A Subprime Conversation

So what's the worst that could happen?

Earth could be hit by a asteroid wiping out life as we know it.

You know what I mean.

Just trying to put it in perspective. Where do you want to start?

At the beginning.

O.K. In the beginning, there was financial innovation, and it was good. Or so we thought.

You're not funny. So financial innovation caused the housing boom? How?

It wasn't just financial innovation. Several factors came together at once. Financial innovation created complicated financial instruments from mortgages that were sliced and diced - think of a salad of chopped up mortgages - and put together in ways that made it difficult for people to see if there was mold or something hidden in the pieces.

Huh? Mold?

These financial instruments were made up of little pieces of of lots and lots of different types of mortgages and because of that they had risks that were difficult to assess - we say they lacked transparency or that they were opaque - and this led people to assess that these financial instruments were safer than they actually were. People who bought these financial instruments were taking on far more risk than they thought.

Why did they make that mistake?

Several reasons, and this is what I meant by many factors coming together at once. One factor was people believing that the boom would continue, that housing prices would continue rising for the foreseeable forever. There were people, serious analysts, who said that we had entered a new financial world, one where new financial instruments coupled with the decline in the variability of GDP in the mid 1980s had created a new financial environment where risk had fallen considerably. There were plenty of people who wanted to believe this was true.

There were also stories about why housing demand would remain robust, and so on, that helped to keep things going. Another factor was the failure of regulators and bond rating agencies. These failures were big contributing factors as well.

O.K., let me see if I have this. Financial innovation, lack of transparency leading to misperceived risk, the belief the boom was a new trend rather than an aberration, and the failure of regulators and rating agencies fueled the housing boom?

So far, so good. But there's also the question of where the funds that fueled the boom came from. Here, I'd add two more factors to your list, high savings rates in Asia and in oil producing countries, and a low interest rate policy by the Fed needed to ease the fallout from the last asset bubble that popped in 2001. Both of these factors helped to create the liquidity needed to start and sustain the boom.

As this crisis developed, the Fed didn't seem to react very fast.

It took awhile for policymakers and financial market participants more generally to recognize and accept that there was a problem developing in financial markets. There was some turmoil during and before summer 2007, and there were certainly people who recognized that the coughs in financial markets meant the system had more than a mere cold, but it wasn't until late summer, around August 9th I think, that events finally caught the attention of policymakers and market participants generally.

What happened?

There was a "significant liquidity event," the suspension of a fund in Europe triggered widespread worry and a flight to safety. This caused banks to begin demanding reserves as insurance against potential problems, and this in turn sent the federal funds rate far above its intended target at the time of 5.25%.

I kind of remember that. Is that when the Fed first dropped rates?

Yes. Initially they used traditional monetary policy tools, textbook open market operations, to lower the federal funds rate by three quarters of a percent.

Did that work?

Temporarily at best, but it didn't get at the heart of the problem so it was not a long-term fix. The strains on the system were outside the traditional banking system, places the Fed had no authority to operate, or if they had the authority they didn't have the institutional structure in place, so the Fed had no way of attacking the problem directly by dealing "face to face" with the troubled institutions. As a result, commercial paper markets and credit more generally began drying up - a troublesome sign.

"Danger Will Robinson, Danger!!!"

Yep, and good job with the flailing robot arms. With credit markets drying up, the Fed needed to try something else so it took what I thought at the time was a fairly innovative action, though now it's easy to see that far, far more was going to be needed.

What did they do?

The Fed began accepting a wider array of assets at the discount window - the place where banks take out loans from the Fed. They didn't take just any assets, these were highly rated, fairly safe assets, but it was a broader set than before.

How did that help?

It allowed traditional banks to act as intermediaries between the discount window and troubled institutions. Here's how it works. Suppose you are a financial institution outside the traditional banking system holding highly rated financial paper that, because of the fear in the financial marketplace, the fear that assets may have hidden risks or that markets might collapse, cannot be traded for needed funds. Thus firms hooding these illiquid assets face a liquidity crisis.

The discount window helps, or was supposed to help, by allowing these firms to trade the illiquid financial assets to a traditional bank for cash, then the bank would immediately take the assets to the discount window and use them as collateral to replace the cash they had just given to the financial institution. In essence, the Fed trades cash for the illiquid assets, the bank is just a go between who makes a little on the spread. And to help even further and make the spread more attractive, the Fed also lowered the discount rate by half a percentage point to encourage banks to use the discount window and distribute funds to troubled institutions.

Sounds like a good deal for banks, but you said "supposed to help," so I gather this didn't work as planned?

Banks were hesitant to visit the discount window because of the stigma attached to doing so. The worry was that when investors found out that a bank had visited the window, they would worry the bank was in trouble, and that would cause the trouble investors feared as they withdrew assets from the bank. So banks were unwilling to risk their own health just to make a few bucks on the spread, and because of this the liquidity didn't get to the institutions that were in trouble. The problem was that the fear in the markets made people wary of hidden risks. That made it difficult, even for banks that appeared healthy on paper, to visit the discount window without triggering wariness among investors.

