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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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Criminal

The most criminally ingenious short squeeze in history, engineered by those cunning Germans at Porsche.

Fortunate for them that they’re a “car company.” If a hedge fund had tried to pull that in Germany, the managers, the PMs, the traders, the analysts, the back office IT, and everybody else in the same building would have already been packed off to the gas chambers by now.

Since hedge funds are “bad,” and Hank Paulson is “out to kill the bad HFs and regulate the rest,” David Einhorn can be allowed to squirm in his final moments, instead, as he chokes on a large short position.

All the prime broker intermediaries (GS, MS, Soc Gen, etc) will be repaid the difference in money printed at Treasury, so at the end of the day, what do they care, whether they were caught on the wrong side or not?

GS told us to post 500 percent margin today to keep our VW short position.

(We posted it.)

It was a small position, luckily.

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Didn’t get this memo. No sir.

Fetch your tin helmets once again. The European Central Bank is opting for a monetary purge. So too is the US Federal Reserve, now ruled from Dallas.

Über-hawks and Cromwellians have gained the upper hand at the great fortress banks. Whether or not they admit it, both are embarked on policies that must lead to retrenchment across the Atlantic world.

The City mood turned wicked as the full import of this policy switch sank in last week. On Wall Street, the Dow’s 396-point dive on high volume late Friday had an ugly feel.

“There is now the distinct possibility of a simultaneous sell-off in global bonds, equities and commodities,” said Jonathan Wilmot from Credit Suisse.

I dunno. I saw Lehman almost die again, and we all knew that the Fed was ready to fire a paper fusillade in the hole.

Trichet’s hawkishness is not in doubt. Bernanke’s is. Spain and Ireland do not a dovish majority make.

Bernanke’s hawkishness is in doubt.

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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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… 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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IFR:

[13:57 US GOVTS: Fallout From Credit Crisis Seen in TIC Data]

Boston, May 15. Though foreigners continued to buy treasuries (a record $55 bln) and agency ($18 bln) paper hand over fist in the latest March TIC data the net flow for the month was actually a negative $48 bln. While far from an expert in these numbers it appears that the shortfall was made in the private flow category and specifically bank liabilities which fell $115 bln.

The thinking is that the latter number ($115 bln) represents a falloff in US bank lending to their European counterparts over the heighten counterpart concern engendered by the subprime/credit crisis. If so, this may be yet another reason why the Fed is contemplating expanded both the size and term maturity of the TAF program.

Either way, the data is causing quite a stir on the Street and is seeing a knee-jerk buying and curve steepening reaction in the treasury market as traders try to sort out what it all means.

Interesting.

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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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I’m not sure Felix Salmon is as dumb as he thinks.

May 6 2008 6:49PM EDT

Fannie Mae’s Weird Rally

I’ve seen a lot of financial institutions see their stock soar on the day they release atrocious quarterly results, and in fact I had them in mind this morning when I kicked off a blog entry with the words “Fannie Mae’s stock is certain to tank today”.

Ahem. FNM closed up 8.9% at $30.81 per share, for no obvious reason. Which is not to say that journalists didn’t try to find one: both Reuters and Fortune seem to have decided that it was the conference call which did it.

Really? This conference call? I skimmed the whole thing, and couldn’t see anything particularly upbeat in there, even after realizing that when the Seeking Alpha transcribers had CEO Daniel Mudd saying that “we will feed stock this book business that we are putting on for many years to come,” in fact he was saying “feast on this book of business”.

Of course, the reason that Fannie Mae is doing such great business is that at the moment it’s pretty much the only game in town. As house prices continue to fall, Fannie Mae continues to lose money – and if house prices ever recover, then it will have competitors again. Yes, the mortgages it’s buying now might well be profitable long into the future, but I don’t see any of Fannie Mae’s management making the case that the profits from its present business will ultimately exceed the losses being suffered in the markets.

Even Mudd himself seemed pretty downbeat at times. “The summary is, we still believe that ’08 and ’09 will be tough years as home prices return to the trend line,” he said. “No news there, but an updated forecast there.”

