As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem, not the unregulated hedge funds

TO BE NOTED: From the NY Times:

Talking Business

Hedge Fund Manager’s Farewell

By JOE NOCERA

Two weeks from now, a seven-year-old hedge fund called Alson Capital Partners will return around $800 million to its investors, and shut its doors for good.

The fund was founded and managed by Neil Barsky, 51, a former Wall Street Journal reporter-turned-Morgan Stanley analyst, who started his first hedge fund in 1998, just as the “hedge fund decade” was gaining steam. He was an old-fashioned stock picker who ran Alson Capital as a classic “long-short” stock fund, meaning that he bought companies he thought had good long-term prospects, while shorting companies he thought were likely to fall off the cliff. At its peak, Alson Capital had $3.5 billion under management, charged a 1.5 percent management fee, took 20 percent of the profits, and, when you include Mr. Barsky’s predecessor fund, produced compounded annualized returns of 12.11 percent a year. It’s fair to say he’s made a pretty penny.

Mr. Barsky is also a source of mine. In the decade or so that I’ve known him, I was able to quote him by name only once. As he explained to me recently, hedge fund managers who become too visible can make their investors wonder, “Why are you spending all your time on TV when you should be managing my money?” But he was one of the people I turned to when I wanted to learn what was really going on in the market. He is blunt, sardonic, funny and passionate, an insider who never lost his outsider’s perspective.

So when I read that he was quitting, I went to see him. I was hoping he would be willing to reflect on his life and times as a hedge fund manager, on the record this time. Happily, he was.

•

A bit of context first. For all the talk these last few years about the risks to investors of “secretive, unregulated” hedge funds, they certainly haven’t turned out to be the big problem, have they? Like most hedge funds, Alson Capital had a rough year in 2008, down more than 20 percent. Indeed, thousands of hedge funds lost, in the aggregate, hundreds of billions of dollars last year, and hundreds have shut down. But nobody in government is calling for a hedge fund bailout because hedge funds losses, however painful to investors, don’t create systemic risks to the nation’s financial apparatus. As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem, not the unregulated hedge funds.

Why did all the fear about hedge funds turn out to be unjustified? One reason is that most hedge funds didn’t have the kind of 30-1 leverage ratios that the big banks had. Mr. Barsky’s fund, for instance, didn’t need much leverage to carry out his long-short strategy. But even if he had wanted to “lever up,” as they say, his prime broker — that is, the investment bank that did his back-office work — probably wouldn’t have let him.

In a wonderful irony, the banks and investment banks that were themselves drowning in debt were fearful of allowing their hedge fund clients to carry too much debt. They still remembered Long Term Capital Management, a hedge fund that a decade earlier had, indeed, brought the financial system to the brink because of its extreme leverage.

The second reason is that, while hedge fund managers could make extraordinary sums, they had far fewer incentives than Wall Street traders to take truly insane risks. “Ninety percent of my net worth was in the fund,” said Mr. Barsky, and that is true of most hedge fund managers. Wall Street traders got rich by making deals that brought short-term profits, even if they “blew up” later. Hedge fund managers who blew up hurt not only their investors but themselves. “As long as the hedge fund manager has his own capital in the fund, the risk equation is different,” Mr. Barsky said.

Although his fund lost money in 2008, it did not blow up; as he put it, the 20 percent loss was “not a disaster but not good.” Although he was forced to make redemptions to investors who bailed out, enough remained that he could have stayed in business. What really caused him to exit the hedge fund business is that he felt ground down by the relentlessness of the job.

“When you manage a hedge fund,” Mr. Barsky said, “the cost is the incredible stress you endure. You can never escape it. You are never free. The thing that is different about running a hedge fund is that your investors own you.”

The goal of a hedge fund manager is not to beat an index, as it is for a mutual fund manager, but to generate positive returns no matter what the market is doing. Failure to do so would invariably mean redemptions, and could often mean the end of the business. “Hedge funds are fragile,” Mr. Barsky said. Over the years, I could always tell when Mr. Barsky was feeling especially stressed; he did not hide it well.

He was also tired of the ways the business had changed. “When I first started in 1998, we used to send out quarterly numbers. Now investors want weekly numbers. Professor Louis Lowenstein” — the iconoclastic and recently deceased Columbia University business law professor — “has a great line in one of his books: ‘You manage what you measure.’ ”

Mr. Barsky shrugged, as if to say: don’t feel sorry for me. “That’s life,” he said. “None of us should ever lose sight of the fact that we were in one of the most profitable industries ever. I’m just saying it became a little less fun. And last year was no fun at all.”

•

Finally, though, Mr. Barsky felt that staying in business would mean having to operate in an investing environment that he no longer quite understood. Making macro bets about the economy was suddenly more important than individual stock picking. And that wasn’t his strength. Besides, at 51, he felt he had another act left in him, and he wanted to find out where life might take him if he were no longer in the business of running money, particularly in the arena of public policy, which fascinates him. “So,” he concluded, “giving people their money back was the best course for everyone.”

Although Mr. Barsky has clearly gotten rich, he was surprisingly clear-eyed about the societal imbalances of hedge fund mania. The industry, he told me, “was part of this huge trend towards the celebration of wealth. Hedge fund managers overearned. It just became too easy. There has been a massive misallocation of human resources. I have so many smart guys here who were making seven figures. And I think it is a fair question to ask: what would they have been doing in 1948 — going into the foreign service? If Obama does anything, the best thing he could do is change a generation’s values.”

He continued: “I have a friend whose son is a senior at Princeton. She said all his friends want to work for Goldman Sachs.” He added, “We have an overground railroad to finance. It is not the best way for a society to be run.”

One of the things that struck him when he first started working on Wall Street, he said, was “how compensation-oriented Wall Street is. When I was a journalist, I could get rewarded in 100 ways, including being on Page 1. Wall Street is the other extreme. There is a singular focus on compensation that is simple, it is clean, but ultimately it is unhealthy.” He thought the outcry over the Merrill bonuses was helping the rest of the country see Wall Street’s skewed priorities more clearly.

