Not everyone is going to want to play in our casino. Why should they? The last time, they got fleeced.

TO BE NOTED: From Forbes:

"Why We Can't Get Along
Thomas F. Cooley 04.01.09, 12:01 AM ET

Gordon Brown was on the stump in the U.S. and around the world last week in advance of the G-20 meetings taking place in London. He has argued fervently for a multilateral approach to the many problems that confront the world economy and proposed an ambitious set of goals for the G-20 meetings. Why does it seem like he is tilting at windmills? Perhaps it's because the current world economic crisis, far from uniting us in a common struggle to solve common problems, is instead fostering a "coliseum" culture in which the U.S., China and Europe are all giving each other the back of their hand.

The level and passion of the criticism is rising, and rather than collaboration and multilateralism we are seeing a hardening of positions and a growing resentment of the U.S. A big part of the problem has been the United States' arrogance in lecturing the rest of the world about fiscal and monetary policy and our hypocrisy in putting in place beggar-thy-neighbor trade policies as we try to revive our economy. This swaggering approach to our allies was supposed to have ended with the Bush administration, but it has been replaced with a self-righteous assertiveness that the rest of the world is not buying.

There is no doubt that this summit will result in a reaffirmation of the commitment of the G-20 to fight protectionism and increase cooperation. They will talk the talk. But they did the same at the November summit in Washington, and that resolve didn't survive the plane ride home.

Many countries have raised tariffs, restricted imports, blocked takeovers by foreign companies and reinstated subsidies. They have jumped to the defense of home industries by filing complaints with the world trade organization over dumping--the practice of flooding another country with goods at below-market prices. More importantly, bailouts and subsidies are inherently protectionist because they prop up operations of uncompetitive or insolvent firms at the expense of more efficient producers who are often foreign.

The United States has been pretty egregious in its protectionism. It threw down the gauntlet to Mexico over the trucking industry, inserted self-defeating Buy American provisions in the stimulus package and increased restrictions on foreign-born workers, to cite just a few examples. We are not the worst offender, nor are we approaching the Smoot-Hawley foolishness of the 1930s. But rather than show leadership on such an important issue, we proclaim one view but act otherwise.

We have been singularly inept in dealing with the most important emergent economic power, the Chinese. We got off to the wrong start immediately in January when Timothy Geithner, the Treasury Secretary, told U.S. lawmakers that President Barack Obama, "backed by the conclusions of a broad range of economists--believes that China is manipulating its currency."

The criticism provoked a backlash that has increased in intensity. China is the largest buyer of U.S. Treasury bonds, and they have begun voicing concerns about the safety of those investments. The massive amounts of U.S. debt issued have pressured bond prices and also threatened the strength of the dollar, which could further reduce the value of holding Treasuries. The dramatic expansion of the Federal Reserve's balance sheets also worries them. Last week, the Chinese showed mettle by suggesting that the dollar should no longer be the world's reserve currency. And Geithner gaffed again, saying this was "worth thinking about" (dollar falls) ... and then saying, "probably not" (dollar recovers).

More recently, we have been lecturing the Europeans that they need to be more like us in their efforts to stimulate their economies. Britain, like the United States, has undertaken an aggressive fiscal stimulus, slashed interest and greatly expanded the balance sheet of the central bank to make more reserves available to banks. But Germany and France have opposed calls for further large stimulus packages and even greater deficit spending. The European Central Bank has kept interest rates higher than they are in the United States and Britain.

Secretary Geithner pressed the Europeans to adopt a coordinated fiscal stimulus, suggesting an average 2% stimulus this year. But the E.U., led by the Germans, says it is more important to assess the impact of fiscal measures already announced rather than announce new ones.

The economic pundits, led by Paul Krugman, have also jumped all over the Europeans for not adopting enough stimulus. But the Europeans don't think the Americans have invented fire, and they are concerned--rightly--about the impact of the staggering deficits on future generations. The discussion has also completely ignored the fact, as I wrote in my column last week, that the demographics of Western Europe are very different from ours. The population is older and is aging faster. This means the burden of their debt on future generations will be greater.

Chancellor Angela Merkel has also pointed out that social democracies, through their welfare systems, have more powerful stabilizers. These have a built-in stimulative effect that is missing in the U.S.

So to the question--Can we all just get along? It is one thing to show leadership--and quite a different thing to lecture others on what they should do. We have to acknowledge that we are in the midst of the biggest fiscal and monetary crapshoot ever. Not everyone is going to want to play in our casino. Why should they? The last time, they got fleeced.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes."

"So let's assume that fraud gets a free pass. "

Arnold Kling picks up a point made by John Paulson in his congressional testimony that I agreed with. First, here's Paulson:

"The Institute, launched with a $15 million grant from investment management firm Paulson &
Co. Inc., will provide funding and training to organizations that help homeowners negotiate
alternatives to foreclosure. The majority of the funds will be grants to support direct legal
assistance to borrowers in 10 or more states to fight foreclosure, predatory lenders and abusive
loan servicers. It will do this primarily by providing money to top non-profit legal-aid groups and
law school clinics."

