Grim,

It's waaaay too late for me to even think about commenting on this, but I have a suggestion: If you can edit that base post, maybe some horizaontal rules between the sub-posts, so tomorrow's readers can follow it more easily?

[Grim, MV: I took MV's suggestion, and the small liberty of blockquoting and horizontal-ruling to make it more readable. --NM]

Just re-publishing my comment from other thread (with some typos corrected and clarifications) and a new comment at bottom:

I think there are several causes of the problems we're now facing, a few of which I've seen in working with credit default swaps:

1. regulatory and legislative push to make loans to debtors with poor credit;

2. a failure of the Fed to raise interest rates sooner after the 9-11-01 attacks, contributing to overheating in the housing sector, fueling speculative borrowing and buying;

(To this one could add other long-standing artificial stimuli for home-building, such as the mortgage interest deduction and Freddie and Fannie.)

3. an unhealthy separation of loan origination business from the credit risks of loans originated, with the result that the originators, who securitized and sold the loans on the secondary market, had little incentive to police quality;

4. failure of rating agencies to understand RMBS products;

5. failure of rating agencies to understand systematic risk to financial guaranty companies of "wrapping" RMBS risk with credit default swaps;

6. failure of investors (including credit default swap protection buyers) to conduct their own diligence of these products of securitization rather than simply relying on rating agency ratings of the products and of financial guaranty insurers;

7. failure of state financial guaranty insurance regulators to properly police financial guaranty companies and the continuing policy of such regulators to favor same-priority municipal bond policyholders over asset-backed securities policyholders;

8. abusive shortselling;

9. "too big to fail" moral hazard problems.

Note that credit default swaps and rmbs, etc. aren't regulated much because the players are supposed to be "sophisticated" and understand the risks. They cannot be sold to general investors in the US.

All that said, the politicians asking for limits on executive pay and equity interests in participating banks don't understand what the "bail-out" is supposed to do. It is not to save troubled lenders (though that might be a secondary effect). It's purpose is to add liquidity to the credit markets, without which businesses that need financing (as almost all do) won't be able to obtain it, and will fail, destroying value (and jobs) in all sectors of the economy (which will further depress housing prices and the ability of homeowners to pay their mortgages, further depressing the value of the RMBSs). To work, the banks (not all of which are near failure) have to want to participate, and cutting the decision-makers pay or demanding that shareholders allow their interests to be diluted is not the way to get participation.

Don't take that an an endorsement of the "bail-out." I think it has a good chance of failing precisely because politics is getting involved and reducing its effect -- a lot of this depends on credibility, which, like the credibility needed to effectively conduct Middle Eastern foreign policy, tends to be eroded when partisan politics becomes a factor, and we're only a few weeks before a major election. In addition, with the amounts involved, it's simply too big a target for pork-barrelling. We'll be fleeced.

Even more fundamentally, I don't trust the government to get the pricing right. How is it supposed to figure out what none of the market participants can figure out? In short, I fear we'll end up putting in the money and not solve the problem.

I don't claim to have the answer, but I have to believe it starts with policies to strengthen the lenders that are least infected with the results of poor decision-making rather than those most infected -- and the same goes for mortgagors.

The bottom-line root cause of this problem is overdependence on credit at all levels. Having the federal goverment borrow even more money to throw at the problem seems a step in the wrong direction.

New comment: I have seen a couple of good alternative suggestions:

1. impose a temporary moratorium on bank dividends;

2. selectively (and temporarily) relax bank reserve requirements (but increase surveillence); this might include relaxing mark to market valuation rules;

3. modestly increase deposit insurance premiums.

Some of the weakest banks would probably fail. Then the FDIC (and anologous agencies) take all the assets RTC-style. Cheaper than buying and weeds out (rather than bails out) the weaker players.

In a rational economy, regardless of what was happening in the secondary, tertiary, quaternary, etc. markets, a surplus of housing stock should have led to a decrease in the unit price of said stock.

So again, it's tulips.

It is not the bad mortgages that were written that bought us to this spot. It is the bundling and leveraging of these instruments that got us here by turning a housing bubble into an attack on the entire world financial system and capitalism, itself.

Look further upstream than sub-prime market for the instruments that allowed the problem to metastasize. The problem is there. Bad mortgages could not have possibly brought down the investment banking and industry. The creation of highly leveraged and financial markets and instruments could and did.

Couple of things about Fannie. The reason why 2008 had 18 calls was that everyone knew it was going down . Maybe not admitting it in government work, but it was going to happen.

And, that reform wasn't largely to make it either more capitalized or less involved in the market - it was to switch oversight to the new FHFA and a few things about Katrina.
Additionally, it wasn't so bad that the OFHEO didn't allow it to expand into a collapsing market . This was part of the executive branch, and the explicit move to allow the GSEs to drop capital requirements in order to move markets. One interesting note from that is
Until recently, the Bush administration has sought to force the companies to reduce their holdings of mortgages and related securities, arguing that they were taking too many risks. But the current financial scare has prompted the administration to join Congress in urging Fannie and Freddie to play a bigger role in the market with the aim of restoring calm. Yesterday, Sen. Charles Schumer (D., N.Y.) called on Ofheo to "significantly reduce" the capital requirements at both firms.

So - don't believe anything which leans too hard on the Bush administration was the sole voice of reason, repeatedly asking for help, and had the ability to save us all if only we had listened! They may have thought it was a risk, but had no problem making it riskier - OFHEO is all them. Spurred on by D's, some R's, and a lot of industry(this action made industry very happy).

