Philadelphia Reflections

The musings of a physician who has served the community for over six decades


American banking was invented in Philadelphia. The banking center of America has moved away and changed in extraordinary ways but the foundations remain.

Recent Convulsions in World Finance
Few people choose to study economics; most people don't want to. But world economics have got in such a state that lots more of us had better give it some thought.

Sociology: Philadelphia and the Quaker Colonies
The early Philadelphia had many faces, its people were varied and interesting; its history turbulent and of lasting importance.

New volume 2012-07-04 13:46:41 description

Second Edition, Greater Savings.
The book, Health Savings Account: Planning for Prosperity is here revised, making N-HSA a completed intermediate step. Whether to go faster to Retired Life is left undecided until it becomes clearer what reception earlier steps receive. There is a difficult transition ahead of any of these proposals. On the other hand, transition must be accomplished, so Congress may prefer more speculation about destination.

A New Era in Politics: Clinton, Obama, and Trump
New forms of communication made the party system largely obsolete.

Banking Panic 2007-2009 (1)

Mankind hasn't learned how to control sudden wealth, whether in families, third-world countries, or the richest nation in history. The world banking crisis of 2007 is the biggest example yet.

IN lifting a billion people from desperate poverty to moderate prosperity, economic globalization has been a premier good thing for the world. Globalization however made many financial stumbles in developing countries; in 2007 even America finally stumbled, badly. Few people now dispute three basic facts: huge new wealth was dumped on the globalized monetary system. Somehow this caused a housing bubble in America. And somehow this bubble toppled Wall Street. Two years after its sudden explosion, opinion about cause is divided into two main camps. One maintains a house of cards is certain to collapse; it's futile to play blame-game when it does. The other viewpoint is that responsible people know enough not to sneeze near a house of cards, so it matters who did sneeze. This article examines the two propositions, concludes that still a third theory is more likely, and propounds it. Fixing a mess this complex so it never happens again, is a project too large to succeed unless many people grasp what it was really all about. Even if they can't fix the problem, at least they can listen to the Greek physician Hippocrates: Don't make it worse.

Perhaps real estate stresses, banking stresses, and the stresses of emerging economies all relate to the same flaw in human character, the difficulty adjusting to sudden great wealth. The goal here, however, is not philosophical elegance, but to get out of an economic mess, at a minimum not worsening or repeating it. The world monetary order may well be at the root of the problem, but world monetary order can wait until more tangible things are fixed. So, in this article it comes last, except for this initial declaration: A wealthier world made America richer, too, and we shamefacedly admit we couldn't handle it.

Hovering in the background, moreover, the computer information revolution made everything move faster, surprises come sooner; problems quickly grew huge before being recognized. Over a hundred other national banking crises have erupted in the past thirty years of the computer era, mostly confined to small poor countries with scant experience. World history shows sudden new wealth, while welcome, violently disturbs the existing order. It is little different whether new wealth comes from gold rushes or striking oil, from inventions, or new forms of securities trading. Previous wealth and experience help steady the balance, but to think one is immune to the nouveau riche weakness only means one has not tasted large enough doses of it.


Michael Millken

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.

Chairman Alan Greenspan

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 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 the 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 a "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 is 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 a balance maintained by the 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".

Federal Reserve Building

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. The 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. The 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 ensure 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.

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.

{bottleneck of computer}
bottleneck of computer

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.

* * * * *

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 counterparties, 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, the lack of feedback 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.

* * * * *

{Gaussian, or}
Gaussian, or

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.

Inverted Yield Curve: The Depositors' Viewpoint

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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? {bottom quote}

An old friend, than 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 minibonds. These bundles 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 the 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 are 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.

{Credit Crunch}
Credit Crunch

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 stewardship 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, highly 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 a concern that the Fed might not be able to determine how much money, or credit, or liquidity -- 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, kickbacks, 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.

What's a Mezzanine Loan?

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It seems like kicks just keep getting harder to find... {bottom quote}
Paul Revere and the Raiders

A French word for a balcony, mezzanine is derived from Italian and Latin. In architecture it describes an indoor balcony floor or elevator stop, using up spare space below the high ceiling but above the ground floor of a bank or department store. Evoking this familiar image, mezzanine has become a word to describe things which get shoe-horned into the vertical space between two other things, often as an afterthought.

In the mortgage world, the meaning you want to be careful about is a loan sandwiched between the owner's equity and the first mortgage, potentially leaving it unclear whether the "mezz" is equity or mortgage, but in fact often a warning the property buyer had to borrow to make his down payment. Persuasion efforts at the time of investor re-purchase of a mezzanine loan are apt to focus on the rich double-digit income which would result from everything going well with the loan, falling back on a cheap acquisition price for the real estate in case of a foreclosure. However, mezzanine loans are a comparatively new product, and the full range of consequences are not common knowledge. In the first place, the 2008 wave of foreclosures was not anticipated, so the risk of rich double-digit interest payments was badly underpriced. Even more important, the mezzanine loan seems somehow senior to the first mortgage, but that is meaningful only if the amount recovered from the foreclosure significantly covers the residual of the first mortgage. Even if the total acquisition cost after the foreclosure is a bargain, the big problem in 2009 has proven to be the freezing up of the financial system, with the effect that no one can be certain what the final house value will be, and consequently what the value of the mezzanine loan should be. The resulting bad name that mezzanine financing acquired in this uproar has further frozen the market with fear.

There are other definitions of a mezzanine loan in use, so the first message to investors is to make certain what meaning the term intends in a particular case. If the interest rate was underpriced, the principle of the loan was overpriced. The market will only clear when all parties reach an agreement about the degree of overpricing of the asset, the degree to which the foreclosure recovery fails to cover the first mortgage, and the risk premium needed to cover the uncertainties. Mortgage professionals will eventually puzzle all this out, but until then the existing mezzanine loans will be yet another major obstacle to the recovery of the impaired financial system.

It may or may not be helpful to understand another way of describing this puzzle. A mezzanine mortgage describes 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 held by those who pledge to repay the mezzanine mortgage. Thus, both the first mortgage and this second one can foreclose and receive nominal full value independently, rather than standing in sequence with each other to receive the same pledged asset. In this somewhat legalistic view, the mezzanine is not senior to the first mortgage, but independent of it, holding the owner's equity as security rather than the house. 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. This is the view that emerges from trying to price a layer in the middle by disregarding the bottom of the heap which is hopelessly lost, as well as the top of the heap which is safe and sound. After first slicing away the best grade of mortgages, the residual middle-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 retained a AAA rating, while their stock lost 75% or more of its market value.

Language moves fast on Wall Street, particularly when a new concept needs to be packaged in a sales environment. Within a few months, mezzanine financing in common parlance quickly came to mean Alt-A. And Alt-A came to be defined as a mortgage or a package of mortgages in which the borrower was neither asked his income nor asked to prove it if the matter was challenged. That may not be exactly accurate when referring to any particular security, or package of securitized debt. But in common parlance, Alt-A was the term used when someone described mortgages where the lender knew very little about the borrower.

Having a general sense of the uncertainties, the general reader may perceive why this issue freezes up the market, and someday may be ornamental to explaining it all to one's grandchildren. But that's about all; most people become glassy-eyed, and start to run away.


Paul Revere & The World He Lived In Amazon


Paul Revere & The World He Lived In Amazon

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's a Collateralized Debt Obligation (CDO)?


Securitized debt obligation (SDO) might be a better term than a collateralized debt obligation (CDO), but it never caught on, so the unwary easily confuse CDO with CDS, an entirely different derivative called a credit default swap. There will be a lot to say about credit-default swaps in the present financial muddle, but for now, we focus on the process of securitization. A CDO accomplishes the transformation of debts into securities, usually by aggregating a large number of similar debts (mortgages, construction loans, college tuition loans, etc) into an issue of bonds or stocks. In so doing, it goes from banking to finance. A bank deals with depositors, and it also deals with borrowers; its function is that of an intermediary between the people who have spare cash and other people who need to borrow it. Finance is one step removed from banking; the people who lend and those who borrow are often dealing with different institutions, who deal with each other or through an exchange. When the securitization process is complete, the lenders and the borrowers only begin the process at each end and most of the transactions end up in the hands of investors far removed from the original loan.

Although with more middle-men there are more fees to middle-men, securitization in the financial market's deals in large volumes and ordinarily introduces some important cost efficiencies. Instead of the expensive process of many bank branches painfully assembling a myriad of deposits in order to assemble enough to lend out a mortgage, much larger lumps can be assembled in Wall Street capital markets with little more than a phone call. It is possible to borrow wholesale from Wall Street, avoiding the expensive situation of sometimes having more money to lend than requests for loans, while someone else has more loans than cash to lend. Furthermore, the expensive risk of "borrowing short and lending long", that eternal nightmare of 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 loan requirements, another efficiency.

Unfortunately, the resulting creative destruction of bank branches creates one major offsetting disadvantage. The days are mostly long gone when bank managers would drive around and check whether mortgaged houses were painted and roofs kept in repair, but banks still usually have a better idea of the reputation and appearance of their customers than anyone in faraway 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 survive this present test, it will surely replace the expensive old system and traditional banks will have a pretty hard time competing with it. Indeed, if things work out, the present colossal mess will be shrugged off as a good idea temporarily overwhelmed by its own success.

And if things don't work out, we certainly have a problem. The outcome revolves around figuring out some way to measure the risks and segregate them remotely by computer, thus replacing the local bank manager, whose job is to avoid the risks by looking at them one by one. Since at this point in the story we know in advance it didn't work, the flaw in the securitization of mortgages lies right here.

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 it's 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 the money is tight. Flexibility allows for an 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 the 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.

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 rating 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.

{Atom Bomb}
Atom Bomb

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

Sovereign Wealth Funds

Alexander Hamilton

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 -- 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 a 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 a 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 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 worldwide 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 disenfranchises 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 the 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 mega banking 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.

Murky Crisis

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

{Black Hole}
Black Hole

This prevailing wisdom can lead to mysteries where informed professionals puzzle through dramatic events, yet after six months remain unsure how bad things really are. When the subprime credit crisis began in August 2007, the average size and total number of outstanding mortgages was approximated, and from that it appeared impossible for overall losses to exceed $90 billion. Six months later, write-offs at least that large had been declared, but estimated future losses then ranged 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 a weakening of one currency and strengthening of the other; after which world-wide wealth would remain unchanged. Real worldwide losses in a crash related 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 other 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.

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, may not be able to pay his bills, so don't lend to him. Because the problem was large and worldwide, 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 having to do with mark-to-market.

A Wall Street broker is required to readjust his portfolio worth to market prices, 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 even though they had spent nothing. 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 retain the price of 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 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 American 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 from 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 ultra-fast 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 historical 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. Before things collapsed, Carlyle had bought $21 billion of real estate loans but had received only a twentieth of that in payments 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 have left it with a 17% cushion. Extreme leverage of this new ultra-fast 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 widespread 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.

We must not conclude this little history lesson without stressing its basic point. When huge amounts of money seemed to disappear from the system, the only explanation available was that interest rates had suddenly gone up, resulting in existing bond prices going down. If so, central banking chairmen could make money re-appear by forcing interest rates down and holding them down. Conceivably, some other explanation for the vanishing money might more precise. But even so, forcing interest rates down ought to make money re-appear. This very simple description of events has been characterized as a "revival of Keynes-ism" , although most of us were accustomed to other descriptions of what Keynes attempted in the depression of the '30s. Nevertheless, it accurately capsulizes what Ben Bernanke about did in this one.

After Six months

Phase One: An early recession, with ominous signs of inflation. (Six months of blind man's buff. Stocks down 8-10%, signs of inflation, moderate foreclosures, house prices decline around 10%, increased unemployment, consumer confidence down, oil and gold up, dollar down.)

Phase Two: Government attempts to put out fires. Priorities are set by emergencies as they arise. So far, lowered interest rates, $600 per person stimulus package, offers to substitute government bonds for securitized debt, expand Fannie Mae. The critical need is to abandon these approaches quickly unless they somehow correct the underlying problem and assist in long-term reforms.

Phase three: Long term reform. Task forces, gathering ideas from all sources, seek to identify the critical issues that caused this problem and keep it from happening again. Dangers: politics (D v R), conflict between East (mainly concerned with fuel prices) and West (mainly concerned with housing surplus), foreign meddling or hostility, collapse of China or other developing economies. We may assign too high a priority to those who are suffering, and neglect to do what will work. Some short-term emergency may get out of hand and disrupt more basic solutions. All problems begin as solutions.


What are the possible underlying problems?

1. We have too much debt and leverage, and far too much is concentrated in home real estate mortgages. Did the slanted tax exemptions do this? Did the innovative mortgage methods do it? Did we develop an excess inventory of houses just by too rapid a pace of good things?

2. The cost of buying a house is greatly in excess of the cost of renting a comparable house, overturning a century of the previous history. Meanwhile, owner equity is less than half of national home prices. If prices decline, owner equity will be even less.

3. Banks and insurance companies are becoming obsolete. Should we rescue them, or put them out of their misery?

4. Wall Street got rich by doing obscure things. Should we punish them, or are they the only people able to save the situation?

5. What will we do if China collapses, the cheap dollar ruins Europe, or international trade is paralyzed by protectionism?

6. Should we revise the entire world monetary system, either by going back to a commodity-based currency, or switching to an equity-based currency? If that is too radical, how do we control a completely debt-based currency now that its flaws are appearing?

What's a Repo?

Bear Stearns

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.

J.P. Morgan

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.

Hedge Fund

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.

Black Swan

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?

The 'repo' market from Marketplace on Vimeo.

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 news media 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.

{Paul Volcker}
Paul Volcker

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 hyperinflation 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 war, 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.

Frozen Markets

{top quote}
Markets cannot clear without transparency. {bottom quote}
Vikram Pandit

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 news media, 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 a 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.

{Abby Hoffman}
Abby Hoffman

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 widespread 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 underway, 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.

{Frozen Markets}
Frozen Markets

Repetitive Trading.In recent weeks, a professor at the Wharton School made a name for himself with 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 profit 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.

O'Neill's Parable Perhaps he oversimplified matters, but the 72nd Secretary of the Treasury of the United States certainly made a clear point about frozen markets. "Suppose," he said, "You imagine ten bottles of crystal-clear drinking water."

"Next, suppose someone suddenly announces the news that one of those bottles contains deadly poison. Nobody will buy a single one of those bottles, even though there is only a 10% chance that any one of them has poison. That's a frozen market."

The Housing Bubble

{Alexander Hamilton}
Alexander Hamilton

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 whimper 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 firm 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.

{Housing Bubble}
Housing Bubble

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.

The Cause of the Subprime Crisis

HowTo Create A Subprime Derivative

Curing Stagflation

{Walter Baghot}
Walter Baghot

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 the 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. The 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

{Soaring Gas Prices}
Soaring Gas Prices

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 pipe dream. 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

{Federal Reserve Bank of Philadelphia}
The Federal Reserve Bank of Philadelphia

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 the 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 are 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 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 the calculation of costs, rather than an inability to pay. As matters now stand, thirty percent of mortgages issued in 2005 is 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)}
The Global Interdependence Center (GIC)

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. The 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.

{top quote}
No one who actually needs a bailout should be allowed to have one. {bottom quote}
Henry Kaufman

That's all pretty succinct, and likely contains a lot of wisdom. But it was a 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 the 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.

{Henry Kaufman}
Henry Kaufman

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 have 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.

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.


American Stock Market

Novation is a term that perhaps nobody but a specialist expert can now define, but is nevertheless destined to be politicized in the coming election campaign to the point where almost everybody could be shouting it like a war cry. That is unless the hired political consultants decide some other feature of credit derivatives serves warcry purposes better. We're talking sixty trillion dollars here, about five times the size of the domestic American stock market.

Someone owned or thought he owned pieces of paper worth this staggering sum, which can be regarded as side bets on the bond market. Just as in a horse race, where you don't usually own the horse when you bet on the winner, you needn't own the bonds to bet on whether they will default. The side bet is often between two outsiders who acquired their bets through, well, novation. The process begins as a credit derivative, in which someone gets paid an annual sum in return for agreeing to pay off -- if the bond defaults. That could be regarded as a useful insurance policy, making more credit available by making it safer to buy bonds. The bondholder gives up a little interest in return for assurance the bond is now completely safe. Sucker.

Sun Belt Mortgage

Like the Sun Belt mortgage originator, the originators of these derivatives often wasted little time clipping off a fee and passing the carcass to someone else. And that process got repeated until the accumulating fees in the chain slowed the process to a point where the weakest or most reckless holder got into danger. The game might have slowed to the point where it became self-correcting, but what actually seems to have happened is that much of the long-term debt involved was financed by short-term borrowing, and the start of some rumors triggered a run on the bank. Not exactly, of course, but when institutions which had made one-week or one-month loans stopped lending, it only took a few days for the money to run out and Bear Stearns was quickly unable to pay its bills even though it started the week with $18 billion in reserves.

Securities and Exchange Commission

That short description is about the best that can be made out of an opaque situation, based on what the Securities and Exchange Commission is willing to tell reporters about its investigation. More will be forthcoming, and no doubt some villains and fools will emerge with a lot of blame. For example, the price of credit derivatives concerning Bear Stearns debt had been creeping up steadily during the month before the explosion; whether somebody knew something bad, or whether there really was something bad is presently unclear. It's disconcerting to learn that Goldman Sachs was dumping this paper, and JP Morgan Chase was mostly buying it, but it's early days for unfounded suspicions. More will come.

Now to return to novation. We legal novices learn that novation transfer is the same as assignment transfer, except all parties have to agree to novation before it can take place. That's going to make it harder for a lot of people to deny they knew what was happening. The astonishingly large sums involved are apparently not entirely real, because in some way the old debt is not extinguished, and the new debt is merely added to the sum total outstanding. That surely means the same debt is counted several times, and the apparent sum is to some unknowable extent much larger than the underlying reality. This also accounts for the amazing speed of growth. In January 2007 the total was said to be about $25 trillion, in January 2008 it was reported to be $42 trillion, and in May 2008 it was said to be $60 trillion. Things which move that fast can quickly spin out of control, especially when short term creditors need to do nothing much for a couple of weeks as their money emerges from the pool. Some people did sell short, of course, but whether that was panic or malicious must probably be left to politicians to declaim.

Surely the most terrifying part of this simple story is that so much money could be moved around without public awareness. When the $25 trillion figure emerged, a number of people asked what in the world was going on, and kept asking that question for eighteen months. Nobody knew nothing.

Federal Reserve Changes Its Business Model

Americans generally do not begrudge the success of neighbors; the achievement of someone else takes away nothing from me. In that spirit, we like to see developing countries rise up out of poverty. A more prosperous world is a safer one.

{Federal Reserve Bank of Philadelphia}
Philadelphia Federal Reserve

Rising international prosperity can, however, disrupt matters. When developing countries become producers, they can get inflation if they suddenly have more money than they know how to spend. Sudden wealth can come from discovering oil or gold or copper; slowly learning how to manufacture something is a safer way to prosper. Inflation and huge internal income disparities often lead to revolutions, so the wiser countries sterilize local money by exporting it. Coups and dictatorships are what happens if a developing country doesn't export its inflation; sudden wealth gives the appearance of being underserved. Conversely, our recent dot-com and Sunbelt real estate bubbles show what happens to the neighbors if developing-world inflation gets dumped on them. Eventually, of course, developing countries eventually balance their new production with new consumption, and the world settles down to a new balance. Never mind denouncing the rubbish the newly-rich decide to consume; its only problem for others lies in using up the world's resources faster. Developing countries commonly export inflation to other nations in the form of commodity inflation. The neighbors can soon have a commodity bubble on their hands; when any bubble bursts, a sharp recession can quickly follow, and after that, some other kind of bubble appears. What is new and disruptive is not oil or gold or copper; it is too much money.

With luck, these disruptions consequent to a neighbor's prosperity are soon overcome by improvements in productivity. But productivity itself can create a bubble. One huge productivity windfall for America is the astonishing thirty-year extension of longevity we have experienced; in time, we will surely devise occupations for retirees more productive than thirty-year vacations. Such balancing adjustments right now seem most likely to grow out of electronic productivity, using home sites as work sites.

So in short, America must read just like everyone else and one systematic readjustment has just surfaced at the Federal Reserve. The flood of money from China and the Persian Gulf sought an outlet in our economy, adopting the device of shifting American credit sources from banks to Wall Street ("securitization"). Cheap money once derived from bank deposits in local banks; since it now often originates abroad, it now must travel through the "carry" trade and similar innovative channels for foreign surpluses to get to Wall Street investment banks, which in turn distribute the money ("credit") to American businesses which can use it more productively than the developing countries can. Through securitization (turning loans into securities), Wall Street was able to make home mortgages directly, with only token involvement of local banks. Credit markets froze up because the new procedures had neglected to enlist local bankers in the process of checking the credit-worthiness of borrowers. So long as Wall Street can continue to find new sources of cheap money, this upheaval of finance is likely to be permanent because it is desired by both sides. Access to cheaper loans and access to safer investment harmonize the needs of the haves and the have-nots. Because in its haste this new development precipitated a banking crisis, there is some danger that Congress will overreact by prohibiting securitization rather than correcting its flaws. In every participant's eyes, it's cheaper and more efficient, but new efficiency threatens old inefficiencies. This one threatens the old deposit-based banking system, and since the Fed's control of the currency is based on its control over the depository banks, it threatens the Federal Reserve. That's the real driving force behind the Fed seeking control of non-traditional credit sources; that's now where the money is.

On March 16, 2008 things came to a head with the impending collapse of Bear Stearns, a Wall Street investment bank heavily involved in Credit Derivatives. There are rumors the rescue plan implemented over a weekend had actually been devised and held ready long before then. Many imperfections now surface with experience, but at least the plan had likely been explored as thoroughly as logic without direct experience ever allows. For example, the dispersal of manufacturing around the globe favored making pieces of a product and selling them to an assembler, rather than enveloping the whole process of making a product in one giant corporation. It's cheaper, that's why they do it. But the process of buying and selling pieces to other companies greatly expanded the need for short-term credit. Therefore, it was quite unexpected that Lehman Brothers, which specialized in such short-term loans, suddenly went bankrupt for lack of quick access to capital. In the panic, it is unfortunate that Lehman apparently concealed its situation from investors. There is a danger that Congress will draw the wrong moral and somehow block the globalization of manufacture.

The Federal Reserve Act was passed by Congress in 1913, and most observers believe the Fed's inexperience in 1932 repeatedly made matters worse in that formerly greatest of all bank panics. The new plan of 2009, therefore, had to step around some limitations imposed by Congress in the past, the political pressures generated by an impending presidential election, and the powerful resistance from private industries whose future was affected. The adroitness with which such a complex matter was handled over a weekend will surely become legendary, but maybe not soon. Probably because of existing legal roadblocks, three "lending facilities" were created, but a single device was at the heart of it. Instead of lending money, the Federal Reserve offered to swap securities with new non-bank managers of retail credit. The investment banks held massive security for loans which could not be sold in paralyzed markets but could be swapped or used as security for a loan, particularly if the government stood behind the innovative transactions. Wall Street in a word had plenty of wealth, but could not turn it into money fast enough to pay its bills. So sidestepping the legal constraints, instead of giving Investment firms money as a lender of last resort, the Federal Reserve swapped Treasury Bills for the "frozen" assets held as security for mortgage loans. The securities had been "caught in a loan" as the expression goes. There isn't much difference between Treasury bills and cash, or between exchanging bonds and selling them. But the new approach could be quickly and legally accomplished, and once done, the Federal Reserve was the master of investment banks. It became effectively their lender of last resort. A great deal of advance thought must have gone into devising this readjustment to the reality that over half of loans were not backed by bank deposits, but by the securitized debt of foreigners. Regulations will ensue, hearings will be held and laws passed, but the Fed has regained control of the money supply if it can manage to make this maneuver understandable by the public.

There was a moral hazard in this; the presence of a lifeguard tempts swimmers into deeper water. It was somewhat inflationary in the midst of an inflation threat. No doubt the Federal Reserve regards these negatives as prices worth paying, and they probably are. The decisive remaining issue is not whether the initial shape of this transformation is exactly correct; it surely isn't. Just as was true in 1932, what will ultimately matter most will be whether, with this altered stance, the Fed will adjust quickly and appropriately to future difficulties. And whether politicians will even permit it to do the right thing, assuming anybody then knows what the right thing might be.

High Oil Prices and The Federal Reserve: Chicken or Egg?

{Chicken or the Egg?}
Chicken or Egg?

Although there is little public gloating from the green environmentalists, the price of oil has finally and decisively soared, with Americans actually taking public transportation to work. Although it would seem that more conservation would result from paying attention to household heating than to automobile mileage, it is summer and vacation driving is more on the public mind than buying sweaters for a lower thermostat setting. The rise of oil prices by 40% in a year has started conspiracy theories and drags the Iraq war into the presidential election chatter. It's quite true oil consumption could not have risen 40% in the developing world of China and India, and nothing drastic has happened to world oil reserves or extraction. A glance at the accompanying charts shows that oil prices have risen much like commodities in general; it

Trader's Option

Let's make this as succinct as we can: The Trader's Option is this: what risks will the trader likely take with his employer's money, when he is placed in the position of getting half of any winnings, but when he fails, he only gets fired. Almost any newspaper reports the millions and millions commonly available to lucky traders. There are indeed some timid souls who refuse to take risks of this sort, but on Wall Street, no one wants to hire them. Wall Street wants buccaneers, unafraid of risks. Make your pile as big as you can, take your lumps when you stumble, goodbye. Most of the time, someone else will hire you after six or ten months. No one will ask whether your failures were due to lack of skill or lack of luck. Napoleon once summed it up. He didn't hate unlucky generals, he just fired them.

The odds for the trader are not bad: The Trader's Option compensates richly for the turmoil of a sudden short period of unemployment, which tough-minded traders regard as the price of doing business. But what about the employer? It was his money the trader lost; if the mistakes are bad enough, the firm will go out of business. Unfortunately, often not.

If the traders are poorly trained and poorly controlled if the risk management is more talk than performance, the managers, of course, need to be fired, but ultimately the company goes out of business. But if the Federal Reserve comes along and rescues the company with an infusion of cash when no one else will consider it, moral hazard is created. The Buccaneers will take this rescue as a challenging dare to take even more risks in the future; in the long run, more banks will fail because of soft-heartedness than from tough love. No one worries about the offending bankers, the worry is that the innocent bystanders will get hurt. This is counterparty risk. If the bank is big enough, tangled up with every other major firm, almost everyone in the country could be an innocent bystander.