Earlier in his career, while still at Morgan Stanley, Mr. Barsky helped edit “Buffett: The Making of an American Capitalist,” written by his good friend, the writer Roger Lowenstein (who is also Louis Lowenstein’s son). As he talked about that experience, I asked him if he had modeled his own investing style on Warren Buffett. He let out a small chuckle.

Then he stood up and walked over to his desk, where he showed me two framed letters, one he had sent to Mr. Buffett, and the Oracle of Omaha’s reply. They were written in the fall of 2000, shortly after Viacom had spun off its Blockbuster unit. Mr. Barsky had bought the stock — and then had written to Mr. Buffett suggesting that he buy the company.

Mr. Buffett sent back a one-sentence reply: “I’ve thought about the business a lot but have never been able to come up with a conviction as to where the industry will be in 10 years.”

“Ten years!” Mr. Barsky said. “I think of myself as a long-term investor and I have a two- or three-year horizon.” He shook his head. “In addition to an outsize intellect, Buffett has something that very few investors have. He has a temperament that makes him suitable to being a great long-term investor.”

“I don’t feel a sense of defeat,” Mr. Barsky said, as I was preparing to leave. “We have done well by investors and by our employees. We comported ourselves ethically. Three months ago,” he added, “I started to read books on Buddhism. What I learned is how much of what we do is ego-driven. Why do I feel I have to be the best hedge fund manager? I started to have perspective. You probably want your hedge fund manager to eat raw meat. But as we unwind, I’m pretty comfortable with my mind-set.”

Sounds like he’s getting out just in time."

Congress would be unable to resist the urge to start making banking decisions once they agreed to put up $700 billion to help save the banking system

TO BE NOTED:

---

May 13, 2009, 1:06 pm

Why Governments Shouldn’t Run Banks

By Joe Nocera

The most depressing story I’ve read in awhile was one in Tuesday’s New York Times, entitled “Workers Pressure Banks To Keep Clothier’s U.S. Plants Open.” The bank in question is Well Fargo, which of course was the unhappy recipient of government bailout funds, to the tune of $25 billion — money it claims it never needed and now cannot give back. The clothier in question is Hartmarx, which makes Hart Schaffner & Mark as well as Hickey Freeman suits.

Hartmarx is bankrupt. Wells Fargo, its banker, does not believe that lending it more money makes any sense since, as it put it in a statement, “it has no reasonable likelihood of being repaid.” Companies in this position are usually liquidated. But Hartmarx is one of the few remaining clothing companies that makes its suits in America, employing 3,600 mostly unionized workers.

So naturally, the union is pressing Wells Fargo to find a buyer instead of overseeing a liquidation — a buyer, no less, who will keep the company’s U.S. operations going (even though, presumably, the union cost structure is one reason the company is broke). What is the union’s leverage? Why, of course: it is the fact that Wells Fargo took bailout money. The union argues that because Wells Fargo is a ward of the Treasury Department, it has a responsibility to do what’s right for the country, and not just for the bank. And it has a staunch ally in Representative Phil Hare of Illinois, who once worked at Hartmarx, and vowed that if Wells Fargo allowed the company to be liquidated he would be “their worst nightmare.”

“You need to stand up for the American worker, like Congress stood up for the banks when times were tough.”

This is exactly what many conservatives feared when the bailout bill was pushed through last fall — that Congress would be unable to resist the urge to start making banking decisions once they agreed to put up $700 billion to help save the banking system. But while it’s one thing to try to rein in executive compensation (which, frankly, I don’t have a problem with), it is quite another to begin making lending demands. Let’s face it: banks got into this fix in large part because they made sloppy, ill-advised lending decisions, giving money to people, and companies, that couldn’t pay it back. In effect, the union and Mr. Hare are now demanding that Wells Fargo make, well, a sloppy, ill-advised lending decision. The purpose of the loan might be different than it was during the bubble, but the result will be the same: more money will be lost, and the bank will be weaker.

There are, without question, thousands of cases where small businesses that are perfectly healthy are seeing their credit lines frozen or withdrawn by suddenly frightened bankers. But this isn’t such a case. Hartmarx is a crippled company. Wells Fargo’s needs to make a business decision that will help make the bank healthier not weaker. If Mr. Hare gets his way, and if other representatives start making similar demands — as they surely will — the bailout money is going to wind up being a noose around the necks of the banking system."

It is almost a zero-sum game: the government or the bondholders?

TO BE NOTED: From the NY Times:

"Talking Business
Same Data, Conflicting Forecasts

By JOE NOCERA

So where were we?

In the month since I last wrote in this space, there has been a surge of financial optimism. Banks that are supposed to be in deep trouble have reported profits (though there were a few too many accounting gimmicks for my taste). Some of them, like Goldman Sachs and JPMorgan Chase, are talking about wanting to give back their government bailout money. Bank stocks, moribund not so long ago, have been rising a bit. Other economic indicators suggest that, if the economy hasn’t exactly turned around, at least the pace of decline is slowing. There has been talk of “green shoots” from the Federal Reserve chairman, Ben Bernanke, and “glimmers of hope” from President Obama.

So perhaps the better question to ask this week is where are we? Can we come out of our financial fallout shelters yet, or are there more economic bombs still to drop? Will the results of the stress tests, due out next week, make things better or worse? Have the Obama administration and the Federal Reserve managed to stop the bleeding? Can we start breathing a little easier?

Because Wednesday was the 100th day of the Obama presidency, you could scarcely turn around without bumping into people at a conference or symposium asking, more or less, those same questions. This week, I dropped in on a few of them.

•

Wednesday morning, the Regency Hotel, New York. A liberal group called the Franklin and Eleanor Roosevelt Institute is holding a breakfast in which the featured speakers are the Columbia University economist (and Nobel laureate) Joseph Stiglitz, the M.I.T. economist (and Nobel laureate) Robert Solow, and the former Senate Banking Committee chief economist, Robert Johnson.

