Saturday, March 28, 2009

The real American Patriot is a British guy

No one does a better job at playing American Patriot against our parasitic banking system and their captive regulator, the Federal Reserve, than Willem Buiter of the Financial Times. After reading Buiter, you realize how morally bankrupt our financial system really is. No one in the American press writes as well as Buiter about the US financial system. There is no one defending the principles of Americanism better than this British journalist. Buiter's latest piece sums up the situation perfectly. I will be Bad-Blogger and quote it in its entirely. It is a must-read.

Willem Buiter of the Financial Times takes down Geithner and the Fed.

More on robbing the US tax payer and debauching the FDIC and the Fed

March 26, 2009 5:34pm
The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership. The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support. Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.

As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .

The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.

Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.

I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.


The FDIC is supposed to be an independent agency of the US federal government. Its website tells us that “The FDIC receives no Congressional appropriations - it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities” . The FDIC also has no borrowing capacity except that granted it by the US Treasury.

The operating budget of the FDIC for 2009 is $2.24 billion, a big increase from the $ 1 billion set in 2008, but still a tiny number. Its current Treasury borrowing limit is $30 bn, again nowhere near enough to make an impact on the black hole that is the asset side of the balance sheet of the US cross-border banking system. With an insurance fund of just over $45 billion, the FDIC insures more than $5 trillion of deposits in U.S. banks and thrifts. The insurance fund is therefore less than one percent of the amount of insured deposits.

The near-demise of the US banking system means that, should even a single large deposit-taking bank go bust, there is not enough money in the kitty to pay off all insured depositors. The FDIC would have to borrow - hence the usefulness of the increase in the borrowing limit. It is both unwise and illegitimate to use that borrowing limit instead to subsidise potentially non-viable banks (likely to still be non-viable even after the subsidy) as well as the private investors who plan to purchase these banks’ bad loans through the Legacy Loans Program.

The FDIC’s Mission Statement is clear: “The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” I don’t see anything there about guaranteeing debt from or loans to private entities wanting to buy bad loans from bad banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 also does not, as far as i can see, authorise the FDIC to engage in the kind of quasi-fiscal activities it is engaging in through the Temporary Liquidity Guarantee Program (see below) and is about to engage in under the Legacy Loans Program.

But help is on the way! Senate Banking Committee Chairman Chris Dodd of Connecticut is proposing, in a bill submitted on March 5 2009 (the Depositor Protection Act of 2009) to increase the FDIC’s Treasury borrowing limit from $30 billion to $500 billion. With the deposit insurance limit now at $250,000 at least until the end of 2009 (up from $100,000) and so many large deposit-taking banks in the US insolvent but for past, present and anticipate future hand-outs from the tax payer, the increased borrowing limit of $500 bn may come in handy to make whole the insured depositors if and when one or more large banks keel over.

But this does not appear to be the use (the proper use) that the US authorities have in mind for it. Instead the increase in the FDIC’s Treasury borrowing limit to $500 billion is likely to be diverted to the entirely improper use of providing debt guarantees for debt used to co-finance the purchase bad loans from the banks under the Legacy Loans leg of the Private-Public Investment Program (PPIP). This quasi-fiscal role of the FDIC is on top of the earlier prima-facie illegitimate use of FDIC resources under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), under which the FDIC guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies.

The FDIC, under the TLGP also provides full coverage of non-interest bearing deposit transaction accounts, regardless of dollar amount. This is a legitimate use of its resources, albeit an unwise one. As of February 28, 2009 the amount of debt insured under the TLGP was more than $268 billion. After debauching the Fed to pay for the bail-out of insolvent US banks, the US administration is now subverting the purpose of another so-called independent government agency.

The debauching of the FDIC is, however, different in one respect from that of the Fed. The Fed has an independent source of revenue - seigniorage, that is, the revenue from issuing base money, part of which is non-interest-bearing (bank notes) and part of which (commercial bank deposits with the Fed) earns an interest below what the Fed earns on its assets.

The FDIC has no independent source of revenue (ignoring the premia charged for the deposit insurance, which is chicken feed). Getting the FDIC to guarantee loans is therefore just a cute and non-transparent way of having the US Treasury guarantee those loans. But it’s off the books, off-budget and off-balance sheet as far as the US Treasury is concerned. With a bit of luck the guarantees will not be called. And if they are called - well, that will be then and this is now. If the FDIC can insure $ 5 trillion worth of deposits with a mere $45 bn fund, think of what amount of lending the FDIC can guarantee when it borrows its full allotment of $500 bn! The bill will be presented to the tax payers later.

