I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them

TO BE NOTED: From the FT:

"Why Obama’s conservatism may not prove good enough

By Martin Wolf

Published: May 12 2009 19:56 | Last updated: May 12 2009 19:56

“If we want things to stay as they are, things will have to change.” Thus wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems to me the guiding principle of the Obama presidency. To many Americans, he seems a flaming radical. To me, he is a pragmatic conservative, albeit one responding to extraordinary times. In his own way, Mr Obama is following the path trodden by Franklin Delano Roosevelt.

Nowhere is his conservatism more obvious than in the handling of the economic crisis. What we have seen unfolding, from the president’s choice of Lawrence Summers and Tim Geithner as his principal policy advisers, to last week’s “stress tests”, is classic conservative policymaking. The aim is simply to get the show back on the road. As Mr Obama told The New York Times: “I’m absolutely committed to making sure that our financial system is stable.” Stability is a quintessentially conservative aim. Many radicals on the right and left insist that undercapitalised banks should be recapitalised right now. But Mr Obama sees this as far too risky.

The results of the stress tests were a big step along the road the administration is taking. They impose enough pain to appear credible, but not enough to be disruptive. The 10 affected banks will easily raise the needed money: a total of $75bn (€55bn, £59bn). Their market valuations duly soared.

Douglas Elliott of the Brookings Institution has provided a comparative analysis of how the US regulators reached their conclusions.* He contrasts their numbers with those of the International Monetary Fund, in its latest Global Financial Stability Report, and Nouriel Roubini of RGE Monitor and New York University. He also allows for the fact that the IMF and Mr Roubini look at all losses in US banking, while the tests apply to 19 institutions that hold some 70 per cent of US banking assets.

Estimated losses for 2009 and 2010 by the US regulators, the IMF and Mr Roubini are $535bn, $321bn and $811bn, respectively. So regulators were noticeably more risk-aware than the IMF, albeit less so than Mr Roubini. Against these losses are set the expected earnings (after dividends) over these years, plus a provision for 2011 losses. Here the regulators estimate earnings at $363bn, against an assumed $210bn for the IMF and Mr Roubini. This means the reduction in capital is estimated at $172bn by the regulators, $111bn by the IMF and $601bn by Mr Roubini. But, after allowing for planned capital-raising and excess earnings in the first quarter of 2009, the final reduction in capital is just $62bn for the regulators and a mere $1bn for the IMF, but as much as $491bn for Mr Roubini.

There are two important numbers in the above analysis: possible losses, and the buoyancy of earnings. Yet there is a final number of no less significance: how much capital does a bank need? The answer is: how long is a piece of string? Since many of these banks are deemed too big to fail, taxpayers are risk-bearers of last resort. The capital requirement depends partly on how well the government wants to be cushioned against possible losses and partly on how well bond-holders want to be insured against the possibility that government might refuse a rescue.

At the end of 2008, the ratio of total common equity to US banking assets was 3.7 per cent. Without the explicit and implicit insurance provided by government, it would surely have been higher. As the IMF notes, in the mid-1990s, before the leverage boom, the ratio was 6 per cent. In the 19th century, before deposit insurance, it was much higher still.

The conclusions are three: first, the government’s exercise is more conservative on losses than that of the IMF, albeit far less so than Mr Roubini’s; second, most of the capital to be raised will come from the earnings of a banking system able to borrow on the favourable terms arranged by the central bank and then to lend more expensively to its customers; and third, the target capital ratios – Tier 1 risk-weighted capital of 6 per cent of assets and Tier 1 common equity capital of 4 per cent – are not especially onerous.

The purpose of the exercise was indeed conservative: to make it credible, though not certain, that the existing banking system and assets can survive the likely battering. This has been done well enough to satisfy the markets. But these banks will also be unable to expand their balance sheet significantly in the near future.

The biggest question is how far this exercise will help restore the economy. Commercial banks provide only a quarter of financial sector credit in the US, down from close to 40 per cent in the mid-1990s (see chart). Much of the rest came from various forms of securitisation. Unless and until the latter markets reopen fully, private sector credit is likely to be constrained. How far that constraint is binding depends on how far highly leveraged borrowers are willing to borrow, particularly when the collateral against which they borrow has lost value. For this reason, it is the huge stimulus – the least conservative parts of the economic package – that will deliver the recovery. These are also the least upsetting to the interests of powerful lobbies, particularly in finance.

More radical approaches – allowing more banks to default, for example – would have increased uncertainty in the short run and so undermined the return to stability Mr Obama craves. But here the president must reckon on a longer-term danger: that the rescued financial system will, in time, start to lay the foundations for another and possibly still bigger financial crisis in the years ahead.

Ensuring the rescue of a financial system packed even more than before with complex and “too-big-to-fail” institutions may well be the cautious response to this crisis. But it leaves the government with the even more onerous task of imposing effective regulation in future. Unhappily, the record of regulation of generously insured financial systems is extremely poor. The mobilised self-interest of highly rewarded players easily overwhelms the constraints imposed by far less well-rewarded and almost certainly less able regulators.

The more the crisis unfolds, the more evident it is that incentives in the financial system were (and are) badly distorted. I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them. At the end of this, then, there will be one big test: will the number of institutions thought “too big to fail” be as large as now and, if so, how will they be controlled? If the answers are still not clear, there will need to be yet more change.

*Implications of the Stress Tests, May 11 2009, www.brookings.edu
Write to martin.wolf@ft.com
More columns at www.ft.com/martinwolf"

Equity investments are preferable to debt, a contributor to the current financial crisis, Taleb said.

TO BE NOTED: From Bloomberg:

"Global Crisis ‘Vastly Worse’ Than 1930s, Taleb Says (Update1)

Share | Email | Print | A A A

By Shiyin Chen and Liza Lin

May 7 (Bloomberg) -- The current global crisis is “vastly worse” than the 1930s because financial systems and economies worldwide have become more interdependent, “Black Swan” author Nassim Nicholas Taleb said.

“This is the most difficult period of humanity that we’re going through today because governments have no control,” Taleb, 49, told a conference in Singapore today. “Navigating the world is much harder than in the 1930s.”

The International Monetary Fund last month slashed its world economic growth forecasts and said the global recession will be deeper than previously predicted as financial markets take longer to stabilize. Nouriel Roubini, 51, the New York University professor who predicted the crisis, told Bloomberg News yesterday that analysts expecting the U.S. economy to rebound in the third and fourth quarter were “too optimistic.”

“Certainly the rate of economic contraction is slowing down from the freefall of the last two quarters,” Roubini said. “We are going to have negative growth to the end of the year and next year the recovery is going to be weak.”

Federal Reserve Chairman Ben S. Bernanke told lawmakers May 5 that the central bank expects U.S. economic activity “to bottom out, then to turn up later this year.” Another shock to the financial system would undercut that forecast, he added.

‘Big Deflation’

The global economy is facing “big deflation,” though the risks of inflation are also increasing as governments print more money, Taleb told the conference organized by Bank of America- Merrill Lynch. Gold and copper may “rally massively” as a result, he added.

Taleb, a professor of risk engineering at New York University and adviser to Santa Monica, California-based Universa Investments LP, said the current global slump is the worst since the Great Depression that followed Wall Street’s 1929 crash.

The Great Depression saw an increase in global trade barriers and was only overcome after President Franklin D. Roosevelt’s New Deal policies helped revive the U.S. economy.

The world’s largest economy may need additional fiscal stimulus to emerge from its current recession, Kenneth Rogoff, former chief economist at the International Monetary Fund, told Bloomberg News yesterday.

“We’re going to get to the point where recovery is just not soaring and they’re going to do the same again,” he said. “We’re going to have a very slow recovery from here.”

Fiscal Stimulus

The U.S. economy plunged at a 6.1 percent annual pace in the first quarter, making this the worst recession in at least half a century. President Barack Obama signed a $787 billion stimulus plan into law in February that included increases in spending on infrastructure projects and a reduction in taxes.

Gold, copper and other assets “that China will like” are the best investment bets as currencies including the dollar and euro face pressures, Taleb said. The IMF expects the global economy to shrink 1.3 percent this year.

Gold, which jumped to a record $1,032.70 an ounce March 17, 2008, is up 3.6 percent this year. Copper for three-month delivery on the London Metal Exchange has surged 55 percent this year on speculation demand will rebound as the global economy recovers from its worst recession since World War II.

Commodity prices are also gaining amid signs that China’s 4 trillion yuan ($585 billion) stimulus package is beginning to work in Asia’s second-largest economy. Quarter-on-quarter growth improved significantly in the first three months of 2009, the Chinese central bank said yesterday, without giving figures.

