The Cause of the Subprime Crisis

The Housing Bubble

Since ups and downs of the American economy have relentlessly followed each other since the time of Alexander Hamilton, it's unfair to blame the President who happened to be in office when each bump began; but we do it anyway. Two bubbles began during the presidency of George W. Bush, the dot-com surge then the collapse of 2001, and the housing bubble which rose from the ashes of that collapse, crashing in turn in the summer of 2007. Both episodes can be viewed as responses to the world money surplus which grew out of globalization, which itself can be viewed as growing out of the computer revolution which started around 1975. Maybe that's wrong, but it's common to believe it is right. The world economy is an over-inflated tire, so bubbles appeared at weak spots. When money fled the stock market of electronics stocks, it moved to American real estate, facing us with the choice of another bubble to follow this one unless the collapse of this bigger bubble deflates so badly we have to wimper through a depression for a couple of decades.

This grand preamble is intended to answer whether a housing surplus caused the bubble, or a money surplus did. Economists at the Federal Reserve, charged with examining such questions, are firmly of the view that money surplus came first, causing too many houses to be built. The money surplus, in their view, grew out of the tendency of people (in this case, Chinese) to get prosperous before they learn how to spend their new wealth, so they save it. Without further debate, we will assume excessive savings in developing countries tended to swamp the world financial markets, and if it hadn't been this bubble it would have been some other. We went 18 years without a major recession, and would have to go another two decades -- forty years, in all -- for things to work themselves out calmly. It's a pity, but that's the price of being too successful.

A briefer capsule of the housing bubble would describe how surplus funds in the banking system made it cheaper to lend out mortgage money, which soon led to surplus houses, which caused the prices of houses first to go up and then to go down, soon followed by the banking system, and maybe through banks to the rest of the economy. Stock speculation is easier to manage, because houses take a very long time to disappear once you build them. Judging by the experience of the 1929 crash, it takes nearly twenty years for confidence to return after a bad crash, so perhaps the loss of confidence takes longer to recover than real estate prices. In fact, Europe looks as though it may take a century to recover its nerve, and by that time Europeans could be permanently in the dustbin of history. It can all be an unpleasant set of reflections.

Frozen Markets

Lots of people, perhaps far too many, borrow money. Many fewer are involved in the institutional lending of money, although still quite a few; but only a handful of those few have much familiarity with the mechanics of bank panic. Meanwhile, terms of art get propelled through the newsmedia, accepted as established fact by almost everyone, but placed in a peculiar storage category. Almost everyone knew the markets froze up all over the world; almost no one could define what was meant by that.

It meant that it was suddenly impossible to buy or sell financial instruments which normally are bought and sold by the thousands every hour. Some things were more thoroughly refrigerated than others, suggesting they were possibly at the heart of the problem, and some things took longer to thaw than others. One's grandparents could relate times in the 1930s when local towns had to pay their policemen and school teachers with script because they could not obtain currency. So frozen markets could become serious, not just a day off from school. Basketball games and election campaigns continued to dominate the news, but deep within the newspapers markets continued frigid for quite a while, ominous and mysterious ice caverns.

Many factors contributed as causes, and perhaps the greatest causes have not even been identified a year later, but two phenomena seem to explain a lot. The first was wide-spread reluctance to accept current market prices as realistic, because no one likes to believe money is forever lost. The validity of market based prices carries the assumption that weight of opinion will push prices in one direction or the other; if prices go too far, opportunists will push them back. Markets don't set prices, they "discover" prices by finding the price which temporarily balances the opinions of the universe of buyers and sellers. If you were Zeus, you might chortle at how wrong they all were, but nevertheless the consensus "discovers" the price that clears the market. What Zeus thinks has nothing to do with it. The process of orderly matching of bids can come briefly to a halt for any number of silly reasons; Abby Hoffman once paralyzed the trading floor of the New York Stock Exchange by throwing dollar bills over the rail of the visitors gallery, with a single hundred-dollar bill hidden among a lot of singles. Ramming an airplane into the building will do it longer, even for a while after the unexpected event is understood. But a lasting freeze-up is more likely to occur when the trading process unexpectedly drives all prices up or down, giving a signal that no longer is opinion equally divided, everybody is in total agreement that prices are going in a single direction, and no one therefore knows how high or low they are going to go. If everybody wants to sell, no one will buy.

Ordinarily, only a tiny sample of stocks or bonds are involved in daily trading, establishing a signal for what the rest --locked in banks or safe deposit vaults -- are worth. Most important are the inert securities "caught in a loan", being held as security for a loan on the presumption they are worth somewhat more than the loan. If the market abruptly decrees they are worth less than the loan, the bank will call for extra collateral, and failing that, will sell the collateral. When there are sudden runs in one direction or another, it becomes impossible to say what the collateral is worth; it's a good time to get out of the lending business if you can. Because no one dares buy, no one is able to sell; if you can't tell what the collateral is worth, no one will lend. That's pretty much what a frozen market looks like.

A variation of this concept arises when a banker refuses to sell because the emergency sale at a distressed price will "publish" a false price, which will then be applied to all of the rest of the bank's holdings, suggesting that those immense piles of securities in the vaults are really worthless. When distressed prices do surface, major banking concerns will refuse to acknowledge them as true prices. Because refusing to honor the "going price" is very disruptive, regulators force institutions to "mark to market" every day at the end of the day. If marking to market amounts to an admission of insolvency, that's unfortunate. A brokerage house forced into receivership because of obviously fallacious pricing can be even more bitter when it is recognized that commercial banks are not forced to mark to market, even with exactly the same securities. Banks are permitted to declare that securities are a long-term investment, marked on their books at the purchase price rather than the market price. Such maneuvering however gradually forces the bank out of the lending business at the same time that truly worthless paper is allowed to masquerade as sound securities. In the long run, it's bad for the economy, and in the long run the bank goes out of business anyway, it just takes a few months longer. While this process is under way, the regulators will force weakened banks to issue more stock, thus diluting the value of the existing owners, a sort of punishment for improper management. Under the circumstances, a major incentive is created to avoid letting the world know how you stand. Transparency, as they say, suffers.

Repetitive Trading.In recent weeks, a professor at the Wharton School made a name for himself with a theory with the power to become a law of the market place because of its power to explain some quirks. Repetitive trading in the financial marketplaces differs significantly from the market for used cars, say. If a single trade takes place for a high-priced item, the buyer and seller concentrate their efforts on getting that one price as favorable as they can; usually, the seller has superior information and more practice, so he sells for a profitable margin over the real market price. Most customers hate this flea market. On the other hand, when two brokers make ten or twenty trades a day for months on end, they become valuable clients to each other. The value of sustaining the relationship is greater than the occasional opportunity to pull a fast one, so it becomes a fact of life that an imbalance in one direction will be compensated by a collusive imbalance in the other direction in some subsequent trade. Although an occasional customer may get a poor execution from his broker, the market as a whole is smoothed out and volatility is probably reduced. There's less stress and strain on the brokers in the middle of the trading profession, until one day things go bang. Suddenly the value of the relationship seems quite minor compared with the potential for betting wrong in a congested market, that is, a stampede. So, such traders withdraw from the market as much as they can.

What's a Derivative?

The intention of the next few sections is to sort out some of the confusing components of the credit crunch of 2007, in which novel financial instruments called derivatives played a central part. Before we get into that, let's try to answer the question just posed: why did the monetary authorities respond to a surplus of cheap credit by apparently making it worse, flooding the economy with still more cheap credit? The sudden return to normal interest levels, it would appear, posed a threat of recession so severe it seemed necessary to make inflation worse in order to combat the impending deflation. The Federal Reserve may of course be planning only a brief inflationary move, or a sharp inflationary move soon followed by a sharp deflationary reversal. Its purpose appears to be, to prevent an impending wave of mortgage foreclosures by holding interest rates down, disregarding the abnormally low long-term interest spreads which had recently seemed such a problem. Whatever its tactical purposes, such bewildering reversals are a signal the Federal Reserve regards the present situation as dangerous. Some degree of inflation, possibly a large one, is going to be created but the Fed seems to think it has no choice. Before getting to that dilemma, let's sort out some of the ingredients of the credit crunch that seems to have triggered this mess.