It's irresponsible to say that the new legislation would have saved things, it would have just changed it = and both parties chose not to come to agreement in the Senate. Also,
first standing up not to rejecting expansion of the GSE's total portfolio size, but making sure things changed first
relaxing rules to inject capital
bouncing around last year, and having to dump mortgages on the market

It's fine to look at them as problematic, but understand it was also looked at as a tool, a much more subtle one than the $700B bailout.

I think I recommended it earlier here, but I'd go again for listening to This American Life's Giant Pool of Money .

It covers up to the securitization of loans, though I think it skips out on the Credit Default Swaps, which is just chaos in itself.

This isn't bad either, from a few months ago (warning! Fresh Air! Danger!)

Both of these have the added benefit of being immeshed in problems, but not touched by the doubly toxic combination of impending disaster+40 days from a presidential election.

The CDS were bad thinking, proposition bets with money that didn't really exist; but also, the odds of the proposition bets were badly evaluated because the bets were converted from subprime to AAA bonds?
Yes. Think about these two scenarios.
* I have 100 loans, 99 are spectacular and low risk, 1 is iffy. Give me $20mil for this so you get the payments over 30 years, and you can also go get some insurance(CDS) by paying .1%/yr of it's value in case you lose money or there is a major event (GSE being taken over/bankruptcy of a major player/overall corporate ratings drop/etc).
* I have 100 loans, 70 are fine, 20 are ok, 5 are shaky, 5 are way risky. Give me $20mil for this so you get payments over 30 years, and you get insurance by paying 5%/yr of the value.

This is largely done by intuition and you get removed from the initial risk(lending to a homeowner), which makes it harder. And as Andrew put above, once the ratings agencies go cross eyed in their own grasping, things start to line up poorly. Again - being a combination of intuition and past performance, it's hard to just say that one lot is AAA and another is AAa.

When things were going up, houses were being flipped, and people were paying mortgages - that .1% was easy money. Once things went badly, that .1% didn't cover the true downside risk, where the second scenario may have.

While it is fashionable to blame all financial woes on deregulation, I have to look at what I see as the facts. Like, the capital markets didn't make "creative loans" for decades, however; they began to in the mid to late 90's. Odd how that was the same time the Executive Branch changed the Community Reinvestment Act's (CRA) rating formula from one that was processed based to one that was results based. This was well intended and I personally took advantage of a "creative loan" to buy a house in a locally impoverished community, re gentrification as it is called. Anyway, The CRA rating was taken into account when large banks wanted to do anything that required fed approval and that is a lot. Once one bank began to gain market share with their "creative" loan packages, others chose to follow suit. It is from this point that I feel greed took over. However, to watch us try to totally disregard the possibility of unintended consequences being associated with social feel good policies is to propagate the problem, IMO.

Now, we have a housing stack that exceeds buyers who can afford them. We have banks stuck with various non-performing loans, while the value of the performing ones are less than what is owed. So what do we do? We could let the banks eat their humble pie, but then they won't be making the home loans needed to clear the excess housing stock. This will further depress the home values for all of us who made wise decisions. It is a truly screwed up situation with enough blame to go around. However, when Nancy Pelosi says democrats share NONE of the blame, it further makes me suspicious of culpability. The major problem I see, is one of Moral Hazard and for me that is a societal slippery slope we have been traveling down for quiet some time.

Low interests rates are healthy.

I'm reminded of a time I was in ER triage with a high fever. The nurse took my blood pressure and told me it was 115/80. "Best BP I've had in years," said I.

"Yeah," replied the nurse, "but your pulse is 120 so we're admitting you."

[Pneumonia that, I'm glad to say, was caused by bacteria who surrendered at the first approach of something-cillin.]

The low interest rates of the early Bush Administration, in conjunction with Greenspan's endorsement of balloon mortgages and people pulling the equity out of their houses, turned the home into an ATM. If you look at manufacturing at that time, it was in a deep recession, whose effects were canceled out by continued spending in the consumer sector. People didn't have to give up the higher standard of living they had attained under the Democrats; they just used their savings. Why did Greenspan do this? I suggest the inability of the government to do any pump priming because what would have been surpluses had already been turned into deficits, mostly by the Bush tax cuts. But a housing bubble was an almost-inevitable result.

Translation- low interest rates are usually a good thing. But not with George Bush as president. The same can be said about low infant mortality rates, winning the lottery, and the existence of unicorns.

Everyone knows Clinton ran the perfect economy single handedly and Bush ran the country in the ground to somehow enrich his oil buddies back in Texas. Its all part of the plot to sell all that oil he secretly piped in from Iraq and the natural gas pipeline from Afghanistan. Yee-haw.

When I am out of my depth on an issue, I go back to a few simple rules and first principles. Here, those would seem to be:

1. The government's role in the economy should be limited to providing currency and the associated (derivative?) credit liquidity, preventing fraud, and providing a secure and stable regulatory environment that ensures predictability.
2. The (Federal) government should not own for-profit enterprises of any kind, in whole or in part. The government exists to provide those goods and services which cannot be provided otherwise, such as a common defense and foreign policy, as well as regulation of international and interstate commerce.
3. For a free market to work, businesses and individuals must be allowed to fail when they make bad decisions. These failures clear out the bad ideas and investments, making room for new (hopefully good) ideas and investments. Internet commerce is healthier for the .com collapse, rather than less healthy, even though it was painful at the time.
4. The markets do not exist as a vehicle for politicians to enact social policy. This is in some ways a derivative of rule 2 — Fannie and Freddie are and always have been bad juju.

