Fin/Inv

Chris Whalen has a particularly tough-minded post at Reuters in which he explains why QE does little for the real economy (similar to the conclusions reached by the Bank of Japan regarding its own QE) and why its benefits for banks fade over time. Key sections:

When interest rates are low, savers move their preference for liquidity to infinity, especially after the past several years of market breakdown. Retirees spend less because the interest earned on bonds and savings has plummeted….

When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (NIM) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.

Just as the earnings of leveraged investors like banks are starting to suffer due to zero rate policy, so too the spending by all manner of savers, from retirees to companies and not-for-profits to municipalities, is falling too. Fed Chairman Bernanke and the other members of the FOMC are killing the real economy to save the banks — but none of the benefit flowing to the banks is reaching U.S. households. In fact, the Obama Administration has been providing political cover for the Fed to conduct a massive, reverse Robin Hood scheme, moving trillions of dollars in resources from savers and consumers to the big banks and their share and bond holders.

Yves here. A big error the Fed made during the crisis was overly sharp rate cuts when markets swooned. The cliche was “75 [basis points] is the new 25.” A lot of commentators got nervous when the Fed cut its Fed funds rate below 2% because that put it on the path to ZIRP. But there were so many other distractions that concerns about the level of policy interest rates got lost in other crisis issues.

Whalen further argues that increased concentration in the banking industry has allowed the big banks to strangle credit:

“In every Fed easing event during my career in finance (1986, 1992, 1998, 2002), it was the wave of refinancing of debt after the Fed eased interest rates that put permanent disposable income into the hands of households,” notes a former Fed official who worked in the banking industry for decades. “In this last easing, however, FNM, FRE and the TBTF banks have conspired to break the transmission mechanism for monetary policy and are now strangling the U.S. economy to save themselves from past errors.”….

First, the Obama Administration should use the power provided in the Dodd-Frank legislation to force an accelerated cleanup of bad assets and to mandate refinancing and principal reductions for performing loans with viable borrowers….

Second, President Obama also needs to focus on the growing competitive problem in the U.S. mortgage sector…

The top three banks control 55% of all mortgage originations. The top 10 banks control 95%. The top five run the only surviving channels to sell loans to Fannie Mae (FNM) and Freddie Mac (FRE), and force their pricing upon the entire banking industry. Small banks give up half the economics of a typical loan to sell a loan to FNM or FRE indirectly, through WFC or JPM. Why is there no antitrust investigation of the top banks by the Department of Justice?

The Obama Administration should move to restructure FNM and FRE now, not in 2011. The Treasury should use its existing authority under the conservatorship to force FNM and FRE to make rules changes to allow for the refinancing of all existing residential mortgages, if only to reduce the current cost of the debt and increase disposable income for households…

President Obama should make some political hay over the fact that loan origination margins for the top four banks have gone from ½ point to over 4 points in the last two years. This is the subsidy for Wall Street above and beyond the zero interest rate policy of the Fed.

My quibble about the Fannie/Freddie refi idea is that this more deeply entrenches the role of the GSEs when Whalen argues against their powerful role, and it also creates large amounts of low yield paper which if we escape our near deflation conditions, will mean big time losses to the chump holders (and until we get over causing pain to bondholders, having Bill Gross hold a lot of securitized low yield mortgages means Bill Gross will be lobbying for more ZIRP and QE). Plus this move (by design) is a subsidy to homeowners and not renters. I’d prefer more straightforward ways of getting cash to ordinary consumers. But putting more heat on the banks is very much in order. And if they don’t like official criticism, they have only themselves to blame.

The “lax” is clearly a tad inflammatory, but tweaks in Basel III rules to allow dubious quality items like mortgage servicing rights as Tier I capital speak volumes. In addition, the various noises from policy makers makes clear that they aren’t willing to make banks raise capital level by much due to fears of the impact of lower loan availability on economic growth (more equity behind lending means higher lending costs, since equity is more expensive than debt). And with that not-very-strong starting point, the banks have pushed for even weaker rules.

Should this come to pass, Credit Suisse, via a Wall Street Journal story, is already predicting the outcome: more bank mergers. This is would be yet another example of the costs of not taking a tough enough line with banks (the 2009 example being explicit and covert bailouts, without forcing changes in top management and boards at the struggling banks, was diverted to a significant degree to record bonuses, rather than its intended aim, building up capital levels). The latest antiicpated bad outcome, per the Journal (hat tip Richard Smith):

Interesting, therefore, that analysts at Credit Suisse, have just published a research report entitled “Opportunity Knocks,” which sees a “blue-sky” 78% potential upside from current share price levels based on higher returns, lower-than-expected cost of equity and benign macroeconomic scenarios.

If the blue-sky background does indeed pan out and profits rise as bad loans decline, bank share prices will improve to the extent that they will start to have the confidence to start looking at acquisitions that are more than just the opportunistic ones seen post-crisis.

This will especially be the case if, as expected, the new Basel III capital rules are pitched at such a level that many banks turn out to have excess capital. Most bankers have enough sense not to talk about this openly just now, but acquisitions will be one way of spending the money. One assumes that in this new banking environment, acquirers will have to convince regulators that the resulting solvency position is more than adequate. Given the ability of bankers to destroy value for their shareholders this would seem to be fundamental.

We doubt many readers are of the “benign macroeconomic scenario” school, but this is classic bad incentives at work. I haven’t seen any international studies, but US studies of bank efficiency have consistently found larger banks to be slightly MORE costly to operate as asset size rises, once a not very high threshold is reached. So the widely touted rationale of cost savings is bunk; each bank in a merger could have achieved the same cost level on its own.

So why do deals like this continue? Because banks CEO pay is positively correlated with bank size. Empire building is a very profitable exercise for bank executives. And the top echelon of the acquired bank is bought off via golden parachutes.

The result is more TBTF banks, the last thing we want from a policy standpoint. But it looks like fear of taking the banksters down a notch is going to lead to more of the same, which is ultimately more looting of taxpayers.

The English language needs a new word to describe the nature and degree of disconnectedness from reality represented by Dick Fuld. He occupies a weird funhouse realm in which he did no wrong, those mean people in DC and the evil shorts brought down a viable enterprise. Remember, this is the man who certified financial statements goosed up to the tune of $50 billion via Repo 105, a ruse that ought to have been an accounting fraud but wasn’t, says he never heard of it, yet considers himself sufficiently well informed about what was happening at his former firm to be a qualified judge of whether it could have survived. Frank Partnoy concluded:

The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.

The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman’s high credit default swap valuations were reasonable because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s valuations the objective benchmark?

Or page 547, where the report describes how Lehman’s so-called “Product Control Group” acted like Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO positions, and deferred to the traders’ models, saying “We’re not quants.”

Economics of Contempt comes to a simpler conclusion, that Lehman was misrepresenting the size of its liquidity pool “in a huge way.”

But no matter how you look at it, even with the voluminous Valukas report, no one has come up with a plausible explanation as to the magnitude of Lehman’s black hole. As we noted:

But the numbers do not add up. The bankruptcy administrator has put the losses at $130 billion (although that number is still in play) and was (remarkably) denying that Lehman had a solvency problem at the time of its collapse, when the tenor of the Government section suggests the reverse. In addition, Lehman’s net worth as of May 31, 2008 was reported at $26 billion. So if we accept the $130 billion estimate, the swing from reported net worth to losses realized was over $150 billion. We still have no satisfactory explanation of how that took place.

“Denial” and “pathological” are near cliches and therefore far too weak to describe the fantastically distorted lens through which Dick Fuld views the world. He seems to believe if he can get enough people to repeat his delusions, that will make them true. Bloomberg apparently had an advance version of his written submission to the Financial Crisis Inquiry Commission (sadly, I don’t see it yet at the FCIC website), and it appears to be a doozy. From Bloomberg:

Richard Fuld, former chief executive officer of Lehman Brothers Holdings Inc., said regulators relied on “flawed information” in denying his company aid that was extended to competitors.

“Other firms were hurt by their plummeting stock prices,” Fuld, 64, said in prepared remarks submitted to the Financial Crisis Inquiry Commission for a hearing in Washington today. “Lehman was the only firm that was mandated by government regulators to file for bankruptcy. The government was then forced to intervene to protect those other firms and the entire financial system.”….

“Lehman was forced into bankruptcy not because it neglected to act responsibly or seek solutions to the crisis, but because of a decision, based on flawed information, not to provide Lehman with the support given to each of its competitors and other nonfinancial firms in the ensuing days,” said Fuld.

Yves here. There is a wee problem with this account. With Lehman’s books unreliable (this is something pretty much everyone on the Street knew prior to its collapse, that its asset values were inflated in a serious way), a government remedy was out of the picture. Even with the monster AIG rescue, there were a lot of decent assets that could serve as collateral for loans. But was there really anything solid at Lehman? The gaping maw of losses in fact confirms that the hesitation of any actor to step into the breach was warranted.

Or maybe Fuld still believes in the tooth fairy:

The market responded with enthusiasm to reports that the Tooth Fairy has agreed to acquire Lehman. The purchase price has not yet been determined and will be set by Dick Fuld wishing upon a star, clicking his heels three times, and being transported back to that magical place where Lehman still sells for over $70 per share.

In related news, Lehman has agreed to sell all of its level III capital, including CDOs, ABSs, pet rocks, baseball cards, slightly used condoms, and credit default swaps written by MBIA and Ambac. Lehman’s level III capital will be acquired for 150% of its face value by Tinkerbell, who will carry it off to Neverland to be fed to a crocodile. Lehman is financing 90% of the acquisition at an interest rate that has not been announced; Tinkerbell’s up-front payment consists of a handful of pixie dust, three crickets, and a bullfrog. Analyst Dick Bove estimates that the bullfrog could eventually be transformed into three princes and a pumpkin coach. The deal gives Lehman no recourse to any of Tinkerbell’s assets other than the Level III capital. If Tinkerbell defaults, Lehman’s successor entity will stick its hand down the crocodile’s throat and attempt to get it to regurgitate. The firm’s historical value-at-risk analysis shows that sticking your hand down a crocodile’s throat is completely safe.

A key paragraph in a post on a new paper by Jim Hamilton:

We can summarize the implications of that forecast in terms of the following scenario. Suppose that the Federal Reserve were to sell off all its Treasury securities of less than one-year maturity, and use the proceeds to buy up all the longer term Treasury debt it could. For example, in December of 2006, this would have required selling off about $400 B in bills and notes or bonds with less than one year remaining, with which the Fed could have effectively retired all Treasury debt beyond 10 years. The figure below summarizes the implied average change in forecast for the 1990-2007 period as a result of this change for interest rates of various maturities. Yields on maturities longer than 2-1/2 years would fall, with those at the long end decreasing by up to 17 basis points. Yields on the shortest maturities would increase by almost as much. While our estimates imply that the Fed could make a modest change in the slope of the yield curve, it would not make any difference for the average level of interest rates.

Note Hamilton clearly states that the Fed could clearly lower rates further. As Scott Fulwiler commented via e-mail:

They just have to announce the rate they want and be willing to buy everything offered at that price. Since the real point of QE2 is to cut longer-term rates, the only conclusion is that they don’t understand the fundamental fact that their operations are about price, not quantity.

Also, Hamilton’s evidence should work in reverse–i.e., don’t fear the Chinese dumping all their lt Treasuries . . . 17bp for every $400B.

I’d love to see a study that parses out the impact of Fed announcements. It might be that talk really is cheaper than action.

By William K. Black, Associate Professor of Economics and Law at the University of Missouri-Kansas City and author of The Best Way to Rob a Bank is to Own One

One of the great advantages of blogs is spurring informative debate. The debates also tend to morph as commentators develop their arguments. I want to address the initial and the morphed debate that Yves’ column kicked off: The Continued Stealth Takeover of the Courts. Yves warned that corporate CEOs are making concerted efforts to direct political contributions in a manner designed to elect judges that will champion CEOs’ interests. Note that I stress that the person that controls the corporation, typically the CEO, is the key actor and that the CEO commonly maximizes what he believes will be his interests at the expense of the corporation and its shareholders, creditors, and employees. This harms the nation. Yves’ blog prompted responses that eventually morphed into a debate about the role of law and economics in judicial decision making and discussion of what students are being taught in law and economics.

I have taught five multidisciplinary courses at the University of Missouri – Kansas City that integrate law, economics, criminology, finance, regulation, political science, and accounting. One of those courses is law and economics. My spouse, June Carbone (a professor at UMKC Law), and her co-author Naomi Cahn discuss the role of elected v. appointed judges in their recent book Red Families v Blue Families. You can see why we are interested in these debate topics.

The Supreme Court’s Citizens United decision allows businesses to make unlimited political contributions to judges and politicians. When judges are elected, the need for these contributions inherently turns judges into politicians. Sympathetic judges are corrupt businesses’ most valuable allies. Corporations and their senior officials can commit civil or criminal wrongs with impunity if their case is assigned to a friendly judge. The Robber Barons often had judges on their payrolls. Judges can serve a corporation as both a shield and a sword. They can declare statutes and regulations unlawful. They can issue favorable decisions when corporations sue their critics, which can intimidate, tie up, or even bankrupt the critics.

The fact that corporations are “investing” so heavily in getting pro-business judges elected demonstrates that their CEOs believe that the election of friendly judges will increase their incomes and decrease the risk that they will ever be sanctioned. It’s a business decision – not a decision based on which judicial candidate would be more qualified or better serve justice. CEOs want to win cases when doing so would be unjust and contrary to the law, which is why they hire top attorneys and make the contributions necessary to elect judges they believe will be allies. The empirical evidence in Texas shows that judicial elections and contributions produces perverse dynamics. One study showed that hiring the former law firm of a Texas Supreme Court justice markedly increased the chances that the Texas Supreme Court would exercise its discretion and hear your appeal from an adverse decision. Hiring the former law firm of the Chief Justice of the Texas Supreme Court produced an even greater chance of having one’s appeal heard.

Yves noted that the Chamber of Commerce was leading the effort to elect CEO-friendly judges. The Chamber is one of the points of intersection in the discussions about electing judges and whether law and economics has played a perverse role in causing catastrophic policy, regulatory, and judicial blunders. The Chamber distributed a plan for a hostile takeover of university departments of economics and finance (and the courts and the media) proposed by Lewis Powell (the soon to be Supreme Court Justice). Extremely conservative “law and economics” proved to be central to this effort. The law and economics movement began as a non-ideological approach to explaining and aiding judicial decision-making. The scholars leading the movement had diverse views. The Olin Foundation transformed law and economics into an ultra ideological field dominated almost exclusively by passionate opponents of government “interference” in “free enterprise.” Olin specialized in creating well-funded positions in academia for scholars that had an “Austrian” approach to economics. Austrian economics has, generally, become more extreme since its formative years when Hayek warned that mixed economies (e.g., the U.S. and Europe) were inevitably consigned to the Road to Serfdom. Here is how the National Review praised the Olin’s takeover of the field:

Law and Economics: The John M. Olin Foundation has devoted more of its resources to studying how laws influence economic behavior than any other project. The law schools at Chicago, Harvard, Stanford, Virginia, and Yale all have law-and-economics programs named in honor of Olin. “You should not forget that without all the work in Law and Economics, a great part of which has been supported by the John M. Olin Foundation, it is doubtful whether the importance of my work would have been recognized,” said Ronald Coase, who won the 1991 Nobel Prize in economics.

In addition to these centers specializing in law and economics, Olin created scores of endowed chairs at a wide range of universities. Some of these are in economics departments and others are in law. Olin also indirectly funded the “boot camps” at which U.S. judges were taught Austrian economics as if it were undisputed science. The academic journals in law and economics are dominated by virulent opponents of regulation. The textbooks used to teach law and economics treat economic theory as having demonstrated conclusively the folly of most government actions purportedly designed to help the public. (I say “purportedly” because Austrians almost always claim that the government intervention was really designed to benefit a special interest rather than a substantial portion of the public.)

Here are two examples that illustrate how false, but so influential and harmful these Austrian nostrums have become through teaching falsified economics to thousands of lawyers. Austrian law and economics is based on suppositions that have long been known to be false. Dickens famously had Mr. Bumble (in Oliver Twist) respond to being informed that the law supposed him to be responsible for his wife’s behavior by remarking that if the law supposed such an absurdity then “the law is a ass.” The dominant law and economics text on corporate law for years was by Easterbrook and Fischel. Judge Easterbrook is a colleague of Judge Posner on the 7th Circuit and Fischel was for a time Dean of the University of Chicago’s law school. They assert that “a rule against fraud is not an essential or even necessarily an important ingredient of securities markets” (1991: 283). Their book was written after Professor Fischel, as a consultant to three of the most notorious control frauds of the 1980s, tried out their theories in the real world – and found that they failed catastrophically. Fischel praised the worst frauds. Fischel & Easterbrook did not disclose to their readers that their theories were falsified in the real world. Note how extreme their claim was, the utter certainty of the claim, and the lack of any data supporting the claim – a claim they knew to be false. The taught students that, in the context of securities, we did not need:

1. Any laws against securities fraud
2. The FBI and the Department of Justice
3. The SEC
4. Any rules against fraud
5. Any ability to bring civil suits

Fraud is impossible because securities markets are “efficient” and act as if they were guided by an “invisible hand.” Markets cannot be efficient if there is accounting control fraud, so we know (on the basis of circular reasoning) that securities fraud cannot exist. Indeed, when Easterbrook and Fischel try to explain why the securities markets automatically exclude frauds their faith-based logic becomes even more humorous. They claim that honest securities issuers send one or more of three “signals” of honesty to guide investors to purchase their securities – and that only honest firms can send any of these three signals.

1. Hire a top tier audit firm
2. Have their CEO own a substantial amount of stock in the company
3. Cause their firm to have extreme leverage

In reality, accounting control frauds “mimic” each of these signals and each signal aids their frauds. Easterbrook and Fischel’s ideas are not merely wholly ineffective against accounting control fraud – they are outright criminogenic. That is why Fischel praised the real world accounting frauds when he was a consultant. Each of the three massive accounting control frauds that Fischel praised sent each of these three signals – and they sent them years before Easterbrook and Fischel wrote their book and made claims they had seen repeatedly falsified by Fischel’s fraudulent clients without warning their readers.
Note the continuing damage that these three law and economics dogmas about “signaling” honesty had in the current crisis. Regulators continued to treat professionals as if they were “independent” and provided expert judgments on which regulators should rely. Basel II, for example, reduced capital requirements dramatically if the rating agencies gave a high rating to a toxic mortgage derivative. Economists, criminologists, and reality had long falsified the claim but theoclassical law and economics never challenges its foundational dogmas.

