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I hear repeatedly from our fellow citizens "where is my bailout?" For those who have been wondering the fine journalists at Vanity Fair have found the paperwork so you can begin applying now for, as the application says, "free government cash." (Click image for Large Version.)
Now that the NBER has decided to endorse my view that we went into recession last December which I first first claimed last January, I think my points about the efficacy of fiscal stimulus still apply.
As for spending already pledged to save us, the figures are growing at a rate that has even astounded someone as bearish and cynical as myself. Barry Ritholtz has given us a breakdown and a spreadsheet to track it:
I suspect given the continuing issues and a President intent on expanding the government balance sheet even more than our present one that that spreadsheet will get quite a bit larger. All that money to save a $13 trillion economy. What a mess.
Meanwhile the housing market continues to collapse, as the lights repeatedly seen at the end of the tunnel seem to really just be a series of oncoming trains. Lots of charts and analysis here and here.
Also, he has a great Mea Culpa on why he missed this, and a discussion that fits right into my theme about how many missed this meltdown, and advice for those of us who did and might think too much of ourselves:
I should mention first that the few people who did see it coming were not necessarily any wiser than anyone else. Some of them had predicted nine of the last five recessions. A stopped clock is right twice a day. Even those who claim to have foreseen this mess couldn't make the case well enough to alarm very many other people. And if you want to know if they were really wise or just selling a different story because the market was less crowded on the pessimistic side, you'd have to look at their bank accounts. Did they put their money where their mouth was?
Wall Street and economics are littered with the figurative corpses of those who got a big call right and got lots of attention and then became a joke as their prescience proved to be just luck.
Megan McCardle gives a touching and heartfelt explanation of why opportunity cost has to be considered in regards to GM in "Save the Rustbelt."
Speaking of Megan, she has inspired a true decining institution to ask for a bailout:
But Megan McArdle at The Atlantic came up with a compelling argument:
"The news business is special. Without us, you wouldn't know anything. Besides, it provides millions of low-paying, insecure jobs to overeducated yuppies who are going to move back home, into your basement, if you don't do something, quick.
"And the news business is the other industry that can, all by itself, send the real economy into a tailspin. You think you're worried about a depression now? We could make you really depressed. I'm not threatening, or anything; I'm just saying, it's a nice country you've got here. It would be a real shame if someone convinced consumers to stop buying Blu-Ray players and shift their savings into canned guns and ammunition."
Meanwhile Hormel is betting that the present economic situation is a bullish sign for Spam! Fascinating stuff really, as Spam has a number of devotee's. My wife spent time in Hawaii this summer studying Pearl Harbor, and came back and marveled at the many uses Spam is put to there, including in faux Sushi.
The insufferable Peter Schiff has a video going around, which frankly, is just brilliant. He may be unpleasant at times, but he nailed this thing, and took mounds of abuse while doing so. More importantly, I KNOW HOW HE FEELS!
The resentment, irritation, condescension and, at times, outright hostility to my Cassandra act makes me wish I had a video of my own. Sigh...
Oh well, it pays to remember that Cassandra was right. I was never as sure of myself as Peter, but risk management isn't about knowing you are right, but knowing what could go wrong and whether it wis likely enough to act upon.
As an aside, Peter is no big government type, and he goes to prove that despite the media focusing on Roubini and others (who do deserve a lot of credit) that people across the ideological perspective warned of this. Thus having seen this coming is not the same as being correct about what to do about it, since those who saw the oncoming train differ markedly on that score.
From the early 1920s through 1985, the average level of debt-to-GDP in this country was 155%. The highest peak in history (until the recent debt boom) was in the early 1930s, when debt-to-GDP soared to 260% of GDP. In the 1930s, the ratio then cratered to 130%, and it remained close to that level for another half century. (See chart below).
In 1985, we started to borrow, and last year, when we got finished borrowing, we had borrowed 350% of GDP. To get back to that 155%, we need to get rid of more than $25 trillion of debt.
Do we have to get back to 155% debt-to-GDP? No, we don't have to. But given what happened after the 1920s, and given what people will probably think about debt when they get through getting hammered this time around, we wouldn't be surprised if we got back there. It seems to be sort of a natural level.
The banks have written off $650 billion so far. So we suppose that's a start.
