"Liberalisation’s Limit"

Martin Wolf says he's been under a "delusion" about the ability of securitization to carry risks outside of the traditional banking system and reduce the need for regulation:

The rescue of Bear Stearns marks liberalisation’s limit, by Martin Wolf, Commentary, Financial Times: Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve ... declared this era over. ... Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns... I do not know whether the risks justified the decisions... Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices... This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions.

Greater regulation must be on the way. The lobbies of Wall Street will ... resist.... But, intellectually, their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice... It is also a matter of efficiency. ...

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion. ...

Yet the extension of the Fed’s safety net to investment banks is not the only reason this crisis must mark a turning-point in attitudes to financial liberalisation. So, too, is the mess in the US ... housing markets. ... Again, this must not happen again... The ... aftermath will surely be much more regulation than today’s. ...

One note: Free markets is not the point. Producing well-functioning, competitive markets is the goal, that's when our models say the outcome is optimal. If removing restrictions gets you in the vicinity of the competitive outcome, and most often it does, then that is the right thing to do. But if making markets as free as we can doesn't produce a competitive outcome, then another approach is needed (and the extent to which an intervention that overcomes a market failure and produces a more competitive market reduces freedom is a debate for another day, but I don't see why it necessarily does).

Martin Wolf says regulation is coming, but "lobbies of Wall Street will ... resist" any change. That's what happened when financial markets were subjected to new regulations during the New Deal, but bankers are lucky - we're all lucky - their objections didn't stop the changes from being enacted. Daniel Gross notes the ways in which those changes are still helping us today:

The New New Deal, by Daniel Gross: In the 1930s, Franklin Delano Roosevelt saved American capitalism from its own self-inflicted wounds by erecting a new financial infrastructure—often over the vociferous opposition of the bankers and investors whose poor judgment had helped precipitate the Great Depression. During the New Deal, the government reacted to a disastrous systemic failure by creating the sort of backstops, insurance, and risk-spreading mechanisms the market had failed to develop on its own, such as deposit insurance, federal securities registration, and federally sponsored entities that would insure mortgages.

Despite sustained efforts to tear down the New Deal ... the 1930s-vintage infrastructure has proved remarkably durable. ... Although the Tennessee Valley Authority has yet to pitch in, four 70-year-old agencies are helping to cushion the blow of the housing bust. Let's count them.

1. The Federal Home Loan Bank system. Last year, the model of originating and securitizing mortgages began to break down... Mortgage companies that relied on the capital markets (rather than deposits) to raise the money for mortgages suddenly found themselves starved for cash. Many of them turned to the FHLB, which was created in 1932 (so let's give that one to Herbert Hoover) and provides capital to lenders. Indeed, had it not been for the FHLB, it's possible that the nation's largest mortgage lender, Countrywide Financial Corp., might have gone under. ... On Monday, the FHLB pitched in again ... to ... double the number of mortgage-backed securities issued by Fannie Mae and Freddie Mac...

2. The Federal Housing Authority. The FHA, which was created in 1934, insures mortgages made ... to borrowers who are creditworthy but not particularly affluent. As the mortgage market grew ... and subprime lenders peddled credit to underserved markets, the FHA may have seemed outdated. But in the wake of the subprime debacle, the FHA has suddenly become an important part of the effort to stanch the rising tide of foreclosures. ...

3. The Federal National Mortgage Association (Fannie Mae), which was created in 1938. Fannie Mae purchases ... mortgages under a certain size ... and packages them into securities, which it effectively insures. ... Fannie Mae and its brother government-sponsored enterprise, Freddie Mac, are playing a central role in the federal response to the housing crisis. ...

4. The Federal Deposit Insurance Corp. The FDIC, which was founded in 1933 and insures bank deposits, is playing more of a passive role. Many of the financial institutions that have failed or suffered near-death experiences in the current crisis—subprime lenders, jumbo lenders...—essentially fell victim to runs on the bank. ... But one sector has been largely immune from runs on the bank—banks themselves. Even as banking companies have racked up significant losses..., and even as some tiny banks have failed, Americans haven't rushed to yank their cash out of their checking and savings accounts. ...

Quoting Martin Wolf once more, he says "times of crisis are when new functions emerge." This article is something I came across in a search - it's an "interview" of Carter Glass by the Minneapolis Fed - that discusses how crises cause change (you'll see why interview is in quotes).

Two additional topics are discussed in the "interview" that have come up here recently, the erosion of the "walls between commercial and investment banks" that occurred in the late 1990s (that's when this interview was conducted), and the erosion of regulatory authority as banks found ways to evade regulations, i.e. "national banks had created affiliates as a way of doing precisely those things that the National Bank Act prohibited them from doing." Thus, in that respect, the motivation for the regulatory change that produced the Glass-Steagall act is the same as the motivation for more regulatory control today - the existence of a shadow banking system outside of regulatory authority that has the ability undermine faith in the financial system, or to produce feedback effects that can cause banks under the Fed's authority to fail:

A Conversation with Carter Glass, The Region, December 1997: Since Carter Glass has been dead for over 50 years, we were naturally surprised that he agreed to be interviewed by The Region. ... Woodrow Wilson claimed that Glass, as a member of the House of Representatives, had "snarled the Federal Reserve Act through Congress out of one side of his mouth" and speculated that Glass might have accomplished even more using his whole mouth. ... Out of deference to his extreme advanced age of 139 and perhaps worried about his reputation for being easily provoked, we eased into the following conversation as gently and graciously as we knew how.