A derivative is really pretty clever. It sorts out and monetizes any or all of the risks of a business. It frees up capital by putting a price on risks, just as insurance does, without requiring ownership of the whole company or industry. Flexibility is created, and in the case of real estate loans, surplus cash in one region can be redeployed in another region where money is tight. Flexibility allows for increased velocity of transactions, and increased velocity of turnover is equivalent to having more money to work with. It was not so long ago that mortgages were obtained from the local building and loan, and thus were constrained by the savings deposits of the local community. Far Eastern and Arab savings are now no longer held captive by primitive local banking systems.

There are worries about derivatives, however. For all their advantages, derivatives remain strange and mysterious, and thus, always a potential target for populist politicians. They are also a zero-sum game, which means that for everyone who makes money there must be someone else who loses exactly the same amount. That's of course true of debt in general; it's true of loans, and of bonds, but derivatives are new. Finally, derivatives were a quick success, which makes them dangerous competitors in the creative destruction game. It even makes them annoying to non-competitors, who get trampled by stampedes.

In the particular version of derivatives of concern in real estate, derivatives stripped away the risk that borrowers would default on their payments. That made mortgages available to more marginal borrowers, adding only a small cost for the insurance provided. It allowed more accurate, hence lower, pricing of mortgages by assessing the rate of default in a whole region rather than house by house. The theory was good and the savings to everyone were considerable. But success became a problem. No longer inhibited by a shortage of capital, mortgages and home ownership were greatly promoted. Unfortunately, the demand for mortgages in America had been artificially stimulated by implicit government protection against foreclosure, by government sponsored mortgage agencies with implicit government backup, and by tax deductibility of mortgage interest which was denied to other forms of household borrowing. If a loan was needed, some way was sure to be devised to make it a mortgage loan.

HowTo Create A Subprime Derivative

What's a Securitized Debt Obligation?

In an important way, securitized debt obligations (SDO) is a better term than collateralized debt obligations (CDO), because it mentions the main advantage they claim. Instead of the expensive process of many bank branches painfully assembling a myriad of deposits in order to have enough to lend out as a mortgage, large lumps can be assembled in Wall Street capital markets with little more than a phone call. It is possible to borrow what you need wholesale from Wall Street, avoiding the expensive situation of having more money to lend than requests for loans. Furthermore, the expensive risk of "borrowing short and lending long", that eternal nightmare of the banks, is blunted. And the source of funds available for lending can become national, or international, rather than limited by the savings of local community surrounding the bank. Surpluses can be matched to requirements, another efficiency.

Unfortunately, the creative destruction of bank branches creates one major offsetting disadvantage. The days may be long gone when bank managers would drive around and check whether houses were painted and roofs kept in repair, but still banks had a better idea of the reputation and appearance of their customers than anyone in Wall Street would ever have. Some method of risk assessment would have to be devised to replace the bank's eye on the client. It was devised, it was clever, and it was cheap. Unfortunately, its adequacy for the job is now in question as the CDO market chokes up. If it manages to pass this present test, it will surely replace the expensive old system. If things work out, the present collossal mess will be regarded as a good idea temporarily overwhelmed by its own success.

And if things don't work out, we certainly have a problem.

Securitization

It is not fanciful to link the credit crunch of 2007 with the savings and loan problems two decades earlier. Both bubbles were related to home mortgage financing, and the first bubble turned destructive by seeking money to keep itself going. If dammed-up surpluses of the Middle East and China could be made available to American mortgage lenders, there seemed to be ample demand for them. Furthermore, while Michael Millken is mostly known for his prison sentence, he had nevertheless made an important observation. Risky mortgages were generally overpriced. That is, the aggregate extra cost of subprime defaults was appreciably less than the aggregate extra interest being charged for them. If some way could be found to make the risk premium more appropriate to the actual risk, home mortgages would get permanently cheaper, and mortgaging profits would likely be gratifying. Mortgages needed a better system for establishing appropriate interest rates, and they needed more of that underemployed wealth of the Orient. Derivatives suggested themselves as a solution for both issues.

The unaccustomed wealth of Asia and the Persian Gulf was put under heavy pressure to migrate to America by lack of local investment opportunities, but was bottled up by rudimentary banking systems in the developing world. As ways were found to get around obstacles for exporting this money, the danger increased of "asset bubbles" inflating whatever they touched, for example the dot.com stocks in 2001. The pressure indeed needed to be deflated, but carefully. Furthermore, certain accords reached in Basle around 1982 made it even easier for banks to issue loans, while the favored tax treatment of interest from residential real estate loans directed lending to home mortgages. Indeed, the calculated cost comparison between buying a home or renting it had once remained identical for fifty years, but began to diverge in 1982. By 2007, it was significantly more expensive to buy than to rent, even though many analyses suggested a housing surplus existed, particularly in California and the Southwest. While the interest-rate premise was correct, the earlier campaign against "redlining" probably did encourage loans to people who could not afford the house, and there was momentum to this idea. But the most obvious stimulus to continued high-priced home purchasing, in the face of a growing over-supply, was the momentum of abundant cheap money. To mop up a growing housing surplus, initially low "teaser" interest rates were offered for ARMs, or adjustable rate mortgages which could abruptly adjust upward after a few years. A growing problem was being set up to go over a cliff. Chairman Alan Greenspan fretted at his seat on the Federal Reserve Board that it was difficult -- a conundrum -- why market interest rates for long term borrowing did not rise enough to put a stop to this. In retrospect, it seems likely the risk premium had long been too high, and was now reaching for more appropriate levels. Derivatives were a main instrument for bringing rates down, and they did it with breathtaking speed, perhaps overshooting in the process. As is often the case with innovation, the risk of failure was overemphasized, while the dangers of success received little attention.

Credit derivatives can also be viewed as a form of insurance, protecting the lender if the borrower defaults. That doesn't sound like a bad thing. True, all insurance creates "moral hazard" that encourages risky behavior by reducing its pain. No one, it is said, washes a rental car. But in a housing surplus, the insurance protection allows banks to take more chances in marginal situations, using up the surplus. Young folk are allowed to get started in life; the poor are allowed to enjoy the American dream. Unfortunately, some will abuse the privilege by buying speculative houses in a rising market, and "flip" them. Many will buy bigger houses than their income can support. Some, who should more wisely rent because their employment prospects are not secure, will be tempted to buy. All of these considerations are wrapped up in the interest rate the lender charges, so eventually interest rates will rise to a level that anticipates -- discounts -- them. Interest rates did not rise. The old levels of risk "premium" did not reappear.

It seems now that increased demand stimulated by derivatives was not resisted by a shrinking supply of money, with balance maintained by adjustment in interest prices. Indeed, a good even brilliant idea was crippled by a series of responses to the puzzling environment. Banks learned to sell pretty much any mortgage as quickly as it was created; after that, the extra risks were none of their concern. It has been suggested that banks be required to retain a portion of any loan they originate but to do so would exhaust the bank's lending capacity during a bonanza of business. Standards for a bank's lending capacity are set by the Federal Reserve, as a multiple of their retained profits or reserves. Those capacity limits had been relaxed by the Basle accords, but only on condition the banks restricted themselves to AAA-rated loans. This will turn out to be a critical point, because it put unwarranted reliance on the opinion of the rating agencies, and in any event led to "tranches".