Easterbrook provided a classic example of faith-based law and economics’ misplaced faith in private professionals in a decision that prompted Robert Prentice’s wonderful article: The Case of the Irrational Accountant: A Behavioral Insight into Securities Fraud Litigation (2000). The plaintiff alleged that he was the victim of a securities fraud that the outside auditor had aided. Easterbrook’s opinion stated that the plaintiff should not be allowed to engage in discovery designed to support this claim because it would be “irrational” for an audit firm to aid a securities fraud. Easterbrook’s logic is so irrational on so many different levels that it proved a treasure trove for Professor Prentice. In the interest of space, consider only four aspects of why Easterbrook’s logic fails. First, Easterbrook is the one who co-authored the textbook claiming that serious securities fraud cannot occur. That makes him someone that cannot admit that fraud exists. He certainly doesn’t want plaintiffs finding facts demonstrating fraud. Second, the same textbook claimed that only honest corporations could hire a prestigious audit firm. He premised this (long falsified) dogma on the claim that it would be irrational for an audit firm to give a clean opinion to a control fraud. If the plaintiff had been allowed discovery and demonstrated the falsity of this dogma it would falsify Easterbrook’s entire thesis. Third, theoclassical economics rests on even more fundamental dogmas – economic actors are supposed to act rationally and almost entirely to maximize their self-interest. Empirically, even economists have long known what non-economists have always known – these dogmas are often false. Why should a plaintiff not be permitted to discover evidence that accountants act irrationally? Fourth, Easterbrook assumes away reality even if we assume rational behavior. The “auditor” acts through humans called audit partners. Audit partners gain income, power, and status within the firm primarily by bringing in large clients. Accounting control frauds understand this and select audit partners that will give them clean opinions. They also put prospective audit partners in competition with each other to intensify the “Gresham’s” dynamic that turns market forces perverse and causes bad ethics to drive good ethics out of the profession. Top economists had explained why this dynamic explained why S&L accounting control frauds had consistently hired top tier audit firms and been able to get clean opinions from them despite the fact that their financial statements were fraudulent.

As James Pierce, Executive Director of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) explained:

Accounting abuses also provided the ultimate perverse incentive: it paid to seek out bad loans because only those who had no intention of repaying would be willing to offer the high loan fees and interest required for the best looting. It was rational for operators to drive their institutions ever deeper into insolvency as they looted them.

The National Commission on Financial Institution Reform Recovery and Enforcement (NCFIRRE) (1993), reported on the causes of the S&L debacle. It documented the distinctive pattern of business practices that lenders typically employ to optimize accounting control fraud.

The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax…. [It] had grown at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used to make the institution look profitable, safe, and solvent. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization through high dividends and salaries, bonuses, perks and other means.

The top tier audit firms knew that the “typical large failure” “invariably” involved fraud by senior S&L executives, who used “every accounting trick available” in order to create fictional income in order to aid the executives’ looting of the S&L. These lenders followed a distinctive pattern – deliberately making bad loans – that was rational only for accounting control frauds. The unique pattern that optimized fraudulent accounting income was simple for an auditor to spot. The S&L accounting control frauds always hired top tier audit firms and virtually always succeeded in getting clean opinions for fraudulent financial statements. That was supposed to be impossible under Easterbrook and Fischel’s theories. NCFIRRE explained the “agency” problem that Easterbrook and Fischel missed.

[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good.

Theoclassical law and economics scholars continued to chant the second signaling dogma – though falsified throughout the S&L debacle and Enron era accounting control frauds – throughout the nonprime mortgage era. They asserted endlessly that modern executive compensation “aligns” the interests of the CEO with the shareholders’ interests. The reality was that it frequently magnified the long-standing misalignment of those interests. That is the key point of Akerlof & Romer’s classic article – the CEO profits by using accounting fraud to loot the bank that he controls. He arranges his executive compensation to be extremely large and based primarily on short-term reported accounting profits. Akerlof and Romer explain why accounting fraud is a “sure thing”— mathematically guaranteed to report extreme (albeit fictional) profit in the short-term. The combination of accounting control fraud (“blessed” by a top tier audit firm’s clean opinion) and deliberately misaligned (anti) “performance pay” is that the CEO is guaranteed to become wealthy – immediately. Moreover, by using seemingly normal executive compensation bonuses to become wealthy he coverts large amounts of firm assets to his personal benefit while minimizing the risk of prosecution. The result of a strategy that employs deliberate adverse selection in lending is typically a bankruptcy that wipes out the shareholders. No greater misalignment of the interests of the CEO and shareholders is possible than that caused by modern CEO compensation. Modern executive and professional compensation are often criminogenic, yet theoclassical economists strive even now to preserve the ability of CEOs to loot through perverse executive compensation.

The third “signaling” dogma, however, is never discussed today by theoclassical law and economics scholars. The Austrians generally ignore the endemic accounting control fraud (their heroes have always been business cowboys) in their explanation of why we suffer recurrent, intensifying financial crises. The Austrians love to blame the Federal Reserve and “easy money” for producing low interest rates. The Austrians claim this led to excessive leverage, and blame the global crisis on extreme leverage. It is inconvenient to this new meme to recall that the extreme law and economics scholars used to light candles to leverage and chant its praises as a unique signal of honesty. Accounting control frauds do optimize fictional accounting income by engaging in extreme leverage. The leverage is a tactic of the accounting control frauds that drive modern crises, not the cause of the crisis. Because accounting control fraud produces exceptional reported income it is easy for the frauds to borrow enormous amounts (lenders virtually break down the frauds’ doors in their eagerness to lend). The more money an accounting control fraud borrows, the greater the sums the CEO can loot.

Michael Milken was the original high priest of the extreme leverage dogma and the claim that it signaled honesty (Fischel was his acolyte). Milken was, of course, an expert at signaling honesty while practicing control fraud. His time in prison only increased his hate for U.S. government “interference” in “free markets.” The Milken Institute, therefore, now commissions articles about the ongoing crisis that emphasize (in huge fonts):

From Main Street to Wall Street, one common thread runs through all facets of this story: excessive leverage.

http://www.milkeninstitute.org/pdf/Riseandfallexcerpt.pdf (p. 9)

That’s right – the fraud whose entire junk bond business model at Drexel Burnham Lambert rested on the dogma that corporations had too much capital and needed to massively increase their leverage (e.g., through LBOs) is now running an institute whose scholars claim that (far lesser) leverage that modern U.S. banks employ is the primary cause of global catastrophe. Of course, there’s no mea culpa by Milken admitting that his earlier dogma was false.

The fact that, empirically, accounting control fraud is a severe problem is no barrier to theoclassical law and economics ignoring control fraud. I invite readers who have taken law and economics and corporate law classes to inform me whether their textbooks discussed Akerlof and Romer’s article: Looting: The Economic Underworld of Bankruptcy for Profit. Akerlof was awarded the economics version of the Nobel Prize in 2001 and Romer is also a brilliant economist. Neither Easterbrook nor Fischel is an economist. Akerlof and Romer’s article explains how the managers that control a firm use accounting fraud to create a “sure thing” of fictional profits. The managers get rich, the firm dies. Akerlof & Romer provide theory, data, and real world examples. The lawyers that seek jobs at the financial regulatory agencies are the lawyers most likely to have taken law and economics and corporate law courses in which Easterbrook & Fischel’s claims were treated as objective science. In my experience, it is vanishingly rare for them to even be aware of Akerlof & Romer’s work or the work of white-collar criminologists documenting and explaining accounting control fraud.

When regulators believe that control fraud is impossible – they make control fraud certain by eviscerating regulation and supervision. The most infamous recent example of this is Alan Greenspan (like Fischel, a former consultant to the most infamous S&L control fraud – Charles Keating’s Lincoln Savings). Greenspan refused to believe that fraud could occur in financial markets. He refused to take any effective regulatory steps against what the FBI had warned him (in 2004) was an “epidemic” of mortgage fraud even though they correctly predicted that it would cause a “crisis.” The Fed had unique regulatory authority under HOEPA to regulate all mortgage lenders.

Law and economics has, for over two decades, been dominated by theorclassical economic dogmas that have proved false. These dogmas are premised on an ideological hate for regulation – even by democratic governments. The Olin Foundation did not buy the souls of the economists and lawyers to whom it provided fellowships and endowed chairs. It simply selected true believers for its largess. It knew how desperately eager universities were to raise funds. There are now tens of thousands of law and economics graduates that have taken a class in theoclassical law and economics. They were taught that theoclassical economic assertions (often falsified decades ago) were objective facts devoid of ideological content. They have been taught that economics has proven that regulation is unnecessary, hopeless, and harmful. Some students accept this dogma as revealed truth, but many reject it. (If your goal as a professor is to indoctrinate students you should prepare for a life of disappointment.) Few economics, business school, or law students have been introduced to effective regulation or economic/finance theories that have proven to have predictive strength. It is the non-ideologues we need to reach and inform them about the reality-based alternative to the faith-based version of economics they were taught.

The New York Times reports on a welcome development: some banks are getting cold feet about lending to projects that are legal but still produce environmental damage:

After years of legal entanglements arising from environmental messes and increased scrutiny of banks that finance the dirtiest industries, several large commercial lenders are taking a stand on industry practices that they regard as risky to their reputations and bottom lines.

The article does note that in some cases, there may be less to this than meets the eye. Some banks may simply be using good citizenship as a cover for exiting businesses in which they are not competitive. Although the article emphasizes pressures applied by various environmental groups on a wide range of issues, this does not seem a sufficient proximate cause.

It seems instead that the banks in question are recognizing that the lines are shifting in this area and that concerns about global warming and resource scarcity mean the odds are high that taxes or more restrictive regulations may be imposed that could have a significantly detrimental impact on the profit of companies that engage in questionable practices (the Times story clearly mentions the financial considerations but does not present them as central). Thus while the Times presents the banks as reluctant cops, it might be more accurate to see them as leading indicators, since they have the most to lose if wrong footed by changes in government policies on environmental damage.

Thus the banks’ growing caution is a sign that more stringent environmental protection standards are indeed likely in the years to come

Andrew Ross Sorkin has a rather curious piece up today at the New York Times in that it purports to explain why the banking industry is up in arms about Obama, yet buries and/or omits some key issues.

It’s pretty well known that big financial firms have been throwing their weight around, no doubt encouraged by how successful that strategy has been throughout Obama’s tenure. So throwing another tantrum might be a shrewd strategy. Sorkin reports:

Daniel S. Loeb, the hedge fund manager, was one of Barack Obama’s biggest backers in the 2008 presidential campaign…

So it came as quite a surprise on Friday, when Mr. Loeb sent a letter to his investors that sounded as if he were preparing to join Glenn Beck in Washington over the weekend.

“As every student of American history knows, this country’s core founding principles included nonpunitive taxation, constitutionally guaranteed protections against persecution of the minority and an inexorable right of self-determination,” he wrote. “Washington has taken actions over the past months, like the Goldman suit that seem designed to fracture the populace by pulling capital and power from the hands of some and putting it in the hands of others.”

So why this type of volte face? As Sorkin tells us:

Mr. Obama was viewed as a member of the elite, an Ivy League graduate (Columbia, class of ’83, the same as Mr. Loeb), president of The Harvard Law Review — he was supposed to be just like them. President Obama was the “intelligent” choice, the same way they felt about themselves. They say that they knew he would seek higher taxes and tighter regulation; that was O.K. What they say they did not realize was that they were going to be painted as villains.

Yves here. Please. Are you going to seriously tell me big financial players are up in arms because Team Obama occasionally calls them bad names? That explanation is so obviously bogus as to call for a look for the real reason. There’s a much more straightforward explanation, and it’s called “follow the money.”

The key omission from this story is the name Rahm Emanuel. Rahm, a former partner at Wasserstein Perella, was particularly effective at fundraising from private equity funds and hedge funds.

So re-read this key phrase: ” They say that they knew he would seek higher taxes and tighter regulation; that was O.K.” But what the article buries in plain sight is the fact that the plans to tax hedge and PE funds carried interest at ordinary income tax rates, rather than a preferential capital gains tax rates, has the 2 and 20 crowd seeing red. And in case you had any doubts, there was no justification for this special treatment in the first place. Loren Steffy of the Houston Chronicle noted (hat tip Independent Accountant) provides a deft skewering:

Dear IRS: Please note that beginning this year, I am no longer earning an income. From now on, I am compensated through what I like to call column interest. It isn’t pay. It’s a capital gain that I receive in exchange for providing about 2,000 words a week to this newspaper. Please lower my tax rate accordingly. hey, you can’t blame me for trying. After all, a similar strategy has worked for years for money managers at hedge funds and private equity firms. … The private investment community is decrying the move as a massive tax increase, is if oblivious to the fact that it’s enjoyed an unfair tax break for years. … Let’s set aside the rather silly notion of private equity as an engine of job creation–most buyouts result in big job cuts–and focus on the inequality. Private equity managers typically collect a 2 percent annual fee on assets in the fund, which is taxed as income. They also scoop up 20 percent of their funds’ annual profits, which is known as carried interest. … Profit-sharing plans for just about everyone else are taxed as income. … Tax law is a murky world, but one basic principle of our tax code is that people who perform similar jobs for similar pay should receive similar tax treatment. That’s not the case in the investment world.

Sorkin does mention Steve Schwarzman’s infamous outburst (”likened the administration’s plan for taxes on private equity to ‘when Hitler invaded Poland in 1939.’”) but does not indicate the fact that this is the major reason for the falling out among Obama’s former backers. It’s one thing to raise taxes generally, the big boys can stomach that. But it’s quite another to raise taxes in a way that targets them. (And note, by the way, that this measure failed, but the industry was still deeply offended at this show of disloyalty).

Similarly, Sorkin later argues for the reasonableness of the revolting businessmen:

Mr. Loeb’s views, irrespective of their validity, point to a bigger problem for the economy: If business leaders have a such a distrust of government, they won’t invest in the country. And perception is becoming reality.

Just last week, Paul S. Otellini, chief executive of Intel, said at a dinner at the Aspen Forum of the Technology Policy Institute that “the next big thing will not be invented here. Jobs will not be created here.”

Yves here. This is patently ridiculous and disingenuous. First, Sorkin chooses to overlook that Otellini’s comments about inventions and jobs is based on his throwing in his weight with the venture capital industry, which was one of the groups that fought the proposed taxes on carried interest. The argument, implicitly is that the VC industry would shrink or disappear were there no carried interest tax break, and that we’d therefore see much less new business formation.

Both those ideas are questionable. Yes, the VC business as it is currently constituted might shrink, but a lot of angel investors do deals as principals or with small syndicates. One can as easily argue with so many people now possessing Wall Street experience, we’d likely see capital move through new channels to small ventures.

But more important, the idea that VC is critical to new business growth is complete urban legend. Amar Bhide, in the first systematic study of successful new ventures, determined that VC contributes very little to the funding of new businesses, even the most successful ones (his proxy was the Inc. 500).

Second, the line that Sorkin parrots from big businesses, “Be nice to us or we’ll quit investing,” is also bunk. Guess what? As we’ve indicated, big businesses were net disinvesting even during the corporate-friendly Bush Administration. And to the extent they are leery of investing now, far and away the biggest reason is macro uncertainty. It’s awfully hard to plan if you aren’t sure whether the outlook is for inflation or deflation. But businesses will cavil like crazy about government intervention because it is one of the few variables they might be able to influence.

And it’s also remarkable that Sorkin can treat the self-serving and misleading canard, “We’re mad that Obama is treating us like bad guys” seriously. For anyone at the TBTF firms, it’s patent rubbish. The firms got overt and back door bailouts so they could shore up their equity capital, and what do they do? Pay a big chunk of government-provided largesse out to themselves in record 2009 bonuses. It’s one of the most blatant acts of looting on record, and the industry deserves every bit of scorn the authorities can muster dumped on its head.

I’m a bit mystified, given the abject failure of various government-devised “save the mortgage borrower programs,” that the Neighborhood Assistance Corporation of America’s mortgage mod marathon’s aren’t getting more coverage, and that limited media attention may be contributing to falling turnouts at its events. It’s telling that a Google News search confirms that the best recent story on this US program comes in the UK’s Guardian:

… For five days, the Neighbourhood Assistance Corporation of America (Naca), a not-for-profit organisation, is working round the clock to help homeowners hang on to their houses. More than 12,000 people have signed up in advance and more than 20,000 are expected to turn up, travelling from as far afield as California, Georgia and Maryland….

Inside, hundreds of loan advisers sit behind trestle tables. They are colour-coded: Bank of America workers wear red, Citigroup are in blue and Wells Fargo are in black. Even the moribund government-supported refinancing giants Fannie Mae and Freddie Mac are here, but their budgets don’t run to natty coloured clothing.

Borrowers go through orientation and financial counselling sessions. Then, for the luckier applicants who can show a steady income, the loan advisers have the power to reduce interest rates or even write off a proportion of loans.

Yves here. What the Guardian does not state clearly enough is that NACA, working with borrowers, does the part that has been a stumbling block for servicers: it works through a borrower’s finances to determine viability on an individual basis. From NACA’s website:

NACA has developed the industry standard in utilizing technology for mortgage counseling, processing and underwriting. While other lenders employ software to underwrite loans using risk-based pricing that considers only the applicant’s credit score, debt ratios and loan-to-value, NACA utilizes customized, state-of-the-art technology which enables NACA to engage in character-based lending. NACA has developed a proprietary software system called NACA-Lynx™ that stores, manages, and manipulates the information and documentation necessary for NACA’s underwriting. This software allows for consideration of a Member’s overall circumstances and incorporates their own explanations of credit history in order to make a character judgment on their ability to make the mortgage payments. NACA-Lynx is a totally paperless mortgage counseling, processing and underwriting system. No other system exists that compares to the sophistication and comprehensive nature of the NACA-Lynx.

