protecting insurers -- who are among the big holders of bank debt -- is one of the reasons that we've protected bank bondholders

TO BE NOTED: From Clusterstock:

"Treasury Will Expand TARP To Bail Out Insurers (HIG, LNC, PRU)

Joe Weisenthal|Apr. 7, 2009, 9:41 PM|

Print

Tags: Wall Street, Treasury, Bailout, TARP, Financial Services, Insurance, Financial Crisis, Tim Geithner

HIG Apr 7 2009, 07:38 PM EDT

8.45	Change	% Change
	-0.96	-10.20%

LNC Apr 7 2009, 07:41 PM EDT

6.89	Change	% Change
	+0.51	+7.99%

PRU Apr 7 2009, 06:41 PM EDT

22.10	Change	% Change
	-0.71	-3.11%

Life insurance companies are facing many of the same solvency challenges as banks, and have been trying desperately to get under the TARP. Some, like Hartford Insurance (HIG), have announced acquisitions of thrifts banks in hopes of garnering eligibility.

In fact, Hartford has been nursing its potential acquisition to the tune of $20 million in loans while it finds out whether the move will make it eligible.

Well it looks like they're in luck.

WSJ says the move to allow insurer participation will be announced in the next few days:

How much money would be available to the insurers remains unclear. The Treasury says it has about $130 billion remaining in TARP funds. Life insurers that are bank holding companies have been eligible for TARP for some time, but the Treasury had not yet given the green-light to approve their applications.

Several have applied, including Prudential Financial Inc. (PRU), Hartford Financial Services Group Inc. (HIG) and Lincoln National (LNC) Corp. No decisions have been made yet about which applications will be approved, these people said.

Bear in mind that protecting insurers -- who are among the big holders of bank debt -- is one of the reasons that we've protected bank bondholders so far. Obviously, that alone isn't enough.

Just $130 billion left though. Might take some creativity to stretch it out, since the prospects of getting more from Congress are daunting."

Temporary receivership and restructuring. Fast, simple, effective. And, most importantly, it works.

From Clusterstock:

"Geithner's Flip-Flop: The Untold Story

Henry Blodget|Feb. 17, 2009, 7:19 AM|12

Tags: Economy, TARP, Treasury, U.S. Government, Financial Crisis, Recession, Timothy F. Geithner, Banks, Credit Crisis

Tim Geithner spent 19 months hammering out his plan for how to save the banking system. Then, at the last minute, after realizing that the whole thing was a gigantic, fabulously expensive hairball, he junked it.

So now we're back to square one.

Neil Irwin and Binyamin Applebaum, Washington Post:

Just days before Treasury Secretary Timothy F. Geithner was scheduled to lay out his much-anticipated plan to deal with the toxic assets imperiling the financial system, he and his team made a sudden about-face.

According to several sources involved in the deliberations, Geithner had come to the conclusion that the strategies he and his team had spent weeks working on were too expensive, too complex and too risky for taxpayers.

They needed an alternative and found it in a previously considered initiative to pair private investments and public loans to try to buy the risky assets and take them off the books of banks. There was one problem: They didn't have enough time to work out many details or consult with others before the plan was supposed to be unveiled...

At the center of the deliberations with Geithner were Lawrence H. Summers... Lee Sachs, a Clinton administration official.... and Gene Sperling, another former Clinton aide. The debates among them were long and vigorous as they thrashed countless proposals and variations. Sometimes, Fed Chairman Ben S. Bernanke, Federal Deposit Insurance Corp. Chairman Sheila C. Bair and Comptroller of the Currency John C. Dugan joined in...

Senior economic officials had several approaches in mind, according to officials involved in the discussions. One would be to create an "aggregator bank," or bad bank, that would take government capital and use it to buy up the risky assets on banks' books. Another approach would be to offer banks a government guarantee against extreme losses on their assets, an approach already used to bolster Citigroup and Bank of America.

As the first week of February progressed, however, the problems with both approaches were becoming clearer to Geithner, said people involved in the talks. For one thing, the government would likely have to put trillions of dollars in taxpayer money at risk, a sum so huge it would anger members of Congress. Officials were also concerned that the program would be criticized as a pure giveaway to bank shareholders. And, finally, there continued to be the problem that had bedeviled the Bush administration's efforts to tackle toxic assets: There was little reason to believe government officials would be able to price these assets in a way that gave taxpayers a good deal.

By Wednesday, Feb. 4, Geithner was leaning toward a different approach that his former colleagues at the Federal Reserve had developed months earlier, the source said. This involved a joint public-private fund to buy up the assets. Private investors, likely hedge funds and private-equity funds, would put up capital, and the government would loan money to the fund. If the private investors made wise decisions about which assets they bought, they would be able to pay back the government and make money for themselves...

And if the private investors made dumb decisions, hey, no worries--the taxpayer would pick up the tab. (Our assumption). (Keep reading >)

Geithner had 19 months to work through this and the problems only became clear in the first week of February?

Here's a simpler plan: Temporary receivership and restructuring. Fast, simple, effective. And, most importantly, it works."

Me:

Don the libertarian Democrat (URL) said:

Feb. 17, 9:39 AM

He didn't really change direction. The whole point was to avoid nationalization at any cost. In that, he kept going merrily off a cliff, costing us time and money. We've wasted months now while Debt-Deflation has gotten much worse. Hold on tight!

The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides.

