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Go Home The Return Of Big Government

THE PLANK SEPTEMBER 19, 2008

The Return Of Big Government

BY ROBERT GORDON

Bill Clinton declared that the era of big government is over. George Bush is bringing it back.

With America facing the largest financial crisis in a generation, it’s striking that free market ideology offers no answers. Virtually no one is arguing that the government should just let these companies fail. Scholars from at least one prominent conservative think tank are declining interviews, according to Marc Ambinder. As Treasury Secretary Hank Paulson put it, “Raw capitalism is dead.”

The centerpiece of Paulson’s plan announced today is a new agency to buy up troubled mortgage assets. The idea is to take bad assets off the hands of financial institutions, restoring confidence in their books and thawing frozen credit markets. It’s a more systemic and proactive approach than we’ve seen in the past week. Paulson estimates that no more than $500 billion in assets will be bought, but some outside experts put the figure above $1 trillion.

Paulson is right to call for aggressive action that is proportional to the scope of the problem. We have no other choice. But there are more questions than answers about how this will work in practice.

One central question: how will Treasury set a price for these assets when the market cannot? If the price is too low, financial institutions will be forced to swallow unnecessary losses. If it’s too high, irresponsible investors will walk away with ill-gotten profits while taxpayers take a bath. Answering this question is the key to determining whether today’s proposal is closer to the bailout of Chrysler (which netted the Treasury a small profit) or the bailout of the savings and loans (which cost taxpayers $125 billion).

Financial aid should not start and stop with large financial institutions. It's American families who are feeling the most pain, and helping them -- like helping financial institutions -- will strengthen the economy. Homeowners are the first priority: we need to rewrite mortgages to make them affordable, and we need to do it in batches. Case-by-case changes are too slow. We also need to head off the damage foreclosures cause neighbors and communities by buying and rehabilitating those properties. Congress should also follow rapidly pass expansions of unemployment benefits and investments in clean-energy jobs.

The immediate consensus behind passage of Paulson’s plan shows that, when it comes to addressing our country's most urgent problems, money is no object. Congressional leaders did not blink at the 12- or even 13-digit outlay. We should remember that when it comes to other priorities, such as universal health care. The problem is a lack of political will, not a lack of resources.

The tragedy is that none of this was necessary. Regulators looked the other way when investors borrowed heavily to increase their potential profits, ignoring the growing risk of failure and its impact on the economy. They failed to prohibit mortgages that could never be repaid and to head off the resulting wave of foreclosures. It turned a blind eye to fraudulent short-selling and to rating agencies giving top grades to shaky bonds.

President Bush today tried to discourage these criticisms by saying, “There will be ample opportunity to debate the origins of this problem. Now is the time to solve it.”

That’s obviously a self-serving view for the man who’s watched over the economy for the past eight years. It’s also wrong: finding the holes in our supervision of Wall Street will allow us to patch them. It is the job at hand, not a distraction. 

--James Kvaal

SHARE YOUR THOUGHTS

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57 comments

The similarities to the S&L crisis are superficial.  Those institutions were being liquidated and certain creditors protected.  In this case, the institutions just want the taxpayers to relieve them of losses on their bad assets while keeping their equity and continuing in business.  That is an unconscionable socialization of losses following huge profits and compensation packages for the investors in, and senior managers of, such institutions.  

What this situation really requires is a mechanism for in-place recapitalization where the bad assets are removed by fiat, along with the non-ordinary course liabilities, the operating business issues new equity securities that flow to the stakeholders along with the bad assets, and there is a mechanism for orderly liquidation/marketing of that asset pool and equity to pay off the old stakeholders.  That way, the institutions don't fail, but the investors don't get to put their hands in the pockets of the taxpayers either.  

If, as in the S&L crisis, depositors and customers need to be protected, fine.  They are not in a position to evaluate investment risk as a part of doing ordinary business and cannot be expected to if commerce is to proceed smoothly.  But investors should not be able to shove their losses onto the public.  As well, there needs to be much tighter regulation of the assets and liabilities of ALL institutions that are effectively part of the money supply.  Let speculators speculate on whatever they want, but keep banking institutions insulated from those risks.  Then, the next time there is an investment bubble, we won't have to ride to the rescue.  Even more likely, with the banks (broadly defined) sidelined from financing the investment bubble, it probably won't develop much steam in the first place, the outcome we should really want.

- roidubouloi

September 19, 2008 at 9:53pm

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I have only one quibble--the suggestion that because Congress is willing to spend trillions to prevent the financial structure of the country from collapsing, we have trillions laying around that we can use for health care.  We don't -- save for huge emergencies, price is still an object.

- ryanburke

September 19, 2008 at 10:48pm

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I have only one quibble--the suggestion that because Congress is willing to spend trillions to prevent the financial structure of the country from collapsing, we have trillions laying around that we can use for health care.  We don't -- save for huge emergencies, price is still an object.