The NACA-Lynx is a web-based system. Thus, all of NACA’s offices are able to access the system via the NACA data center seven days a week, 24 hours a day with real-time updating. The data center is equipped with servers in a storage area network and utilizes off-site back-up and redundancies for all equipment. Each NACA staff person has a computer with a high speed processor, a multi-function scanner/printer/copier, and a large screen, high-resolution LCD monitor for easy viewing by both the staff person and the Member as the work is done in the NACA-Lynx.

A NACA staff person would scan the Member’s documents into the NACA-Lynx and return the original documents to the Member without NACA needing them or copies for its files. In addition, the Member can fax or e-mail their documents directly into NACA’s data storage using an individualized, dynamically generated NACA Cover Sheet bearing their unique ID number. Members fax their documents toll-free to NACA’s fax server at 1-877-FAX-NACA (1-877-329-6222). The Member’s ID is read by the fax server using optical character recognition software and then automatically routed into the Member’s pending file. A NACA staff person assigned to the file is notified of the incoming document via e-mail and transfers the document from pending status into the Member’s permanent file by reviewing the document and completing some basic data entry.

Florida, where an event is taking place ought to be ripe grounds for this sort of program, with the Mortgage Bankers Association reporting that one in nine homes in the state is at risk of foreclosure this summer. Yet participation at this event fell short of expectations despite being held in one of the mortgage crisis epicenters and being open to borrowers from all over the country. As the Palm Beach Post reports:

About 8,200 households had sought help from the Neighborhood Assistance Corp. of America through Monday afternoon, fewer than the non-profit group had expected.

NACA, which works with homeowners to get lower monthly mortgage payments through loan modifications, began 24-hour-a-day counseling sessions Friday morning at the Palm Beach County Convention Center.

The Boston-based company will be at the convention center until 8 p.m. today when it will end its second five-day visit to West Palm Beach.

About 24,000 people attended the first event in February, with 16,097 loans receiving a modification.

Yves here. As noted at the top of the post, this program seems to be very much underpublicized. I did find some reports in Florida papers, but virtually none outside the state. I’m wondering whether readers have any informed guesses as to whether the shortfall for the latest event was merely a one-off, a function of lack of press, or an indicator of borrower issues (inability to organize needed paperwork? proof that only a few are willing to expend effort to save a deeply underwater mortgage? general defeatism given all the deserved bad press about government mortgage mod programs?)

It’s often the travail of a blogger, and small media generally, to have its story picked up by bigger fry without acknowledgment. But it’s one thing when a writer suspects having made a contribution to another’s story (there is, after all, the possibility of parallel inquiries bearing fruit on different timetables); quite another to have firm grounds for knowing a journalist was aware of your work.

I’m of two minds in writing this post. ProPublica has gone to some lengths to publicize CDO abuses, which we have long considered to be central to the crisis, yet not to have gotten sufficient attention because, well, CDOs are hard. Complexity, opacity and leverage, branded as “innovation,” have served the financIal services industry well, often to the detriment of customers and taxpayers. Yet many accounts of the crisis, in classic drunk under the streetlight fashion, have tended to focus on phenomena that are comparatively easy to understand. So we and ProPublica are on the same side in this process, that of trying to unearth bad practices in the hopes of supporting other efforts to curb them.

But we are puzzled at how chary ProPublica is in giving credit to aligned efforts. This wouldn’t be so troublesome were they not making bold claims about their own work. Their latest release is on CDO managers, a topic which has come under increasing focus. Note the section we have highlighted from their latest piece:

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged.

“First time” is a strong claim. It can be read as referring narrowly to a the particular study commissioned by ProPublica. But the problem is that there are prior efforts, with real analytical underpinnings, that have covered this terrain.

Consider this section from a May 2007 paper by Joe Mason and Josh Rosner, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptionsm” an article we have pointed to repeatedly:

Without investors willing to purchase the last classes of securities – typically, about 10 percent of the securities sold – the prior classes bear the risk. If the prior classes are not willing to bear the risk, the other 90 percent of the mortgage pool cannot be funded, that is, the mortgage originator cannot sell the loans. Hence, the last classes of securities are providing about 10:1 leverage for the structure of RMBS, so that every dollar of lower-tranche RMBS supports about $10 of higher-tranche RMBS.

Specific types of CDOs have arisen that specialize in holding such risky classes of securities have become popular in recent years, providing a great deal of funding for lower-tranche RMBS at that 10:1 leverage ratio…. the 90 percent of the RMBS structure above the lower-tier (junior) tranches cannot be sold until those 10 percent lower-tier (junior) tranches are sold. Because the 90 percent of higher-tier (senior) securities in an RMBS cannot be sold without selling the 10 percent of lower-tier (junior) securities first, even a small decline in CDO funding of mezzanine RMBS investments relative to the total RMBS market can have a large effect on RMBS funding, and therefore consumer mortgage funding…

This early work admittedly does not provide a percentage estimate of RMBS sold to CDOs, but the flip side is that Mason and Rosner had found the dead body in the room, that CDOs were keeping the subprime market going and would be a crucial point of failure, BEFORE the CDO market had started to implode.

And in May of this year, Jody Shenn of Bloomberg came up more spadework on the role of CDO managers, focusing on three CDOs, Neo, 888, and Octonian underwritten by Merrill and managed by Harding, headed by Wing Chau. Harding was a de facto captive CDO manager of Merrill but was presented as independent. Note that ProPublica focuses on these same two deals in its account:

Neo CDO Ltd. was a complex construction. More than 40 percent of its holdings were slices of collateralized debt obligations sold by Merrill, according to Moody’s Investors Service and data compiled by Bloomberg. Many of those were CDOs made up of other CDOs backed by bonds linked to home loans. About one-sixth of Neo was invested in junk-rated debt….

Managers such as Chau were at the center of a financial machine that pumped out more than $200 billion of mortgage- linked CDOs in the months before the subprime crisis spread. They picked the securities that went into CDOs and held themselves out as independent agents. Now potential conflicts of interest and questions about what banks disclosed have drawn regulators’ attention….About two-thirds of his [Chau's] business came from Merrill, according to Bloomberg data.

Shenn’s article also discusses, with data, the troubling relationship between Merrill and Citigroup CDOs, in what appears to be mutual backscratching masked by complicit managers like Harding, another focus of the ProPublica story.

As we alluded at the outset, ProPublica cannot claim to be unaware of the work on CDO managers that Tom Adams has published on this blog. He had lunch with Jake Bernstein and Jesse Eisinger in April, the week after publishing a post entitled “The Myth of Insatiable Investor Demand.” The piece was in response to the testimony of Citigroup officials before the FCIC as they tried to excuse their failures by blaming continued investor demand for the CDOs. Despite the common perception in the mainstream media and the insistence of the Citi executives, third party investors were not demanding more CDOs. In reality much of the demand came from other CDOs the banks were creating and from the banks themselves. As a result, the meme of “investor demand” was an illusion, the same one noticed by Mason and Rosner in 2007, and the banks and CDO managers were clearly to blame for failing to police for deflating market well before it ultimately collapsed.

Not surprisingly, the lunch conversation included considerable discussion of the dubious role of CDO managers.

While we are pleased to see the depth of reporting that Pro Publica has dedicated to issues that we have long felt were poorly understood by regulators, law makers and the investing public, we are troubled by not simply a lack of attribution, but an effort to deny (the “first time” claim) the substantial efforts others have made on this topic. We’ve also found evidence of other patterns of collusion and market manipulation not covered in ProPublica’s piece. This matters because those reading ProPublic’s assertion of the definitiveness of its work might be dissuaded from looking for other reports on this topic.

We are hopeful that even though Goldman has settled with the SEC on the Abacus transaction, the ProPublica article, which is detailed and written to engage lay readers, will bring renewed interest among the mainstream media, regulators, lawmakers and even private litigants on the problematic practices of the banks and CDO managers. These are issues near and dear to our hearts. As we wrote,

[R]iskier and riskier loans were being originated at effectively lower costs for issuers with little outside feedback. In one big happy family among the mortgage issuers, CDO managers and CDO investors, there would have been little motivation to worry about increasing risk or wider spreads. They were all keen to keep the great fee machine rolling.

We remain puzzled as to why ProPublica seems loath to acknowledge aligned efforts, particularly when we are working towards the same objective. We commented on it regarding ProPublica’s Magnetar story, where they were presumably in the awkward position of having invested substantial effort in a story, then to have an independent party beat them to the punch by six weeks, and unearth critical details (the structure of the deals and most important, their systemic impact) which were absent from their investigation. We we far from the only parties to notice a repeat; we received sympathetic e-mails from journalists and readers, the funniest being from John C. Halasz, “You’ve been, er, retro-scooped once again.”

Giving credit to people who have made a contribution to your efforts is the norm in academia and blogging. Why are journalists, particularly ones with established reputations, so reluctant to do the same?

A few days ago, we noted:

When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.

Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint)…..

So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.

Tyler Cowen points to a Bank of Japan paper by Hiroshi Ugai, which looks at Japan’s experience with quantitative easing from 2001 to 2006. Key findings:

….these macroeconomic analyses verify that because of the QEP, the premiums on market funds raised by financial institutions carrying substantial non-performing loans (NPLs) shrank to the extent that they no longer reflected credit rating differentials. This observation implies that the QEP was effective in maintaining financial system stability and an accommodative monetary environment by removing financial institutions’ funding uncertainties, and by averting further deterioration of economic and price developments resulting from corporations’ uncertainty about future funding.

Granted the positive above effects of preventing further deterioration of the economy reviewed above, many of the macroeconomic analyses conclude that the QEP’s effects in raising aggregate demand and prices were limited. In particular, when verified empirically taking into account the fact that the monetary policy regime changed under the zero bound constraint of interest rates, the effects from increasing the monetary base were not detected or smaller, if anything, than during periods when there was no zero bound constraint.

Yves here This is an important conclusion, and is consistent with the warnings the Japanese gave to the US during the financial crisis, which were uncharacteristically blunt. Conventional wisdom here is that Japan’s fiscal and monetary stimulus during the bust was too slow in coming and not sufficiently large. The Japanese instead believe, strongly, that their policy mistake was not cleaning up the banks. As we’ve noted, that’s also consistent with an IMF study of 124 banking crises:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.

But (to put it charitably) the Fed sees the world through a bank-centric lens, so surely what is good for its charges must be good for the rest of us, right? So if the economy continues to weaken, the odds that the Fed will resort to it as a remedy will rise, despite the evidence that it at best treats symptoms rather than the underlying pathology.

There’s been an interesting dialogue between Streetwise Professor and Deus ex Macchiato on the matter of the practical impact of the pending Basel III rules, which will rejigger, in a pretty significant way, bank capital requirements (see here and here for details). The reason Basel III matters is that the Treasury has been touting it as the remedy for all the things that didn’t get done in the financial reform hoopla: if the banks are forced to have “enough” capital (query what “enough”) is, and better liquidity buffers, the likelihood of a financial crisis will be lower.

As an motherhood and apple pie statement, it’s hard to argue with that sort of thing, but making it operational is quite another matter. And here’s where the chat between Streetwise and Deus comes in. Per Streetwise Professor:

Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls. If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks. The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks. That’s why I am very leery of global capital regimes, a la Basel. If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global…

This is a story about relative prices. In a risk based capital regime, some risks are mispriced relative to others. Banks load up on those mispriced risks. Since all face the same distorted pricing signal, they tend to trade the same way. They held more capital than they were required to, but that provided a false sense of security because the required levels of capital did not accurately reflect the risks.

There is, in fact, dysfunction in the financial system. That dysfunction, in the first instance, is the result of the deadly combination of implicit and explicit guarantees that stoke moral hazard, and woefully inadequate and scarily expansive capital requirements that are intended to make it difficult for banks to exploit that moral hazard, but fail to do so.

Let’s examine this a bit further. It’s important to recognize that the mispricing of risk under Basel II was a significant contributor to the global financial crisis. Eurobanks, which were subject to Basel II rules as of 2006, entered the crisis with lower capital levels than their US counterparts. Moreover, many engaged in a particular form of capital arbitrage that played a direct role in stoking the credit bubble, which was holding the AAA rated tranches of CDOs and insuring them (usually in part) to further reduce the amount of capital they had to hold. So the concern is valid.

Even with the likely (in Streetwise’s view, inevitable) mispricing of risk, the impact might not be as significant as he contends if the capital levels for the underpriced risk was still high enough. In other words, I’m not certain I buy the strong form of the “crowded trades” argument, a risk based capital regimes is inherently flawed. And Streetwise effectively concedes that point:

The capital required against certain instruments (government debt being another example) was too small relative to the true risks of those instruments. So too many banks loaded up on them.

But from a practical standpoint, his concerns are valid. The unrecognized crowded trade problem only make matters worse. Even if the authorities were to come up with a sound program, the crowding in the strategies that were cheap on a relative basis would make them riskier, and hence the render the required capital levels insufficient.

Let’s face it, the notion that we are going to have adequate private sector equity in the banking system anytime soon, if ever, is a fantasy. The way that Fannie and Freddie have stepped in to become become virtually the only mortgage issuer/securitizer, with the obvious aim of propping up the housing market and bank balance sheets, is a highly visible example of the extent of back door support to undercapitalized banks. Team Obama is of course trying to divert public attention from the continuing high level of support and regulatory forbearance via its continued iMission Accomplished “Paid back the TARP” three card monte.

Richard Smith did a bit of quick and dirty math to determine what it would take to adequately capitalize the shadow banking system:

Let’s just ignore the liquidity issue for the moment, and ignore the variety of business models of the various kinds of shadow bank, and require the shadow banks to put up a not very demanding 5% capital cushion and regulate to that, somehow. Assume, for simplicity, that we want to keep all that lovely shadow banking activity going and that shadow banks’ assets are identical in size to their liabilities; that 5% capital cushion would then be 5% of $8-16Trn. That’s between $400Bn and $800Bn of capital to raise.

Or, perhaps more likely, our shadow banks take 50% losses on 15% of their loans that they never never want to do again (the CDO bonanza, etc), and then need 5% equity on the rest. That way our shadow banks would need $925-$1,850 billion in equity. Which is impressive, but fair enough: the traditional banking system has about $1.3Trn of equity, and we know the shadow banking system is the same size, or somewhat bigger, and more prone to runs. Why, pray, should it not at least be capitalized to the same level, either by new capital, or by shrinkage?

Yves here. It is politically unacceptable to make banks raise that much capital. Not only would the firms howl blood murder, but policymakers are unwilling to take the economic hit of a quick or even attenuated return to sounder practices. So we have state subsidies of various sorts like ZIRP standing in.

That further means we have a continuing moral hazard problem. Basel III can’t solve the problem because despite the officialdom’s fantasies to the contrary, they simply won’t get enough equity into the system. That might not be as terrible as it sound if the authorities were willing to admit that and were using other approaches to monitor and reduce risk, in particular, much more aggressive regulation, and far more intervention on pay practices.

In the stone ages of investment banking, when firms were partnerships, it would have been unheard of to take on a lot of moderately long-dated, risky, illiquid, bespoke, hard to value assets and fund them in short term where they’d be exposed to rollover risks. Similarly, in those days, the major players all held a lot more in capital than was required by regulators (reg cap was regarded as overly permissive but constraining in certain circumstances, so it still needed to be managed). Investment banks were cautious not only because the partners had unlimited liability (they could lose everything) but also because they most if not all of their wealth tied up in the firm and could access it only gradually after departing, as younger partners bought them out over time. That forced them to maintain modest lifestyles relative to their net worth and to be concerned about the long term viability of the franchise.

We have a massive agency problem in the financial services industry. The crisis was a textbook case of looting. The major firms are now more powerful by virtue of being bigger and fewer, and official denials to the contrary, are in a better position to loot than before. The belief that higher capital requirements can be the mainstay of solving this problem is wishful thinking.

This post first appeared on November 16, 2007

A colleague was so kind as to send me the text of a speech given at the Graham & Dodd breakfast a few weeks ago by David Einhorn, CEO of hedge fund Greenlight Capital.

The speech has gotten play only in some personal-investment-oriented blogs like Seeking Alpha and Naked Shorts. Even though they are fine sites, it’s nevertheless a shame the speech hasn’t gotten broader interest. First is that most of the commentary focused on the general thrust of his argument but failed to pass on key bits of information that are likely to be news to most readers. The second it that there is still a considerable gap between what market participants know compared to legislators, regulators, economists and commentators. Yet somehow the industry types get a serious hearing when they reach an audience (i.e., when they are lobbying), but when people with insight but no axe to grind have something to add to the debate, too often it gets short shrift.

It was sobering for me to learn a few things from the speech. On the one hand, as someone who is not in the marketplace (and lacks access to a Bloomberg terminal), I am in the same position as a journalist: I am only as good as my sources. But on the other, some of the things that I picked up seemed fundamental, yet I haven’t seen them either in the press or the academic articles I’ve read.

Einhorn tells us that the securitization process is flawed (”securitization is a mediocre idea” is the nicest thing he had to say about it) and that the rating agency role is in need of root and branch reform. The entire speech is very much worth reading, and his comments are pointed and insightful. However, he does not fully draw out the implications of what he found.

The rating agencies’ role was even more deeply compromised that most commentators recognize. Their practices made it cheaper to issue the very sort of paper that is was most profitable for them to rate. They did it by letting the creators and sellers of structured credit products play on the popular perception and regulatory fiction that all AAAs are created equal, when in fact, the more complicated the paper was (and therefore more costly to rate) the more risk it was allowed to carry in each rating class.

Some key observations:

The credit problems we have are experiencing are not the result of subprime contagion, but of charging too little for risk-bearing. There was concern in some quarters about systemically low credit spreads, yet participants were confident liquidity would always the abundant. Einhorn believes that the complacency about risk was at least partly due to the securitization process, in which most investors looked heavily to the ratings in their evaluation process.

But just as some animals are more equal than others, so to are ratings:

Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%, while a corporate bond’s default rate is 1.8%, and a CDO’s is 2.7%. An A rated muni has the same change of default as and AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates and CDOs.

This isn’t an accident. About a decade ago, Moody;s said, “No matter what types of instruments the ratings apply to, no mater where the issuer resides, and no matter what the currency or market in which the security is issued, Moody’s ratings are intended to have the same relative meaning in terms of expected credit loss.”