We will probably never know for certain whether the chaos from letting Bear Stearns fail would have been worse than the moral hazard we now have from rescuing Bear Stearns. What's absolutely clear is that we must quickly get out of the position where these choices have to be made. The completely sensible position is laid out in the proposal by the Federal Reserve to establish a central clearinghouse for financial instruments like Credit Derivatives, which will collect proportional assessments from all participants in the market, to be held in reserve against a market collapse. Not to protect the offending firm which mismanaged its affairs -- that firm must die -- but to protect all the innocent bystanders, the counterparties whose funds were tied up and possibly lost by the offender. The purpose of this insurance policy is not to protect the offender, but to free the hand of the Fed to snuff him out promptly. No one gets hurt here except the offender, and he better get wallopped.

Because the assumption is that a well-run firm will police its ruffians better than an outside regulator can ever hope to do, and will do so even more vigorously if there is absolutely no hope of pardon. The alternative to this bloody-minded approach is the regulation approach -- the Keystone Kops approach.

August, 2007: Sudden Financial Jolt

{top quote}
For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. {bottom quote}
Alan Greenspan, Feb.16, 2005

In early August, 2007 the stock market was sailing along nicely. A great many people were on vacation. September is traditionally the month for severe market reversals, but this year in early August there was not much sign of an impending jolt. The stock market's Dow Jones Industrial Average had reached an all-time peak over 14,000. Long term interest rates were abnormally low, it is true, but that anomaly had gone on uneventfully for years; anyway, even Alan Greenspan said he didn't understand it. Suddenly, the Dow Jones Industrial Average dropped 400 points in ten minutes, on heavy volume. It takes a big volume of sales to move the market that much, that quickly. Somebody knows something, but I don't know what it is, was the thought at ten thousand trading desks watching computer screens, worldwide. A quick check with networked friends showed that nobody else seemed to know what was stirring things up, either. In retrospect, we still don't know who did the first heavy selling, but it soon spread to hedge funds. Hedge funds have a lot of money, and vast banks of computers to do their selling. When the computers of heavy traders detect sudden selling volume, they are programmed to sell, too. Don't ask questions; somebody must know something, so get out, get out the door without a backward look. Not only was someone selling big, but probably selling short. The commentators on cable TV started jumping up and down, talking all at once.

{Alan Greenspan Graph}
Graph: Prices of 10-yr Bonds

About a day later, someone made a shrewd guess. The problem seemed to center on those low-interest rates for long-term bonds because those low rates were abruptly going higher. In the language of the market, the "spread" between short-term and long term rates was widening or at least returning to normal. Not knowing why the spread had narrowed, no one knew why it had stopped being narrow; but it was nevertheless a clue where the problem might be centered. About a month later, rising interest rates seemed even more central when clues to many other suggested culprits had proved false. The selling concentrated on blue-chip stocks, but there was nothing the matter with blue chips. They had been sold because other markets were frozen with fear; if someone needed cash, there was nothing else the market would buy. The "quants", the traders who programmed computers to react without thinking, had merely reacted in sports jargon, to a 'head fake' in the blue chips. Meanwhile, interest rates continued to spread apart; someone big was selling a lot of long-term bonds, and was really serious about it.

{Alan Greenspan}
Alan Greenspan

Come to think of it, if long-term interest rates were returning to normal because someone was selling bonds, then, of course, they had been too low for years because someone else was buying too many bonds. Maybe the Middle East oil barons had a hand in it, but more likely it was the Chinese government, who were known to hold a trillion dollars of U.S. Treasury bonds. Some years ago, Chairman Alan Greenspan of the Federal Reserve worried out loud that by historical standards, public markets [in this case, the Chinese government] were agreeing to accept interest rates for long term debt that seemed much too low for the risks undertaken in loaning it. Worse still, the reasons were unclear. Greenspan called it -- a conundrum. Home mortgages are long term debt, and here's maybe another clue. For political reasons, tax laws had effectively made mortgages the cheapest way to borrow. For another, the reverse mortgage, or home equity loan innovation, transformed home mortgages into the equivalent of ATM machines. A great many young people who might have been better off renting a place to live were persuaded that owning a house was essential to improving 18% credit card interest into 6% mortgages, and tax-sheltered 6% at that. Hidden in this borrowing revolution was the unrecognized temptation to maintain far less owner investment in the house that had been true in the past. It became cheaper to borrow, riskier to loan. American homebuyers were subsidized to borrow, and for whatever reason, Chinese were inclined to lend.

If interest rates go up, the value of bonds with low coupons goes down. Plenty of non-Chinese owned bonds, mainly American banks, and insurance companies. If these bonds had been purchased as long-term investments, there was no sense in selling them, and it was merely annoying that stock market prices for bank and insurance stocks dropped to reflect this lessened value of their holdings. If the banks and insurance companies merely held the bonds to maturity as they had always planned to do, bond values would return to their original price. True, there were rumors that bonds related to California and Florida real estate were in an unsound bubble. But if every one of those bonds became worthless, which was unlikely, it would only amount to $100 billion in losses. That's, of course, a lot of money, but easily absorbed by a big economy. Many of those bonds were insured, and at least half of real estate value is usually recovered in mortgage foreclosure. A lot of people would be inconvenienced by markets frozen with fear, and panic selling of various sorts would make the markets volatile. But this was mainly a liquidity crisis, roughly equivalent to a man with a $20 bill who was temporarily unable to get a candy bar out of a dispensing machine.

Supported by such talk, the stock market went down moderately but steadily. After a year, it was down two thousand points, or perhaps 15%. We seemed likely to have a recession, but periodic recessions are a healthy way to correct irrational exuberance. Most Americans do not own Florida and California real estate, don't use the banks and insurance companies in those regions, and have a reserved opinion about those who do. Somehow, it was overlooked that the very first banks to collapse in this upheaval had been in Germany, France and England.

In retrospect, in 2011 we

Securities Trading Across Time Zones

Almost every day, stock market averages take a sharp jump, either up or down, a few minutes before closing time. Two explanations are usually offered. Regulations require brokers (but not banks, unfairly) to "mark to market", which is to reveal their newly calculated positions based on market prices, whether they traded or not. Those whose assets changed market value are aware of it, and may see an opportunity to speculate on the market's reaction prior to opening their own Kimonos. Mutual funds settle their accounts with customers based on end-of-day prices, but often fill their orders based on prices prevailing during the day; it's one of the advantages of exchange-traded funds (ETF) over index funds that they trade and settle at the same time. Short sales and hedges often wait to the last moment to close their positions; hedge funds and quantitative traders may lie in wait for this to happen and take advantage of it. Some quantitative traders use computers to transact tens of thousands of trades in an hour. The sums of money involved can often be considerable, and it wouldn't matter what different time was selected for a closing hour; the phenomenon would simply shift its timing to match. A second main reason for this explosive end of day activity is the New York Stock Exchange rule that members of the exchange must transact all business in listed stocks during business hours on the floor of the exchange. The self-serving motives behind that rule are evident to all; so a growing proportion of trades, possibly a majority, are transacted on other exchanges five minutes before the New York exchange opens and five minutes after it closes.

When some world-shaking event takes place after the closing bell, it is possible to watch the reaction of the world's stock exchanges moving around the world hour by hour, time zone by time zone. Announcing major financial news is often intentionally delayed until the New York markets are closed, as was the case with the forced merger of Bear Stearns into JP Morgan Chase. Other markets are open, however. The Japanese markets, in this case, responded with a 3% drop, and it was followed all night by a 3% drop every hour in each successive time zone until finally, the New York markets opened unchanged the next morning. After that big Kahoona had its say, all littler markets then scuttled back into line.

With electronic exchanges and trading becoming increasingly common, there is no technical reason why all exchanges worldwide could not remain open every day of the year, twenty-four hours a day. To make that work, however, all trading would have to be conducted by the machines without reference to human opinion. The machines can respond to sales volumes even better than floor traders can, but they would not respond to contingent orders on the specialists' books, or to the opinion of floor traders that hysteria was somehow getting out of hand. With some adjustments, even this could be handled, but the customers would resist. Customers have to get some sleep, even if machines do not; customers want to be able to change their minds in response to market action. Modern portfolio management theory suggests these customers might be better off if the whole thing were on auto-pilot. But just try to tell that to the customers; even the little old ladies would shake their umbrellas at you if you suggested it.

That doesn't mean the public is ready to go back to the Buttonwood tree, once a week. In France, the government has responded to the public clamor by shortening the work week to thirty hours, with plenty of long weekends. Where a holiday falls on Thursday, Friday is automatically a holiday as well. When it falls on Saturday or Sunday, Monday is a holiday. France isn't very religious, but is intensely respectful of scads of Saint's days. That happens often enough that there are quite a few five-day weekends.

Philadelphia's Global Interdependence Center was recently touring Paris during one of those five-day weekends, on a Friday. The Americans were the only people in a town of five million people who were wearing ties and jackets, and the natives at the sidewalk tables didn't need to hear our accents to know who we were. A visit had been arranged at the Bourse, for a nice lunch with the marketing folks and a sales pitch by an official of the stock exchange. With masterful diplomacy and graciousness, we were told interesting stories about the history of the place, ending up with a description of their deep sorrow that so few Americans list their stocks on French Exchanges, or even trade their European holdings in France. After all, Paris is only a one-time zone away from London.

"It isn't the time zone, sir", spoke up one American unaccustomed to wine with lunch. "It's the five day weekend."

Buying Corporate America with Cheap Money

The Rock of Gibralter

In the summer of 2008 Philadelphia was astonished to read that the rock of Gibraltar, our family controlled Rohm and Haas had been sold to Dow Chemical company for $15.4 billion; corporate control will shift to Michigan. A week later, the Hercules Powder Company of Wilmington was sold, and then Budweiser Beer was sold for $56billion to a Belgian firm. The big old philanthropic families were cashing out.

While it may be true that taxes and philanthropic inclinations will lead this cash mountain to be transferred to non-profit foundations of benefit to the local communities, these sales are all a blow to the prestige and vitality of the cities which were once power centers of the world. Worse still, these prominent families with access to expert investment opinion may have reached the conclusion that it was better to have the cash than the business, or better to have the flexibility to shift the cash to more promising investment opportunities. Maybe they seek to diversify, or flee to gold, or invest in commodities, the next coming bubble. To what extent the falling value of the dollar motivated the purchase by foreigners or through foreign intermediaries is unclear, but it would surely be a consideration for foreigners to ponder. Worse still, these families may have decided they need to transfer more of their assets abroad. The glamorous investment advisors to large universities and major foundations are certainly advising their clients to invest much or even most of their funds to foreign investments.

Under the circumstances, one would wish that foreign investors would shrug off considerations of national pride and concentrate purely on the economics of their transactions. But not likely; just as we grieve to lose these brand names, they must be thrilled to show off their new possessions, and eventually to use their control to shift power. The Secretary of the Treasury makes the unhelpful declaration that a strong dollar is important since he does not need to continue that avoiding a steep recession is more important.

That's the way it is. Keynesian economics waters the currency causes a fire sale of assets and fires the flames of inflation. Now, what?

After a Year of Crisis, Fannie and Freddy Finally Get the Spotlight

{Freddie Mac Corp.}
Freddie Mac Corp.

A year after potential financial collapse burst on the scene, the public (and Congress) are beginning to understand what collateralized debt obligations (CDO) are, and how Fannie Mae and Freddie Mac work. It begins to seem they are much the same thing in different clothes, that securitization of mortgages began with Fannie Mae if not Farm Credit in 1916, and that these bewildering new Wall Street CDO creations are just new variations of an old idea. The devil, as always, is in the details.

{Freddie Mac}
Freddie Mac Corp.

Originally, Government Sponsored Enterprises (GSE) began in 1916 with the Farm Credit System and entered the home mortgage secondary market in 1938 with the creation of FNMA (Fannie Mae). Populist in the first case and Depression-fighting in the other, the idea was that third-party reinsurance would make mortgages safer, and thus lower interest rates for a favored population segment (farmers and homeowners). Although no promises were made to bail out failing loans, GSEs eventually grew large enough to seem able to force the government to rescue them in the event of failure. They were claimed to be "too big to be allowed to fail". In addition to this implicit government backing, there was a twist created by making debt interchangeable with equity. "Securitization" was a process of bundling many mortgages into a package sold to the public as a stock issue. Since FNMA was a creditor, rising interest rates created profits for the shareholders, while falling interest rates depressed share prices. Steady predictable mortgage prices could be offered to homeowners, while the risk was transferred to the shareholders. To a certain but much lesser degree, some of the risks of falling real estate prices were transferred to the shareholders as well. Finally, the reduced risk in this arrangement led to lower prices for mortgages, regardless of the state of the economic cycle.

{Michael Milken}
Michael Milken

To some unknowable degree, enthusiasm for mortgage-backed securities in the private sector was enhanced by fear or even loathing of government involvement in the financial system style of banana republics or the Weimar Republic in 1922. To compete with the lower interest rates of government-backed security, the efficiency of the private sector could be combined with innovations made possible by the computer. Mathematical models were devised to calculate mortgage interest rates by working backward from the default rate in a huge universe of mortgages. During the savings and loan crisis two decades earlier, Michael Milken had promoted the idea that prevailing interest rates on mortgages were higher than were justified by the prevailing rate of default in a large pool. If the uncertainty of risk for a single mortgage could be submerged within the fairly certain risk of a large pool, it should be possible to offer generally lower prices than even those of the government-backed GSE system. In spite of the recent panic, the reasoning behind both systems, government and private, seemed to suggest that securitization of debt continues to be a sound idea.

What appears to have been unanticipated was that house prices would rise in a bubble stimulated by a flood of money from the Far East and the Middle East. When that bubble inevitably burst, the resulting drastic decline in house prices would trap everyone who had borrowed a fixed amount as a mortgage at the top of the real estate market. Those who bought and held their houses before 1980 could ride out the gyrations of the real estate market, but everyone who bought an overpriced house after that was at risk that prices would eventually return to normal -- and bankrupts them with that high fixed debt. If these people outnumber the rest of the country, they can use their voting power to force the rest of the country to bail them out, but that's the way civil wars get started. It remains to be seen whether some political compromise can be arranged between those who bought houses at foolish prices, those who felt enriched by owning more valuable houses, and those few who watched with dismay.

Meanwhile, there is another important decision to be made, as to whether to permit either form of securitization to be used as an American scapegoat for a mess caused by Chinese prosperity. There is indeed much to be criticized in retrospect about the conduct of Main Street, Wall Street -- and K Street.

Securitization: Pass the Hot Potato

{Fannie Mae Corp.}
Fannie Mae Corp.

It would be pardonable to say that since securitization of home mortgages is a generally good thing, we might overlook any minor differences in approach between Fannie Mae (FNMA) and CDOs (Collateralized Debt Obligations), and let the customers decide which approach is preferred. Unfortunately, they both encompass a fatal flaw that has somehow escaped adequate notice. As mortgages pass from one holder to the next in sequence, both the buyer and seller seek to avoid the worst-risk mortgages and retain for themselves the best-risk ones. Get stuck with too many bad-risk properties, and you will go broke. When the credit markets suddenly woke up to this reality in August 2007, it was impossible to know who was holding good stuff and who was holding toxic mortgages. The markets "froze", which is to say most traders just walked away from participation until the situation clarified.

{Rising house prices}
Rising house prices

Furthermore, with existing systems this seems to be something that will inevitably happen. A small-town bank tries to sell every mortgage it originates to an aggregator, but a few mortgages just aren't salable. The small town bank might well be able to sell mortgages to people who can't afford a house, but the aggregator is wise to the world, and won't buy the worst of them, so they silt up in the hands of the originating bank. Some originating banks may be deft enough to hold on to the very best risks and sell the rest, but a lot of banks will be turned away by dealers who are smarter than they are. At every step in the chain, there will be the same contest, so eventually, everybody comes under suspicion. Add to this trap the irony that an environment of rising house prices simply increases the size of the defaults when the pyramid finally topples, and it may temporarily blind everyone to the risks being run, thus making it all worse. Somehow or other, the average down payment on the mortgages you hold must be larger than the average drop of house prices in a slump, else you will be transferring the risk from the homeowner to yourself. A strong case can be made that the fault in the recent crash was not predatory lending; it was a failure to demand adequate down payments.

{Bear Stearns}
Bear Stearns

However you define an "adequate" down payment, it is clear that the recent rise of house prices particularly in the regions of greatest overbuilding, put a conventional 20% down payment completely out of reach of many first-home buyers. Since house prices have declined 20% and may decline 20% more, a determination of lenders not to lend more than 80% would have prevented a lot of overbuilding. If mortgage aggregators had refused to purchase mortgages that lacked an adequate down payment, the originating banks would soon have stopped issuing them. Consequently, the necessary fortitude should have been applied at the last step before securitization. It's possible to believe the people at Bear Stearns now wish they had done so.

If we then turn to the GSEs, the significant extra risk of Fannie Mae is political. Holding $5 trillion of debt more or less guaranteed by the U.S. Government, the Secretary of the Treasury repeatedly told congressional hearings that assuming its default would double the national debt. Double the national debt is what is meant by being "too big to be allowed to fail." Since this appalling situation willy-nilly relieves Fannie Mae of any worry about collapsing, the only way to force Fannie Mae to insist on adequate down payments is by Congress passing a law that they must. Congress seems to lack the political will to pass such rules in an election year, or probably any other year. The mandate for fifty years has been for Fannie Mae to make housing "affordable" and keep homeowners from losing their homes. It would be an unimaginable tragedy if Congress ran away from this dilemma, and accepted the hyper-inflation which would result from suddenly doubling the national debt. Unimaginable, but likely.

Banks: Fragile and Dangerous

Counterparty Risk

A bank can't function without deposits, and it can't function unless it can sell shares. So a bank will collapse if there is a run, or if the price of its stock declines severely; public opinion has a lot to do with the success of a bank. What's more, banks have a lot of dealings with each other, so a panic can quickly spread from one bank to another. That's known as counterparty risk. The laws require a bank to maintain a certain ratio of equity to assets, which is to say a ratio of the collective worth of its stock compared with the collective worth of its outstanding loans. The intent of this rule is to make sure the stockholders lose every dime of their investment in the bank before the depositors lose anything. Facing the total loss of their investment in almost every serious difficulty, bank stockholders are very twitchy.

{Fannie Mae}
Fannie Mae

If the bank is doing poorly for some reason, the stockholders get wind of it, and the price of the stock declines as stockholders sell out. The effect of this is to bring the "capital ratio" below the required level, and the authorities will require the bank to sell more stock. That will, in turn, dilute the value of the stock of the existing shareholders, decreasing the stock value. So the effect of a sharp drop in share prices will have almost the same risk to the bank as a run on the cash by the depositors because now the shareholders will sell more stock in the hope of getting out before it declines further in value. This happened in 2008 with the stock of Fannie Mae, which dropped from about $70 a share to $10 in a few weeks, prompting the Federal Reserve to offer to loan cash reserves, and if necessary to buy the stock. After that, it sent investigators to measure the solvency of Fannie Mae.

Indy Mac

This historic episode illustrates the valuable role of the stock market in sensing trouble before regulators are aware of it, and helps explain to Congressmen who want to pass abusive legislation that "The stock market won't let you do that." A week or so earlier, Senator Charles Schumer (D, New York) had made public a letter expressing his concern about IndyMac, another large bank, with the immediate result that there was a run on that bank which made it collapse. So, not only are there banking situations which Congress does not dare meddle with -- there are even situations which the Senate Banking Committee does not dare talk about openly. Naturally, this sort of situation wounds the egos of Congressmen, but a number of left-leaning and high-handed foreign countries have in the past nationalized their banks, with disastrous results. When a bank gets to a certain size, it is as fragile as a land mine. And just as dangerous to tamper with.

How Should We Reform Real Estate Finance?(1)

As any surgeon knows, first you must stop the bleeding. After that, the surgeon needs a medical consultant to quote Hippocrates to him: don't make matters worse. But political crises differ from medical ones in one important feature. A crisis presents an almost heaven-sent opportunity to make political changes which have long been held back by interest groups at loggerheads, each side chanting, "If it ain't broke, don't fix it." Something is quite evidently broken in the present American system of financing home real estate. The majority of the population who could care less about mortgages, now see that something wrong with mortgages could ruin our country.

As a first generalization, we need to stop worshiping houses. In the old Quaker maxim, the worship of buildings is idolatry. Just because some overpaid celebrity owns five houses does not translate into a rule that every single American ought to own his own home, or that every single home ought to contain every gadget to be found in Hollywood. Depending on the distribution of age groups, probably no more than half the population ought to own a house. The rest would be better off renting, so they can readily move to another state for a better job. Or move from the city to the suburbs where the schools are better. Or reduce useless commuting time by moving closer to work. Or move to be closer to grown children, or into a retirement village. A new economy involves creative destruction of old economies; those workers who won't move, will be marooned. Therefore, a tenacious resistance to moving from an old neighborhood, state or region is a costly luxury. A culture which encourages nostalgic immobility, or a sociology concept that permanent home ownership is "a right", both impair the nation's competitiveness in what is going to be one whale of a competitive world. At the least, we can stop repeating the falsehood that it is cheaper to own than to rent. It isn't and it probably hasn't been true for a century.

On the size of housing, there must be some ambivalence. Beyond doubt, computers have encouraged more people to work at home, and working mothers are desperate to find a way to work and care for children at the same time. Big-screen televisions and ubiquitous portable computers have massively moved entertainment from the movie houses downtown and in the shopping malls, back into the living room. The scene of everyone in the family wordlessly communicating with some invisible friend has given a new slant to David Reisman's Lonely Crowd. So, perhaps there is some utility in enlarging the house, which is no longer just a place to sleep and eat. Nevertheless, a gigantic second home in Florida has "tax dodge" written all over it.

Finally, America has wastefully invested far too much in housing. Housing is like gold; it may well be costly, but it has no intrinsic utility, no ability to produce national growth, as is true of starting a business, investing in a stock portfolio, or just depositing in a savings account. In the early stages of inflation a house may be a hedge like copper futures, but in times of economic stress -- up or down -- its constant maintenance costs are a millstone around the neck of all but the wealthy. At the beginning of the Twenty-first century, we find ourselves with far too many houses, most of which are too big for the needs of the owner. Our culture needs to stop worshiping that idea. And, yes, the Secretary of the Treasury and the Chairman of the Federal Reserve must temporarily ignore these fundamental truths, and stop the bleeding. Once they do, we will find houses are considerably cheaper.

How Should We Reform Real Estate Finance?(2)


NATION-WIDE PRICE DECLINES. One much-mocked slogan from the real estate boom days was: real estate prices never go down. More precise words which justify ever saying such a thing are: national home price averages have not declined significantly in 75 years when corrected for inflation. But regional prices bounce around plenty. Deception lies in hinting overstretched homebuyers can't lose their shirts, which they definitely can and definitely will. However, the underlying steadiness of real estate values resurfaces if bursts of irrational exuberance average against sudden bouts of panic. When reversion to the mean is recognized, it might be fairly cheap for the real estate market to re-insure itself, one region (or time period) balancing another. Distressed housing is generally found in regions of an industrial slump; such regions need stimulus. Inflated house prices are found in gold-rush regions; they need restraint. We have said in other places that a universal 20% down payment would be required to protect individual mortgages against the risk of a major national decline in house prices; in earlier epochs, such down payments were regularly demanded. However, if one region's downs balance against another region' sups, the remaining risk would be the simultaneous national decline, which must be rebalanced over longer time periods. By definition alone, that's less common, hence cheaper to insure against. It can still occur, but there would be more tranquil time to build up loss reserves. We might as well say right here that sad experience with political raids on entitlement "lock boxes" (like Social Security) emphasize the need to protect reserves from politics by sharing control with independent entities.

The suggestion made here is: to divert the capital gains tax liability of real estate sales away from the U.S. Treasury, toward a fund for purchasing bank equity in depressed regions. This is regionally counter-cyclic and can be made nationally counter-cyclic because although more equity expands the ability of banks to loan, investors suspect a bank is in trouble whenever it announces a public stock issue. (Of course, selling stock might also mean the bank has more business than it can handle). Sales of bank stock by the proposed fund, however, would always be regarded as a sign the bank really doesn't need assistance. Periodic rebalancing of the fund should amount to buying low in one region or time period and selling high in another, generating more long-term reserves for really severe national dips. The one voiced concern with this scheme is that the present $250,000 capital gains exemption on home sales might unduly starve the fund; one more example perhaps of political meddling stimulating unwise real estate ownership but nevertheless suggesting a possible adjustment lever for implementing the counter-cyclic intent of the scheme.

The point of using capital gains liability as a funding source is a general perception that the government isn't exactly entitled to tax capital gains created by inflation. Using a pro-cyclic revenue source for a counter-cyclic program should force the fund to respond to market forces for raising cash, propelling it toward hard-nosed investment choices when pressure builds to spend it for political purposes. But, if additional revenue exactions from homeowners ever prove to be needed, they should be voluntary, matched with participation rights. Involuntary taxation would be much resented; people threatened with a foreclosure cannot contribute, while anyone with 20% equity in his home is secure and does not need additional insurance. So, holding adequate equity in the house should excuse a homeowner from the reinsurance scheme, thus creating an inducement to save up to reach that threshold. It should be noted in passing that holding an 80% mortgage, whether by down payment or paying it off, considerably reduces client temptation to "give back the keys" when sales values decline below the size of a mortgage, because of it's less likely with a buffer zone. Surrendering the house has even acquired a wry description based on two keys in an envelope: "Jingle equity."


MORAL HAZARD. Much has been made of the risk that an originating bank will exercise less care about loans to risky clients when the plan is to sell the mortgage immediately to an aggregator. Some salesmen are "predatory", some clients are "dodgy". Loans which do not even require verification of the borrower's income or assets are "liars loans", ranked in the "mezzanine class of Alt-A" to obscure the real meaning. Almost immediately the cry has gone up to make the originating banks "have some skin in the game", which is to say they should retain a portion of each loan in their own portfolio. To do so would reduce the bank's working capital and hence its ability to loan so much, evidently a good thing at the moment. Just how much of each loan to require would have to vary with the economy, raising the question of who is to say.

