The NYT says Paulson is shifting the focus of the bailout.
Mr. Paulson said the $700 billion would not be used to buy up troubled mortgage-related securities, as the rescue effort was originally conceived, but would instead be used in a broader campaign to bolster the financial markets and, in turn, make loans more accessible for creditworthy borrowers seeking car loans, student loans and other kinds of borrowing.
“During times like these with a slowing economy and some deterioration in credit conditions, even the healthiest banks tend to become more risk-averse and restrain lending, and regulators’ actions have reinforced this lending restraint in the past,” Mr. Paulson said at a news conference.
The WSJ has the full text of Paulson’s exhortation.
This change of emphasis looks a lot better than rescuing bankrupts. But it still raises the question of whether the moral hazard problem has been solved. The Treasury has boilerplate plate encouragement to lend responsibly. But since when have exhortations to responsibility reliably worked? And besides, the whole point of the Paulson’s actions is to lend, lend and lend.
It is essential that banking organizations provide credit in a manner consistent with prudent lending practices and continue to ensure that they consider new lending opportunities on the basis of realistic asset valuations and a balanced assessment of borrowers’ repayment capacities. However, if underwriting standards tighten excessively or banking organizations retreat from making sound credit decisions, the current market conditions may be exacerbated, leading to slower growth and potential damage to the economy as well as the long-term interests and profitability of individual banking organizations. Banking organizations should strive to maintain healthy credit relationships with businesses, consumers, and other creditworthy borrowers to enhance their own financial well-being as well as to promote a sound economy. The agencies have directed supervisory staffs to be mindful of the procyclical effects of an excessive tightening of credit availability and to encourage banking organizations to practice economically viable and appropriate lending activities.
Open thread. Are we digging ourselves out a trap or straight through to China?
I think we are digging toward China,
and, China is digging toward us.
I hope our GPS devices work as well as the 1860′s era railroad surveyor instruments.
What if we miss somewhere in the Earth’s core.
Okay, assuming I understand this, it appears that rather than having the government buy up and somehow make good all those bad mortgages they instead plan to give the banks MORE money to lend and told them to try and not waste it all by stuffing it in Hooters waitresses’ bras THIS time.
So all those people who danced in the streets because an Obama win meant they would not have to pay off their home mortgages and make their car payments got took? Who woulda thunk that?
As for the Moral Hazard, I recommend that rather than closing Club Gitmo we convert it into a prison for the executives involved in this as well as a Debtor’s Prison for the people who defaulted on more than one house.
And also eliminate the middleman and just give the money directly to the Hooters waitresses.
RWE said:
“And also eliminate the middleman and just give the money directly to the Hooters waitresses.”
Maybe after I get laid-off, I can get a job at Hooters?
We were told, just weeks ago, that it was absolutely, positively, incontrovertibly, indubitably necessary that we spend $700 billion to buy up bad mortgage securities from Wall Street or the world would end. And if you don’t agree you’re a moron! Shut up and give us the money! NOW!
But as it turns out- no, they’re not going to be buying bad mortgage securities- they’re going to- well, they’re not exactly sure yet, but something. They’ll think of something! They’re financial geniuses! And they went to Princeton! Or Harvard! Or Yale! Or some other place those snotty nerds went, not the regular nerds with the acne and the cheap clothes, the ones got their clothes from J. Crew and were in student government!
So the plan now is, and listen up this is important, LEND MONEY! Lend prudently, to people who can afford to pay it back, who are borrowing sensibly, but mainly just LEND MONEY!
“Maybe after I get laid-off, I can get a job at Hooters?”
How you look in short shorts?
Since there are only a few weeks left in the Bush Administration, Paulson should refrain from any funny business. No more bright ideas. No more course changes. Just glide straight as you can from now until January 20.
As soon as Obama starts to read his inaugural speech, hand over the office keys to any random Democrat in the Treasury Department and disappear immediately.
To china, pass the buckets!
This time when the guy with his hair on fire runs past my house I’m going to pay more attention!
An Update on the Bailout by Tyler Cowen
Of the initial $350 billion that Congress freed up, out of the $700 billion in bailout money contained in the law that passed last month, the Treasury Department has committed all but $60 billion. The shrinking pie — and the growing uncertainty over who qualifies — has thrown Washington’s legal and lobbying establishment into a mad scramble.
The Treasury Department is under siege by an army of hired guns for banks, savings and loan associations and insurers — as well as for improbable candidates like a Hispanic business group representing plumbing and home-heating specialists. That last group wants the Treasury to hire its members as contractors to take care of houses that the government may end up owning through buying distressed mortgages.