And on any call where an executive starts talking about “creating a significant long-term shareholder value as we ramp everything up to serve our mission,” you have to wonder if there’s really any substantive good news. There’s certainly bad news:

Florida is very over built. It will take a long time to correct. Values continue to fall and delinquencies continue to increase hitting 232 basis points in March up from about hardly 60 basis points in December and up from 49 basis point a year ago.

Still, all that said, I was very wrong: I said the stock was going down, and it went up. Yet more reason, if any is needed, never to listen to me on the subject of stock prices.

Any theories on this, other than the default conspiracy theory (that the Fed is propping it up)?

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More trash for the Fed to haul out?

Merrill Says Level 3 Assets Jump 70% in First Quarter (Update2)

By Joyce Moullakis

May 6 (Bloomberg) — Merrill Lynch & Co. said so-called Level 3 assets climbed 70 percent in the first quarter, as the largest U.S. brokerage reclassified commercial mortgages and other assets as hard to value.

Merrill’s Level 3 assets, the firm’s most difficult to value, rose to $82.4 billion as of March 28 from $48.6 billion at the end of December, according to a regulatory filing today. The New York-based company’s ratio of Level 3 to total assets rose to 8 percent from 5 percent.

While many subprime-related assets that lost almost 100 percent of their value since July were categorized in Level 3, other holdings such as private-equity stakes, real estate and rarely traded corporate debt are also included because market prices for them aren’t available. More assets have become difficult to value in the last three months as investors shunned a wider array of credit, freezing the trading of securities.

“Valuation-related issues confronted by ourselves and market participants since the second half of 2007 include uncertainty resulting from a drastic decline in market activity for certain credit products,” Merrill said in the filing.

Merrill fell $1.75, or 3.4 percent, to $49.65 as of 10:15 a.m. in New York Stock Exchange composite trading.

The company transferred $5.6 billion of European commercial mortgages and $12.2 billion of credit derivative assets to Level 3 from Level 2, the filing showed.

Merrill’s Level 3 assets include mortgage-related holdings which sit within trading assets of $9.3 billion, according to the filing. Derivative assets accounted for $20.6 billion, loans measured at fair value for $12.5 billion, credit derivatives for $18 billion and private equity and principal investments for $4.3 billion, it said.

Goldman, Morgan Stanley

Other New York-based securities firms have also had a rise in Level 3 assets. Goldman Sachs Group Inc.‘s holdings of the assets surged 39 percent to $96.4 billion in the fiscal quarter ending in February. Morgan Stanley reported a 6.1 percent increase to $78.2 billion.

Citigroup Inc., the biggest U.S. bank, yesterday said Level 3 assets rose by 20 percent in the first quarter to $160.3 billion.

Merrill also said it’s received requests from government departments for information on auction rate securities and the recent failure of auctions, the filing said. The firm is “cooperating” with the requests.

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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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the monolines (Ambac and MBIA — remember them?) are going to be the next “crisis” … again. (h/t Alea)

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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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More on JPMC

from Institutional Risk Analytics:

… On that same note, author Martin Mayer makes an interesting comment on the BSC debacle and leverage generally in this week’s issue of Barrons:

“In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It’s an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit. The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps… Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don’t know who will wind up with obligations they thought they had insured against and they can’t meet.”

For some months now, we’ve been pondering what happens to all of those net short credit default swap portfolios at dozens upon dozens of hedge funds that will be going out of business this year due to the Great Unwind. Hedge funds have no permanent capital, thus there are no assets available to support the defeasance of a book of net-short OTC derivatives positions should the fund be forced into involuntary liquidation.

In such a scenario, you can forget about netting; won’t be nothing left to net, in or out of bankruptcy. And since the old habit of simply writing more CDS contracts is not available once the fund starts liquidating, we wonder if leading CDS dealers like JPMorgan (NYSE:JPM) won’t be forced to take these trades back as hedge funds expire. What’s the “fair value” of a book of short OTC derivative positions taken by a dealer in payment of other debts?