Credit Derivatives

China will avoid a recession this year, though it will not be able to pull Asia out of its economic slump as the region still depends on U.S. demand, New York University’s Roubini said.

Equity investments are preferable to debt, a contributor to the current financial crisis, Taleb said. Deflation in an equity bubble will have smaller repercussions for the global financial system, he added.

“Debt pressurizes the system and it has to be replaced with equity,” he said. “Bonds appear stable but have a lot of hidden risks. Equity is volatile, but what you see is what you get.”

Currency and credit derivatives will cause additional losses for companies that hold more than $500 trillion of the securities worldwide, Templeton Asset Management Ltd.’s Mark Mobius told the same Singapore conference today.

“There are going to be more and more losses on the part of companies that have credit derivatives, those who have currency derivatives,” Mobius, who helps oversee $20 billion in emerging-market assets at Templeton, said at the conference. “This is something we’re going to have to watch very, very carefully.”

Taleb is best known for his book “The Black Swan: The Impact of the Highly Improbable.” The book, named after rare and unforeseen events known as “black swans,” was published in 2007, just before the collapse of the subprime market roiled global financial institutions.

To contact the reporters on this story: Chen Shiyin in Singapore at schen37@bloomberg.net; Liza Lin in Singapore at Llin15@bloomberg.net."

they expected to be bailed out

TO BE NOTED: From the FT:

"Insolvent banks should feel market discipline

By Matthew Richardson and Nouriel Roubini

Published: May 6 2009 14:48 | Last updated: May 6 2009 14:48

Joseph Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. The government stress tests on the 19 largest US banks, the results of which are due be announced on Thursday, could have facilitated this process. The opportunity looks likely to be missed.

The tests, which measure how viable banks are under adverse economic conditions, have no “failed” category, even if as many as 10 are reported to need additional capital. But, given that the economic environment already reflects the tests’ worst-case scenario and that recent estimates by the International Monetary Fund of financial sector losses have doubled in six months, the stress test results will not be credibly interpreted as a sign of bank health.

Instead, market participants will conclude that banks requiring extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help.

Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.

Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialised risk. Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?

One possible reason is the “Lehman factor” – the bank runs that would occur as a result of a big failure. But we have learnt from the Lehman collapse and know not to leave the sector high and dry when a systemic institution fails. Just being transparent about which banks clearly passed the stress tests would alleviate many of the fears.

Another reason is counterparty risk, the fear of being on the other side of a transaction with a failed bank. But unlike with Lehman, the government can stand behind any counterparty transaction. This will become easier if a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.

That leaves the creditors – depositors, short- and long-term debt-holders and preferred shareholders. For the large complex banks, about half are depositors. To avoid runs on these deposits, the government has to provide a backstop. But it is not clear it needs to cover other creditors of a bank, as the failures of IndyMac and Washington Mutual attest.

Even if systemic risk were still present, the government should protect the debt (up to some level) only of the solvent banks, not the insolvent ones. That way, the risk of the insolvent institutions would be transferred back from the public to the private sector, from the taxpayer to the creditors.

The government may be able to avoid the mess by persuading long-term creditors to swap their debt for equity, at a loss. The recent failed effort with Chrysler suggests this will not be easy. But a credible threat of bankruptcy could scare creditors into negotiation, to avoid bigger losses.

Suppose the systemic risk problem is solved. The other argument against allowing banks to fail is that after a big loss by creditors, no one would be willing to lend to banks – which would devastate credit markets. However, the creative-destructive, Schumpeterian, nature of capitalism would solve this problem. Once unsecured debtholders of insolvent banks lose, market discipline would return to the whole sector.

This discipline would force the remaining banks to change their behaviour, probably leading to their breaking themselves up. The reform of systemic risk in the financial system would be mostly organic, not requiring the heavy hand of government.

Why did creditors not prevent the banks taking excessive risks before the crisis hit? For the very same reason creditors are getting a free pass now: they expected to be bailed out. For capitalism to move forward, it is time for a little orderly creative destruction.

The authors are professors who contributed to the recently published Restoring Financial Stability: How to Repair a Failed System"

unduly fond of very large banks when the superiority of that model is in question

From Naked Capitalism:

"Richardson and Roubini Call for Bank Resolution, Diss Stress Tests

History repeats itself, the first time as tragedy, the second time as farce. But when it's your farce, sometimes it's hard to appreciate the humor.

We've railed about the stress tests since they were announced, but the chicanery, starting with the March 10 Citi and Bank of America pronouncements that they had had a decent couple of months, have lead to a big rally in bank shares. Of course, before we get too excited, it's important to remember that Citi is still trading at a bit over $3 and Bank of America at just over $10.

Nevertheless, the insistence of the cheerleading is looking strained, particularly when pretty much every professional investor we know is skeptical of the rally, even those who had the foresight to buy into it early. And even an equity broker (generally of the bullish persuasion) commented on earnings season: "One third had earnings that beat expectations, one third were short, and one third were delusional."

I've also noticed more than a few headlines, particularly on Bloomberg, that take any snippet of the positive and play it up. For instance, one a few days ago called a morning when stocks opened down and then moved into weakly positive territory as 'stocks gain" which was technically accurate, but when the averages again fell into losses, it was "stocks fluctuate." Please. Similarly, tonight Bloomberg tells us, "Chrysler Bankruptcy May Not Dent Economy as Cutbacks Were Set". The point of the story is that (assuming the bankruptcy goes according to plan, an open question) the plant cutbacks and furloughs had already been planned as part of the restructuring. But that means that much damage was inevitable, regardless. Saying "Bankruptcy May Not Dent" is not the same as "Bankruptcy May Do No Incremental Damage," which is what the story really says. I plan to keep closer tabs on this and readers are encouraged to e-mail sightings of misleading headlines.

Back to the matter at hand. Matthew Richardson and Nouriel Roubini, in "We Can't Subsidize the Banks Forever," provides a welcome bit of reality to the unwarranted optimism about banks. Having companies look viable as the result of massive, and seeming open ended subsidies does not say much about how they'd be faring ex life support. And even worse are the distortions. We've seen that large scale banking with score based credit paradigms has fared badly. Yet these companies are being subsidized to the detriment of smaller regional and local players who are closer to their communities and can incorporate local knowledge into their credit decisions. But no, just as old style computer jockeys had trouble accepting that big iron might be inferior to PC and distributed processing, so to the powers that be seem unduly fond of very large banks when the superiority of that model is in question.

From the Wall Street Journal:

The results of the government's stress tests on banks, to be released in a few days, will not mark the beginning of the end of the financial crisis.....the overall message is that the sector is in pretty good shape.

This would be good news if it were credible. But the International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak -- $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators' conclusions.

The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' "worst case" scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010.

The stress tests' conclusions are too optimistic about the banks' absolute health, although their relative assessment is more precise, because consistent valuation methods were used....We fear that we are back to bailout purgatory, for lack of a better term. Here are some suggestions for how to extricate ourselves.

First, while Treasury Secretary Timothy Geithner's public-private investment program (PPIP) to purchase financial firms' assets is not particularly popular, we hope the government doesn't give up on it. True, the program offers cheap financing and free leverage to institutional investors, which will lead to the investors overpaying for the assets. But it does promote price discovery and remove the assets from the bank's balance sheets -- necessary conditions to move forward.

And to minimize the cost to taxpayers, banks must not be allowed to cherry-pick which legacy assets to sell. All the risky loans and securities banks were never meant to hold should be on the block. With enough investors participating in the PPIP program, the prices of the assets should be competitive, and there should be no issue of fairness raised by the banks.

Yves here. With all due respect, the program is voluntary, and the whole point is NOT price discovery but to permit banks to unload crap assets at at least the inflated carrying price on their books. It does NOT serve the intended goal, a hidden subsidy, otherwise. The banks don't need more liquidity, they need to fill the hole that would otherwise be caused if these assets were valued fairly. These assets trades actively. The issue is not price discovery, but that the banks don't like the prices on offer. Back to the piece:

Second, the government should stop providing capital, loan guarantees and financing with no strings attached. Banks should understand this. When providing loans to troubled companies, they place numerous restrictions, called covenants, on what these firms can do. These covenants generally restrict the use of assets, risk-taking behavior, and future indebtedness. It would be much better if the government focused on this rather than on its headline obsession with bonuses.

For example, consider the fact that the government, while providing aid to banks, did not restrict their dividend payments. A recent academic study by Viral Acharya, Irvind Gujral and Hyun Song Shin (www.voxeu.org) notes that banks only marginally reduced dividends in the first 15 months of the crisis, paying out a staggering $400 billion in 2007 and 2008. While many banks have been reducing their dividends more recently, bank bailout money had been literally going in one door and out the other.

Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn't the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior -- and it's incredible that there are no restrictions against it.

Third, stress tests aside, it is highly likely that some of these large banks will be insolvent, given the various estimates of aggregate losses. The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors. This is fair: Metaphorically speaking, these are the guys who served alcohol to the banks just before they took off down the highway.

And we shouldn't hear one more time from a government official, "if only we had the authority to act . . ."

We were sympathetic to this argument on March 16, 2008 when Bear Stearns ran aground; much less sympathetic on Sept. 15 and 16, 2008 when Lehman and A.I.G. collapsed; and now downright irritated seven months later. Is there anything more important in solving the financial crisis than creating a law (an "insolvency regime law") that empowers the government to handle complex financial institutions in receivership? Congress should pass such legislation -- as requested by the administration -- on a fast-track basis.

Yves here. We have been saying that pretty much since the Bear collapse. We also called then, for the power that be to go into the firms that were most at risk (and throw in a few better ones so as not to create stigma) and go over their books with a fine toothed comb. The stress tests come nearly a year late, and are no where granular enough. Back to the article:
The mere threat of this law could be a powerful catalyst in aligning incentives. As the potential costs of receivership are quite high, it would obviously be optimal if the bank's liabilities could be restructured outside of bankruptcy. Until recently, this would have been considered near impossible. However, in 2008 there was a surge in distressed exchanges of debt for equity or preferred equity.

Still, the recent negotiations with Chrysler's creditors suggest large obstacles. The size and complexity of large banks' capital structures make debt-for-equity exchanges an even taller task, particularly because creditors will want to hold out for a full bailout along the lines they have been receiving.

The government should be able to dangle an insolvency law as an incentive to cooperate. This will result in a $1 trillion game of chicken. But given the size of the stakes, and the alternative of the taxpayers continuing to foot the bill, it's the best way forward.

Me:

Don said...

The following are the context of this crisis:

1)Since we saved AIG, everybody, I mean everybody, has been hanging tough for govt money.
2)Since we let Lehman fail, everybody has been unsure of our commitment to guarantees. With China, it actually started earlier.

The stress test didn't work because:
1) It's being invested on as part of the investment strategy of how much govt intervention there will be.
2) The stress test was supposed to actually be a govt guarantee to make these banks solvent come what might. Unfortunately, the credibility of the US govt is not sound.

For me, we should not have let Lehman fail, but have guaranteed everything. Once we let Lehman fail, we should have guaranteed everything. Subtlety will not work well in alleviating Debt-Deflation. You can either clearly get out, or get in full force. Since only government guarantees stop Debt-Deflation, all eyes have been turned on the level of govt guarantees since Lehman. The implicit strategy has worked, but not well. No one knows if implicit means explicit or not.

We have a bill to deal with seizing large financial concerns:

"March 25, 2009
tg-70

Treasury Proposes Legislation for Resolution Authority

Treasury Secretary Timothy Geithner on Monday called for new legislation granting additional tools to address systemically significant financial institutions that fall outside of the existing resolution regime under the FDIC. A draft bill will be sent to Congress this week and several key features are highlighted below.

The legislative proposal would fill a significant void in the current financial services regulatory structure and is one piece of a comprehensive regulatory reform strategy that will mitigate systemic risk, enhance consumer and investor protection, while eliminating gaps in the regulatory structure. "

http://www.treas.gov/press/releases/tg70.htm

I'm assuming that they're talking about this.

"Yves here. We have been saying that pretty much since the Bear collapse."

Nothing against you, but I'm wondering what people are actually calling for now, and why Bear was seen as a turning point. If it was Debt-Deflation, what would you have done? Without backing assets, showing that the problem was imminent was a terrible risk. That's what I heard Dizard saying. The governments would need to pretty much bankroll the unwinding.

If you can't convince people of that now, how would you have convinced them of that then?

Don the libertarian Democrat

May 5, 2009 11:21 AM

Don said...

Let me please add this:

To the extent that Bear worked, it was because it showed that the govt would back the unwinding, if it came to that. At whatever point either:

1) The unwinding began to get out of control.
2) The govt's commitment to backstopping the unwinding was not total.

You were going to begin the crisis. To risk 1, by making clear the depth of the problem, without doing 2, would have put us right where we are now or worse, no matter when it began.

Don the libertarian Democrat

May 5, 2009 11:35 AM

massive monetary easing and zero policy rates; quantitative easing; unconventional monetary and credit actions

TO BE NOTED: From Forbes:

"Light At The End Of The Tunnel ...
Nouriel Roubini, 04.02.09, 12:01 AM ET

I was interviewed on Tuesday on CNBC's "Squawk Box" on my views on the economy, the stock market, the problems with the banks, the Geithner plan and whether there's light at the end of the tunnel.

As I pointed out in the interview, the rate of economic contraction will slow from the -6% of the first quarter to a figure closer to -2%. And next year the economic recovery will be so weak--growth below 1% and the unemployment rate peaking at 10%--that it will still feel like a recession even if we may be technically out of it. So, compared with the bullish consensus that sees positive growth at 2% by the third and fourth quarters of this year and a return to potential growth by 2010, my views are consistently more bearish.

Still, compared with the sharp contraction in U.S. and global growth in the first quarter of this year, the rate of economic contraction will slow down for the U.S. and other advanced economies by year-end. That is only a mild improvement in what is still a severe U-shaped recession, with a very weak and tentative recovery by 2010.

I also pointed out on CNBC that the stock market has predicted six out of the last zero economic recoveries. For the last 18 months, we've had six bear market rallies, and at the beginning of each one of these suckers' rallies the delusional perma-bulls repeated that this was the beginning of a bull market rally. And for six times these perma-bulls were totally wrong as the rally fizzled and new lows were reached. And for six times I correctly pointed out that these were bear market rallies.

But such perma-bulls have no shame in showing up over and over again on CNBC and talking up their books and being proved wrong over and over again. As I have never been a "perma-bear," in spite of the "Dr. Doom" nickname, I will be the first one to call the bottom of this severe recession and the bottom of the bear market when I see sustained evidence of robust and consistent economic recovery.

I see the latest rally as another bear market rally, as over the next few months, the news--macro news, earnings news, financial news, corporate default news, financial firms insolvency news and so on--will be worse than expected by the consensus. Look how wobbly the stock market was on Monday when the expected news that the Big Three are in Big Trouble led to a 3% to 4% market fall. Do you listen to Tim Geithner, who says that some banks need "large amounts of assistance," and who is now pushing--like Bernanke--for fast-track Congressional approval of a law that will allow the takeover of systemically important financial institutions and bank holding companies? This market recovery has still very shaky legs, and it will continue to lurch until the U.S. and global economic recovery does occur and is more robust and sustained.

The global economic contraction is still very severe: In the Eurozone and Japan there is no evidence of "green shoots" or positive second derivatives; and in the U.S. and China such evidence is still very, very weak. So investors and markets are way ahead of actual improvements in economic data. And the idea that stock prices are forward-looking and bottom out six to nine months before the end of a recession is incorrect.

First, we've already had six bear market rallies and, despite the "prediction" of stock prices, not a single economic recovery. Second, in 2001 a short and shallow eight-month recession was over by November, but stock prices kept falling for another 16 months until March 2003. This time around, the recession will be of at least 24 months duration--three times as long and five times as deep, in terms of GDP contraction, as the one in 2001. This time the deflationary forces are global, not just in the U.S. and Japan. This time we have the worst financial and banking crisis since the Great Depression, while in 2001 there was no banking crisis. This time we've got the worst housing recession since the Great Depression, with home prices still bound to fall another 15% to 20% for a cumulative fall of 40% to 45%. This time corporate default rates on junk bonds are predicted by Moody's to peak at 20%, not the 13% of the previous recession.

Thus, the idea that a weak U.S. and global recovery with massive deflationary pressures and a severe financial crisis and massive corporate defaults will lead to a robust recovery of earnings and a sharp persistent bull-market rally in equities is totally far-fetched.

As I have argued before, the risk of an L-shaped near-depression will be significantly reduced if aggressive policy actions were undertaken. That risk of near-depression is now lower than it was three months ago--but not gone altogether--as policy makers in the U.S. and globally have finally gotten religion and taken out all their policy bazookas, missiles, rockets and artillery and started to use them.