[h/t Elephant Bar]
Maybe that’s why all the great literature was written before high tech revolutionized communications.
Can you imagine Carson McCormac writing:
“It’s the cacophony. The dismal cacophony. It’s not the one thing.”
“to ensure that they consider new lending opportunities on the basis of realistic asset valuations”
More easily said than done in the midst of a
Roiling Sea of Distress.
—
“In a time of universal deceit, telling the truth is a revolutionary act.”
- George Orwell
I agree that this is a move in the right direction. The notion that the Treasury was going to properly analyze and price illiquid, under-performing asset and buy them from banks was unrealistic from the start. Now the banks are stuck with those assets, and must work them out the way they should have from the beginning; the Treasury investment program is giving them time to do this, and exacting a price that lowers the odds that the taxpayers will have to pay for any of this mess.
A little-known aspect of the Treasury’s bank investment program is that they’re only investing in banks with a strong credit rating. Every bank gets rated by regulators based upon the strength of their balance sheets, which really means the quality of their assets. As I understand it, the rating is from 1 to 4 (it may be 1 to 5; I’m not certain), 1 being the strongest, and 4 being the weakest. Only banks with 1 or 2 ratings are automatically eligible for investment. Banks with a 3 rating get additional review, and may get some capital. Banks with a 4 (or lower) rating get a big bucket of jack squat.
This means that Treasury is essentially strengthening the strong, and weakening the weak. Those who don’t get Treasury money will almost certainly have to sell to those who do. This will have the overall benefit of strengthening the financial system.
But it may also explain why Treasury is keeping the recipients of its largess confidential. Bank ratings are kept strictly confidential; there is no way to find out this information, and if you know it, you’re not allowed to disclose it. So, if the Treasury discloses who it invests in, it gives the market information about the asset quality of the banks, especially for banks that are not publicly traded (since asset quality is somewhat easier to judge for a public company than a private one, although not much). Disclosure, then, could lead to bank runs, which would force those banks into the arms of the FDIC, and expose the system to more risk.
Instead, my prediction is that within the next 90 days, we’ll see major consolidations begin to occur in the financial services industry. And the credit crunch will not end until the wave of consolidations begins to peak.
Then, we’ll all have to start worrying about inflation.
So we’ve got that going for us. Which is nice.
L3
This has the Japanese economic malaise written all over it. First it was “buy, buy, buy”, then “sell, sell, sell”, and now the US consumer is going …well should we say a bit conservative and not spending and “saving,saving,saving” is in (not like the Japanese house wife) but more like the employed worker in the 1930′s… the Big Bad Old Wolf is at the door and by this time next year, we’ll be deflated, downsized, and DEPEDENT (do da checks come in yet?)…lovely time for a Democrat controlled government…hold on to your wallets ’cause old Unkie Sam is here to help ya.
One additional comment on why the bank investment program will make money for taxpayers.
The investment is in the form of preferred stock. It is non-callable for five years. This means the money cannot be repaid by banks for five years.
The preferred stock pays a 5% dividend. It also gets warrants – basically a call option on the bank’s stock, IOW the right to buy the bank’s stock at the price on the day the investment is made – for another 15% of the amount invested. These warrants are probably worth another 5-7% of additional return (although it could be much higher or zero). This means the expected return on the stock is about 6% per year.
Currently, the Treasury can borrow in the form of 5-year notes at an interest rate of about 2.5%. This means it will make a profit of 2.5-3.5% of the amount loaned.
After five years, the preferred can be repaid by the bank. If it is not repaid, the dividend rate increases to 9%. This gives the bank a huge incentive to repay the investment.
So let’s say the Treasury invests $400B under this program. The taxpayers get an annual profit of about $10B, with the possibility of getting another $2B+ annually in bank stock appreciation. Since it’s only investing in strong banks (see previous post), it is highly likely to be repaid.
Hence, the taxpayer is not taking a huge risk, unless the whole system melts down. But the Treasury is betting that shoring up the banks will make such a meltdown unlikely.
Let’s hope they’re right.
L3
3Case
Short shorts and panty hose are an abomination (not a reference to the POTUS-elect) and an affront to nature
OK, one more comment before putting the kids to bed.
The shoring up of the financial system is likely to stabilize it; the signs are promising, anyway. But that won’t stop us from going into a deep and long recession.
The reason is simple: consumer spending is 70%+ of GDP, and consumer spending is going to shrink. The latest projections I’ve seen predict a decline in real US consumer spending by 1% in 2009. A decline of this magnitude has not occurred since 1980, the year of stagflation and Carter’s malaise.
