Paul Krugman: The Widening Gyre

The financial crisis is still spreading, and emerging market economies are now "in big trouble":

The Widening Gyre, by Paul Krugman, Commentary, NY Times: Economic data rarely inspire poetic thoughts. But as I was contemplating the latest set of numbers, I realized that I had William Butler Yeats running through my head: “Turning and turning in the widening gyre / The falcon cannot hear the falconer; / Things fall apart; the center cannot hold.”

The widening gyre, in this case, would be the feedback loops (so much for poetry) causing the financial crisis to spin ever further out of control. The hapless falconer would, I guess, be Henry Paulson...

And the gyre continues to widen in new and scary ways. Even as Mr. Paulson and his counterparts in other countries moved to rescue the banks, fresh disasters mounted on other fronts. ...

The really shocking thing ... is the way the crisis is spreading to emerging markets — countries like Russia, Korea and Brazil.

These countries were at the core of the last global financial crisis, in the late 1990s... They responded to that experience by building up huge war chests of dollars and euros, which were supposed to protect them... And not long ago everyone was talking about “decoupling,” the supposed ability of emerging market economies to keep growing even if the United States fell into recession. ...

That was then. Now the emerging markets are in big trouble. ... What happened? In the 1990s, emerging market governments ... made a habit of borrowing abroad; when the inflow of dollars dried up, they were pushed to the brink. Since then they have been careful to borrow mainly in domestic markets, while building up lots of dollar reserves. But all their caution was undone by the private sector’s obliviousness to risk.

In Russia, for example, banks and corporations rushed to borrow abroad, because dollar interest rates were lower than ruble rates. So while the Russian government was accumulating an impressive hoard of foreign exchange, Russian corporations and banks were running up equally impressive foreign debts. Now their credit lines have been cut off, and they’re in desperate straits.

Needless to say, the existing troubles in the banking system, plus the new troubles ... are all mutually reinforcing. Bad news begets bad news, and the circle of pain just keeps getting wider.

Meanwhile, U.S. policy makers are still balking when it comes to doing what’s necessary to contain the crisis.

It was good news when Mr. Paulson finally agreed to funnel capital into the banking system in return for partial ownership. But ... the ... plan ... contains no safeguards against the possibility that banks will simply sit on the money. ... And sure enough, the banks seem to be hoarding the cash.

There’s also bizarre stuff going on with regard to the mortgage market. I thought that the whole point of the federal takeover of Fannie Mae and Freddie Mac ... was to remove fears about their solvency and thereby lower mortgage rates. But top officials have made a point of denying that Fannie and Freddie debt is backed by the “full faith and credit” of the U.S. government — and as a result, markets are still treating the agencies’ debt as a risky asset, driving mortgage rates up at a time when they should be going down.

What’s happening, I suspect, is that the Bush administration’s anti-government ideology still stands in the way of effective action. Events have forced Mr. Paulson into a partial nationalization of the financial system — but he refuses to use the power that comes with ownership.

Whatever the reasons for the continuing weakness of policy, the situation is manifestly not coming under control. Things continue to fall apart.

Comments

[a]

"But ... the ... plan ... contains no safeguards against the possibility that banks will simply sit on the money. ..."

You can only lend money if you think you're going to get it back. Who would want to lend money to GE? Or any number of other American corporations, which are so highly leveraged that a feather could push them over into insolvency? Who wants to lend to American households, who are already so indebted that they will need a decade to pull themselves out?

"But top officials have made a point of denying that Fannie and Freddie debt is backed by the “full faith and credit” of the U.S. government — and as a result, markets are still treating the agencies’ debt as a risky asset, driving mortgage rates up at a time when they should be going down."

Paulson's plan was to kick the can down the road for the new Administration and the new Congress. That's all.

[goldbull]

i wonder.. wat will be the situation in Asia in next two to three years..

[anne]

http://www.cs.rice.edu/~ssiyer/minstrels/poems/289.html

1919

The Second Coming

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

Surely some revelation is at hand;
Surely the Second Coming is at hand.
The Second Coming! Hardly are those words out
When a vast image out of Spiritus Mundi
Troubles my sight: somewhere in sands of the desert
A shape with lion body and the head of a man,
A gaze blank and pitiless as the sun,
Is moving its slow thighs, while all about it
Reel shadows of the indignant desert birds.
The darkness drops again; but now I know
That twenty centuries of stony sleep
Were vexed to nightmare by a rocking cradle,
And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?