These more aggressive and front-loaded policies include massive monetary easing and zero policy rates; quantitative easing; unconventional monetary and credit actions to reduce the spread between market rates and government bond yields; significant--if in some cases still insufficient--fiscal policy stimulus; policies to restore credit growth and reduce the credit crunch; policies to clean up toxic assets of banks; policies to recapitalize banks and take over the insolvent ones; policies to reduce the tsunami of foreclosures and reduce the debt servicing and debt burden of distressed households; policies to support emerging market economies under stress; and policies of appropriate regulatory forbearance to restore credit and liquidity in financial market.

These policies will not restore positive growth in advanced economies until next year, but will reduce the rate of economic contraction to a more moderate pace by the end of 2009. Thus, as I noted earlier, the rate of the advanced economies' economic contraction will slow down from the peak contraction of this year's first quarter (-6%) to a more modest contraction in the fourth quarter (-2%) and a very weak positive growth (0% to 1% in U.S., Europe and Japan) in 2010 with still sharply rising unemployment rates peaking at 10% in these advanced economies. This will be an improvement compared with the fourth quarter of 2008 and first quarter of the 2009 collapse of global economic activity, but still a much more bearish scenario than the bullish case of positive and high (2%) growth by the third and fourth quarters and return to potential growth by 2010.

So the road ahead is still very, very bumpy. The worst for the degree of economic contraction may be behind us by the second or third quarter of this year, but there will not be any robust and sustained recovery as the damage of the financial and real excesses of the last few years will have lasting effects on actual and potential growth for the U.S. and global economies. And the burden of trillions of dollars of additional fiscal deficits and debts in advanced and emerging economies will be a drag on actual and potential growth for years to come.

But if aggressive policy actions are accelerated after the G-20 meeting in London, one can expect a slow and painful process of mending the U.S. and global economy that will still take a long time. That will, however, allow us to see the light at the end of the tunnel some time next year, first for the real economies, next for financial markets and finally for the financial system and its wounded institutions.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes."

So to nationalize large insolvent banks--and minimize the fiscal costs and financial collateral damage and systemic risk of such a takeover

TO BE NOTED: From Forbes:

"We Need A New Insolvency Regime For Banks
Nouriel Roubini, 03.26.09, 12:01 AM ET

Finally, after a year of delays, the Treasury secretary and the Fed chairman have agreed about the need for a new insolvency regime for systemically important financial institutions (bank holding companies and non-bank financial institutions). This new insolvency regime will allow government to take over in an orderly way--as opposed to a disorderly Lehman-like bankruptcy--insolvent systemically important financial institutions.

This new conservatorship/receivership regime of insolvency could be similar to the one used to manage the orderly takeover of Fannie Mae and Freddie Mac. While banks have a receivership regime based on the Federal Deposit Insurance Corp. taking over insolvent banks and working them out in an orderly way, bank holding companies and non-bank financial institutions do not have such a conservatorship/receivership regime outside of Chapter 11 or Chapter 7 bankruptcy.

That is why the government had to bail out the creditors of Bear Stearns and AIG, and why the collapse of Lehman was disorderly. We need an orderly system to wind down systemically important financial institutions and bank holding companies as many assets, credit default swaps and bonds of banks are at the holding-company level, rather than at the bank level.

Suppose the government was planning to nationalize a large bank--say Citigroup, for the sake of argument--that was to be deemed insolvent after the appropriate stress test. While the FDIC could then take over the bank, the relevant bank holding company would not be under the FDIC receivership; it would instead go into a Chapter 11 or Chapter 7 bankruptcy. And the other non-bank components of such large financial institutions--its broker dealer, insurance companies, etc.--would also end up in Chapter 11 bankruptcy.

So in order to orderly take over large, systemically important banks, the FDIC receivership model works only for the bank leg of the bank; it does not work for the bank holding company or for its non-bank financial arms.

And certainly FDIC receivership does not apply to independent broker dealers and other non-bank financial institutions for which a disorderly in-court bankruptcy is the only option. An orderly wind-down of Bears Stearns or Lehman or AIG would have required a special receivership/conservatorship, as Chapters 11 or 7 would have pushed into automatic default the unsecured debt of these institutions and triggered a mess with their credit default swaps (CDS).

That is why the government decided to bail out--at huge cost to the taxpayers--the creditors/counterparties of Bear Stearns and AIG; and when it decided not to bail out the creditors of Lehman, a global financial meltdown followed Lehman’s bankruptcy. This is also the reason why the government has been, so far, wary of nationalizing large, systemically important banks.

A special insolvency regime would give the Treasury time to figure out whether the unsecured debt of the institutions should be worked out, and how it should be worked out; it also allows a more orderly workout of CDS and other credit derivatives issued by the financial institution.

Thus, the signal given by Messrs. Bernanke and Geithner--of their support of a special insolvency regime for systemically important non-bank financial institutions--is very important. It will allow the orderly takeover/nationalization of large banks and the same orderly takeover of non-bank financial institutions.

It is high time to pass legislation that enables this special insolvency regime. If such a regime had been in place a year ago, the expensive bailout of the creditors/counterparties of Bear Stearns and AIG could have been avoided, and the collapse of Lehman would have also been prevented.

Similarly, today--as soon as the stress tests are done--some large and systemically important banks (and their holding companies and non-bank financial arms) will have to be taken over. To do it an orderly way, we absolutely need a special insolvency regime like the one we have for the bank arms of bank holding companies, and like the one we had for Fannie and Freddie.

So to nationalize large insolvent banks--and minimize the fiscal costs and financial collateral damage and systemic risk of such a takeover--we need to pass such legislation immediately. The time for Congress to act is now.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes."

So the Geithner plan it is.

From Free Exchange:

"The next phase

Posted by:

Economist.com | WASHINGTON

Categories:

Financial markets

FELIX SALMON links to a piece by Matthew Richardson and Nouriel Roubini in the New York Daily News, that captures, as Mr Salmon notes, an emerging pattern among economic writers—the conclusion that for all the Geithner plan's faults, it's the least bad option at this point. I think that Mssrs Richardson and Roubini hit the nail on the head when they write:

We have to anticipate the likelihood that some banks will resist selling their loans and securities...We may then have to start asking, "Why keep insolvent banks afloat?" And having asked that, we will have to search for ways to manage the ensuing systemic risk.

Either way, once the plan is fully implemented, we will be entering a new phase of the financial crisis. The water is choppy. Let's hope we are strong swimmers.

It's important to step back and consider where things stand at the moment. The American economy appears to have reached a point at which it's deteriorating more slowly than it did in December and January. Recovery in 2009 is not unfathomable absent some unanticipated new crisis. There are lingering questions about how to deal with insolvent banks and how to capitalise the rest of them, and TARP funding is nearly spent. The public, however, is bail-out weary and angry, and the Congress is unwilling to legislate in the face of that anger, and is further constrained by institutional bottlenecks.

The goal, then, is to take steps toward resolving the banking problem with the limited resources available, without doing anything too crazy that risks digging the economic hole deeper. (I know some economists are of the opinion that the riskiest thing to do is to leave insolvent banks afloat for another six months, but I think they'll agree that the cost of six more months' worth of zombies is far lower than the cost of another Lehman.) In light of all that, Mr Geithner's plan looks quite reasonable.

Here's what we'll know in a few months time. We'll know which banks opted to participate in the plan and which banks did not. We'll know a good deal more than we do now about where some of the toxic assets out there should be marked, and those prices will have the ratification of the government and the private auction participants. As a result, we'll have a much better idea who is clearly, irresolvably insolvent—a judgment that will likewise be ratified by both the government and the private market participants. And the Obama administration wil be able to take those judgments to the Congress and say, "We have no choice but to do something about these banks in violation of their charters. Give us the tools we need so that we don't have to liquidate the banks and send the economy spiralling down all over again". And of course, in a few months we'll also have a better sense of which trajectory the economy has chosen to follow.

Of course, a lot has to go right to get to that point in one piece, some of which is within the control of the Treasury (which is hopefully employing teams of lawyers and economists to sniff out potential avenues for abuse), and some of which isn't. It would be wise to be devising backup plans to their backup plans. I don't see another option out there that clearly performs better than this plan on: 1) cleaning up balance sheets, 2) working with available resources, and 3) avoiding serious risks to the financial system. So the Geithner plan it is."

Me:

"Don the libertarian Democrat wrote:

March 25, 2009 23:25

"I don't see another option out there that clearly performs better than this plan on: 1) cleaning up balance sheets, 2) working with available resources, and 3) avoiding serious risks to the financial system. So the Geithner plan it is."