Indeed, if you think of BSC not as a broker dealer, but instead as a clearing customer of JPM, then the logic of the acquisition makes perfect sense. JPM could not let BSC go into Chapter 11 because doing so might have started a chain reaction among the OTC derivative counterparties of both firms.

Between JPM, BSC and BSC’s customers there were three levels of leverage, making the ratio of Economic Capital to Tier One Risk Based Capital computed by The IRA Bank Monitor (4.7:1) for JPM at the top of the leverage pyramid seem entirely too generous! If you impute even a fraction of the downstream leverage residing with clearing customers to JPM, the giant bank’s capital shortfall becomes alarming.

A bank holding company, after all, is thinly capitalized and in many ways was the precursor of the hedge fund model. On a parent-only basis, JPM’s $314 billion asset balance sheet includes $200 billion representing investments in its subsidiary banks and non-bank units, supported by half as much equity and more than $200 billion in debt.

And remember that JPM’s on-balance sheet capital does not even partially support the counterparty risk of its vast OTC derivatives businesses, thus the BSC acquisition was a “must do” deal for Mr. Dimon. Think of it this way: JPM is essentially an uncapitalized, $76 trillion OTC derivatives exchange with a $1.3 trillion asset bank appendage. By the way, we are working to include factors for OBS securitizations in the next iteration of our Economic Capital simulation in The IRA Bank Monitor.

But you understand that Fed officials still believe, even today, that the US markets are not over-leveraged.

The story goes that shortly after Ben Bernanke was confirmed as Fed Chairman, he attended a dinner in New York attended by the heads of the major banks. All the big banksters were there. After dinner, Chairman Bernanke gave a speech and he at one point reportedly commented that the financial markets were “not very leveraged,” causing audible laughter from the audience.

According to one attendee, Lehman Brothers (NYSE:LEH) CEO Dick Fuld eventually spoke up and, while declaiming any intention to disagree with Chairman Bernanke publicly, told the newly minted Fed chief that his comments about the degree of leverage in the financial markets were mistaken. JPM CEO Jamie Dimon, who also attended the dinner, was reported to second Fuld’s comments.

I don’t agree with the larger points of the article at all (a long-winded argument against mark-to-market accounting). If an asset is “too illiquid” to mark to market, then it has no business being traded on a public market, and can only be traded in a “dark market” transaction (off-market, basically). What the hell is the point of having a public market if you can’t accept the posted numbers?

It’s only now, ex post, that the broker dealers think this is so unfair; yet they implicitly accepted the complexities of pricing when they traded these securities in public markets for years.

All that has been said ad nauseam by many people smarter than me. The question now is, we do have a huge collective inventory of product, which is now impossible to value since mutual trust between financial institutions has collapsed, as it should after an orgy of absurd over-valuations.

Should we maintain the old prices (which we know are too high), or let the chips fall where they may? There is no middle option, because any intervention will, by definition, err on the side of propping up inflated prices.

The answer is obvious.

We will never know whether or not Armageddon would have occurred, had the Fed not stepped in and bailed out JPMC/BSC.

What we do know is that Bear Stearns and JPMC were bailed out; the mortgage origination industry has been effectively nationalized via the FHLBs; the dollar demolished; the risk-free rate, defined as the rate on US Treasuries, has been permanently raised by MBS-Treasury convertibility. Finally, the nerve center of the credit default swaps market — financials CDS — have been effectively nationalized, defrauding everyone who prudently insured against catastrophe, so that a favored clique of broker-dealers who have already made these same mistakes many times before, could be bailed out yet again.

And this is some kind of capitalist country?

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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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Libor

… via Bloomberg:

Banks That Misquote Money-Market Rates to Be Banned (Update1)

By Ben Livesey

April 16 (Bloomberg) — The British Bankers’ Association said it will ban any member deliberately misquoting lending rates at daily money-market operations amid concern that some contributors are providing misleading quotes.

The global credit squeeze has raised concern lenders have been manipulating the so-called fixing process to prevent their borrowing costs from escalating, the Bank for International Settlements said in March. Participants have complained to the BBA, the Wall Street Journal said today, citing a person familiar with the matter. The BBA holds its annual board meeting today.