Mr. Stiglitz, though a supporter of the president, has been a vocal critic of the administration’s response to the banking crisis, and he doesn’t let up here. “Obviously, I think there is a better way to deal with the crisis,” he says. “Banks made bad loans, and the question is: who is going to pay for those losses? It is almost a zero-sum game: the government or the bondholders?”

He goes on to suggest that the government should stop trying to protect bondholders and instead force them to convert their debt into equity. This would help bolster the banks’ capital without tapping any further into taxpayers’ funds. It is also an idea that the Treasury Department stiffly opposes, fearing that it will create a new round of bank panic, and make it even harder for banks to raise private capital.

Mr. Solow, meanwhile, criticizes the stimulus package as too small. “The drop in consumer spending was too big, and probably couldn’t be filled with a good $800 billion package, and this one was festooned with things that weren’t going to stimulate spending soon.”

Later, at a brief press conference, I ask Mr. Stiglitz how he would grade the new administration’s efforts. To my surprise, he says, “Compared to what went before, I would say it’s an A plus plus.” Then he lapses back into his complaint about the administration’s coddling of bondholders. I then put the same question to Mr. Solow, who says he thinks the administration has done “extraordinarily well” — and then complains that it should be doing more for individual homeowners. Do they really mean it? Or is that “A plus plus” a form of political grade inflation?

•

Wednesday afternoon, the Princeton Club, New York. The American Society of Magazine Editors is holding a luncheon panel on the financial crisis, with Allan Sloan of Fortune, Mark Zandi of Moody’s Economy.com, and, er, me. Mr. Zandi is practically overflowing with optimism. “I think the totality of the policy response has been excellent,” he tells me after our panel has finished. “Aggressive. Creative. With a few tweaks it will ultimately work.” He predicts that the stimulus will kick in this summer — though he says that he would have favored a tax holiday. (“If they had eliminated the payroll tax for the second half of 2009,” he says, “it would have been a tremendous boost for both employers and employees.”) He sees a “massive refinancing boom” under way, which will save homeowners $25 billion on mortgage costs, and might prevent a few foreclosures. He thinks the stress test results — according to news accounts, six banks will require more capital — will bring about renewed confidence in the banking system because we’ll finally be able to see what the truth is. He thinks Treasury Secretary Timothy Geithner “has found his footing.”

On the way home, I pick up the latest copy of The Economist. It warns against “the perils of optimism,” and suggests that if we become too complacent about the prospect of better times, it will “hinder recovery and block policies to protect against a further plunge into the depths.” Sigh.

•

Thursday morning, Drexel University, Philadelphia. A group called the Global Interdependence Center is holding a half-day conference on the financial crisis. First up, Christopher Whalen of Institutional Risk Analytics. He has been a scathing critic of the banks. “My friends are all telling their clients the worst is over, it is time to buy,” he says. “My response is: what are you buying?”

He adds that bondholders need to take some pain, and echoes Mr. Stiglitz’s proposal to make the bondholders convert their debt to equity. A month ago, nobody was talking about this. Now it has become the idea du jour.

Nancy A. Bush, a longtime bank analyst, says that the Troubled Asset Relief Program is “the most destructive thing I have ever seen. The government has ensured mediocrity in the banking industry. It has done enormous damage in the eyes of investors, who are no longer sure that a bank is a safe investment anymore.” She calls it the TARP Trap.

Just then, the moderator takes the stage to announce that Chrysler has filed for bankruptcy. So much for optimism.

Next panel: Robert A. Eisenbeis of Cumberland Advisors gives a talk titled “Are things really that bad?” His answer is, no. “We are far from the Great Depression,” he declares, and he has the charts to prove it. When measures like gross domestic product and corporate profits are charted against other recessions, this one looks pretty bad. But when they are charted against the Great Depression, they look like a piffle. In the depths of the Depression, for instance, G.D.P. dropped by a staggering 50 percent, compared with the current drop of 2 percent or so. “The people who are fear-mongering are not looking at the data,” Mr. Eisenbeis concludes.

He is followed by a funny, fast-talking woman named Diane Swonk, the chief economist at Mesirow Financial. “We’ve gone from a sense of free fall in the fourth quarter of 2008 to a point where we have pulled the ripcord and the parachute has opened. But we don’t know where we are going to land, or whether it is going to be in enemy territory,” she says. “There are three areas where consumer spending has increased,” she remarks at another point. “Guns. Condoms. And alcohol.” In between jokes, she says the deleveraging of America is going to be a painful process.

Finally, the former St. Louis Federal Reserve president William Poole, now a senior fellow at the Cato Institute, gives a keynote speech arguing “too big too fail” is a concept that has done enormous harm. He wants to see some market discipline imposed on the banks — so that if they mess up again, we won’t have to come to their rescue. Who can disagree?

•

Thursday evening, the Metropolitan Museum, New York. The big guns are out tonight, on a panel sponsored by The New York Review of Books and PEN World Voices: Niall Ferguson of Harvard, Paul Krugman of Princeton (and The New York Times), Nouriel Roubini of New York University, former Senator Bill Bradley and George Soros, among others. The Met’s big auditorium is packed.

This is doom-and-gloom central. Lots of talk about zombie banks, failures to understand history, regulatory foolishness. Mr. Bradley, who speaks first, suggests that if the government’s plan to save the banks doesn’t work, it should simply buy Citibank — “its current market cap is about $17 billion,” he said — clean it up, and spin it off to the American people in a rights offering. Mr. Ferguson, a provocative historian, keeps saying that the United States is becoming akin to a Latin American economy: “At what point do people stop believing in the dollar as a reserve currency?” he asks ominously.