These general principles tell me that bailing out the idiots is a bad idea. In the term "idiots" I include those who took out loans they couldn't afford, made loans that they couldn't afford to insure or lose payment on, bought financial instruments whose value and risk they couldn't confidently assess, or provided leveraged funding to buy these shaky instruments while being unable to afford the failure of the instruments to pay off. All of these are simply poor, poor decisions. You do not take a loan you cannot pay. You do not offer a loan you cannot afford to lose, or whose loss you cannot insure against. You do not buy financial instruments unless you understand the risks and can cover the losses if the risks materialize. You do not provide funding to others to do these things if you cannot afford to recoup the losses from their assets or from your insurance.

Yet the bailout being proposed protects all of these people except possibly the first. I initially was thinking that this would be OK if the government took an ownership stake and still found some way to punish the executives who made the errors, but the more I think about it, the more principles 2 and 3 above come into play, and the more I think that the markets, and not the government, should do the punishing.

But what about the first principle, the idea that the government should provide liquidity to the market? Fundamentally, the argument that the Bush administration and the Fed (and let me be clear, I trust Bernanke's evaluation of the problem, even if I do not necessarily agree with his proposed solution) are making is that not bailing out these companies will stop them from lending whether they collapse or not, until they can absorb the losses already or about to be incurred; will stop other financial institutions from lending to avoid finding themselves in the same position; and will as a result dry up the credit market to the point that they are worried about a replay of the Depression.

OK, so the government has to provide liquidity. Why not provide it directly, rather than indirectly? Does the government really have to buy the bad debts of failed companies? Is there no other way to provide credit to companies for operations, bypassing the investment banks?

If the song hang together or swing together ever meant anything this financial crisis is it. Democrats and Republicans are guilty and complicit in it.

the posters here have given a pretty good analysis of what has hapenned. the question I have is given that Paulson and Bernake are proposing this do you want to give $700,000,000,000 to the guys whom couldn't act before now?
link

Well, if we think we've described the problem reasonably well, let's move on to solutions.

It looks like Credit Default Swaps are the thing that takes this from being a $250B problem and makes it a trillon(s?)-sized problem. What would be the repercussions of Congress declaring all those pertaining to this issue to be null and void -- in essence, setting aside the "proposition bets" on failure? It seems like that would greatly shrink the size of the problem, and the amount of money required to fix it.

If voiding the CDS bets is a good idea in this crisis, should they be banned for the future as well? Or do they normally serve a necessary function in the economy, and the real problem here is just how the oddsmaking got messed up?

Presumably those holding (trillions of dollars in!) CDS would sue to get them reinstated, so Congress would need to include in the bill a limit that would prevent such lawsuits. They do have Constitutional jurisdiction to do that, in Article III, Section 2: so we could move forward on the CDS issue, either to nullify them in this one case or to ban them outright, if that was a thing people decided was wise.

What would be the repercussions of Congress declaring all those pertaining to this issue to be null and void -- in essence, setting aside the "proposition bets" on failure?

We become a Banana Republic. All those pieces of paper are someone's property. Congress cannot retroactively nullify property interests. Congress can buy them. It can invalidate them going forward. (Similar problems with the ideas of retroactively cutting executive compensation or putting the government first in line among creditors)

so Congress would need to include in the bill a limit that would prevent such lawsuits. They do have Constitutional jurisdiction to do that, in Article III, Section 2

Congress does have jurisdiction stripping authority, but the extent of it has never been tested. This might be a situation where it would fail. In areas like immigration, national security or Congressional spending power (the bailout), there are not significant Constitutional issues anyway. Taking property without just compensation is probably a bridge too far.

It is a pleasant change to read analysis and comment minus most of the usual colouration of political partisanship. It assume this results from the reality, that in this debate we don't 'know' [in the usual partisan sense], that all that's good is our team's doing, and all that's bad is theirs. In short the debate represents more of a quest for truth rather than a sermon. Thank you commenter's.

All those pieces of paper are someone's property. Congress cannot retroactively nullify property interests.

Well, they can keep the paper.

Honestly, though: if you're going to use eminent domain as the model ("Congress can buy them"), how do you determine the fair market price? Full face value? That's what leaves us with a problem where the losses far exceed all the actual money that ever existed, the values of all the homes on which all of these bets were placed.

Or can you say, "If we let the financial markets crash, your 'trillion dollars' would suffer from massive devaluation of the dollar; so we'll pay you at the a rate equal to what they would be worth if we didn't act to save the markets"? Thus, instead of a trillion dollar problem, you've got something managable -- you can estimate what the dollar would be worth in the event of a crash, or in a print-money-to-buy-us-out scenario, at a high enough rate to bring down the cost of the buyout.

Unfair? I'm not sure it is -- certainly not as unfair as the proposition bets turned out to be. It looks to me like an honest approach, since the dollar would be strongly devalued if Congress didn't act to save the market. So "buy" the paper for what it would be worth if you didn't act.

What to do about it?

If America is to own all these mortgages, let's own them. I have contacted my Senator with the following suggestion:

All purchased mortgages should be placed in real Social Security lock-box, for use in alleviating revenue shortfalls to that system.

The duration of many of these instruments is well-matched with Baby Boomer retirement. If the mortgages turn good, we all benefit, perhaps greatly. If not, Social Security is no further behind.

What I do not wish to see is for any potential profit from this arrangement get slurped up into "general revenue" and used to subsidise the Alabama Peanut Queen Festival or whatever.

There is no potential profit for the government. These same companies will buy back anything of value in that paper for pennies on the dollar. And all our elected officials will help them do it.

Looking down the road though, the next problem i see is what happens when the government needs to foreclose on some of these loans. How long until a moratoreum on foreclosures is enacted? The idea (idiotic as it is) has been bandied about this year, and that was before the government was directly in the mortgage business.

Beware the 'business' that prints its own money.

