Financial Skeptic Bulletin, October 2008

Quick cash a lure when it 'doesn't matter what your credit is like'

At People's Pawn in Springfield, Mass., the collection of DVD players, televisions and other electronics just keeps getting bigger.

As many as 200 a people a day come in to "sell all their stuff so they can get gas money," said Efren Rivera, who works at the shop. "Some people have to pay their mortgages."

The story is similar at EZ Cash Pawn in West Palm Beach, Fla., where the shelves are so stacked with electronics, musical instruments, guns, fishing poles, scuba gear - you name it - that people are being turned away.

"I have no choice," said Robert DeSantis, the shop's owner. "I have tools in the warehouse now - every single tool you can think about."

With the economy in the tank and high energy prices eating away at Americans' paychecks, pawnshops are prospering.

Unlike the bank, where tough times make it harder to get a loan, "with us, doesn't matter what your credit is like," said Todd Faircloth, owner of Georgia Loan and Pawn in Albany, Ga. "You can come in and borrow from us if you've got merchandise."

Sometimes, pawning's a good option
When you pawn an item, you are really taking out what financial professionals call a "secured non-recourse loan." Sometimes, according to Jean Chatzky, a financial columnist and author of "Pay It Down: From Debt to Wealth on $10 A Day," that loan might be your best option to cover an important bill.

Pawnshop loans charge interest, anywhere from 5 percent to 20 percent a month, depending on the merchant's assessment of the merchandise and the reliability of the customer. At 20 percent, a $75 30-day loan repaid on time would cost the customer $15. By comparison, penalties for bounced checks and late credit card payments average double that.

"Pawning can be a relatively less expensive option," Chatzky said - but only if you pay back the loan on time. If you don't, "you're going to pay another month's interest," plus a storage fee, she said.

The National Pawnbrokers Association said 80 percent of customers reclaim their pawned property on time, providing a steady stream of interest income that increases as the economy worsens. With more people being driven in the doors by hard times, it's a good time to own pawnshops.

The business has become so lucrative that First Cash Financial Services Inc. announced plans this month to shut its auto lending division so it could focus on its pawnbroker operations. The company, which operates more than 250 pawnshops and payday lending shops, said its pawnshop profits rose by 26 percent in the first quarter of the year, topped by a 39 percent rise in the second quarter.

"Our core pawn business is tremendously profitable and continues to grow at record levels," said Rick Wessel, chief executive of the company, which expects to open 10 to 20 new U.S. stores by the end of the year.

Likewise, Cash America International Inc., which operates more than 500 pawnshops in 21 states under the Cash America Pawn and SuperPawn brands, reported that second-quarter profits rose by 52 percent over the same quarter last year. It projected that profits would rise by another 13 percent to 20 percent over that when it reports third-quarter results later this month.

"Higher loan demand continued our trend of increased revenue from pawn loans, and we experienced better-than-expected retail sales activity during the quarter," said Daniel Feehan, the company's president and chief executive.

'Grills for bills'
Those retail sales are another way pawnbrokers make money.

Loans are typically made for about about half the value of an item. Whenever a customer defaults, the pawnbroker can offer shoppers a bargain while making a profit on the loan.

"Pawnshops have always done consistently very well in a down market," said Randy Stormberg, owner of Bend Pawn and Trading Co. in Bend, Ore., who said business was up by 30 percent in his store. "They are there with merchandise at about half the price of new."

Much of that merchandise is gold coins and jewelry. With the price of gold fluctuating between $800 and $900 an ounce, many pawnbrokers won't even bother to offer a gold item for sale; instead, they will have it melted down for its raw metal, Stormberg said.

Pawnbrokers say they're getting a lot of unexpected items from people hoping to cash in on the boom in gold.

Fort Myers Estate Jewelry and Pawn in Fort Myers, Fla., hit the headlines earlier this year when it reported that an unidentified athlete had pawned the gold medal he won at the 1980 Olympic Games. And across town at Larry's Pawn Shop, Ryan Champagne does a brisk business in "grills for bills" - gold teeth.

"When somebody comes in, you don't want to be handling their teeth. So I grab a paper towel and just weigh it like anything else," Champagne said.

A couple of years ago, it was unheard of for someone to come in offering his or her gold teeth for sale, but "now, it's a little more frequent than it was two years ago, there's no question about that," said DeSantis of EZ Cash in West Palm Beach.

"I expect to see a lot more - a whole lot more," he said. "It's not getting better. It's getting worse."

[Oct 18, 2008] Manufacturing, the Recovery, and What Lies Ahead By Stormy

"Americans sold never to be repaid loans to the world to finance their consumption. It worked once, and in huge size, but it wont work twice." You need start to produce valuable goods...

Angry Bear

The big picture is always important. Today's report of the dramatic fall of the factory index is incredibly bad news, a significant part of the that big picture:

The Federal Reserve Bank of Philadelphia's general economic index plunged to minus 37.5 this month, less than forecast and the lowest reading since October 1990, from 3.8 in September, the bank said today. Negative readings signal contraction. The index averaged 5.1 last year.

How we respond to this fact has to be seen in a global context. We have watched one bubble burst; we are now about to confront the explosion of a negative bubble, a kind of black hole that we have been cultivating for some time: our manufacturing sector. The easy explanation is not always the correct one. Many will blame the present deep recession on just the financial crisis.

That is not the full story.

For over a decade, we have watched our manufacturing flee elsewhere; watched our largest companies outsource and offshore--with barely a peep from many economists. We have added jobs to government, health care, and service industries; manufacturing jobs have dwindled. Even many of our important service industries--in IT, medicine, and accounting--, we have outsourced, off-shored in the name of efficiency. Even Research and Development is leaving these shores.

In short, the engine for our real recovery lies littered around us, rusted, broken, unattended, and ignored. I am not going to wage my usual complaint about the WTO or our trade policies, or push once again for fair, not free, trade. Nor will I complain that globalization was too rapid, too poorly structured. It is too late for all that. What's done is done.

What I want to do is to adumbrate the directions in which the U.S. and the world seem to be going. Then I want to offer what I see as the only hope.

The U.S. is in for a long downward slide. The fixes that are being proposed will be temporary, at best. To some extent, Europe and other developed countries will be tied to U.S. fortunes; many have sowed the same seeds that the U.S. has. But there is hope--and it may seem an unusual one to those who have understood me. That hope is China, hope that China moves as quickly as possible from an export platform to a more consumer based economy, hope that China is wise enough not to continue those policies that have drawn foreign company after company into its fold. (Those countries that can feed China's thirst for raw materials will do well.)

The Short-term Fix

Krugman clearly states how the U.S. will respond: "Lets Get Fiscal." Massive government spending will be the policy, regardless of U.S. indebtedness:

• spending to support ailing communities whose tax bases have collapsed,
• spending to increase unemployment insurance for our service-oriented economy and to what is left of our manufacturing industry,
• spending on our infrastructure to provide jobs,
• spending to help students no longer will be able to afford an education,
• spending to help those pushed over the edge by one medical crisis.

Can we do otherwise? No. But understand this is our last fix.

After it is over, we will have to pay the bill; we will have to return to that place where all ladders start. It will be a long climb. We will have to protect our people from predators, both at home and abroad; we will have to give them a safe place to work, free of medical worries, free of worries that an education is too expensive. We will have to construct policies that allow our people to compete fairly among the nations of the world. No more platitudes about being competitive; no more platitudes about freedom and democracy; no more celebrations that we are the best. Clearly, we are not gathering any laurels lately.

Competitiveness is not just one man working hard; it is a society structured so that all hard work counts.

Hard work, hard planning, hard thinking will be in order. We will have to see beyond one minute, one day, or one year. We will actually have to have some kind of vision for our future. Our government will be our collective instrument, not the whims and greed of a few important individuals. We may finally understand that democracy is hard, hard work, not the celebration of this or that personality. Then and only then will we begin that long climb upward.

China: Policies and Growth

With a population of over 1.3 billion people and with an impoverished third world economy, China's sudden entrance onto the world stage was an enormous counterweight to the industrialized nations. No country has ever had such an impact on the world, not even Japan as it climbed from the devastation of World War II. How is China doing now, a mere seven years after its entry into the WTO?

• Reserves: an astounding $1.7 trillion--and growing
• GDP growth: 9.7% with projected growth around 8% next year. (IMF predicts 9.3%.)
• Currency exchange rate: 6.8360. Recently lowered (to protect some industries)
• Inflation rate: 4.6% (Down .3% from last month)

While its growth will slow, China seems to be weathering the storm. How did China, a barely industrialized, impoverished nation achieve all this? Quite simply, it played perfectly its one great trump card: its 1.3 billion people. It then fashioned its playing field to exploit that advantage, by offering juicy inducements to foreign firms.

1. It instituted a two-tier tax rate, giving the advantage to foreign firms. Foreign firms were taxed at 15%; indigenous firms, at 30%) In key industries, foreign firms were given a tax holiday if they promised to stay for ten years.
   
2. It instituted no immediate provisions to protect its labor force from substandard working conditions, unscrupulous employers, or substandard pay.
   
3. It used tax rebates to leverage exports on selected items. In short, no taxation for exported consumer goods. For a more complete discussion of how export tax rebates work, see data here and discussion here and here.
   
4. It pegged its currency to the dollar in order to further leverage its exports.
   
5. It ignored environmental degradation. (Most environmental regulations can be viewed as a hidden tax, advantaging companies that produce the pollution as well as those non-polluting companies who make use of the products that the polluting companies provide: Energy, for example.)
   
6. It subsidized the cost of oil, thereby making energy cheaper for all.

In short, China combined labor, tax, and environmental arbitrage together with its immense and impoverished population to build an unrivaled export platform, an export platform that fed the Western consumer with goods produced in many instances by foreign firms from industrialized nations. The next stage--already in motion--is to cultivate its own companies. Flushed now with cash, China is in an excellent position to do so.

The Hope

As I said above, the hope is that the world -- and China especially -- takes a breather and reconsiders how the game has been played. There is too much at stake. We simply cannot afford the kind of arbitrage to which I have pointed. It is too dangerous for all. We have to hope that China moves from being primarily an export platform to a consumer-based society. We have to hope that China vigorously begins to levy all those hidden environmental taxes, which in turn will raise the price of goods as well as clean the environment. We have to hope that China rapidly protects its labor force from predation, that it allows real bargaining between employer and employee. We have to hope that export rebates disappear entirely. We have to hope that China provides its people with the kind of social net that some more advanced countries provide. We have to see hope that China understands that an all-too rapid climb to becoming frontier nation can have disastrous global consequences. And when all of this is done, we have to hope that then--and only then, we are ready to compete fairly in the marketplace of ideas and products.

Read More on "Manufacturing, the Recovery, and What Lies Ahead"

[Oct 18, 2008] Finally, A Meaningful Improvement in the Money Markets

naked capitalism

Even though much has been made of itty bitty falls in Libor from very elevated levels, leaving Libor still at very elevated levels, we have a sign that the massive efforts of commercial banks to lubricate the money markets is finally having an effect. 30 day commercial paper rates eased meaningfully, although they still remain high.

Note that 30 to 90 day CP are the most popular tenors; we need to see more improvement at the 30 day and longer maturities before we declare victory, but this is a move in the right direction.

From Bloomberg:

Rates for one-month commercial paper fell to a three-week low after central banks joined forces to pump cash into money markets and government backed loans.

Average yields offered on the highest-rated commercial paper placed by dealers and due in 30 days fell 0.48 percentage point today to 3.45 percent, according to data compiled by Bloomberg. Rates fell 0.83 percentage point this week to the lowest since Sept. 26 from a nine-month high of 4.28 percent.

``The infusion of capital by the government into the banking system should improve balance sheet health greatly and gradually, make unsecured lenders more comfortable,'' Barclays Plc analysts Piyush Goyal and Kurush Mistry said yesterday in a report.

Comments

printfaster said...

Yves,

It is not the commercial banks that are unsticking and buying CP, it is the Fed. Quoting also from Bloomberg:
The Fed said last week it will create a special fund to buy commercial paper, seeking to unblock the financing that drives everyday commerce for American

Even commercial paper is being nationalized. Perhaps the Fed will recognize sheets of toilet paper as foreign currency and buy them to inject more funds into the economy. We should be so lucky. All of the money is being sent to incompetent bank executives so they can hold on to their precious overpaid jobs

Phil said...

http://www.marketwatch.com/
Taking a back seat to bailout
Rules for governance, exec pay watered down in government plan.

If you want to get sick read this article.

October 17, 2008 8:46 PM

Cash Mundy said...

FairEconomist: your A2/P2 comment is interesting. I got curious and found out where the Fed Publishes this info, and a description of A2 vs. P2 paper at Calculated Risk.

October 17, 2008 8:58 PM

printfaster said...

Phil, I don't even care about pay packages. I want them unpaid. Fired. Out. The banks are obsolete and do not provide the purpose for which they have been chartered, and that is to finance business activity. The whole financing industry for itself is a sham. It is finance for finance sake. It is financing billion dollar bonuses last year for Gunnie Sacks, which is what they executives should be wearing.

When I think of how much money has gone into lower Manhattan, it makes one ill. That money needs to go back to main street to create industry which creates its own demand. Not the demand for financial products.

Yech.

doc holiday said...

OT; this was nice, from a post in another part of The Universe, by someone named, Dr. Michael Yanakiev

> Richard Dooling wrote in the New York Times: "Somehow the genius quants - the best and brightest geeks Wall Street firms could buy - fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and - poof! - created $62 trillion in imaginary wealth."

Those algorithms were based on risk assessments that were seriously flawed, based only on the risk to the market at that moment, rather on cold, hard empirical data about a person's ability to pay and what would happen if a lot, rather than a few of them, stopped. As George Dyson (son of the quantum physicist Freeman) wrote in Edge last week: "The problem starts, as the current crisis demonstrates, when unregulated replication is applied to money itself. Highly complex computer-generated financial instruments (known as derivatives) are being produced, not from natural factors of production or other goods, but purely from other financial instruments." What is also becoming clear is that the financial markets are far more automated than ever before. There is a growing sense that much of this was made by machines, with the quants feeding the beast ever more intricate lines of code. Dooling has a growing conviction that we are now at the mercy of a financial system based on "arrangements so complex only machines can make". It seems we are at the mercy of the machine.

Not a Great Depression, a Great Rebalancing

http://discussionleader.hbsp.com/haque/2008/10/the_great_rebalancing.html#comments

Arete said...

Yves,

there was a concerted effort by Chase NY to lend 1 month cash (unsecured) in the market Friday. Citi bank joined in after the market started moving.

To give you an idea of the magnitude of this, they started lending at approx. 5% (way above 1month usd libor note), and ended up lending at 3% (could have been lower after I left. The amounts involved were not trivial and it explains a lot of the movement in the eurodollar strip, the swap spreads and probably even the long end of the usd irs curve. I would guess Chase got a little persuasion to start lending out the cash, it wasn't coming from trader level in any case!

So what.... well USD libors should collapse Monday. So what again... as one person said yesterday, "the panic to get out of panic trades has started".... and there are ALOT of panic trades out there that I think will all have to exit a very small door next week as sentiment comes back from the brink....

[Oct 18, 2008] Some Curious Parallels with the 1930s

naked capitalism

The Hoover administration first tried to fix the problem without involving the government directly. Instead, the government merely facilitated the formation of the National Credit Corporation, a private central lending institution. Sound familiar? Remember the MLEF (Master Liquidity Enhancement Fund), a SIV of SIVs that Treasury tried to coordinate back in the fall of 2007, only to have the banks refuse to pitch in.

Next, the Hoover administration (a lot of New Deal institutions were Hoover inventions) attempted to bolster bank capital through direct government loans through a government agency called the Reconstruction Finance Corporation. The loans didn't do the trick though. We tried some direct government lending support for faltering institutions: AIG, discount window lending to investment banks, government support for JPM purchase of Bear Stearns, FDIC guarantee of Citi's planned purchase of Wachovia. While this lending support might have helped prevent a worse crisis, it did not solve the current one.

The Roosevelt administration then pushed through the Emergency Banking Act (cf. Emergency Economic Stabilization Act) that expanded the RFC's powers to include government purchase of preferred stock from banks. Banks didn't want to sell preferred to the RFC. It took RFC chair Jesse Jones telling the American Bankers Association that if they didn't get with the program and start lending again, the government would go into the direct loan business itself. The banks sold preferred to the RFC. I can only imagine what Secretary Paulson told the 9 bank CEOs would happen if they didn't sell to Treasury.

In the end, the RFC bought lots and lots of preferred stock from banks. By 1935, nearly 1/3 of bank stock value was held by the RFC. The dividend on the preferred stock? Then, as in the current deal, it was 5%.

The recapitalization of banks alone was not enough to get them to start lending, however. They didn't have enough credit-worthy borrowers. Government had to get into direct lending itself. Compare this with Secretary Paulson's declaration that the banks that received the forced equity injection from the Treasury had to deploy it. But also notice, that we've moved in the direction of government direct lending anyhow: the Fed is buying commercial paper (using a special deposit from the Treasury to do so) and FHA-insured refinancings as part of the hapless HOPE for Homeowners Act are equivalent to mortgage lending.

In the 1930s, the government had another major lever, however, to get credit markets going again in the 1930s. RFC preferred stock, unlike the preferred shares that Treasury is going to buy today, came with equal voting rights to common. The RFC exercised this to put its own managers in place at major financial institutions. The result was a distinctive type of state-capitalism. Arguably, Treasury might have done better to take preferred stock that would give it stronger control over bank management.

Steve said...

The problem is a little different this time: securitization didn't exist in the 1930's, LBO'd companies didn't employ millions of Americans, consumer spending wasn't even a third of today's 70% of GDP, the US was a net creditor, and US companies hadn't issued fraudulent paper worldwide. The government isn't going to replace the securitized markets where businesses raised debt for the last 10 years. How much are over-levered companies going to need over the next year to stay in business? --It won't be coming from the capital markets. The banks can't possibly take on balance sheet the leverage they have floated through the economy, and I don't believe the government can either.

[Oct 18, 2008] The astonishing sign off of a wealthy fund manager in full

Telegraph

The full text of the letter written by fund manager Andrew Lahde

Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, "What I have learned about the hedge fund business is that I hate it." I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they look forward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don't worry about my employees, they were always employed by Mr. Springer's company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life -- where I had to compete for spaces in universities and graduate schools, jobs and assets under management -- with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it...

