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Archive for the ‘federal reserve’ Category

It has been abundantly obvious from day one that Ben Bernanke has no understanding of “liquidity” — whatsoever.

Only 2 months (?) after Bernanke helicoptered $122 billion to AIG, AIG has come cap in hand to Uncle Sam with a down face and a confession: “The money’s all gone.” AIG supposedly wants $200 billion in new money.

AIG in talks with Fed over new bail-out

By Francesco Guerrera in New York

Published: November 8 2008 02:00 | Last updated: November 8 2008 02:00

AIG is asking the US government for a new bail-out less than two months after the Federal Reserve came to the rescue of the stricken insurer with an $85bn loan, according to people close to the situation.

AIG’s executives were last night locked in negotiations with the authorities over a plan that could involve a debt-for-equity swap and the government’s purchase of troubled mortgage-backed securities from the insurer.

People close to the talks said the discussions were on-going and might still collapse, but added that AIG was pressing for a decision before it reports third-quarter results on Monday.

AIG’s board is due to meet on Sunday to approve the results and discuss any new government plan, they added.

The moves come amid growing fears AIG might soon use up the $85bn cash infusion it received from the Fed in September, as well as an additional $37.5bn loan aimed at stemming a cash drain from the insurer’s securities lending unit.

AIG has drawn down more than $81bn of the combined $122.5bn facility. The company’s efforts to begin repaying it before the 2010 deadline have been hampered by its difficulties in selling assets amid the global financial turmoil.

AIG executives have complained to government officials that the interest rate on the initial loan – 8.5 per cent over the London Interbank Borrowing Rate – is crippling the company.

They compared the loan’s terms with the 5 per cent interest rate paid by the banks that recently sold preferred shares to the government.

One of AIG’s proposals to the Fed is to swap the loan, which gave the authorities an 80 per cent stake in the company, for preferred shares or a mixture of debt and equity.

Such a structure would reduce the interest rate to be paid by AIG and possibly the overall amount it has to repay. An extension in the term of the loan from the current two years to five years is also possible, according to people close to the situation.

The renegotiation of the loan could be accompanied by the government’s purchase of billions of dollars in mortgage-backed securities whose steep fall in value has been draining AIG cash reserves.

AIG is also proposing the government buy the bonds underlying its troubled portfolio of credit default swaps in exchange for the roughly $30bn in collateral the company holds against the assets.

Losses on the mortgage-backed assets, which were acquired by AIG with the proceeds of its securities lending programme, and the CDSs caused the company’s collapse.

Since the government rescue, they have continued to haunt AIG, which is required to put up extra capital every time the value of these assets falls. AIG and the Fed declined to comment.

Red staters get a lot of sh*t from their coastal cousins for being stupid. I will say one thing in red staters’ defense, though: it truly takes a blue coast, blue-blood stupidity to concoct such dangerous national policy as Bernanke’s.

It’s the kind of stupidity that only an Ivy League education can buy.

What is Bernanke going to do when he issues $2 trillion in Treasuries next year, and nobody buys?

All the people who thought they got a great deal when Pepsi priced its last bond at 7.5% are going to feel pretty damn stupid 12 months from now. Either that, or AAA corporates will have lower yields than Treasuries.

At the primary dealer desks, there is no net Asian sovereign demand for US sovereigns anymore.

Right now, Uncle Sam is printing the money and planning to float Treasuries “soon.” I am not exaggerating. It is the dirty secret that every FX macro desk at every major institution knows: the Treasury is printing now and issuing later.

In the ivory towers at Treasury and the Fed, “printed” money will be converted to Treasuries soon, because the Fed and Treasury (okay, just the Fed) think that there is an “irrational” “liquidity crisis”, which will abate any day now.

It won’t abate. It will get worse: all bond yields are based on Treasury yields. Treasury yields are definitely going up in the next year. All other yields (corporates … munis … ) will go up too.

That will be the real “credit crisis.” We are just mostly through the second act.

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on today’s seismic Treasury selloff:

“The point is that the world was long Treasury, and we can see how they’ve been suckered.”

In other news, more insanity from the federales, who think they can permanently reduce commodities prices by shoving out leveraged players.

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Thomas Palley, Open Society Institute pontificator emeritus cum DC-cocktail laude, mocks himself best when he’s most honest. As do most political people.

Defending the Bernanke Fed

Filed under: U.S. Policy, Uncategorized — Administrator @ 6:37 am

Federal Reserve Chairman Ben Bernanke has recently been on the receiving end of significant criticism for recent monetary policy. One critique can be labeled the American conservative critique, and is associated with the Wall Street Journal. The other can be termed the European critique, and is associated with prominent European Economist and Financial Times contributor, Willem Buiter.

Brought up on the intellectual ideas of Milton Friedman, American conservatives view inflation as the greatest economic threat and believe control of inflation should be the Fed’s primary job. In their eyes the Bernanke Fed has dangerously ignored emerging inflation dangers, and that policy failure risks a return to the disruptive stagflation of the 1970s.

Both argue the Fed has engaged in excessive monetary easing, cutting interest rates too much and ignoring the perils of inflation. Their criticisms raise core questions about the conduct of policy that warrant a response.

At least he didn’t call us “liquidationists.” Generous.

Rather than cutting interest rates as steeply as the Fed has, American conservatives maintain the proper way to address the financial crisis triggered by the deflating house price bubble is to re-capitalize the financial system.

Correct.

This explains the efforts of Treasury Secretary Paulson to reach out to foreign investors in places like Abu Dhabi. The logic is that foreign investors are sitting on mountains of liquidity, and they can therefore re-capitalize the system without recourse to lower interest rates that supposedly risk a return of ‘70’s style inflation.

“Supposedly.

The European critique of the Fed is slightly different, and is that the Fed has gone about responding to the financial crisis in the wrong way. The European view is that the crisis constitutes a massive liquidity crisis, and as such the Fed should have responded by making liquidity available without lowering rates. That is the course European Central Bank has taken, holding the line on its policy interest rate but making massive quantities of liquidity available to Euro zone banks.

In other words, the Buiter critique advocates one set of interest rates for banks, and a very different one for individuals, without regard to respective credit risk. Presumably, there would be no arbitrage between these two bifurcated markets. Presumably, liquidity provisions to other banks–“inflation by other means”–would both 1) save the banks, and 2) not institutionalize higher prices on the tabs of the people who didn’t take the stupid risks.

Never made much sense to me either. [I used to like Buiter because he was the only person who trashed Bernanke way back in the day. Unfortunately his “lender of last resort” bailout loophole was an unforgivable leap of illogic, and while formally very different from the Bank of Japan’s disastrous early-1990’s bailout, was functionally indistinguishable.]

According to the European critique the Fed should have done the same. Thus, the Fed’s new Term Securities Lending Facility that makes liquidity available to investment banks was the right move. However, there was no need for the accompanying sharp interest rate reductions given the inflation outlook. By lowering rates, the European view asserts the Fed has raised the risks of a return of significantly higher persistent inflation. Additionally, lowering rates in the current setting has damaged the Fed’s anti-inflation credibility and aggravated moral hazard in investing practices.

The problem with the American conservative critique is that inflation today is not what it used to be.

It’s different this time.

1970s inflation was rooted in a price – wage spiral in which price increases were matched by nominal wage increases. However, that spiral mechanism no longer exists because workers lack the power to protect themselves. The combination of globalization, the erosion of job security, and the evisceration of unions means that workers are unable to force matching wage increases.

DC establishment liberal: “Inflation is okay now, because workers have to eat all costs themselves.” As if workers will just sit back and take this? As if they can’t read these internet posts, which presume weakness, ignorance and stupidity on the part of American workers?

The problem with the European critique is it over-looks the scale of the demand shock the U.S. economy has received. Moreover, that demand shock is on-going. Falling house prices and the souring of hundreds of billions of dollars of mortgages has caused the financial crisis. However, in addition, falling house prices have wiped out hundreds of billions of household wealth. That in turn is weakening demand as consumer spending slows in response to lower household wealth.

Different. This. Time.

Countering this negative demand shock is the principal rationale for the Fed’s decision to lower interest rates. Whereas Europe has been impacted by the financial crisis, it has not experienced an equivalent demand shock. That explains the difference in policy responses between the Fed and the European Central Bank, and it explains why the European critique is off mark.