How large could the bill be, that is, how much money could be transferred from the US tax payers to the banks or the investment funds bidding for toxic assets?

The potential for subsidies to the private parties involved in the PPIP’s Legacy Loans and Legacy Securities Programs is truly astonishing. Jeff Sachs, in a recent Financial Times column, provides a representative calculation for the Legacy Loans Program. Note that this is targeted not at toxic assets (assets whose value is unknown) but on bad loans, whose (low) fundamental value can be ascertained without too much effort.

What follows paraphrases Jeff Sach’s argument and calculation. I put all of it in quotation marks, even though a few words have been changed.

“For every $1 of bad assets that an investment fund authorised under the PPIP buys from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the bad assets purchased by the investment fund fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the bad assets. The investment fund is not responsible for part of the FDIC loan not covered by the liquidation value of the bad assets. At most it loses the equity it put in.

Consider a portfolio of bad assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The fair value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, i.e. $360 billion.

Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC non-recourse loan. The FDIC makes a “heads you win, tails the taxpayer loses” offer to the private investors.

With a little arithmetic, we can calculate the size of the transfer from the tax payer to the banks and the investment funds. In this example, the private investment fund will actually be willing to bid $636 billion for the $360 billion of fair value of the bad assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders.

Under the rule of the Geithner-Summers Plan, private equity investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion each. The FDIC will loan $546 billion. (All numbers are rounded). If the bad assets actually pay out the full $1 trillion (which happens with 20 percent probability), there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.

Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.

The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the bad assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than it gets in payouts on the bad assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.”

The problem of collusive behaviour between the private investment funds and the banks for whose assets they bid will undoubtedly rear its ugly head. Indeed, the banks could set up their own investment funds (through SPVs registered in places where information is even harder to obtain than in Liechtenstein) and so make sure the underpriced put provided by the FDIC through its non-recourse loan can indeed be exercised.

This is a very bad deal for the tax payer indeed. And the Legacy Securities Program works on the same principles, although the non-recourse leverage provided by the Fed will be less than that provided by the FDIC for the Legacy Loans Program.

The Fed

I have written at length before about the ever-expanding quasi-fiscal role of the Fed. This began as soon as the Fed began to take private credit risk (default risk) onto its balance sheet by accepting private securities as collateral in repos, at the discount window and at one of the myriad facilities it has created since August 2008. It is possible - I would say likely - that the terms on which the Fed accepted this often illiquid collateral implied even an ex-ante subsidy to the borrower. But the Fed is refusing to provide the necessary information on the valuation of the illiquid collateral, interest rates, fees and other key dimensions of the terms granted those who access its facilities, for outsiders, including Congress, to find out what if any element of subsidy is involved.

Should the borrowing bank default and should the collateral offered also turn out to be impaired, the Fed will suffer an ex-post capital loss on its repos and other collateralised lending operations against private collateral. It does not have an indemnity from the Treasury for such capital losses.

The Fed also created the Maiden Lane I (for Bear Stearns toxic assets), Maiden Lane II (for AIG’s secured loans and Maiden Lane III (for AIG’s credit default swaps) special purpose vehicles in Delaware. The losses made by Maiden lane II and III when the Fed paid off the investors (counterparties) of AIG at par, were, however, not booked on the balance sheets of the two Maidens, but were booked on AIG’s balance sheet, keeping Maiden Lane I and II, and the Fed, clean for the time being. The financial shenanigans used by the Fed (in cahoots with the US Treasury) to limit accountability for these capital losses are quite unacceptable in a democratic society. Clearly, the US authorities are using the financial engineering tricks and legal constructions whose abuse by the private financial sector led to our current predicament, to engage in Congressional- and tax payer accountability avoidance/evasion. To watch the regulators engage in regulatory arbitrage is astonishing.

With the onset of credit easing, the Fed now also takes private credit risk onto its balance sheet through outright purchases of private securities (including commercial paper and possibly corporate bonds) and by making non-recourse loans through the TALF (that is, though unsecured lending). There is no full (100 percent) Treasury guarantee for this credit risk taken by the Fed. In fact, the $1 trillion TALF has at most $100 billion of Treasury funds to back it up.

I don’t envy Ben Bernanke the extremely uncomfortable position he finds himself in. He can insists on minimizing the quasi-fiscal role of the Fed by insisting on a 100% US Treasury guarantee for any credit risk, other than the credit risk of the US sovereign, that the Fed assumes. In that case the amount of financial ammunition that the US state, broadly defined to include the US Treasury, the FDIC and the Fed, have at their disposal to deal with financial sector reconstruction is inadequate. Or he can compromise the independence of the Fed and let the central bank be used as an off-balance sheet and off-budget special purpose vehicle of the US Treasury, reducing transparency and undermining democratic accountability. Talk about a rock and a hard place.