Here's how things roughly went. Investment banks learned to buy up and combine great bunches of these mortgages into a bundle. The bundle was then sliced into tranches of lesser bundles, attempting to sort out the bundles by their credit rating. Elegant mathematical formulas were brought forward which did a fairly good job of sifting the potentially weak loans away from another bundle that was largely risk-free. Those better sub-bundles, thought to warrant a AAA rating, were then sold to institutions who were restricted to them by the Basle accords, but paid a lower interest return than the mortgage pool they came from. That was already an uncomfortably low rate by historical standards, now made lower. However, in view of its superior quality with default risk removed, it could be bought with borrowed money, eventually creating an adequate but leveraged return after costs. Debt was thus piled on debt, and the process repeated with exaggeration on the next lower quality tranche, the AA paper. And so on down to the lowest grade, which was thought to contain all or almost all of the default risk in the whole mortgage pool. People who bought the lowest tranche were real risk takers, experts who knew what they were doing, receiving a premium interest return to do it. Because this process was thought to create a sophisticated assessment of the true risk in the bundle, it was thought it would justify lower rates for everybody, squeezing out the unnecessary cushion of comfort. It was a plausible idea, and if it worked, it would be a brilliant one. But it had a big unrecognized flaw. It assumed that essentially all of the defaults would occur at the bottom of the pile, or possibly at the next higher level. There would be no defaults in the AAA level until all of the lower tranches had been wiped out -- an almost inconceivable economic calamity.

Ingenuity was then carried to yet another level. Credit derivatives are a form of insurance against default, but there was a more traditional form already in existence. Several so-called monoline companies offer insurance against default, backed by the enormous strength of pooled resources of a number of the largest strongest financial institutions in the world. The rating agencies assess their strength as AAA, the highest quality. Now, it was reasoned, if a tranche of mortgages rated AA by the agencies were insured by an insurance company, itself rated AAA, then the effective risk to the investor was really only AAA, or negligible. Alchemy. Lead was turned into gold. Unfortunately when the panic finally hit, monoline insurance stock which was considered rock-solid at $80 a share, was soon selling for $15. The flaw in all this was that the rating of the bond was based on the credit rating of the borrowers. No one had supposed that people who were quite able to pay their debts would walk away from them. When home prices fell only ten or so percent, many of them fell below the cost of the borrowed-up mortgage. Instead of feeling horror at defiling their credit reputation, many of these prosperous borrowers regarded foreclosure as simply a business decision. The protection of monoline default insurance was trivialized when one of the smartest investors in the world, Warren Buffett, announced he proposed to form a company to insure municipal bonds, and only municipal bonds, against default. Since that might strip away what had become the only profitable portion of the monoline portfolio, the prospect of such crippled companies paying housing claims would be bleak. Pseudo AAA tranches were now clearly back to being AA, and even real AAA tranches were under a cloud. All of this was not anticipated.

There remain two other questionable developments in this colorful adventure: the role of the rating agencies, and off-the-books behavior by the regulated mortgage originators.

What's a Tranche?

Tranche is a French word, referring to a slice of something. In the bond market, a bundle of bonds can be divided into tranches according to the date of issue or the duration to maturity. In recent years, the term has suddenly become synonymous with segmentation of securitized mortgages according to the probable risk of default. More briefly, the tranches refer to quality ratings by independent rating agencies, like Moody's or Standard and Poor.

What is an NRSRO?

Congress created the concept of a "Nationally Recognized Statistical Rating Organization" in 1976. As an aftermath of the Sarbanes Oxley movement, in 2005 credit derivatives were also required to be rated by the Credit Rating Agency Reform Act. A government stamp of approval was thus placed on a handful of rating agencies, and some argue it would be better to increase competition rather than constrain it by an approval process. Others are fearful of political influence. The ratings agencies themselves have expressed concern that efforts to increase transparency will impair confidentiality, and point out the existing system has seemed to work well for a century.

Nevertheless, defaults and paralysis of the credit system did occur, made worse by over-reliance on NRSRO ratings . Very likely, increased experience with this new debt security market will lead to a more accurate correspondence between predicted default rates and actual ones. No doubt, bond underwriters will make greater effort to stratify risk within the tranches with their own resources, using the opinion of independent rating agencies more as a check. Meanwhile, there may be a need to modify prevailing approaches. When evaluating a simple bond issue for a municipality or a corporation, only the financial strength of that entity is important. With the tranching approach, however, it is possible that risk estimation within each individual tranche might be perfect, but somehow be undermined by misjudgment of risk premiums to be assigned to each tranche. When risk premiums are generally compressed, there may not be enough to go around to all of the tranches.

There are seven firms currently registered as NRSROs: * A.M. Best Company, Inc. * DBRS Ltd. * Fitch, Inc. * Japan Credit Rating Agency, Ltd. * Moody's Investors Service, Inc. * Rating and Investment Information, Inc. * Standard & Poor's Ratings Services

Debt Rating Agencies

Three years ago, a gathering of bank executives were asked if they had an understanding of derivatives; it became instantly clear they hadn't the foggiest. More recently than that, Robert Rubin no less, admitted he first heard the term, credit derivative, a year earlier. When such an innovation means thirty or more $trillions quickly, it creates opportunities for quick learners. Everybody else relies on experts. But even if you grasp the credit derivative idea quickly, its innate complexity defeats you. Thousands of loans are jumbled together, shaken, diced and sliced, sold, and reassembled in new packages. The choice was clear: a banker must either decide to stay clear of such mysteries no matter how profitable they seem, or else rely on the opinion of triple-A rated agencies of long and honorable standing. A great many people decided to go with agency opinion, combined with a determination to sell these things as fast as they got them. The agencies did their best with an almost impossible task, and the sales volume soared.

In a computer age, such complexity can be quickly defined, traced from start to finish, evaluated in mass quantity, bringing final pricing decisions down to manageable form. But the bottleneck of computer programming limits the ability to address this rush job as quickly as its terms and direction are shifting. When computers catch up, much of this problem will come under control, without time-outs, new rules, or perplexing restraints. Meanwhile the response emerged: keep as little inventory as you possibly can, and meanwhile take a chance on the agency opinion. No doubt, other options were considered: play your cards close to your vest, position yourself to jump clear of trouble as soon as you hear of it. Billions, simply billions of dollars were to be made if you were quick and bold.

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Naturally, this pretty crude approach becomes steadily safer as experience showed its strengths and flaws; in time it might even be replaced by an auction between counter parties, creating a market for price discovery. Or perhaps packaging firms would strengthen their own evaluations to a point where each firm's reputation could compete with the rating agencies in risk assessment. Nevertheless, lack of feed-back was crippling until computer programming caught up. Market participants demand reasonable correspondence between ratings and subsequent default rates. In the meantime everyone flew by the seat of his pants. Unfortunately, in that meantime everything blew up.

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Mathematics contribute some insight into why it happened so soon. The Law of Averages forces a huge number of random opinions to assume a Gaussian, or "normal", distribution curve of rather narrow fluctuations. When opinions are constrained to a handful of rating agencies, however, volatility spread gets much wider, or "fractal". In the wry shorthand of market traders, a hundred-year probability then seems to occur every four or five years. Paradoxically, wide unexpected jolts are not caused by an increasing number of opinions, but the reverse. In investing circles it is said that the higher it goes, the more volatile it gets, and more likely to crash. "Chartist" observers notice this phenomenon in reverse; a period of declining volatility is known as a "pennant formation", often observed to precede a sudden reversal in market direction. Whether preceded by megaphones or pennants, when someone cries "Fire!" in a crowded theater, public opinions narrow down to only one -- get out the door.

What's a Mezzanine?

Mezzanine is a French word for a balcony, derived from Italian and Latin. It is familiar in architecture when it describes a balcony floor or elevator stop, using up spare space below the high ceilings of the ground floor of a bank or department store. Using this familiar image, it has become a word to describe things which get shoe-horned into the space between two other things, often as an after thought.

The word is used in so many different jargons that multiple meanings lead to abuse and confusion. In the mortgage world, two meanings are particularly important to distinguish. Until recently, a mezzanine mortgage only described a second mortgage (by implication, a first mortgage must pre-exist), in which the security for the loan is not the structure being mortgaged, but the ownership shares of the structure which are held by those who pledge to repay the mezzanine mortgage. Thus, both the first mortgage and the second can foreclose and receive nominal full value independently, rather than standing in sequence with each other to receive the same pledged asset. The legal process of foreclosure is facilitated, even though the recovery may not differ much.