- ryanburke

September 19, 2008 at 10:48pm

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While taxpayers are in this case acquiring (crappy) assets, they're assets nonetheless. That is, it's not a $1 trilliion payment, it's a $1 trillion investment. As James Kvall noted, the S&L bailout *only* cost taxpayers $125 million.

Assuming that's a worst case scenario, we should be wary of attempting to compare directly a financial market bailout to a universal healthcare initiative, whose dollars-and-cents return on investment is harder to calculate directly.

- thetraytiger

September 20, 2008 at 12:19am

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If the taxpayers are taking bad debt off the books, the taxpayers ought to be getting equity in return. Or at least something of appropriate value. Otherwise, it is just the socialization of losses, along with the privatization of profits.

It is interesting that there has been no real free marketeer "solution" to this problem. I did see a brief bit about some Republican congressment saying that more tax breaks for corporations were somehow the answer, but that is the closest. "Recession: tax breaks for the rich are the solution. Growing economy: tax breaks for the rich are needed to keep it going. Complete breakdown of the capitalist system: tax breaks for the rich are the only way to save the economy!"

- JEFF FREY

September 20, 2008 at 1:18am

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As I said in another thread, McCain's atitude towards what's happening is either cynical or irresponsible. Cynical if he says that he has nothing to do with the bailouts (knowing that, if in power, he would have no other alternative but to accept government intervention on a large scale...). Irresponsible if he thinks that the US Federal institutions should just leave the world fall apart independently of consequences (sticking to his totally discredited libertarian ideology even if it means the end of the world...).

- luispc

September 20, 2008 at 3:54am

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McCain (paraphrased):  "Let's see, I'm against too much government, so I'm against regulation.  But I'm against greedy Wall Street, so I'm for regulation.  But I'm different from President Bush, so I'm against regulation.  My friends, you can always count on me for straight talk."

- JackR

September 20, 2008 at 6:57am

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Roid has it right, as usual.

Anyone seen "Sex and the City, the Movie"? Of course not. Good for you.

But it is a remarkable parable for our times, revealing the Sodom and Gomorrah we've become, where consumerism is our aesthetic, our religion, our national pastime.

Shop 'til you drop? Well, we've dropped.

So do we just pick ourselves up, dust ourselves off, and head back to the mall?

I wonder what Palin's advice would be to young women who are spendaholics?

- fougasseu

September 20, 2008 at 8:56am

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Poor McCain is in a pickle being for being against regulation, before he was against being for regulation. It was that wretched FDR I tells ya abetted by the the creation of the Fed that twas the source of our woes. They're sayin that just as there ain't no atheist in foxholes there's no libertarians in financial meltdowns or somethin. Of course not. Just as FDR prolonged the Depression with his intervention our malaise will be prolonged forever with lifelong nausea-causing financial chemotherapy.

If your neighbor's house is on fire, you don't haggle over the price of your garden hose. Yeah but what if he ignores your advice to get some of those dried leaves away from that sparking wiring that he won't fix and to stop renting rooms to heroin addicts who fall asleep with lit cigarettes in their mouths? Now you've got to give him your garden hose he puts out the fire but continues his careless ways and your house will always be in danger. The solution-build a firewall and let his house burn down next time. But alas, the Ron Paul Firewall Co. has gone out of business, not having had a Goldman Sachs alumni on it's board when it was cash strapped.

- lesserliz

September 20, 2008 at 9:32am

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This is the ultimate "starve the beast" -- for all the blathering we do here about the presidential election, just what is the next president going to do?  National health insurance?  How?  Stay forever in Iraq and Afghanistan?  How?   Tax *cuts*?!   The next adminstration's hands are tied more than any in recent memory -- the only big differences will be on social issues (immigration would normally have been a difference, but not here).  

- Lymon1

September 20, 2008 at 9:39am

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I don't disagree that the government needed to act in this cast, and I can see a plausible argument that Paulson and Bernacke have the right idea.  But the devil is in the details.  If I see a plan that takes the bad mortgage debt off the investment banker's books without rewarding them for having it in the first place (that is, pays something close to what the debt is actually worth, with loans to cover the spread) AND then writes down the mortgages to the mortgage holders to make them plausibly affordable while steering between the Scylla of foreclosure, and the Charybdis of giving them a free pass - then I'll be happy.  But opportunities for creating and reinforcing moral hazard here are huge.

Once you handle the money, then we should be talking about regulation that forces meaningful computation and exposure of risk.   This needs to be comprehensive - no one who is selling or acquiring a mortgage, at any stage in the pipeline, should ever be able to hide risk, or pass all of their exposure on.  The last is key.  The reason the country is littered with stupid, unsound debut, is because the debt was created by mortgage brokers who were never significantly exposed to the asset risk they were creating by selling stupid products to gullible buyers, and the consolidating agencies were able to hide the asset risk they had assumed, through clever bundling.  One start here would to be put a tight cap on fees in every stage of the pipeline, so that the profit in the mortgage has to be returned by interest spreads over time, not extracted up front in fees that are bundled into the mortgage (this is also good medicine for investment banking in general, BTW.

