Cause for Depression

The Overall Idea

2008-10-18T19:27:00.013-07:00

Think of it as a picture guide to the ongoing earthquake in the world of high finance. Through charts, graphs, and tables, we will try to understand the dimensions of the current financial crisis--its origins and causes, its likely consequences, its potential remedies.

In seeking to understand the crisis, we need to begin with the credit mechanism. We are living through the bust of one of the greatest credit cycles of all financial history. In order get a handle on the seriousness of the bust, we must register the mania that fed the boom.

I look first at some measures indicative of the financial turmoil. For those unfamiliar with the financial markets, this provides a birds-eye view of the most important indicators, together with links for fresh updates.

The next three sections deal with the causes of the crisis, in which we examine the role of the housing boom and bust, the general growth of credit market debt, and the explosion in derivatives. The general pitch here is that the crisis has arisen above all from the extremities of debt and leverage that built up in the financial system over a long period.

Then it’s on to a consideration of consequences and remedies. The basic question--how much insolvency exists within the financial system?--is vital in assessing the wisdom of various bailouts and rescues, the opportunity costs associated with the government-mandated maintenance of the "FIRE" sector (Financials, Insurance, Real Estate), and how the global imbalances that have marked the last fifteen years are likely to change.

I conclude with some lessons and a collection of paper topics for interested students to consider.

The presentation is generally pitched to the intelligent undergraduate who doesn't know much but is eager to learn. Though prepared for anyone who believes, with me, that a chart is worth a thousand words, I put it together with my students primarily in mind. It began as a 25 minute presentation at Colorado College, then grew.

The whole financial crisis now ongoing must appear as fundamentally bewildering to young people, they who just assumed that their parents' generation knew what it was doing. Alas, no. Understanding what is going on is itself very difficult; finding the right answers is a huge challenge. These are notes and fragments to further that undertaking.

There are two ways of navigating this site: through the "Labels" section, which presents each chapter in an orderly fashion, or through the Table of Contents below.

10/30/08

2008-10-18T19:20:00.023-07:00

INTRODUCTION
--The Overall Idea
--Table of Contents
--Summary of Argument
--Updates and Acknowledgments

FINANCIAL STRESS
--Doom Is Busting Out All Over
--World Stock Market Capitalization Crumbles
--Twin Peaks
--Stock Market Volatility
--High Yield Bonds Over 20%
--High Yield Credit Spreads Top Levels of 2003
--AAA Corporate Bonds: Compared to What?
--LIBOR and Financial Stress
--Flame-Broiled Mortgage Spreads
--TED Spread from 1980s
--Commodities Tank
--Consumer Credit Crashing
--One Big Happy Human Family
--The Banking System: The Issue of Trust
--Carry Trades Unwinding
--Measuring Inflation
--Unemployment Mythologies and the "Misery Index"
--If You Want More,
--Minsky Moments

HOUSING BUBBLE
--California at Height of Bubble
--In the Long Run We're All Dead
--Financial Firm Profitability and Real Estate
--The Big House
--Regional Variation in Housing Declines
--US Homeowners with No or Negative Equity
--One in Six Homeowners Under Water
--Future Housing Prices
--Out of Whack: House Prices and Disposable Income
--Rent Ratios Mean Housing Will Fall Further
--A Cautionary Lesson from Japan

DEBT BINGE
--Total Credit Market Debt is Way High
--Debt to GDP from 1920s
--History is Not Bunk
--Profits of Financial Firms
--Debt Fueled the Equity Boom
--Margin Debt
--Consumer Debt Outstanding
--About That Loan
--National Debt as Percent of GDP (from 1950)
--The Two National Debts
--Understated Obligations
--Stairway to Heaven: Yet More Unfunded Obligations
--Total US Debt and US Debt/World Equity Ratio
--2009 Deficit to $2 Trillion, 12.5% of GDP
--Maxims on Debt and Credit

DERIVATIVES JUNGLE
--One More Bad Thing
--Credit Default Swamps
--Happiness Through Bilateral Netting
--The Mothership of the Derivatives Structure: JP Morgan Chase
--Leverage Ratios at European Banks
--Leverage Unbound at the Investment Banks
--Slicing and Dicing Those Damn Derivatives

SCALE OF LOSSES
--Estimates of Losses
--The Housing ATM and Losses on Real Estate
--Losses and Liquidity
--Preparing for a Rainy Day?
--House Debt as Percent of Compensation
--The Importance of Being Credit-Worthy
--A Comparison with Japan

RESCUES AND REMEDIES
--Deteriorating Balance Sheet at the Fed
--The Greatest Bailout of Them All
--Cash for Trash: The Fed's Balance Sheet
--Paulson Plan, circa October 14, 2008
--Zingales is a Hero; Paulson is a Lout
--The Major Scandal
--Last Resort
--Poor Goldman Sachs
--The Grand Alternative
--The US Hedge Fund and the Bond Conundrum
--Uncle Sam's Adjustable Rate Mortgage
--Twin Towers

GLOBAL IMBALANCES
--Crazy World Order
--Deficit on Current Account Contracting
--Our Best Friends: Foreign Central Banks
--Flight to Quality by Foreign Central Banks
--The End of Bretton Woods II
--The Linked Dangers Foretold (Sort Of)

LESSONS
--Six Lessons from the Financial Crisis
--Implications for "Defense"
--Joseph Stiglitz Excoriates Economists
--Paper Topics
--The Ten Commandments
--The Ten Steps
--Further Reading
--Man, Did I Screw Up
--We Value What We Save in a Crisis

Summary of Argument

2008-10-18T19:15:00.003-07:00

The world financial system is undergoing a kind of seizure, with assets crashing more wildly than they have done since the Great Depression. At the core of the crisis is the mayhem in the credit markets, where interest rates are going up sharply. The popping of the housing bubble has brought to dramatic pitch the unsustainable levels of US debt across wide sectors (not just housing). The extreme leverage on dodgy assets characteristic of US and European financial institutions has made many of them insolvent if their assets are judged on a “mark-to-market” basis. Various signs point to a deep recession, at a minimum, possibly much worse.

The financial crisis will have extraordinary implications for just about everything. It marks the birth of a new era quite as much as 9/11 did. We need to reflect about the lessons, nearly all of which are rather grim, and start asking in earnest about the political and economic consequences.

I give US authorities very low marks in their response to the financial crisis. Paulson and Bernanke have mistakenly characterized the crisis as a liquidity rather than solvency issue. They have also failed to introduce any coherent limit on the government’s acquisition of toxic private debt. The Paulson Plan is especially wrong-headed, as being neither equitable to the taxpayer nor efficacious in its stated aim (getting banks to lend again). The commitment of public funds to insolvent institutions must have shareholder wipeouts and debt-to equity conversions as a basic feature. The real bill of the US government’s strategy has been minimized in a kind of shell game, but the opportunity costs will likely prove tremendous. There is much cause for depression in both the terrifying implications of an economic collapse and in the response of US authorities to the crisis.

10/26/08

Updates and Acknowledgments

2008-10-18T19:10:00.009-07:00

While I have heard the term “blogbook,” I don’t recall having seen one, despite having spent a good part of my existence in the last six years “surfing the web.” By a blogbook I mean something that, utilizing blogging technology, is to be approached as a book, with a chapter organization and such.

Google's webhosting service, Blogspot, is not made for blogbooks, though it is easily adaptable to that purpose. But one note of caution: Ordering within each of the chapters depends on time of posting, so my time stamps are not necessarily indicative of the actual time the material was posted. I have altered them to allow for an orderly presentation. The initial foray of posts was made in mid-October 2008, and the time-stamps will stay ordered in that time frame; since then, I have mostly been updating with links for further reading. When I make a substantive change to a post, I will signify that by a date at the bottom of the entry indicating the date of the latest update.

Doing a blogbook is an odd writing experience. My normal method is to write something, then fiddle with it endlessly. I always think I’m done, but this invariably proves an illusion. I’m never quite done. I have also found that I have to post something several times before I correct all the typos and haywire formatting. That’s fine if you’re writing a book and no one is reading it, but odd if you’re doing your composition and revision in plain view.

A great many websites that contain charts like those appearing here are in the business of investment advice. They are basically trying to figure out which way the various asset classes are going to move—up or down?—and they attract readers because they help answer the question: where should I put my money?

I do not find that an obnoxious question; I have devoted considerable time, not necessarily well spent, to thinking about that very thing. But the focus of Cause for Depression is otherwise. The question that it asks is not: how is the investor or future pensioner to survive in the coming turmoil? Instead, the focus is on public affairs. What is the nature of the crisis that government must address? Has it responded judiciously to the crisis? What lessons for financial governance may we draw from the experience? What are the implications for the world economic and financial system? I don’t pretend to exhaust these subjects, but they and questions like them are what draw my primary interest in this presentation.

My deeper interest, though one that is barely registered here, is with the implications for American foreign policy. What will be the features of the new era that has now suddenly fallen upon us? How should the nation adapt? The nexus between the financial crisis, on the one hand, and our energy and environmental problems, on the other, also excites my rapt attention. I hope to get to those one of these days.

While I would sincerely like to go to a place where the words “finance” or “derivatives” were never uttered, I will probably keep updating, mostly with links to new information and developments. The financial crisis is a hell of a lot more exciting than baseball, if you ask me, but it does have the aspect of watching a not-so-slow-motion train wreck. Repellent, but enthralling! And very consequential.

When possible, I’ve tried to indicate where to find updated sources of information for the material presented here. Given my harsh view of "derivatives," I'm obliged to say that this compendium is almost entirely derivative. I’m deeply indebted to my blogroll for ideas, inspiration, and many of the charts contained herein.

If you are intrigued by what you find here, my idea for further research is pretty straightforward: Just put my blogroll into your Google Reader, and follow along with Yves, Tim, Mish, Jesse, Mike, Barry, Willem, and the rest as they illuminate the great transformation now occurring.

10/25/08

Doom is Busting Out All Over

2008-10-17T11:00:00.002-07:00

2008 will go down as one of the wildest years in financial history, having witnessed two huge earthquakes that have reordered the political and economic landscape, just as surely as the collapse of the twin towers did on 9/11/2001.

One shock in 2008 was the meteoric rise in energy prices, which crested just shy of $150 a barrel in the summer, followed by an equally bloodcurdling descent. Whole US industries--airlines, trucking, housing, autos--responded in the summer with a near death experience.

Following this oil shock was the cratering of various markets in September and October, which brought to a sudden new intensity the bear market in just about everything that began in the last part of 2007. Commodities, seemingly exempt, succumbed in August after oil prices peaked in July. Emerging markets crashed. Europe crashed. Latin America crashed. Asia crashed. And, of course, so did the good ole' USA.

The dark specter--a return of another Great Depression--seemed suddenly to be decidedly more than a remote possibility. It would be a capital historical irony for that to happen, for US officials have for three generations taken the avoidance of that experience as their lodestar. At least, that is what they thought they were doing. Yet there it was again, big as life and twice as ugly, baying at the door.

Scary times.

The charts that follow in this chapter on financial stress provide a sketch of the havoc now ongoing. Then we'll look to causes, consequences, and remedies.

Six Lessons From the Financial Crisis

2008-10-17T10:30:00.003-07:00

1. The conclusion seems irresistible that the defenders of capitalism proved its undoing. The most zealous proponents of free markets put them at profound risk. The financial institutions that stood at the epicenter of the world economic order proved to be based on a scam, at the center of which was the privatization of profit and the socialization of risk. Capital markets whose fundamental rationale was the most efficient allocation of scarce resources for investment failed miserably in their basic function. The most egregious rates of executive compensation ever produced the biggest failures of economic leadership ever. To those of us with a sentimental attachment to free markets as against command economies, all this is a blow.

2. We are made aware of how grave a responsibility is the management of a country’s currency. Money and credit are like oxygen; taken for granted in most circumstances, but when withdrawn inducing asphyxia. In terms of economic theory, the whole experience bears out the vital importance the Austrian economists placed on the credit cycle and underlines their skepticism toward fractional reserve banking. This is not to urge a return to the gold standard, but it is to urge derision and contempt upon those who constructed the house of cards and who ignored its vulnerabilities. There are many villains in the piece, but Alan Greenspan will surely stand out in retrospect as bearing the heaviest responsibility. Blithely indifferent to the dangers of debt and derivatives, he led us down the garden path.

3. We move inexorably toward the socialization of credit risk and a much larger role for the state in the direction of the national economy. Courtesy of Bush and Greenspan, Marx has made a comeback. In The Communist Manifesto, the fifth proposal in Marx’s ten point plan for placing the means of production in the hands of the proletariat was the “centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly.” Marx didn’t get it quite right; we’re getting there via the dictatorship of the kleptocracy. But hey, it's a start.

4. The collapse of America’s credit bubble is very likely to lead, both here and abroad, to the revival of various forms of national socialism. That is not a prediction of the revival of German National Socialism, but simply that the direction of economic affairs is likely to be swayed much more by the dictates of nationalist and socialist impulses. The Euro is especially vulnerable to the centrifugal forces unleashed by the crisis, with unfavorable consequences for the European experiment. Sheer cronyism may win out over state socialism, to be sure, and financial internationalism will battle to survive against the reassertion of nationalism. Still, I wouldn't underestimate the power of nationalist and socialist tendencies in the new era.

5. The opportunity cost of the financial bailout is huge. Moreover, insofar as it is based on the idea of reflating the financial, insurance, and real estate sectors (the FIRE economy), it is very dangerous to long term economic revitalization. The old Wall Street model is broken because most of the things they made money on (securitization, fees, leverage) turned out, in due time, to be based on a fundamental misapprehension of risk. Real estate remains overvalued by various traditional measures. A far more logical use of public resources is the tackling of our energy and environmental problems, both of them requiring large investments in infrastructure and alternative energy. We face the challenge of a generation in adapting to these challenges; the economic crisis, and the response given to it thus far, constitutes a formidable obstacle in doing so.

6. The financial crisis has opened up a great gap between our aspirations and resources. This must have profound implications for American foreign policy. We have a foreign policy more ambitious than that crafted in the heady days of unipolarity in the late 1990s, when observers marveled at the sheer surfeit of American power in its military, economic, ideological, and cultural dimensions. Though American power has weakened on every count, there is no reconsideration of objectives. The last thing that presidential candidates wish to do is to reconcile themselves to limits on American purposes. It goes entirely against the American grain, which treasures happy talk and fairy tales over the recognition of constraint. But finance is inexorable: it sets limits, diminishes horizons, induces constraint. Surely a profound adjustment in America's world role is coming.

Implications for "Defense"

2008-10-16T23:14:00.003-07:00

The national security establishment has barely begun to register the severity of the financial crisis and what it may mean for American foreign and defense policy. The crisis has utterly disordered national finances. It will produce further cascading demands on the public treasury. Given these factors, the constraints on policy are going to be much more exacting than the national security establishment now believes. Defense will not prove to be “recession proof.”