In recent years, however, the term has also been used to describe a second round of tranches in a securitized pool of mortgages. After first slicing away the best grade of mortgages, the residual lesser-grade bundle still contains differing levels of risk, and the top grade of a second sorting process can be skimmed off as enough better than the rest to qualify as value overlooked. When this salvaged subgroup is then insured by a ("monoline") insurance company which itself has a AAA rating, it can be claimed the salvaged bundle has effectively upgraded from, say, AA to AAA. Obviously, the validity of this financial alchemy depends on accurately down-grading the dross left behind. The most important misjudgment in this mezzanine process however was the unexpected undermining of market opinion about the insurance companies standing behind it. Many of them retain a AAA rating, but their stock lost 75% or more of its market value.

Inverted Yield Curve: The Depositors' Viewpoint

Much has been made of risks for giant creditors in the 2007 credit crunch. What about the little creditors, the depositors with their savings at stake?

An old friend, then over ninety years old, once growled that Paul Volcker, the esteemed even heroic Chairman of the Federal Reserve, was only interested in saving "the banks". It's certainly true that many members of that board are elected by banks in the different regions, but it isn't easy to see how the Chairman could help banks if he wanted to, or why he would want to. It takes only a moment of reflection to realize, however, that all banks would naturally want to charge the highest possible interest for their loans, and pay the lowest possible interest to depositors. Essentially, everybody is their adversary.

Except the Federal Reserve, which needs its regulatory power over banks to control the amount of money in circulation, in order to stabilize the currency both at home and abroad. In another place, we discuss the remarkable ingenuity and the worrisome weaknesses of this arrangement, but for now let it suffice that it's the arrangement we have.

The difference between the prevailing return on deposits and the return on loans is called the yield curve, because short term rates, which the Federal Reserve controls, normally slope upward toward higher long term rates, which the Federal Reserve does not control. Essentially, the Fed controls what depositors are paid, but has no direct control over what borrowers are charged. Depositors are savers, and it is widely agreed that Americans do not save enough. To some degree, that must be the fault of the Federal Reserve. And when market conditions force a decline in the rates charged borrowers, the Federal Reserve must allow the banks to squeeze the depositors' rate of return, or banks will go bust. That's all my old friend was trying to say when he criticized a national hero. Luckily for Volcker's reputational legacy, he needed to boost interest rates dramatically in order to stop inflation, and that put plenty of interest in the pockets of old folks with money in bank deposits, while unfortunately it throttled borrowers unable to obtain loans except at very high prices. He stopped inflation in its tracks, but at the price of hurting business.

For over a year before the 2007 credit crunch, short-term rates (and depositors' interest return) were higher than long term rates (and borrowers' interest cost), an infrequent occurrence called an inverted yield curve. The difference between the Bernanke problem and the Volcker problem was that this time long rates were stuck at historically low levels, probably because of international situations. Depositors were protected and banks were made to suffer, although their reserves were invisibly eroding. One has to suspect the housing bubble was allowed to go on, to some degree to rescue the banks. With inflation starting to appear, interest rates needed to be raised, and with a national election approaching, deposit returns needed to rise to placate elderly savers. Furthermore, banks had a relatively new competitor for deposits, the money market funds.

The inverted yield curve put savers in a strange position. Normally, they had to balance in their minds the higher interest rates obtainable by investing in bonds, against the inflexibility of locking up the money for long periods. With an inverted curve however, bonds looked like the dumbest possible investment when they paid less interest than money market funds. Bonds were thus under pressure to raise rates, but they didn't rise. Greenspan's conundrum still persisted, but the situation highlighted one of the unpleasant consequences of correcting it. If interest rates rise, the price of existing bonds must go down; somebody's going to lose money. That's what was soon going to happen, once the credit collapse got started. Bond prices might dip and return if you didn't actually sell, but if you urgently needed cash in the meantime, you had to call on your money market savings. The spreading of the problem from one asset class to another was likened to the spread of a contagion.

In a sense, that's isn't quite accurate, because the similarity of bank deposits and money market funds is to some extent an illusion. Money market funds are mini bonds. These bondlets share the characteristic with bonds that rising interest payments result in falling prices for the principal involved. To preserve the appearance of interest-bearing cash they have a par value of a dollar a share, and the interest they pay is really a dividend. To preserve the appearance further, when interest rates must rise, fund owners make strenuous efforts to avoid "breaking the buck", or lowering the principal value, even to the extent of investing their own money to support the price. Rising interest rates are hard on money market funds, and most funds are owned by banks. The banks are under pressure by other factors in the credit squeeze, so it would not be inconceivable that they would be forced to break the buck. Elderly savers would not like that development and in an election year could make their displeasure felt. A great many people might wish to shift their savings from money market funds back to bank deposits, which are largely insured. A commotion of this sort would bring more attention to a comparison of different funds, leading to wide-spread discovery that the money market funds, which stock brokerage accounts employ as "sweep" funds for dividends and spare cash, have long paid substandard interest rates because of ignorance and inertia by the clients. And so, the contagion threatens to spread further.

Bank Accounting Off the Books

Banks have long operated in a dual system of regulation, state and federal, which permits some shifting back and forth between regulators. Mergers sometimes confuse matters further, and a system of one-bank holding companies adds to the stew. Local banks, waving the red shirt of domination by Wall Street at their state legislatures, have resisted interstate banking in a wide variety of ways. Sometimes a customer finds that funds transfer between two branches of the same bank must be treated as out-of-state action, and so on. Inevitably there is a certain amount of dealing by subsidiaries which is not recorded on the books of the home bank of a bank conglomerate in ways prescribed by the subsidiary's regulator, or not recorded at all. Equally inevitable is the accusation of off-the-books illegality by competitors, politicians, or the merely captious. Fine points of these legal and accounting arguments must be left to experts, peer review, and courts. Muttering Enron at every opportunity, accusers may be right that some of these arrangements have stepped over the line; partisans in Congress and the legislatures on the other hand may be correct that existing law is bad law. This is not a good place to debate either point.

It does seem appropriate to notice that banking has long been massively inefficient, and that much of this inefficiency has been imposed by regulators. Regulators represent the public, more or less, and the public is rightly nervous about stweardship of its assets. Dual regulation offers refuge from the ancient fear of confiscation by the sovereign, and is worth a certain amount of inefficiency if it works. But it does create loopholes, and it does impair transparency. In the case of the credit crunch of 2007, it sequestered bad debt in off-the-books ways, perhaps creating tax avoidance, but mainly creating distrust among counterparties. In those days of awful turmoil, no one knew what was going on, multi-billion dollar losses were being confessed by premier institutions, so transactions were delayed, avoided, or rejected. Transactions with anybody. When the time comes to reconsider regulations, it should be emphasized that by far the most damaging component of the whole mess was lack of transparency. Once more, a massive computer programming effort is entirely capable of restoring transparency to the existing regulatory structure, higglety pigglety though it may be. After we achieve transparency we might consider achieving efficient transparency, and after that perhaps ponder fairness in transparency. When a trader calls another, and asks to buy a zillion shares, the happy recipient of the call likes to glance up at his screen to see what the other fellow is worth, before he shouts, "You got it!"

What the Federal Reserve might well call the highest priority calls for respect, as well. Ever since we began the century-long transition from a gold standard for money, there has been concern that the Fed might not be able to determine how much money, or credit, or liguidity -- is actually in existence. We have reached a point in this process where the Fed has largely stopped trying to measure monetary aggregates, and merely adjusts its tools to keep the money supply sailing between the rocks of inflation and recession; if neither rock is in sight, the amount of money is about right. That system has served us for eighteen years, long enough to spark hope that it can be permanent. But when a rocky shore does make an appearance, the Captain of the ship must know how much slack he has, and how reliable his sonar. For huge sums to be obscured within bank subsidiaries or delayed marking to market, is to increase the chance we will run up on the rocks when it might have been avoided. He too needs transparency, but he also needs prompt obedience to his orders. The rest of us passengers are rightly concerned when he appears before Congress and admits he is not sure what the situation is. As long as that is the case, fairness -- and dogma -- be damned.

