come forth quickly with its subsidy, or make it clear from the beginning that no subsidy was coming

TO BE NOTED: From the NY Times:

"Waiting for the Subsidy

By Casey B. Mulligan

Casey B. Mulligan is an economics professor at the University of Chicago.

Subsidies can have a perverse effect on activity if they are debated too long. The banking sector bailout is one example; the purchase of hybrid automobiles by Chicago cab drivers is another.

Hybrid automobiles can save gas, especially in urban driving conditions when the automobile is moving slowly or idling, where alternative power sources have a bigger advantage. A problem is that the purchase price of hybrid vehicles is often higher, and many are less spacious than the more ubiquitous sport utility vehicles.

A significant fraction of the taxicab fleet may be well suited for hybrids, because many of the miles driven are in urban conditions, and often the vehicles have only one passenger. Thus I have been surprised to notice so few hybrid taxis in Chicago, where less than 1 percent of cabs are hybrids.

by Ray Tsang

[via Apture]

In an admittedly unscientific survey, I watched for Toyota taxis with about 100,000 miles. I assumed that many drivers of Toyotas would be likely to buy a Toyota for their next taxi, and that the Prius — the company’s hybrid model — would get their consideration. I asked the drivers about buying a Prius.

The drivers told me about the Chicago City Council’s debates about transforming the city’s taxi fleet.

The council has debated mandating hybrid purchases. But the rumor among taxi drivers is that in addition, or perhaps instead, the city or another government agency will eventually subsidize the purchase of a hybrid. Drivers have decided that they should not purchase a Prius or another hybrid until the subsidy arrived. Buying one now would mean overpaying.

Regardless of whether it is realistic to expect Chicago to someday subsidize purchases of hybrid taxis, the fact is that some cab drivers are considering the possibility. If taxi drivers consider future subsidies in their industry, then so must bank executives.

Last fall the public learned that banks were not selling many of their legacy mortgages and mortgage-backed securities, despite the impression that ownership of the assets was hindering the banks’ lending. A variety of theories have been put forward to explain this failure, and to suggest what the government might do to fix it.

But the lack of trade in mortgage-backed securities may have something in common with the lack of trade in hybrid Chicago taxicabs. The secondary market for legacy mortgages may have stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy. As I wrote last week, banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to step in eventually and help push the prices of the assets higher.

There would have been two preferable possibilities: for the government to come forth quickly with its subsidy, or make it clear from the beginning that no subsidy was coming. With both Chicago taxis and the secondary market for mortgages, the government did neither. Instead, it only fueled rumors that subsidies were on the way, and froze the same markets it intended to stimulate."

"any fissure in this regulatory structure will lead to a race to the bottom."

TO BE NOTED: From the WaPo:

"Plan to Expand Financial Oversight May Add New Risks

By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, April 7, 2009; A17

The Obama administration's plan for a sweeping expansion of financial regulations could have unintended consequences that increase the very hazards that these changes are meant to prevent.

Financial experts say the perception that the government will backstop certain losses will actually encourage some firms to take on even greater risks and grow perilously large. While some financial instruments will come under tighter control, others will remain only loosely regulated, creating what some experts say are new loopholes. Still others say the regulation could drive money into questionable investments, shadowy new markets and lightly regulated corners of the globe.

And a shortage of manpower raises questions about the government's ability to keep up with the vast and complex financial markets.

In congressional testimony last month, Treasury Secretary Timothy F. Geithner laid out the principles of the administration's proposals. He called in part for designating a federal agency that would be responsible for identifying financial companies whose failure could endanger the wider economy and for giving the government greater authority to wind down troubled financial firms. He also proposed new regulations for hedge funds, venture capital funds and private-equity funds, as well as for complex financial instruments known as derivatives.

These plans seek to mitigate some of the dangers exposed by the financial crisis. But while weak regulation is partly responsible for the current turmoil, the unintended consequences of government action over past decades also played a role.

At the top of the Obama administration's agenda is the creation of a regulator that can peer into any corner of the economy to root out threats that could shatter financial markets.

But some experts warn that such a "systemic risk regulator" could unleash new hazards if it can identify certain companies as being too large to fail. This could create an incentive for firms to grow dangerously big so they can win a government guarantee against failure. If a company has the promise of government protection, its creditors might be willing to lend it money at below-market rates because of the reduced probability the company will collapse and they won't get paid back.

The danger of this incentive is twofold. For one, a firm may be willing to take on more unreasonable risks. Second, if a company gets access to unusually cheap financing, its rivals are at a competitive disadvantage.

"If these entities are now perceived to be too big to fail within the protective net, then they get an advantage vis-à-vis other institutions that are not so perceived," said Lawrence White, an economics professor at New York University. "The creditors to these guys become even less inclined to monitoring and more inclined to say, 'Hey, let the government do it.' "

In the view of many financial experts, that is exactly what happened to mortgage-finance companies Fannie Mae and Freddie Mac before the government seized them last year. Congress chartered both companies to provide financing to lenders to make home mortgages. Their debt didn't carry the official backing of the U.S. government, but many creditors assumed the government would step in if the companies faltered.

That meant the interest rates Fannie Mae and Freddie Mac had to pay to borrow were just slightly higher than what the U.S. government had to pay. With access to cheap financing, the firms borrowed hundreds of billions of dollars and bought or guaranteed trillions of dollars in mortgages. Some of these went bad in recent years. Last fall, the companies nearly collapsed as a result, prompting the government takeover.

Geithner's proposals for hedge funds and derivatives also drew concerns from some financial experts. Geithner proposed that hedge funds register with the Securities and Exchange Commission and disclose information about their operations.

But some who closely track the industry warn that may encourage more investors to put their money into hedge funds without actually protecting against fraud and risky investment practices.

"The government is going to be more hands-on, and that's going to imply to people the government is vetting the risks relevant to a hedge fund," said Jason Scharfman, managing director of Corgentum, a firm that evaluates whether hedge funds have proper safe internal procedures. "It exposes investors to a false sense of security that they don't need to perform adequate due diligence on the hedge funds they're investing with."

The SEC and other agencies may not have the manpower to adequately oversee new markets.

In recent months, the SEC has disclosed that the number of agency staffers available to police the market has stagnated even as the size and complexity of the market has grown far greater. For instance, only one in 10 investment advisers -- the designation under which most hedge funds register -- is examined every year by the SEC.

Meanwhile, the special inspector general overseeing the Treasury Department's financial recovery plan has just 30 employees. The inspector general's chief of staff recently said that his operation would need an agency the size of the FBI -- which has nearly 30,000 employees -- "to truly cover this by ourselves."