Defining a coherent philosophy in foreign affairs and defense strategy that is respectful of limits is vital. Especially deserving of reconsideration are the grand plans to reorder the Middle East and Central Asia via military power, to make all the world democratic, to expand NATO to embrace Georgia and Ukraine, to threaten or undertake preventive war against suspected proliferators, and to bring the entire world under intimate surveillance. We could save a lot of money if we stopped trying to do what we’re not very good at doing anyway.

The defense establishment is like a huge ship that is difficult to turn and next to impossible to stop in its tracks. But serious savings could be had by reducing force structure and limiting modernization. The most important step is to repudiate the Bush Doctrine and to rivet US military power to defensive purposes. The ground forces, slated to expand, should be reduced.

Obama is seemingly not ready to do any of this. Biden is more hawkish than dovish and will reinforce the tendency toward business as usual. But stark financial constraints and the accompanying search for limits on external ambition will define Obama’s presidency; he needs to realize that sooner rather than later.

First posted: 11/02/08

California at Height of Bubble

2008-10-16T22:47:00.004-07:00

The inflation and subsequent puncturing of the housing bubble has played a great role in the unfolding crisis. Housing is vital because it is the collateral behind a great deal of US debt. Essentially, a great pile of debt and derivatives was erected on a dubious foundation. A leader of the pack was California. With a little money down, which was still required at the beginning of the boom, and you could just print money.

California, like Florida and Arizona, was an extreme case. But the mania was general. From 2000 to 2006, the total retail value of housing in the United States doubled, going from roughly $11 trillion to $22 trillion in just 6 years.

As of October 2008, the situation had deteriorated dramatically.

At the end of 2008, Mr. Mortgage delivered yet more New Year's glum in this table, which he calls "the scariest housing-related chart ever."

In the Long Run We're All Dead

2008-10-16T22:46:00.000-07:00

This New York Times graphic shows the valuations of housing when a house was just a home (and not a vehicle for speculation).

Financial Firm Profitability and Real Estate

2008-10-16T22:16:00.000-07:00

A vital source of the profitability of financial firms arose from mortgage-related assets, which includes both residential and commercial real estate. This graph, from Kevin Philip’s Bad Money, shows the importance of those toxic “mortgage related assets” to total earning power.

The Big House

2008-10-16T21:45:00.002-07:00

This Financial Times chart, from March 2008, shows the close link between US equities and visits by prospective homebuyers. The housing data, from the National Association of Homebuilders, is advanced twenty months to show that housing is a leading indicator for the stock market and the economy.

Regional Variation in Housing Declines

2008-10-16T21:30:00.000-07:00

Since the bubble burst, there has been plenty of regional variation in housing patterns. The worst hit areas are Phoenix, Las Vegas, Miami, San Diego and various other cities in California.

Calculated Risk, October 1, 2008

US Homeowners with No or Negative Equity

2008-10-16T20:59:00.002-07:00

In this chart, Calculated Risk makes an estimate of the number of US homeowners with no or negative equity in their homes. At the end of 2008, according to CR, the figure is likely to be 15,433,000. If housing falls 30 percent from the peak, 20.5 million homeowners would be underwater; if it falls 35 percent from the peak, 23.4 million would have no or negative equity. How big the mortgage losses would be depends upon how many people walk away from their homes.

As Calculated Risk explains: "As of Q2 2008, prices had fallen almost 18% from the peak, and for the graph, I estimated that prices will decline about 22.5% from the peak by the end of 2008. (this seems conservative). This means about 15.4 million households will be underwater or already foreclosed on by the end of 2008.

The last two categories are based on various estimates for the price bottom (peak-to-trough). The 30% decline was suggested by Paul Krugman in December 2007: What it takes). The 35% decline is close to the "severe recession" case presented by JPMorgan last week.

Not every homeowner with negative equity will default, in fact many of these homeowners will only be underwater by a few percent. But if we estimate one half of homeowners with negative equity will eventually default, use a 50% loss severity, and a 35% price decline (23.6 million households with negative equity), and use the median house price from the Census Bureau of $216 thousand, we get $1.3 trillion in mortgage losses for lenders. I think this is probably high (probably fewer than 50% will default), but this does give a general idea of the potential losses.

If we use one third of homeowners, the mortgage losses with a 35% peak-to-trough price decline would be about $840 billion."

One in Six Homeowners Under Water

2008-10-16T20:58:00.001-07:00

The Wall Street Journal reports that the fall in home prices "has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults. . . . About 75.5 million U.S. households own the homes they live in. After a housing slump that has pushed values down 30% in some areas, roughly 12 million households, or 16%, owe more than their homes are worth, according to Moody's Economy.com.

The comparable figures were roughly 4% under water in 2006 and 6% last year, says the firm's chief economist, Mark Zandi, who adds that 'it is very possible that there will ultimately be more homeowners under water in this period than any time in our history.'

Among people who bought within the past five years, it's worse: 29% are under water on their mortgages, according to an estimate by real-estate Web site Zillow.com." 10/08/08

Not everyone is taking it well.

World Stock Market Capitalization Crumbles

2008-10-16T17:00:00.003-07:00

Click this link for an updated version of the Dow Jones World Stock Index. Math whizzes, please tell me how much it would be worth if it hit the lows of 2003.

This page from stockcharts can be used to see charts on a wide variety of other financial indices.

10/26/08

Twin Peaks

2008-10-16T16:59:00.006-07:00

This lovely mountain view from Jesse's Café Américain gives the last twenty years of financial history at a glance. The chart was made on October 10, 2008. For more historical perspective, see the bear market interactive chart at the New York Times.

Stock Market Volatility

2008-10-16T16:59:00.002-07:00

Stock market volatility in early October 2008 surged beyond any comparable level in the post 1945 era. Only the 1930s displays comparable mayhem. Bespoke Investment Group explains the above graph as follows: “Over the last month (23 trading days [since October 3, 2008]), the S&P 500 has seen 10 days where the index rose or fell (mostly fell) by more than 3%. You have to go all the way back to 1938 to find another one-month period where there were this many 3% days. As shown in the chart, there were many multi-year periods between 1950 and 2007 where the S&P 500 didn't have even one 3% day. If you're not a regular market participant and someone that is tells you we are experiencing something that hasn't happened since the Great Depression, they're not joking!”

Kim Zussman, in "Mother of All Swans," has also put together a long term historical chart measuring volatility. Zussman used the daily returns of the Dow Jones Industrial Average from 1928 to early October 2008 and calculated the standard deviation for every non-overlapping 10 day period. The Crash of 1987 is still at the top of the charts on this one.

Both charts above were made in early October 2008. Here's the latest snapshot of two widely used measures of volatility, the VIX and the VXO (click for updates). As you can see, both blew well past the post-1945 record as measured by Bespoke and are back to the wild levels of the 1930s.

Markets, despite being the results of millions of individual decisions, have personality. Sometimes they are the very picture of bourgeois respectability. At other times, like now, the alternating moods swings of euphoria and panic resemble the turbo-charged highs and suicidal lows of a crack addict. "Nothing better! I'm gonna die!" Such is the wonderful world of the American capital markets, circa 2008.

If you want to learn more about volatility, the go-to-guy is Bill Luby at Vix and More.

High Yield Bonds Over 20%

2008-10-16T16:46:00.004-07:00

This New York Times graphic is updated daily for high-yield bonds as well as other measures of credit stress.

This is bad news for businesses dependent on access to the credit markets, some of which face impossible rates above 20 percent to borrow anything. It’s also bearish for stocks, because bondholders get paid off before stockholders in a liquidation.

High Yield Credit Spreads Top Levels of 2003

2008-10-16T16:45:00.017-07:00

This chart from Bespoke Investment Group shows the “spread” or difference in yields between two classes of bonds: high yield or "junk" bonds and comparable Treasuries issued by the U.S. government. High yield bonds do well in times of economic expansion, as investors anticipate the great returns from the scenarios sketched in prospectuses. They do poorly in times of contraction, as the yields are driven higher (and the price lower) by fears of bankruptcy. The snapshot above was taken by Bespoke on October 2, 2008.

The chart below (click for updates) measures the same thing as the chart above, but does so by taking the ratio between two exchange traded funds (HYG & TLT) that are proxies for high yield bonds and comparable long-term Treasuries. The panic in the week of October 6-10 drove the ratio down more than 30 percent from mid-summer 2008. "The corporate bond market," wrote one specialist on October 21, "is a broken shattered vessel and a shoddy reminder of its once mighty and powerful self."

AAA Corporate Bonds: Compared To What?

2008-10-16T16:44:00.006-07:00

While we're on the subject, there's two other relationships to monitor.

One is the ratio of investment grade corporate bonds, rated AAA, with US Treasury bonds. That ratio has been going down, in a "flight to safety."

The other is the relationship between investment grade corporate bonds and high yield corporate bonds. That ratio has been going up, also in a "flight to safety." (click for updates).

Remember: these are not just squiggles on a chart. They have profound implications for the health of businesses and for future levels of unemployment.

Crazy World Order

2008-10-16T15:59:00.009-07:00

This (somewhat dated) chart from the Economist sets forth in a nutshell the evolution of the world economy over the last fifteen years. Economists called this “Bretton Woods II.”

If you look closely enough, you can see the following: China and other emerging markets grew into export powerhouses. American corporations moved manufacturing “offshore.” To finance the purchases of foreign goods, Americans went into debt. Who lent us the money? By and large, the people who were sending us the goods.

The explosive growth of exports from China and the emergence of the US credit bubble were opposite sides of the same coin. Americans borrowed money to buy homes and saw them appreciate tremendously in value. Wall Street bought the mortgages, sliced and diced them, and sold them to foreign investors with a grade AAA seal of approval, courtesy of oblivious ratings agencies and undercapitalized insurers. Exporters bought the paper. In recent years, the United States sucked in 85% of the world’s savings. It turned out that Chinese peasants were speculating (they bought the paper courtesy of their central bank) in the wild manias of Miami, Phoenix, and Inland Empire real estate. (Until it started fleeing from agency debt, as it did in November 2008, China accounted for "about 50% of all central bank holdings of Agencies.")

It wasn’t that complicated of an arrangement. The world sent us its goods; in return, we sent paper (really, electrons) bearing promises to pay in the future.

That arrangement is crashing.

10/25/08

Deficit on Current Account Contracting

2008-10-16T15:58:00.009-07:00

At last count, the current account deficit increased to $183.1 billion (preliminary) in the second quarter of 2008 from $175.6 billion (revised) in the first quarter.

This chart, covering a five year rather than fifty year period, shows a broader contraction since 2006. Almost certainly it will continue to contract. For the debt to be paid, surpluses must be run. Will it be paid? Good question.

Our Best Friends: Foreign Central Banks

2008-10-16T15:57:00.005-07:00

(click to enlarge)

Foreign central banks have added greatly to their holdings of Treasuries over the past 2 years. While this was going on, Brad Setser commented (April 14, 2007) that the world's biggest current account deficit had been "financed almost exclusively by the official sector over the last two quarters."

On this point, questions abound: Will the official sector continue to step up to the plate? Do they have any choice? Can government decisions arrest, mitigate, deny the broader pull of private capital?

Flight to Quality by Foreign Central Banks

2008-10-16T15:50:00.010-07:00

So is there a difference in the US government guarantee of Treasury debt and "agency" debt--that is, the debt issued and guaranteed by Fannie Mae and Freddie Mac? Foreign central banks apparently think so; they have made a big change in their buying patterns over the past several weeks, as this chart from Brad Setser shows.

Setser explains the graph as follows: "Over the last 52 weeks, foreign central banks have added $321b to their Treasury holdings at the New York Fed (and no doubt more to other accounts) and $147b to their Agency holdings — for a total of $468b. And there clearly has been a big shift towards Treasuries recently. The rise in Treasury holdings over the last two weeks, annualized, tops $1 trillion. The fall in Agency holdings over that period (after the bailout of the Agencies), annualized, also tops $1 trillion."

That is interesting. Foreign central bankers are not just thinking about the maintenance of their currencies; they are thinking about credit quality, just like private investors are doing.

10/16/08

The End of Bretton Woods II

2008-10-16T15:40:00.016-07:00

The great imbalances had to end. Nothing like that could possibly go on forever, right?

It seems apparent that the arrival of "Peak Credit" will have profound implications for those imbalances and for the world economic disorder to come.

China stands to suffer as much, perhaps more, from this unraveling as the United States. Pity the creditor, who built up an enormous export industry directed to the American market, funded its ravenous appetites, and has now made the unpleasant discovery that his debtors are deadbeats.

We shall see what this means for Chinese exports, but the following older chart, incorporating data as of August 2006, shows how closely the growth of exports tracked the H-Share index of Chinese shares traded in Hong Kong.

Here's a snapshot of another H-Share index as of October 17, 2008. It suggests that exports will follow share prices down.

The logical choice for China is a big domestic spending program, reworking its factories and investments to improving the standard of living of ordinary Chinese. A novel concept: make things for themselves rather than for us. They have gotten with the program in this regard.

This is not, in the first instance, “decoupling”—China will suffer greatly from the bust. But it does portend a new monetary system. As a “reserve currency” in the sense in which we have known it for a very long time, under the two Bretton Woods regimes, the dollar is kaput.

Though some believe that China's appetite for US Treasury debt will not wane, there is a strong countervailing argument. Notes Ronald Solberg: "The concept of Bretton Woods II -- wherein foreign investors were the lender of last resort extending vendor financing for their exports sold to the US (consumer) -- was predicated on the stability of sustained household consumption. With the US household suffering from declining home prices, falling real wages, job loss and collapsing confidence, the American consumer will take years to recover their former spendthrift ways. With this missing critical link in the global relationship, it is suspect whether foreign governments will be willing to significantly increase their holdings of US dollar debt, if there is not the quid pro quo of increased export receipts from further US consumer spending."

Russ Winter also sees the same dynamic: "The half trillion dollar domestic spending initiative from China has neutron bomb potential," he wrote on November 10, 2008. "As Asia (and others) have the savings pools and currency reserves, this also means they have the capital to carry out their plans. I believe they are going to be 'calling home' monies previously lent to the US to do so, and will be MIA when future funding is asked for. Thus this could serve as THE Pearl Harbor moment for the US, and make the big bailouts and monster borrowing plans highly problematic without much higher interest rates."

For background on "Bretton Woods II," see the 2004 paper by Roubini and Setser and the update by Setser here.

Recall also that Japan had a 15% rate of domestic saving in the early 1990s after their bust; the government's subsequent massive borrowing could be financed by Japanese households, whose purchases of government debt kept bond prices low. That is not the case with US households today.

11/29/08

Deteriorating Balance Sheet at the Fed

2008-10-16T14:44:00.004-07:00

This chart with data from late September 2008 shows how sharply the balance sheet of the Federal Reserve had deterioriated towards the end of that month. Though the initial "Paulson Plan" was styled as a rescue of the banks, it was primarily a recapitalization of the Federal Reserve. The imminent demise of the US central bank was among the terrors evoked by US officials in their demand that Congress pass the legislation immediately.