... ... ...

With that I say good-bye and good luck.

All the best,

Andrew Lahde

[Oct 17, 2008] More tarnish on the Greenspan legacy

Friday, October 17, 2008

Though former Fed chairman Alan Greenspan has been remarkably silent lately, perhaps no longer feeling the need to issue weekly "recession probability alerts" since it has become clear that we are now in the midst of one, his detractors have become more vocal.

In fact, criticism of monetary policy over the last two decades seems to be gaining something of a critical mass in recent weeks, a development that is quite understandable given the earth-shattering events that have unfolded in financial markets.

Even Ben Bernanke seems to be pointing a finger at his predecessor, though the current Fed chairman is certainly not without blame for the current mess as he has long been a proponent of the central bank's "hands off" approach toward asset bubbles, hedge funds, and all sorts of other late-20th century bright ideas that have caused so much trouble over the last year.

This report in today's Wall Street Journal captures the new thinking at the Fed:

The Federal Reserve and academics who give it advice are rethinking the proposition that the Fed cannot and should not try to prick financial bubbles.

"[O]bviously, the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it," Fed Chairman Ben Bernanke said this week.

The bursting of this decade's housing bubble, which was accompanied by a bubble of cheap credit, has wrought inestimable economic damage. The U.S. economy was faltering before the crisis in credit markets recently intensified, rattling financial markets and sending home prices down further. Even if the government's decision to take stakes in major banks works, it could take weeks for money to flow freely again.

Obviously. Well, better late than never.

Hopefully, this won't be a case of being too late.

In today's American Banker can be found this story with a "Greenspan Mess" sighting right there in the title.

[Note to financial writers: This kind of takes the thrill out of it for those of us who realized what was coming years ago and now spend a good deal of time on the lookout for others who are just catching on. Remember the rule: the two words must be within two paragraphs or one hundred words of each other.]

Greenspan's Fingerprints All Over Enduring Mess

In the fable "The Emperor's New Clothes," two make-believe weavers purport to spin a fine suit of clothes for the emperor, which is made of beautiful material that possesses the wonderful quality of being invisible to any man who is unfit for his office or unpardonably stupid. The potentate and his subjects acknowledge that the garments are very fine indeed. That is, until one little child sees the emperor marching in a procession, and says at last: "But he has nothing on at all" - and the grand swindle is exposed for all to see.

The U.S. economy as well as economies around the world have been going through wrenching experiences lately, and much more is likely. Former Federal Reserve Chairman Alan Greenspan is the architect of the enormous economic "bubble" that has burst globally. No longer is he revered as a "potentate." His reputation is in tatters. Giulio Tremonti, Italy's Minister of Economy and Finance, has said: "Greenspan was considered a master. Now we must ask ourselves whether he is not, after [Osama] bin Laden, the man who hurt America the most." That speaks volumes.

Greenspan let things get out of control, and the prices of U.S. homes rose to stratospheric levels. Americans and their counterparts abroad borrowed like drunken sailors because of their newfound wealth and net worths, and no one believed that the party would end. While borrowers were told to read the fine print about the risks of adjustable-rate mortgages and the like, few people worried about the future

And to think that I actually attempted to change the name of this blog about 15 months ago, thinking that laying a good portion of the blame at The Maestro's feet had already become conventional wisdom.

Bill Bonner at the Daily Reckoning steps in during the former Fed chairman's silence to pen A Letter from 'Alan Greenspan' About the Deterioration of the U.S. Economy, seeking to explain what might be going through the man's mind now that the financial world is collapsing along with his legacy.

Some excerpts:

This is not by any means the first thing I have written. I have written much over the years. But it was all written for a purpose, which only a few were able to discern. Most readers foolishly saw the cluttered mind of a dithering economist or the clumsy, stuttering pen of a professional bureaucrat. Many listening to my wandering speeches and twisting sentences thought that English was not my first language. They thought they detected a faint accent, like that of Henry Kissinger or Michael Caine. They mocked me as "incomprehensible" or "indecipherable." They watched what they thought was an obsequious bureaucrat squirm. They had no idea what I was really up to and what I can only now reveal.
...
I had weaseled (why not be honest about it?) my way to the top post by knowing the right people and by making myself generally agreeable, and helpful, and by not saying anything anyone could disagree with. That was the original reason for what the press called "Greenspan speak." My private thoughts remained mine alone. All the public and the politicians got was gobbledygook, but for good reason.

They would not have wanted to hear what I really thought. So, I did not tell them. For I knew well and good what generally happened when politicians and central bankers got their hands on soft money and a compliant central banker. I was not born yesterday. They use their control of the money to cheat people. It is as simple as that. (I explained this early on in my career; fortunately, no one bothered to read what I wrote. Otherwise, I never would have gotten the job.) If central banking were an honest métier, there would be no reason to have it at all. Private banks could do the job better.

But people are ready to believe anything. Somehow, they think that a collection of rich financiers and power-mad politicians got together to create and run a central bank for the benefit of the people! Well, I've got news: it doesn't work that way.

Go read the whole thing - Bill was in classic form when he wrote this but, in my view, he gives the former Fed chairman far too much credit.

I've long thought it was more of a "childlike idealism", a severe character flaw common amongst economists, rather than a "knowing deception", as some believe, that caused the man to do what he did.

Oh well, what's done is done.

[Oct 16, 2008] NY Times: House Prices Far From Bottom

Jamie Dimon: "If you are not fearful, you're crazy"

CalculatedRisk

From Vikas Bajaj at the NY Times provides an overview: Home Prices Seem Far From Bottom

Home prices across much of the country are likely to fall through late 2009, economists say, and in some markets the trend could last even longer depending on the severity of the anticipated recession.

In hard-hit areas like California, Florida and Arizona, the grim calculus is the same: More and more homes are going up for sale, but fewer and fewer people are willing or able to buy them.

Yes, house prices are still too high.

[Oct 16, 2008] Consumer Prices Flat in September

"But inflation rates, particularly at the headline level, should fall further in coming months". That's bad for TIPS...

naked capitalism

The markets may take some cheer from the marked reversal in inflationary pressures, but the flip side is that the change points to deflationary forces starting to take hold. From the Wall Street Journal:

U.S. consumer prices were flat in September, a government report showed, the latest indication that falling energy prices and the economic downturn are rapidly easing pressure on inflation.

The figures, which included a slim gain in core prices excluding food and energy, should make it easier for Federal Reserve officials to lower official interest rates even further to address severe strains in financial markets

... ... ...

The consumer price index was unchanged in September, the Labor Department said Thursday. It fell in August for the first time in almost two years. Excluding food and energy, the CPI advanced 0.1% last month. Both figures were 0.1 percentage point below Wall Street forecasts, according to a Dow Jones Newswires survey....

Consumer prices rose 4.9% on a year-over-year basis, down from August and now well off the 17-year high of 5.6% reached in July. The core CPI grew a more modest 2.5% compared to September 2007, though that's still well above the Fed's long-term goal of 1.5% to 2%.

But inflation rates, particularly at the headline level, should fall further in coming months. Oil prices tumbled again Wednesday, closing under $75 per barrel for the first time in more than one year. Leading consumer price indicators like import and producer prices each posted big drops in September for a second-straight month

[Oct 16, 2008] Brad Setser Follow the Money " Blog Archive " An unlimited guarantee requires unlimited access to financing …

• October 13th, 2008 at 2:55 pm
  John Smith Says:

  Is "guaranteed capitalism" a contradiction in terms, as our Libertarian friends point out?

  But is it not the end result of "peoples' capitalism", which tries to turn "workers" into "investors", and increase the base of people who back the free market uncritically?

  Investment gains are now expected for life by our "investor class" (primarily the top 35% of our population). Government-guaranteed investments are the price they demand for not "acting like workers" on the job and w.r.t normal gov't programs.

  Wouldn't the latter be cheaper? Wouldn't the welfare costs of greater unionization and expanded social security be less than our maniac bubbles and frenzied gov't guarantees?
  

• October 13th, 2008 at 2:56 pm
  moldbug Says:

  Can any Japan experts explain how this differs from the route Japan took? It seems pretty similar to me.

  AFAIK the basic problem in Japan was that the government could lend all the money it wanted to the banks, but the banks if anything wanted to contract their balance sheets. They had few incentives to open new loans in an environment of falling asset prices.

  Today's Fanny and Freddy are in a slightly different position - they are acting as genuinely nationalized entities, lending because they are forced to lend. To get the rest of the "private" financial system to work this way strikes me as a difficult step. The government is pushing on a string, and the string is the "private" management of the zombie banks - who clog up the pipe between Uncle Sam, who wants to lend, and his faithful subjects, who want to borrow.

  And turning a zombie into a non-zombie is, as you note, difficult. Among other things, in an environment where assets sell for nine cents on the dollar, it takes a lot of recapitalization to make a bank solvent!

• October 13th, 2008 at 3:23 pm
  john Says:

  Comment #2. Fascinating comment. However, "the people" were willing participants in this fantasy too. Part of that "survival of the fittest" mentality combined with the I'm-above-average-dumb-ass-optimism that is present in most Americans. Regardless of how "it caught on", however, it'll be a long, LONG time before any American political party can go on TV and tell "the people" that they are hopeless dumb-asses and can't be trusted with their own money; even if it IS true. If I recall, it was only a few years ago that dumb-asses were clamoring to invest their Social Security funds in the scam-market.

  My own opinion is that this stems from the majority-ethic group still hoping (against hope) that the Republicans will EVENTUALLY help them get even with "those people", and hence, while they are vainly waiting, will ignore being ripped-off themselves. They've cut-off-their-noses-to-spite-their-faces; for the last 20+ years.

[Oct 15, 2008] What Went Wrong By Anthony Faiola, Ellen Nakashima and Jill Drew Washington Post Staff Writers

October 15, 2008 | Washington Post

How did the world's markets come to the brink of collapse? Some say regulators failed. Others claim deregulation left them handcuffed. Who's right? Both are. This is the story of how Washington didn't catch up to Wall Street.

A decade ago, long before the financial calamity now sweeping the world, the federal government's economic brain trust heard a clarion warning and declared in unison: You're wrong.

The meeting of the President's Working Group on Financial Markets on an April day in 1998 brought together Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt Jr. -- all Wall Street legends, all opponents to varying degrees of tighter regulation of the financial system that had earned them wealth and power.

Their adversary, although also a member of the Working Group, did not belong to their club. Brooksley E. Born, the 57-year-old head of the Commodity Futures Trading Commission, had earned a reputation as a steely, formidable litigator at a high-powered Washington law firm. She had grown used to being the only woman in a room full of men. She didn't like to be pushed around.

Now, in the Treasury Department's stately, wood-paneled conference room, she was being pushed hard.

Greenspan, Rubin and Levitt had reacted with alarm at Born's persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble -- deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time.

Unlike the commodity futures regulated by Born's agency, many newer derivatives weren't traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street's top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what.

Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them -- and if so, how.

Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures. Born's agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market.

At the April meeting, the trio's message was clear: Back off, Born.

"You're not going to do anything, right?" Rubin asked her after they had laid out their concerns, according to one participant.

Born made no commitment. Some in the room, including Rubin and Greenspan, came away with a sense that she had agreed to cool it, at least until lawyers could confer on the legal issues. But according to her staff, she was neither deterred nor chastened.

"Once she took a position, she would defend that position and go down fighting. That's what happened here," said Geoffrey Aronow, a senior CFTC staff member at the time. "When someone pushed her, she was inclined to stand there and push back."

Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today.

The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all.

In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas.

"We knew it was a big deal [to attempt regulation] but the feeling was that something needed to be done," said Michael Greenberger, Born's director of trading and markets and a witness to the April 1998 standoff at Treasury. "The industry had been fighting regulation for years, and in the meantime, you saw them accumulate a huge amount of stuff and it was already causing dislocations in the economy. The government was being kept blind to it."

Rubin, in an interview, said of Born's effort, "I do think it was a deterrent to moving forward. I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way. My recollection was, though I truly do not remember the specifics of the meeting, this was done in a more strident way."

Rarely does one Washington regulator engage in such a public, pitched battle with other agencies. Born's failed effort is part of the larger story of what led to today's financial chaos, a bipartisan story of missed opportunities and philosophical shifts in which Washington stood impotent as the risk of Wall Street innovation swelled, according to more than 60 interviews as well as transcripts of meetings, congressional testimony and speeches. (Born declined to be interviewed.)

Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system.

A New Chain of Risk

Futures contracts, one of the earliest forms of a derivative, have long been associated with big market failures. Harry Truman's father was financially wiped out by agriculture futures, and rampant manipulation by speculators contributed to the market collapses of 1929. Regulators have long known that new trading instruments have a way of giving reassurance of stability in good times and of exacerbating market downturns in bad.

Futures -- essentially, a promise to deliver cash or something of value at a later time -- are traded on regulated exchanges such as the Chicago Mercantile Exchange, regulated by the CFTC. But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the "lack of basic information" allowed traders in derivatives "to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority."

The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.

By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy.

The global derivatives market topped $530 trillion as of June 30 this year, including $55 trillion in the suddenly popular credit-default swaps; that $530 trillion represents all contracts outstanding. The total dollars at risk is much smaller, but still a hefty $2.7 trillion, according to an estimate by the International Swaps and Derivatives Association.

To make sense of those figures, compare them to the value of the New York Stock Exchange: $30 trillion at the end of 2007, before the recent crash. When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay.

Instead of dispersing risk, derivatives had amplified it.

The Regulatory Rift

Born, after 30 years in Washington, found herself on President Bill Clinton's short list for attorney general in 1992. The call never came. Approached about the CFTC job four years later, she took it, seeing a chance to make a public service mark, colleagues say.

For several years before Born's arrival at the futures commission, Washington had been hearing warnings about derivatives. In 1993, Rep. Jim Leach (R-Iowa) issued a 902-page report that urged "regulations to protect against systemic risk" as well as supervision by the SEC or Treasury. Sen. Donald W. Riegle (D-Mich.), while acknowledging that swaps helped manage risk, saw "danger signs, on the horizon" in their rapid growth. He and Rep. Henry Gonzalez, a Texas Democrat, introduced separate bills in 1994 that went nowhere. Mary Schapiro, Born's predecessor, made her own run at the issue through enforcement actions.

In an earlier decade, President Ronald Reagan had described the CFTC as his favorite agency because it was small and it had allowed the futures industry to grow and prosper. Born swept into the agency, the least known of the four major regulators with primary responsibility for overseeing the nation's financial markets, determined to enforce its rules and tackle hard issues.

"One theory at the time was she was so disappointed not to be running Justice -- that she got this tiny agency as a consolation prize and was hell-bent to make it important. I'm not sure that was in her mind, but it was a point of criticism," said John Damgard, president of the Futures Industry Association. Damgard disagreed with Born's approach but said he respected her for fighting for her principles.

Daniel Waldman, Born's law partner at Arnold and Porter and her general counsel at the futures commission, said Born let the industry know she meant business. "She got into a knock-down, drag-out fight with the Chicago Board of Trade over the delivery points for soybean contracts," he recalled. "She believed it was her obligation under the statute to review decisions by the exchanges. If they didn't meet agency requirements, she was going to say so, not look the other way."

Born didn't back off on derivatives, either. On May 7, 1998, two weeks after her April showdown at Treasury, the commission issued a "concept release" soliciting public comment on derivatives and their risk.

The response was swift and blistering. Within hours, Greenspan, Rubin and Levitt cited their "grave concerns" in an unusual joint statement. Deputy Treasury Secretary Lawrence Summers decried it before Congress as "casting a shadow of regulatory uncertainty over an otherwise thriving market."

Wall Street howled. "The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association.

Although Born said new rules would be prospective, Wall Street was afraid existing contracts could be challenged in court. "That meant anybody on a losing side of a trade could walk away," Brickell said.

He spent months shuttling between New York and Washington, working on Congress to block CFTC action. "I remember getting on an overnight train and arriving at Rayburn by 5:30 a.m.," he said. "I watched the sun rise and then went to work on my testimony without a whole lot of sleep."

Born, who testified before Congress at least 17 times, tried to counter the legal question by saying that regulation would apply only to new contracts, not existing ones. But she relentlessly reiterated her conviction that ignoring the risk of derivatives was dangerous.

In June 1998, Leach, who had become chairman of the House Banking committee, thrust himself into the regulatory rift. He herded Born, Rubin and Greenspan into a small room near the committee's main venue at the Rayburn House Office Building, thinking he could mediate. "This is the most unusual meeting I've ever participated in," Leach recalled. "I have never in my life been in a setting where three senior members of the U.S. government reflected more tension. Secretary Rubin and Chairman Greenspan were in concert in expressing frustration with the CFTC leadership. . . . She felt, I'm confident, outnumbered with the two against one."

Leach thought the futures commission lacked the professional bench to handle oversight. He pressed Born not to proceed until the Treasury and the Fed could agree which agency was best suited to the role. "I tried to take the perspective of, 'I hope we can work this out,' " he said. "Both sides -- neither side, gave in."

Rubin said, in the recent interview, that he had his own qualms about derivatives, going back to his days as a managing partner at Goldman Sachs. He later wrote in a 2003 book that "derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements," forcing dealers to put up more capital to back the swaps. "But that will almost surely not happen, absent a crisis."

Asked why he didn't suggest stricter capital requirements as an alternative in 1998, Rubin said, "There was no political reality of getting it done. We were so caught up with other issues that were so pressing. . . . the Asian financial crisis, the Brazilian financial crisis. We had a lot going on."

Crisis and Ice Cream

When the warring parties faced off next, in the Senate Agriculture committee's hearing room July 30, 1998, it was not a neutral battleground to air their differences. Chairman Richard G. Lugar, an Indiana Republican, wanted to extract a public promise from Born to cease her campaign. Otherwise, Congress would move forward on a Treasury-backed bill to slap a moratorium on further CFTC action.

The committee had to switch to a larger room to accommodate the expected crowd of lobbyists representing banks, brokerage firms, futures exchanges, energy companies and agricultural interests, according to a Lugar aide. A dubious Lugar opened the hearing by telling Born: "It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth."

Born would not yield. She portrayed her agency as under attack, saying the Fed, Treasury and SEC had already decided "that the CFTC's authority should instead be transferred to and divided among themselves."

Greenspan shot back that CFTC regulation was superfluous; existing laws were enough. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," he said. "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."