So why not just stop announcing who gets loans?

That's essentially what the Fed did when they created the Term Auction Facility, called the TAF. This allowed banks to bid for a preset amount of funds, but the important part was that the winners were anonymous. Banks could borrow funds from the Fed and funnel them to where they were needed without risking their own health by having it revealed that they are borrowing from the Fed.

But even that wasn't enough?

Problems continued, bond insurance markets, student loan markets, municipal bond markets - the list goes on and on - the troubles have not stopped and they appear to be widening.

So is that it, has the Fed run out of options, are we all doomed?

The Fed doesn't seem to think so. The TAF wasn't the last attempt to create an institution that would be able to get funds to the points where they are needed and, more importantly, to remove risk from the system and ease the fear that has frozen these markets. Recently, they created the Term Securities Loan Facility, or TSLF. This will accept a broader array of assets, in particular highly rated mortgage backed securities that have been illiquid, and deal with a wider array of customers that go beyond traditional bank boundaries.

How will this help, by providing liquidity to these banks?

I don't think liquidity is the main point this time, at least not through increasing the overall quantity of assets, though they are liquefying mortgage backed securities and other assets they take in trade. That is, this is more of a trade in assets - illiquid for liquid - rather than a change in the quantity of assets. The hope is that this will provide temporary relief to markets by removing some of the risk, relief that lasts long enough for markets to begin recovering on their own.

What do you think? Will this work?

I think the Fed will need to assume more risk than they have to date to unfreeze markets, and even that might not be enough. Remember, there are unrecoverable losses that must be suffered. When we talk about relief we mean that we hope things aren't worse than they need to be, that a small fire doesn't jump borders and become a large devastating fire, but so far the fire has continued to spread so it's too early to say we have this thing fully contained - and most signs point the other way. For example, we saw the troubles with Bear Sterns, though I found it encouraging that the Fed showed it was willing to take aggressive action if and when it is needed.

If it were my choice, If I were king of the Fed, I'd do more. First, I'd trade for any financial assets at a price that fully reflects the risk of holding that asset. The Fed should trade a non-risky assets, money or government bonds, for risky private sector assets at a risk adjusted price. And to promote these trades, the risk adjustment could be reduced - the amount the discount is reduced would be just like adding reserves to the system.

Can you explain that last part?

Suppose the Fed takes a mortgage backed security off the hands of a bank that wants to reduce its risk profile, and pays the bank 80% of its value, the 20% "haircut" is to compensate for the risk of holding the asset. The Fed could pay 90% instead. If it were an asset worth $100, for example, the Fed would give the bank $90 in reserves in trade for the asset. That would break down into $80 on a fair risk-compensated trade, and $10 extra in reserves.

What if the Fed loses money on these trades?

That could happen. But these assets could also increase in value as well, precisely because the Fed is holding them and reassuring markets. If the Fed makes a fair trade, e.g. pays 80% in the example above, it is as likely to make money as lose money. The assets could, of course, be mispriced meaning that the Fed has more or less risk than it thinks, but even in the very worst case - every single asset they hold falls to zero - I'm not sure it would be a disaster.

And I'm not sure you aren't nuts.

Think of the example above. Suppose that the value of the asset the Fed holds falls to zero after the trade. The trade was permanent, so there s no margin call or anything like that - the Fed owns the asset and it is worth nothing. Then, in the end, it is no different than the Fed simply printing that same amount of money and giving it to the banks as new reserves, it is an increase in the money supply. It is a large increase, and it could surely be inflationary, but inflation is not the main worry when financial markets appear on the verge of a downward spiral that could drag the economy down along with them.

The idea is to trade less risky assets, money and government bonds, for risky assets at a fair price, perhaps with a premium attached to encourage these trades, remove as much risk as possible from the system, and hopefully ease the fear that has been so pervasive. The amount of the trades could be capped to avoid taking every single risky asset in the economy in trade, and there are ways to set the incentives so that only the riskiest assets will be traded. The Fed might make money if things turn out better than expected and the assets go up in value, they might lose as well - that is the risk they assume and that is by design. But unlike they private sector, they have already replaced their losses by printing the money used to purchase the assets. They are gambling with money created out of thin air.

Yeah, you're smarter than the Fed. The Fed prints money, buys risky assets, problem solved. Yep, that'll work. Don't be offended, but what other ideas are out there?

Well, I've tried to talk in fairly general terms, but the actual details - involving repos, etc. - would be quite a bit more complicated. Most of the analysis we are hearing lately says that we are not going to be able to avoid using public money in one way or another to bail out troubled institutions. I agree with that, I think that is becoming increasingly likely. Our first allegiance has to be to protect those who did nothing to cause the troubles we are experiencing, and it may be necessary to use public money to minimize the chances of a widespread downturn. The actual details of each proposal differ, and most proposals pay more attention to the actual details and intricacies of credit market institutions than I did in my example, but the point is generally the same - the Fed tries to erase fear by making it clear that steps will be taken to avoid worst case outcomes.