From the FT:

"A capital-less financial system

January 26, 2009

by FT

By Ricardo Caballero

World financial markets are being ravaged by uncertainty and fear. The prices of all forms of explicit and implicit financial insurance have skyrocketed and hence, by a basic identity, the prices of risky assets have plummeted or the corresponding markets have disappeared.

Nowhere is this scenario more problematic than in institutions with strict capital requirements, such as banks, insurance companies, and monolines. For them, fire sale asset prices quickly wipe out their capital and, simultaneously, destroy their option to raise new capital since equity values implode.

The conventional advice is for these institutions to deleverage and to raise capital. While this is sound advice when dealing with a single institution in trouble, I believe this is exactly the opposite of what we need at this juncture of a massive systemic crisis.

Forcing institutions to raise capital, be it private or public, at panic-driven fire sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fuelling the downward spiral. This is self-defeating.

The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. If it is, then a solution to the financial crisis is in sight since it would free up trillions of dollars of hard to raise funds, covering more than even the most extreme estimate of losses.

I believe it is feasible to run such a system for a while, because, essentially, distressed financial institutions need (regulatory) capital for two basic purposes: To act as a buffer for negative shocks, and to reduce their risk-shifting incentives by exposing them to their losses.

However these two functions can be replaced, respectively, by the provision of a comprehensive public insurance, and by strict (and intrusive) government supervision while this insurance is in place.

A few days ago the UK announced a policy package that almost got it right, by pledging to insure banks’ balance sheets and other private liabilities.

Unfortunately, it backfired and caused a worldwide run on financials because it did not dissipate, and even exacerbated, the fear of forced capital raising (or nationalisation).

The events following Lehman’s demise should have taught us that this fear needs to be put to rest until we can return to normality. Financial institutions are too intertwined to predict with any precision the impact of diluting any significant stakeholder, and the markets are too fearful to feed them more uncertainty. Strong guarantees with strict supervision, and the commitment of no further capital injections at fire sale prices (directly or through convertible bonds) should go a long way in building a foundation for a sustained recovery.

With some dismay, I read that an enormous amount of time is being spent discussing what should be the price of the insurance and the first-loss threshold. It seems to me that given the extreme severity of the crisis and the asymmetries involved in failing in one or the other direction in each of these issues, the answers are rather obvious: The price of the insurance should be very low – say risk-neutral pricing plus 20 or 50 basis points of markup; and the first-loss threshold should be sufficiently low that no new capital will need to be raised in the short run if a loss arises.

The second intervention of Citi offers a micro-model of such an intervention, but it needs to be scaled up within each bank and massively across all banks and other key financial institutions. It also needs to be made much more attractive to all systemic financial institutions, even those that are not in deep distress.

What about the taxpayers? The best that can happen to all of us is that the financial crisis ends as soon as possible. This is the first priority, the rest can wait. If the transfer to the financial institutions ends up being too large for society’s taste, then it is always possible for the government to undo some of it through ex-post taxation of excessive earnings. Conversely, if the transfer is too low (the price of the insurance and the first-loss threshold too high), it may well be that we do not get another chance, at great cost not only to financial institutions but also to taxpayers.

Ricardo Caballero is head of the department of economics, the Ford international professor of economics and co-director of the World Economic Laboratory at Massachusetts Institute of Technology

Here's me:

“We have more capital so we don’t have to sell good assets in bad markets,”

From the FT, I actually understand what Liddy of AIG is saying:

http://www.ft.com/cms/s/0/86c1cf26-aefc-11dd-a4bf-000077b07658.html?nclick_check=1

“Mr Liddy said that with the new plan, the authorities wanted to avoid a repeat of the credit markets paralysis that followed the collapse of investment bank Lehman Brothers, which went bankrupt just before the first rescue of AIG.

“The collapse of Lehman caused the credit markets to freeze up. Had AIG gone, it would have been even more significant,” Mr Liddy said.

Mr Liddy pledged to press on with a wide-ranging programme of asset sales aimed at raising funds to repay the $100bn in capital injected by the government.

He said the extension of the duration of the main government loan from two to five years and the cutting of the loan’s value from $85bn to $60bn would ensure AIG did not have to dispose of businesses at fire-sale prices.

“We have more capital so we don’t have to sell good assets in bad markets,” he said. AIG has not announced a single major disposal so far, partly because potential buyers have not been able to get funding.”

How is this any different than what you are proposing? If we loan them the money or guarantee it, it comes to the same thing, doesn’t it?

What if the assets turn out to be worthless in the case of AIG? You would tax them afterward, assuming that they survive? What if they merge? How long would it take to get the money back? Are you going to change our system of government so that they can’t lobby away onerous conditions, as they already in fact have?

The financial stocks went down because of nationalization, but I doubt that Walmart fears nationalization. The uncertainty and guarantees are the key, but your plan doesn’t offer either. Plus, it asks the citizenry to accept getting rid of capital standards when many people are calling for them. Doesn’t that add to uncertainty? And leaving proven buffoons in charge? That adds to certainty.

The only certainty that I see is that the banking lobby is damned powerful. So powerful that, after causing a systemic crisis, we’re bending over backward to save them.

I hate to keep pushing a guy named Bagehot, but how are these terms you are proposing onerous? They sound like a gift from God for the banks and their shareholders. The uncertainty is about them, not simply the government.

Posted by: Don the libertarian Democrat | January 26th, 2009 at 10:52 pm | Report this comment Your comment is awaiting moderation."

After I'd written the damned thing, I read this:

"The FT Economists' Forum is a discussion among some of the world's top economists. As a general rule we accept comments from invited members only, but submissions from others will also be considered.