Honestly, though: if you're going to use eminent domain as the model ("Congress can buy them"), how do you determine the fair market price? Full face value?

"Just compensation." Find an appraiser, ask a jury. The government can make an acceptable offer. It's really the government's problem if it can't figure out what or how to pay.

Sidenote: These issues were discussed with the 9/11 airline bailout. Everybody that was killed or injured on 9/11 had a potential cause of action against the airline industry, i.e. they had property. The government did not want the airline industry to go under so it presented a compensation package to the victims which required them to waive their right to sue. It was an attractive enough package that people were willing to give up their lawsuit of unknown and indeterminate value.

If the Credit Default Swaps are worthless, then there is no property and no compensation is needed.

But if these were legitimate transactions that the government did not ban, I think we act in our peril to undo them after the fact. All of our business transactions will become more expensive to discount for the risk that the transactions later become unpopular.

I don't see the existence of CDS as the problem. If the protection buyer owned the reference asset, it's essentially an insurance policy, i.e., a risk-shifting mechanism. That only works, of course, if the protection seller (insurer-like entity) remains solvent, which is often not the case now, so it's become false security in many cases -- not because the device is bad but because risks were miscalculated and concentrated rather than spread about. Spreading risk is the whole concept of insurance.

CDSs are being torn-up now in exchange for work-out walk-away consideration, including equity, but such consideration doesn't make-up for reversion of the risk to the buyer, which now has to book the mark-to-market liability on its balance sheet.

The CDS problem was that the parties didn't properly value the risk involved with the reference assets, asset(mortgage)-backed securities. The mechanism itself is not flawed if everyone can come close to properly assessing the risks involved. In this case, protection buyers relied on the credit ratings of the protection sellers, who relied on the credit ratings of the reference securities. Independent diligence of the securites was largely absent.

Ugghhh, my lips to Hillary's ears:

"Let's Keep People In Their Homes
By HILLARY RODHAM CLINTON"

...
"We should also put in place a temporary moratorium on foreclosures and freeze rate hikes in adjustable-rate mortgages."

WSJ

Anybody who really wants to see the bottom fall out of the real estate business, here's a great way to do it. Do feel like paying your mortgage this month? Hillary wants to help.

When we talk about accountabiliy, we better not forget the thousands of people that knowingly bought houses on speculation that they can't afford. And if you dont know how an ARM works but signed the papers anyway you probably need the lesson in bankruptcy, because common sense obviously didnt pan out.

Here's my (probably ill-considered) proposal. Banks can put any loan they chose up for auction. The government provides a minimum bid (say 20 cents on the dollar). Anybody can buy the note, but if goes to the government the property is plowed under and the 20 cents on the dollar is converted to a tax lien against the person on the original mortgage

This way, banks get the bad loans off the books, albeit at some cost to them. Private money I assume will provide most of the funds, and in the case where the taxpayer is put on the hook, the person with the original mortgage doesn't get off scot-free.

Where are the flaws in this idea?

#19:

If the protection buyer owned the reference asset, it's essentially an insurance policy, i.e., a risk-shifting mechanism.

Let's talk about this idea. I've heard people say this several times, but I don't think I grasp why this would be so. From my perspective, it reads this way:

1) I have a loan I expect to be paid off.

2) You offer me a bet: if the loan is paid off, you give me a small sum of money, but if it is not paid off, I give you a large sum.

3) The loan either is, or is not, paid off.

Now, how does this shift (or even spread) the risk? It certainly increases MY risk: formerly if the loan is not paid off, I'm out the value of the loan; now, I'm out the value of the loan plus a large sum of additional money.

It creates new risk -- formerly you had no risk, but now you are at risk of losing a small sum if I get paid off as arranged.

So it looks like the CDS is functioning to increase risk across the system. It's not really spreading my risk to you: it's increasing my risk while creating new risk for you.

#21:

I think that sounds like a reasonable approach, but would like to hear what others say.

[republish of my comments from the other thread]

All that said, the politicians asking for limits on executive pay and equity interests in participating banks don't understand what the "bail-out" is supposed to do. It is not to save troubled lenders (though that might be a secondary effect). It's purpose is to add liquidity to the credit markets
-ricg

Fine, those institutions that are put off by the terms can go it alone. In the meantime the federal government can capitalize its own bank with the 700 billion to 1 trillion being suggested for the floundering banks that got themselves into quicksand. The banks that are strong enough to survive will survive, those that are not will have their assets purchased by the new federal entity for pennies on the dollar.

There's no liquidity crises. There are reckless banks that are functionally insolvent and they should fail. Furthermore, it can by argued that we suffered from a case of too much liquidity, much of which was used for speculation rather than on the real economy of productive work. And do you really believe that encouraging already maxed-out consumers to assume even more debt is sound economic policy? This is precisely the kind of thinking that got us here in the first place.

To work, the banks (not all of which are near failure) have to want to participate, and cutting the decision-makers pay or demanding that shareholders allow their interests to be diluted is not the way to get participation
-ricg

As should be obvious to all by now the decision makers were the problem, what makes them worthy participants in the solution now? In fact, this level of incompetence in the real world gets you fired. As to shareholder concern about the dilution of their stock, well... that's just too bad isn't it? That's the price of insolvency. Investors who put up the money to rescue the bankrupt get an equity stake. Don't like the deal? Then take a hike, kick some rocks, scram...

For a different perspective, here is an economist that argues for debt forgiveness, through it's not clear to me which debt he would forgive:

_Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well,
soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders._

Link

I am unconvinced that striking a clause from a contract that would have undermined Congress' specific power to value money is "precedent" for the government to go around writing-off debts. But from an economic standpoint sounds like it would work. And I might be less grouchy about it if my car loan, house loan, student loan and credit card loans were forgiven.