I agree with this. I have also read the Treasury Department and FDIC's web pages on this, as well as this:

http://financialstability.gov/

I found the plan a bit vague as to specifics, but quite clear as to, given their assumed limitations, the reasons and hopes for the plan. Now, I could be simply misunderstanding it, so, as per usual, I read the blogs. This is the first time that much of the commentary seems much less clear than the government. It's a bit like being at a math or logic conference and not understanding where the assumptions of the proofs being given are coming from."

With this plan, it will still be a hard swim, but, at least, there is a path to shore.

TO BE NOTED: From the NY Daily News:

"Give credit to Timothy Geithner's new toxic asset plan

By Matthew Richardson and Nouriel Roubini

Wednesday, March 25th 2009, 4:00 AM

For the economy to be viable, the financial system must be healthy. For this to occur, the system needs to be cleansed of its poorly performing loans and so-called toxic securities backed by loans. This way, once creditworthy institutions and individuals come to the market looking for capital to borrow, financial firms will be in a position to lend them money.

Secretary Timothy Geithner's new toxic asset plan is a serious step in the right direction in that it creates a public-private partnership to buy the troubled assets of financial firms - in other words, to do the necessary cleansing. Up until now, with all the government bailouts, the financial system has been barely treading water. With this plan, it will still be a hard swim, but, at least, there is a path to shore.

The plan essentially calls for private asset management firms - private equity, hedge funds, mutual funds, pension funds - to invest side by side with the government.

The private investors need the government because there are so many bad loans held in the financial sector that only the government's balance sheet can handle taking them over. The government needs help from private investors so it doesn't get hoodwinked by the banks.

Why will investors participate? The deal is structured so that firms will be responsible only for losses on their initial investment. The hope is that by giving this big "freebie," the government will induce investors to participate, and that competition among them will lead to higher offer prices for the loans and securities, thus encouraging banks to sell them.

A lot of ifs, but if indeed successful, the plan accomplishes mission No. 1, namely the removal of the bad assets from banks' balance sheets. Even if banks wanted to do this on their own, they can't because the market for these illiquid assets has dried up.

But let's not have any illusions. The government bears the risk if and when the investors take a bath on the taxpayer-provided loans. If the economy gets worse, it could get very ugly, very quickly. The administration should be transparent in making clear that there is still a wealth transfer taking place here - from taxpayers to investors and banks.

Also, while this plan is designed by the Treasury, many of the big guarantees are being made by the Federal Deposit Insurance Corp. and the Fed. Why not use only Treasury funds? Well, then the administration would have to deal with Congress. While the populist hysteria of last week suggests this end run might make sense, there is something a little worrying about circumventing the legislative process on such a huge investment.

Moreover, there's the issue of transparency - or lack thereof. No one knows what the loans or securities are worth. Competing investors will help solve this by promoting price discovery. But be careful what you wish for. We might not like the answers.

Finally, we have to anticipate the likelihood that some banks will resist selling their loans and securities. Why? Currently, the government has been giving them the option to keep holding them with the hope that market conditions will improve.

Going forward, the government must insist on the banks' involvement in the new program. The reason that financial institutions must be pressured is that they are the cause of the financial crisis. They took advantage of loopholes to avoid regulatory requirements, taking a huge bet on securities they were never meant to hold in the first place.

What happens if removing toxic assets from a bank's balance sheet at near-market prices shows it is effectively insolvent? Then we will have to face the elephant in the room. We may then have to start asking, "Why keep insolvent banks afloat?" And having asked that, we will have to search for ways to manage the ensuing systemic risk.

Either way, once the plan is fully implemented, we will be entering a new phase of the financial crisis. The water is choppy. Let's hope we are strong swimmers.

Richardson and Roubini are professors at the NYU Stern School of Business and have contributed to the recently published book, "Restoring Financial Stability: How to Repair a Failed System."

Essentially, they say, we have to bite the bullet: it might be unpleasant, but it's necessary.

From Felix Salmon:

"Is the Geithner Plan the Least-Worst Option?

Matthew Richardson and Nouriel Roubini have a good and concise view of all the problems with the Geithner bank bailout plan:

Let's not have any illusions. The government bears the risk if and when the investors take a bath on the taxpayer-provided loans. If the economy gets worse, it could get very ugly, very quickly...
There is something a little worrying about circumventing the legislative process on such a huge investment...
No one knows what the loans or securities are worth. Competing investors will help solve this by promoting price discovery. But be careful what you wish for. We might not like the answers...
We have to anticipate the likelihood that some banks will resist selling their loans and securities...
We may then have to start asking, "Why keep insolvent banks afloat?" And having asked that, we will have to search for ways to manage the ensuing systemic risk.
Either way, once the plan is fully implemented, we will be entering a new phase of the financial crisis. The water is choppy. Let's hope we are strong swimmers.

The amazing thing is that this laundry list of problems appears under the headline "Give credit to Timothy Geithner's new toxic asset plan": Richardson and Roubini actually consider themselves supporters of the scheme. Essentially, they say, we have to bite the bullet: it might be unpleasant, but it's necessary.

I'm beginning to detect something of a pattern here: there are no really full-throated supporters of this plan outside the Administration; there's no one who thinks it likely that nothing will go wrong. Instead, there is a group of people who have reasonably concluded that this is the least-worst option, in light of political constraints: essentially, it's better than nothing, which is the only realistic alternative given that Congress is in no mood to pass anything bailing out banks right now.

I am though worried about the banks' participation in this scheme -- especially the Big Four. In order for this to have a chance of succeeding, they all need to participate, but they can't overtly or covertly cooperate. I hope that Treasury is hiring some serious auction-design and game theory experts right now, because there does seem to be a large number of ways in which this plan can be gamed, especially when the banks have shown no particular enthusiasm for participating."

Me:

"Essentially, they say, we have to bite the bullet: it might be unpleasant, but it's necessary"

That's where I ended up. By the way, check this out from Business Week:

http://www.businessweek.com/print/bwdaily/dnflash/content/mar2009/db20090323_101082.htm

"Pressure from Bank Regulators

Then again, they may not have much choice. The federal government owns significant stakes in most of the big banks, giving Administration officials and key members of Congress a toehold to pressure the banks. And bank regulators hold considerable sway over the assets that banks hold, and sell, even in ordinary times.

Indeed, asked if the FDIC and banking regulators will pressure banks to sell assets under the program, Bair was vague, but suggested they would. "There will be a consultative process with the [banking] supervisors," Bair said, "and yes, this program will be among the tools available" to improve bank finances.

Administration officials said banks may actually be willing to take a hit by selling the assets at a lower price if it lets them clean up their balance sheets and get access to the now-wary capital markets again. "This will make it easier for them to raise private capital," Geithner said. "

I have to give them credit for working on being able to seize big banks and other financial firms if insolvent, working on Fraud, and moving on QE. It's getting better.

By DonthelibertarianDemocrat Posted: Mar 25 2009 3:25pm ET

Here is the transcript of a debate this week on the financial crisis.

TO BE NOTED: From Paul Kedrosky:

Transcript of Debate on Financial Crisis

By Paul Kedrosky · Friday, March 20, 2009 · Discuss · ShareThis

Here is theHere is the transcript of a debate this week on the financial crisis. . It featured Jim Chanos, Niall Ferguson, and others. You can get the full transcript here, or check it in the following Scribd box:

Financial Crisis 031709

Publish at Scribd or explore others:

Merging two zombie banks is like have two drunks trying to help each other to stand up.

From Paul Kedrosky:

"QOTD: Roubini on Zombie Banks, and Plan "N"

Merging two zombie banks is like have two drunks trying to help each other to stand up.
-- Nouriel Roubini (RGE Monitor -- 02/10/09)

The entire Roubini piece on bank nationalization -- or Plan "N" as he calls it -- is worth a close read, with these being the key paragraphs:

So why is the US government temporizing and avoiding doing the right thing, i.e. take over the insolvent banks? There are two reasons. First, there is still some small hope and a small probability that the economy will recover sooner than expected, that expected credit losses will be smaller than expected and that the current approach of recapping the banks and somehow working out the bad assets will work in due time. Second, taking over the banks – call is nationalization or, in a more politically correct way, “receivership” – is a radical action that requires most banks be clearly beyond pale and insolvent to be undertaken. Today Citi and Bank of America clearly look like near-insolvent and ready to be taken over but JPMorgan and Wells Fargo do not yet. But with the sharp rise in delinquencies and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit in a matter of six to twelve months even JPMorgan and Wells will likely look as near-insolvent …

…So while Plan A is now underway today’s very negative market response to this Treasury plan suggest that it will not fly. Markets were expecting a more clear plan but also a plan that would bail out shareholders and creditors of insolvent banks. Unfortunately that is not politically and fiscally feasible. It is thus time to start to think and plan ahead for for Plan N (“nationalization” of insolvent banks).