Taking a step backward, the whole credit crunch has brought to the world's attention that real estate transactions are both immense, and immensely inefficient; a great deal of money is to be made if any step in the chain can be streamlined. Therefore, real estate agents, real estate lawyers, title insurance, surveyors, advertisers, inspectors and everyone else who makes a living from real estate sales -- can expect to be drawn into an annoying process of inspecting the premises, promises, kick-backs, referral fees and marketing costs of a whole expensive process, first blasted open to inspection by implementation defects while computerizing the mortgage step. It appears to be high time for it.

Murky Crisis

One of the Wall Street's better maxims advises: Never let your competitors smell blood. Talking too much can injure perfectly honorable firms because in business there is usually a vulnerable time before opportunities can be consolidated, or miscalculations corrected. Trial and error innovation is progress. Transparency, humbug.

This prevailing wisdom can lead to mysteries like the present one, where thousands of well informed professionals struggle to puzzle out an explanation for pretty dramatic events, yet after six months no one can be entirely sure how bad things really are. When the subprime credit crisis began in August 2007, the number of outstanding mortgages was quickly approximated, and from that it appeared impossible for overall losses to exceed $90 billion. Six months later, write-offs at least that large have been declared, but estimated future losses now range around $600 billion, give or take $300 billion. But wait, in a zero-sum game, winners must match losers so the economy as a whole should remain unchanged. Even if winners and losers are in different nations, the result would at worst be weakening of one currency and strengthening of the other; after the adjustment world-wide wealth would remain unchanged. Real world-wide losses in a crash relate to whether wealth is created or destroyed, not whether it has been transferred from one firm to another. As an aside, the supply-side viewpoint is that taxes effectively remove wealth from the private sector for protracted periods and therefore are equivalent to dropping into a black hole; but liberals mostly dispute this, so it is not discussed here.

One of the indisputable ways to expand or contract wealth is, unexpectedly, through a change in prevailing interest rates. When interest rates rise or fall, the value of debt or bonds goes in the opposite direction. So, when derivatives or efficiencies lower interest rates, wealth is created. When realism, panic -- or fear of inflation -- cause interest rates to rise, wealth gets destroyed. What matters most to individuals is whether they own bonds during the time when interest rates are changing. No one necessarily gets any richer; in an inflation, bondholders lose money because money truly disappears. The only way to make money in this situation is to sell short, but that's too special and too small to affect this discussion.

So recently, spreads widened, or the risk premium returned to historic levels, or subprime mortgages got more expensive, or six other ways of saying the same thing: interest rates went up, value was destroyed. Anyone holding a certain kind of bond lost money, and may not be able to pay his bills. Because the problem was large and world-wide, no one could be sure who was holding the bag, transactions stopped, the credit market "froze up". Some very prominent firms soon declared losses of $5-10 billion each, so anyone might be an unsafe counterparty. Even if time passed and other firms did not declare losses, general distrust persisted, for a complex reason.

A Wall Street broker is required to mark to market, every day. Active traders, trying to keep as little inventory as possible, constantly face the possibility of imbalances, temporary cash shortages, which would make them unable to pay bills. Therefore, when interest rates go up, Wall Street investment firms lose a lot of money on the underlying bonds in their hands and must declare so publicly. Firms hate it, because it could well trigger margin calls from their lenders. If no shares are traded, however, the price of the shares appears to remain at its price at the last trade. That's what is often meant by markets "freezing up" ; if no one registers a sale at a lower price, it can't be meaningfully "marked to market." Banks, by stark contrast, are allowed to play by different rules. When the value of their bonds or other securities goes down, the accounting rules permit them to declare the bonds are a long-term investment, where they do not need to be marked to market. Investment banks thus must declare huge losses when they haven't sold anything, while commercial banks may hold exactly the same portfolio and declare no loss at all. Whether this disparity is fair or unfair, wise or unwise, is entirely beside the present point. The disparity confounds the general inability to say who is in trouble, thus whether the economy is in dire straits or just experiencing a state of confusion. At the least, it makes banks appear to be solid and solvent, while other investment institutions may appear to be in worse trouble. Aside from investors losing money by making wrong choices, there is a political risk in an election year that Congress or regulators could make wrong choices. A reckless young French trader happened to underline this risk, quite pointedly.

America was having a bank holiday on Martin Luther King's birthday, so our financial markets were closed but European markets were open. While American traders sat helplessly at home watching the news, European stock markets abruptly collapsed on heavy selling. Federal Reserve Chairman Bernanke promptly dropped short-term interest rates by seventy-five basis points (0.75%) between meetings of his board, creating a panic situation the next morning. It seems in retrospect that he had not been informed that a rogue trader at a prominent French bank had obligated that bank for $75 billion of unauthorized positions, which bank authorities promptly liquidated at a $7 billion loss soon after they discovered it. The newsmedia concentrated on the racy story of a French scalawag, but there was a more important story. Because of bewildering financial convulsions whose full dimensions may not be known for another year, Ben Bernanke the financially best-informed person in the World got into a panic and made a choice he might not have made if he had the full facts. If that was the case, poor intergovernment communication unnecessarily gave us a dose of inflation to contend with. Or, perhaps Bernanke got a needed wake-up call that the economy risks getting tangled up for several years by banks trying to ride out their bond portfolios to maturity instead of making loans. Refusing to acknowledge losses is what gave Japan a recession which is now in its fifteenth year. Try this nightmare: if the American consumer quits buying imported goods, Japan then China could collapse with consequences beyond conjecture. It is impossible to imagine Congress restraining itself in such a mess, and nearly impossible to imagine their getting it right when they do act.

As if to illustrate the point, the Carlyle Capital collapse in March 2008 demonstrated how violently markets can now be roiled by even a small quirk in the banking system when huge volumes of money are propelled through it by computers before the rest of the financial world wakes up. A prudent banker would normally make a loan for appreciably less than the value of the collateral. Depending on the historic volatility of the collateral, it might be reasonable to lend 80%. But Carlyle was an investment fund, selling shares to the public worth several hundred million dollars. Borrowing $20 billion from banks, especially Deutchebank, Carlyle bought mortgage-backed securities for the investment fund. Before things collapsed, Carlyle had bought $21 billion of real estate loans but had received only a twentieth of that from investors. The market price of the secutities thus only had to fall by 3% before the whole structure became insolvent. In the conventional 80% collateral example, a 3% decline would still leave it with a 17% cushion. Extreme leverage of this new sort would probably never have been considered by the German bank if it related directly to mortgages without a complicated middle-man. Whether anyone at the German bank realized this transaction was substantially the same thing at 20 times the risk is presently unknown, but it seems doubtful. The fact that at a relatively quiet moment DB suddenly called back its loan suggests that someone at the bank finally did wake up and ordered an end to the arrangement. Congress can now pass a law forbidding such structures if it wishes, but that will be mere grandstanding. Future textbooks of banking practice will surely all riducule the absurdity of this transaction; the risk of it nearly vanishes however at the moment of its wide spread recognition for what it is. Far worse would be for Congress to pass pious laws which essentially say that nothing innovative must ever happen for the first time, or that banks must stop using high-speed computers.

Sovereign Wealth Funds

At Third and Chestnut Streets in Philadelphia there is a Japanese restaurant occupying the site where Alexander Hamilton once lived and devised the modern banking system. There's no historical marker, possibly because Hamilton's involvement in the Whiskey Rebellion and his political switch of the nation's capital from Philadelphia to the District of Columbia made his memory distasteful to local town fathers. It was at this place Hamilton devised the idea that what America needed most was a national debt -- a national debt was a national treasure. Just about everyone was appalled, especially Thomas Jefferson and Albert Gallatin. George Washington didn't know about such things, but he trusted Hamilton and so we got a sovereign debt as cornerstone of national finance because no one wanted to oppose Washington. Wrangling over this radical idea became a central issue in the next eight presidential elections. After that, we had a century of wrestling with substituting the Federal Reserve for precious metals as a way of controlling the money supply. In more sophisticated form, our sovereign debt now forms the bedrock basis for the Federal Reserve's control of the banks and the monetary system. Just when things seemed settled, we confront something new and possibly just as revolutionary, the sovereign-wealth fund.