“The scale of the crisis has overwhelmed the response,” Mr. Krugman says. To the extent there are green shoots, he added, “it means that things are getting worse more slowly.” Mr. Roubini practically scoffs at the notion that we might see positive economic growth in the second half of the year. Mr. Soros says that “we are currently facing a deflationary situation. But when credit restarts, the fear of deflation will be replaced by fear of inflation, and there will be pressure for interest rates to rise.” Something to look forward to, I suppose.

I can’t say that I left the Metropolitan Museum with any more clarity than when I began my little symposia tour. I’d heard some good ideas, and cheery news among the dire forecasts. What it did cause me to realize is that all these smart economists and forecasters are looking at the same set of data, and coming to radically different conclusions based on their politics, their temperament and their idiosyncratic reading of history. Just like the rest of us.

Next week, the results of the stress tests will be unveiled, and we’ll see it all over again. Some of the same people I saw on stage this week will say the tests are a whitewash, while others will claim that they’re an important step on the road to recovery. Both sides will marshal persuasive data and strong arguments, providing plenty of fodder for the next round of conferences.

At least that much is certain."

everybody had an opinion this week about the government’s new toxic asset plan, most of them in wild conflict with one another

From the NY Times:

"This Time, Geithner’s Plan for Banks Makes Sense

By JOE NOCERA

Will it work?

Isn’t that the only thing that matters at this point? The big, new plan to solve the banks’ toxic assets problem, unveiled earlier this week by Treasury Secretary Timothy Geithner, has come under intense scrutiny in the blogosphere and elsewhere. The plan would create incentives for private investors to put up small amounts of equity, side by side with the government, to buy toxic assets from the banks’ balance sheets. To sweeten the deal, the government will also be putting in debt, at leverage ratios that could reach as high as six to one — and will provide guarantees against most of the potential losses.

The Treasury estimates that the program “will generate $500 billion in purchasing power to buy legacy assets — with the potential to expand to $1 trillion over time.” (And yes, “legacy assets” is the new euphemism for toxic assets.)

Even before the program was officially unveiled, critics were all over it, from every imaginable point of view. Paul Krugman, The New York Times Op-Ed columnist, described the plan as “cash for trash,” and declared that “it fills me with a sense of despair.” There was anger on Main Street that the government debt amounted to a subsidy to help rich hedge fund guys get even richer.

Was the new program really an attempt to find “price discovery” for these assets — as the government claimed — or was it instead an effort to paper over, using taxpayer money, the true dimensions of the losses? And wasn’t leverage what got us into this mess in the first place? How was piling on more debt going to help solve the crisis?

People who believe that easing certain accounting rules, like mark-to-market, is the best solution were dismayed that the government wasn’t doing that instead. People who believe that nationalizing the banks is the best solution were dismayed that the government wasn’t just biting the bullet and taking over troubled banks.

And on and on.

Having spent the better part of this week mucking around in the details of the new plan, I concluded, somewhat to my surprise, that it might well work. By this, I certainly don’t mean that it will, all by itself, revive the economy. But I think it could put a real floor on the price of the bad assets — critically important to stabilizing the banks — and change the market psychology so that securitized assets can begin to trade again, which is important to get credit flowing. And it will give regulators a far sounder basis to ask Congress for more money to recapitalize banks — or take them over, if it comes to that.

As for the complaint that it will make rich guys richer, well, you can’t win ’em all.

•

“We need to face up to it sooner or later,” said Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation. By “it,” Ms. Bair was referring to the losses still embedded on the banks’ balance sheets. To her, the Public-Private Investment Program, as the feds have labeled it, is most definitely not an attempt to disguise losses. It is, instead, an effort to shine a clear, bright light on them. “A necessary cleansing process,” says Ms. Bair.

The P.P.I.P. (inside the beltway, they have already started calling it P-pip) is, in fact, two separate programs. One deals with the kind of mortgage-backed securities that we’ve all come to think of as toxic assets. The other deals with loans that have not been securitized — for things like commercial real estate, or residential mortgages or small businesses — that banks hold on their books. The former program will be run by Treasury and the Federal Reserve; the latter will be managed primarily by the F.D.I.C.

As it turns out — and this was also something of a surprise — there is a consensus, both in Washington and on Wall Street, that mortgage-backed securities have been marked down to levels that have started to approach reality. These securities come under mark-to-market rules, so they have to be marked down as they decline in value. They are the primary reason the banks have had to take write-down after write-down, decimating their capital.

Still, to get investors to buy those assets — and get a market flowing again — they still need some leverage to bolster potential returns. Critics complain that the government-provided debt amounts to a bribe to get investors to purchase the assets at inflated prices. But I don’t think that’s what’s really going on. Instead, it appears that the government is trying to return some normalcy to the workings of the market.

“There is something called the leverage cycle,” said John Geanakoplis, an economics professor at Yale. During the bubble, he continued, when the country was awash in debt, toxic assets rated AAA were leveraged at an outlandish 16-to-1 ratio. That leverage was the primary reason those assets made such big returns. Now we’re in the opposite end of the cycle. There is no leverage at all available — yet without it, the return on these assets would simply be too small to make them interesting enough for investors to purchase. The only entity capable of injecting leverage in the system is the government.

It makes perfect sense that the government would want to supply that leverage, though certainly not at the extreme 16-to-1 ratio that characterized the bubble. Though the government will go as high as six to one, what I hear is that most of the assets will have less leverage than that. If the program works — that is, if the assets begin to make money for investors — it could draw more private lenders into the marketplace. Suddenly the market for these assets would become liquid again, and banks could mark the assets remaining on their books with some real confidence. Isn’t that what we want?

The second surprise, to me, is that the whole loan program is in some ways more important than the mortgage-backed securities program. The reason is that, unlike securitized loans, these assets do not have to be marked to market; indeed, as long as the borrowers are current on their loan payments, they don’t have to be marked down at all. And yet it is obvious that many such loans are in deep trouble — and the banks haven’t faced up to that yet.