In his testimony on the future of regulation, Geithner also said that most derivatives should be regulated. Of particular concern are credit-default swaps, which are essentially insurance contracts between two parties to cover losses should a bond default. These swaps were behind the near-collapse of American International Group. And because trillions of dollars of swap agreements were made over recent years, it was difficult for the government to determine the extent to which they posed a threat to the entire financial system when the crisis escalated last fall.

Geithner proposed that swaps be traded through a central clearinghouse, allowing regulators to keep an eye on the derivatives market and give investors more confidence that their partners are legitimate. This would apply to standard swaps -- for instance, one to protect against a General Electric bond going bad.

But others would be exempt. This would include nonstandard swaps, such as one to protect against the default of a multilayered security composed of residential and commercial mortgages.

Several experts cautioned that leaving any room for exemptions could be devastating.

"It could give incentives for parties to issue less standardized or very customized contracts which would not be required to be cleared," said Houman Shadab, senior research fellow at the Mercatus Center at George Mason University.

There could be a rush to use nonstandard swaps if there's an opportunity to get around a clearinghouse, which would impose additional costs.

Michael Greenberg, a University of Maryland law professor and former top official at the Commodity Futures Trading Commission, said "any fissure in this regulatory structure will lead to a race to the bottom."

The Obama administration's initiative also poses a risk that financial firms will move their activities offshore to avoid heightened regulation. Last week big industrial nations met in London to work on international regulatory reform, and some European countries want even tighter regulation than does the United States. But that doesn't solve the problem of lightly regulated island regimes such as the Cayman Islands or Netherlands Antilles, or developing financial centers in Asia and the Middle East.

"More regulation here will undoubtedly lead to more money flowing to places with a less heavy regulatory framework, in an effort to keep costs down," Andrew P. Morriss, a professor who studies regulation at the University of Illinois at Urbana-Champaign, said in an e-mail.

Morriss warned that money currently flowing into the United States from international investors could go elsewhere, such as China, "if we try to make it hard to come here."

the buyer and seller of the CDS were making a bet for which the taxpayers were implicitly picking up the downside

TO BE NOTED: Another Implicit Guarantee post: From Econbrowser:

"Moral hazard and AIG

We are now suffering the consequences of one of the most spectacular financial miscalculations in history, after investors around the world discovered that trillions of dollars invested in securities derived from U.S. home mortgages were far riskier than they had originally believed.

Part of this miscalculation can be attributed to misguided quantitative models that were used to assess those risks. The key inputs for those models were assumptions about underlying default rates and their correlations across different borrowers. Default rates and correlations were quite low up until 2005, because rising home prices made default a decidedly inferior option to refinancing for even the least credit-worthy borrower. But the rising home prices were themselves caused by the huge flow of capital for lending to this market, sucked in by the illusion of safety. When the flow of credit stopped and house prices began to fall, the same forces operated impressively in reverse, now leading otherwise credit-worthy borrowers to default in increasing numbers.

But I would argue that another factor contributing to the illusion of safety was severe distortions in the markets for derivative contracts based on those underlying mortgage-backed securities. The seller of a credit default swap promises to make a payment to the buyer in the event that the security against which the contract is written goes into default. From the perspective of the buyer, a CDS is like an insurance policy against default. Some institutions might be interested in buying such contracts even if they did not have long positions in the securities against which the CDS was written, as a hedge against risks of other related investments.

And who would want to be on the sell side of these contracts? Insurance giant AIG was one big player. At first blush, you might think this could be a reasonable role for such an institution, since from the point of view of the buyer a CDS could function much like an insurance policy. But from the point of view of the seller, this is a very different product from conventional insurance. Selling more fire insurance policies helps the insurer to diversify, because fires across different communities have little correlation. But there is a common risk factor at the core of recent housing market developments. By selling a bigger volume of CDS, AIG was simply taking a bigger lopsided position on a single one-sided bet. And AIG lacked the financial resources to make good on those contracts in the event that the housing downturn became as severe as it has now proved to be.

But that raises a separate question. Could it make any sense for AIG to sell and someone else to buy a promise on which AIG in fact could not deliver? From the point of view of AIG-- at least the specific players within AIG running these operations-- one could argue that the answer is yes. In selling the CDS, they were receiving huge payments. As Forbes reported last September:

A big part of the reason was most likely that AIG's financial products unit, run by Cassano since 1988, was a veritable money machine, pouring $6 billion of riches into AIG's coffers from 1988 until 2005.... According to The Times, compensation ranged from $423 million to $616 million for Cassano's group. That would be about 20% of the unit's revenue, meaning Cassano was being paid like a hedge fund manager.

This understanding of AIG's incentives may have been what prompted Federal Reserve Chair Ben Bernanke to sound off last week:

if there's a single episode in this entire 18 months that has made me more angry, I can't think of one, than AIG.... AIG exploited a huge gap in the regulatory system.... There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets-- took huge losses. There was no regulatory oversight because there was a gap in the system.

So let's grant that Cassano and his cohorts may have had ample incentive to sell the product. But who would buy? Though he may not have been thinking of AIG and its counterparties in particular, Bernanke aptly described one potential answer in his remarks today on financial reform to address systemic risk:

In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm.

Could AIG's counterparties have been thinking that their payments would come not from AIG but from the Federal Reserve and taxpayers? If that's what they thought, some of them at least would appear to have been correct. Gretchen Morgenson reported this weekend:

When A.I.G. couldn't meet the wave of obligations it owed on the swaps last fall as Wall Street went into a tailspin, the Federal Reserve stepped in with an $85 billion loan to keep the hobbled insurer from going bankrupt; over all, the government has pledged a total of $160 billion to A.I.G. to help it meet its obligations and restructure operations....

Edward M. Liddy, the chief executive of A.I.G., explained to investors last week that "the vast majority" of taxpayer funds "have passed through A.I.G. to other financial institutions" as the company unwound deals with its customers....

On Wall Street, those customers are known as "counterparties," and Mr. Liddy wouldn't provide details on who the counterparties were or how much they received. But a person briefed on the deals said A.I.G.'s former customers include Goldman Sachs, Merrill Lynch and two large French banks, Societe Generale and Calyon....

How much money has gone to counterparties since the company's collapse? The person briefed on the deals put the figure at around $50 billion.

To the extent that the buyer and seller of the CDS were making a bet for which the taxpayers were implicitly picking up the downside, the CDS market, rather than helping institutions effectively manage risk, would have been a factor directly aggravating systemic risk.