REGION: Senator, thank you very much for coming. It's a wonderful privilege to meet the man who invented the Federal Reserve System.

GLASS: It's nice to be here; I don't get out much any more. As to my inventiveness... The true mastermind of the Federal Reserve banking system was Woodrow Wilson..., but many others made constructive contributions...

REGION: ...The Federal Reserve has been dismantling the Glass-Steagall Act's walls between commercial and investment banks. As one of the architects of those walls, do you regret the changes?

GLASS: If you put yourself in my place and time, you would have done as I did. Our subcommittee did not act out of any prejudice or in a whimsical or inadequate way. We consulted practical bankers and experts extensively. We did everything but sleep with experts, and we learned that national banks had created affiliates as a way of doing precisely those things that the National Bank Act prohibited them from doing..., affiliates were the slippery conjurations of lawyers. Shrewd men operated them and entwined the parent banks in great difficulties. Banks lent their names, prestige and tradition of sound banking operations to these affiliates, and on that basis did people invest and transact business with them. When calamity struck, not all bankers felt a responsibility to the citizens they had enticed. Not all bankers could afford to.

Our subcommittee heard testimony about many virtuous affiliates, but we also heard of abuses, especially in securities dealings, and the weight of informed opinion was that the affiliate system was riddled with vicious practices. Two of the country's most eminent bankers who testified had already got rid of their affiliates without any governmental prompting, but opinion varied about whether affiliates should be liquidated, or whether they should be separated from the commercial banks, or whether their powers should be trimmed and they should be subjected to more or less severe supervision, as banks were.

We could not single out exceptional cases. Congress must act by general legislation, and in the end we aimed for a happy medium. We allowed a decent period for banks and their securities affiliates to uncouple, and we subjected other affiliates to greater or lesser safeguards and supervision, depending on their activities. We hoped those measures would answer the public's loss of confidence, protect depositors and investors, and help prevent Federal Reserve facilities from being used in support of stock and commodity gambling, which had brought on the Depression and about which I had been warning for 14 years or more...

REGION: ...The insurance of S&L deposits put the government to great expense not long ago. ...

GLASS: "Great expense" is a tepid description of a catastrophe. The best reform of government insurance would be to wash the land entirely clean of it, though it take all the waters of Abanah and Pharpar to do it. If it were not so tragic, it might be amusing how many people discovered the problem of moral hazard only after the savings and loan associations went bust. When we passed the Federal Reserve Act, we knew all about moral hazard. One version of our currency bill would have devoted half the Reserve banks' excess earnings to deposit guaranty, but every plan that experts and politicians devised was either a sham or would have visited the sins of reckless banks either upon the government or upon banks that themselves bore no taint of wickedness or improvidence, and would thus encourage sin. No one ever proposed a solution to that problem that satisfied me, or has yet. When I stood before the House of Representatives in 1913 and declared that not one dollar of government funds should ever go toward the guaranty of bank deposits, the welkin rang with applause from both sides of the aisle.

REGION: But surely the government bears a responsibility. Bank failures impose calamitous losses on individuals who are not well positioned to protect themselves.

GLASS: In my experience, once a man learns that he is at risk, he will find a way to protect himself. And there is no better learning experience than to see his neighbor lose a portion of his deposits in a panic. ...

President Wilson, the best educated president we have ever had in political philosophy, deplored philanthropic government, but the country has grown accustomed to it. Protecting citizens against loss is a philanthropic goal, but as we predicted in 1913, the national government cannot keep bank losses at a tolerable level, once it has shifted risk to itself—or, rather, to its taxpayers—without a mammoth and expensive bureaucracy to dictate banking practices in ever more minute and oppressive detail to experienced and practical bankers. I am more persuaded than I ever was that the government should not be in this business.

REGION: That confuses me. Isn't your name on the bill that put the government in this business?

GLASS: A legislator may sponsor a bill for different reasons...; and in emergencies he may support emergency measures that are unsuited to calmer times. It was clear that the country needed prompter and more orderly arrangements for liquidating banks. A man wrote me from Missouri, for example, that his bank had been six years in the hands of a manipulative receiver and he had not seen one cent of his money. I also recall a Montana bank whose affairs could not be wound up in under 28 years. Those problems deserved legislative correction.

REGION: It's too bad you needed a banking crisis to get that legislation.