The bottom line is that current criticism of the Bernanke Fed is unjustified. Whereas the Fed was slow to respond to the crisis as it began unfolding in the summer of 2007, it has now caught up and the stance of policy seems right. Liquidity has been made available to the financial system. Low interest rates are countering the demand shock. And the Fed has signaled its awareness of inflationary dangers by speaking to the problem of exchange rates and indicating it may hold off from further rate cuts. The only failing is that is that the Fed has not been imaginative or daring enough in its engagement with financial regulatory reform.

Copyright Thomas I. Palley

The bottom line is, DC policy emerati are profoundly ignorant, sycophantic, and irresponsible people.

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“With Bold Steps, Fed Chief Quiets Some Criticism”:

[…]

“It has been a really head-spinning range of unprecedented and bold actions,” said Charles W. Calomiris, professor of finance and economics at Columbia Business School, referring to the Fed’s lending activities. “That is exactly as it should be. But I’m not saying that it’s without some cost and without some risk.”

[As yours truly noted back in November, Charles Calomiris wrote a verbose and obtuse article for VoxEU which proclaimed that there was no credit crisis — a restatement of his August claim that there was no credit crisis. I guess that makes him almost as good a forecaster as Bernanke is. ]

Timothy F. Geithner, president of the Federal Reserve Bank of New York, and a close Bernanke ally, defines the Fed chief’s “doctrine” as the overpowering use of monetary policies and lending to avert an economic collapse. “Ben has, in very consequential ways, altered the framework for how central banks operate in crises,” he said. “Some will criticize it and some will praise it, and it will certainly be examined for decades.”

Mr. Bernanke’s actions have transformed his image as a self-effacing former economics professor.

“I am tempted to think of him as somewhat Buddha-like,” said Richard W. Fisher, president of the Dallas Federal Reserve Bank. “He’s developed a serenity based on a growing understanding of the hardball ways the system actually works. You can see that it’s no longer an academic or theoretical exercise for him.”

Did he just say “Buddha-like”?

Within the Bush administration, Mr. Bernanke’s willingness to work with Democrats in Congress on measures to prevent mortgage foreclosures has stirred unease. “The fact that he, an appointee of George Bush, has come very close to advocating — though he hasn’t quite advocated it — a piece of legislation that George Bush threatened to veto is an illustration of his willingness to put his head on the chopping block,” said Alan S. Blinder, a professor of economics at Princeton and friend of the Fed chief.

One reason Mr. Bernanke is sticking his neck out is that he believes the broader economy’s recovery depends on the housing sector, which remains in a serious slump. Plenty of new evidence surfaced on Tuesday that this year’s spring home-buying season will be dismal, with one report showing that prices fell 14.1 percent in March from a year earlier and another that new-home sales are down 42 percent over the last year.

Among Democrats, Mr. Bernanke, a Republican, had previously been criticized by such party luminaries as the two former Clinton administration Treasury secretaries, Robert E. Rubin and Lawrence E. Summers, who worried that he was downplaying the dangers of a recession. But that view has changed.

“I think in the last few months they’ve handled themselves very sure-footedly,” Mr. Rubin said of the Fed. Many Democrats in Congress agree.

“They say that crisis makes the man,” said Senator Charles E. Schumer, Democrat of New York and the chairman of the Joint Economic Committee. “He’s made believers out of people who were just not sure about him before.”

To lessen the chances of a financial collapse, Mr. Bernanke engineered the takeover of one investment bank, Bear Stearns, and tossed credit lifelines to others with exotic new lending facilities — the Fed now has seven such lending windows, some of them for investment banks as well as commercial banks.

He also allowed the Fed to accept assets of debatable value — mortgage-backed securities, car loans and credit card debt — as collateral for some Fed loans. For the first time ever, he installed Fed regulators inside investment banks to inspect their books.

Much to the dismay of conservative economists, Mr. Bernanke has also presided over an extraordinarily aggressive series of interest rate cuts, lowering the fed funds rate seven times, to 2 percent from 5.75 percent, since last September, though it has signaled a pause in further rate-cutting barring a further crisis. …

Bernanke and Paulson are the worst thing that’s happened to capitalism since Arthur Burns and Richard Nixon. Carter would have been awful, but conditions were so bad by 1979 that he had to authorize significant deregulation and capital gains tax cuts (from 35% to 28%, from memory) kicking and screaming.

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MZM (NSA) v USD value v commercial lending

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… underwritten by PIMCO’s Bill Gross.

Just in time for the huge TIPS burp a couple of nights ago, when massive buying pushed the 5-year TIPS yield down to -.77.

I’ve been a huge fan of the SS hypothesis for a long time, so it’s good to see the world’s biggest fixed income guru practically copy-paste from the Shadow Stats website for his latest letter.

Without further ado:

What this country needs is either a good 5¢ cigar or the reincarnation of an Illinois “rail-splitter” willing to tell the American people “what up” – “what really up.” We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate’s preacher – Democrat or Republican – should be a significant factor in how we vote. We care more about who’s going to be eliminated from this week’s American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher’s seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have – we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.

It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome – better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America’s wealth migrates into foreign hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on a geopolitical scale, that our allies are dropping like flies. “Yes we can?” Well, if so, then the “we” is the critical element, not the leader that will be chosen in November. Let’s get off the couch and shape up – physically, intellectually, and institutionally – and begin to make some informed choices about our future. Lincoln didn’t say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we’ve been doing a pretty good job of that for a long time now.

I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, “Haute Con Job.” I wasn’t an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an “informed” American could make.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S. An observer’s immediate take is that there are glaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.

This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity “miracle” may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized “one price fits all” commodity driven global economy? I suspect not. Somebody’s been foolin’, perhaps foolin’ themselves – I don’t know. This isn’t a conspiracy blog and there are too many statisticians and analysts at the Bureau of Labor Statistics (BLS) and Treasury with rapid turnover to even think of it. I’m just concerned that some of the people are being fooled all of the time and that as an investor, an accurate measure of inflation makes a huge difference.

The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that “would have been” based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren’t they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on “core” as opposed to “headline” inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation’s mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO’s Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether “headline” will ever drop below “core” for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian’s recent Secular Outlook summary suggest otherwise.

The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress “real” as opposed to nominal inflation additive yields, today’s acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market’s assumption of low relative U.S. inflation in comparison to our global competitors.

William H. Gross
Managing Director

The SS hypothesis extends to unemployment statistics, as well. In most European economies, anyone unemployed between 19 and 55 years of age is apparently counted as unemployed. The massive graduate education and “nonprofit” apparatus in the United States (Peace Corps, Teach for America, etc) means that many Americans who are effectively unemployed — and who often use such institutions to say that they “have something to do” — are not counted as such.

When you add up all the American distortions, the US economy expressed in European metrics comes to approximately 7 percent inflation, 8 percent unemployment, and very low growth.

Which begs the question of what European governments do to cook their own books, which is something I can’t know. Gold-buggery seems to be an overwhelmingly American phenomenon, and virtually all research into effective gold price support has come from Americans, which means that the CPI-skeptic worldview is very familiar with the nuances of American book-cooking, but not at all familiar with European equivalents.

However, European bonds are not nearly the economic anchor that American fixed income and equities prices are.

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The credit crisis has separated true libertarians from phony libertarians, and separated true liberals from phony liberals.

The phony liberals have inadvertently mocked themselves throughout the entire credit crisis, manning the barricades to defend the greatest act of socialism for the rich in US history. Ditto for supposed “libertarians,” eg Robert Rubin, Bruce Kovner, and the vast majority of institutional Wall Street which found itself drowning in its own quagmire, and changed their tune faster than you can say “WTF.”

Anyway, here’s the link.

The editorial in question is by Robert J. Shiller, who is a professor of economics and finance and famous analyst of speculative bubbles. A specialist in behavioral economics, in the application of psychology to understanding financial markets. A co-founder of Case Shiller Weiss, that house price index we talk about a lot. His editorial, “The Scars of Losing a Home,” speaks not of lofty academic economic concepts but of human sympathy, of things that are “really important.” With references from famous academic psychologists. I haven’t taken this kind of a tiger by the tail since I went after Austan Goolsbee last year.

Yes, it was only a year ago that the distinguished Dr. Goolsbee wrote this on the same editorial page:

And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.

When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.

For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.