The Greatest Bailout of Them All

2008-10-16T10:23:00.014-07:00

This chart, which initially appeared here in early to mid October, attempts to show the relative size of the Paulson Plan’s $700 billion authorization to buy up impaired securities from financial firms; follow this link for a brief history of the various bailouts.

This is a pretty cool chart, but look for it to undergo radical revision in the months and years ahead. That big blob on the right, in all probability, is going to get much larger. The AIG and Fannie/Freddie bailouts really belong in the big blob, and the AIG bailout is now $123 billion (oops, $150 billion) as opposed to the $85 billion first estimated. The Fannie and Freddie total ($200 billion) is the amount the Feds injected into these firms, but in all likelihood will not cover the potential liabilities on the bonds, which could be very large. Ultimate costs for the Savings and Loan bailout of the early 1990s are estimated at $220 billion, of which taxpayers were responsible for $178 billion. But initial estimates were only $20 billion. Funny how that works.

Think back to those initial estimates of the Iraq War's likely cost--No more than $50 billion! It will practically pay for itself!--and you will be in the right frame of mind to assess current governmental expectations. 10/16/08

Update, 11/28/08: I will keep the previous chart up as an artifact of happier days, but the size of the big blob has been advancing fast and furiously. Two separate estimates, one by Bloomberg and the other by the San Francisco Chronicle, give the latest estimates at $8.5 trillion (as of Thanksgiving, 2008). The first chart was put together by Jake of Econopic and given a few finishing touches by Jesse. The table at the bottom is from the Chronicle, via, Tim.

One More Bad Thing

2008-10-15T20:04:00.016-07:00

The gross excess displayed in the housing bubble and the debt binge are serious enough. They would portend, under any circumstances, profound financial distress and economic hardship. But there is one more danger that really does set this crisis apart in financial history, which has its fair share of crazy manias and shattering crashes. At the apex of this mountain of debt are financial derivatives of decidedly recent invention. Created, paradoxically, to manage the “risk” of taking on so much debt, they added a whole new layer of leverage to the system. Warren Buffet called them "financial weapons of mass destruction" for good reason.

This chart estimates the notional exposure to derivatives in the US banking system at $160 trillion; estimates for the world are usually around $600 trillion, following the Bank for International Settlements, though some estimate it as high as $1,000 trillion. Hey, it's only one quadrillion. This compares with a world GDP of some $60 trillion. “Notional” refers to the value of the underlying assets on which the derivatives are based, not to be confused with the “net” exposure of financial institutions, of which more later.

These instruments, despite their enormous size and implied leverage, have almost entirely escaped governmental regulation. They do not trade on an exchange; they are illiquid and highly complex. Their massive growth, which violated long-standing rules of financial probity, occurred under the watchful eye of the Bush-Cheney administration.

Next time someone says that “everyone is to blame” for the financial crisis, please do me a favor and trot out this chart. Indubitably, at the top of the Wall of Shame should be the custodians of the financial system since 2001, who aided and abetted the construction of this indefensible “house of cards.”

The New York Times also has a nice graphic showing the amazing growth of derivatives since 2002.

October 15, 2008

Credit Default Swamps

2008-10-15T19:33:00.013-07:00

Especially alarming is the large growth in credit default swaps in the US Banking system. This chart from contraryinvestor shows only $16 trillion in exposure, while it is generally estimated (no one really knows) that there are some $60 trillion outstanding worldwide.

Credit default swaps can be understood in one of two ways: as insurance underwritten against the risk of default, or as “naked put options.” In either case, they are sold in order to collect the premium. Wizened traders call this picking up pennies in front of a bulldozer. This strategy, together with "securitization," was a huge source of profit in recent years for the FIRE economy, more important than gaming the markets through inside information.

Unfortunately, the banks and insurance companies that pledged this protection did not have the capital to back up these claims in case of default. That responsibility now falls on you, Mr. and Mrs. Future Taxpayer.

Happiness Through Bilateral Netting

2008-10-15T18:55:00.021-07:00

This chart shows that US Banks offset their exposure through “bilateral netting.” But the “Value at Risk” formulas on which these contracts are based, notes Contrary Investor, assumed 100% counterparty solvency and liquid markets, neither of which exist at this point in time. This chart in effect shows the potentially cascading consequences of defaults within the system.

The American International Group and Lehman Brothers collapses in September 2008 were especially important. Essentially, they threatened to destroy the “hedges” that other institutions had put on their various exposures.

How big is this "counterparty risk?" That is not clear. The settlements from the workout over the Lehman bankruptcy seemed to cheer the markets as not as bad as had been feared, but the whole thing is a vast swamp of which the extant public information is extremely limited.

This "transparency" question is in basic ways the most damnable aspect of the entire thing. The utter lack of any transparency is a vast satire on the many lectures given, to Asians and others, by American financial leaders for the past ten years and more. Think of the pious political or religious leader caught in flagrante delicto, and you will have acquired a clear picture of the moral significance of the financial crisis. Except it's a lot worse, being in the realm of calamitous consequences to the public good, both here and abroad.

Despite continued paeans to transparency, pledged by both Bernanke and Paulson in congressional testimony, the Federal Reserve, notes James Quinn, "has since withheld the names of all financial institutions that have borrowed from the Fed - and will not reveal the collateral that they have put up for those loans. Bloomberg News has sued the Fed under the Freedom of Information Act to force it to reveal where $2.2 trillion of taxpayer money has gone. The Bloomberg lawsuit argues that the collateral lists 'are central to understanding and assessing the government's response to the most cataclysmic financial crisis in America since the Great Depression.'"

Ha! $2.2 trillion! That seems a bit dated now! As of November 24 Bloomberg totes up the guarantees at over $7 trillion. Barry Ritholtz sees it going to $10 trillion. About the collateral behind these public guarantees, for which the taxpayer is on the hook, we get bland assurances but no information. The trenchant Willem Buiter makes the case here against Bernanke's transparently weak justifications for total secrecy. "This form of Publikumsbeschimpfung by the central banks is simply not acceptable in a democratic society."

11/29/08

The Mothership of the Derivatives Structure: JP Morgan Chase

2008-10-15T18:47:00.007-07:00

JP Morgan Chase is the queen bee of the derivatives structure, with something like 50% of all derivatives exposure. It was undoubtedly a “counterparty” to Bear Stearns on a large number of derivatives, which helps explain the “rescue” engineered by the Fed. Though this was styled as a rescue of Bear Stearns, it was also, and perhaps more importantly, a rescue of JP Morgan. Now the funny thing is that JPM has held up better than any other financial institution in the maelstrom, though it has the most exposure to the entire derivatives complex--that is, it would seem most exposed to "counterparty risk." And yet it almost broke out to a new high during the October 2008 maelstrom. Strange.

Leverage Ratios at European Banks

2008-10-15T18:03:00.003-07:00

It is not only US financial institutions that are in jeopardy from the credit crunch. American International Group, rescued by the US government in September 2008, wrote between $300 and $450 billion of credit insurance for European banks, which enabled the the stolid Europeans to maintain leverage ratios way beyond prudent lending standards. How much of this is impaired? AIG extended those guarantees, as it explained in its last annual report, “for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee.” In effect, as Paul Kedrosky comments, “AIG thus helped to organize regulatory arbitrage on a gigantic scale.” The impending liquidation of AIG forces these banks to “find other ways of obtaining the ‘regulatory capital relief’ they appear to need urgently.” Hence the massive rescue programs mounted by European governments.

Source: Paul Kedrosky. More here.

October 15, 2008

Leverage Unbound at the Investment Banks

2008-10-15T00:00:00.007-07:00

This chart from the Milken Institute demonstrates the excesses of the credit boom and also suggests why all five investment banks have either gone out of business (Lehman), been folded into another bank (Bear Stearns into JP Morgan, Merrill Lynch into Bank of America), or converted to a bank holding company (Goldman Sachs and Morgan Stanley). The investment banking model, as it prospered in this decade, came to rely on “securitization”—collecting enormous fees for bundling together various debts—and “insurance” for guaranteeing the debt via credit default swaps, each strategy then being levered to the hilt. The model depended on the ready provision of short term credit. It’s now dead as a doornail.

One interesting feature of this chart is that it shows leverage in the high teens to high twenties in 2000. Recent attention (see Barry Ritholtz) has focused on the 2004 rule change by the Securities and Exchange Commission removing leverage requirements. According to press accounts, the net capital rule, imposed in 1975 to regulate the broker dealers, required “that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.”

So explain to me: how is it that the investment banks are shown in this chart as having leverage ratios as high as 28 to 1 in 2000? If the facts are as they are described in the Milken Institute chart, we must ask: Was it brought to the attention of the SEC in 2004 that the investment banks had been blissfully ignoring the regulation for oh these many years? Were they or were they not in compliance? How did this happen? Who is responsible?

LIBOR and Financial Stress

2008-10-14T22:55:00.003-07:00

(click to enlarge)

Adjustable rate mortgages, credit cards, and student loans are linked to LIBOR, as this graph from Bloomberg shows. By shooting up over 400 basis points during the October crisis (click for updates), it made all of those much more expensive. The price of credit is going up sharply. In conjunction with the "resets" in adjustable rate mortgages, it will force a large number to pack it in. So there's tremendous hardship in those "400 basis points."

The following chart from the St. Louis Fed looks at the LIBOR/OIS spread as a summary indicator of financial stress, and shows the significant worsening in September/October 2008.

Flame-Broiled Mortgage Spreads

2008-10-14T22:51:00.011-07:00

The spread (or difference in yields) between five year Fannie Mae notes and similar Treasury notes has traditionally also been a sign of financial stress, and the spread passed historic levels on October 14, 2008.

This relationship is complicated. Fannie Mae was brought into government receivership in 2008 after its stock price collapsed in the summer. The US government has guaranteed the debt, with apparent conviction. Yet if the US government stands behind the “agency debt”—named after the “Government Sponsored Enterprises” or “G.S.E’s,” of which mortgage buyers Fannie Mae and Freddie Mac are the biggest and baddest—why shouldn’t treasuries and agencies trade at the same value? Why the premium? If Mr. Market distrusts the U.S. Treasury regarding the agency debt, why should he be super-confident about the Treasury debt? Here are a couple of factors--unintended consequences from the Treasury bailout, a sharp drop in foreign central bank buying--that are relevant in considering these questions.

It is possible to spend your existence pondering such matters, which thank God I have not done (until recently).

TED Spread from 1980s

2008-10-14T22:50:00.002-07:00

This chart gives a long term view of the TED spread--that is, the difference in yield between Treasury bills issued by the U.S. government and the 90 day Eurodollar. At 2% when this chart was drawn, it subsequently shot up to 4.64% on October 10, 2008. There is an updated version available at the New York Times and Bloomberg. Further discussion at Macroblog, where this chart first appeared.

Commodities Tank

2008-10-14T22:47:00.004-07:00

The Baltic Dry Index is a leading indicator of industrial production and trade (click for update). It charts the cost of freight movements in 26 of the world's biggest shipping lanes of "dry" materials, such as coal, iron ore and grain which feed into the production of finished goods some weeks or months ahead. It rose above 11,600 in July 2008 and subsequently fell to 715 on November 28, 95% below the June high (click for updates).

This collapse in the BDI was the most dramatic exemplification of the sudden and brutal bear market in commodities, and shows the intimate relationship between the credit dysfunction and world trade. The "inability of shippers to get banks to accept letters of credit from other banks" notes Yves Smith, will lead, if not reversed, to "Smoot Hawley on steriods."

You can see the powerful disinflationary forces across the commodity sector in the series of links gathered by Russ Winter at his perceptive Winter Watch:

"Coffee, higher costs to the economy? No, abating.
Drinks and beverages? Maybe Joe can afford his sixpack again.
Metals, higher costs to the economy? No, enormous relief.
Copper cathode for transmission lines? huge relief
Logs? Timberrrrrr!
Rubber? meets the road
Rice, panic buying? No, hoarding bubble has burst.
Oranges, prices killing consumers? Nao mais.
Beef? Rollar coaster but on the down slope.
Shrimp? cheapest in years
Olive oil? cheapest in years.
Soybean meal used to feed poultry? the hyperinflationary spike is gone, good riddance!
Cotton for clothes? Look for big sale items this Christmas on clothes, and hardly distressed selling."

11/28/08

Consumer Credit Crashing

2008-10-14T22:43:00.012-07:00

From Bloomberg, October 20, 2008: "Borrowing by U.S. consumers fell in August by $7.9 billion, the most since statistics began in 1943, to $2.58 trillion as lenders curbed access to loans." Clicking the link above will take you to a snapshot of the latest data on consumer credit. This index excludes loans secured by real estate (also collapsing) but covers most short-term and intermediate-term credit extended to individuals. The September and October data will show it falling much further.

The now suddenly altered credit environment occurs against the background of the low levels of household savings. "From 1960 until 1990, households socked away an average of about 9 percent of their after-tax income." Thereafter, savings steadily declined, with Americans putting away less than 1 percent of income in the last three years. As these charts show, household balance sheets badly deteriorated.

Savings declined as Americans leveraged their cash to investments in stocks and real estate. How has that worked out? "Household net worth, as measured by the Fed, fell $2 trillion in the second quarter from a year earlier -- and that was before the stock market's nosedive wiped about $3.9 trillion off investors' portfolios in the past month and a half."

This is some kind of double whammy for the middle and upper-middle class, but it also affects the poor and rich. With both credit and wealth evaporating, the American household's "debt/equity ratio" has just done a moonshot.

Class assignment: Is this the "new normal"? Who does it affect the most? What are the implications?

One Big Happy Human Family

2008-10-14T22:42:00.008-07:00

This is a worldwide crisis; the global capital markets and the world economy are a tightly linked system. That is one of the meanings, perhaps the primary meaning, of “globalization.” How far it will “uncouple” because of the financial crisis is a great unanswered question.

One of the ironies of the meltdown is that the countries previously deemed most immune (China, Brazil, India, Russia) have gotten hit harder than the US market, where the crisis undoubtedly originated. That is something to think about. Do not underestimate the power of money to foster resentment, ill will, dark malicious feelings. Remember your Machiavelli, who advised the prince that it is better to be feared than loved, but in no case should he be hated: “above all he must abstain from taking the property of others, for men forget more easily the death of their father than the loss of their patrimony.” The losses are rousing the American people to anger. The same causes will produce the same effects abroad.

Emerging stock markets have fallen by about fifty percent and were hit especially hard in the October 2008 crisis (click for updates). Emerging market bond spreads have also widened considerably, though they are far from decade-ago levels. On this website you can see spreads on twenty different countries and regions. The following snapshot, taken on October 19, 2008, gives the view from 1997.

Class assignment: pick a country, read its press, and summarize the role the United States is seen to have played in the financial crisis by public opinion in the country.

The Banking System: The Issue of Trust

2008-10-14T22:39:00.002-07:00

Paul Kedrosky writes:

"People keep talking about the perils of nationalizing the banking system. Newsflash: There currently is no banking system, if by that you mean a network of organizations lending to one another and to quality companies in a predictable way. (Look at the spread on today's IBM issue for an example.) Instead, there are a bunch of paralyzed deposit-hoarding institutions stuck in a game theory experiment that no-one understands or can exit.