One more thing, though it's playing second fiddle right now and getting to be a bit late to use it, there's always fiscal policy - I argued for more aggressive fiscal quite awhile ago, but that didn't happen and I doubt we'll get much more in terms of fiscal policy than what is already planned.

Well, I don't mean to - yawn - say I'm getting bored or anything, but, well, I should get going. But one more thing. Is the meteor about to hit. Again, are we all doomed?

I'm an optimist, and when I look at the data we are not there yet - we haven't passed into the zone of no return - but there's no doubt we are headed in that direction, and unfortunately slamming on the policy levers as hard as we can may not be enough to keep us from slipping into a recession. Deep down, I still have hope it won't be so bad, that suddenly the trouble will pass and we'll pull out of this, but it's not looking good - our celebrated robustness and flexibility may not be enough to deal with a shock this large - and analysts everywhere are increasingly gloomy.

That's not a real answer to the question. You didn't actually say what you think will happen.

I wouldn't bet my house on things getting better.

Real funny.

I thought you said you have to go.

[Update: Later...]

Oh, hi again - didn't expect to see you here.

Hey. I was thinking - about our earlier conversation - I saw a proposal from Brad DeLong after I talked to you, but it seemed different than what you were saying. What does he want to do?

I should have talked about that proposal as it's something I thought was a good idea several weeks ago when Alan Blinder first proposed it. Brad wants to, as quickly as possible, set up an institution to purchase mortgages and reissue them at more attractive terms. The goal is to limit the number of foreclosures and restore stability to financial markets.

How is that different from what you proposed?

His proposal differs from mine in two ways. First, the government buys mortgages directly rather than buying mortgage backed securities, then reissues those mortgages at more attractive rates. Second, Fannie Mae rather than the Fed purchases the assets since that is the fastest way to put the mortgage purchase plan into action.

Would this prevent defaults and foreclosures, is that the idea?

That's the hope, and if it does restore confidence in financial markets, then there would be no reason for the Fed to do as I proposed and remove risk from the market by purchasing risky mortgage backed securities (since they would no longer be as risky).

Hope? Is that all it is?

It's more than that. I think purchasing mortgages would help to stabilize the mortgage market, so, as I've said in the past, I am in favor of the mortgage purchase plan, particularly since it helps homeowners directly. I am just not sure that it will be enough by itself to get credit flowing again.

Why?

One reason is that loan characteristics are different today, e.g. they are longer, so the experience of the past may not be a very good predictor of what will happen this time around. Because of the uncertainty about whether purchasing mortgages will be enough to stabilize markets, I would like to see a combination of both policies, purchase troubled mortgages and purchase troubled financial assets at the same time, particularly since the purchase of financial assets can be put into place very quickly, an important consideration right now. I should also add that other measures, e.g. regulatory change, could also be put into place so his is not all that can be done. For example, as Richard Green has noted, it will be important for regulators to ensure that there is no incentive for borrowers and lenders to repeat the behavior that led to the need for intervention.

I"ll keep my fingers crossed.

Comments

[Borrowers Are the Only Ones Who Matter]

"Our first allegiance has to be to protect those who did nothing to cause the troubles we are experiencing..."

By this, of course, is meant borrowers who supposedly did no wrong (except to break their promise to repay loans, which is apparently not wrong in the US). No one cares whether savers, pensioners, or workers experience a lower standard of living from the stagflation generated. Policy is all about borrowers all the time. No one else matters.

The problem is that the current crises was caused by total and complete disregard for the welfare of high saving Asian and oil nation nationals. Continuation of the US policy of total contempt for the welfare of savers eliminated domestic saving, eventually drove away foreign savings, and yet further contempt for savers is the policy being proposed to return savings to the US. (Er, inflation will erode the value of mortgage packages being hawked to foreign savers, regardless of whether they are repaid in nominal dollars.)

Well, keep right on ripping off savers if you like, but they will eventually go away, and never return.

[bullbust]

What if the Fed loses money on these trades?

That could happen. But these assets could also increase in value as well, precisely because the Fed is holding them and reassuring markets. If the Fed makes a fair trade, e.g. pays 80% in the example above, it is as likely to make money as lose money. The assets could, of course, be mispriced meaning that the Fed has more or less risk than it thinks, but even in the very worst case - every single asset they hold falls to zero - I'm not sure it would be a disaster.

This really shows how naive you are. 20%? "increase in value"? You have no idea.

House prices have _doubled_. Did incomes double? No.

Can you grasp the idea that stocks of well managed companies - not fly by night, sock puppet companies - have lost more than 50% in the NASDAQ crash?

And that was when you had to have 50% down to speculate, and in far more liquid investment.

Housing had 0% down, very little liquidity, and mark-to-illiquid market valuations used for HELOCs during the bubble.

You have no idea about what a bubble this is.

Understand this - without the prospect of dumping the house on yet another speculator, housing payments are a millstone for WELL OFF prime buyers who are in ALT-A loans and Option loans. That disaster is yet to come.

Those payments were all being made in expectation of an investment return. Not even the WELL OFF can AFFORD the payments for pure housing consumption.

