"Anatomy of a Crisis"

Barry Eichengreen says two key regulatory changes, one in the 1970's and one in the 1990's, are key factors in the crisis:

Anatomy of a Crisis, by Barry Eichengreen, Commentary, Project Syndicate: Getting out of our current financial mess requires understanding how we got into it in the first place. ...I would insist that the crisis has its roots in key policy decisions stretching back over decades.

In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers. The second, in the 1990’s, removed the Glass-Steagall Act’s restrictions on mixing commercial and investment banking. In the days of fixed commissions, investment banks could make a comfortable living booking stock trades. Deregulation meant competition and thinner margins. Elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves.

In response, investment banks branched into new businesses... They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

It is important to note that these were unintended consequences of basically sensible policy decisions...

The other element in the crisis was the set of policies that gave rise to global imbalances. The Bush administration cut taxes. The Fed cut interest rates in response to the 2001 recession. Financial innovation, meanwhile, worked to make credit even cheaper and more widely available. This, of course, is just the story of subprime mortgages in another guise. The result was increased US spending and the descent of measured household savings into negative territory.

Of equal importance were the rise of China and the decline of investment in Asia following the 1997-1998 financial crisis. With China saving nearly 50% of its GNP, all that money had to go somewhere. Much of it went into US treasuries and the obligations of Fannie Mae and Freddie Mac. This propped up the dollar and reduced the cost of borrowing for US households, encouraging them to live beyond their means. It also created a more buoyant market for the securities of Freddie and Fannie, feeding the originate-and-distribute machine. ...

Now, a bloated financial sector is being forced to retrench. ... The one anomaly is that the dollar has strengthened in recent weeks. With the US no longer viewed as a supplier of high-quality financial assets, one would expect the dollar to have weakened. The dollar’s strength reflects the knee-jerk reaction of investors rushing into US treasuries as a safe haven. It is worth remembering that the same thing happened in August 2007, when the sub-prime crisis erupted. But once investors realized the extent of US financial problems, the rush into treasuries subsided, and the dollar resumed its decline. Now, as investors recall the extent of US financial problems, we will again see the dollar resume its decline. ...

Comments

[hari]

Having now looked at the proposal tabled by Paulson, I've great reservations particularly on the proposal to disallow legal challenges in court shld parties find it necessary to do so from their own intrinsic interest in the case(s), as it may be.

The q' is why is Treasury disallowing court action against its (monopolistic) decision(s)? Not for efficiency, I trust?

Me thinks this is not only dangerous but unconstitutional. And needs to be remedied by Pelosi, if Congress ends up having any say at all on outcome of this taxpayer bailout.

Otherwise, from experience elsewhere, we know this is how Treasury (and Bush) are *incapacitating* the legal process thru which this $700 Billion bailout of toxic CDS and whatnot will be decided *arbitrarily* by Treasury - ie. it's simple power grab in its most non-transparent form of governance - will surely comeback to haunt the powers which finally authorize it willy-nilly in interest of stability.

[hari]

The anatomy of the current crisis needs to be properly and objectively analysed with a view to legislating how regulatory framework can be structured to avoid similar and more complicated failure of the financial system in future.

It's also imperative that any adjustment and restructuring of the financial system be fully discussed and considered in the context of globalization and its impact.

[Lafayette]

The new Robber Barons

Article: In response, investment banks branched into new businesses... They borrowed money and put it to work to sustain their profitability.

Now, let's see if I get this right:
* Deregulated fees led to lower transactions costs, which -- after all - is goodness.
* But, it led also to more competition in a formerly preserved environment and therefore investment banks had to work harder, which, after all, is goodness as well.
* And that prompted the banker, in order to maintain and enhance profitability, to enter the magical world of "financial engineering", which is also not such a bad idea in and off itself.
* But, of course, in the frenzy for profit, they started taking short-cuts. But, that was OK, because the economy was relatively buoyant, which always covers a multitude of sins occurring off-scene (or in this case, off-balance).
* But, the market bubble popped, as everyone expected it to do, because frenzied markets have always popped throughout history, which is an historical fact.
* But during those interim years of madness before the Great Pop, a good many people made one helluva lotta money. But, hey, how did they do that?

Because Barry Eichengreen has not mentioned an important historical detail, which is -- you guessed it -- Reckless Ronny and his drastic reduction in marginal tax rates.

What propelled the investment bankers to enter aggressively and stupidly into the financial engineering folly of risk-management? Because transaction margins had decreased and was impoverishing them? C'mon, that is NOT the primary reason.

It was because they were prompted by the HUGE amounts of money they could pocket from lower net taxation of shared profit gains. Remember, finance sector profits in that period advanced from 10% of the Total Profits, as accounted in GDP, to 40%. The profits were there for the taking ... and keeping.

Do we want this madness to happen all over again?. Keep marginal taxation rates where they are today and we roll the dice on our children's financial destiny. Never underestimate this breed’s penchant for greed.

Why should they care of the consequences? We pay the piper, by forgoing future economic benefits, not them. They are now rich – perhaps a bit less rich – but these new Robber Barons will remain rich. Believe me, they have no moral compass whatsoever.

[save_the_rustbelt]

Couple of thoughts:

We cannot compete in the world with a 1960s financial system.