The solution to a systemic breakdown in tightly-coupled systems is to uncouple the systems, build in slack, and break the feedback mechanisms -- and not necessarily in that order. In this context you can do that most directly by either recapitalizing a select set of banks immediately, or by letting banks fail and consolidate. Either way, you end up with uncoupling and the eventually reappearance of trust, whether through a government backstop or through defaults and collapse. I tend toward the former approach, but I fully understand its risks and the attractiveness of the latter to some people.

Either way, trying to fix things on the fly, without breaking the feedback mechanisms, and without introducing slack to protect a fragile and badly damaged system from the next inevitable lurch, is stupid, destructive and childish."

The Banking System, Nationalization and Slack

This summarizes a crucial issue, but I strongly favor the less costly and more equitable proposal set forth by Luigi Zingales.

Carry Trades Unwinding

2008-10-14T22:31:00.006-07:00

In a "carry trade," speculators borrow money from a currency whose interest rates are low and invest in currencies where yields and opportunities are higher. When their investments crater, as now, they must buy back the currency whence they borrowed the funds. The Japanese Yen was the favored currency for carry trades in the recent past, and in the fall 2008 financial crisis the trade unwound savagely, as this chart of the Aussie dollar against the yen shows (click for updates).

The Euro/Yen cross has also taken a nosedive, though the longer term chart does not suggest unreasonable valuations at 1.19 (its price on October 24, 2008--click for updates)

The dollar has fallen sharply against the yen but risen dramatically against the Euro and most "emerging" currencies. In late November 2008 it touched 89 and had retraced nearly 38% of its decline from 2002. (click for updates)

This development confounded many expectations. Most political economists had imagined that a crisis, if it came, would be bound hand and glove with a dollar crisis, but the demand for liquidity has perversely created a tremendous demand for dollars, as liabilities must be settled in the "reserve currency." The dollar itself was a "carry currency": investors or speculators in commodities, notes Ronald Solberg, funded their positions "with US dollar-denominated credit, in effect, creating a US dollar short position. Now that these commodity carry trades are being unwound, it exacerbates commodity weakness and contributes to US dollar strength."

In the panic, European banks required to settle their liabilities in dollars expressed fury with Washington and New York for having been sold a bill of goods.

11/28/08

Future Housing Prices

2008-10-14T19:23:00.004-07:00

This chart from PaperMoney allows you to see not only the past trajectory of housing prices but also the future movement as projected in the futures markets, where the Case Schiller index is traded. Note that this snapshot, taken on October 14, shows a significant recovery in housing prices as estimated in these futures contracts. Good luck to those speculators! From the link above, you will need to check the date-boxes for the futures contracts at the bottom of the page, then update, in order to see the anticipated future prices.

Estimates of Losses

2008-10-14T19:00:00.018-07:00

Nouriel Roubini, a prescient observer who forecasted in 2006 and 2007 the financial crash, believes total credit losses will be "closer to $3 trillion'' than the $1 trillion to $2 trillion he previous estimated. Legendary prognosticator Marc Faber puts the total bill at $5 trillion. The International Monetary Fund put the figure at $1.4 trillion on Oct. 7, 2008. As of October 14, financial firms had reported $637 billion in losses, according to data compiled by Bloomberg.

Estimates of losses are inherently conjectural. For residential real estate, the question becomes: how many people walk away, such that the lenders absorb the losses, and how many stay in their homes, even though they are underwater? But housing is just one element of the picture. There are also credit card loans, auto loans, student loans, all of which have been hammered by the rise in interest rates. Commercial real estate, heavily dependent on the credit markets, was also driven to historic heights during the boom, with price to rental ratios reaching unprecedented levels. On top of this was overlaid the growth of extreme leverage throughout the financial system. Because of the interlocking nature of the obligations among financial institutions, the failure of several imperils the survival of all.

The great dilemma of government policy is fairly straightforward:

If financial institutions “mark to market” the various assets on their books, a great many are insolvent. To allow them all to fail would imperil the entire financial system and lead to a cascade of bankruptcies. On the other hand, to save them through governmental action risks “moral hazard” on an unprecedented scale, bailing out the foolish choices of Wall Street at the expense of taxpayers. It also imperils the balance sheet of the Federal Reserve and the US government.

The main point to keep in mind is that one cannot arrive at a just view of the government's bailout program without considering the likely scale of the losses. The higher these prove to be, the more irrational and wasteful will appear the current attempt to prop up financials and bail out current shareholders with public capital. It is only if the crisis we face is a liquidity crisis--a short term rush for unencumbered cash--that Paulson and Bernanke's approach stands a chance of vindication. But we have every reason to believe that insolvency is in fact at the root of the problem.

Cash for Trash: The Fed's Balance Sheet

2008-10-14T16:32:00.022-07:00

The government's strategy for dealing with the financial crisis, such as it has been, has been to exchange "cash for trash." This is definitely a work in progress, but as of October 8, 2008, this is how it looked. Note the stark contrast with the late September situation. The Federal Reserve is putting on to the government's balance all the bad stuff that was on the banks' balance sheets. You, American taxpayer, are now the proud owner of lots of "toxic paper," in the vast stratosphere of the "inverted pyramid" of derivative invention. Hooray. There is a guide to the acronyms in this report from Cumberland Advisors, where the chart appears.

In early November the Fed Balance Sheet Surpassed $2 trillion, and Dallas Fed President predicted it could surpass $3 trillion by January 2009.

Lee Hoskins, a former president of the Cleveland Federal Reserve Bank, sums up why Bernanke will win no plaudits in the Central Bank Hall of Fame: "The Fed has violated two principal tenets of central banking. First, don't lend to insolvent institutions, and second, don't lend on anything but the most pristine collateral -- and at a penalty rate."

The following chart from the November 22 Barron's, in which Hoskins' grim observation appears, sums up the data as of November 12, 2008. Barron's (which generally has been bullish all the way down, Alan Abelson apart) notes that were the Fed a commercial lender, "it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed's current capital ratio, or capital as a percentage of assets, is 1.9%." Its balance sheet, Jack Willoughby notes, " is as leveraged as any hedge fund's: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%." The loans will "self-liquidate" if the financial crisis eases but will be an albatross if it does not.

Contemplating these unprecedented moves in early October, blogger David Merkel assessed the implications as follows:

"What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from [private to public] hands. That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

* Inflation when the Fed monetizes the debt,
* Depression from vastly increased taxes,
* Debt repudiation (whether internal, external, or both), or
* Japan-style malaise for a long time."

Just how unprecedented the Fed's actions have been is also shown in this graph from West- Coast Whiner (Wcw), who frankly has a lot to complain about but maintains a generally cheery disposition. Notes Wcw: "Any time that a properly normalized series starts rivaling the freaking Depression, you have to worry."

12/01/08

The Linked Dangers Foretold (Sort Of)

2008-10-14T16:12:00.013-07:00

Martin Wolf of the Financial Times writes:

"These linked dangers between external and internal imbalances, domestic debt accumulations and financial fragility were foretold by a number of analysts. Foremost among them was Wynne Godley of Cambridge university in his prescient work for the Levy Economics Institute of Bard College, which has laid particular stress on the work of the late Hyman Minsky."

Brad DeLong has a different take:

“We—all of us from Nouriel Roubini to Lawrence Summers to John Taylor to Tim Geithner (except perhaps Ben Bernanke, who really did seem to believe in a long-run global savings glut)—were expecting a very different financial crisis. We were expecting the Balance of Financial Terror between Asia and America to collapse and produce chaos. We were expecting a free fall in the dollar’s value that would push and be pushed by large-scale capital flight from America that would produce high interest rates and a collapse of construction and investment. We were expecting a collapse of imports into the United States that would produce a free fall in employment and in political stability in Asia. We expected the Federal Reserve and the U.S. Treasury to be powerless—for we expected the safe asset that banks and investors would scramble for in the chaos to be anything but U.S. Treasuries and reserve deposits at the Fed. And for the avoidance of a catastrophic balancing-down of the world economy we expected the United States to have to depend on the kindness of, well, not strangers exactly but of a disorganized congerie of national Treasuries and central banks that were unused to a world without a Kindlebergian hegemon.

We are not having that financial crisis. And it looks like we will not have that financial crisis: if the past year’s financial chaos in New York has not provoked a run on the dollar, it is hard to envision a scenario that would. Instead we are having a very different financial crisis: catastrophic failures of risk management throughout the entire banking sector have caused a relatively minor—by the standards of the global economy—collapse in housing prices in Riverside County, CA, Dade County, FL, and a few other places to freeze up global finance to a degree that has not been seen since the Great Depression. The first good thing about this situation is that it does not call for different central banks and Treasuries to do different things, but rather for them all to do the same thing in unison without fouling each other’s oars.”

I see a couple of problems with DeLong's analysis. One point is simply that those expectations may yet prove to be true. It isn't over. The sharp rally of the dollar in the fall of 2008 was against the background of its previous sharp decline and reflected an "artificial dollar shortage."

Not to be picky, but it's also misleading to pair "catastrophic failures of risk management throughout the entire banking sector," which undoubtedly existed, with a "relatively minor—by the standards of the global economy—collapse in housing prices in Riverside County, CA, Dade County, FL, and a few other places." The US housing mania was just the tip of a vast iceberg of debt.

The unbalanced US debt/World equity ratio must put continued pressure on the dollar or bonds, and probably both. We are getting high interest rates on everything except Treasuries (an anomaly primarily to be understood as a reflection of panic into anything that doesn’t fluctuate by ten percent daily); we will almost certainly get a steep fall in domestic construction and investment. The resentment caused by the way in which dollar dependency has inflicted pain and suffering on others, even though the crisis originated in the United States, is a profound long term negative for the dollar's status as a reserve currency.

The collapse of the American credit bubble will just as clearly lead to a crisis in Asian economies. The massive consumption fed by easy credit in the United States, with McMansions springing up in a distant wilderness accessible only by Hummers, is just the obverse of tens of thousands of Chinese factories geared to the western market. The deflation of the credit bubble here means bankruptcies and weakness there, a prospect that Asian bourses are clearly anticipating.

So I would say that we are getting that financial crisis, though via a route and with consequences that no one exactly foresaw.

Measuring Inflation

2008-10-14T15:33:00.008-07:00

Measures of financial stress in the real economy are obfuscated by the unreliable nature of government statistics. The guy who has delved most deeply into this is John Williams of Shadow Government Statistics, whose perspective is summarized in this February 2006 interview. In this chart, the red line shows the “headline” inflation figures given out in official government releases. The SGS Alternate CPI is calculated according to the methodologies in place in 1980.

Total Credit Market Debt is Way High

2008-10-14T13:35:00.003-07:00

This little chart from the Financial Times is, as it were, the master chart, the one that tells you just about everything you need to know about the debt problem. Total credit market debt as a percentage of GDP reached 350% in 2008, with financial, government, non-financial, and household debt making new records.

The FT graph is a bit sly in its representation of government debt, as it almost seems the thing is contracting. Appearances are deceiving, as we see below.

The three graphs that follow, courtesy of Contrary Investor, give a better breakdown of the overall picture from the non-governmental side of things.

The rise of financial debt has been the most meteoric, growing from almost nothing in the 1950s to nearly 120% of GDP in 2008.

Household debt took off in the 1980s and is now about equal to GDP, way above the long term average.

Non-financial corporate debt seems a piker by comparison with these debt-imbibing sectors, but it too followed the trend, rising from less than 25% to nearly 50% of GDP since the 1950s.

Yves Smith observes that the official debt estimates need to be treated with some caution. "There are some items that are arguably overstated (lines of credit are included at their full amount), but others are not included (second and third mortgages, and perhaps most important, contingent exposures like AIG's credit default swap guarantees)."

11/25/08

Debt to GDP from 1920s

2008-10-14T13:31:00.006-07:00

Like the previous chart, this gives total credit market debt as a percent of gdp, but over a longer period of time--from the 1920s.

Note the big surge in the ratio that took place during the Great Depression. That was due not to the expansion of debt but to the collapse of GDP. The collapse of incomes and the deflation in prices made debts contracted during the 1920s boom two or three times more onerous than previously, precipitating default and bankruptcy.

It is the comparison between our current 350% debt/GDP ratio and the 140 to 170% ratio during the 1920s and the 1945-1980 period that is most striking. Over the long run, that lower ratio may come to appear much more “normal” than our recent stratospheric attainments. A happy and healthy capitalism = debt/GDP ratios below 170%? I’m mighty tempted by that hypothesis, personally.

History is Not Bunk

2008-10-14T13:30:00.012-07:00

Here's an even longer term view, though measuring non-public debt as a percentage of GDP (rather than, as in the previous charts, total credit market debt). The maker of the chart, with the red line, is suggesting the contours of a long or Kondratieff wave, but it is the gold line to which we draw attention here. It shows the unprecedented nature of current debt levels.

This is especially a problem for the Anglosphere--Britain and Australia also imbibed deeply the sweet elixir. The White Man's Burden, it turns out, is debt. The chart below from Australian economist Steve Keen makes the point.

In the midst of a debt crisis, the question naturally occurs: how is it that the authorities seemingly took no notice as debt levels reached these historically unprecedented levels? What were they thinking? Keen supplies a disturbing answer:

"It has happened because Central Banks are run by economists, and the dominant “Neoclassical” faction within economics ignored the real lessons of the Great Depression.

The false lesson that Neoclassical economics preaches is that the market economy is fundamentally stable, and the Great Depression was caused by the monetary authorities tightening credit in the aftermath to the Stock Market Crash, rather than loosening it.

The real lesson of the 1930s is that a credit-driven market economy is fundamentally unstable, and a Great Depression occurs when debt-financed speculation results in excessive private debt at the same time as inflation is low."

Under "the misguidance of conventional economic theory," and with their "Neoclassical eyes fixated on the rate of inflation," central bankers and other official organs ignored the huge buildup of private debt. "This is why the sudden collapse of the world economic order took economists by surprise. They were looking at their mathematical models, which ignore private debt (and indeed money!), rather than at the real world, where debt is king."

10/27/08

Profits of Financial Firms

2008-10-14T13:18:00.007-07:00

The profits of financial firms, as this chart from Kevin Philip's Bad Money shows, shot up to 40% of total corporate profits over the last two decades, far outpacing manufacturing. The chart goes to 2004, a fact which malign technological forces are preventing me from displaying properly.

Debt Fueled the Equity Boom

2008-10-14T13:14:00.009-07:00

Over the 2004-07 period, US corporations went on a share-buying spree, funded largely through increased debt. The blogger Suddendebt notes that “the net amount of equity withdrawn from US markets through buy-backs, buy-outs and LBO's . . . reached a record $210 billion in the 3Q2007, from near zero in early 2004. The US has never before experienced such a sustained equity withdrawal in the history of its public markets. In just four years between 2004-07 total net equity withdrawn came to over $1.6 trillion, an enormous sum when compared to US market capitalization (end-2003: $14.3 trillion, end-2007: $19.9 trillion). The effect was to provide a constantly growing underlying "bid" for cash shares, one that leveraged the performance of indices: while total capitalization rose only 39% in the above period, the S&P 500 index gained 67%, i.e. 70% faster. Where did the money for the buy-backs and LBO's come from? Some came from corporate earnings, which reached a record ratio of GDP; but most of it came from debt. Record low credit spreads and volatilities encouraged CFOs and private equity funds to buy shares with borrowed money . . . .”