“It’s very important to us that we preserve the integrity of the figures,” said Lesley McLeod, a BBA spokeswoman in London. “It’s something we have been looking at. If we find that people have been putting in figures which don’t reflect accurately their financial figures, the ultimate sanction is to throw them out of the pond.”

The BBA asks 16 member banks every morning to say how much it would cost them to borrow from each other for 15 different periods in currencies including dollars, euros and pounds. It then calculates averages, known as the London interbank offered rates, or Libor, which are used as benchmarks for companies, lenders and investment banks around the world.

The BBA represents lenders such as HSBC Holdings Plc, Europe’s largest bank by market value, Royal Bank of Scotland Group Plc and Barclays Plc.

`Credibility Weakened’

“Libor will survive, although its credibility is severely weakened,” Paul Calello, Credit Suisse Group’s head of investment banking, said in a speech at the International Swaps and Derivatives Association annual conference in Vienna today. “Continuing to base an enormous amount of derivative contracts on an index with credibility problems is a serious issue we must address.”

Money-market rates began surging last year as the fallout from the U.S. housing slump left banks wary of lending to all but the safest borrowers. The three-month dollar rate was at 2.73 percent today, the highest since April 3, according to BBA data. That’s 48 basis points more than the Federal Reserve’s target rate for overnight lending between banks, compared with an average of 11 basis points in the first half of last year.

Liquidity concerns, the cost of wholesale market borrowing and Libor rates will be discussed at today’s annual board meeting, McLeod said. The BBA holds a review of its daily money market operations every year, concluding in June.

`Calls Coming Down’

Eurodollar futures contracts, which are based on traders’ expectations for three-month dollar Libor, rose today amid concern that rates may increase at tomorrow’s fixings as banks exercise more care when giving quotes, said Ian Lyngen, an interest-rate strategist at RBS Greenwich Capital in Greenwich, Connecticut. The implied yield on the contract expiring in June climbed 13 basis points to 2.69 percent.

“The risk is that there are calls coming down from the highest level of the 16 different banks associated with the Libor process saying this better not be us and if it is, it better not be us tomorrow,” said Lyngen. “Some people have estimated that there is up to 30 basis points of inaccuracy in Libor rates. We might find out tomorrow what it really was.”

Money markets would benefit from increased transparency and “trimming,” or the discarding of extreme rates quoted by participating banks, the Basel, Switzerland-based BIS said in a study released in March with its quarterly report. The system still worked as it was meant to do when rates started rising last year, it said.

“The design worked as intended to moderate the influence of strategic behavior and changing perceptions of credit quality,” researchers Jacob Gyntelberg and Philip Wooldridge wrote. The divergence of rates quoted for different currencies “reflected dislocation in the underlying interbank markets more than shortcomings in the design of the fixing mechanisms.”

This will be fixed soon one way or another. Any bank that gets kicked out of the BBA for fudging its Libor rates will very quickly become the next Bear Stearns.

And the USD will be further besmirched.

Note that gold has rallied >2% in the last two days. We’re headed for $1150.

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I will let the idiocy speak for itself.

The Inflation Solution to the Housing Mess

By JOHN H. MAKIN
April 14, 2008; Page A15

The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street. If instead we let housing prices fall another 25%-30% – as predicted by the Case-Shiller Home Price Index – it’s almost certain that Washington will end up nationalizing the mortgage business.

So far, the Fed’s lending programs have not provided adequate liquidity to financial markets: Reserves supplied to the banking system have grown at a tiny 0.6% annual rate since December. That’s because the reserves the Fed is injecting by lending are effectively pulled out or “sterilized” by its sales of Treasury securities. The Fed has been selling these securities to keep the fed funds rate at the level targeted by its Federal Open Market Committee directives.

Congress and the Treasury have proposed voluntary measures to help mortgage borrowers, but the impact on mortgage availability has been nil. As average house prices plummet – declining at a 23% annual rate over the three months ending in January – lenders are sharply curtailing access to mortgage-based, home-equity loans. The 15% of U.S. mortgage holders with negative equity in their homes have no access to credit, and 20% with marginal equity have limited access at best. Overall access to credit is contracting: Ask Americans trying to utilize home-equity lines or arrange student loans.