Without much fanfare, the rating agencies abandoned this process…..Instead, for each type of bond, they use a different rating scale with a different so-called “idealized default rates” for each rating. The idealized default rate for a municipal bond at a given rating is less than the idealized default rate for a corporate bond, which is less than the idealized default rate for an asset backed security which is less than the idealized default rate for a CDO….

Nomura Securities pointed out that hypothetically, if you took an AA+ rated asset backed security and repackaged it all by itself and called the repackaged instrument a CDO, it becomes AAA because the CDO has a higher idealized default rate than the asset backed security.

Einhorn points out that the rating agencies’ fees are correlated with their willingness to look the other way with credit losses. CDOs carry the highest fees, ABS next, and regular corporate ratings are cheaper still. But of course, the agencies will argue that the more complex structures are more labor intensive to rate and therefore warrant higher charges.

Regardless, this system, of higher idealized default rates for securitizations has the effect of promoting securitizations. And the higher idealized default rates promoted CDOs.

For a financial institution, the very fact that the loans with the same loss profile will get a higher rating in an ABS than if they sit on their balance sheet means that it is uneconomic for them to keep them on their balance sheet (note that this is independent of the traditional impetus for securitization, namely, the cost of deposit insurance). The rating agencies have stacked the deck via their rating process to make it even cheaper to securitize assets than it would be if investors knew the true exposure to loss.

Now mind you, we are NOT saying that securitization would not have happened without the rating agencies gaming the scorecard. Back in the early 1980s, when AAA still meant AAA, McKinsey was showing its banking clients charts illustrating how securtization had a significant cost advantage relative to traditional lending (message: investment banks are and will continue to eat your lunch). But the rating agencies’ actions played a significant role in the underpricing of risk, and almost certainly made the ABS and CDO markets larger than they would have been with proper risk measurement and disclosure.

A number of observers have criticized investors for being so dependent of rating agencies. Aside from regulatory requirements that mean many investors need to consider rating in their evaluation process, Einhorn gives us another reason: at least as far as structured credits were concerned, the rating agencies had far better information about the deal than end investors:

Have the rating agencies developed an expertise in analyzing these structures? Perhaps, but more pertinent, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. The underwriters give the rating agencies much more information that is contained in the prospectus. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This means that they can receive confidential information not available to other market participants. This is kind of like a confessional where the priest delivers a public opinion on the extent of your virtues or sins – and your spouse has to guess what a AAA or BBB means about your fidelity.

In the recent crisis, the rating agencies say they shouldn’t be held accountable for their opinions because they are…..nothing more than journalists engaged in free speech. What would it be called if you paid a leading publication to do a story on you and you could putt it before press if it were unflattering? Funny, that is not free speech but “for-profit speech.” According to the rating agency party line, if people disagree, they are free to ignore the ratings. However, a credit rating is not an ordinary opinion. It is a “special” opinion – an insider opinion, because it is based on a different information set. I can’t replicate a rating analysis because I am not privy to the information. Therefore, I am not on an equal footing to be able to decide whether I agree or disagree with a rating agency. Since they know more than I do, the presumption has to be to agree. The rating agencies are structurally set up to have “insider opinions.” They just don’t want legal liability for having issued conflicted and flawed insider opinions.

Incidentally, this lack of information has made it harder for the market to find a clearing price of distressed pieces of structured deals. Without enough information in the market – other than a credit rating – it is hard for informed buyers and sellers to know what to do, once the credit rating comes into doubt.

There is not justification in the credit markets for having the rating agencies have access to deal structure information that is kept secret from investors. The only party that appears to benefit is the investment banks, who might have some structuring tricks they’d like to keep secret from their competitors. By contrast, there is an argument for rating agencies and analysts having access to corporate information of a strategic nature that they would be loath to reveal publicly. But equity analysts lost their Reg FD exemption and the world did not fall apart. There is far less justification for a Reg FD exemption of any kind in the debt business. Einhorn argues that the information that rating agencies possess should be made public.

A final tidbit from Einhorn:

In early September, a senior Moody’s executive….at a small private dinner….said, “Moody’s would never lower the credit ratings of a financial guarantor, because that would put the guarantors out of business.”

The Jackson Hole conference starting today is expected to include a talk by Ben Bernanke on the benefits and costs of further monetary easing, which in ZIRP-land means quantitative easing. Gavyn Davies put up a good short list of arguments made against QE at the Financial Times, and most do not look terribly persuasive. One which I found interesting was:

“QE will weaken the Fed’s balance sheet, and undermine confidence in the institution.” This was a very powerful argument in Japan in the 1990s, which reduced the amount of quantitative easing which the BoJ was willing to undertake. If the Fed simply buys Treasuries, it is hard to see how this weakens the balance sheet, unless you believe that the US government could default on its debt. However, if the Fed were to buy private sector assets, like securitised debt and/or equities, then it could subsequently have to take mark-downs on these assets, and many people would see this as a problem. But the Fed probably should not be treated like a private bank, which would suffer a loss of solvency if it suffers a mark-down on its assets. The Fed does not have to mark-to-market like a private bank. And, anyway, does it ultimately matter if the Fed has a negative net worth? The answer would be yes if it undermines the public’s faith in the institution, causing people to reduce their holdings of dollars, in exchange for goods, or foreign currencies. But this is just another way of saying that there is an inflation constraint on the Fed’s ability to increase QE, which everyone would accept. So the balance sheet argument only holds as a special case of the inflation argument.

I think Davies is missing a part of the dynamic here. The intensity of the battle over Bernanke’s reappointment and the partial victory for the Audit the Fed movement are tangible signs that the Fed’s aggressive action during the crisis has led to a hard pushback from Congress. Part of it may be deserved loss of faith in an organization that utterly failed to see the crisis coming and refused to exercise any control over banks; another may be that Congress recognizes full well that the Fed was acting as an extralegal, off-balance-sheet funding vehicle for the Treasury, meaning a route for circumventing normal budgetary processes. So if the Fed were to balloon its balance sheet to, say, $5 trillion, my sense is that there would be enough concern about the scale of Fed operations, particularly if the problem is a lingering economic malaise rather than a crisis, to produce concern in some quarters and lead to Congressional prodding (recall, by contrast, that the 2009 QE was implemented when banks still were on the ropes). So the fear of political action may also be playing into how the Fed views this issue.

The problem (which many economists and analysts will readily acknowledge) is that QE is being used as a stand in for fiscal policy, and it is a not so hot second best in an economy where firepower was already deployed to spare banks pain and prop up asset values. And in the US, stimulus was not well targeted, in addition to being half-hearted.

George Magnus of UBS, in Thursday’s Financial Times, made a lesser of two evils argument in favor of QE:

Better, if necessary, to print money and be damned, rather than tighten policy and be damned. Under the former, there is always redemption by withdrawing the stimulus if circumstances warrant. Under the latter, there is only chaos.

While I am not unsympathetic toward the case for QE, I think Davis made the most potent argument at the top of his post:

“Quantitative easing was tried in 2008/09, and it did not work.” True, the Fed expanded the size of its balance sheet by about $1.5 trillion dollars in a matter of a few weeks in 2008, so QE was certainly tried. We do not know what would have happened if this had not been done, but there seems a strong chance that the banking collapse would have been worse, and the economic recession much deeper, without QE. In that sense, the policy ”worked”, but the cure does not seem to have been permanent. It is hard to isolate the real reason for this. It may be because QE is an ineffective policy tool, or it may be because not enough of it has yet been done. Take your pick.

This is narrowly true, but misses the point. When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.

Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint).

And even more important, to the extent money costs matter, the relationship between price and activity is asymetrical. Too costly funding can kill a project. But cheap money (except for scamsters) is not going to make a businessman wake up and say, “Gee, my borrowing rate has fallen 2% in the last six months. I really should go out an open an new store.” He’ll do that ONLY if money being 2% higher was a binding constraint. The prospects for his business are always a first order consideration, the cost of money second order.

So the state of demand in his market is a major consideration, and for most businesses, that’s a function of the health of the overall economy. Most businesses see lousy conditions and surveys of small businesses (which employ over half the people in the US) show them expecting their businesses to face even more difficult conditions in a year. Various bank surveys similarly show weak demand for business loans.

So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.

Einstein defined insanity as doing the same thing over and over again and expecting different results. And to me, the most compelling reason to be against QE is that policymakers will nevertheless hope it might be effective if used again. They will therefore refrain from trying more politically difficult, but more promising course, namely, restructuring debts and using government spending to cushion the impact, with a keen focus on measures that will restore competitiveness and reduce our trade deficit.

The very minute the Paul Volcker, who proposed the sound idea that government backstopped banks not engage in proprietary trading, said that trades done on behalf of customers were meant to be excluded from this proposal, anyone familiar with trading could see he’d just deep sixed his idea.

Proprietary trading existed LONG before banks decided to create separate “prop” desks to speculate with house money. And even in the era of prop desks, in the vast majority of cases when a prop trader puts on or exits a trade, who is the end buyer? A customer.

So the measure of whether a bank is making bets in its customer dealing book isn’t the composition of its counterparties, it’s how much in the way of bets it winds up carrying (traders, just like rug merchants, can shade the prices they buy and sell at to keep from accumulating too much inventory). It would have ben possible for regulators to devise rules, such as value at risk limits, requirements that dealers hedge or otherwise “flatten” their positions beyond a certain size level within a specified time period. Even with provisions like that in place, some desks will be exposed when markets turn chaotic, but it should be far fewer, with much less loss exposure.

Instead, as the New York Times recounts, life in big bank land continues more or less as it did before, including large losses when traders make bad bets:

But for all the talk of shutting down trading desks and reassigning employees to prepare for the Volcker Rule, proprietary-style trading will probably survive, if under a different name.

This year, for example, several large insurance companies approached Goldman Sachs, looking to bet that the markets would not stay quiet. Goldman gladly took the other side of the trades, but when the markets turned choppy in May, the firm was caught short and quickly lost $250 million.

Goldman, through a spokesman, declined to comment on its losses on that investment. But in a conference call with analysts last month, the bank’s chief financial officer, David Viniar, explained: “We didn’t hedge it fast enough. Things spiked really dramatically, really fast.”

Months before that trade, though, Goldman Sachs’s research department named a bet against volatility as one its top 10 trading strategies for 2010. Goldman followed its own advice and put its own money in play by failing to adequately hedge the trade with the client who wanted to bet on volatility, which would have given Goldman a neutral position. In this way, a client-oriented trade can effectively become a proprietary bet…..

“Goldman tends to have businesses that have a customer focus with a proprietary overlay,” said one hedge fund manager and Goldman alumnus who insisted on anonymity. “That overlay can effectively allow them to make directional bets by using the customer flow to get them there.”

But Goldman is hardly unique when it comes to walking the fine line between serving clients and taking positions.

Late last year, with clients eager to bet that coal prices would rise, JPMorgan took the other side of the trade and amassed contracts on hundreds of millions of dollars on coal — enough to dominate the European market.

Initially the trade went JPMorgan’s way and yielded profits, but in April the Morgan traders were caught off guard when European coal futures abruptly started rising. In fact, the wrong-sided bets erased all of the previous gains, and by the middle of June, it had turned into one of the commodities unit’s biggest losses — nearly $130 million.

Frankly, now that financial markets reform has moved from the Congressional shadowboxing stage to the arm-wrestling in smoke-filled room sort-out-the-details-that-matter stage, the retreat from public scrutiny has, of course, served as a cover for further watering down of measures that were not very strong to begin with.

Yesterday we noted that major companies were outraged at the notion that major institutional shareholders might be able to propose board candidates. The argument in effect was that the odds were high that shareholders, a group that clearly can’t be trusted to make sound financial decisions, would immediately vote in a hedge fund or union stooge who would destroy the enterprise. The SEC was nevertheless expected to pass the measure on a party line vote.

Well, we learn today that they did, with a wee wrinkle. They chose the weakest variant of the measure being contemplated. As the Financial Times noted on Tuesday:

The proposal allowing investors to put their own nominees for board seats alongside the company’s nominees is expected to be approved by the Securities and Exchange Commission…

The new power is expected to be restricted to investors with a 3 per cent or greater stake in the company who have held the shares for at least two or three years, people close to the situation said. The SEC commissioners have the power to exempt smaller companies from the rule, should they wish to do so.

Despite this setting a new precedent, the 3% hurdle is a daunting level, since as I read the SEC’s announcement, this is the level required for a single shareholder. And the SEC further decided upon the longer holding period of three years.

Pray tell, how many companies even have shareholders that meet these criteria? The Business Roundtable must be quietly chuckling over this win.

Update 5:00 PM: Jim Ledbetter provides an answer to the question above. Superficially, the number of 3% shareholders looks larger than I thought, but there is also reason to believe the overall stats mean less than one might imagine. From his post:

As part of its deliberation over this rule, the SEC produced a study that combed through the filings of 6,416 companies in late 2008. According to the study, 33 percent of companies have one or more shareholders who meet the 3 percent, three-year thresholds; 10 percent have two or more shareholders; 4 percent have three or more; 1 percent have four or more; and no one has five or more. That alone implies that the rule would cover more than 2,000 companies.

Yves here. That means based on a narrow reading of the rule, less than 1/3 of the companies fall into the category of having a shareholder that can nominate a board member. And perhaps most important, the rule allows a 3% group to nominate only one board member per proxy, not a slate, so the impact is limited (this was a key point I neglected to mention).

The open question is how many of these 3% are independent. You have quite a few public companies where the founders/early owners still hold large stakes (think Microsoft and Oracle as positive examples, HealthSouth as a big negative). You also have cases where individuals and families wind up with large stakes by having sold a business to a large company and getting shares rather than cash as consideration (shares are not taxed until sold). In general, individuals and family offices are far more likely to be long term shareholders; institutional investors generally trade more often, since they are more short term return driven, while individuals often care more about after-tax returns.

A good bit of news, however, Ledbetter dug into the SEC rules (I was not able to find it quickly on the site last night, my bad, and the SEC’s several page summary was ambiguous on this point) and his reading that shareholders can cooperate to get to 3% (but then why the study on individual shareholders?)

I think we all know the answer to the question in the headline, courtesy F. Scott Fitzgerald, “The rich are different than you and me.” And the fact that they have more money means their defaults are couched as pure business decisions. But mere homeowners, told to view their house as an investment, are now castigated if they act as any professional would and cut their losses.

The Wall Street Journal article on, ahem, voluntary commercial real estate defaults points out that some of the very biggest names are in the walk-away camp and through the article points out the similarities in decision process between commercial real estate strategic defaulters and their retail kin:

Like homeowners walking away from mortgaged houses that plummeted in value, some of the largest commercial-property owners are defaulting on debts and surrendering buildings worth less than their loans.

Companies such as Macerich Co., Vornado Realty Trust and Simon Property Group Inc. have recently stopped making mortgage payments to put pressure on lenders to restructure debts. In many cases they have walked away, sending keys to properties whose values had fallen far below the mortgage amounts, a process known as “jingle mail.” These companies all have piles of cash to make the payments. They are simply opting to default because they believe it makes good business sense.

Yves here. Note another difference with having more money. The bank might actually negotiate with you. Back to the article:

These pragmatic decisions by companies to walk away from commercial mortgages come as a debate rages in the residential-real-estate world about “strategic defaults,” when homeowners stop making loan payments even though they can afford them. Instead, they decide to default because the house is “underwater,” meaning its value has fallen to a level less than its debt.

Banking-industry officials and others have argued that homeowners have a moral obligation to pay their debts even when it seems to make good business sense to default. Individuals who walk away from their homes also face blemishes to their credit ratings and, in some states, creditors can sue them for the losses they suffer.

But in the business world, there is less of a stigma even though lenders, including individual investors, get stuck holding a depressed property in a down market. Indeed, investors are rewarding public companies for ditching profit-draining investments. Deutsche Bank AG’s RREEF, which manages $56 billion in real-estate investments, now favors companies that jettison cash-draining properties with nonrecourse debt, loans that don’t allow banks to hold landlords personally responsible if they default. The theory is that those companies fare better by diverting money to shareholders or more lucrative projects.

Yves here. And similarly, it might be better for consumers to get a millstone of a house off their neck and get on with trying to rebuild their finances…..

Boy, when you think you’ve seen the worst in utterly shameless, self serving tripe, someone manages to outdo it. Admittedly, it’s awfully hard to beat Steve Schwarzmann’s recent one-two punch of utter canard wrapped in tasteless hyperbole, that of Obama proposals that private equity kingpins pay taxes on what is really the fruits of their labor like other working stiffs was a ” a “war… like when Hitler invaded Poland in 1939.”

But no, Pimco’s Bill Gross bests Schwarzmann in making it clear to the great unwashed his unabashed belief that what is good for him is good, period. Schwarzmann is a tad less horrid by at least limiting his grandiose claims to his own industry. Gross is marginally less offensive to good taste (although a discussion of his body odor in an investment piece is certainly a novel wrinkle), but makes it up by insulting his audience’s intelligence, namely, by presenting himself as a staunch ally of the little guy.

In case any of missed it, one of the major screwups of the crisis just past was the failure to make shareholders and bondholders of dud financial firms (or ought to be dud, the power that be have gone to great lengths to present the fiction that many insolvent players were merely having a wee liquidity crisis) take losses. These investors signed up to be risk capital, and even if bailouts might have been inevitable, they would have been much smaller and more palatable if the people who had failed to do their job in monitoring their holdings suffered too. And who was the chief lobbyist for the “you better not make bondholders take any pain” camp? None other than Bill Gross.

So get a load of this drivel in his current newsletter:

I’ve had a lot of high perspiration “Right Guard” moments in my life, although I futilely try to live by Gillette’s 1984 advertisement of “never let ‘em see you sweat.” External composure during times when others around you are losing theirs is a quality that leaders are presumed to require, so I walk like a man and talk like a man, while all the while a little boy inside me is screaming, “Run!” The only time I ever remember totally losing it, though, was when I reached the head of a reception line for Bill and Melinda Gates, nearly 10 years ago. “Nice to meet you, Mike,” I said, and my armpits needed a full can and then some for the rest of the evening.