If you are a non-member submitting a comment, please include your relevant academic or financial background."

Yet another damned club that won't let me in!

Sorry Paul, but as Wittgenstein said, " If a rabbit could speak, we could not understand it".

Via John Mauldin. I live with a rabbit, so I couldn't resist:

"(A conversation with Bun Bun, the author's Netherlands Dwarf pet bunny( IS IT RABBITNESS? OH, I'M SORRY. THAT'S QUINE. )
and early-morning debating partner.)

PMc: Good morning, Bun Bun. Ready for our end of year chin wag?

BB: Again? And the question is not whether I'm ready, but whether you're ready. You're looking haggard, man, like a horse rode hard and put up wet. I never see you anymore, where you been?

PMc: First off, I ain't a horse. But I do catch your drift. As to where I've been, I've told you before: either at work or at my little rental cottage down on the water. I rented it for a weekend getaway, and found the water so soothing to my soul that I essentially live there now. So you got this big house all to yourself, Precious.

Except when my son, Jonnie is home from college, of course. He likes this space more than down on the water, not the least because I'm rarely here, I suspect. But that's only a suspicion. You know anything about that?

BB: Don't act dumb, Mac. He's 19 years old and has more girlfriends than the Fed has special liquidity facilities. Enough said, except that I think he ought to be taxed one fresh head of romaine lettuce( MY RABBIT LIKES THIS AS WELL ) for me every time he shows me off to a date. Remember, I just get to live here in your study, while he has roam of the whole house.

PMc: Okay, Okay. I'll work on that for you. Meanwhile, how do you know about all the Fed's liquidity facilities?

BB: Simple. Jonnie explained them to me, telling me the Bank of Ben is now doing for the capital markets what the Bank of Dad does for him: liberal liquidity provisions against all sorts of collateral, including the mere promise( I MUST HAVE MISSED THEIR PROMISE. PERHAPS IT WAS IN RABBIT LANGUAGE. ) to behave in a more socially acceptable and responsible way in the future.

PMc: That's not exactly right, Bun Bun. Well maybe it is with respect to the Bank of Dad, but it is not the case with the Bank of Ben. As a general rule, also called the law of the land, the Federal Reserve is not in the business of lending on a wing and a prayer, but rather good collateral.

BB: You mean like you giving money to Jonnie but taking his iPod and putting it in the desk drawer until he pays you back?

PMc: Sorta like that, but in the case of the Fed, they wouldn't give Jonnie the purchase price of his iPod, but some lesser amount against the re-sale value of his iPod, minus a haircut( DON'T SAY THAT TO A RABBIT. ).

BB: You mean that Ben would make him get a haircut, maybe even a shave, before taking in his iPod as collateral against a loan?

PMc: No, even though that's not a bad idea. In the collateralized lending business, in which the Federal Reserve traffics, a haircut is the margin of safety the lender demands for a loan against the re-sale value of the collateral. In your example, if an iPod cost $200 new and has a secondary market value of $100, the Fed would not even lend $100 against it, but rather some haircutted amount, say $75.

BB: So Ben would take Jon's iPod and put it the drawer, give him 75 bucks, and if he didn't pay off the loan, Ben would sell it for anything greater than 75 bucks, even if it's quoted at 100 bucks today?

PMc: Yep, that's more or less the mechanics of the matter, though to the best of my knowledge, the Federal Reserve has never taken in iPods at its various lending facilities. Very much unlike the Bank of Dad, who is not really in the banking business but the welfare business.

BB: But Jonnie told me that the Fed really can be like you, Mac, lending to anybody against anything with no-recourse, if the Board of Governors declares an emergency. He said something about a section 33. Was Jonnie wrong? You are paying way too much tuition for that fancy college he goes to if they are teaching him stuff that is wrong.

PMc: Jon's answer is not so much wrong as incomplete, similar to his efforts to clean up his room. And it's not section 33; it's section 13(3) of the Federal Reserve Act of 1934 which allows the Fed to lend to anybody( EVEN THEMSELVES? ), but not against anything.

The Fed can do so only if (1) a super majority of the Board of Governors - not the Federal Open Market Committee, known as the FOMC - declares the need for such lending to be the consequence of "unusual and exigent" circumstances, and (2) such lending is done against collateral that is "indorsed or otherwise secured to the satisfaction" of the Fed's lending officers.

BB: Technical details, I say, Mac. Jonnie was essentially right: if the Fed declares that the stuff is hitting the oscillator, the law allows for the Fed to unplug the oscillator, just so long as it dutifully declares that said oscillator is indeed an oscillator that needs to be unplugged. Jonnie said that's what the Fed has been doing ever since some stern dude named Bear needed a loan against a bunch of iPods with the batteries stripped out of them. Is that true?

PMc: I think perhaps I need to have a conversation with Jon's economics professor, who needs to remember that you are supposed to teach students textbook economics before teaching them real-world economics. But yes, back in March, the Fed invoked Section 13(3), for the first time since it was passed into law in 1934, to make a big loan that it otherwise wouldn't have been permitted legally to make.

But it wasn't to a stern dude named Bear, but rather to a special purpose vehicle, known as an SPV and named Maiden Lane LLC, which was set up to lend against dodgy mortgages previously held by the investment bank named Bear Stearns. The Fed made this loan to facilitate the merger of Bear into a bank named JP Morgan, so that Bear Stearns didn't go bankrupt, blowing the financial system sky high.

BB: All technical details, no? Your boss Mr. Gross is right, you are far too wonkish sometimes. Jonnie had the essence of the transaction down, no? In that case, the Fed's lending principles were similar to those of the Bank of Dad, no?