GLASS: It is nearly impossible to get banking reformation in this country without a crippling national emergency, and even then, bankers tell us to wait for better times because their situation is precarious and reform will break them. But when better times arrive, they tell us to wait yet awhile, because reform will upset their fragile prosperity. Bankers and their myrmidons and hired pigwidgins always threaten a torrent of disasters. They think the time is always right to reform others and the time is always wrong to reform them. Furthermore, if Congress waits as bankers instruct and gives some new villainy time to take hold and become familiar, bankers then defend the practice as if it were a birthright of finance handed down to them from Justinian by way of the Medicis and Alexander Hamilton himself, with which it would be impious and disruptive for the government to interfere.

In this fog of selfish rhetoric, all a poor member of Congress can do is keep a list of needed improvements and bide his time until a financial catastrophe gives him his chance, and then he must legislate at once or wait for the next debacle. This is a wasteful, unscientific process. It delays useful remedies until the banking system is racked with infection, and it brings in desperate cure-alls, quack nostrums and overdoses that may be worse than the disease and, though meant to be temporary, often continue for decades after the fever breaks. ...

Comments

[save_the_rustbelt]

Free markets are only good for workers, as we drive American workers down to raise workers in other parts of the world.

Sometimes the grand schemes of liberals and neoliberals do not work so well.

So who represents liberalism these days, Robert Rubin or Sherrod Brown?

[Regulations]

"Mortgage companies that relied on the capital markets (rather than deposits) to raise the money for mortgages suddenly found themselves starved for cash."

The debacle in the 30s showed that it was necessary to regulate banks that raised money via deposits. The recent wanton fraud shows that it will be similarly necessary to regulate shadow banks that raise money in the capital market. If neither the banks, nor shadow banks, can be allowed to fail in great numbers, then market discipline cannot weed out the nonsense. This leaves only regulations. Let us hope that the regulation writers will use wisdom.

[hari]

Mark -

This is an amazing development to get Martin Wolf to agree to my thesis that deregulation is the central culprit of hi fi disease right now...Add to it Justinian Roman justice and Medici Renaissance and Alexander Hamilton's writings on liberalism...you have arrived at a defining historical juncture when Libertarian principles of laissez-faire economics come directly into conflict with maintenance of state law and order.

Paine would say, 'It's time to break the suffocating chains of capitalist bondage'.

Glass "interview" is not necessarily remedial medicine for the affliction of greed but a cogent sense of reality based social systems under democratic rule. Right now the system has been woodwinked by those who control capital and its utility. Of course, they do generate income and wealth but the society-at-large doesn't seem to get any real net benefit or rent from their excesses.

At the turn of 20th century, the "Ruler Morality" ruled on European continent. The French Revolution made a bloody break from that age-old aristocracy and people's democracy was invented...with all its social distortions and conflict of interest.

Martin Wolf knows his economic history, and the writing is clear on the demise of globalization, and 24/7 hi fi markets without regulatory oversight....

Glass is clear and cogent in analysing what really matters to advancement of society-at-large. Woodrow Wilson was indeed a philosophical professional. However, I'm not confident present Congress can handle the case of subprime SIVs, CDOs, and whatnots...without making a goulash of it all!

That's why Fed must be brought to order (under its legislative ordinance) to give vent to ways and means of overcoming the deregulated markets. The ball is now in Feds court...and they must be required to follow the laws on the book on financial markets oversight.

[gordon]

Prof. Thoma: "If removing restrictions gets you in the vicinity of the competitive outcome, and most often it does ..."

I would love to know what Prof. Thoma has come up with "most often" by way of competitive outcomes (no barriers to entry is assumed) without regulation. Legal activities only, please.

[op]

"This is not just a matter of simple justice... It is also a matter of efficiency"

ahhh wolfy invokes the OUR LORDS third commandment

thou shalt have no gods before me
saith
OUR LORD except ..... "EFFICIENCY "

a matter of efficiency

risk taking regulation
at the synthetic security trading windows ???

i'd prefer
this gargoyle even :
" it's a matter
of periodic total output "

the credit system if it locks up
slows the out put rate of real products
thus the input rate (to real folks)
of ...maybe even ...the necessary
basic means of happiness
in plain english

its a matter of " social welfare "

"Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion"

one might wonder why that hope in the first place

increased risk baring "efficiency"
or increased
total risk load capacity

or closing the loop of risk

let the same ring of cuffs
take the gains and the loses
full rewards and full punishments

guess there's a compliance problem

when the risk takers agents
run the printing press
if today comes up heads in aggregate they win
but if it comes up tails in aggregate we lose

[save_the_rustbelt]

Dani Rodrik has an interesting commentary in his blog.

[op]

"If removing restrictions gets you in the vicinity of the competitive outcome "

" and most often it does"

that second bit ..in our second best of an economy ....
well it has a degree of generality
i'd avoid mark

the record shows
the belt way mecca
loves its pilgirm rent seekers

and a reg-web that catches most
but has a few well placed loop holes
for the inside trackers
is often more efficient
at squeezing out rent max
and narrow max
distributing it

don't most
post greenwald -stiglitz welfare models
suggest
its the class of regs
that prevail in the contest for
"specific orderings of specific markets"
that are pareto inferior
and not to no regs
but to another set
of possible regs

maybe regs just as class biased
but
that fall mostly on what now is the rent seeking and collecting class
by and for another class
of econ con agents
the present rent paying class

its a case of distributional efficiency

leading to a broader welfare enhancement
and a higher total welfare

fair ???

my fair is your outrage
in these matters

[kharris]

"Free markets is not the point. Producing well-functioning, competitive markets is the goal, that's when our models say the outcome is optimal."