In the first two quarters of 2008, the trend sharply reversed. See update from New York Fed (page 11).

The practice of going into debt to buy back stock leaves no margin for adverse fortune and has put many companies at risk. See Border's sad tale, as related by Jeff Matthews. Its $250 million share repurchase plan in February 2005, when the stock was $25, received plaudits on Wall Street but, as Matthews notes, "it crippled a once wonderful chain of bookstores." Its "repurchase program was far too aggressive. Five years ago Borders had a $1.9 billion market value and more cash than debt on its books. Today, Borders has a $50 million market value (yes, that’s right, $50 million) and more debt than cash. Like, $525 million in debt against $38 million in cash. Oh, and the stock’s current price? $1.00 a share." At best, notes Matthews, this reckless exchange of equity for debt has mortgaged the future; at worst it has destroyed the company.

11/28/08

Margin Debt

2008-10-14T13:11:00.009-07:00

Traders on Wall Street were also highly leveraged. Margin debt topped out at $381 billion in July 2007, surpassing the $275 billion achieved at the top of the tech and telecom bubble in 2000. A collapse in margin debt is part of the general deleveraging now ongoing. It contributes to market volatility as traders are subject to margin calls and forced selling.

The above chart, from the folks at contraryinvestor, is out of date, and margin debt fell sharply into the fall of 2008. The table below from the New York Stock Exchange shows it at $233 billion at the end of October 2008.

The column on the right showing credit balances in margin accounts provides an even more dramatic picture of the deleveraging: it fell from an all-time high of $386 billion in August 2008 to $187 billion in October 2008, down over 50%.

It will be interesting to see if the November margin figures show a decline to 2002 levels. If not, that would be a significant divergence from the equity averages, which for a time went through the 2002-03 lows.

Investment Tools has updated charts on margin debt here.

11/28/08

Consumer Debt Outstanding

2008-10-14T13:10:00.004-07:00

Consumers were not laggards in the debt accumulation business. Though mostly encumbered with home mortgage debt, consumer credit has also risen substantially.

About That Loan

2008-10-14T13:06:00.024-07:00

As households have gone deeper into debt, their "financial flexibility" has badly deteriorated, as Contrary Investor shows in this disturbing chart, definitely a contender for chart of the year.

Think about this in relation to the sudden increase in the cost of credit noted here and here, and you gotta conclude that household spending will decline precipitously.

This is our financial system: When going into debt would be bad for you, you can have all you want. When you need it, you can't have it.

National Debt as Percent of GDP (from 1950)

2008-10-14T13:06:00.012-07:00

This chart shows the great contributions to national indebtedness made by the Republican administrations of Reagan/Bush and George W. Bush. Thanks guys for the fiscal responsibility. Did you know that “defense is not a budget item”? Well, you haven’t been paying attention. “Deficits don’t matter,” as Vice President Cheney advised. Reagan proved it.

The Two National Debts

2008-10-14T12:45:00.012-07:00

How big is the national debt? $10.3 trillion? $5.8 trillion? Both those figures are bandied about, and both, strangely, are accurate in their way. The reason is that the government keeps two sets of accounts: the General Fund and various trust funds, the largest of which are Social Security and Medicare.

This chart is a snapshot from the moving clocks at zfacts.com, which are a wonder to behold. Clicking on the link (scroll down) shows a General Fund running deeper in the red and the trust funds as accumulating surpluses, such that the net national debt is now $5.8 trillion.

We know, however, that there will come a time when the trust funds for Social Security and Medicare turn from generating surpluses to deficits. The surpluses now accumulated, moreover, are not sufficient to cover the retirement needs of the baby boomers, and both Social Security and Medicare face severe long term funding problems. It is therefore reasonable to segregate the general fund from the retirement funds in estimating the national debt--that is, to place it at $10.3 trillion.

That figure is the debt we have accumulated to run the government, fight our wars, pay interest on the debt, and bail out our bankers. It, rather than $5.8 trillion, is the most apt figure for estimating the size of the public debt. As the national debt clock illustrates, that $10.3 trillion figure is growing rapidly. I mean, $16,637,366 in 174 seconds is pretty darn fast. But as the next chart shows, the $10.3 trillion figure actually understates the true dimensions of the fiscal gap.

October 17, 2008

Understated Obligations

2008-10-14T12:29:00.012-07:00

As this alarming table from Grant's Interest Rate Observer shows, the US government has obligations well in excess of that covered by its non-marketable securities and its bills, notes, and bonds.

*** Included in Grant’s reckoning are some $12.5 trillion in guarantees associated with the housing and financial sectors. A year and a half ago, the dominant view held these guarantees as very unlikely to be called and therefore not really countable against future demands on government resources. In 2008, we know better.

*** The Federal employee and veterans benefits, at $4.7 trillion, also do not appear in the official debt statistics, yet must be paid as surely as the interest on the Treasury bond.

*** Then there's the cavernous future, the deep deep pit, that compromises Social Security, Medicare, and Medicaid obligations.

Stairway to Heaven: Yet More Unfunded Obligations

2008-10-14T12:26:00.009-07:00

This graph from Grant's Interest Rate Observer shows spending on Social Security, Medicare and Medicaid climbing relentlessly after 2012.

Alarming as this is, that stairway to heaven is unlikely to be climbed; surely a day of reckoning will come before the entire geriatric class is supported by a small band of workers taxed at a 90 percent marginal rate. But it’s undoubtedly a huge bill as the worker-to-retiree ratio slips downward from 3:1 to 2:1.

Charles Hugh Smith shows below that we will have to keep running just to avoid falling down.

Total US Debt and US Debt/World Equity ratio

2008-10-14T12:19:00.014-07:00

This chart from the Grandfather Economic Report estimates total American debt at $53 trillion. Unlike the $48 trillion sometimes cited, Grandpa includes the federal debt to trust funds (but not other unfunded obligations in Social Security and Medicaid, nor the $12 trillion in financial and real estate guarantees).

Whatever the exact size of total US debt, it's fair to say that it is practically equivalent to world GDP, estimated at $60 trillion. As we saw earlier, world stock market value reached a high of $62.57 trillion on October 31, 2007 but had fallen to $42.21 trillion on September 30, 2008. It then shaved off another $10 trillion as markets crashed into late October. Let's peg it at around $30-35 trillion until updated figures come along.

Taking total US debt at $50 to $60 trillion, and world stock market capitalization at $30 to $40 trillion, we’ve still got total US debt at some 120% to 200% of world stock market value, gyrating daily. In other words, the debt owed by Americans is some 160% larger, give or take whatever, than the expected future earnings of all the world's publicly listed corporations!

Can this possibly be sane?

P.S. Surely econopicdata could serve us up with a nice set of charts showing variations on the "US Debt/World Equity Ratio." Thanking you in advance.

10/26/08

Slicing and Dicing Those Damn Derivatives

2008-10-14T11:58:00.011-07:00

Securitization is way too complex for ordinary mortals to understand, but the following discussion (shortened from Matt Miller’s deconstruction at thedeal.com) may help.

"About six in 10 subprime mortgages were securitized in 2003, which became part of a much larger pool called residential mortgage-backed securities (RMBS). At the beginning RMBS were packaged by mortgage type, but subsequently all mortgage types (Alt-A, conventional, jumbo and FHA/VA mortgages) were mixed and matched. FDIC-insured institutions alone held $1.2 trillion of these in 2006.

These mortgage-backed securities, given AAAs rating until June 2007, are part of a much bigger pool called asset-backed securities. That market totaled $10.7 trillion in 2006 and included commercial mortgage-backed securities, auto loans, credit cards and student loans.

At the next level, the underlying assets are divided primarily into a debt-recovery pecking order into tranches -- senior, mezzanine and equity -- and then pooled. These are called collateralized debt obligations. A CDO can be backed by everything from corporate bonds to real estate investment trusts. A collateralized loan obligation is a CDO backed by bank loans. The CDO market in 2006 totaled $2 trillion.

CDOs themselves can also be divided and combined in various fashions, then sold off. These funds-of-CDO-funds are called CDO squared. That process can be repeated with CDO squared, creating CDO cubed.
Leverage fueled the acquisition of these instruments at every level. The result: A 20% drop in value could easily wipe out an investment.

To mitigate the risk of failure, creditors and holders of these securities bought credit default swaps, a kind of insurance policy originally crafted for corporate debt. The market for these doubled from June 2005 to the end of 2007.

At beginning of 2008, the notional value of contracts outstanding stood at $62.2 trillion, while replacement value eclipsed $2 trillion.

Most of the firms that took the biggest role in issuing asset-backed securities (e.g. Countrywide, Lehman Brothers, Bear Stearns, and Washington Mutual) are now defunct."

OK, got that? Still confused? You may find further enlightenment in Charles Daví’s Derivative Dribble and in older posts at Sudden Debt.

See also this very clever visual guide to the crisis, via Barry Ritholtz.

The Housing ATM and Losses on Real Estate

2008-10-14T10:59:00.007-07:00

There are various ways of estimating likely total losses on residential real estate. Myself, I like this chart. If we return to the lending standards of the 1980s and early 1990s, when you had to put 20 percent down and get a fixed term mortgage at a high interest rate, it would follow that the equity withdrawals of the past seven years (the famed “Housing ATM”) will be roughly equivalent to the losses on residential real estate. Even if the government revives the mortgage insurers, such that households only have to come up with a 10 percent down-payment, the credit terms will not support (barring hyperinflation) a return to the prices that prevailed in the boom.

The main point: If we stipulate that it was above all a credit boom that fueled the real estate boom, the puncturing of that bubble will probably wipe out a good portion, perhaps all, of everything “taken out.” A lot of other factors--the vast oversupply of units, especially--will affect this question, undoubtedly, but I also like this "money taken out" as a reasonable metric for losses.

Another way of expressing this point is that manic conditions in the credit markets create "fictitious capital," a term from the Austrian economists (Ludwig von Mises and Friedrich Hayek). A rough definition of the term is capital multiplied by debt and leverage. Return credit conditions to some degree of "normality," and the fictitious capital disappears.

Extend the thought experiment: just how much value was extracted by the Wall Street money machine over, say, the last seven years? I can't find an aggregate amount, in nominal dollars, of total financial sector profits for that period, one inclusive of reported profits, bonuses, and other executive compensation, but such a thing could be constructed with some legwork. So, in our thought experiment, let's take that total and make an estimate of how much of the profit essentially derived from extremely artificial credit conditions, as with the "equity take-outs" in residential housing. Adjust the total profits by separating "that which is a good business in normal times" from "that whose business model was based on unlimited credit and high leverage." Then make an estimate of potential losses on the basis of that.

Analysts have spoken, with good reason, of privatized profits and socialized losses. My thought is a bit different: that probable losses can be measured in relation to previous profits. Certainly worth thinking about. It suggests a different criterion than either "mark to market" or "mark to maturity" in estimating "total losses."

Paulson Plan, circa October 14, 2008

2008-10-14T10:25:00.013-07:00

The plans they are a changin'. It's difficult to keep up. The latest iteration has the following features:

"Mr. Paulson said the Treasury would make $250 billion available to banks to help recapitalize those banks and to get them lending again, among themselves and to businesses and consumers.

In addition to injecting money into the banks, according to the plan, the United States would also guarantee new debt issued by banks for three years — a measure meant to encourage the banks to resume lending to one another and to customers.
The F.D.I.C. would also offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses — bringing the United States in line with several European countries, which have adopted such blanket guarantees.
And the Federal Reserve would start a program to become the buyer of last resort for commercial paper, a move intended to help businesses get the money they need for day-to-day operations.
On Monday, big banks agreed to take investments totaling about $125 billion. Citigroup and JPMorgan Chase will receive $25 billion each. Bank of America, which is acquiring Merrill Lynch, and Wells Fargo, which is acquiring the Wachovia Corporation, will receive $25 billion. Goldman Sachs and Morgan Stanley will receive $10 billion each. And Bank of New York Mellon and State Street will get $2 billion to $3 billion.
Another $125 billion is allocated for thousands of small and midsize banks. They will be eligible for government investments reflecting a similar proportion of their assets." (NYT, 10/14/08)
Update, 10/19/08:
This New York Times chart shows government commitments going off a cliff.

Losses and Liquidity

2008-10-14T03:00:00.024-07:00

What are losses? I can't really answer that question. I get the big concept, but the details elude me. The loss of some $25 trillion from the crash of stock markets would certainly seem to qualify as a loss, but it's not the sort of loss that people estimating losses are thinking about. They're looking at defaults and write-offs. At least I think that's what they're looking at.

Next question: What is money? What is liquidity? That's unclear to me too. One thing I do know: the old standard definitions--the now electric M1, M2, and MZM, the skyrocketing Adjusted Monetary Base, the late great M3--no longer suffice to understand money or liquidity.

In their booklet, New Monetarism (2006), two investment professionals, David Roche and Bob McKee, give an original take on the "what is money and liquidity?" question, an essential preliminary to the "what are losses?" question.

With this graph describing a "liquidity pyramid," the authors seek to see visually the new structure of money--the new world financial order that grew up over the last decade, now breaking. It is a world that is emphatically not captured by the traditional measures of money.

"Today global liquidity is like a massive pyramid standing on its head," they warned two years ago. "It represents at least ten years of GDP and is growing at least five times faster than GDP." There are four levels:

a) "At the bottom of this inverted pyramid is a tiny triangle of central bank power money."

b) That expands into "broad money," basically the only form of money recognized forty years ago.

c) "On top of broad money now comes a much bigger slice of the liquidity pyramid, composed of securitised debt markets, where much traditional bank lending now gets sold off as bonds."

d) "Finally, at the top come the massive derivative and other exotic asset markets, compromising nearly 75% of total global liquidity."

This was written in 2006. The term "inverted pyramid" was meant to suggest that the system could not long stand and would soon verify Minsky's hypothesis that a lengthy period of stability led inexorably to instability. They were right.

There is another important implication. The way we measure money, inflation, unemployment is so skewed by political convenience and bureaucratic habit, to say nothing of fossilized imaginations, that the reported aggregates are often worthless and usually misleading. Beware constructing theories on the basis of these official statistics. Students must frequently dig into the assumptions behind reported statistics in order for them to be at all useful.

So there we are. The "shadow banking system" is not captured in the traditional monetary aggregates, just as inflation and unemployment are not adequately captured in government statistics, with their convenient methodological adjustments.

Citizens! You are justly angered by the malefactors of great wealth! Spare some annoyance, at least, for Washington's misleading statistics.

10/25/08

Preparing for a Rainy Day?

