your plate making ends meet now."

Well, if people are poor enough, No. They can't. They need to live.

"But what if we had a more progressive tax system, with taxes only levied upon those of us who can afford to save? We might well trim spending on fripperies to save more. We would then be in the world of Ricardian equivalence, in which public borrowing was offset by private saving."

So, people who can save will.


"My point is simple. What allows Darling’s fiscal policy to work is the fact that taxes fall upon people who can‘t save. If the poor were better off - and so able to save - or if taxes were more progressive, fiscal policy would be less powerful.
Personally, I’d prefer a world of greater equality and less powerful fiscal policy. But not everyone shares my preference."

I agree, but I'm not sure I accept the reasoning. For one thing, oddly, if the rich will save in anticipation of future taxes, why not tax them now, and obviate that problem. Another possibility would be to raise taxes until they don't want to save. One could also tax their savings. I'm not advocating any of these things, but there do seem possibilities to counter this effect where it exists.

"The pathogen that has fatally infected swathes of the banking industry is now contaminating non-financial companies"

Don't show this post to Rod Dreher. Mark Glibert on the FT:

"One way in which the current recession/depression/meltdown (take your pick) will differ from previous economic collapses is the granularity of information now available. The world is awash with more data than ever before, generating a plethora of ways to scare yourself silly.

The Bank of England, for example, produces what it calls a Financial Market Liquidity Index, a global measure of stress that gauges how far a basket of nine indicators strays from its historical mean. The index gets updated twice a year; this week's bulletin, which recalculates the level up to Oct. 17, showed liquidity at its lowest level in at least 17 years."

Great news:

"The next wave of headlines to scare shoppers out of the mall is likely to come when companies find they can't pay their debts. Credit-rating company Moody's Investors Service predicts that the default rate among sub-investment grade borrowers will surge to 7.9 percent in a year, from 2.8 percent at the end of the second quarter of 2008 and from just 1.3 percent 12 months ago.

``With the global credit crisis intensifying and credit spreads widening, it is increasingly likely that corporate default rates will spike sharply in the next 12 months,'' Kenneth Emery, the director of default research at Moody's, said in a research report published earlier this month.

The Markit iTraxx Crossover index of credit-default swaps on mostly speculative-grade companies traded as high as 920 basis points this week. That level suggests investors and traders are anticipating more than half of the companies in the index will default, based on bondholders recouping 40 percent of their money from companies that fail to keep up their debt payments.

Going Bust

At a recovery rate of 20 percent, the implied default level is about 45 percent. At a salvage percentage of just 10 percent, the index is still suggesting about 40 percent of its members will renege on their commitments. It is hard to see how consumer confidence will recover when companies start going bust."

This might not happen, but the signs going forward aren't good.

"This is not particularly urgent, since my voting "options" were New York and DC"

Meghan McArdle getting way too existential about voting:

"It has come to my attention that someone posted as me in the comments section, claiming that I had registered as a Democrat. This is not true; sorry for anyone who was misled. I've never registered as a member of a major party, and I find it hard to imagine doing so for other than very temporary reasons, like having some desperately strong preference in a primary."

Here's my comment:

You're worrying about this too much. Just send me your ballot and I'll fill it out for you.

"Wall Street firm doesn’t feel compelled to lower its leverage or pull back in any of its business lines."

From the NY Times, some clever investing:

"Those statements would seem to run counter to the widely held view that Goldman will need to make big changes as a result of its new designation.

Ever since Goldman and Morgan Stanley changed to bank holding companies in September, executives at both firms have said they are already in compliance with capital requirements imposed on bank holding companies.

Nevertheless, there has been relentless speculation that, because of the conversion, the two firms would be forced to sharply lower their leverage ratios and cut back on certain riskier areas of their business.

A week ago, an analyst from the Tabb Group, a financial market research and advisory firm, echoed this view. Speaking specifically of Goldman, he told Bloomberg News: “The government is going to want to ensure that there isn’t a meltdown like this again. They’re going to have to use less leverage.”

Here's my comment:

“If Goldman did have to lower its leverage ratio to placate the government, Goldman indicated that it would probably decrease its exposure to its high-leverage and low-return businesses like U.S. Treasury and agency securities traded in its matched book, he wrote.

In essence, then, Goldman thinks it could lower its overall leverage without having to significantly reduce risk (and the prospects of high returns) from its investments. That’s because the government’s gross leverage calculation does not discriminate between low-risk and high-risk leverage.

Mr. Freeman said he thinks that outcome “would be the exact opposite of the Fed’s intentions (of healing the capital markets and restoring robust liquidity.).”