That would mean reducing (de-leveraging) our economy's debt load by 25 trillion. I have no idea how you cut even 10 trillion in debt without massive economic dislocation.
Nov. 13 (Bloomberg) - In a surprise move today, Whoopee Cushions Inc was approved bank holding company status by the Fed to enable the company access to the recently revised TURD scheme.
Imported far-eastern whoopee cushions have decimated the domestic industry over the past two decades, leaving former giants of the industry controlling a mere 0.1% of the domestic market. Some observers point to the poor reliability and high labor costs of domestic products as a defining factor in the industry's demise, but it appears the government are prepared to spend now and ask questions later.
Chairman and CEO, Chuck Chuckles said "It is vital that the government recognizes the role we play in the modern US economy. Whoopee Cushions Inc has been the backbone of US manufacturing for over 400 years and if we were to go under it would mean 100,000 people needing to learn new skills and find work in more productive industries. I think you will agree, that is something nobody wants to see happen".
Finance Director Mr Magoo, 12, added "Whoopee! I'm off to structure some whoopee cushion backed securities to sell to the government at inflated prices". At time of going to press it is not known whether the pun was intended.
Consistent with Environmental Security Hypothesis predictions, when social and economic conditions were difficult, older, heavier, taller Playboy Playmates of the Year with larger waists, smaller eyes, larger waist-to-hip ratios, smaller bust-to-waist ratios, and smaller body mass index values were selected. These results suggest that environmental security may influence perceptions and preferences for women with certain body and facial features.
I wonder if the juxtaposition of that headline and that photo were intentional?
Anyway, over at Risk and Return I follow up Dale, McQ and my discussion of the markets and the economy during the last couple of podcasts with some thoughts, observations and suggested readings on the investment climate we are in now. Lots of links, some enlightening graphics and views from those who saw this coming, including, ahem, me.
There are hopeful signs, but large risks. How cheap are stocks? What are the risks that remain? Will recent government moves help?
My own view is that some of it will, though it is not ideal, but possibly close enough for government work.
Let me know what you think in the comments here or via e-mail.
Yves Smith hits a theme I have been harping on (including on tonights podcast) the Federal Reserve, and central banks in general, are making things worse in may ways by destroying the incentive for banks to lend or borrow from one another. She quotes James Bianco of Arbor Research:
The Fed's massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don't even bother to make a decent market for inter-bank loans anymore. No reason to, they don't need them anymore as central banks have replaced them.
I would suggest more subtle factors should also be emphasized besides how this distorts rates on loans. If banks do not need each other then they don't communicate. Thus the hard work of investigating what counterparties real credit risk is goes undone. The market is shunting that off to governments. Furthermore, banks have no incentive to arrive at a believable accounting of their assets, they can wait and hope for a bailout rather than find a way or terms that other banks will accept.
The Markets have spoken, the best place to invest in the world is...Iraq!
Now it's stock and awe in Baghdad!
As the Dow plummeted nearly 700 points yesterday to fall well below the 9,000 mark, the Iraqi stock exchange - where this broker was merrily keeping up with her booming business - was flourishing, buoyed by four-year lows in violence and hopes of a reconstruction windfall.
Last month, Iraq's general index went up nearly 40 percent, about the same percentage the Dow dropped over the past year. The jovial trading-floor mood is reminiscent of Wall Street's bygone 'greed is good' era of the 1980s.
I am often asked about individual bank stocks, especially JP Morgan. Generally my answer is that Bank of America, JP Morgan and a few others look to be likely survivors, but how profitable they will be I am really unsure.
JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means...what? I don't know, and frankly if anybody really does they aren't telling me. In essence I am left telling people that I have to treat that as a "black box." Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.
Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn't matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.
The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)
What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz's:
"Lehman Brothers Holdings Inc.'s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman's collapse, creditors said.
JPMorgan had more than $17 billion of Lehman's cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank ``froze'' Lehman's account, the creditors claimed.
JPMorgan, the biggest U.S. bank by deposits, financed Lehman's brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman ``suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,'' according to the filing.
The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said."
Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:
Ron Kirby notes: "I wrote about a very strange occurrence - the reporting of J.P. Morgan "transferring" 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning...It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was "BAILED OUT" last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail - to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase."