I actually think Goolsbee’s piece was the high-water-mark of the “subprime helps the poor” talking point. You certainly don’t hear much about that these days. Less than two months after Dr. Goolsbee’s earnest op-ed, we got an interview in the very same NYT with one Bill Dallas, CEO of the famously defunct Ownit Mortgage, effusively testifying to his own burning desire to help out the unfortunate in a way that finally put paid to the respectability of that line (“‘I am passionate about the normal person owning a home,’ said Mr. Dallas, who is also chairman of the Fox Sports Grill restaurant chain and manages the business interests of the Olsen twins. ‘I think owning a home solves all their problems.'”) Plus by now we’ve got some numbers on the 2007 mortgage vintage, the one that Dr. Goolsbee was afraid wasn’t going to ever materialize if we tightened up lending standards too much. A year ago we were looking at a 13% subprime ARM delinquency rate. Per Moody’s (no link) the Q4 07 subprime ARM delinquencies were running 20.02%. And that is not, you know, “just” another 7%. By now, those delinquent borrowers in Goolsbee’s 13% have probably mostly been foreclosed upon and are off the books. The 20% or so who are now delinquent were either part of the 87% that Goolsbee thought were “successful homeowners” last year, or else they’re those lucky duckies who bought homes after the publication date of Goolsbee’s plea that we not tighten standards too much.

Of course Shiller wasn’t exactly spending his time a year ago defending the subprime mortgage industry on the grounds that it put poor and minority people into ever-so-humble homes with balloons attached. I seem to recall him mostly arguing that homebuyers were engaged in a speculative mania. In a June 2007 interview:

Well, human thinking is built around stories, and the story that has sustained the housing boom is that homes are like stocks. Buy one anywhere and it’ll go up. It’s the easiest way to get rich.

At the time, that kind of statement struck some of us, at least, as not possibly the entire story either, but in any event a useful corrective to the saccharine silliness of the “Ownership Society” and Bill Dallas solving everyone’s problems by letting them put Roots in a Community (for only five points in YSP).

So I hope I can be just a tad startled by the New Shiller:

Homeownership is thus an extension of self; if one owns a part of a country, one tends to feel at one with that country. Policy makers around the world have long known that, and hence have supported the growth of homeownership.

MAYBE that’s why President Bush’s “Ownership Society” theme had such resonance in his 2004 re-election campaign. People instinctively understand that homeownership conveys good feelings about belonging in our society, and that such feelings matter enormously, not only to our economic success but also to the pleasure we can take in it.

So it’s no longer irrational exuberance or plain old speculating; it’s now an instinctive affirmation of some eternal verity of the human psyche? The ultimate patriotism: the definition of self so tied up in ownership of a slice of the motherland that to rent becomes not only psychologically dangerous–these people without selves can’t be up to anything good–but politically dangerous as well? Is it possible that Shiller can mean what he is writing here?

If you just scanned the first few paragraphs of Shiller’s op-ed you might come away with the impression of a sincere but somewhat hackneyed plea for us all to have a bit of sympathy for the foreclosed among us, foreclosure not in anyone’s experience being a walk in the park. Fair enough. It being Sunday in America, I suspect millions of us are being treated to exhortations to take a kinder view of the unfortunate than we often do; we need those exhortations; we are often lacking in sympathy. Hands up all who disagree.

But you keep reading and you find Shiller trying to explain the “trauma” of foreclosure. And that’s where this really gets weird:

Now, let’s take the other perspective — and examine some arguments against the stern view. They have to do with the psychological effects of strict enforcement of a mortgage contract, and economists and people in business may need to be reminded of them. After all, too much attention to abstract economic statistics just might make us overlook what is really important.

First, we have to consider that we cannot squarely place the blame for the current mortgage mess on the homeowner. It seems to be shared among mortgage brokers, mortgage originators, appraisers, regulatory agencies, securities ratings agencies, the chairman of the Federal Reserve and the president of the United States (who did not issue any warnings, but instead has consistently extolled the virtues of homeownership).

Because homeowners facing foreclosure must bear the brunt of the pain, they naturally feel indignation when all of these other parties continue to lead comfortable, even affluent lives. Trying to enforce mortgage contracts may thus have a perverse effect: instead of teaching homeowners that they should respect the contracts they sign, it may incline them to take a cynical view of the whole mess.

We need to modify mortgage contracts to keep homeowners from becoming cynical? That’s somehow more respectable an idea than the one saying we should throw them out on the street to “teach them a lesson”? If Shiller is serious that all those other parties are “to blame,” then why isn’t the obvious solution to throw them out on the street? There seems to be an assumption here that nothing can be done to punish those who are “really” to blame, so we’re left managing the psyches of those who can be punished. And that’s not cynical?

This the point at which Shiller dredges up the most stunningly unfortunate quote from William effing James (1890) to define the “fundamental” psychology of homeownership:

Homeownership is fundamental part of a sense of belonging to a country. The psychologist William James wrote in 1890 that “a man’s Self is the sum total of all that he CAN call his, not only his body and his psychic powers, but his clothes and his house, his wife and children, his ancestors and friends, his reputation and works, his lands and horses, and yacht and bank account.”

Now, that’s breath-taking. Horses. Yachts. His wife and his children. Ancestors. The whole late-Victorian wealthy male WASP defining the “Self” (with a capital!) as the wealthy male WASP surveying his extensive possessions, an oddly-assorted list that ranks the family and friends somewhere after the clothes and the house. (Yes, James did that on purpose.) The kind of sentiment that was a caricature of the late-Victorian male even in 1890. And Shiller drags this out in aid of generating sympathy for homeowners? Really? You couldn’t find some psychological insight about the emotional relationship of people to their homes that doesn’t speak the language of the male ego surveying his domain, sizing himself up against all the other males to see where he ranks?

(James on the psychological effect of losing one’s property: ” . . . although it is true that a part of our depression at the loss of possessions is due to our feeling that we must now go without certain goods that we expected the possessions to bring in their train, yet in every case there remains, over and above this, a sense of the shrinkage of our personality, a partial conversion of ourselves to nothingness, which is a psychological phenomenon by itself. We are all at once assimilated to the tramps and poor devils whom we so despise, and at the same time removed farther than ever away from the happy sons of earth who lord it over land and sea and men in the full-blown lustihood that wealth and power can give, and before whom, stiffen ourselves as we will by appealing to anti-snobbish first principles, we cannot escape an emotion, open or sneaking, of respect and dread.”)

I’m actually, you know, in favor of some sympathy for homeowners, but one thing that does get in the way of that for a lot of us is, well, the rather disgusting shallowness that a lot of them displayed on the way up. There is this whole part of our culture that has sprung into being since 1890 that takes a rather severe view of conspicuous consumption, unbridled materialism, and totally self-defeating use of debt to buy McMansions, if not yachts. We were treated to a fair amount of that kind of thing in the last few years. In fact, we had Dr. Shiller explaining to us last year that a lot of folks just wanted to get rich, quick, in real estate.

It is undeniably true, I assert, that not everyone was a speculatin’ spend-thrift maxing out the HELOCs to buy more toys, and that part of our problem today with public opinion is that we extend our (quite proper) disgust for these latter-day Yuppies to the entire class “homeowner.” But it is surely an odd way to engage our sympathies for the non-speculator class to speak of it in Jamesian terms as the man whose self is defined by his Stuff, and whose psychological pain is felt most acutely when he recognizes that he is now just like the riff-raff.

It’s worse than odd–it’s downright reactionary–to then go on to that evocation of homeownership as good citizenship and good citizenship as “feel[ing] at one with [the] country.” This puts a rather sinister light on Shiller’s earlier insistence that we need to make sure people don’t get too “cynical.”

I see that Yves at naked capitalism was just as disgusted by Shiller as I am:

Now admittedly, this is not a validated instrument, but a widely used stress scoring test puts loss of spouse as 100 and divorce at 73. Foreclosure is 30, below sex difficulties (39), pregnancy (40), or personal injury (53). Change in residence is 20.

Note that if we as a society were worried about psychological damage, being fired (47) is far worse than foreclosure (30), and if it leads to a change in financial status (38) and/or change to a different line of work (36) those are separate, additive stress factors. Yet policy-makers have no qualms about advocating more open trade even though it produces industry restructurings that produce unemployment that does more psychological damage than foreclosures. As a society, we’ll pursue efficiency that first cost blue collar jobs, and now that we’ve gotten inured to that, white collar ones as well (although Alan Blinder draws the line there).

But efficiency arguments don’t apply to housing since we are sentimental about it. And it’s that sentimentality that bears examination, since it engendered policies that helped produce this mess.

I would only add that we are about five years too far into a war that has not made a majority of us “feel at one with that country.” I think of another really important policy change we could be pursuing right now to shore up everyone’s psychological estrangement from their patriotic self-satisfaction. But “efficiency arguments” don’t apply to wars, either.