-- William Butler Yeats

[ken melvin]

Anne - Turning and turning in the widening gyre - Funny, up on Hawk Hill in the Marin Headlands yesterday watching the hawks gather courage to cross the Golden Gate strait, this was the line that came to my mind.

Does there come a time when it is wise to forgive the debts and start over?

[kharris]

Of course, the most likely reason that this particular poem would run through Krugman's head is that this is, by actual count about three years ago, the most quote bit of poetry in the Congressional Record. Memmbers of Congress, when they feel things are not headed in the appropriate direction, seem to know of no other poetic way to make the point than to cite these lines. The line from the poem that is most quoted is the bit about "the best lack all conviction..."

[anne]

http://www.nytimes.com/2007/02/12/opinion/12mon4.html?ex=1328936400&en=4e730cfb17f81f87&ei=5090&partner=rssuserland&emc=rss

February 12, 2007

What Yeats's 'Second Coming' Really Says About the Iraq War
By ADAM COHEN

The Brookings Institution, the prominent Washington research organization, just released a report on the Iraq war entitled "Things Fall Apart." When Representative Jim McDermott, Democrat of Washington, took to the House floor last year to demand that President Bush present a plan for Iraq, he called his speech "The Center Cannot Hold." Blogs are full of the observation that "the blood-dimmed tide is loosed" in Iraq these days.

These phrases all come from William Butler Yeats's "Second Coming." Yeats's bleakly apocalyptic poem has long been irresistible to pundits. What historical era, after all, is not neatly summed up by his lament that "The best lack all conviction, while the worst/Are full of passionate intensity"? But with its somber vision of looming anarchy, and its Middle Eastern backdrop (the terrifying beast Yeats warns of "slouches towards Bethlehem"), "The Second Coming" is fast becoming the official poem of the Iraq war.

The pundits who quote it, though, are picking up on Yeats's words, but not his world view. As Helen Vendler, the great Harvard poetry scholar, and others have pointed out, "The Second Coming" is really two poems. The first eight lines are filled with the pointed aphorisms that pundits like so much, while the rest of the poem suggests the unpredictability of how history will unfold. This second, less quoted part is the one that speaks most directly to the grim situation in Iraq.

Yeats wrote "The Second Coming" in 1919, an especially dismal moment in history. Europeans were shell-shocked from World War I, and deeply cynical. Yeats's homeland, Ireland, was lurching toward civil war. The old order in Russia had just been toppled by a revolution that Yeats — who had a fondness for aristocracy — feared would spread across the continent and the globe.

Yeats's perspective on the world's troubles was not what many people who quote him today might suspect. For one thing, he was not a Christian. He dabbled in theosophy and the occult, and considered Christianity an idea whose time had passed. "The Second Coming" is not, as its title and the Bethlehem reference might suggest, an account of the return of the Messiah. What is being born is nothing resembling Christ.

As for his politics, Yeats was hardly a democrat, and he did not care much for "progress" — which makes him an odd choice for people who hope to turn Iraq into a vibrant democracy. Yeats was attracted to fascism, and he rebelled as a youth against the adults' talk of progress by embracing its opposite. "I took satisfaction in certain public disasters, felt sort of ecstasy at the contemplation of ruin," he once wrote.

The first eight lines of "The Second Coming," as Ms. Vendler notes, are the philosophical part of the poem. A rational, thinking observer — a pundit, of sorts — is describing the world in definite, if foreboding, terms. "The falcon cannot hear the falconer" paints a vivid image of the natural order coming apart. "Mere anarchy is loosed upon the world" describes an onslaught of destruction almost matter-of-factly.

But after those eight lines, the poem suddenly becomes, as Ms. Vendler notes, "oracular." Like the Delphic oracle, this Yeats speaks cryptically. "Surely the Second Coming is at hand," he says — but of course, "surely" here means its opposite: what follows is not certain at all. Yeats goes on to announce "somewhere in sands of the desert/ A shape with lion body and the head of a man" — an indefinite creature in an indefinite place.

The poem reflects, as Harold Bloom, the Yale professor and literary critic, says, Yeats's belief that a "change in god" was coming, "and that the 2,000-year reign of Christianity was about to end." But it does not reveal who this god will be. Its last two lines are a question: "And what rough beast, its hour come round at last,/ Slouches towards Bethlehem to be born?"

"The Second Coming" is a powerful brief against punditry. The Christian era was about the ability to predict the future: the New Testament clearly foretold the second coming of Christ. In the post-Christian era of which Yeats was writing there was no Bible to map out what the next "coming" would be. The world would have to look toward Bethlehem to see what "rough beast" arrived.