In the last 35 years business ethics have deteriorated badly, as the great generation has been replaced with the me first boomers.

No one on Wall Street seems to fear going to prison, we need to correct that oversight.

[bakho]

The 1990s boom generated a huge amount of investment capital that did not have enough good places to go. One good place was to pay down the US debt. Another was to invest in public infrastructure and workforce education. Another is sustainable energy. Another was to address nagging social problems in the US and the world.

Because these are areas that give broad returns that are distributed they are not favorable to small pools of investors seeking to maximize profit. Bush fiscal policy, tax cuts and governing philosophy ensured that we failed to address serious needs of our country and economy and ensured that the financial sector had even more money to compete for decreasingly productive investments.

The whole enterprise led to a huge misallocation of resources. The financial collapse is the systems way of purging excess investment capital. Recapitalizing the system responsible for the mess is unwise. Better to target the greatest needs of society that have broad economic returns and let the excess capital squeeze out of the financial sector.

[Two Factors]

"They borrowed money and put it to work to sustain their profitability."

This is where the negative short rates come in. They borrowed money created out of thin air (inflation), and used it to leverage their bets 30 (or more) to 1. This effectively transferred purchasing power from the general consumer to the rich.

"Now, as investors recall the extent of US financial problems, we will again see the dollar resume its decline..."

This is another way of saying that foreign savers will loan less to us in the future (less credit). We still have no significant domestic savings to replace it with. The falling dollar will make us pay more for oil, sending citizens fleeing even further into inflation hedges (which can't be loaned out).

[a]

This "want of a nail" analysis may be comforting, but the real problem is that Americans went into too much debt to fuel a lifestyle they could not afford. No one seems to be speaking much about reining that lifestyle in. On the contrary everyone seems to be trying to think of ways to keep it going.

[Two Factors]

"No one seems to be speaking much about reining that lifestyle in."

The 2nd mandate forbids this. To fulfill the 2nd mandate, borrowers must be encouraged to borrow/spend ever more to keep demand high/growing. Even if national demand is already far higher than potential domestic output.

[save_the_rustbelt]

Paulson on Meet the Press yelling "the sky is falling in one week."

[robertdfeinman]

I'm going to claim that this entire issue is really very simple. That it is simple and that the underlying failures are easy to understand is why it is being complexified by those who are the guilty parties.

The collapse was caused by too highly leveraged investments, the same thing that caused the crash in 1929. When you have a bet where one only needs to put up 3% (10% in 1929) then it only takes a small movement downward to generate a margin call. It doesn't matter what the entity that is being traded on margin is, it only matters how easily the margin call can be covered.

Such leveraged bets can never be covered by selling the underlying assets. It doesn't matter what the new settlement price is, the ratio between "value" and price is just to high.

The mortgage crisis is also very simple. Some fraction of loans have and will fail. Let's say 20%. These loans, unlike the bets between financial institutions, are backed by real assets. Even with a pessimistic projection that the home values should end up at, say, 70% of the original price on average. So we have a loss to the system of about 14% - a shock, but not fatal.

Any combination of re-adjusting the mortgages, an orderly selling of foreclosed properties (including keeping them in the bank's inventory until things settle down) and new capital to allow the banks to meet reserve requirements can do the trick.

There is no way to save the money of the financial margin players that's why they are tying the "crisis" to the unrelated housing downturn. Paulson has over $100 million in stock (not counting options) from his former firm. Notice that this is the one that will probably survive.

Any "bailout" for financial firms is really a way to pay back gamblers who lost their bets. It has nothing to do with preserving the housing market, or keeping the overall economy sound.

This type of misdirection worked for the S&L crisis and it will probably work this time as well. There is no way out of a Ponzi scheme without someone losing money. In this case the players are trying to make it the taxpayers.

[robertdfeinman]

I'm going to claim that this entire issue is really very simple. That it is simple and that the underlying failures are easy to understand is why it is being complexified by those who are the guilty parties.

The collapse was caused by too highly leveraged investments, the same thing that caused the crash in 1929. When you have a bet where one only needs to put up 3% (10% in 1929) then it only takes a small movement downward to generate a margin call. It doesn't matter what the entity that is being traded on margin is, it only matters how easily the margin call can be covered.

Such leveraged bets can never be covered by selling the underlying assets. It doesn't matter what the new settlement price is, the ratio between "value" and price is just to high.

The mortgage crisis is also very simple. Some fraction of loans have and will fail. Let's say 20%. These loans, unlike the bets between financial institutions, are backed by real assets. Even with a pessimistic projection that the home values should end up at, say, 70% of the original price on average. So we have a loss to the system of about 14% - a shock, but not fatal.

Any combination of re-adjusting the mortgages, an orderly selling of foreclosed properties (including keeping them in the bank's inventory until things settle down) and new capital to allow the banks to meet reserve requirements can do the trick.

There is no way to save the money of the financial margin players that's why they are tying the "crisis" to the unrelated housing downturn. Paulson has over $100 million in stock (not counting options) from his former firm. Notice that this is the one that will probably survive.

Any "bailout" for financial firms is really a way to pay back gamblers who lost their bets. It has nothing to do with preserving the housing market, or keeping the overall economy sound.

This type of misdirection worked for the S&L crisis and it will probably work this time as well. There is no way out of a Ponzi scheme without someone losing money. In this case the players are trying to make it the taxpayers.