I raise this issue not to be yet another voice clucking that we need to get tougher on AIG or others in order to prevent moral hazard, though that is one reasonable inference to draw from the discussion above. But the issue for me has always been not to exact retribution or instill market discipline, but instead the very pragmatic question of how to use available resources to minimize collateral damage. I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question then is, what combination of parties is going to absorb the loss?

The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund. But if they are to contribute, the plan must be something other than doling out another $100 billion every few months to try to keep the operation going a little longer, but instead requires seizing this bull by the horns. Split AIG into a core business we want to protect-- with enough equity to be a viable operation, and a hefty fraction of the existing management team fired-- and a derivatives business that's going to be systematically liquidated in large part by abrogation of outstanding contracts.

Then there's the domino effect to consider. What do we do when this brings down the next player who can't continue operations without those payments AIG (or the taxpayers) were supposedly going to deliver? I say, we implement the parallel operation there.

That's my proposal for how to dismantle the derivatives house of cards. One trillion at a time."

In layman’s terms, he was asking for a clearer legal path to nationalization.

From the NY Times:

"Banks Counted on Looting America’s Coffers

By DAVID LEONHARDT

Sixteen years ago, two economists published a research paper with a delightfully simple title: “Looting.”

The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.

Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.

He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.

•

The term that’s used to describe this general problem, of course, is moral hazard. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.

This form of moral hazard — when profits are privatized and losses are socialized — certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It’s an important distinction.

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Mr. Bernanke actually took a step in this direction on Tuesday. He said the government “needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm.” In layman’s terms, he was asking for a clearer legal path to nationalization.

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer — a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday — that the next candidate for looting already seemed to be taking shape.

It was an obscure little market called credit derivatives."

Me:

"With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise."

"Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Thank you for this post. I believe that looting was the main cause of this crisis. At least now, some people will finally see its importance.

I'd like to add this quote:

WHY BANKS FAILED THE STRESS TEST
Andrew G Haldane*
Executive Director for Financial Stability
Bank of England
13 February 2009

http://www.bankofengland.co.uk...

"No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and
show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that
event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.
All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did
banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big
one came, his bonus went and the government duly rode to the rescue. The timeconsistency problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities"

Don the libertarian Democrat

— Don, Tacoma, WA

Hazardous Materials? Jim Surowiecki on overblown moral-hazard concerns.

From Felix Salmon:

"Extra Credit, Monday Morning Edition

Why stimulus spending should go to public art

Bailouts for Bunglers: Paul Krugman on why the government should nationalize.

Hazardous Materials? Jim Surowiecki on overblown moral-hazard concerns.

OpenTable files for IPO, finally: And it might actually make sense, even in this market.

Me:

"The patchiness of the moral-hazard argument doesn’t mean that we should simply rubber-stamp another bank bailout; that may be both unjust and a poor strategy for whipping the financial sector into shape. But it does mean that the failure of Lehman Brothers was an unnecessary and costly sacrifice to moral-hazard fundamentalism. It also means that we should not sit quietly by because we fear that government action today will lead to reckless market behavior years from now. Moral hazard has its costs. But, so far, our fear of it has proved much more expensive."

I agree about Lehman, but not about moral hazard. It's very important. However, it must be swift, explicitly expected, principled, and onerous. We've had none of these. Lehman was free market policy for the hell of it. Read a chap named Bagehot. Pronounced Sinj'n.

However, by nationalizing some banks, we can both do the right thing and scare the hell out of the bankers. A moral hazard enema, if you'd like. And if you would, see a therapist.

By DonthelibertarianDemocrat Posted: Feb 02 2009 10:36am ET


Response to ccm Feb 02 2009 10:15pm ET

Although the Bank usually in the end supplied the market, its “faltering way”
caused needless uncertainty and more severe panics than if it communicated clearly
that it could be counted on (Bagehot 1873, 64). According to Bagehot, the rules—
to lend freely at penalty rates on sound collateral—under which assistance would be
provided should be stated also.

The public is never sure what policy will be adopted at the most important
moment: it is not sure what amount of advance will be made. The best
palliative to a panic is a confidence in the adequate amount of the Bank
reserve, and in the efficient use of that reserve. And until we have on this
point a clear understanding with the Bank of England, both our liability to
crises and our terror at crises will always be greater than they would
otherwise be. (1873, 196–97)

http://www.independent.org/pdf/tir/tir_07_3_wood.pdf

Bagehot’s Lender
of Last Resort
A Hollow Hallowed Tradition
—————— ✦ ——————
JOHN H. WOOD

My last try.

By DonthelibertarianDemocrat Posted: Feb 03 2009 00:12am ET

With an increased burden of regulation, financial innovation will probably provide new forms of regulatory arbitrage to circumvent the new rules

Good post by John Plender on the FT:

"For the late John Kenneth Galbraith, an acute observer of market folly, finance and innovation were fundamentally incompatible. Every new financial instrument, he said, “is, without exception, a small variation on an established design, one that owes its distinctive character to the ... brevity of financial memory”. The world of finance “hails the invention of the wheel over and over again, often in a slightly more unstable version”. ( I DON'T AGREE )

After the devastating collapse of a credit bubble that had seen explosive growth in new financial instruments, many politicians might feel Galbraith, if anything, understates the damage wrought by financial innovation.

So the post-bubble policy agenda is bound to address important questions. Is financial innovation a blessing or a curse? Given, at the very least, that it is double-edged, should innovation in finance be curbed, or kept far removed from the conventional commercial banking sector? And how possible is it anyway to control the inventiveness of banking’s rocket scientists on Wall Street and in London or the eagerness of their employers to make money from their ideas?( YOU CAN'T. IT'S A SILLY ARGUMENT. )

The extent of the detritus bears thinking about. Subprime mortgages( QUITE SIMPLY BAD LOANS ) that promised home ownership to millions on low incomes have inflicted the misery of repossession. Increasingly complex forms of mortgage-backed paper left the banks that invented them at the mercy of both a liquidity( A CALLING RUN ) and a solvency crunch( ALSO FROM A CALLING RUN ).

Those such as Alan Greenspan, the former chairman of the US Federal Reserve who claimed that financial innovation was distributing risk to the people in the system best able to shoulder it, have been proved comprehensively wrong( HE WAS CORRECT. IT'S THE GOVERNMENT. ). Instead, the dictum of Warren Buffett, the “sage of Omaha”, that derivatives were financial weapons of mass destruction has been vindicated as one bank after another turns to its government for support( THAT WAS THE PLAN ).