Even faced with this kind of dilemma, however, certain practices are clearly improper and unacceptable. The (ab)use of the Maiden Lane SPVs to hide some of the losses made by the Fed and the US Treasury and to channel money non-transparently to AIG counterparties (in the case of Maiden Lane II and III is just plain wrong. So is the refusal to make public the information required to judge the appropriateness of the terms and conditions attached by the Fed to the use of its facilities.

Conclusion: we need banking; we don’t need these banks

The raiding by the US Treasury of the financial resources of the FDIC and the Fed is not just unwise, illegitimate and possibly illegal, it is also unnecessary. For some reason, perhaps an example of cognitive capture of the Treasury and White House policy makers by the spin doctors and skilled persuaders of Wall Street, Tim Geithner, Larry Summers, Ben Bernanke and Sheila Bair all appear to believe that to save the banking sector you have to save the existing banks as going concerns. Indeed, in view of the astonishing survival rate of CEOs and other top managers in the zombie banks, they may even believe that to save the banking system you have to rely on the continued contribution of those whose past best efforts brought us this crisis and debacle.

All that matters is banking as a function and activity, that is, new lending and borrowing by banks. When a massive disaster strikes the existing banks, it is essential to decouple the stocks of existing assets and liabilities from the flows of new lending and borrowing. The good bank model does that.

Both Fed Chairman Bernanke and US Treasury Secretary Geithner have called for the creation of a special resolution regime (SRR) with prompt corrective action (PCA) for non-bank systemically important institutions. Bernanke clearly had AIG in mind when he told the US Congress on March 20, that there was a need for a special insolvency regime that “permits the orderly resolution of a systemically important nonbank financial firm”. With a proper federal resolution authority, AIG could have been put into conservatorship or receivership and could have been unwound slowly, with not just the shareholders but also the unsecured creditors taking the haircuts (losses) justified by the financial condition of AIG. Bernanke’s words that a proper special resolution regime for non-banks would permit the Conservator or Administrator to “unwind it slowly, protect policymakers, and impose haircuts on creditors and counterparties as appropriate,” truly are music to my ears.

I also agree with Chairman Bernanke’s statement that “given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.”

But with a proper SRR, there can be orderly failures of major financial firms, banks and well as non-banks. The US has a proper SRR for FDIC-insured banks. That now includes all Wall Street banks. The orderly failure and resolution of one of more Wall Street banks need therefore pose no threat to financial stability. Indeed, with the limited resources the US authorities have at their disposal, the failure and orderly resolution of all dodgy Wall Street banks may well be the best way to stabilise the financial sector and to get financial intermediation - new lending and borrowing between banks and the non-financial sectors - going again. With the information the authorities now are acquiring (I hope) about the soundness of the large banks (whose balance sheets and financial fitness are being scrutinised as part of the Treasury’s Capital Assistance Program), the authorities will soon know which banks should be allowed to survive and which ones should be put out of their and our misery.

Why hasn’t the FDIC’s special resolution regime been used to resolve the large Wall Street zombie banks, but just the tiddlers in the boonies (OK, add WAMU)?

Any large, deposit-taking Wall Street bank (the old bad bank or OBB) with a significant amount of non-insured deposit liabilities on its balance sheet and a survival-threatening amount of toxic assets, can be split into a new good bank and a new bad fund virtually with the stroke of a pen, using the proposal by Bulow and Klemperer and Hall and Woodward (see also Buiter (1) and (2)). The new good bank gets the insured deposits and the non-toxic assets. If liabilities net of insured deposits of the OBB exceed toxic assets, the new good bank will have positive equity. Give that equity in the new good bank to the new bad fund. The new bad fund does not have a banking license and cannot make new loans or acquire any new assets. It simply manages down its portfolio of existing assets in the interests of its owners. It gets no further government financial support of any kind. If it fails, it goes into Chapter 11 or Chapter 7. Both the shareholders and the unsecured creditors can be expected to take a hit. That is as it should be.

If the new good banks needs additional capital, it can go to the market or obtain it from the government. Government guarantees (just from the Treasury, please) are only granted to new bank borrowing or bank lending.

Save banking. Allow the zombie banks to die.