Nouriel pretty much nails it."

Me:

The banks are more like vampires than zombies. Roubini and Taleb are correct about Nationalization. The argument that the government can't run anything, even for a short time, after bankers have led us to financial ruin is strange. Also, the FDIC is the government. It will, in fact, take over the banks, since allowing banks to fail without the FDIC swooping in might lead to a bank run, which is the last thing we need. The way the market would signal a failing bank is a bank run, which is why the FDIC swoops in unannounced as a rule, if I'm not mistaken.

David Ignatius does not seem to understand the difference between the words "know" and "fear."

From Brad DeLong:

"Washington Post Crashed-and-Burned Watch (David Ignatius Edition)

David Ignatius does not seem to understand the difference between the words "know" and "fear." It's an important difference.

Ignatius writes:

David Ignatius - The Death of 'Rational Man': What allowed some people to see the financial crash coming while so many others missed its gathering force? I put that question recently to Nouriel Roubini, who has come to be known as "Dr. Doom" because of his insistent warnings starting in 2006 that we were heading into a global firestorm.... Roubini knew two things: Housing prices wouldn't keep going up forever, and when they went down, they would take a big piece of the financial system with them. From then on, it was a matter of watching the data...

The problem--OK, one problem--is that David Ignatius does not appear to know that (the very smart) Nouriel Roubini also feared and also insistently warned, earlier, of an even bigger financial crash that did not happen:

Roubini and Setser, February 2005 http://tinyurl.com/dl20090207: [In the early 2000s] The Federal Reserve responded aggressively to the sharp falls in US equity markets, and the Bush Administration added a massive fiscal stimulus to the Fed’s monetary stimulus: as Ken Rogoff (2003) has noted, the US recovery was the best recovery money could buy.... [F]oreign central banks were unwilling to let their currencies fall against the dollar, and intervened massively... a seemingly unlimited credit line from the world’s central banks funded the expansion of the US fiscal deficit, preventing the growing stock of Treasuries from crowding out private investment....

A cooperative grand bargain... offers the best chance for unwinding of the US external imbalance without a sharp deceleration of US and global growth. However, such a bargain looks increasingly unlikely.... China may be willing to add $240 billion, or even $300 billion, to its reserves for another year. We doubt it will be willing to do so for two more years.... [T]he risk [of] a disorderly unraveling... a sharp correction of the US dollar and of the US bond market, a surge in US long-term interest rates, a sharp fall in the price of a wide variety of risky assets (such a equities, housing, high-yield bonds, and emerging market sovereign debt) – are growing. Such an unraveling could result in a sharp economic slowdown in the US. It will force countries that now depend on US demand growth for their growth to adjust as well...

Why oh why can't we have a better press corps"

Me:

I'm not sure what your argument is. Are you saying that, because he was wrong before, he couldn't be correct now? Are you saying that he was lucky? That he specializes in predictions and then counts on people forgetting the ones that don't come true?

As to what he knew, it does seem possible that he knew that housing prices would have to come down or at least stabilize at some point. So, for me, he knows one thing.

Could he also have known that it would take a big piece of the financial system with it? I don't think so. I would argue that the government's actions have contributed to the problems. He couldn't have known those actions, for example, in advance. But I do believe that anyone who follows Fisher's Debt-Deflation model at all could have known that there was a real possibility of the housing market drop causing a major problem, and, unless we acted quickly and effectively, the problem could spiral out of hand. Knowing that, people who were aware that on the Sunday before Lehman was left to fail Merrill was likely to go next, could know that the chances of a debt-deflation spiral occurring were very possible.

As to whether I'm using the word "know" correctly, that's a tough problem:

349. "I know that that's a tree" - this may mean all sorts of things: I look at a plant that I take for a young beech and that someone else thinks is a black-currant. He says "that's a shrub"; I say it is a tree. - We see something in the mist which one of us takes for a man, and the other says "I know that that's a tree". Someone wants to test my eyes etc.etc. - etc.etc. Each time the 'that' which I declare to be a tree is of a different kind.
But what when we express ourselves more precisely? For example: "I know that that thing there is a tree, I can see it quite clearly." - Let us even suppose I had made this remark in the context of a conversation (so that it was relevant when I made it); and now, out of all context, I repeat it while looking at the tree, and I add "I mean these words as I did five minutes ago". If I added, for example, that I had been thinking of my bad eyes again and it was a kind of sigh, then there would be nothing puzzling about the remark.
For how a sentence is meant can be expressed by an expansion of it and may therefore be made part of it. Wittgenstein On Certainty

Posted by: Don the libertarian Democrat | February 08, 2009 at 12:34 PM

"This is the sort of thing of which political revolutions are made"

Rod Dreher gets it:

"Dr. Doom speaks:

U.S. financial losses from the credit crisis may reach $3.6 trillion, suggesting the banking system is "effectively insolvent," said New York University Professor Nouriel Roubini, who predicted last year's economic crisis.

"I've found that credit losses could peak at a level of $3.6 trillion for U.S. institutions, half of them by banks and broker dealers," Roubini said at a conference in Dubai today. "If that's true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis."

More:

"The problems of Citi, Bank of America and others suggest the system is bankrupt," Roubini said. "In Europe, it's the same thing."

Meanwhile, Financial Times columnist is so angry at the mess bankers have made that he counsels, only half in jest, it would appear, that it's time to "Shoot the bankers and nationalize the banks." Get your Trotsky on, lad!

More seriously, if Obama is ultimately forced to nationalize American banks, he had damn well better throw the entire leadership class of those failed institutions out on their ear. It is revolting, the idea that those top bankers could have driven their institutions into the ditch, and still be in the driver's seat after the taxpayers, at monumental expense to themselves and their children and children's children, will have hauled them out.( THAT'S IT )

This is the sort of thing of which political revolutions are made."

I agree. This could turn very ugly if the government is seen as rewarding an incompetent and even fraudulent financial sector, while leaving average citizens out in the cold. A bad brew.

"But desperate times lead to desperate actions by desperate policy makers."

Roubini on ZIRP:

"The Fed decision to cut the Fed Funds range to 0%-0.25% has formalized the fact that, over the last month, the Fed had already moved to a zero-interest-rate policy, or ZIRP, and started a policy of quantitative easing (QE) as its balance sheet has surged over the last few months from $800 billion to over $2 trillion.

The Fed is now undertaking even more unorthodox policy actions. These actions are occurring while the U.S. and the global economy are at risk of a protracted bout of "stag-deflation" (stagnation and deflation).

While it is now fashionable to talk about such deflationary risks (and the latest U.S. Consumer Price Index figures confirm that we are entering into deflation ) some of us were worrying about the coming deflation well before the mainstream--concerned with short-run and unsustainable increases in commodity prices--discovered the deflationary risks in the global economy.

It was clear to those who saw, early on, the risks of a severe U.S. and global recession, that deflationary rather than inflationary pressures would emerge alongside a slack in goods, labor and commodity markets. Welcome to the world of stag-deflation or, as Paul Krugman would put it, the world of "depression economics."

So what is the outlook for 2009? And what is the likely policy response to the risks of a global stag-deflation?

The outlook for the U.S. and the global economy is now very bleak and getting worse as the global economy experiences its worst recession in decades. In the U.S., recession started last December and will last at least 24 months until next December--the longest and deepest U.S. recession since World War II, with the cumulative fall in gross domestic product possibly exceeding 5%.

In comparison, the last two recessions in 1990-91 and 2001 lasted only eight months each and the cumulative fall in GDP was only 1.3% and 0.4%, respectively. There is also a risk that this deep and protracted U-shaped recession (the mainstream consensus view of a V-shaped short and shallow recession is now out the window) may morph into a more severe Japanese style L-shaped recession unless aggressive fiscal policy and recapitalization of the financial system is enacted.

The recession in other advanced economies (the euro zone, the U.K., other European economies, Canada, Japan, Australia and New Zealand) started in the second quarter of this year, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then. I don’t expect growth in the advanced economies to recover before the end of 2009.

There is now also the beginning of a hard landing (growth well below potential) in emerging markets as the recession in advanced economies, falling commodity prices and capital flight all take their toll on growth.

Indeed, the world should expect a recession (growth in the -1 to -2% range) in Russia and a near recession (growth close to zero) in Brazil next year, owing to low commodity prices. There will also be a very sharp slowdown in China and India that will be the equivalent of a hard landing for these countries. In China the latest figures for electricity use, exports and imports suggest that the economy is already close to the hard landing scenario of a growth rate of 5%. The deceleration of growth in China is much more rapid than expected.