My fellow bleeding heart liberals like Goolsbee found themselves defending the subprime industry in the name of increasing minority homeownership. Now we’re treated to the spectacle of Shiller arguing for homeowner bailout legislation in the same terms that Bush used to defend the “Ownership Society.” Housing policy, I gather, makes strange bedfellows. It certainly makes strange editorials.

Shiller’s unwitting self-parody embodies the principle at the heart of the TAF and every other tentacle of the Wall Street bailout. Far more than “economist statistics which can cause us to lose sight of what’s really important,” what’s REALLY important is protection of those Selves which include “lands and horses, and yacht and bank account.”

You can *not* make this stuff up.

Pardon my French, but our economy is being run by f*cking idiots.

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Bernanke wingman Frederic Mishkin today, parroting Barney Frank:

I would like to emphasize the importance of regulatory policy. Monetary policy–that is, the setting of overnight interest rates–is already challenged by the task of managing both price stability and maximum sustainable employment. As a result, it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices.

Of course, some aspects of such policies are simply the usual elements of a well-functioning prudential regulatory and supervisory system. These elements include adequate disclosure and capital requirements, prompt corrective action, careful monitoring of an institution’s risk-management procedures, close supervision of financial institutions to enforce compliance with regulations, and sufficient resources and accountability for supervisors.

More generally, our approach to regulation should favor policies that will help prevent future feedback loops between asset price bubbles and credit supply. A few broad principles are helpful in thinking about what such policies should look like. First, regulations should be designed with an eye toward fixing market failures. Second, regulations should be designed so as not to exacerbate the interaction between asset price bubbles and credit provision. For example, research has shown that the rise in asset values that accompanies a boom results in higher capital buffers at financial institutions, supporting further lending in the context of an unchanging benchmark for capital adequacy; in the bust, the value of this capital can drop precipitously, possibly even necessitating a cut in lending.

=============

Choking tomorrow’s legitimate commerce — or rather, driving it to less profligate nations — to pay for yesterday’s illusory and Fed-stoked boom.

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You should tell them that the Rubin- and Krugman-endorsed bailout of the US financial sector has cost $475 billion in Fed stocks of US Treasuries. $1,500 for every man, woman and child in the United States.

Granted, those Treasuries have been swapped for MBS. But if it weren’t for the price support provided by the Federal Home Loan Banks, Fannie Mae, and Freddie Mac, those MBS would be completely toast. A large percentage of the trillion-plus in Fannie and Freddie leverage over the past 9 months, the FHLBs’ $400 billion, and the Fed’s $475bn — X% of $1.8trn plus in toto — is toast. X is not a small number. And it was blown in 9 months.

That’s the real fiscal irresponsibility of the Bush Administration.

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Regular finance-focused readers have probably noticed that I’ve neglected economic commentary recently. That’s because 1) there hasn’t been much net marginal information recently to clarify what I see right now (monstrous reflation in the West, looming monstrous deflation in the East, looming war in the Mid-East, commodities as The Big Thing through late July). 2) the geopolitics of Lebanon is probably the single most influential thing going on (for commodities markets, anyway) with such a corresponding lack of true public analysis.

Anyway, as I have scrolled through my lonnnnnng list of finance blogs and gotten more and more bored, one wasteful meme in particular has infected more and more online financial discourse. (Which is still way ahead of the NYT and WSJ, who are probably wondering how best to appeal to the estrogenated millenials, i.e. the yuppie female/ gay demographic,  with more front-page fashion coverage.) Let’s call it the Complex Systems Meme.

The Complex System Meme is what all the Smart Guys In The Room, the quants, talk about these days. CSM exhibits a predictable life-cycle.

  1. Quant adds long, verbose, high-syllable-per-word, hypertechnical, and thus unfalsifiable comment to a mainstream financial blog.
  2. Blogger, realizing he’s in the presence of a Smartest Guy In The Room, gracefully and tacitly hands over the reins of discussion to Quant.
  3. Many, many jargon-intensive paragraphs ensue. Frequently sighted examples of jargon intensity include “information latency,” “Knightian uncertainty,” “systems architecture,” “the financial transmission mechanism,” “the securitization process is driven by nonlinear systemic processes,” “counterproductive proliferation of systemic dependencies,” “constructive ambiguity” (Greenspan’s fave), and “reflexivity.” The liquidity of discussion within the broader discursive framework of the weblog, if you will, exhibits a six-sigma nonlinear growth trajectory.
  4. At this point, 100.00% of common sense has been scared the hell out of the room. Only certified high priests of quantology, and their most zealous qualitative admirers, remain.
  5. After paragraph count has vaulted into the upper two digit range, absolutely nothing has been said that couldn’t have been stated much more simply.
  6. However, Quant’s intellectual stature has been established beyond all dispute. If anything, the transaction cost of challenging him (requiring at least as many ubersyllabic paragraphs as were just hemorrhaged) has become prohibitive.

Verbose commentary wastes everybody’s time.

I don’t blame quants for crappy writing, just as I don’t blame myself for crappy quantification. The problem is that carpet-bombing a discussion with unnecessary technical verbiage excites a majestic awe in influential qualitatives least able to challenge — but best able to disseminate — quants’ “solutions” to the “problem,” which are at least as benighted as everybody else’s, yet treated with greater credibility.

Everything in life is nonlinear.

Just because liquidity is an economy of scale, doesn’t make it a national imperative of the federal government. In the long run, economic surplus of even the largest economies of scale is captured by the operators of that system. For example, mass transit seems like a great idea on paper, and it is — in the medium run. However, the workers and conductors of any mass transit system quickly realize that society is capturing much more surplus from their activity than they are. So their rational best choice is to unionize, and go on strike, holding the broader economy hostage until they capture (in the form of higher salaries, pensions, etc) the entire social surplus of that activity. Such is the case with the French railway workers’ union.

Liquidity isn’t nearly that nonlinear — I’m just using a more dramatic example to make the point.

Every commodity, whether it’s oil, debt, or whatever, has a parabolic marginal cost/marginal benefit curve. “Scale economies'” MB/MC curves currently seem to offer higher rates of return with greater investment, until some point farther off in the future, than those of corresponding industries. Over time,  scale economies become identical to those of non-economies of scale, except that the production side has fewer participants. Fewer producers relative to consumers means that consumers’ bargaining power asymptotes to zero. Consumers get mad, and government steps in and regulates producers. Leveraging of producers’ superior bargaining power ends. In the long long long run, both producers and consumers enjoy more surplus. In theory.

The market for lending, ostensibly a sacrosanct economy of scale, obviously went into negative territory on that curve. Now it’s snapping back. Government interventions to maintain the current level of debt are only going to cause a snapback much more “nonlinear” than whatever nonlinear correction we would otherwise have undergone.

Getting wrapped up in “the nonlinear nature of liquidity” only obfuscates the discussion for everyone. Every process is nonlinear relative to itself at the distribution of previous moments in time. But processes tend to be much more linear relative to all other processes. Since we’re talking about subsidizing one somewhat nonlinear process (debt-funded liquidity) at the expense of all other nonlinear processes, why bring nonlinearity into the discussion at all.

If smart people spent their time weighing on other Smart People to solve simple problems, instead of taking themselves so seriously and flaunting their technical knowledge, maybe we would actually get somewhere in terms of stopping BS Bernanke & Co. from butchering the financial credibility of the United States, and actually get some return on all this talking/typing time investment.

When that starts happening, and private parties are barred from free-riding off of AAA government bond ratings courtesy of taxpayer sweat, I will crawl out of my dollar-bearish, euro- and “safe” fixed income-uberbearish hibernation. And maybe the future of finance will become an interesting topic to blog about again. It’s just that with Fannie Mae et al. going $400bn-$1.1trn in debt, in addition to the Fed ~$400bn of Treasuries exchanged for worthless MBS, AND $500 billion in FY09 debt, the medium term US bond rating is already staring at either much higher taxes or an epochal downgrade. Capital is already leaving in anticipation of necessarily higher taxes, which will mean still higher taxes on whatever capital is left. Prescriptions of “solutions” to the current “credit crisis,” as if we can outsmart mean reversions of debt if we just think hard enough, are as stale as they are futile.

And in case you were wondering what the point of all that bloviation was … it was just a rant. It’s frustrating, waiting and wishing for a better alternative to capital flight.

[*] unless the abbreviation damages rhythm too much

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May 2 (Bloomberg) — A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

The Fed’s loans to Bear Stearns were “a rogue operation,” said Anna Schwartz, who co-wrote “A Monetary History of the United States” with the late Nobel laureate Milton Friedman.