The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.
Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?
I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the "too big to fail" label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?
I don't know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.
How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.
The New York Times treats us to a multimedia look at the day that the S.E.C. decided to allow the five largest US investment banks to substitute advanced mathematical risk models for traditional capital requirements that I have discussed before.
"We've said these are the big guys," Mr. Goldschmid said, provoking nervous laughter, "but that means if anything goes wrong, it's going to be an awfully big mess."
"I'm very happy to support it," said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: "And I keep my fingers crossed for the future."
Okay, let us call this a major mistake. I have huge problems with financial risk models, but experience with them was lacking. The problem is how clueless the SEC was long after it should have been clear what a disaster they were overseeing.
"We have a good deal of comfort about the capital cushions at these firms at the moment." - Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.
On March 11th?
The 2004 decision also reflected a faith that Wall Street's financial interests coincided with Washington's regulatory interests.
"We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing," said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).
"Letting the firms police themselves made sense to me because I didn't think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We've all learned a terrible lesson," he added.
From someone who could have been an anonymous hero had he made any difference:
"With the stroke of a pen, capital requirements are removed!" the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. "Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?"
He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.
In my opinion hedge funds (most of which are less risky than traditional investing) get a very misleading treatment in the press, but Mr. Bole has made a very good point. One type of hedge fund scares the heck out of me, and that is the leveraged debt funds, of which Long Term Capital was for a while the most successful version.
Where do the traders for these funds come from? The trading desks of Wall Street's behemoths. What were they doing there? Operating massive leveraged debt funds disguised as investment banks.
Fannie and Freddie (who also use elaborate mathematical risk models) ply a similar trade. We not only didn't learn from Long Term Capital's meltdown, we institutionalized the types of models they used to profit and control for risk throughout our financial system.
That is what we allowed our financial system to become, a regulated version of a levered debt fund.
Of course the article spends a lot of time making the case for more regulation, and enforcing those regulations. It also complains that maybe the plan would have worked if Cox had actually used the power to monitor the banks that the deal to allow them to use the models gave them:
Mr. Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general's report have suggested that a major reason for its failure was Mr. Cox's use of it.
"In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn't oversee well enough," Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005.
I see it somewhat differently. Intrusive regulation and monitoring of firms as complex as these will not work. Instead you use simple rules that do not require near as much supervision or competency, but limit risk. That is what capital requirements do, they should have never given them up.
The complete audio of the 55 minute meeting where this was decided can be found here.
I have argued in the past that the Federal Reserve's policies may be helping in some ways, but hurting in others. Way too much borrowing and lending is running through the Fed which is drying up lending between banks. It also reduces the need for banks to find reasons to communicate and trust each other, keeping the atmosphere of mistrust alive.
On a similar note one of Yves Smiths commenters left this comment, which is well worth pondering when thinking of the bailout plan being considered:
One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe's demand deposit into a fixed-duration loan.
The problem we're having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn't make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight - a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it's got to win 90 auctions in a row - a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can't make into useful-duration loans.
Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.
When Paulson dumps out his 700 billion in treasuries it's going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson's billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson's billions divert credit from working capital to long-term mortgages - from where it's most needed to where it's most wasted.
Even if the giveaway adequately props up the banks, which I doubt, they still can't make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.
I think it's very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson's plan will increase the supply of, say, inventory loans. It's not that every economist in the world is an idiot, it's just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson's plan falls into the category of very expensive way to hurt ourselves.
Let us look at one of the ways that we are being panicked unnecessarily, and why incidentally we can help many of these financial institutions in the fashion I discussed in my last post. In my next post we will discuss ways in which we are not being misled, and why we in my mind should do something about this.
My favorite proposal for helping financial institutions-Updated
Posted by: Lance
I do believe we should be doing something as a nation, through our government, to avoid the not insignificant chance of a total financial meltdown. I have seen several things proposed that I find interesting, and I will get into them and other longer term issues in coming days. I had hoped to address this all comprehensively, but time just isn't allowing that, so let us do so piecemeal.
Today I would like to endorse one proposal that aligns exactly with my thoughts on this, which is we need to recapitalize banks in a more effective, less arbitrary manner while protecting taxpayers and homeowners as well.