This is the real problem with regulation. These investors can be very clever people, and are adept at shifting the terrain. That’s why regulation always seems to be correcting the last problem.

The solution is either to regulate or supervise risk, especially any investment that shifts risk to a third party or magnifies risk. In other words, broad principles.

Their strategy falls into the latter.

— Posted by Don the libertarian Democrat

"He knew the money fund was not insured, as bank deposits are. "

If it's not guaranteed, what? You tell me. Diana B. Enriques in the NY Times:

"The national “bank holiday” that ushered in the New Deal in 1933 locked up the public’s cash for four days. The crisis that hit last month at the Reserve Fund, the nation’s oldest money market fund, has frozen hundreds of thousands of customer accounts for more than six weeks — with no sure end in sight.

At least 400,000 people, and perhaps as many as a million, can’t get access to their savings, a problem that has quietly persisted in spite of widely publicized federal efforts to restore confidence in money-fund investments.Some of these customers — who, like most Americans, assumed their money funds were as safe and accessible as bank accounts — are getting desperate."

So, lesson learned:

"The Reserve Fund’s prolonged crisis is particularly baffling to Michael Brunner, a research scientist in Columbus, N.J., who has been a customer since the fund first opened its doors in 1970. He knew the money fund was not insured, as bank deposits are. “But after 30 years, one doesn’t think it will go bad,” he said.

He can manage without his frozen assets, he added — but he is furious that he still has to, after so much time.

“People talk about this like it’s something that happened,” he said. “But this isn’t something that ‘happened.’ This is still happening. I still don’t have my money and I still don’t know what’s going to happen to it.”

We'll see what happens here, but not insured means just that. However, we'll see if the government intervenes.

He argued that to step away from mark-to-market accounting would be to return to “fiction writing,”

Interesting post on the NY Times:

"Stephen A. Schwarzman and Bruce Wasserstein agree on several things, including whether the financial crisis had grown worse than anyone had expected, whether Lehman Brothers should have and could have been saved and whether banks should start lending again. (The answer to all three is “yes.”)

But on the matter of fair-value accounting, the private equity mogul and the investment banking chief must agree to disagree."

Here's my comment:

“whether Lehman Brothers should have and could have been saved ”

They answered “yes”. I still think that this is an important to ask and have answered because it tells us that people in the investment and financial world were expecting a bailout, which is important to understanding what has followed.

— Posted by Don the libertarian Democrat

"the 5 per cent consumption tax after three years in order to avoid leaving a huge bill to future generations."

Check out this stimulus plan in Japan in the FT:

"Taro Aso, Japan’s prime minister, on Thursday unveiled a Y5,000bn ($50.8bn) economic stimulus package, the second in two months, warning of the damaging impact the global credit crisis would have on the world’s second largest economy.

“A storm that comes once in 100 years is raging,” Mr Aso said of the global financial turmoil."

More weather comparisons.

Okay. $50 billion more.

“We can’t wait for the typhoon to pass,” Mr Aso said."

More weather comparisons.

Check out what's on tap:

"In an attempt to deflect criticism of fiscal irresponsibility, Mr Aso pledged not to issue deficit bonds to pay for the stimulus package and said he wanted to raise the 5 per cent consumption tax after three years in order to avoid leaving a huge bill to future generations."

1) In 3 years, 5% consumption tax. I assume that's what it means. ( Very interesting. A time-line for debt and deficit reduction. But will it defeat stimulus )
2) Cash to people: $600 for a family of 4 ( Not much. Same problems as here. Might be saved )
3) Increase tax breaks on mortgages ( This is interesting given bubble fears going forward )
4) Highway tolls reduced ( Not much )
5) Increased money for banks ( Maybe )
6) Loan guarantees for smaller businesses ( Won't work )
7) B of J reduces rates ( Problematic going forward )
A: Too small to impact GDP ( True )
B: Tax in 3 years might cause people to save rather than spend ( True, in Japan )
C: Since yen is rising, reduce dependence on exports and resources ( Good luck )
D: It's a political move, not economic ( So what? )

We can compare this with other plans in other countries.

" The irony is that Japanese regulators were once hugely protective of retail investors"

Yves Smith on Naked Capitalism about PRDC's in Japan:

"This Times Online story is frustratingly vague about the exact nature of these complicated and risky foreign exchange products sold to Japanese retail investors. While the size of the problem ($90 billion) may seem not all that bad in comparison, say, to subprime exposures, recall that these trades are likely to be unwound in a compressed period of time when currency markets are already volatile, thus increasing the potential for havoc.

The irony is that Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them. That attitude clearly went out the window.