Such a dip makes a fall in GDP inevitable, and will continue a cycle of contraction that will impact the real economy (job, output, investment). This means things are going to get a whole lot worse before they get better, regardless what happens in financial markets. Yes, the banking system will be saved. But that won’t be enough to avoid the pain of consumer delevering.
We’ve consumed beyond our incomes for too long. The piper must be paid, and he’s knocking on the door.
The good news, however, is that we will come through this. It will be painful, and the dislocations will be many. But we’ll get there eventually.
Time for more music.
http://www.youtube.com/watch?v=e0daTVnJmt8&feature=related
(With apologies to W
)
L3
L3,
Can you take some time off from your very busy schedule and take over from Paulson. Just do his talking for him. The man cannot for the life of him, make a statement that is easily understood. I got the same feeling you did about the stock investment plan. Although the detail about buying 1 and 2 rated banks I did not know. But just about every knuckle head (including Rush) was screaming at the top of his lungs just like Barney Frank!
Jim
Here is what the flip side of stimulus looks like
Merchant fleets left becalmed throughout ports of Asia as trade winds blow themselves out
Beware this Saudi deal to help bail out Britain. It comes with a devastating IOU
Leo Linbeck #10, 12, 14
Thanks for your clarity.
Jim
Interest rates may be cut to 0% to beat downturn
In raising the possibility of further dramatic cuts, Mr King also confirmed that the Bank’s previous concern with keeping inflation in check has been cast aside. Instead, his monetary policy committee will focus on keeping the UK from sliding into a Japanese-style deflationary spiral.
Slashing rates will kick-start inflation, but the Bank knows that with commodity and food prices set to drop, sky-high prices will no longer be a realistic concern.
THe bailout, and big government in general, is poised for a big comeback in 2009. Watch for it!
I know, how about we take what’s left of the bailout $350 million and give every person over the age of 21 who isn’t a millionare $1 million dollars? This way it would definately go back into the economy (quickly) because people will pay off mortgages, cars, bills, etc…
L3: Good explanation on your part. I’ll concede that the latest proposal is not without merit. And in all probability is superior to buying bad mortages.
Nonetheless, it frightens me out of fecal matter. It seemsa to be based on a flawed theory, that of macro-economic stimulation.
The late Murray Rothbard (Hiya 3 Case!) used to be fond of claiming that there was no such thing as macro-economics. I of course managed to set him straight. I pointed out that human behavior certainly could be measured in broad aggregates or else there could be no such thing as actuaries.
Murray countered nicely by pointing out that he really was trying to say that there could be no such thing as some grandiose project that would overcome a nationwide case of the doldrums.
Right as rain. Hoover Dam, for example has benefited countless millions over the years, however its stimulus effect was limited to the construction site and nowhere else.
This is a fortunate aspect of economics. What precludes the aforementioned stimulus also means that we have a built-in damage control mechanism against disasters. 9-11 was not good for the economy, but the disaster area was limited to ground zero and environs.
The inescapable corollary is that all stimulus is necessarily micro-economic in nature. World War II for example consisted of micro-economic stimulation in every nook and cranny of the country. (It also stimulated every crook and nanny, but that is a different story.)
Now todays liquidity is apparently brouhgt on by “bad debt”. Both commercial and investment banks have bills they cannot pay,
so they are hoarding what cash they have and are not making deals. The influx of treasury funds will (maybe) cause deals to be closed but does not solve that bad debt problem.
Thus any relief might well be very brief indeed. Then the malaise will resume.
Additionally, letting the less solvent firms fail is certainly not bad in and of itself. Those that cannot remain solvent need to be replaced. However to force failure on some by force-feeding others will mean that no replacements can emerge since all available cash flow is directed elsewhere.
This reduction of liquidity will take place far and wide and in many, many different areas. Result looks like micro-economic retardation almost everywhere. This in turn will replicate what Hoover helped start and what Roosevelt continued for nine long years.
Why not (a) raise cash (revenue bonds?), (b)
pay their bad debts for them, (c) seize their best paper in return. This will leave them “poverty-stricken” but liquid. They will have money they are free to lend and all that sub-prime paper will still produce adequate cash flow to fund higher-quality new loans.
The seized mortages etc will suffice to both service and retire the bonds. There will be irregularities in the repayment schedule but the cash flow will be there. And it will go to wherever there are bondholders. Which can be in every nook and cranny as well as to every crook and nanny.
Finally, as payments come in and bond obligations reduce, the people paying those mortages etc can be forgivn large chunks of their principal and have their monthly obligations reduced and eventually eliminated way ahead of schedule. And that would be micro-economic stimulation with attitude!
Enough out of me. Your comments and those of others will be welcome.
PS I do hope that my fears are grossly exaggerated, but I am getting more nervous than I used to be.