The unsustainable rally

The stock market has been in bull market mode for the past three weeks. Many are saying that we have seen the bottom are now in a bull market. I think this is all hogwash. Here are some reasons why this is not the bottom:

The economy is not improving nor is it likely to improve soon. We may be nearing the low in home sales and also auto sales. But that doesn't mean we will have a quick rebound in either. Sales of homes or autos require financing. While financing for either is available and at reasonable interest rates, it is only available for those with good credit and money for a down payment. That means that most Americans and businesses are excluded from more credit.

Nobody with good credit wants to borrow anyway. In an economy like this, there are few places to invest so why borrow money? Why would anyone borrow money to open a restaurant when so many are failing and closing down? Businesses are being penalized for having lots of debt so why would any business add more debt right now? House prices are falling so fast that it makes sense to wait to get a lower price in the future.

The key thing to note here is that you can only lever up once. Once you have turned the balance sheet of a country into a heavily indebted one, you can't add any further credit. The Fed and Treasury are desperate trying to find someone else capable of levering up and continuing the spending. Who is available? The government of course is one. The government can borrow and spend and offset the retrenchment in spending to some degree. But there are limits there. If they add much more Federal debt, the Fed will have to purchase it. This is obviously just printing money and eventually our foreign creditors will say enough is enough and stop buying dollar denominated debt.

The other party is private capital: hedge funds and private equity who will always borrow if they can be assured at getting a good return on the borrowed money. Geithner's plan is to lever up these groups in order to offload some of the toxic assets on bank balance sheets. This plan will face some obvious political problems. There is some serious danger that taxpayers will get stuck with some major losses which will make Geithner and Obama's chance of keeping their jobs quite slim. This plan can only work if private capital ends up making a profit. But if the profit is too large, this will stoke populist outrage and for good reason. It is already looking like a massive wealth transfer from the taxpayer to banks and private capital. Some have called this the biggest wealth transfer since the government gave away land to the railroads in the 19th century, the beginning of the last gilded age.

Even if this dicey plan works, they are really just ways of inflating out of the debt problem. Will the rest of the world who holds dollars as reserve currency put up with us debasing the currency to avoid paying the price of our profligacy? We will find out this week at the G-20 meeting. My guess is that this week will coincide with a loss of faith in the current rally. The market will realize that the rest of the world is not on board with the US plan of printing our way out of trouble. You just have to look ahead a little further. What is the Bernanke/Geithner plan really? What is the endgame? Is there really any reasonable way for this to turn out OK? I think not. I am using this really as a chance to sell stocks that are turning up due to the hope of economic recovery although I hold very few of them anyway. Gold is looking more and more attractive as is resource stocks like Uranium miners. Recession resistant, low debt, multinationals that have a high fraction of sales in other currencies also look good, like my long-held core position in Johnson & Johnson. Eventually I think China will get tired of buying treasuries and will start buying up our multinational companies in addition to commodities.

Sunday, March 22, 2009

Why are there no homebuyers?

House prices will continue to drop. The reason is simply supply and demand. There are lots of houses for sale and too few buyers. Why are their too few buyers? Lets list the reasons

1) The speculative buyers are gone. Speculative buyers are non-existent when prices are dropping. They know there is no point in buying until prices level off. They were probably at least 10% of the market at the top of the bubble.

2) The subprime and other uncreditworthy buyers can no longer get loans even if they wanted them. They were at least 20% of the market at the top of the bubble.

3) Before the bust, you didn't need a down-payment. Now you do. A 20% downpayment on an average $200K house is $40K. In addition, many banks now want to see enough liquid resources, cash, bonds etc, to cover 6 months of principal and interest. That adds another $6K for this house. How many people have $46K sitting around in cash? We don't need to speculate. A Met Life study was just published on this. The question was, "How long could you meet your financial obligations if you lost your job. Only 15% of people said longer than 6 months. For people younger than age 44, the natural home buyer demographic, the percentage is 9.5%. But to put down a 20% down payment you would really need this answer to be at least a year. The number who answered that was 10% overall and 5% for those under age 44. How horrifying is that statistic for those hoping the housing market will rebound? The stringent requirements on down payment and liquid resources now being demanded by banks can be met by about 5% of the natural home buying population!

4) If people had money before the bust, they probably lost much of it in the stock market. If you were young and were saving up money to eventually buy a house, you probably had most of that in the stock market. That is what your financial advisor would have told you to do. If you are young, you want a "risky" portfolio they said. You probably have about 40% less now.
If indeed you just lost 40% of your wealth, you are probably not looking to make major purchase, especially an asset that is still falling dramatically in value. In addition, you are probably worried about losing your job in this terrible economy. So why buy until the economy recovers and you are sure your job is safe.