Maybe instead of ivory tower academics running the Fed, we had real world practicing economists like Kasriel, Roubini or Hatzius, this sort of mess may not have happened

[Cyrille]

I think Mark has a very good idea about the magnitude of the problem.

Yet some risky assets are not subprime-mortgage backed. So the example of 80% was not ludicrous in the least!

[bullbust]

Then, in the end, it is no different than the Fed simply printing that same amount of money and giving it to the banks as new reserves, it is an increase in the money supply. It is a large increase, and it could surely be inflationary, but inflation is not the main worry when financial markets appear on the verge of a downward spiral that could drag the economy down along with them.

No different? Angelo Mozillo gets to dump his carp onto BAC, and later on to the FED via BAC.

He keeps his 100s of millions. That is $100,000,000. If the price of gas, milk, or bread doubles who should he care?

Jimmy Cayne? If Bear Stearns stock loses 80%, he still gets to keep 200 million of his Billion. If the price of gas, milk, or bread doubles who should he care?

Tell me why, if I'm paying double for my bread, milk and gas, because of inflation, why should I let these crooks have any wealth?

I will bail the system out, but first I want to see these crooks and shareholders lose everything.

I want to hear one sensible argument, for bailing out the system _and_ the Crooks.

Why should I do that, instead of nationalizing them? If they are already bankrupt, they have zero value. Why should I, the taxpayer, create value and gift it to the shareholder?

[Bruce Wilder]

bullbust has a point.

predation, theft and fraud played a large part in what has gone on.

blaming a crime wave on the shortcomings of the police does not solve the problem of crime that pays.

[Sarah]

A very good analysis as far as it goes-- but I agree with Bruce Wilder.

I'd also like to see some acknowledgment that firing most of the police force-- and hiring a bunch of the police commissioner's drinking buddies to supervise the remainder of the beat cops-- was not exactly the brilliant innovation in market efficiency it was presented as being.

[esb]

Good morning Mr. Thoma.

The country you are looking at is the United States of America, mired in a potentially fatal economic calamity.

The nation permitted a vast array of con men to create and sell various forms and categories of worthless instruments, and now the victims want their money back.

Your mission, should you decide to accept it, it to avert the debacle without precipitating an entirely new crisis.

As usual, should you or any of your IM team be caught or killed, the Secretary will disavow any knowledge of your actions.

Good luck Mark.

(You're going to need it.)

This tape will self-destruct in five seconds.

[ilsm]

Who is knitting the story of hunger, despair and suffering among the common man while this debacle is paid with the piteous savings of the third world and lower 4.5 quintiles of the US.

And what value the OASDI trillions whne the money is inflated?

Madame LaFarge please?

[hari]

Finally Mark has identified the playing field and nature of the warfare and strategy required to win or atleast not to give up altogether....

I don't accept that the general public is responsible for this free market hi fi disaster...and the market makers must take their responsibility...even if they've to fall on their own swords.

Before coming here, I again returned to Summers and Bernake on video at Bloombergs, and it's abundantly clear that Recession is already underway...and might get worse depending on nature/type of further policy actions by Fed. Fed as lender of last resort may accelerate the downturn and force market to collapse; or, given the possible cooperation with other CBs, dollar depreciation may be stopped and, with it, market bottom somehow is forced into action...that's a big hope!

[Blissex]

«I want to hear one sensible argument, for bailing out the system _and_ the Crooks.
Why should I do that, instead of nationalizing them? If they are already bankrupt, they have zero value. Why should I, the taxpayer, create value and gift it to the shareholder?»

The sensible argument is very simple: you are a loser.

If you have to worry about the raising prices of milk and bread, you are one of the undeserving, exploitative and parasitical losers that hold back the american economy, while the CEOs of countrywide, Citi, Sterns, have demonstrated amazing productivity by generating lots of wealth (for themselves and their class).

The American Way is that losers are not welcome except as low wage immigrant cattle -- and winners get rewarded by the Fed for their contributions to the USA economy (and the campaign funds of politicians).

[ken melvin]

Neat. Msrs. Beckett and Hofstadter both are smiling. Suspect they too see that the smoke, mirrors and curtains aren't really real.

[anne]

Nicely done, and plan anyway.

"One more thing, though it's playing second fiddle right now and getting to be a bit late to use it, there's always fiscal policy - I argued for more aggressive fiscal quite awhile ago, but that didn't happen and I doubt we'll get much more in terms of fiscal policy than what is already planned."

[baileyman]

If the financial innovations had resulted in all the lending being done against houses still valued at trend line levels, not 60% above trend, would there have been any problem?

[ken melvin]

What benefit speculation in houses?

[robertdfeinman]

Once again the popular press is leading to a muddle. The problem is not "complex" financial instruments that no one can understand, or the lack of transparency, but good, old fashioned, fraud and speculation.

Fannie Mae and Freddie Mac had a very simple business model, and it worked quite well for an extended period of time. They bought up mortgages from originators and thus gave the banks fresh capital to use for new loans. This was needed because the banks could not attract enough capital the traditional way, from depositors. For whatever reason people just weren't willing to put sufficient money into bank accounts.