PMc: What's with all the no's, Bun Bun? You are starting to sound like a lawyer, leading the witness. Jonnie hasn't started dating girls in law school has he?

BB: Not that I know of; he's only a sophomore in college, for goodness sake. Just yanking your chain, Mac. But the way Jonnie explained it to me, the Fed really did do something very novel when it dealt with that Bear oscillator. It put some $30 billion of Bear's dodgy assets( THEY ARE ASSETS ) into that Maiden Lane thingamabob, telling JP Morgan that it had to stand up for the first $1 billion of losses and that the Fed would stand up for the remaining $29 billion, no recourse to JP Morgan. Is that right?

PMc: Yes, that's right, it was indeed an unusual Fed loan, and the Fed declared that it was, so as to legally be able to make it.

BB: But didn't you say that the Fed must be "secured"? How could making JP Morgan stand up only for the first $1 billion of losses against a $30 billion portfolio of iPods without batteries be deemed a secure loan?

PMc: Enough, Bun Bun, enough. I like your inquisitiveness, but sometimes some things are just best accepted as the way the world works, not how some textbook says it is supposed to work.

You're triggering a memory that goes back some twenty-five years ago, when Paul Volcker was chairman of the Federal Reserve. That was before CNBC, so guys who do what I do, called Fedwatchers back then, had to literally travel to Washington, DC to hear Mr. Volcker deliver the Fed's semi-annual report to Congress.

Some Congressman, whose name I've long since forgotten, was really getting after Mr. Volcker, demanding that he detail something that Mr. Volcker didn't want to detail. So Mr. Volcker took a long draw on his cigar and blew a big fog of smoke and said: "Congressman, we did what we did and we didn't do what we didn't do." And that was that, no more explanation needed.( WASN'T IT CLEAR? )

BB: Hold on here. This Volcker dude was smoking a cigar while testifying before Congress? Was the session held outside?

PMc: No, Princess, it was held in a stately Congressional hearing room. And I was sitting right behind him. Back then, it was not against the law to smoke a cigar indoors, though most considered it impolite.

Even I did, and I rarely begrudge a man a good smoke, because Mr. Volcker's cigars were so cheap that they smelled like burning car seats when he puffed them. But he didn't care. At least not back then. A few years later, he gave up cigars.

But that wasn't my point. While Congress is the legal boss of the Federal Reserve, Congress is a boss with 535 heads( PICK ANOTHER PART OF THE ANATOMY MATE ), and sometimes the Fed boss simply has to do what he has to do, blowing smoke, literally or metaphysically, after the fact.

BB: So is this what the Fed did in making that funky loan against Bear Stearns' funky assets?

PMc: No, Bun Bun. Well maybe, as the Fed didn't and hasn't disclosed all the details of just how funky the funky stuff was. But the Fed, and especially Chairman Ben Bernanke, made clear to everybody that would - or wouldn't - listen that the Fed was not happy about making that loan, and didn't want to have to ever make such a loan again( CAN'T HE HAVE HOPES? ).

Not that the Maiden Lane loan didn't need to be made at the time, to save the capitalist financial system( WE DON'T HAVE ONE. WE'RE A WELFARE STATE. ) from its debt-deflationary pathologies( A CALLING RUN ). But the loan should have been made by the fiscal authority, not the monetary authority, with express blessing from Congress, who have express blessing from the electorate to do such things. For you see, Bun Bun, if there is the equivalent of the Bank of Dad in Washington, DC, it is supposed to be the Treasury, not the central bank.

BB: All very interesting, very interesting. Is this why the Fed refused to make a loan to that Lee Man chap when he was teetering on the edge of bankruptcy, feeling remorse for having made a loan against that Bear dude's stinky stuff?

PMc: It's Lehman, not Lee Man. And I don't know about any remorse for the Bear loan, Princess. All I know is that the Fed was not happy about it. Thus, when it came time to decide whether to lend against Lehman's stinky stuff, the question became just how stinky it was versus the Bear dude's stuff. Ben and the NY Fed Chief Tim Geithner decided it was just too stinky( THEY NEED BETTER OLFACTORY SENSES. ) and took a pass( JUST CHANGE ONE LETTER. ). Or, as Mr. Volcker might have said, they didn't do what they didn't do( DOESN'T A DOUBLE NEGATIVE MAKE A POSITIVE? ).

BB: In which case, why didn't the Treasury step up and make the loan? After all, you said the fiscal authority can legally do what the monetary authority can't. Why didn't the Treasury unplug the oscillator, rather than let Lehman go down, effectively turning the oscillator on high?

PMc: Again, we'll never know precisely, Bun. But most fundamentally, the Treasury didn't have the express authority from Congress to do so. At least that is what Treasury Secretary Paulson says, while pounding the table with his shoe, Khrushchev style.

Could he have found some way, say using the Foreign Exchange Stabilization Fund? It's a fund of near $50 billion that the Treasury has Congressional approval to spend, if such spending is deemed necessary to keep the dollar from going wonky. Mr. Paulson later used it to establish a guarantee program for Money Market Mutual Funds. So conceptually, he could have used it to keep Lehman out of bankruptcy. I wasn't there, so I don't know. I certainly would have, but that assertion ain't worth a cup of coffee unless you have 4 bucks to go with it.

BB: So Lehman went down, and as was feared when the decision was made to prevent Bear from going down, the financial system blew sky high?