If a country can have a debt, it can have a surplus. Using that surplus to buy corporations was seen as nationalization, just a way- station on the road to socialism or communism. Somehow, what to do with national surpluses never became an issue, probably because it was easier to spend than to save. More recently, surplus funds have fallen to governments from oil or other natural resource discoveries, usually soon in the hands of a despot, combined with rudimentary banking systems that make it hard to invest locally. In 2008 these accumulations world-wide are estimated to exceed $3 trillion. Dubai has about $600 billion, and other countries like Singapore are not far behind. Traditionally, such funds end up in places like Switzerland where they more or less disappear from sight. While a few small countries have experimented with openly investing in stocks and bonds, the matter only surfaced as a real issue after the subprime mortgage mess of 2007. As a consequence of upheavals whose full nature is still obscure, financial giants like Citicorp, Merrill Lynch, and Morgan Stanley found themselves facing liquidation unless they could acquire billions of dollars by selling large blocks of their stock in a hurry. Thus the Americans, who would never contemplate their own government buying controlling shares of leading American corporations -- were jolted to see we had made foreign powers welcome to do so.

Furthermore, this might quickly get out of hand. The Chinese government, unashamedly communist, now holds 70% of American government bonds. Not only would a rapid bond liquidation be disruptive, but the purchase of corporations' controlling stock might be worse, The effective conversion of Wall Street into a street in Chinatown would have highly destabilizing consequences. Since holding vast quantities of bonds has created no problem, it would seem the main international difficulty lies in the voting power of common stock ownership. It might seem possible to prohibit sovereign foreign states from voting their proxies, although it is easy to imagine circumvention by straw-men. A more promising way to sterilize the voting power would be to forbid direct foreign nation ownership except through index funds. One questionable feature of this approach lies in the narrowing minority control which is created as index funds keep growing to a size that disinfranchises almost everybody except the management of corporations, or encourages predatory raids on a small sliver of outstanding listed stocks by promising future golden parachutes to CEOs and others who acquire stock by incentive options and then join in the raid.

Finally, it merits rumination about the growing vulnerability of banks, as agents of the Federal Reserve in its duty to stabilize the currency. The recent credit crunch delivered a setback to securitization of debt, it is true, but nevertheless the trend of several decades has been to weaken local banking. The eventual disappearance of banks is not inconceivable. Banks have consolidated into larger banking giants, but the recent troubles of Citicorp show that megabanking does not defend banks from securitization. We have to hope the Federal Reserve is considering responses to this threat to monetary management which are more productive than just a bunker mentality.

What's a Repo?

On St. Patrick's Day, 2008, Bear Stearns became insolvent and was given to J P Morgan. The Federal Reserve assumed all risks. Effectively, the fifth largest investment bank in America was nationalized for $2 a share, because no private bank would buy it at any price. A year earlier it was worth $170 a share, even one trading day earlier it sold for $26.

At the heart of this catastrophe were "repo's", or repurchase agreements. (They should not be confused with repossessions of cars and other hard goods bought on time, which are also called repo's.) Although most people had never heard of the high-finance version of repo's, the volume of these instruments had grown to $5 trillion by January 2005, presumably even several times larger than that when they caused the nationalization of Bear Stearns. Newsmedia accounts offered the guess that 16% of the resources of the whole financial sector were caught in open repo's when the music stopped. Repo's must be awfully good, or awfully bad.

They were both of these things at once. Like so many innovations in the post-computer era, they offered a major cost saving to an inefficient transaction system, but were so successful they overwhelmed the institutions which flocked to their reduced cost. The unanticipated difficulties might have been imagined, but they were not adequately guarded against. Essentially, these loans limited exposure to a few days, a feature that made them appear quite safe. Unfortunately, tons of these loans could expire simultaneously if a rumor got started and everyone held off using them for a week. With a run on a bank, at least people have to take action to withdraw their money; but with these things, simple inaction quickly led to massive cash shortages at the bank. Speeding up the loan process had made it cheaper, but made it vulnerable.

Consider the inefficient complexities of a bank loan. The bank wants collateral, perhaps 80% of the value of the loan. The ability of the borrower must be investigated, a clear title assured, and papers arranged for transfer in case of defaulted collateral. Lawyers must organize the agreements, and it all takes time, costs money. To go through all this for a one-week loan for anything less than huge transactions is simply not practical. So the idea was devised to sell the collateral to the lender at a discount, together with a repurchase agreement to buy it back at full price. For safety sake, the discount could be greater than the interest cost, and part of it returned if all went well. The collateral could be held by a third party, who essentially guaranteed the details while the collateral itself never moved. Bear Stearns had perfected these variations at such favorable prices they dominated the market for them with hedge funds; the margin for error narrowed when interest rates dropped, cash got scarce when investors got uncomfortable, the whole hedge fund industry was suddenly paralyzed, and everything connected to hedge funds was frozen secondarily. Much of this was handled automatically by computers, so huge volume made it impossible for anyone to know who might be insolvent. It seemed comparatively harmless to decline to play this game for a few days, but it was not harmless if most people decided to do so at the same time. The daily variations of interest rates and/or duration generate a ("Gaussian") normal distribution curve for the risk, predicting serious deviations will occur once every two centuries. But when events --even false rumors -- suddenly get everyone's attention at once, small daily fluctuations no longer bear much relationship to the frequency of violent fluctuations. Once-in-a century events start to happen every few years. At those times, the public stops speaking with a million voices and shouts in unison. Quite often, there is no cataclysmic event to trigger it. Like the conversational babel of a dinner party, it can all stop at once for no particular reason.

The mathematics of this matter could be taught to a tenth-grade math class. It starts to get beyond everybody's anticipation however when two such Black Swan events happen at the same time. In this case, an unanticipated pause for a few days bumped into the rule that non-bank institutions must mark their portfolios to the market every day. But for days at a time in this crisis, there could be no trading in certain issues; there was no market to mark to. How then can you demonstrate your solvency -- what might your competitors be hiding during these unannounced market holidays? And, since banks are in the same pickle but aren't required to mark to market, how can you trust them to pay bills? When you see European banks, who must obey new rules called Basel II, go bankrupt and get nationalized, how can you be sure American banks, who needn't obey Basel II until 2009, are any safer bet?

Progress is progress, but how much of it can we cope with?

Credit Crunch Turning Point, at Eight Months?

Ever since financial markets got jittery in August 2007, pundits generally agreed that things would not settle down before the second half of 2008. That seems to have been a safe thing to predict, but not exactly the same as confidently predicting that things will change for the better in the summer of 2008. Things could, unfortunately, get a lot worse.

Let's try to predict how history will remember these puzzling times. So far, the problem has been an American home real estate matter; America built too many houses, particularly in Florida and the West Coast. Houses were built because they could be sold, so the source of the difficulty was cheap credit for mortgages, and that was in turn traceable to Arabian oil prices and Far Eastern industrial progress. But never mind the cause, the event was a domestic American home mortgage issue, with the rest of the world sort of looking on. Whenever America got its mortgages straightened out, the crisis would be over. The other way history may describe things is far more ominous. Prosperity for the Middle and Far Eastern countries generated more wealth than their primitive banking systems could manage, so they exported it in the form of world inflation. America was pioneering in some innovative credit and investment streamlining, which was not entirely rationalized when it suddenly got toppled by a tsunami of world credit excess. Wall Street and Washington were the actors in stage center, but the underlying problem was a world problem, taking years to correct, and requiring heroic efforts to save it. If it could be saved. Politicians and newsmedia will emphasize any mistakes, but a solution will depend on whether or not we get some bold successes. The second quarter of 2008 will begin to show whether we need to keep cool, or blow the bugle.

To some extent, it was necessary to wait the better part of a year to see how strong our beleaguered institutions would prove to be, how many of the dubious mortgages would actually default, how many of the innovative lending practices would have to be forbidden, or revised. For example, it unnerved many people that so many "subprime" mortgages defaulted in the first year after the house was bought, suggesting that the house purchase was wildly inappropriate. On examination, however, it turned out that overzealous lenders had skipped the normal practice of insisting that money be set aside in escrow for tax and insurance payments. When tax and insurance collectors demanded immediate payment, the borrowers just skipped payments on the mortgage. Lenders will probably avoid this trap in the future, but if not, legal prohibition is fairly simple because it is so obvious. However painful this small problem may prove to be, its correction will be soon forgotten.