Um, no. Optimal outcome is our goal. You made the point yourself, but missed the point you were making. Many's the time I've had to correct those who claim that "free markets" are the goal, the highest good. My answer is always that the goal is optimal human welfare, however we may define that. You have substituted a model for free markets. Just take the additional step. Substitute human welfare for the output of models.

[op]

the carter glass "play"interview
is worse then
the john adams series now on hbo

like
tom hanks and
that old peckerhead with the hallowing voice
that gave us this pop tart adams
the author of this piece
is more disney then gibbon

[op]

"Free markets is not the point. Producing well-functioning, competitive markets is the goal, that's when our models say the outcome is optimal."

i second that notion

or is it
i third it

[op]

kharris
i think you and mark agree completely
i read this passage of his
to say pretty much what you say
albeit more abstractly

the model out come optimized
in most run thrus
is "human welfare "

[op]

Paine would say, 'It's time to break the suffocating chains of capitalist bondage'

yes a would indeed

but to save it from itself
is the mission of the brightest and best...
elect-able pols

[joey]

Does the Fed have the wherewithal to take care of this?

[Barry]

"In my experience, once a man learns that he is at risk, he will find a way to protect himself. And there is no better learning experience than to see his neighbor lose a portion of his deposits in a panic. ..."

Oh, J*s*s H. F*cking Chr*st.

If I were granted limited dicatorial powers by President Obama, it looks like clean sweeping the Fed of all free marketers would be step #1. And I mean 'clean sweep' in the sense that Stalin would have meant.

[ken melvin]

A fourth:

leading to a broader welfare enhancement
and a higher total welfare

What's the net?

[Organic George]

Hari,

Just a tip of the hat to a well written first paragraph.

I will use it as an excellent example of wordsmithing on a difficult technical topic

[bakho]

All markets operate under RULES, period. It is only a matter of how much regulation is imposed what those regulations should be.

[op]

So who represents liberalism these days, Robert Rubin or Sherrod Brown?

we shall see ....
its a tussle for the soul of the dembot party

ps i'm not sure shoo fly brown's for real

at least
not in the strict sense
bondage bobby was is and will be

best outcome

a stake driven thru rubin's heart

aahh yes

but some one will pull it out
some day
and he'll visit us again

[reason]

The Wolf at the door says "Beware the Ides of March"? Where are the Delphic Oracle and Cassandra when you need them?

[op]

organic george

i like you're encouragement of wordsmithing
tip
i think you'll find
bruce wilder
to be
the local river god
on that beat

[op]

reason

that's
not bad delphics on your part btw

[dd]

Sherrod Brown:
Aye on Gramm-Leach
http://www.govtrack.us/congress/vote.xpd?vote=h1999-570

Aye on Commodities Futures Modernization Act of 2000
http://www.govtrack.us/congress/vote.xpd?vote=h2000-540

[jamzo]

well said kharris!

[wjd123]

GLASS: It is nearly impossible to get banking reformation in this country without a crippling national emergency, and even then, bankers tell us to wait for better times because their situation is precarious and reform will break them. But when better times arrive, they tell us to wait yet awhile, because reform will upset their fragile prosperity.

Why not start regulating now?

What is to stop investment banks from taking the 2 1/2 percent money they borrow from the Primary Dealer Credit Facility and placing leveraged bets with it?

Doesn't this generosity by the Fed open the way to a new bubble forming or investment banks gambling with goverment subsidies causing an even bigger crisis next time?

Was there anything stopping the Fed from putting some restrictions on how money from the Credit Facility is used?

Since we are in the middle of a crisis, why not start regulating right now instead of waiting for the next crisis the Fed's actions are making more likely.

[Winslow R.]

"In my experience, once a man learns that he is at risk, he will find a way to protect himself. And there is no better learning experience than to see his neighbor lose a portion of his deposits in a panic. ..."

I have to admit.........I agree.

Of course, I preface this admission with the idea we need a 'safe' depository institution that has no need to be 'competitive'.

Surprise, this institution already exists!

The 'barrier to entry' created by monopoly banks, should be removed and allow all citizen depositors access to a Fed deposit account which would pay interest slightly below the current Fed funds rate. 100% protection with almost no regulation needed as the Fed would have no need to 'invest' those deposits. No FDIC needed.

Second best proposal would be a Fed account offered at your local bank. Your bank would give you the option of putting your money into a Fed account.

All other bank accounts would lose their FDIC backing. Shrink the banking sector down to size so that we can .....you know the rest.

The financial sector needs to assume a smaller role in our economy so that entrepreneurs can flourish in the return on their investments. No good reason to invest in America when the returns are only going to be captured by the financial sector.