The Senate proposal would cost more than $100 billion and extend and expand many individual and business tax breaks, including tax credits for the production and use of renewable energy sources, like solar energy and wind power.
The bill would also extend the business tax credit for research and development, expand the child tax credit, protect millions of families from the alternative minimum tax and provide tax relief to victims of recent floods, tornadoes and severe storms.
In a delicious bit of soon to be civics geek trivia, the Senate worked around the Constitutional restrictions against voting on tax legislation not already considered by the House by attaching the bailout plan along with a tax extender bill to the Mental Health & Addiction Act (which passed the House several months ago).
You gotta love our government.
In addition to the Paulson plan details, various tax cuts and dealing with the AMT it includes a very helpful proposal, increasing government insurance on bank deposits from 100k to 250k.
The Federal Reserve has for a long time eschewed increasing the money supply directly, and instead has manipulated credit to affect the economy and control inflation. This has led to three important things which are in my opinion at the root of this crisis.
Asset price inflation (at least initially) as opposed to broader price inflation.
A massive increase in leverage (debt to magnify returns) throughout the financial system and our economy.
A massive increase in the size of the financial sector relative to the rest of the economy. Since it is built on leverage, financial sector compensation has soared and led to concentration of wealth in financial hands.
The last fascinates me, as a sector which should be a relatively small part of the economy functioning as intermediaries has through leverage achieved profits (a redistribution of wealth from the rest of our citizenry) far from the size their intermediary function can possibly justify. These intermediaries for example accounted for about a third of the market capitalization of the S&P 500 before they crashed and burned. How do the intermediaries deserve a market cap that amounts to around half of those for whom they intermediate?
The answer is increased leverage. I'll address this in more detail later, but the Federal Reserve has finally decided to expand the monetary base, which has consistently grown at a very slow, or non existent rate. From David Merkel:
Check out the very far left side of the graph and look at the vertical takeoff.
David fills us in on the details:
Look at the H.4.1 report. We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically. They are pumping the "high-powered" money into loans:
$20 billion for Primary credit
$80 billion for Primary dealer and other broker-dealer credit
$70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
$40 billion for Other credit extensions
$80 billion for Other Federal Reserve assets
-$20 billion netting out other entries
Making it an increase of roughly $270 billion from last week's average to Wednesday's daily balance. Astounding.
In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets. Now, I've written about this before, but it bears repeating. What happens if the Fed takes losses on lending programs. It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more. The Fed isn't magic; it's a quasi-extension of the US Government in a fiat currency environment. It's balance sheet is tied to the US Treasury.
Yves Smith at Naked Capitalism is correct. The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars. I've felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc. The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going. What will they offer them? The national parks?
True, all true, but possibly if they are going to provide monetary stimulus this might be a better way than cutting rates, now and in the future.
I was not in favor of the Paulson plan if you haven't caught that yet. Still, the pitiful display from our congress today set a recent low.
First, faced with an unpopular and contentious bill which she feels for the good of the nation must be passed, we get a partisan and divisive speech from Nancy Pelosi:
Pelosi had said that the $700 billion price tag of the measure "is a number that is staggering, but tells us only the costs of the Bush Administration's failed economic policies - policies built on budgetary recklessness, on an anything goes mentality, with no regulation, no supervision, and no discipline in the system."
Pure horse hockey. More importantly, if Pelosi believes her rhetoric about the importance of this bill the poor judgment, lack of leadership and inability to understand the importance of statesmanship in a crisis should be grounds for immediate dismissal from her post.
Then, we get this pathetic response from the Republican leadership:
"I do believe that we could have gotten there today had it not been for this partisan speech that the speaker gave on the floor of the House," House Minority Leader John Boehner (R-Ohio) said, adding that Pelosi "poisoned" the GOP conference.
Deputy Minority Whip Eric Cantor (R-Va.) held up a copy of Pelosi's floor speech at a press conference and said she had "failed to listen and to lead" on the issue.
The Speaker had blasted the Bush administration in her speech and Minority Whip Roy Blunt (R-Mo.) asserted that some GOP lawmakers, who had reluctantly agreed to support the bill, might have changed their minds following Pelosi's remarks.
"Might" have effected them? What whining. If it is false it shows the same tin ear that Pelosi demonstrated. If it is true it is even worse. Either way, did it not occur to them how petty it would look in a moment of crisis?