Andrew Hilton, director of the Centre for the Study of Financial Innovation, a London-based think-tank, even argues that “you can make the case that banking is the only industry where there is too much innovation, not too little”.( SILLY )

Economic literature offers both passionate advocates and passionate opponents – which is understandable, given that the impact of financial innovation on social welfare is impossible to measure. Supporters say new instruments, technologies, institutions or markets lower transaction costs, make( THEY CAN ) markets efficient, help solve social problems and contribute to economic growth.

Sceptics highlight obvious costs. Galbraith, in A Short History Of Financial Euphoria (source of the earlier quotation) emphasised the pervasive role of debt: “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets ... All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment( TRUE, BUT THAT'S THE NATURE OF INVESTING. ).”

From barter to Fuggers’ fall

The double-edged nature of financial innovation has been apparent throughout the ages. Coins improve on barter because they economise on information and transaction costs. Paper money has the additional advantage of being less cumbersome than metal. Yet, as the Chinese found between the 11th and 14th centuries, a paper currency carries inflationary risks.

The most inventive bankers of the 16th century were the Genoese, who developed the equivalent of interest rate swaps in their lending to the Spanish government. They also devised a form of securitisation to use inflows of silver into Spain to finance the delivery of gold in Antwerp to pay Spanish troops in the Low Countries.

According to the historian Fernand Braudel, the Fuggers, pre-eminent bankers of the day in Germany, were profoundly suspicious of this apparent financial sleight of hand. So innovation provided the Genoese with a competitive weapon that helped displace the Fuggers as financiers to the Spanish treasury.

In both these cases innovation was providing a solution to a problem – another long-standing pattern. In China a scarcity of bronze led to the introduction of iron coinage, which was so inconvenient to transport that paper provided an attractive alternative. As for Europe, economic historians William Goetzmann and Geert Rouwenhorst argue that it was the financing requirements of the Crusades that encouraged Italian city-states to develop bond markets.

The cost of hostility to financial innovation may be high. Some historians speculate that a lack of financial development helps explain why the Chinese, who discovered the steelmaking process in the 11th century, did not produce the first industrial revolution.

His verdict captures very precisely the shuffling of asset-backed paper and the slicing and dicing of risk that marked the credit bubble. A huge debt-powered financial superstructure was built on top of the real economy to the point where high-octane finance became increasingly out of touch with productive enterprise.( WRONG )

Yet Galbraith was too sweeping. The financial system does many things. Among others, it provides a means of payment and exchange; it transfers the spare cash of savers to those with investment opportunities; it allows assets to be traded; and it provides insurance, whether in conventional contracts or in such instruments as swaps, options and other derivatives.

In all these areas, innovation has provided tangible benefits( TRUE ). Computerisation has improved the payments system, while technology such as automated teller machines has been a huge convenience to retail bank customers. The internet is transforming the availability of financial information and is lowering transaction costs in broking. Like many other innovations in retail finance, these advances do not involve the creation of debt.

Even in those areas that do, the outcome can still be beneficial. The development of the swaps market, for example, led to the new disciplines of treasury and risk management whereby the banks’ ability to swap fixed for floating interest rates and vice versa allowed them to insure against rate volatility. Currency swaps fulfilled a similar function. With the huge increase in market volatility stemming from deregulation and the abandoning of fixed exchange rates in the 1970s, this ability to hedge was a boon to banks. At the same time, computerised trading increased the efficiency of markets.

More often than not, innovation is satisfying genuine demands( YES ). Where the curse comes in is that many innovations are double-edged. Plastic cards, in so many ways a benefit to bank customers, may lead to over-­indebtedness, a growing social problem. Derivatives can be used to punt as well as to hedge. Credit default swaps were developed as insurance to protect investors against a failure to honour loans or bonds. Then came the collapse of Lehman Brothers, which revealed the extent to which people had underestimated the risk( TRUE ) of their counterparties defaulting.

As the economist Burton Malkiel points out, a benign instrument( THAT'S WHAT IT IS ) designed to reduce risk turned into a monster that came close to destroying the entire financial system( NO. HUMAN BEINGS DID THAT. ).

During the credit bubble, innovation was in one sense satisfying urgent demands all too well. Low-income families wanted mortgages and the banking system provided them. Investors wanted income in the period where even junk bonds offered a diminishing premium over the yield on government bonds, as excess savings in Asia and the petro-economies drove yields down. Yet in the euphoria, would-be home owners overstretched themselves, while banks dropped lending standards( TRUE ) and fraudsters made hay( TRUE ).

Another recurring difficulty lies in assessing risk in innovations, which by definition have no lengthy record. By relying on inadequate historical data( TRUE ), credit rating agencies made asset-backed paper look better than it was. Risk was mispriced( TRUE ) as banks provided investors with a toxic solution to the problem of yield compression, whereby the spread between government bond yields and low quality corporate bond yields became absurdly narrow.

In recent testimony to a congressional committee by James Simons of Renaissance Technologies, a hedge fund, said fanciful ratings( COLLUSION ) of mortgage-backed securities facilitated the sale of “sows’ ears ... as silk purses”. As well as being mispriced, risk was mismanaged, because the underlying methodologies were fundamentally flawed( TRUE ).

The damage caused by bubbles can be greatly increased where innovation leads to information loss. Computerisation and the internet have improved the transparency of much of the financial system. Yet most of the asset-backed paper in the bubble was traded not on organised exchanges but on dealers’ screens and telephones. Instruments such as collateralised debt obligations helped make the system more opaque and more hostage to counterparty risk – the chance that the person on the other side of a transaction fails to deliver. That is because there was no centralised clearing and settlement in which all contracts were guaranteed( IT'S THE GUARANTEE THAT IS IMPORTANT ).

A more fundamental explanation of why innovation can be counterproductive reflects a desire to escape the heavy hand of the state( YES ). Merton Miller, the late Nobel laureate, declared in a 1986 paper that “the major impulses to successful financial innovations have come from regulations and taxes”.( I AGREE COMPLETELY )

If that makes innovation sound subversive, regulatory arbitrage (locating a trading business in a place that has the laxest local laws) can nonetheless have economic and social benefits if directed at bad policy( TRUE ). The US in the 1970s, for example, responded to rising inflation by reviving a Depression-era measure called Regulation Q, which put a cap on deposit interest rates in the hope that by keeping banks’ cost of funds down, mortgage loans would be less expensive.

This was a classic example of attacking the symptoms of a disease, not the causes. It victimised small depositors, who were left with negative real rates of interest as inflation soared. The markets’ response was to invent negotiable certificates of deposit that escaped the constraint of Regulation Q because they were a paper instrument rather than a conventional deposit. European banks internationalised this, offering unregulated deposit rates to larger investors via the new eurodollar market, which helped rejuvenate the City of London in international finance.