2008-10-14T02:55:00.004-07:00

As the banks were taking ever more dubious loans onto their balance sheets, or hiding them off their balance sheets, as with the notorious SIVs, were they setting money away for the inevitable turn of the credit cycle?

Of course not. This chart from Barron's, though dated, shows the general tendency.

Household Debt as % of Compensation

2008-10-14T02:01:00.018-07:00

Estimates of losses cannot escape reckoning with the fundamental disparity between household debt and total employee compensation (wages, salaries, pension contributions). The same disparity, with a different formula, is expressed here. The total debt of American households was 79% of total compensation in 1978. It had more than doubled to 174% in 2008. “The problem is quite simple, all over the West,” explains the blogger Hellasious ("Hell as IOU's') at suddendebt.com. “There is too little earned income at the foundation of the economy to support massive debt and thus overinflated asset prices.”

In the right hand column of my blogbook is a mortgage calculator. Most college students are probably unfamiliar with how that works. But you will find out, one of these days. You should fiddle around with it, keeping in mind the ratio in the above chart. So:

* make your imaginary calculations in relation to the income levels of representative groups of Americans,

* make note of the difficulty faced by households in raising downpayments on a home (because of low household savings and falling values in the equity and real estate markets, where most household wealth is registered),

* then throw in the rising level of long term mortgage rates,

* and draw your conclusions.

Out of Whack: House Prices and Disposable Income

2008-10-14T01:42:00.005-07:00

Over the last decade or so, residential real estate got way out of whack in relation to disposable personal income. If lending standards return to the stricter ways forged from the last great deflation, it is difficult to see how this ratio can avoid falling at least to the range of the early to mid 1990s. Given the historic tendency of markets to overshoot, a return to the 120 range or below could easily occur. The old maxim says that the likely depth of the fall must be considered in relation to the mania that attended the rise. This is tricky because "real" values might decline while "nominal" values stabilize, which is dependent on the overall rate of inflation.

Source: http://www.oftwominds.com/blogjuly08/empire-debt7-08.html

Rent Ratios Mean Housing Will Fall Further

2008-10-14T00:25:00.001-07:00

This chart from the New York Times (October 16, 2008) suggests that housing prices have much further to fall. If credit conditions become tighter for mortgages, as they surely will without massive government subsidies, it makes renting far more attractive than buying.

The Importance of Being Credit-Worthy

2008-10-13T22:00:00.001-07:00

This chart, from data gathered by Albert Edwards, shows that tightening credit and worldwide default rates are soul-mates. Edwards' view is that a deep global recession is inevitable. He calls it "The Vortex of Debility." Nice phrase, ugly prospect.

Unemployment Mythologies and the "Misery Index"

2008-10-13T21:05:00.016-07:00

This chart, also from John Williams' Shadow Government Stats, shows the unemployment rate according to three different methodologies. The official rate in red is especially misleading because it is dominated by assumptions about job creation in a normal economic expansion (the so-called birth/death model). In 2008, it kept showing expansion in financial services and construction, when anybody who could read a business page knew that wasn’t so.

The Bureau of Labor Statistics calculates a broad measure of unemployment (U6), also given in the chart; Williams has adjusted for that in his SGS Alternate Unemployment Rate to reflect discouraged workers "defined away" when the methodologies were recalculated during the Clinton Administration.

Adding the inflation rate and the unemployment rate together gets you a "misery index." Coined by the economist Arthur Okun, the phrase entered the political arena in the 1970s, with Jimmy Carter declaiming against a misery index of 13.57 in the summer of 1976. Then Ronald Reagan made it a centerpiece of his campaign in 1980, when the misery index reached a high of 21.98.

According to official government statistics today, the misery index is at 13.5, a lot lower than it was in 1980, and you could go lower than 10 and be feeling awfully chipper if you used the "pce/deflator" to calculate inflation. But if you measure inflation and unemployment according to the methodologies in place in 1980, as Williams has done, it's at about 26.

Update: The Peterson Institute is out with a "new and improved" misery index (see the chart below) that pegs it at 24.2 in the first half of 2008, in contrast with an "official" rate at 13.5, a difference of 10.7 points. Gary Hufbauer and colleagues are using pretty conventional figures for inflation and unemployment--that is, a CPI of 8.4% for the first half of 2008, in contrast with Williams' estimate of some 12%, and an unemployment rate of 5.1% for the same period, in contrast with Williams' whopping 14%.

The Peterson innovation is to add some weightings for equity and real estate prices in its "augmented misery index," which boosts it to 24.2.

However, using Williams' inflation and unemployment numbers, and adding 10.7, gets you a misery index of 36.7.

Anybody for a drink?

The authors of the Peterson Institute study seem most interested in getting their misery index to talk to presidential approval ratings, whereas my main interest is in misery as such. In 2004, there was a guy with a website who showed the close inverse relation between gasoline prices and presidential approval ratings, and I admit to having studied this closely in that presidential race, thinking that it would matter. Then the Bushies engineered lower gas prices into the fall, indicating that they were studying this master political indicator with the same rapt attention.

11/02/08

If You Want More,

2008-10-13T21:00:00.012-07:00

The chart above shows the rate at which municipalities can borrow in the short term money markets. It is calculated every Wednesday by the Securities Industry And Financial Markets Association.

Here are a few other credit indicators highlighted by the blogger Accrued Interest.

Calculated Risk also promises a daily update on credit conditions. See here and here.

The St. Louis Federal Reserve has a good section on interest rates, plus much more.

Markit.com contains a wealth of vital information on credit derivatives. Unfortunately, the charts usually go back only about three months, so it is difficult to get historical perspective. Someone at markit needs to take this website in hand and give it a good scrubbing, especially in synthesizing the data and providing the historical material.

10/26/08

Minsky Moments

2008-10-13T20:58:00.005-07:00

In summation of these various indicators of financial stress, we have arrived at “The Minsky Moment.” Named after Hyman Minsky, an iconoclastic economist ignored by the mainstream, it refers to the time when market crashes create a severe demand for cash. Minsky foresaw that long periods of stability could subtly lay the ground for seismic periods of instability, and he propounded a sort of natural history of that process, one that well describes the current period of cardiac arrest.

At its core, as Justin Lahart explains the matter, “the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. ‘This is likely to lead to a collapse of asset values,’ Mr. Minsky wrote.”

So here we are at the Minsky moment with its mad scramble for cash and its collapsing asset values. Lahart wrote that on August 18, 2007, in The Wall Street Journal, and insisted that the Minsky moment had arrived. We have subsequently learned that the Minsky moment can span a yet longer period of time. We seem to be having a lot of these Minsky moments lately. Thou shalt not be a Minsky era, let us pray.

A Comparison with Japan

2008-10-13T20:57:00.002-07:00

The spectacular fall of Japanese markets after 1989, in which land and equity prices followed one another down in a long spiral, inevitably suggests comparisons with the contemporary American predicament. But the comparison provides no cause for optimism, for Japanese households, at the height of the bubble, had a high rate of domestic savings of 15 percent of household income. Yet this cushion did not arrest the fall in equity and real estate values. Household savings, calculated without reference to equities and real estate, have been zero for some time in the United States. And household finances are deeply impaired by high debt and collapsing asset values.

Keep this chart in mind as we go forward and survey US responses to the crisis.

A Cautionary Lesson from Japan

2008-10-13T20:48:00.006-07:00

How far could housing prices fall? Here's a bracing reminder from the Japanese experience after the equity and real estate markets fell apart in 1990.

Zingales is a Hero; Paulson is a Lout

2008-10-13T11:00:00.017-07:00

Luigi Zingales offers a plan far superior to that which Secretary of the Treasury Henry Paulson announced on October 14, 2008. The latter is an unconsionable bailout of firms that made extremely bad choices. That a public bailout should be offered without detriment to shareholders in financial firms--they of the absurd business models and catastrophic miscalculations--is a scandal. It is especially obnoxious because Paulson has a personal stake in the outcome and perpetrated himself while at Goldman Sachs many of the abuses now coming acropper.

The intellectual failure to offer rebuttals to competing plans or to give them serious consideration is a pathetic commentary on the quality of US economic leadership. Scare-mongering and threats of economic terrorism just about exhaust their arsenal of argumentation.

Congress ought not to have given Paulson what is essentially a blank check. It is their failure, too.

As compared with the Paulson plan, Zingales's proposal is a much better deal for the public, more respectful of basic principles of free enterprise, and more efficient in returning to a more normal credit environment.

The essence of the Zingales approach is to facilitate a process whereby insolvent firms are recapitalized in a two step process: existing shareholders are wiped out, as is the basic rule in treating with insolvent firms, and bondholder claims are converted from debt to equity. That constitutes an immediate recapitalization, addresses the fundamental problem of the debt overhang, and would allow a faster return to credit market stability than the approach the US government has favored. It is also far more consistent with elementary principles of justice and law. It is only a sort of “money grows on trees” attitude, and the ability of policymakers to confuse the public with a shell game in which true costs are minimized, that allows this to proceed. It has enormous opportunity costs.

The following extract from Zingales describes how governmental action could facilitate this recapitalization. His approach is a terrific example of the contribution that professional economists can make to public policy, combining an intricate knowledge of market incentives with shrewd legislative proposals that both facilitate the public good and affirm fundamental principles of law and justice. In light of the abuse that economists have received, even from within the breed itself, it remains important to remember that we depend upon the various geniuses resident within the profession to help us find a way out.

You should read the whole thing, but here is an extract from Luigi Zingales on how to recapitalize the banks.

"The core idea is to have Congress pass a law that sets up a new form of prepackaged bankruptcy that would allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are pre-specified and banks could come out of it overnight. All that would be required is a signature from a federal judge. In the private sector the terms are generally agreed among the parties involved, the innovation here would be to have all the terms pre-set by the government, thereby speeding up the process. Firms who enter into this special bankruptcy would have their old equity-holders wiped out and their existing debt (commercial paper and bonds) transformed into equity. This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. In other words, they are close to being insolvent. By transforming all banks’ debt into equity this special Chapter 11 would make banks solvent and ready to lend again to their customers.

Certainly, some current shareholders might disagree that their bank is insolvent and would feel expropriated by a proceeding that wipes them out. This is where the Bebchuk mechanism comes in handy. After the filing of the special bankruptcy, we give these shareholders one week to buy out the old debtholders by paying them the face value of the debt. Each shareholder can decide individually. If he thinks that the company is solvent, he pays his share of debt and regains his share of equity. Otherwise, he lets it go.

My plan would exempt individual depositors, which are federally ensured. I would also exempt credit default swaps and repo contracts to avoid potential ripple effect through the system (what happened by not directing Lehman Brothers through a similar procedure). It would suffice to write in this special bankruptcy code that banks who enter it would not be considered in default as far as their contracts are concerned.

How would the government induce insolvent banks (and only those) to voluntarily initiate these special bankruptcy proceedings? One way is to harness the power of short-term debt. By involving the short-term debt in the restructuring, this special bankruptcy will engender fear in short-term creditors. If they think the institution might be insolvent, they will pull their money out as soon as they can for fear of being involved in this restructuring. In so doing, they will generate a liquidity crisis that will force these institutions into this special bankruptcy.

An alternative mechanism is to have the Fed limit access to liquidity. Both banks and investment banks currently can go to the Federal Reserve’s discount window, meaning that they can, by posting collateral, receive cash at a reasonable rate of interest. Under my plan, for the next two years only banks that underwent this special form of bankruptcy would get access to the discount window. In this way, solid financial institutions that do not need liquidity are not forced to undergo through this restructuring, while insolvent ones would rush into it to avoid a government takeover.

Another problem could be that the institutions owning the debt, which will end up owning the equity after the restructuring, might be restricted by regulation or contract to holding equity. To prevent a dumping of shares that would have a negative effect on market prices, it is enough to include a norm that allows these institutions two years to comply with the norm. This was the standard practice in the old days when banks, who could not own equity, were forced to take some in a restructuring.

The beauty of this approach is threefold. First, it recapitalizes the banking sector at no cost to taxpayers. Second, it keeps the government out of the difficult business of establishing the price of distressed assets. If debt is converted into equity, its total value would not change, only the legal nature of the claim would. Third, this plan removes the possibility of the government playing God, deciding which banks are allowed to live and which should die; the market will make those decisions."

That's actually the second part of the Zingales plan. The first part addresses how to deal with the housing bust, which finds so many homeowners "underwater,” that is, owing more on their homes than they are worth. In the old days, renegotiation could take place between a bank and a mortgage holder, but that is not possible today because of “securitization.”

Here's the key element in the plan: “Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.”

Utilizing the Case-Shiller index measuring house price changes at the zip code level, “the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.”

In exchange, “the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.”

“The reason for this sharing of the benefits is twofold. On the one hand, it makes the renegotiation less appealing to the homeowners, making it unattractive to those not in need of it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up 50% of the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

Since the option to renegotiate (offered by the American Housing Rescue & Foreclosure Prevention Act) does not seem to have been stimulus enough, this recontracting will be forced on lenders, but it will be given as an option to homeowners, who will have to announce their intention in a relatively brief period of time.

The great benefit of this program is that provides relief to distressed homeowners at no cost to the Federal government and at the minimum possible cost for the mortgage holders. The other great benefit is that it will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions’ balance sheets.”

My comment: I have a child-like enthusiasm for Zingales' plan to recapitalize the banks. About his plan to re-negotiate mortgages I am not so sure. I am thinking it could probably be improved, but am sure I am not the fellow to improve it.

Some questions for students to consider for a tutorial paper: what is the impact of the plan if we assume differing levels of house depreciation? Taking, say, a 20%, 30%, and 40% decline in housing values, what would be the implications for the economy of this workout? What are the major alternatives to this plan? How does it differ from the government's approach and from that of Obama and McCain? What are strengths and weaknesses? Assess this not only in relation to "efficiency"--how to get the economy moving again--but in relation to traditional principles of law and justice.

11/01/08

The Major Scandal

2008-10-13T10:55:00.007-07:00

Willem Buiter (of the Financial Times and the LSE) nicely diagnoses the major scandal entailed in Paulson's plan to recapitalize the banks.

Buiter argues that the US taxpayer is getting a “terrible return” from Paulson’s promise to supply $250 billion to the banks, “bound to rise to probably around twice that amount.” It is basically a “free gift.” In Paulson’s program, “the injection of capital is through non-voting preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injection into Goldman Sachs).” There are also no attractively valued warrants; the shares “can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks.” Unlike in Belgium, the government gets no vote even as it ponies up the funds. Unlike in Britain, whose preference shares get a 12 percent yield and board members, the US taxpayer gets a 5 percent yield and no say in the running of the firm.

The major scandal, as Buiter notes, is that neither in the latest iteration of the Paulson Plan nor in the bailouts of AIG and Freddie and Fannie did unsecured senior creditors have “to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out” of each bailout whole. “There were no up-front haircuts, charges or mandatory debt-to-equity conversions.”