`No Business’

“To me, it is an open and shut case,” she said in an interview from her office in New York. “The Fed had no business intervening there.”

There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation’s largest source of funds for home mortgages.

Yield differences between Fannie Mae’s five-year debt and five-year U.S. Treasuries have fallen to 0.55 percentage point, from 1.15 percentage points on March 14, the day the Fed’s Board of Governors invoked an emergency rule to lend $13 billion to Bear Stearns.

“The market understood that this is the method by which Fannie Mae and Freddie Mac could be bailed out if necessary,” Poole said.

Wall Street Impact

The cost of default protection on Merrill Lynch & Co. debt fell to 1.4 percentage point by April 30 from 3.3 percentage points on March 14, CMA Datavision’s credit-default swaps prices show. The cost of protection on Lehman Brothers Holdings Inc. securities has fallen to 1.5 percentage points from 4.5 percentage points over the same period.

Fed Board spokeswoman Michelle Smith declined to comment, as did New York Fed spokesman Calvin Mitchell.

On March 16, two days after the Fed provided its Bear loan, it agreed to finance $30 billion of the firm’s illiquid assets to secure its takeover by JPMorgan Chase & Co.

The Standard & Poor’s 500 Financials Index had lost 12 percent in the three weeks prior to March 14; Geithner defended the loans before the Senate Banking Committee on April 3, saying that the Fed needed to offset risks posed to the entire financial system.

A systemic collapse on Wall Street would also mean “higher borrowing costs for housing, education, and the expenses of everyday life,” Geithner, 46, said.

While the Fed must by law withdraw its financing backstop for investment banks once the credit crisis passes, investors will probably still bet on its readiness to intervene. …

[…]

The Fed also influenced market incentives last month when it introduced the so-called Term Securities Lending Facility. The program is designed to lend up to $200 billion of Treasury securities from the Fed’s holdings to Wall Street bond dealers in return for commercial and residential mortgage bonds among other collateral. Congress has noticed the program favors mortgage credits, and Dodd has asked the Fed to swap some of its $548 billion in Treasury holdings for bonds backed by student loans.

Back to Congress

Bernanke rejected Dodd’s request in an April 25 letter, saying it’s up to Congress and the Bush administration to address diminishing profits on the loans. He didn’t explain why the Fed is reluctant to swap Treasuries for bonds backed by student loans.

“If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,” Vincent Reinhart, former director of the Fed board’s Division of Monetary Affairs, said in an interview. “That’s the consequence of crossing a line that had been well established for three- quarters of a century.”

Having extended welfare to Wall Street Republicans, the Fed cannot now refuse Democratic client industries, such as government-sponsored enterprises, education financiers, etc.

Additionally, the Fed will be on the hook for the “containment” bailouts it arranged in the first stage of the credit crunch. The Bank of America acquisition of Countrywide, for example, was widely seen as a Fed “containment” move. CFC owed at least $51 billion of debt to the FHLBs, and $38 billion is the latest figure Bloomberg is bandying around. Bank of America appears poised to take every BofA asset it can and shovel the debts to the government into a bogus holding company, which will go bankrupt. It will be entertaining to watch the FHLBs make good on a $38 billion hole in their balance sheet. Ambrose Evans-Pritchard said that at one point, Citigroup owed $98 billion to the FHLBs. Assume that has been cut 25 percent by a combination of a slight credit recovery and the Fed taking a lot of what can’t be sold; that still leaves $75bn. The FHLBs are going to have to start calling in loans. There will be another deleveraging frenzy. What’s the Fed going to do then, since it’s already forked over $400 billion of its $950bn in Treasury “bullets” to the banks? Putting bad debt in different buckets doesn’t change the fact that it’s bad debt, especially when the new bucket is owned by the government.

S&P estimated a couple of weeks ago that Fannie and Freddie alone would require a bailout of between $420 billion and $1.1 trillion – enough to jeopardize the United States’ AAA bond rating. Presumably that didn’t include Sallie Mae, the student loan originator.

At any rate, the renewed sense of optimism on equities among “the big boys” ™ has been palpable for at least a week. Wall Street is once again cranking up the leverage. Hence the shift out of commodities and into equities effected by the tacticals (hedge funds) at the expense of the dinosaur pension funds and endowments, which piled into commodities very late.

The data junkies tell me that broad money (MZM) strongly leads narrow money (BASE). The deflation-will-be-the-end-of-us-all crowd (eg, Mish Shedlock, John Mauldin, coming from somewhat different angles) has generally pointed to BASE as at least a quasi-justification of what Bernanke is doing. Bond vigilantes have pointed to MZM as a portent of severe future inflation. Obviously, I think the bond vigilantes are correct.

For now, the “inflationary bull market” classes (leveraged equities and base raw materials) have won the argument against the stagflation asset classes (eg precious metals). As long as the Fed dilutes Treasuries by swapping them for MBS, precious metals will still woefully underperform. Gold has been hammered for the past few weeks and although I am still quite bullish about it in the 6-24 month time horizon, the past four weeks have obviously been very unkind to that thesis.

Short Treasuries; long equities and precious metals.

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Forget about NYC ever recapturing London’s financial crown. What sane hedge fund manager would de-privatize all his information, and submit to “surveillance” by the very Praetorians who have exacerbated every shock of the last 20 years?

Treasury eyes stronger powers for Fed

By Gillian Tett in London and Krishna Guha in Washington

Published: April 29 2008 23:23 | Last updated: April 29 2008 23:23

Meanwhile, data showed accelerating US house price declines and further declines in consumer confidence.

The Federal Reserve could use proposed new regulatory powers to try to stop credit and asset market excesses from reaching the point where they threaten economic stability, the US Treasury said on Tuesday.

David Nason, assistant secretary for financial institutions, said the Fed could even use its proposed “macro-prudential” authority to order banks, hedge funds and other entities to curtail strategies that put financial stability at risk.

By “leaning against the wind” in this way, the US central bank could “attempt to prevent broad economic dislocations caused by potential excesses”, he said.

His comments come amid debate inside the Fed as to whether it should try to do more to contain asset price bubbles, following the housing and dotcom busts. Some see enhanced regulatory powers as a better tool for this than interest rates.

The proposed new powers – outlined in a Treasury blueprint published last month – require legislation and may never be authorised. But policymakers see the plan as offering a template for future regulation.

The blueprint envisages giving the Fed roving authority to collect, analyse and publish market data from a wide range of institutions, from banks to hedge funds.

“The market stability regulator must have access to detailed information about all types of financial institutions,” said Mr Nason.

Hedge funds are uneasy about this proposal. However, many European central bankers are eager to acquire the kind of macro-prudential powers the Treasury would like to give to the Fed.

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Harsh

“Greenspan came onto my radar screen in the late sixties as a seller
of economic and financial advice to the investment industry. To be
brutally honest, he was considered run of the mill by anyone I knew
then or have met later who knew his service then. His high point in
most memories, was a famous call in January 1973 that, “it is rare
that you can be as unqualifiedly bullish as you now can,” a few days
before a market decline of over 60% in real terms, second only to the
Great Crash in a century, accompanied also by a bitter recession.
This was one of the first of a long line of terrible prognostications
for which he has remarkably not been remembered, except by a handful
of us amateur historians. “

–Jeremy Grantham, on Alan Greenspan

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What would happen when non-government T-bill chumps figure out that they’re getting between negative 5 percent and negative 9 percent real interest on a 2-year Treasury note?

… In March, consumer prices rose 0.34 percent, for an annualized rate of more than 4 percent, according to the U.S. Department of Labor. That’s only slightly lower than the 2007 annual rate of 4.1 percent – which was the highest inflation rate this decade.

On the other hand, so-called core inflation – which excludes energy and food prices because they are considered volatile – rose only 0.15 percent, or 2.4 percent over the past year, which is close to the Federal Reserve’s 2 percent comfort zone.

For the Federal Reserve, the core inflation rate amounts to a green light to continue its policy of lowering interest rates in order to keep the economy from falling into a deep recession. A higher inflation rate could conceivably make the central bank freeze or raise interest rates.

But many economists say the core rate does not show how inflation is affecting the typical consumer. Because salary raises for most people are not keeping pace with the rising cost of living, people are using a greater percentage of their wages to buy a smaller amount of goods.

“Food prices and the price of gas are really eroding the purchasing power not just of the working class, but people in the middle class, who are already beginning to have a hard time making ends meet,” said business-trend consultant Joel Kotkin.