- sdemuth

September 20, 2008 at 10:01am

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Another sucker punch for liberals. And we thought we'd be stuck with a couple of wars which cost $10 billion a month? If we thought Bush was kicking that can down the road, what is this? I believe McCain was too dumb to see this coming but it could be worse for a guy with no plan. It's clear the tone will be, "This is not the time to point fingers. We have to look to the future.". Now the GOP will growl, "Well, let Barack explain how his tax and spend will work when we're worse than broke...". They'll urge people to head to Obama's website and see all the programs that would be dreamy if we had a way to pay for them. It's like a union sitting down with management to negotiate a new contract. "Sorry folks, because of mumble, mumble, but the good news is some of you will have jobs if you take a pay cut but there will be permanent lay-offs and the bad news is our other plants are being closed so we don't know how long we can keep our rust belt operations open."

What better way to silence anyone who proposes a shift in spending to address health care, fossil fuel dependence and anything that smacks of Big Government. Barack must feel like he's been bidding on a giant piece of land, lined up investors and just as it looks like he may have the high bid he finds out a levee broke and the property is under water and contaminated with hazardous waste. It will sit idle because he doesn't have the money to clean it up. The guy he was bidding against? No problem! He was going to strip mine for coal and that's safely hundreds of feet below the surface. He can proceed as soon as the company that will do the digging receives a tax break...but it will be worth it  as he'll provide a domestic source of energy.

Short story: Hey Mr. Optimist, we spent you inheritance.

- michael

September 20, 2008 at 10:08am

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Roid has some good thoughts. Paulson has seen fit to allow these institutions and investors the maximum pain. That's how it works. The best I can tell at this point is that he has been fairly mercenary in the terms. Precious few have been spared any pain. The market place has extracted its pound of flesh. As such we (taxpayers) may yet end up on the plus side of the deal. It was the utter loss of confidence in the larger market place that he is addressing.

sdemuth is right about a more direct liability arrangement of financial instruments. I'm fairly sure this will take place. Derivatives cannot be allowed to hide and pass on the risk with the illusion of no consequence. There is indeed consequence as we have seen.

- boxofrox

September 20, 2008 at 11:11am

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Cry Havoc and unleash the dogs of class war! Let there be UHC, higher taxes etc. Maybe it will crowd out eternal war as the price of vigilance. Pay for everthing out of current revenues. Ya want to invade another country, your Soc Sec check will be $200 less each month until it's over etc.  Ya want to bail out AIG everyone gets a surtax until it's marked to market.

- lesserliz

September 20, 2008 at 11:27am

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JEFF FREY, far as I can tell from reading the papers, the government is taking the equity along with the debt.

Plenty of shareholders and partners have lost all their equity in these various "bailouts"-- Bear Stearns, Lehman, AIG, etc. The government is mainly interested in bailing out the international financial system by making a market for the mortgage paper and derivatives.  

They're greasing the machine, but also acquiring large chunks of the machine in return for the grease.  I have also read that the government, when it bailed out the S&Ls, made money ultimately by selling off the acquired assets slowly at decent prices.  (Some have disputed this.)  Chrysler, too, paid back its loan, with interest.

I don't think the trillion dollars is going entirely down a black hole never to be seen again.  And the government may not make a direct profit back on the investment.  

But, saving the world seems ultimately to be a good investment.

- ChanRobt

September 20, 2008 at 12:13pm

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The Roi is right, but there are two other critical differences between the Garbage Machine and the S&L RTC.  One is the international dimension.  I am guessing that the Garbage Machine is going to accept assets held by foreign institutions even if of US origin (e.g., defaulted Lehman bonds held by the People's Bank of China of which there are quite a few).  So how will the foreign governments prevent their financial institutions from competing on a non-level playing field?  Either they will have to set up their own garbage machines (I don't think so) or we will soon see a challenge at the WTO that this is state intevention which is in contravention of the WTO convention.  Should be fun.

The other big difference is the type of "assets".  The RTC bought up property which eventually went up in value.  The Garbage Machine is taking paper.  These assets are dead and will in most cases never increase in value.  They are CDOs issued by SIVs with no underlying assets anymore once in default.  The Garbage Machine is really a loss-making machine.

- gennitydo

September 20, 2008 at 12:15pm

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By the way, "sub-prime loan" is another way of saying, give mortgages to people without asking them to prove they have income to pay the for it.  

This was a concept pushed and arm-twisted very hard by the Democrats in the guise of helping disadvantaged minorities and other poor people get the benefits of home ownership.

That was the government fucking up.  Then the private sector saw the immense opportunity, and multiplied the damage with teaser interest rates which later repegged up to unaffordable mortgage payments.  

And most damaging, packaging these crappy mortgages into instruments that were sold at way above their true worth.  Everybody went along, even knowing it was a fiction, because everybody was making incredible profits.

Inevitably, the markets finally noticed they'd overpaid for these assets, and the cards crashed.