Yves here. So get this, Bill really is a normal guy, he gets nervous when meeting a bigger dog! But of course the only bigger dog than Bill Gross is Bill Gates. The extended commentary on his bodily responses to a verbal gaffe is a further weird effort at Average Joeness. Back to the piece:

Last week was an equally challenging situation as I ventured back to the Treasury in Washington D.C. which, considering how often we’re painted as powerful Washington players, was my very first official visit of any kind in over 35 years at PIMCO.

Yves here. If you are powerful, you don’t need to go to Treasury yourself to make your position known. Phone calls and emissaries will suffice. Back again to the letter:

Yves here. Bill Gross as Man of the People? Utterly ignorant the ways of the the Beltway? Assuming his “Que” story bears any resemblance to reality, he was toying with them to see how they’d react to faux cluelessness, a way to test other people in the room’s reaction to an off the wall comment. And presented differently for mass consumption.

Now keep in mind that, prior to the publication of this letter, various reports on the Fannie/Freddie meetings in which Gross deigned to participate made it clear that he was in the extortion game. As we noted earlier:

Get a load of this…Bill Gross is making threats:

Mr. Gross said Pimco would not invest in bundles of mortgages that lacked government insurance unless the borrowers had made down payments of 30 percent or more.

This isn’t even credible. If other fixed income managers were to invest in Fannie/Freddie insured deals (presumably based on an assessment of risk v. yield), Pimco would follow. For competitive reasons, they couldn’t sit on the sidelines and pout.

So Gross needs to cover his tracks and tell us why what is good for him is really good for us. No, really. He tells us based on twelve months of post crisis shell shock, and refusal to let housing prices correct to long historical level of reasonable valuations relative to incomes and rental yields, that since the government has been intervening to prop up housing, and therefore bonds, and therefore Bill, that is the new natural state of affairs and therefore must continue:

Ninety-five percent of existing mortgage creation over the past 12 months were government guaranteed. The private market was nowhere to be found because they charged too much. It was the cost of private origination and securitization, perhaps more than any other factor, that justified government involvement. Prime, but non-conforming, mortgages (jumbos, insufficient down payments) were being purchased by PIMCO in the hundreds of millions of dollars every week, but at yields of 6, 7, and 8%. If that was the risk/reward tradeoff, compared to FNMA and FHLMC yields at 3.5–4%, how could policymakers pretend that the housing baton could be quickly and cost-effectively passed back to the private market? Few, if any, could afford a new home at those interest rates. If you were a believer in the dominance and superiority of private markets, how could you deny the signal that markets were sending – that the risk was too high given the substantial losses of recent years?

We’ve been writing about the buyers’ strike in private mortgage paper for some time, and guess what? We haven’t seen any evidence to support Gross’s theory. We had a private securitization market that comported itself pretty well for nearly 20 year before the derivatives types started colonizing it. Yes, we would have had a housing bust and investor losses, but it was the leverage of credit default swaps and heavily synthetic CDOs that turned what actually would have been a contained subprime problem into a global financial crisis. Private investors want to see lower housing prices (meaning some value in the house if it defaults), better investor protection, more prudent underwriting, and home buyers with reasonable down payments. The big reason we have no private securitization market is not Gross’s cost story, it’s the direct result of bad policy choices: trying to keep housing prices at artificial levels, and failing to take any meaningful steps on securitization reform.

Gross gives us phony scare talk:

As the Treasury contemplates the “transition” from Agency conservatorship to either public or private hands, how could private market advocates reasonably assume that pension, insurance, bank, and PIMCO-type monies would willingly add nearly $5 trillion of non-guaranteed, in many cases junk-rated mortgages to their portfolio? They would not.

Yves here. As strange as it may seem, even with subprime losses as bad as they are, a lot of AAA rated bonds are paying out just fine (their lower rated tranches, of course, are a completely different story, and a fair number of former AAA pools are in bad shape). And no private investors are going to tolerate a re-run of 2004-2007. People are pretty good at not repeating recent, hugely painful, errors. So his claim, “in many cases junk” is unfounded in our new reality.

And this part is actually funny:

And why do I and PIMCO support this view? Is it some self-interested, money-making plot to allow us to dominate the bond market? Hardly. Any investor would recognize that it’s better to have a 6 or 7% yield instead of 3–4%, so it would be better for PIMCO to let the Administration flood the private market with non-guaranteed, private mortgage product and let us vultures feast on the pickins.

Yeah, right. Tell me what would all the bonds Pimco NOW owns look like if they were priced to yield 6-7%? The result would be massive losses. This is Bill talking his book, pure and simple, and trying to pretend his economic interests lie elsewhere. But that’s his posture all the time, it simply happens to be shockingly obvious in this missive.

I normally relegate stories that focus on personal finance to Links, but this article by Naomi Wolf, “Banks Siding Against the Customer in Fraud Cases,” (hat tip reader Francois T) is such an appalling illustration of how predatory the banking industry has become that I felt it was worth highlighting to readers.

When a customer is a depositor, its bank is a fiduciary under the law. Per Wikipedia:

A fiduciary duty[2] is the highest standard of care at either equity or law. A fiduciary (abbreviation fid) is expected to be extremely loyal to the person to whom he owes the duty (the “principal”): he must not put his personal interests before the duty, and must not profit from his position as a fiduciary, unless the principal consents. The word itself comes originally from the Latin fides, meaning faith, and fiducia, trust….

When a fiduciary duty is imposed, equity requires a stricter standard of behavior than the comparable tortious duty of care at common law. It is said the fiduciary has a duty not to be in a situation where personal interests and fiduciary duty conflict, a duty not to be in a situation where his fiduciary duty conflicts with another fiduciary duty, and a duty not to profit from his fiduciary position without express knowledge and consent. A fiduciary cannot have a conflict of interest. It has been said that fiduciaries must conduct themselves “at a level higher than that trodden by the crowd”[3] and that “[t]he distinguishing or overriding duty of a fiduciary is the obligation of undivided loyalty.”[4]

Yves here. Note the responsibility of the fiduciary. Crudely speaking, it is required to put the principal’s interests first. Yet the banks, when confronted with fraud against their customers, do the exact opposite. Not only are they concerned only with escaping liability, it appears their success in making the customer bear all costs (even in cases where the bank might have been clearly at fault) means they also lack incentives to take preventive measures.

In addition, it contains a very important lesson: if you think a bank account has been compromised, close it immediately, no matter how much your bank balks (and since banks resist this course of action, you may need to be ready to withdraw funds and open accounts at a new institution).

From Wolf:
I

n 2005 I started to notice irregularities in a checking account I held with WaMu; but the irregularities were ambiguous. I sought at various times over the course of the next two years to go over all my statements — but had trouble getting all my records from both online banking and from my branch itself. A busy working parent, I was certainly not as proactive as I should have been — and, like many consumers of bank services, since we had family accounts and two mortgages at WaMu for many years, and had good relationships with our local branch, I also made the mistake of trusting the bank.

I noticed eventually that checkbooks were missing from my home, and finally my accountant got enough of the records to see an unmistakable pattern of fraud, and called my attention to it. I filed a police report and alerted WaMu to the fraud. For month….I complied with what the WaMu bank officials directed me to do — which was to leave the accounts open so they could investigate, they said, the fraud. If the fraud is reported within six months of confirmation of fraud, it is liable for the loss.

Then the same officials who had directed me to keep the accounts open, disappeared — systematically, for just over six months. When I sought to talk to the fraud department, I still could not get records — including my own missing bank statements — even to see the full extent of my losses. The bank officials who had directed me to keep my accounts open were unavailable at the branch — over the course of many attempts to speak with them. The police at the Sixth Precinct needed to see the missing documents, but even they could not force WaMu to hand over their — my — records. (WaMu’s own internal emails cite a $300,000 figure for my loss from fraud — I still did not have enough of my records to identify the loss. It is illegal, by the way, to withhold from an account holder his or her own records).

At eight months after the fraud discovery was confirmed — eight months of trying to communicate with officials and a fraud department who were oddly unavailable or unresponsive — I received a form letter from the WaMu Fraud Department advising me that according to the regulations, I had had a six month window for taking action; and (since WaMu had played out the clock for eight months) the letter asserted that I had waited ‘too long’ and my case was closed.

Inadvertently, subsequent to that, a WaMu bank official handed me the wrong file — wrong from his point of view; illuminating from mine, and from any consumer’s. It contained emails, some of which you can see at TheSmokingGun.com, from WaMu bank officials to one another — and including emails from and to their counsel, PR department and and the fraud department — that take as given that stonewalling a client with a fraud claim on the bank is standard practice; and yet one freaked-out bank official in the emails warns his colleagues that if their mechanisms in this regard became known, their practices would be all over the newspapers.

I was stunned by what seemed from the emails to be a systemic practice. Why would a bank want to perpetuate bank fraud rather than fight it?

As I researched the issue and spoke to other consumer bank account holders whose accounts had been corrupted by fraud, and to consumer advocates, I learned how systemic experiences such as mine — and worse experiences — are becoming. I heard from consumers across the country from all walks of life who had also been misdirected by their banks, or told that for various technical reasons their corrupted accounts could not be closed, and then faced difficulty reaching fraud departments or officials once the fraud was confirmed….

Customers assume that banking regulation and Congressional oversight means that if they find fraud on their checking accounts, there is accountability — which is not in fact the case; strong bank lobbyists translate into weak protections for consumers and, as you can see from the emails, the bank’s reasonable assumption that most customers in this situation will not be able to hold them accountable. And indeed, since legal action is time-consuming and expensive, most defrauded bank customers do eventually give up and go away…..a bank’s fraud investigation department is actually likely fraudulently representing itself as the customer’s, rather than solely the bank’s, advocate. Banks such as WaMu — and now Chase, which bought WaMu — expect such people to simply go away. They — and we — should, rather, reach out to our elected representatives for wholesale reform — and put each and every such case online, so consumers can see the worst offenders for themselves, and, with the power of the internet and their own consumer choices, protect themselves and demand accountability.

This post first appeared on November 10, 2007

The equity markets seem to have finally realized that conditions are ugly in the credit markets, due to get uglier, and the mess will pull down the real economy.

And the bad news continues.

The dollar index fell to a new low. Wachovia said the value of its subprime securities, largely “super senior” tranches of CDOs, fell $1.1 billion and it was witnessing sharp falls in housing prices in some areas of the US.

We had questioned the optimistic assumption of a few weeks ago, that investment banks were taking deep enough writedowns to put their woes behind them. How can you possibly do that unless a market is at or near bottom? Wall Street analysts have indicated that they expect further writeoffs at the Wall Street firms. Consistent with that view, Bank of America and JP Morgan said in their SEC filings that the fourth quarter would bring more writedowns. In particular, Bank of America noted that it expected “significant dislocations” in the market for CDOs. Fannie Mae reported a loss double that of a year ago. Capital One said it was seeing a faster-than-expected increase in credit card delinquencies.

But what I believe will be the largest single source of trouble in this sorry credit picture is coming to the fore: collateralized debt obligations.

CDOs are structured investments that contain a variety of assets, often tranches of residential mortgage securitizations (often the BBB or BBB- portion), commercial mortgages, pieces of collateralized loan obligations (LBO debt), and sometimes whole residential mortgages, There are also CDO squared (CDOs made from CDOs) and CDO cubed, and synthetic CDOs (CDOs constructed from the cashflows of credit default swaps written as credit enhancement for other CDOs). Because the assets in CDOs are heterogeneous, and the mix is particular to each deal, the structures vary tremendously as well.

In other words, CDOs are arcane and hairy paper. Ever since subprimes went wobbly, CDOs looked primed for trouble. For more background, see here and here.

There is no method for reporting on CDO issuance or on subprime loans outstanding (there are classification issues for subprimes, and that is compounded by the fact that many of the originators were mortgage brokers who had no reporting obligations). But to give a sense of relative importance, the estimates we’ve seen of the size of the subprime market range from $1 to $1.3 trillion (rated subprimes are $565 billion). By contrast, the estimates of CDOs outstanding are all over the map, but the ones we find more credible range from $2.0 to $3.9 trillion (we have also seen smaller estimates, but when the Financial Times, which has done far and away the best job of covering this market, reports that global CDO issuance in 2006 alone was $2.6 trillion, we tend to put our faith in the bigger numbers.

The reason for the disparity may have to do with what was counted. There are both passive CDOs, which are more like a conventional asset backed securities deal, versus managed CDOs, in which funds are raised on a blind basis and given to a CDO manager, who then buys the CDO holdings and can and does trade the holdings to improve results It is also an open question as to whether the variation in estimates is due to the inclusion or exclusion of synthetic CDOs, whose assets are credit default swaps written on CDOs. One source reported that synthetic CDOs were nearly 1/3 of total CDO issuance in the first quarter of 2007.

As readers probably know all too well, CDOs had been valued using models that the rating agencies had developed solely for credit rating purposes. Investors had carried CDOs on their books at more that they were probably worth, at first out of ignorance, because they didn’t realize the subprime paper they held was weaker than it had been historically, and later out of convenience (why recognize losses if you don’t have to and no one else seems to be doing so either?). And the investment banks were similarly able, in the absence of price discovery, to carry the CDOs on their books (they wound up owning them by not being able to sell out the full amount they created) without marking them down too much.

Those days are rapidly coming to an end. CDOs were the big culprits in the Merrill and Citigroup writedowns. And we have two developments coming to a head on the same time frame. The first is that new accounting rules gives companies far less latitude in how they value this paper. As the Financial Times explained it:

They are the “buckets” into which financial statement preparers must classify financial assets under FAS 157, a new US accounting standard for financial years beginning in November…

At the top of the bucket hierarchy is Level One, involving assets with prices quoted in active markets, such as mainstream stocks. Level Two contains less-traded securities and uses prices for assets very like the one being valued.

At the bottom lurks Level Three, assets with “un observable inputs”, meaning their value is calculated via a series of assumptions. Most collateralised debt obligations end up here.

While these categories may be familiar to many readers, what is not as widely know is that another rule, FASB 159, pushes institutions to put positions into the lowest bucket possible. Thus, no phony-baloney Level 3 valuation if there is a way to come up with a gridded or extrapolated Level 2 value.

The second development is that markeplace changes are forcing the revaluation of CDOs. Having first gone through re-rating subprime bonds, they are now tackling CDOs, and downgrades will force commercial banks, investment banks, pension funds, and other holders to recognize losses.

More worrisome is the rerating process is putting CDOs into default. As the Financial Times explains:

Fire sales of mortgage assets from complex debt vehicles began in earnest after the trustee of a $1.5bn complex debt deal managed by State Street Global Advisors started liquidating its portfolio.

Ratings downgrades for mortgage securities have pushed a clutch of such deals into default. Trustees have issued default notices for more than 14 collateralised debt obligation deals in recent weeks, representing securities with a face value of more than $10bn.

A default means the most senior investors in the CDO can liquidate the underlying assets to get their money back. Analysts say more deals are on the brink of default.

$10 billion is a pretty small amount by bond market standards, but the process of liquidating CDO assets is going to weaken prices even further in the mortgage securities market, and financial institutions will have to remark their positions in line with these new, lower values. And there is every reason to believe that CDO liquidations will accelerate.

Another problem that investors are discovering to their dismay is that CDOs have a tremendous amount of embedded leverage. That means, in lay terms, that comparatively small changes in the cash flows from their underlying assets have a large impact on their value. That is why, when the rating agencies re-rate the CDOs, the downgrades can be staggeringly large, not a mere one or two rating grades, but 11, 13, even an unheard of 18 grades.

And this casts the ratings into even further doubt. What does a triple A mean if, as one wag put it, you can go to lunch and due to a downgrade, you can come back and find that it is now junk? That simply doesn’t occur with other instruments in the absence of fraud. So the problem isn’t simply that the rating agencies might have come up with overly high ratings when the CDOs were issued because they had overly optimistic estimated for likely defaults. You have the further problem that any downgrade is likely to be dramatic. So even if you believed that your CDOs AAA was really an AAA, you’d still value it less than AAAs on other securities because the downgrade slope is so steep.

Now a fair question is whether the dim view of CDOs is overdone. According to Bloomberg, Morgan Stanley argued that case in a recent research note:

More than $350 billion of collateralized debt obligations comprising asset-backed securities may become “distressed” because of credit rating downgrades, Morgan Stanley said in a report today.

“The pace of ABS CDO downgrades will pick up significantly over the next few weeks,” wrote analysts led by Vishwanath Tirupattur in New York. “Given the degree of market dislocations and the potential size of the market, there is clearly an opportunity for attentive investors.”…

Bonds are considered distressed when investors demand yields at least 10 percentage points above similar-maturity Treasuries. Morgan Stanley said many of the CDOs of asset-backed securities sold in recent years are trading on an interest-only basis, signaling investors expect to receive little of their original principal back.

I for one would not try to catch that falling safe. While the higher-rated tranches of many CDOs almost certainly have some value, the problem is that these instruments were sold way beyond their natural market due to misplaced confidence in their ratings. Consider how small the market would be if the paper carried no rating.

Moreover, most fixed income investors are professional money managers subject to performance pressure. Even if one of them thought certain CDOs were cheap, he’d still hesitate to buy them out of concern that the prices would drop further before they rallied, and he’d show losses on those positions (and worse, have to explain to his boss and/or clients why he bought CDOs). Very few are going to step in until the market appears to be improving, and between now and then, we are likely to discover there is way too much CDO paper relative to who wants to own it now.

And let’s consider an ugly factoid. In its third quarter results, Merrill wrote down its CDO holdings by an estimated 30% or more. These were reported to be almost entirely AAA rated. This does not allow for either the further deterioration, nor the fact that downgrades are proceeding, which will impair value even more.

Take an estimated $3.0 trillion in CDO outstandings. Apply a mere 25% loss to them. That’s $750 billion, roughly four times greater than mainstream estimates of subprime losses.

Now admittedly there is subprime paper included in those CDOs, so there is some double counting, but the CDOs’ subprime holdings reportedly contain mainly the BBB/BBB- tranches, which is a portion of the value of the initial RMBS securitization.

Houston, we have a problem.

Update 11/13, 3:30 AM: Thanks to the Financial Times’ MergerMarket blog (hat tip Felix Salmon) we have some better data on CDO market prices, and how much Merrill wrote down various grades of CDOs:

However, AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches, according to a sellsider and a buysider…..