So to sum up, about 70% of households do not have enough liquid savings to buy a house. This may be even higher for the subset of people that no not already own a house. The supply of possible home buyers is probably only 1/5 of what it was at the top. The supply of homes is only down about 20% from the peak. So supply and demand imbalances mean that house prices will continue to fall until a balance is reached. There is only two ways out of this situation. One is to wait several years for people to save money and for house prices to fall to more affordable levels. The other is for the government to subsidize housing and bring the uncreditworthy back into the market. I don't see that happening given all the anger at these junk mortgages being made in the first place.

Now there is mortgage insurance and FHA for people with no down payments but that adds more in fees on top of higher mortgage rates for people with poor credit. These people are probably paying 8% interest rates including MI. Why not wait? If you wait, you can save money to increase your down-payment, improve your credit score and in addition benefit from the fall in house prices. In addition, there is talk that the Obama administration will offer 4.5% fixed rate mortgages to help move housing inventory. If you wait a couple of years, save money, get a much lower interest rate and benefit from a 20% drop in home prices, you might reduce your mortgage payment by almost half.

So waiting is the obvious thing to do. Because of this, house prices should drop for another few years.

Saturday, March 21, 2009

How to scam the Geithner plan

The Geithner plan is nothing but a scam to stick the taxpayer with the losses that should go to the banks' shareholders first and the banks' bondholders second.

Basically the plan works like this. The Fed or Treasury loans money to some investor. This is a no-recourse loan with say 3% down on the part of the investor.

Yves at Naked Capitalism has already started this thread so lets take her example.

Lets say the bank, Citi for example, has an asset with face value $100MM carried on the books at $80MM and which is currently getting markets bids at $30MM. Lets say that it turns out to be worth $50MM and that it takes 5 years for this to become evident. So if Citi is forced to selling into the market now or mark-to-market they will take a $70MM loss or an additional $50MM loss from the present write-down. If they hold to maturity, they will lose $50MM total and $30MM from the current mark.

Now if some investor shows up and wants to make a bid at $75MM with the Fed's borrowed money, they are risking only $2.25MM (3%) of their own money. Citi now has to write down $5MM more on this sale. This plan saves them $25MM.

In this case, the investor loses their bet and ends up losing $2.25MM. The bank has the $5MM write down and the taxpayers loses $22.75MM. Clearly the bank is getting the best deal.

But what if no investor wants to bid? How can the banks scam this system? It is not hard to come up with ways. Let me list a few possibilities:

1) The bank could make a no-recourse loan to the investor. Now the investor really has nothing to lose. The bank can only lose the difference between their mark and the bid plus the loan to the investor.

2) Another way that Yves brings up is for the bank to sell a CDS to the investor that pays off if the assets go bad.

3) The investor bids high with intent to lose in some quid-pro-quo with the bank. Maybe the bank will give them a loan at low interest rate or some other favor. This would probably be completely undetectable.

4) The investor could just buy call options on the bank's common stock and then bid for all of their crummy assets at face value or even higher. How about that!? They would be throwing away all of their investment purposefully in order to buy a large piece (maybe even all) of a clean bank. This way would maximize taxpayer losses. It would not even have the involve conspiracy with the bank. It is really just a way of using the enormous leverage to manipulate the stock price of the bank.

The reason why it is so easy to think of ways to scam this system is that it is inherently a scam from the beginning. These hedge investors are sophisticated and are sure to find ways of hedging their exposure so that is a chance of a big return with no risk. It is a complete hand-out to them. It is obviously a hand-out to the banks. That is the whole point. The taxpayer is the fish at the table. They are obviously going to get screwed one way or the other. This plan stinks of corruption and must be rejected.

The tide is turning

It is easy to conclude that Americans are stupid. How could they vote Bush into office twice? How can they not understand how Washington really operates as one party dedicated to maintaining the dominance of the financial elite. Well, Americans are not really stupid. Rather, they are just distracted. Americans work harder than any other people. A typical couple with children both work 40 hours a week or more. They have a long commute on top of that and when they are home, need to do all the business of running a household as well as spending some time with the family. In the their meager spare time, they try to relax. Most don't feel that they need to fully understand the functioning of the financial system or deep questions of political philosophy. When it comes to politics, most make up their minds quickly. They go with their gut. They certainly don't have time to do in depth research into the issues. That is what the news is for right? Well, that is the other problem. The news has become dominated by large corporations and doesn't offer a wide spectrum of opinions. This isn't conspiracy theory. They are just businesses and have learned that the most profitable business model is to focus on feel-good entertainment not highly controversial subjects. News stations have learned that you get more viewers when you focus on Eliot Spitzer's sex scandal than the UN oil for food scandal or the travesty in stealth bail outs of powerful financial firms.