There is plenty of blame to assign.  To greedy politicians buying votes from the poor.  And to greedy bankers seeing they'd been handed a platinum opportunity-- insisted upon really-- by the government.  And they did their worst.

It seems to me, however, that crappy those these mortgages may be, they are backed by an actual house somewhere.  And a house isn't worthy zero.  These housesin aggregate, ought to be worth a hell of a lot more than a dot-com company with no income and no actual business model.  

th dot-coms went to zero with no hope of coming back.  Homes aren't going to go to zero.  Unless they're abandoned.

- ChanRobt

September 20, 2008 at 12:24pm

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gennitydo, you write, apparently knowledgeably, "...They are CDOs issued by SIVs with no underlying assets anymore once in default.  The Garbage Machine is really a loss-making machine."

Isn't most of the bad paper backed somewhere along the line by hard assets-- houses sitting on land?  It would be helpful to know why you say there are no underying assets.

- ChanRobt

September 20, 2008 at 12:26pm

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Err no.  These are securitizations.  Once the issue (the SIV) is in default, the waterfall just happens automatically with the liquidation proceeds distributed pro rata to the different tranches.  The trustee is not going to spend time and money (Iots of it) actually enforcing the underlying mortgages.  There is no upside in it for the trustee or the bondholders.  Let someone try to claim breach of duty of care.  It is hard to prove and the trustee will have the excellent argument that they had to liquidate as quickly as possible due to the market conditions.

- gennitydo

September 20, 2008 at 12:36pm

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What troubles me, a career hourly-wage worker (despite long-term unemployment I do still make a teensy-weensy "income" which is not taxable because their isn't [yet] enough to tax), isn't additional "pain." It is my suspicion that, complex and unfathomable as the rescue plan seems to the naked eye, the details will result in the wrong people moving on to wreak another havoc elsewhere.

I expect most of the irresponsible parties to this debacle to get their losses reimbursed somehow, some way, with Congressional approval and Presidential assent, the cost to taxpayers lovingly hid in the details.

- tomeg

September 20, 2008 at 12:39pm

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ChanRobt - Just to be a bit clearer.  The trustee is just going to offload the mortgages to the highest (only) bidder as quickly as possible.  The Garbage Machine will be just another bondholder and will have no say in how the trustee administers the assets.  Look for the vulture funds to make a killing buying up the underlying assets from the trustees and look for the Garbage Machine to get 11 cents on the dollar in liquidation proceeds.  The old game is finished.  Viva el nuevo juego.

- gennitydo

September 20, 2008 at 12:46pm

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gennity, thanks.  very helpful info

- ChanRobt

September 20, 2008 at 1:08pm

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apropos to what tomeg wrote, "...complex and unfathomable as the rescue plan seems to the naked eye, the details will result in the wrong people moving on to wreak another havoc elsewhere."

John Meriwether was the founder and managing partner of Long-Term Capital Management, the failure of which in 1998 nearly precipitated a worldwide meltdown.  Wall Street put money together to save the financial system, but LTCM went under making a lot of rich people a lot less rich.

So, did Meriwether disappear and become a janitor at the Harvard Business School?  

Uh, no.  As the WSJ reports today, "...Mr. Meriwether quickly resurfaced. He opened a new firm bearing his initials, JWM Partners LLC, and has managed it since.

This year, Mr. Meriwether, 61 years old, has lost more than one-fourth of his investors' money -- more than $300 million -- in his biggest hedge fund. The fund's size has dwindled further as investors have pulled out."

In other words, Merriwether had no problem after the catastrophic fall of the fund he founded and managed in creating another fund and getting people to invest billions in it.

Now he's about to founder again and take billions of his clients' money with him.

Can somebody tell me why he was able to so quickly and easily go back into buseinss and get people to invest with him again?

It's astounding.  Even in Hollywood, with all its excesses, if you produce an enormous stinker that loses millions, you're not producing again any time soon.

- ChanRobt

September 20, 2008 at 1:23pm

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...this isn't the end. This won't silence automakers, airlines and those ready to get in line with a convincing case for aid. Anyone who believes this action will do more than stop this specific catastrophe ignores how many other businesses and industries are on the brink and they can't wait a year or more for a full recovery.

After the cheers die down we'll be hearing "Well, what about me?!" and the answer can't be, "We're done helping...". I doubt Bush can postpone action because those treading water won't make it to the next guy.

- michael

September 20, 2008 at 1:29pm

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I don't know. I'm of the inclination to think that Paulson et al will work a tough deal on behalf of his client. (us) I can imagine contingencies which might work both to the resolution of the bad and advantaging the upside. I guess we'll just have to wait and see.

- boxofrox

September 20, 2008 at 1:32pm

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Chan, I am not sure whether your statement about the taxpayers getting equity is right or not. I'm still trying to figure this out. I don't have the background to grasp the details of this bailout intuitively, so I am trying to learn enough to understand what we are really buying. If we are buying the bad mortgages directly, then we would indeed own a bunch of foreclosed houses and soon-to-be foreclosed houses. But if we are buying securitized investments backed by the bad mortgages then I am not really sure what we would own. Some of the posts here are a good start, but I would need more info to have an opinion I feel confident about.