The stalemate persisted. Then, in September a crisis arose that gave credence to Born's concerns.

Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-to-capital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don't know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript.

Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world." She spoke of an "immediate and pressing need to address whether there are unacceptable regulatory gaps."

The near collapse of Long Term Capital Management didn't change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market.

The battle left Born politically isolated. In April 1999, the President's Working Group issued a report on the lessons of Long Term Capital's meltdown, her last as part of the group. The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change -- a recommendation that brokerages' unregulated affiliates be required to assess and report their financial risk to the government.

Greenspan dissented on that recommendation.

By May, Born had had enough. Although it was customary at the agency for others to organize an outgoing chairman's going-away bash, she personally sprang for an ice cream cart in the commission's beige-carpeted auditorium. On a June afternoon, employees listened to subdued, carefully worded farewells while serving themselves sundaes.

In November, Greenspan, Rubin, Levitt and Born's replacement, William Rainer, submitted a Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States."

Toward Self-Regulation

Throughout much of 2000, lobbyists were flying in and out of congressional offices. With Born gone, they saw an opportunity to settle the regulatory issue and perhaps gain even more. They had a sympathetic ear in Texas Sen. Phil Gramm, the influential Republican chairman of the Senate Banking Committee, and a sympathetic bill: the 2000 Commodity Futures Modernization Act.

Gramm opened a June 21 hearing with a call for "regulatory relief." Peering through his wire-rimmed glasses, he drawled: "I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws -- and I think you could say the same about regulation -- is like asking a man to wear the same clothes he wore when he was a boy."

Greenspan and Rubin's successor at the Treasury, Larry Summers, still held sway on keeping the CFTC out of the swaps market. But Treasury officials saw an opportunity to push forward on a self-regulation idea from the Working Group's November 1999 report: an industry clearinghouse to hold pools of cash collected from financial firms to cover derivatives losses. But the report had also called for federal oversight to ensure that risk-management procedures were followed.

The swaps industry generally supported the clearinghouse concept. One amended version of the bill made federal oversight optional. Treasury officials scrambled to act, and a provision introduced by Leach requiring oversight prevailed.

The House passed the bill Oct. 19, but then the legislation stalled. Gramm was holding out for stronger language that would bar both the CFTC and the SEC from meddling in the swaps market. Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power.

On the night of Dec. 15, with the nation still focused on the Supreme Court decision three days earlier that settled the 2000 presidential election in George W. Bush's favor, the act passed as a rider to an omnibus spending bill. The clearinghouse provision remained. At the time, it seemed like a breakthrough.

A clearinghouse would have created layers of protections that don't exist today, said Craig Pirrong, a markets expert at the University of Houston. "An industry-backed pool of capital could have cushioned against losses while discouraging risky bets."

But afterward, the clearinghouse idea sat dormant, with no one in the industry moving to put one in place.

'An Absolute Siege'

In 2004, the SEC pursued another voluntary system. This one, too, didn't work out quite as hoped.

For years, Congress had allowed a huge gap in Wall Street oversight: the SEC had authority over the brokerage arms of investment banks such as Lehman Brothers and Bear Stearns, but were in the dark about deals made by the firms' holding companies and its unregulated affiliates. European regulators, demanding more transparency given the substantial overseas operations of U.S. firms, were threatening to put these holding companies under regulatory supervision if their American counterparts didn't do so first.

For the SEC, this was deja vu. In 1999, the SEC had sought such authority over the holding companies and failed to get it. Late in the year, Congress passed the Gramm-Leach-Bliley Act, dismantling the walls separating commercial banks, investment banks and insurance companies since the Great Depression. But the act did not provide for any SEC oversight of investment bank holding companies. The momentum was all toward deregulation.

"I remember saying at the time, people don't get it -- the level of missed opportunities to address some of these problems," said Annette Nazareth, then the SEC's head of market regulation. "It was an absolute siege on regulation."

Five years later, the European regulators were forcing the issue again. Restricted by Gramm-Leach-Bliley, the SEC proposed a voluntary system, which the big investment banks opted to join. The holding companies would be permitted to follow their own computer models to assess how much risk they were taking; the SEC would get access to make sure the complex capital and risk-management models were up to the job.

At an April 28 SEC meeting, commissioner Harvey Goldschmid expressed caution. "If anything goes wrong, it's going to be an awfully big mess," said Goldschmid, who voted for the program.

Last month, the SEC's inspector general concluded that the program had failed in the case of Bear Stearns, which collapsed in March. SEC overseers had seen Bear Stearns's heavy focus on mortgage-backed securities and over-leveraging, but "did not take serious action to limit these risk factors," the inspector general's report said.

SEC officials say the voluntary program limited what they could do. They checked to make sure Bear Stearns was adhering to its risk models but did not count on those models being fundamentally flawed.

On Sept. 26, with the economic meltdown in full swing, SEC Chairman Christopher Cox shut down the program. Cox, a longtime champion of deregulation, said in a statement posted on the SEC's Web site, "the last six months have made it abundantly clear that voluntary regulation does not work."

It was too late. All five brokerages in the program had either filed for bankruptcy, been absorbed or converted into commercial banks.

Second Thoughts

On Sept. 15, 2005, Federal Reserve Bank of New York president Timothy F. Geithner gathered senior executives and risk-management officers from 14 Wall Street firms in the Fed's 10th-floor conference room in lower Manhattan for another discussion about a voluntary mechanism. Also arrayed around the wood rectangular table, covered by green-felt tablecloths, were European market supervisors from Britain, Switzerland and Germany.

E. Gerald Corrigan, managing director of Goldman Sachs and one of Geithner's predecessors at the New York Fed, had reported in July that the face value of credit-default swaps had soared ninefold in just three years. Without an automated, electronic system for tracking the trades or collateral to back them, the potential for systemic risk was increasing. "The growth of derivatives was exceeding the maturity of the operational infrastructure, so we thought we would try to narrow the gap," Geithner said in an interview.

Talks have continued on a range of issues, including how to set up a clearinghouse with reserves in case of default -- the same concept in the 2000 legislation -- and what kind of government oversight would be allowed. But three years later, there is no system in place. Some major dealers have preferred to go it alone, and no one in the government told them they couldn't.

With last month's death spiral of American International Group, the world's largest private insurance company until it was seized by the government, regulators saw their fears play out. AIG had sold $440 billion in credit-default swaps tied to mortgage securities that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its credit-default swap contracts to post billions in collateral that it didn't have. The government swooped in to prevent AIG's default, hoping to ward off another chain reaction in the already shaky financial system.

The economic crisis has added momentum to the Fed's attempts to organize a voluntary clearinghouse. Geithner held two meetings last week with several firms and major dealers interested in setting up such a mechanism. Last week, the Chicago Mercantile Exchange announced it would team with Citadel Investment Group, a large hedge fund, to launch an electronic trading platform and clearinghouse for credit-default swaps. Other private companies and exchanges are working on their own systems, seeing opportunities for profit in becoming a shock absorber for the system.

The crisis has prompted second thoughts. Goldschmid, the former SEC commissioner and the agency's general counsel under Levitt, looks back at the long history of missed opportunities and sighs: "In hindsight, there's no question that we would have been better off if we had been regulating derivatives -- and had a clearinghouse for it."

Levitt, too, thinks about might-have-beens. "In fairness, while Summers and Rubin and I certainly gave in to this, we were not in the same camp as the Fed," he said. "The Fed was really adamantly opposed to any form of regulation whatsoever. I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets."

Researchers Brady Dennis and Robert Thomason contributed.

[Oct 15, 2008] Banks and "Innocent Fraud"

naked capitalism

John Kay, in "Banks got burned by their own 'innocent fraud'," argues that banks got themselves and the world at large in a heap of trouble via self delusion. Had the bets embodied in their products been presented in simpler terms, they would have recognized that they were bogus and bound to lose money. But the complicated structures blinded them to the fact that they were bound to end in tears.

Kay draws the term "innocent fraud" from John Kenneth Galbraith and describes it as:

the process that systematically benefits one group at the expense of another but generally falls short of outright criminality.

I have trouble with the construct, and am always amazed how activities, if perpetrated by someone outside by the banking classes, are seen in a different light. The damage wrought by the credit crisis is truly colossal, but the fact that the perps (for the most part) thought the products worked and the benefits were shared makes them "innocent?" I don't buy that. Criminality is too low a standard for deeming behavior innocent of not.

[Oct 15, 2008] Four consequences of US pension losses By Chrystia Freeland

"What you might call the 401(k) effect has had two political consequences and, in the medium term, will probably have two even more powerful social ones. The first impact is a shift in the public's appetite for radical government action. The same constituents who besieged their members of Congress, calling on them to oppose a "Wall Street bail-out", are now demanding to know why the government has not acted more decisively. The second result has been a big shift in the polls in favour of Barack Obama, who seemed to be faltering a month ago but is now predicted to be heading for a landslide victory."

October 12 2008 | FT.com

Last week's dizzying rush of events and economic and market data threw up one number which can serve as your Rosetta Stone for understanding what impact the global financial crisis will have on American society: $2,000bn (€1,500bn, £1,200bn). That is the amount Americans have lost from defined-contribution 401(k) pensions over the past 15 months. Peter Orszag, director of the Congressional Budget Office, cited the figure in public testimony last Tuesday, so today the vanished retirement savings will be even greater.

The hit to the 401(k)s – nearly triple the amount Hank Paulson asked for to rescue Wall Street and more than double the cost of the war in Iraq – most directly connects what had been a crisis of financial institutions and esoteric financial instruments with the lives, and old-age security, of millions of middle-class Americans.

The credit crunch has been gnawing away at the world's financial sector for more than a year, but as recently as a fortnight ago – the date the House Republicans defied their own party and voted against Hank Paulson's bail-out plan – it still did not have much traction with Main Street America. That started to change even as members of Congress were casting their no ballots – because the US equity markets plunged in response. In the two subsequent weeks they have plummeted further, with the Dow closing 18.2 per cent, its sharpest drop ever.

The Dow matters to the Joe Six-Packs of America because this is a society of shareholder capitalism. Until this month's sell-off, more than 60 per cent of Americans owned shares, up from just over 10 per cent in 1980. The result is a culture in which business television reporters are celebrities with photo spreads in Vanity Fair, Warren Buffett is a national hero, and the group Republican strategists call "the investor class" forms a majority of the population.

In boom markets, that is a good thing. But it means that a market sell-off is felt beyond Wall Street. What you might call the 401(k) effect has had two political consequences and, in the medium term, will probably have two even more powerful social ones.

1. The first impact is a shift in the public's appetite for radical government action. The same constituents who besieged their members of Congress, calling on them to oppose a "Wall Street bail-out", are now demanding to know why the government has not acted more decisively.
2. The second result has been a big shift in the polls in favour of Barack Obama, who seemed to be faltering a month ago but is now predicted to be heading for a landslide victory. Months of a slowing economy, falling house values and petrol prices spiking above $4 a gallon were not enough decisively to shift the political debate to "the economy, stupid", the field on which the Democrats yearned to play. But the plunge in the Dow – computed with terrifying exactness in the 401(k) statements millions of Americans receive every month – has, and barring a war or a domestic scandal it will likely propel Senator Obama to the White House.
3. The third, social consequence is not yet being felt, but it soon will be. The culture that gave us the term "retail therapy" seems about to rediscover the virtues of thrift. The assets that Americans measured to calculate their net worth – their homes and stock portfolios – have fallen sharply in value. And the personal credit they used to keep up with the Joneses in a society where so many people seemed to be getting so rich has dried up. One sign of the Zeitgeist: Gawker, the popular, waspish media blog (published by a friend and former FT colleague) this week offered recession-busting survival tips for hip New Yorkers, including buying lunch from street carts and cooking at home.
4. The fourth consequence of the 401(k) effect hangs in the balance, and its resolution could affect not just the US but the rest of the world. Shareholder capitalism was a vital part of how America connected its most important political tenets – capitalism and democracy which, since the fall of the Berlin Wall, it has been exporting around the world with success. Now that the markets have turned on America's Main Street capitalists, the question is whether their faith will be shaken. Watching TV stock-pickers enthusiastically suggesting we now have a buying opportunity, it seems the answer, for now, is not yet.

[Oct 14, 2008] Retirement Savers Lost $2 Trillion by Emily Brandon

Retirement Savers Lost $2 Trillion October 8 | Yahoo (U.S.News & World Report)

Stock market turmoil has wiped out roughly $2 trillion of Americans' retirement savings over the past 15 months, according to the Congressional Budget Office.

The value of pension funds and retirement accounts dropped by roughly $1 trillion, or almost 10 percent, in the year ending June 30, the CBO told the House Education and Labor Committee Tuesday, citing Federal Reserve data. Since then, asset prices have dropped even further. The CBO says that retirement assets may have declined by as much as $2 trillion over the past 15 months.

"To the extent households view balances in defined-contribution plans as part of their overall portfolio of wealth, a decline in those balances could lead people to reduce or delay purchases of goods and services," says Peter Orszag, director of the CBO. "It could also lead some workers to delay their retirement." The CBO says this multitrillion-dollar loss in retirement wealth could further slow the ailing economy.

Individual 401(k) participants' average losses ranged from 7.2 percent to 11.2 percent in the first nine months of 2008, according to an Employee Benefit Research Institute analysis of 2.2 million participants. Over two thirds of the assets in 401(k)-style defined-contribution plans are invested in equities, either directly or through mutual funds. During the first nine months of 2008, stocks were down, with the S&P 500 index losing more than 19 percent. Fixed-income investments fared better, with the Lehman Aggregate index gaining 0.63 percent and three-month treasury bills gaining 1.54 percent.

The recent market turmoil may be disproportionately affecting older Americans. Older employees generally have less of their money in stocks and stock funds than do younger workers, which shields them somewhat against catastrophic losses. But older workers' average account balances are markedly higher, so they have more to lose in a significant downturn and less time to recoup losses before retirement. "In the last few weeks, we've been confronted with older workers' and retirees' lives being turned upside down; their panic tops off an already existing state of chronic anxiety about retirement futures," says Teresa Ghilarducci, a professor of economic policy analysis at the New School for Social Research.

Two potential solutions to retirement losses offered by the CBO are working longer to offset financial declines and sensibly allocating your assets to avoid bearing the risks associated with tumultuous markets as much as possible. For example, most workers should invest in diversified index funds rather than individual stocks.

Here's another potential strategy to insulate yourself against stock market risks.

[Oct 13, 2008] Fed Leads Unprecedented Push by Central Banks to Flood Market With Dollars

"Someone described it as the incredible ebb tide before the tsunami. The dollars beach is dry, but soon they will all come back and cover the buildings."

naked capitalism

From Bloomberg:

The Federal Reserve led an unprecedented push by central banks to flood the financial system with dollars, backing up government efforts to restore confidence and helping to drive down money-market rates.

The ECB, the Bank of England and the Swiss central bank will auction unlimited dollar funds with maturities of seven days, 28 days and 84 days at a fixed interest rate, the Washington-based Fed said today. All of the previous dollar swap arrangements between the Fed and other central banks were capped.

``By providing unlimited dollar funds they are acting on the back of the G-7 plan to ensure the system is fully liquidized,'' said Lena Komileva, an economist at Tullett Prebon Plc in London. ``We're going to see even more liquidity provided and more aggressive rate cuts are coming.''

Leaders of the world economy have redoubled efforts to unfreeze credit markets and avert the worst global recession in thirty years after last week's 20 percent slide in the MSCI World Index. Policy makers from the Group of Seven nations pledged at the weekend to take ``all necessary steps'' to stem a market panic and European governments are today announcing plans to avert a banking collapse across the region.

The cost of borrowing in dollars for three months today fell to 4.75 percent from 4.82 percent, the highest this year. The rate for euros over the same timeframe declined to 5.32 percent from 5.38 percent.....

``Taken together, the latest moves increase the chances that we will begin to see some relaxation of the intense funding stresses,'' Dominic Wilson and other economists at Goldman Sachs Group Inc. wrote in a note today. ``This is because bank solvency risk should decline as the government offers protection.''

As well as slashing interest rates in concert last week, global central banks are expanding their toolkits to push down money-market rates. The Fed on Oct. 7 said it will create a special fund to buy U.S. commercial paper and the ECB last week said it would offer financial firms unlimited euro funds. The Bank of England is scheduled to revamp its own money-market operations later this week.

Comments

baychev said...

One reader in another post linked an article in WSJ according to which European banks are big borrowers in USD commercial paper. If they can't roll over they have to liquidate their positions or borrow elsewhere, hence this new 'facility'.

October 13, 2008 10:05 AM

Anonymous said...

Although I like this blog, and especially the discussions here, I'm getting more confused now. It sounds like the FED is just so powerful, with unlimited supply of dollars. Why do you people worry about a meltdown in the last few days? Is there any downside for FED to do this?

October 13, 2008 10:19 AM

fresno dan said...

Trends can continue past sustainability - but eventually they can't continue. And that can happen suddenly. As some point everyone will realize that dollars are just pieces of paper, and the dollar will re-adjust, and in my view, dramatically.

October 13, 2008 10:25 AM

wintermute said...

The worldwide shortage of dollars is indicative of a huge unwinding of dollar denominated assets and debt. Think of it as stage one in a process of obtaining liquid investments - cash. This is temporarily boosting the dollar.

The big unknown is how long the foreign holdings will remain in dollars. It will be a wait-and-see whether the US economy handles the credit crisis better than others. If US country risk remains higher than other centers - stage two of the unwind begins and dollars are converted to other currencies or gold and commodities.

October 13, 2008 10:32 AM

printfaster said...

Let's see if we can break down what is happening.

Here is the equation for velocity of money:

Velocity = GDP or economic activity
------------------------
Money supply

Let's take a look at what happens when the US economy tanks, ie GDP sinks, then velocity goes down. Let's say credit collapses, cutting the money supply, then velocity starts going up, or to keep economic activity at the same level velocity goes up. We are seeing the demand for dollars because of credit collapse in an attempt to keep economic activity from tanking.

If the Fed and treasury try to up the money supply in an attempt to keep velocity from running out of control (high velocity means running with a paycheck to buy essentials before the price goes up), then eventually the total value of that money decreases in terms of a reference, say gold.

The need for money is being seen in the current drop of gold price (liquidation to find dollars), and rise in the dollar. As the effects of the fed and treasury work through, the results will be the devaluation of the dollar, until a rise in economic activity can compensate.