PMc: I might have been using a bit of hyperbole earlier when I said that, Bun Bun. But your Ockham's Razor conclusion is essentially correct.

BB: Never heard of such a razor, Mac. I think Jonnie uses something called a Gillette when he shaves that scruffy beard off every six weeks. What's an Ockham's Razor and what does it have to do with you becoming a much older man in the 100 days or so since Lehman was consumed by the oscillator?

PMc: Ockham's Razor is not a device for removing whiskers, but rather a mode of logic from the 14th century, defined loosely as cutting away all non-essential arguments when trying to answer a question or solve a problem. Which you just did, wonderfully, Bun Bun, when you asserted that what happened after Lehman went down was exactly what policy makers feared when they prevented bankruptcy for Bear: a systemic lock up of the global financial system.

BB: And out of that lacuna was born the TARP (Troubled Assets Relief Program), which explicitly gives the Treasury the authority and the money to unplug oscillators that need to be unplugged, when the Fed lacks the power to do so?

PMc: Yea verily, I say unto thee, Princess. You are a rather smart rabbit. Lacuna, that's a nice word. I don't recall saying it in front of you before. Where did you learn it?

BB: Looked it up on the web myself, and it precisely defines living in this place, while you live in the cottage. Take a hint, dude.

PMc: Taken. Now back to the matter at hand. The TARP, which Congress fought intensely about, and is still fighting about, given how the Treasury has used it to date, does indeed fill a gap in the federal safety net against systemic risk. It allows the Treasury to go where the Fed can't, literally lending to anybody against anything, or simply injecting equity into anybody against nothing, if necessary to maintain the capitalist financial system as a going concern( GOOD LUCK FINDING IT. ).

BB: So is it 21st century socialism or welfare? Or is that a difference without a distinction?

PM: Bun, how am I to answer your machine gun questions if you keep answering them yourself? But yes, you've called it what it is. For my taste, I prefer the word socialism, but it does have a kernel of welfare in it, too. Whatever you call it, the TARP is a huge new tool for the visible fist of Treasury to support the invisible hand of capitalism.

BB: A fist, you say? How about calling it the taxpayers providing a hand out?

PMc: Ain't going there, Bun. Wouldn't be prudent, as the current President's father used to say. It is what it is, as everybody seems to say these days, in defense of what is unpalatable, but also necessary.

BB: So, if there was a positive externality of Lehman's demise, it is that policymakers finally found their socialist mojo, putting in place the necessary laws for the government to lever up and risk up its balance sheet more than proportionate to the private sector's new-found proclivity to do just the opposite?( NOT QUITE )

PMc: Nice way to put it, Bun, with the operative phrase being "more than proportionate". That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging( A CALLING RUN ) and the paradox of thrift( PEOPLE ARE SAVING WHEN THEY SHOULD BE SPENDING. ) are beasts of burden that capitalism simply can't bear alone. Only the Minsky Solution can lift that load.

BB: Ah, Minsky. I knew you would get ‘round to him, it was only a question of how long you could restrain yourself. You and I recently talked a lot about Professor Minsky, complete with his Forward Journey, followed by his famous or infamous Moment, followed by his Reverse Journey. But I don't recall talking about his Solution. I know I'm going to regret this, but could you refresh my memory?

PMc: Thank you, Princess, for asking. I'm quite sure a number of those listening in on this conversation similarly share your reservation about letting me loose to pontificate on Minsky. So out of respect for both you and them, I'm going to act on the old cliché that a picture is worth a thousand words, maybe more. Here's a stylized graph, created by my colleague and friend Ramin Toloui, that captures all you need to know about Minsky right now.

BB: You are a kind man, Mac, spoiling me relentlessly. Looking at the graph, which I see starts in 2003, you have the Forward Minsky Journey unfolding, complete with the ever-risky steps from Hedge to Speculative to Ponzi Finance. The Shadow Banking System expands explosively. And then, you have the Minsky Moment in August 2007.

And then you have the Reverse Minsky Journey, as Ponzi Units evaporate, Speculative Units morph after the fact into Ponzi Units, and even Hedge Units take a beating, as the Shadow Banking System contracts implosively. And then the pain stops with this new thing called the Minsky Solution, followed by something called Reflation.

But I don't see a precise date on the graph for when this happens. Are we there yet? Is the pain going to stop? Like, now?

PMc: Nice framing and clearing of the graphic, Bun Bun. Have you been taking an on-line course from Communispond while I haven't been looking?

BB: Nope, I just look up cool words on the computer. You never take me out on the speaking circuit, so I don't need to learn how to dance the Communispond dance steps.

Stop dodging the question, Mac. I presume this Minsky Solution thing is that "more than proportionate" socialist response( IS THE GOVERNMENT SEIZING THE MEANS OF PRODUCTION? ) that we were talking about just a moment ago?

PMc: Precisely - if you weren't a bunny, Bun, I'd call you grasshopper! That is precisely the Minsky Solution: the government not only steps up to the risk-taking and spending that the private sector is shirking, but goes further, stepping up with even more vigor, providing a meaningful reflationary thrust to both private sector risk assets and aggregate demand for goods and services.

BB: Okay, I got it even though I hate the notion of being called a grasshopper. So answer my question, master: Are we there yet? And if so, doesn't that mean that it's now time for all good peoples, and bunnies, to sell their T-bills and canned green peas into cheap corporate bonds and stocks( YES )?