If these congressman or women really didn't support the bill and were going to vote for it anyway, the idea that they would change their votes because Pelosi was her normal clueless self is enough to deprive them of my vote forever. It is even more damning if they thought the bill was necessary and voted against it due to her behavior.
If they did, then they wouldn't have banned short selling. People may have noticed that the ban hasn't helped, and today we see one of the real costs.
See, when markets collapse like today, short sellers dive into the market to cover their short positions, in these times they are often the only ones buying. They aren't there today, and the market has lost one of its stabilizers.
Frankly, this whole affair has been drenched in idiocy.
Larry Summers and Mark Thoma argue that if done right the bailout will mean we can solve this crisis and still have everything we want, tax cuts, health care spending and all kinds of other goodies. Larry argues:
Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs. The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton's emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers...
Does this sound familiar? I can hear it now. A vacation sir is consumption but a home, ah a home, that's investment. Investments pay off. Just look at the American experience. Rising home prices! Never a downturn. Isn't that encouraging? Hell, at prices like these you can hardly afford not to buy. Yes sir, a home that's a wise investment. And that makes you sir, a wise investor. And a wise investor, well a wise investor can certainly afford a nice vacation.
How the economy performs isn't really the issue as much as the housing market. Chrysler was bailed out at a cyclical low, we are not at a cyclical low in housing, we aren't even at a cyclical average. We aren't even close.
Nor was Chrysler such a rousing success anyway. The bailout of Detroit only postponed the pain for the American auto industry and kept them from either going out of business or becoming better, if probably somewhat smaller organizations, and the costs to us all will eventually be pretty damn high. That isn't even factoring in cementing the idea of "too big to fail" in corporate America. That encourages larger organizations rather than more profitable ones to be created.
Continuing the discussion on tonight's podcast, one of the recurring themes of much of the commentary on our current financial crisis is that the cause is too much deregulation. Possibly there is some truth to this, though the evidence is rather vague. The most disturbing figure in all this is Barney Frank. "We need stricter standards on loans."
Except, the problem here wasn't lack of regulation, but that the regulations were not enforced, or fraud, by lenders, brokers and their clients. More laws doesn't help. This was also a failure of long standing, not new. I would suggest simplifying and increased enforcement would be a better option. "Restrict leverage"
Harder to say than do. Besides, the main institutions which took too much leverage were regulated (no matter how much Barney Frank and others try and obscure that fact.) Banks operate with leverage in the low double digits, but I have heard of no calls to restrict them to lower levels. So who does that leave? Well, in 2004 the SEC exempted five investment banks from the required 12-1 capital ratios, and no one else. Which five?
Goldman Sachs Morgan Stanley Merrill Lynch Lehman Brothers Bear Stearns
Two have ceased to exist, one has been merged into Bank of America, and the last two have have just become bank holding companies. Yep, it was just announced, Morgan and Goldman have become banks.
Back to that in a moment, first lets look at the relaxation of the net capital rule:
The SEC allowed five firms - the three that have collapsed plus Goldman Sachs and Morgan Stanley - to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.
"They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding - three of the five broker-dealers have blown up."
The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.
The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.
So what prompted this rule change?
In 2004, the European Union passed a rule allowing the SEC's European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker dealers with capital of at least $5 billion, enabling the agency to oversee both the broker dealers and the holding companies.
This alternative approach, which all five broker-dealers that qualified - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily joined, altered the way the SEC measured their capital. Using computerized models, the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based model for calculating risk that led to a much smaller discount.
So much for the idea this issue is an American, unregulated, laissez faire model that has blown up and we should follow Europe's lead. In fact, I recommend this link highly:
...the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to around 2,000 billion euro, (more than Fannie Mai) or over 80 % of the GDP of Germany. This is simply too much for the Bundesbank or even the German state to contemplate, given that the German budget is bound by the rules of the Stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. The total liabilities of Barclays of around 1,300 billion pounds (leverage ratio over 60!) surpasses Britain's GDP. Fortis bank, which has been in the news recently, has a leverage ratio of "only" 33, but its liabilities are several times larger than the GDP of its home country (Belgium).