This skepticism about predicting the future has more relevance to the Iraq war than any of the poem's much-quoted first eight lines. The story of the Iraq war is one of confident predictions that never came to pass: "We will find weapons of mass destruction"; "we will be greeted as liberators"; "the insurgency is in its last throes."

The confident predictors who have been wrong in the past do not hesitate to keep offering up plans. That is true of President Bush, certainly: he talks about what his "troop surge" will do as if he had never been wrong before. It is also true of the pundits. The co-author of "Things Fall Apart," the Brookings guide to going forward in Iraq, is Kenneth Pollack, who is — incredibly — best known for his 2002 book "The Threatening Storm: The Case for Invading Iraq."

It is bizarre to see shards of "The Second Coming" appended to the Brookings report, or to any of the other plans and prognostications about the war in Iraq. Yeats, who grew up feeling "sort of ecstasy at the contemplation of ruin," did not just welcome whatever new order his rough beast was ushering in. He believed the only way it could plausibly be spoken of was in the form of a question.

[wudu]

... and all that;
anyways, still some catcing-up to go here. but the time is scarce.

when done, one just might support
hmmm
...the other candidate`s economic plan?

"catch 22".

[anne]

Ken Melvin:

"Does there come a time when it is wise to forgive the debts and start over?"

Passage of legislation limiting personal bankruptcy filings in the Administration has made this more difficult, when uninsured large cost pressures have increased.

Thank you for the note on hawks "gathering courage" to cross the Golden Gate Strait.

[Too Expensive]

Median new home prices are $218,400, still way too high. That is why they are not selling. They are still priced for creative financing, but those days are gone. Build smaller homes on less expensive lots already, and sales will pick up. Youngsters can't borrow truck loads of widgets from China anymore to pay for the McMansions.

[anne]

"Youngsters can't borrow truck loads of widgets from China anymore to pay for the McMansions."

What does this mean, and what is borrowed from China by whom? I do understand our desperate need to always, but always find a reason to blame others, especially China, for any of our problems, but I get confused about even the pretense of reasoning, or the lack of, for this sort of nonsense.

[flow5]

There's been a currency crisis percolating since 1950. Today the dollar has been dethroned as the reserve, standard-of-value, and transactions currency of the world.

Since actions sufficient to eliminate our deficits are highly improbable, the dollar will eventually decline to a level which will eliminate them. At that level our standard of living, for this and other reasons including financing the federal debt, will be much lower than at present.

[Too Expensive]

"...always find a reason to blame others, especially China, for any of our problems..."

I am not blaming China, I am blaming high prices. Lower prices are better for the consumer.

[anne]

Expensive:

"I am not blaming China, I am blaming high prices. Lower prices are better for the consumer."

That however is just what reasonable relations trade offer.

[Too Expensive]

"That however is just what reasonable relations trade offer."

Homes cannot be imported, so trade is irrelevant to their price. Importable goods are not allowed to drop the CPI, so trade offers no general price relief either.

[anne]

http://www.nytimes.com/2008/10/27/opinion/27krugman.html?ref=opinion&pagewanted=print

October 27, 2008

The Widening Gyre
By PAUL KRUGMAN

In Russia, for example, banks and corporations rushed to borrow abroad, because dollar interest rates were lower than ruble rates. So while the Russian government was accumulating an impressive hoard of foreign exchange, Russian corporations and banks were running up equally impressive foreign debts. Now their credit lines have been cut off, and they’re in desperate straits....

[This public-private debt dichotomy is understanding of what had happened in Thailand and Korea by 1997, but what was avoided in China and curiously enough even avoided in more open Hong Kong.]

"Relations trade" is really trade relations....

[anne]

"Importable goods are not allowed to drop the CPI, so trade offers no general price relief either."

Huh???

[Too Expensive]

"Huh???"

The Fed creates more money to compensate for import prices. That is, the Fed raises the price of food to compensate for lower LCD TV prices. Since the consumer now has to spend more on food, the price of imports doesn't help them in the least. The process harms those at the bottom, since they buy more food than they do fancy imported TVs. The standard of living of the bottom 50% falls steadily under this policy.

[jalrin]

Anne,

I think what he means is that expanded trade reduces the income for those who are in the business of prducing tradables while not reducing the costs of non-tradables. The result is that it is relatively more expensive for persons in the tradable sector of the economy to purchase non-tradable goods (even if the the absolute price is not affected).