PMc: I didn't put a date on that box, Bun, precisely to avoid answering the question as to precise timing. All I can say is that the timing is ripening, with the Fed now committed to an all-in reflationary campaign. This includes not just expanding its lending facilities, but doing so in joint ventures with the Treasury, now armed with TARP money, which can serve as the equity in new SPVs that are essentially government-sponsored Shadow Banks( THE ONLY WAY TO STOP A CALLING RUN. ).

The recently announced Term Asset-Backed Securities Loan Facility, known as the TALF, and scheduled to come on in February, is a perfect example of just such a joint venture, with the Treasury putting up $20 billion of equity and the Fed putting up $180 billion of loans senior to the Treasury.

The TALF will effectively step around the risk-adverse commercial banking system and provide warehouse financing directly for securitization of new consumer and business loans to Main Street. It's a really cool innovation, which is likely to be expanded or replicated. And most important, it is likely to get reflationary traction.

The Fed also stands ready to print $600 billion of money to buy directly $500 billion of Agency MBS (Mortgage-backed Securities) and $100 billion of Agency debentures, so as to pull down and hold down long-term mortgage rates. The buying of the debentures is already under way, and the buying of MBS is likely to start in a matter of weeks.

And if necessary, the Fed is openly willing to print money to buy longer dated Treasuries, providing a further downward gravitational force for long-term interest rates. As my friend Colin Negrych argues, and indeed forecast when the rest of the world thought he was nuts, there is nothing like a 2% handle on longer-term Treasuries yields - the credit risk-free benchmark - to make private sector assets more valuable.

BB: But where are Ben's helicopters tossing out money?

PMc: Bun, you know that I don't like references to Helicopter Ben. It's a cheap shot, absolutely a cheap shot, fired by people who haven't bothered to actually read his famous November 2002 speech, when he discussed an anti-deflation technique conceived by the great Milton Friedman - a money-financed tax cut.

That said, it is indeed a fact, a glorious fact, in my view, that the Fed does presently stand ready to print as much money as necessary to accommodate the financing of an all-in reflationary fiscal policy thrust, as promised by President-elect Obama. Through holes in the floor of heaven( THEY SPEAK HEBREW THERE, YOU KNOW. ), Hyman Minsky weeps tears of joy.( ME TOO )

Call it good, very good: the monetary and fiscal authorities, separately yet together, going all in. And call me cautiously optimistic that Reflation will get traction.

BB: I hate that phrase, Mac, absolutely hate it. And you're the one that taught me to hate it. What is cautiously optimistic? Either you are or you aren't, no?

PMc: Touché, Bun, touché. With respect to the willingness of policy makers to do the right reflationary thing, we can drop the adverb cautiously. I'm flat out optimistic. But prudence demands that I at least acknowledge that even the best laid reflationary plans might go awry, at least in the short run.

BB: Well if that might happen, how can you call them the "right reflationary thing"? All in means all in, no?

PMc: Yes it does, Bun Bun. But it doesn't mean that all sectors and all companies have to flourish in response. The "right reflationary thing" is a macro concept, not necessarily a micro concept. It doesn't mean extending the soothing socialist hand to every square inch of the capitalist landscape.

The right reflationary thing to do is to systemically save capitalism from its inherent debt-deflationary pathologies, not to eliminate capitalism. Recall, capitalism at its micro core is a process called creative destruction( MAYBE IT CAN HAPPEN TO SYSTEMS ), churning resources from yesterday's technologies and work methods to the more productive ones of tomorrow.

BB: Ok, that makes some sense. In my world, that's called the survival of the fittest. Wouldn't make sense for government to try to overrule that force of nature, I agree( OF COURSE, IF THE FORCE OF NATURE TOSSES US ASIDE, WE'VE NO RIGHT TO WHINE ABOUT IT. ). But it would make sense for the government to put out a forest fire that threatened to consume all us creatures, right?

PMc: Nice way to put it, Princess. Very nice! It's a delicate balance.

BB: Thank you. In your world of investing, it seems the analog would be to go long the forest, because the government is going to keep the flames of deflation from burning it down, while taking a selective approach to going long particular creatures. Is that about right?

PMc: Yea verily, I say unto thee again. But with just a slightly finer point on the matter: In order to save the capitalist economic forest, there are certain creatures that the government must necessarily also save. The right investment strategy is to go long both the forest and those creatures.

BB: Fair enough. Now name them!

PMc: We have been publicly naming them for months here at PIMCO( I LISTEN TO WILLIAM GROSS AND ADMIRE HIM, BUT AREN'T YOU PIMCO LOT DOING QUITE WELL WITH BUYING FUNKY ASSETS FOR THE FED? WHAT ABOUT GMAC? HOW'D YOUR BONDS DO? ), Bun Bun. Well maybe not always particular names, but rather the attributes of those names. The most important is explicit government support( I AGREE ), which is most notably the case with the debt issued by banks that get to drink a triple-thick socialist shake( WHICH PIMCO IS HELPING TO PREPARE. ): Equity injections from the Treasury, debt guarantees from the FDIC, and access to the munificent liquidity facilities of the Federal Reserve.

BB: But isn't it time to get a little more daring than that? What would be wrong with starting to average into some funds in the major stock and bond indexes, as a play on your thesis that the American capitalist economy is a going concern? Yes, I know that means you would be indirectly going long some individual names that will be on the fatal end of the creative destruction process, but isn't that always the case?( A GOOD POINT )

PMc: I can't argue with you, Princess. Your suggested strategy is consistent with the all-in reflationary policy responses. Yet caution is still warranted. I'd tilt it toward corporate bonds over corporate stocks, however, as seemingly little known in the popular press, high grade corporate bonds have, on a risk- and volatility-adjusted basis, been beaten up even more than blue chips stocks this year.( I AGREE. JUST LIKE PIMCO'S ADVICE. )

BB: I'm glad you are finally seeing it my way, Mac. Sometimes, you can be so thick, letting the pursuit of the perfect become the enemy of grasping the good. Do some of my trade for the Morgan Le Fay( FROM CAMELOT? ) Dreams Foundation portfolio, okay?

