My comment was made in the context of the sheer size of the problem. Like your merchant seaman friend, I too thought, from July 2007 onwards, that there was a huge potential problem with sub prime mortgage mess and the tepid Fed’s response to it.

However, I don’t remember ever seeing until the last couple months that the scale of the problem was in the TRILLIONS of dollars. A couple hundred billion dollars maybe, with a few large banks going down like WaMu. Okay the financial system would be hurt by that, but it would not be like the situation we face today.

L3 was stating that the current set of rules and laws will be enough to corral the miscreants if they play with the 2 Trillion dollars of play money that the Treasury has lent out with virtually no transparency or accountability. My point was that if the full Trillion dollar extent of the sub prime crisis was hidden, in a much more transparent situation, then the Treasury lending out or giving away( we’re not really sure are we?) 2 trillion is even more problematic.

BTW, Greenspan warned against the excesses of Freddie and Fannie before he left office. He saw a potential problem; he just didn’t see the collapse coming as a result. Paulsen and Bernacke to my knowledge never warned against the problems of Freddie and Fannie until after the sub prime crisis began. Sub prime lending accelerated to unbelievable heights on their watch. They didn’t even curtail subprime lending once even the media knew there was some sort of problem. Their response from July 07 on was always too little , too late , until they they wanted the bailout.

And yet the merchant seaman with whom I stood watch last spring told me that Washington Mutual and Wachovia would likely fail due to their large sub-prime portfolios.

It just gets curiouser and curiouser.

Maybe I’m wrong but I believe only a tiny percentage of the population was aware until the last two months that Fannie and Freddie were giving guarantees for high risk sub prime loans, that likely would go bad, to the tune of trillions of dollars. That practice went on for years and actually accelerated after the Fed raised interest rates in an aggressive fashion in late 05. Reasonably prudent banking regulation and regulators should have blown the whistle on that huge risk years ago.People as brilliant as Alan Greenspan, who had access to an incredible amount of market information didn’t see it coming. Sure, certain people questioned the practices of Fannie and Freddie, but it was never explained in simple plain spoken terms to the public what was at risk.

You’re saying “the agent knows that verification will take place and the incentive to cheat is greatly diminished, perhaps eliminated. ‘Verification” or appropriate assigning of blame did not occur in the subprime crisis. The media and the Democrats not only successfully assigned blame to other less culpable parties, but they actually benefitted tremendously in political terms from the sub prime crisis.

What the Fed and Treasury are doing now is almost totally without checks and balances. There is no accountability at all. And the financial maneuvers the Treasury is engaged in are far more complex and opaque than what happened at Fannie and Freddie. If what the Treasury is doing now goes to hell, as it most surely will, how will be public be able to discern at all what happened? With the media slanting almost everything to benefit the left, the true story, just like in the case of Fannie and Freddie ,won’t be told.

And if the public can’t figure out what went wrong, how will they be able to evaluate the cures and remedies to fix our financial problems?

It seems accountability restraints of our financial/political system have seemingly jumped the tracks into unknown territory where the probability of a societal game changing train wreck is almost certain.

The question is whether the incentives of the Principal (the US taxpayer) are aligned with those of the Agent (the Fed). If they are, the IA is not a problem, since the Agent will take the same actions the Principal would in the absence of IA.

If I’m a shareholder of a company (a Principal) and the CEO (Agent) owns 20% of the company, takes no salary or bonus, and has few other assets, there’s not really a P-A problem. The CEO’s self-interested actions will be aligned with my self-interest, and we’re good to go. (This is simplified, but good for illustration purposes.) There is clearly IA (the CEO knows more than me), but not a P-A problem.

So the question is: are the incentives of the Fed aligned with those of the taxpayer?

My take is that they’re pretty closely aligned. This $2T was in the form of a loan. The Fed wants to get repaid in full, with interest, just like the taxpayer. Hence, the main issues are pricing and collateral quality. In this respect, they’re acting just like other bankers.

There are two possible bad outcomes here:

1. They make a bad loan.
2. They don’t make a good loan.

If they make a bad loan, they lose money (the Fed does report its financial performance, BTW). This is not a good outcome, and those who were responsible are likely to suffer negative consequences. Like other banks, a bad loan officer will be found out eventually, when the bank has to report higher loan loss reserves. They may get away with it for a while, but they’ll eventually be found out. And if they’re self-dealing in any way (making bad loans to their in-laws, for instance), they’ll do the perp walk.

But the Fed also has to serve as lender-of-last-resort, and provide liquidity to the system, lest we fall into a deflationary spiral (think Great Depression). This means that not making good loans is, in this situation, potentially worse than making bad ones. When markets seize up, liquidity is crucial to restarting them. The risk, of course, is inflation.

However, these sorts of loans are not necessarily inflationary; a lot depends upon the collateral being offered. If the collateral is money-market fund assets, then the net change to M3 is zero. If they’re subprime loans, then M3 increases.

So, it is devilishly difficult to assess whether these loans are good, bad type 1, or bad type 2. You need to know the collateral and the interest rate.

But there is a reason not to disclose this information too soon. The main reason is to make it harder for arbitrageurs to game the system. If the interest rate is lower than the return on the asset, which the Fed might choose to do for some period with certain banks that had significant liquidity issues but were otherwise healthy (e.g. a run on the bank), in order to keep those banks from failing. This might be very much in the taxpayer’s interest if it kept a good bank from failure and a forced liquidation of all assets at a deep discount.

Armed with that information, however, other borrowers could demand a similar rate on that collateral, causing a transfer of wealth to healthy banks from the taxpayer with no “failure-prevention” benefit.

Fact is, there are lots of well-funded players licking their chops at the opportunity to game the system. By creating total transparency, you run the risk that small mistakes by the Fed will be amplified by arbs at great cost to the taxpayer. You also run the risk that the firms who come to the “window” will be marked by short sellers for attack, further eroding their financial strength and increasing the likelihood of failure, and loan defaults.

At the end of the day, the overall performance of the Fed will become public, and most or all of this information will get disclosed. Therefore, the Agent knows that verification will take place, and the incentive to cheat is greatly diminished, perhaps eliminated.

So, on transparency, the question is not whether to disclose. The question is when. And the right answer to that question is far from certain.

L3

Corporations face the problem when they pay facilitators in foreign lands. What is a bribe and what is a payment for arranging a meeting? Is your agent doing anything at all?

It looks as if any pretense of competence, control, and restraint has vanished as the Bush years end. And it certainly isn’t all his fault. But it is his watch.

http://nomedals.blogspot.com