[anne]

"The Fed creates more money to compensate for import prices."

OMG! Austrianism, the economics and not thank goodness the people, and complete nonsense as Austrianism is.

[me]

Too many nuclear weapons out there for this kind of stupidity.

The consequences of pushing people too far are utterly different than they were in the past.

Get the damned ports functioning and the grain shipments to the people who need to eat this winter.

Sort the money out later.

[Too Expensive]

"...while not reducing the costs of non-tradables."

Actually, increasing the cost of non tradables by encouraging additional monetary expansion. The extra money created is not distributed equally to all consumers, but lavished on a few borrowers (such as hedge funds). The magic money elves in our society only place additional money under the pillows of a few selected people, rather than giving everyone a share.

[Cyrille]

I never realised that trade relations had a direct effect of lowering real home rates.

They're pretty amazing, those trade relations.

[donna]

Mish has more bad currency news:

http://globaleconomicanalysis.blogspot.com/2008/10/currency-crisis-meltdown-in-europe.html

[Worker]

The notion that the banks are taking money to "hoard it" is kind of silly. It is even sillier to believe that the pols should try to direct lending.

With the anticipated "cram down" legislation, lending to consumers, or at least any consumer underwater would be an especially foolish act.

When I see a bank making such an effort, I will short it hard.

[Worker]

Funny Michael Lewis commentary:

Hedge fund manager tries to short himself...

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a5PEgwA8j68M

And the Andrew Lahde letter on which it is loosely based

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aVUE96d.HKyw

[Joen]

"The really shocking thing ... is the way the crisis is spreading to emerging markets — countries like Russia, Korea and Brazil."

Strange that he doesn't mention Argentina that managed to get into trouble all by itself again. Remember, Argentina defaulted, paid the IMF to do whatever it wanted with it's policy and became friends with Chavez and Hugo Morales. Now Argentina's president Cristina Fernandez (wife to the previous president) announced that they are going to grab 30 billion dollars from the private pension funds. Why? Because the government is broke again and elections are coming soon. The price of soy and other agricultural commodities fell, reducing revenues from the heavily taxed imports. Oil prices fell too, leaving Chavez in a tough spot not being able to lend any more money to Argentina.

"That was then. Now the emerging markets are in big trouble. ... What happened? In the 1990s, emerging market governments ... made a habit of borrowing abroad; when the inflow of dollars dried up, they were pushed to the brink. Since then they have been careful to borrow mainly in domestic markets, while building up lots of dollar reserves. But all their caution was undone by the private sector’s obliviousness to risk."

Is this guy a macroeconomist or what? The government now borrows from domestic markets? What does that do? It reduces the supply of domestic funds available to firms in the private sector so if they want to borrow like before they have to go to the international markets.

[Lafayette]

Krugman: But ... the ... plan ... contains no safeguards against the possibility that banks will simply sit on the money. ... And sure enough, the banks seem to be hoarding the cash.

Well, yes, Paul. You surprised that a bank did not call to convince you to take out a loan?

Besides, I don't know who's feeding you the above information, but banks in London are making euro loans at three to six month horizons.

Besides, as you have noticed yourself, we are in the midst of a horrible economic downturn. Why on earth should investors borrow money ... to invest in what?

[Chris]

Anna Schwartz, Friedman's co-author, made the same comment that banks are flush with cash but are hoarding it and not lending. So what is HankyPanky going to do?

[Lafayette]

Cohen: Yeats goes on to announce "somewhere in sands of the desert/ A shape with lion body and the head of a man" — an indefinite creature in an indefinite place.

Yates was employing clearly the Egyptian Sphinx here. But, it is curious to think that he would refer to a second coming, a sort of rebirth, in Bethlehem. The Sphinx would be analogous to what in its rebirth in Bethlehem?

The Jewish state? Methinks, yes. It was not an uncommon thought in the second decade of the 20th century and would become more current in the 1920s and 30s. (The fifth Zionist Congress had taken place 18 years before in 1901.)

But what does the first part have to do with the oracular second part of the poem? What comes apart with the birth of the Jewish State ... the Middle East?

Hmmmmnnnn .....

[prostratedragon]

Might not be the same kind of phenomenon, as has oft been the case with Argentina. You could try a "krugman argentina" search for some possible insight.

[save_the_rustbelt]

Watched CNBC at lunch time for amusement.

Apparently, the hedge fund industry is melting down very fast.

Be very, very afraid.