Buiter emphasizes the “moral hazard” objection to proceeding in this vein, arguing that “we are laying the foundations of the next systemic crisis” by this conduct. That may be—it is indeed a horrible precedent--but the far larger point is simply that the whole proceeding upends and makes a total mockery of basic principles of bankruptcy law. It’s as if the shareholders of an insolvent firm decided that they were going to simply make off with all the excess cash and potted plants, stiff their creditors, and waltz away unimpaired. You can’t do that. There is an order to these things. There are several laws on the books against it. That shareholders must suffer first from insolvency, with the creditors picking up the scraps, is like some sort of first principle, is it not? Yet the US government’s policy violates this principle and allows both shareholders and creditors to gain unfair advantages at the expense of the public.

There is a proper role for the state as the “lender of last resort” in panics; it is not the idea of government intervention that is objectionable. The government should probably be willing to commit public funds and guarantees in a supplementary vein in the aftermath of the bankruptcy and recapitalization procedure that Zingales calls for. To do so in the first instance, however, is a simple fraud on the public, a great crime committed in broad daylight. 10/24/08

David Merkel also makes the key point, though somewhat tentatively: "I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity. This extinguishes debt claims, and accelerates the healing of the economy. This would be true reform." Right. It would have been clearly better! 10/25/08

Buiter continues to hammer away at the absurdity and incompetence of the government's approach, as the AIG price tag rises to $150 billion. 11/11/08

Robert Reich aptly calls it "Lemon Socialism." He rightly wonders why the shareholders of insolvent firms "should not be cleaned out first, and their creditors and executives and directors second -- before taxpayers get stuck with the astonishingly-large bill." The powers that be have crafted an absurd form of political economy in which "taxpayers support the lemons" and "capitalism is reserved for the winners." 1/24/09

Here are some additional links sympatico with this general line of criticism:

Blodget, "Why are We So Afraid to Fix the Banks the Right Way?" 1/19/09

Tilson, "Preventing the Greatest Heist in History," 1/20/09

Last Resort

2008-10-13T10:30:00.000-07:00

There is a passage in Bolingbroke, an eighteenth century British sage much admired by John Adams, which expresses nicely a precept of statecraft relevant to the financial crisis. The problem illuminated concerns the respective roles, in threatened insolvencies, of shareholders, creditors, and governments (which must be prepared to act “in the last resort” when the entire financial system is threatened).

Bolingbroke is describing the proper British strategy in response to the danger that a single great power should dominate the European continent, and he sets forth what would today be termed by political scientists “an offshore balancing strategy.” Bolingbroke says: Britain should look upon “the powers of the continent, to whom we incline, like the two first lines, the principes and hastati of a Roman army: and on ourselves like the triarii, that are not to charge with these legions on every occasion but to be ready for the conflict whenever . . . necessary.” Never commit the whole, says Mr. B, unless the whole is at stake (pp. 56-57).

The shareholders are the principes, the creditors and bondholders the hastati, and the government’s lender of last resort function is the triarii. The idea is to let the first two lines bear the brunt of the fighting in the first and second instances, carefully husbanding one’s strategic reserve.

My view is that Paulson and Bernanke committed the triarii way too early, when the general equity averages were only down 20%. Probably this stemmed from their misunderstanding of the situation as a liquidity rather than solvency crisis. They also seemed to be unaware that there was a relevant ordering among different stakeholders—that is, they failed to distinguish adequately among the principes, the hastati, and the triarii in their generalship. Quite apart from various tactical blunders and obnoxious threats, the strategic concept was unsound.

It is interesting to think about the “last resort” function across a variety of fields. It is important not only in central banking but also (as with Bolingbroke) in military strategy. The concept plays an important role in theories of the just war. Someone could do a dissertation comparing the last resort function across these various domains. That would make a good book. Good luck finding a job!

11/01/08

Poor Goldman Sachs

2008-10-13T10:00:00.000-07:00

It’s kind of ticking me off that Goldman Sachs received only $10 billion of taxpayer money in Paulson’s latest “plan.” The firm is severely undercapitalized and needs help. Its greater need for equity infusion as against other less deserving companies is clearly shown in the following charts.

Over the last decade, Goldman Sachs is up only 120% as against the S&P 500 Large-Cap Index. Poor Goldman Sachs.

The chart below is also pretty ridiculous in showing that Goldman has outperformed the Dow Jones Industrial Average by only 100%. The Dow is so old economy, filled with clunkers like GM.

GS's advantage over the tech-heavy Nasdaq-100 has been pared back from the glorious 275% advantage of a few years back, but we're still bullish. Tech doesn't really contribute much to the economy. Here's hoping that we can hold the early 2006 breakout at about 150%.

Coincidentally, our hero sprang into action on the day, September 18, 2008, that his old firm threatened to break below the long term Goldman Sachs: Russell 2000 ratio. Not gonna happen.

The following chart shows Goldman powering ahead of the Wilderhill Clean Energy Index. It confirms, of course, Efficient Market Theory. Previously I had been skeptical of that idea. Now I'm a believer. Taxmoney should go into the superior business model, as demonstrated by the record of the investment banks. That way, we can compete in the world economy. Alternative energy is for hippies. Let the market decide.

In conclusion:

In a world of uncertain values, we need a new standard of value. So to hell with the gold standard and the Dow:gold ratio favored by bears. Gold is a barbarous relic. Until January 20, 2009, at least, the coin of the realm is the Goldman standard.

10/26/08

2009 Deficit to $2 Trillion, 12.5% of GDP

2008-10-12T21:25:00.012-07:00

This chart from the International Political Economy blog was a September 2008 estimate of the likely government deficit in 2009. But estimates keep rising. According to Morgan Stanley's chief economist, 'The 2009 budget deficit could be close to $2 trillion, or 12.5 percent of gross domestic product, more than twice the record of 6 percent set in 1983." Anyone for $3 trillion? Do I hear $3 trillion?

Maxims on Debt and Credit

2008-10-12T21:20:00.002-07:00

Maxims represent the accumulated wisdom of the human race and should always be consulted as a potential corrective to current infatuations. They are often a lot more valuable, as expressing the essence of a situation, than ponderous theory building enterprises. Herewith, therefore, a collection of voices rising from the grave to illuminate these deep questions of debt and credit. Except for the last entry from Benjamin Franklin, to which I am very partial, all are drawn from H. L. Mencken, A New Dictionary of Quotations On Historical Principles From Ancient and Modern Sources (Knopf, 2001).

"Debt is the slavery of the free." Publilius Syrus: Sententiae, c. 50 B.C.

"Debt is better than death," James Howell, Proverbs, 1659.

"Pride does not like to owe, and self-love does not like to pay." La Rochefoucauld, Maxims, 1665.

"Better go to bed supperless than rise in debt." John Ray, English Proverbs, 1670.

"Out of debt, out of danger." Thomas Fuller, Gnomologia, 1732.

"Living upon trust is the way to pay double." Ibid.

"Sins and debts are always more than we think them to be." Ibid

"Debt is a preceptor whose lessons are needed most by those who suffer from it most." R.W. Emerson, Nature, 1836.

"There are but two ways of paying debt--increase of industry in raising income, increase of thrift in laying out." Thomas Carlyle, Past and Present, 1843

"A national debt, if it is not excessive, will be to us a national blessing." Alexander Hamilton, Letter to Robert Morris, April 30, 1781

"I place economy among the first and most important of republican virtues, and public debt as the greatest of the dangers to be feared."
Thomas Jefferson, Letter to Governor Plumer, 1816.

"The principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale." Jefferson, Letter to John Taylor, 1816.

"It is incumbent on every generation to pay its own debts as it goes--a principle which, if acted on, would save one-half the wars of the world." Jefferson, Letter to Destutt Tracy, 1820.

"Public credit means the contracting of debts which a nation never can pay." William Cobbett, Advice to Young Men, II, 1829.

"We are opposed to the issuing of interest-bearing bonds of the United States in time of peace." Democratic National Platform, 1896.

"He that hath lost his credit is dead to the world." George Herbert, Outlandish Proverbs, 1639.

"Credit lost is like a Venice-glass broken." John Ray, English Proverbs, 1670

"In this institution of credit, which is as universal as honesty and promise in the human countenance, always some neighbor stands ready to be bread and land and tools and stock to the young adventurer." R.W. Emerson, The Conservative, 1841.

"No man's credit is as good as his money." E.W. Howe, Sinner Sermons, 1926.

"Credit, like a looking-glass
Broken once, is gone, alas!"
Author unidentified.

"As a very important source of strength and security, cherish public credit. One method of preserving it is to use it as sparingly as possible." George Washington, Farewell Address, September 17, 1796.

"In those circumstances we cannot be too careful to preserve the friendships we have acquired abroad, and the Union we have established at home, to secure our Credit by a punctual discharge of our obligations of every kind, and our Reputation by the wisdom of our councils: since we know not how soon we may have a fresh occasion for friends, for credit, and for reputation." Benjamin Franklin to President of Congress, October 22, 1783.

The Grand Alternative

2008-10-12T20:18:00.012-07:00

From The Oil Drum:

"Rather than spending a trillion dollars on buying toxic derivatives, or on a war, these funds would be better spent in helping private enterprise jump-start the above referenced conservation techniques and alternate energy research and implementation. The use of our hard-earned tax dollars to help accelerate these initiatives would create jobs and new businesses. The bottom-line is that solving the energy problem - which must be dealt with anyway, and soon - is the perfect solution to solving the consumption- and credit-induced economic dislocation we are now beginning to experience. There would be a third, important benefit. Energy conservation, increased natural gas use and alternate energy implementation all help lower CO2 emissions."

One of these days I will track down that link, but this passage gets to the core of the issue. 1 or 2$ trillion here cannot be $1 or $2 trillion there. There has been little discussion of opportunity costs in discussion of the financial bailout, but it pretty obviously forecloses just about every other policy initiative one might fancy.

London Banker eloquently summarizes what is at stake:

"If the core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years, then no amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes. Bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation."

10/27/08

Joseph Stiglitz Excoriates Economists

2008-10-10T21:16:00.015-07:00

Joseph Stiglitz excoriates the economics profession (along with Wall Street, Greenspan, and Bernanke) in a talk delivered in Germany on October 3, 2008. I've managed to misplace the link, but here are my notes:

Of Bernanke: “To destroy the financial system in so few years was an achievement. Only somebody who had studied the Great Depression could have done it so quickly."

The models that economic students study, Stiglitz says, are irrelevant to the current crisis: “You can’t have a debt crisis in a representative agent model. The model that our students have been studying for the last umpteen years has nothing to say about the current crisis.” Imagine a student studying in a leading American university who is asked the question, “‘What do you think about the current crisis?,’ and he says, ‘Well, I haven’t even thought about that, it’s not in our models. That’s a different subject. We don’t study that in our university.’” Stiglitz says that it’s an embarrassment to the economics profession “that our leading model in macro has absolutely nothing to say about these issues.”

Stiglitz then goes on to microeconomics, just to be “even-handed.” Most economists, he comments, still believe in the neo classical synthesis, which says: “Once we solve the macro problems, the market solves efficiently the allocation problems, the micro allocation problems.” He goes on to reject the assumption that failures only come in huge doses and identifies plenty of massive inefficiencies at the micro level, such as General Motors spending $100 billion and ending up with a company worth $10 billion. (Alas, he said that on October 3. Its market value was in the next week sliced in half). After commenting on some of his early academic work showing inefficiencies in how corporations approach taxation (doing that which is economically less advantageous in order to please unknowing shareholders), he comes to the main course: the massive misallocation of resources that preceded the bust in housing especially, but across other credit markets as well.

“What are financial markets supposed to do? They’re supposed to mobilize capital, allocate capital, manage risk, and in return for that, for providing those social services, they get compensated. Well, they got compensated; in recent years they’ve gotten over thirty percent of corporate profits….but that doesn’t include executive pay and bonuses, which themselves were huge.” While reaping immense rewards, the industry failed in its essential tasks of rational capital allocation and the management of risk.

Stiglitz notes that the financial services industry resisted innovations that would make the economy more efficient, that the incentive structures were fubared (a rough translation), and that the investors who bought those securitized mortgages with AAA ratings acted irrationally. There was an "irrationality and stupidity" that was pervasive and that “goes beyond information asymmetry.” The bizarre feature of the situation is that Wall Street had living proof, in the collapse of Long Term Capital Management in 1998, of the dangers of placing credence in the “probability distributions” hawked as science in the models. But the experience taught Wall Street nothing.

There was a logical contradiction here. The inventors of these sophisticated instruments claimed that they were creating new products to manage risk that transformed financial markets. But they used data collected before the creation of the products. “So they believed that their model had changed the world, but they used prices as if it had not changed the world.”

Stiglitz notes the ways in which securitization created a new moral hazard problem and failed to provide real diversification. “You don’t get diversification if you have correlated systemic risk.” Bad models as used by credit rating agencies and banks, with the idea that they were managing risk, did nothing of the kind.

He also makes an excellent point about the intellectual incoherence of Wall Street. The idea behind securitization was that it made markets more efficient. “As you slice and dice models, you don’t change fundamentals, you just bring down transaction costs.” That was the economic theory. In practice, however, Wall Street made enormous profits from the fees derived from securitization. In other words, they were raising transaction costs!

Stiglitz asks why Wall Street didn’t act in a more prudent way and failed to see that the originators had an incentive to write bad mortgages. By lending, say $100,000 in a nonrecourse mortgage, which would allow the buyer to walk away if the price went down, banks were in effect giving options to poor people. Since it’s not the normal practice of banks to give money away to poor people, it didn’t make sense. But very few on Wall Street saw it, until nearly the bitter end.

Stiglitz doesn’t comment here on the Paulson Plan, but he does look toward ways in which the financial sector should be regulated. The leading ideas are that asymmetric short term incentive structures should not be allowed, that we need a “Financial Products Safety Commission” that would bar “weapons of mass destruction inside our financial system,” and that speed limits need to be placed on the rapid expansion of financial institutions, because experience shows that this invariably causes net losses when they bust at the end of the day.

There is more, but this gives the main points.

Anatole Kaletsky also weighs in on the need for an intellectual revolution in the economics profession.

Paper Topics

2008-10-09T18:23:00.017-07:00

Hey college students, let’s talk paper topics.

Here’s one idea: Compare and contrast the diagnoses of the Great Depression offered by Neoclassical economists, Keynesians, monetarists, and the Austrian economists, reading as much of John Maynard Keynes, Milton Friedman, Friedrich Hayek, and Ludwig von Mises as you can. Then speculate on how they would analyze the contemporary crisis and seek to resolve it. Identify their contemporary followers and use them as a guide to this question. This would get you into the deep waters of contemporary economic theory, and it is of vital contemporary importance to figure out which school offers the best interpretation. Infinite variations could be played on this basic paper idea, mixing and matching as you like. What would Schumpeter think? What would Minsky say?

Next topic: Financial regulation. How did it evolve over last two decades, and with what consequences? Assess nature of contemporary market dysfunctions that it is the responsibility of regulatory bodies to mitigate. Assign responsibility for decisions taken, whether for good or ill. Propose sensible reform. There you have your four-part paper. Financial regulation is a big topic--look at this snarl. You could narrow it by centering your investigation on one regulatory body (e.g. Federal Reserve, Securities and Exchange Commission, CFTC). The thing is: you want to keep your focus on that which keeps the entire system viable, so don’t get too narrow minded on me.