[dd]

More regulation is not happening under this regime. This crisis will be used as an opportunity to silence consumer/investor/savers and send them further down the arbitration blackhole.
Here is the template:
http://www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf
Here are the real authors:
http://crapo.senate.gov/issues/american/documents/FINALExecutiveSummaryCompetitivenessReport.pdf

This is the goal:
"The comments came ahead of the release of Treasury's review of U.S. financial regulators, scheduled to be released before the end of March. Paulson said the plan will come out ``soon,'' as part of his push to streamline the regulatory system to improve American competitiveness."

Can't wait for the new new Paulson report? No problem as it will be a rehash of this "plan:"
Say goodbye to "protections" and hello to investor "vigilance." Personal favorite:
"Improving Investor's Contributions to Market Discipline"
http://www.ustreas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf

Yep, it's investors' fault that housing is a bubble and shame on those same investors when the old pension plan crashes and burns. And what of global financial institutions? Nothing to see there; just a little "strengthening" of risk management practices.

[dd]

Paulson quote source:
Paulson Urges Broader Fed Oversight of Wall Street
http://www.bloomberg.com/apps/news?pid=20601103&sid=ampB7aZh3E9c&refer=news

[dd]

Now that IBs are safely ensconced in the Fed's embrace it's time to cut deadbeat homeowners loose:
"In a speech Wednesday to the U.S. Chamber of Commerce, Paulson said most of the new ideas circulating on Capitol Hill, which would generally provide taxpayer money to help reduce loan amounts and refinance mortgages at lower rates to keep homeowners from foreclosing, "are not ready for the starting gate."
http://www.marketwatch.com/news/story/paulson-holds-firm-against-govt/story.aspx?guid=%7B28A81D81-005B-4D7C-8D76-E4A4E1DBE5F6%7D

[anne]

Mark Thoma:

"Martin Wolf says he's been under a 'delusion' about the ability of securitization to carry risks outside of the traditional banking system and reduce the need for regulation."

Perfectly stated; such has been the purposeful delusion fostered by conservatives who are wildly regulatory beyond selling absolute commercial non-regulation.

Notice the responses of George Bush and John McCain to our mounting financial and general economic problems; notice the non-responses.

[bp]

and the extent to which an intervention that overcomes a market failure and produces a more competitive market reduces freedom is a debate for another day, but I don't see why it necessarily does

we are liberators
not concentrators

we occupy no one
to spread risk to everyone

competition, like risk
is adverse selection in reverse

in the game theory box
a pareto outcome

if at least one bear sterns is better off
and no jp morgan is worse off

then no winner
need reward any loser

as competition moves resources
to their highest valued abuse

[Winslow R.]

This is lining up to be a struggle for power between the fiscal market and the monetary market.

The fiscal market has a very stong government entity, which extracts some 2 trillion in returns, called the IRS through taxes.

The monetary market has a very weak government entity, which extracts some 34 billion in returns, called the FED through interest.

A better balance in extraction will lead to greater income and wealth equality. Currently the system tilt is requiring fiscal bailouts of monetary failure.

[kthomas]

Winslow, well-said.

The last two weeks, you've been my hero, amigo!!!

[Bruce Wilder]

bakho: "All markets operate under RULES, period. It is only a matter of how much regulation is imposed what those regulations should be."

I think the libertarian conceit that there is a choice between rules and no-rules, or between more-rules and less-rules, is only a debating tactic, and not a reflection of the real situation. Once a system develops, its complexity dictates the need for rules, and the rules will exist -- the only operative policy question is what the rules should be, and not "how many" rules there should be.

[Bruce Wilder]

The thing about Glass-Steagall is that the wall of separation did create two financial worlds -- one with lots of insurance/regulation, and one without.

The whole point of the insurance/regulation world was to create a Frank Capra movie -- to allow ordinary people to channel their savings into institutions, which would, in turn, offer mortgages in low-risk, fixed-rate form.

Securitization is re-creating a high-risk world. A high-risk world benefits the plutocracy, because it creates conditions, which transfer wealth and income from the poor and middle class to the very wealthy.

So, we get a shadow banking sector in the world of high finance, which is very, very risky. And, it is a perfect reflection of a consumer finance world, which has been created, where people lose their home equity and pay 33% credit card rates.

I am very suspicious of this focus on extending regulation to the shadow banking sector, because I am so appalled by the introduction of consumer loan sharking. The two developments are of a piece, two aspects of the same tendency.

[swells]

Brtuce, your points are well-made. I do have a question. What regulatory force gets applied to the government itself in the event special interests dominate the political process? Not so much I think. While I agree with the need for more intelligent regulation of financial markets, I am also of the opinion that there must be more intelligent regulation of the political class for that to come about. I no longer believe elections are enough and that to benefit from the salutary effects of participatory democracy we are going to need to give individuals a veto over their own individual participation in most political shemes.

[Bruce Wilder]

Those inclined, as Prof. Thoma is, to think about things in a theoretical competitive market framework -- I have objections to this method, but I let them pass unremarked -- should be be thinking, in the case of financial markets, about competitive markets as games in a casino.

The relative positions of large bettors and small bettors, skilled and unskilled players, and those who can make markets -- that is play the role of dealer/operator and collect house odds, ought to be considered.