Computers, which did so much to bedazzle these matters, ought to be able to clarify them as well. It seems possible that to label the tranches with their varying proportions of originator retention might be adequate because the market would penalize risky behavior at a higher cost. It might not be necessary to go even this far; maintaining a rating system for different originating banks, based on their default rate at two years, or delinquency rate at six months, might serve the purpose. Some sort of informal arrangement already seems to be operating among "vulture" investors. Mortgagees report that if they miss a mortgage payment, their credit card interest rates mysteriously go up within two weeks. With similar reporting system in place, it should not be difficult to evaluate the differences between banks which had originated mortgages, and in turn label for investors, the risk history of various tranches of various mortgage-backed securities. The great attractiveness of securitized loans is their efficiency and reduced cost. When hazardous behavior leads to higher costs for the perpetrator, the market will take care of the discipline. If clever computers make it harder for crooks to conceal responsibility, matters may quickly respond.

EXCESS LIQUIDITY. It's quite plausible to contend the housing crash had its origin elsewhere, in tidal waves of money from abroad. In that case, fortifying the mortgage market will only lead to bubbles somewhere else. Oil is a likely example, and commodities, in general, seem a likely place to look for the next bubble. After that, some other bubble. Eventually, "nominal" inflation will resemble a giant swiss cheese, with only wages standing as "core" inflation. Since cheap labor abroad started this whole spiral, eventually American labor will find its wage level effectively depressed to match the foreign one by the inflation of every other cost in the economy. Somewhere along the line, foreign labor will lose its price advantage, and foreign consumption will rise to equal our own. The attractiveness of immigrating to America will decline, as will the attractiveness of buying American stocks. Buying American goods will increase, however, and somewhere an equilibrium will be achieved. Only efficiency enhancement seems like a nearby frontier we can conquer, and the securitization of debt is one of the great efficiencies of the century. The most important thing we can do about the real estate credit crunch of 2007-2010 is to recognize that it grew out of comparatively minor fumbles with a magnificent idea. Let the financiers pick up the ball, and run with it.

Merrill Lynch Illuminates the Mortgage Crisis

John Thain

On November 1, 2007, John Thain replaced Stanley O'Neal as CEO of our biggest brokerage firm. Thain was paid $83 million to take the job, and Stan O'Neal was paid $161 million to go away. Naturally, such large compensation packages for what looks like managing a failure received a lot of notoriety. However, a major purpose of such large salaries probably was to allow the new CEO to protest he hadn't created the problem, and reward the old CEO for allowing it to be said he had. Mixed up in this news attention somewhere is the downfall of the most prominent African-American businessman in American history, just as another African-American is running for election to the Presidency.

{Merrill Lynch}
Merrill Lynch

Merrill Lynch purchased home mortgages from banks, repackaged them, and sold them to the public through its large distribution system. Somewhere along the line, Stan O'Neal presided over a corporate decision that, since these novel securities were paying a 30% return, Merrill Lynch should keep them in its own account rather than sell them. When credit markets froze up in August 2007, there were few public buyers available, probably adding to the inventory. In any event, Merrill was suddenly seen to be holding about $100 billion of toxic securities. With the markets in turmoil, it was hard to say what these things were worth but surely less than Merrill had paid for them. Accountants and accounting rules forced the company to "write down" the value on the company's books to a varying degree. In July 2008, however, the securities were sold, firmly and finally determining what they were really worth. The sale of around $100 billion in face value was for around $2 billion, plus splitting the difference on around $6 billion more with Lone Star, a Texas company run by John P. Grayken, which specializes in salvaging value from questionable securities. A cute sale-and-loan arrangement attracted admiration in accounting circles but is not central to the story. In the long run, Merrill is only sure to get $2 billion but might get one or two billion more. Out of $100 billion that Stan O'Neal had acquired.

{Ministry of Finance}
Ministry of Finance

The day after the fire sale was announced, newspapers carried an illuminating story. Earlier in the year, Merrill had improved its lending limits (and diluted its stockholders capital) by selling stock to the sovereign wealth fund of the nation of Singapore. It was now revealed that this purchase contained a covenant that if the stock price fell below the Singapore price, Merrill would pay Singapore the difference. While this sort of covenant is not rare in situations where a loan is disguised as a sale for regulatory purposes, it now became clear that Merrill was under other pressures to put an end to progressive announcements of write-downs. The company would be wise to sell the toxic paper before it did more damage. That is, to put an end to bad publicity as embarrassing matters continued to come to light. After all, every investor would like to be allowed to buy stock whose price could only go up.

{Fannie Mae}
Fannie Mae

The other stockholders of Merrill Lynch may not agree, but it was probably the right bullet to bite. Merrill had been one of the few American firms allowed to do business in post-war Japan. They surely watched with dismay when the Japanese Government tried every imaginable expedient to avoid recognizing similar losses, including phone calls from the Ministry of Finance to forget about accounting rules. Nothing worked for Japan, so they had a deep ten-year depression which isn't entirely over. The market sniffs out the truth. You might as well confess, at least be able to re-deploy fragments of frozen capital to get out of your mess, instead of just pretending losses don't exist. John Thain's effort may not be worth $83 million a year because no one is worth that, but he is worth it if anyone is. So far.

It remains to be seen whether Lone Star will forever remain a vulture capitalist, or whether they will be seen as forging the weapons that defend securitization from banishment. Because of all the uproar, the market for securitized mortgages has disappeared. Except, that is, for Fannie Mae which already owns half the mortgage reinsurance in America. Government Sponsored Enterprises have good reason to resist public scrutiny of their books, but that is what is implicit in developing computerized measuring systems for prudent mortgage securitization. It seems elementary and obvious that computers are capable of inexpensive accurate monitoring of all the participants in this arcane process. But a reliable process of transparency for the securitization process cannot be developed except with access to real test data. It would appear that Lone Star is just about the only major entity with the necessary brains, money, and access to live data which would be required to put together an effective system. If you stop to think about it for a moment, you remember that John Thain came from running the New York Stock Exchange and before that had made a name running the computers of Goldman, Sachs. There's at least a chance that something good can emerge from this mess.

Securitized Debt: Fumbled, But Magnificent

{(Merrill Lynch)}
Merrill Lynch

Merrill Lynch admitted it lost a hundred billion dollars in 2008, maybe more. To read the news accounts, one would suppose the only news was it overpaid its executives. To put the matter in some sort of perspective, the really astonishing thing was they lost $100 billion -- and didn't go bankrupt. Just imagine how profitable business must be to take losses like that, with maybe more to come, and remain standing. Securitization of debt may be hard to understand, but it's gold mine. Mortgages are currently the biggest part of it, but securitization -- changing debts into bonds--can apply to any debt, so we are discussing a fundamental change in the definition of debt which generates enormous efficiencies. The government-subsidized variety held by Fannie Mae and Freddie Mac represents half of the mortgages in the country, some $5 trillion dollars worth, equal to the national debt. The other half was fast on its way to becoming involved in the private-sector variant, Collateralized Debt Obligations (CDO), when the markets nearly collapsed under the strain. Let's do some rough math.

The fundamental insight was that risk was overpriced in the market. Since sovereign governments can print money, their debts will always be paid; they are risk-free if you ignore inflation. Thirty-year government bonds pay 4.5% interest, so thirty-year private debts must pay more because they contain some risk of default. The extra interest, which normally varies from one to thirteen percent, is called a risk premium. During inflationary times, the risk premium can be considerably more, but then it's an inflation-risk premium. Loan sharks often charge fifty percent on top of normal interest; call that the Mafia premium. Whatever. The central point which has only recently been recognized is that computers allow you to calculate the actual rate of default on risky mortgages. The going rate of the risk premium had long been priced considerably higher than the actual experience of default. The risk premium was bigger than the risk. Once you know that, you see that only one problem remains: how do you capture that extra interest rate, and pocket most of it yourself?

That's really all there is to this supposedly complicated business. The incentives are huge. If you could extract one percent from $10 trillion of American mortgages, you would extract what Merrill Lynch just lost, a hundred billion dollars. A conservative guess might be that the "un-earned" risk premium of American mortgages would come close to a quarter of a trillion dollars, every year. That's just home mortgages; there are plenty of debts with other kinds of collateral. So the gold rush was on. The influx of Far Eastern and Middle Eastern money drove down interest rates, so it became comparatively easy to borrow huge amounts of money to lend out at a premium that still looked pretty good to the home purchaser, but left plenty for the packager. The ingenuity of this packaging and the monumental task of organizing an international distribution network are not to be scoffed at. But it is not described here, because it distracts attention from the main points. This was a gold rush, it was quite complicated, and there were loose ends that nearly toppled it.

But the fact nevertheless remains that all economies for all time will be stimulated by a permanent reduction of interest rates in the debts of every nook and corner of life. More people everywhere will be able to afford things they couldn't afford, and it will be a legitimate part of commercial life, not a government hand-out.

Nevertheless, there are losers. Over a period of eighty years, Fannie and Freddie had gradually accumulated half of the mortgages in America, by enjoying an informal guarantee by the Federal Government with its printing presses. Their rates were lower than commercial rates, so why wouldn't a homeowner take advantage of the fact? However, these new Wall Street arrangements which nobody seemed to explain, might be cheaper still. Since the securities were effectively bundles of thousands of mortgages, everything depended on what proportion were held by sound honest people, and how many were held by, let us delicately say, subprime borrowers. In the hurry to get into the Gold Rush, inadequate information was collected, and some of it was just plain inaccurate. It would have been a straight forward administrative task to devise a safe system, but there was no time. The first to move into a new field sweeps the field.

So now there remain only the Government Sponsored Entities, Fannie and Freddie, to re-insure home mortgages, because in the panic the market for CDOs pretty well dried up, and why not. The immediate problem is that years of political influence peddling has undermined the quality of these giant organizations, currently enjoying panicked protection by allied Congressmen up for election. The government has teams of accountants combing through their books to see if they are salvageable. The Secretary of the Treasury said ten times if he said it once, that by guaranteeing the debts of these agencies, he has doubled the national debt. It doesn't inspire confidence to hear that.

But even if Fannie Mae can be patched together for the short term, there is a long term concern. Eventually, Wall Street will get its shop in order, too. At that point, it will be possible to know if the efficiencies of securitizing debt result in lower rates to the customer -- than mortgages subsidized by the government. If it's anywhere near close, our government made a bad bet, worth $5 trillion dollars.

The Trigger and the Cliffhanger

Our own John Fulton recently told the Right Angle Club the market gossip about just who did what, and to whom, in the March 2008 beginning of the investment banking collapse. It begins to look as though Merrill Lynch had quite a bit to do with the mechanics of starting this impending market melt-down, although lots of other people helped.

Bear Stearn

Going back to 2005, Merrill was late to the securitized debt party and stretched to catch up. The broker reportedly sold large quantities of mortgage-backed securities (CDO) to the two hedge funds run by Bear Stearns. A buyer was able to convince himself such securities might pay as much as 20% income if leveraged up -- so attractive that Merrill independently decided to keep a lot of them for its own account. Nevertheless, the primary business of any broker is to buy and resell quickly, holding as little inventory as possible. Such sales, especially to hedge funds and institutional investors, were largely on margin. When suddenly the price of CDOs started to fall -- the rumor is that some unknown European bank started unloading them -- someone at Merrill made the decision to issue a margin call, that is, ask for cash to replace the loans. Bear Stearns reportedly asked for extra time to get the money together, but Merrill was adamant. So, Bear Stearns had to sell some of the CDOs in question to raise cash, dropping the market price. (this had not been the case seven months earlier when a bewildering market saw good stocks being dumped to cover losses in bad stocks.) But remember, in addition to the securities sold to Bear Stearns, Merrill itself had acquired huge quantities of similar CDOs; the internal coordination of Merrill has to be doubted. So the market value of what Merrill held declined, too, quickly forcing Merrill to announce an $8 billion mark-to-market write-down of its holdings, eventually followed by write-downs approaching $100 billion. In time, its own losses greatly exceeded the debt it was forcing Bear Stearns to pay. Merrill had shot itself in the foot.

{New York Stock Exchange}
New York Stock Exchange

At that point, suddenly no one would write Merrill insurance against price declines through the Credit Derivative market, so it's stock price declined on the New York Stock Exchange, further reducing the amount it was allowed by regulators to lend. Because Bear Stearns was a major bookie in the Credit default swap market, both the insurers and the insurees were at risk; doubled-up "counterparty risk" was so enormous the Federal Reserve and U.S. Treasury felt they had to bail the situation out, even though other failing institutions of comparable size had been allowed to disappear. At a minimum, two parties were at risk, at worst, a whole daisy chain of companies insuring other overlapping companies multiplied the risks to much more than the loss that originally triggered the chain reaction. At $62 trillion, the Credit Derivative market is so much larger than other markets that anything to calm it seemed an urgent necessity. (As a matter of fact, when the swaps were sorted out they canceled each other by at least 90%) Every bettor had seemingly felt justified in betting the ranch, because some other bettor stood behind them, and then another and another; hard though it is to believe, that was nearly the case. Since Bear Stearns held thirty times as much debt as its total stockholder equity -- quite a different situation--, an average price drop of only three percent was enough to wipe them out. When margin calls went out to people who themselves had to issue more margin calls to pay the bill, the chain reaction did indeed bring markets to a precipice.

Until better gossip surfaces, this is the description now in circulation for the details of the slide which got going in March 2008. A larger view might be that things were starting to get ugly in 2005, and Merrill should never have entered this particular market at all.

{Fanny Mae Freddy Mac}}
Fanny Mae Freddy Mac}

We are definitely not out of the woods. John Fulton pointed out the next crisis is that Fannie Mae and Freddy Mac are best regarded as insolvent. But since the credit crunch dried up the other half of the CDO market for mortgages, only Freddie and Fanny now remain to support housing transactions, with $5 trillion at risk in the market. That's about the size of the national debt, so when the Government assumed the risks of these two corporations, the national debt was effectively doubled. That could potentially send the dollar into a tailspin, along with U.S. Treasury bonds, while sending the price of oil skyward. So far, the Chinese have been remarkably cooperative, and Ben Bernanke and Hank Paulsen have been remarkably sure-footed.

So, what do we do if we fall into this abyss? Well, one thing debtors usually consider when threatened with insolvency is to walk away from either their debts or their creditors. In the nation's case with its debts, one major victim would be our system of entitlements. The national debt is now effectively $10 trillion. The unfunded entitlements are about $52 trillion; this is much the larger problem. Is it really true? Are we really saying these things?

John did indeed keep us awake, which is the major duty of a Right Angle speaker. .

TARP Demands But Does Not Create a New Standard of Fair Value

{Grandfather tell his Grandson stories}
Grandfather & Grandson

Grandfathers tell their wide-eyed offspring that a thing, anything, is only worth what you can sell it for. Not necessarily what you paid for it, or what it cost to make, or what it may be worth in the future. That thing whatever it is worth what you and someone else agree to exchange it for, right now. Our economy depends on the idea that one person would rather have the object, the other person would rather have the money, and when they agree on the exchange of the money for the object, both parties walk away feeling better off. Multiply these little improvements millions of times, and the economy constantly grows richer, just by exchanging.

{Fire Sale}
Fire Sale

Now, any seller has an option to refuse an offer, waiting for a higher price. This time option is essential to the wealth idea underlying trade; if you simply must have the money before a satisfactory offer appears, you will surely sacrifice some money on the trade. Maybe your counterparty makes a little more money but between you two, wealth is generally not created by fire sales. By definition, you sold before you got a fair offer, so wealth may even have been destroyed and at best the other person's gain just equals your loss. So, everyone is enjoined to conduct business and affairs in a way that makes it possible to wait to trade until a fair offer does appear, but even that maneuver is not as satisfactory as an immediate fair trade.

In the frozen markets of 2008, trade is coming to a halt because so many people are holding off on sales; wealth is definitely being destroyed in the process. Government intervention is proposed as a method to assign a fair price and make trades. The process is generally that the government will offer to buy these frozen securities, hoping to hit fair value precisely and hoping both sellers and buyers will accept that price. Since the government agents are spending other people's money, they will likely overpay and must lean against that tendency.

If the government pays too little, buys the securities and then resells them at a higher more nearly fair value, the government will make a profit, but the seller suffers. That's really not the intention at all. Skinning the seller is not desirable because wealth is destroyed in the process; keep it up and a recession will result. On the other hand, if the government pays too much, it will eventually lose money. The world economy will suffer from any outcome other than striking just the right price. Therefore, the government insists on receiving a warrant against the common stock of the seller who made an unearned profit, so the profit returns to the government. If there is no profit, the warrants are worthless, so they can be seen as a harmless disincentive against overpayment. In 1991, a similar credit bubble overtook Scandinavia after the fall of the Soviet Union and the unification of Germany. When it all shook out, the Swedish and Finnish governments lost 2-3% of their GDP on the interventional sales, Norway's made a profit of 0.2% of GDP. During the bubble preceding intervention, Scandinavian real estate, and the stock markets went up roughly 200% before they crashed; four years later, both real estate and stocks were up over a thousand percent.

It seems churlish to mention it, but this plan is only a stop-gap. It may get markets unfrozen, but when trading resumes they may thaw down to lower prices. In fact, prices are almost certain to fall if we face up to a realization that prices were too high, to begin with. House prices were just too high, oil prices were too high, and maybe a lot of other things were overpriced. As a nation, we borrowed too much, bought too much, forced prices too high. Leveraging, borrowing and prices all must, therefore, come down. But slowly and gradually, please. We will eventually grow our way out of this housing glut; floods, fires, and population growth will eventually use up the housing surplus.

{Credit Bubble}
Credit Bubble

Meanwhile, we have a short-term and long-term problem with determining fair value without ongoing transactions to verify them. In the short term, some government employee must judge the fair value of securities locked in frozen markets. When the crisis is over, that job is done. In the longer run, it will be necessary to maintain a continuing estimate of the value of the securities held by banks and corporations, so the proportion of debt can be calculated. Recent debts of investment banks were often 33 times the value of their stockholder equity. That seems to be too risky, and perhaps the regulators should insist on ratios of 10 to one, such as most commercial banks maintain. The best ratio is one problem, but a greater one is that no one can be sure what the underlying equity is worth unless an active market provides a precise comparison. There has been a tendency to turn to accountants to calculate an answer to this uncertainty.

In November 2007, FAS 157 was issued, declaring that fair value will be whatever the owner can sell a security for. In frozen markets, that sometimes proved to be nothing at all and obviously caused problems. This Financial Accounting Standard replaced Statement 125, which declared that fair value was whatever an informed buyer would be willing to pay. These two standards, in the absence of active real transactions, can differ so widely in a frozen market that statutory measurements of corporate riskiness are sometimes highly inappropriate. No amount of splitting the difference will satisfy the participants when serious issues are at stake since their resolution depends on the time available to find a willing counterparty, and during that interval whether alternative resources are available to satisfy creditors. Many traders have misperceived the signal when perfectly healthy securities had to be dumped in frozen markets. When the store of healthy securities runs out however, distressed debts must be liquidated at a loss. The qualifiers -- trading volumes, available reserves, illiquid reserves, historical volatility -- of a more accurate estimation of riskiness are evident, but it is not clear that a unified scoring could describe them.

World Finance, Columbus Day 2008

{Prime Minister Gordon Brown}
Prime Minister Gordon Brown

WITH voters watching three weeks before the 2008 American presidential election day, finance ministers and their political masters met to decide a basic question: dare they risk disaster to save the existing system, or play it safe by sacrificing small banks to rescue big ones? That is, guess if the situation is so bad only strong rowers can be allowed in the lifeboat, or whether things are really manageable enough to try to save everybody but at the risk of worse consequences for failure. For example the credit default swap mystery; there are $60 trillion notional value insurance policies in existence to cover $20 trillion of bonds. Is that massive double-counting, or an actual disaster so severe it makes every other consideration trivial? Answer quick, please, the ship looks like it might sink. At first, it seemed strange a Labor government in England would propose saving only the strong until you realize that Prime Minister Brown is protected from his Left, while the Democrats in America want to use a fairness argument to win their election. A Republican lame-duck president must do the deciding, a man who has been shown to be both a tough politician and a fearless gambler; playing things safe is not his style. The Dow Jones average soared a thousand points in a day's trading on the prayer that things were finally under control. But take a look around.

Little Iceland and Switzerland are proud to house some enormous banks. But if those banks approach failure, their homeland treasuries are far too small to bail them out.

On the other hand, little Hungary has a negligible banking system, so Hungarians commonly borrow money from foreign banks. The national currency devalued by half in this crisis, so most Hungarian mortgages doubled in price. Reserve systems based on national governments suddenly look obsolete.

Try another approach. Little Ireland went ahead and guaranteed all deposits in its financial institutions. Money from England and the rest of Europe immediately poured in to enjoy that guarantee, forcing other grumpy nations to match the unwise Irish offer. There's a sense that nations are losing control of their affairs.

Europe consists of 27 nations, of which fifteen are in the Euro zone. There are common currency and a constrained central bank, but can this gaggle of geese possibly agree on concerted action in this crisis? America was once in this situation under the Articles of Confederation, but even after almost losing the Revolutionary War, George Washington was nearly unable to get the colonies to form a union. Even after this experience, the Southern Confederate States later adopted the same system of a central currency without a central government and really did lose their war.

Are we to infer from Prime Minister Brown's attitude toward banks that he might soon suggest ditching little nations in order to save bigger ones?

Financial Institutions of the Future

Things which normally dominate newspaper front pages, like presidential elections and World Series baseball, are now found back among the brassiere ads -- displaced by the stock market, credit market, banking and investment crisis of 2008. However, like the wake of a ship at sea, the past could be pointing to the future. Contemplate all the mighty financial institutions which have simply vanished.

It may even be trivial to say that Lehman Brothers and Bear, Stearns have disappeared. The fact is every investment bank has disappeared.

Lehman Brothers

And that's not all by a long shot. Savings and Loans have disappeared. Small commercial banks, and even most of the pretty big ones have disappeared. We may soon be left with half a dozen major banks and no lesser ones. Commission-based stock brokerage is now a rarity. Insurance? Well, the longevity increase of thirty years over the past century gave life insurance an enormous unearned windfall; when that flattens out, will such institutions still prosper? Individual corporate stocks are quickly vanishing into the homogenized soup of index funds, just as the securitized debt was digesting home mortgages before the current uproar. The ranks of stock analysts are thinning out; it no longer matters as much if they have a conflict of interest with nonexistent investment banks and stock brokers. All of this disappearance of institutions is in the recent past, and it mostly isn't coming back. Perhaps hedge funds and private equity companies will take over, but it is really too soon to say if they will survive, either.

Credit Cards

Credit cards have been overused and abused; that can be corrected. But the credit card system is supported by exorbitant fees charged to participating merchants; the card industry could easily disappear if the merchants devise a way to escape this private taxation; merchants universally wish to do so. The currency version of money is trying to disappear as fast as practical ways can be devised to measure value and transactions electronically. The remorseless pressure behind reducing all transactions to electronic form is created by the greatly reduced cost of it. And that pressure is magnified by electronically speeding up transactions; the faster money turns over, the more its virtual size increases. The converse, of course, is that a slow-down reduces its size. Like a giant tuna, the money supply dies of lack of oxygen if it slows down.

It can be seen in retrospect that banks are dying because everybody else stole their products by providing cheaper alternatives, mostly with computers. In the process, the national economy gets more uniform, less dependent on local agencies. Something of value has been lost, of course, particularly the local assessment of the capabilities and requirements of local customers; somehow, that seems to be expendable. But one thing, perhaps two, cannot be dispensed with.

Warren Buffett

For fifty years, we have grown accustomed to the idea that the electronic records of our institutions are accurate. That's definitely not so. Even a reliable firm makes a myriad of errors in its many transactions, catches them with redundancy and cross-checks, and presents the cleaned-up product once a month or maybe even once a day. But even though the illusion of flawlessness is maintained for the customer as much as humanly possible, it is not inherently flawless. Systemic breakdowns will always expose uncorrected flaws caught in the process, while disincentives are created by this one-sided system to spend money perfecting and refining its quality control. It's better than the old manual systems, of course, but its flaws are constantly exposed by the remorseless external pressure to do things faster, in bigger volume, in greater complexity. We approach the point where every individual needs to maintain a duplicate computer system to verify his accounts. Individual telephone bills, for example, require the aid of a computer to explain what another computer produced, brokerage transactions need computerized counterparty challenge to expose hidden fees and costs. We all know how lack of transparency brought securitized mortgages to their knees. We will soon learn that the meaning of credit default swaps defies even expert comprehension. The mysteries of university tuition discounts, hospital insurance, and even supermarket discounts cry out for safeguards to generate transparency. It may be true that even billionaires like Warren Buffett do not bother to check the accuracy of all accounts presented to them, trusting the fairness of the counterparty. But that does not contradict the need for balance. Institutions of independent public accounting are surely going to make an appearance in the future, telling people what they have and what they are paying for.

The other component which seems to be missing in our transaction system is a well-developed and widely available profession of financial advisors, equipped with electronic tools to provide their badly needed services affordably and accurately. Not only do agents and advisers need some tools, but they also need the political power to force high-handed vendor systems to permit universal customer verifications; the hooks and portals to their private systems need to be developed to make this system workable, and that will not be willingly forthcoming. But they must be provided because any independent advisor/auditors need to be subject to constant reverse-confirmation if we are to escape creating a gigantic imperfect-agency problem. But it always remains that a vendor is not an agent of the customer; his ultimate duty is only to provide an arms-length transaction with transparency. It is the customer's duty to secure his own verification system. When that occurs, it will become part of the third party duty to consent to safeguards against his own imperfect agency. But that's for later. At the moment, independent auditors of the sort needed, scarcely exist.

Much can be gained by searching to correct the flaws of the past whose significance is suddenly apparent. With a stroke of genius, the 2008 reforms of the Bush administration offered a government guarantee of safety for bank accounts which pay no interest. The light finally dawned that businesses use banks for settling up accounts and are more or less indifferent to the interest paid on deposits. When there is a bank panic or a run on a bank, deposits are shifted from bank accounts to Treasury bills in order to find safety; that's now unnecessary. If a bank account pays no less interest than a Treasury bill and is just as safe, why move it? Under the traditional system, deposits seeking safety depleted the load capacity of the bank and erected a barrier to recovery from the slump that often caused the problem. Why didn't we think of this before?