By equity I meant equity in the firms we would be bailing out. Why not give them a choice: write off your bad investments, take your lumps and do as you please in the future, or if you want the bailout then you hand over a fraction of your company to the government along with the bad debts (something proportional to the debts bought out). Presumably erasing the bad debts would make the company vable and stable, and ready to go back to making profits again. Then, over a period of time the government would sell back its stake and recoup part of the taxpayer investment in the bad debts. Maybe it is crazy, but some of the news reports make it sound like the proposal is that the government simply buys up the bad debts and Wall Street goes back to doing what it likes. I can believe that the news reports don't do the actual proposal justice, but I'd like to hear the details explained in a clear way.

As I said, I don't know if my idea is any good, but that is what I meant. Just giving them money to erase their bad debts and leaving the government to write off half a trillion dollars of unrecoverable debts would be worse. Not to mention unfair to companies that actually behaved responsibly, and did not reap the large profits that came with these risky investments before the bubble burst.

- JEFF FREY

September 20, 2008 at 4:20pm

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"It seems to me, however, that crappy those these mortgages may be, they are backed by an

actual house somewhere.  And a house isn't worthy zero. "

I think it's not that simple. Since those "assets" are not only composed by the houses but also by the payments (with huge interests) the house buyers would have payed for 20 or 30 years + the penalties of the faults of the same buyers + the interests banks were charging one other on the money (this in several degrees), etc., etc.

So at the end of the day if the house worthed 10 (and now with the downfall of the market it worths 5 or 6), the "asset" on it  "worths" now something like 100.

The problem, if you ask me, is completely unproductive speculative activity that has made many -- in several degrees of exploitation and speculation -- very, very rich with "financial engineering"... What good old Christians named sinful usury, but on a massive scale and on several degrees of profiting.

"But, saving the world seems ultimately to be a good investment."

This is all very uncomfortable. One's most imediate instinct is to say "let them all burn", since they are guilty as sin. And one would probably let them all burn if their burning didn't spread into the entire economy, leaving millions of inocents jobless, homeless, etc.

So I understand that something must be done (by the good old State, who is back) if this spreading is an actual risk (is it?).

But I do hope that whatever is done doesn't mean that the "bad guys" come out laughing and with their pockets filled. I do hope that they come out "on bail" (effectively), bounded to act within strict currents and to socialize profits (at least until every last public cent has been recovered).

I'm not a economist so I wouldn't know how to achieve such goals. What I do know is that anything short of  that would mean something very ugly. At least morally.

- luispc

September 20, 2008 at 5:15pm

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ChanRobt said:

"Can somebody tell me why [Meriwether] was able to so quickly and easily go back into buseinss and get people to invest with him again?

This one is easy to explain. Mr. Meriwether is a crackerjack salesman, and people have very short memories, especially when there is a lot of money to be made and the risk is high; often, the higher the risk, the more heedless the investor.

- tomeg

September 20, 2008 at 6:14pm

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$700 billion dollars and all I got out of it was reading a blog on TNR.

gennitydo, thanks for the info too.

I witnessed Commies turn Capitalist in China improving the lives of hundreds of millions of its citizens, now I get to watch the Republicans turn Commie. What a freaking world we live in.

And Channy, no the world was not about to go down, you overestimate Wall Street and the American economy. I gotta wonder how much longer the Asians are going to finance our mess though.

- blackton

September 20, 2008 at 7:06pm

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Just in case anyone missed it, here is the full explanation of how we got into this mess:

docs.google.com/TeamPresent

- gennitydo

September 20, 2008 at 8:35pm

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blackton writes, "...And Channy, no the world was not about to go down, you overestimate Wall Street and the American economy."

Blackie, the banking system is a delicate machine, based on faith and the most recent experience.

Last weeks banks were refusing to do the basic interbank loans they make to each other every day.  Hundreds of billions a day.  That's the grease that keeps the worldwide machine working.  If suddenly no grease, and the oil pressure is gone long enough, the engine is destroyed.

China depends on this machine as much as we do.  And a lot of their assets are in dollars or only have value as long as we are buying from them.

So, I think you "misunderestimate" the danger we all were in.  Just look at the history of 1929-1939.

- ChanRobt

September 20, 2008 at 8:56pm

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P.S., I don't believe that if this is done skillfully it is literally going to cost us a trillion bucks.  

Some of the job will be done by guaranteeing loans not by actually spending the money.  Other money will be retrieved-- sometimes at a good profit-- by selling assets.

What the government and other deep pockets types like Buffet can do in these situations, is have the luxury of time.

If you are liquid, you don't have to sell assets overnight at fire sale losses.  You can afford to take months or years to sell them off on favorable terms.