Steve Diamond has a link to a good backgrounder on the financial crisis.
The End of Wall Street’s Boom
So is the physical bank site considered a micro economic model? The Starbucks, the TP suppliers and Hooters too are affected by deflationary pressures. At the end of the day it is their ability to pay a bill that has grown out of all proportion to their income. If the feds buy the bad paper, what happens to it? The million dollar question is still how to turn a bad loan into a good loan. It is still a losing proposition.
Is the global top down model really that different from the businesses affected by construction of that dam.
I earlier commented:
“Maybe after I get laid-off, I can get a job at Hooters?”
3Case asked:
“How you look in short shorts?”
Unfortunately, not good enough. I have a Ph.D. in aerospace engineering. I once commented to a colleague who has a Ph.D. in mathematics that with our advanced degrees and highly trained intellects, we could probably find work as nude dancers. My colleague responded that dancing in the nude was an option for him but he had his doubts about me.
I think we are digging our way straight through to China… or maybe angling off to the Middle East. There’s hope on the horizon after all for our economic woes and the government and Wall Street are already looking that way. What won’t we do for money?
“Sharia Finance: last gasp of America’s doomed economy”
Hoover Dam, for example has benefited countless millions over the years, however its stimulus effect was limited to the construction site and nowhere else. – Dave
World War II for example consisted of micro-economic stimulation in every nook and cranny of the country. – Dave
Marc Reisner wrote in Cadillac Desert that the ability to mobilize and rapidly produce war materiel during the post-Pearl Harbor period would not have been possible without the energy from large hydropower produced by dams in the mid-west constructed by Corps and BuRec during ’30′s and ’40′s.
It’s a minor point but maybe not. We do not currently have the energy production capacity to support the micro-economic stimulus to reverse the recession from consumer deleveraging – certainly not in a carbon-constrained environment. Which means any recovery will be slow not fast. Painfully so.
Steve Forbes says that $20 trillion investment will be required to supply world’s energy needs over next 20 years. And we are decommissioning dams.
Eggplant – too funny – putting on my best CNBC news anchor voice: “so, Mr X given Armageddon in the next 5 years, where would your money be now?” “I like health club stocks.”
JFSanders,
[Paulson] cannot for the life of him, make a statement that is easily understood.
Don’t be so hard on the SoT. He’s simply complying with the Bush’s First Law of Communication:
Cheers.
L3
I agree that this is a move in the right direction. – Leo
Which of course doesn’t mean we’ll get to where we want to be – particularly under circumstances where we all want to be different places.
While it seems likely to me – only in a purely statistical sense – that the big moves will be effective, one not so hidden danger is the growth of regulation in all the wrong places, not to mention increasing pressure from the international community to standardize regulatory control.
The effect of TARP on stabilizing “good” banks seems to have been effective. It can all be wiped out with frenetic congressional legislation to ensure “economic justice”, to take a cheap shot.
We’ll see.
Dave,
Good thoughts. The biggest concern I’d have about your idea is b) paying their bad debts for them. This creates a moral hazard we’d best avoid, if we can. Of course, if things get bad enough, we may have to. Sigh.
I do hope that my fears are grossly exaggerated, but I am getting more nervous than I used to be.
I’m with you. I’ve noticed that the bigger the Black Swan, the longer it takes to absorb its full implications. I think we’re still coming to grips with the implications of 9/11. And 2009 years after the Incarnation, we’re still trying to understand what that means. “So that Jesus dude was both God and man? What the heck is that all about?”
Your comment on micro vs. macro is right on. The challenge is that politicians (and their appointees) have to act micro but talk macro. It’s what the press and the voters want, and their entire raison d’etre is to appeal to those two groups.
The really hard part of the coming recession will be to get people to replenish their savings, their personal financial design margin, if you will. After years of expectations that they can spend what they bring in (or more), this will be a painful adjustment.
Several of our companies will be paying nice bonuses this year. I’ve been giving a speech at every one of our Quarterly Business Reviews (meetings of the management teams) that, while it’s their money and they can do what they want, if I was them I’d put their bonus in the bank, or use it to pay down off their credit cards. The coming recession will be hard on everyone, and this time next year they’re gonna want to have the cash more than they’re going to want to have a new ride.
Besides, they’ll be able to get some amazing deals at GM’s Going-Out-of-Business sale.
Cheers.
L3
slade,
Agreed in full. Continuous tinkering will cause disaster.
L3
Regarding the hazard of over or wrong regulation, Blackrock Chairman Fink noted the different skill sets of the two top candidates for Sect. of Treasury. Summers is more of an economist while Geithner is more of a tactician.