Other emerging markets in Asia, Africa, Latin America and Europe will not fare better and some may experience full-fledged financial crises. More than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Venezuela and Ecuador (a country that has just defaulted on its sovereign debt) in Latin America.

What is the policy response in the U.S. and other countries to this risk of a global stag-deflation?

The Fed decision to cut the target for the Fed Funds rate to the 0% to 0.25% range is just underwriting what was already obvious and happening in reality: While the target Fed Funds was until Tuesday still 1%, in the last few weeks--following the massive increase in liquidity by the Fed--the actual Fed Funds was already trading at a level literally close to 0%.

So the Fed just formalized what had already been happening for weeks now, i.e., that the Fed Funds rate was already zero and that the Fed had already moved to quantitative and qualitative easing (QE) in the form of a massive increase in the monetary base and aggressive use of monetary policy to reduce short-term and long-term market rates that are stubbornly high in a sign that the credit crunch is severe and worsening.

I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now, 12 months into this severe recession--a recession that will last at least another 12 months (if not, as is possible, much longer)--the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy, or ZIRP, for the U.S.) and the Fed has moved into uncharted unorthodox monetary policy as a severe stag-deflation is taking place.

And, as predicted by me over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a long time (as a way to push lower long term Treasury yields); purchasing agency debt and agency MBS in massive amounts; and even considering purchasing long-term Treasuries as a way to push lower long-term government bond yields that are already falling sharply.

More aggressive policy actions may be undertaken by the Fed as a severe credit crunch shows no signs of relenting. In a 2002 speech on deflation, Ben Bernanke spoke even of helicopter drops of money, monetizing fiscal deficits and even buying equities.

The latter actions have already been partially undertaken: The Fed is effectively already monetizing U.S. fiscal deficits as the purchase of markets assets is financed with the Fed printing presses rather than the TARP program. And now, with the Fed considering the purchase of long-term Treasuries, such monetization of deficits will be made more formal.

Also, since the TARP has been turned into a program to recapitalize financial institutions (and thus boost their capital and market value), the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the financial system). Once the Fed starts to buy the long-term Treasuries financing the TARP program, this indirect Fed purchase of U.S. equities will be even clearer.

While Fed actions to reduce mortgage rates--via purchases of agency debt and agency MBS--are partially successful as long-term mortgage rates are falling, most of the Fed purchases of private assets have been so far limited to very high-grade securities.

Thus, the gap between the yield on high-grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is sharply rising; ditto for the gap between agency MBS and private label MBS. Also, while long-term Treasury yields are sharply falling, the spread of corporate bonds--both high-yield and high-grade--relative to Treasuries remains huge as a sign of a severe credit crunch.

Thus, as a next step, the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit ratings. That would mean the Fed will take on even more credit risk than it is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policy makers."

This post seemed to be simply a list of what's happening. Not much to disagree with. As for the predictions, I've no idea.

Some Really, Really Scary Things Were Not Facing

I guess that it's all in how you see things. In the 1930s, Totalitarianism was a real possibility. It was not clear to people that Capitalism could survive in any form. For my religion, it wasn't clear any of its adherents would be alive. There were plans for a museum dedicated to its extinction. Most of the vaccines that have extended our lives weren't around. A war of tremendous loss had been recently fought, and a worse war was on the horizon. The decisions made about the economy and how to deal with it were made in that context. There is no way to meaningfully compare the decisions of the 1930s to our time except in very tenuous ways. In abstracting out some principles and policies that might help us, we are losing the most meaningful aspects that influenced those decisions. The look back at the 1930s is more like a search for a narrative similar to ours, which can give us hope that our narrative ends as well for us as did that earlier saga.

This is what I call the Existential Situation or Context or Background to our time. It is similar to the concept that Wittgenstein, Austin, Merleau-Ponty, and their modern followers use to understand Human Agency in all its facets. That's why, when reading the article on Fortune entitled "8 Really, Really Scary Predictions, I wasn't at all frightened. If the economic conditions were to lead to enormous and awful social transformations, then I'd be very worried. But, so far, I don't see that happening. Some do. But, to dip into our 1930s narrative, they are akin to the people in the 1930s who were sure that the only choice was between Communism and Fascism. The role of the individual and human agency to determine the fate of the world was lost on them, and so they only saw the world as competing systems, a competition in which Communism and Fascism were far more ruthless and cunning and therefore destined to survive at the expense of a weak and decadent Capitalism. Jot that down in your notebook for reference.

The list has a few of my favorites:
William Gross
Jim Rogers
Nouriel Roubini
and I'm going to add Robert Shiller and Meredith Whitney, who, although I've criticized them mostly on this blog, I actually like and respect. That's the Paradox Of Human Agency out of which all interesting thought arises.

First, Roubini:

"We are in the middle of a very severe recession that's going to continue through all of 2009 - the worst U.S. recession in the past 50 years. It's the bursting of a huge leveraged-up credit bubble. There's no going back, and there is no bottom to it. It was excessive in everything from subprime to prime, from credit cards to student loans, from corporate bonds to muni bonds. You name it. And it's all reversing right now in a very, very massive way. At this point it's not just a U.S. recession. All of the advanced economies are at the beginning of a hard landing. And emerging markets, beginning with China, are in a severe slowdown. So we're having a global recession and it's becoming worse."

Everything has a bottom. The point is to keep our heads and focus on what works as we try this and that policy. Roubini's view is less Pessimistic than Mechanistic, which is unusual for him.

"Sherif Ali: Truly, for some men nothing is written unless THEY write it."

William Gross:

"While 2008 will probably be best known as the year that global stock markets had their values cut in half, it was really much, much more. It was a year in which every major asset class - stocks, real estate, commodities, even high-yield bonds - suffered significant double-digit percentage losses, resulting in the destruction of over $30 trillion of paper wealth. To blame this on subprime mortgages alone would be to dismiss an era of leveraging that encompassed derivative structures of all types, embodying a belief that economic growth was always and everywhere a certainty and that asset prices never go down. As 2008 nears its conclusion, we as an investor nation have been forced to face a new reality. Wall Street and Main Street are fearful that a recession may be replaced by a near depression.

The outcome essentially depends on the ability of the Obama administration to rejuvenate capitalism's "animal spirits" by substituting the benevolent fist of government for the now invisible hand of Adam Smith. Federal spending and guarantees in the trillions of dollars will be required to fill the gap created by the deleveraging of private balance sheets. In turn, lenders and investors alike must begin to assume risk as opposed to stuffing money in modern-day investment mattresses. The process will take time. Twelve months of the Obama Nation will not be sufficient to heal the damage of a half-century's excessive leverage. The downsizing of private risk positions - replaced by government credit - will also result in reduced profit margins and a slower rate of earnings growth after the bottom is reached. "

I agree with Gross. The revival of the "animal spirits" is the key to solving our malady. We must have policies that target and fight the enormous fear and aversion to risk and the accompanying flight to safety. We should be walking, not running.

"Sherif Ali: Have you no fear, English?
T.E. Lawrence: My fear is my concern. "

Now Shiller:

"We don't currently have anywhere near the level of unemployment that we had in the 1930s, but otherwise there are many similarities between today's environment and the Great Depression, with things happening today that we haven't seen since then. First of all, there's the magnitude of the stock market's move up and down. The real (inflation-corrected) value of the S&P 500 nearly tripled from 1995 to 2000, and by November 2008 was down nearly 60% from its 2000 peak. The only other comparable event was the one in the 1920s where real stock prices more than tripled from 1924 to 1929 and then fell 80% from 1929 to 1932. Second, we've had the biggest housing bust since the Depression. Third, we've seen 0% interest rates. We've actually seen briefly negative short-term interest rates. That hasn't happened since 1941. There was a period from 1938 to 1941 when we were bouncing around at zero and sometimes negative, but that hasn't happened since.

And the list goes on: Our numbers don't go back as far as the Depression, but consumer confidence is plausibly at the lowest level since then. Volatility of the stock market in terms of percentage changes day-to-day is the highest since the Depression. In October 2008 we saw the biggest drop in consumer prices in one month since April 1938. Another thing is that it's a worldwide event, as it was in the Depression.

I'm optimistic that we'll do better this time, but I'm worried that we're vulnerable. One of the lessons from the Depression is that things can smolder for a long time. What I'm worried about right now is that our confidence has been hurt, and that's difficult to restore. No matter what we do, we're trying to deal with a psychological phenomenon. So the Fed can cut interest rates and purchase asset-backed securities, but that only works in really restoring full prosperity if people believe that we're back again. That's a little hard to manage."

