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Showing posts from October, 2008

The Group That Time Forgot

I had planned to write about Nobel Prize in economics and its latest recipient, Paul Krugman, but got distracted and the news got stale. Just a brief comment so I could scratch this one off of my to-do list.

The most telling part of the choice was the formal statement of the Royal Swedish Academy of Sciences explaining the choice. It said, in part:
Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars.So, the ladies and gentlemen of the Prize Committee who must have been locked up incommunicado in the basement of Ricardo household since the 18th century think that everyone thinks that Japanese are supposed to export rice; Americans, car; Germans, beer an…

Why Homeowner Mortgage Relief Ain't Going to be Easy

Like many others, I was rather shocked last month on hearing about the need for a $700 billion bailout of Wall Street. The early storyline was that financial firms were saddled with too many securities backed by distressed U.S. home mortgages and, in a climate of fear and panic, they couldn't sell them at fair value. So that meant the government would have to step forward and act as a buyer.

Setting aside the fact that this narrative was disingenuous at best, dishonest at worst (the assets are most likely cheap because -- surprise -- they're simply not worth that much), I found the approach bass ackwards. It seemed more efficient to work from the ground up. Namely, if the securities were hard to value because of uncertainty over the mortgages they held, why not provide a structure for homeowners and lenders to rework troubled mortgages? In this “trickle up” approach, the securities would gradually become more stable and thus easier to trade. It seemed like a pretty good idea.

I …

What Creates Volatility?

Gillian Tett of the Financial Times is one of the better financial journalists, perhaps the best. She was the first to make heads and tails of the structured investment vehicles before many who should have known better had any idea what an SIV was.

But reporters only report what they see and hear. And that, when it comes to the analysis of financial events, is not sufficient. The outward appearance of events has a driving force that remains hidden from the naked eye.

So there she was in her today’s column, writing about the return of unprecedented volatility which “has left many investors and bankers utterly dazed and confused”. Throughout the article, her focus remained entirely on people: “[The situation] remains a delicate war of investor psychology and computer models.”

The subject of finance is not people. It is capital in circulation. So, how do we explain the volatility if the people are taken out of the explanation?

By way of answer, here are a few quotes from Vol. 1 of Speculativ…

The Blog’s Target Audience

A friend with marketing bent pointed out that despite infuriating gaps between postings, the readership of the blog was increasing. He asked who the target audience was.

The target audience is an advertising concept – like “teenager”, for example – devised to help sell products of one kind or another.

This blog has no target audience. Or, rather, everyone is its target audience. It is intended for everyone. If you must, think of it as an intellectual bell. Ask not for whom it tolls, for it tolls for thee.

Genuine Insights, Bold Recommendations, Expressed Resolutely

Speaking of T. S. Eliot, he disdains the intellectual vanity, of the kind his Mr. Appolinax exhibits: “There was something he said that I might have challenged.”

Now read this from a commentary by Larry Summers in today’s Financial Times:
In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.That doubling of the share of income going to the top 1 per cent of the population could conceivably be a problem – something “amiss”, he says – this ex president of Harvard and ex Treasury secretary has realized only in retrospect.

He then offers his recommendations.
Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the…

The Danger of Clinging to Myths of Security

In my fairly voracious reading on the current financial mess, I've yet to see anyone tackle in thematic fashion the idea of “myths of security.” I think this is a highly relevant subject (a tad philosophical, but not too much heavy lifting I promise), as it helps explain why an asset bubble can become grossly inflated. Security is, after all, the comforting touchstone to reality we seek when we’re faced with counterintuitive evidence, such as home prices surging 20 percent a year.

So what myths of security allowed the housing market to soar so high? By myths of security, I refer to a false sense of safety or comfort. These myths create what might be called a “security premium” in prices of assets, such as homes. In other words, investors are willing to shell out more money for assets perceived as safe and reliable.

A quick detour: Why is this last sentence true in general? 1. The pool of investors, and thus the overall demand, grows larger for safe investments. Example: pension fund…

A Market “Walking, Loitering, Hurried”

What kind of a card game is being played if the lower card trumps the higher card?

Low poker, of course. That is an easy one.

What kind of a credit game is being played if subordinated debt trumps senior debt?The auction that settled figures for the senior and subordinated bonds of Fannie Mae and Freddie Mac, the US government mortgage agencies, has led to widespread confusion and some participants losing out. In both cases the recovery rate for the senior debt – which in real-world defaults get first claim on all assets – came in lower than for the subordinated debt. Now you are totally confounded and dumbfounded by this because you know that:
With the US government guarantee, there is not supposed to be a “recovery rate” – how much a bond pays on a dollar. That should be par, or 100 cents on a dollar.
The recovery rate for senior debt cannot be lower than the subordinated debt because by definition, senior debt gets paid ahead of subordinated debt.
Yet, there it is, the Financial Times

Shakespeare and the Credit Rating Agencies

The current crisis in the financial markets is being portrayed as, above all, a failure of trust. Banks are seeking unreasonably high rates to lend to each other because they don't know who is hiding skeletons in the closet and may be teetering on the brink of insolvency. But if you really want to understand the concept of trust squandered, you would do well to look at the plight of the credit rating agencies.