Last week was a liquidity crisis.  Only the Feds had the cash and the nerve (or no choice) to do something about it.

- ChanRobt

September 20, 2008 at 8:59pm

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thanks for that, gennity.

- ChanRobt

September 20, 2008 at 9:00pm

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p.s., gennity, are you in finance, or do you teach it?  You sound like you know what's what on a more intimate level than most.

- ChanRobt

September 20, 2008 at 9:01pm

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I am sort of on the periphery of the capital markets.  Only fee-based stuff not the big bucks.  But I can see a lot of what is going on from where I sit.

- gennitydo

September 20, 2008 at 10:18pm

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Awesome gennity - thanks.  I thought after Milken and Enron there would be better oversight - but I guess if there is money to be made, instruments will be invented to make it.

- icarusr

September 20, 2008 at 11:32pm

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For what it is worth, Paul Krugman concludes that the plan as written should be killed, and his blog post gives a link to the draft text (which to my non-specialist eye mainly says that we are authorized to buy up to $700 billion of various assets, and not much else).

krugman.blogs.nytimes.com/.../no-deal

- JEFF FREY

September 21, 2008 at 2:33am

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They're dreaming if they think 700 bn is going to make a dent in the problem.  They'll need double that at least to clean up the balance sheets of the major US banks.  There is over 400 bn worth of defaulted Lehman bonds out on the market alone.

It is a pretty open-ended proposal with everything left to the discretion of the Treasury.  God forbid McCain wins and Phill Gramm takes over this authority in January 09.

- gennitydo

September 21, 2008 at 9:49am

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gennitydo: Okay. Help me out here. Are you saying that those Lehman bonds are worthless? Or are they simply out of contract? As well, is it not true that AIG has functioning insurance provisions, the benefits of which will accrue over time?

- boxofrox

September 21, 2008 at 10:15am

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We are likely to hear that the sobriety kicker was when on Wednesday night the Fed interjected 180 billion into the banking system on a worldwide as needed basis as to facilitate liquidity only to find that nearly every dime stayed parked. Worldwide banking paralysis seizure. Not rigor...... yet. Paulson et al told their little tale and apparently it had an effect upon members of Congress. As it should have.

Look. All socialist leaning partisans should be leaping for joy. There will be a pound of flesh that will be exacted to the satisfaction of those so inclined. The philosophical breech has been that profound.

- boxofrox

September 21, 2008 at 10:32am

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The Lehman bonds are not totally worthless but they're unlikely to fetch more than 0.25 on the dollar.  Bonds are priced in nominal value so that full repayment at maturity in 100%.  Lehman bonds are selling at around 30-40% now and I think this will go down when everyone realizes how much ot Lehman's best assets have already been sold as counterparties realized their collateral (I helped with this part).

The point is that there is a major valuation problem.  The Treasury plan is to buy up bad assets from the banks.  This means that the sale will be between the USG (some poor GS-7 at Treasury) vs. the Wall Street banks that have all the info (a half-dozen Wharton MBAs).  Who will get the better of this deal?  I'm guessing that the Wall St banks will have the upper hand and Treasury will pay over value.

Treasury will then hold the assets until liquidation.  The liquidation will either be the trustee selling the underlying assets (mortgages in most cases) to the "highest" bidder.  The trustee's incentive is to offload this ASAP as the workload far exceeds fees in default situaitons for all corporate trust departments.

Or if the trustee can't offload the mortgages, then it will be the administrator liquidating the assets which will take 10-15 years after all the liitgation that this will spawn.  Remember also that the CDOs are mostly issued by SIVs which are companies or trusts established under the laws of Guernsey or Caymans or BVI.  The administrators of these companies/trusts will need to be appointed under and act under local law.

AIG surely has functioning insurance policies, but the problem is that the liabilities for their underwriting of credit default swaps far outweigh the value of such policies.  Not to scare all of you unduly because a lot of this is synthetic stuff and so the "valuations" are absurd, but this may give you some idea of the magnitude:

Here's business correspondent Bob Moon and host Kai Ryssdal on American Public Media's Marketplace from back in the spring.

BOB MOON: OK, I'm about to unload some numbers on you here, so I'll speak slowly so you can follow this.

The value of the entire U.S. Treasuries market: $4.5 trillion.

The value of the entire mortgage market: $7 trillion.

The size of the U.S. stock market: $22 trillion.

OK, you ready?

The size of the credit default swap market last year: $45 trillion.

KAI RYSSDAL: That's a lot of money, Bob.

- gennitydo

September 21, 2008 at 11:38am

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Here is some good info on the position of AIG.  You can see that their total exposure to credit defauly swap is 441 bn (or a little less than 50% of all liabilities) and, more importantly, that this exposure is 69% to European banks.

www.efinancialnews.com/.../2451864754

- gennitydo

September 21, 2008 at 11:55am

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gennitydo: Thanks for your helpful info. Tops. Please feel free to make yourself available in the coming brouhaha. There seems to be a decent degree of tyranny by accounting going on here. Synthetic and real and mysteries to behold yet untold. Perhaps a little outside of the box is required? As if we aren't already way outside the box already.