[ken melvin]

"This propped up the dollar and reduced the cost of borrowing for US households, encouraging them to live beyond their means.

Methinks lacks mention of the underlying loss of earning poser.

Seconding Hari, and a look at the net benefit of such as derivatives, hedge funds, ..., and other assorted forms of churning.

"No one seems to be speaking much about reining that lifestyle in. On the contrary everyone seems to be trying to think of ways to keep it going.

Precisely the contradiction my Dear Watson.

[save_the_rustbelt]

Robertf:

Good analysis.

How do we limit damage to Main Street? Or can we?

[Lafayette]

Wall Street Casino

TF: They borrowed money created out of thin air (inflation), and used it to leverage their bets 30 (or more) to 1. This effectively transferred purchasing power from the general consumer to the rich.

How so? Give a concrete example.

The investment banks borrowed money from various creditors (aka "investors") ... and not "thin air". That they borrowed 20 or 30 or 40 times more money than they had in assets is a different question.

Not even in a Las Vegas casino would they allow a person to do this. But on the Wall Street Casino, apparently everything goes.

Or went ....

[robertdfeinman]

STR:
If I was smart enough to be able to figure these things out, I'd be rich.

The real issue is what do we mean by "Main Street"? We have evolved into a society where jobs that make things have been replaced by jobs which shuffle papers (or money). So if the financial services sector collapses than about 20% of the GDP goes with it. Is this Main Street?

If we create a universal health care system (not universal insurance) than about 1,000,000 jobs in the insurance industry and its allied middle men go too.

If we stopped building useless military hardware and either blowing it up or storing in the desert than thousands of jobs would go as well.

What do we replace these make-work jobs with? This is what I've been pondering for about five years now, and have yet to come up with anything that sounds implementable.

All I've come up with is that mechanized manufacturing can produce stuff faster than is needed (in the developed world, at least) and as a consequence we have created a variety of mechanisms to boost demand. This includes advertising, planned obsolescence, fashion changes and shoddy materials. All this manufacturing requires a continual flow of raw materials, and we don't know how to cope with the looming shortages either.

As for the type of impact you are worried about, I think that the discussion of the other day about what to do for workers is a good place to start. Policies aimed at putting people to work on neglected projects could provide a cushion to the expected rise in unemployment as well as creating some needed infrastructure.

I'm not as pessimistic as you are about finding trained workers, during WWII, the country figured out how to take housewives and turn them into skilled assembly line workers in airplane and other factories. Where there is a will, there is a way.

[save_the_rustbelt]

Somewhere in the blizzard of information this morning I've heard that Paulson would parcel out the $700B in $50B packages to WALL STREET FIRMS to work out.

This is like hiring a paroled computer hacker as a computer security expert.

Stephanopolis is asking Paulson some tough questions.

Paulson seems to be worried about the financial system, but homeowners are on their own.

Damn.

[Fred]

They are pushing this monster through fast before J0ohn Q Public realized whst is happening is has to be stopped . Write and call your congressmen and both presidential candidates . Get involved in local protests.

[CathyG]

I sent this to Sens Cornyn, Hutchison and Rep. Marchant last night. Of course, since I'm not a lobbyist for the financial industry and am not doling out millions in contributions/bribes I have little hope that they'll make the changes necessary to make this a little more equitable. No, I suspect the rape of the taxpayer will go on as planned:

Dear Senator Cornyn -

I've read early releases of the legislation being proposed to bail out the financial system and am very concerned about three points:

1. There are no provisions to share the pain of this. Any organization that receives more than a dime of taxpayer money should be subject to the following: A. Incompetent and greedy management needs to be removed and their bonuses for the last five years clawed back. B. Shareholders need to take a huge hit. The ecstatic giddiness shown Friday on the stock exchange was obscene. C. Debt holders need to absorb half of the losses on any securities that are marked below initial value - and nearly all of them will be.

2. There is no ownership for the taxpayers. If we are taking on the cost of absorbing toxic assets, taxpayers should own the bank and be in a position to enjoy the uptick at some future point when it can be re-privatized. Right now it looks like taxes are going to be showered on the bad debt of the banks, leaving management, shareholders and debt holders whole with no provision for paying back the ordinary tax paying citizens. This is a calumny.

3. There is no explanation of how this will be paid for. The only possible way to cover this is to immediately repeal the hopelessly mis-guided Bush tax cuts.

Thank you,

[gina]

Take every cent out of the banks a massive run will ensure that the corrupt system falls then build a better one on the ashes that is the only way a phoenix can rise otherwise it will be a very long recession/depression fraught with violence Ie let them eat cake

[hari]

I've been listening to what Gordon Brown/PM said to Labour Party Conference (Manchester) yesterday. It's the same Gordon who along with GWB stopped Merkel's idea of regulating Hedge Funds at G-7 meeting in Germany, couple of years ago.

Now, he's talking about *crisis of global capitalism* and suggesting that national regulators are not enough to cope with the complexity of problems - demanding a global set of rules and regulations to monitor the money markets.

From what I know, this is sudden birth of realism and genuine concern by Gordon - he's fighting leadership role in Labour Party also - and may be next Admin in Beltway will allow a more genuine attempt to come to grips with evolving global financial system.