Meanwhile, the collapse of house prices and the attendant damage to credit markets have become so severe that the Fed has been forced to create new policy measures at a fast clip, including the radical decision to take $30 billion worth of Bear Stearns’ risky mortgages onto its own balance sheet, and to open the discount window to investment banks.

The bottom line is this: The Fed could have watched a run on investment banks quickly turn into a run on commercial banks, or protected the creditors of investment banks (like the depositors of commercial banks) at the expense of Bear Stearns’ shareholders. The Fed wisely chose the second alternative.

Still, the Fed’s intervention has done no more than buy a respite from the crisis in the financial markets. The monetary easing I’m recommending can occur by having the Fed print money to purchase mortgages directly, or purchase Treasury securities directly. The latter is probably more desirable because it adds higher-quality assets to the Fed’s balance sheet. The Bank of Japan was also forced to reflate by printing money in 2001, after two years of a zero interest-rate policy failed to lift the economy out of a prolonged recession that had moved Japan to the brink of a deflationary crisis.

Fed reflation – to slow the fall in home prices and alleviate the distress for households and lenders – carries many risks. But the alternative is to struggle with a patchwork of inadequate efforts to shore up mortgage markets, while the Fed sticks to its current tactic of pegging the fed funds rate without increasing the money supply. This, I would submit, is even more risky. It risks a severe recession that will only intensify the drive for reregulation of financial and mortgage markets after the election.

Printing money is a radical step that enables the Fed to stop pegging the federal-funds rate and start increasing market liquidity directly. In any event, there is substantial evidence that the fed funds rate has been well above the equilibrium level. One piece of evidence is the accelerating deterioration in credit markets and the real economy that ensued even while the Fed cut the rate. Even more compelling, consider the sharp widening of the gap between the fed funds rate and the yield on three-month Treasury bills.

That gap, usually close to zero, measures the intensity of demand for riskless assets relative to the Fed’s target rate in the interbank market. At the time of the Bear Stearns crisis on March 16, the fed funds rate was an extraordinary 250 basis points above yields on three-month Treasurys. This corresponded to a “10 sigma,” or ten-times-the-typical deviation from the mean event. Statistically, 2 or 3 sigma is a very unusual event suggesting, in this case, an unusually strong preference for riskless T-bills. Four or 5 sigma represents a serious risky event, and 10 sigma is an outright panic. Based on this gap criterion, the August 2007 crisis onset was a 5-sigma event, while the October 1998 LTCM crisis and the 1987 stock market crash were each 4-sigma events. This suggests that even at those earlier times of crisis there was less fear as expressed by a run into riskless Treasurys. Ominously, after dipping close to 5 sigma after the Bear Stearns crisis, the gap has crept back above 6 sigma.

The Fed should announce its intention to add to its holding of Treasury securities in order to provide additional liquidity. It should cease pegging the fed funds rate while this policy is in effect. While there is no guarantee, direct injection of money holds some promise of alleviating the worst of the credit crisis. This means that, after the election, Congress will not feel justified in nationalizing mortgage markets.

While there is a substantial risk that inflation may rise for a time – this would be the policy goal – monetization is more easily reversible than nationalization of the mortgage market. Meanwhile, Fed officials concerned about inflation should rethink their view that it is impossible to identify an asset bubble before it bursts.

The postbubble period has yielded some very unattractive policy alternatives. They clearly underscore the rationale for having the Fed target asset prices – in a world where asset markets affect the real economy more than the real economy affects asset markets.

Mr. Makin is a visiting scholar at the American Enterprise Institute.

The fact that the so-called conservatives (really, Bruce Kovner and KKR shills) at AEI are the chief advocates of quantitative easing, and the demolition of the dollar, is 75% of the explanation for why so many die-hard, cynical, pasty-white conservatives will be sitting out November.

What could be worse than validating the policy of the Bernanke/Paulson regime.

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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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