But the times are a changing. People laid off from work, suddenly find themselves with more time to think about why they are out of work. The moral and financial bankruptcy of our way of life is becoming all to obvious. It was common sense after all, that a unsustainable trend could not continue. House prices couldn't rise forever with wages being stagnant. The Chinese wouldn't finance our over-consumption forever. Every adult who has ever dealt with their own household budget gets this now. That is why 45% of Americans think we will have a repeat of the Great Depression. This number is perhaps only 10% for actual economists who are supposed to know better. However what economists think doesn't matter. It is the spending and investment habits of ordinary Americans that will determine if demand returns enough to support the economy. If people think we will have a Depression and act accordingly, you can be assured that we will.

The Obama/Geithner/Summers/Bernanke plan of financial engineering our way out of this crisis has zero support. The people don't buy it. The markets don't buy it and even the news organizations, for example New York Times's Paul Krugman don't buy it.

It is all pretty simple when you look at the big picture. The wealthy class of the world, the net savers, made bad loans to the net borrowers and that money has been spent or transferred to others. Those loans will default and the money is not coming back. Therefore the wealthy lending class has lost much of their wealth. The Obama plan so far has been to make pretend that the money is not yet lost. If we could all just clap our hands and wish Tinkerbelle would come back to life, then Tinkerbelle will come back to life. And that might work, if people really are stupid, if they are able to ignore the fact that they are out of work and keep spending in an unsustainable way. If they can only ignore that their house and stocks have fallen in value by half. This of course is ridiculous. The Obama plan is on its last legs.

This wonderful video shows an interview of Brad Sherman, Democrat from California, telling the CNBC hosts that the emperor has no clothes. The Zeitgeist is prominantly on display. The CNBC hosts represent the old way of thinking; that the system must be propped up at all cost to avoid an apocalypse. This populist uprising will lead to the end of capitalism as we know it, they say. Sherman doesn't buy it. A system where capitalists can make outrageous profits but need the tax payer to remove all the downside risk is not capitalism at all.

Friday, March 20, 2009

What is wrong with the Wall Street culture?

Goldman Sachs put on a little dog and pony show today to explain to the witless public that they had almost no net exposure to AIG and so the bail out of AIG was NOT a de facto bailout of Goldman.

This is how it works. Goldman and AIG had a special business relationship. Goldman bought junk mortgages from fraudulent, predatory lenders and other toxic assets and bundled them into securities to sell to some unsuspecting fool such as a municipal pension fund in Norway . To convince these utter marks that Goldman had some skin in the game, they held on to some of the mortgage exposure. See, if they are good enough for Goldman, they are good enough for your stupid Norwegian backwater. Except, they didn't really keep the exposure on the books. No way! They aren't stupid. They hedged this exposure with AIG. They bought insurance contracts with AIG, the so called credit default swaps (CDSs). So if the shit hits the fan in the mortgage market, Goldman will be OK even if the Norwegians get their cold white asses handed to them.

But then their business partner, AIG, started to look kind of sickly. Whoops. Looks like that hedge might not be reliable. How do we hedge our hedge? At this point there was no one else willing to write a big insurance contract against mortgage defaults since they were already defaulting. No one sells flood insurance during a flood. If AIG goes down, Goldman would as well. How would Goldman get out of this one? By shorting the bejesus out of AIG, that's how! They took out CDSs on AIG that would pay out if AIG went down. That's right. They bet that their business partner would fail so that if they did, on the whole, they would come out OK. So in the end, says Goldman, we couldn't care either way what happened to AIG, the fools getting foreclosed on or those dumb Norwegians. We took responsibility for our company and made sure that we would come out OK regardless what happened. So we are innocent of all these accusations of needing a stealth bailout.

What really amazes me is that they thought this would somehow convince people to leave them alone. See, we didn't need a bailout. We already bet that AIG would fail. In fact we bet that all of you would fail. We have no exposure to any of you. We are betting against Norway as we speak. Pretty sure they are going down. We should know since we are the ones that sold them all this garbage.

This culture of Wall Street is now about forming business relationships and then making sure you have no "exposure" to the fate of these partners. That is, business relationships are now like some disease that you are get "exposed to". Prudent business policy now is to actively bet against your business partner's very survival so that if they go down, you come out just fine. What kind of culture are we breeding on Wall Street. It is everyone for themselves. No one trusts anyone. No one is willing to form normal business relationships where you and your partner are truly in the same boat. Goldman's meeting today displayed this more clearly than I have seen before. The amazing thing is that didn't even consider that what they were admitting to was worse than what they were trying to defend their company against.