Now you can notice the rather rancid approach of Eichengren from Berkeley....

[Two Factors]

"The investment banks borrowed money from various creditors (aka "investors") ... and not "thin air"."

Investment banks and hedge funds borrow short money. Central banks lower short rates by creating money out of thin air, and loaning the new money out (via intermediaries) until rates fall to the desired level. This results in a de facto (rate subsidized) thin air loan to promote highly leveraged bets.

30 to 1 leverage would not take place to the same degree, if market short rates prevailed (positive real interest rates). The thin air subsidy to short rates magnifies the total leverage in the system. Negative real short rates create more demand for short credit. Hedge funds et al were using Japanese short money for years to leverage their bets (Yen carry trade), but the US hedge funds et al kicked into overdrive when US short rates went negative. Derivative contracts have little regulation, and virtually unlimited leveraged bets can be made using them. This leverage can vaporize large companies/funds overnight if the bet goes against them.

[Bruce Wilder]

BE: "these were unintended consequences of basically sensible policy decisions"

What a steaming pile!

Lafayette covered some of this, but, what a ridiculously tendentious narrative!

This country is so thoroughly screwed. In only eight years!

Some narratives more complete, honest and accurate:

http://www.naomiklein.org/shock-doctrine

Kevin Phillips: The Destructive Rise of Big Finance

[Bruce Wilder]

John Yoo is never enough.

[bakho]

Yes, Americans are too deeply in debt. However, that is because the GDP growth is NOT trickling down. All the growth is in the hands of the wealthy who "loan" it to the lower classes instead of paying us our fair share of the growth. The Bush administration is enabling one big company store. The company store is in danger of going under because the peasants cannot pay their bills. The bailout only exacerbates the inequality problems unless the money for the bailout is taken from the wealthy and some of it transferred to lower class people who need to pay bills.

[shortgamma]

At this point, I think the entire issue has moved beyond leverage in financial firms. Interest rates on long term debts are as low as they are, in part because banks borrow short and lend long. If banks can't or won't do that, then long term rates have to be much higher (what rate would _you_ charge to lend to a business for 30 years with no prospect of getting your money back sooner?). That's the difference between a world with lots of liquidity and a world without it -- if you can't sell a debt, your alternative is to wait 'til maturity and see what happens. At the moment we are moving quickly towards that illiquid world. In that illiquid world not just our financial institutions, but also our industrial ones, are all insolvent. That's the bleak alternative now facing congress, and us.

[Lafayette]

The New Millennium America

rdf: What do we replace these make-work jobs with? This is what I've been pondering for about five years now, and have yet to come up with anything that sounds implementable.

And yet, it's relatively easy.

First of all, the numbers of jobs lost are exaggerated. Secondly, depending upon the sector, those job loses will result in lower costs for the SERVICES that are provided. That can only be goodness, since it means more of the service will be consumed. This is the evident truth as regards particularly national Health Care.

Secondly, if we embark upon Infrastructural Renewal, there are three kinds of jobs that can be created. The first is the planners and implementer managers (civil servants) and the doers who will receive the federally funded subcontracts to build and run:
* Renewable energy sources (windmills, tide-mills, geothermal and biomass systems),
* Non renewable energy sources (nuclear generators, sequestered carbon emission generators, etc.),
* More efficient transportation systems (suburban and long-distance) including high-speed train lines,
* Reformation and significant investments in both Secondary and Tertiary Education, to enhance the quality of the former and affordability of the latter,
* Entry-level housing for the sub-prime victims (no, not free housing, but low interest rate mortgaged housing)
* Renewed inner-city infrastructures (down-towns, urban housing, town-center commerce that revives town centers),

NASA spent billions going to the moon and employing the Shuttle to do near earth experimentation. Why does no one complain about a Public Enterprise that escapes the mold of Private Enterprise, but employs private enterprise sub-contractors to assure competition? All that for an objective, space exploration, that has no real immediate need. (I am not diminishing the value of space exploration, just readjusting its priority.)

Why can't a NASA-like organization assume the responsibility of building the New Millennium America; federally planned, funded and implemented, but privately built and publicly owned.

But, yes, where's the money going to come from? All the above will take trillions, but over 10 to 15 years. There will most certainly be new rules to play by. Uncle Sam using the rest of the world to fund it's Credit Gluttony will have to end. Still, within that constraint, America is rich in both financial resources and skilled abilities. It can be done, were there the will to do it.

America has to change its habits. This current unprecedented chaos does not indicate that such is absolutely necessary? But, from the ashes of the old rises the new phoenix. (Where do we think Schumpeter got his idea for Creative Destruction? From Greek mythology).

[methinks]

robertdfeinman@ 06:23 AM

Principled, simple and cogent. Something alien to political economists.

[Vader]

Government projects to sop up surplus workers.

1. Reclaim land.
2. specialty Agriculture.
3. Solar roofs on all dwellings.
4. speciality care for the elderly.
5. more social services to service inner city youth.

If we can dream up such an economy that we had, we surly can dream up something better.

[black swan]

"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

Translation: Bush not longer needs Congressional authorization to appropriate funds.