One of the sources of panic in 2008 was the enormous size of credit default swaps, several times larger than the entire American stock market, many times larger than the national debt. How could we allow such a vast over-insurance to occur? But as some appreciation of a large amount of credit swapping with foreign nations began to grow, things calmed down. If that should unravel the mystery, it is certainly far easier to determine the proportion of international swapping than to set up detailed accounting reports for $60 trillion of default insurance, particularly when the record-keeping intermediaries suddenly go bankrupt.

{Alan Greenspan}
Alan Greenspan

As soon as the calamity of mortgage-backed securities made its appearance, hands were wrung that originating banks were not required to retain a piece of the mortgage. It seems sensible to impose this requirement on the only party in the chain with the opportunity to evaluate and screen the risks, face to face. So, we can probably expect legislation with the effect of requiring originating institutions to retain "a piece of the action". The principle may need to be extended into other areas, as well. Investment banks until fairly recently were partnerships, not corporations. The capital of an investment bank was supplied from the personal resources of the partners, who usually retired at quite an early age rather than retain big risks without actively coping with the constant pressures of hands-on oversight. Investment banks found they could not raise enough capital from rich partners who were constantly tempted to cash out, so they incorporated and sold stock to the general public. The consequence was the managers were placed in the position of taking big risks with other people's money, and able to pay themselves huge salaries without the constant snooping of rich partners at the next desk. For the time being, investment banking has been totally absorbed into other institutions, but the culture shock of mixing risk takers with risk avoiders will surely lead to something else. Like originating banks with mortgages, the originators of IPOs need to acquire some personal risk of their own, because their essential innovations will always race ahead of the imagination of underpaid plodding regulators. Instead of making a game of outwitting the regulators, investment banking must place much more reliance on the examples within their midst, of rich young kids turning themselves into paupers by assuming the wrong risks.

While we are wallowing in the idea of reconfiguring world finance to avoid the mistakes of the past, some thought should be given to goals. Alan Greenspan was able to win every argument with his reputation of guiding the economy through eighteen years without a major recession. Now that we have resigned ourselves to a return of the business cycle, maybe we should ask whether it is wise to go eighteen years, or even five years, without a correction. Some of this has to do with election cycles, so it isn't easy. But perhaps we have learned that perpetual prosperity is a mirage, small frequent readjustments are better.

Rescuing International Finance?

Let's begin this discussion of international finance by relating the story of how the United States solved the same problem in 1913. This wasn't a ho-hum bit of history, it set the pattern the world is now about to adopt or reject. Remember, our current lame duck President comes from Texas.

Federal Reserve Building

In 1913, the Federal Reserve system was created. It had various purposes, but it essentially stripped the state governments of the ability to adjust interest rates and placed that power in Washington DC. The appointment process to the Fed board was tinkered with to achieve as much independence from politics as possible, although it was unrealistic to think politics would be totally excluded. Politicians never give up power voluntarily, but in this case, they also escaped blame for the unpleasant things a central bank is occasionally called on to do, so it was a deal. The remaining uncertainty thus became the question of whether the states would yield to federal authority on interest rates, something they had consistently resisted ever since the Constitution was ratified. The first resister was Texas.

{Franklin D. Roosevelt}
Franklin D. Roosevelt

It suited the Texas economy to have lower interest rates than other states, but the fledgling Federal Reserve decreed that the nation as a whole needed higher rates. In a fairly typical Texas style, Texas just lowered rates anyway. Almost immediately, nobody would deposit money in Texas banks, who were flooded with requests for loans from the rest of the country. That situation couldn't last more than a few days, so Texas capitulated, and no state has defied the Federal Reserve since then. In this little story lies the hope that a similar international banking arrangement can be devised, and announced shortly after November 15. That would probably put George W. Bush in a class with George Washington and Abraham Lincoln in the history books, his current low popularity not withstanding. For that reason alone, there is cause for concern about the newly elected incoming President. The worrisome historical model at this level lies in the refusal of newly elected Franklin D. Roosevelt to cooperate with the lame duck Herbert Hoover during a similar economic crisis of 1933. On the level of "practical" politics, Roosevelt got away with this deplorable behavior, by enacting many of Hoover's proposals six months later and taking full credit. The country was much worse off as a result, but Roosevelt nevertheless seems to have achieved enduring historical praise for his imaginative ideas. This time, one would hope that fear of the blogosphere, the London Economist and the Wall Street Journal would make such behavior politically unprofitable for either Obama or the maverick McCain. But you never know.

{Henry Paulson}
Henry Paulson

Now, to return to the present crisis. In a sense, every type of financial institution from banks to hedge funds, every nation from America to Zimbabwe, and every expert from Hank Paulson to Barney Frank -- has been tested, and occasionally failed quite visibly. People are scared, have every reason to be. But on the other hand, sound reasoning will never defeat politics and financial greed, except in a rare crisis containing obvious general danger. So, this mess represents an opportunity for the think tanks to be given a chance at leadership, just as John Maynard Keynes was listened to respectfully at Breton Woods in 1944. It was just about the last time a guru got his way without the use of financial power or an overwhelming voter mandate. As Franklin Roosevelt is reported to have said, "I don't understand a word the man says, but we must do something."

{Barney Frank}
Barney Frank

Let's use a few examples out of a great many available. Ireland issued a guarantee for all the deposits in its banks. Immediately, money poured into Irish banks from British depositors, unsettling the British banking system. So the United Kingdom had to issue the same guarantee, and then other nations followed. America rescued Bear Stearns, Fannie Mae, and AIG, and finally called a halt at Lehman Brothers. Other nations copied this approach of rescuing institutions in trouble until the Bank of England copied the Swedish approach of 1991 of reversing this approach. If you are in a sinking lifeboat, you want to rescue the best rowers, not the weakest. But there are some small countries with big banks, like Switzerland and Iceland, where it would be impossible for a small government to rescue a huge international bank within its borders. Conversely, the Eastern European countries have essentially no local banks. In the case of Hungary, most home mortgages were held in Austrian and Swiss banks. When the flow of funds forced a devaluation of the local currency, the cost of almost every mortgage in Hungary doubled, and the national government could do nothing about it.

Let's mention what may well be the largest such factor in this international banking game, the so-called Japanese carry trade. When the overheated Japanese stock market collapsed fifteen years ago, the Ministry of Finance responded by lowering interest rates to one or two percent. Taking into account the inflation rate, Japanese banks were paying the borrower to take their money. So, the international banking community promptly responded by borrowing money in Japan at 2% and lending it out in Germany at 8%. Amounts of money in the trillions churned through this money machine. An unknowable but large amount of this money originated in China, which was trying to prevent its surpluses from provoking a revolution with inflation. The Japanese carry trade is at an end except in reverse, as money is flowing back to the now seemingly safe Japanese economy. Perhaps even a casual reader can look up from the World Series and the presidential election, to realize that absolutely everybody is scared, and possibly scared enough to do something cooperatively. It means loss of national power and sovereignty for everybody, a reconsideration of the European Common Market, and setting aside any disruptive schemes to discipline Premier Putin's behavior as a hidden by-product. As Frank Roosevelt said, we don't understand a word of it, but we must do something.

The World Bank Logo

Among the small practical ideas advanced, one of the most promising is to persuade the Chinese government to float its currency. We have historically tolerated small primitive countries when they try to struggle out of poverty by artificially cheapening their currency. In China's case, and before that in Japan's, cheapening the currency in order to stimulate exports has been politely referred to as "pegging the currency to the dollar". Pegging it low, that is. But Japan and China are no longer barefoot and aspire to become important figures in international finance. China is said to resist this proposal on the grounds that it needs 7% annual growth to prevent social unrest leading to a revolution. To some extent, this is probably just bargaining talks, and the counter-proposal offered is to strengthen Oriental power within the International Monetary Fund, as part of the process of increasing the power of the now-indolent IMF. We will have to wait for November 15 to see if clever little schemes like this one will suffice for the purpose. Much depends on China's willingness to cooperate, but even more, depends on the validity of blaming present messes on currency manipulation for the purpose of mercantilism. Beggar thy neighbor behavior has certainly been common; the question is whether it was the main cause.

If all those think tanks led by the Bank of England, have found the stone whose removal will start a benevolent avalanche, a second Breton Woods conference might just get us out of the soup; within two years we should be pleased with the way our cleverness restored the world to prosperity. If not, more grandiose ideas must be desperately considered. Europe must abandon all those silly five-hundred-page constitutions and form a national union. In our own case, that worked for eighty years and then we had a civil war, but even a repetition of all that sounds better than what we now face. If Europe simply cannot seize the moment, it is very likely to retreat into insignificance. Under those changed circumstances, the world economy will amount to three nations: China, India and the USA. We have yet to learn whether the Chinese and particularly the Indian governments can summon up enough domestic leadership to deserve a place in international leadership. And that presently is far from certain.

Mercantilism Dies Hard

{Mercantilism to  Americans}
Mercantilism to Americans

Whatever mercantilism was supposed to mean can be debated by captive college students; mercantilism to Americans is and was just a bad thing having to do with economics, mentioned only when the speaker is searching for an epithet. Our present understanding of the mercantilist term is that brutal government action, even war, was employed to benefit favored citizen merchants, while the economics of a whole nation of consumers was subverted toward enhancing state power. All of this rapacity was for the betterment of one nation at the expense of its neighbors, and at the expense of its colonies. The surprisingly vague but more modern term of fascism is often substituted, to denote evil uses of government to promote the interest of combined military and industrial elite, to the general disadvantage of everyone else. Because so many opponents of mercantilism were upset about specific forms of mercantilist activity, Adam Smith is associated with the idea that mercantilism was the opposite of international free trade, and the American founding father are associated with the idea that mercantilism embodied everything we disliked about colonialism. Some prominent 18th Century leaders constructed a body of theory to defend mercantilism and firmly established the idea that the whole approach was founded on long-discredited sophistry. In recent times, the only reputable economist to defend parts of mercantilism was John Maynard Keynes, who approved of the idea of emphasizing third-world exports in order to assist developing countries into a modern economy. Whatever is the underlying idea behind this mercantilist idea that has caused so much trouble, and includes so many disconnected features?

Allow an amateur theory. In my view the fundamental misconception underlying mercantilism was the idea that economic relations between individuals and nations are a zero-sum game; what I gain must be at the expense of someone else's loss. Almost every child believes that many or even most everyday transactions seem to confirm it, and vast multitudes of mankind believe it to the end of their days. But as part of the Industrial Revolution, the counter-intuitive realization began to spread that cooperative behavior, within limits, could sometimes result in all participants becoming better off, harming no one. Perhaps it was even a universal idea. Adam Smith popularized the idea that when two parties freely participate in the free trade of a marketplace, each one can come away from the trade feeling better off; one party would rather have the goods, the other party would rather have the money, and they trade. Multiplied millions of times, the expansion of free trade would enrich whole nations, even the whole world. George Washington may not have understood all that, but he did know that England was injuring him with rules about insisting British subjects must conduct all foreign trade in British sailing vessels, must not manufacture locally, must do this, must not do that.

Exporting was good, importing was bad, manufacturing was to be concentrated in the mother country, consuming was to be discouraged -- what was the unifying theory behind all this? It would seem to have been the gold standard. Gold was durable, and its supply was limited. It had certain undeniable advantages, but its overall effect was to restrain industrial progress. If the economy is constantly expanding, but the supply of gold is relatively limited, the price or value of everything will go steadily down over time. In George Washington's time that was particularly irksome with regard to the value of his plantation, and his vast land holdings of Ohio land. It was also true of everything else that was reasonably durable. If everything is measured in gold, and gold is limited, then the accumulation of gold is ultimately the only way to accumulate wealth. The English nobility who were profiting from the system might not perceive it, but the colonists could perceive it in their bones. Small wonder that modern banking, economics and innovative finance took root in the American colonies. If not first, at least most vigorously. Small wonder we had a revolution men would die for, while the British were merely annoyed and mystified.

Vast areas of Asia, Africa and the Middle East are still committed to the idea that the only way to get rich is to steal from others; since everyone wants to get rich, everyone steals. Someone has reduced this idea to a simple game theory called the Prisoner's Choice. If two prisoners tattle on each other, both will be severely punished. If both prisoners refuse to testify, both will go free. If one tattles and the other remains mum, the tattler will go free and the loyal comrade will get hanged. Reduced to its simplest level in a series of repeated games, the theory states that it's better for everybody to cooperate most of the time, but you must be willing to play tit for tat if the other party cheats. Be cooperative as much as you can, but never forget to wallop a cheater, and then forgive him later so he can have a chance to play nice. Lots of people will think you are a sucker if you play nice, so, unfortunately, it is necessary to retaliate -- swiftly and painfully -- when someone cheats. Centuries of American history are explainable with this simple game theory.

And not just with tribesmen and Nazis. When Winston Churchill finally realized that the Bretton Woods Conference was going to mean the end of the British Empire, he was almost tearfully plaintive with his friend Frank Roosevelt, but he said he understood.

And six years later, when Churchill's protege Anthony Eden invaded Egypt over the Suez Canal, Dwight Eisenhower the hero of the Normandy Invasion that saved England, suddenly turned nasty. England would immediately abandon that invasion, or Eisenhower would foreclose on British debts and ruin them.

That was the end of British colonialism, and in a sense, it was the final end of the Revolutionary War.

Helping the home owner


The Treasury's lender/investor support programs may have stopped October's (2008) bank-run and foreclosure panic. But it is generally agreed the crisis would not bottom and turn around until a way is found to slow the fall in house prices, the root cause of the housing crisis.

Both the City of Boston and the FDIC (at IndyMac, which they now run) are trying to address the mortgage uproar at its source: the homeowner, in trouble after paying too much for a house. Cheap mortgages tempted him to overpay, so still deeper causes trace back to Far Eastern prosperity, supported by a Chinese currency pegged too low in order to stimulate exports. These grander visions will probably be topic of the November 15 monetary summit.

Meanwhile, Boston has dozens of blocks of foreclosed houses. That city is attacking its local problem from two directions: (1) matching up 1st-time home buyers with homeowners in distress and (2) working with mortgage servicers to adjust troubled mortgages. In both cases, the objective is to keep the houses occupied and out of foreclosure. But if new home buyers again pay too much for the house, the problem is not entirely solved.

Remember, there are three elements to a mortgage: principal, interest rate and term.

Adjusting the principal is currently off the table but efforts are being made to fix and lower the interest rate and lengthen the term so resulting payments do not exceed 38% of gross monthly income. Sometimes this can't be done and the homeowner loses the home. But it helps quite a number of people.

Interest modification is resulting in mortgage terms of 40 or 50 years. That sounds almost like indentured servitude but at least such grass-roots efforts are starting to provide some relief for those who were swept into the housing bubble.

(It's interesting that one unintended consequence of securitization is that the counterparty to these negotiations is the mortgage servicer, not the original lender or the current holder. The effect of this is to reduce the natural resistance of a bank to lend more than it thinks the house is currently worth. Original lenders are a new mix of people; they sold the mortgage on to the current holders, who are a widely diffuse group of investors, both institutional and retail, who in most cases also cannot easily be identified. An exception is that in several cases where attempts were made to adjust the principal instead of the interest or the term, class-action lawsuits were initiated by several hedge-fund investors. That mainly explains why adjustments to interest rate and term are the current focus rather than principal. For obvious reasons, stock market short-sales seldom evoke the same response, at least from hedge funds.)

Taking Risks Demands Its Price


Someday, books will be written about who discovered what, and sold what, to make S & P futures suddenly go up and down 300 points in ten minutes on August 17, 2007, soon followed by violent volatility in many other markets. Confusion reigned for a few days, but within a week there was general agreement about the difficulty: the "spread" of interest rates between risky loans and very safe ones had been too narrow for months, and was reverting back to normal. Risk had been mispriced; a risky loan was just as risky as it ever was, as everyone should have realized. If the risky borrower was unwilling to pay higher interest rates, why would any lender bother with him? Since this had been obvious all along, why had lenders temporarily believed otherwise, charging rates scarcely higher for dodgy loans than for well-secured ones?

{Alan Greenspan}
Alan Greenspan

Alan Greenspan (in 1996) had called this question a conundrum, but it's getting easier to understand. The emergence of prosperity in one decade among 200 million impoverished Chinese had resulted in wealth which found its way into international markets, much like a gold rush or the discovery of oil. Sudden huge wealth often cannot be easily assimilated, hence was available to loan at cheaper rates. The globalization of world finance has vastly improved the speed of markets to absorb money gluts, but in this case, had the unfortunate effect of spreading it out into less sophisticated corners of the world economy. It particularly affected residential mortgages, which proved to be the weakest link in the chain of lending and borrowing. Ten years of low-interest rates pushed up the prices of existing homes, tempting builders to overcharge for new construction, and inexperienced buyers to pay those inflated prices with cheap mortgages. Between them, Congress and the banks had devised ways to exploit this situation, making the collapse worse when it came. The interest on home mortgages was preferentially tax deductible, so it became the favorite way to borrow. Banks made it easier to refinance at a lower rate as the spread gradually narrowed. To make it even easier, reverse mortgages converted home ownership into an ATM machine with tax deductibility. Because home prices were steadily rising, banks were willing to reduce down payments, on the assumption that home equity would soon rise to represent the amount formerly required as a down payment. As it would have, perhaps, if homeowners had not promptly drained it out the back door of reverse mortgages. Second homes became a cheaper way to have a vacation; steadily rising prices encouraged outright speculation, called flipping. Congress reinsured mortgages, eventually most of them, through FNMA, and then pressured Fannie Mae to insist on spreading the joys of home ownership to people who could not afford the no-down-payment houses they were romanced into buying. Investment banks offered to buy the mortgages from the local originating banks in order to package them into securitized bundles, which thus deprived the originating banks of any incentive to reject eager buyers, no matter how dubious their credit standing. What is more, this process provided a conduit for spreading bad credit risk into the equity markets, including the equity of the banking system itself, and creating the temptation for hedge funds to start runs on the banks in novel forms. There once was a time when customers lined up at the back door to make withdrawals in a bank run. Since investment banks obtain their deposits by borrowing wholesale, they simplified the process of starting a bank run when the speculative process reversed. Which it did on August 17, 2007, possibly not spontaneously, but certainly inevitably.

Home mortgages were once loans for thirty years; even now, they extend for many years. Homeowners stay in one house for an average of seven years. For legal reasons going back two hundred years, they are non-recourse loans, meaning the house alone is at risk to the mortgage lender, who may normally not pursue the homeowner for assets other than the foreclosure, even if the other assets are considerable. In a housing bubble, this creates a special hazard for lenders during the inevitable decline of house prices back to normal. As house prices fall, as they should and will, many homeowners will find it is cheaper to walk away from a foreclosure than to pay off the mortgage. It has been calculated that potentially as many as 50% of mortgages might eventually find themselves in this squeeze. The situation differs from a car loan, for example. Every new car is worth 20% less than the sale price, immediately after the sale. But this does not tempt car buyers to walk away from their loan, because the car loan is a recourse loan. The uncomfortable prospect is that financial reverses alone might not be the reason homeowners submit to foreclosure. If this particular antisocial behavior loses its stigma, a very large proportion of mortgages could be foreclosed on owners who are perfectly able to pay them off.

{Barney Frank and Chris Dodd}
Barney Frank and Chris Dodd

For all these reasons, house prices are the main bubble in an economy overstimulated by cheap money, and mortgage financing is at the root of a banking crisis. The banking system itself is precarious because it too responded to the temptation of abundant credit at abnormally low-interest rates. The process took the form of over-leveraging in order to magnify profits in a competitive market. Greed was not the only motivation; corporate raiders in the form of Private Equity could swoop down on any company unwise enough to accumulate internal cash. The new owner would then substitute debt for cash, and the prudent company (under new management, of course) was no better off than if it had itself over-leveraged. The Federal Reserve limits commercial banks to loaning thirteen times their stockholder equity, but investment banks had the foolhardiness to borrow thirty times equity. A decline of only three percent in the value of their loans wipes them out. The Federal Reserve Bank of New York, by the way, is leveraged at over a hundred times its equity. The Fed can print money to pay its debts, of course, but the result is a falling value of the dollar in international exchange and ultimately, world inflation. No one predicts the half-way point in this decline to be sooner than two years, which means a recession lasting at least four years. The first two efforts of public officials to halt the decline, the purchase of toxic debt and direct lending to banks, have been abandoned as failures, and the Barney Frank/ Chris Dodd offer for Congress to repurchase mortgages was simply pathetic, with only two hundred responses when over two million were anticipated. If the public loses faith in the ability of the government to do anything about the matter, prices can be expected to overshoot on the downside, not just return to normal. House prices do need to decline, but slowly enough to avoid a panic. And American banks and businesses need to reduce the extent of their borrowing, but without measures which impair the ability of new businesses to make loans, or the ability of shaky businesses like the Detroit auto industry, to survive.

In closing, a word is needed to explain why the foreclosure of $100 billion of California and Florida bungalows should threaten a collapse in the trillions. Economists have fallen into the habit of equating interest rates with risk; the more risk, the higher the interest rates become. That's true, but the risk is not the only factor affecting interest rates. Since they are essentially the rent paid for the use of someone else's money, interest rates respond to the supply of money interest rates, just as supply and demand of rental housing affect rents. The flood of liquidity from developing countries into the world economy pushed interest rates down, but somehow that was taken to imply that risk had decreased. When interest rates go up again, for whatever reason, the money will effectively evaporate. The best example of this relationship is in the bond market. When interest rates go up, the principal value of existing bonds declines. With interest rates of 5% as an example, bond prices go up and down twenty times as much as the interest rate, but in the opposite direction. To repeat: when general interest rates rise, money in the economy disappears about twenty times as fast. That's a succinct description of what started to happen, when the prevailing risk premium returned to its normal higher level, on August 17, 2007.

Forbidden SNL Clip

NBC pulled the original of this Saturday Night Live video from their Web site and replaced it with this edited version.

NBC deleted the section in which Herbert and Marion Sandler described swindling their clients and ultimately Wachovia. The original video had a caption that described the couple as "People who should be shot." Furthermore, the actor portraying Herbert Sandler said "And thank you, Congressman Frank, as well as many Republicans for helping block Congressional oversight of our corrupt activity."

Herbert and Marion Sandler sold Golden West Financial Corp to Wachovia in 2006 for $24 billion, precipitating Wachovia's failure and eventual sale to Wells Fargo.

Constitutionality of the Monetary System

{The Constitution}
The Constitution

In noting that our Constitution has lasted for over two centuries, we assert that this simple short document has largely anticipated everything important to anticipate, including the Industrial Revolution, atomic warfare, and the Information Age, to name a few. When an occasional issue arises that is not only unmentioned in the Constitution but where no one is certain what to do, our system leaves us spiritually adrift. Such an issue is found in o0ur monetary system, where we have been wandering for two hundred years.

The founding fathers worried a great deal that popular majorities would abuse minorities, particularly in the case of the majority poor people voting themselves the property of minority rich ones, or that debtors in the majority might dishonor the rights of creditors. Although we have developed a welter of laws about debt and creditors, bankruptcy and taxation, they are if anything too specific. What is lacking is a few general words in the Constitution about the principles of credit and money. The problem now is the same as it was in 1787; we don't know what to say.

{Albert Gallatin}
Albert Gallatin

For a very long time, some very well educated people were strongly opposed to the creation of a bank, later to mean a banking system. Alexander Hamilton's proposition that a "national debt is a national treasure" was greeted with horror by several Presidents, as well as by Albert Gallatin, one of the most sophisticated financial thinkers of the time. Underlying this perplexing reaction to the simple proposal to create a bank was surely the perception that making the Federal Government into a substantial debtor creates a powerful ally to all debtors in their eternal struggle with all creditors; the outcome of such an unequal struggle would inevitably be to the disadvantage of creditors. In common parlance, the word capitalist seems to imply a creditor. It took a very long time for it to become understandable that debtors, too, were essential beneficiaries of a capitalist system, but that idea still often meets with dissent. However, when millions of the world population belong to religions which prohibit the payment of interest, it should not be surprising to find many Americans who cannot get their heads around the idea that debtors and creditors need each other to an equal degree.

In the case of inflation, governments have always been somewhat favorable to debauching the currency. Naturally, a major debtor hopes to repay its debt with cheaper money. Since it has more or less always been necessary to use police powers to maintain a common currency, Kings and governments have long been in control of money, whether that means gold bars or beaded wampum. And for the same length of time, governments have been discovered bending the rules in favor of themselves. Bronze has been substituted for gold, the edges of coins have been shaved, the printing presses print paper money unrestrainedly, and the consumer price index has been manipulated to encourage inflation. Political parties have sought votes from debtors by promising to regulate banks, promote silver as a substitute for gold, disadvantage foreign competitors, inhibit or manipulate the value of the currency on foreign exchanges.

{Alan Greenspan}
Alan Greenspan

For forty years we have operated without any fixed standard for money. Money for all that time has lacked any physical representation or discipline. Money has become a computer notation. At first, it was based on calculations of monetary aggregates, a bewildering concept promoted by Milton Friedman. More recently, it is entirely based on inflation targeting as promoted by Alan Greenspan. With a target of maintaining steady prices, an inflation rate of 2% is set as a specific target for the Federal Reserve. If inflation falls below that target, more money is created; if it rises above that level, less money is created. How much there is of it does not matter; it's beyond calculation. Although this simplified description fills almost any listener with doubts, it seemed vindicated by seventeen years without a notable recession. Even though events beginning in 2007 raise pretty serious doubts, it may still prove to be the best possible monetary system.

Even though this most fundamental of all commercial issues cry out for a simple principle to be stated in the Constitution so that neither populist congressmen not rapacious financiers can ruin us, it is not presently possible even to imagine what a new Constitutional amendment would, should or even could say. Meanwhile, some immense power rests in the hands of shadowy figures whom we blindly trust, for lack of a better idea about how we should select them or what we should instruct them to do.

Financial Meltdown Documentary

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Philadelphia City Controller

{Alan Butkovitz}
Alan Butkovitz

The Right Angle club was pleased to hear the City Controller, Alan Butkovitz, give us an insider's view of the municipal finances, but was a little startled to hear how badly the national banking crisis has affected our city. While of course the city does a lot of things, its present finances can be summarized as mainly consisting of two things: the pension system and the management of police/fire/corrections.