Thanks again.

- boxofrox

September 21, 2008 at 12:30pm

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Thanks Jeff Frey for that link. I hope that Krugman text will be read by many...

"The philosophical breech has been that profound"

Yes. But one should run away from the sort of people who are happy with this.

People that are willing to put human suffering (not felt by the perpetrators themselves but by many others) on their test tube in order to confirm their "grand scheme of things" are not to be trusted...

There are of course lessons to be taken. But the most important one must be learned by capitalists and socialists alike: there isn't any grand scheme of things" that worths the suffering of one innocent human being...~

- luispc

September 21, 2008 at 2:19pm

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One of the things exposed here, which I assume any half-sophisticated financial observer knows, is that the value assigned to anybody's balance sheet-- whether an individual applying for a line of credit, or Goldman Sachs-- is pretty damn arbitrary.  

And when you're talking about enormous institutions making trades by the milisecond, obviously these assets can rarely be examined at all, let alone with much accuracy.

Of course, it's no secret that the "value" of anything is only what somebody most recently paid for it.  For the financial system to work at all, everyone must suspend disbelief every-much as a child listening to Hans Christian Andersen or a kid watching Transformers.

- ChanRobt

September 21, 2008 at 3:25pm

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luispc writes, "...there isn't any grand scheme of things" that worths the suffering of one innocent human being.."

The problem is, luis, no scheme, whether Democracy, Communicsm, Capitalism, Christianity, or Socialism works unless a significant number of people put their faith in it.

All systems are faith based.

Communism, after all, worked for 62 years.  Capitalism has worked for 200 or so.  the Roman Catholic Church has survived for 2000 years.

We all must arbitrarily agree to believe in something.  Logically, there is no reason to believe in any one system because contradictions, fallacies, and frailties can be found in them all.

A system works as long as it works.  If too many people stop believing in a given system, it stops working.  

So the question is, Do systems fail because more because of weaknesses in the system, or simply because people eventually grow tired of any system?  Or because too many people at some point cheat the system, which makes it break down?

I'm sure there are many in the Soviet Union who believe to this day that Communism is perfectly viable, but that the weakness and corruption of Soviet citizens is what killed it.

- ChanRobt

September 21, 2008 at 3:34pm

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"All systems are faith based (...) We all must arbitrarily agree to believe in something."

I agree with the first assertion. But vehemently reject the second.

On the first, it is true that all systems implemented in these last centuries were based in a set of myths and narratives, some of them unbelievable: the belief that from the pursuit of strictly selfish interest general welfare would come (the basic belief behind free market capitalism); the belief that from the violent afirmation of the proletariat the end of history would result; the belief that history was dominated by one race destined to dominate all other races, etc.

And it is true that those systems only subsisted because the correspondent "political religions" were widely shared, if not by the majority, by a very significant minority.

But one thing is also true: those "political religions" turned into possibilities because they occupied the empty space created by an agressive secularism. And they were very perverse possibilities. Since, using Carl Jung's terms, they were "fairy tales" in which the eschatological elements of Christianity were present with one (the essential) absent: the ethical element.

The "end of history" in Christianity means the moral perfection of man, his reaching of the "internalization" of the moral meaning of Christ, his reaching of his true humanity (something that Roman Catholicism never knew, being it an historically transitional "platonism for the people").

And those "political religions" were formaly eschatological  without being substantively eschatological. Meaning: they created an "end of history" or an "end of story" ("the greatest good of the greatest number", for instance) to be reached independently of indisposable moral dictates, of indisposable moral absolutes.

Precisely because of this they had the virtuality of turning men into beasts. Indeed, they "convinced" men to inhabit roles that had nothing to do with goodness, to be performed in terms that are totaly independent from moral dictates (for instance, the role of the trader that has to be SMART, but doesn't have to be GOOD and that consequently, at a certain point, eliminates jobs or compromises pensions funds without thinking for a moment about what he is doing in moral terms...)

So, there is one moral lesson to be taken out of this. And it surely is not that we must "arbitrarily choose a system". It is that we are in no position to renounce to some moral absolutes. We know that all other narratives (all "fairy tales" that formally resort to the eschatological elements of Christianity without tying man to an indisposable and framing Good) have the violent capacity of destroying man, of turning man into a beast that inhabits (believingly) some "grand scheme of things" that has nothing to do with his own humanity.

We have already "chosen" too many systems. And we have already watched too many painfull downfalls.

Sorry if this was too long. And I hope I could explain myself.

- luispc

September 21, 2008 at 4:54pm

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Boxo: I don't see why you'd think socialists or leftists would be jumping for joy here.  And of course the very title of this post is misleading.  Bush, not Clinton, has created Big Government; and it has been the conservatives who have turned the State into an agent of ideological warfare over the last generation.  Left-leaning liberals such as myself have been arguing for balanced budgets and smaller (but more focussed) governments for a very long time.