[salao85]

Eichengreen's says that the the repeals of commissions fixing in securities (good for the public) and the repeal of Glass Steagall (good for banks that had to compete with foreign universal banks) were essentially sound ideas that had unintended consequences in that it encouraged non-bank banks to develop high risk business lines. If that was the case why didn't anyone point this out? While avoiding appeals to greed and corruption as causes of the crisis as Eichangreen asks there is surely a great big question hanging over this entire affair - why is it in every other article that I read people are saying nobody ever understood the products? Then on top of this that regulators couldn't be expected to understand them - because they are so much poorer and by extension not as talented?!?!

How about paying regulators commensurately or even more than market participants, make them multi millionaires surely that would help with these sorts of problems in future - and be so much cheaper in the long run.

[anne]

http://www.nytimes.com/2008/09/21/world/europe/21britain.html?ref=world&pagewanted=print

September 21, 2008

British Prime Minister's Grip on Job Is Weakened
By JOHN F. BURNS

LONDON — In the 1960s, Harold Wilson, another embattled Labor Party prime minister faced with a disastrous economic crisis, coined a phrase that has come down the decades as a measure of the cruel vicissitudes of public life. "A week is a long time in politics," he said.

In the past week, Gordon Brown, 10 Downing Street's current occupant, has faced an economic crisis in Britain's banking and mortgage sector as severe as anything that confounded Mr. Wilson, and the buffeting it has given the government has further weakened Mr. Brown's already shaky standing in the Labor Party and with the electorate. Only 15 months after he succeeded in his long effort to push Tony Blair into retirement and take the prime minister's job, he faces the very real threat of being driven from office himself.

Whether Mr. Brown can survive to lead Labor against the resurgent Conservatives in an election that must be held by June 2010 may be clearer after what Labor insiders are describing as a do-or-die event for the prime minister: his speech on Tuesday to the annual Labor Party conference in Manchester. But as he prepares for that daunting moment, Mr. Brown, 57, the dogged son of a Scottish Presbyterian minister, may reflect that it has been a year, more than just a week, that has caused the drastic reversal in his fortunes....

More than anything, Mr. Brown has suffered from the battering he has taken on his main claim to the Downing Street job: his reputation, during a decade as Britain's finance minister under Mr. Blair, of being a "safe pair of hands" in preserving the long run of prosperity in Britain that now seems to be over. Over the spring and summer, he declared that Britain's economy was fundamentally sound, that the threats it faced were global in nature, stemming primarily from the United States, and that the country was better placed than any other in Europe to weather the downturn.

But those claims now stand widely discredited. Increasingly, the view among British economists is that Mr. Brown, in tandem with Mr. Blair, allowed Britain to float on a sea of debt, much of it tied to an unsustainable boom in housing prices, with the government blithely reluctant to step in and apply the brakes. Among those critics, Mr. Brown is regarded now as a man in denial, a criticism that gained momentum last week when he said he was committed to "cleaning up the financial system" and curbing "irresponsibility" by banks and investment houses, without even a glancing acknowledgment that the excesses occurred on his watch as finance minister.

Senior government ministers have described a similar pattern in their encounters with the prime minister. After a cabinet meeting earlier in the week to discuss policies to be unveiled at the Manchester conference, British papers quoted several unidentified ministers as expressing shock.

They said Mr. Brown had used much of the session in an angry denunciation of Mr. Cameron and the Conservatives, and had said little about Labor steps to redress the situation. "There were people staring at their hands, some scribbling on their papers, someone else on a BlackBerry," The Times of London quoted one participant as saying....

[jean]

So, Bruce Wilder, are we being shock doctrined? I think so, but it's just a 'gut' feeling. And that doesn't count.

[Care]

"...speciality care for the elderly."

There is a shortage of this, which the unemployed could provide. In Japan, a barter system has sprung up to provide this type of care. A youngster gives one hour of care, and is credited with the hour in his barter account. When he needs care himself, one hour of care is provided via his barter account.

This became popular because the Yen mediated system was not providing needed care. A person who provided one hour of care, and was paid in Yen, only got about 1/2 hour of care in return. The provider paid income taxes on the Yen, the Yen was inflated away before he needed the care, and then he had to pay extra to his own provider so the provider could pay his own income tax on the Yen. Result, one half hour of care in the future in return for one hour of care now. Little care was provided under this system.

[Bruce Wilder]

jean, I think the authors of the rescue are also the architects of the crisis

the moral hazard most in evidence is a political one: the American People have proven that they will hand political power to those, who fail the country spectacularly.

[donna]

Some mortgages fail, yes. But the risks were considered in terms of that, I bet with normal distributions, and NOT on the basis of a LOT of loans failing at once. The "fat tail" killed them, by not considering that the home mortgage business is cyclical in nature with boom and bust cycles and thus NOT a normal distribution.

I can't believe with all those quants they all failed to see this. Obviously a good many of those quants were told to shut up when the game got too dangerous. We need to find those people and get them in congress to testify as to who REALLY made the bad decisions out of greed, and those folks need to spend some time in jail.

[donna]

And if we do this bailout, and nobody ends up in jail, then my money will never, ever see the inside of any of those banks ever again. I already bank pretty much exclusively with local credit unions. I advise everyone else to do the same.

I don't want them living on their damned yachts while my tax dollars bail them out, that's for sure.

[Jesse]

From the NY Times 9/20 article by Joe Nocera.