Mayors of this city for several decades have been following the national pattern of government to transfer its deficits to the pension funds of the employees. That has the effect of shifting the cost of present operations into the far future and avoiding present confrontations by promising even more generous pension benefits in the future. Over time, the future gets closer and closer; to a large degree, it is right now. Pension funds are largely independent organizations, supposedly receiving current contributions to be invested for future distribution. That requires an assumption about how much investment growth will be achieved in the meantime, now set by the Philadelphia Board of Pensions at 9%. That's not impossible to achieve in some medium-term intervals. But it's optimistic, even inconceivable, for long-haul investing; over periods of thirty or more years, most experts say that 4% is about all anyone gets. More to the point, 9% is particularly unachievable right now, in the present crash of national financial markets. That's bad enough, but repeated shortfalls in contributions to the fund have left it funded at 53% of the calculated requirement to pay the pensions of the future, even using the unrealistic 9% return assumption. A few years ago, Mayor Rendell worried about the underfunding and brought it up to 70% with a billion-dollar bond issue. Unfortunately, the crash in the markets has brought it right back down to 53% again. So, it's fair to say the pension fund is a couple of billion dollars short, even if you accept a 9% income accumulation -- which you probably can't, but at least it brings the pension fund to 70% funding in forty years. Call it four billion dollars short, just to be conservative, since it is presently admitted to being two billion. That isn't Mayor Nutter's fault, but it's sure his problem; and if it gets worse, it will be seen as his fault.

The other expense item of note includes 42% of the budget in the police, fire and prisons systems (education is handled separately through the school board). If you fired all those people, or they quit, we wouldn't have a city, we would have a jungle. But the Controller describes all three as terribly mismanaged, with the local police stations in a deplorable state of disrepair and degradation, bathrooms you wouldn't think of using, and so on. The fire department has only a minor number of fires to fight, perhaps four or five hundred a year, but it includes the emergency rescue services which respond to a couple hundred thousand calls a year. The rescue people report to the firemen, and there is social friction between the two, working to the disadvantage of rescue. It costs about $500 to respond to a call, and it isn't entirely satisfactory to send a fire truck to help someone with a heart attack. The Controller had a number of horror stories about administrative mismanagement in this area. As far as prisons go, everybody knows prisons are bad places, and ours are no exception. Confrontation with the unions is definitely in the future for the Mayor, and the city is going to be in pretty bad shape if he doesn't win some arguments.

That's the expense side of the municipal budget; the revenue side is equally gloomy. The offhand comment was that real estate taxes could double without bringing the pension system under control for twenty years. If our taxes are significantly higher than neighboring cities, or even just the same as in cities with superior uniformed services, it will be hard to attract and hold business taxpayers, causing municipal finance to spiral downward. Along the course of this patter-song, it isn't exactly reassuring to learn that it now takes the City 21 days to process a check and that absenteeism in some departments runs to 20%. We've heard a lot of denunciation of Mayors Giuliani and Bloomberg in New York, but their absenteeism runs 3% because investigators are sent to the house of an absentee, who is subject to court martial if he isn't home.

Somewhere in this nightmare lurks the hidden migration of the unionized workers. Starting with Mayor Rizzo or even earlier, the uniformed services were the main political support of the Democrat political machine. Quietly, they have moved out to the suburbs where the schools are better and the taxes are lower, and it is now said that 70% of union workers live (and vote) outside the city limits. The unions talk tough, bluffing through the uncertainty when their members can no longer provide the votes to be so fearsome. To some degree, their weakening political power is augmented by using their pension funds to provide construction loans for new commercial real estate. Some of that political clout is used up by the need to get zoning variances and tax abatements for the projects. A lot of these power shifts are hard to assess from the outside, but a trend is clear.

The controller didn't mention it, but the city is not only a pension investor in bonds but also an issue. Interest rates are about as low as they can get while the Federal funds rate is nearly zero, so there is only one direction they can go in the future -- sooner or later they will go up. By the iron law of bond financing, the value of the underlying principle will then go down. That could provide an opportunity to buy them back at lower prices, or it could break the city's financial back financing higher interest payments. However, for the pension fund side of things, exactly the opposite is true. Maybe Hizzoner can tap-dance around these dangers and opportunities, but most mayors would have trouble pronouncing the words.

It's part of the job description for the controller to be a pessimist. But the most you can make of this mournful dirge is to hope he is completely wrong.

Oriental Money


Rapid enrichment of the Asian poor is the most momentous event of world economic history. In a variety of leggings and blockings the Chinese Communist government held their currency (the yuan renminbi) at levels appreciably below true value in purchasing power and refused to let it float, thus augmenting cheap labor in selling goods abroad at low prices. Foreign attempts to share this wealth, particularly direct foreign investment in domestic Chinese businesses, were severely controlled. From China's viewpoint, the beneficial result was that foreign investors were prevented from upsetting the yuan by either gold-rush investing or suddenly withdrawing their money, as indeed they had done to many other developing countries, many times. However, artificial constraints channel economies into unexpected new directions. As an avowedly communist country, the profits of China's new prosperity could be held by the government, and an amazing 59% was actually held as "savings", with that government easily able to spend 10% of its gross domestic product buying U.S. Treasury bonds. Ultimately, China bought a trillion dollars of U.S. bonds.They got the bonds, we got the money. This flood of new money into the American economy lowered interest rates abnormally. The resulting low rates then stimulated reckless American borrowing, which found its way into a housing boom with cheap mortgages. The confused responses of America to this novel situation will be discussed later, but it must be remembered that both Japan and Germany have quite recently been almost equally single-minded in their export-driven policies. China is the biggest offender, but China will have important allies in the debate.

{Chinese Factories}
Chinese Factories

Abnormally low interest rates. In other circumstances, easy borrowing at low-interest rates might have stimulated business investment in plants and equipment, but American business was preoccupied with shifting domestic factory production abroad to enjoy abnormally low labor costs. The Chinese (and other export-driven nation) government for its part severely blocked direct foreign investment in Chinese factories. The ultimate unintended consequence of these primarily Chinese decisions could be stated thus: it stimulated an American housing boom at the expense of the Chinese peasantry. Things might have gone on to produce other results, but instead came to a sudden paralysis on August 9, 2007, when investors (probably using hedge funds) decided the credit markets had reached unsustainable tension and started selling in large volume. Somehow, this somehow had to do with the American mortgage industry going haywire, because almost everyone suspected that was the case. We now focus on how mortgages went haywire while remembering this was mostly a result of forced adaptations breaking under the external strain of too much easy credit coming from abroad. If it hadn't mortgaged, it probably would have been something else. But it was mortgaged.

American monetary authorities, committed to inflation targeting of short-term interest rates, were probably deceived by low long-term interest rates into believing the Far East Trade imbalances were not seriously inflationary, and might even be deflationary. To protect American banks from paying more for deposits than they could charge for loans, the Federal Reserve lowered short-term rates, which would definitely be inflationary. What happened to America was what happened to a hundred smaller countries; sudden withdrawal of foreign investment caused a recession. In our case, the foreigners did not actually withdraw their money. It was effectively frozen in place by funny business in our own special financial innovations, which we will now describe, growing out of the difficulty that just about anybody entitled to a mortgage already had one. Several steps removed from the commercial credit-paper problem that upset some insiders, panic in the stock market suddenly started on a nice summer morning. On August 10, 2007 the Dow Jones Industrial Average unexpectedly dropped 400 points in ten minutes. The trumpet had sounded.

The full history was of course vastly more complicated than this densely concise synopsis of it, so in fairness, a few main amplifications must be added. China, while large, represented only forty percent of the economies of the newly developing world. Neither Japan nor Germany is a third-world country, but they behaved the same way. Volatility in available reserves of Middle East oil contributed an independent bubble in the midst of the main (home real estate) one. Japan's long depression contributed to a diversion. The secondary economic powers, particularly in Europe, rushed in to imitate what seemed like a new financial paradise, making their resulting problem somewhat worse by having enough sophistication to dabble, but less than enough to cope with unprecedented volatility across national borders. There were also some moderate-sized wars in the Middle East and the usual amount of self-serving international politics. These things must be mentioned, but they are not significantly relevant to the unfolding of the main problem. Which was: A billion desperately poor people grew prosperous in less than a generation. Their government loaned their money to the rest of the world, who then enjoyed a revel of abundant cheap credit. The commotion found a weak spot in American home mortgages, bringing the world financial system to a humiliating halt for confusing but nontrivial reasons.

In theory, the world should now devise a more unified monetary system. It would certainly help to address the conflict between an internationalized economy and the traditionally heedless national control of local currencies. With urgency bred of crisis, a new international monetary system might emerge in time to be helpful with the coming recession. Smaller steps might be more achievable; the question is whether they will be adequate. Everyone's most pressing problem is to concentrate on patching together the American banking and mortgage system, possibly buying time to get the world to cooperate on broader issues. The miracle-maker who can devise the right monetary system, sell it to a suspicious world, and implement it in time to do some good -- would rightly deserve to be sainted.

Let's now tell the story of the unraveling of the American banking system. It's important to know where America stands if it is to exert world leadership.

iPhone, Skype, Land Lines and International rates

Skype on the iPhone

Skype on the iPhone works exactly as you would expect.

The iPhone automatically detects all wireless hotspots in the vicinity (it does this with or without Skype installed and it uses the wireless connection for all internet traffic while connected.)

Start Skype and you can see who's online and have a conversation with them or call them off-net through Skype just as you do on your computer.

The only deficiency I can see is that you can't multi-task while Skyping; while using the cell phone you can switch to other applications but with Skype doing this disconnects the call.

The AT&T cell + data package seems to be less money than Verizon's and the iPhone beats the pants off a Blackberry.

I have broken free from the landline tether.

I had a land-line Verizon home phone number forever but I have canceled it.

That number had been call-forwarded to my cell phone
- About $60 a month.

So I now have a Skype-in number:
call that number and if I'm offline (most of the time) the call will forward to my cell phone @ $0.02/minute.
- Exactly $60 a year (for the number, plus charges for any calls which I expect will be very few.)

$720/year vs. $60/year. Duh.

Why have any number other than my cell phone at all? In my case, I need a local area code for the guard at the gate of my condo where the phone is blocked for all non-local calls. Skype also offers international Skype-in numbers so your mother in France can call you with a local number. Etc.

The iPhone is an option for international cell phone use but it can be expensive. Here are AT&T's recommendations to reduce this expense.

When using your service outside the U.S., Puerto Rico or U.S. Virgin Islands (for either voice or data), international roaming rates apply. Your iPhone provides access to email, Visual Voicemail, Web browsing and other applications that can use a significant amount of data, so remember-international data roaming can get expensive quickly.

How iPhone Users Can Minimize International Data Charges:


{Bank Owned}
Bank Owned

In such circumstances, banks could be expected to start holding back. But no, there was too much even cheaper money available for banks to borrow, leverage up with more borrowing, and re-lend to homeowners. It got to the point where a dollar of the bank's own money supported thirty dollars of loans to customers, and homeowners still lined up for more. The solution to the conundrum was suddenly clear: too much cheap money was in circulation, and it was coming from China and the Middle East. Because the prices of houses were going up steadily, banks took a chance on the plain fact that thirty-to-one announces that a loss of house value of 3% means the mortgage is losing money. A couple of other ugly facts are somewhat less obvious: when interest rates go up, the value of the loan goes down. Secondly, when banks reduce their thirty-to-one borrowing to a safer twenty-to-one, the de-leveraging raises interest rates still more, lowering home values still more. A downward spiral can easily get started. Historically, banks were protected by the homeowner's down payment; down payments had become minimal. Adjustable rate mortgages were now popular, a process of shifting the risk of interest fluctuations from the bank to the homeowner, as the homeowner would soon learn if interest rates rose.

{top quote} We faced a big problem caused by too much cheap money, and we struggled to save the situation -- by injecting more cheap money. {bottom quote}

Time passed, abnormally low-interest rates had persisted after Greenspan's public mutterings. The weak point was the home mortgage, exactly where risky loans are artificially encouraged by implied congressional protection. Reluctant to see foreclosures, politicians stood ready to command mortgages to walk on water. Although it was pretty evident that lending standards were lax, the differing degrees of risk were not reflected in the "risk premium" or width of the "spreads." That is, bond investors remained mysteriously content to be paid interest rates scarcely greater for risky investments than for safe ones such as U.S. Treasury bonds. The markets viewed those two as essentially equivalent. Since these interest rates and the risk evaluation they reflect are set by supply and demand in the credit markets, the persisting anomaly of low rates had to be traceable to either excessive cheap money, or investor overconfidence. In retrospect, it was both. Foreign money flowed in from Far East prosperity and Persian Gulf oil profits. Whether it pushed in or was sucked in, remains a matter of opinion. Wall Street greeted this bonanza with "securitization" -- new lending mechanisms for home mortgages--and builders went into high gear building more houses, especially in California and Florida. They built too many because it's hard to walk away when business is brisk. Because of distorted tax structures, mortgages were the preferred means of borrowing for any private person. Eventually, the bubble burst; it remains to be seen whether we would now go on to some other bubble (commodities, for example) or sink into a protracted depression. If it's to be depression, a new uncertainty arises. When investors accepted low rates in the expectation that politicians would bail out bad mortgages, they surely predicted rightly. The real risk is, it won't do any good.

{Alan Greenspan}
Alan Greenspan

As Greenspan was implying, prosperity usually puts upward pressure on interest rates but this time it remained a coiled spring; house prices made unprecedented rises for several years in a row but mortgages remained cheap. In mid-August 2007, bank turmoil in a couple of European banks suddenly prompted a rise in worldwide long term interest rates, more or less obscured by a lurching drop in the stock market. It seems likely this unexpected stock movement created misleading signals; in a day or two stock prices recovered. It was mortgage interest rates snapping back toward normal levels that truly mattered because that predicted excessive home prices would now surely decline; even worse, house plus mortgage might soon cost more than overstretched consumers could afford, provoking panic selling of houses. In any case, house prices could be expected to fall until it was no longer cheaper to rent than to buy, and it was then an open question of whether rents might also be chased down further. Patterns were hard to identify at first; different parts of the country overbuilt to different degrees. Even worse spirals could be imagined, too. If a house must be sold for less than the unpaid mortgage, a homeowner is tempted to surrender the mortgage and walk away, so foreclosures might be more common than economic conditions alone would warrant. If homebuilding stops because of a housing glut, immigrant laborers may -- or may not -- go back home, after first looking around to see if patches of the country are still building houses. A recession may spread, the national election in November may turn our unexpectedly; all sorts of things might -- or might not -- happen.

Banks had been the most strained by all the good fortune of cheap foreign credit because they make their profit on the "yield curve" -- the difference between what they pay for deposits and what they charge for loans. For over a year, the yield curve had been inverted, meaning banks were often close to paying depositors more than they got back from borrowers. Dropping interest rates paid to depositors would increase bank profits, but go too far with that and depositors will be chased away to money market funds, or treasury bills. The problems of banks became the problem of the Federal Reserve. The Fed controls short-term lending costs but generally lets the bond markets establish long term rates. With long rates abnormally low for a long time, banks were severely tested to make a profit, which for them essentially consists of paying depositors low short term rates, and lending debtors the money at high long term rates. A very narrow spread between short and long rates deprived banks of their means of support. This "flattening of the yield curve" became threatening to banks and also to the Federal Reserve, whose whole system of controlling the money supply was based on their control over banks. Subsequent to the crash, a number of commentators led by the Cato Institute have severely criticized the Federal Reserve for maintaining low short-term interest rates for too long, and others have even attributed a motive of supporting the Bush administration by inflating the currency. It is unnecessary to place this construction on the Fed's behavior. If the banks depend for survival on the difference between long and short rates, and if the Fed is powerless to raise long rates, there is nothing to do but lower short rates. This has the unintended effect of stimulating inflation, and Greenspan has later admitted he regrets it. But he seems willing to accept the implication that he was dabbling in politics, rather than admit to what is more likely to have been the cause of this behavior. The whole theory of how the Federal Reserve currently combats inflation is based on "inflation targeting", in which the central bank essentially ignores every other signal and responds to its measurements of inflation in the economy. These measurements were also distorted by the flood of Chinese money, so the very force which was causing inflation was also making it appear that inflation was not a big concern. Since the value of money in current times is almost entirely a decision of the central banks, it seems too central bankers that public trust in that process must be preserved at all costs. And, indeed, when the behavior of Congress is observed on C-span television there can be a reason to be quite sympathetic with the plight of our monetary policy leaders. There remains however little doubt that the formulas for detecting inflation require some modification for changing circumstances.

So to go back a few years to the time when the bubble in housing prices was getting started -- banks had resorted to some new and therefore risky procedures that seemed to side-step their difficult situation. With borrowers flocking in the door, banks were able to sell the loans of constantly rising size to the secondary market as fast as fresh borrowers came in. To understand this inflammatory issue, it is probably necessary to go back to the depression of the 1930s. At another time of confused floundering in the financial markets, public opinion centered on splitting up the functions of big banks for easier control by government regulators. Commercial banks, who obtain their lendable funds by accepting deposits, were forbidden to be incorporated with investment banks, who obtain their lendable funds by selling bonds. And incentives or regulations were modified to direct home mortgages to savings and loan banks. Forty years later, the Arab oil embargo precipitated a monetary situation where interest rates rose to nearly 20%. Savings and loan banks, holding enormous amounts of thirty-year mortgages at roughly 6%, had to close their doors because they could not remain, viable paying depositors, such rates. Thousands of savings and loans, holding nearly 50% of the home mortgages in America, went out of business. A vacuum was thus created, and some other mechanism for financing mortgages was extremely welcome. With almost inhuman ingenuity and innovation, Wall Street invented the CDO and marketed hundreds of billions of dollars worth.

It had elements of a Ponzi scheme but perhaps it was controllable. The banks who merely originated loans did create an undeniable moral hazard because they naturally took less precaution with loans they were immediately going to sell to someone else. No one, it is said, bothers to wash a rental car. Meanwhile, the strain of an inverted yield curve began to take its toll on the banks; after a year of it, their reserves started to get depleted.

Whether banks pushed or were pulled is debatable. Probably the bigger part of the growing problem was created by those ingenious investment banks on Wall Street, who were buying these increasingly risky mortgages and loans by the truckload. Bundling up thousands of mortgages into a new creature called collateralized debt obligations (CDO), they sold them to the public as "securitized debt". In effect, debt was partially converted to equity -- little bonds into big bonds, but the riskiest little bonds sifted out and converted into equity. It was a remarkably imaginative revolution in finance, but even if every step was absolutely perfect there could always be a danger that the generation of many $trillions worth of new paper would topple existing arrangements by simply going too fast for other systems to adjust. That's what happened, although there were inevitably also some design imperfections that got ignored for too long.

{housing bubble burst}
housing bubble burst

So the financial world started to crash in the middle of August 2007, while the rest of us were enjoying a summer vacation. The housing bubble burst; the party was suddenly over. The television was filled with scenes of traders jumping up and down, screaming orders to each other. Commentators commented excitedly every five minutes, and pundits screamed that the Federal Reserve must do something. All of this communications uproar conveyed the impression that a final explosion of some sort had taken place, and we could, therefore, expect a long period of post-bomb silence. But that really was not what seemed to happen. The stock markets dipped but recovered. House prices were down a little, in some places. Gas and oil prices remained too high and went a little higher. The Federal Reserve dropped short-term interest rates a few fractions of a percent, long term rates scarcely moved at all. In the background, America was fighting two overseas wars and a presidential primary campaign, but somehow they weren't part of the equation. Rather, it was explained that the consequences of August would be delayed, taking many months to unwind. A crash, in other words, in slow motion.

That might be so. It often takes months to buy and sell houses; their value may have declined, but a thing is worth what you can sell it for, so you can't be sure what they are worth until houses are actually sold. Essentially the same thing is true of stocks and bonds, and it's hard to know if securities are worth the amount of the comparable most recent sale. or if you should measure them against what you suppose will be the price when you sell later. Auditors and bank regulators are rigid about their answer: banks must "mark to market" if they intend to base future loans on the securities in their vaults. The rest of us would rather wait and see and must do so for tax purposes. You can scarcely blame bankers for hoping the turmoil creates a V-shaped dip that can safely be ignored. Even if it does not, a protracted economic pause can create time to patch things up, generate new sources of income to replace what is lost, if it is lost. Only the gold market seemed to disregard such assurances, gold was emphatically on the rise. After six months of relative calm, it was still possible to believe this was a passing flurry, or to believe we were floating downstream to a tumble over another waterfall. America in the 1930s and Japan in the 1990s had discovered that drift and uncertainty can sometimes last fifteen years. After a brief recital of the events leading up to August, we next embark on a more detailed (but simplified) discussion of what went on, eventually leading to conjectures about what comes next, particularly what the Federal Reserve can and should do about it.

{Market Flooding}
Market Flooding

Spreads, as bankers say, widen and narrow. Last August, the risk-premium demanded risky lending was stubbornly lower than history suggested was normal. In fact, the prevailing interest rate for mortgages and other long term loans was lower than interest-bearing cash in the form of money market funds was paying, a rather uncommon situation called inverted yield, or an inverted yield curve if you draw a picture of it. Stubbornly low long-term interest rates became a particular concern for the Federal Reserve and the commercial banks it regulates because the spread between long rates and short ones was not only where banks made a profit but how the Fed regulates the money supply. Since now the only way to maintain a profitable differential was for the Federal Reserve to lower short-term rates, it forced the Fed to hurt retirees and be inflationary by flooding the market with cheap short-term reserves. To put it another way, a flood of Chinese or Arab money into long-term bonds could only be kept in balance by a matching American flood into short-term ones. Inflation was already beginning to worry the Fed, so this development was unwelcome. At the extreme, it might force a choice between promoting inflation -- and bankrupting the banks. Add to this the conjecture that old-fashioned banking was eventually destined to vanish anyway, into some bright new computerized efficiency devised by Wall Street wizards; and you have to wonder if the very worst consequence might be to prevent creative destruction from taking place. It's awesome how simple changes multiply into a turmoil you can hardly understand.

{Quantitative traders}
Quantitative traders

On August 17, that risk premium squeeze went away. Long term rates for risky bonds went up, but safe bonds like U.S. Treasuries stayed about the same. While it is always a relief to see things return to normal, the gruesome fact is that money, or at least value, had to be destroyed to accomplish it. The nature of the secondary bond market is that a rise in the interest rate causes a corresponding drop in the price of bonds, a loss which will only be restored by increased interest over a long subsequent period of years, possibly not until the bond reaches maturity. That means for a long time more money is lost on bond principal than is gained on bond interest. An incentive to sell everything else is thus created for the bondholder, creating a contagion of selling. To return to Mr. Greenspan's conundrum, a suppressed interest rate had been creating an illusion of wealth whose disappearance was now reluctantly acknowledged. Some bondholders tried to dump before the full effect was felt, others held back from selling but eventually had to liquidate something to raise working capital. Panic selling spread, and unanimous fear of the unexpected caused "congested" trading, all in a downward direction. The Federal Reserve first helped out by dropping the interbank discount rate (the rate one bank charges another when one of them finds it needs to borrow to keep its books in balance) the next morning, but that action carried further messages of panic. Quantitative traders ("Quants") who programmed their computers to sell on signals of trouble were misled by huge sell activity which actually avoided the long bonds at the root of the problem, primarily because no one would buy them. Astonishing quantities of sell orders of perfectly good securities were accordingly issued by the obedient computing machines. Nobody knew what was going on, but everyone suspected something had been funny about bond rates for two years. Those who did not sell were ready to sell, and would certainly not buy. All markets were congested; credit markets were soon frozen solid. Someone was going to go bankrupt, but there was no time to find out who it was. Without transparency, markets will not clear.

{Credit derivatives}
Credit derivatives

Clarifications eventually surfaced in jumbled sequence. The main difficulty was concentrated in those new mechanisms for financing home mortgages, "derivatives" for which unfamiliar abbreviations leaped into excited jargon. Subprime loans, better called unwise loans were sold to victims, or maybe abused by speculators. "Credit derivatives" based on mortgages and other assets were discussed knowingly by those who a year earlier had never heard of them. The huge size of these mysterious instruments merits emphasis. There had been $26 trillion worth of credit derivatives in existence six months earlier, some said it was now $42 trillion. (A year later it was to be $62 trillion.) Compared with that, the entire mortgage debt of the country was said to be only $9 trillion, and the entire U.S. equity market was something like $13 trillion. Even congressional investigating committees were afraid to say much about something that big, that new, and that obscure.

Most confusing of all was to compare the growing consensus about the underlying difficulty with the solution now demanded by Wall Street, and apparently accepted by the Federal Reserve, our President, and our Congress. We started out with a problem created by foreign money flooding into our mortgage market; that's more or less comprehensible. The Fed then lowered short-term interest rates, Congress produced fiscal stimulus; both of these things created cheaper money, more credit and a lower international value for the dollar. The centerpiece of the solution was to create still more cheap credit, both at the Federal Reserve and with a Congressional Stimulus Package, when the problem was we already had too much cheap money.

Please, sirs. Would you mind saying that again, slowly?

Second Mortgages Want to Be First

{Chrysler Logo}
Chrysler Logo

In a bankruptcy proceeding, there has long been a traditional conflict between the holders of first mortgages and the holders of second mortgages. It goes like this: since the holder of a first mortgage gets paid first, his incentive is to hurry up the process and get the money. The holder of a second mortgage, however, only gets paid what is left, so this party will normally wish to stall proceedings in the hope the market will improve and give the second mortgage a better payout. Normally, this sort of predictable dispute is covered by contracts, and in any event, most banks hold both kinds of mortgages and are neutral about what is just and fair. In the current banking crisis, however, the major banks have developed an incentive to favor the second mortgage, so they have a new view of what is just and fair. Four of the largest banks hold a total of $440 billion of second mortgages but have very few first mortgages because they were sold off in the securitization process. The banks mostly retained the function of servicing first mortgages, however, so they now have quite a conflict of interest.

Something like this seems to be going on with the resolution of the Detroit auto makers, with the difference that politicians tend to favor the interest of the auto workers in the bankruptcies because there are more voters to be influenced. And in the case of the auto companies, there are stockholders who will be wiped out by a bankruptcy unless the liquidation of the company assets produces enough cash to satisfy the creditors, secured and unsecured. After all, stockholders aren't creditors at all; they are owners of the company. No matter how things turn out, however, the secured creditors would normally have the first call on whatever is salvaged. So, it's one class of secured creditor against another, or else it is the secured creditors against the "stakeholders", employees or any other unsecured creditor. If the government intervenes, there is the additional issue of the Fifth Amendment of the Constitution, which prohibits the government from the "taking" of private property without just compensation. Representative Conyers of Michigan, whose political allegiance is not in doubt, has introduced legislation to prohibit lawsuits in these matters. So now, the prospect grows of a constitutional clash between Congress and the Supreme Court, over the Constitutionality of such a law which denies due process. So that gets us into the fourteenth amendment, too. If we look beyond the technicalities, the looming clash is between President Obama and Chief Justice Roberts. One of them wants to take money from secured creditors and make it available to someone with more political clout; and the other surely wants to preserve the sanctity of contracts, the rights of property holders, due process, and the right of the Supreme Court to declare contrary laws to be unconstitutional.