The international issues are much more difficult. From August 2007 to April 2008, American interest rates went steadily down; by their standards, they went down a lot. Many hot money investors took this as a sign that America was going to pay off its debts by deliberately provoking inflation; European countries have done this for centuries, even including England under Sir Stafford Cripps. That's why the gnomes of Switzerland keep vaults full of gold, and the oil moguls of OPEC have learned to keep their oil in the ground. Indian women bought more gold bracelets to jangle around, and the Australian markets went through the roof. Two governors of the Federal Reserve, including Philadelphia's own, voted against lowering interest rates "at this time". Paul Volcker, who once smashed the economy in order to smash inflation, hasn't spoken out yet, but simply trotting him out to a banquet is sufficiently vocal testimony at this stage of matters. No one has yet mentioned the hyper inflation episode of the Weimar Republic, but that episode was so catastrophic no one has to mention it in Germany or Austria; everybody remembers. As a matter of fact, the Europeans are so concerned to show the euro is strong, it is actually excessively strong and will surely be moderated. Our strongest ally in this Kabuki dance has been China, but a few rash words about Taiwan would test that severely. Are we trying to inflate away our mortgage debts -- absolutely not. Will we be able to prevent a serious recession by "stimulating" the economy -- it remains to be seen.

And finally, will wars, elections, blunders or general jitteriness force us all into a general rearrangement of the currency systems of the whole world, another Bretton Woods Conference let's say? No, of course not. But it wouldn't hurt to have the graduate students in Economics departments perform a few theoretical exercises, just for the practice of it.

Curing Stagflation

On Wednesday April 30, 2008 the Federal Reserve lowered short term interest rates by 0.25% (to 2%) . It had been rumored they would lower rates even more, but it became more than a rumor that two members of the Open Market Committee resisted. Paul Volcker the former chairman gave a speech describing what he had successfully done in similar circumstances, which was to raise interest rates, not lower them. On the same day, Brian Westbury published an opinion piece in the Wall Street Journal, advocating that the Federal Reserve lift interest rates back to their natural rate, which is somewhere north of 5%. A day earlier, John L. Chapman had written in the same publication that the dollar needed strengthening, which is effectively the same as raising national interest rates. All of these dissenters are more fearful of stagflation than recession, or November elections. All of them are echoing the classic opinion of Walter Bagehot, editor of The Economist between 1860 and 1877 . Nevertheless, the people entrusted to act are still lowering interest rates, and the rest of us retreat before their superior information sources.

Bagehot (pronounced baa-joe) always made his points in few words. The solution to what is now known as stagflation is to raise interest rates to punitive levels, while cutting taxes. Punitive levels are of course punishing, and unpopular. Furthermore, since the Democratic candidates for President have boxed themselves into advocacy of raising taxes because President George W. Bush had cut them, the tax-cutting part of Bagehot's terse prescription is also opposed, D versus R. To explain a little, stagflation defines a situation where there is simultaneously rising unemployment and rising inflation. That's not supposed to happen according to the rule of Phillips Curve. The theory behind the Bagehot approach is that the unemployment in this circumstance is caused by the inflation, so you must attack the inflation with higher interest rates, even though a lot of people will be fearful that unemployment is caused by other things, and will go up. Raising interest rates will likely worsen unemployment temporarily, so it takes grit to do it and keep doing it. Industry must be encouraged to invest by dangling inflated untaxed profits in front of its greedy nose. Class warfare opposition is likely to be fierce and unfair. This whole situation prompted one observer to wish we had Gerald Ford back as President, because he was the only President in fifty years to have the country's interest at heart. That's perhaps extreme, but the general reaction is supportable.

It begins to look as though some economist ought to make himself famous with a curve. Going from left to right, it would show that inflating the currency by lowering interest rates will initially help a recession and unemployment. But above a certain level, continued inflating will generate more unemployment by injuring employers. Let's call it a Bagehot Curve.

Linking Oil Prices to the Credit Crisis

When two unexpected things happen at once, it's natural to think them related, but it nevertheless has been a little hard to see how soaring gasoline prices would be caused by falling prices of California homes, or the other way around. If these explosions are indeed unrelated but only occurred at the same time, it leads to the "perfect storm" theory that neither alone could cause a market freeze-up, but perhaps two at once would overwhelm the safety buffers of international markets. Whichever way it turns out to have been, there is a political hazard. The cold northeastern part of the country is mainly concerned about the cost of home heating fuel, while the warm southwestern states naturally focus more on the housing glut and falling home prices. The political danger would be that congressional representatives of the two regions might get polarized along those lines, potentially blocking effective national action to rescue either problem.

All of this may turn out to be a pipedream. Eight months after the financial panic began, evidence has been brought forward that a quite sizeable amount of the rise in the price of oil, as much as half of it, may be due to speculative activities by hedge funds, attempting to use oil as a hedge against the falling dollar. Since the dollar is falling because of interest rates lowered by the Federal Reserve attempting to rescue banks, as well as stimulus packages passed by Congress for the same purpose, everything may be part of the same parcel. If this theory proves out, it helps concentrate government action on the basic culprit, and quiets at least some of the blame game.

It even suggests a partial solution might be to persuade Europeans to be less protective about the abnormally strong Euro, and let it ease a bit. This is the third identifiable source of the weak dollar, which the American public has so far largely ignored. During a presidential election campaign, the aroused American car driver might be persuaded to raise quite a fuss about what those non-voters across the ocean are up to again.

Mortgages From the Bank's Viewpoint

There has been much talk of the "moral hazard" for banks in acting as mere salesmen for mortgages they plan not to keep, ending up with "no skin in the game". But when a bank sells a mortgage to a mortgage packager, the bank gets rid of a lot of problems which the new owners of the loan didn't understand well enough when they got into the deal. After all, the securitization of loans is a new and complicated business in itself, and the investment bankers may have been a little bedazzled by the obvious efficiencies of the new system. Securitization provides an excellent way to transfer money from cash-rich foreign nations to local homeowners in cash-hungry regions, at a better price than either party would have been able to obtain locally. And mortgage prices are further reduced by largely ignoring the financial prospects of the anxious borrower on the other side of the desk in favor of lumping his risks and advantages with those of fifty others. The price is then no longer set by hiring a shrewd and experienced banker to ponder the speech patterns, family background and demeanor of each applicant; such bankers tend to set the price too high just to protect themselves. The idea of bundling and securitizing is a brilliant and useful innovation which must not be destroyed in a national convulsion of revenge. Yes, prices must be adjusted upward somewhat to account for careless salesmanship; but once that risk has been priced, it's likely ample savings will still emerge, compared with the old one-by-one underwriting system.

Unfortunately, that's far from a complete description of the risks involved in holding a loan for five to thirty years. The risk of default and foreclosure is quite small at first, rising to a peak after the mortgage is about five years old, after which the rate of default steadily falls. During the first year, however, the banker anxiously watches the national delinquency rate -- missed payments -- and compares it with his own, or that of the locality, and compares those rates with earlier years. If all these delinquencies seem to occur at historic rates, the banker can normally breathe easy when a loan gets to be five years old. In the meantime, he has to agonize over whether local or national economic conditions are somehow going wrong, and whether some particular cohort is going to create unexpected losses which must be recovered by raising prices on new loans. The contract has been signed; while tempestuous re-negotiation of terms is possible along the way, it is expensive and often fruitless. Each year's delinquency and default rate is compared with other years, attempting to discern whether a trend is starting, or reversing. If home prices are steadily rising, it is one thing, if they are falling it is quite another. Reading these tea leaves is combined with trade gossip, at conventions and the like. Out of this the market establishes prevailing prices; the more things are lumped together, the fewer the issues which matter.