The end result is severe monetary inflation, even though the current dynamics are for deflation.

Someone described it as the incredible ebb tide before the tsunami. The dollars beach is dry, but soon they will all come back and cover the buildings.

October 13, 2008 10:40 AM

donna said...

More like a bathtub than a tsunami. We're pouring in more money, but the drain is still open. Someone has to take the losses from the CDS mess, and the central banks are still trying to save all the players. But the money is simply gone, it doesn't exist and can't be monetized. They're trying to spread out the losses, but there still have to be losses.

Anonymous said...

What are the best indicators to forecast the potential for hyperinflation?

There's no need to worry about hyper-inflation short term. Just small increases in long interest rates will set off another chain reaction of deleveraging, deflation and institutional failure.

What happens to the remnants of the residential and commercial real estate markets when prime mortgage rates go up to, say, 8.5%? And at a time when real incomes are falling and lending standards are being torques down?

Like the man said last night, sell this pop.

LJR said...

It is becoming quite clear why Japan allowed all that bad debt to stay on the books. And this was BEFORE the wholesale abuse of Credit Default Swaps.

My question is whether the world governments are going to stand behind the CDS that come with the banks they recapitalize. If so they simply can't let the market discovery mechanism work and mark to model will rule the day.

Japan could survive because the bad loans weren't protected by swaps. Not the case this time. Either the government has to "simulate" an income stream for bad loans or let the swaps pay off. Am I missing something here?

Anonymous said...

More like a bathtub than a tsunami. We're pouring in more money, but the drain is still open.

The cycle of a stopped up flushing toilet is far closer to the truth.

Everyone's stale nostrums, worn-out cliches and false historical analogies are failing. The scene changes like a kaleidoscope daily. That's the neat part of truly revolutionary times. What was too radical to consider last week is already overcome by events next week.

Now, when this week's Ancient Regime rescue plan peters out in a week or a month, what next?

This is not a mass failure of financial systems. It's a mass failure of financiers.

Soros's sock puppet Obama promises "real change", unlike Goldman Sachs dominated Bush/McCain. And what's his latest bold change? A pathetic copy from FDR's playbook: Bank holiday - foreclosure holiday.

Obama's a #2 alright. But he's not FDR II. He's Gorbachev II.

[Oct 13, 2008 ] Daily Kos State of the Nation by Devilstower

I think that corruption was on both sides republican and democratic so obvious bias toward republicans should be taken with a grain of salt ;-). Still the compete absence of checks and balances is really astonishing.

Sep 21, 2008 | dailykos

"Once is happenstance. Twice is coincidence. Three times is Enemy Action."
-- Auric Goldfinger

James Bond's wealthy nemesis may have had an obsession with gold, but he judged, quite correctly, that if people keep putting your plans awry, that was likely their intent.

In 1982, the same year John McCain entered the Senate, a bill was put forward that would substantially deregulate the Savings and Loan industry. The Garn-St. Germain Depository Institutions Act was an initiative of the Reagan administration, and was largely authored by lobbyists for the S&L industry -- including John McCain's warm-up speaker at the convention, Fred Thompson. The official description of the bill was "An act to revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans." Considering where things stand in 2008, that may sound dubious. It should.

Seven years later, the S&L industry was collapsing. What was the cause? Garn-St. Germain handed the S&Ls a greatly expanded range of capabilities, allowing them to go head to head with full service banks, but it didn't give them the bank's regulations. Left to operate in an anarchistic gray area, S&Ls chased profits, indulged in amazing extravagances, and cranked out enough cheap mortgages to fuel a real estate boom. They also experimented with lots of complex, creative -- and risky -- investments, even though they didn't have the economic models to really determine the worth of the things they were buying. The result was a mountain of bad debts and worthless "assets." Does any of that sound eerily (or nauseatingly) familiar?

It wasn't a foregone conclusion. In 1985, three years after the deregulation of the S&Ls, the chairman of the Federal Home Loan Bank Board saw that the situation was already looking shaky, with the potential to become much worse. He instituted a rule to limit the amounts and types of investments S&Ls could carry on their books in an effort to head off disaster. However, many savings and loans -- among them Lincoln Savings & Loan Association of Irvine, CA, which was headed by a fellow named Charles Keating -- promptly ignored these rules.

Now enters a familiar cast of characters. First to pop up was the universally beloved Fed-chief-to-be, Alan Greenspan. Greenspan argued against the loan board's new rules, and persuaded Reagan to appoint one of Keating's pals to the board to blunt the requirements. A quintet of senators, among them John McCain, began having meetings with both the management at Lincoln and the regulators at the loan board. ] Alan Greenspan also helped out with a letter to the regulators, asking that Lincoln be exempt from the new rules. With their help of Greenspan and their pet senators, Lincoln was able to stay in business an additional two years, at the end of which they failed -- taking the life savings of 21,000, mostly elderly, investors with them.

How involved was John McCain? McCain and Keating had known each other since 1981 and had become fast friends. Of all the "Keating Five," it was McCain who moved into the life of the Lincoln S&L chief. The two men vacationed together multiple times, with the whole McCain clan (babysitter included) heading out for Keating's private Caribbean property on Keating's private jet. McCain didn't think to actually report these trips, or pay for them, until the investigators were breathing down his neck. And McCain took his payment in the form of more than just vacations. Keating and other members of Lincoln's parent company padded McCain's pockets with $112,000 in campaign contributions.

In John McCain's biography, he called his meetings with Keating and regulators "the worst mistake of my life," though from the text you'd think this was a spur of the moment decision, not something that McCain did repeatedly over a space of years. Still, you might think that a "worst mistake" would stay fresh in his memory.

It certainly didn't fade quickly for the country. Following the S&L crisis, the Resolution Trust Company was formed to swallow up the debt of Lincoln and 746 other S&Ls gone wild, and taxpayers were left with the $125 billion bill. The resulting budget deficit forced cutbacks in other programs. The artificial real estate boom collapsed and housing starts fell to their lowest levels in decades. Finally, the whole nation settled in for a period nasty enough that three years later someone could still campaign around the idea "It's the economy, stupid."

Even so, by 1999 Phil Gramm -- who had entered the Senate two years after McCain and quickly become the economic guru of the Keating Five maverick -- put forward the Gramm-Leach-Bliley Act. This Act passed out of the Senate on a party line vote with 100% Republican support, including that of John McCain. (To be fair, the bill eventually passed again with a wide margin following revisions in the House.)

This act repealed part of the Glass-Steagall Act. This may sound like a bunch of Congressperson soup, but the gist of it is that Glass-Steagall was put in place in 1933 to control the rampant speculation that had helped cause the collapse of banking at the outset of the depression, and to prevent such consolidation of the banks that the nation had all its eggs in one fiscal basket.

Gramm-Leach-Bliley reversed those rules, allowing not only more bank mergers, but for banks to become directly involved in the stock market, bonds, and insurance. Remember the bit about how S&Ls failed because they didn't have the regulations that protected banks? After Gramm-Leach-Bliley, banks didn't have that protection either.

Gramm wasn't done. The next year he was back with the Commodity Futures Modernization Act, which was slipped into a "must pass" spending bill on the last day of the 106th Congress. This Act greatly expanded the scope of futures trading, created new vehicles for speculation, and sheltered several investments from regulation.

As with both Gramm-Leach-Bliley and Garn-St. Germain, large parts of this bill were written by industry lobbyists. This famously included the "Enron Loophole" that exempted energy trading from regulation and was written by (big suprise) Enron Lobbyists working with Gramm. Not coincidentally, Senator Gramm, the second largest recipient of campaign contributions from Enron, was also key to legislating the deregulation of California's energy commodity trading.

Thanks to this fortunate trifecta of Gramm-crafted legislation, Enron was able to create "EnronOnline" and trade electricity in California with absolutely no oversight or transparency. They quickly worked out how to game the system. Previously, there had been only one Stage 3 rolling blackout in the history of California. Within months, the system had been manipulated by traders to generate 38 such blackouts and wholesale electrical prices had gone up more than 3000%. Despite production capacity equal to four times the demand during winter, energy traders even engineered a blackout in mid-January.

During the confusion of these deliberate "shortages" and "price spikes," the California administration of Gray Davis -- blind to speculator manipulations because of the walls erected by Gramm's legislation -- was forced to sign energy contracts at enormous rates. There was little choice, because most of California's public utilities were on the brink of bankruptcy from the rising wholesale prices.

In a single year, Gramm's legislation allowed speculators to bring the state to its knees. Enron alone looted California of $11 billion. The manipulations of the energy market were also a major factor in Davis getting the hook, helped usher the governator into power, and they still have repercussions in California's budget battles today. By the end of that year, the depth of Enron's deception could no longer be hidden, and the whole company came crashing down in the largest bankruptcy in history -- at the time. This brought more billions lost in mutual funds and pension funds across the country, and played a major role in the economic downturn of 2001.

But that was only the second act. The combination of Gramm-Leach-Bliley and the Commodity Futures Modernization Act was a toxic cocktail whose total damage was greater than the sum of its parts.

The first Act promoted bank buyouts and mergers that reached such an insane pitch that the average consumer could only keep up by tracking the changing names on their checks and credit cards. Mercantile buys Ameribanc and Mark Twain. Firstar buys Federated and First Colonial. US Bancorp buys Mercantile and Firstar. And, because it allowed brokerages and insurance companies to mingle with banks, the Act cemented a trend that was already (and illegally) underway in which all those terms had become rather quaint. Is Wachovia a savings bank, an investment bank, a brokerage, or an insurance provider? The answer is "yes."

In allowing financial institutions to grow to Godzilla-sized proportions, Gramm-Leach-Bliley helped ensure that we would have financial entities that were "too big to fail." Rather than choosing to enforce rules that kept these institutions apart, the deregulators chose to create monster bankeragasurances whose downfall (and existence) was enough to threaten the whole system.

But if Gramm-Leach-Bliley removed the limits on size and scope, these new institutions still needed fuel. With many financial transactions operating on razor thin margins, and increasing automation sapping the profits from trading of all sorts, they needed a new way to generate the funds required to swallow their brethren in the merged fiscal corporation pond. For that, the Commodity Futures Modernization Act was a godsend.

Among those instruments which the CFMA sheltered from regulatory scrutiny was something called the "credit default swap." A kind of insurance one bank could exchange with another, credit default swaps supposedly made it safe for banks to take on ever riskier forms of debt. The Act didn't invent these swaps, though they were relatively new. Instead, by placing them in a state where they were not only unregulated but almost perfectly opaque, credit default swaps were turned into the perfect vehicle to fuel a Wall Street revolution. No one had any idea what these things were actually worth, they were traded "over the counter" without being administered by any exchange, and even the SEC could monitor their existence only indirectly.

Who would cheer for a new kind of financial instrument that was difficult to understand, invisible to regulators, and impossible for even the whizziest of Wall Street whiz kids to value? Guess.

More recently, instruments that are more complex and less transparent--such as credit default swaps, collateralized debt obligations, and credit-linked notes--have been developed and their use has grown very rapidly in recent years. The result? Improved credit-risk management together with more and better risk-management tools appear to have significantly reduced loan concentrations in telecommunications and, indeed, other areas and the associated stress on banks and other financial institutions.

--Alan Greenspan, 2002

Get that? Greenspan loved credit default swaps. He opined again and again that such instruments would be the salvation of the industry by spreading around risks. To the mighty Greenspan, both their complexity and their lack of transparency were good things, since swaps would only be handled by the big boys who knew how to play with fire.

When questioned about his support of Gramm's legislation, John McCain called his friend (and by then, campaign co-chair) Gramm "one of the smartest people in the world on the economy" and pointed out that Greenspan also favored the acts Gramm and his coalition of lobbyists had authored. If both Gramm and Greenspan were on his side, McCain couldn't possibly be in the wrong.

Except, of course, that he could.

From the beginning, there were plenty of people in the financial community whose opinion of these unregulated credit swaps was not as rosy as that of Gramm, Greenspan, and McCain. Chief among those speaking in opposition was SEC Chairman, Arthur Levitt. Levitt argued that what the industry needed was more transparency, especially when it came to complex instruments like default swaps, and he testified to this before Gramm's Senate Banking Committee,.

"In my judgment, the risk of this regulatory approach is simply unacceptable for America's investors."
--Arthur Levitt, 1999

Gramm paid no attention.

Credit default swaps did allow the banks to share risks. So much so, that banks raced each other in an effort to find more risks. They made it possible for the down payment on homes to become 3%, 1%, 0%. Skip the credit check, avoid the employment requirements, damn the torpedoes, full speed ahead! We've got a credit default swap, we can do anything!

The encouragement and "safety" that credit default swaps provided made the sub-prime mortgage market possible. Just as with the deregulation of S&Ls in the 1980s, the market was suddenly flooded with easy credit. The result was a real estate boom, soaring home prices, and a plague of "Flip that House!" shows on cable.

As the banks piled up crappy mortgages, they heaped on ever more of the credit default swaps -- and they still had no idea how to value the things. Worse, they began to trade the swaps themselves as if they were an investment, treating them like something worth holding instead of a big bundle of cartoon bombs whose fuses were already lit. Since very few loans were falling into default at the time, owning a default swap seemed like a way to collect fees without ever paying out. Banks wanted more, and more, and more.

A secondary market for trading swaps exploded into existence, and swaps were traded with absolutely no consideration for the nature or quality of the underlying investment. Swaps changed hands a dozen or more times, growing in "value" as they went. Worse still, no one regulated who could buy a swap, so it was (and is) perfectly possible for a company to acquire swaps that theoretically cover billions of dollars in loans, even if that company doesn't have a red cent on hand to cover those swaps should the loans default.

How big did this market become? Here's business correspondent Bob Moon and host Kai Ryssdal on American Public Media's Marketplace from back in the spring.

BOB MOON: OK, I'm about to unload some numbers on you here, so I'll speak slowly so you can follow this.

The value of the entire U.S. Treasuries market: $4.5 trillion.

The value of the entire mortgage market: $7 trillion.

The size of the U.S. stock market: $22 trillion.

OK, you ready?

The size of the credit default swap market last year: $45 trillion.

KAI RYSSDAL: That's a lot of money, Bob.

As in three times the whole US gross domestic product, Bob. And the truth is that Moon probably underestimated. The unregulated and poorly reported credit default swaps may have actually passed $70 trillion last year, or about $5 trillion more than the GDP of the entire world.

So, are you starting to get an idea of just how big a genie Phil Gramm and his pals unleashed?

With some regularity over the last eight years, fiscal whistle blowers have tried to raise their hands and register a protest. Um, sirs? Is it altogether a good idea to run up debts exceeding all the assets it's even possible to hold? But so long as no one actually had to pay off on the swaps, the party went on. Even usually conservative (in the fiscal sense) companies like AIG started to worry that they were being left behind and leapt headlong into the swap pool.

Shortly after Greenspan's departure in 2006, the Federal Reserve took the unusual step of issued a joint statement along with the SEC to warn about the risks associated with credit default swaps. But by that point, the damage was already severe. If swaps lost their value, most of those who had played the game would find their giant firms abruptly valued in pocket change. The only solution was to cover the problem with still more swaps and keep moving.

Then a funny thing happened. After years in which banks had handed out loans willy-nilly, guarded by the indestructible swap, people and companies started to really default on those loans. Credit slowed, home prices fell, and the whole snake started to eat itself tail first. Suddenly, credit default swaps were not sources of limitless cash. It turns out that an insurance policy -- even a secret, unregulated policy -- is occasionally expected to pay. Speculators started to look at the paper they were holding and for the first time realized it could all be worthless. Worse, it could (and did) represent a massive debt; one that no one had the funds to cover.

When Bear Stearns fell apart last March, it was only suspected that a big part of the effort in saving the giant investment bank was keeping their holdings in credit default swaps from unraveling and spreading to other institutions. Naturally, part of solving this problem involved creating a new credit default swap to cover Bear Stearn's potential debt. But the all-purpose swap was starting to lose its power. Shortly after Bear Stearns went belly up, AIG reported the largest quarterly loss in the company's history, taking a $11 billion hit on revaluing its holdings of swaps. The party was definitely coming to a close.

When AIG finally collapsed this week, there was no doubt about the primary cause of its failure. The previously well grounded company had "gotten itself involved with something called credit default swaps." Point of irony alert: Arthur Levitt now serves on the AIG board... or at least he did until the government had to take over most of AIG to salvage the company from the very idiocy Levitt had warned of in 1999.

This week, the Bush administration announced the beginnings of a plan to salvage what remains of the financial markets. At first glance, it appears that the plan will consist mainly of creating a kind of "garbage pit," a fund or group of funds -- cousins of the Resolution Trust that was created during the S&L crisis -- into which those people who have dabbled in bad debts can toss their problems. Only this time the cost to the taxpayers is at least $700 billion... and a big bite out of representative democracy.

The expansion of unregulated Savings and Loans in the 1980s brought on the collapse of that industry, a crippling of the economy, and left taxpayers holding the bag. Maybe that was only happenstance. Those pushing for the Garn-St. Germain Depository Institutions Act may not have known what they were doing.

The deregulation of the California electricity market, along with the protections provided to Enron through Phil Gramm's lobbyist-written legislation brought blackouts, fiscal and political chaos, and left taxpayers holding the bag. But the people who engineered that event -- people like Gramm and Greenspan -- had already seen what happened with the S&Ls. They should have known better. Still, perhaps that was only coincidence.

The sub-prime mortgage crisis that has not only come so close to utterly destroying the markets, but has ruined the value of many people's homes and left millions with mortgages they can't pay, was also the outcome of the deregulation created by these men. The very predictable outcome. When taxpayers are left holding the bag for $1 trillion this time around, it's hard to believe it's any sort of accident.

This is enemy action. This is a bullet deliberately fired into the economy by men willing to exercise their ideology regardless of the cost to taxpayers. Men who have every expectation that they can plunder the system again and again, while the public picks up the tab. John McCain may not have had his finger directly on the trigger, but he was there. He assisted. These were his personal friends and philosophical comrades. He may not be the high priest, but he has been a loyal acolyte in the cult of deregulation.

It may come as a surprise to the champions of deregulation, but nobody likes regulation. The restrictions that were placed on banks, S&Ls, and other institutions in the 1930s weren't put there because someone thought it would be fun. They were put in place because they addressed problems that had just been clearly and painfully revealed. They were put in place because they were necessary.