A difference with a distinction – or not.
Can you take some time off from your very busy schedule and take over from Paulson. – JFSanders
Oh they’re there – in spades and on steroids, so to speak. They’re just otherwise occupied.
The ambiguity and the moving off mark quality coming from Paulson’s public statements is – not improbably but a good bet – a reflection of the political influence mucking up the system. Paulson cannot be viewed as a UAW spokesman. That would be a Democratic Congress and a Democratic President-Elect.
It reminds me of Fallujah when close observers, and then the public, started to get a bad feeling about the way the war was being conducted.
The really hard part of the coming recession will be to get people to replenish their savings – Leo
Particularly difficult when those of us who had already absorbed our elementary lessons of financial thrift and prudence saw our efforts savaged by the cascading collapse of the “house of cards” while the “over-leveraged consumer” is rewarded with a bailout.
L3, Under the circumstances I don’t think that paying their debts is a bad moral example. Or at least not a terrible one.
Their bad paper has created debts to be paid right now. Their good paper produces more than enough cash flow to do the job, but pays
over time. So to take the latter in return for curing the immediate problem certainly is not welfare. Perhaps “vigorish” would be a better word.
Which reminds me: Ever hear P J O’Rourke on bond ratings?
D-Rated bond—–like money lent to a younger brother;
AAA-Rated bond—–like money lent to a younger brother by the Gambino family.
Slade and L3; I am also of the opinion that this continuous lowering of interest rates is counter-productive.
Banks need liquidity. That means they need deposits that stay there for a while. Way to get such deposits is to pay lots and lots of interest on them.
Of course, interest paid out has to be covered by interest paid in. That means higher rates to borrowers. If they do not do that, they do not get the depositers and without depositers they cannot make any loans at all. What we are now seeing.
I remember the Volcker Fed and its interest-rate spike of the 1979-81 time frame. Painful but it did help cure stagflation. Something similar should prove equally beneficial in curing deflation.
28. slade:
Hoover Dam, for example has benefited countless millions over the years, however its stimulus effect was limited to the construction site and nowhere else. – Dave
World War II for example consisted of micro-economic stimulation in every nook and cranny of the country. – Dave
Marc Reisner wrote in Cadillac Desert that the ability to mobilize and rapidly produce war materiel during the post-Pearl Harbor period would not have been possible without the energy from large hydropower produced by dams in the mid-west constructed by Corps and BuRec during ’30’s and ’40’s.
…………
I took a tour of Hoover Dam this past January. Hoover passed the enabling legislation for the dam back in 1922. Building started in 1932. A ten year gap.
Today the dam is a profitable enterprise for the bureau of reclamation dept of interior US gov.
Its make money on both water and energy.
It takes water to make energy and energy to make water.
Interesting meditation.
Failing Like Japan
Instapundit is considering an Obama-bailout of the NY Times itself which is due to go bankrupt about May of 2009. Unfortunately, although it’s supposed to be a joke, it sounds too real and likely to happen.
Charles said:
“I took a tour of Hoover Dam this past January. Hoover passed the enabling legislation for the dam back in 1922. Building started in 1932. A ten year gap.”
I’ve always wanted to tour Hoover Dam.
The ten year gap is typical for a big civil engineering project like Hoover Dam. After the economy hits bottom and it’s time to dig out, some good public works projects would be to build lots of nuclear power plants and nuclear fuel recycling infrastructure (sort of a repeat of TVA). Write the legislation such that everything for the project must be Made in the USA, e.g. no Chinese or Korean steel. Structure the deal towards recreating heavy manufacturing in America. Setup the nuclear power plants to replace existing fossil fuel power plants (“green” power is somewhere between feel-good nonsense and an investment scam). At the same time, try to rebuild the American automobile industry around electric automobiles based upon a unified design (have a government mandated standard car where part interchangability is required). Battery powered electric automobiles are probably a non-option but it might be possible to come up with alternative storage schemes, e.g. fuel cells that run on high density fuel. Use the nuclear power plants to produce the high density fuel (no clue what that would be). Conventional fuel cells run on hydrogen. Unfortunately hydrogen is low density and carries with it many other technological difficulties. It would be worth spending a couple hundred million dollars of research money to develop a fuel cell that runs on a high density fuel.
Of course all of these bright ideas require billions of dollars that we probably won’t have and also require about a decade to complete. It’s unlikely that we’ll even get started rebuilding the country while Obama is still President (he’ll be too distracted squandering inflated dollars on socialist pipe dreams). Also, we’ll probably be spending our last remaining wealth killing off what remains of the Islamic world. The future is very dark indeed…
Hoover passed the enabling legislation for the dam back in 1922. Building started in 1932. A ten year gap. – Charles
The point of modern analysts being that Hoover Dam could not be built today – for any amount of money or time.**
Noe that’s something to meditate on.