"Then again, maybe the S.E.C. is trying to cover up its own culpability in this crisis. Four years ago, the agency pushed through a rule that allowed the big investment banks to take on a great deal more debt. As a result, debt ratios rose from about 12 to 1 to more like 30 to 1. Guess what Lehman’s debt ratio was when it went bust? Yep: 30 to 1."

[anne]

Jesse's reference....

http://www.nytimes.com/2008/09/20/business/20nocera.html?hp&pagewanted=print

September 20, 2008

A Hail Mary Pass, Hoping to Find a Receiver in the End Zone
By JOE NOCERA

It was the end of the worst week for financial markets since 1929, and Treasury Secretary Henry M. Paulson Jr. looked sleep-deprived.

He had begun the week agreeing to let Lehman Brothers go bankrupt, arguing that the government had to stop putting taxpayers' money at risk. Then, midweek, he brokered a deal to rescue the American International Group with an $85 billion loan from taxpayers — arguing that the risk to the financial system was too high to allow the world's biggest insurer to fail.

Neither move had done anything to stop the financial tsunami. So on Friday morning, just as the markets were opening, Mr. Paulson unveiled the government's latest attempt to stop the bleeding. Maybe it was because he was so tired, but there was none of the glass-half-full blather that is de rigueur for a cabinet secretary. Instead, his flat, just-the-facts-ma'am voice and weary body language conveyed an unusual sense of urgency.

The core issue, he said — the mistake that had led to all the other mistakes — was that "lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing." True. As for Wall Street, toxic mortgage-backed securities had become "frozen on the balance sheet of banks and financial institutions." He added, "The inability to determine their worth has fostered uncertainty about mortgage assets and even about the financial condition of the institutions that own them." True again.

And that really is the crux of the matter — the financial system has seized up. But so far, the government's actions haven't helped. Letting Lehman go bust may have sounded good at the time, but it has had disastrous consequences.

It has led to complete chaos in the multitrillion-dollar market for credit-default swaps and was a crucial reason Morgan Stanley was forced to scramble to stay alive this week. It is also why questions were raised about the viability of Goldman Sachs, a firm with a pristine balance sheet and almost none of the bad assets that are bringing down other firms....

[anne]

Barry Eichengreen could be argued with intensely about the opening of the investment markets in the 1970s and 1980s which allowed for low cost long term investing in a way broadly impossible before then. That investment markets turned increasingly speculative has for years been attributed by John Bogle to an increasing dominance of corporate-finance managers over owners, but beyond strong support by David Swensen of Yale, along with support by economists at Princeton and as usual by Warren Buffett, Bogle has just not been attended to.

[anne]

Bogle has repeatedly for years been pointing at the progressive increase in speculative investment going along with the separation of management from ownership, so that years ago even the average turnover of portfolios by mutual fund managers had reached 100%, meaning that investors are overwhelmingly turned to speculators never understanding that or why and paying excessive costs for the speculation.

There is a reason though Vanguard became a massive investment house by avoiding or making transparent any management speculation.

[lonesome moderate]

For those who want to read the entire article, you need to hit the "stop" icon on the browser as soon as the text loads (otherwise you'll get an error message and the article goes away). Or, after the article goes away you can click the "refresh" icon and then immediately the "stop" one.

[roger]

save the rustbelt - I always find the mantra of how we have to "compete" amusing. It is usually rolled out to block anything progressive. It, of course, ignores the fact that non-progressive economic policies have left us in the "competitive" position of running half a trillion dollar trade deficits annually. Is this what is meant by competition? The establishment, under the banner of "competition", has liquidated the national savings, hammered down the average wage, and produced a now crashing system of absurd credit.

I'd rather go back to the days of not competing, since it was on the whole more prosperous.

[bullbust]

Lehman employees to get 2.5 billion in bonus

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4795072.ece

Staff at Lehman’s New York office who helped to cause the world’s biggest corporate bankruptcy are to share in a $2.5 billion bonanza.

The bonus, which has been described by London staff as a “scandal” has been pledged by Barclays Capital, the British-based bank that last week acquired Lehman’s American operation and took on 10,000 staff.

The $2.5 billion (£1.4 billion) pot, which has been ring-fenced as part of the acquisition, has caused huge resentment among the 5,000 staff in the firm’s European and Middle Eastern operations who are not guaranteed to be paid after this month...

[rufus]

In hindsight how foreboding was this comment from the Nobel Prize winning co-author of the options pricing model:

http://economistsview.typepad.com/economistsview/
2007/03/because_the_sys.html

'He(Myron Scholes) adds: "My belief is that because the system is now more stable, we'll make it less stable through more leverage, more risk taking." ...'

A soothsayer prediction that the unregulated market mover positions taken by LTCM were bound to occur again?

[macquechoux]

donna says...

Donna I am curious just who should go to jail? What laws were being broken? Freddie Mac comes to mind, but hasn't that been settled? Just curious.

[Ken Houghton]

I've been threatening to do this as a blog post for a while, but let's do a small version here.

"It is important to note that these were unintended consequences of basically sensible policy decisions..."

It is important to note that economists should never again be allowed to use the phrase "unintended consequences" when it makes them look stupid. (And, whatever else Barry Eichengreen may be, he is certainly not stupid.)