It's bad enough if John McCain didn't know that. It's far worse if he did.

[Oct 13, 2008 ] Readers Journal-A 70 Trillion Dollar Counterfeiting Ring

oftwominds.com

Now we go to the 70 trillion dollar credit default swap market of last year. If only 1 to 2 percent "service fee" were charged in these transactions (which are based on illusory assets), we're talking nearly three-quarters to one-and-a-half trillion dollars in real term fees being siphoned off (i.e. hijacked from) the global economy for no productive, but merely parasitic, purpose. If these fees are attached to phony assets, as I have propounded, than that means a net loss of, say, a trillion dollars of capital taken right out of the system. No wonder we have a liquidity crisis.

[Oct 12, 2008 ] The Financial Crisis: Why Were Warnings Ignored?--Posner

When Becker and I blogged on the financial crisis last Sunday, the bailout had just been announced. The reaction of the stock markets and of senior government officials here and abroad suggests that the premise of the bailout--that the financial crisis is a liquidity crisis that can be resolved by the government's buying the assets of troubled banks at prices equal to the value the assets would have if there were a market for them (that is, if there were adequate liquidity to enable transactions)--was mistaken. The crisis appears to be one of solvency rather than (or perhaps along with) one of liquidity; banks, along with insurers of bonds and other securities, are undercapitalized and so, as I suggested last week, require a capital infusion rather than just a purchase of frozen assets.

All of which merely underscores the enormous cloud of uncertainty that has enveloped the crisis and left economists struggling to understand the causes, magnitude, future course, and cures of what is shaping up as the biggest economic bust since the Great Depression of 1929 to 1933. Last week's stock market crash may also reflect doubts about the government's competence to deal effectively with the crisis. There is a sense that its reluctance to take an equity stake in the banks reflects a doctrinaire hostility to public ownership.

But here is the biggest mystery of all: why was the crisis not foreseen? An article on the front page of the business section of yesterday's New York Times attributes that blindness to "insanity," more precisely to a psychological inability to give proper weight to past events, so that if there is prosperity currently it is assumed that it will last forever. This explanation is implausible--often people fail to adjust to change because they expect the future to repeat the past--and unhelpful, especially when one remembers that the academic specialty of Federal Reserve Board chairman Bernanke is the Great Depression.

We can get more help in answering the question of unpreparedness, or neglect of warning signs, from the literature on surprise attacks, notably Roberta Wohlstetter's great book Pearl Harbor: Warning and Decision (1962). As she explains, there were many warnings in 1941 that Japan was going to attack Western possessions in Southeast Asia, such as the Dutch East Indies (now Indonesia); and an attack on the U.S. fleet in Hawaii, known to be within range of Japan's large carrier fleet, would be a logical measure for protecting the eastern flank of a Japanese attack on the Dutch East Indies, Burma, or Malaya. Among the factors that caused the warnings to be disregarded are factors that may also have been decisive in the neglect of the advance warnings of the financial crisis now upon us: priors (preconceptions), the cost and difficulty of taking effective defensive measures against an uncertain danger, and the absence of a mechanism for aggregating and analyzing warning information from many sources. Most informed observers in 1941 thought that Japan would not attack the United States because it was too weak to have a reasonable chance of prevailing; they did not understand Japanese culture, which placed a higher value on honor than on national survival. Securing all possible targets of Japanese aggression against attack would have been immensely costly and a big diversion from our preparations for war against Germany, deemed inevitable. And there was no Central Intelligence Agency or other institution for aggregating and analyzing attack warnings.

Much the same is true of the warning signs of the current financial crisis. Reputable business leaders and economists had been warning for years that our financial institutions were excessively leveraged. In mid-August of this year the New York Times Magazine published an article foolishly entitled "Dr. Doom" about a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini, who for years had been predicting with uncanny accuracy what has happened. In September of 2006--two years ago--he had "announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac." By August of this year, when the Times article was published, Roubini's predictions had come true, yet he continued to be ignored. Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics. Bernanke had repeatedly stated that it was unlikely that the mortgage defaults that accelerated after the housing bubble burst in mid-2006 would spill over to the financial system or the broader, nonfinancial economy. In May of 2007, for example, he said: "Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market." It has been more than two years since the housing bubble burst. One might have thought that that was enough time to enable the experts to discover that our financial system was in serious trouble.

Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks. Borrowing and then lending the borrowed funds is inherently risky, because you have fixed liabilities but (unless you invest in risk-free assets such as short-term Treasury Bills) risky assets. But it was believed that the risks of borrowing had been reduced and therefore that leverage (the ratio of borrowing to capital) could be increased without increasing risk. Bayesian decision theory teaches that when evidence bearing on a decision is weak, prior beliefs will influence the decision maker's ultimate decision.

Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble--and then Congress or the Administration would have been blamed for the fall in home values and the increase in defaults and foreclosures. In addition, it is very difficult to receive praise, and indeed to avoid criticism, for preventing a bad thing from happening unless the probability of the bad thing is known. For if something unlikely to happen doesn't happen (as by definition will usually be the outcome), no one is impressed; but people are impressed by the costs of preventing that thing that probably wouldn't have happened anyway. This is why Cassandras--prophets of doom--are so disliked. It usually is infeasible as a practical matter to respond to their warnings--but if the prophesied disaster hits, those who could have taken but did not take preventive action in response to the warnings are blamed for the disaster even if their forbearance was the right decision on the basis of what they knew.

The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown. The cost of a disaster has to be discounted (multiplied) by the probability that it will occur in order to decide how much money should be devoted to reducing that probability. No one knew the probability of a financial crisis such as we are experiencing. Even Roubini did not (as far as I know) attempt to quantify that probability.

Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk. Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks and other financial institutions and of regulatory bodies, and among academic economists, financial consultants, accountants, actuaries, rating agencies, and business journalists. But there was no financial counterpart to the CIA to aggregate and analyze the information--to assemble a meaningful mosaic from the scattered pieces. Much of the relevant information was proprietary, and even regulatory agencies lacked access to it. Companies do not like to broadcast bad news, and speculators planning to sell a company's stock short do not announce their intentions, as that would drive the stock price down, prematurely from their standpoint.

In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.

Of all the puzzles about the failure to foresee the financial crisis, the biggest is the failure of foresight of professors of finance and of macroeconomics, with a few exceptions such as Roubini. Some of the media commentary has attributed this to economics professors' being overly reliant on abstract mathematical models of the economy. In fact professors of finance, who are found mainly in business schools rather than in economics departments, tend to be deeply involved in the real world of financial markets. They are not armchair theoreticians. They are involved in the financial markets as consultants, investors, and sometimes money managers. Their students typically have worked in business for several years before starting business school, and they therefore bring with them to the business school up-to-date knowledge of business practices. So why weren't there more Roubinis? I do not know. And why, if not more Roubinis, not more financial economists who took the warning signs sufficiently seriously to investigate the soundness of the financial system? I do not know that either.

[Oct 12, 2008] IMF warns that markets could collapse by another 20% - Times Online

The world is on the brink of financial meltdown, the head of the International Monetary Fund (IMF) said last night. His bleak warning came as finance ministers tried to calm the frenzy in markets that saw share prices crash by more than 20% last week.

Separately, the IMF's chief economist predicted that shares could slump by another 20% before stabilising. G7 finance ministers pledged to take all necessary steps to support the banking system and stave off an economic slump.

Dominique Strauss-Kahn, the head of the IMF, warned that the measures so far "have not yet achieved the goal of stabilising markets and bolstering confidence".

He said: "Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown." Countries would need to take further measures, including interest rate cuts and steps to bolster the banks.

[Oct 12, 2008] From the Archive - Op-Classic, 1990 - Gloom at the Stock Exchange. By Henry Kaufman

In case of 1990 crisis the collapse of the USSR and dollarization of former "socialist camp" territories saved the USA. Newly independent countries absorbed tremendous amount of dollars like water. That's why the Greenspan Fed managed to maintained a 1.75% Fed fund for 33 months (December 2001 to September 2004) without negative consequences at all. Repeating the same trick -- keeping rate at 1% from 2002 (accounting scandals) till June 2004 -- was a complete disaster. New markets created new demand that was the real basis of a stock boom of 1994-2000. This time there is not USSR to collapse. Some of them are bankrupt (Ukraine, Baltic countries) some have reserves (Russia, and some 'stans") but they cannot serve as "consumer of last resort" for bailing out the US this time. Like Andrew Leonard noted in his Salon aprticle Alan Greenspan on the mortgage crisis I didn't do it! "capitalism triumphed all over the world, and then proceeded to eat itself. "

February 23, 1990 | NYTimes.com

Every week, the Opinion section presents an essay from The Times's archive by a columnist or contributor that we hope sheds light on current news or provides a window on the past.

In 1990, in the wake of the collapse of Drexel Burnham Lambert and the failure of savings and loan associations, the economist Henry Kaufman foresaw an unhappy new era in which we would have to pay for Wall Street's recklessness.

Wall Street Heads For Darker Days

The demise of Drexel Burnham Lambert Inc. has been portrayed as the end of an era, and in many ways it is. But it also marks the beginning of a new, darker era in which Wall Street and the nation will pay a heavy price for the excesses of the last decade.

Drexel Burnham's collapse is symptomatic of a deeper problem: the abuse of the American credit system. The consequences of this abuse now abound.

Hundreds of savings and loan associations will have to be closed down, costing taxpayers hundreds of billions of dollars. Many other financial institutions have been significantly weakened by poor-quality loans and investments. The credit quality of American corporations is at its lowest point since the Great Depression, despite seven years of economic expansion.

The abuse of the credit system began more than a decade ago, through a series of events and developments that loosened the structure of the financial system. That fostered a highly aggressive financial entrepreneurship that severely impaired the remaining code of prudent financial conduct.

The credit system suffered further from the Government's willingness to allow deregulation to proceed in the absence of adequate new safeguards, improved official financial supervision and stricter rules of financial conduct. Instead, from Main Street to Wall Street, excesses multiplied through the employment of novel financial techniques and liberalized credit standards that were unthinkable even two decades ago.

Hardly anyone in authority stopped to question the implications for the financial system. The facile rhetoric was that the ''marketplace'' would discipline the wrongdoers in our financial system.

But relying on the market to discipline financial institutions is generally unacceptable. It is too blunt a weapon for financial institutions, which are thinly capitalized and closely linked through myriads of transactions with other institutions.

Financial institutions are the holders and, therefore, the guardians of our savings and temporary funds, a unique public responsibility. Truly letting the marketplace discipline the financial system would mean acquiescing in an avalanche of potential failures - including many salvageable financial institutions and many of their customers.

The excesses of financial entrepreneurship have been abetted by a kind of ''hollowing out'' of the financial regulatory system. Because of piecemeal legislation, official supervision and regulation is highly fragmented. That has meant heavy and inefficient overlapping authority in some areas and enormous regulatory gaps in other areas.

Specifically, the two agencies with responsibility for the securities industry, the Securities and Exchange Commission and the Federal Reserve Board, hold opposite - and probably irreconcilable - theories of financial regulation and supervision.

In a nutshell, the Fed believes that the holding-company parent and all affiliates of a bank or securities firm ought to be supervised on a consolidated basis. The S.E.C.'s legal authority is narrowly focused on the broker/ dealer operation of a securities firm.

Thus, under the terms of its mandate from the S.E.C., the New York Stock Exchange must concentrate its surveillance on the broker/dealer. It has little authority to go into other affiliates of the broker/dealer's parent, even if they are involved in financial activities.

This regulatory fragmentation, and the loopholes it provides, has not been lost on Wall Street. The leading securities houses have all sought to increase their financial leverage by forming elaborate holding companies. To this end, they use creative, though permissible, accounting techniques to hide from public view their gross asset and liability structures.

Thus, the end of Drexel Burnham does not mean the end of the unwinding of the financial recklessness of the past decade. Continued slow economic growth or a business recession will bring forth failures that are still hidden in the financial fabric.

For many firms in the securities industry, the franchise that they once had will not be recaptured. Wall Street's special role as adviser and investment banker to business and to other financial institutions is waning rapidly. The foundations of this role were based on trust. That trust has been shattered by conflicts of interest that were created when many securities firms rushed to participate in hostile takeovers and direct acquisitions of nonfinancial businesses.

In the wake of the Drexel failure, the task of rebuilding a strong financial base for our corporations and financial institutions will require tax inducements, the strengthening and centralization of official financial supervision and the establishment of standards to hold corporate directors accountable for objective evaluations of corporate management performance.

Under such a stiffened regulatory approach, Wall Street firms would probably be confronted with more stringent capital requirements and closer supervision of all the activities under their holding companies. With the loss of much of their franchise, the number and size of securities firms will eventually shrink. Many will become parts of banks or other financial institutions.

Already, there are voices here and there in the securities industry calling for an end to Glass-Steagall, the Depression-era law that required banking and securities to remain separate businesses. This may signal that a merger with a commercial bank might be a preferred way out of the troubled position that many Wall Street firms now face.

Outside Wall Street, few will mourn this outcome, especially in view of the excesses of the recent past. But however understandable that reaction may be, there will be an indirect economic consequence that we all will have to shoulder.

In the more concentrated U.S. financial structure of tomorrow, conflicts of interest will flourish. This will invite governmental intrusion, less innovation and, ultimately, a more inefficient allocation of capital.

[Oct 11, 2008] Soros Lambasts Paulson, Call for Intervention

Soros understood the coming credit default swaps fiasco is coming six month before it occurred. And those guys in Fed and Treasury with all their research staff and facilities did nothing to prevent it... As one reader noted: 'Once upon a time, there was something called "The Peter Principle"....'

April 3, 2008 | naked capitalism

George Soros, in today's Financial Times, joins a long list of critics of the Paulson financial services reform plan, although even to dignify its bureaucratic legerdemain with the label "reform" is singularly misleading.

Soros departs from his peers in sketching out where he thinks regulators went wrong and offers two specific proposals, I am particularly keen about his idea of moving credit default swaps to an exhange; as I've discussed before, that is one of the cleanest and most sensible options available, and it would be viable in a large, active market like CDS.

From the Financial Times:

The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants' biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed's decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

The Bush administration has resisted using taxpayers' money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers' money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.

Comments

Anonymous said...

"You lose all the advantages of derivative."
The problem: The CDS market, as played today, has very little real value ? An insurance policy that can't pay off when the S**t hits the fan is not an insurance policy, it is a scam.

Just like a mortgage that can't pay.

Andrew Teasdale said...

Agreed.
I have felt for a long time that an OTC market merely places the risk above the banking system.
An exchange is the only way to diversify, price and manage risk. It will also reduce "transaction" returns since one of the reasons for OTC contracts are the higher returns on creating them.

I would also recommend that all derivative contracts be ultimately exchange traded. A competitive capitalist system depends on pricing competition and transparency.

The financial institutions have forgotten that they are the medium through which the capitalist system operates and not the end itself.

The explosive development of OTC derivative markets since 2000 has corrupted the financial system that supports capitalism.

Andrew Teasdale

The TAMRIS Consultancy

By the way, this really is a great blog

Dave Raithel said...

Michael Greenberger was interviewed by Terry Gross earlier today (my time.)

http://www.npr.org/templates/story/story.php?storyId=89338743

Interesting history on Phil Gramm's legislation to legalize what let UBS lose all that money. Interesting observations on Paulson's irrelevant regulation reshuffle. Interesting claim that "we'd" be better off if "Las Vegas" ran things given the current rules...

Once upon a time, there was something called "The Peter Principle"....

Soros- "Paulson must go. His entire mode of operation is the ...

Soros: "Paulson must go. His entire mode of operation is the problem"

Comments

H. L. Mencken - Wikiquote When a candidate for public office faces the voters he does not face men of sense; he faces a mob of men whose chief distinguishing mark is the fact that they are quite incapable of weighing ideas, or even of comprehending any save the most elemental - men whose whole thinking is done in terms of emotion, and whose dominant emotion is dread of what they cannot understand. So confronted, the candidate must either bark with the pack or be lost... All the odds are on the man who is, intrinsically, the most devious and mediocre - the man who can most adeptly disperse the notion that his mind is a virtual vacuum. The Presidency tends, year by year, to go to such men. As democracy is perfected, the office represents, more and more closely, the inner soul of the people. We move toward a lofty ideal. On some great and glorious day the plain folks of the land will reach their heart's desire at last, and the White House will be adorned by a downright moron.

[Oct 12, 2008] PAULSON: The Fox Guarding the Henhouse - Sen. Bernie Sanders (I-VT)

As GlobalPundit noted "Translation: Paulson was one of the architects of the crisis! Paulson also benefited personally from the casino economy he helped engineer. After creating billions of dollars in bizarre financial products that are now nearly worthless, he left Goldman Sachs with a personal fortune of over $700 million."

Bernie Sanders on the Senate Bill

by Dollars & Sense

Bernie Sanders, the Socialist senator from Vermont, joined 24 others in voting against the bailout bill Wednesday night. He had earlier submitted an amendment that would have established a five-year, 10 percent surtax on families with incomes of more than $1 million year and individuals earning over $500,00 to raise $300 billion to help bankroll the bailout. The amendment was set aside in a voice vote.

In a statement on his web page, Sanders noted

"This bill does not deal with the absurdity of having the fox guarding the hen house. Maybe I'm the only person in America who thinks so, but I have a hard time understanding why we are giving $700 billion to the Secretary of the Treasury, the former CEO of Goldman Sachs, who along with other financial institutions, actually got us into this problem. Now, maybe I'm the only person in America who thinks that's a little bit weird, but that is what I think."

[Oct 12, 2008] A final obituary for the 401k

The Mess That Greenspan Made

Some are calling this the "death knell" for 401k plans or, as is the case below, the "final obituary" for these plans as an entire generation comes to grips with the reality of being a stock investor in the middle of a stock bear market.

This Wall Street Journal article($) that also conveniently appears at Yahoo! Finance has all the details:

The market downturn has wreaked havoc on workers' retirement savings and raised more questions about 401(k) plans, which were already under intense scrutiny.

This year through Thursday, the average 401(k) account balance dropped roughly 19% to 25%, depending on the participant's age and tenure with the plan, according to Employee Benefit Research Institute.
The downturn comes at a time when regulators and lawmakers were already taking a hard look at 401(k) plans. Major pension legislation passed in 2006 encouraged employers to automatically enroll workers in 401(k)s to help get retirement savings on track.
...
Some retirement-plan experts see current market conditions dealing a decisive blow to 401(k)s. Teresa Ghilarducci, professor of economic policy at the New School for Social Research, calls the downturn "a final obituary" for these plans. She adds, "Even with all the financial education in the world, [workers] can't control how old they'll be when there's a financial downturn."