The mortgages were bundled into pools which were grouped by interest rate and expiration date. If every homeowner stayed in their home and paid on time then the resulting bond would act just like a traditional one. But because there was the opportunity cost risk of early repayment as well as the (small) risk of default the bonds paid a higher rate than traditional ones. A standard trade off, higher yield for more risk.

This stopped working when the mortgages were issued to borrowers who didn't meet prudent criteria for taking on the debt. Those servicing the loans got their fees with no risk. This included appraisers, mortgage brokers, lawyers, title insurance companies and the lenders. With no skin in the game the temptation for them to bend or break the rules became irresistible.

Since these new mortgages didn't meet the criteria of the existing agencies a parallel universe of mortgage bundlers arose. They also took on little risk (or, at least, believed so), they made their profits as middlemen. This was a variety of musical chairs, not investment. If there was to be a problem each thought they could get out before the music stopped. Obviously this was misguided optimism. The lenders who financed this market were also imprudent. Who in their right mind would lend money to Carlyle Capital when it only puts up 3% of its own cash?

There is nothing "complex" about this. The stock market crash of 1929 was caused by those unable to cover at 10% margin. The lesson was learned and margin rates for stocks now tend to be about 50%. So if 10% was too risky, then why lend to those with 3% down?

That's not lack of transparency, that's just speculation. The failing was allowing the market to arise in the first place. The blame for this gets spread around widely: Rubin and Clinton for allowing the elimination of Glass-Steagall, the gutting of the SEC, the policies of Greenspan, etc. Collapses like this don't just happen, they have to be nurtured.

[evagrius]

"There were people, serious analysts, who said that we had entered a new financial world, one where new financial instruments coupled with the decline in the variability of GDP in the mid 1980s had created a new financial environment where risk had fallen considerably. There were plenty of people who wanted to believe this was true."

There were people, serious analysts, who said that we had entered a new financial (gambling) world, one where new financial instruments ,( decks of cards with all aces), coupled with the decline in the variability of GDP in the mid 1980s had created a new financial environment where risk had fallen considerably ,( and everyone's a winnah). There were plenty of people who wanted to believe this was true, ( and that Santa Claus and the Tooth Fairy really did exist).

P.T. Barnum's adage has to be revised; " There's a sucker born every second".

"New financial instruments".

[Cynthia]

Maybe I'm just too old-fashioned for today's economy, but I believe it's a bad idea to treat your primary residence as an investment, and it's an even worse idea to treat it as a launchpad for investing!

[RW]

I believe many were actually treating housing, including their primary residence, as a pay raise, a way to compensate for the reality of stagnant wage growth and uncertain job markets. Not prudent perhaps but no necessarily speculation either.

[James Kroeger]

I want to hear one sensible argument, for bailing out the system _and_ the Crooks. Why should I do that, instead of nationalizing them?

Why indeed. I'm nearly 100% convinced that the only way it will be possible to (A) fix the broken financial industry, (B) achieve justice (i.e., punish severely those who were responsible for creating the whole mess), and (C) restore the economy to prosperity quickly is by nationalizing the banking industry. Congress should follow a plan that is perhaps something like this:

The plan should be to allow any and all banks to fail that are in danger of failing. The Treasury should then be authorized to quickly buy up the assets of the failed institutions at fire sale prices as an agent for The People. One option would be to incorporate the bank into a new National Bank of the United States of America and then immediately open it up for the business of lending again, after a quick taxpayer financed re-capitalization fix.

The pain would be brief and confidence would be completely restored to the would-be borrowers of the country. Those banks that are able to survive the carnage should be allowed to continue to stay in business, as long as they are able to compete with an institution that has no concern whatsoever for something called 'profit.'

How else will it be possible to punish severely those who foisted this unholy mess upon us with their flaunting of moral hazard principles? Don't get me wrong...I'm not willing to see the bottom half of income earners suffer in order to punish the bad guys. I think that aggregate demand and lending levels can be maintained at healthy levels even while we are allowing the private banking industry to collapse into dust.

If the Federal Government takes the kind of steps that I am recommending, any kind of economic pain associated with the transition will be over and done with in maybe six months or so. The bad guys get punished, moral hazard again become an element of private banking, the taxpayers actually get something for the bailout they have got to fund anyway.

What is so sacred about the private financial industry, anyway? Their 'competition' has not led them to lower the costs of their customers. It has encouraged them to compete on a level of obfuscation. It has encouraged them to lobby Congress constantly for favors. It led to the 'innovations' in obfuscation that led directly to this current disaster. Please someone, name one thing that a 'competitive' private banking industry has done for the Average American that a government-owned bank could not have provided.

Nationalization: the right prescription at the right time. Justice AND restored prosperity.

[anne]

http://krugman.blogs.nytimes.com/2008/03/15/the-few-the-proud-the-ignored/

March 15, 2008

The Few, the Proud, the Ignored
By Paul Krugman

Dean Baker * is mad at Robert Rubin for suggesting that “few, if any” people saw the financial meltdown coming.