Ignore that Gramm-Leach-Bliley is one of the reasons Gore didn't Win Big in 2000 (just as, after the Dems cave on this one, Obama will not Win Big in 2008). Look only at the fundamentals:

You have two entities (call them CB and IB) who in the same general market, but which by and large serve different segments of that market. They do this in large part because the segments have different needs, and the relationship is essentially symbiotic. (That is, CB's clients often need IB's services, and IB's clients maintain simplier relationships with CB.)
For capital access, CB >> IB: we're talking orders of magnitude, due to the ability of CB to access its much larger deposit base.
For ideas, IB > CB: it's a small but noticeable advantage, based in large part on IB's ability to offer profit participation in its (smaller) part of the market.
Given the above, what happens if you take away the restriction on competition? Hint: look at the comparative advantages and do a reasonable projection of the relationship between them.
Anyone who tells you that the pending extinction of the IBs was an unintended consequence of GLB is either lying, doesn't know what he's talking about, or hasn't thought through the initial differences between the CBs and IBs.

[anne]

Rufus's reference:

http://economistsview.typepad.com/economistsview/2007/03/because_the_sys.html

March 3, 2007

"Because the System is Now More Stable, We'll Make It Less Stable"
By Mark Thoma

[anne]

There is a paper I have (but where and by whom?) from an MIT researcher discussing the inherent instability in apparently stable economic systems. I took the work to be a clever tautology, but I need to think through the argument again. Where?

[flow5]

(1) The FED let the commercial banks determine the growth of the money supply. Foreign-dollars were not sterilized. The money supply can never be managed by any attempt to control the cost of credit.

(2) Commercial banks increase the money supply when they make loans. I-banks lend existing money. The thrifts have experienced disintermediation, but the commercial banks haven't experienced disintermediation since the Great Depression.

(3) The solution is to get the CBs out of the savings business. What would this do? The CBs would be more profitable, the supply of loan funds would grow, and the thrifts would avoid these meltdowns. The GOSPEL

[rufus]

http://economistsview.typepad.com/economistsview/
2007/03/because_the_sys.html

March 03, 2007
"Because the System is Now More Stable,
We'll Make It Less Stable"

“Was the financial system ever in danger from LTCM's collapse, as widely predicated in press accounts at the time? I half-expected Mr. Scholes to pooh-pooh the worry as apocalyptic. Instead he pauses, finally saying: "I don't know the answer. ...
We'll never know. A phone call was made. The New York Fed agreed to intervene and organize a notorious "bailout" by the creditors to prevent a fire-sale liquidation.
Mr. Scholes was doubly marked for notoriety because he had just a year earlier been awarded the Nobel Prize, along with Mr. Merton, for their work on derivatives pricing. He readily acknowledges that the episode was financially and personally embarrassing: "In life you pay tuition, right? Sometimes you pay too much tuition. Sometimes learning is costly." ...”
What I believe may be more at the hear of what Scholes is saying here, as he alludes to later in the interview, that amounts of leverage and risk are strategic decisions each firm must make and learn from. Just as Black-Scholes model may be sound in its mathematical basis, it makes no predictions or probability calculations as to what impact pricing will have based upon a single or multiple firms strategic decisions regarding tolerable levels of risk and leverage.
Just a Coase’s theorem states that free markets will allocate externalities; it makes no moral/ethical judgment as to their allocation over time (e.g. artificially low resource costs in the past create necessary inflated resource costs in the future when externalities’ costs are not allocated efficiently). It is the job of government through regulation to properly align allocation of externalities, risk, and punishment/reward with society’s goals.

[anne]

Now and then, I am sent risk matrices to play with and see whether I can translate and simplify them. The problem however from what I understand is not the risk within a particular frame but risk to the frame as such. I can understand banks buying high return mortgage bond packages in keeping with the risk limits in a frame and never questioning what Goldman Sachs analysts questioned which was the impossibility inherent in a mortgage system that in becoming higher return or more costly to households could not be afforded either with a pause in the rise in housing prices or an economic weakening.

[anne]

Not that I ever anticipated such financial problems, but I wrote years ago that the mortgage market made no investment sense beyond package-specific risk-reward models. Even as there came to be noticeable mortgage problems in African American communities though, the idea by supposedly otherwise conservative investors that high return mortgages were more risky than anticipated by frame was ignored. Even though hedge fund money was being openly raised to bet against mortgage packagers at the very time.

[anne]

Remember John Bogle again, and understand the a growing distance between management and ownership as such distorts how we calculate general risk. Who actually controls the broad policy of a bank-captive hedge fund, the investors or the managers. The answer of course is the managers, driven in turn by bank manager superiors.

[rufus]

"Who actually controls the broad policy of a bank-captive hedge fund, the investors or the managers. The answer of course is the managers, driven in turn by bank manager superiors."

Agreed. However, while there is likely malfeasance in the representation of risk by managers to investors, it seems to be apparent that through the course of financial history investors have consciously decided to stomach more and more risk with the probability dependent promise of high return. But is it a greater appetite for risk on the part of the investor? Bailouts like LTCM contribute to the problem of Moral Hazard that we are running headlong into again today. As long as risk is underwritten then its actual value is never experienced, and investors do not alter strategic decisions. Reset the board and here we go again.