[Bruce Wilder]

swells: "I am also of the opinion that there must be more intelligent regulation of the political class"

More and better Democrats.

[hari]

It's interesting after Feds rescue/intervention of BS, DeutscheBank/CEO/Ackermann went public in German media expressing the limits of deregulation...and demanding Gov intervention to establish transparency and oversight of hi fi markets.

[Andrew]

I found this to be an excellent metaphor for the regulation of the financial industry:

I have been on a lot of international travel lately -- to Beijing, Mumbain, Tokyo, Berlin, London, Brussels, and Tel Aviv. In all of these places, I met angry and frustrated finance ministry bureaucrats, central bankers, retail bankers, investment bankers, and other fund managers.

All of them had a single message that rang a bit like the US accusing China of shipping out poisoned pet food and lead-paint covered toys. They said American regulators failed. "You exported poisoned financial products."

[kthomas]

Thx for the link, Andrew.

If you could but see my tears, as I weep for these poor, disenfranchised foreign investors. Oh the humanity!

[swells]

Bruce, I don't see that much difference between republicans and democrats to be honest. Republicans are a little more willing to grant some leeway to one's control over one's property as long as one toes fairly strictly to the line of their moral agenda. Democrats are a little more willing to grant a bit of leeway vis a vis one's individual morality as long as one doesn't believe that property is anything other than a priviledge doled out by government.

Neither seems adequately concerned with liberty and the responsibilities attendant upon it from my perspective.

[Spectator]

We have to wonder if the cure is worse than the disease. Most regulated industries, and specially where large sums of money and complex legal issues abound, deliver the spoils to those that buy influence and power. Hard to hope for any moderation in this case.

Free markets generally work, except where the government interferes with the failure of the incompetent and imprudent. While not perfect, that is better than one that can be bought with campaign contributions and outright corruption.

[George]

There are two problems with the argument here.

First is the notion that moral hazard is at work here with respect to Bear Stearns. The problem is that the people who directly rewarded for taking the risk have largely taken that reward with them, while the shareholders of Bear have borne the brunt of the punishment. The MDs and SMDs of Bear who were paid giant bonuses for booking revenue from securitizations have taken millions home already. They've also taken a beating in terms of their Bear holdings, but those numbers pale in comparison to that of shareholders who benefited relatively little from the profits of securitization. So the moral hazard construction ends up not being applicable in my opinion.

The other problem, as Richard Bookstaber notes in "A Demon of Our Own Design" is that in a realm of deregulated markets and the dogma that discourages regulation in general, we are constantly creating new financial instruments which have unknown risk profiles, and more importantly, we have no idea how they will interact with other instruments during crisis scenarios and it is beyond our knowledge to determine it in advance. So we are left to be reactive, which often yields inadequate results and genuine suffering, all because we are too dogmatic to acknowledge that not all regulation is bad. It is as if we feel the need to set our house on fire just to see how it will react when set on fire. That seems to counterproductive.

[evagrius]

" Bankers and their myrmidons and hired pigwidgins always threaten a torrent of disasters. They think the time is always right to reform others and the time is always wrong to reform them."

Myrmidon;Classical Mythology. one of the warlike people of ancient Thessaly who accompanied Achilles to the Trojan War.
2. (lowercase) a person who executes without question or scruple a master's commands.

Pigwidgeon

\Pig"wid`geon\, n. [Written also pigwidgin and pigwiggen.] A cant word for anything petty or small. It is used by Drayton as the name of a fairy.

Great terms to use. It's obvious from this that our education has sunk.

[op]

More and better Democrats.

bruce start defining
better Dembos
and you'll run yourself out
the left side of
the big donor hospitality tent

comes a time when the party isn't big enough for
both a prog agenda and heavy donors

notice hillary picks alan greenspan
and bondage bobby
for her blue ribbon A team

[swells]

George, if it is obvious that we are always creating new investment vehicles with unknown risk profiles, how can it be obvious that those same unknowns could be regulated effectively? My take on it, I'm a bit of a simpleton so I like to keep things simple, is that human beings are not particularly well-equipped to handle leverage of most any kind. Give someone a big enough track hoe and by golly there will be mountains moved! All I've seen in my life is one round of regulation followed by a round of inventiveness to defeat regulatory intent, followed by more regulation, etc., ad nauseum. When do we get back to the fundamental question? Is there some way to reduce the leverage humans employ in life to some scale that fits with our somewhat backward state of emotional and rational development?

says...

"When do we get back to the fundamental question? Is there some way to reduce the leverage humans employ in life to some scale that fits with our somewhat backward state of emotional and rational development?"

Give everyone an equal start and I'd put that number at about 5. 20% down gets you the house.

[ken melvin]

Seems it's the combination of leverage and speculation. If housing prices were stable, nothing down would not necessarily be bad, though such might lead to speculation with houses or financial paper.

[billy]

http://interfluidity.powerblogs.com/posts/1206422478.shtml

Counterparty of last resort?