PMc: As you wish, Bun. And thank you for honoring her memory and wanting her portfolio to do well. Because by doing well, she can continue to do good, lots of good. With that lovely thought, let's end this chin wag with Morgan's favorite prayer of the season. You have the honors.

BB: Thank you, Paul.

May God bless you and keep you,
May God's face shine upon you
and be gracious to you,
May God lift up his countenance
upon you,
And give you peace.

Paul A. McCulley
Managing Director
December 23, 2008"

Sorry Paul, but as Wittgenstein said, " If a rabbit could speak, we could not understand it".

"In such circumstances, the recent lull in sovereign defaults is likely to come to an end."

I seem to disagree with this. Let's hope I'm correct.I think that historical precedents are of little value, because the context is essential to the reaction of individuals in a particular crisis. Reinhart and Rogoff see economies as machines, that function more or less the same over time. I don't feel that the context of 2008 was as frightening as 1968, let alone the 1930s. That means it will be far easier to turn ourselves around in this context. A Financial Crisis occurs in a particular place and time, and cannot meaningfully be divorced from it. From Yves Smith:

"Past Financial Crises Suggest Pain Far From Over

Economists Carmen Reinhart and Kenneth Rogoff have been publishing various findings from a large-scale data set they have constructed of past financial crises. They have looked back as far as 800 years, but not surprisingly, most of their output has consisted of analyses of modern crises (you can find some earlier discussions here and here).

They have released a summary of a presentation that they will present this weekend at the AEA conference. It's refreshingly straightforward, and offers some sobering implications for our current. mess.

Their work has shown that financial crises are more severe and protracted than "normal" recessions( THAT'S A TAUTOLOGY ). In some of their previous presentations, they had parsed out financial crises in advanced economies versus those in developing countries, and were surprised to find their trajectories( THEY GO DOWN THEN UP ) were remarkably similar, so their latest product looks at both types together. It also includes two prewar developed country episodes where Reinhart and Rogoff had sufficient housing price and other relevant data.

Their latest piece looks at how crises generally progress and resolve themselves. The usual outcomes are worse than most commentators forecast for the US (save the fall in average real estate prices):

1. Real housing price declines average over 35% over a six year period. Note in other crises, residential real estate was not necessarily a focus of the bubble. Even excluding Japan (which has suffered a 17 year housing price decline) the average is over 5 years.

2. Equity prices fall 55% over three and a half years.

3. GDP fall an average of 9% (read that twice)

4. Unemployment increases 7% over previous norms.

5. Government debt "explodes", increasing an average of 86% of GDP, but the cause is typically not a banking industry recapitalization, but maintaining services in the face of collapsing tax revenues and countercyclical measure ex financial system measures. ( ALL THESE ARE, OF COURSE, POSSIBLE. BUT NOTHING IS WRITTEN. )

Note the sample included countries subjected to IMF bailout requirements 1990s Asian crisis, like Indonesia and Thailand, which led to dramatic declines in output and sharp increases in unemployment, but (at least as popularly reported) sharp rebounds from the trough.

Other comments from the paper:

The housing price decline experienced by the United States to date during the current episode (almost 28 percent according to the Case–Shiller index) is already more than twice that registered in the U.S. during the Great Depression..

It is interesting to note ...that when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than do the advanced economies. While there are well-known data issues in comparing unemployment rates across countries, 3 the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress....( WAGE FLEXIBILITY COULD ALWAYS HELP EMPLOYMENT PERCENTAGES )

How relevant are historical benchmarks for assessing the trajectory of the current global financial crisis? On the one hand, the authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience( WE SIMPLY LIVE IN A LESS FRIGHTENING WORLD ). On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors( NOT A USEFUL DISCUSSION ). A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion( BAGEHOT'S PRINCIPLES NEEDED FOR THAT ).

Since the onset of the current crisis, asset prices have tumbled in the United States and elsewhere along the tracks lain down by historical precedent.....The global nature of the crisis will make it far more difficult( BUT NOT IMPOSSIBLE ) for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults( THESE MIGHT PROVE USEFUL, IN ONE OF MY STRANGER PROPOSALS ) is likely to come to an end."

"I think we're in a bad state of the world when we rely on theorists."

Justin Fox has an interesting post:

"I've done a lot of bashing here of those who think the 1999 repeal of the Glass-Steagall Act separating banking from the investment business is to blame for all our troubles. I've also argued that securitization—at least fancy-pants securitization—has been partly at fault. So it was interesting to hear an economist I admire make the opposite arguments Thursday. The occasion was a Columbia Business School symposium on on Preventing the Next Financial Crisis, and the economist was MIT's Bengt Holmström.

Holmström is a theorist, and he has charming habit of reminding people that his theories are just, you know, theories. But at the same time he has ample experience with real-world economic phenomena. He's been on Nokia's board of directors for a decade, and he once briefly served on the board of a Finnish investment bank. ("Never go on the board of a bank, because you will never know what goes on there.") Most important, he was back home in Finland (at the Helsinki School of Economics) during the Scandinavian financial crisis of the early 1990s."