[anne]

Agreed; but risk need not be misrepresented rather than underestimated because of a distancing of management and ownership which has been the point of Bogle and Buffett. Buffett we know is even now buying assets, but how could this be for what is essentially a catastrophe risk insurer, an insurer who takes on outsized risks to begin with?

[anne]

That there is a meshing of management and ownership, ordinary workers as well, at Berkshire Hathaway and a proper assessment of risk in an outsized risk market is no accident. Notice too the absence for years of worker stife at Berkshire.

[rufus]

Yes, but surely you cannot suggest that even the ‘ordinary employees’ at BH are completely reflective of the general population of this country. I agree that there is definitely a movement towards the combination of ownership and management, even at non-financial services companies that conduct employee ownership programs of one type or another (dangerously Marxist though), and to my mind accountability is inherent when stakeholders are mining the fort. I still believe and have no reference at this moment to prove, that this organizations structure is still in the minority. This is likely also why so many persons are beginning to and will feel victimized by the current crisis.

[rufus]

My point in alluding to the LTCM Bailout and referencing the Black-Scholes Model, is in response to usual knee jerk reaction of, 'it’s not the economy stupid…it’s the economists stupid'. Blaming the models and the economists is reactionary and results from a lack of understanding of economic theory.

Pardon this reductionist analogy, but we could fault Einstein for his work in quantum physics, but there is nothing inherently evil in the equation E=MC^2. Although ethical and moral judgments can quite accurately be made as to its application, as in deciding to develop atomic weapons and kill tens of thousands of civilians with them.

Many wish to blame the economists or the models; perhaps it is base ten mathematics that is to blame. But the reality is that greed and avarice are idealized traits in American Culture, “greed is good”. It is paradoxical to me that ‘greed’ does not carry the negative connotation that the word ‘welfare’ does.

Our protestant reformation colony is based upon an ethos of works. Those who are financially successful are naturally bright and talented, right? Is it any wonder we praise and reward these individuals accordingly.

One cannot say that production where MR=MC, or maximizing profit where one maximizes utility is any more inherently evil than E=MC^2. Again, it is in the application and the subjective nature of utility (i.e. what we value) that reflects the norms of the American Society. The pursuit of wealth above all else, as a sign of divine prosperity is our creed, and while the faithful pursue these lofty heights, they want to find others to blame for who they are when their objectives are dashed.

[anne]

Right you are, and therein is the point.

[rufus]

Pardon my philosophical rant on this economics forum, but my frustration lies in the blame game and the perfunctory call for involvement or concern over the current crisis.

It is just as easy to say its those economists and their models that got us into this mess, as it is for me to say it is the political apathy and preoccupation with instant gratification that has us revisiting it. Soapbox yielded.

[ken melvin]

* Renewable energy sources (windmills, tide-mills, geothermal and biomass systems),
* Non renewable energy sources (nuclear generators, sequestered carbon emission generators, etc.),
* More efficient transportation systems (suburban and long-distance) including high-speed train lines,
* Reformation and significant investments in both Secondary and Tertiary Education, to enhance the quality of the former and affordability of the latter,
* Entry-level housing for the sub-prime victims (no, not free housing, but low interest rate mortgaged housing)
* Renewed inner-city infrastructures (down-towns, urban housing, town-center commerce that revives town centers),

[ken melvin]

let me try again:

Lafayette – bit simplistic methinks:

Renewable energy sources (windmills, tide-mills, geothermal and biomass systems),

Doubtful these employ the equivalent of current energy producers

Non renewable energy sources (nuclear generators, sequestered carbon emission generators, etc.),

Initial production would provide a boost much like one from infrastructure, etc, After that …

More efficient transportation systems (suburban and long-distance) including high-speed train lines,

Wonderful idea, it’s just that I don’t see a net gain in employment.

Reformation and significant investments in both Secondary and Tertiary Education, to enhance the quality of the former and affordability of the latter,

Here I couldn’t agree more. I think the long term gains from education and a additional mental and physical healthcare offer the greatest of returns.

Entry-level housing for the sub-prime victims (no, not free housing, but low interest rate mortgaged housing)

Renewed inner-city infrastructures (down-towns, urban housing, town-center commerce that revives town centers),

You’ll get no argument from me on quality of life issues. Nor, on the importance of culture.

In re the service industry: It encompasses the things above, offered a great opportunity to distribute the wealth from automation , globalization …, but was sabotaged by those wanting to hire cheap labor at home including.

[ken melvin]

Bruce Wilder says...

John Yoo is never enough.

Priceless

[Winslow R.]

"The dollar’s strength reflects the knee-jerk reaction of investors rushing into US treasuries as a safe haven."

I hope Barry is betting heavily against the dollar.

[Lafayette]

Caveat Emptor

sal: Then on top of this that regulators couldn't be expected to understand them - because they are so much poorer and by extension not as talented?!?!

C'mon, this IS reaching a bit too far, isn't it? Let's presume it is tongue-in-cheekish.

The talent is around. If a financially engineered product was invented by mankind it certainly can be understood by mankind.

What is more difficult to understand is its accumulated consequences. But, who cares, one might say -- the only prevailing criteria or value judgment was, "Does it work?".

The subprime mess worked, for a while, like all bubbles. And, when the bubble bursting became one enormously systemic failure, people ask themselves "Uh ...why didn't someone warn us?".

The answer to that question is and always has been since Roman times, Caveat Emptor.