..The New York Fed will take, through a limited liability company formed for this purpose, control of a portfolio of assets valued at $30 billion as of March 14, 2008. The assets will be pledged as security for $29 billion in term financing from the New York Fed at its primary credit rate...

..Essentially, the Fed will own this investment fund and the Bear portfolio outright. JPM's position is basically a call option on the fund's assets at $29B plus time-value whose value is capped at $1B plus time-value. (JPM is long a call option and short the same option at a higher strike price.) The Fed can deny all it wants that it is considering purchasing mortgage-backed securities. That is the economic effect of this arrangement. The Fed is buying up mortgage-backed securities and other unspecified assets at "the value of the portfolio as marked to market by Bear Stearns on March 14, 2008."..

...I have a simple question, one to which I think taxpayers deserve a simple answer. Will this new "limited liability company" have contingent liabilities to any parties other than the Fed, J.P. Morgan, and BlackRock for ordinary management fees? Will its portfolio consist of any positions that would make the fund a counterparty, potentially with obligations to pay, not merely rights to receive, future cash?

If the answer is no, a plain statement of that would be nice. If the answer is yes, then don't count on the "limited liability" of this investment company to provide taxpayers much protection. It's strikes me as implausible that a fund backed by the Fed would default on obligations to third parties. We've had central banks touted as lenders of last resort, market-makers of last resort, and fools of last resort. We'd better think very carefully before letting the Fed become a derivatives counterparty of last resort. The very idea represents a subsidy to those we may not wish to subsidize. There's never been such a thing as a risk-free derivatives counterparty. Every holder of a derivatives position has an implicit option to declare bankruptcy and not pay should circumstances move decisively against them. Parties who retain an option to default while the other side of the contract is taken by someone who cannot are gaining something of value, something I'm not sure we want to give. Should counterparty risk move from a theoretical bogeyman to an actual crisis, the scale of sums at risk could be large, even on a portfolio whose current net value is only a few billion dollars, as those owing the Fed refuse to pay while Fed is obliged to cover "offsetting" positions from the public purse.

[op]

NOT THE BRUCE I'D INVITE TO THE DANCE

" I could spin out an anti-Clinton story, here, but I am just not certain it is fair. I am left just slightly disappointed, wishing Clinton had a better campaign, and Clinton's campaign had a better candidate. But, I don't really feel like I know much for sure, about whether she would be a better candidate or a better President than Obama."

at what point bruce does this cave in on itself ???

"wishing Clinton had a better campaign, and Clinton's campaign had a better candidate"

yes a clinton campaign without clinton
yikes

[George]

Swell,

Leverage obviously makes everything more difficult. It's not the question of creating new instruments - its that we create them so fast and allow them to be bought and sold without understanding them. Between the Fed, Treasury, FASB, etc. have plenty of tools available to them in order to curtail this if they want to. Its difficult to argue that we should tolerate the risk of a complete meltdown because we're ideologically opposed to regulation - this is purely a question of pragmatism. While regulation may not always be palatable, the alternative could be far worse. If Bear had been allowed to fail, the world financial markets would have melted down that Monday, which is an outcome that affects everybody, whether they acknowledge it or not, and the effects are not short-term in nature and create real human suffering.

Part of the problem is the presumption that people who create, buy or sell them understand them, which is clearly not the case. As I said, the other problem is that they don't know how they interact with other instruments. For example, who would have thought that CDOs could impact the market for leveraged loans? The short answer is that they don't in a sterile analysis, but in a real-world situation where overall credit gets rationed and institutions are selling whatever they can to make margin calls, you create a situation where the outcomes are not only unpredictable, but unimaginable.

The market hates nothing more than uncertainty. The irony is that a lot of instruments were designed to offset uncertainty, but ultimately have contributed to more of it. This clearly contradicts the open market argument - that the market will find ways to innovate and become better in the absence of regulation. This has clearly been proven to not be the case over and over. To bifurcate the argument into all regulation or no regulation is dishonest - there is certainly a sophisticated middle ground that can be achieved that creates incentives for financial innovation, but tempers it with as much transparency and analysis as possible, as well as some restrictions on "shadow banking" so that we don't end up in these situations that can spiral out of anybody's control. To do otherwise is to cut off one's nose to spite the face.

[Cynthia]

I'm not sure why Martin Wolf thinks that the dream of capitalism died on March 14, 2008. If he'd just think a little bit more he'll suddenly realize that capitalism is only a dream, never to become reality.

[JRossi]

So the head of Deutsche Bank no longer believes in the self-healing powers of the market. That's gratifying to know. I wonder when he gave up believing in Santa Claus and the Easter Bunny. Probably last year at the latest.

[gordon]

Aha! Found it! About a year ago Prof. Thoma put up a long post on the difference between free markets and competitive markets, noting the long list of prerequisites needed to obtain the efficiency benefits of competitive markets. The post is here.

An extract: "Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic, though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern...

The list [of prerequisites] goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principle agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient".

This old post clarifies the issue a lot, I think, and I recommend it to anybody who is getting worried about markets and regulation. It does open up a whole other can of worms about whether it is possible to set up a regulated market with incentives which mimic perfect competition, but maybe that's for another day.