Merrill Lynch in the third quarter discounted its own super senior ABS CDO holdings by an average 19%, while mezzanine AAA notes were written down by 37%.

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The banks giveth and the banks taketh away, big time.

This chart from a Wall Street Journal article on credit card interest rates says a great deal:

Even though banks are getting all kinds of bennies from the Fed and regulators, such as a nice steep yield curve and lots of regulatory forbearance (econ-speak for extend and pretend), they are still out to extract a pound of flesh from the retail borrower. Since that has been a core element of their business model for the last decade, it is probably not so surprising that they are loath to give that practice up.

Now some will argue, correctly, that consumers need to delever. But guess what? They are paring debt levels, including credit cards. The number of open accounts has fallen by over 20% since the peak, as has the balance outstanding (over 6%). And not all of this has been voluntary. Banks have been shutting accounts and cutting credit lines.

But (drumroll) increasing interest rates, particularly when the banks are getting very sizeable subsidies, means that more of the money consumers pay to credit card companies goes to interest, less to reducing principal (of course, the banks will maintain that they are merely recouping lost income from penalties, since new credit card rules have curbed abusive practices).

A more serious issue is that not all consumer debt is consumer debt. Credit cards have long been an important source of funding for small businesses. Generally speaking, banks will lend only to relatively large, established “small” businesses, or against assets. For instance, Amar Bhide, in his landmark book on new venture, found that the biggest sources of funding for new enterprises were savings, friends and family, and credit cards. Small business owners often use credit cards to contend with temporary cash flow shortfalls or seasonal borrowing needs. And I’ve known some who have maxed out their credit cards to save their companies.

And in our modern, lend by FICO template world, the cutbacks in credit and increases in prices are often arbitrary. Early in the downturn, for instance, I had readers complaining to me that they had their credit lines cut even though they had an unblemished record and over 700 FICO scores simply because they lived in one of the epicenters of the housing meltdown. Some of those readers included small business owners whose businesses were not local or in real estate, but the curtailment in credit would make them collateral damage.

Yet another example of what Michael Thomas described back in 1998, after the Long Term Capital Management affair:

The thirteen-digit ($1,250,000,000,000) number that’s being tossed around – the chin-scratching classes like to speak of “systemic risk” – is designed to convince us little people that there is a crisis at hand and therefore, if we somehow end up paying for it, it’s for our own good. In other words, to save the king’s castle, it is necessary to destroy the people’s village

From the Wall Street Journal:

New credit-card rules that took effect Sunday limit banks’ ability to charge penalty fees. They come on top of rule changes earlier this year restricting issuers’ ability to adjust rates on the fly. Issuers responded by pushing card rates to their highest level in nine years.

In the second quarter, the average interest rate on existing cards reached 14.7%, up from 13.1% a year earlier, according to research firm Synovate, a unit of Aegis Group PLC. That was the highest level since 2001.

Those figures look especially stark when measuring the gap between the prime rate—the benchmark against which card rates are set—and average credit-card rates. The current difference of 11.45 percentage points is the largest in at least 22 years, Synovate estimates.

By comparison, the spread between 10-year Treasurys and a standard 30-year fixed-rate mortgage is just 1.93 percentage points, near historical averages, according to mortgage-data provider HSH Associates.

New York Times writer Louise Story recaps a bold thesis put forward by David Moss of Harvard Business School, namely, that high levels of income inequality stoke financial crises:

The possible connection between economic inequality and financial crises came to Mr. Moss about a year ago… A colleague suggested that he overlay two different graphs — one plotting financial regulation and bank failures, and the other charting trends in income inequality.

Mr. Moss says he was surprised by what he saw….

“I could hardly believe how tight the fit was — it was a stunning correlation,” he said. “And it began to raise the question of whether there are causal links between financial deregulation, economic inequality and instability in the financial sector. Are all of these things connected?”

Professor Moss is among a small group of economists, sociologists and legal scholars who are now trying to discover if income inequality contributes to financial crises. They have a new data point, of course, in the recent banking crisis, but there is only one parallel in the United States — the 1929 market crash…

Even scholars who support the inquiry say they aren’t sure that researchers will be able to prove the connection. Richard B. Freeman, an economist at Harvard, is comparing about 125 financial crises around the globe that occurred over the last 30 years. He said inequality soared before many of these crises. But, Mr. Freeman added, the data from different nations is difficult to compare. And Professor Freeman says he has found some places, like the Scandinavian countries, where there were crises without much inequality, suggesting that other factors, like deregulation, may be the best explanations…

Margaret M. Blair, who teaches at Vanderbilt University Law School and is active with the Tobin Project, the nonprofit organization Mr. Moss founded a few years ago to study issues like economic inequality….is researching whether financial workers promote bubbles and highly leveraged systems, even unconsciously. Ms. Blair said that because financial bubbles often lead to higher returns, financial workers have the potential to make more, and this pattern can influence their trading strategies and the policies they promote. Those decisions, in turn, drive even greater income inequality, she said.

Yves here. This is intriguing, but I am inclined to believe that income inequality is either a symptom of conditions that can produce bank crises (like excessive financailization of an economy) or a secondary contributor. If you simply look to Minsky’s theory of financial instability, a rise in what he calls speculative units and Ponzi units would benefit leveraged speculators, and shift incomes and wealth away from ordinary workers to those who can attach themselves to capital. Carmen Reinhart and Kenneth Rogoff similarly found a strong correlation between a high level of international capital flows and more frequent financial crises. It isn’t hard to imagine that large scale international capital flows would be associated with the prominence of large international ventures which again could distribute a lot of winnings to a comparatively small (in societal terms) number of beneficiaries. The article also mentions deregulation as a possible prime cause. The neoclassical experiments with radical deregulation, such as Chile and Russia, witnessed plutocratic land grabs, rising inequality, and economic upheaval.

I’m curious to get reader views on where income inequality fits among the factors that generate financial meltdowns.

This post first appeared on September 21, 2007

In an intriguing article today, “The Bank loses a game of chicken,” Martin Wolf, the Financial Times’ chief economics writer, followed the lead of the Bank of England’s Governor Mervyn King in backing down from their shared view that central bankers should be willing to let all but those banks “too big to fail” go under.

For those who have somehow missed this saga, King in a submission to Parliament last week reiterated a very tough stand on the principle that banks should bear the consequences of their bad decisions unless their collapse posed a systemic threat. A mere two days later, the Bank of England, in a joint decision (as prescribed) with the Treasury and the FSA, organized a rescue of the number five building society, Northern Rock. Northern Rock was clearly too small to pose a threat to the financial system, and there was a hue and cry as a result of King’s abrupt reversal.

Wolf argues that commercial banks have the upper hand in any showdown where a bank is at risk of failure. He is clearly distressed at this asymmetry; bank investors profit in good times yet can socialise their risks when conditions become adverse. Wolf goes as far to call for nationalization (in context, it isn’t clear whether he was calling for nationalization of the banking system or of Northern Rock alone).

UCSD economist James Hamilton made a similar observation about how, push come to shove, central bankers have to relent even if the risk of moral hazard is real. While he was talking about Fannie Mae and Freddie Mac in his presentation at the Fed’s conference at Jackson Hole, his reasoning has broader application:

The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run…. The problem arises when the losses on the institution’s assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent….

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do.

Wolf explains how even a second-tier institution like Northern Rock in effect became too big to fail.

Wolf is clearly frustrated with the current regulatory regime which allows banks to enjoy the upside while being able to have taxpayers take the downside risk. But there are solutions other than simply nationalizing banks. For example, after the savings and loan crisis, McKinsey partner Lowell Bryan called for banks to hold risk free assets like Treasuries in the same amount as guaranteed deposits in a separate entity, in effect segregating the government guaranteed activities of a bank from commercial operations.

As the events in the UK show, banks are ultimately wards of the state. It’s time regulators recognized that uncomfortable fact and devised a more effective supervisory scheme.

From the Financial Times:

The chaos of the last week over Northern Rock raises questions about the workability of the “tripartite system”, created by Gordon Brown in 1997, under which the Financial Services Authority supervises individual banks, the Bank deals with systemic crises and the Treasury provides public money. As the governor noted in his testimony before the House of Commons Treasury committee yesterday, the Northern Rock debacle also demonstrated the difficulties created by today’s company law and system of deposit insurance: the former precluded covert assistance, while the inadequacies of the latter almost ensured a run on the bank. The only point to add on Northern Rock is that the government should have added nationalisation to its decision to provide a deposit guarantee. Taxpayers should not bail out shareholders. Equity is risk capital. In banking, risks must include the drying up of liquidity….

The only reason for intervening, then, would be “strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in future.” Since then Mr King must have decided that the threat to the financial system posed by the unwillingness of banks to lend had become too dangerous. By advancing three-month money against mortgage collateral, the Bank has, as a result, abandoned two of its principles for acting as lender of last resort.

Albeit welcoming what it called “the more flexible approach” – that is, the defeat – of the Bank, the British Bankers’ Association demanded unconditional surrender, noting “concerns about the 100 basis point penalty paid by users of the standing facility”. In short, it wants the Bank to provide limitless liquidity against questionable security, without penalty. Will the Bank resist this pressure? I hope so, but doubt it.

In a game of chicken, the loser is the player who swerves first out of the way of the other driver’s car. Since the Bank is concerned about the health of the economy, while the banks are concerned only about their survival, the former is at a huge disadvantage. Apparently, the banks told the authorities they would not lend to their weaker brethren until the Bank opened its wallet. The threat was credible and the Bank swerved.

Am I unfair, then, in blaming these events on the irresponsibility of the banks? Consider that, even though the world economy has enjoyed years of good growth and the US housing market, epicentre of the crisis, has weakened but a little, credit markets are frozen. Consider, too, that the banks both created the radioactive securitised obligations and set up the special investment vehicles (off-balance-sheet banks) that they must now rescue at the expense of lending to everybody else. Consider, not least, that banks exposed themselves to the risk of illiquidity from which they expect a public rescue, at no charge.

Yet the banks are winning, not only because they are a formidable lobby, but because they can inflict such damage. Today, as a result, the government has guaranteed deposit liabilities and the Bank has taken a big step towards rescuing them from self-inflicted illiquidity. So Mr King is losing his gamble on toughness. Let us at least understand why. Our sophisticated financial system suffered a typical collapse in self-discipline. Now the authorities are under huge pressure to rescue it from its folly. Mr King’s “mistake” – what critics call his “inflexibility” – was the view that banks should no more enjoy a rescue than other businesses. Fortunately, the Bank’s provision of liquidity is not yet free. Let Mr King stick to his guns on the penalty. If not, still more dangerous crises will come.

John Plender in his comment at the Financial Times, “Great dangers attend the rise and fall of great powers,” does a fine job given the space constraints of discussing the fraught process of changes in global economic and political leadership.

I thought it would be useful to quote Plender at length, with some additional observations, in the hope of eliciting reader input and reactions. From the Financial Times:

It is a discomfiting historical fact that great power shifts in the global economy are dangerous. They have tended to coincide with extreme financial dislocation, currency turbulence and trade friction. This is because the aspiring new boy on the block is usually a protectionist-inclined creditor country that is reluctant to shoulder international responsibility commensurate with its economic strength.

Consider the transition from British to US hegemony after the first world war. From 1918 the US rejected the Versailles treaty, opted out of the League of Nations and had nothing to do with German reparations, although it collected war debts from the allies. Britain’s liberal attitude to trade allowed the US to run a big trade surplus. Meantime, the young and inexperienced Federal Reserve pursued lax monetary policies in the Roaring Twenties while unwisely trying to prop up the ailing pound.

Yves here. There are a number of different ways to frame this change, both as to when it took place and what its triggers were. World War I forced the end not merely of British ascendancy, but the powerful hold of monarchies and landed aristocracy on political power through much of Europe. No one saw this sea change coming; the summer of 1914 was gay, and while many saw war in the offing, it was expected to be a short affair.

Similarly, I’m not certain whether greater US engagement could have shifted the tide sufficiently after World War I to have prevented many of the woes that followed. The US was a late entrant and thus would have no basis for playing a leading role in crafting a post-war order. Many stakes were put in the ground with the Treaty of Versailles. Moreover, the US appears not to have been up to the task of international stewardship, even if it had aspired to that position. Keynes’ Economic Consequences of the Peace depicts the US representatives as skillfully manipulated and marginalized. Back to the Financial Times:

When the Fed belatedly pricked the resulting bubble in 1929, the Jazz Age came to an abrupt end, banks collapsed and the depression ensued. As the US exported its problem of deficient demand to the rest of the world, it failed to provide leadership to prevent an outbreak of disastrous competitive devaluations and was unwilling to act as a global lender of last resort to collapsing banks.

Yves here. The US was having enough trouble attempting to right its own economy, particularly since initial enthusiasm for Roosevelt by quite a few businessmen and financiers quickly soured. The idea that the US could act as a lender to foreign banks seems quite implausible. And I’m not certain this supports Plender’s argument, that the US should have done more. As we’ve noted before, there are tradeoffs among international integration, national sovereignity, and democracy. Plender is arguing (basically) for the US running roughshod over national sovereignity and democracy to salvage an international financial order. There are very few windows where the stars align for that strategy to be both politically viable and economically sound. One was in the wake of World War II devastation, when the US, with 50% or world GDP, was unquestionably dominant, and the Axis nations were prostrate politically. Back to Plender:

The next case in point is postwar Japan. Japanese economic growth was export-led, fuelled by an undervalued yen and subsidies for exporters. It was a model that worked as long as Japan was not a significant economic power. Yet by the late 1960s Japan was the second largest economy in the world. It was also running a huge trade surplus with the US.

International efforts to address imbalances and stabilise an overvalued dollar in the Reagan era had unintended consequences – not least that Japanese intervention in the yen-dollar rate had the same bubble-inducing outcome as the Fed’s efforts to prop up sterling in 1927. The pricking of the bubble led to 20 years of economic stagnation.

Yves here. There’s an implication that Japan should have sought a dominant role, but first, Japan was and is a military protectorship of the US, and second, Japanese would really rather not deal with foreigners. Moreover, Plender suggests Japan’s real estate and stock market bubbles were an accident. In fact, the authorities were in favor of them, because they thought the wealth effects of higher asset values would spur more domestic consumption, which would in turn offset the dampening effects of the fall in exports caused by the rise of the yen. The authorities raised rates because the bubbles were producing income and wealth disparities and undermining Japan’s highly valued social cohesion.

Back to Plender:

China’s challenge to the US is similarly export-led and its current account surplus is the biggest contributor to the Eurasian savings glut that led to the credit bubble and the global imbalances behind the financial crisis. Yet despite its success, China’s economic model generates wasteful over-investment and under-delivers to ordinary people, who have the lowest share of private consumption in GDP in Asia. In a country that enjoys double-digit growth rates, employment growth has been running at a paltry 1 per cent a year, while real returns on savings are negative. As with Japan at its peak, the economy delivers a poorer quality of life than the per capita income figures suggest, with pollution, adulterated food and bad employment conditions posing threats to health…

What is needed globally is for both debtor and creditor countries to rebalance their economies. The debtors need to tidy their balance sheets, while the creditors need to bump up domestic consumption, let currencies float and reduce export dependence. This would also be in China’s own interest because its economy is in disequilibrium. It cannot, among other things, prevent inflation and asset-price bubbles while running an artificially low exchange rate. Yet the obstacles to change are formidable. The key to rebalancing towards consumption, says Mr [Charles] Dumas [of Lombard Street Research], may be relaxation of government control over its citizens, which is unlikely to happen. There are also powerful lobbies against change, not least the inefficient producers who have been featherbedded by a cheap currency and whose economic survival depends on continuing undervaluation.

There is, then, a Chinese policy impasse. How does the world escape from its dire potential economic consequences? One scenario might be muddle-through: the US responds to an impending economic slowdown with looser fiscal and monetary policy, at the cost of racking up more debt and a crunch later on. Another would see US fiscal conservatives prevent budgetary loosening, while monetary policy remains lax. This would cause the US current account deficit to shrink sooner rather than later.

Either way, the risks of a protectionist backlash against China would rise. Under either scenario, the world’s creditor countries would ultimately see their chief market dry up. The main difference is in the timing. When, you might well ask, will the creditors wake up?

Yves here. Notice how Plender sees the political obstacles in China put the onus on the US to force changes. Most policymakers are wedded to the idea of free trade, but with a high unemployment rate and slack resources, the US would come out ahead by implementing protectionist measures (although corporate CEOs might not fare as well). As unemployment continues to be high and foreclosures continue to exact a toll, pushing back against mercantilists like China will look more and more attractive.

Yves here. Doug Smith, the author of On Value and Values: Thinking Differently About We In An Age Of Me, raised some interesting questions about how the debate about recovery is being framed. The most common approach is to look it in terms of GDP, and look at various indicators to see is progress towards resumption of GDP growth is being made. But how useful is looking primarily through a GDP framework? Various economists, more prominently, Joseph Stiglitz and Amartya Sen, have questioned the utility of GDP as a measure of collective welfare. Even discussions around our dubious “recovery” include some odd constructs (which are really defenses of the status quo), like a “job loss recovery.”

From Doug Smith:

When looking at the recent deterioration in economic indicators, I was reminded of a question raised at dinner several months ago: What is the actual bar or threshold for a ‘real recovery’?

Now, put aside for the moment the important question about ‘rates of change’. They are critical to determining recovery — indeed, the most basic indicator that is used. The conversation at dinner, however, was grounded in a different concept/question: Do we need to return to heights of, say, 2005 or 2006 to have a true recovery?

Think about it this way. Pick a year when the economy — at least according to those in power — was really humming. Ignore for the moment whether that was the financial sector or the ‘real’ economy. Just pick some year when it was all good. Conceptually, take that year and make it “100″.

Do we need to get back to “100″ for there to be a real recovery?

This is worth asking because many would maintain that “100″ was and is an unsustainable illusion. A sleight of hand. In part, again, this illusion was due in part to the financiailization of the economy — the increasing dependence of GDP et al on a house of cards (credit etc), asset inflation and all that.

The point here though is more forward looking in order to raise issues about the nature of the objectives being pursued. If “100″ is not sustainable in any way, then isn’t setting an objective — explicitly or implicitly — to get back to “100″ also an illusion? And, if so, isn’t that a destructive red herring that can only lead to poor choices? What if, say, “90″ is the best possible sustainable level we might get back to for, again, say the next 5 to 10 years? If that’s so, then it means seeking “100″ is seeking to be more than 10% beyond sustainable. Is that wise?