All over the country, businesses like real estate development companies are using loans they took out in good times to finish projects that are going to be problematic, to say the least. Chances are high that those loans are unlikely to ever be paid back in full. I heard one story this week about a borrower who actually approached the bank and laid out his dilemma. The bank’s response? It granted an extension of the loan for months — with no fees. That is akin to what the Japanese banks did during their decade of insolvency: they rolled over loans to borrowers who they knew could never pay the money back, in order to avoid taking losses that would wipe out the banks’ capital.

There are plenty of investors who would be happy to take bundles of, say, commercial real estate loans off the hands of the banks and work them out — but only if they can get them for a price that makes sense. Good money can be made both for the investors and for the government, which, lest we forget, will get 50 percent of the upside. But the banks are going to be extremely reluctant to give up those loans, because by doing so, they would have to acknowledge the losses on their books.

That is why it is so important that the F.D.I.C. is managing this program. However much banks may not want to sell into the program (and for all the government’s insistence that the program is voluntary) it will be nearly impossible for a bank to resist the entreaties of its primary regulator. All indications are that Ms. Bair and her crew are going to use the program as a tool to force the banks to come clean on the health of their loans.

Once this process gets under way, does it mean that banks are likely to need additional capital? You bet it does. There are going to be new holes in balance sheets, and they’ll need to be plugged. But in the best of all possible worlds (a guy can dream, can’t he?), private capital will come in because investors will finally see that those bad assets no longer constitute a bottomless pit. Even if that assumption turns out to be overly optimistic, it will be far more politically palatable for the government to recapitalize the banks — or close them down, or even take them over, if need be — knowing that we finally can value the bad assets. You really can’t nationalize a bank without being able to make an ironclad case, to the public, that it is hopelessly insolvent. The P.P.I.P. will help make such a case.

When I asked Thomas F. Steyer, the head of Farallon Capital Management, the big West Coast hedge fund, whether he thought America was acting like Japan during its lost decade, he scoffed. “We were interested in some of the assets in Japan, but whenever we asked them when they were going to start dealing with them, the answer was always ‘in two years,’ ” he replied. “Japan fell apart in 1989, and we were having those conversations in 1998 and 2000. Our country is moving on this. This administration has only been in office for a little more than two months, and they are already grappling with this.”

Is the plan perfect? Surely not. Is it guaranteed to do the trick? Of course not. But it is an effort to try something that seems to make a certain amount of intuitive sense, and could, in the best case, make our banks a little healthier and a little better able to extend credit.

It doesn’t represent the end of the crisis, not by a long shot. But it represents the beginning of something we should be applauding, not condemning: cold, hard reality."

"I’m Just a Cockeyed Optimist

By Joe Nocera

I’m not really a blogosphere kind of guy, as you may have noticed, but this sure was a blogosphere kind of week. Simon Johnson, Paul Krugman, Brad DeLong, Justin Fox, John Hempton — everybody had an opinion this week about the government’s new toxic asset plan, most of them in wild conflict with one another. And of course, in classic blogosphere fashion, most of them spent at least part of the week arguing with one another.

I was on Charlie Rose early in the week, in a panel with Mr. Krugman and my colleague Andrew Ross Sorkin. We were a moderately glum group, I must say; though the market had gone up some 7 percent that day of the Treasury announcement, we shrugged that off as irrelevant (which it mostly was), and pronounced the plan just more of the same old, same old. But then, after we got off the air, Mr. Rose brought on Tom Steyer from Farallon Capital and my friend Daniel Alpert of Westwood Capital, who were much more positive about its prospects for succeeding.

That got my attention. So I decided, for my column this week, to dig a little deeper and find out why they were so optimistic, and whether their optimism was justified. As it turns out — and somewhat to my surprise — I wound up agreeing with them.

Of course I don’t necessarily expect you to agree with them — or me. But whichever way you come down, I hope to hear from you.

My column, by the way, is going on hiatus for a month as I head off for a short book leave. I’ll try to blog a little more frequently in the interim. See you in May."

Me:

“most of them in wild conflict with one another”

I am a blogosphere kind of guy, but the commentary on PPIP was actually awful. Many people made extreme assumptions to make a point, sometimes ignoring the plain meaning of the White Paper. It was hard to say they were wrong, since their assumptions seemed implausible or ungenerous, but not impossible. They were the equivalent of arguments in philosophy that begin “Suppose you’re a brain in a vat…”.

“All indications are that Ms. Bair and her crew are going to use the program as a tool to force the banks to come clean on the health of their loans.”

“it will be far more politically palatable for the government to recapitalize the banks — or close them down, or even take them over, if need be — knowing that we finally can value the bad assets.”

That’s how I saw the program. And, mentioning the blogosphere, the Economics Of Contempt has convinced me that we need more time in order to do what we might well need to do, and that is seize a few big banks. Frankly, that’s what I’d like.

Given the constraints and assumptions that they are working under, the plan is a decent attempt. I also give it more credence given the ideas about changing the financial system that Geithner and Bernanke have recently proposed. I don’t agree with everything there as well, but it’s a hell of an improvement over what has come before.

— Don the libertarian Democrat

the Congress needs to find a better way to determine sophistication

From the NY Times:

"Sophisticated?

Joe Nocera’s excellent column on Bernie Madoff and his victims today illustrates one of the great fictions of Amercan regulation — that rich people are automatically sophisticated.

The current securities laws provide one set of rules for pubic investors, with protections and regulations. But a money manager can evade many of those rules if he markets only to so-called qualified investors. To qualify, you don’t need to know the difference between a bond and bondage, or whether revenue and profit refer to different things. You just need to have enough assets.

If you’re into fraud, the rich are obviously more attractive targets. If the revised securities laws do provide exemptions for the supposedly sophisticated, the Congress needs to find a better way to determine sophistication."

Me:

The law just says that you’re rich enough to lose money. That’s it. The reason rich people prove such easy targets for Ponzi Schemes is because they’re rich, there’s a presumption that they’re smart. At least, that’s what they want to believe, and the PS creator reinforces that.