Part of the reason AIG was so important was because its insurance was being used to hide the true leverage of European banks which are far more leveraged than US banks, but used AIG's guarantees as assets which masked that effect. Go ahead, read the whole thing.
This is not brain surgery. This is not an area where more regulation is needed, we just need to impose existing regulations across the board like we used to do, and pray that Europe doesn't drag us down as they cannot deleverage without tanking their system.
The other area where ridiculous levels of leverage existed were, with the active and almost fanatical support of Barney Frank, the cases of Fannie and Freddie, which were leveraged 40-1 or more. Once again, there is no need for more regulation here, there was a need to shrink these monstrosities and remove their implicit government backing. "Regulate hedge funds"
Uhh, hedge funds have done rather well in this environment. It isn't hedge funds which have brought the financial system to its knees through their failure, it has been investment banks (Lehman, Bear) commercial banks (IndyMac, Washington Mutual)and Government Sponsored Entities (Fannie, Freddie being the largest.)
I chuckle every time I hear the activities of these groups being compared to "giant hedge funds." What an insult to hedge funds, the majority of which use little to no leverage. Barney Frank keeps claiming that it is the unregulated sector which has gotten us in trouble, but it has been the least regulated which have done the best. Hedge funds don't expect to be bailed out, and losses far smaller than a typical mutual fund has suffered (or heaven forbid, bank stocks) leads to massive redemptions by investors. The press sensationalizes that by calling it a "hedge fund blowup" but in fact it is the discipline and risk of sudden, uncompensated failure which keeps their leverage in check. Lose 15% in the hedge fund world and not only is your income cut drastically as performance fees disappear, but your assets flee. Lose 85% or more in the regulated world, like Washington Mutual, and the government is pulling out the stops to save you, and especially your creditors. Both hedge fund managers, and especially hedge fund investors, know the score. Lose money and you are on your own. This has led to losses on a far smaller scale than elsewhere, and in many cases out and out profits. Bring Back Glass Steagall!
The most inane attack on financial deregulation is the constant drumbeat about the repeal of Glass-Steagall, which has the added appeal of being something you can pin on Phill Gramm. Unfortunately that simple rule change doesn't help. It isn't the large diversified commercial banks which have failed most spectacularly, it has been investment banks which lack the stability of banking deposits and banks too concentrated in particular lending markets. Exactly what has Glass Steagall's supposed demise (and it really hasn't changed that much anyway) contributed to this?
I can think of no way in which it is implicated at all, despite Kuttner, Krugman and Barney Frank's heated, but unsupported claims, to the contrary. In fact, Glass-Steagall is now defacto dead anyway. The changes to Glass Steagall make it possible for Merrill to have merged with Bank of America and Bear Stearns to be acquired by JP Morgan. Barclays Bank now owns Lehman's brokerage and Morgan Stanley and Goldman Sachs have just decided to turn themselves into bank holding companies:
Now, Goldman and Morgan Stanley, which have been the subject of merger speculation in recent weeks, can become direct competitors to larger firms like Citigroup, JPMorgan Chase and Bank of America. Those firms combine investment-banking operations with the larger capital cushions that come with retail deposits, giving them a stability that pure investment banks lack.
JPMorgan acquired Bear Stearns this spring in a fire sale brokered by the federal government, while Bank of America has agreed to buy Merrill Lynch for $50 billion. Barclays of Britain agreed to buy the core capital-markets business of Lehman Brothers out of bankruptcy late last week.
Announced without fanfare on Sunday night, the move signals the final end to the Glass-Steagall Act, the epochal legislation of 1933 that signaled a split between investment banks and retail banks. A law passed in 1999 repealed the earlier regulation, though Goldman and Morgan remained independent investment banks.
Morgan Stanley had sought other ways to bolster its capital, and had been in advanced talks with China's sovereign wealth fund and others about raising as much as $30 billion, people briefed on the matter said Sunday night.
Actually, this is pretty sharp, and the kind of market based solution I far prefer to what the government is planning. They both need actual banking operations, and this opens up an opportunity:
By becoming bank holding companies, Goldman Sachs and Morgan Stanley gained some breathing room in the immediate term. But it likely lays the groundwork for additional deal making. Given the expected bank failures this year, it is possible Goldman and Morgan Stanley could seek to buy them cheaply in a "roll-up" strategy.