John Williams, who spent more than two decades as an economic consultant to Fortune 500 companies, said the government figures understate the true rate of inflation. …

I am getting a little tired of hearing about food inflation, by the way. I bet that a hedge fund got about 100 people to buy massive amounts of food at bulk wholesalers around the country, loaded them on a container for China, and sold the rice for a gigantic profit. The food inflation meme is getting deafening.

Having said that, there’s no doubt that the Fed’s inflation statistics are dripping with phoniness. “Core inflation” is a joke and everyone knows it.

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I have always thought that there’s something uniquely soporifying about DC that makes most who live there especially complacent and/or ignorant, kind of like the lead plumbing of many “established” Roman cities poisoned most urban dwellers into senility by age 55.

George Will, though, gets it. He has just enough of a flicker of cynicism for him to ask, “Hey, wait a second … what the hell is everybody doing, trusting the Federal Reserve?

What the Fed’s Job Isn’t

By George Will

Some say the world will end in fire,
Some say in ice. …

— Robert Frost

WASHINGTON — And some say it will end because of subprime mortgages. But for those who cultivate fears of catastrophes as excuses for expanding government supervision of other people’s lives, the bad news is that the world is not going to end — not from global warming or economic cooling or anything else. Today’s untethered Federal Reserve will, however, make the muddle-through interesting.

The late Sen. William Proxmire, a populist Democrat who represented Wisconsin for 32 years, wanted all members of Congress to write on their bathroom mirrors, so it is the first thing they read each day, this: “The Fed is a creature of Congress.” Congress created the Federal Reserve pursuant to its constitutional power “to coin money” and “regulate the value thereof.” Fortunately, Congress has left the Fed free to go about its business.

But suddenly the Fed is undergoing radical “mission creep.” The description of the Fed as the “lender of last resort” is accurate without being informative. Lender to whom? For what purposes? Last resort before what? Did the bank “lend” $29 billion to Bear Stearns, or did it, in effect, buy some of the most problematic securities owned by Bear? If so, was this faux “loan” actually to J.P. Morgan Chase? The purpose of the money was to give Morgan an incentive to buy Bear — at a price so low that an incentive should have been superfluous.

In 1979, when the government undertook to rescue Chrysler, conservatives worried not that the bailout would fail but that it would work, thereby inflaming government’s interventionist proclivities and lowering public resistance to future flights of Wall Street socialism. It “worked”: Chrysler has survived to endure its current crisis. The fallacious argument in 1979 was that Chrysler was then “too big to be allowed to fail.”

Today’s argument is that Bear Stearns was so connected to the financial system in opaque ways that no one could guess the radiating consequences of its failure — the financial consequences or, which sometimes is much the same thing, psychological.

But what is now the principle by which other distressed firms will elicit Fed interventions in future uncertainties? By what criteria does Washington henceforth determine whether a large entity is “too connected to fail”?

The Fed has no mandate to be the dealmaker for Wall Street socialism. The Fed’s mission is to preserve the currency as a store of value by preventing inflation. Its duty is not to avoid a recession at all costs; the way to get a big recession is to engage in frenzied improvisations because a small recession, aka a correction, is deemed intolerable. The Fed should not try to produce this or that rate of economic growth or unemployment.

After the tech bubble burst in 2000, the Fed opened the money spigot to lower interest rates and keep the economy humming. And since the bursting of the housing bubble, which was partly caused by that opened spigot, the Fed has again lowered interest rates, which for now are negative — lower than the inflation rate, which the open spigot will aggravate.

A surge of inflation might mean the end of the world as we have known it. Twenty-six percent of the $9.4 trillion of U.S. debt is held by foreigners. Suppose they construe Fed policy as serving an unspoken (and unspeakable) U.S. interest in increasing inflation, which would amount to the slow devaluation — partial repudiation — of the nation’s debts. If foreign holders of U.S. Treasury notes start to sell them, interest rates will have to spike to attract the foreign money that enables Americans to consume more than they produce.

Having maxed out many of their 1.4 billion credit cards, between 2001 and 2006 Americans tapped $1.2 trillion of their housing equity. Business Week reports that the middle-class debt-to-income ratio is now 141 percent, double that of 1983. Because anxiety is epidemic, bipartisanship has reared its supposedly pretty head.

Republicans and Democrats promise cooperation, compromise and general niceness using other people’s money. If Congress cannot suppress its itch to “do something” while markets are correcting the prices of housing and money, Congress could pass a law saying: No company benefiting from a substantial federal subvention (which would now include Morgan) may pay any executive more than the highest pay of a federal civil servant ($124,010). That would dampen Wall Street’s enthusiasm for measures that socialize losses while keeping profits private.

georgewill@washpost.com
Too little too late.
I thought the figure was higher than twenty-six percent. The People’s Bank of China alone holds over $1.7 trillion, although a large and growing fraction of that is actually euros (I’d guess that about 80 percent of China’s stash — $$1.35trn or so — is in dollars.) Dubai’s aggregate holdings are also enormous, over $900bn. Japan holds over $900 billion. Russia holds over $500bn, although again a lot of that is euro-denominated. Vietnam holds $50bn. Taiwan holds, I think, $450bn. South Korea’s is about $250bn, going from a spotty memory. India, Germany and Brazil are surging.
There are other exporters like Singapore and HK batting above a quarter trillion in forex reserves, but their assets are significantly more diversified.
All in all, 26 percent of $9.4trn (about $2.3trn) sounds way too low.

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The bailout of Bear Stearns was, in effect, a bailout of JPMorgan Chase.

Chase wrote the most credit default swaps of anyone. They also had by far the largest number of open but uncleared swaps (i.e., JPMC sells one side of the swap to a counterparty, but cannot spin off its own side — overwhelmingly, the “BSC will not default” side of the default-swap bet — because no market participants *wanted* credit default swaps). In other words they were a huge risk for JPMC.

Of course, (I think) nobody knows the exact distribution of swaps JPMC had regarding Bear Stearns. However, it’s almost certain that a preponderance of the credit default swaps were Bear Stearns swaps, considering how few people there were who would bet that Bear wouldn’t default.

And everyone on the other side of JPMC’s open, uncleared BSC credit default swaps was defrauded. They paid for default protection, and the unprecedented, extralegal, Fed-brokered absorption of BSC by JPMC defrauded all of those people.

Indirectly, everyone who purchased financial default swaps has been defrauded, because the Fed now accepts garbage for whatever you say its value is — as long as you’re one of the “sweet 16” broker dealers. None of the banks will ever go bankrupt, which means that all the private sector actors who saw BSC coming were defrauded, while JPM, the primary market maker of credit default swaps which greased the wheels with merry abandon, gets bailed out.

And the Fed’s “bailout,” in the form of exchanging AAA Treasuries for “AAA” (garbage) mortgage-backed securities, is a tax on everybody who was stupid enough to trust the “full faith and credit of the United States Treasury.”

The credit default swap market — the venue for private buying and selling of insurance against default — has been inflated out of existence, because its largest (financials) segment has been rendered too big to fail by a moronic/compliant Fed. What is all that default protection worth now? Nothing.

This dose of regulatory fascism (the invalidation of a tens of trillions of dollar market), has, by the way, been brought to you by the Republicans.

It’s always good to put the Greenspan – Rubin – Bernanke free-base, free-lunch, free market brand of capitalism in perspective: it’s a fraud.

Let’s just say that if Paulson or Bernanke or Jamie Dimon happened to be black, and walking out of a bank, he’d be shot dead on sight or handed 25 years in the slammer, for robbery (as well as aggravated assault with an assault weapon, etc).

(TOH to “mystery” for that lesson …)

Oh, by the way, this isn’t the first type of “screw the intelligent bears” move Bernanke has pulled. Remember the bogus “discount rate” cut that Bernanke announced half an hour before close of business last Friday? All those options purchased by all the intelligently bearish people were rendered worthless.

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“More, faster, please.” I don’t agree with every single sentence here, but by far the most important issue is Bernanke’s inflationist fundamentalism. Without further ado–

How Greenspan & Bernanke Invalidated Friedman
Monday, April 14, 2008 | 03:01 PM
in Credit | Derivatives | Economy | Politics

Hedge fund manager Scott Frew is a friend and occasional fishing partner. He had a few words to say about this morning’s discussion re: Volcker and Bernanke:

I wanted to flesh out some of what Barry wrote earlier about former and current Fed Chairs Volcker and Bernake. We must begin with Bernake’s now infamous Deflation speech. It is certainly “The Speech.” And I think in many ways it’s a terrifying document.