I agree completely, of course, that we're dealing primarily with a psychological or human agency problem. Our focus and policies should focus on that.

"[Lawrence has just extinguished a match between his thumb and forefinger. William Potter surreptitiously attempts the same]
William Potter: Ooh! It damn well 'urts!
T.E. Lawrence: Certainly it hurts.
Officer: What's the trick then?
T.E. Lawrence: The trick, William Potter, is not minding that it hurts."

Now Jim Rogers:

"We are in a period of forced liquidation, which has happened only eight or nine times in the past 150 years. The fact that it's historic doesn't make it any more fun, of course. But it is a pretty interesting time when there is forced selling of everything with no regard for facts or fundamentals at all. Historically, the way you make money in times like these is that you find things where the fundamentals are unimpaired. The fundamentals of GM are impaired. The fundamentals of Citigroup are impaired.

Virtually the only asset class I know where the fundamentals are not impaired - in fact, where they are actually improving - is commodities. Farmers cannot get a loan to buy fertilizer right now. Nobody's going to get a loan to open a zinc or a lead mine. Meanwhile, every day the supply of commodities shrinks more and more. Nobody can invest in productive capacity, even if he wants to. You're going to see gigantic shortages developing over the next few years. The inventories of food worldwide are already at the lowest levels they've been in 50 years. This may turn into the Great Depression II. But if and when we come out of this, commodities are going to lead the way, just as they did in the 1970s when everything was a disaster and commodities went through the roof."

I have said over and over that, just as on the trip up, people were disregarding the fundamentals, so they are doing on the way down. We need to be able to see more clearly.

"Prince Feisal: Gasim's time has come, Lawrence. It is written.
T.E. Lawrence: Nothing is written.
Sherif Ali: You will not be at Aqaba, English! Go back, blasphemer... but you will not be at Aqaba!
T.E. Lawrence: I shall be at Aqaba. That, IS written.
[pointing to forehead]
T.E. Lawrence: In here. "

Now Meredith Whitney:

"What the federal government has done so far- with TARP, bailing out Citigroup, etc. - has stemmed the bleeding, but what it hasn't done is fundamentally alter the landscape. Yes, there's been a tremendous amount of capital thrown into the system, but my concern is that it's just going to plug the holes. It's not going to create new liquidity, which is what the system so desperately needs.

When the government announces these plans, investors get excited and hopeful. But details have been slim, and while I appreciate the government saying, "We've been wrong here. Let's try something different," the strategy changes have not solved anything. So far we've had TARP 1.0, TARP 2.0, and TARP 3.0, and I'm certain there will be a 4.0, a 5.0, and a 6.0. There has to be, because the companies cannot raise the capital they need, which means that the default provider of capital has to be the federal government.

What happens in 2009? Frankly, it's hard for me to predict what's going to happen next week, never mind next year. What I will say is that I expect all these banks to be back in the market looking for more capital. We'll also have a wholesale restructuring of our banking system, probably toward the end of 2009. There will be banks getting smaller, banks going away, and banks consolidating. At the same time, though, I think you'll see more new banks created. We've already seen more applications. And it's a great idea: You start with a clean balance sheet and make loans today with today's information. Plus, right now you've got a yield curve that's good for lending."

A very pragamtic and sensible approach. And I agree with her about the banks.

Let's throw in a few more points. Wilbur Ross:

"We are clearly in a serious recession, and more aggressive action is needed to turn things around. The federal government initially underestimated the scale of the mortgage and housing crises and later panicked into an ever-changing series of ad hoc measures that at best dealt with some of the effects of the original crises. But homeowners have now lost $5 trillion, and 12 million families have mortgages in excess of the value of their homes. Therefore the economy will not stabilize until mortgages are adjusted down to the value of homes, with affordable payment schedules, and until new mortgages become available across the home-price spectrum. Till then, the poverty effect of falling house prices and unemployment moving up toward 7% will hold consumer spending back from its former 70% contribution to our economy.

I'm optimistic about the choices that President-elect Obama has made for his economic team, and I've got some suggestions for what they should do. Hopefully the new Treasury Secretary, Tim Geithner, will incentivize lenders to restructure mortgages by guaranteeing half of the reduced principal amount and sharing among the government, homeowners, and lenders any subsequent appreciation. Lenders would gain liquidity by selling the Treasury-guaranteed portion of the loan, and government would receive annual insurance premiums to further protect it against loss. That would cost taxpayers nothing now and probably little or nothing in the future.

Addressing unemployment is paramount. Detroit needs government support in order to implement independently verified concessions from all stakeholders - not just labor - which are sufficiently large to permit profitable operations even if auto sales remain as low as 11 million cars per year. A pre-negotiated bankruptcy may be necessary in order to implement the restructuring, but both the industry and the economy are too fragile to withstand the domino effect that a free-fall bankruptcy would have on a car company, its dealers, and its suppliers.

In addition, to avoid reversal of the 242,000 jobs created by state and local governments in the past 12 months, Washington should provide or guarantee funding for sorely needed infrastructure projects that would create immediate construction jobs and meaningful amounts of permanent jobs.

If President Obama promptly and decisively resolves these problems, whether or not he adopts my recommendations, and restores public confidence, he can end the recession by early 2010. If not, the economy will languish for a long time. Given the economic uncertainty, investors who are too worried to buy equities might consider tax-exempt bonds with yields around 6%, equivalent to almost 10% before federal, state, and local taxes."

I like this response. It seems politically very close to my own, and he also focuses on the ad hoc nature of the government's response.

"Prince Feisal: You, I suspect, are chief architect of this compromise. What do you think?
Mr. Dryden: Me, your Highness? On the whole, I wish I'd stayed in Tunbridge Wells. "

John Train:

"I presume that although we are in a severe recession it will not decompose into a full-scale depression, because that is what everyone is afraid of and desperate to avoid. Wall Street likes to say that the market has anticipated five of the last three recessions - the point being that a market crash frightens the authorities into taking necessary action.

Keynes observed that pragmatic businessmen often could not imagine that they were the slaves of defunct economists, but ironically, never is this more true than today of Keynes himself. So we run a huge deficit to postpone the worst. That means inflation, so bonds are unsatisfactory.

Investment opportunity is the difference between the reality and the perception. And since many equities are priced as though a depression might be on the way, many of them are attractively priced."

The difference between perception and reality. Another epistemologist manque. I agree. That's basically the problem. We need to learn to see again.

"Auda abu Tayi: [as Lawrence sets out across the desert with Daoud and Faraj] You will cross Sinai?
T.E. Lawrence: Moses did!
Auda abu Tayi: And you will take the children?
T.E. Lawrence: Moses did! "

Sheila Bair:

"The private-label mortgage-backed securitization markets are a prime example. Trillions of dollars of investor money funded millions of mortgages that borrowers had little chance of repaying. Investors relied heavily on ratings agencies, which in turn relied too heavily on mathematical models instead of analyzing the underlying loans. To be sure, borrowers, brokers, lenders, securitizers, as well as state and federal regulators, all bear responsibility for the widespread deterioration in lending standards. But the problem was compounded by the fact that those ultimately holding the risk - the investors - did not look behind their investments at the quality of the mortgages themselves. If they had, they would have seen high loan-to-value ratios, little income documentation, burdensome fees, and steep payment resets. They would have seen mortgages unaffordable from the beginning, originated based on the assumption that home prices would continue to rise and borrowers would refinance. Of course, we now know that as home prices began to depreciate, borrowers were unable to refinance, leading to massive foreclosures and further price declines. This self-reinforcing downward spiral is at the core of the economic problems we face today.

We will dig out of this. And when we do, I hope for a back-to-basics society - where banks and other lending institutions promote real growth and long-term value for the economy, and where American families have rediscovered the peace of mind of financial security achieved through saving and investing wisely. We need to return to the culture of thrift that my mother and her generation learned the hard way through years of hardship and deprivation. Those are lessons learned that the current crisis is teaching us again."

This is all true. It was actual human decisions that caused the mess. What we need to do is find the presuppositions that they were working under and whether their actions are something worse than lack of foresight and stupidity.

"Club Secretary: I say, Lawrence. You are a clown!
T.E. Lawrence: We can't all be lion tamers. "

Did you find this all that scary? Troubling and needing a mountain of compassion and hard work, but not necessarily scary. Imagine no FDIC at all.

So, that's my take. And, paradoxically, I used the example of British actions in WW I which can be said to have led to many of our current maladies worldwide.

"T.E. Lawrence: The truth is: I'm an ordinary man. You might've told me that, Dryden. "