From the Times Online:"

Please read the story. Here are my posts, with Yves thrown in:

Don said...

See John Gapper on FT here:

"The accounts showed that it was common for Japanese retail investors to be offered leverage of 20 times or more for their cash. In other words, they could deposit the equivalent of $1,000 and take trading positions of $20,000. A lot of them had used the opportunity to buy higher-yielding foreign assets.

The trade worked fine for Japanese investors as long as currencies remained stable and they could in effect switch yen into higher-yielding assets denominated in other currencies. But the sharp rise in the yen - and comparative fall in the value of these foreign assets - is probably landing Mrs Watanabe and her friends with big losses.

Here, to expand the point, is a prescient piece from FT Alphaville a year ago."

Don the libertarian Democrat


Don said...

"The important thing to know about Mrs Watanabe is that, temporarily at least, she has all but stopped flapping her wings"

Who is Mrs. Watanabe?

"Mrs Watanabe is crude shorthand for Japan’s $15,000bn pool of savings, the deepest in the world and worth more than the annual economic output of the US. These vast resources are somewhat apocryphally marshalled by Japanese women, who have traditionally held a firm grip on family finances."

Let's see:

1) Rising yen
2) Lower interest rates
3) Next bubble

David Pilling in the FT:

"The yen carry trade has not been the only cheap source of liquidity in recent years. But Ashraf Laidi, chief currency strategist at CMC Markets, reckons it has been the biggest. He quotes figures suggesting that Japanese households alone, discounting savings mediated through life assurers and other institutions, have mobilised $500bn in outbound funds. That leaves aside speculators, who have borrowed unknowable amounts of yen to invest abroad, often on highly leveraged terms.

Just as state bank bail-outs risk moral hazard, more recklessness and the need for future bail-outs, so the unwinding of the carry trade carries with it the danger of the next great bubble. In Japan, the central bank appears to have reacted to a rising yen and sinking stock market by contemplating the uncontemplatable: a rate cut. Even the rumour of such has provoked a mini equity rally and a weakening of the currency.

This is poison for the BoJ. It hated having to keep rates low, fearing that cheap money can cause bubbles in real estate, in capital investment and in the carry trade. Its sightings of inflationary danger everywhere provoked mirth among outside experts. But few are laughing now."

And so:
"If Japan really is about to reverse course towards zero interest rates, it will once again become the source of almost free money for anyone with an appetite to invest. Worse even than that, says Mr Laidi, is the potential for an even more dangerous dollar carry trade. The Federal Reserve has been desperately cutting rates, and lopped another half point off again on Wednesday. The nearer US interest rates approach zero, the greater the incentive to move dollars into higher-yielding assets elsewhere.

These gyrations do nothing to solve the underlying problem, which is that Asia has an excess of savers and the US and Europe an excess of spenders. Unless that is solved, the world seems condemned to repeat the swings of recent years, as capital is arbitraged between countries where money is cheap to those where it is expensive."


1) Dollar carry trade

2) Asia saves, the West spends

3) Here we go again

Is this real?

Don the libertarian Democrat


Don said...

Following an earlier comment about Japan, if you have domestically:
1)Low interest rates
2)Stagnant stock market
3)Stable exchange rate
4)Low inflation
Doesn't it make sense that you would try and invest overseas? And after the tech bubble, doesn't it make sense that you would look for bonds that would provide you higher yields?
Naturally, if any of these variable change significantly, you could be in trouble. So when the story says:
"The products combine exposure to foreign exchange, interest rate differentials and domestic inflation"
it's not saying anything profound.
And when we read this:
"The PRDC's complexity disguised from the buyers the fact that they were taking on the same big foreign exchange risks as the regular carry trade but with additional exposure to global interest rate volatility."
it's a little hard to credit, since I just described the investment's worth and problems in a few short lines?

Don the libertarian Democrat

And Yves:

Yves Smith said...


The shortcoming in the list above is 'stable currency". In a world of floating currencies (or mainly floating, and Japan was not one of the ones maintaining a dollar peg) the FX risk is huge, although for extended period (perhaps up to a couple of years with not too much movement) it can look low.

And if you read the stories on Japanese retail currency traders, they were as frenetic last year as day traders in the tech bubble here.

The yen was in fact cheap, so the risk was that despite the pickup in yield, you would lose far more due to a fall in the higher-yielding currency. When I was a kid, no one would EVER think of making deposits in higher-yielding currencies, everyone understood that the high yield was a big big signal that a price fall was in the cards.

And me again ( the dummy ):

Don said...

Yves, Thanks. Great point. I was just about to mention these PRDC's on a post about securitization. I think that you make my case, and that we're both on the same page.