Here's my comment:

"Since this is mainly legal help, and the loans are called abusive, maybe we should be doing what I say, which is examine the legality of these loans."

Here's the Kling post:

"Thomas Cooley writes,

The most important role for public policy is to provide incentives for servicers to restructure and modify loans, to make certain that shared appreciation contracts are part of the policy mix, and to address the legal barriers to modifying securitized loans.

Pointer from Greg Mankiw.

My wife says that I became too angry and agitated at the hearing when Ed Pinto suggested that we need a major effort at loan modifications. I do become angry and agitated every time one of these suggestions gets made.

What are the standards that you are going to use to determine eligibility for loan modification?

Many (most?) of the loans that you would be modifying involve fraud. Sometimes, it was the borrower who deliberately committed fraud. But most of the time, it was the mortgage broker. We won't be able to sort that out. So let's assume that fraud gets a free pass."

See, I don't make that assumption. However, it's becoming obvious that my idea, and Paulson's it seems, to legally challenge these mortgages is going nowhere. I suppose people will claim that it will take too long, but I actually believe that people simply don't want to deal with this legal mess. Now, it's possible that people might begin taking Fraud, Negligence, Fiduciary Mismanagement, and Collusion seriously, given this Madoff mess among others, but I'm not holding my breath.

"What we need is an honest housing market, with legitimate owners, legitimate renters and prices that balance supply and demand. Loan modifications undermine the honesty of the market. They delay the necessary adjustments. With foreclosures, it might take two years for the housing market to find a bottom. With loan mods, it will take at least ten years.

Why is loan restructuring so popular? I think it's because people are in denial. They want to think that there is some feel-good way to avoid severe adjustments in housing. But loan restructuring will worsen the pain, not relieve it."

I don't know what the correct adjustment is, and I doubt that anybody does, even experts. I don't mind a few marginal attempts to ease this fall, or try and feel out a bottom, but, as of now, I still believe that we should let housing prices fall, for reasons I've already given. Namely, I believe that it would be better for the buyers. I agree with Kling that the most generous explanation of this Flight From Fraud is yet more Wishful Thinking, a desire to get this mess over as quickly as possible, whether or not the plans offered for renegotiating mortgages would in fact do that. One big problem I have is that I believe that servicers and lenders, and, in some cases, borrowers, realize that there is this Flight To A Quick Solution Through Government Action, and have been holding out or dragging their feet in hopes of provoking such action.

As I've said with TARP, the only real solution would be for the government to go in and impose a settlement, but, in this aspect of our crisis, the legal problems are, in my mind, insurmountable. They would result in unconstitutional seizures of property, at the very least. The solution, to the extent that there is one, is going to be a number of attempts to help this situation which will, in the best possible case, marginally ease the problem. God forbid we make matters worse, but that's a real possibility.

Again, I believe that Massive Fraud is being left unexamined and unprosecuted. Stick that up your Moral Hazard Pipe and smoke it.

"Households and investors may be holding out for better terms, bigger bailouts and for investors to be made whole"

Thomas F. Cooley on Forbes considers mortgage relief efforts:

"According to the most recent data, as many as one in 10 mortgages in the U.S. are delinquent or in foreclosure. The continued decline in housing prices has been exacerbated by the decline in the economy. The housing sector is caught in a continued downward spiral.

Foreclosure is a slow and costly process and represents significant dead weight loss for the economy. Estimates are that the cost of foreclosure is 30% to 35% of the value of a house. Moreover, there are externalities that are associated with properties that do foreclose in that they contaminate the value of neighboring properties. This issue is also critical because reducing losses to default and foreclosure will help stabilize the financial system by reducing the actual losses--and the uncertainty about them--that are passed through the financial system to the holders of the mortgages and mortgage-backed securities. Default losses are concentrated in the "first loss" and mezzanine tranches of collateralized debt obligations, which has made them highly toxic to the financial institutions holding them."

I didn't know that about CDOs.

"Here is the question: Given the attention that has been devoted to the problem of troubled mortgages and the number of programs that have been put forward to address them, why so little impact? The simple answer is that the programs are badly designed.'

How so?

"Some examples: Hope for Homeowners is a Federal Housing Administration program designed to modify existing loans by writing down the principal, offering insurance against further default and introducing shared appreciation on the property. Fannie Mae and Freddie Mac laid out plans for restructuring mortgages that lower payments but extend the term on the loan or involve balloon payments. The Federal Deposit Insurance Corporation (FDIC) has proposed to restructure troubled mortgages by lowering payments, but with no write-down of principal and with a balloon payment due at the end. So far, the response to these programs has been minor. Why?

First, they start with lousy incentives. Both Hope for Homeowners and the FDIC programs are available to homeowners who are delinquent by several months in their payments. If you want to restructure your mortgage, what does this tell you? Stop making payments! Sensibly, most bank restructuring programs require borrowers to show good faith by keeping payments current before they will consider restructuring."