_Here's my (probably ill-considered) proposal. Banks can put any loan they chose up for auction. The government provides a minimum bid (say 20 cents on the dollar). Anybody can buy the note, but if goes to the government the property is plowed under and the 20 cents on the dollar is converted to a tax lien against the person on the original mortgage

This way, banks get the bad loans off the books, albeit at some cost to them. Private money I assume will provide most of the funds, and in the case where the taxpayer is put on the hook, the person with the original mortgage doesn't get off scot-free.

Where are the flaws in this idea?_

-SG

I see three flaws SG.

1. That 20 cents re-capitalizes the reckless since in all likely hood those mortgaged backed assets are worthless. Politically, how to you justify putting tax liens on taxpayers who've just bailed out the the wealthiest and most reckless people in history?

2. If by "getting" the bad loans off their books means "putting" them in my pocket how does this reduce or even discourage moral hazards in the future?

3. There is nothing to suggest that private money will come anywhere near this garbage. The foreign central banks and sovereign wealth funds have already been burned in this game. What if Paulson throws a party and no one comes?

Grim, my understanding of the situation is limited, but I think you have it backwards. The bet should be:

If the loan (which I am owed) is paid off, I pay you a small amount of money. If the loan fails to be paid, you pay me a large sum of money--presumably (but not necessarily) at the full amount of the loan.

This way the risk is spread around, and I accept that my total payoff on holding the loan will be lessened by the amount (premium) I paid by "losing" the bet.

I think the problem came where institutions lumped a number of these bets together and incorrectly gauged the quality of the underlying mortgages. So if you made 1000 of these bets with me, you would expect to get the value of 1000 small premiums since mortgages are traditionally "safe" investments and you would win the bets; but if you reported these bets as assets... you get into the really big balance sheet problems once the underlying assets start going into default.

#26:

I'm certainly in the same boat -- only now trying to learn just how these systems work. What you describe is indeed reasonably called "risk spreading."

The problem for me is that I can't see how what we're looking at here is a setup of the sort you're describing. What I don't see, in other words, is why the value of the CDS payouts is so much greater than the total value of the homes on which all these mortgages were based? If the subprime default is valued at around $250B, and the CDS were simply insurance policies to make sure you get your investment back in case of default, then the payout should be roughly equivalent to the cost of the defaults -- i.e., not more than $250B if that's how big the defaulted loans were.

The CDS "insurance" seems to be the place where the genuinely huge sums appear. That's not insurance as I understand it -- where, if I lose $100, you pay me $500. Normally insurance is directly tied to the value of the thing being insured, not some multiple of it.

SG: Where are the flaws in this idea?

None except the political flaw. It's premised on the unacceptable notion that the defaulting mortgage borrower is ultimately responsible for the crisis. Nevermind that this crisis would not have happened if the mortgage payments were made as promised. They are the victims.

Coldtype:

I'm accepting as a given that something is going to be done for the financial industry. I don't like that fact, but it seems unavoidable.

My proposal sets a floor on the banks losses at 80%. That's a hell of a haircut - more than I think the current bailout proposal is going to do. It also gives a value to the assets so given mark-to-market requirements, it should reduces the amount of recapitalization needed.

I'm not convinced that you're not going to find buyers for much of this real estate at 21 cents/dollar. You say it's worthless - I just don't believe that.

And the taxpayer who gets the lien is the guy who took out a mortgage and didn't pay. Why should he get to walk away free and clear? Making him kick in 20% in the worst cases doesn't offend me in the slightest. I admit that my political sensibilities may not be representative, but I don't think making those who took out bad debts bear the lion's share of the governments cost seems like good politics to me.

So in essence if the property has value > 20%, some third party comes through - the bank eats the loss, but the debtor and tax payer aren't on the hook. In the worst case the bank eats 80%, the debtor eats 20% with the government floating the 20% and getting it back through an income tax liability. And the property is removed from the market to reduce inventory.

Actually, I still have a question and a few observations and out-of-depth opinions on the problem itself.

The question is simple: I keep seeing this described as an effect of deregulation on the one hand, the weird-ass mortgage repackaging on the other. I have enough financial acument (I'm not completely ignorant) to believe that the root cause was the mortgage repackaging that was going on, causing various problems, and exacerbating and being exacberated by, others.

But, is there a fundamental piece of de-regulation that allowed this to happen? Or is this a secondary or tertiary effect? Is there a point in time where the repackaging of mortgages in this fashion would have been outright illegal? It's a fine point, but it's important in my mind. I think the answer is no, but I have no real confidence in my answer.

The observations and opinions are partially contained in the problem: It seems to me that the major "villain" here was the repackaged mortgages and the system that allowed them to permeate. Grim's description of the repackaging and re-repackaging, and Lazarus' assertion that this could happen multiple times strikes me as... well, as credit laundering. And as an engineer, my thoughts turn to Bayesian analysis: "Given the rating of this here tranche as AAA, what is the likelyhood that it or any element of it has previously been rated at lower than AAA?" That answer, in a sound system, would seem to me to need to approach zero, when in fact it seems to have been approaching one.

All of which (and again, this tracks, barely, with my spotty undergrad level of understanding) lead to a whole bunch of institutions holding these things, and then getting the downgraded and needing cash on hand to cover the paper losses, which sometimes turned out not to be possible resulting in bank failures and panics: If you need to raise cash, and your portfolios are all infected or potentially infected, you die.