That illustrates how markets can act as an escape valve and an adjustment mechanism. Yet the outcome is not always so benign. In the credit bubble, much of the impetus for driving loans off bank balance sheets into securitised form came from the risk-weighted capital regime introduced by the Basel committee of international bank regulators( TRUE ). By encouraging off-balance-sheet activity, the regime turned banking into a shorter-term, more transactional business.

This “originate and distribute” model – in which banks turned conventional loans into fancy securities and sold them on to a pool of investors – reduced the incentive( NO EXCUSE ) for banks to monitor the creditworthiness of those to whom they lent. It was a case of churn out the loans and let the devil take the hindmost.

The latest Basel bank capital accords, which failed to avert financial crisis, have been criticised for:
●A poor focus on liquidity.( TRUE. NO IDEAS ABOUT A CALLING RUN ) )
● Internal risk rating that allowed banks a high degree of discretion.( INEVITABLE )
●Encouraging pro-cyclicality in the system. ( OK )
● Giving an excessive role to credit rating agencies.( TRUE )

In addition, banks had an incentive to increase leverage( THAT'S THE CAUSE ) – identified by Galbraith as a recurring cause of systemic damage( YES ) – as they piled more liabilities on to a very slender capital base.

Measures of leverage based on Basel’s “tier one” capital ratio, which were the main focus of analyst attention, appeared less frightening than those based on conventional accounting, which revealed a more disturbing picture that went largely unobserved. The outcome was that banks ended up more highly leveraged( TRUE ) than most hedge funds. Nothing illustrates better how the law of unintended consequences can contribute to financial blow-ups.

An endemic difficulty also arises with insurance, whether conventional contracts or hedging instruments such as credit default swaps. It relates to moral hazard, whereby the existence of a safety net causes people to adopt more risky behaviour( LIKE GOVERNMENT GUARANTEES ). The result is that while insurance reduces the risk to the individual, it increases the risk to the overall system.

Perhaps the most dangerous examples of moral hazard are deposit insurance and the readiness of central banks to act as market makers or lenders of last resort. Owners of insured deposits have little incentive to monitor the creditworthiness of banks where they place their money. Large depositors exercise little discipline over banks they see as too big to fail( THAT'S MY MAIN CAUSE ). After the bubble, the Fed’s role as lender of last resort was extended to investment banks and to AIG, the insurer. So moral hazard is now more widely entrenched across the financial system.( IT ACTUALLY ALWAYS WAS )

Many of these drawbacks can be addressed to ensure that the blessings of innovation outweigh the curses. This is certainly true of the opacity that prevails in over-the-counter markets for securitised financial instruments, where little information about transactions is made public. Banks now see it is in their own interest to shift securitised business to exchange traded markets with centralised clearing houses backed by capital from trading members( A GOOD IDEA ). This will introduce transparent pricing and volume information while reducing counterparty risk, which is what the regulators want.

But moral hazard can be addressed only by regulation, by penalising management and shareholders when banks are bailed out( YES ), or by allowing big banks to go bust( YES ). More regulation almost certainly has implications for the rate of innovation( I AGREE ), which tends to go in waves. With politicians and watchdogs now preoccupied with the curses rather than the blessings of financial ingenuity, an innovation slowdown is probably inevitable( YES ). New and risky financial products may attract higher capital penalties under a revised Basel regime.

Yet there are those, such as Robert Shiller of Yale University, who argue that much of the damage could have been avoided if finance had been democratised and innovation used to manage individual home owners’ risks through, for example, house price futures markets that allow home owners to insure against falls in prices( I AGREE ). Others say derivatives could help address problems such as water shortages, since futures markets can smooth imbalances of supply and demand.( I AGREE )

Certainly the urge to innovate will not go away( NO WAY ). For bankers, it offers huge advantages. In retail banking, patented inventions such as Merrill Lynch’s cash management account in the 1970s allowed what was then a securities house to make a big dent in the deposit base of the conventional banking system with a genuinely attractive product. At the wholesale end, producing a new financial mousetrap gives banks an entrée to corporate clients and institutions.

Yet the biggest spurs to innovation in future may be those identified by Miller. The cost of bailing out banks will put big pressure on public finances( TRUE ). It would be surprising if governments do not look to increase the tax take from companies to relieve some of that pressure( PROBABLY ). Companies will look to banks, lawyers and accountants to find novel instruments to mitigate the damage.( THAT'S IT )

With an increased burden of regulation, financial innovation will probably provide new forms of regulatory arbitrage to circumvent the new rules, just as it did after the introduction of Basel One in the early 1990s.( VERY TRUE )

Miller found, after predicting a lower rate of innovation back in 1986, that it is always dangerous to forecast any slowdown in what financial ingenuity can bring about( I AGREE ). The backlash to today’s financial crisis will inevitably provide tasks for the next generation of regulatory arbitrageurs( I AGREE )."

As for innovation, what's needed is supervision, done by reviewing the practices of all investments that:

1) Increase Leverage

2) Shift Risk To Third Parties

3) Magnify Risk

In other words, focus on the broad outlines and purpose of the investments. In the case of CDOs and CDSs, the desire was to lower capital requirements, for example.

In the end, government guarantees and fraud will be seen as the main culprits, not innovation.

“We would like to sputter in shock and disbelief. "

Not a good sign.From The Big Picture:

"GMAC: 0% Financing for Subprime FICO Scores

By Barry Ritholtz - December 31st, 2008, 12:55PM

I found this quote from GM Sales & Marketing chief to be astounding:

“’Six hundred twenty is not a subprime score,’ GM’s sales and marketing chief Mark LaNeve told Automotive News. ‘That’s a very creditworthy buyer. Hopefully, we’ll have access to more of the market that is out there.’”
- Automotive News (12/30/08)

Bill Ryan of Portales Partners adds the following:

“We would like to sputter in shock and disbelief. General Motors Acceptance Corp. (GMAC) lost $5B in the 9 months ending September 2008 (on an operating basis). It has $100B in subprime and nonconforming mortgages through its ResCap subsidiary, and the government just lent them $5B at an 8% interest rate.

In addition, General Motors (GM) just announced a 0% financing option to car buyers.

So it turns out that we are now subsidizing a globally uncompetitive carmaker that does not understand what qualifies as a subprime FICO score and is offering 0% loans financed by a government (taxpayer) investment that costs 8%.

We guess they are hoping to make it up on volume.”

Astonishing.