[anne]

STR:

"Apparently, the hedge fund industry is melting down very fast."

A significant problem at such a time is there is no way of knowing.

[anne]

http://www.nytimes.com/2008/10/22/business/worldbusiness/22argentina.html?ref=business&pagewanted=print

October 22, 2008

Argentina Nationalizes $30 Billion in Private Pensions
By ALEXEI BARRIONUEVO

BRASÍLIA — Argentina's government said Tuesday that it would seek to nationalize nearly $30 billion in private pension funds to protect retirees from falling stock and bond prices as the global financial crisis continues.

The measure, confirmed in a speech in Buenos Aires late Tuesday by Cristina Fernández de Kirchner, Argentina's president, was criticized by political opponents and analysts as a move to shore up government coffers to try to head off a fiscal crisis in 2009, when Argentina might be struggling to make billions of dollars in debt payments.

The announcement sent the Buenos Aires stock market, the Merval, down nearly 11 percent, and led analysts to question whether the nationalization, which is subject to approval by the Argentine legislature, puts property rights at risk and threatens the rule of law in the country.

It may be the first time a Latin American government has expropriated cash. The move is expected to give the government breathing room as falling commodity prices drive down tax revenue from agriculture by as much as $6 billion next year, according to some estimates. Commodity prices have fallen as fears of a global slowdown have grown.

Argentina's precarious fiscal situation predated the global financial crisis.

Argentina is one of the world's top five exporters of beef, soy, corn and wheat, and falling prices for those commodities have diminished the government's main sources of revenue. The country spent much of its windfall during this decade's commodity boom paying off debts and subsidizing fuel and other consumer items to stimulate rapid growth.

Now it may face a struggle to pay some $22.4 billion in debt obligations and other payments due next year, Daniel Kerner, an analyst with Eurasia Group, a risk consulting firm, said.

So far, other governments in South America, including Brazil's and Chile's, have said they will tap Central Bank reserves or stabilization funds amassed during the commodity boom to help important export industries withstand the global credit crisis.

Mrs. Kirchner characterized Argentina's move as government protectionism in line with bank bailouts in Europe and the United States. "We are making this decision in an international context in which the leading countries in and out of the G-8 are protecting their banks, while we are protecting our retirees and workers," she said in a televised speech.

She dismissed criticism that the move was simply a grab for cash, noting that the private pension plan put in place 14 years ago had produced a low rate of return for holders this year.

But analysts said the move could hurt Argentina. "This will be a major blow to the country's isolated capital markets, and will probably dampen consumer and investor confidence further," Mr. Kerner said.

The opposition leader Elisa Carrió, who ran against Mrs. Kirchner for president, told Radio Mitre on Tuesday that the government was trying to "loot the funds of retirees."

According to the plan, all the assets in individual accounts would be transferred to the state's "pay as you go" system, and affiliation to the state system would be mandatory, effectively putting an end to the current dual system.

Regional elections are scheduled for October 2009. By taking over the pension funds the government can continue to spend on programs that help it retain political support, which Mrs. Kirchner lacks after a debilitating four-month strike by farmers over export taxes that ultimately ended in defeat for the government.

If the move is approved, her government may have secured an important electoral asset, which could help guarantee Mrs. Kirchner's political survival.

[lonesome moderate]

"The really shocking thing ... is the way the crisis is spreading to emerging markets — countries like Russia, Korea and Brazil."

Korea is an emerging market? By this standard there are precious few "developed" countries that are not getting clobbered, or about to be. Of course, that's probably Krugman's point.

[anne]

Russia, Korea and Brazil are part of the Morgan Stanley emerging markets index. Brazil and Korea being the 2 larget such market. Then come China, Taiwan and Russia. Hong Kong though is part of the developed market index.

[oops]

the banks don't get the money until later this week so they couldn't lend it yet.

doubt there is going to be a lot of lending until we get a better picture of what the "C" is in gdp for the next few quarters.

[Bruce Wilder]

anne: "A significant problem at such a time is there is no way of knowing" [whether the hedge fund industry is melting down].

If you have a moment, maybe you could expand on this, for those of us unfamiliar with the hedge funds. What is it that we cannot know, or infer? What makes them more opaque, if they are, then, say, a bank or a mutual fund?

[anne]

The reporting requirements for hedge funds are minimal relative to ordinary mutual funds, the express reason being competitiveness. Hedge fund managers successfully avoided more transparency by arguing that this would drive the funds to other countries. Alan Greenspan expressly asked that more transparency not be ordered for the funds, using the competitiveness stance along with the idea that the funds competing against each other would ultimately protect investors against abuse.