There's a bit more detail in the WSJ story about the dire consequences of poor choices made by plan participants and this report in the Washington Post is worth a look as well (actually, the WaPo article is quite good and comes with a photo of a distraught Homer Simpson doll on the floor of a stock exchange).

The 2006 legislation that resulted in automatic enrollment wasn't such a bad idea, but legislators may rue they day they made the default option stocks instead of stable value funds or money market funds.

I suppose this is all just part of the "ownership society" that has been in the process of tumbling down all around us over the last year or two.

The whole concept of having individuals manage their own retirement accounts always seemed to be fundamentally flawed except in rare cases where individuals choose to spend about half of their waking hours reading and writing about these things.

Even then you don't always get the results you desire

[Oct 12, 2008] Whom Are We Saving? Oh, yeah, Rich Dudes. I forgot

Well, we have seen one three-page plan: "Give me the money, honey. I know what do to. Just don't hold me responsible." Then we saw another longer plan: "Give me the money, honey. I will try to follow its fuzzy outline, but I want to be able to adapt to circumstances." Now we see another: "Well, maybe we should buy some shares. You know, be owners--but not influential owners. We can't tread on any rich toes, gouty from all those sweets."

Angry Bear

I wonder whom we are saving here?

Treasury officials began canvassing banks and investment firms about the possibility of having the government buy stakes in them. The new bailout law gave the Treasury the authority to buy up almost any kind of asset it wanted, including stock or preferred shares in banks.

Industry executives quickly told Mr. Paulson that they liked the idea, though they warned that the Treasury should not try to squeeze out existing shareholders. They also begged Mr. Paulson not to impose tough restrictions on executive pay and golden-parachute deals for executives who are fired.

Mr. Paulson heeded those pleas. In his remarks on Friday, he carefully noted that the government would acquire only "nonvoting" shares in companies. And officials said the law lets the Treasury write most of its own restrictions on executive pay, and those restrictions can be lenient if they are applied to a set of fairly healthy companies.

Well, we have seen one three-page plan: "Give me the money, honey. I know what do to. Just don't hold me responsible."

Then we saw another longer plan: "Give me the money, honey. I will try to follow its fuzzy outline, but I want to be able to adapt to circumstances."

Now we see another: "Well, maybe we should buy some shares. You know, be owners--but not influential owners. We can't tread on any rich toes, gouty from all those sweets."

Damn, Paulson thinks he is playing Hamlet, here. Cut to the chase, Hank. Either you know what you are doing or move aside.

Well, I want a voting share! And, since the largest shareholders are most probably the biggest crooks, I want to crowd them out. Let's buy enough shares to control the firms, to nationalize them, with no prospect of selling them back at a discount to some rich dude that is looking to make a future killing.

As majority stockholder, my first vote is to fire the CEOs. Fire them the old fashion way. Let them take only personal mementoes--you know, the picture signed by Bush or Reagan or Cheney. And I want security watching in case they try to snatch something--or they make a move towards their computers. Security guards will escort them to the street.

I want banks to serve the public not private interest.

[Oct 11, 2008] Bill Moyers Journal Market Fundamentalism and the Madness of Crowds

This week on the JOURNAL, Bill Moyers spoke with prominent investor and political activist George Soros about the economic crisis and its underlying causes.

Soros attributed much of the current downturn to an erroneous faith in the market to govern itself:

"There has been some kind of an ideological excess: namely, market fundamentalism for the last 25 or so years… It's that markets will correct themselves, that you should leave it to the markets, and there is no need for government intervention in financial affairs. Letting markets run rampant, and that doesn't work…

Sometimes we get carried away. You know, in the Middle Ages people were religious. And so they had tremendous discussions about how many angels can dance on the eye of a needle. Now, if you believe that angels can dance then that's a legitimate question. And this is exactly what has happened here. You thought that you could slice and dice and engage in this kind of financial engineering. And it became very, very sophisticated and got carried away."

In his famed MEMOIRS OF EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CROWDS, 19th century historian Charles Mackay chronicled numerous economic disasters caused by irrational human behavior, including the tulip mania in 17th century Holland. Mackay wrote:

"In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first. … Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper…

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

[Oct 11, 2008] How How to Save the U.S. Economy by Richard C. Cook

The cause of the financial failure is that the producing and consumer economy is "maxed out" and is unable to repay existing loans much less new ones. This is because purchasing power in the U.S. has collapsed.

Purchasing power has collapsed not only because we have outsourced our industry abroad and allowed our infrastructure to crumble, but also because of structural defects identified decades ago by C.H. Douglas and John Maynard Keynes. These defects occur due to the need for retained earnings (i.e. savings) to overcome the Law of Diminishing Returns. This leads to insufficient aggregate demand; i.e., the gap between prices and purchasing power that is endemic in an industrial economy.

The problem is not the collapse of the stock market which simply reflects the deflation of the bubble economy. The problem is the oncoming recession/depression caused by the absence of an economic engine to generate new producing power.

[Oct 11, 2008] Lehman Brothers demise triggers huge default

Times Online

Lehman's corporate debt default promises to increase the stress across global credit markets. Sean Egan, of the Egan-Jones ratings agency, said: "This is a killer. Lehman said a month ago that it was in terrific shape and now you can't even get ten cents on the dollar for its debt.

"It underscores the deep structural flaws in our financial system, knocks confidence in the financial markets and raises the cost of capital. It also demonstrates that we are experiencing not only a crisis of confidence, but a [real] crisis."

About 350 banks and investors are thought to have insured an estimated $400 billion of Lehman's debt through complex derivatives, known as credit default swaps. These include Pacific Investment Management, the manager of the world's largest bond fund, Citadel, the US hedge fund, and American International Group, the insurer that the US Government recently bailed out with two loans totalling about $123 billion.

The Times has learnt that the US Treasury has been overwhelmed with requests from executives of other beleaguered sectors who are seeking a similar bailout scheme for themselves. It is thought that representatives from the US car and airline industries have approached the Government for assistance. It is understood that Mr Paulson does not believe that it is his job to help them. Rather, he is intent on addressing the root problems of the financial crisis

[Oct 11, 2008] Was Bush's statement today the equivalent of a "Hoover Moment"

Mish's Global Economic Trend Analysis

Was Bush's statement today the equivalent of a "Hoover Moment"?

"The fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis."

Herbert Hoover, statement to the press, Oct. 25, 1929.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

[Oct 10, 2008] What would Jim Rogers do?

It's very clearly a crush, a liquidation when people sell everything regardless of valuation. I looking at total, absolute panic. But there is not bottom, until people start to say there will be no bottom. Agricultural commodities still will enjoy almost the same demand, so in roger view they are relatively inexpensive. He would buy index but he is unsure as demand for metal will weaken further. He is buying gold. Plans that are coming from Washington and other capitals are hugely inflationary, and in six month or a year that should be visible. Bernanke and Paulson lost credibility so large part of market collapse is crisis of confidence.

The Mess That Greenspan Made What would Jim Rogers do (interview by Bloomberg )

This discussion really strikes at the heart of the current dilemma - do you try to lessen the impact of the current meltdown in an attempt to insure you'll avoid another Great Depression, or, do you just let markets do what they want to do and then pick up the pieces and start over?

Slower with less pain or fast and painful? Obviously, Rogers favors the latter:

I would tell you what has always worked throughout history and I'll tell you what has always not worked.

The Japanese tried this in the 90s, they kept putting band-aids on and they wouldn't let people fail. You remember the term "zombie" companies, "zombie" banks? Well it's eighteen years later and the Japanese stock market is still down over 75 percent. They talk about the 90s as a lost decade.

America tried it in the 70s - they wouldn't let anybody fail. We had one of the worst economic decades in American history - high interest rates, high inflation, a collapsing currency. It didn't work.

Korea in the 90s, took a hit. They had a horrible two or three years but, since then, they've been one of the most rapidly growing economies in the world. The Russians took a horrible hit - since then, they've been one of the most rapidly growing economies in the world.

This is not politics, this is not philosophy. I'm telling you what has worked throughout history and what has not worked throughout history.

Look it up.

When asked about letting banks collapse one by one, this reply came:

Let 'em fail two by two or three by three. I mean, what is this? Banks have been failing since the beginning of time and they're probably going to fail again until the end of time.

The way it's always worked successfully has been, let the incompetent fail and the competent people - banks, mainly in this case - take over the incompetent banks and everybody starts over.

Yeah, you have a very bad year or two but we've had the worst excesses in the credit market we've had in world history. Never before in world history have people been able to buy a house with no money down, and many of them bought four or five houses with no money down and no jobs, and then the bankers were saying, "This is fun, let's do it with car loans, student loans, credit card loans".

We've had horrible excesses -this has to be cleaned out.

He also noted that the current recession is going to be the worst since World War II.

The video is in high demand at the moment, so good luck getting it to play.

[Oct 10, 2009] Blogger naked capitalism - Post a Comment

Anonymous said...

Dear Yves

I've been studying the "credit default swaps" market for some time. It is said that there are $58 trillion of these outstanding. Though some are off setting many may be built on leverage and unreserved.

What will happen as a result of the Lehman auction today and similar events is that those solid institutions that underwrote CDS contracts which they than turned around and hedged with an off-setting CDO will still be obligated contractually for the CDO they underwrote while losing their protection to a bankrupt counter-party. They will than have unhedged exposure and may be taken down by the same bankruptcy or another depending on whom they underwrote. A few major bankruptcies will take down the whole $58 trillion edifice like a "house of cards."

The only way to resolve this is for the U.S. government to declare "force majeure" and annul these contracts. Parties will be relatively little scathed financially as they will lose only the premium flow and un-callable protection where they have underlying securities to protect.

An Economist
Steve Sposato

Kady said...

@Steve Sposato. I agree with you, with one proviso. It seems clear to me that the govt should step in and allow only those w/ actual ownership of the bonds to settle up (I believe part of the problem is that people were buying default protection against bonds that they did not in fact own, correct?) For those who do not own bonds, they can be made whole (premium paid back) but should in no way be allowed to get full $.9025 on the dollar. This should cut down significantly the exposure of those who underwrote the Lehman CDOs.

This is just ridiculous.

Owe Jessen said...

@ Sposato: The problem of your proposal is that the banks who used CDS for "regulatory arbitrage" - read circumventing regulatory requirements - would be even more undercapitalized than they are right now.

October 10, 2008 1:05 PM

>

fresno dan said...

First, I'll grant I'm none too bright. Now that is out of the way, why do I hear the CEO of Lehman complaining why he wasn't saved. Should he have been backstopped until recovery was only 1 cent on the dollar (O, right, the economy was magically suppose to return to 4.5% growth per annum and Lehman could have leveraged to 130)

October 10, 2008 1:09 PM

doc holiday said...

Just before the collapse of Lehman Brothers, executives at Neuberger Berman sent e-mail memos suggesting, among other things, that the Lehman Brothers' top people forgo multi-million dollar bonuses to "send a strong message to both employees and investors that management is not shirking accountability for recent performance."
Lehman Brothers Investment Management Director George Herbert Walker IV, second cousin to U. S. President George Walker Bush, dismissed the proposal, going so far as to actually apologize to other members of the Lehman Brothers executive committee for the idea of bonus reduction having been suggested. He wrote, "Sorry team. I am not sure what's in the water at Neuberger Berman. I'm embarrassed and I apologize.

[Oct 10, 2009] Your Money - Switching to Cash May Feel Safe, but Risks Remain - NYTimes.com

How NYT can print such a crap. This is just a regular investment guru baloney. In reality, if you own stocks or commodities you should never allow profits run too high ;-). It is attempts to make a killing that cost us so dearly. I doubt about the wisdom of letting your 401K account shrink more then 5% At this point one need to sitting in cash especially if this is a baby boomer. Also missing a couple of bad days compensates for missing a couple of good days. Often overcompensates as 5% a day moves are more probably down then up.

At some point, stocks will indeed fall enough that investors will remove the money from their mattresses and put it to work, causing prices to rise significantly. But, as Bonnie A. Hughes, a certified financial planner with the Enrichment Group in Miami, put it to me, there won't be an e-mail message or news release that goes out when this is about to happen. It will be evident only afterward, on the few days when the market surges.

And it gets worse for those who think they won't have any trouble investing in stocks again later. Medium- or long-term investors who are considering a big move into cash right now are probably making an emotional decision, at least in part. For those who follow through, the same instincts will probably hurt when trying to figure out when to reinvest in stocks.

"The emotional forces that drove them out of the market aren't likely to let them back in 'until things are better,' " Dan Danford of the Family Investment Center in St. Joseph, Mo., said in an e-mail message. "And for most people, things won't feel better again until the market has already moved back up." In fact, he added, plenty of people may not allow themselves to get back in until the market has already risen significantly.

[Oct 10, 2009] Radical Measures May Be In The Wings - Financials US News Story -

CNBC.com

Even before details of the latest measures began to trickle out, there was heightened concern about the health of big institutions and the need for direct government support.

" I don't wish to spread alarm on the line people but the big issue confronting the market is I'm afraid the health and sustainability of Morgan Stanley and Goldman Sachs " Hugh Hendry, Partner and CIO at Eclectica, told CNBC early Friday.

[Oct 10, 2009] Early Boomers and the Economic Mess

October 03, 2008 | Robert Reich's Blog

The economic meltdown is hurting everyone. But if you're an early baby boomer over the age of 55, you may be in particularly big trouble. In an economic crisis, many employers lay off older workers first because their seniority makes them more expensive. And studies document that older workers who lose their jobs face more difficulties finding new ones.

That's not the biggest problem you face. The house you've been living in for twenty-five or thirty years and were planning to cash in for retirement is worth far less now than the last time you looked. So is that 401-k plan you were counting on.

And you don't have enough time before retirement to make up for these losses -- certainly not enough time to reap the gains you expected between now and then. If the economic crisis is as bad as some predict, housing prices and share values might not bounce back for five years or more. Japan's meltdown took ten years to correct.

We early boomers – and note I said "we," because, sadly, I'm one of you – once had all the advantages. We entered the housing market in the 1970s and 80s, when houses were still cheap, and reaped the gains when late boomers came into the market and pushed prices up. We also got the plumb jobs because we were first into the post-industrial economy, before the boomers who followed us. And many of us got into the stock market early on, and rode that great wave.

So maybe now we're paying the price for our good fortune then. But that doesn't make this any less painful.

One saving grace. At least the Bushies didn't have the votes to privatize Social Security. Had they got their way -- and were we now completely reliant on the stock market for our retirements -- we early boomers would be in, as the President's father used to say, deep doo doo.

Blogger Robert Reich's Blog - Post a Comment

When are we we going to start to see serious numbers of people charged and arrested for wire fraud, conspiracy, etc.? Trust will not return to the markets until people are assured that those who cheated them are in jail, or, no longer work in the financial sector. And folks, that is a lot of people!

Let me again quickly run down the list of those eligible for arrest:

• real estate agents and brokers (please arrest some of them; I won't mention names). They colluded to increase the price of homes to get fatter commissions;
• appraisers who said homes were worth more than they actually were;
• city and county bureaucrats who knew property appraisals were coming in too high but loved the increasing property tax revenues;
• mortgage brokers and companies who offered liar loans (no documentation) and changed loan conditions at closing;
• regular banks who started doing what mortgage companies did when they saw all the money being made;
  Fannie & Freddie officials who bought all of the phony and unsupportable mortgage paper, knowing most of it was toxic;
• Ditto for Wall St. banks, who sliced it up (securitized) into little pieces and sold them off to investors around the world;
• Ditto for the insurance companies (i.e. AIG) who rated these investments AAA!;
• Federal government-idiots, bought and paid for-most of them need to go to jail.

As you can see, since most of the financial and legislative system is criminally corrupt, no one of consequence is going to jail. Which means trust will not be restored anytime soon.

Robert Reich's Blog

The Meltdown (Part III) What does it mean that the Dow closed below 10,000 today -- returning to levels first seen nearly a decade ago, in early 1999? Many interpret it to mean that the stock market is finally reacting to the credit crisis. A more accurate assessment is that it's finally catching up to the consumer crisis.

After the market closed today, Bank of America announced a significant deterioration in people's ability to repay credit-card and other consumer debt.

The central fact is this: consumers in the real economy are coming to the end of their capacities to keep spending. They can't take on any more debt. And with the costs of energy, food, and health insurance all soaring, they're doing the only thing they can. They're pulling in their belts. They're leaving the malls. They're not buying a new car or TV or anything else they can do without.

For years, regardless of the business cycle, American consumers were the Energizer Bunnies of the world economy. Their spending kept it going. But now the Energizer Bunnies have turned into scared rabbits, and they're going back into their holes.

Yes, we need better regulation of Wall Street in order to avoid the sort of bubbles and distrust that have generated a credit crisis. But even more than that, we need to get money back into the pockets of average American consumers -- including major investments in infrastructure, affordable health care, and a more progressive tax code.

[Oct 09, 2008 ] The IMF's Outlook: Worried

"In other words, we are all Wall Street now..." Recovery in 2009 ?

From Chapter 1 of the IMF World Economic Outlook, released yesterday:

The world economy is now entering a major downturn in the face of the most dangerous shock in mature financial markets since the 1930s. Against an exceptionally uncertain background, global growth projections for 2009 have been marked down to 3 percent, the slowest pace since 2002, and the outlook is subject to considerable downside risks. The major advanced economies are already in or close to recession, and, although a recovery is projected to take hold progressively in 2009, the pickup is likely to be unusually gradual, held back by continued financial market deleveraging. In this context, elevated rates of headline inflation should recede quickly, provided oil prices stay at or below current levels.

The emerging and developing economies are also slowing, in many cases to rates well below trend, although some still face significant inflation pressure even with more stable commodity prices. The immediate policy challenge is to stabilize global financial markets, while nursing economies through a global downturn and keeping inflation under control.

Over a longer horizon, policymakers will be looking to rebuild firm underpinnings for financial intermediation and will be considering how to reduce procyclical tendencies in the global economy and strengthen supply demand responses in commodity markets.