These companies slapped attractive ratings on dubious mortgage-backed securities. Investors then snapped up the securities, reassured by the seals of approval bestowed by Moody's and S&P. Of course the ratings agencies had a conflict of interest so huge it was surprising that Washington regulators never had a Homer Simpson “d’oh” moment: Whichever bank created a security also paid for it to be rated. It's like a poor student who can buy good grades, except with more disastrous consequences, as we are now seeing.

How bad did it get? In an informal instant message ex…

Hank Paulson: He Isn't One of Us

The John McCain line about Barack Obama could easily apply to the U.S. Treasury Secretary. Paulson, as you may recall, submitted an awful $700 billion bailout plan that was fortunately improved through the legislative process. But Paulson had to be dragged kicking and screaming into doing the right thing (agreeing to take ownership stakes in firms that take bailout money, so as not to leave taxpayers too much on the hook). He apparently preferred to just blow $700 billion on a mountain of bad assets and cross his fingers that they'll be worth something in five years.

Hank Paulson is now paid by the U.S. taxpayer, but he still hears most clearly the siren call of Wall Street, where he once headed Goldman Sachs and argued against regulations that could have helped avoid this current mess. Considering his conflicted heart, we would do well to monitor the Treasury closely during bank rescue operations. Paulson still wants to play Santa Claus; he has already said that the government wil…

Fannie and Freddie: Not the Boogeymen

Check out this article from the Washington bureau of McClatchy Newspapers about why Fannie and Freddie shouldn't be the fall guys for the global financial crisis. The structure and logical flow are a bit choppy in places, but the central contention is dead on. It was good to see the authors argue the point forcefully, which newspaper reporters are often too timid or self-conscious to do. Anyway, the excerpt below shows how Fannie and Freddie were laggards in subprime lending, not leaders.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep troub…

And Now a Word from our Sponsor

Now for some good news about the market for credit default swaps (those insurance-like products that guarantee the value of corporate bonds and mortgage-backed securities). These details are by way of a clearinghouse for trades that goes by the name Depository Trust and Clearing Corporation (DTCC).

* Pleasant surprise #1: DTCC, which claims to handle the "vast majority" of trades on credit default swaps, says it has registered $34.8 trillion of such contracts. That would make the credit default swap market about half of earlier estimates of $60 trillion, thus reducing its "neutron bomb" capacity for widespread destruction.

* Pleasant surprise #2: Less than 1% of its credit default swaps are for mortgage-backed securities. So, presumably, even if these securities (whose value rests on the fortunes of the cratering U.S. home market) take a tumble, that won't trigger huge CDS claims.

* Pleasant surprise #3: The net payout in the Lehman bankruptcy, from the sellers of…

Halloween Costume Idea: Go as a Credit Default Swap

We are now entering a new roller coaster phase of the financial crisis. The G7 meeting this weekend produced little more than the illusion of a hint of group resolve. The communiqué that was issued contains fine-sounding principles but no plan of action. Markets will likely respond no more than if they had been slapped with a wet noodle.

The real news this week will be quietly going on behind the scenes: a scramble for cash to meet credit default swap obligations after the Lehman Brothers bankruptcy. That's a mouthful, and since I created this blog for curious people who aren't from the world of finance, I'll go slow here.

First, when you go bankrupt, your owners are wiped out. In Lehman's case, this means the stockholders. The bondholders, being creditors, are in a better position. They get to divvy what's left of the carcass, if you will. For every dollar they lent to Lehman, they may get 70 cents, 50 cents or even 10. Turns out, unfortunately, it's pretty clos…

Pin the Blame on the Donkey?

The search for a scapegoat in the U.S. financial crisis will reach new heights if markets around the world continue to gasp and flounder. Banks are still terrified to lend to each other. Who can you really trust in a high-stakes shell game where mounds of bad assets are hidden somewhere, but where exactly?

One narrative of the financial crisis would lay the blame at the feet of Fannie Mae and Freddie Mac. The two mortgage giants, conservatives contend with increasing vigor, were pushed hard by Congress (especially by Democrats) to lend more to low-income families who had poor credit. What brought this mess upon us, so goes this interpretation of events, were meddling politicians, not failures of regulation or the free market.

It’s a nice story, especially for those who tend to see bleeding-heart liberals behind every tree (or hugging every tree). But it’s like trying to put a size 6 foot inside a size 12 shoe – not a good fit. Sure, Fannie and Freddy screwed up. They did buy home loans …

Who Could Have Seen This Coming?

In a front page article this past Friday, The New York Times suggested that an obscure decision by the Securities and Exchange Commission in ’04 to loosen the debt limits of the broker/dealers had set the stage for the meltdown in financial markets.