As for systematic dangers, these were minimally recognized even after the failing of Long Term Credit in 1998 actually threatened to close bond markets. After all crisis was avoided with Long Term credit, and the sense was that there is "always" a regression to the mean that can be expected when a market is moving to extremes. I suggest this is not sensible.

[anne]

The sense I have is that finance ministers and central bankers have to work as pragmatists now, since there are a set of systematic problems appearing the extent of which are not understood. The market threats have already fed to threats to broad economies, unlike 1987, and are significantly broader than in the financial contagions and recessions of 1997-1999, and I think the recessions developing will take quite a while to undo.

I think beyond what will be a broader financial rescue, there must immediately be a Keynesian approach similar to that of Japan but immediately is passing by quickly.

[ken melvin]

CBS's 60 minutes had a bit on hedge funds last eve:

http://www.cbsnews.com/stories/2008/10/26/60minutes/main4546199.shtml

Seems billions could be made betting on all going to hell.

[ken melvin]

The Bet That Blew Up Wall Street
Oct. 26, 2008(CBS) The world's financial system teetered on the edge again last week, and anyone with more than a passing interest in their shrinking 401(k) knows it's because of a global credit crisis. It began with the collapse of the U.S. housing market and has been magnified worldwide by what Warren Buffet once called "financial weapons of mass destruction."

They are called credit derivatives or credit default swaps, and 60 Minutes did a story on the multi-trillion dollar market three weeks ago. But there's a lot more to tell.

As Steve Kroft reports, essentially they are side bets on the performance of the U.S. mortgage markets and the solvency on some of the biggest financial institutions in the world. It's a form of legalized gambling that allows you to wager on financial outcomes without ever having to actually buy the stocks and bonds and mortgages.

It would have been illegal during most of the 20th century, but eight years ago Congress gave Wall Street an exemption and it has turned out to be a very bad idea.

While Congress and the rest of the country scratched their heads trying to figure out how we got into this mess, 60 Minutes decided to go to Frank Partnoy, a law professor at the University of San Diego, who has written a couple of books on the subject.

Ask to explain what a derivative is, Partnoy says, "A derivative is a financial instrument whose value is based on something else. It's basically a side bet."

Think of it for a moment as a football game. Every week, the New York Giants take the field with hopes of getting back to the Super Bowl. If they do, they will get more money and glory for the team and its owners. They have a direct investment in the game. But the people in the stands may also have a financial stake in the ouctome, in the form of a bet with a friend or a bookie.

"We could call that a derivative. It's a side bet. We don't own the teams. But we have a bet based on the outcome. And a lot of derivatives are bets based on the outcome of games of a sort. Not football games, but games in the markets," Partnoy explains.

Partnoy says the bet was whether interest rates were going to go up or down. "And the new bet that arose over the last several years is a bet based on whether people will default on their mortgages."

And that was the bet that blew up Wall Street. The TNT was the collapse of the housing market and the failure of complicated mortgage securities that the big investment houses created and sold around the world.

But the rocket fuel was the trillions of dollars in side bets on those mortgage securities, called "credit default swaps." They were essentially private insurance contracts that paid off if the investment went bad, but you didn't have to actually own the investment to collect on the insurance.

"If I thought certain mortgage securities were gonna fail, I could go out and buy insurance on them without actually owning them?" Kroft asks Eric Dinallo, the insurance superintendent for the state of New York.

"Yeah," Dinallo says. "The irony is, though, you're not really buying insurance at that point. You're just placing the bet."

Dinallo says credit default swaps were totally unregulated and that the big banks and investment houses that sold them didn't have to set aside any money to cover their potential losses and pay off their bets.

"As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps. And there was no 'there' there. There was no money behind the commitments. And people came up short. And so that's to a large extent what happened to Bear Sterns, Lehman Brothers, and the holding company of AIG," he explains.

In other words, three of the nation's largest financial institutions had made more bad bets than they could afford to pay off. Bear Stearns was sold to J.P. Morgan for pennies on the dollar, Lehman Brothers was allowed to go belly up, and AIG, considered too big to let fail, is on life support to thanks to a $123 billion investment by U.S. taxpayers.

"It's legalized gambling. It was illegal gambling. And we made it legal gambling…with absolutely no regulatory controls. Zero, as far as I can tell," Dinallo says.