What’s more, no one likes the idea of being left out of an exclusive club when you’re rich. Being a client of a particularly adept manager is a club that many would kill to be in. I’m already sensing the writing of a Law and Order episode about just such a scenario.

What possible test could you give these rich people? They have people to take tests for them.

Finally, to a great extent, these frauds rely on friendship and trust. What’s the test for finding friends that you can trust? I bet that loss of friendship and trust hurts people as much as the money in some cases. You might as well try introducing a test that people are ready to have children or marry. There are no tests for some aspects of life but experience.

— Don the libertarian Democrat

That would be us, the taxpayers.

From Joe Nocera:

"Is A.I.G. the Worst of Them All?

By Joe Nocera

I realize that there is a lot of competition for the title of “Rottenest Financial Institution,” but if you ask me, the American International Group should be right at the top of the list. Given that the company is about to report a $60 billion loss — and the government is going to have to devise yet another plan to keep it from defaulting — I took the opportunity this week to take a deeper look into the practices that led to its troubles.

To put it bluntly, they were shocking. But they are also extremely complicated and difficult to understand, much less explain. Suffice it to say here that A.I.G.’s credit default swaps — insuring toxic assets that soon went sour — were a form of Wall Street gamesmanship, built on bad assumptions and fueled by short-term greed. When I asked one former A.I.G. executive, Robert J. Arvinitis, what the larger economic purpose of A.I.G.’s credit default swaps were, he laughed. “The purpose was to keep the sausage factory going for the investment banks.”

My column this week is an attempt to unravel, and explain, some of A.I.G.’s seamier practices. It may be easier to get outraged at Merrill’s bonuses, or Lehman’s bankruptcy, or Bank or America’s idiotic deal-making. But you ought to put aside at least a little anger for A.I.G. No company has cost you, the taxpayer, more money. And no company deserves it less."

And:

Propping Up a House of Cards

By JOE NOCERA

Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions. The recent quarterly losses suffered by Merrill Lynch and Citigroup — “only” $15.4 billion and $8.3 billion, respectively — pale by comparison.

At the same time A.I.G. reveals its loss, the federal government is also likely to announce — yet again! — a new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. To ease the pressure even more, the Federal Reserve actually runs a facility that buys toxic assets that A.I.G. had insured. A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. Not that it’s worth very much; A.I.G. shares closed Friday at 42 cents.

Donn Vickrey, who runs the independent research firm Gradient Analytics, predicts that A.I.G. is going to cost taxpayers at least $100 billion more before it finally stabilizes, by which time the company will almost surely have been broken into pieces, with the government owning large chunks of it. A quarter of a trillion dollars, if it comes to that, is an astounding amount of money to hand over to one company to prevent it from going bust. Yet the government feels it has no choice: because of A.I.G.’s dubious business practices during the housing bubble it pretty much has the world’s financial system by the throat.

If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.

I don’t doubt this bit of conventional wisdom; after the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world’s biggest insurer to fail? Who would want to take that risk? But that doesn’t mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.

“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.

•

When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: “regulatory arbitrage” and “ratings arbitrage.” The word “arbitrage” usually means taking advantage of a price differential between two securities — a bond and stock of the same company, for instance — that are related in some way. When the word is used to describe A.I.G.’s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be “scam.”

As a huge multinational insurance company, with a storied history and a reputation for being extremely well run, A.I.G. had one of the most precious prizes in all of business: an AAA rating, held by no more than a dozen or so companies in the United States. That meant ratings agencies believed its chance of defaulting was just about zero. It also meant it could borrow more cheaply than other companies with lower ratings.

To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. “It was a way to exploit the triple A rating,” said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic.

Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price.

That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.

Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions.

The regulatory arbitrage was even seamier. A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed to use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.

How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.

•

At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.

It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.

There’s more, believe it or not. A.I.G. sold something called 2a-7 puts, which allowed money market funds to invest in risky bonds even though they are supposed to be holding only the safest commercial paper. How could they do this? A.I.G. agreed to buy back the bonds if they went bad. (Incredibly, the Securities and Exchange Commission went along with this.) A.I.G. had a securities lending program, in which it would lend securities to investors, like short-sellers, in return for cash collateral. What did it do with the money it received? Incredibly, it bought mortgage-backed securities. When the firms wanted their collateral back, it had sunk in value, thanks to A.I.G.’s foolish investment strategy. The practice has cost A.I.G. — oops, I mean American taxpayers — billions.

Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.

I asked Mr. Arvanitis, the former A.I.G. executive, if the company viewed what it had done during the bubble as a form of gaming the system. “Oh no,” he said, “they never thought of it as abuse. They thought of themselves as satisfying their customers.”

That’s either a remarkable example of the power of rationalization, or they were lying to themselves, figuring that when the house of cards finally fell, somebody else would have to clean up the mess.

That would be us, the taxpayers."

Me:

Your comment is awaiting moderation.

“or they were lying to themselves, figuring that when the house of cards finally fell, somebody else would have to clean it up.

That would be us, the taxpayers.”

This gets my vote. Of course, we keep doing it, so why shouldn’t they?

— Don the libertarian Democrat

A surprisingly common criticism of the TARP is that it didn't require banks receiving bailout money to lend to small businesses and consumers.

From the Economics Of Contempt:

"Why why shouldn't force banks to lend

A surprisingly common criticism of the TARP is that it didn't require banks receiving bailout money to lend to small businesses and consumers. Joe Nocera of the NYT penned a whole column about "the dirty little secret of the banking industry," which was that "it has no intention of using the money to make new loans."

Elizabeth Warren's TARP Oversight Panel has also criticized the Treasury for not requiring banks to lend money. For example, the Panel's second report stated:

If, as Treasury has stated, the goal of capital infusions was to increase consumer and small businesslending, why were funds not concentrated among businesses with substantial small business and consumer lending or authorized only when a financial institution presented a business plan to use the funds for small business or consumer lending?