It's a good sign when a theorist knows what a theory is in relation to the world.

"That Scandinavian financial crisis--a favorite topic of this blog--was similar in so many ways to today's crisis: There were lots of real estate loans gone bad, sharp drops in house prices, bankrupt banks, and government takeovers of the various national financial systems. "But there was zero securitization," Holmström said."

That's a very important point.

"Holmström's theoretical contributions mainly have to do with the economics of information, and that's where he located the problem in both Scandinavia in the early 1990s and the U.S. now. There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

"The key is who should hold what," Holmström said. Complex, high-information assets don't pose big financial-system risks in and of themselves. Earlier this decade, "the Nasdaq fell 90% and nothing happened." The problem is when leveraged liquidity providers (a.k.a. banks) end up with lots of high-information assets on their books. "When you're in the liquidity providing market and rolling over 25% every night, you don't have the luxury of wondering whether you can trust somebody."

I disagree with this. I agree with the Steve Hsu post that Banks do deal in and need to engender trust. This should not and cannot be overlooked. Trust and Negligence don't necessarily go together.

"A financial crisis happens when market participants suddenly realize that what they thought were reliable low-information assets are really risky high-information assets. And that usually happens after an extended period during which market participants become willing to accept almost anything as a low-information, liquid asset. Holmström: "If you come to the phase of the cycle where everybody thinks everything's liquid, you're going to have a problem."

You do if it's false.

"Holmström said he doubted government could ever regulate away that occasional tendency. "How do you prevent people from considering equity to be the same as Treasuries? You can't legislate that." But he did think was something to the idea of treating liquidity providers differently from other financial players."

Besides regulations, there are legal and ethical standards of business that should necessitate giving people a clear picture of what they're buying. Obviously, since there's crime, you can't just legislate against that either if you mean by regulate or legislate totally prevent.

"During the Q&A, an audience member who said he was at Salomon Brothers when Citicorp and Salomon's parent Travelers merged in 1998 ("I watched those nice stodgy Citi bankers try to boogie like the Salomon Brothers investment bankers") wondered if Glass-Steagall repeal wasn't part of the problem.

Replied Holmström: "I'm for going back to some separation between liquidity providers and the rest of the market. I don't think it's coincidental that this happened after Glass-Steagall repeal."

A couple of other people on Holmström's panel then chimed in with the argument I've made--that the issue was letting investment banks and other market players (it all began with money market mutual funds) grow into a liquidity-providing shadow banking system, an evolution that began long before Glass-Steagall repeal.

"Investment banks led the way, but commercial banks decided they liked it too," retorted the ex-Salomon guy in the audience. "The abolition of Glass-Steagall put this kind of behavior in the hands of people with much bigger balance sheets."

See, this isn't yet a very well thought out theory. A followed B in time.

"Holmström's summation: "I'm a theorist. I'm allowed to speculate. I think we're in a bad state of the world when we rely on theorists."

He is absolutely correct. Below, he also is, sadly, correct:

Update One more nice Holmström quote from my notes, on nationalizing banks:

One of the things governments can do very easily is take over banks, because they're very bureaucratic. It's much harder to take over institutions where imagination is required."

"(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

Nick Rowe with an interesting post on Worthwhile Canadian Initiative:

"But we didn’t know how to design a financial system which is robust enough to cope with people making bad decisions. If some people paid too much for their houses, and other people lent them too much money, the result should have been too many houses built, too few other investments built, and a change in the distribution of wealth when house prices went down and loans went bad. But that should have been the end of it, instead of just the beginning."

I agree.

"How do we stop it happening again? Perhaps we can’t. Perhaps a capitalist financial system is inherently prone to crises, and no amount of tinkering can stop it happening again. Since alternative systems are worse (and also crisis-prone in their own ways), perhaps we just have to live with it, wait for crises to happen, then let the government try to patch up the mess. Maybe that answer is right (and 300 years of history tends to support it). But I refuse to accept it. We have to do better."

I agree.

"This financial crisis, like others, has three main components:

1. A bursting bubble.
2. Leverage.
3. Duration-mismatch (borrowing short and lending long).

(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

I agree with this completely, and so I commented:

"(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

Thank God you said this. I've been saying this as well, and it's great to find someone who agrees with me.

On the Soros testimony the other day:

"Take for example credit default swaps (CDSs), instruments intended to insure
against the possibility of bonds and other forms of debt going into default, and whose price
captures the perceived risk of such a possibility occurring. These instruments grew like Topsy
because they required much less capital than owning or shorting the underlying bonds.
Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of
the underlying bonds and five times the entire US national debt. Yet the market in credit default
swaps has remained entirely unregulated."

( Agree: but he misses the point. CDS's filled the need, which were investments with less capital. Something else would have worked if they didn't. It wasn't the investment, it was the need which created the investment )

Posted by: Don the libertarian Democrat | November 16, 2008 at 02:41 PM

"There are four ways we can try to prevent financial crises:

1. Prevent bubbles. If central banks had raised interest rates sufficiently high, they could have burst the housing bubble before it got too big. But not all assets were over-priced, and high interest rates would have done harm in the rest of the economy. And this cure also relies on the policymakers keeping their heads while all around them are (in hindsight) losing theirs. Policymakers are people too. And in any case, a real shock could have had a similar effect on average house prices. A financial system ought to be robust to real shocks, as well as to bursting bubbles."

I don't agree with this this. The Fed using rates like this is blunt and damages the whole economy, not simply the one in which bubbles occur.

To be continued in the next post.