So Ricg's and Jeff Medcalf's claims about liquidity crunches seem on target to me, and I thought the point about the government stepping in only to provide necessary services-- in this case, liquidity in crisis-- seems particularly wise. It would seem like this would be a point where both Republicans and Democrats can agree, if they're not extremists in their market orientations. (An extremist Republican, verging into capital L Libertarian-land would argue that liquidity is not essential; an extremist Democrat, verging into capital S Socialist land would... I dunno, try to rig the outcome at the base of the pyramid instead of the top, or try to make the strings of the bail-out permanent? Either way, I think these attitudes are crazy. If they don't apply to you, then great! For the purposes of this discussion, you are not an extremist!)

Unfortunately, what I don't have is anywhere near the financial acumen to point out an alternate plan to what is being proposed at the moment.

Key questions in my mind, though, are these:

1) What have we done in the past? How does this differ from, say, the S&L bail-out?

2) Are those differences necessary because of a different situation? (Possibly; a real liquidity crisis in the banking community would hurt. Not just the banks, but also the big and little companies needing finance, and the common workers who need the jobs that finance creates. It's not obvious to me that the S&L crisis, unsolved, would have led to a crunch of this magnitude and with this speed.)

3) Of all the other proposed solutions, do any of them work fast enough to stave off the crisis?

#17 from Mark Buehner at 5:35 pm on Sep 25, 2008

There is no potential profit for the government. These same companies will buy back anything of value in that paper for pennies on the dollar. And all our elected officials will help them do it.

That is the long and the short of it. I heard the head of Pimco say, when he said that his company was not going to by bonds of financial companies a few weeks ago, We can get them cheaper if we wait and buy them off the government.

I think it is obvious that their must be a well thoughtout Securities Law put into place and it should be the top priority of the new Congress. I think the bailout will make things worse, but we seem to be stuck with it.

#25 from Coldtype at 7:33 pm on Sep 25, 2008

What if Paulson throws a party and no one comes?

I think their is distinct possibility of a dearth of buyers. The effects of that scenario are too grim to contemplate.

"I think it is obvious that their must be a well thoughtout Securities Law put into place and it should be the top priority of the new Congress"

Yup. Of course this will be the same body that expedited this fiasco for their buddies (and donators) in the first place. Now theyre bailing them out, and tomorrow they will help them eek out even more profit. Somebody needs to be talking about why Chris Dodd is allowed anywhere near this process. Its like allowing a murder suspect into the evidence locker.

SG, if we absolutely have to swallow something your suggestion is certainly more palatable than what's on the table now. The problem is that Paulson and the Banksters don't expect to take any haircut at all. What's worst is that for our 700 billion (so far) we get no equity stake while conceding dictatorial powers to Paulson who's been operating as a virtual adjunct of Wall Street.

#22

#19:

If the protection buyer owned the reference asset, it's essentially an insurance policy, i.e., a risk-shifting mechanism.

Let's talk about this idea. I've heard people say this several times, but I don't think I grasp why this would be so. From my perspective, it reads this way:

1) I have a loan I expect to be paid off.

2) You offer me a bet: if the loan is paid off, you give me a small sum of money, but if it is not paid off, I give you a large sum.

3) The loan either is, or is not, paid off.

Now, how does this shift (or even spread) the risk? It certainly increases MY risk: formerly if the loan is not paid off, I'm out the value of the loan; now, I'm out the value of the loan plus a large sum of additional money.

It creates new risk -- formerly you had no risk, but now you are at risk of losing a small sum if I get paid off as arranged.

So it looks like the CDS is functioning to increase risk across the system. It's not really spreading my risk to you: it's increasing my risk while creating new risk for you.
__________________________________

You've got it backward. CDSs work like this. I lend someone money which they promise to pay back with interest. I take the risk they won't pay me back (the "credit risk").

I go to a third party and offer to make relatively small (total needs to be smaller than the interest on the loan for this to work for me) fixed, periodic payments in exchange for that party's promise to pay any amount of the loan principal or interest the borrower does not pay.

I've shifted the credit risk (with respect to the borrower) to the CDS counterparty (the protection seller) in exchange for the fixed payments (like insurance premiums). It's on the hook to the extent the borrower breaks his promise.

In theory, the third party (the protection seller) analyzes the credit risk to determine what the fixed payment should be. It sells credit protection to many other lenders on the theory that statistically, only a small number of borrowers will default. It can use some of the pool of fixed payments its collected from all the lenders to pay the lender of the defaulting borrower and still have enough left over to turn a profit.

The risk is spread because each protection buyer loses only its fixed payment and none is hit with the ultimate disaster of a complete default of its borrower.

Unless ... the protection seller's statistical analysis of the true level of risk is off and the pool of fixed payments is insufficient to fully pay all lenders of defaulting borrowers or it becomes uncreditworthy for some other reason. That may lead the lenders into a false sense of security and complacency.

Unlike insurance, CDSs do not require the protection buyer to actually have an insurable interest, e.g., hold the loan. That's what increases the risk system-wide, because miscalculations can go well beyond the loss on the reference obligation.

Hmmm.... let's see. $700,000,000,000 divided by 93,000,000 (the number of net taxpayers in 2006) is about $7500 per taxpayer. Can I just have my check, and bail myself out? Not that I need bailing out. I'm one of those net taxpayers, who not only keeps foolishly making money, but then I go ahead and don't blow it or make stupid debt decisions. Makes it hard to get the government to ease your pain if you don't get into it in the first place. Of course, I get the government to cause me pain so that can bail out those who don't stay out of financial trouble.

Not that I'm bitter.