FYI: Subprime is defined as those credit applicants with a FICO score below 660. Hence, GM plans on shoveling its excess inventory out the door — with a 8% hit on the financing — and the taxpayer bailout holding the bag.

A brand new chapter on Moral Hazard has just been written. I expect will will see significant costs for this profligacy down the road."

This deal is poor. I can't deny that.

"it is safe to lend to them at low rates … no matter how leveraged they are or how many risky bets they are making"

From Brad Setser:

"By bsetser

Tyler Cowen argues that the “Committee to Save the World” made a mistake in 1998 by, well, saving the financial world. They thus missed an opportunity to teach the banks a lesson in sound risk-management.

He specifically argues that the Fed (actually the New York Fed) shouldn’t have called the big banks together to recapitalize LTCM. The recapitalization didn’t require any Treasury funds or draw on the Fed as a lender of last resort, so calling it a bailout obscured the meaning of the term bailout – the fed catalyzed a private bailout of LTCM but it didn’t do a true government bailout. You might even say that the Fed catalyzed a bail-in of LTCM’s creditors. But by acting, Cowen argues that the Fed set a precedent that creditors of big financial institutions don’t take losses, and thus encouraged bad bets.( I AGREE WITH COWEN THAT IT SET A PRECEDENT, IN THAT THIS IS IN FACT GOVERNMENT INTERVENTION. WHO KNOWS WHAT THE GOVERNMENT WOULD HAVE BEEN WILLING TO DO? HOWEVER, IT'S CLEAR THAT THEY WOULDN'T COUNTENANCE A CALLING RUN. I DON'T AGREE THAT THE NY FED SHOULDN'T HAVE INTERVENED.)

I am not totally sure. The big banks called to the New York Fed were the creditors of LTCM and they were in some sense “bailed-in.” To avoid taking losses on the credit that they had extended to LTCM, they had to pony up and recapitalize LTCM.*( WERE ANY GOVERNMENT GUARANTEES OR INDUCEMENTS USED? )

It just so happened that the market recovered and it was possible for LTCM to exit many of its positions without taking large losses, or in some cases any losses. The banks that took control of LTCM when LTCM was on the ropes were able to unwind LTCM’s portfolio in a way that didn’t result in additional losses. But the result Cowen desired — large losses for the banks and broker-dealers who provided credit to LTCM – was quite possible if LTCM’s assets weren’t sufficient to cover all its liabilities. No creditor of LTCM was able to get rid of its exposure as a result of the Fed’s actions.

Lehman’s creditors didn’t get a chance to do a similar deal. There were too many of them — and there was too little time. I suspect, though, that Lehman’s creditors and counter-parties would be far better off if they had all agreed to pony up say 10% of the money they had lent to Lehman and in the process had provided Lehman with enough equity to allow it to be unwound in a more orderly way( I AGREE ).** They still would have taken losses, but those losses might well have been smaller – even counting the new money they put in – than the losses that Lehman’s creditors will incur as a result of Lehman’s bankruptcy filing( I TEND TO AGREE ).

Moreover, it seems a bit strange to look at LTCM in isolation( WE SHOULDN'T ).

LTCM, remember, came just after Russia defaulted.

And Russia was at the time considered the quintessential moral hazard play.

A host of financial institutions thought it was too nuclear to fail, and thus concluded that that they could safely pocket the high coupon on Russia’s GKOs (short-term Ruble denominated Russian securities) …

Bad bet. Then Treasury Secretary Robert Rubin concluded that it wasn’t possible to save Russia without effectively turning Russian credit into US credit. He wasn’t willing to do that. He wasn’t willing to support the disbursement of the second tranche of Russia’s IMF program after Russian burned through the first tranche really quickly.

Not providing Russia more money then was a risky call. Kind of like letting Lehman fail. Russia, remember, had nukes. Lots of them. The national security types weren’t thrilled by the prospect of a bankrupt nuclear power.

Russia’s creditors (including Lehman) took large losses at the time( A CALLING RUN WAS AVERTED. ). That presumably should have taught them a lesson or two about managing risk – it was more or less what I suspect Dr. Cowen would have prescribed.

It also implies that LTCM wasn’t the Lehman of 1998.

It was more like one of the institutions that was found to be swimming naked after Lehman defaulted.

LTCM was bailed out by its creditors (you might even say its creditors were bailed in … ). Today, the big financial institutions are truly getting bailed out. Most would be bust if not for Treasury capital injections and Fed liquidity support( TRUE ).

Nor was LTCM the only big borrower that got a bit of help after Russia didn’t get bailed out.

Brazil, like Russia, had a lot of short-term debt that had to be rolled over. Now it so happens that most of Brazil’s domestic debt was owed to domestic banks not foreign investors – and that really helped. The analogy isn’t perfect. Brazil also had a pegged exchange rate. It, like Russia, had pegged to the dollar at too high a rate to be sustained after Asia’s crisis cut into global demand for commodities and reduced private capital flows.

Brazil not surprising came under a lot of pressure. But it also got a decent sum of money from the IMF. That loan supplemented Brazil’s reserves and allowed for a more orderly exit from its fixed exchange rate than otherwise would have been the case. They delay made possible by the IMF (and the government’s heavy intervention) in the foreign exchange market allowed a lot of Brazilian firms to hedge their dollar exposure, so they didn’t go bust when the real eventually was devalued. And Brazil didn’t default. Not in 98. Not in 99. And not in 2002, when it also had to draw on the IMF after Argentina’s default.

Ending moral hazard consequently would have implied letting Brazil go – not just letting LTCM go. The odds are that a Brazilian default soon after Russia’s default would have brought done a major financial institution or two, and brought about a major systemic crisis.( NOT GOOD )

I am personally though glad that this wasn’t what happened. Brazil actually was suffering from a liquidity crisis as much as a solvency crisis. Or rather the IMF provided it with a cushion that allowed it to make the fiscal adjustment needed to assure its long-term solvency — and that was something it was willing to do. That kept its liquidity crisis from morphing into a solvency crisis. The line between the two often isn’t as clean in practice as in theory (apologies for all the detail; I wrote an equation-free book on this with Dr. Doom before he was Dr. Doom).

I doubt Brazil would be better off today if it had defaulted in 98 or early 99. Defaulting on domestic government debt does bad things to the long-term health of any country’s domestic banking system. It creates a really bad hangover – and leaves a country permanently more vulnerable to a run( I AGREE ).