Instead, what if there is some “90″ that is consistent with sounder foundations for the real economy, real growth and real futures — something that might be characterized by such things as (1) jobs with living/good wages; (2) reductions in sources of uncertainty such as illness, job loss and so forth; (3) a rise in ‘utility’ banking that’s focused on investments in growth tied to real business, real innovation and so forth; (4) a shrinking of the casino activities of the financial sector; (5) bringing heretofore externalities (e.g. environment) into full pricing; (5) a different balance of distribution in wealth and income …. and so on?

What if we should be seeking that “90″ instead of the 2006 “100″?” We can always shoot to beat that benchmark, but a 90 that corresponds to what in an accounting sense is higher quality “earnings” seems like a sounder long term goal than trying to restore a smoke and mirrors 100.

A story by Ellen Brown gives a good summary of how the widespread use of a national electronic mortgage registry called MERS, designed to save mortgage securitizers the cost and bother of recording mortgages at the local courthouse, is backfiring spectacularly.

Although in a industry as large and diverse as the mortgage industry, one has to generalize with caution. Nevertheless, early in this century, the mortgage securitization industry took the view that recording mortgage at the local courthouse was a tad barbaric, and sought to streamline the process via the use of a national electronic mortgage registry called MERS.

There were two wee problems with this idea:

1. Real estate is governed by state law. A “mortgage” really consists of two elements, the note (the IOU) and the mortgage (in some states, called a deed of trust), which is the lien. In 45 of 50 states, the note is the critical instrument; the mortgage is a mere “accessory”. You need to demonstrate that you are the owner of the note (the “real party of interest”) in order to foreclose.

2. Many of the securitizers got very sloppy with the transfer of the note to the securitization entity, a trust. Theyv’e tried to rely on MERS to prove ownership, or worse to foreclose in the name of MERS. A rising tide of state court decisions is nixing this approach.

The article muffs some details. It isn’t all 62 million HOMES (as the title suggests) that could be difficult to foreclose upon if challenged. MERS may have 62 million MORTGAGES, but this appears to include some second liens, and some of those are in the five states where MERS is hunky dory. And not all states have MERS-unfavorable rulings on the books. But judges in some states are looking to decisions in other, so the fact that quite a few states have important decisions against MERS will make it easier for judges in other states to take that position.

The finesse that MERS has tried to use, when challenged, is that it is a nominee. But in most states, the real party in interest has to be the plaintiff, a mere nominee can’t take legal action without the real party in interest (in this case, the note owner) also joining the action. Moreover, a nominee is a party authorized to act on behalf of another party. But there is no evidence, no paper trail to demonstrate that MERS is authorized to act on behalf of the trust, nothing contemplated in the pooling and servicing agreement that governs the securitization, no fees paid by the trustee to MERS, no agreement, etc.

The article cites a recent case in California which accepts MERS’s contention that it is a nominee, but finds that is insufficient for MERS to foreclose:

The latest of these court decisions came down in California on May 20, 2010, in a bankruptcy case called In re Walker, Case no. 10-21656-E–11. The court held that MERS could not foreclose because it was a mere nominee; and that as a result, plaintiff Citibank could not collect on its claim. The judge opined:

Since no evidence of MERS’ ownership of the underlying note has been offered, and other courts have concluded that MERS does not own the underlying notes, this court is convinced that MERS had no interest it could transfer to Citibank. Since MERS did not own the underlying note, it could not transfer the beneficial interest of the Deed of Trust to another. Any attempt to transfer the beneficial interest of a trust deed without ownership of the underlying note is void under California law.

In support, the judge cited In Re Vargas (California Bankruptcy Court); Landmark v. Kesler (Kansas Supreme Court); LaSalle Bank v. Lamy (a New York case); and In Re Foreclosure Cases (the “Boyko” decision from Ohio Federal Court). (For more on these earlier cases, see here, here and here.) The court concluded:

Since the claimant, Citibank, has not established that it is the owner of the promissory note secured by the trust deed, Citibank is unable to assert a claim for payment in this case.

The broad impact the case could have on California foreclosures is suggested by attorney Jeff Barnes, who writes:

This opinion . . . serves as a legal basis to challenge any foreclosure in California based on a MERS assignment; to seek to void any MERS assignment of the Deed of Trust or the note to a third party for purposes of foreclosure; and should be sufficient for a borrower to not only obtain a TRO [temporary restraining order] against a Trustee’s Sale, but also a Preliminary Injunction barring any sale pending any litigation filed by the borrower challenging a foreclosure based on a MERS assignment.

While not binding on courts in other jurisdictions, the ruling could serve as persuasive precedent there as well, because the court cited non-bankruptcy cases related to the lack of authority of MERS, and because the opinion is consistent with prior rulings in Idaho and Nevada Bankruptcy courts on the same issue.

Earlier cases focused on the inability of MERS to produce a promissory note or assignment establishing that it was entitled to relief, but most courts have considered this a mere procedural defect and continue to look the other way on MERS’ technical lack of standing to sue. The more recent cases, however, are looking at something more serious. If MERS is not the title holder of properties held in its name, the chain of title has been broken, and no one may have standing to sue. In MERS v. Nebraska Department of Banking and Finance, MERS insisted that it had no actionable interest in title, and the court agreed.

Yves here. Some of the earlier decisions have actually been pretty tough too. In Kesler, the Kansas Supreme Court ruled:

The relationship that MERS has to Sovereign [the creditor] is more akin to a straw man than to a party possessing all the rights given a buyer….in the event that a mortgage loan somehow separates interests of the note and the deed of trust, with the deed of trust lying with some independent entity, the mortgage may become unenforceable.

The reason some foreclosures have been performed in the name of MERS is a combination of laziness plus inability to prove, or in some cases, even determine, which trust (the foreclosure should be filed in the name of the owner, which would be the securitization entity, a specific trust) owns the note. Judges, when the foreclosure is challenged, have tended to dismiss the foreclosure without prejudice, meaning if someone can show that they own the note, they can then foreclose (no one is disputing that the borrower owes someone money; the question is whether the party in court is the right one. This isn’t an idle concern. There are cases where the same note has been sold into more than one trust, exposing the borrower to the risk that it could be hit multiple times for the same debt if the courts get cavalier about foreclosure).

Why are judges getting bolder? After all, as some readers will inevitably protest, the result looks inequitable, some people get to live in free houses.

First, comparatively few people contest foreclosures. If you can’t afford the house, why fight to keep it? The vast majority are victims of servicing errors they can’t get resolved, or people who have filed Chapter 13 bankruptcies, where the lender is trying to pierce the bankruptcy stay and seize the house. There are far more people getting “free” houses because they have stopped paying their mortgage but the bank has not foreclosed on them.

Second, at least in some jurisdictions, judges may be of the view that banks are foreclosing (and clogging up their courts) rather than work with borrowers (for most other legal matters, judges like to see that the parties have made a good faith effort to resolve their dispute before going to court). There is evidence to support that; foreclosure rates are lower on bank-owned mortgages (where there are incentives to reduce losses and take half a loaf by doing a mod) than on securitized mortgages (where the servicer is paid to foreclose and is not paid to mod, except when bribed to do so by special Treasury programs). Normally, you’d expect judges to favor banks over deadbeats, so the fact that that increasing numbers are deciding against them says they are troubled by the legal issues (abuse of process) and/or the lack of good faith dealing (efforts to remedy the situation by taking a meaningful haircut, as opposed to a mere catch up plan, which includes paying back late fees, usually charged in violation of Federal law so as to produce more compounding of fees).

These cases are on the verge of a tipping point, where the focus shifts from what these decisions mean to borrowers, to what they mean for investors. The officialdom seems to fantasize that somehow, the private securitization market will come to life, but someone needs to deal with this dead body in the room before than can happen.

This is a particularly clear and succinct explanation of the role of Treasury auctions in monetary operations at Pragmatic Capitalism (hat tip BondSquawk), in a post I urge you to read in its entirety, “The Myth of the Great Bond “Bubble.”

The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system. So, when the government auctions bonds they are merely targeting reserves in the system. This action is mandated by Congress as an accounting tool and so is seen as a source of funding, however, in reality the Central Bank is merely draining reserves that the Treasury already spent into existence – reserves that were deposited at various banks (read this process in greater detail here). Therefore, it’s incorrect to argue that there won’t be buyers of U.S. bonds – with the banks earning 0.25% on their reserves and the government offering anything above that (depending on duration) the trade is a no-brainer for the banks who hold these reserves. The government is basically offering them free money and the Central Bank keeps control of the money supply in exchange (at least in theory). What is not occurring is some sort of funding mechanism. The Fed could care less if the auctions are 2X, 3X or 4X oversubscribed. They don’t get extra money when this occurs. They don’t get a gold coin that can then be spent. So long as they meet the 1:1 bid to cover the auction is a huge success because they drained their targeted reserves and convinced Congress that we aren’t going bankrupt.

Yves here. This is the part most people don’t appreciate: the Federal government spent PRIOR to the bond auction by crediting bank accounts. The government does not fund its spending via bond auctions.

Readers may wonder why I haven’t written about my visit on Monday to the Treasury, but truth be told, I headed out afterward with Mike Konczal and Steve Waldman to get a drink, and we all looked at each other quizzically. I said something along the lines of “I’m not certain there is anything to write about,” and they nodded in agreement. I had less than a half page of notes.

That isn’t to say we didn’t spend nearly 2 1/2 hours in a high-ceilinged conference room, and that we didn’t engage with Treasury officials, including Timothy Geithner, in what looked like conversation. But the assumptions of both sides re process as well as substance were so far apart that it often felt like we were talking past each other.

One part of the dynamic was the home court advantage the Treasury enjoys. This is their drill, their offices, they no doubt used their spiel on others and have it pretty well debugged, and more important, they play well off each other (they give the impression of having good rapport with each other; there was some banter on their side). So they have message discipline and stay unified and still manage to look relaxed and informal. By contrast, we seven bloggers (the others were Tyler Cowen, Alex Tabarrok, Phil Davis, and John Lounsbury) were on hold in the very large corridor till the conference room cleared up, which meant we didn’t even have the chance to ask each other, “And what do you want to ask about?” Our interests were likely to be (and were) somewhat divergent, but it would have been nice to know to what degree.

Despite our heterogeniety, we all took a skeptical posture towards the Treasury team. One has to think they anticipate that, which then begs the question of what they expect to accomplish with these meetings. We aren’t journalists, so the access card does not work; the infrequency and format of these sessions means they don’t build personal rapport (and there are good reasons why not; from our end, it costs time and money to go to DC; from their end, we aren’t important enough to warrant more frequent contact).

So they may have other motivations, but a safe assumption is that they regard this as marketing, and a famous cliche is “50% of what I spend on advertising is wasted, I just don’t know which 50%.” We probably look like part of the wasted 50%, but they can’t be certain, and the costs to them of having this sort of meeting are low, so they might as well keep the experiment going.

In the last session I attended (November), one consultant (Lee Sachs) and one official (Assistant Secretary for Financial Institutions Michael Barr) made presentations, which did provide some focus. This time, Barr (who was even more Midwestern earnest than last time) threw the session open to questions from us, and quickly got a complaint (repeated in various forms over the meeting) that the Treasury had done a poor job of explaining what its goals had been for financial regulation and what the finreg bill stood for.

We’d ask questions (usually too long and complicated), they’d offer replies which were sorta responsive but not really, in that the kept stressing what had been done and why that meant the banking system was much safer (higher capital requirements, living wills, central clearing of “standard” derivatives), and we weren’t buying it, but our pushback (predictably) went nowhere.

The most revealing bits were the asides and the use of language (for instance, the first remark on housing included a mention of renters; the fact that they see this as a group to be concerned about suggests the officialdom will be loath to do too much for homeowners, hopeful analyst reports from the Street to the contrary). One interesting set of exchanges involved regulatory authority. Steve Waldman and Tyler Cowen both made articulate cases (Tyler from remarks in the meeting, Steve from pattern and practice) that there was good reason to doubt the authorities would use their clout; there was no effective reply because none could be made (it basically boils down to “trust us”).

One bit I am still puzzled about is the amount of time Geithner spent with us. He is famed for keeping a tight schedule, and he showed up at 4:30 PM and stayed 50 minutes, which was 20 minutes beyond the official meeting close. Although the Treasury staffers who had run the session before arrived Geithner were articulate and knowledgeable, he is particularly adept in this smallish meeting format and seemed to noodle our questions enough so that his responses were typically more direct yet managed to incorporate a lot of thoughtful nuance (not that he didn’t avoid certain issues, mind you; he argued that Treasury had limited authority on a certain issue; I pointed out ways in which Treasury more than enough leverage to bring a bank to heel; he avoided acknowledging the matter I raised; more on that in due course). He did make some minor disclosures (like saying he wasn’t supposed to talk about Fed policy, then doing just that, hinting that the catfood commission might recommend changes in taxes, which in context might mean more consumption taxes, as in a VAT).

I could try to reconstruct in more detail who said what to whom, and I’ve avoided reading other posts on the meeting (I’ve been told Alex Tabarrok posted right away and have seen the headlines for John Loundsbury’s posts). But I’m not sure I can reconstruct them, and more important, I’m not certain what (or more accurately, whose) ends it serves.

Finally, one reader did tell me Alex Tabarrok got some comments criticizing him for falling into Treasury’s orbit by meeting with them. While in theory one could lose one’s edge by staring the opposition in the eye, sports teams do this as a matter of course. If we saw the staff of the Treasury more often and we had something to gain, that could be a concern, but these sessions take a lot of time, and I question what the upside for bloggers is. The immediate one is getting one’s nose inside a new tent, but that is a matter of novelty and wears off after the first encounter. I suspect the main effect is that we and Treasury each sharpen our games a teeny bit by engaging directly on points of contention.

One of the minor aspects of the econoblogger session with the Treasury on Monday (more on that shortly) is that several of the invitees said something along the lines of, “You guys did a great job in the crisis.”

What is disconcerting is how this view has now become conventional wisdom, despite the panicked Fed reaction (being way behind the curve, then overreacting and making 75 basis point cuts the new normal, with the result that short rates are now so low that the Fed is boxed in), denial and failure to investigate the seriousness of looming problems (for instance, Bear’s implosion should have led to a full bore investigation of the credit default swaps market, which would have led straight to AIG); the inconsistent bailout processes; the heinous language and process of the passage of porked-up TARP.

And now we have the aggressive selling of “how well it all worked.” For starters, consider the misleading “banks have paid back the TARP meme.” Yes, thanks to other back door, less visible bailouts, super cheap interest rates, regulatory forbearance (aka, extend and pretend, starting with bank second mortgages and HELOCs). This is simply a shell game, with the banks eager to pay back the TARP for the worse possible reason, so the top brass could escape restrictions on compensation.

An interesting proof of the success of the power-that-be’s PR campaign is the blogosphere silence on a Barry Ritholtz post of Monday, “2008 Bailout Counter-Factual.” I’m what would normally be late to it, but I can’t find another blog in my RSS reader having commented on it.

Barry makes an aggressive case, that none of the bailouts were necessary:

Imagine a nation in the midst of an economic crisis, circa September-December 2008. Only this time, there are key differences: 1) A President who understood Capitalism requires insolvent firms to suffer failure (as opposed to a lame duck running out the clock); 2) A Treasury Secretary who was not a former Goldman Sachs CEO, with a misguided sympathy for Wall Street firms at risk of failure (as opposed to overseeing the greatest wealth transfer in human history); 3) A Federal Reserve Chairman who understood the limits of the Federal Reserve (versus a massive expansion of its power and balance sheet).

In my counter factual, the bailouts did not occur. Instead of the Japanese model, the US government went the Swedish route of banking crises: They stepped in with temporary nationalizations, prepackaged bankruptcies, and financial reorganizations; banks write down all of their bad debt, they sell off the paper. Int he end, the goal is to spin out clean, well financed, toxic-asset-free banks into the public markets.

Thus, Bear Stearns is not bailed out by the Fed. Instead, the FOMC chair tells JP Morgan’s CEO “You have 9 trillion dollars in exposure to Bear derivatives. Instead of guaranteeing you $29 billion for a risk free takeover, we will start preparing a liquidation plan for Bear. And given your exposure to them, we best plan one for JPM too. (and if you don’t like that, you can kiss our ass).”

Tough talk, but the outcome would have been much better: JPM would likely have bought Bear anyway, if for no other reason than to prevent someone else from buying them, and forcing JPM into bankruptcy, to pick up their assets for pennies on the dollar. That would have set a much better tone for future bailout expectations, versus the massive moral hazard the Fed created with the Bear bailout.

Lehman? Prepackaged bankruptcy, less disruptive.

AIG ? There never was an implicit government guarantee that all counter-parties dealing with AIG-Financial Products — a giant leveraged structured finance hedge fund hiding under the skirt of the regulated insurer — would be made whole. But the Bush/Paulson/Bernanke bailout created one. Instead, AIG-FP should have been carved out for dissolution/wind down, while the insurer could have continued to exist on its own. AIG would have had the liability for the government’s costs, but the counter parties? They would have gotten zero. If you go to Vegas and shoot craps in the alley way behind the casino, don’t expect the gaming commission to collect your winnings. But that is what we did with AIG.

Fannie & Freddie: Two more crappy banks that should have been wound down. These were publicly traded companies that were guaranteed lower interest rates — not an infinite backing from taxpayers. They should have been wound down like all any insolvent bank. Today, they serve as the mechanism for backdoor bailouts of the rest of the wounded banking sector.

Yves here. Readers may take issue with many of Barry’s claims, but consider a few not well understood factoids. Re the Bear bailout, Bear had substantial unused credit lines from Japanese banks and the Japanese were astonished and relieved that they were not drawn down. I don’t have the exact amount, but it was unquestionably over $1 billion. There was no reason for the Fed to subsidize the JPM deal; Bear could have pulled down the credit lines pre closing. This would admittedly been senior credit rather than the junior funding that the Fed provided, but the point is there were ways to reduce the JPM commitment ex going to the central bank sugar daddy.