**I expect many have seen the *viral* email or some form thereof of Noah building a 20/21st century ark. Noah tells God he can’t get all the necessary permits, etc. just as the rains start to pour. He pleads with God not to destroy the earth and God says not to worry. “The Government beat me to it.”
Also one of the apparently little noticed parts of the Paulson speech yesterday was the incentive program to get private capital back into the banking system. Because I am old and stupid, I forgot the details, but I clearly remember that was one of his “bullet” talking points. That is a very good initiative.
slade said:
“The point of modern analysts being that Hoover Dam could not be built today – for any amount of money or time.”
It’s my understanding that dams for power production are an obsolete concept anyway. The reservoir silts up after a few decades. I’ve always wondered if it would be possible to de-silt a reservoir, i.e. let the water out and then haul away the mud to farmlands with heavy machinery. It’s probably one of these goofy situations where the energy required to haul away the mud is greater than the original energy produced by the dam.
Eggplant -
I hadn’t heard that but I wasn’t advocating hydropower – just adding yet another comment to the bitter legacy of over-regulation – one that threatens to complicate development of a modern energy program. I do know that “nowadays” the reservoir storage lost to siltation is a parameter in hydraulic design. My expectation is that some estimate was used in design of Hoover since both Corps and BuRec have long long history in sediment engineering.
Charles, you cited (#20):
“Interest rates may be cut to 0%…”
This is what is known in real analysis as an infimum, or greatest lower bound.
That is, in the set of possible interest rates, you just can’t go any lower.
So what then?
Jamie Irons
My father briefly served on a California state water commission. He told me an interesting story. There are many late 19th and early 20th century dams in the Sierra Nevadas that are completely silted up (they’re worthless for flood control or power production).
So why not dynamite these old dams and let the river wash away the silt?
According to my father, these old reservoirs are loaded with accumulated mercury from 19th century gold mining (mercury was used in old fashioned gold separation methods). If the old dams were dynamited, the agriculture down stream would be poisoned by the sudden release of accumulated mercury.
Who would have foreseen this happening? It reminds me again that it’s not nice to fool with Mother Nature.
46. Jamie Irons:
That is, in the set of possible interest rates, you just can’t go any lower.
So what then?
………..
beats me. I understand that the general idea is to offset massively deflating economies (due to massively shrinking debt to equity ratios by private banks) with massively inflating government fiscal and monetary policy.
I don’t know how it will play out. Likely a lot of the federal fiscal dollars will be pissed away. Hopefully some of the federal fiscal dollars will be high powered.
Monetary policy may do more good than fiscal policy. But that’s just my wag.
Chinese stimulus vs. U.S. bailout
US elite thinking on all things from demographics to environmental policy since the 1960′s has been driven by the idea that resources were declining and limited.
This was an inaccurate way to describe the situation.
What had happened since the 1960s was that the technological base created at the turn of the 20th century had moved from a geometric ability to exploit resources to a relatively smaller arithmetic ability to exploit resources.
It wasn’t that resources had become finite. Rather it was that the tools ability to exploit nature had begun to reach their limit.
We are today creating a technological base with geometric ability to exploit natural resources.
If you want to see how dollars can be well spent-check out how the chinese are doling out their big stimulus package.
China’s Stimulus Package May Boost California, Japan (Update1)
We are today creating a technological base with geometric ability to exploit natural resources. – Charles
Almost but not quite.
Coupled with an exponential ability to constrain exploitation of natural resources – with the attendant consequences of good, bad, and ugly.
L3 – I have a few questions for you.
Just finished reading an article by Michael Lewis of Liar’s Poker’s fame at Portfolio.com.
In the article, he alleges that the big Wall Street Investment banks, because of the almost insatiable appetite of the market for CDS, were able to repackage pools of BBB tranche CDS’s and the rating agencies like Moody”s and Standard and Poor’s would rate them AAA. Then these newly repackaged CDO’s would be sold for big bucks.
Why were the bond rating agencies allowed to rate these bottom of the barrel junk bonds as AAA? Are they not liable for fraud? What happens if the DOJ or a pool of investors goes after the whole management teams at the Credit Agencies. Who replaces these agencies if they are gone?
Michael Lewis quotes John Getfreund former CEO of Salomen Brothers as saying ” I don’t understand the product lines”, and implied that top management let the traders go wild.
Lewis also said the big accounting firms auditing Wall Street’s books had no idea what they were looking at when auditing CDO’s and CDS’s.