It is now clear the designers of this elegant system underestimated the degree to which the system itself would change its own environment. If loans get cheaper, weaker borrowers are able to risk them. One of the beauties of the new system is to permit an international traffic in funds surpluses; the deterioration of the dollar was unexpectedly large for an issue which had been irrelevant to real estate under the old Jimmy Stewart system. Home prices rose faster than normal, and then they fell more than normal. That created a risk that more people would abandon their mortgages out of calculation of costs, rather than inability to pay. As matters now stand, thirty percent of mortgages issued in 2005 are showing delinquencies; no one is sure whether that will revert to a more normal rate, and when. Or whether the dumping of property on the market will depress prices, leading to a spiral of more mortgages being abandoned. As these warning signs of rising delinquencies appeared, they were noticed. It is not necessary to postulate some particular blunder or conspiracy which started a rush out the door.

In other words, no one knows what these loans will be worth in five years, so no one knows what to charge for one today. The result is a freeze; nominal prices may remain the same for a while, but no one will pay such prices until things stabilize. No one knows how long this uncertainty will last, but it could be a number of years. Meanwhile, a calamitous amount of debt and securities sit on the market, unable to move. Bad deal.

Proposal: A Second Federal Reserve

The Global Interdependence Center (GIC) holds an annual monetary conference of considerable eminence, and this year it was held on the grounds of Drexel University. A featured speaker was Henry Kaufman, who has long been the voice of Salomon Brothers, a New York investment bank. Since one of the main activities of that firm has long been bond trading, what Mr. Kaufman has to say about the current credit situation is of considerable interest. Wasting no time with preliminaries, he dove right into the topic, which is characteristic of speakers with too little time to say what's on their mind.

Securitization has, in his opinion, been excessive. Computers have provided increased interconnectivity, increased speed, and consequently lack of transparency in the credit markets. Consequently, senior managers and directors lost track of events and therefore failed to restrain risk-taking. Especially, SIVs (hidden subsidiary corporations) increased risk without restraint. Excessive management compensation has had the effect of relaxing management control, and there has been too much credit floating around. Capital was chasing investment instead of the other way around. But in addition the architecture of the system is at fault, and the problems just happened to hit subprime mortgages first. Short term money was supporting long-term obligations, which can be described as a conflict between the amount of risk and the duration it was at risk. No one who actually needs a bail-out should be allowed to have one.

That's all pretty succinct, and likely contains a lot of wisdom. But it was quick preamble, after which the highly practiced speaker slowed down for the real point. The Federal Reserve, charged with maintaining stability, was timid and sluggish in recognizing the magnitude of the situation. There was a main focus on restraining inflation and increasing Fed transparency, while neglecting regulation. He didn't say so directly, but one gathers he approves of regulation, disapproves of transparency, and is somewhat dovish about inflation. In other words he is joining if he did not initiate, a gathering political chorus demanding more government regulation and less reliance on the market place to structure the economy.

So it comes down to this. Since the Federal Reserve is too preoccupied regulating small banks, it has been outmaneuvered by the big ones. What's needed is to form a new regulatory agency in charge of big banks and investment banks, with big-picture management of the institutions that really matter. He didn't make any suggestions about who should be the first chairman.

The rest of the audience will probably be long dead after Henry Kaufman's image continues to shine, but nevertheless there are some awkward features to this analysis and proposal. It fails to put enough emphasis on the blistering speed with which new schemes have been devised which really do benefit mankind even though the driving motive behind them may had been the purest sort of greed. The efficiency of the financial industry has been enhanced in a thousand ways, causing the cost of transactions to drop appreciably. The increased velocity, while it may have been motivated by a desire to cash in before others compete for it, is well known to increase the effective amount of money in circulation. The market finds itself with the tuna problem: to slow down is to die. One can even suspect that the excessive management compensation does not identify the buccaneer, it often represents the bribes engineered by young geniuses and intended to be offered to the older has-beens to get out of the road. Surely, the managers who have come up through the ranks are in a better position to ask questions and impose prudent restraints, than a new cadre of Washington bureaucrats who only hear of a gimmick after it has been run off the road.

It's easier to see what's the matter with this proposal than to identify what is better. The young cowboys at the computer screens of Wall Street are already better paid than the highest level of Washington, and their future aspirations are to become zillionaires in just a few more months. Someone fresh from these combat zones indeed knows what's going on, but he isn't going to give it up to become a regulator. So, Washington will instead recruit their brightest most idealistic classmates from the same Ivy League colleges, and train them in the most esoteric economic theory, They will be brilliant and attractive, idealistic and energetic, But they won't learn what's going on until that thing no longer matters and a new unsuspected one has taken its place. The only people who have a chance of controlling this zoo have been bribed to keep out of the way by astonishing compensation packages. If it's reform and regulation we need, here is the place to begin. Let's wait a bit to see what this thumping crash will do to get their attention.

Philadelphia Reflections forum

Premature Solutions to the Credit Crisis of 2007

One of the things being said in Academia in 2008 is that the 1929 crash was the result of many futile attempts to preserve the gold standard. That's the first time that particular formulation has surfaced in eighty years. It may not be correct at all, and even if correct it doesn't say what should have been done about it. Life is short and the Art is long, but somebody must do the best he can with the information available. Unemployment was over 30% in those days, and hundreds of Americans froze to death in the Depression because they could not afford to heat their rooms. Right or wrong, there are times when some action must be taken. But if you can possibly sit tight and figure out a sensible thing to do, it's certainly better.

So, we hear proposals from Henry Kaufman to create a separate Federal Reserve for big institutions alone, while others say banking oversight is already too fragmented between the Fed, the Controller of the Currency, the Secretary of the Treasury, the FDIC, state banks and national banks, the SEC, the Bureau of Management and Budget, and on and on. This line of argument takes the formulation that we should regulate mortgages, no matter who is involved in them, rather than banks, on non-bank institutions. On one point everyone is in agreement, that we need more information more quickly, more transparency, less asymmetry of information. At the same time, everyone is aware that it probably will eventually be possible to describe this whole mess on one sheet of paper; the truth is totally hidden by information overload. Don't talk so much; say something.

At the GIC (Global Interdependence Center) recently, a brilliant professor of the Wharton School gave a magnificent summary of the situation, now nine months old, enumerating a number of insights which had not even occurred to an audience of bankers and businessmen. They applauded enthusiastically, and then someone asked how Credit Default Swaps fit into this picture, since they had not been mentioned. It immediately became embarrassingly evident that the professor knew almost nothing about that topic beyond a couple of pat sentences. But Credit Default Swaps now total trillions and trillions of dollars, more than doubling in a year. Since they are private transactions unreported to regulators, no one has measured the matter or will divulge what has been measured. But since they represent a volume several time the size of the underlying debt market, and every swapper swaps with someone else, it seems inevitable that huge imbalances exist somewhere. It would be nice to have a general idea out of whose pockets the excesses come, and into whose pockets they go. Maybe all this is irrelevant to the present crisis, but it isn't irrelevant to the distrust and fear in the markets. If someone proposes a law about this situation, he had better have divine guidance.

An example of what causes markets to freeze up because people are afraid to buy, comes from an anonymous person in an elevator. Speeding between floors, he remarked earnestly to a friend, that when he worked for Goldman Sachs his department churned out dozens of innovative debt instruments. If one of them happened to get popular, then and only then did they set about devising ways to measure them, and adjust the prices. It's impossible to stop rumors of this type because they sound so plausible. In fact they may even be true.

In fact, some of the most incisive comments come from people with no insider information at all. Such as a businessman who listened intently to the lecture and then called out, "Where were the accountants in all this? Aren't they paid to know what is going on?" The answer was that FASB rules should be tightened up. Maybe so, but it sounds a little thin.

The political risk is considerable. Only 6% of the population is old enough to remember 1929 and its aftermath, only 25% more can remember 1973, and 25% more can remember 1991. That means that nearly fifty percent of the public can never remember a severe recession at all. A politician running for office could tell them anything, and they would have no reason to challenge it. Or put it this way: the advisors who elected a young President could tell him anything, and it isn't certain he would fire them for it.