I’d say that there are two levels to this. First, a lot of people — including Dean, me, Calculated Risk, and others — saw that there was a huge housing bubble. It remains amazing that so many alleged experts failed to see the obvious.

What’s going on now, however, is beyond that: the “financial accelerator,” with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse of the whole system, was not, I think, so widely foreseen. Certainly Nouriel Roubini was on the right track; I can claim to have described something quite a lot ** like what’s now happening, though I covered myself by making it a slightly jokey scenario rather than a straight prediction. But in Rubin’s defense, I don’t think many people saw how much the system itself would break down.

In the larger sense, though, Dean is right. Even now, those who saw the risks are somewhat marginalized in public discussion, while those who airily dismissed all the warnings are still treated as men of good judgment.

* http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=03&year=2008&base_name=robert_rubin_still_doesnt_know

** http://select.nytimes.com/2007/03/02/opinion/02krugman.html?scp=1&sq=krugman+meltdown&st=nyt

[anne]

http://select.nytimes.com/2007/03/02/opinion/02krugman.html

March 2, 2007

The Big Meltdown
By PAUL KRUGMAN

FEB. 27, 2008

The great market meltdown of 2007 began exactly a year ago, with a 9 percent fall in the Shanghai market, followed by a 416-point slide in the Dow. But as in the previous global financial crisis, which began with the devaluation of Thailand's currency in the summer of 1997, it took many months before people realized how far the damage would spread.

At the start, all sorts of implausible explanations were offered for the drop in U.S. stock prices. It was, some said, the fault of Alan Greenspan, the former chairman of the Federal Reserve, as if his statement of the obvious — that the housing slump could possibly cause a recession — had been news to anyone. One Republican congressman blamed Representative John Murtha, claiming that his efforts to stop the "surge" in Iraq had somehow unnerved the markets.

Even blaming events in Shanghai for what happened in New York was foolish on its face, except to the extent that the slump in China — whose stock markets had a combined valuation of only about 5 percent of the U.S. markets' valuation — served as a wake-up call for investors.

The truth is that efforts to pin the stock decline on any particular piece of news are a waste of time.

Wise analysts remember the classic study that Robert Shiller of Yale carried out during the market crash of Oct. 19, 1987. His conclusion? "No news story or rumor appearing on the 19th or over the preceding weekend was responsible." In 2007, as in 1987, investors rushed for the exits not because of external events, but because they saw other investors doing the same.

What made the market so vulnerable to panic? It wasn't so much a matter of irrational exuberance — although there was plenty of that, too — as it was a matter of irrational complacency.

After the bursting of the technology bubble of the 1990s failed to produce a global disaster, investors began to act as if nothing bad would ever happen again. Risk premiums — the extra return people demand when lending money to less than totally reliable borrowers — dwindled away.

For example, in the early years of the decade, high-yield corporate bonds (formerly known as junk bonds) were able to attract buyers only by offering interest rates eight to 10 percentage points higher than U.S. government bonds. By early 2007, that margin was down to little more than two percentage points....

[anne]

All I would include is that our choice of fiscal policy through a time of war and tax cuts forced us to borrow and forced the Federal Reserve to finance the borrowing, and direclty contributed to our financial crisis. We have been fighting a war while pretending the war is costless but a $3 trillion war is not costless no matter the pretense.

[hari]

In his "A Subprime Conversation" Mark is finally doing what I've been asking him to do - doesn't matter if it's long and winding - a good lecture on the basics of the subprime problem.

We've had our "morality" discussion....

This is now more serious and, may be, depressing, if Fed can't turn the ship around. I've been getting N Roubini newsletter for some time now...Paul is NOW mentioning that he got it right from the beginning! NR is a dispassionate analyst with a vengence to find the bottomline...and state it the way he finds the facts. That's why they invited him to Davos!

The great American shipcraft can still be averted from the reefs...

[anne]

Mark Thoma has been insisting on the need for fiscal policy intervention and changes, and Thoma is too darn right because I fear that will be at least a year away. I am hopeful the Fed is properly dealing with the financial crisis, but fear the effects of a slow,slow economy.

[hari]

In today's Links there's is a piece by Justin Fox which deals with speech given this week to Economic Club(Stockholm) by boss of Swedish Riksbank (CB) on the current financial crisis. He claims it's a lot like the problems he'd to deal with in 1990s during the failure of the banking sector in Sweden. It's long and detailed speech on the subject (in Swedish).

[Farrar]

Kroeger is absolutely right. The sensible solution is to nationalize insolvent banks. In fact, the FDIC already has the authority to take over insolvent commercial banks. I suspect, however, that their staff has been cut to the bone, and that they no longer have enough examiners to send in and prove a big bank insolvent.

And obviously it won't be done as long as the present administration is in power, so "crackpot" ideas like Kroeger's and me are largely ignored.

I would like to see some serious arguments, however, on why a Kroeger like solution would not be likely to restore confidence and keep the economy humming along.

[Cynthia]

"...many were actually treating housing, including their primary residence, as a pay raise, a way to compensate for the reality of stagnant wage growth and uncertain job markets."

RW -- what you say is so sad but so true.