[Anthony (Tony) Wikrent]

kharris says...

"Free markets is not the point. Producing well-functioning, competitive markets is the goal, that's when our models say the outcome is optimal."

Um, no. Optimal outcome is our goal. You made the point yourself, but missed the point you were making. Many's the time I've had to correct those who claim that "free markets" are the goal, the highest good. My answer is always that the goal is optimal human welfare, however we may define that.
Yes, that is the crux - how are "optimal outcome" and "human welfare" defined, and perhaps more importantly, who defines them.

Laissez faire has proven useless in meeting national goals. When we had to fight World War 2, we put laissez faire and "free" markets aside. When we put a man on the moon, we put laissez faire but used "free markets" to obtain the best equipment at the lowest cost.

Now, we must move the nation away from a dependence on imported fossil fuels. We have been talking about this since the 1970s, since Hubbert forecast U.S. oil production would peak in the early 1970s, and it did; since the oil embargo and subsequent energy crisis; since Jimmy Carter. In the time since, laissez faire and "free" markets - neo-liberalism in general - has been the ever more dominant (actually, domineering) economic paradigm, and it has proven to be an unmitigated disaster for achieving the national goal of energy independence, let alone establishing a new economic basis to replace fossil fuels entirely.

Think about this: if the worst fears of global warming are realized - even if only the public perception is created that those fear are created, in the case that we are seeing a natural cycle of earth's heating - economists who preach neo-liberalism could very possibly be seen as perpetrators of hate crimes, or worse. Maybe even subject to capital punishment. Sound far-fetched? Before you argue the point, spend a night or two browsing through some of the recent science fiction. You will be shaken.

[swells]

Gordon, thanks very much for your thoughtful reply. Good information there. I guess I'm taking a more fundamental view of leverage in the sense that I also see regulation as a form of leverage. In this sense, I am talking about leverage as a force mutiplier for accomplishing some work. My point basically is that humans do not seem to be particularly well suited to the efficient use of the immensely powerful forms of leverage we are discovering. I think mainly because of our inability to foresee unintended consequences.

I would think that unintended consequences might be just as likely to follow from regulatory schemes as they are likely to follow from the creation of new financial instruments.

So, my question is basically how we deal with unintended consequences in general when the forms of leverage of all stripes are becoming more powerful in what looks like a logarithmic progression. Observing that most phenomena follow some power law distribution over time, is it not likely the case that we will suffer some major upset that flows from some application of high force multiplication no matter the realm as long as we are using progressively more powerful forms of leverage? Whether that realm concerns finance, regulation, genetic engineering or weaponry is perhaps immaterial.

[hari]

@ Swell -

You're raising a Talmudic inquiry...when dealing with unintended consequences in dealing with laissez-faire economics.

In my experience in drafting complicated language in miltilateral settings I've always sought to find language which approximate more or less the desired consensus under debate between sovereign nation-states. Lowest common denominator is not, I suggest, a slautory strategic concept when confronted with the type of subprime meltdown we're witnessing...principally because of fradulent thinking and risking moral hazard.

Moreover, Talmudic method can also imply infinity in terms of reasoning and whatnot. I sometimes think or assume there was such a methodology invoked when subprime SIVs were bundled for distribution. Hedge Funds utilize mathematic formulas built by Ph.D.s to extract rent from underutilized
markets. Thus, infinity seems within their reach or concept of laissez-faire economics...Otherwise I can't see inherent value in their strategic methodology or framework of operations in the global market.

[swells]

hari, Sorry but I don't understand your point. If by Talmudic you mean inane discussions of exactly which points of an irrational belief system should be interpreted which way, then I demur.

What I'm trying to consider is the more fundamental landscape of which the current financial market turmoil is a singular feature, in my view. My interest got prompted by considering the potential for deadly mischief that is now available to small groups via misuse of the powerful technologies that are being developed. That lead to considerations of the issue as a systemic risk that needs to be considered.

[hari]

I agree with you there is mischief in hi fi market place and they have hijacked laissez-faire capitalism to its ...scale.
That's all I am trying to focus on ...because this is a malise created indeed by a small group or cabal with deadly mischief in mind...sometimes also called GREED!

[Blissex]

«What is to stop investment banks from taking the 2 1/2 percent money they borrow from the Primary Dealer Credit Facility and placing leveraged bets with it?
Doesn't this generosity by the Fed open the way to a new bubble forming or investment banks gambling with goverment subsidies causing an even bigger crisis next time?»

Fool! That's precisely the goal of making that 2 1/2 percent money available. Lending at deeply negative real interest rates is *intended* to both make borrowers a lot of money in risky arbitrage and to fuel a new bubble in some asset or another, to both bail out Republican campaign donors, and to create a new ''feel good'' factor among the asset owning politically active classes.

Do you think mobody at the Fed know what is the effect of lending money at nominal rates way below inflation to *investment bankers*?

While there are two bad wars going on and an election to be won the home front needs to be kept happy, and "the next time" is someone else's problem.