There are a few other paper ideas set forth in this presentation, one on housing, another on how public opinion in other countries is interpreting what is going on.

Finally, think about this: Evaluate the response of the Bush administration to the financial crisis. Compare its response to insolvent banks with previous bailouts in the United States and abroad. Identify a template of responses that nations have made to banking crises and assess, respectively, their equity and efficiency. In other words, what is most fair? What solves the problem with the least expenditure of public resources? Then use your conclusions to assess the wisdom of the approach from Bush, Paulson, Bernanke and Cox. If appropriate, suggest an alternative approach tailored to the immediate crisis. On the scale of financial fraud and gross iniquity, of moral turpitude and political corruption, of fatal incomprehension and stark ineptitude, where does it rank? At the bottom? Or at the top?

OK, so it’s a loaded question. Please draw your own conclusions without fear or favor.

11/01/08

The Ten Commandments

2008-10-09T18:20:00.001-07:00

No, these were not delivered by Moses, but by the blogger Hellasious ("Hell as IOUs") at suddendebt.com, near the top of the bubble on March 5, 2007. These very useful admonitions took the form of "Ten Things I Need To Remember":

"1. The stock market is not the economy. Just because a whole generation has grown up following rising stock quotes, it does not mean they are good indications of copper output or computer sales.
2. Financial services are not creators of economic activity. Just because people can get yet another 0% introductory APR credit card, or a 0%-down mortgage with negative amortization for 12 months, that does not mean the economy is expanding.
3. Central bankers are not magicians. No matter what they say or do, they cannot create jobs, income or wealth. All they can do is raise or lower short-term interest rates; sometimes they can't even do that (just ask BOJ).
4. Foreign central banks are not perennial lenders of last resort to OCC (Other Countries' Consumers). They cease to be when it's not to their own countries' benefit (just ask BOJ and PBOC).
5. Tax cuts are like rat poison: judiciously applied they get rid of excess government meddling in the economy. Overdoses, however, end up killing the future.
6. Globalization is also like rat poison: judiciously applied it gets rid of lumbering, inefficient producers. Overdoses, however, end up killing domestic middle classes.
7. Shopping is not equivalent to producing. Just because GDP figures are still calculated using decades-old methodology (when most "things" were still made locally), it does not mean that the national economy benefits from frequent trips to the MartMall.
8. Credit Default Swaps are not equivalent to bonds. They are not even counterfeit bonds. They are simply naked puts on someone else's credit.
9. Always ask for more return for assuming higher risk. Just because I'm a fool, it doesn't mean my neighbor is one, too.
10. Excess always corrects and frequently begets the opposite excess."

Venture forth into the wilderness, my children, with these glad tidings.

10/26/08

The Ten Steps

2008-10-09T18:15:00.005-07:00

Jeremy Grantham was a Cassandra warning against the excesses of the boom. In his October 2008 report, "Reaping the Whirlwind," he summarizes, in ten key points, his perspective on the causes, consequences, and remedies of the financial crisis:

1. “We had an intended period of excess increase in money supply, loan growth, leverage, and below normal interest rates.”

2. This produced “‘the first truly global asset bubble’ in all assets everywhere with only a few modest exceptions.”

3. The authorities, rather than tightening regulations, “partially dismantled them.” Attempts to rein in the growing risks were ignored by Democrats and Republicans alike. When the bubble broke, authorities mischaracterized what was happening: “all was said to be contained and the economy was claimed to be strong.”

4. The ultimate bubble was in risk-taking itself. “The asymmetry here was that if things worked out badly they would help you out . . . but if all went well you were on your own . . . Ah, the joys of pure capitalism.”

5. Investors and authorities were deluded “by the concept of rational expectations, or market efficiency,” which postulated “that we were all far too sensible for major bubbles to appear.” Lulled by these beliefs, investors “were actually paying to take risks for the first time in history” in the last year of the mania.

6. It was not the breaking of the Nasdaq bubble in 2000 nor the breaking of the housing/credit bubble in 2007 that were the outlier events. The true outliers were “the bubbles forming in 1998 and 1999 and in 2003 through 2007.”

7. “If everything goes right (as a bubble breaks) there will always be lots of pain. If anything is done wrong there will be even more. It is increasingly impressive and surprising how much we have done wrong this time!”

8. By far the biggest failing of the financial system “has been its unwillingness to deal with important asset bubbles as they form.” Both Greenspan and Bernanke are the villains in this rogues’ gallery. If you want to avoid a devastating bust, you have to limit manias in their ascent.

9. Addressing the lethal blow given to financial institutions by the destruction of trust is imperative. “Concern about moral hazard is secondary and must be put into abeyance for the time being.”

10. The market is like “an impetuous river that, when turbulent, inundates the plains, casts down trees and buildings, removes earth from this side and places it on the other; every one flees before it, and everything yields to its fury without being able to oppose it; and yet though it is of such a kind, still when it is quiet, men can make provision against it by dykes and banks, so that when it rises it will either go into a canal or its rush will not be so wild and dangerous.” OK, that’s Machiavelli on fortune, and not the esteemed Mr. Grantham on the markets, but this seems to be what JG has in mind here.

I have my doubts about point 9b, but may be mistaken. Take these dicta into the wilderness, too.

Grantham’s valuable reports are available to the public, though access to the GMO site requires registration.

10/26/08

Man, Did I Screw Up

2008-10-09T17:00:00.004-07:00

This is a portfolio tracking screen from MarketWatch that has only one position. It is a naked put on the Dow Jones Industrial Average, with a strike price of 130 (corresponding to 13,000 on the Dow Jones), with a December 2009 expiration. When I sold it back last winter and collected $4.85 billion, I frankly had no idea that the markets were going to collapse. Otherwise, I wouldn't have done it. You can see that the premium of $4.85 billion, which seemed easy pickings at the time, had become a deep red liability of $21.86 billion on November 21, 2008.

How can that be possible, you ask? The chart below shows the general vector.

When you sell a put at 10 and it goes to 55, this is not an auspicious development, believe me.

Warren Buffett made a transaction similar to mine, except that his company, Berkshire Hathaway, doesn't have to pay off for 13 or so years, when the puts expire. Surely the government will debase the currency, making 13,000 on the Dow easily obtainable. Thank goodness, too, that Barron's believes Berkshire is only underwater by $5 billion on the trade, because on basically the same deal yours truly was hurting to the tune of $21.86 billion. How does Buffett collect such a large premium from that naked put without being underwater like I am?

Here are some facts about Berkshire's financial position from the bullish Barron's article.

11/23/08

The US Hedge Fund and the Bond Conundrum

2008-10-09T11:12:00.007-07:00

The mother of all bailouts has yielded a strange progeny: the United States as a Giant Hedge Fund.

Think back to the chart earlier showing the blowout of high yield bonds and credit spreads.

Note that the toxic paper the US government has taken on trades at an even deeper spread than junk bonds.

Note also that the public has an insatiable appetite for short term Treasury bills, whose yields have practically disappeared in the “flight to safety.”

Note in the chart above, finally, that investors have also rushed to the apparent safety of long term government bonds, which offer interest rates from 3.5 to 4.0 percent.

The bond conundrum, circa 2008, is simply this: How can the government take on all this bad debt without fatally impairing its own credit rating?

As investors have fled from all else besides government debt, the government has taken on the “all else.” Its guarantee makes its own debt equivalent in value to the debt it has taken on, does it not? That strongly suggests that long term government borrowing rates are going up. Every other asset class has crashed; why not government bonds?

Take up the debate over bonds--the eternal conundrum between inflation and deflation--in rival statements by Mish and Gregor. 10/26/08

Consider also another aspect of the bond conundrum, vividly portrayed by Jake at econopic in this chart of the total return of government bonds (including agencies) as against investment grade debt over the last 30 years:

The annotations are from Jesse.

11/19/08

Uncle Sam's Adjustable Rate Mortgage

2008-10-09T11:00:00.018-07:00

I begin to re-think the “US as Giant Hedge Fund.” Hedge funds are in the business of making money, whereas the Treasury, despite its protestations, surely knows it is going to lose money. So thus far the hedge fund analogy fails.

Here’s a better one: Paulson and Bernanke are just like a freshly married couple about to buy a home in California in 2005. Sure, it costs $650K, and they only make $75K between them, but the initial payments are modest and the house will surely appreciate. Here's the deal: they pay only 1.6% on their "2-28 mortgage," meaning that the mortgage will reset in two years at a rate just above LIBOR.

This transaction, which the California couple is now greatly regretting, is the perfect picture of what the US government now proposes to do. With short term rates near zero, it has a cheap source of financing for its debt; the flight to safety has given it the opportunity to take out an adjustable rate mortgage with a super-low teaser rate. As of September 30, 2008, the rate on its short-term bills was only 1.6%, well below levels (4.7%) of a year before.

The problem is this: if average interest rates on government debt go up, as I think it very likely they will, the government’s debt will “reset” to a higher level—just like that now underwater couple that is faced in 2008 with much higher reset mortgage costs to pay down the debt on a depreciating asset. Notes Mr. Mortgage: "The same household that earns $75k per year that two years ago could buy a $650k home with no money down can now buy a $275k home with 10% down. It now takes at least $150k a year and a large down payment to buy a $650k home."

The following chart of mortgage resets, on the happy analogy of our California couple, suggests something of what is in store for the US government's debt over the next several years. (There is more on the government's debt structure here.)

"Hair of the dog that bit you" is indeed, as Jim Grant says, "the unifying theme" of the government’s response to the insolvency of our financial institutions. It's Alt-A all the way.

10/23/08
Updated 11/25/08

Twin Towers

2008-10-09T07:00:00.001-07:00

When Lehman Brothers and American International Group collapsed in mid-September 2008, it was like the fall of the twin towers seven years before. Symbols of American financial prowess had crumbled to dust, betokening a world shaken to its very foundation.

Important as the crisis is in its own right, it is the response of the government—its way of molding into stone in ten days measures that will have consequences for ten years—to which I draw attention. After 9/11/01, the mind of the Bush administration was made up quickly. They were going to war, first with Afghanistan, then with Iraq. Public discussion of alternatives, and criticism of the administration, was virtually non-existent in the mainstream media. Most Americans have reconsidered the Iraq War and think it was a big mistake. But we’re still there.

The mood now is different, but there is the same essential dynamic, in which great crisis produces the demand that something be done immediately, foreclosing the opportunity for deliberation. It follows inexorably that the executive must be entrusted with the details, because circumstances change and confidentialities must be preserved. Voila! There you have your ill-considered, secret, untransparent decisions, made in a rush, entailed upon the subsequent generation. The collective response is something like: We Need to Act! No Time to Think!

This is hardly the model of republican deliberation for which American political institutions were once renowned. It is very unbecoming to a polity that purports to respect constitutional values.

The phenomenon is probably best seen as a rather grotesque form of “path-dependency,” that is, the idea that where you end up depends on where you start. Paul Krugman got a Nobel Prize for his variations on that proposition, demonstrating that for some industries small initial advantages can make a big difference. But Krugman was thinking about how industries achieved a competitive edge. The concept of path-dependency is equally relevant to how polities reach dysfunctional decisions. The September/October 2008 decisions of the US Treasury and Federal Reserve will cast a very long shadow.

Chalk up another cause for depression.

10/26/08

We Value What We Save in a Crisis

2008-10-08T15:31:00.003-07:00

The following extracts from an eloquent post by London Banker get to the nub of what is wrong with the response of US and Western authorities to the financial crisis: They have done nothing to shield essential economic "sectors from the ill effects of the financial sector implosion while giving virtually unlimited funds to the banks authoring the collapse." The contrast between US and Chinese responses is telling. He begins with an anecdote from Sherlock Holmes:

“When a woman thinks that her house is on fire, her instinct is at once to rush to the thing which she values most. It is a perfectly overpowering impulse, and I have more than once taken advantage of it. . . . A married woman grabs at
her baby; an unmarried one reaches for her jewel-box.”-- A Scandal in Bohemia, by Arthur Conan Doyle
When a central bank thinks its house is on fire, it too will rush to save the thing valued most. In the United States, the central bank has rushed to save the bonuses and dividends of its Wall Street clientele by hiding away the bad assets that can no longer be foisted on gullible investors. In Europe too the response of central banks has been to save the wholesale banking and securities industry rather than the consumers and businesses underlying the real economy’s longer term productive strength.
For a comparative of what is valued elsewhere, it is worthwhile to look at what is being saved. I received in my inbox yesterday documents outlining the efforts being taken by the Hong Kong and Chinese authorities to address the liquidity crisis in their respective jurisdictions. They are available online here (Hong Kong) and here (PRC). The contrasts with the West are striking, and humbling. Hong Kong is swiftly introducing a scheme to guarantee credit to SMEs (small and medium enterprises) and exporters. China is introducing controls to limit bank credit to over-extended speculative sectors, accelerate rebuilding in the regions affected by the earthquake earlier this year, and promote improvements in local infrastructure, education and economic adjustment.
Holmes would have been disgusted by a married woman who grabbed her jewel-box in preference to her baby. In the same way, I am disgusted by the central banks preserving the privileges of the financial elite in preference to the jobs, incomes and businesses powering the real economy. The US and UK authorities may criticise the banks for their inaction in freeing up lending to commercial businesses constrained by the credit crunch. The Hong Kong and Chinese authorities are
implementing guarantee schemes and innovating initiatives to rapidly address the problem. . . .
The crisis in debt markets has been rolling since the sub-prime collapse of August 2007. The increasing illiquidity of commercial paper, trade credit, municipal finance and other debt markets was foreseeable and inevitable. And yet the central banks and treasury authorities of the Western nations have done nothing to shield these essential sectors from the ill effects of the financial sector implosion while giving virtually unlimited funds to the banks authoring the collapse.
Any discussion of China always invites criticism of its anti-democratic governance. It is worth remembering that the philosophical defense of democracy lies in the proposition that it is more likely over time to serve the interests of the electorate than a system which disenfranchises the people from the determination of their leadership. If the democratically elected governments - through their appointed executives and central bankers - are free over an extended timespan to ignore the interests of the people, then how is a Western democracy superior to a Chinese bureaucracy? From looking at the policies and practices of the past year, the merits of Western democracy are not immediately apparent in ensuring that policy responses to the financial crisis are aligned with the interests of the people. Even over the past decade, it is not clear that the policies of the democratic Western governments have aimed to strengthen and broaden the economy to benefit of the electorate rather than a narrow, self-serving elite. . . .
If the promoters of democracy want to strengthen their case, they might best do so by ensuring that their leadership adheres to policies which promote the longer term health and well being of the economy as a whole rather than the short term enrichment of an undemocratic elite."
11/28/08

How My Kids Saw It

2008-08-24T18:58:00.005-07:00

Such was my Christmas present for 2008, courtesy of the rascals below.

January 1, 2009