#23

"All that said, the politicians asking for limits on executive pay and equity interests in participating banks don't understand what the "bail-out" is supposed to do. It is not to save troubled lenders (though that might be a secondary effect). It's purpose is to add liquidity to the credit markets."
-ricg

Coldtype: Fine, those institutions that are put off by the terms can go it alone. In the meantime the federal government can capitalize its own bank with the 700 billion to 1 trillion being suggested for the floundering banks that got themselves into quicksand. The banks that are strong enough to survive will survive, those that are not will have their assets purchased by the new federal entity for pennies on the dollar.

There's no liquidity crises. There are reckless banks that are functionally insolvent and they should fail. Furthermore, it can by argued that we suffered from a case of too much liquidity, much of which was used for speculation rather than on the real economy of productive work. And do you really believe that encouraging already maxed-out consumers to assume even more debt is sound economic policy? This is precisely the kind of thinking that got us here in the first place.

ricg response:

Well, as I said, I'm against the bail-out, too, but if we ARE going to spend $700 BB trying to do it, we should do what it takes to give it a maximum chance of success at its primary aim, which is to solve the liquidity crisis, even if it ends up rewarding bad actors. It is there I disagree with you. There is a liquidity crisis, and it will harm many healthy businesses (that won't have access to credit) if some action isn't taken quickly. But I agree with you that this bank subsidy is the wrong action, but if this is the road we're taking, then you have to have the major players participating to generate the critical confidence in the "system."

Your idea of government bank making direct loans is interesting but also a bit radical and may would take far too long to execute. The Fannie/Freddie situation is enough evidence for me to reject the idea of the government becoming a financial services market participant. My solution would be to loosen reserve requirements temporarily until the crisis passes, increase surveillence and if some banks fail, then that will be the mechanism by which the FDIC will inherit the bad assets. Its funds would go to insured depositors rather than to banks. Of course some government money may be needed to shore up the FDIC, but perhaps after the crisis passes, FDIC premiums could be increased to repay those advances.
_______________________________________ricg: "To work, the banks (not all of which are near failure) have to want to participate, and cutting the decision-makers pay or demanding that shareholders allow their interests to be diluted is not the way to get participation"

Coldtype: As should be obvious to all by now the decision makers were the problem, what makes them worthy participants in the solution now? In fact, this level of incompetence in the real world gets you fired. As to shareholder concern about the dilution of their stock, well... that's just too bad isn't it? That's the price of insolvency. Investors who put up the money to rescue the bankrupt get an equity stake. Don't like the deal? Then take a hike, kick some rocks, scram...

ricg: Again, I wouldn't have the gov't buy the assets, but if it does, you need willing bank partners, including those that won't participate on those terms, to build confidence. I'm not talking about insolvent banks. I'm talking about solvent ones who nevertheless are not loaning money to healthy businesses.

You know, the whole thing has always seemed ridiculously incomprehensible to me until I asked my wife (who just happens to work in a senior capacity for a provincial securities commission here in Canada, so I figured she'd at least have an informed opinion on it) to explain it to me.

She thought for about 10 seconds and then said, "Easy. Greed + easily exploited loopholes = eventual disaster."

And I thought... yep, sounds about right, actually.

"Not that I'm bitter."

If you are not voting for Obama, you are (and clingy too).

Grim at #15
_ if you're going to use eminent domain as the model ("Congress can buy them"), how do you determine the fair market price? Full face value?_
While this might be a good idea in a sound time, introducing a Constitutional question to a bailout isn't exactly going to settle the markets down.

Mark Buehner at #17
There is no potential profit for the government
Well, there is. $700B is going to be put at risk. There is a chance that all of this is lost, very slight - or that they can split out the good from the bad, and sell that good at a higher rate than they bought it, and sit on the bad... For years.
Likely we'll take under a $400B loss, especially depending how fast you want to unload these. Major buyers (pension funds) can't touch them even if they are almost free, foreign buyers are likely to stay away, banks may end up being once burned.

PD Shaw at #19
_If the Credit Default Swaps are worthless, then there is no property and no compensation is needed.)
They're not worthless. Without getting too technical.
* Company A has $10mil in CDS based on default(or event) from Company B, the payout coming from Company X1. Company A pays Company X1 a small yearly fee.
* Company X1 has $9mil in CDS based on default of Company B to Company A, payout coming from Company DO_NOT_TRUST_ME, with DO_NOT_TRUST_ME getting a small yearly fee
* Company A has $15 mil in CDS based on default from Company C, the payout coming from Company X2. A pays X2 a small yearly fee
* Company A has $5 mil in CDS based on either X1 or X2 not being able to cover their debt, coming from Company DO_NOT_TRUST_ME. A pays DO_NOT_TRUST_ME a small yearly fee
* Company C has $10 mil in CDS based on Company B defaulting on their debt to Company A, paybable by Company A. Company C pays Company A a small yearly fee
* Company X1 has $2mil in CDS based on default/event/downgrade of Company DO_NOT_TRUST_ME, payable by Company A. Company X1 pays A a large yearly fee.

Each of these have tangible value which adds to the bottom line, and protects them in case of 'events'. Written by contract, and no real regulation, or making sure that these can be paid out.
And, also bring in drips of revenue from this almost universal small yearly fee.
Some are worthless, some do a very very good job of making sure that risk is driven down and money can flow easier, and they all do a good job of bouncing money around.

Grim at #22
Now, how does this shift (or even spread) the risk? It certainly increases MY risk: formerly if the loan is not paid off, I'm out the value of the loan; now, I'm out the value of the loan plus a large sum of additional money.
In the hopefully not brain numbing example above, the first example above shifts much of your risk elsewhere, so that you can have a greater comfort level giving out your money. The second example, the payee also lowers their risk.