...A worrying aspect of this latest bout of turbulence is that there are now increasing signs that market strains are starting to fall more heavily on the nonfinancial corporate sector and on emerging markets. If sustained, such strains could well foreshadow a more severe macroeconomic impact of the financial crisis than previously anticipated.

... ... ...

The recent surge in borrowing costs for nonfinancial firms has taken place against the backdrop of a gradual worsening of their risk profiles over the course of the financial crisis. The market-based measures of default risk and leverage ratios have risen across the credit spectrum in both the United States and Europe -- not only for low-grade bonds, as would be expected during a slowdown, but for high-grade bonds too (middle panel of second figure). For high-grade corporate bonds in the United States, for example, the probability of default has doubled since June 2007, although it remains below the levels experienced in 2004, in part owing to strong corporate balance sheets, particularly, ample internal funds.

[Oct 8, 2008] The Big Picture

What about hedge funds and other products of excessive deregulation ?

To repeat my prior arguments, the proximate cause of the Housing crisis were

1) Ultra-low rates; and

2) Abdication of traditional lending standards, thanks to

3) originators ability to resell mortgages for securitization purposes, and hence,

4) not have to worry about loan defaults.

The credit crisis was caused by

1) the above securitized mortgage paper, that was

2) rated triple AAA by Moody's and Standard & Poors, which then

3) Which was then "insured" by credit default swaps (CDS) -- the unreserved for, shadow insurance products 4) whose exemption was made possible by the Commodities Futures Modernization Act. That legislation exempted these derivatives from any supervision or regulation.

The lack of reserve requirements is why there is now $62 trillion in CDS, many of which will never pay their counter parties the promised insurance.

If you are going to blame Fannie/Freddie/CRA, or George Bush or Barney Frank, you are missing the big picture.

[Oct 8, 2008] russian-stock-market-collapse

It is important to understand that the USA risks are wider the domestic. What if American financial institution will be declared persona non grata in some or many countries ? That effect can be much stronger then generally transitory boycott of American goods after the Iraq invasion...

naked capitalism

doc holiday said...

I'm providing various unsubstantiated information from the internet below -- please do your own DD. Nonetheless, IMHO, world leaders will wake up in a few weeks and suspend derivative trading on a global basis, but I assume it will take a much larger event, like a country club closing, or maybe a few countries going under, or seeing Buffett on CNBC freaking out about his declining fortune, as he screams for help.

• FYI: The size of the world stock market is estimated at about $60.9 trillion USD at the end of 2007. The world derivatives market has been estimated at about $480 trillion face or nominal value, 12 times the size of the entire world economy.
• Libor, set by 16 banks in a daily survey by the British Bankers' Association at about noon in London, determines rates on $360 trillion of financial products worldwide, from home loans to derivatives.
• The equity sell-off has eviscerated some $4.6 trillion of global stock market wealth in the past three weeks alone, according to the market capitalization loss on MSCI's main world equity index. Over the last 12 months, that figure is more than $12.4 trillion, of which some $7 trillion comes from the United States.

• Fannie and Freddie already own or guarantee more than 40 percent of the $12 trillion in U.S. home loans.
• Total Global GDP is about $50 Trillion
• The market for Derivatives like Credit Default Swaps is over $60 Trillion
• US Treasury Debt/deficit maybe $12 Trillion
• Iraq War, maybe $3 Trillion
• Global Government Bailout Packages closing in on $1 Trillion.

This is new world order stuff folks and American backed derivatives are going to be viewed as financial terrorist weapons of mass destruction. IMHO, we will see American securities banned and suspended in many countries that will reorganize and kick out global entities that are connected to accounting fraud. If we don't re-engineer Wall Street immediately, this systemic collapse will change the course of the world within one year

[Oct 8, 2008] Wolfgang Munchau: Policy Errors Risk Turning Credit Crunch Into Depression

naked capitalism

Wolfgang Munchau in EuroIntelligence argues against conventional wisdom, which is that modern policy tools and institutional arrangements will keep the credit crisis from morphing into a depression. He contends that the policy errors, the result of political considerations, have been substantial. He also says that Treasury Secretary Henry Paulson devised the badly-flawed Troubled Assets Repurchase Program to benefit Goldman. Although this is a widely-held view, few financial commentators have been willing to say so in writing. He also discusses how EU member nations are wasting firepower rescuing institutions for competitive reasons when they should have been allowed to fail.

Thomas Palley is even more critical of US policy, arguing that it has focused on the traditional banking system, and has failed to address the escalating crisis in the shadow, or in his usage, the parallel banking system. Key sections:

The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years....

In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.

Though the parallel banking system engaged in riskier lending than the traditional banking system, those differences were a matter of degree. Traditional banks like Washington Mutual, Wachovia, and Citigroup have also all lost huge sums. However, the traditional banking system is more protected for two reasons.

First, traditional banks are significantly funded by customer deposits...Second, traditional banks are significantly shielded from mark-to-market accounting because they hold on to many of their loans...

From EuroIntelligence (hat tip reader Saboor):

.... ... ...

Financial crises do not automatically produce recessions or depressions. Only bad policy cab turn a crisis into a catastrophe. The 1930 Great Depression could have been avoided if governments had not pursued pro-cyclical policies, and most important, if central banks had not allowed deflation. We have learned from those mistakes, but are committing new and possibly bigger ones. Government is our one and only safety net. It could, if it wanted to, provide basic financial services, that could easily fulfil three economic functions that are attributed to finance: to provide liquidity, to share risk, and to allow agents in the economy to make inter-temporal choices. You don't need CDOs and CDSs for that. A network of central bank branch offices, in combinations with a relatively small number of national, or nationalised banks, could temporarily offer the vast bulk of all financial service of wider economic relevance. The way to go is to shrink the financial system and nationalise the systemically important financial institutions. I have heard there are about 45-50 in the euro area though this is not a precise guess, and subject to change over time. After the financial sector is stabilised, it is time to rebuilt the system, to allow the government later re-privatise its assets, ideally subject to different incentive structures than those that have led to this crisis. In theory, governments could even make money on it. I doubt it. But at the very least, governments can minimise losses.

But if you squander valuable resources on second-rate institutions such as Hypo Real Estate, for the wrong reasons, your freedom of manoeuvre will be constrained at the moment you need it the most...

[Oct 7, 2008] Retirement accounts have lost $2 trillion so far Financial News - First the took away pensions. Now they take away those meager sums that people saved.

Yahoo! Finance

Americans' retirement plans have lost as much as $2 trillion in the past 15 months -- about 20 percent of their value -- Congress' top budget analyst estimated Tuesday as lawmakers began investigating how turmoil in the financial industry is whittling away workers' nest eggs.

... ... ...

"Unlike Wall Street executives, America's families don't have a golden parachute to fall back on," said Rep. George Miller, D-Calif., the panel chairman. "It's clear that their retirement security may be one of the greatest casualties of this financial crisis."

... ... ...

Some experts argue that the hefty tax subsidies that Congress has put in place in recent decades for 401(k) and other worker-contribution accounts have made people's retirement income less secure by shifting risks, decisions and costs from employers to people who often know little about investing.

"They are fatally flawed," Teresa Ghilarducci, an economist at the New School for Social Research, said of the tax-advantaged plans. "They're too risky, and it's not good policy to have workers run their own retirement plan. They want government help."

Common mistakes workers make include overinvesting in a single stock -- often their company's -- and participating in funds that carry large fees or involve excessive risk, the witnesses said.

... ... ...

The current market turmoil adds to an already difficult retirement savings picture for Americans, who are increasingly shouldering the burden of managing and funding their own company-sponsored retirement savings plans as firms eliminate traditional pensions.

Even before the recent downturn, older Americans were on track to continue working longer. Twenty-nine percent of people in their late 60s were working in 2006, up from 18 percent in 1985, according to the Bureau of Labor Statistics. Over the next decade, the number of workers who are 55 and older is expected to increase at more than five times the rate of the overall work force, the BLS reported.

Falling home values and now the decimation of much of their savings could plunge older Americans into period of austerity not seen in decades, Miller said: "The fear factor is huge, and they don't see the availability of resources to them to get well."

[Oct 7, 2008] Lessons From Modern Economic Crises (Not for the Fainthearted)

The rule of thumb for 401K investors is that in housing crisis equity prices will drop 50% and the equity price bust can last ten or more quarters

October 7, 2008 | naked capitalism

Now that the world is in the throes of the mother of all financial messes, economists are scrambling to develop expertise. Carmine Reinhart and Kenneth Rogoff recently had this beat largely to themselves. but in the last two weeks, the IMF came out with a stud of 124 modern banking crises.

The latest addition to this growing body of knowledge comes from Stijn Claessens, M. Ayhan Kose,and Marco E. Terrones at VoxEU.

While we will excerpt the paper at greater length below, here is the key paragraph:

The episodes of credit crunches and housing busts are often long and deep. For example, a credit crunch episode typically lasts two and a half years and is associated with nearly a 20 percent decline in real credit. A housing bust tend to last even longer: four and a half years with a 30 percent fall in real house prices. And an equity price bust lasts some 10 quarters and when it is over, the real value of equities has dropped to half.

[Oct 7, 2008] IMF says rapid and decisive global action needed to stem crisis -

October 7, 2008 | Times Online

The IMF's call came as it issued a startling new estimate that the total losses inflicted on US banks by the continuing crisis could balloon to $1.4 trillion (£798 billion). This was up from its previous estimate in April of $1 trillion in losses, and compared with $760 billion written off by American and global banks up to the end of September.

... ... ...

"The global disappearance of trust in counterparties and widespread cash hoarding that has surfaced recently has made it inevitable that, if a resolution plan is to achieve an orderly deleveraging process that limits the damage to the financial system and the economy, the authorities will need to play a major role in it," it said.

It gave a strong warning that a global strategy from the authorities, rather than piecemeal national measures, was needed. "Actions to stabilise the global financial system should be coordinated across countries and, in particular, across major financial centres," it said.

[Oct 6, 2008] "One Hell of a Job," Brownie By Stormy

October 06, 2008 | Angry Bear

The old world order is not just slipping away; it is running out the door. Or, to change the metaphor, the structures of the old order are falling so fast that is difficult to keep track of the debris on the streets.

While the CEO of Lehmann Brothers, that "gorilla of greed," Dick Fuld, has a small point when he says that the crisis is not just a crisis of Wall Street, he certainly has been part of the capitalistic gang that has driven the U.S. over the cliff, dragging many other countries with it.

Yes, the fashioners of globalization have done a hell of a job, Brownie. The rich got really rich, but they simply could not keep the party going indefinitely, these great scions of capitalism. Today's offerings that spell out parts of the crises are from here and India. Both are worth reading in their entirety.

M R Venkatesh spells out how China could wreck the U.S. economy, as if it needed more help, simply by selling some of their U.S. dollar denominated holdings.

the recent bailout package being approved in the US Congress needs to be viewed in the context of the spurt in the accumulation of forex reserves of China by about $500 billion in the last six months to about $2 trillion in aggregate.

Why is China engaged in this exercise? What could be its implications on the on going global financial crisis? Could China trip the bailout package announced by the US last week? Crucially what are the implications for the existing global order?

What is intriguing in the Chinese forex reserve build-up is that both trade surplus and foreign direct investment account only for a part of this gargantuan pile.

Be nice to China.

William M Tab in The Monthly Review sees Four Crises of the Contemporary World Capitalist System:

the financial crisis, the loss of relative power by the United States, the rise of other centers of accumulation, and resource depletion and ecological crisis.

The Washington Consensus has been discredited, and although the damage it causes continues, it has not achieved Washington's goals. There has been a uniting of much of the world into a coalition of the unwilling. If serious left-wing governments took power in many countries of the South, there could be dramatic reconstruction of the global political economy.

During the Bush presidency, the United States lost one in five manufacturing jobs and that too is part of financialization and globalization. Wages have been pushed down, pension benefits curtailed, health care burdens shifted onto workers and their families, employees made to work part-time or fired and hired back as "temporary" workers, and so on-all in order to meet profit targets and to finance the huge debts companies are burdened with as a result of widespread borrowing to finance takeovers. More people are working part-time or as temporary workers and are pessimistic about the prospects of their children. They see their government captured by the corporations and the wealthy.

We are now witnessing the loss of what Charles DeGaulle once called the "exorbitant privilege" of the United States, derived from its role as issuer of the international currency. George Soros, speaking to the World Economic Forum in January of 2008, suggested, "It's basically the end of a sixty-year period of continuing credit expansion based on the dollar as the reserve currency."11 The advantage the United States has enjoyed by being able to borrow in its own currency has been undercut by abuse, outsized current account deficits, and the buildup of dollars in foreign hands. This has progressed to the point where the money creation and lower U.S. interest rates implemented by the Federal Reserve to stave off financial collapse have driven down the currency's value and encouraged further flight from the dollar.

There is one other piece I thought I might include, but it does require extensive comment: The Financial Development Report (January 2008) from the World Economic Forum. Suffice it to say that its conclusions were:

On the basis of this holistic view, this year the United States scores top honors in the rankings closely followed by the United Kingdom. The collective strength of financial intermediaries and markets in these countries, spanning banks, investment banks, insurance companies, equity markets, and bond markets is unparalleled.

The circle has been squared at last. I do understand that placing just its conclusions before you is a bit unfair, but I am feeling particularly nasty today. Parts of the report are truly superb; others are just latrine filler.

[Oct 6, 2008] Brics slump as investors flee emerging markets - Times Online

The Bric stock markets crumbled yesterday as investors in emerging market stocks - including Brazil, Russia, India and China - suffered their worst one-day losses in history.

Exchanges in Russia and Brazil halted trading as their benchmark indices plummeted 18 and 10 per cent respectively. India's Sensex index lost nearly 6per cent as foreign investors fled amid fears that a serious global downturn beckons. China's CSI 300 Index lost more than 5per cent, to extend its losses for the year to 60 per cent. Last night the MSCI Emerging Markets Index, which tracks bourses from Chile to Jordan, was down more than 8.2 per cent, leaving it poised for its biggest one-day slide on record.

"Foreign funds are panicking," Deven Choksey, of KR Choksey, the Bombay brokerage, said. The Indian slump has been driven by the exodus of nearly $10 billion (£5.7billion) of overseas money this year as investors seek sanctuary in US Treasury bonds.

As the markets opened yesterday, sentiment soured in the wake of an early Asian sell-off amid a toxic blend of high borrowing costs and lower commodity prices, traders said. Across the Bric nations, commodity and financial stocks led losers as oil dipped beneath $90 a barrel and fears grew that the global crisis would claim more victims outside the United States.

Related Links

• No sign yet that the bubble of fear will burst
• Investors drop Brics for Middle East

Sberbank, Russia's biggest bank, dropped as much as 22 per cent. Gazprom, the country's biggest company, which holds its gas export monopoly, plummeted by 19per cent.

Russia is seen as particularly vulnerable because investors have borrowed heavily to pump money into the market and now face unanswerable margin calls. Investors gave little heed to the Kremlin's pledge to pump $150 billion into the economy through loans and tax breaks.

[Oct 6, 2008] Europe demands US 'take responsibility' for financial crisis - Times Online

The European Commission delivered an unusually sharp rebuke to the United States yesterday over its failure to endorse its $700 billion (£394 billion) rescue package for the stricken financial services industry.

Twenty-four hours before the Commission tables draft pan-European legislation to toughen up capital requirements for banks, Johannes Laitenberger, its spokesman, said: "The turmoil we are facing has originated in the United States. It has become a global problem. The US has a special responsibility in this situation . . . we expect that the decision will go through soon. The US must take its responsibility in this situation, must show statesmanship for the sake of its own country and for the sake of the world."

The Commission's unusual decision to deliver the statement, unprompted, reflected the degree of frustration in Brussels at the failure of the US to take measures to calm financial markets. The organisation contrasted the paralysis in Washington with the action that British, French, German, Irish, Dutch, Belgian and Luxembourg authorities had taken over the previous 48 hours to try to shore up confidence in the banking sector.

"The last hours have shown that European authorities are assuming their responsibilities. This again shows that public authorities in Europe can live up to the task of preserving financial stability and protect savings," Mr Laitenberger said.

[Oct 5, 2008] Nick Rowe on What Caused the Financial Crisis

This Nick is just a primitive neo-classical apologist, but some comments are really interesting...

Economist's View

Opening Salvo: Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.

Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.

What is a bubble? Everybody talks about the house price bubble, but nobody defines what it means.

Comments

Benoit says...

premise one: In the long term, a well diversified global portfolio always has positive growth.

premise two: Maximizing returns is achieved by leveraging as much as possible those investments in sectors that are guaranteed to grow.

conclusion: profit!

Nothing can go wrong right?... right???

===

Ryberg says...

This is not anywhere near as difficult as you are making it.

Understand first what a Ponzi scheme is. It is like a chain letter (which the US Postal Service made illegal many years ago). A schemer assures you positive returns if you "invest" today. Tomorrow the schemer gets 10 more "investors" and pays you off. You are now convinced that the schemer has a great "investment" so you plow your money back in along with 100 more "investors". The 10 "investors" are paid off so handsomely that they "reinvest" with a 1000 more "investors". It works wonderfully as long as more "investors" enter than are being paid off. And with "reinvestments", that can happen for a long time. Even decades and whole generations. Eventually, however, there will not be enough new "investors" to cover the promised returns to existing "investors". When word gets out that the promised returns can't be paid, at least some "investors" will want their money back, making it even harder for the scheme to work. This is when the Ponzi scheme can collapse.

Note there are no goods or services that need to be exchanged and there is no requirement for capital investment capable of producing future goods so principles of economics do not apply. Forget about g and r. We are talking about gullible people getting duped by unprincipled people.

So who are these gullible and unprincipled people? Look in the mirror.

Why did real estate prices rise? Because people could borrow money to buy it. We didn't ask if it was worth the money because we knew its price would continue rising so we could always get our money back. We were told that real estate always increased in value so this was a safe "investment". If we bought just like the thousands of others who were buying we could make money without having to produce anything. Capital gains without real capital is the essence of a Ponzi scheme.

Now let the financial engineers from Wall Street Investment Management banks enter into the game and we have a Ponzi scheme on steroids. They introduced financial derivatives and derivatives on derivatives. They didn't produce anything tangible but they did grow exponentially. Now that is one heck of a balloon. A bank might take $1 of capital and lend it out 10 times in mortgages. But a hedge fund could borrow a million dollars of Treasury Bonds and buy $25-50 million of mortgages from the banks, thus increasing their capital and enabling them to issue another 100 mortgages each. Hedge funds make huge amounts of money on the spread between the short term Treasurys and the long term mortgages. Banks make large (not huge) amounts of money on the origination of mortgages. And "investors" have proof that rising real estate prices will always reward them so they take to flipping real estate.