The story had lots of tidbits in the tradition of the best tabloids: a bright spring afternoon, a basement meeting, a pensive commissioner and a Cassandra in the form of a software developer – a clueless geek with extra time on his hands, really – who wrote to warn the commissioners that they were about to make a grave mistake.

Whether the piece was a hatchet job on Christopher Cox, the SEC chairman – it probably was – is not important. (The article opened by quoting Cox talking about the broker/dealers – “we have a good deal of comfort about the capital cushions at these firms at the moment” – and went on to ask, How could Mr. Cox have been so wrong? The answer is that Cox was wrong, but when it came to ignorance about what was about to hap…

On the Lighter Side

Image
From the “how NOT to do Wall Street PR” department
The photo above accompanied CNN’s Friday story about the House passing the financial rescue bill. I know the intent was to show Wall Street's jubilation. But what we got was this well-fed trader who appears to be laughing at, not with, the U.S. taxpayer (especially since the market took a dive Friday).

How to make your own financial crisis. Step one: get a snow blower. Step two: fill it with money. Step three: turn it on.

“I wouldn't have loaned me the money. And nobody I know would have loaned me the money.”
-- Clarence Nathan, as quoted in the New York Times. Nathan had no job and no assets, but received a $450,000 mortgage.

My favorite 15-word analysis of the Paulson plan, which Congress passed, to buy hundreds of billions of dollars of toxic financial assets:

Throw a trillion dollars down a rathole with no debate and no alternatives considered.
Brilliant.
-- poster Jeffrey Knoll, in the comments section of Econbrowser.

Gazing into the Crystal Ball

Congress, in an appalling failure of imagination, approved Treasury Secretary Paulson's wrongheaded plan to bail out financial firms that acquired too many risky assets. He got his $700 billion check (in installments) to start snapping up distressed bonds and other investments that have taken a tumble in the U.S. housing meltdown. Ironically, members of Congress who voted for the unpopular legislation will probably glumly console themselves that they made a tough but necessary stand. Come on. It requires little courage to play the role of the outraged lapdog. Not one of 535 legislators deemed it worthy to craft an alternative, despite all the better ideas put forth by economists on the right and left.

But what's past is past, so let's look forward. Here are my predictions for the post-bailout bill future.

1. This bill, despite all the hoopla, won't even be the big rescue effort. We’ll see a more aggressive, all-encompassing solution that will probably involve seizing ban…

The Bailout: The One Thing I Don’t Get

It’s early Friday morning. In hours, the House will vote on what would be a historic $700 billion bailout of Wall Street. The bill will likely pass, though it’s essentially the same as the version the House shot down on Monday. (The Senate sprinkled on some pork and tinkered with FDIC limits on deposit insurance.)

What’s puzzling is that, facing the financial crisis of a lifetime, Congress can’t manage to draft even one alternative to the lousy Hank Paulson plan at the heart of this legislation. They could’ve been working on something since Monday. They could’ve consulted the legion of economists who have burst forth brandishing better proposals. In fact, I have yet to read a worse idea than what the Treasury Secretary wants to do: Buy a slew of bad assets with taxpayer money while failing to directly recapitalize struggling banks. This seems exactly the prescription for a long, drawn-out endgame of this mess with the likelihood we’ll start chucking good money after bad.

There is a vibr…

Your Bailout Bill, Presented by the Other White Meat

The Senate overwhelmingly passed a version of the bailout bill that, instead of taking the bull by the horns, seized the pig by the ears. Amid what may be the greatest financial crisis of their lifetimes, Senators rolled up their sleeves ... and began stuffing the legislation with pork. Most egregious example seen so far: a tax exemption for certain kinds of wooden arrows designed for children.

Now, if the House can browbeat a few members into switching their “nay” votes, the $700 billion rescue of Wall Street will be complete. That something needed to be done quickly was becoming frighteningly apparent. The New York Times did a nice job of laying out, in plain language, how the financial system could come undone.

It's a shame though that legislators crafted such a poor bill. They could've driven a hard bargain. They could've said to Wall Street firms, “Hey, we’ll buy your bad assets, even pump in capital, but we want to own a chunk of your company in return, no exceptions.…

A Report From the Money Markets

In several places, I have written about the crisis in the money markets.

Today’s Financial Times had an article on this subject under the heading “Triple blow spurs central banks”. As usual, there was no mention of the cause of the “blows”, only reporting of the facts. I thought two paragraphs in particular might be of interest to the readers of this blog. [Italics added for emphasis].

The first paragraph was about the result of an auction:
Yesterday morning in Europe the ECB offered $30bn of overnight money and found banks scrambling for the cash, willing to bid vastly over the 2 per cent policy rate of the Federal Reserve. The money was ultimately lent at a rate of 11 per cent.To the best of my knowledge, this rate differential is unprecedented in any dealing of the Western banks with a Western central bank.

The second paragraph is about freeze in the “wholesale” money markets which I described in the previous entry:
The lack of any business in wholesale money markets was demonstrated b…