Regulation and big government are not synonymous, just as deregulation has not resulted in smaller governments.  In any event, the chief difference between the Right and the Left, if those have any meaning, is not so much big or small government, or regulation or deregulation, but *government to what purpose*?  Alaska sings individualism and basks in Federal largesse; DeLay and his gang went after Clinton's blow-job and sold the Federal Government machinery to Abramoff.

Government, yes; and regulation at the Federal, yes: but for strictly collective and national purposes, and not individual, private or local reasons.

No liberal, or left-leaning person would be jumping for joy right now, knowing that the only way to save the US economy is put the US economy in hock to the hilt to the Chinese and thereby constrain US government spending for social and politicial objectives for a generation.  The announcement of the bail-out - that is, the recognition for the need for one - is occasion for mourning by anyone who truly believes in the importance of government action to achieve collective social objectives.

- icarusr

September 21, 2008 at 5:44pm

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I think it is now obvious to all that Paulson's plan was simply a giveaway to Wall Street and one that was purposely exempted from any oversight or judicial scrutiny.  This is because the plan only works if Treasury buys the bad assets at above market price.  Paulson has apparently admitted this to Congress.  From a staffer (apparently) that participated in the discussions:

"Behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

....  this program is going to swing into action with the clear but not honestly disclosed intent of buying assets at above market prices when future markets and the analysts with the best track records on forecasting this decline (you can add Robert Shiller, CR at Calculated Risk, and Nouriel Roubini to the list) believe it has considerably further to fall."

- gennitydo

September 21, 2008 at 10:49pm

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If the banks won't sell at the market price, they can't be that desperate for cash.  So, what's the crisis?

If the banks are on the edge of bankruptcy, they'd lose all discretion and the bankruptcy courts would decide what to sell and when.  No?

- ChanRobt

September 21, 2008 at 11:29pm

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icarusr writes, "...No liberal, or left-leaning person would be jumping for joy right now, knowing that the only way to save the US economy is put the US economy in hock to the hilt to the Chinese..."

Uh, ick, no liberal or left-leaning person who doesn't have a large, well protected trust fund ought to be jumping for joy.  Lefties have to eat and have a roof over their heads to, correct?

- ChanRobt

September 21, 2008 at 11:31pm

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Chan: Boxo said, "All socialist leaning partisans should be leaping for joy."  I was replying to him.  I have no idea what you find problematic in what I said.

Gennity: Thanks again.  Even when their instincts are correct, the Republicans manage to screw it up.  The one thing I can say is thank God for the class action lawsuits that will be launched against the partners at these banks.  Greed is good, for the banker, the lawyer and the plaintiff.

- icarusr

September 22, 2008 at 12:58am

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ChanRobt - Actually, I think it is the opposite.  If they don't sell above the market price, then they will go bankrupt.  Otherwise they would sell at market price or pledge the securities as collateral and get enough cash to stay afloat.  I think that Paulson knows that for the banks to survive (presumably Morgan Stanley and Goldman Sachs) they must sell above market price and probably substantially above market price.  There is only one potential buyer which could buy at that price and that is why Paulson needs the plan to be exempt from oversight and judicial review.

I think we are running into a major roadblock.  I see that Thursday seems to be some sort of deadline.  Treasury is implying that if the deal is not done by Thursday bad things will happen.

My view: would it really be so horrible for Morgan and Goldman to go down?  Some lessons would be learned that way for sure.

- gennitydo

September 22, 2008 at 3:18am

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icarusr, sorry, I ought to have addressed my remarks to boxo.  So, I will.

Boxo, how will all these joy jumping Leftists eat if the near meltdown brings us 1933?

- ChanRobt

September 22, 2008 at 8:56am

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OK, gennitydo, I understand your point.

However, if these mortgage backed securities are actually overly depressed right now because of the panic, the Govt conceivably will do fine selling them at their leisure as the housing market regains it equilibrium.  That is, if the govt doesn't pay overly inflated prices to which the houses have no hope of returning.

- ChanRobt

September 22, 2008 at 8:58am

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Seasoned with sardonic. It might be a bit like the beer bash and breaking the seal with the first pee in the trees. More frequent trips will ensue henceforth. It's hard not to imagine the tentacles of re-regulation overshooting their grip by virtue of the leverage this crisis has conjured. Just as surely as UHC would introduce a national exercise regimen. I truly hope that I am absolutely wrong.

The tyranny of bureaucrats and accountants. Like it or not this is an invitation the likes of which left leaning folks will find attractive.

- boxofrox

September 22, 2008 at 9:51am

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Just to be clear I support the actions taken by Treasury and the Fed. I think Paulson et al will surprise to the upside on our (the taxpayers) behalf. The price we'll pay for these interventions is advantaging the upside of expansions. But this was unavoidable. We were risking the collapse of accepted valuations throughout the world economies.

- boxofrox

September 22, 2008 at 10:03am

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