Unless someone backs off, the situation would seem to be as monumental as Franklin Roosevelt's Supreme Court-packing proposal. Because -- there is every reason to anticipate a 5-4 vote by the Supreme Court, a 5-3 vote if Justice Souter is not replaced by that time, and strenuous efforts to alter the balance.

Steep Yield Curve: A Useful Subsidy?

The steepness of the federal interest rate curve -- ten-year treasury bonds pay more interest than three-month treasury bills, and the rate for intermediate time intervals slopes gradually from one to the other -- is a function of the Federal Reserve; the slope of this curve concisely describes current Fed policy. The Federal Reserve controls the money supply by raising or lowering short-term rates, which "affects the slope at the short end", and mainly in this way restrains or encourages inflation, or alters the exchange value of American currency. For the most part, long term rates are set by the public bond market. Once in a while, the Federal Reserve does buy or sell long-term treasury bonds to modify long-term rates in the economy. By affecting rates at either end, the result is some kind of change in the slope of the curve.

Because banks make interest payments to depositors near the short-term federal rate, while the same banks charge borrowers at near the public long-term rate, the current slope is the main determinant of bank profits. Banks borrow short and lend long. If Federal Reserve tinkering steepens the curve more than it would be without interference, then bank profits are subsidized. Of course, it works the other way as well; in a banking crisis, yield curves can be steepened to rescue banks from failure, thus potentially sacrificing ideal monetary levels temporarily. For the most part, what is good for the banks is good for the economy; but it remains that bank profits are subsidized much of the time. Artificially widened yield curves either punish savers by lowering interest rates on their savings accounts or else punish borrowers by increasing interest rates on mortgages and other credit. For political reasons, the pain is usually shared among voting blocs. It can be argued this invisible subsidy of banks by the public creates a compensating benefit of economic stability despite occasional bubbles and recessions like the present one. However, the Federal Reserve system has been in operation for almost a century, revealing a long-term bias in favor of inflation, which is a subsidy of debtors by creditors. Present policy deliberately targets a steady rate of 2-3% inflation; the gold market responded to a century of this by raising the price of gold from $17 to $900 an ounce. A 1913 penny has become a dollar (before taxes) you might say. You might also say it took the Federal Reserve less than a century to make the present dollar worth a penny.

If gradual inflation is a consequence, a fair question must arise whether the Federal Reserve is worth its cost. Compared with an inflexible, relentlessly deflationary Gold Standard, yes, it is. Even accepting the monetary crisis as partly created by central banking, the international dominance of the American economy and recent smoothing of banking instability testify to the durable use of the Fed. But another criticism must be faced: In subsidizing depository banks with an artificial yield curve, is the Fed backing the wrong horse for the future? To answer that question, examine two components: With computer technology rapidly advancing, can the Federal Reserve accommodate non-banking competitors to banks? And secondly, international central banking appropriately accommodate globalization? There are, after all, aspects within the 2007-20?? a crisis which suggests -- maybe it can't.

Steady inflation of 1000% per century may well be preferable to 19th Century volatility of 1000% every ten or so years. But a gradual rise of, say, 500% or less each century might be even better. Relentless political pressure on the Federal Reserve has typically been used to explain its slow retreat from truly stable prices, and this defense takes the form of mentioning its dual mission of minimizing unemployment while holding prices as steady as possible. In recent years, European political rhetoric goes further, aspiring to add the right to employment to their fifty-page Bill of Rights; similar utopianism has crept into our own news media. Governments for thousands of years have cheapened their currencies. But while the drift is clear, our own pace is set by the amount of subsidy required to maintain a steep yield curve. As retail banks have struggled to compete with the wholesale investment banks, their increasingly uncompetitive costs require a greater subsidy from the yield curve. It is always going to be more expensive to aggregate deposits for lending purposes than to raise large sums by floating a bond issue. Securitization is here to stay because retail banks have consolidated and savings banks have gone out of business by the thousands; the mortgage industry can no longer survive without substantial amounts of mortgage-backed securities. Nor should it; securitization is a sensible route for importing capital from nations with a trade surplus. Depository banks long ago lost the borrowing business of corporations large enough to float their own bonds; securitization provides a means for smaller borrowers to share the same efficiency. After it has tried everything else, Congress will eventually devise a reasonable regulatory system for derivatives. Except for smoothing the transition to whatever proportion of market share the investment banks can justify, perhaps all of it, the subsidized yield curve impairs efficiency. It would be a mistake to allow some foreign nation to exploit such an opening before we do. The technical problem for all central banks is to devise a suitable alternative method of controlling the currency, other than by targeting inflation with adjustments in interbank lending rates.

Observers led by Martin Wolfe the economist for the Financial Times feel the 2007-20?? financial crisis can be adequately explained by Chinese pegging their currency too low, and could be rectified by persuading the Chinese to float their currency. Regardless of this extreme view, globalization is clearly both a good thing and an inevitable one. Thus some form of discipline must be devised to prevent central banks from destabilizing it for their own advantage. Wolfe proposes the use of a strengthened International Monetary Fund, which is unfortunately apt to project international politics into a process which could be harmed by it. An alternative to be examined might be to pool sovereign wealth funds as a pooled currency reserve, although this system probably could not withstand present extremes between surplus and debtor nations, so getting world acceptance could be protracted. Ultimately, everyone realizes that the real backing for an international finance system is the net worth of the whole world. But the example of Lloyd's of London is a haunting one; no one relishes putting absolutely everything at risk, down to the last shoe button. In the event of a disaster, everyone wishes to hold back some nest egg to use for recovery. Because of the same line of thinking, almost no one would trust foreigners to control more than a limited share of their future.

The future of international monetary relations is thus quite murky, but current pressures would seem to be driving something fundamental to change. When it does, regulating artificially manipulated yield curves had better be kept in mind.

Milton Friedman on Capitalism

Fixing the Financial Mess

Two years after August 2007, it remains uncertain whether we know enough about how the great financial disaster came about. There may be other shoes to fall on the floor, announcing unexpected dimensions of our problem. In particular, the recovery may be brief, followed by a resumption of downward trends we had hoped were finally behind us. That seems to have happened in 1937. If it happens again in 2010, what seemed like a three-year recession may prove to have been a twelve-year one, with early successes exposed as mere flashes in the pan.

Nevertheless, politicians are searching for answers to give the public; no one wants to delay solutions if they exist. Analyses can be revised if new information appears. Presently attractive approaches can be divided into three categories: International, Regulatory, and Goal-focused.

{Martin Wolfe}
Martin Wolfe

International monetary diplomacy. There is a fairly uniform agreement that a major source of instability came from the unprecedented transformation of third-world countries into economic powerhouses. As many as a hundred million people were raised up from poverty in less than a generation; there was an inevitable commotion in the world's economy as a result of a fundamentally very good thing. The British economist Martin Wolfe is the chief spokesman for the view that there was almost nothing the Americans could do about the upheaval, although the Chinese government made it much worse by pegging its currency too low. This line of analysis leads to the proposal of world monetary diplomacy, offering the Chinese greater influence in the International Monetary Fund in return for floating their currency, and negotiating a greater role for the IMF in world finance.

Regulatory restructuring. With or without the creation of a new international monetary order, others feel that individual nations must create internal regulatory barriers to prevent the ebbs and flows of international currency from circumventing local laws, upsetting local stability. The problems daunting this approach are two: many nations will fail to respond adequately, with consequences which could overwhelm those nations who institute responsible reforms. And second, the recent pace of financial innovation has been so rapid that regulation is easily circumvented. Draconian controls would surely lead to a loss of local competitiveness, and disadvantaged local captives would soon rebel. Urgently needed regulation and effective regulation often prove to be two different things.

Goal-focused adjustment. In recent decades, considerable success resulted from forcing the system to produce a certain desired outcome, essentially ignoring the myriad intermediate adjustments. Inflation targeting has come to be a description of stable prices forcibly maintained by one technical method (also called inflation targeting in a narrow sense). It lets the economy produce its own responses, and if necessary lets academics produce their own explanations. Unfortunately, this approach in time translates into Congress announcing there shall be no inflation, and the Federal Reserve responds, lo, there is no inflation. Since Congress has very little idea what is involved in this process of waving Merlin's wand, transparency, financial innovation, and reduced transaction costs can suffer unduly before the underlying dynamics reach the surface of public awareness. In short, there are too many hidden steps between public awareness and the feedbacks which modulate the policy. One of those steps is apt to be a blatant denial that policy had a given adverse effect.

Federal Reserve Rolls the Dice

Lehman Brothers

For the year preceding, it was general opinion that the financial crisis was caused by $100 billion or so of mortgage-backed securities, mostly California and Florida home mortgages. But around Labor Day 2008 Lehman Brothers collapsed, and the problem became twenty times as large. What that was about is unclear, but seemingly had to do with money market funds being treated as "funds in transit" in consequence of the international monetary agreement known as Basel I, and thus not requiring bank reserves to be maintained for them. It will take time to unravel the intricacies of, and assign the blame for, this mess. However, the markets responded by refusing to trade at now uncertain prices, thus "freezing up". The response of the Federal Reserve was to double the money supply through international markets, mostly using "Central Bank liquidity swaps". The participation of various countries in this action has not been made public.

The doubling of the money supply required borrowing between one and two trillion dollars. After five months, or just after the inauguration of the new Presidential Administration, the markets had seemingly started to function more normally, and the stock market had rallied somewhat. The obviously bewildered leadership of both political parties agreed to the proposal to purchase $1.75 trillion of the troublesome assets, taking them off the market and presumably hoping the markets would function as if they did not exist. By July 2009 this operation was only about half completed. Not only was there disagreement about what these securities were really worth, but the banks which held them were reluctant to allow prices of what they continued to hold to be driven down by comparison with these forced transactions.

{Federal Reserve Bank of Philadelphia}
Federal Reserve Bank of Philadelphia

In any event, the second stage of this huge government bailout of the banking system is projected as follows: The portfolio of assets would be worn down, either by allowing debts to mature, or by selling them at what is hoped will be advantageous prices. Who will buy them is to some extent dependent on the state of the economy, and to some extent on the perception of the fairness of the pricing. The Federal Reserve Bank of St. Louis has been assigned the task of designing a public formula for how much to buy or sell, depending on selected indicators of the economy. A public formula is felt to be necessary in order to reassure the markets that purchases and sales are not being made in response to secret information or unsuspected problems.

The reasoning would be that if these assets are sold to speculators at fire-sale prices, the money supply will shrink inappropriately, and the recession will be prolonged by the need to borrow replacement reserves for the monetary system. Unduly profitable sales would probably lead to inflation, since the present level of monetary reserves is twice as large as was thought appropriate, as recently as a year or two ago. But this maneuver by a central bank has never been tried before, and the results may well differ from present predictions. The Federal Reserve is prepared to take as long as ten years to accomplish the complete maneuver, but that plan presumes ten years of recession and five congressional elections. It also implies that the economy could swing between 7% annual inflation, and 7% annual deflation, in the two worst cases, and assuming nothing extraneous happens to the economy.

{Federal Reserve Bank of Philadelphia}
President Barack Obama

In the meantime, two other ominous notes. Although the nationalities of the lenders have not been made public, one can safely assume the Chinese are a major component. Since they are refusing to lend us money beyond two, and at the most five, years, we would be indefinitely in the position of borrowing short and lending long. In other situations, that imposes a risk of depositors starting a run on the bank. And secondly, it is hard to imagine that Mr. Obama's presently ambitious programs in healthcare, environmental protection, two wars and several election cycles, will be allowed to proceed without enormous public resistance to even further fiscal deficits.

Commercial Credit Sinks Globalization

Lehman Brothers

In August, 2007, the world sort of woke up to the housing bubble in California and Florida, along with the ingenuity of securitized mortgages. About $100 billion was involved, and credit markets froze up as the risk premium of low quality loans (relative to U.S. Treasury bonds) gyrated furiously, almost always in the direction of down. There was a staggering amount of credit default swapping, some $60 trillion, but it did not seem to be unraveling. Why in the world did a problem of that magnitude, while admittedly large, lead to continuing panic which was widely believed to require $4 trillion in rescue funds eighteen months later? There were obviously some big missing pieces of this puzzle. Worse than a money panic itself, was the realization that we only understood about 5% of the problem after a year of investigation.

The case in point is that in the fall of 2008, world trade almost came to a total stop. How does $100 billion of dud mortgages in California, discovered a year earlier, do that? It would appear that Lehman Brothers was one of four or five large banks who were so overstretched in securitized mortgage debt that it looked as though they would collapse without huge infusions of government money. The government rescue team knew they could not rescue every bank that looked shaky, and they knew that rescuing anybody carried the risk that this kind of episode would be repeated in the future, as a result of knowing that any sort of risky behavior would be protected by the government treating big banks as "too big to fail". To bring the collapsing markets to their senses, some relatively big bank had to be allowed to fail, and it turned out to be Lehman. The CEO of Lehman afterwards expressed public bitterness that Lehman suffered while others were saved, but it was clear that there were too many people in the lifeboat, so someone had to go overboard or they would all sink. Lehman went bankrupt.

What had not been considered in the choice of Lehman, was its heavy involvement in commercial credit, short-term loans, sometimes only overnight, with inventories as collateral. Because of the huge volume of commercial credit, with extremely fast turnover, the conventional payment mechanism was a repurchase agreement. In a repo, the loan takes the form of a sale with a guaranteed agreement to repurchase in a short time. The mechanics of lending are greatly simplified by actually selling the inventory of, say computer chips, for enough more to pay the interest cost, associated with an agreement that the lender owns the security outright if there is a default by a date certain. The arrangement is very clever and efficient, but it has one flaw: the bank really has no use for a boatload of computer chips. Commercial credit repos had grown to immense size. When the banks encountered a credit freeze, the collateral simply could not be transformed into anything useful to the banks, even though industries throughout the world were on the edge of collapse for lack of components to assemble. It was a dangerous mess, all right.

Underlying all of these moving parts was globalization of the industrial process. It was not very long ago when automobile manufacturers like Ford would own the majority of the steps in the process, down to growing trees to provide wood for the floor-boards. Or IBM would make substantially all of the parts of a computer and assemble them as a a final product. But, in order to take advantage of cheap labor or available resources of other types, pieces of components of cars and computers started being fashioned together in several foreign countries and shipped to another foreign country for assembly. In the most extreme case, only the design and marketing of a product might take place in America, while everything else was assembled in many places. Almost every step of a complex manufacture involved paying the subcontractor for his piece, using the pieces as collateral for a loan to pay for itself. Because a tangible price was being charged for delays in the process, "Just in time" assembly was absolutely essential.Everything had to work like gigantic clockwork, but if it did, it considerably reduced the price and increased the sales of the final product.

The collapse of Lehman Brothers (ultimately triggered by real estate mortgage securities), caused the whole world's manufacturing to come to a halt in just a few days. When the nature of the problem became apparent, it was comparatively easy to patch up, at least by a government savior who had unlimited amounts of money available, and was willing to spend "whatever it takes".

What's left to do, now, is to figure out a system that will prevent international trade paralysis without slowing down or eating up the profitability of globalization. A great deal is at stake in repairing a problem we didn't even recognize as a possibility. And probably similar things remain to be discovered.

Job Loss Map

Selling Entire Towns

{Jason Duckworth}
Jason Duckworth

Recently, Jason Duckworth of Arcadia Land Company entertained the Right Angle Club with a description of his business. Most people who build a house engage an architect and builder, never giving a thought to who might have designed the streets, laid the sewers, strung out the power and telephone lines, arranged the zoning and otherwise designed the town their house is in. But evidently it is a very common practice for a different sort of builder to do that sort of wholesale infrastructure work -- privatizing municipal government, so to speak. A great deal of what such a wholesale builder does involves wrestling with existing local government in one way or another, getting permits and all that. In a sense, the existing power structure is giving away some of its authority and does so very cautiously. Sometimes that involves suing somebody or getting sued by somebody. Perhaps even greater braking-power on unwelcome change is that the wholesale builder is in debt until the last few plots are sold, and realizes his profit on stragglers. Since it often happens that the last few plots are the least desirable ones, this is a risky business. Big risks must be balanced by big profit potential, and one of the risks of this sort of privatization is that too much consideration may be given to the players at the front end, the farmer who sells the land and the builder who must keep costs down, at the expense of the long-range interests of the people who eventually live in the new town. Top-down decision making is much more efficient, but its price is decreased responsiveness to citizen preferences.

{For Sale}
For Sale

As it happens, Arcadia specializes in towns designed to look like those built in the late 19th Century. Close together, a front door near the sidewalks, front porches for summer evenings. To enhance the feeling of being in an older village, Arcadia specifies certain rules for the architecture, to make it seem like Narberth or, well, Haddonfield. Until recently, suburban design emphasized larger plots of land, and few sidewalks, with streets often ending in cul-de-sacs instead of perpendicular cross-streets in the form of squares. The "new urbanism" appealed to those who were seeking greater privacy, revolving around the idea that if you wanted anything you drove your car to get it. Three-car garages were common, groceries came from distant shopping centers. There are still plenty of new towns built like that today, but Arcadia appeals to those who want to be close to their neighbors, want to meet them at the local small stores scattered among the houses. In the 19th Century, this sort of town design was oriented around a factory or market-place; since now there are seldom factories to orient around, the appeal is to two-income families who want to live in an environment of similar-minded contemporaries. The whole community is much more pedestrian-oriented, much less attached to multiple automobiles.

Since Mr. Duckworth mentioned Haddonfield, where I live, I have to comment that the success of living in a town with older houses depends a great deal on the existence of a willing, capable yeomanry. Older houses, constantly at risk of needing emergency maintenance, need available plumbers, roofers, carpenters, and handy-men of all sorts. Because it is hard to tell a good one from a bad one until too late, this yeomanry has to be linked together invisibly in a network of pride in the quality of each other's work and willingness to refer customers within a network that sustains that pride. A tradesman who is a newcomer to the community has to prove himself, first to his customers, and almost more importantly to his fellow tradesmen. If you happen to pick a bad one, good workmen in other trades are apt to seem mysteriously reluctant to deal with you as a customer, because you too are somewhat on trial. Maybe you don't pay your bills, or maybe you are picky and quarrelsome. In this way, the whole community is linked together in a hidden community of trust. Over time, the whole town develops certain recognizable social characteristics that a brand-new town doesn't yet need. If that time arrives without a network of reliable tradesmen, the town soon deteriorates, house prices fall, people move away.

{Fannie Mae}
Fannie Mae

It's curious that the residents of such a town are a breed apart from the merchants in the nearby merchant strip. If the merchants of town life in that same town, there is much less conflict. More commonly, however, the merchants rent their commercial space and commute from distant places. That disenfranchises them from voting on school taxes and local ordinances and creates a merchantile mentality as contrasted with a resident community, dominated by high school students. One group wants lower taxes, the other group wants to get their kids into Harvard. One group wants space for customer parking, the other group is opposed to asphalt lots. And in particular, the residents want to avoid garish storefronts and abandoned strip malls. Since the only group which has an influence on both sides of this friction are the local real estate agents and landlords, their behavior is critical to the image of the town. When real estate interests are not residents of the town it is ominous, and they are well advised to remember that the sellers of houses are the ones who choose a real estate agent for a house turn-over. There's more to this dynamic than just that, but it's a good place to begin your analysis. Suburban real estate interests are constantly tempted to get into local politics, but politicians are the umpires in this game, and it soon becomes bad for their business if real estate agents potentially put their thumb on the scales.

{FHA Seal}
FHA Seal

All politics is local, but all real estate is not entirely local. The present intrusion of the Federal Government into what is normally a purely local issue has become more pointed in the present real estate recession. Almost all mortgages are packaged and sensitized by "Fannie Mae and Freddy Mac". By overpaying for the mortgages they package, these two federal agencies are subsidizing the banks they buy the mortgages from. Or, that is half of the subsidy. The other half is the Federal Reserve, which presently lends money to banks at essentially zero interest. Acquiring free money from the "Fed", while selling mortgages to Fannie Mae at above-market rates, the federal government supports the banks at both ends. And that's not quite all; there is something called the FHA, Federal Housing Authority, which guarantees mortgages. Essentially an insurance policy, the FHA guarantee is issued for a cost to home buyers who meet standards set by Congress (for which, read Barney Frank and Chris Dodd). Although houses during the boom were selling for 18 times the estimated rental value, they are now selling for 15 times rental. FHA will insure such risks, but the banks won't lend more than the normal proportion, which is 12 times rental. Consequently, almost all mortgages are FHA insured, while the federal administration storms with a fury that the banks "won't lend". And indeed it begins to look as though banks will never issue uninsured mortgages until home prices fall another 25%. If home real estate prices do decline to a normal 12 times rental, a lot of people (i.e. voters) will be unhappy, and not just homeowners who bought at higher prices. The market is fairly screaming that you should sell your house and rent, but so far at least, these federal subsidies seem to be holding prices up. When normal pricing arrives, the recession is just about over, but it certainly won't feel that way if you are a seller.

ZNOTE: Banking Panic 2007-2009


Brunnemeier's Explanations for the 2007 Crash

{Ben Bernanke}
Ben Bernanke

The Chairman of the Federal Reserve from 2005-2014, Ben Bernanke, spent much of his time explaining current economic tangles to committees of Congress. At a hearing, his suffering audience asked for some homework. "Please suggest a few articles you think we should be reading." Two of his four resulting suggestions were written by Markus K. Brunnermeier, Professor of Economics at Princeton. Some of what Brunnermeier said was already known, some of it was novel. Of greater significance was that Bernanke, a scholar of economic collapses, and then vested with the power to investigate just about any lead, would make a public endorsement of Brunnermeier's analysis to Congressmen who actually held the power to implement laws. They weren't talking to an audience of helpless college students. Congressmen knew less about the minutia of the topic, but they had the power to act on their beliefs.

No doubt, further investigation will uncover more kinks in the hose, and subtleties will prove particularly arcane, or particularly blameworthy. Nevertheless, we seem to have probably reached the point to assume the main features of the catastrophe were on the table, articulated to people not easily deceived. Moreover, Congressmen had already adopted one 2000 page law that almost none of them had read; this must not be permitted to keep happening. So among other things, let's hope they have at least learned to be careful. If Brunnermeier and Bernanke have given us a list, let's expose it to public discussion. What's usually important is what they do, not what motives they claim.

{Markus K. Brunnermeiere}
Markus K. Brunnermeiere

1. Following the dot-com collapse in 2001, the Federal Reserve held interest rates abnormally low, claiming fear of even more severe deflation from the bubble bursting uncontrolled. By this description, the housing bubble was really the second dip of a double bubble. Within endless successions of bubbles, a futile issue is which tooth of the buzz saw cut off your finger. What determines your conclusion is the point where you chose to start. In this case, the preceding seventeen year period of "Great Calming" may perhaps make routine stress-test analysis possible. For contrary example, was a seventeen year quiet period without a major recession actually a coiled spring? If you can guard against such exceptions, perhaps correct conclusions may be reached.

2. The emergence of the developing world, especially China, from extreme poverty into relative affluence generated huge wealth surpluses which no economy was ready to absorb without danger of inflation. There is a feeling that China should have allowed its currency to rise. However, the same was said of Japan two decades earlier, and in any event, we may not have had the power to change it.

{top quote}
In summary, then, the emerging problem was one of too much cheap credit. Because of related uncertainties, this was a storm we probably could not prevent. {bottom quote}

3. For decades, America has sought the goal of universal home ownership. Borrowing to buy a home has been encouraged by tax-favored mortgages, loosened credit, and bankruptcy standards, and weak borrowers have been supported by government guarantees in the form of FHA, Fannie Mae, Ginny Mae, and Freddie Mac. The Savings and Loan crisis can be viewed as another variation on the theme of wider home ownership. Meanwhile, renting has been discouraged by low returns for the landlord, with the additional hazard of reducing the mobility of the workforce, particularly in a recession.

4. Home mortgages have traditionally been issued by local lenders. However, cheap credit was primarily available from China, so new conduits needed to be constructed. The process of securitization of mortgages through aggregation and packaging as marketable bonds was a swift and effective way to put the cheap Chinese credit to work, serving the acknowledged national desire to promote home ownership.

{top quote}
In a second summary, cheap credit from the Orient pushed us toward some sort of bubble. Our own encouragement of home ownership assured the bubble would be a housing bubble. Perhaps some other form of a bubble would be preferable; if that is the case, our government is at fault. {bottom quote}

The first four bullets in this analysis constitute conventional argument why we had the collapse of a housing bubble in August 2007, and this collapse in some way is supposed to have led to a recession. In his recent memoir, Tony Blair of England reduced the argument to a politician's catchy phrase. "We didn't have a market failure, we had a failure of one sub-segment of one portion of the market." But that is not exactly true. In August 2007 the markets experienced a sudden liquidity crisis, a lack of ready cash to pay immediate bills. A sudden worldwide shortage of cash caused a halt to the trading of just about everything. People could not collect their bills so they could not pay their bills. Survival in this environment depended less on how wealthy you were than on how much loose unemployed cash you happened to have when the music suddenly stopped. Possibly because of the real estate bubble, and possibly for other reasons, the whole world was in a trading frenzy, and cash was king. At this point, Brunnermeier is surely right that the comparatively small amount of real estate defaults was tiny in comparison with the trillions of dollars lost in the crash. He searches for "amplifiers". The possibility exists however that panic and hysteria resulted in bizarre losses, simply because everything uses money, so a shortage of money paralyzes everything. Consider the following issues:

5. It is said that 70% of stock market trades are now conducted between two unattended computers. The finest mathematicians in the world are probably programming those computers, but transaction speeds are now measured in nanoseconds. There is no time to evaluate events; it is inconceivable that every event has been anticipated. Imposing sudden pauses in trading, even for five or fifteen minutes, has proven to be remarkably effective in combating false rumors. However, the shift in trading from deposit banks to investment banks has created a whole host of unexpected advantages for the first trader who ducks out of the market. A traditional "run on the bank" is essentially based on first-mover advantage. But when short-term loans must be turned over in a day or two, simply pulling out for a day amounts to a run on the bank of a slightly different sort. It's the exploitation of the first-mover advantage in commercial credit, money market funds, repo's, daily auctions and many other nooks and crannies. A liquidity crunch makes many people into first-movers who didn't intend to be one.