Nor am I convinced that Dr. Cowen’s solution – standing aside as LTCM failed – would have ended moral hazard.( NOT BY ITSELF )

LTCM after all was an unregulated hedge fund. It wasn’t a regulated bank. Or a big – and sorta-regulated- broker-dealer. If LTCM had failed, I suspect that policy makers would have stepped in to prevent any major regulated financial institutions from failing as a result of its exposure to LTCM, or its own LTCM-style bets. Rather than ending the expectation that big banks and big broker-dealers were too big-to-fail, the failure of LTCM might have reinforced that sense( I AGREE ).

The real moral hazard in the financial system – in my view – comes not from expectations that if a firm like Goldman (or Lehman) makes a bad bet on a country like Russia (or a bad bet on US commercial real estate) the government will come in and protect the firm from losses on those investments. Rather it comes from the expectation on the part of those lending to places like Lehman and Goldman that these institutions are too important to fail, and thus it is safe to lend to them at low rates … no matter how leveraged they are or how many risky bets they are making.( THAT'S IT EXACTLY )

If that is right, ending moral hazard in 1998 would have required allowing an institution like Lehman to fail in a way that imposed large losses on Lehman’s creditors. Not just allowing LTCM to fail in a way that imposed large losses on firms like Lehman. ( IN A WAY THAT SHOWED THE GOVERNMENT WOULD NEVER INTERVENE )

And, well, right now a lot of people seem to think allowing an institution like Lehman to go bankrupt in 2008 was a mistake.( IT WAS )

To me the real failure during the last crisis was the failure of regulators to clamp down more seriously on leveraged institutions once the markets calmed.( IF THIS MEANS BAGEHOT'S PRINCIPLES, I AGREE. IF IT JUST MEANS TINKERING WITH THE REGULATIONS, THEN I DON'T AGREE. )

Losses in Russia – and a close call with LTCM did lead to a bit more prudence for a while. Regulators did start to pay more attention to the financial firms that were providing a lot of credit to big hedge funds. But that started to seem a bit superfluous in a context where (for a period) the banks actually were lending less to hedge funds, in part because the big hedge funds were shrinking. Not just LTCM. Tiger too … even Soros.

Most macro funds got burnt on the yen carry trade in 98.

And when the party got going again this decade — and hedge funds and private equity firms and the broker-dealers and the banks (through off balance sheet vehicles) all started to gear up — there was a team at the Treasury that wasn’t at all interested in regulating the financial sector. And the Fed – Greenspan especially – was never very keen on tight regulation.

Given all the scale of this year’s crisis, I certainly cannot rule out the possibility that Dr. Cowen is right and we would all be better off now if we had had a deeper crisis in 1998. A crisis that scarred the banks as deeply as it scarred most emerging markets might have produced a world where the banks wanted to increase their capital as badly as most emerging markets wanted to increase their reserves.( MAYBE )

But I doubt that that outcome would have been possible without standing by and watching a lot more institutions than just LTCM fail( I AGREE. IT COULD HAVE LED TO A RUN ). One big borrower — Russia — did fail rather spectacularly in 1998. Its failure created large losses for a lot of banks (far more than most were expecting, as some banks’ risk models at the time didn’t allow for a default on ruble denominated debt … ). The yen carry trade also unwound in ways that led to big losses at a lot of hedge funds. And that wasn’t enough.

My bottom line: getting rid of all moral hazard – and forcing creditors to evaluate the real risk of lending to a large, highly leveraged financial institution rather than bet that some large institutions were too big and too complex to fail – would have required a lot more that letting the market sort out LTCM with a gentle nudge from the Fed. It would have required allowing the set of institutions that were lending to LTCM to have failed …( AND EVEN THEN... )

And I suspect it would ultimately have meant allowing solvent but illiquid institutions (and countries) to fail. That is a bit further than I would be willing to go( I AGREE ).

*Bear Stearns excepted. Bear didn’t participate in the equity injection.
** Lending here should be read as shorthand for all credit exposure, even if it isn’t structured as a loan. And no doubt one complication of a plan based on “recapitalization from Lehman’s creditors” was that a lot of Lehman’s creditors had lent on a secured basis, and thus had little direct exposure to Lehman (though lots of exposure to a firesale of Lehman’s assets in the secondary market).
Relitigating 1998 …"

I agree with Setser, but I also agree that LTCM did add to the belief about implicit and explicit government guarantees. Whatever happened in Russia or Brazil or Mexico, our government was not going to let a Calling Run occur here. They were probably wise with LTCM.

I've concluded that we need a LOLR or final guarantor in order to prevent a Calling Run. Like the FDIC, its terms should be clear from the outset. The hope would be that it would allow the time for deals to unwind without inducing a panic. Implementation of Bagehot's Principles would help solve this problem, and possibly even rid us of it.

"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.

"The TARP is no longer the TARP. It the TERP. That’s Troubled Equity Relief Program."

From Alphaville, a rechristening of sorts:

"Hank Paulson, revisionist.

Not to be confused with the Moral Hazard Generation Scheme.

Mortgage assets aren’t even going to be bought anymore. This is revisionism of a grand scale and we don’t imagine congress will be pleased. We don’t want to spoil the fun though. Excepts of the revised TARP plan and its redacted history, courtesy of the Treasury Secretary:
Implementing the Financial Rescue Package

More recently, we have also taken extraordinary steps to support our financial markets and financial institutions. As credit markets froze in mid-September, the Administration asked Congress for broad tools and flexibility to rescue the financial system. We asked for $700 billion to purchase troubled assets from financial institutions. At the time, we believed that would be the most effective means of getting credit flowing again.

During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets - our initial focus - would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.

Of course, before that time, the only instances in which Treasury had taken equity positions was in rescuing a failing institution. Both the preferred stock purchase agreement for Fannie Mae and Freddie Mac, and the Federal Reserve’s secured lending facility for AIG came with significant taxpayer protections and conditions.

Until earlier this week.

As we planned a capital purchase plan to support the overall financial system by strengthening balance sheets of a broad array of healthy banks, the terms had to be designed to encourage broad participation, balanced to ensure appropriate taxpayer protection and not impede the flow of private capital.

Onto the really important part:

Priorities for Remaining TARP Funds

We have evaluated options for most effectively deploying the remaining TARP funds, and have identified three critical priorities. First, we must continue to reinforce the stability of the financial system, so that banks and other institutions critical to the provision of credit are able to support economic recovery and growth. Although the financial system has stabilized, both banks and non-banks may well need more capital given their troubled asset holdings, projections for continued high rates of foreclosures and stagnant U.S. and world economic conditions. Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit. Third, we continue to explore ways to reduce the risk of foreclosure.

Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets."

Here's my comment:

Posted by Don the libertarian Democrat [report]

"Not to be confused with the Moral Hazard Generation Scheme.'
I'm not confused. That's exactly what T(A)(E)RP is.