[SanFranciscoJim]

We will not get any substantive policy action until The Decider is out of office. Even now, he is downplaying economic problems and claiming that the economy is solid.

So we have to do with what The Fed can come up with until next year and I suspect that Bernanke has pretty much used up all the arrows in his quiver. Though I am certainly not an economist.

This failure reminds me of the classic engineering failures I studied in school: multiple safeguards removed or defective, leading to a cascading set of failures. First we removed Glass-Stiegel, then the ability of the Fed to control the money supply was removed due to the new exotic trading instruments that the hedge funds used. Couple that with an economy that was allowed to run "hot" with the twin deficits for too long, and a Fed who only used a hammer (monetary policy) for every problem it encountered and we finally have the mess we see today.

What other controls were removed in the financial system which allowed the current crises to come to a head? I know it seems like pointless complaining and finger pointing, but I think a "root cause analysis" will be instructive and help us figure out where to go next. It certainly can help us during the next down of the business cycle, if we use the opportunity to replace some of the defective controls.

[hari]

The Swedish CB boss used an analogy while finishing his long speech analysing the credit crunch a la US - he said, "you've to fix the house roof while the sun is shining". (my translation).

[dissent]

Gail Collins, today, NYTimes:

The country that elected George Bush — sort of — because he seemed like he’d be more fun to have a beer with than Al Gore or John Kerry is really getting its comeuppance. Our credit markets are foundering, and all we’ve got is a guy who looks like he’s ready to kick back and start the weekend.

I like Prof Thoma's analysis but, like most economic analysis, it gives short shrift to the political dimension.

The fact is, Americans have been indulging the 'inner dumbass' since Reagan. Something for nothing - credit for nothing - houses for nothing, the endless prosperity of rising real estate values, really rests on the cultural shift that produced the Laffer Curve (and conservative dominance).

This collapse is a product of a wholesale abandonment of seriousness and competence. The Clinton impeachment was a earlier example of same.

What did Bush tell the (former) 'masters of the universe' in New York on Friday? “You’ve helped make our country really in many ways the economic envy of the world,” he told the Economic Club of New York.

Yeah, right.

The problem is, you can't be dumb and lucky forever. We as a country have run through our trust fund.

[d_rumsfeld]

Isn't this just a problem of leverage from the top to the bottom? Borrowers were leveraged 20:1 or more to buy houses. Investors are also leveraged 10 or 30:1 on those mortgage instruments.

Well, housing in California has fallen about 20% from the peak prices in less than 2 years. This is just a margin call on an overleveraged borrower. The problem is that the borrower can't pay. And the cascading defaults will continue regardless of what scheme of intervention is invented by the Fed.

It isn't clear to me whether the "reduction in risk premium" by the Fed that you are proposing is meant to incorporate real numbers, but the problem is that the haircuts on all mortgage backed securities are much larger than the 10% you propose. Given that we are not prone to socializing the gains by these banks and investors when the market goes up, I see no reason to socialize the losses when the market goes the other way.

[anne]

http://shakespeare.mit.edu/Tragedy/juliuscaesar/juliuscaesar.3.1.html

1599

The Life and Death of Julius Caesar
By William Shakespeare

Act III. Scene I.

Rome. Before the Capitol; the Senate sitting above.

A crowd of people; among them ARTEMIDORUS and the Soothsayer. Flourish. Enter CAESAR, BRUTUS, CASSIUS, CASCA, DECIUS BRUTUS, METELLUS CIMBER, TREBONIUS, CINNA, ANTONY, LEPIDUS, POPILIUS, PUBLIUS, and others

CAESAR

[To the Soothsayer] The ides of March are come.

Soothsayer

Ay, Caesar; but not gone.

[SanFranciscoJim]

Yes, I agree that we are all against "socializing the losses" but what other choice do we have? We can't let all the banks fail, or can we? I would like to see all those who made outsized gains by gambling on risk (e.g. hedge funds) take their losses, as they should. If possible, we (or the shareholders) should claw back some of the $1B bonuses that were handed out back in the day.

But that doesn't mean we can afford to just let all the big banks go under. It is not quite clear to me what irreplaceable value Goldman Sachs offers the economy and I am more than happy to see firms like that go under, if they deserve it. But the Wells Fargo's and Bank of America's of the world are another thing and I suspect that if Goldman goes under, the others fall then, too.

[SanFranciscoJim]

Thanks anne, that one made me chuckle.

[Winslow R.]

Mark my quibble is you lay too little blame on the fiscal policy that did occur i.e.Iraq.

Citizen banking is the solution. Allow creative destruction to transform the financial system into a truly competitive market. Why else has the financial sector grown, when efficiency brought about by technology should make it shrink?

Why promote handouts to the 'very well to do'?

[bakho]

Underlying this mess is massive misallocation of investment capital. Rather than investing in energy independence or new technology, investment was mis-directed to the "apparently more lucrative" financial markets. Instead of domestic manufacturing or infrastructure, investment dollars were used to create a housing bubble. So we have tied up our investment capital in housing too large for homeowners to afford that is inefficient and expensive to heat and cool. This is similar to the massive misallocation of investment by the FSU to build cities in the middle of nowhere with expensive supply routes and little comparative advantage to their location.