It's not smart. However, wouldn't this incentive theoretically lead to more people taking advantage of the offer?

"Another problem is that restructuring per se is not a great solution. For the most part, it simply kicks the can down the road. Lowering current payments but requiring either a balloon payment or an extended payback term postpones the problem without solving it. Moreover, since it does nothing to address the negative equity of the homeowner, it increases the probability of secondary default if prices or owners' incomes continue to fall. For all of these reasons, owners become essentially like renters, with all of the adverse incentives that may imply."

It's not a great solution, but we're not looking for great here.

"The existing approaches to loan modification do not balance the incentives of the borrowers and the lenders. Shared-appreciation mortgages (which are a component of the FHA plan) do this well. Shared-appreciation restructurings offer a debt for equity swap whereby, in return for modifying the loan, the borrower must give up some of the future appreciation in the value of the property. Designed properly, this would discourage borrowers from seeking modifications if they can continue to pay their mortgage."

This would seem to be a good plan.

"The biggest obstacle to loan modifications by far is securitization--the fact that an estimated 80% of the troubled loans have been sliced and diced and sold to many investors. This gets in the way of servicers who might otherwise be given incentives to modify loans in ways that are in the best interests of society. Existing commercial law allows loan servicers to make only changes that are in the holder's best interest--"not materially adverse to the Owner." The law also says that if a mortgage is in default or in the servicers' opinion close to it, then servicers have no authority to make changes in interest rates, or principal amount, or time of payments."

This is a problem, although people seem to disagree on how big it is. Servicers might have more leeway than many have assumed, and are simply using this problem as a bargaining chip.

"Could Congress pass a law that allowed servicers to modify loans by invoking a standard such as "a good faith effort to advance the collective interests of holders"? Possibly it could, but it may run into the problem that the constitution provides that "Congress shall make no law impairing the obligations of contract."

That's problematic.

"The most important role for public policy is to provide incentives for servicers to restructure and modify loans, to make certain that shared appreciation contracts are part of the policy mix, and to address the legal barriers to modifying securitized loans. It may well be that policy inaction and dithering is the largest barrier to progress to date. Households and investors may be holding out for better terms, bigger bailouts and for investors to be made whole. If so, it is simply because the leadership in Washington has been unable to focus on an unambiguous approach to the problem. In the meantime, neighborhoods collapse."

That's been the real problem. People are waiting for government largess. It's a terrible problem, because, politically, it doesn't look good if the government isn't seen as trying to help homeowners as well as financial concerns. Everybody in this process knows that. That's why there has been no solution. There's no good compromise available as yet. Somebody is going to have to blink.

"to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle"

Thomas F. Cooley gives the general consensus view of risk in Forbes:

"There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

If there is a moral to this story it is probably to do with the filters we put on historical events. Succession and causality are often confused. As are the limits on our ability to think historically. What we see right now is only the great conflagration that consumes us, leaving us little appetite, and even less oxygen, to moderate our responses and hold onto a broad historical outlook."

I don't credit this, and now I think that I can explain why.

Many years ago, I read an essay which I've tried to find, but can't, about the modern conflict between Great Britain and the IRA. The essay started by stating that each side dated the conflict differently. For Great Britain, it began in the 20th Century, but for the IRA, it began in the 17th Century. The differences in dating led to completely opposite developments in the narrative and explanation of the problem.

So, when Cooley says this:

"Take, for example, "the Great Moderation."

The last really sharp recession in the United States was from 1981 to 1982, when real output fell by more than 4% below trend, and the unemployment rate rose to over 10%. It is often referred to as the Volcker Recession because it was triggered in part by then Fed Chairman Paul Volcker's efforts to squeeze inflation out of the U.S. economy.

Following that recession, something remarkable happened. The volatility in the U.S. economy declined sharply. Even though we have had two recessions in the ensuing years--in 1991 and 2002--both were relatively mild and short-lived.

Surprisingly, the U.S. economy remained dramatically more stable in spite of some major disruptions in financial markets in the U.S. and abroad over the same period. There was a major stock market crash in the U.S. in October 1987; the Mexican Financial Crisis in 1994; the Asian Financial Crisis in 1997 and 1998; the Russian debt crisis and the Long-Term Capital Management crisis in 1998 and the bursting of the dot-com bubble. In addition, there were the terrorist attacks of 9/11, and the U.S. got itself involved in two wars. In short, there were many dramatic events both in the U.S. and abroad--and yet the aggregate U.S. economy was relatively calm."

He leaves out the S & L Crisis. To me, the obviously most important factor. The implicit and explicit government guarantees to intervene in a crisis. So, we approach the history of this debacle from, not only philosophical differences, but historical differences. To me, the most important fact is how humans react to crises in real life, and what they are actually acting upon.

I've used this example before. Take illegal immigration. It's illegal. What do the government's actions over the last 20 years tell you about any implicit or explicit guarantees about whether the illegal immigrants will basically all allowed to remain in the end?

I don't know how to resolve this difference.