Similarly, Lehman was allowed to go into a disorderly collapse for poor reasons: namely, that it was politically unacceptable, after the Bear rescue, to bail out Lehman. But not bailing out does not mean “do nothing.” One tidbit from the Valukas report on Lehman (hat tip Economics of Contempt) is that Vice Chairman Don Kohn told Ben Bernanke in June 2008 that the view on the Street was that Lehman was as goner. If Kohn was hearing that, the New York Fed had to be hearing similar rumors.

Yet as Andrew Ross Sorkin’s Too Big to Fail makes clear, no one took the possibility of a Lehman bankruptcy serious. No one in the officialdom talked to a bankruptcy attorney.
This is a complete failure of planning. As a result, Lehman didn’t merely file for bankruptcy; it filed with a thin form, with no preparation of any kind. It collapsed in the most disruptive manner possible. And that was made even worse due to another, long-standing failure of oversight: the utter mess of Lehman’s derivatives book (how could anyone certify they had adequate financial controls?). So you had a legal train wreck compounded by an operational nightmare.

And it was the chaos unleashed by the Lehman failure that in turn led to the “No More Lehmans” policy, and the widespread view that extreme measures to prevent a big financial firm from failing were warranted. But this misses the fact that just as people can die violently or peacefully, so to do can company unwindings be more or less traumatic.

The biggest obstacle to Barry’s counterfactual is the fall 2008 timing. The sort of measure he described probably would have required a closure of trading markets (which September 11 showed did not bring the world to an end) and in a worst case, a full blown bank holiday. No one was willing to do anything that radical-looking; perversely, the course of least resistance was to tap the last reserve, the US taxpayer.

Full disclosure: I’ve known Amar Bhide for roughly 25 years (we both worked on the Citibank account at McKinsey, albeit never on the same project) and although we correspond only occasionally, I continue to regard his as a particularly keen observer and original thinker. He was briefly a proprietary trader, then an associate professor at Harvard Business School (first in finance, later in enterpreneurship), then a professor at Columbia’s business school, and after taking a sabbatical to write a book (A Call for Judgment, due out in two weeks) is joining the Fletcher School of Law and Diplomacy in a newly-established chair.

Amar has an article at the Harvard Business Review which encapsulates some of the core arguments from his book. I’m providing a few extracts here because it appeals to my sensibilities and I therefore think NC readers will like it as well. The most interesting bit to me is the aspect that I highlight in the headline to this post: that the evolution of finance, particularly in its near universal adoption of standardized models in lending processes bears a troubling resemblance in its process and outcomes to a centrally planned economy (funny that people like to dump on the Fed for interest rate setting, and miss the other. widespread aspects of de facto centralization, via standardization and over-reliance on models). Some of his arguments overlap ones I’m made repeatedly here. For instance, I’ve decried the fact that shifting lending from loan officers in branches to standardized, score-based templates resulted in considerable loss of information: face to face assessment of the borrower (does he understand what he is getting into? Does he regard the loan as a serious commitment?) and knowledge of the community (How healthy is his employer? What is the outlook for the local economy?)

Bhide comes to similar conclusions to ones reached here and in ECONNED, and his framing may help finance skepticism get greater traction. From his HBR article:

Because natural laws and mathematical inferences cannot predict behavior, algorithms are built upon statistical models. But for all their econometric sophistication, statistical models are ultimately a simplified form of history, a terse numerical narrative of what happened in the past. (The simplifying assumptions of most statistical models are in fact so great that they can almost never be used successfully to reconstruct the very historical data used to construct the models.) They reveal broad tendencies and recurring patterns, but in a dynamic society shot through with willful and imaginative people making conscious choices, they cannot make reliable predictions….

This doesn’t mean statistical controls and data-mining programs are useless in human affairs. They can debunk false assumptions and stereotypes or suggest new rules of thumb. Faced with a large number of choices (as when thousands apply for one job), they can provide a quick, objective first-cut screen. But predictions of human activity based on statistical patterns are dangerous when used as a substitute for careful case-by-case judgment. They nonetheless continue to gain ascendency. Nowhere has this been more apparent—or more dangerous—than in the financial industry…..

The traditional lending model was built around case-by-case judgment. Home buyers would apply for loans from their local bank, with which they often had an existing relationship. A banker would review each application and make a judgment, taking into account what the banker knew about the applicant, the applicant’s employer, the property, and conditions in the local market. The banker would certainly consider history—what had happened to housing prices, and the track record of the borrower and other similarly situated individuals. But good practice also required forward-looking judgments—assessments of the degree to which the future would be like the past. Dialogue and relationships were also important: Bankers would talk to borrowers to ascertain their beliefs and intentions. And staying in touch after the loan was made facilitated judgments about adjusting terms when necessary….

Over the past several decades, centralized, mechanistic finance elbowed aside the traditional model. Loan officers made way for mortgage brokers. At the height of the housing boom, in 2004, some 53,000 mortgage brokerage companies, with an estimated 418,700 employees, originated 68% of all residential loans in the United States. In other words, fewer than a third of all loans were originated by an actual lender. The brokers’ role in the credit process is mainly to help applicants fill out forms. In fact, hardly anyone now makes case-by-case mortgage credit judgments. Mortgages are granted or denied (and new mortgage products like option ARMs are designed) using complex models that are conjured up by a small number of faraway rocket scientists and take little heed of the specific facts on the ground….

The buyers of securitized mortgages don’t make case-by-case credit decisions, either. For instance, buyers of Fannie Mae or Freddie Mac paper weren’t, and still aren’t, making judgments about the risk that homeowners would default on the underlying mortgages. Rather, they were buying government debt—and earning a higher return than they would from Treasury bonds. Even when securities weren’t guaranteed, buyers ignored the creditworthiness of individual mortgages. They relied instead on the models of the wizards who developed the underwriting standards, the dozen or so banks (the likes of Lehman, Goldman, and Citicorp) that securitized the mortgages, and the three rating agencies that vouched for the soundness of the securities.

Dispensing with judgment has also helped funnel the mass production of derivatives into a few mega-institutions, posing systemic risks that their top executives and regulators cannot control.

Little good has come of this robotization of finance. Reduced case-by-case scrutiny has led to the misallocation of resources in the real economy. In the recent housing bubble, lenders who, without much due diligence, extended mortgages to reckless borrowers helped make prices unaffordable for more prudent home buyers.

The replacement of ongoing relationships with securitized, arm’s-length contracting has fundamentally impaired the adaptability of financing terms. No contract can anticipate all contingencies. But securitized financing makes ongoing adaptations infeasible; because of the great difficulty of renegotiating terms, borrowers and lenders must adhere to the deal that was struck at the outset. Securitized mortgages are more likely than mortgages retained by banks to be foreclosed if borrowers fall behind on their payments, as recent research shows.

When decision making is centralized in the hands of a small number of bankers, financial institutions, or quantitative models, their mistakes imperil the well-being of individuals and businesses throughout the economy. Decentralized finance isn’t immune to systemic risk; individual financiers may follow the crowd in lowering down payments for home loans, for instance. But this behavior involves a social pathology. With centralized authority, the process requires no widespread mania—just a few errant lending models or a couple of CEOs who have a limited grasp of the risks taken by subordinates.

Yves here. This is a particularly succinct indictment of modern finance. It’s unlikely to get the traction it deserves because no new paradigm is waiting in the wings. As Thomas Kuhn argued in his Theory of Scientific Revolutions, scientific (and by implication, intellectual) frameworks persist even as evidence against them mounts, with ever-more patches and work arounds, until a new generation embraces a different paradigm.

But modern finance is a sort of lingua franca, computationally convenient, and most important, a lot of people have businesses deeply embedded in the current way of doing things. And the regulators are just as deeply invested. I found this section of a recent New York Fed paper on the shadow banking system simply astonishing (I’ve wanted to shred other significant elements of this article, but that is a serious undertaking that has to wait a bit). It listed the advantages of securitazation….without offering a list of disadvantages. To wit:

There are at least four different ways in which the securitization-based, shadow credit intermediation process can not only lower the cost and improve the availability of credit, but also reduce volatility of the financial system as a whole.

First, securitization involving real credit risk transfer is an important way for an issuer to limit concentrations to certain borrowers, loan types and geographies on its balance sheet.

Second, term asset-backed securitization (ABS) markets are valuable not only as a means for a lender to diversify its sources of funding, but also to raise long-term, maturity-matched funding to better manage its asset-liability mismatch than it could by funding term loans with short-term deposits.

Third, securitization permits lenders to realize economies of scale from their loan origination platforms, branches, call centers and servicing operations that are not possible when required to retain loans on balance sheet.

Fourth, securitization is a potentially promising way to involve the market in the supervision of banks, by providing third-party discipline and market pricing of assets that would be opaque if left on the banks’ balance sheets.

Yves here. Notice the Panglossian subtext: everything is for the best in this best of all possible worlds of securitization. Not only is there no consideration of the downside, such as the near-impossibilty of dealing with troubled borrowers on a case-by-case basis, but there is no acknowledgement that the same benefits could have been achieved by other, sometimes cheaper, means.

For instance, the first advantage, greater diversification, can be achieved by a less costly route, by selling loans. The second finesses the real problem with mortgages, that the US is pretty much alone among advanced economies in offering thirty year fixed rate mortgages on a large scale basis. Floating rates are the norm elsewhere.

A fixed rate mortgage made sense in a low interest rate volatility environment, but the product continues to exist when its effect is to shift interest rate risk on to banks, who in turn blow up on it periodically (first the savings and loan crisis) and leave taxpayers with losses. So ultimately, it isn’t banks that bear the interest rate risk, but the taxpayers who backstop banks. How sensible is this? What about a compromise, like floating rate mortgages with floor and ceilings (for example, if you got a 4.5% floater now, its floor might be 2.5% and its ceiling might be 6.5%). That way, borrower still can make sensible budgets, since their exposure is capped, but they bear a fair bit of the risk of interest rate movements.

Point three is about the cost savings from standardization and scale, when as anyone who has dealt with a servicer can tell you, it is often at the expense of service quality.

Point four, which is a naive recitation of the canard that investors can supervise banks, is refuted by Bhide’s piece. Supervision was not done in a decentralized way; instead, the greater complexity of structured credit products led investors to rely on expert opinion (ratings agencies) and models. From a related comment by Donald MacKenzie in today’s Financial Times:

The languages of today’s complex financial markets often consist not simply of words and numbers but also of technical systems. The credit crisis has shown the importance of their powers – and limits.

Although few outsiders have heard of it, the single most important language of mortgage-backed securities and similar products is a system called Intex. It includes a computer language for defining deals’ intricate cash flow rules, a graphics-based tool for designing deals, and a truly remarkable computerised “library” of the parameters of the underlying asset pools and the cash flow rules of more than 20,000 deals….

Intex’s power as a language is to make instruments such as mortgage-backed securities mentally tractable. I confess I’ve always found them daunting. The rules governing a deal can occupy hundreds of pages of impenetrable legal prose, and the economic value of the deal’s tranches depends on three complex characteristics of the underlying mortgage pool: the rate at which borrowers prepay (redeem their mortgages early), their propensity to default, and the loss severity (the proportion of the debt that cannot be recovered if a borrower defaults).

In July a friendly banker showed me Intex in action. He chose a particular mortgage-backed security, entered its price and a figure for each of prepayment speed, default rate, and loss severity. In less than 30 seconds, back came not just the yield of the security, but the month-by-month future interest payments and principal repayments, including whether and when shortfalls and losses would be incurred. The psychological effect was striking: for the first time, I felt I could understand mortgage-backed securities.

Of course, my new-found confidence was spurious. The reliability of Intex’s output depends entirely on the validity of the user’s assumptions about prepayment, default and severity. Nevertheless, it is interesting to speculate whether some of the pre-crisis vogue for mortgage-backed securities resulted from having a system that enabled neophytes such as myself to feel they understood them.

Yves here. It may seem churlish to point fingers at Intex (”Its’ a tool! You can have operator error with any device”), but pervasive use of models allows people to think all too superficially about situations. I noticed a marked decay in the understanding of businesses when PCs became widespread. Yes, doing projections and multiple scenarios became trivial. But in the stone ages of finance, bankers and analysts had to look at financial statements and go into footnotes to find details to put into spreadsheets, and they had to do any massaging to make the presentation comparable themselves. The grappling with the data produced a far greater appreciation of what the underlying reports actually contained, and also meant any scenarios were thought about before being analyzed and any not-pretty results were given more serious consideration. Now, it’s trivial to keep tweaking a model until it tells the story needed to support a sales pitch. The degree of abstraction has made it all to easy to airbrush risk out.

To return to Bhide, his piece provides further grist for thought, and I hope you will read it in full.

It is truly astonishing to watch how determined the economics orthodoxy is to defend its inexcusable, economy-wrecking performance in the runup to the financial crisis. Most people who preside over disasters, say from a boating accident or the failure of a venture, spend considerable amounts of time in review of what happened and self-recrimination. Yet policy-making economists have not only seemed constitutionally unable to recognize that their programs resulted in widespread damage, but to add insult to injury, they insist that they really didn’t do anything wrong.

Even worse, the latest excuse, from the Boston Fed, is that they are blameless because no Serious Economist could have recognized the bubble. From the Wall Street Journal Economics blog (hat tip Richard Alford):

Should economists and policy makers have identified the housing market bubble before it burst? The answer is most likely no, says the Federal Reserve Bank of Boston, because economic theory was not up to the challenge.

“Economic theory provides little guidance as to what should be the ‘correct’ level of asset prices — including housing prices,” the new paper published by the bank says. It was written by economists Kristopher Gerardi, Christopher Foote and Paul Willen.

“While optimistic forecasts held by many market participants in 2005 turned out to be inaccurate” those projections were not “unreasonable” given what was understood about the economy and housing market dynamics in the years before housing prices crashed and helped create one of the worst economic downturns in generations.

The paper notes economists were clearly not of one mind about the implications of rising housing prices. Some saw them as consistent with economic fundamentals, and driven by factors like the need for shelter to house a growing population, a favored explanation of central bankers themselves during those years. Others simply punted, offering no view.

Then there were those with negative views, many of whom have been sharply critical of the economics profession, and of policy makers.

“The pessimistic case was a distinctly minority view, especially among professional economists,” the paper observed. “The small number of economists who argued forcefully for a bubble often did so years before the housing market peak, and thus lost a fair amount of credibility” in the process. Others called a bubble with “arguments fundamentally at odds with the data” that became available after the fact, the economists write.

That paper notes that for the most part, regardless of the view economists held on housing, the science of economics wasn’t really even equipped to deal with the issue. “Academic research available in 2006 was basically inconclusive and could not convincingly support or refute any hypothesis about the future path of asset prices.” That meant anyone could argue anything.

Yves here. This recitation is truly embarrassing, in that the writers clearly see this abject failure as completely reasonable, as opposed to compelling evidence that the discipline is not qualified to provide policy advice. What could be more damning than admitting that economics was incapable of seeing the blindingly obvious?

The problem is that mainstream economics sees prices as a virtuous. Everything cal be solved by price. If there is some unbalance in the economy, it merely means prices need to rise or fall, the impediment must be stickiness or some other inefficiency that is preventing the magic price setting mechanism to do its magic work. Mainstream economists also believe that price mechanisms lead to optimal outcomes from a social welfare standpoint. There is a reason that this line of thinking. aka neoclassical economics, became dominant (and Keynsianism is merely a branch; Keynes himself believed economies were fundamentally unstable, while the neoclassical types believe that markets are always and every self correcting). It’s very favorable to the business community. (Note this is a simplification; ECONNED provides a long form treatment of this topic).

So there are quite a few reasons this “noneofuscouddanode” tale is sheer bunk. First is that economics is really really bad at fieldwork. How often do economists go and muck about in the phenomena they opine about? Nobel Prize winner Wassily Leontief, in the 1970s, did a tally of economics papers and found that a mere 0.5% had economists gathering data they then analyzed. The rest were pure theory papers or had the writers crunching data sets they had found. And on those rare occasions when economists do do their own data gathering, they are not very good at it due to the lack of interest in the profession in this activity. I’ve read surveys designed by economists to address particular issues, and it’s evident that they aren’t even remotely current with good, let alone best practices (for instance, asking people about their whether they will buy something or take an action relative to their finances is guaranteed to elicit wildly unreliable answers. No savvy marketer would use this approach).

Second, some very unfashionable schools of economics, namely the Austrians and the Marxists, both recognized the imbalances in the economy prior to the bust. It wasn’t just housing; the negative personal savings rate and the widening trade deficit with China were red flags.

Third is the through-the-looking glass logic: “Well, it took those (supposed) few who saw the bubble a long time to be proven right!” So how could you expect us to listen to them?” Huh? The bubble was hardly a secret, save maybe to central bankers (and that isn’t even true, William White of the BIS was issuing warnings as was ignored). The Economist made it a cover story in June 2005. And if the bubble had been arrested then, the damage would not have been very serious. The fact that it went on so long is perversely used as an excuse, when bubbles by nature go on absurdly long (as the recent example of the dot com mania vividly demonstrated). As we saw in this crisis, by the beginning of 2007, risk was so underpriced across all credit products that most market participants knew it was going to end badly, yet the vast majority stayed the course because exiting what might be too early had costs. Everyone acted as if they could all push through the door when the party stopped, and that of course proved false.

There is a good reason why economists may not be able to prick bubbles, but contrary to the Boston Fed’s lame excuses, it’s political. Ian Macfarlane, the former head of Australia’s Reserve Bank, did see that Australia’s housing market was overheated, and in 2004, used a combination of jawboning and a couple of interest rate increases to take some air out of it. But he was at the end of his term, and his successor did not continue with his efforts.

Macfarlane wrote in 2005:

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community’s wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy….

No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.

Yves here. Now there are other measures that regulators can use to attack bubbles, since the ones that are most damaging involve borrowed funds. They can take measures to restrict the gearing used in the markets that are superheating. But Macfarlane’s comment about the resistance to intervening rings true. Just imagine the howling you would have heard from homebuilders, realtors, bankers, home decorators, land speculators, you name it, had the authorities been able to severely restrict no-doc loans and had required a minimum downpayment, say, of 10% for non FHA loans. It isn’t yet clear we have the political will to take on the people who win short term from borrowing binges.