"I mean it sounds a little like a bookie operation," Kroft comments.

"Yes, and it used to be illegal. It was very illegal 100 years ago," Dinallo says.

In the early part of the 20th century, the streets of New York and other large cities were lined with gaming establishments called "bucket shops," where people could place wagers on whether the price of stocks would go up or down without actually buying them. This unfettered speculation contributed to the panic and stock market crash of 1907, and state laws all over the country were enacted to ban them.

"Big headlines, huge type. This is the front page of the New York Times," Dinallo explains, holding up a headline that reads "No bucket shops for new law to hit.”

"So they'd already closed up 'cause the law was coming. Here's a picture of one of them. And they were like parlors. See," Dinallo says. "Betting parlors. It was a felony. Well, it was a felony when a law came into effect because it had brought down the market in 1907. And they said, 'We're not gonna let this happen again.' And then 100 years later in 2000, we rolled them all back."

The vehicle for doing this was an obscure but critical piece of federal legislation called the Commodity Futures Modernization Act of 2000. And the bill was a big favorite of the financial industry it would eventually help destroy.

It not only removed derivatives and credit default swaps from the purview of federal oversight, on page 262 of the legislation, Congress pre-empted the states from enforcing existing gambling and bucket shop laws against Wall Street.

"It makes it sound like they knew it was illegal," Kroft remarks.

"I would agree," Dinallo says. "They did know it was illegal. Or at least prosecutable."

In retrospect, giving Wall Street immunity from state gambling laws and legalizing activity that had been banned for most of the 20th century should have given lawmakers pause, but on the last day and the last vote of the lame duck 106th Congress, Wall Street got what it wanted when the Senate passed the bill unanimously.

"There was an awful lot of, 'Trust us. Leave it alone. We can do it better than government,' without any realistic understanding of the dangers involved," says Harvey Goldschmid, a Columbia University law professor and a former commissioner and general counsel of the Securities and Exchange Commission.

He says the bill was passed at the height of Wall Street and Washington's love affair with deregulation, an infatuation that was endorsed by President Clinton at the White House and encouraged by Federal Reserve Chairman Alan Greenspan.

"That was the wildest and silliest period in many ways. Now, again, that's with hindsight because the argument at the time was these are grownups. They're institutions with a great deal of money. Government will only get in the way. Fears it will be taken overseas. Leave it alone. But it was a wrong-headed argument. And turned out to be, of course, extraordinarily unwise," Goldschmid says.

Asked what role Greenspan played in all of this, Professor Goldschmid says, "Well, he made clear in his public speeches and book that a Libertarian drive was part of the way he looked at the world. He's a very talented man. But that didn't take us where we had to be."

"Alan was the most powerful man in Washington in a real sense. Certainly a rival to the president and had enormous influence on Capitol Hill," Goldschmid says,

"And he was at the height of his power," Kroft adds.

Within eight years, unregulated derivatives and swaps helped produce the largest financial services economy the United States has ever had. Estimates of the market for credit default swaps grew from $100 billion to more than $50 trillion, and you could bet on anything from the solvency of communities to the fate of General Motors.

It also produced a huge transfer of private wealth to Wall Street traders and investment bankers, who collected billions of dollars in bonuses. A lot of the money was made financing what seemed to be a never-ending housing boom, selling mortgage securities they thought were safe and credit default swaps that would never have to be paid off.

"The credit default swaps was the key of what went wrong and what's created these enormous losses," Goldschmid says.

"Is it your impression that people at the big Wall Street investment houses knew what was going on and knew the kind of risks that they were exposed to?" Kroft asks.

"No. My impression is to the contrary, that even at senior levels they only vaguely understood the risks. They only vaguely followed what was going on," Goldschmid says. "And when it tumbled, there was some genuine surprise not only at the board level where there wasn't enough oversight but at senior management level."

They didn't know what was going on in part because credit default swaps were totally unregulated. No one knew how many there were or who owned them. There was no central exchange or clearing house to keep track of all the bets and to hold the money to make sure they got paid off. Eventually, savvy investors figured out that the cheapest, most effective way to bet against the entire housing market was to buy credit defaults swaps, in effect taking out inexpensive insurance policies that would pay off big when other people’s mortgage investments went south.

"I know people personally who have taken away more than $1 billion from having been on the right side of these transactions," says Jim Grant, publisher of Grant's Interest Rate Observer and one of the country’s foremost experts on credit markets.