6. Globalization has tended to externalize transactions within an international corporation into many sales steps between suppliers and assemblers all over the world. While this transformation has been accomplished with remarkable ease, it still vastly increases the volume of short-term loans, subject to the new form of a bank run, by hesitation whenever liquidity dries up.

{top quote}
Boom times and inexperience with new techniques created unsuspected instabilities. Major examples are found in computerization, globalization, derivatives, and -- curiously -- diversification. {bottom quote}

7. For fifty years, diversification has been regarded as a safeguard, particularly when the various components are in independent environments. A liquidity crunch wipes out the advantages of diversification, however, because every sale involves money. Just as important is the hidden risk that failure in one area may drag down another. The most drastic example in the recent crisis was in the "Monoline" insurers, who insured only municipal bonds until recently when they diversified into insuring mortgage-backed securities. And of course, when subprime mortgages collapsed, they took down municipal bonds, with many more ripple effects after that. Diversification improves safety, but only if the entities which fail are inconsequential to the whole portfolio. Innovative bundling and tranching of securities can create hidden aggregates with the power to spread contagion if they injure the credit rating, or bond rating, or reputation rating of a company. Advanced mathematics could probably establish guidelines for the danger points, but then other advanced mathematics will find ways to evade the analysis.

8. Credit default swaps are merely short-term insurance policies against definable risks, and they have greatly increased the willingness of international commerce to take risks they would otherwise avoid. However, they are also hidden over-the-counter transactions; when they grew in a couple of years to be several times the size of the entire stock exchange, they frightened the regulators. When the crunch came, regulators were not reassured to be told that most of these swaps were in opposing directions, which would surely "net out" to a comfortable equilibrium. As matters turned out, credit default swaps did not apparently cause many financial failures. But when it was learned that it would take nearly three years to untangle all the paper at AIG, it was highly unsettling. Innovators and mathematical quantitative traders will always outwit regulators because they have a far greater incentive to get ahead of the curve. But more midnight accusation sessions at the time of a crash simply cannot be tolerated. If clearing credit default swaps through an exchange does not improve transparency, something else must be suggested and tried. The issue here is the huge volume of transactions. It should not be impossible to devise volume standards, above which all future innovations must develop transparency mechanisms.

{top quote}
In the fourth summary, the default of subprime mortgages was fairly serious, perhaps amounting to two or three hundred billion dollars. However, the liquidity crunch was much more serious, requiring $850 billion just to get the markets open, and leading to stock market losses in the trillions. More research is needed to decide how much of the difference is explainable by the existence of amplification mechanisms, as Brunnermeier believes, or whether a more substantial explanation for the recession lies in world-wide leveraging and deleveraging. The size of the mortgage defaults was clearly not large enough to explain the crash, but it may have been large enough to destabilize key elements of the system into a domino effect of some sort. The distinction is somewhat semantic, with its main value in moderating political opinion about the issue of "too big to fail". That is, the general public perception of the role of huge economic forces, as opposed to blunders by a few key firms.{ILQ-End} {bottom quote}

9. The liquidity crisis of the summer of 2007 was a brief, almost total, lock-up. This is not to imply that worldwide cash shortages had necessarily been building up for months until the system crumpled; simple miscommunication could explain a brief lock-up just as well. But there can be little doubt that chaos convinced major decision-makers they would be wise to conserve their own cash more carefully. The instantaneous main conclusion was that certain interest rates had been too low, and would soon go up. A rise in interest rates forces a decline in the value of the loan, the bond, or the guarantee. If interest rates double, the principle will be worth only half as much for the duration of the loan; even refusing to sell the asset leads to an opportunity loss throughout the duration to maturity. For a while, there was uncertainty just how many roles the subprime mortgages were playing, but it scarcely mattered. Alan Greenspan had famously remarked that low long-term interest rates were a "conundrum". If they went back up to conventional levels, it would not so much matter that foreclosures would rise from 5% to 10% or even 20%. What would matter was that the 80-95% of un-foreclosed mortgages would become 5% bonds in a 10% bond environment, and hence destroy many times as much wealth. Since that cat was out of the bag, it might be a long time before it got stuffed back. Looking back for causes, it was suddenly clear that we had created a situation where everyone was terrified interest rates would become normal. If they became normal suddenly, bankruptcies would be wide-spread. If they went back slowly, fearful paralysis might last a long time. The Federal Reserve had already lowered short-term rates to nearly zero, so their efforts to ease the pressure on deposit institutions led to the purchase of long-term bonds. It was not reassuring to see that if long rates went up later, the lender of last resort would then likewise be in the position of losing money.

10. At a time when commercial liquidity was weak, the public started to draw down its cash reserves. The protracted experience of low short-term rates was particularly hard on unemployed people, especially retirees, who tend to live on the interest on money market funds and CDs because of a concern for the safety of principal. When ready cash is depleted, such people invade their long term securities; when times are precarious, even the affluent ones decline to invest and limit discretionary consumption. The nation thus begins to use up its cash reserves, and the consumer goods segment of the economy starts to weaken. In a primitive country, this sort of response soon leads to famine; in more affluent America, it is less obvious that cars are getting older, clothes are getting worn out. Meanwhile, businesses are declining to expand or to hire, and cash reserves are possibly even expanding, waiting for a more suitable time to invest. If the subprime mortgages and similar toxic debts can be cleaned up before the nation really exhausts its hidden cash reserves, the recession will pass. If cash reserves ever do get depleted beyond a tipping point, industrial growth will slow, and a twenty-year recession such as the Japanese are suffering, cannot be completely dismissed.

Causes of the 2007 Crash: Political and Technological

Dealing with a topic as complicated as the causes of the 2007 financial crisis, it's quite possible for two viewpoints to be entirely in agreement, until abruptly coming to different conclusions. In this paper, we consider the relative merits of blaming government housing subsidies in various forms, relative to blaming the unanticipated effects of the computer revolution. The subsidy argument has just been succinctly and effectively argued by a lawyer, Peter J. Wallison. Agreeing with every word he writes, I nevertheless hold the perspective that the disruptive effects of the computer revolution were equally responsible, if not more so. Politics versus technology, choose your poison.

{Federal Reserve}
Federal Reserve

Mr. Wallison served as a lawyer in the financial loins of Washington, and thus has the perspective of a Reaganite who sees government as the main problem; with the significant distinction that his proposals for solution also lie in government corrective action, particularly "covered bonds" and step-wise privatization of the Federal Housing Authority (FHA). While agreeing with both reform proposals, my concern here is about too little general recognition in the analysis of how vulnerable the banking system has become, to revolutions made possible by even primitive computers of the 1960s. Such revolutions soon grew many times magnified by the inexpensive high-speed internet. If that analysis is correct, it predicts mere legislative action for the housing industry will prove inadequate; banking has taken a radical new direction.

Mr. Wallison's argument in the January 3, 2011 edition of the Wall Street Journal is admirably succinct. He points out the New Deal Federal Reserve deliberately suppressed interest rates to the benefit of the housing industry, but made a significant exception for the Savings and Loans. (It was forced to abandon that approach by the innovation of money market funds, in turn, made feasible by the widespread adoption of the IBM 360 computer.) When the collapsed, that segment of the market was awarded to the GSEs (Fannie and Freddy Mac, insured by FHA). In 1992, Congress imposed the goal of promoting "affordable housing" on the GSEs, which is to say the subsidization of "subprime" (i.e. high risk) mortgages. By 2007, half of all mortgages were subprime, and by September 7, 2008, Fan and Fred were insolvent, effectively replaced by the Federal Reserve (i.e. the taxpayers) as the final guarantor against national insolvency. It will take a decade to restore the economy from its present setback, but Mr. Wallison's proposals do indeed have some chance of eventually leading to a viable economy. He proposes the threshold for "jumbo" mortgages be reduced by $50,000 every six months until mortgages are effectively privatized. And he also suggests we create a pool of mortgage assets as security for a bond issue, thus privatizing existing mortgages in the way Europeans describe as a "covered bond" system. Go ahead, do it; it might work, and nothing else is on offer.

{IBM 360 Computer}
IBM 360 Computer

Meanwhile take a look at banks; we seemingly can't get along without them. But other institutions are undermining them, with cheaper products made possible by computers. For two centuries, banks transformed short-term borrowing into long-term loans; no one else could do it. It's a simple idea, and it works, that a constant or even rising pool level can be maintained by a steady inflow of short-term deposits. But it is risky; the risk is that some event will precipitate a sudden rush of withdrawals, a run on the bank. Sooner or later, the law of averages catches up. The risk is real, it happens every few years. A price in the form of interest must be imposed to maintain reserves against occasional bank runs, and collectively the whole nation must maintain a central "bank", charging interest to maintain reserves against simultaneous runs on multiple banks. No device has ever been created for a nation to protect against a universal bank panic, which is as effective as placing the risk in the hands of private bankers who can expect to be stripped and shorn if things get out of control. Robert Morris demonstrated this point in 1779, and the nation seemingly must re-learn it every few decades. The IBM 360 computer made it possible to transform short-term into long-term in greater volume and lower cost by allowing banks to get bigger; but it could also perform the short-long transformation in cheaper ways than depository banks do, and from there the bank-competitive process we know as securitization has gone on to commercial credits, auto loans, credit cards, high-velocity stock trading, and mortgage-backed securities. These approaches are often cheaper and more convenient than the trusty old banking system and Credit Default Swaps show its power isn't exhausted; any legislation to prohibit CDS is sure to to be circumvented. Insurance is also on the edge of being threatened. An industrial revolution of this magnitude takes decades of tweaks to become stabilized, but it will suffice for now, if we can establish reasonable protections against the risk shifted into the securitization or investment banking arena. As risk shifts, remuneration for accepting risk must shift as well. This new system for generating capital must not be starved because depository bankers resist the loss of their share of profitability; politics will have much to answer for if that happens.

Most likely, the main obstacles to getting this system fixed will come from overseas. Fifty years of disillusionment with the United Nations will make nations, the United States chief among them, resist loss of sovereignty in something so vital as finance. But that's for the future. For nearly a century, the past has been disrupted by idle notions of the fairness of coerced redistribution, in ways Mr. Wallison has succinctly described. But meanwhile we almost willfully ignore technological upheavals which everyone welcomed but no one fully anticipated.

Lowering the Taxes on Corporations

In the early years of the 21st Century, Ireland lowered taxes on corporate profits to a 12.5% rate, far lower than neighboring countries. Whatever else it did, it promptly encouraged corporations in Germany, Denmark, the United Kingdom, and other neighbors -- to move headquarters to Ireland where taxes were so low. Ireland is primarily rural, and a housing shortage developed in the cities as workers migrated to take advantage of the new jobs. Home prices went through the roof, mortgage applications overwhelmed local banks, who promptly re-sold mortgages to foreign banks. Sound familiar? It caused a housing bubble and then a horrendous international financial crisis. The European Union is financially and politically strained by the consequences and threatened to break apart over it.

Irish Jig

That sounds pretty bad and should be a lesson to others. What Canada and a number of the individual United States got out of it was mainly this: if you lower corporation taxes, it causes prosperity. And so it might if politicians would do it gradually and moderately. Gradually and moderately are unfamiliar words in politics. Furthermore, there has long been a fundamental unfairness in taxing corporate profits twice -- once when the profits are made, and a second time when dividends are paid to shareholders. But it is obviously dangerous business, particularly when the governments involved are inexperienced. Canadians started talking about lowering their taxes to 16.5%, and no one could say whether that is a safe level or not. Within weeks, twenty-nine states with Republican governors were sending up trial balloons about joining this movement, and Governor Mitch Daniels of Indiana was much in demand as a consultant, and maybe a Presidential candidate, because Indiana had lowered corporate taxation some time ago, with favorable results.

This was exactly the sort of behavior James Madison had in mind when he designed the United States Constitution; it gave the people a way of disciplining overbearing state governments. Raise our taxes, and we will move. So there are strong arguments that these governors are approaching the right thing, and equally strong indications that everybody had better be plenty careful how this is approached.

The basic idea is good; double taxation should stop, and there is nothing in Madison's Constitution to prevent the Governors from doing what they say they would like to do. So how's this for a suggestion: if this movement gets started, let's take the opportunity to reduce all corporate income tax to zero. If everybody has the same zero rate, the incentive to migrate will disappear, and that's a good thing.

But if a major revenue source for the states disappears, what will take its place? At that moment of what would look like a crisis, it would be time for a national reconsideration and revision of the tax codes. And that would be an even more desirable outcome, provided it is done in an orderly and sensible way.

Taxes as a Form of Consumption

About half of the American public pays federal income taxes, and among the half who don't, a great many receive a green government payment check, meaning they have negative income taxes. The tax assistance companies, H. and R. Block and the like, had little for their offices and staff to do in January, February and March until someone hit on the idea of processing "fundable tax credits" for a fee. That is, the lower-income segments of the population get the promise of an April tax "rebate" as the consequence of tax-form preparation, so H. and R. Block just loans them the money, discounted for fees and interest. It keeps staff busy, generates revenue. Hardly anyone in the upper income half of the population is aware of all this, so there is little political friction. This whole system of income redistribution quite effectively keeps the two halves of the population sitting in the same chairs at the tax-preparation offices, but in different months of the year; one half getting paid, the other half coughing up the payments.

It thus becomes possible for two inflammatory slogans to bandy about, without starting fistfights or revolutions. The first was overheard at a local bank, one stranger remarking to another, "Has it ever occurred to you that taxes are a form of consumption?" To which the other person replies, "Yes, and taxes are the largest expenditure I make." A nation which once went to war over a two-cent tax on tea is remarkably passive about the ways things have evolved, but this essay is not devoted to unfairness. Prepare to hear how the upper income brackets might reduce their taxes, whether that counts as decreased consumption or not. Whenever you tax something, you get less of it; if you tax public income more, the public will earn less. So, this little essay is serious when it proposes that we all earn less, so we can get taxed less. And being taxed less, we need save less for our retirements.

The general principle is this: income is usually taxed in the year it is earned, with some exceptions, rebates and deferrals. The exceptional situations are often referred to as "loopholes" and therefore live in political jeopardy. However, if a person spends the money or dies while these deferrals continue to exist, the income may escape taxation entirely. In a sense, the largest loophole of all lies in the present fact that nearly half the population pays no income taxes at all, so saving income earned under those circumstances may lead to investment capital, which is later spent during highly taxed periods of that same person's life. Money earned by a child, usually on investments donated by a relative, is an example. Since at present, a child may receive annual gifts of $13,000 tax-free, as much as a half-million dollars can be accumulated in this way, always at the risk that laws may be changed and, further, at risk of spendthrift abuse by a psychopathic child. Whether these are wise risks for a parent to take, depends in large part on what sacrifices are made for the purpose, especially loss of parental restraint of unwise spending. A much more serious argument grows out of the possibility that money in the hands of children who lack experience in deferred gratification may actually provoke recreational drug use, or other sociopathic behavior.

Finally, lack of planning may create opportunities as much as planning does. A person who has paid little attention to financial planning may arrive at an advanced stage where life expectancy is considerably shorter. Savings at that point may be divided into money on which deferred taxes must be paid when you spend it, and money on which taxes have already been paid. More savings will be consumed if the individual triggers deferred tax liabilities, than if he just uses up money on which taxes have already been paid. Therefore, if he ignores lifetime habits and spends after-tax capital first -- the whole nest egg will last longer. But none of this deferred-income tax issue can compare with the problem of income on which taxation has been completely forgiven at the time it was spent, the so-called tax expenditures. The largest such tax expenditures are on the interest of home mortgages, on employer-paid (but not self-paid) health insurance, and employer-paid retirement income. Of these, the least consequential are the retirement income, because the tax is merely deferred, not completely forgiven. The two biggest items are home mortgages, which lie at the root of the 2007 financial crash, and employer-paid health insurance premiums, which triggered the Obama health proposal of 2009. The Obama plan purports to rein in health costs, but is estimated by the Congressional Budget Office to cost the Treasury $100 billion a year.

Extra! In the Fall of 2011, this boring matter suddenly came to the surface, in the form of huge American deficits threatening to bankrupt the country, as they were apparently actually going to do in Greece. As politicians do, many attempts were first made to rename the over-spending issue for partisan advantage. It was, for instance, tax expenditure. It was, possibly, a sovereign debt crisis. In any event, the Congressional Budget Office included such wealth redistribution under the heading of tax expenditure, which totalled a trillion dollars. Since everyone was searching for a painless category to eliminate in order to balance the budget, this term was hard to avoid. As far as Congress is concerned, the national deficit is whatever the CBO says it is, and in this case it lumped a lot of things together which politicians would like to split apart. When you take things in small pieces, it becomes possible to boil the frog by slowly heating it up before it realizes it is cooked. Lumping things together induces the frog to jump out of the pot, but however that may be, it has got lumped together by the referee of such matters, and there is a strong possibility it will stay lumped.

The essential point for accountants to focus on, is that tax expenditures are all counted as revenue when any non-accountant can see they are expenses. For political speech-making purposes, this distinction is vital and no opponent will let another politician wiggle out of it. And the beauty part of it is that it also spotlights three of the most besetting evils of modern politics: the tax exclusion of employer-based health insurance, the home mortgage interest tax exclusion, and the "earned" income tax credit. The first of these is responsible for our health insurance mess, and the other is responsible for our home mortgage crisis; the two main political problems of the day are suddenly plopped into the limelight, just when a lot of people are looking for ways to hide them. Furthermore, this bombshell was fired by a panel of the four outstanding tax economists of the nation, each of them roundly denouncing them as unthinkable ideas that never should have been born in the first place. Alan Greenspan, famous for unintelligible speech, simply said all of these tax expenditures, every one of them, should be eliminated immediately. One would hope that is clear enough. Martin Goldstein, formerly chairman of President Reagan's Council of Economic Advisors, agreed. As did former Governor Engler of Michigan, widely acknowledged to have rescued his state from impending bankruptcy. Senator Nelson, a Democrat from Florida and chairman of the committee, positively beamed with pleasure. It was hard to think this was anything but a turning point in history; let some political candidate disagree, and he can expect to have his audience shown a videotape of this succinct epic in the history of Senatorial hearings. These greybeards said, in what was obviously an unrehearsed moment, just eliminate these three terrible ideas in one stroke, and the national deficit will be reduced by a trillion. That's what they said, and it's easily proved that they had said it.

Power of the Purse

Liberty Bond

In 1917, Congress passed a law, quite possibly not understanding its full implications. From the founding of the republic until that time, Congress had approved the exact amount of each bond issue as enacted, neither more nor less. With the First Liberty Bond Act of 1917, however, Congress began to allow the administration to issue bonds as it pleased, up to some specified debt limit. Periodically since that time, as the amount in circulation approaches the debt limit, Congress raises the limit. No doubt this procedural change seemed like legislative streamlining, making it unnecessary for Congress to interrupt other activities to respond to a debt level which creeps up on its own time schedule. The overall effect of this change was significantly different, however, and probably unintentionally.

If the authorized debt limit is raised by large enough steps, it effectively amounts to Congress turning over debt decisions to the executive branch. Conversely, raising the limit only a small amount soon triggers a repeat request, which by routine becomes so inconsequential that Congress stops paying attention to it. Regardless of the size of the block grant, bulk authorization of blocks of debt results in the power of debt creation shifting toward the President. That was not what the Constitutional Convention intended.

{Founding Fathers}
Founding Fathers

The Founding Fathers remembered taxation as one of the main issues of the revolt from England. Whether by King or President they had no intention of permitting the Executive to tax as he pleased; the issue traced back to the Magna Charta. Nor would they permit unlimited federal borrowing to generate escape hatches which would soon enough transform into higher taxes. Taxes, therefore, must originate in the House of Representatives, and bond issues were approved one by one. Following the 1917 liberalization, it required only fifty years before unrestrained bond limits reached a point where future national debt obligations loomed beyond the easy ability to pay them off. If they were ever pronounced unpayable by the international bond market, interest rates would rise, and eventually, federal bonds would become unsalable. With Greece, Portugal, and Ireland already flirting with bankruptcy, the approaching danger seems quite understandable to the voting public.

{Constitutional Convention}
Constitutional Convention

The issue is constrained by another barrier. The Fourteenth Amendment to the Constitution, Section Four, forbids dishonoring "the validity of the public debt of the United States, authorized by law." Enacted after the Civil War, this Amendment was intended to prevent future states or congresses from reversing the Reconstruction Acts, but it has the additional effect of preventing future Congresses from dishonoring interest and debt repayments on existing debt. The present Congress, therefore, retains the latitude to prohibit the issuance of additional debt but is forbidden from dishonoring existing debt.

This seems like a good principle to re-emphasize, entirely disregarding the merits of the TARP, the Dodd/Frank Act, or Obamacare. Indeed, restating the Constitutional intent for Congress to be chiefly responsible for taxes and debts, seems like a very good thing to do, quite regardless of whether present national debt limits ought to be raised. The 1917 Act was a mistake, probably an unconstitutional one, and should be reversed. Holding conferences in the White House about whether to issue debt raises uncertainty about whose duty it is. The responsibility belongs to the House of Representatives, and should stay there.

Black Swans (Financial Variety)

{Nicholas Baudin}
Nicolas Baudin

The mouth of the Delaware River once teemed with white swans, but black swans were unknown until the French explorer Nicolas Baudin brought home a few from Australia, where they are now celebrated as the state animal of Western Australia. Empress Josephine Bonaparte was delighted with them, made them known as her birds, and thus made the term "Black Swan" more or less synonymous with rare chance occurrences. The implied inference that every white swan contains a remote potential for breeding a black one is doubtful biology, however. More likely, black swans are a distinct species -- Cygnus atratus-- confined to Australia and New Zealand, and just about extinct in New Zealand. In that view of things, the rarity of black swans is equivalent to the prevalence of black ones, mixed within the population of generally white ones. Nevertheless, for this article, it is convenient to continue the unlikely conjecture that most, or perhaps every, white swan contain a small potential to hatch a black one.

{Credit Default Swaps}
Credit Default Swaps

Many theories exist for the discovery that financial crises are commoner than chance alone would seem to predict; if they follow a Gaussian normal distribution curve, it must be somehow different from the distribution curve of smaller fluctuations. Observing this discordance is more or less how the phenomenon was discovered. The normal volatility of economic activity is calculated from the fluctuations observed in, say, twenty years. When that derived curve is extrapolated to include cataclysmic events which by a theory of the unmeasured "long tail" occur every hundred years, speculators have later discovered by actual measurement that, alas, such disasters actually occur much more frequently. Calculated risks derived from such extrapolations have upended many insurance companies and insurance-like vehicles like Credit Default Swaps, who set their premium charges to match the mathematics. Since CDS approached a hundred trillion dollars in the last crisis, it is important to understand the mechanics of this kind of Black Swan if we possibly can.

{Black Swan}
Black Swan

One way to do that is to question the conventional equivalence of risk and volatility ; that is, that the more markets bounce around, the riskier they become. Why should that be true, we might ask. And if it is somewhat true, why does that make it is converse true, those calm seas are safe ones? Those of us who sit and watch the ocean shore soon adopt the habit of speech that high waves at the shore mean a storm is approaching, not that it will ever arrive. After all, the center of the storm may be traveling parallel to the coastline, not directly toward it. And calm seas are particularly undependable predictors; no matter how calm it may be, the next storm might arrive in a few hours, or it may not come for months. Many other analogies spring up, once one puts aside the basic assumption that world economies can be depicted as a linear electrocardiogram. At the very least, they are two-dimensional, possibly three. Possibly four, if you regard time as a dimension.

{Dow Jones}
Dow Jones

It must be noticed that market volatility is universally viewed as linked to bad things, and many efforts have been made by central banks to reduce risk by constraining volatility. Alan Greenspan is famous for having controlled the economy for seventeen years without major depression. Is that necessarily a good thing? Is it equally possible that kinetic energy was constrained within the inflating balloon until the bursting of it was a far more damaging explosion than small planned deflations would have been?

Experimental testing of these ideas has itself been constrained by an inability to predict the explosion point of expanding financial balloons. Planned deflations have been particularly feared, because of lack of assured ways to get them to stop deflating. But practical warnings such as these are not the same as claiming that lack of volatility is always the ideal state.

Mr. Obama Attacks Unemployment

{Barack Obama}
Barack Obama

Ever since two months after his inauguration, Barack Obama has been declaring that the central issue of the re-election campaign of November 2012 will be unemployment, now running at 9.2% of the workforce, and higher among members of his race. To hear it chanted, the issue is Jobs, Jobs, Jobs. His opponents, particularly the Tea Party element of the Republican Party, reply that he is going to remake the issue as Inflation, Inflation, Inflation. The present depression is remarkably similar to the one in the 1930s, except possibly for its unknowable outcome.

{Maynard Keynes}
Maynard Keynes

Both Presidents Hoover and G.W. Bush were caught by surprise by a stock market crash, and both Franklin Roosevelt and Barach Obama were unprepared for it. It has been said that Roosevelt attempted the scheme of Maynard Keynes, while the Republicans in 1932 wanted to balance the budget. A little of that is still uncertain, but it's pretty clear that Obama is now attempting the Keynes remedy, while the Republicans seem to be saying we should balance the budget. But a more accurate description of what is privately promoted is that Obama wants to take money from the public sector and have the private sector pay it back after we recover from the depression. The Tea Party wants to take money from the public sector and pay it back after a private sector recovery. Same thing. Forget about token taxes on the "rich" and diversionary bluster about balancing the budget. They both want to shift money from the public sector to the private one, and they both plan to pay it back later when we can afford to. Or else never pay it back, letting one sector or the other dwindle. But the problem with this proposal from either party is that recovery is likely to take longer to arrive than the next election. Like Franklin Roosevelt, Obama will try to make it appear the recovery has arrived, first. That illusion worked well enough in 1936 for Roosevelt to be reelected in a landslide, but as soon as pump-priming relaxed, the double-dip of 1937 rebounded, adding to the political fury of the Supreme Court-packing issue. Five years of artificial stimulating wasn't long enough in 1937, and very likely won't be long enough in 2012. If Obama can't get past the five-year mark, the Democrats are probably done for, because the public won't stand for a five-year repeat of something that didn't work. The possibility of a third party, or a major two-party rearrangement, would be a real one.