Now if both the top management at Investment Banks have no idea what they’re doing and the auditors have no clue what they’re looking at, how are the regulators going to rein in the excesses and the fraud? Aren’t those accounting firms liable for the bad audits? Isn’t this the Enron accounitng scandal times 100 or a thousand?
Also, what role do Bank reserve requirements play in this game if any? Or does the Gramm Leach Bliley Act, or other current policies let the big investment banks off the hook for holding reserves for these kinds of transactions? How were these Investment banks with billions of government guaranteed deposits allowed to leverage their assets to such an extent?
Unsk,
having just read the fascinating article to which you referred (a really appalling example/ case study of why elites cannot be trusted), I have roughly the same set of questions as those you raise.
Jamie Irons
Unsk -
A little something to think about next time the UAW gets put on the chopping block.
G-L-B Act is huge [h/t The E-Bar] and yet nobody can even spell it.
Gramm of course being you know who of whining fame.
Unsk,
Not sure I can give a good answer all these questions, though they are certainly questions that deserve a good answer. Here’s an attempt at a few:
Why were the bond rating agencies allowed to rate these bottom of the barrel junk bonds as AAA?
My guess (and it’s just that) is that CDOs were rated like insurance (which is what they are), which means you rate the ability of the counterparty to make good if a claim is ever made. The logic is that the triggering event that causes a payout is, in the case of insurance, difficult to predict. What you’re really relying on is the ability of the insurer to make good on their commitment to pay.
Now, the issuer of the CDO is probably not AAA rated. Most investment banks were A or AA rated. So they probably went to a AAA insurance company – an MBIA, or an Ambac, or someone like that – and had them credit-enhance the CDO for a fee. It’s kind of like renting someone else’s credit rating.
The buyer of the CDO is really relying, then, on the credit rating of the insurer. The credit rating agency is really not looking at the underlying rating of the CDO itself. It is, in effect, relying on the insurer’s underwriting.
This means the real screw-up by the rating agency was not in rating the CDO, but rating the insurer. But the insurer probably built some kind of fancy-dancy analytical model that said that these CDOs added little risk to their portfolio, and the rating agency bought off on it. They may have argued that CDOs were negatively correlated to some other asset they held, so the total risk didn’t increase much. They charged a fat fee for the insurance, and the originators got big bonuses. It’s a win-win!
But what they forgot is that in a flight-to-quality meltdown, all correlations go to 1. This means that there is a lot more risk than the insurer and their rating agency thought. Doh!
I doubt this was done with malice of forethought. More like hubris of ignorance. No doubt some enterprising prosecutor can argue otherwise, and we may yet see some poor Moody’s underwriter do the perp walk. But I doubt there was some kind of scam involved. Just a combination of greed and wishful thinking. A dangerous combination.
Now if both the top management at Investment Banks have no idea what they’re doing and the auditors have no clue what they’re looking at, how are the regulators going to rein in the excesses and the fraud?
I’m not sure they can, which is why it is really important that these banks be allowed to fail. No one could conceive of this meltdown, but I guarantee that everyone who worked at Bear Stearns and Lehman and Merrill Lynch will never forget what went down. For the rest of their careers – which will now be much longer than they hoped a year ago – they will extremely reluctant to simply sling crap at buyers simply to make a quick buck. Failure is critical to the efficient long-term performance of every industry. Financial services is no exception.
Attempting to regulate behavior in markets like this actually undermines the long-term stability of the market. It gives everyone a false sense of security, since they can rely on the regulator to analyze products, rather than forcing buyers to do the hard work themselves. It also implies that the regulators have some responsibility to “fix” problems that do eventually crop up. The most important role of regulators, IMHO, is to force markets to be standardized, transparent, and non-collusive. Go much beyond this, and you invite, trouble.
Aren’t those accounting firms liable for the bad audits? Isn’t this the Enron accounitng scandal times 100 or a thousand?
Holding the auditor liable for this sort of stuff is a tricky business. The auditor is supposed to make sure that what the bank reports is accurate. They can’t promise that the investment is a good business deal. That’s the responsibility of management and the board of directors.
Enron is certainly an example of an over-leveraged, trust-based trading business that folded like a cheap suit when investors lost trust. There was clearly some fraud going on there, but that wasn’t why it failed. It failed because it had too much leverage. You may not like Jeff Skilling, but he was probably right when he said Enron failed because of a “run on the bank.”
The fundamental mistake all of these businesses made is that financial engineering creates shareholder value. The reality is that you create shareholder value by delivering better products and services than the competition. But this is hard work. It’s a lot easier to tinker with the capital structure and say “Voila! Equity values have increased! Hooray for me!”