Prior to the move, federal regulations prohibited the two investment banks from pursuing such deals. Indeed, Morgan Stanley's recent talks with Wachovia revolved around Wachovia buying Morgan Stanley.
Being a bank holding company would also give the two access to the discount window of the Federal Reserve. While they have had access to Fed lending facilities in recent months, regulators had planned to take away discount window access in January.
The regulation by the Federal Reserve brings a host of accounting rule changes that should benefit the two banks in the current environment.
Buying up failed banks? I certainly like that better than we taxpayers. Glass Steagall is dead, and this crisis has shown that we should be glad it is.
Meanwhile our government is considering following London's lead and making their lives even more difficult, by banning short selling for a while. Yep, Fannie would have been just fine with mismatched liabilities, toxic assets and corrupt accounting mixed in with 40-1 leverage if nobody had been selling their stock, which is really all a short sale is.
This is crazy, and likely to lead to a much worse environment for both investing and the smooth functioning of capital markets, which are supposed to over time allocate capital. They are not supposed to lead to higher returns regardless of the worth of a company.
Wealth is not created out of thin air, it is supposed to be connected to the actual income stream a company can produce over time.
Market corrections are what keep wealth from being a product of a mere price we would like for assets, which is awfully disappointing to those who want wealth to be a casino where the house always loses, the drinks are free and the girls (or young men) always accommodating. Market corrections are what keep wealth from being a product of a mere price we would like for assets, which is awfully disappointing to those who want wealth to be a casino where the house always loses, the drinks are free and the girls (or young men) always accommodating. This is an attempt at a bailout that will not work, an attempt to create a world where stocks only go up. Unfortunately, capital cannot be allocated away from poor returning investments and toward higher returning options without prices going down on individual companies, and at times in aggregate. It has no more hope of success than forcing people to only sell at higher prices. Once that occurs, there is no reason to have a market in the first place.
Short sellers do not cause markets to go down over time, they just profit from it when a companies stock declines. They do however serve an essential function in capital markets. This function is so essential that the Capital Asset Pricing Model (CAPM) assumes an unlimited ability to short stocks. That isn't realistic, which is one reason the CAPM and its academic cousins such as the Efficient Market Hypothesis don;t work real well in the real world. It does underline the importance of short selling in keeping our markets as efficient as human nature and an unknowable future allow.
A quick post for a fast developing market situation. Today the Fed went to the Treasury and asked for a line of credit. You know, the lender of last resort has had to turn to our Treasury to protect their balance sheet.
Want to see something weird. Go here and look at the treasury market. In the bond world, a 1% move is huge. So check out what has happened in the US Treasury market. Especially the 13 week Treasury bill. It's yield has collapsed by over 90% at this moment in time.
Astounding, truly astounding.
My father who invested (and very successfully) through the late sixties/early seventies nifty fifty era, the bear market of 72-74, the market low in 1981 and Black Monday in 1987 says this is the most incredible market in all of his experience. It certainly eclipses anything I have seen from 1980 forward.
I'll try and resume posting again this weekend now that I have dug out from under the worst hurricane Baton Rouge has ever experienced.
What? You weren't aware? Seems most people are not. I can't say why, since we didn't have power to see what the rest of the country saw.
We were lucky to have a battery powered TV/Radio which at least gave us some local news coverage on one station, which was Gustav coverage 24 hours a day. So my perspective is a bit warped. The rest of my days were spent clearing trees and debris or sitting bored out of my skull in incredibly hot and humid conditions. No lights, no air conditioner, no TV, no internet and nowhere to go. Everything was closed, gas required several hours of waiting, and no stoplights working. My neighborhood looked like a war zone. Now it is hard to see many of the houses with all the trees and debris stacked along the streets, some places almost 10 feet high, a wall of once beautiful live oaks.
Just lost power again at my home due to Ike which, while a long way away, is hitting a city with a power grid made of tissue paper and toothpicks at this point. Much of the city still has no power, and if the wind kicks up like we are told it will I expect we will have most of the city plunged into darkness again.
It does remind you of how dependent we all are on some form of power when it leaves you not for a few hours, or an evening or two, but days on end.
I'll try and post anyway if that does happen, and try and put up some pictures.
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