Saturday, March 14, 2009

The Great Steve Keen

Steve Keen wrote an article in February called The Roving Cavaliers of Credit which struck me as pretty brilliant and very deep.

The idea's expressed by Keen in this article perhaps are not novel but, as is frequently the case, sometimes brilliant writing is about summarizing what is already known, pointing out the importance of a particular point of view and demonstrating what the consequences must be.

Keen is an economist, that is, he has a Ph.D. in economics, but might be described as a rouge economist. He thinks most of what passes for economics is bunk; a view I happen to share. He wrote a book called "Debunking Economics: The Naked Emperor of the Social Sciences".

The main idea in his "Cavaliers" essay is that we don't actually have a fiat currency controlled by the whim and printing presses of central banks like many believe. Rather we have a debt based currency. Debt is money. Steve's blog is appropriately called Debt Watch. Therefore, the quantity of money and also economic growth has more to do with the willingness of people and institutions to borrow more so than the actions of the central bank. Eventually of course a debt frenzy has to reach a point where no one wants to borrow anymore even if interest rates are zero. No more debt is taken on and so no more money is created. At that point, deflation must occur and there is nothing a central bank can do about it.

Sunday, March 8, 2009

The root cause of the crisis

I have been trying to distill the most elemental cause of this great bust. There have been many things suggested such as: too easy monetary policy by the Fed, government intervention in the housing market, excessive greed by Wall Street, deregulation of financial markets etc.

Clearly, all of these things contributed. Most however are really cogs in the feedback machine. What is the root cause of it all?

Actually Alan Greenspan suggested what I think is the best explanation.

The US built up so much debt simply because it was cheap to borrow. Interest rates like all prices in a market economy are set by supply and demand. Now, its is true that central banks can manipulate certain rates in the short term. However most central banks claim to be targeting inflation. That means that they raise rates when they see inflation rising and cut rates when they see it ebbing which usually occurs when recession seems imminent. So in this view, central bankers don't really have much freedom. The best interest rate is the one that allows economic growth with low and stable inflation.

Long term interest rates are set in the market place and depend on the supply of loanable funds and the demand for loans. The interest rate is just the price where supply and demand meet. If inflation is high, fixed income investors demand a higher interest rate.

But inflation, at least the measure reported by the government, has been dropping even since the recession of the early 80s. The best explanation of why is probably the globalization phenomena and the cheap wages of developing countries like China and India. These countries provided cheap labor which resulted in cheaper priced goods which put an end to the wage-price spiral that dominated in the 1970s.

So when interest rates dropped, US debt doubled from 150% of GDP in the early 80s to nearly 300% now. Since the interest rate was lower, this large debt load was serviceable. For the household sector, debt service as percent of personal disposable income went from 11% to 14% which doesn't look as extreme as the total debt increase.

Now unfortunately this debt binge led to financial bubbles and the rest is history. However, the key economic feature is the disinflationary impact of the cheap labor from emerging markets providing a major source of global supply.

However, I think there is another economic phenomenon which gets much less notice. This is the rise of savings capital. The last 50 years has seen a huge increase in the percent of total assets held by institutions rather than individual. For example, pension funds, banks, insurance companies, central banks now hold the majority of the worlds financial assets. The decrease in inflation starting around 1980 accentuated this even further. The inflation which preceded it decimated the value of the fixed income investments held by these institutions. The disinflation which followed did the opposite. As interest rates fell, bonds rose in value. Stocks rose in value as well since 1982 marked a secular low point in the stock market. These institutions held many long dates bonds earning 15% interest rates or higher. These high rates were formerly offset by high rates of inflation but not these became excessively high real returns. The ultimate savers, institutions, got richer.

As these savings institutions got richer, they had more to invest and most had a mandate to invest mostly in fixed income investments. That is, they need to lend out their capital and they did. Low inflation and rising loanable funds, and low interest rates led to more debt for US households and businesses. The final bit was probably due to poor monetary policy as Greenspan juiced the market after the Tech crash, but the bigger debt bubble had been growing ever since inflation started to fall.

So in summary, the debt deflation that we are seeing now has its roots in the rise and fall of the Great Inflation of the 1970s combined with globalization of labor. Both of these pieces were needed and they are related since globalization is one of the things leading to lower inflation. If inflation did not moderate, interest rates would have stayed high and little new debt would have been take on. If there was no cheap foreign labor, the boom would have been arrested by rising wage inflation which would have led to higher interest rates.