I agree that the assumptions seem crazy, my only point was that you would have thought the risks you just rightly pointed out should be easily explainable, even if the products inner workings are complex. From your comments, I was trying to understand how even you were having a hard time with them, and I now see that it's the risk as much as the complexity. I hope I've understood you now, and that my point is clearer.

Don the libertarian Democrat

PS Your blog is great. I'm learning so much from it, but I won't blame my mistakes on you. Take care

Securitization Reconsidered

Okay. Big news. Derivative Dribble explains securitization. Let's go back to the Bloomberg article:

"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. "

Okay. Claims about securitization:
1) bundles loans and mortgages into securities
2) more than $27 trillion of these securities have been sold since 2001
3) that makes these securities the largest U.S. export since 2000

So what? That hardly seems a bother other than the figure being quite large, but, then, good for the U.S.

So now banks outside the U.S. start doing this:
Result: $667 billion in losses: $260 billion or so outside of U.S.: about $400 billion in the U.S.

Okay. These securities lost this money? How?

"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."

Okay, here, I'm lost.

These securities fund:
A. Credit cards
B.Car purchases
C. Leveraged buyouts
D. Subprime mortgages

The "system"
A. Pools loans
B. Spreads risk
C. Makes borrowing cheaper

Voila: A Debt Culture
Does all lowering of interest rates lead to a Debt Culture?

There's $4.2 trillion in money market funds ( deposits paying interest )
Banks made money with the mm funds by funding subprime mortgages and cutting costs
The cutting costs sounds like a good thing, the subprime loans don't

"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."

The banks took in deposits, paid interest on the deposits to the depositors, and loaned the money out to borrowers at a higher rate of interest than they were paying depositors or charged fees. This example doesn't make that clear.

Now, after securitization:

"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."

How do the banks make money in this? If it's lending, do they get interest, fees, what?

"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.''

It is a fee business if there's no capital. That's why I asked how the banks make money on these securities. How does the bank originate a loan without capital?

"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."

So, because of these securities, consumer debt tripled in the U.S., and, since we seem to be rich, other nations did the same thing.

I've already gotten a headache, and we're just coming to CDO's.

"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."

Okay. CDO's use short term debt which is cheap but comes due fast.

"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"."


"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."


``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"

Okay. Short term lending is the problem.

"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."

Only it's not. It looks here like lack of collateral.

We've come a long way. Derivative Dribble asked if I was fair to securitization in the first post I did? No, I wasn't. It looks like the culprits are:

A: Lack of capital
B. Poor loans

A poor loan is a poor loan.

Here's Derivative Dribble:

"So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee."

So remember where I said the banks are making money through fees? Banks are making money on these securities, mortgages through fees.

Of course, whether there is enough capital in a bank, or whether a loan or mortgage is sound, are completely separate questions. So until I hear otherwise from Derivative Dribble, it seems to me that, just like CDS's, the problems are lack of collateral and unwise loans, not the investments themselves.

Can people have been deluded?

See my post about coming up about PRDC's in Japan.

"I was expecting a somewhat sexier story"

Joe Nocera in the NY Times:

"Peeking Under the Kimono: A Big Banker Speaks Out

I received this e-mail message this morning. Its author works for one of the country’s biggest banks. He agreed to let me post it here at Executive Suite so long as I did not use his name. It speaks — quite powerfully, I think — for itself.

I’m a 35-year veteran in the banking industry. And I’ve spent the better part of my career working for the big banks as a small business banker and credit underwriter. Small business lending, in industry terms, is defined as a business that has less than $20 million in revenue and that borrows less than $5 million. I’ve been a lender for most of those years and I’ve been appalled at the changes in the industry.

The government has already done plenty for the big banks. It needs to stop worrying about them now. Instead, it need to pump money into the local community banks because those are the bankers who understand their markets, and know the businesses in their markets. They lunch with small business owners at Rotary Clubs and Chamber meetings. They learn, first-hand, about their businesses and the challenges they face. They go to their stores and factories and “kick the boxes.” And most importantly, they learn about the ways in which those business owners are making the tough decisions in cutting back expenses to stay ahead of this economic crisis."

It seems like a good point. Here's my response:

I was expecting a somewhat sexier story, but no matter.

I know this is going to sound silly from a critic of TARP, but isn’t some of that money supposed to go towards smaller banks? Say, half?

— Don the libertarian Democrat

"Ah,the crack spread.. Bread and butter to the gasoline trader, unequivocal jargon to every body else.."

From Alphaville, and it's not about drug use ( God spare me another chart or index):

"Ah,the crack spread..