The purpose of the equity injections was to recapitalize the banks, which were (and still are) woefully undercapitalized. Forcing them to immediately turn around and make more risky loans—and small business and consumer loans are historically risky loans—is a really stupid idea.

But don't take it from me. Take it from Richard Caballero of MIT, Anil Kashyap of Chicago, and Takeo Hoshi of UC San Diego. Their paper in the December 2008 issue of the American Economic Review, "Zombie Lending and Depressed Restructuring in Japan," examines "the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s." The paper is behind a firewall, but there's a draft version (which might differ slightly from the final version) available here. Since it's hard to understate the paper's relevance to the current criticisms of TARP, I quote at length:

This paper explores the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s. The investigation focuses on the widespread practice of Japanese banks of continuing to lend to otherwise insolvent firms. We document the prevalence of this forbearance lending and show its distorting effects on healthy firms that were competing with the impaired firms.
...
Aside from a couple of crisis periods when regulators were forced to recognize a few insolvencies and temporarily nationalize the offending banks, the banks were surprisingly unconstrained by the regulators.

The one exception is that banks had to comply (or appear to comply) with the international standards governing their minimum level of capital (the so-called Basle capital standards). This meant that when banks wanted to call in a nonperforming loan, they were likely to have to write off existing capital, which in turn pushed them up against the minimum capital levels. The fear of falling below the capital standards led many banks to continue to extend credit to insolvent borrowers, gambling that somehow these firms would recover or that the government would bail them out. Failing to roll over the loans also would have sparked public criticism that banks were worsening the recession by denying credit to needy corporations. Indeed, the government also encouraged the banks to increase their lending to small and medium-sized firms to ease the apparent “credit crunch,” especially after 1998. The continued financing, or “evergreening,” can therefore be seen as a rational response by the banks to these various pressures.
...
By keeping these unprofitable borrowers (which we call “zombies”) alive, the banks allowed them to distort competition throughout the rest of the economy. The zombies’ distortions came in many ways, including depressing market prices for their products, raising market wages by hanging on to the workers whose productivity at the current firms declined, and, more generally, congesting the markets where they participated. Effectively, the growing government liability that came from guaranteeing the deposits of banks that supported the zombies served as a very inefficient program to sustain employment. Thus, the normal competitive outcome whereby the zombies would shed workers and lose market share was thwarted. More importantly, the low prices and high wages reduce the profits and collateral that new and more productive firms could generate, thereby discouraging their entry and investment. Therefore, even solvent banks saw no particularly good lending opportunities in Japan.
...
We find that investment and employment growth for healthy firms falls as the percentage of zombies in their industry rises. Moreover, the gap in productivity between zombie and non-zombie firms rises as the percentage of zombies rises. These findings are consistent with the predictions that zombies crowd the market and that the congestion has real effects on the healthy firms in the economy. Simple extrapolations using our regression coefficients suggest that cumulative size of the distortions (in terms of investment, or employment) is substantial. For instance, compared with the hypothetical case where the prevalence of zombies in the 1990s remained at the historical average instead of rising, we find the investment was depressed between 4 and 36 percent per year (depending on the industry considered)."

And moi:

Don said...

I just read a Ricardo Caballero post in the FT where he says that we should get rid of capital standards:

http://blogs.ft.com/wolfforum/2009/01/a-capital-less-financial-system/#comments

"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'm assuming that he means that doing so will allow banks to lend instead of hoarding cash for a call. But I'll ask the question that I posted him before I read that comments were confined to experts: How does this differ from AIG? We gave AIG money so that they could weather the storm and not sell their assets at a huge loss now, but wait and sell later. The FT had Liddy saying just this in November. But what's the difference in lending them money, which pays interest, and simply cutting their capital requirements and guaranteeing their losses, which we charge a nominal insurance fee on ?

As to your main point, I'm bothered by how TARP was sold, and then changed. If recapitalizing the banks without the money being deployed was the plan, then it should have been sold that way. As an average citizen, that's not how it was sold to me. I think that many citizens, like myself, are a little battered by the arguments used to sell us a plan being one thing, and then, once sold, the plans are changed to something else.

Don the libertarian Democrat

"Given how messy all of these alternatives are, why not simply go down the nationalization route?"

The enormously talented Felix Salmon posts:

"Why Nationalization is the Best Alternative

Kevin Drum is a bit like Joe Nocera: he's reluctant to nationalize, but he doesn't really say why.

It's wise to be wary of nationalization. It should be a last resort( FIRST ), and I've gotten a sense recently that a lot of people are talking about it awfully casually( FOR 4 MONTHS ). Still, it's true that there are some benefits to nationalization, and one of them is that it allows us to avoid the problem of valuing and buying up toxic assets from troubled banks( BINGO! ). If the government owns the whole bank, then the bad stuff can be easily hived off without any kind of valuation at all, and then left to sit for a while before it's sold off -- which is what the Swedes did.
If we have to nationalize, then we have to nationalize. But we should understand the precedents before we do, and go ahead only if we have to.

The only argument I can find in here is an argument in favor of nationalization, not against it. Why should nationalization only be a last resort?( AMEN )

Let's work from an ex hypothesi assumption that a certain bank -- let's call it Citigroup -- is insolvent. This is not an unreasonable assumption, given what happened to the likes of Lehman Brothers and Washington Mutual. But I don't want to get into the details of Citi's balance sheet here: I want to ask what we should do if we've already determined that its assets, many of which fall into the "toxic" category, are significantly smaller than its liabilities.