I am, by the way, in total agreement that Greenspan’s the guy who’s responsible for all of this; the particularly insidious quality of bubbles is that once you’re in one, the future is more or less pre-ordained.

An ironic corollary of that thought is that it pretty much invalidates the entire, mainstream (most certainly including Bernanke and Greeenspan), Milton Friedman-inspired critique/view of the Great Depression as having resulted from bad monetary policy on the part of the Fed as the bubble burst. They needed, according to that critique, to be much looser than they were, and all the problems would have been avoided.

So, in a sense, Bernanke’s an acolyte of that same church (recall him saying to Friedman, at some dinner or something honoring him, Never again; i.e., as a result of the lessons learned, taught by Friedman, the central bank would never repeat those Depression errors,), can’t fall back himself on a “It’s Greenspan’s fault” defense, because that’s antithetical to their whole view of history.

I see The Speech itself as a terrifying document, although it’s also an absolute blueprint for what’s going on today — you’ve got to give Ben credit for foresight; he’s running down the checklist he provided there, item by item, line by line. Too bad none of it’s working, at least to date, but instead is exacerbating the problems.

The other thing to do is to look at the steps along the way, including that represented by this speech, incidentally, by which Ben provided intellectual cover and backdrop for Greenspan’s moves.

The latter task is pretty simple. Let’s first note that Bernanke moved from the Fed, to become Chairman of the Bush’s Council of Economic Advisors, and then back to succeed Greenspan as Fed Chairman. There’s been lots of criticism of the Bush administration, on lots of fronts, for its politicization of many different policy arms. Certainly Greenspan has been criticized, and not just recently, for being an overly political creature, shifting his public statements about fiscal policy and taxation to fit the views of his changing political masters. And there’s been recent criticism that the Fed has come to view itself more as an adjunct member of the Bush cabinet, than in its traditional and prescribed role as an independent policy-making body. Bernanke’s career path exemplifies that sort of politicization, which ought to raise alarms on all sorts of level. Getting to more fundamental issues, he was at all moments a willing and eager accomplice to Greenspan’s rate-cutting efforts and asymmetrical policy responses, all of which engendered moral hazard in the DNA of the markets, and told speculators at every level not to worry, that the Fed had their collective backs. The “global savings glut” answer to Greenspan’s “conundrum” as to the explanation for low long term interest rates is a perfect example of Bernanke playing the geeky intellectual to Greenspan’s smoove political animal, providing an ingenious, and plausible, explanation for a phenomenon that had equally plausible, and far simpler, yet less convenient, explanations. Occam’s razor doesn’t always rule.

Back to the speech, early on Bernanke signals the asymmetrical policy response which characterized the Greenspan Fed from early on, and which has continued under Bernanke. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States. Do you have any recollection of Ben suggesting, at any point, as the prices of a wide variety of goods and services, that middle class Americans purchase on a day to day basis, has skyrocketed, invoking Malcolm X in his willingness to use any means necessary to keep inflation under control? I sure don’t.

Then in the speech he starts talking about how to prevent deflation. The famous “technology, called a printing press” statement is a not-veiled at all threat to simply drive down the value of the dollar. Certainly one way to get people spending is to let them know in no uncertain terms that tomorrow their savings will be worth half of what they’re worth today. Ask any citizen of Harrar — it works for them. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. Bernanke’s been incredibly successful in this endeavor — just look at the price of oil, gold, wheat, milk, rice — the list goes on and on.

The speech runs through all of the other gambits that Bernanke’s been attempting over the last six or so months. At the end, he discusses the case of Japan, and why despite all these theoretical weapons in the Fed’s toolbox, Japan was unable to stave off deflationary forces. He starts that section of the speech by noting significant differences between Japan and the United States — recall that this was November, 2002:

“As you know, Japan’s economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.”

Uh, Dr. Bernanke, I’m not sure you had that quite right, or that the conditions than applicable pertain today. In fact, it appears that our situation today is worse than Japan’s in those respects. The one factor in our favor is that exorbitant privilege of having the reserve currency, of being able to pay off our debt in a currency which only we can print. As Jim Grant said in a recent essay, there’s only one nation that has that ability, and it’s national pastime is baseball. But the advantage of owning the reserve currency is a blessing easily abused. In terms of what our national balance sheet looks like, it seems easy to describe it as more curse than blessing. Bernanke has often seemed blind to the fact that our monetary policy has far-reaching implications, that riots over inflation in the Gulf Cooperative Countries, over food in Egypt and the Philippines, might be connected to our interest rates and the value of the dollar.

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Didn’t see this gem anywhere in US business media. What an Orwellian “surprise” that is.

The Greenspan Fed: a tragedy of errors

Mr Greenspan’s apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince.

  1. The Greenspan Fed (August 1987 – January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
  2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
  3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
  4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
  5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
  6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
  7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
  8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan’s theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08.

Below, I shall elaborate on these eight bullet points, although some of them will be amalgamated and some will come up more than once.

1. The Greenspan Fed’s excessively accommodating monetary policy during 2003 – 2006

Mr Greenspan is correct that a major global decline in risk-free real interest rates was an important factor in the housing booms that occurred in a couple of dozen countries between, say, 2002 and the end of 2006. The Fed, indeed central banks in general, had little to do with this. The extremely high saving propensities of the rapidly growing economies in the Far East and of the Gulf states were a key contributor, as was the extreme conservatism, until recently, of the portfolio allocation policies of the current account surplus countries of the Far East and the Middle East.

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system.

2. The Greenspan-Bernanke put: an example of cognitive state capture by vested interests

[…]

Nevertheless, looking at the available data as a historian, and constructing plausible counterfactuals as a laboratory economist, it seems pretty self-evident to me that the Fed under both Greenspan and Bernanke has responded more vigorously with rate cuts to sharp falls in stock prices than can be rationalised with the causal effects of stock prices on household spending and private investment or with the predictive content of unexpected changes in stock prices.

To me, the LTCM and January 2008 episodes suggest that the Fed has been co-opted by Wall Street – that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception reality is unhealthy and dangerous.

It can be called cognitive state capture, because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator, but through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest.

3. The Greenspan’s Fed unfortunate focus on core inflation

… core inflation in the US has persistently under-predicted headline inflation and headline inflation has been above the Fed’s comfort zone for most of the past six years (see Buiter1, Buiter2 and Buiter3).

This is just technical incompetence compounded by institutional inertia and unwillingness to correct a mistaken intellectual framework, even when it obviously no longer makes sense to stick with it. Even now, the Fed has not been completely rid of this bug.

4. The Greenspan Fed’s failure to appreciate the downside of securitisation

[omitted for sake of brevity]

5. The Greenspan Fed as moral hazard incubator
In 1998, the Federal Reserve System played an important role in orchestrating the private sector bail-out of Long Term Capital Management (LTCM), a hedge fund brought down by hubris, incompetence and bad luck. Although no Fed money, and indeed no public money of any kind, was committed in the rescue, the Federal Reserve System, through the Federal Reserve Bank of New York and its President, William J. McDonough, played a key role in brokering the deal, by offering its good offices and using its not inconsiderable powers of persuasion to achieve agreement among its 14 major creditor banks (ironically, Bear Stearns refused to participate in the rescue). The reputation of the Fed therefore was put at risk.

The reason given by the Fed for its orchestration of this bailout was the fear that, in a final desperate attempt to forestall insolvency, a fire-sale by LTCM of its assets would cause a chain reaction. This rushed liquidation of LTCM’s securities to cover its maturing debt obligations would lead to a precipitous drop in the prices of similar securities, which would expose other companies, unable to meet margin calls, to liquidate their own assets. Such positive feedback could create a vicious cycle and a systemic crisis.

This is the same vicious cycle leading to systemic risk story that was trotted out by Timothy F. Geithner, the current President of the New York Fed, to rationalise the bail out of Bear Stearns.

Notable features of the LTCM bailout were (1) that the existing shareholders retained a 10 percent holding, valued at about $400million, and (2) that the existing management of LTCM would retain their jobs for the time being, and with it the opportunity to earn management fees. A rival (rejected) offer by a group consisting of Berkshire Hathaway, Goldman Sachs and American International Group, would have had the shareholders lose everything except for a $250 mln takeover payment and would have had the existing management fired.

One reason given for allowing the existing shareholders to retain a significant share and for keeping the existing managers on board was that only these existing shareholders-managers could comprehend, work out and unwind the immensely complex structures on LTCM’s balance sheet. These were the same people, including two academic finance wizards, Myron Scholes and Robert C. Merton, joint winners in 1997 of the Nobel Memorial Prize in Economics, whose ignorance and hubris got LTCM into trouble in the first place.