"The cost of the Lehman failure made clear to world leaders the cost of allowing a major broker-dealer bank to go under."

James Suroweicki with a post I completely agree with:

"This gets at, in a way, what the George Mason professor David Schleicher said in an e-mail to Felix Salmon a few weeks ago:

A lack of a Lehman bailout only reduces moral hazard if investors think it is a preview of future actions. But the failure to bail out Lehman has been blamed throughout the world press and by world leaders (see, e.g., Lagarde in France) as the cause of the world-wide credit crisis. The cost of the Lehman failure made clear to world leaders the cost of allowing a major broker-dealer bank to go under. Because it is widely considered a mistake (whether or not it actually was one), the Lehman non-bailout makes a bailout for the next major financial institution more likely. Hence, moral hazard was increased, not decreased by the decision not to bailout Lehman.

Schleicher might not extend his argument to a non-financial institution like G.M. But I think it’s clear that the failure to save Lehman now makes it seem more important—to policymakers and to market participants—to save the automakers. The Lehman collapse: it is the gift that just keeps giving."

Absolutely ( One of Tyler Cowen's Irritating Words ) .

What I would add is that it showed what the markets and investors were counting on.

Here's my comment on Felix's blog:

Posted: Oct 24 2008 6:10pm ET

"People like Carney, then, who care deeply about moral hazard, should probably wish that Lehman had been bailed out, rather than be happy that it wasn't."

That's my position,and I believe that moral hazard, or immoral hazard, is the main, although not only, culprit, that has led us to this point. The problem of implicit and explicit government guarantees and other problems like transparency and collateral were already apparent, we didn't need this awful mess to make the obvious cataclysmic.

Also, given the worldwide repercussions and ripples going forward, we surely didn't need so many people who can hardly afford it paying for this awful lesson.

Here's my reply on John Carney's blog:

Don the libertarian Democrat (URL) said:

Oct. 27, 1:42 AM

"While the apparent adoption of a no more bank failures policy will indeed have serious costs—banks will make riskier loans and engage in riskier trades, investors and counterparties will be less vigilant, and resources that could be used productively will be diverted into the perceived safety of government sponsored banking—these would all have been worse if the government had bailed out Lehman Brothers.'

It's just the opposite. Since we've seen the avalanche caused by Lehman, it won't be allowed to happen again. As for Paulson, he's engaging in CYA, not serious analysis. Besides, in the end, what matters is the cost to the taxpayer. You need to show that intervening after Lehman will be less expensive than intervening at Lehman. Surely the amount spent by the government matters in the end.

"remind me again who’s not on the list. "

Paul Kedrosky comes around on TARP:

"With news tonight that Treasury is once again looking at expanding the list of companies in which it takes equity stakes, I have to confess to shaking my head a little. According to the WSJ, Treasury is mulling taking stakes in “bond insurers and specialty finance firms such as General Electric Co.'s GE Capital unit, CIT Group Inc. and others”.

So, now it’s banks, insurance firms, bond insurers, and miscellaneous finance firms. With auto companies almost certain to get bailed out eventually, remind me again who’s not on the list."

Here's my comment:

I knew that it wouldn't take too long to get you on our side. These guys can't stop. It's just like moral hazard. Once you let the first one or two go, you can't come up with decent enough reasons to exclude people, and you've already compromised, so why not revel in it?

"Natural and understandable, certainly. But also most unwise and dangerous. This is how we got into this mess in the first place."

Willem Buiter with an interesting post on FT about moral hazard, which I hold to be the main problem in this whole crisis:

"Not quite. Sure, the boom looks like the right time to worry about moral hazard and to create the right legal and regulatory incentives to encourage appropriate risk taking. The problem with this recommendation is that it ignores the reality of the political economy of legal and regulatory reform of the financial sector. During financial boom years, the financial sector is rolling in resources and flush with influence. It can buy off, stop or sabotage all attempts at serious reform. The only time the authorities have both the means and the incentives to pursue far-reaching reform of the financial sector is when the financial sector is on its uppers - down and all but out. That means now, when the furies of financial crisis are howling around us.

As regards the two central objectives of establishing the correct incentives for appropriate risk taking (moral hazard, in the loose way in which this phrase is used in the debate) and mitigating the immediate recession, it makes no sense to have a lexicographic preference ordering. Houses on fire provide cute images, but they don’t capture the reality of the choices that have to be made. So the preference ordering between addressing the immediate crisis and moral hazard should not be lexicographic, with the immediate crisis in pole position. A little deeper or longer crisis can be acceptable in exchange for a material improvement in moral hazard.

In addition, Charles Goodhart, Martin Wolf and countless others overstate the extent to which the two objectives of immediate crisis mitigation and addressing moral hazard are in conflict with each other in practice. Often the same quantum of solace can be given to the crisis-hit economy in a number of different ways, some of which are vastly superior as regards their impact on long-term incentives. I will illustrate this with ten examples of what to do and what not to do."

Read the whole post, as he's infinitely more knowledgeable than me. But here's my intrepid comment:

“I hope these ten examples make it clear that we can fight moral hazard and the creation of bad incentives for future excessive risk taking by financial institutions and by all participants in the financial intermediation process, without undermining the effectiveness of efforts to prevent the recurrence of the Great Depression of the 1930s. A crisis is the best time, indeed the only time, to address moral hazard and other perverse incentives in the financial intermediation system.

The time to deal with moral hazard is now, in every action, every policy measure and every initiative taken to address the immediate crisis.”

Your one of my favorite commentators,and you can hope all you want.But with 1,3,4,5,8,9, and 10, you’ve shown that the moral hazard was ignored in practice. At this point, moral hazard means nothing. If the moral hazard were upheld, no one would think it was because of moral hazard. They would simply think that the government had made a fickle and stupid decision to draw the line here and now. Besides, actions matter, and people are now making decisions on those actions, so that moral hazard will be seen not as principled, but arbitrary.

For moral hazard to work, you need to nip the problem in the bud, otherwise it gains its own momentum. It’s too late this time, and stemming government intervention in a crisis is nearly impossible. That’s when voters demand action.

The time to deal with moral hazard is during calmer times, by putting out a clear set of tripwires and actually fulfilling them.

Again, it’s like value investing. The place that you should really be scared and focus on regulations and moral hazard is during the good times. It must work for some, because value investing has worked well for a lot of serious investors who manage to survive crises and even make money during them.

Posted by: Don the libertarian Democrat | November 3rd, 2008 at 3:11 am

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:

"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.