Now the red-blooded American way of dealing with insolvent companies is bankruptcy: either Chapter 11, where the company continues as a going concern, or some kind of liquidation. For a bank, Chapter 11 is pretty much impossible, since you're not going to find anybody to provide debtor-in-possession financing to keep it going. Except the government. And if the government is in possession, then, hey, you've just nationalized the bank.( TRUE )

As for liquidation, that's not an option, because Citigroup is too big to fail. Dumping Citi's trillions of dollars of assets onto the market in a fire sale would depress asset prices worldwide so much that we'd enter a global depression, not just one in the US. ( TRUE. THE CALLING RUN WOULD PICK UP SPEED. )

So what about the bad-bank option? The government buys Citi's toxic assets, taking them off Citi's balance sheet, and leaving behind a healthy bank. Sounds good -- except remember that, ex hypothesi, Citi is insolvent. If the government buys the toxic assets for what they're worth, then that doesn't help, since the amount of money that Citi gets in return isn't enough to pay off the loans that Citi essentially took out against those assets. In housing parlance, Citi's underwater on its recourse loan, and when you're underwater on a recourse loan, selling the house at its market price doesn't make you any less insolvent.

So maybe the government deliberately overpays for the toxic waste( WHICH IS WHAT WILL HAPPEN )? That's a recipe for opacity, and it's very hard to systematize. If you're willing to pay 150% of market prices for Citi's bad assets, shouldn't you do that for everybody else's, too? Even perfectly healthy banks which don't need the money? Or do you just decide that Citi, because it's too big to fail, is going to get a big handout which no one else qualifies for? If you do make that determination, why not just go the whole hog and write a check to the bank outright, and put it straight into Tier 1 equity? Oh, wait, you can't do that, because that's called buying equity, and if you spent that much money on Citi's equity, you'd end up with a majority stake in the bank -- which is nationalization. ( TRUE )

Essentially, any government purchase of toxic assets can be split into two components: the market price, and a subsidy. If the subsidy is greater than half the market capitalization of the bank, and the government doesn't end up controlling the bank, then there's something very fishy going on indeed.( TRUE )

It's worth bearing in mind here the first TARP proposal, which envisaged the government buying up bad assets at some kind of long-term value price which was greater than the distressed market price. That never happened, the bad assets stayed on the banks' balance sheets -- and then, in the fourth quarter, we saw some absolutely monster write-downs from those loans' end-September marks, including $15 billion at Merrill Lynch alone. You still think that the end-September marks were distressed bargain-basement prices?( THAT'S BEEN MY POINT )

Then there's the insurance proposal -- which is cropping up now in the UK after being rolled out in an ad hoc fashion with Citi and BofA here in the US. Robert Peston explains how it works:

Our biggest banks would identify their bad loans and foolish investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets.
But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.

This has all the same problems of the create-a-bad-bank idea: the government still has to come up with a price (a/k/a expected default rate) for the bad assets, and there will still be a huge implicit subsidy, in many cases greater than the bank's market capitalization, for any institution which takes the government up on its offer. After all, the mark-to-market value of the insurer is certain to be massively negative, otherwise Warren Buffett would have set up something like this already on a for-profit basis.( TRUE )

Finally, the government could take the Irish approach, and target the banks' liabilities rather than their assets. Keep the assets on the banks' balance sheets, and simply guarantee all of their unsecured debts. After all, there's a government guarantee on a lot of the unsecured debt already, and there has been for years: it's called the FDIC deposit guarantee.( TRUE )

This is basically a massive bailout for all the banks' bondholders, who thought they were buying risky leveraged single-A bank debt, and who will suddenly find it backed by the full faith and credit of the US government. At this point, it doesn't matter if a bank is insolvent, because it can roll over its debt indefinitely, since that debt has a government guarantee. Indeed, it should be quite happy to lever up as much as it's allowed, and spend its cheap new funds on all manner of risky assets, since that gives shareholders the best chance of making lots of money and recovering some of the billions of dollars that they have lost. It's akin to taking a man with a large debt, pointing him in the direction of a casino, and telling him he has unlimited credit to try and pay that debt off.( YIKES )

The best way for the government to avoid the obvious outcome in such a situation is for the government to take over and run the bank: nationalization. Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well -- i.e., ownership.( TRUE )

Given how messy all of these alternatives are, why not simply go down the nationalization route? It's transparent and easy to understand( I'VE SAID THIS FROM THE BEGINNING. ): if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too.

So I'm interested in what Kevin means when he talks about a situation where "we have to nationalize". Does he mean any situation where a too-big-to-fail bank is insolvent? Or are there further criteria he has in mind?"

Well played! However, I believe that Drum will go for nationlization.

"the problem is not the fact that so many subprime mortgages are trapped in securitization pools."

Joe Nocera in the NY Times on the problem of bunched mortgages, and how to renegotiate them:

"The F.D.I.C., however, begs to differ. As you’ll recall, the agency took over the California bank, IndyMac, which had, as Ms. Bair put it, “a pretty impaired portfolio.” It has since instituted a broad mortgage modification effort that also serves as a laboratory for what can and cannot be done. What the agency has discovered, said Mr. Krimminger, is that the contracts are rarely as constricting as investors and servicers have been portraying them. They do not allow principal reduction, for sure, but they almost never disallow interest rate reduction — or delaying principal payments for a short time. What’s more, Mr. Krimminger said, the servicer agreement simply says that the servicer’s job is to maximize the investment — which often means avoiding foreclosure."

Here's my comment:

“Nothing to prevent mass foreclosures of these loans will be effective unless Congress acts affirmatively to remove liability and provide financial incentives for refinancing. Jawboning bondholders and fiduciaries has not and will not work.”

From last week. Today:

“They do not allow principal reduction, for sure, but they almost never disallow interest rate reduction — or delaying principal payments for a short time.”

Not allowing principal reduction would seem to be a big problem. All the lowering interest rates would do it seems is lower the payments, but it might not be enough. And the legal problems do seem to apply.

I think you’re right back where you started. If it were a clear financial gain to renegotiate these mortgages, it would be done. You still need incentives for the servicers and lenders, and obviously they want a better deal. I thought that you showed why last week. Namely, as an earlier poster said, they want the government to intervene in some way, incentives, subsidies, tax breaks, legislation, to sweeten the deal for them.

For one thing, if servicers get legislation that allows them more room to cut better deals for themselves in the future, that would be a win. How about we just call some of these people and ask them what’s up?

— Don the libertarian Democrat