Saturday, March 7, 2009

What a real stress test would look like

When Tim Geithner announced that banks would undergo a stress test, the press briefly took the view that he was being justifiably firm with the banks. If they could not perform under a dire economic scenario then they would be nationalized, the press figured. Financial bloggers, of course, were not fooled.

A few weeks later they announced the parameters of what such a stress test would look like. Here they are.

Lets focus on their more "adverse" scenario rather than their baseline scenario. The more adverse scenario is a GDP decline of -3.3% in 2009 and +0.5% in 2010. Average unemployment rate of 8.9% in 2009 and 10.3% in 2010. House price declines of -22% in 2009 and -7 in 2010.

First, GDP. Their adverse scenario is only one year of GDP decline. A -3.3% decline is about the same as the recessions in 1974 and 1982. Those were bad recessions but not once-every-50-years type events. For example in the great depression, the GDP decline in the four years following 1929 was -8.6%, -6.4%, -13%, -1.3% for a cumulative decline from 1929 to 1933 of -27%. The annualized GDP decline in the Q4 of 2008 alone was -6.3%. Q1 of 2009 is looking about the same.

Unemployment in the Great Depression reached 25%. Here is a plot of the unemployment rate back to 1948

The stress test is an average of 8.9% in 2009 and 10.3% in 2010. That would be about the same as 1982. It is 8.1% already in the beginning of March 2009.

Finally, lets look at house price declines of 22% in 2009 and 7% in 2010 which would be a 27% cumulative drop from here. This is about what I predict from extrapolating the Case-Shiller index.

So we can see that the adverse scenario is really not much worse than the 1982 or 1974 recessions with house price declines added on. Is this really a good representative of what the worse case scenario is going to be like? We have already shown that the Great Depression was far worse but that should not be surprising. Comparing to 1974 or 1982 is really not a good idea either. The 1974 recession was caused by the oil shock when OPEC raised oil prices considerably. It was alleviated when OPEC agreed to lower prices which lead to a quick recovery. The 1982 recession was engineered by Volcker's Federal Reserve in order to bring inflation down. In that case, ending the recession was easy. They just lowered interest rates and the economy came back strongly. Obviously we can't do that now since interest rates are already zero.

Is there any way that we can estimate what an adverse economic scenario would look like besides saying that it is likely to be worse than 1982 but better than the Great Depression? Well, actually we can. The key is focusing on other recessions in history that followed severe financial crises. Economists Reinhart and Rogoff wrote a paper on the economic aftermath of financial crises. They found about 20 cases and present statistical results that are relevant to what a stressed scenario would look like for the US over the next few years.

Here are some relevant statistics. The average house price decline from peak to trough was -35.5%. Ours seems likely to be slightly worse than that, maybe -40%. That is not surprising since housing was the main feature of our crisis. The worst, Hong Kong in 1997, was -53%.

The average GDP decline from peak to trough was -9.3%. The worst was the US in the Great Depression, about -27%, as we have said. The Fed's adverse estimate of -3.3% is only worse than 3 out of 15 (20%) of the historical examples. Seems hardly adverse. That is more like the rosey scenario.

The average INCREASE in the unemployment rate from peak to trough was 7%. Since we started at 5% unemployment, that would be 12% unemployment, worse than 1982 but not nearly as bad as the Great Depression. But that is just the averages not the adverse or worse than average case.

So now we can answer the question of what an adverse scenario would look like. Lets define that as roughly the 75 percentile (the average for the worst half) from this sample of post financial crises historical examples.

This would be (estimated from R&R's figures):

Real GDP peak to trough decline: -12% (3 years peak to trough)
Peak Unemployment: 16% (5 years peak to trough)
Real house price declines: -42% (7 years peak to trough)

Anyone think the banks would survive under this kind of scenario?

Friday, March 6, 2009

The old hood, Silverlake

The neighborhood in LA that we used to live in is called Silverlake. Silverlake is a hip, gentrifying area along Hollywood boulevard between Hollywood and downtown. It was the about at the epicenter of the LA housing bubble. I was looking on today to see how real estate is doing. Well here is an example

811 Silver Lake Blvd
1228 square feet
3 beds, 3 baths

Since 2000, it has been sold seven different times!

Here is the sales history
11/24/2008 $304,500
11/27/2007 $602,295
11/15/2006 $704,000
08/05/2005 $650,000
10/01/2002 $321,000
04/09/2002 $258,306
12/21/2000 $262,500

Here is a chart so you can appreciate the trajectory better.

The house price appreciation from start to finish is exactly 2% per year.

Now my wife and I rented a place about the same size in the same neighborhood for $1200/month. When this place sold for $704K in 2006, it would have had a monthly mortgage payment of about $4200/month. What were people thinking!?