Unfortunately, all Ponzi schemes end badly. Some "investors" find that even their minimal payments are more than they can sustain in the real economy so they default. When enough default, the prices of the real estate stop rising. More importantly, mortgages get written down to at least the falling price of the underlying property. But the mortages were leveraged several times by the hedge funds and banks. So a small decrease in loan asset prices causes large decreases in financial institution capital.

This is how leverage works. Ponzi on the upside and crash on the down side.

There is no need for any real economic growth. Unfortunately, if there is some economic growth, financial engineers can persuade us (and our government) that all we need to do is restore confidence (in this scheme) and create another $700 billion in debt. The hair of the dog that bit you... And economists can mask the Ponzi balloon by talking about g and r.

The United States has become a giant Ponzi scheme driven by exponentially growing debt, especially debt dreivatives, that is disconnected from any real economy. The sooner this cancer is removed, the sooner real economic forces can operate properly.

===

RW says...

What Ryburg and jamzo said: By all means read your grandparents books, your parents books too (show some respect), but don't skip Hyman Minsky whatever you do.

Add Georg Soros' "The New Paradigm for Financial Markets" to supplement Minsky and you'll probably understand this catastrophe a lot better than Nick Rowe and most members of his audience.

===

dd says...

Nice Chart here:
http://www.thedeal.com/newsweekly/features/chain-of-fools.php

Notice the trickle up profits and the trickle down debt.

[Oct 5, 2008] Wells Fargo- the FDIC didn't blink, so Paulson intervened

Angry Bear

...Marcy Gordon of BusinessWeek (h/t Mark Thoma) sets the record straight:

On Tuesday, the Internal Revenue Service issued guidance boosting banks' ability to offset the losses from loans and other bad debts held by other banks they acquire. The guidance allows banks to take larger tax write-offs against future profits....

Before the IRS ruling this week, there were limits on the amount of certain losses that an acquiring bank could write off against post-combination profits. Now those limits have been suspended, said Jeff Harte, an analyst at Sandler O'Neill.

With banks suffering billions in losses from soured mortgage-related assets, the IRS move "potentially increases buyers' ability to realize tax benefits from bank acquisitions," Harte wrote in a note issued Friday. The change "could spur significant bank industry consolidation," he said.

"We suspect that the new IRS guidance allowed Wells Fargo to place a higher bid for Wachovia today than it might have been willing to a few days ago," Harte said.

And who was responsible for the IRS announcement? Mark Sunshine, guest-blogging at the NYT Economix blog, suggests it was Secretary of the Treasury Paulson:

But Mr. Paulson's fiscal-stimulus work didn't end with the bailout bill.

With hardly anyone noticing, on Wednesday he pushed through very technical and obscure changes to tax regulations that provide a "tax subsidy" for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson's tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the "free markets work without government help" don't understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

Couldn't have said that last better myself.

[Oct 5, 2008] Financial Crisis Now Germany takes hot seat as Europe falls into the abyss - Telegraph

"Unregulated free-market capitalism may be said to have killed itself by greed, vanity and excess, all amply evident before and at the death-scene". Also suffering is the American national foreign affairs ideology...

During the past week, we have tipped over the edge, into the middle of the abyss. Systemic collapse is in full train. The Netherlands has just rushed through a second, more sweeping nationalisation of Fortis. Ireland and Greece have had to rescue all their banks. Iceland is facing an Argentine denouement.

The US commercial paper market is closed. It shrank $95bn last week, and has lost $208bn in three weeks. The interbank lending market has seized up. There are almost no bids. It is a ghost market. Healthy companies cannot roll over debt. Some will have to sack staff today to stave off default.

As the unflappable Warren Buffett puts it, the credit freeze is "sucking blood" out of the economy. "In my adult lifetime, I don't think I've ever seen people as fearful," he said.

We are fast approaching the point of no return. The only way out of this calamitous descent is "shock and awe" on a global scale, and even that may not be enough.

Drastic rate cuts would be a good start. Central bankers still paralysed by a misplaced fear of inflation – whether in Europe, Britain, or the US – have become a public menace and should be held to severe account by our democracies. The imminent and massive danger is now self-feeding debt deflation.

The lesson of the 1930s is that any country trying to reflate in isolation will be punished. The crisis will ricochet from one economy to another until every one is crippled. We are seeing it play again in this drama as our leaders fail to rise above their narrow, parochial agendas.

[Oct 4, 2008] End of an Era on Wall Street - Goodbye to All That - NYTimes.com

That sad thing is that it's 401K investors who are now paying for $5000 bottles of champagne and lavish life style of financial nova riches. Financial Enron has its own puppets and puppeteers. I think leading figures that led us to this debacle should investigated and if found guilty prosecuted to the full extent of the law. The list should definitely include Mr. Greenspan...

"It's the beginning of the end of the era of infatuation with the free market," said Steve Fraser, author of "Wall Street: America's Dream Palace," and a historian. "It's the end of the era where Wall Street carries high degrees of power and prestige. And it's the end of the era of conspicuous displays of wealth. We are entering a new chapter in our history."

To be sure, living large and flaunting it are unlikely to exit the American stage, infused as they are in the country's mojo. But with Congress having approved a $700 billion banking bailout, historians, economists and pundits are also busily debating the ways in which Wall Street's demise will filter into the popular culture.

It's an era that traces its roots back more than two decades, when suspendered titans first became fodder for books and movies. It's an era when eager young traders wearing khakis and toting laptops became dot-com millionaires overnight. And it is an era that roared into hyperdrive during the credit boom of the last decade, when M.B.A.'s and mathematicians raked in millions by trading and betting on ever more exotic securities.

Over all, the past quarter-century has redefined the notion of wealth. In 1982, the first year of the Forbes 400 list, it took about $159 million in today's dollars to make the list; this year, the minimum price of entry was $1.3 billion.

As finance jockeyed with technology as economic bellwethers, job hunters, fortune seekers and the news media hopped along for the ride. CNBC became must-see TV on trading floors and in hair salons, while people gobbled up stories about private yachts, pricey jets and lavish parties, each one bigger and grander than the last.

Finance made enormous and important strides in these years - new ways to parse risk, more opportunities for businesses and individuals to bankroll dreams - but for the average onlooker the industry seemed to be one endless party.

In 1989, tongues wagged when the 50th birthday celebration for the financier Saul Steinberg featured live models posing as Old Masters paintings. That bash was outdone last year, when Stephen A. Schwarzman, head of the private equity firm Blackstone, feted guests at a 60th birthday party boasting an estimated price tag of $5 million, video tributes and the singer Rod Stewart.

"The money was big in the '80s, compared to the '50s, '60s and '70s. Now it's stunning," said Oliver Stone, who directed the 1987 film "Wall Street" and is the son of a stockbroker. "I thought the '80s would have been an end to a cycle. I thought there would be a bust. But that's not what happened."

Now, with jobs, fortunes and investment banks lost, a cultural linchpin seems to be slipping away.

"This feels very similar, historically, to 1929 and the emotions that filled the air in the months and years that followed the crash," Mr. Fraser said. "There is a sense of extraordinary shock and astonishment, which is followed by a sense of rage, outrage and anger directed at the centers of finance."

A WALL STREET hotshot was in a real-estate quandary, and he wanted Barbara Corcoran to help him sort things out.

"This is a finance guy making a ton of money and he was trying to decide whether he should sell the country home in Connecticut, the apartment here in the city or the 8,000-square-foot dream home in Oregon that he just finished," recalled Ms. Corcoran, who has spent years selling high-end luxury properties to New York's elite.

... ... ...

"Money was worshiped and continues to be worshiped," Mr. Stone added. "Maybe that will change now."

Adoration of riches is hardly new, however. In the mid- to late 19th century, the Gilded Age - a term Mark Twain coined in 1873 - offered equally ostentatious displays of wealth and a broadening gulf between rich and poor.

"In the Gilded Age, they built great, enormous palazzos in Newport that they lived in for six weeks a year," said the historian John Steele Gordon, whose book, "An Empire of Wealth," chronicles that era. "During the last 25 years, it's certainly been a gilded age in the sense that enormous fortunes have been built up in an unprecedented way."

... ... ...

DESPITE these gains in the middle class, though, the truly wealthy have pulled away from the pack. Not since the late 1920s, just before the 1929 market crash, has there been such a concentration of income among individuals and families in very upper reaches of the income spectrum, according to researchers at the University of California, Berkeley, and the Paris School of Economics.

Some say that anger over the yawning wealth divide found traction in the highly charged and polarizing debate in Congress over the bailout bill.

Mr. Fraser, the historian, says that anger is informed by the de-industrialization of the American economy in recent decades. Factory closings and the loss of manufacturing jobs that paid decent, middle-class wages coincided with the heady expansion of the financial sector, where compensation soared.

[Oct 4, 2008] The Road Ahead--Some Thoughts By Stormy

Now is not a good time. In fact, the credit crunch may affect areas important to moving ahead: from funding renewable energy sources to rebuilding infrastructure, from a stable local tax base to the creation of jobs through business investment--to say nothing of mitigating the growing effects of pollution and global warming. One side effect has been the creation of ever-larger entities in almost every area--perhaps a dangerous development--as smaller firms in almost every area are gobbled up. Increasingly, the national government, along with these huge firms, will play a larger and larger role. And how much can a government do, especially one that is seriously in debt?

Taking each of these areas separately, I see considerable difficulties.

Funding Renewable energy sources: Cash rich, large utilities will be in the best position.

Even if utilities do have to borrow, they can do so cheaply as government-regulated businesses with guaranteed rates of return which can pass on costs to consumers, said analyst Pavel Mulchanov at Raymond James & Associates in Houston.

Europe may be better off than the U.S. in terms of renewables:

On Monday, US lawmakers said they could run out of time to extend a wind power production tax credit (PTC) and a solar power investment credit (ITC), which have been powerful spurs for installations, in time for a Dec. 31 expiry deadline.

What certainly will happen is that smaller firms, often the genesis for new ideas, will be absorbed. Start-up companies will be unable to find the necessary cash to get a foothold. Our choices for the kinds of renewables we pursue may increasingly be in the hands of larger and larger entities.

How these larger firms choose to allocate investment resources will be important. Will they make wise decisions or be simply governed by short-term returns?

Rebuilding infrastructure: As houses decrease in value, local tax bases will decrease, putting increasing strains on state governments. Once again, the national government will be asked to help, even as its tax base is slowly strangled. While national investment in infrastructure may create some jobs, without a better trade position, there will be little hope that infrastructure in the long run will be enough. Countries that are cash rich and that have good export markets will be better weathering the coming storm, as long as they export items that are essential.

Creation of jobs through business development: Most firms will head for the trenches. If we are worried about "float loans," imagine the attitude towards actual investment. Even when the stock market boomed and the bubble grew, actual business investment inside the U.S. was mediocre. Firms saw better returns in emerging markets that offered cheap labor and tax subsidies. The chances of those firms returning to the U.S. are small--unless, of course, labor here becomes cheap enough--or the cost of transportation becomes prohibitive.

Pollution and global warming: If the argument for meeting these twin demons head-on was that it would adversely affect the bottom line, that argument now, regardless of how foolish, is even more persuasive. Pollution grows apace.

The Gulf of Mexico may just be a glimpse into the future of coastal waters around the world, if this is the case. Already, dead zones have been identified across the globe, from the Scandinavian fjords to the South China Sea to the U.S.'s Chesapeake Bay.

[Oct 3, 2008] Fear and loathing after the credit crisis by John Willman

FT.com

Historical events change behaviour and attitudes. The two world wars, the Great Depression of the 1930s and the 9/11 terrorist attacks on the US each shaped the way a generation thought and acted. The financial crisis will be no different.

Exactly how attitudes will change is not easy to forecast, however. As Niels Bohr, the Danish physicist, once observed, prediction is never easy – particularly about the future. But already some elements of the changed social landscape are emerging.

One is a deep scepticism – loathing, even – of the financial wizards who got the world's markets into this mess. When the House of Representatives voted down Hank Paulson's $700bn bank rescue package on Monday, they did so because they feared the wrath of the voters.

Main Street faced economic ruin with the credit markets closed for business, but those who inhabit it were determined to block any measure that appeared to shore up Wall Street. New York had the feeling of a war zone, said one executive, as angry demonstrators jeered at shell-shocked bankers in the financial district.

The two archbishops at the head of the Church of England also caught the British public mood with their attacks on the City of London last week. Rowan Williams, archbishop of Canterbury and head of the Anglican church, said it was right to ban short selling, while John Sentamu, archbishop of York, called traders who cashed in on falling prices "bank robbers and asset strippers".

"We have all gone to this temple called money," Dr Sentamu said in an interview. "We have all worshipped at it. No one is guiltless."

... ... ...

Bankers, in any case, have never been popular. In London and New York, they bid up the price of homes, forcing ordinary mortals to commute from ever more distant suburbs. And the arrogance and hubris of a group who felt themselves to be masters of the universe means they are winning no more sympathy in these straitened times that Sherman McCoy did when he fell from grace in Tom Wolfe's Bonfire of the Vanities.

... ... ...

Savers are also becoming more risk-averse – understandably, given the runs on banks around the world. Soaring gold purchases are one symptom, but so are transfers of funds between savings institutions in search of a safe home for savings.

[Oct 3, 2008] Recapitalise the banking system By George Soros

October 1 2008 | FT.com

The emergency legislation currently before Congress was ill-conceived – or more accurately, not conceived at all. As Congress tried to improve what Treasury originally requested, an amalgam plan has emerged that consists of Treasury's original Troubled Asset Relief Programme (Tarp) and a quite different capital infusion programme in which the government invests and stabilises weakened banks and profits from the economy's eventual improvement. The capital infusion approach will cost tax payers less in future years, and may even make money for them.

Two weeks ago the Treasury did not have a plan ready – that is why it had to ask for total discretion in spending the money. But the general idea was to bring relief to the banking system by relieving banks of their toxic securities and parking them in a government-owned fund so that they would not be dumped on the market at distressed prices. With the value of their investments stabilised, banks would then be able to raise equity capital.

The idea was fraught with difficulties. The toxic securities in question are not homogenous and in any auction process the sellers are liable to dump the dregs on to the government fund. Moreover, the scheme addresses only one half of the underlying problem – the lack of credit availability. It does very little to enable house owners to meet their mortgage obligations and it does not address the foreclosure problem. With house prices not yet at the bottom, if the government bids up the price of mortgage backed securities, the taxpayers are liable to loose; but if the government does not pay up, the banking system does not experience much relief and cannot attract equity capital from the private sector.

A scheme so heavily favoring Wall Street over Main Street was politically unacceptable. It was tweaked by the Democrats, who hold the upper hand, so that it penalizes the financial institutions that seek to take advantage of it. The Republicans did not want to be left behind and imposed a requirement that the tendered securities should be insured against loss at the expense of the tendering institution. The rescue package as it is now constituted is an amalgam of multiple approaches. There is now a real danger that the asset purchase programmed will not be fully utilized because of the onerous conditions attached to it.

Different focus

'Tarp's adverse consequences could be mitigated by using taxpayers' funds more effectively. If Tarp invested in preference shares with warrants attached, private investors, including me, would jump at the opportunity'

Nevertheless, a rescue package was desperately needed and, in spite of its shortcomings, it would change the course of events. As late as last Monday, September 22, Treasury secretary Hank Paulson hoped to avoid using taxpayers' money; that is why he allowed Lehman Brothers to fail. Tarp establishes the principle that public funds are needed and if the present programme does not work, other programmes will be instituted. We will have crossed the Rubicon.

Since Tarp was ill-conceived, it is liable to arouse a negative response from America's creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers' funds more effectively.

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve - effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

This is how it would work. The Treasury secretary would rely on bank examiners rather than delegate implementation of Tarp to Wall Street firms. The bank examiners would establish how much additional equity capital each bank needs in order to be properly capitalised according to existing capital requirements. If managements could not raise equity from the private sector they could turn to Tarp.

Tarp would invest in preference shares with warrants attached. The preference shares would carry a low coupon (say 5 per cent) so that banks would find it profitable to continue lending, but shareholders would pay a heavy price because they would be diluted by the warrants; they would be given the right, however, to subscribe on Tarp's terms. The rights would be tradeable and the secretary of the Treasury would be instructed to set the terms so that the rights would have a positive value.

Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.

A revised emergency legislation could also provide more help to homeowners. It could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated, based on the Treasury's cost of borrowing. Mortgage service companies could be prohibited from charging fees on foreclosures, but they could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.

Banks deemed to be insolvent would not be eligible for recapitalization by the capital infusion programme, but would be taken over by the Federal Deposit Insurance Corporation. The FDIC would be recapitalised by $200bn as a temporary measure. FDIC, in turn could remove the $100,000 limit on insured deposits. A revision of the emergency legislation along these lines would be more equitable, have a better chance of success, and cost taxpayers less in the long run.

The writer is chairman of Soros Fund Management

[Oct 3, 2008] Goldman Sachs Forecasts "Deeper" Recession

I doubt the it will take less then three years, at least. I think that 401K investors underestimate the gravity of the problem. financial bubble collapsed with Lehman.

Calculated Risk

Goldman is now forecasting Q3 2008 real GDP growth at 0.0%, with PCE at minus 2.5% (annualized as reported by BEA). This is similar to my two month estimate for PCE, see Estimating PCE Growth for Q3 2008. Both PCE and investment will be negative in Q3, but net exports, private inventories and government spending will probably all show positive growth in Q3. So GDP may be close to zero.

A major change in the Goldman outlook is the increase in the unemployment rate to 8% in 2009 (their previous forecast was for unemployment reaching 7% in 2009).

One of the features of recent recessions is that the unemployment rate kept rising for 18 months to two years after the recession officially ended. This suggests that the peak unemployment rate (for this cycle) might not happen until 2011, even if the recession ends in late 2009 - scary. I'll have some more thoughts on unemployment soon.

Note that this is the headline unemployment number. Other measures of unemployment are much higher: See Krugman: The track record

[Oct 3, 2008] The Reckoning - Agency's '04 Rule Let Banks Pile Up New Debt By STEPHEN LABATON