Bread and butter to the gasoline trader, unequivocal jargon to every body else..

But there is more reason than usual to look at it. The spread, which is the difference in price between WTI Nymex front-month futures and Nymex Rbob (gasoline) futures - the so-called refining margin - has gone negative. And it’s been negative since October 3"

Note this chart from a Seeking Alpha post:
Crack Spreads The above indicates that it’s currently not at all profitable for refineries to be running crudes into gasoline. "

Read the post. Anyway, also from this post:

"So what does this all mean? According to Schork it means Americans are clearly driving less, and markedly so. According to the latest numbers from the Federal Highway Administration (FHWA) Americans drove 15 bn fewer miles than a year ago, with the August decline the largest year-on-year on record. The FHWA has even warned there are costly implications for road and bridge repair programmes which are paid from federal fuel taxes."

Perhaps the stimulus plan could address this?

"you can never go wrong by lamenting the decline of the middle class and the stagnation of wages."

Steven Chapman on Reason has a post about what I've called median wage stagnation. He says it isn't so:

"Terry Fitzgerald, a senior economist at the Federal Reserve Bank of Minneapolis, says the answer is simple. Far from declining, he writes, "the economic compensation for work for middle Americans has risen significantly over the past 30 years."

The mistake made by the School of Gloom is looking only at wages, narrowly defined. According to the Bureau of Labor Statistics, average hourly earnings of production and nonsupervisory workers, adjusted for inflation, fell by 4 percent between 1975 and 2005. But those figures deceive because they omit fringe benefits like health insurance, pensions and paid leave, which make up a bigger share of total compensation than before. The numbers also rely on a mismeasure of inflation.

When those flaws are corrected, a very different trend leaps off the page. Median wages, says Fitzgerald, rose 28 percent between 1975 and 2005. Nor were the gains restricted to Bill Gates and Hannah Montana: Significant gains occurred in the middle as well.

The same pattern holds for households. The figures that suggest families are struggling to stay even overlook some types of income, and they don't account for the fact that households have gotten smaller on average. After accounting for such things, Fitzgerald found that "inflation-adjusted median household income for most household types increased by roughly 44 percent to 62 percent from 1976 to 2006."

So I found the study:


The claim that the standard of living of middle Americans has stagnated over the past generation is common. An accompanying assertion is that virtually all income growth over the past three decades bypassed middle America and accrued almost entirely to the rich.

The findings reported here—and summarized in Chart 8—refute those claims. Careful analysis shows that the incomes of most types of middle American households have increased substantially over the past three decades. These results are consistent with recent research showing that the largest income increases occurred at the top end of the income distribution. But the outsized gains of the rich do not mean that middle America stagnated.

Chart: Adding Up the Income Pieces

Why does the debate about middle America matter? Because an accurate assessment of the economic progress of middle America is a crucial input in formulating good public policy. Claims of long-term middle America stagnation—such as those quoted at the beginning of this article—are often part of a broader argument about the adverse impact of globalization, outsourcing and free trade. And middle class stagnation is used as motivation for a specific set of policies. But if middle America has not stagnated—as this analysis has shown—then this motivation for those policies is without merit.

Furthermore, if it is understood that middle America has indeed experienced substantial gains, policy priorities may change. For example, more emphasis might be placed on policies that promote continued economic growth or that target deeply rooted poverty rather than middle class stagnation. But regardless of the specific policy, policymakers and the public should base their decisions on an accurate assessment of how the economy has impacted and continues to impact people’s lives."

I agree with the idea that we should focus government on the needy, and really help them, and not on the middle class. However, we have to have a middle class that feels itself to middle class and not hovering above destitution.

I see a few debatable points in the study:

1) Overstated inflation ( I don't know, take your pick, but don't pick because you like the results )

2) There are fewer persons per household, so more for each person ( This cuts both ways. If households are smaller, it could be because people don't feel as wealthy as they used to and are having less children )

3) Expenses paid by employer, etc. ( This could actually cancel out a bit, if these expenses used to be cheaper and were paid by the employee )

It's a good paper, and Fitzgerald has more on the same subject.

Again, I agree with his emphasis, but not necessarily his conclusion, in the following sense: An emphasis that he and I both want needs to be based on how people actually see their situation. I'm not convinced studies like this can do that, however well argued.

I agree with Chapman about this:

"Thanks to American capitalism, ordinary workers and families are better off today than they were a decade or a generation ago. In the midst of scary economic times, that's a heartening fact to keep in mind. Even if certain Democrats would rather you didn't."

But not for the same reasons. It is still possible that median wage stagnation has occurred. Perhaps a libertarian can never be wrong about things always getting better.