Investors seeking even higher rates of return have been repeatedly conned by the likes of Enron and now the housing bubble. Unfortunately, investors not only include unscrupulous and greedy people, but retirement funds and endowments mismanaged by people with too much incentive to maximize profit and not enough incentive to minimize risk. They operated in a system that encourages managers to hide the risk and maximize the "potential" profits. There are only rewards for risk takers that win and no disincentives for risk takers that lose. The wealthy manage to leave the less guilty holding the bag. The only way to truly punish them is to tax their profits.

[Emmanuel]

all questions to the smart guys:

1. Isn't greed the root of all these sub prime mess?
2. What can the guy who is nice to have a bottle of beer with has to say? Was that "all air" I hear?
3. Why is it that the guys at the bottom are always the ones that the smart guys always mess up with?
4. Is it because the smart guys have other smart guys to look the other way?
5. Who looked the other way around when this complicated sub prime "smart idea" was being devised?
6. Who was it that said, "the people deserve the goverment they elect"?
7. Why can't the Democratic Congress do anything? Is it because the Democrats only have a slim majority?

[Robinia]

Precisely what Bakho says, exept I end with "the only way to truly punish them is to tax their profits and seize their assets when they are in default" Carlyle Capital's assets are seized-- let the "correction" begin, let nobody be spared any loss until the bottom threshhold (federal poverty line?) is reached for that individual. Corporate persons need be provided not even a poverty-level floor by the population at large, but should have 100% of remaining assets seized to satisfy debtors at whatever percentage is possible.

There is is a relationship between great wealth and great greed in the US-- the "bad speculative people" and the "super-rich people" are by and large exactly the same people. It would be a social good and a load off our backs if their assets were managed in future by others.

[Dickeylee]

I'm leaning towards a 5-600 pt drop in the Dow Monday, a 75 basis point cut Tuesday, a Fed backed merger of BS and JP on Wednesday with a rally that won't hold, then a US attack on the reactors in Iran Thursday, along with a bank "holiday" declared soon after as the world has a real panic. I guess we really don't need that asteroid next week after all.

[esb]

Dickeylee:

Well then, I guess you won't be interested in a private weekend transaction for the 30,000 share block of KBE that I'm peddling.

[RNL]

Here's another subprime conversation you might enjoy!

http://thorns.org/rexandlulah/2008-03/11.html

;-)

[Expat]

This crisis is not the End of the World. Most of the damage will be inflicted on rich people and greedy bankers. Who cares? Well, those rich people and bankers care. So do their lackies and butt-boys in Washington. So, we have to keep the game going.

Why not just pay off all mortgages up to one million dollars. Anyone with a lower mortgage or no mortgage gets the difference in cash (e.g. if you have a $100k mortgage,it gets paid off and you get $900k in cash). That's good for America, good for the banks, good for business.

We have learned that China and the Arabs will continue to take it in the ass with respect to the USD, so we might as well drive that bad boy down to 2.50 to the Euro. And, in the interest of protecting Wall Street and all the rich guys, they can be allowed to turn over all their dollars and get back Euros at one to one. Can't piss off the rich people, can we.

Honestly, is anyone surprised that we are in this mess when the people in charge of solving the problem are the ones who got us into it or when they come up with the amazing array of self-serving, stupid plans they have concocted.

[anne]

What is really important is to present a supposed idea as disgustingly as possible, just to show who we really are.

[Anon]

Hey Dickeylee, do you have inside info? seems that VISA was scheduled to go public this Wednesday, with the first full day of trading to take place Thursday. But now they've announced their moving everything up one day, to a Tues/Wed timeframe. Maybe to miss your "called" bank holiday?
You 'Da Man!

[CathyG]

James Kroeger's got it right. But I'd take it a couple of steps further.

Any institution that declares bankruptcy or needs a bailout by American taxpayers who have already been bled white by these vampires’ greed, incompetence and incomprehensibly poor business judgment will be nationalized. Shareholders receive nothing and all executives and board members will be immediately fired. All executives and board members will be required to return salaries and bonuses earned over the last five years with interest because it's absolutely clear that, whatever else they were doing, it sure the hell wasn't their job. All land, buildings, contracts, and assets will become the property of the U.S. Treasury. The lawsuits alleging fraud that are beginning to be filed by the poor suckers who were last to hold the worthless securities these bozos sold will be allowed, but only against the individuals who perpetuated the fraud, not against the nationalized company.

says...

"All land, buildings, contracts, and assets will become the property of the U.S. Treasury."

So all secured debtors, unsecured debt holders "bondholders"; equity owners "consisting of employee owned 401k plans invested within the stock"; will simply be nationalized? Should we simply delete the 14th amendment while we are at it? As for "What is so sacred about the private financial industry, anyway?"; the first thought that comes to my mind is simply, if money that is to be lent is done under the color of the federal government, than failure to pay would be punished how? Or for that matter, if profit is not a motive than is one to assume that interests is not to be charged on debt issued?