What about balancing the budget -- will that work? No one knows, but it seems likely the public would be in a mood to try the one proposal that hasn't been attempted. It's not impossible that a deflation this severe will always take longer than five years to cleanse itself, so nothing at all will work until, in Andy Mellon's words, the evil has been wrung out of the system. At least we might then start telling ourselves that a catastrophe which ruins a whole generation is too hideous a price to pay for a housing spree. Ever again.

National Debt, Presidential Hat Tricks, Shale Gas and Argentina

{Alexander Hamilton}
Alexander Hamilton

This-here speaker at the Right Angle Club began a discussion of the "Fiscal Cliff" razzle-dazzle of 2012, by changing his mind about the causes of the financial crash of 2007. Originally, it seemed as though globalizing 500 million Chinese out of poverty had destabilized the exuberant American mortgage market by flooding it with cheap credit. Supplanting that idea, or perhaps only supplementing it, must now be added the overextension of national debt itself to a point of bringing national borrowing to a halt.

Early in the Eighteenth century the Dutch and English had monetized national assets through a system of national borrowing formalized by Necker in Europe, and Robert Morris and Alexander Hamilton in America. Aside from a handful, no one could understand what they were talking about. Try reading that sentence a second time.

It amounted to guaranteeing all the private credit in the banking, investment, and commerce systems, with a national debt (in the form of Treasury bonds) which monetized all the assets of the whole nation. That action more or less doubled their value, just as any bank loan is seemingly owned by two people at the same time. Carried to an extreme, it might imply that America could turn Guam and Hawaii over to China if we defaulted on our debt. That was never actually intended to happen, and it never has, because all nations now fear the deflation which could result from triggering a massive exchange of national assets. The nebulous issue of "National Sovereignty" interferes with territorial transfers by any means other than war. If one nation defaults against a second nation which is afraid to go to war, it is just the stronger nation's hard luck about the debts it has chosen to support unless a transfer of assets actually happens. The Treaty of Versailles did transfer assets to the victors, and set off World War II, although it is considered bad manners to mention it. That's a simplified view of our international financial system, which admittedly skirts uncertainty about how much national debt is too much.

In fact, no one knows how much is too much until everyone runs for the exits. Now that politicians have control of computers and "big data", a modern description places the blame on Alan Greenspan the former Chairman of the Federal Reserve. For eighteen years Greenspan produced delicious world prosperity by steadily increasing American national debt faster than the American economy was growing. Sooner or later this approach was going to uncover how much was currently too much Federal debt. With silver and gold removed from the equation, one could see that default would certainly loom whenever the size of the debt became so large it could never be serviced by the Gross Domestic Product (GDP), and possibly sooner than that, if enough people could guess what was coming. This reality might be obscured temporarily by reducing interest rates, modifying international trade balances, and inflation. When the stars were in alignment however, the system just had to collapse and start over. Because it happened gradually, perhaps it would unwind gradually. In 2007 what happened was that everybody tried to get out the door at the same time. Essentially, our two political parties made opposite assessments: the party of Hamilton -- Republicans -- announced this system was doomed, while Democrats --the party of Andrew Jackson -- announced they could stave off disaster by making the rich Republicans pay for it. Both parties were partly right but essentially wrong, and the Democrats hired a better magician.

{Henry Clay}
Henry Clay

It will take months or even years to be certain just what strategy was pursued. It would appear the Democrats chose to repeat the performance of the Obamacare legislation, eliminating national debate by eliminating the Congressional committee system of examining details in advance of a vote. Given one day to digest two thousand pages prepared by the Executive branch, no time was allowed for public opinion to form about Obamacare. In the case of the fiscal cliff episode, Congress was given less than one day to consider 150 pages allegedly prepared the day prior to the vote. Some will admire the skill of the executive branch in orchestrating this secret maneuver, but eventually, it must become apparent that policy decisions have been transferred from the legislative to the executive branch of government. Perhaps the Congressional Republicans are as stupid as the Democrats portray them to be, but it is also possible that a decision has been made to tempt the Democratic leaders into repeating this performance several times until eventually, the public is ready to consider impeachment for it. No matter what the strategy, we are now threatened with imagining some moment when gun barrels come level and live rounds slide home. We may pass up the opportunity to criticize Henry Clay for concentrating undue power in the Speaker of the House, or to uncover the way Harry Reid was persuaded to surrender Senate power to the Executive; both miscalculations are fast becoming irrelevant in the flurry of events. We came close to borrowing too much, exceeding our means to pay it back, that's all. A New York Times editorial economist feels we can "grow" our way out of this flirtation with danger, and we all certainly hope so.

Seemingly, there are only two ways to cope with over-borrowing, once we step over the invisible line. A nation may cheat its citizens with inflation, or it may cheat foreign citizens by defaulting on their currency. We are indebted to Rogoff and Reinhart for pointing out there is no difference between inflation and default except the identity of the cheated creditor; so most politicians prefer to cheat foreigners. Either way, cheating makes deadly enemies. Two centuries ago, Alexander Hamilton suggested a third way out of the problem, which we would today call "growth". But here, cheating is pretty easy: If the limit is some ratio of debt to GDP, find a way to increase nominal GDP.

Shale Gas and Argentina

The most astonishing current example of the power of "growth", is shale gas. It may not be totally clean, but it is cleaner than oil or coal, and far cheaper. We suddenly have so much of it the price of energy is artificially lowered, and we talk, not merely of energy independence, but of restoring the balance of international payments by exporting it. Germany is constructing steel mills to utilize iron ingots made in America with gas instead of coal. Pittsburgh was once the center of steel production because that's where the coal was, the most expensive ingredient to transport. Suddenly it is now apparently cheaper to transport the energy source to wherever you find limestone and iron ore. JP Morgan got rich the other way, transporting limestone and iron ore to Pittsburgh, where the coal was. Russia now finds it has lost its leverage over Eastern Europe's energy supply, and the Arabs (?Iranians?) will no longer have a monopoly to provide the wealth supporting Middle-Eastern mischief. China may lose interest in Africa. And in America we may develop the courage to rid ourselves of the corn subsidies for gasoline; cutting the wind and sunlight fumbles also emerge as obvious ways to cut the deficit. That's what we mean by growth. It's so powerful it makes action by any American President seem trivial by comparison.

Presumably, President Obama does not welcome being upstaged by an economic force he doggedly resisted. He may seek ways to imply it was his idea all along. When that happens, rest assured that everyone else is then a fracker. But there is another alternative Presidential path, which in extreme form is emerging in Argentina without much media attention. In short, Argentina discovered signs of oil deposits but was unable to exploit them. A European oil company was enticed to develop the oil reserves at its own expense, and effectively did so in expectation of reward from the resulting oil sales. Suddenly, the Kirchner government expropriated the oil company, paying for it with Argentine bonds. The ink was scarcely dry before the Argentine government abruptly turned around and offered to buy back the bonds for 24 cents on the dollar. And unless someone is willing to send gunboats, the previous owners of the oil company are just out of luck. Appeals to the UN are futile; because on the one-nation, one-vote principle, there are more expropriator votes in the UN than potential victims. The only thing visible which could save capitalism in South America from the revolution in shale gas competition. Presumably, Argentina has lots of shale gas, but who will lend them the money to frack it?

Federal Reserve Power Play

Power Play

Traditionally, the biggest financial problem for governments -- whether kings or democracies -- have been paying for wars. The Revolutionary War (Robert Morris and the King of France), the War of 1812 (Stephen Girard), and the Spanish American War (J.P. Morgan) were essentially financed by a single institution allied with the government. However, the Civil War, World Wars I and II, were so big that ways of spreading the debt had to be found. In all wars, monarchs seek to maintain control of the nation in spite of their own uneasy dependence on funding sources. The Federal Reserve founded in 1913 was thus founded as a private institution with a Federal partner; it was a public-private partnership.

The enormous sums involved created temptations to extend the Fed's power beyond wars into other cataclysmic financial events. The nature of war changed, both as a cause and a consequence. However, in a sense, politics never change. We hear congressional chairmen ask why the private sector has so much to say, and we hear bankers announce the government has no place in private finance. The Federal Reserve itself maneuvers within boundaries of its "independence". Most central banks have a mission statement limiting them to maintaining price stability (against both inflation and deflation), but the United States Federal Reserve has the additional mission of reducing unemployment. Recently, the targets are stated to be 2% inflation and 6.5% unemployment. The Fed Chairman, Ben Bernanke, now seems to feel the traditional tool of manipulating interest rates is inadequate for severe economic shocks, and perhaps inadequate to maintain both goals indefinitely. He has therefore introduced a novel approach, mysteriously called Quantitative Easing.

Acting as the lender of last resort, central banks have used their regulatory power over banks and currency to manipulate short-term interest rates. Because commercial banks make a profit in the spread between low short-term borrowing and higher long-term lending, the "yield curve" controlling short term rates is ordinarily an adequate lever for Fed purposes to control long rates indirectly. This is possible because so many short-term loans are rolled over repeatedly; the extra interest for a similar long-term bond represents public attitudes about the risks of the future. However, in major financial upheavals adjusting short term rates may become inadequate, and Bernanke sought a way to control long term rates directly throughout the private economic sector.

By controlling both ends of the spread, Bernanke gained more control, but with lessened market guidance, he acquired a greater risk of misjudgment. In any event, the Federal Reserve began to accumulate huge amounts of dubious or "distressed" debt. Andrew Mellon once advised Herbert Hoover to "wring the rottenness out of the system". Mellon meant that any bank foolish enough to offer loans to weak counterparties, deserved to go bankrupt, while those foolish enough to accept such loans deserved to be punished. Although such utterances by a very rich man were politically unacceptable during a depression, Mellon was surely correct in observing that extreme financial panics were basically a psychiatric problem. Irrational exuberance occasionally drives markets too high, panic then drives them too low. The modern twist is, at the turn, when everyone tries to get out the door at the same time, markets can freeze up. Mr. Bernanke civilized Mr. Mellon's approach somewhat, but the underlying idea was the same: get the bad loans out of circulation, so bankruptcies and foreclosures stop feeding public overreaction. Underneath this approach runs the assumption most people are not hopelessly overextended; the economy is basically sound. However, bankruptcy has one advantage here, over gentler kinder ways of isolating bad from further injuring the good. When an institution disappears, its problems are permanently removed from the economy. To a large degree, "sterilizing" operations are only useful if market crises are really artificial ones, which fail to notice how sound the economy really is. As our measuring systems get more precise, of course, market crises might someday actually represent the facts of the matter.

Three signal events extended Mr. Bernanke's latitude to act. His personal credibility had been enhanced by successful QE1 management of the 2008 freeze-up of financial markets. He had loaned when others were reluctant, unfroze the markets, and returned a profit for the government. Secondly, the two-decade Japanese recession showed how "zombie banks" resulted from paralyzed inaction on bad loans. And third, the Scandinavian countries had a glamorous recovery from a brief depression, apparently as a result of adopting Calvinistic punishment of economic exuberance. It was a fearsome "good bank, bad bank" approach. The general public may not have this view of events, but they meant a great deal to the Federal Reserve Board of Directors. His credibility allowed Bernanke to survive his unsuccessful attempt through QE2 to stimulate the economy with trillions of dollars in make-work employment financed by the public sector. In essence, QE3 consisted of buying every bond the market refused to buy, even including billions of dollars of mortgage-backed bonds where politicians were excoriating into accepting prices lower than their probably worth. The Federal Reserve accumulated trillions in bonds but did not pay for them by printing money, but rather by increasing the reserves of commercial banks. This allowed them to pay essentially zero interest rates, but maintain a steep interest curve (between short and long term) as an inducement to the banks to loan. So far at least, banks have refused to loan, partly because banks are trying to de-leverage thirty years of excessive lending, and partly because chastened borrowers refuse to borrow. Meanwhile, the "hard goods" the public had accumulated, autos and refrigerators, mergers and infrastructure, were gradually wearing out; someday they would need to be replaced and constitute "growth". In the meantime, the Fed seems to plan to retain the bad debts in its vaults, safely immune to "marking them to market", which is to say holding them until the bond markets assign them higher values while proclaiming their current market value is temporarily under-appreciated. Nevertheless, these bonds will eventually reach their expiration date, and the market price at that moment will reveal the true cost of replacing them with new loans. With charming modesty, Mr. Bernanke admits there are many outcomes he is unable to predict.

Although Ben Bernanke has not announced it, he seems presently willing to hold these bad debts indefinitely. Interest rates are low, so not only is it cheap to hold them, but their value is artificially overstated. Presumably, however, he is unwilling to run a Zombie Federal Reserve indefinitely. Interest rates will, therefore, return to normal, sending the interest cost to the government soaring. Somehow, the public repeatedly fails to appreciate that lowering interest rates increases the market value of bonds by making money appear like magic, whereas raising interest rates depresses bond values by making money vanish. It requires a vibrant economy to withstand such a shock, so raising interest rates can easily precipitate a deep recession. At the first sign of interest rates rising, the prices of all bonds could plummet. Almost every investment advisor in the nation is already advising clients to "lighten up" on bonds. Meanwhile, the elderly small savers holding their savings in banks, are suffering from lack of income; it is remarkable there has been so little complaint, but when it comes, it will persist and have political force. Somewhere the spring is coiling. One real danger is the economy will still be unready for normal interest rates when politics force them to go up. It is frequently estimated to require ten years to be sure that (unlike 1937) a major second depression will not emerge when short-term government debts come due. The big problem with all borrowing that never changes is that someone expects you to pay it back.

Another bleak possibility is that a currency war will break out during the vulnerable interval. The U.S. dollar recently declined sharply, and other countries responded immediately with devaluations of their own. That may have been a test, but if it was, we failed. Just as industries will move to a U.S. state with low taxes, they will move to nations with undervalued currencies. The new multinational corporation permits rapid internal transfers within companies that they need not move their headquarters. Immigrants do move, and if forcibly restrained, will start riots or even revolutions. Currency wars are also very bad news, powerfully inhibiting government action. Consequently, there is a tendency to substitute international debt default, which is the same thing as devaluation in being sudden and done with, unlike inflation which can be insidious. Since it cheats foreigners more than local citizens, politicians prefer devaluation of the currency. But otherwise, there is no great difference between devaluation and inflation.

To repeat, there is little difference between Country A inflating, and Country B defaulting. Mr. Bernanke has temporarily sterilized the inflation alternative by funding his QE3 by expanding bank reserves rather than printing currency. Unfortunately, this has so far hardly stimulated bank lending at all, which itself is beginning to tempt private investors to get directly into the banking business because it offers them a chance for high yield. However, if any significant number of university endowments or pension funds try their hand at being bankers, they are apt to learn there is more to banking than they imagine.

If Quantitative Easing becomes widespread in a world-wide recession, some nation is going to prove to be insolvent. That is, when the central bank has sold off the profitable or break-even securities in the portfolio, the probability exists that some country will find it cannot service its debt. That debt anyway has been shown to be worthless because no one will buy it. Its credit may then be worthless, its currency without value, its markets in an uproar, and its people in revolt. Other countries will be urged to support the failing one, and who knows how panic will spread. Somewhere along the line, the bond markets may take "the bull by the horns" and -- and what? If foreign governments try to intervene, their own currency could plummet. There is, indeed, quite a lot we don't understand.

So it all boils down to two disastrous alternatives for the Federal Reserve to start liquidating QE3 bonds before the economy recovers. Either the bond markets intervene, or the Federal Reserve just continues to hold those trillions of bonds indefinitely, as a Zombie central bank. We could have a second recession, or another rush to get out the door. The prospects are so horrifying that we all have to hope Mr. Bernanke keeps his cool, and gets lucky. As a fallback, whether all that sequestered debt could be transformed into the international reserves for a new Bretton Woods agreement, is now too distant a prospect for outsiders to have a reasoned opinion about. Nevertheless, the interest earnings of debt that large might be able to moderate considerable deflation. Further, the seemingly unlimited ability to create or destroy money through interest rate manipulation should be able to modulate considerable volatility of currencies, perhaps of economies. Ever since the gold window was closed in 1971, it has been asked whether currencies without the backing of some commodity can survive, and the present economic travail may be the test of it. But since an international currency exchange probably cannot be created except in a crisis, let's hope we never have to learn the answer.


Please Let Us Know What You Think


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Taking mortgages away from banks is a promising financial innovation. Unfortunately, it is part of a much longer process of pushing banks out of the banking business, which will remain a very dangerous process until it is complete.

Debt Rating Agencies
Gigantic volumes of innovative debt instruments forced investors to rely on the opinion of rating agencies for what should be a core bank function: know your counterparty.

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?

Bank Accounting Off the Books
Recent waves of mergers, one-bank holding companies, and subsidiaries have tangled the assessment of losses in the credit crisis, slowed the acknowledgment of losses, had an inflationary effect, and the appearance of illegality in an environment of blame seeking.

What's a Mezzanine Loan?
Be careful of mezzanines, especially in the financial world.

What's a Tranche?
The French term for slice.

What's a Collateralized Debt Obligation (CDO)?
SDO's are a way to reduce the cost of debt by reducing the cost of assembling the cash. More questionably, they can reduce the cost of evaluating the credit worthiness of the debtor.

What's a Derivative?
Forget about math textbooks. Derivatives are a way of making or losing the money you dare to risk, without tying up a lot of non-working cash in the meantime.

What is an NRSRO?
For a significant time, the only thing most people knew about credit derivatives was that some were rated AAA, so they must be safe.

Sovereign Wealth Funds
If sovereign debt is a headache, just contemplate sovereign-wealth funds.

Murky Crisis
Six months after the credit crisis began, it's still not clear how bad it is.

After Six months

What's a Repo?
With a dozen small variations, repurchase agreements are a new and streamlined way to make short loans in big volume. Bear Stearns dominated the repo market for hedge funds but the volume got too big to manage when interest rates shifted.

Credit Crunch Turning Point, at Eight Months?
After eight months of American housing mess, we are about to see if things will now finally go right, or turn into an international monetary crisis.

Frozen Markets
After August 17, 2007, it was widely reported that financial markets froze up. What in the world does that mean?

The Housing Bubble
For now, let's call the economic upheavals of 2007 a housing bubble. It followed a dot-com crash, and both bubbles were part of the electronic revolution, beginning in 1975.

The Cause of the Subprime Crisis
Things you suspected but kept to yourself

HowTo Create A Subprime Derivative
It's easier than you thought

Curing Stagflation
More than a century ago, Walter Bagehot succinctly told us what to do about the dilemma of stagflation. We'll get back to him after politicians make us try everything else first.

Linking Oil Prices to the Credit Crisis
For a while it seemed we had two unrelated crises at the same time, a housing crisis, and soaring oil prices. The two may be the same thing.

Mortgages From the Bank's Viewpoint
When a bank issues a mortgage, there are lots of bumps in the road it starts to travel.

Proposal: A Second Federal Reserve
Henry Kaufman recently made a number of wise observations about the monetary situation, followed by a radical proposal that might be rather hard to implement.

Premature Solutions to the Credit Crisis of 2007
Proposals for reforms which would prevent another credit crunch are starting to surface. Even in a presidential election campaign, people are pretty hesitant to suggest dramatic reforms. At least, once said Hippocrates, please don't make things worse.

Here's an obscure legal term at the heart of a sixty trillion dollar perplexity.

Federal Reserve Changes Its Business Model
On March 16, 2008, the Federal Reserve stepped in to stop an impending bank panic. It also changed the rules of the game, rather significantly.

High Oil Prices and The Federal Reserve: Chicken or Egg?
The price of oil has gone through the roof. Will it go higher, or crash? Either way, is that good or bad?

Trader's Option
The Federal Reserve intervenes to protect healthy banks which are temporarily short of cash. Protecting unhealthy banks is quite another matter.

August, 2007: Sudden Financial Jolt
Calmer heads may have seen financial problems building for a decade. The rest of us only noticed a volcano eruption.

Securities Trading Across Time Zones
Closing the securities markets for any reason causes disruptions. Patchwork solutions are often devised. But continuous global 24-hour trading is an idea which conflicts with the need for everybody to get some sleep.

Buying Corporate America with Cheap Money
Threat of recession-induced America to reduce interest rates, and thus to cheapen the dollar. The rest of the world seizes the opportunity to buy huge American corporations on the cheap.

After a Year of Crisis, Fannie and Freddy Finally Get the Spotlight
Fannie Fannie Mae and Wall Street's chancy new CDOs are much the same things, only with different sponsors and a few modified features. Important issues are: which model is better, whether continued competition between the two is useful, or whether both should be abolished.

Securitization: Pass the Hot Potato
Securitization of home mortgages is a generally good thing, but it has one major flaw. Unless we somehow fix it, it will fix us.

Banks: Fragile and Dangerous
Any business can fail, but when banks fail there can be a panic. Every decade or so, America has a bank panic.

How Should We Reform Real Estate Finance?(1)
Of course, first comes damage control. Soon afterward, any crisis presents a political opportunity to reform -- or, to make matters much worse.

How Should We Reform Real Estate Finance?(2)
When the ship springs a leak, patch the leak. When the storm subsides, fix the hole. When you get back to port, ask why you were ever at sea.

Merrill Lynch Illuminates the Mortgage Crisis
John Thain seems to have bitten the bullet at Merrill Lynch, illuminating one piece of the puzzle of our current crisis. But it's probably only one piece.

Securitized Debt: Fumbled, But Magnificent
Forget about subprime lending, Alt-A, and all that other crooked nonsense. Securitized debt remains one of the great inventions of modern times.

The Trigger and the Cliffhanger
It was inevitable that someone would pull a trigger, and market gossip is now shaking loose who actually did. The cliffhanger to come is the insolvency of Fannie and Freddy.

TARP Demands But Does Not Create a New Standard of Fair Value
The recovery plan, which Congress must pass after only a few days consideration, insists on a new definition of value which may be impossible to achieve.

World Finance, Columbus Day 2008
Europe's leaders met in Paris, while finance ministers met in Washington over the three-day weekend in October 2008. Should nations chance total collapse to save the whole system, or sacrifice the weak to save the strong? Unfortunately, the source of the answer may not be financial but political.

Financial Institutions of the Future
Impending financial crisis has pushed everything else off the front page. But looking backward may show where we are likely going.

Rescuing International Finance?
On November 15, 2008, the world financial managers are meeting, either to resolve the whole currency mess -- or to plunge us into unimaginable chaos.

Mercantilism Dies Hard
Diplomacy has been described as war by other means. It's possible to regard both war and diplomacy as economics by other means, a general attitude called mercantilism.

Helping the home owner
The Treasury's support may have stopped the bank-run panic but the mortgage crisis will not bottom out until house prices stop falling, the root cause of the crisis. Unfortunately, house prices are still no bargain.

Taking Risks Demands Its Price
For a few days in August 2007, no one knew why financial markets were suddenly in a jumble. After a week it became clear, risk spreads had been too narrow and were reverting to normal. It would be painful.

Forbidden SNL Clip
Forbidden SNL Clip

Constitutionality of the Monetary System
The Constitution fails us when no one is certain what to do about an important issue.

Financial Meltdown Documentary
PBS Frontline documentary about the financial meltdown during the terrifying days in September 2008

Philadelphia City Controller
A City Controller is expected to criticize the city's administration. Alan Butkovitz does his duty.

Oriental Money
The Chinese did not invent the export-driven economy, or monopolize its use. But their command structure allowed them to exploit it most effectively.

iPhone, Skype, Land Lines and International rates
The iPhone is the bomb and with Skype it is really the most functional cell phone around. Don't leave home without it.


Second Mortgages Want to Be First
Banks would not normally take sides between first and second mortgages. However, securitization took the first mortgages away from big banks, so they now have an incentive to seek political favor for second mortgages.

Steep Yield Curve: A Useful Subsidy?
The interest rate curve is a subsidy to banks, just as surely as farm price supports are subsidies to farmers.

Milton Friedman on Capitalism
Milton Friedman responds to Phil Donahue's question about the plight of the millions of disadvantaged people in the world.

Fixing the Financial Mess
Three general approaches to preventing financial disasters seem to be available. They are not exclusive; a combined approach may be required.

Federal Reserve Rolls the Dice
When Lehman Brothers collapsed, the markets froze. The Federal Reserve responded by doubling the money supply. A few months later, the money was gradually spent buying toxic assets. It may take ten years to sell that toxic paper, and whether we then have inflation or depression will depend on the price they bring. The Chinese are financing this ten-year gamble with two-year loans.

Commercial Credit Sinks Globalization
The financial world woke up to the housing bubble in August, 2007. As a consequence, global trade came to a sudden halt a year later. How's that, again?.

Job Loss Map
See the growth in jobs in the US go to losses.

Selling Entire Towns
Some builders build whole towns without houses and then sell them to custom home builders.

ZNOTE: Banking Panic 2007-2009

Brunnemeier's Explanations for the 2007 Crash
By common agreement among scholars, Markus K. Brunnermeier has come pretty close to a complete description of the causes of the 2007 economic crash.

Causes of the 2007 Crash: Political and Technological
After 4 years, we are gradually piecing out the causes of the second great crash. It seems two main causes were government subsidies of cheap housing in one form or another, and the impaction of computers on banking.

Lowering the Taxes on Corporations
When Ireland lowered corporate taxes, inviting corporate immigration, and then precipitating an international financial crisis, it drew attention from others. Instead of warning them, it encouraged them to imitate Ireland.

Taxes as a Form of Consumption
Most people find taxes are their biggest expense. Why not reduce them?

Power of the Purse
Establishing and revising a national debt limit was a mistake in 1917. Its mistakenness becomes progressively more evident as national debt approaches the point where we could not possibly pay it off, and several foreign countries demonstrate what can then happen.

Black Swans (Financial Variety)
How many financial crises can be understood as "Black Swans" if we regard a financial Black Swan as a case of constrained energy kinetics?

Mr. Obama Attacks Unemployment
The 2012 election campaign has not yet selected its Republican candidate, but Mr. Obama has been officially running for re-election for several months. His big issue is unemployment, and he has staged a dramatic moment for three days after Labor Day, 2011. Sixteen more months of campaigning await us.

National Debt, Presidential Hat Tricks, Shale Gas and Argentina
The Franklin Inn Club discusses Obama's maneuvers in the context of what might have been a better approach.

Federal Reserve Power Play
Evidently, the Federal Reserve feels it never has to restore those bonds it holds to the private sector. The bond market may not stand for it, so hold your breath.