"If you can and you could lay down cents on the dollar to place a bet on the solvency of Wall Street, for example, as some did, when Wall Street became evidently insolvent, that cents on the dollar bet went up 30, 40, and 50 fold. Not everyone who did that wants to get his name in the paper. But there are some spectacularly rich people who came out of this," Grant says.

"Who got richer," Kroft remarks.

"Who got richer, who became, you know, fantastically richer," Grant says.

A lot of them were hedge fund managers. John Paulson's Credit Opportunities Fund returned almost 600 percent last year, with Paulson pocketing a reported $3.7 billion.

Bill Ackman, of Pershing Square Capital Management, said he plans to make hundreds of millions. Both declined 60 Minutes' request for an interview.

Congress now seems shocked and outraged by the consequences of its decision eight years ago to effectively deregulate swaps and derivatives. Various members of the House and Senate have hauled in the usual suspects to accept or share the blame.

"Were you wrong?" Rep. Henry Waxman asked former Federal Reserve Chairman Greenspan.

"Credit default swaps, I think, have some serious problems with them," Greenspan replied.

It appears to be the first step in a long process of restoring at least some of the regulations and safeguards that might have prevented, or at least mitigated this disaster after the damage has already been done.

Where do we go from here?

"We need the most dramatic rethinking of the regulatory scheme for financial markets since the New Deal. If anything has demonstrated that imperative, it's the economy right now and the tragic circumstances we're in," Goldschmid says.

Asked how much danger he thinks is still out there, Goldschmid says, "We don't know. Part of the problem of the lack of transparency in these - in these markets has been we don't really know."

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[Lafayette]

str: Apparently, the hedge fund industry is melting down very fast. Be very, very afraid.

Dear me, dear me, how sad, how sad. (He said gleefully.)

Whatever was the real value-added to the economy of the hedge-fund business? Remind me, please.

[Cynthia]

Wow, Krugman has impressed me to the point of tears to see that he has even outdone the Doctor of Doom when it comes to injecting poetry into the dismalest of all the dismal sciences!

[anne]

http://ebooks.adelaide.edu.au/y/yeats/william_butler/y4c/complete.html#part52

1914

That the Night Come
By William Butler Yeats

SHE lived in storm and strife,
Her soul had such desire
For what proud death may bring
That it could not endure
The common good of life,
But lived as 'twere a king
That packed his marriage day
With banneret and pennon,
Trumpet and kettledrum,
And the outrageous cannon,
To bundle time away
That the night come.

[Dickeylee]

Thank you Ken Melvin, thank you thank you! I missed 60 minutes this week, and this explanation on derivatives is the best I've ever read. I'm forwarding it to everyone I know!

[cent21]

I think it's worth looking at mortgage rates, which to me look like they really are not that much different than they've been for the past 10 years, that is, overall quite low.

You can look at five year trends on Bankrate.com now, and from there, you can see that yes - the one year adjustable rate is higher now than it was in 2003, when the FED purposefully drove it down and proclaimed it was where most home buyers who were savvy to saving money should be. But the one year has come down considerably from the spike at the beginning of the month, down to where it was in August. Still high compared with the artificially low rates established a few years ago, but I'd have pledged alliegance to Ronald Reagan to get these rates 30 years ago.

The 30 year rate, while higher than the lowest rates of the past half-millenium, is about where it was a year ago, down by 25 basis points this month, and pretty close to the median of the past 3 years.

It would be convenient if we could artificially reduce mortgage rates to try to entice buyers and give some current borrowers a prop, but I don't see the rates as particularly out of line with the past year's inflation or uncertainty about the next several year's inflation. If we're heading into a real deflation, they are high. But I see the central banks pumping enough paper that rational lenders probably have reason to fear inflation as much as deflation. For many of those lenders, they're damned if it is (deflation - default on their loan portfolio), damned if they don't (stagflation - loan porfolio with a negative real return, and stillo facing loan defaults).

And all the collateral damage, I think there's fair reason to believe that the tsunami of unprecedented money flows alone can account for much of that. So perhaps in addition to looking for more flood gates to open to staunch another rupture, an equal level of concern should be directed toward damping out the floodgates already sploshing around in various directions. Now, mind, many of those are intended to offset failed institutions obligations to other institutions and prevent a cascading spiral of defaults. But rational behavior and risk taking isn't likely to emerge in the private sector ( or even the public sector outside of the treasury and central banks - for example, states are looking for things to cut, rather than ways to backstop the economy; California having already spent more than it can afford in long term debt) until the massive unpredictable flows begin to ebb.