Any handful of ABD graduate students from a top business school or financial economics programme could have unravelled the mysteries of the LTCM balance sheet in a couple of afternoons. The bail-out of LTCM smacks of crony capitalism of the worst kind. The involvement of the Fed smacks of regulatory capture.

The nature of the bail-out of LTCM meant that there was never any serious effort subsequently to address the potential conflicts of interest arising from simultaneously financing hedge funds, investing in them, and making money executing trades for them, as many investment banks did with Long-Term Capital. Things were even worse because, apart from the inherent potential conflict of interest that is present whenever a party is both a shareholder in and a creditor to a business, the bailout created a serious corporate governance problem because executives of one of the financial institutions that funded the bailout had themselves invested $22 mln in LTCM on their personal accounts. Using shareholder resources for a bail-out of a company to which you have personal exposure is unethical, even where it is legal.

For the Fed to have been involved in this shoddy bailout was a major mistake that soiled its reputation. If the Fed becomes involved (as an ‘enabler’ and/or by putting its financial resources at risk) in the rescue of a highly leveraged private financial institution, be it a hedge fund, an investment bank or a commercial bank, that private institution should immediately be subject to a special resolution regime, including the appointment of a special public administrator. That is, what is needed is an arrangement for all highly leveraged private financial institutions ddeemed too big and too systemically important to fail, akin to the treatment of (insured) commercial bank insolvencies under the Federal Deposit Insurance Act.

Under the rules established by the FDIC Improvement Act of 1991, a legally closed bank’s charter is revoked and the bank is turned over to the FDIC which serves as receiver or conservator. Typically, the old top management are fired and shareholder control rights are terminated. The shareholders do, however, keep a claim on any residual value that remains after all creditors and depositors have been paid off. [2]

From a longer-run perspective, the LTCM bail-out can be seen as a key enabler of the 2008 bailout of the investment bank Bear Stearns, another type of highly leveraged financial institution deemed too big to fail by the Fed. In the case of Bear Stearns too, shareholders were left with something ‘up front’ (two dollars per share initially, subsequently revised to ten dollars per share) and the old management is still in situ. In addition, in the Bear Stearns case, Fed money is directly at risk – the Fed is funding the senior $29 bn of a $30 bn off-balance sheet facility created to warehouse Bear Stearns’ most toxic assets.

If the” too big and too systemically important to fail” argument for bailing out large deposit-taking commercial banks is now also applied to other highly leveraged private financial institutions, including but not limited to, investment banks and hedge funds, then a similar special resolution regime, including prompt corrective action provisions must be in place if rampant moral hazard is not to be encouraged. The Greenspan Fed failed to make the case for or press for such reforms, even after the LTCM debacle. They bear a heavy responsibility for the moral hazard created in 1998 and in 2008, and for the future financial crises that will be encouraged and exacerbated by these failures.

Conclusion

During his years as Chairman of the Federal Reserve Board, Alan Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding also guided his actions as monetary policy maker and financial regulator.

Mr Greenspan consistently saw but half the picture when it came to what makes competitive market capitalism work. He recognised the central roles of greed, self-interest and competition. He failed to appreciate the complementary roles of non-strategic/non-opportunistic forms of altruism, solidarity and cooperation. Both competition and cooperation must be monitored and regulated, lest they become predation and collusion respectively.

Chairman Greenspan emphasized self-regulation, spontaneous order and the disciplining effect of reputation. He failed to appreciate the essential role external or third-party (i.e. state) enforcement of laws, rules and regulations. He did not understand the weakness of reputational concerns as an enforcement or self-discipline mechanism ensuring good behaviour, when credible commitment is limited at best in a world with short horizons and easy exits.

He failed to appreciate the essential role external/third-party (i.e. state) enforcement of laws, rules and regulations, and the indispensability of collective action when faced with the threat of the breakdown of trust and confidence.

Alan Greenspan’s period as Chairman of the Board of Governors of the Federal Reserve System represents to me the nadir of central banking in advanced economic-financial systems during modern times. While monetary policy was only mildly incompetent, the regulatory failures were horrendous. The US and the world economy will pay the price for Mr Greenspan’s misjudgements and errors for years, perhaps decades, to come.

By overselling, at home and all over the world, the virtues of American-style transactions-based financial capitalism and light-touch regulation, Mr. Greenspan has done more to harm the cause of decentralised, competitive market-based financial systems based on private ownership, than even Charles Ponzi.

The spectacular failures, first in 1997/98 and then in 2007/08, of the global tests of Mr Greenspan’s theory that global financial markets do not require global regulators and that even national regulators should use only the lightest of touches, did more to discredit financial globalisation and competitive market systems based on private ownership generally than any event since the 1930s.

I am not as enthusiastic about Buiter as I used to be. While Buiter has brought his stature to bear against Greenspan-Bernanke “monetarism” very effectively, his “market maker of last resort” drumbeat does not seem any different from what Bernanke is actually doing. The market in question (structured finance) crashed because a very large percentage of it was discovered to be worthless. No new market should have been made by the Fed.

However, this column, besides making valuable points with extra venom, brings at least one new idea to bear: the idea of “cognitive regulatory capture” in the United States. This goes to the heart of why the dollar has suffered so badly relative to other currencies. The American regulatory apparatus is perceived to be in thrall to Wall Street, not because of any concrete or provable corruption or favors, but rather because the regulators allow themselves to be intellectually browbeaten into inflationistic action during every crisis.

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WTF:

As reported by The Wall Street Journal, one of the more remote contingencies the Federal Reserve has considered is a mirror image of the Term Securities Lending Facility: it would take the mortgage backed securities pledged to it by dealers in return for Treasurys; then repledge them to other dealers, taking Treasurys back. Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.

Lou Crandall of Wrightson Associates thinks it’s cool idea. His thoughts:

I’ve been discounting the inflated Treasury borrowing option a little bit because the traditional legal view at Treasury has been that the Secretary’s borrowing authority only extends to financing Congressional appropriations. (They cited legal objections last summer when they were urged to pump up their borrowing and put the money back into the [Treasury Tax and Loan] system last summer as a way of providing support.) Running a banking business is frowned upon. I don’t doubt that [Treasury Secretary Henry] Paulson could persuade the Treasury’s lawyers to rethink their position if absolutely necessary, but it would be a lot cleaner to go to Congress for authority to create a larger warehouse for financial instruments.

The reverse swap is intriguing because it is sufficiently exotic that it might sidestep some of the traditional legal issues. My hat is off to whoever thought of it. That is one option that hadn’t occurred to me.

After a quick first reading, it sounds to me as if the idea would be to take the triparty collateral and put it back into the market with a Fed seal of approval. The curious thing about recent repo market disruptions is that counterparties have started caring more about the counterparty than the collateral because nobody wants to be caught up in the uncertainty of a bankruptcy. If the Fed were on the other side, the counterparty risk component would fade away in an MBS repo. [LOL, no sh*t–ed] That’s so creative/outside-the-box that I hesitate to simply assume that’s what the Fed is talking about.

The Fed could provide guarantees in the financing market that would substantially expand its balance sheet resources through the equivalent of a matched-book operation. With sufficient leverage, they could revalidate a huge range of privately-financed mortgage debt. I’m not sure they should or could legally, but it is really interesting and worth chewing over.

For what it’s worth, I really do think this is an idea that would be worth pursuing if the Fed were faced with an emergency need to provide funding through the discount window. …

Conclusion one: Never hire “Wrightston Associates” for anything. This guy is a complete moron.

Conclusion two: The Fed believes that the best way to “solve” this mess is to do the exact same thing that the banks did — put its own name behind an obligation that is fundamentally worthless.

That’s what got us into this mess into the first place.

The only reason the Fed’s guarantee is any better than a private bank’s is that the Fed has the power to create money.

So it will be perceived to be committing to create money in the future, even if no actual money-creating takes place in terms of the Treasuries and MBS on the balance sheet.

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This excellent WSJ graphic has made its way around the financial internets quite a bit in the past 24 hours, and it seems like a good trend to follow.

After all the 4-letter facilities, the repo injections, the alleged repo rollovers, and so on, we have a fairly precise approximation — 35 percent of $910 billion = $310 billion — of direct Fed support to the banking industry.

As for the FHLBs, FNMA and FRE, I’d be much obliged if anyone could point me to any information more substantive than the debt statistics on the FHLB finance website (http://hflb-of.com ).

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