What role do Bank reserve requirements play in this game if any?
They’re hugely important. The reason the I-Banks failed, at the end of the day, is because they were over-leveraged. They did this to goose equity returns. But there is no free lunch; increase leverage, you increase risk; increase risk, you increase the likelihood of failure. I-Banks played with fire. Then ended up betting burnt to a crispy crunch.
Investors in I-Banks loved the returns. The risks, not so much. But they’re two sides of the same coin. Investors rewarded leverage while it worked. I’m not very sympathetic about their losing money when the worm turned.
Or does the Gramm Leach Bliley Act, or other current policies let the big investment banks off the hook for holding reserves for these kinds of transactions?
I-Banks were not regulated by the Fed or the Comptroller of the Currency. That gave them the freedom to leverage as much as their equity investors would allow, which in retrospect was too far. But the investors lost their money, so they reaped what they sowed.
GLB didn’t really change this. All it did was allow commercial banks, which are regulated by the Fed and OCC, to own investment banks. It may have made the situation marginally worse by creating more competition for investment banks, thus driving down their margins, and so encouraging greater levels of leverage to preserve return on equity. But it’s not really a big factor, IMHO, especially compared to the Community Reinvestment Act, which encouraged lots of bad loans.
How were these Investment banks with billions of government guaranteed deposits allowed to leverage their assets to such an extent?
The deposits in investment banks were not government guaranteed, as far as I know. Commercial bank deposits were guaranteed by the FDIC, i.e. the government. But investment bank deposits were uninsured. Generally, those deposits were held in money-market accounts which invested in government securities; there was no government guarantees per se.
At the end of the day, again, the investment banks failed because investors were willing to take a flier on a highly-leveraged company in the hope of generating high investment returns. They screwed up, and paid the price.
Having seen this happen, investors have killed the independent investment bank. The remaining players have chosen to switch to commercial banks, both to raise additional equity and because they probably realize that too much leverage is dangerous to your health.
Hope this makes sense. Cheers.
L3
L3
Thanks for a good explanation.
Unsk
Leo, all due respect, but you write:
GLB didn’t really change this. All it did was allow commercial banks, which are regulated by the Fed and OCC, to own investment banks.
The deposits in investment banks were not government guaranteed, as far as I know. Commercial bank deposits were guaranteed by the FDIC, i.e. the government. But investment bank deposits were uninsured.
I see nefarious intent. Being uninsured removes investments from regulatory scrutiny, which allows riskier investment strategies.
A poster recently described the “union-management axis” as a coupled driver of what became an insolvent business model. The “policy-financial axis” seems a completely parallel coupling, on a much larger scale. It is the “coupling” that collapsed.
The CRA mortgages were government-insured and yet the financial services industry, via the investment banks, contaminated the insured product with MBSs and CDOs. The rating agencies were just along for the ride.
RE: regulatory fallout
“A new era for the IMF.”
The same folks that gave us the Asian Crisis of 1997/8.
Jamie Irons:
Charles, you cited (#20):
“Interest rates may be cut to 0%…”
This is what is known in real analysis as an infimum, or greatest lower bound.
That is, in the set of possible interest rates, you just can’t go any lower.
So what then?
Jamie Irons
Im not formally trained in economics but as I understand it loans have been made with a negative intrest rate in the past durring times of deflation.
Someone correct me if I am wrong but the basic characteristics of deflation are that prices fall, but wages fall faster, and money in general becomes scarce (shrinking money supply). So while each dollar buys more, the dollars themselves are harder for people to obtain. This is hell on the “real” economy.
In this situation I might loan you $1000 today and you might pay me back $950 dollars next year and i will actually have “made money” because next year it will take more work for you to get those $950 to pay me back than the work that It would have taken for me to make the $1000 at the start … and since prices will have fallen over that time the $950 will have more purchasing power on the day you pay me back than the $1000 did on the day that I lent it to you.
its counter intuitive but in theory thats how it works.
in practical terms of course there is very little incentive for any one to make such a loan since they could have an even greater benefit by simply saving the $1000.
in a deflation incentive to lend is basically non existant on all levels … and people that have debt obligations that were contracted while the economy was in an inflationary mode are absolutely ruined since their payments stay the same while their dollar incomes fall.
im not sure how any of this connects to the real world that we live in … but its interesting to think about.
El_Heffe:
Sites like marginalrevolution, econoblog, regmonitor, nakedcapitalism, and voxeu contain informative pieces on this and many other subjects.
I’m not worried, we’ve the _genius_ Harvard boys figuring out how to play the financial, social engineering, magic and diplomacy games… for us, no less, for sure ~