You can choose to open your risk up - in your example, you double down. Nothing wrong with that in the world of unregulated CDS, if you really really trust that this won't happen to you.

Again, I wouldn't have the gov't buy the assets, but if it does, you need willing bank partners, including those that won't participate on those terms, to build confidence. I'm not talking about insolvent banks. I'm talking about solvent ones who nevertheless are not loaning money to healthy businesses
-ricg

Paulson's proposal is that the government buy the garbage debt and re-capitalize these insolvent banks. How does this not imply ownership or at the very least controlling equity in these institutions? After their disastrous performance what claim to competence do the banksters have to counter the argument that these train wrecks should be nationalized? There is no confidence in the system precisely because of these hustlers. Those MBSs and CDSs are the kind of flim-flamery that demands a radical departure from the status quo.

The biggest problem I have with this entire process is how much influence the architects of the debacle have in crafting the "solution". These are hardly honest brokers and should be completely quarantined from decision makers. That's not happening. In fact, many of Wall Street alum Hank Paulson's actions guarantee us a return engagement with this crisis in the future. To pick just one example at random, Paulson has encouraged the Too-Big-To-Fail phenomenon to continue its unhealthy mutation as Rep. Bernie Sanders (I-VT) notes here:

We must end the danger posed by companies that are "too big to fail," that is, companies whose failure would cause systemic harm to the U.S. economy.  If a company is too big to fail, it is too big to exist.  We need to determine which companies fall in this category and then break them up.  Right now, for example, the Bank of America, the nation's largest depository institution, has absorbed Countrywide, the nation's largest mortgage lender, and Merrill Lynch, the nation's largest brokerage house.  We should not be trying to solve the current financial crisis by creating even larger, more powerful institutions. Their failure could cause even more harm to the entire economy

And least we forget the elephant in the room: the potential 750 TRILLION DOLLAR derivatives market lurking in the background all set to go boom. 700 billion does nothing to this hideous beast. As I said before, there is no government solution to this. These debts have to be written down and those who created this monster should be devoured by it.

Dave: Likely we'll take under a $400B loss, especially depending how fast you want to unload these . . .

Yes, I notice that Calculated Risk is assuming a $700B to $400B return (more likely $400B) and that blog seems pretty consistently negative.

These are not thrice junk assets. The lending institutions have been writing-off uncollectable assets, but given the duration and severity of the housing crisis, the market has been assuming the write-offs were rosy-scenarios. When more write-offs were made, it just confirmed the view that everybody was hiding something. Behind the liquidity issue, we have a confidence issue.

But I don't buy into the view that the government might make a profit off of the buy-out. To do so, the government would have to get tough with defaulting homeowners and I don't think the government has the stomach for it.

@ ricg

I think Michael Hudson nails it here as well

#27 from Grim
The CDS "insurance" seems to be the place where the genuinely huge sums appear.
Some is pure insurance, some is gambling on things you know about buy aren't directly involved in, some are nested. You pay me, then another guy pays you, then you pay me and the other guy. While there might only be $10mil of true default risk if this was just plain old insurance, there might be $25m actually invested and having the money move around for a total of $60m between parties, especially if you want to throw in someone saying "hey, tack on this $1mil of auto loans onto a transaction". That $1mil might be fine, but hit hard by an overall bond rating downturn.
Andrew's Russian Dolls.

#30 from Marcus Vitruvius
But, is there a fundamental piece of de-regulation that allowed this to happen? Or is this a secondary or tertiary effect? Is there a point in time where the repackaging of mortgages in this fashion would have been outright illegal? It's a fine point, but it's important in my mind. I think the answer is no, but I have no real confidence in my answer.
I think around 1990 the investment bankers created this as a mirror of what FannieMae had done since 1981(Freddie since 1975?), exploiting a loophole in the S&L cleanup, which was made into full and proper later. They might have been able to do it earlier, can't remember.
So while before this, a bank would normally sit on their loan if they couldn't get it to Fannie, now they could sell it to an investment bank that could package it up, and get rated by a bond agency, and get sold to a pension fund. But not all of them - some, they still had to sit on and be aware of the risk.

If you go to the Left, you'll see a number of people blame Gramm-Leach-Bliley (99). The reason being is that after this, it was a flood, and there was no holding any back. Since this fully allowed banks to walk away from risk that they initiated, and pass on the cost of this securitization, and bond rating, and whatever else back to the consumer.
It is sort of correct - the idea that I may have to pay a real immediate consequence to a failure of judgment might make me a bit jumpier than if I can unload it and only face a problem if things go wrong and people don't trust me (or I go bankrupt), as is the consolidation making fewer points of failure and different judgments. And then, they went wild with derivitaves+CDS.
Fees becoming more important than loans, as my risk is temporary.
Really, Gramm-Leach-Bliley made a lot of things better, but it's easy to say it made this a bit worse.

If you need to raise cash, and your portfolios are all infected or potentially infected, you die.
And by dying, infect others too.

Coldtype,

His plan is to buy "mortgage related assets" from
ANY financial institution headquartered in the United States. There's nothing that says they have to insolvent or even close to it. The problem is an inability to meet reserve requirements to lend at the necessary levels to keep businesses afloat. Bank managers and shareholders are not going to willingly take a very big hit for the privilege of fulfilling their proper role in the economy. They would rather limit lending and wait for better days than sell junk to the gov't on the condition of having their equity diluted or pay reduced. The banks that are so far gone that they would go for that deal aren't the ones the gov't should support or want to own anyway.

ricg

ricg: My solution would be to loosen reserve requirements temporarily until the crisis passes, increase surveillence and if some banks fail, then that will be the mechanism by which the FDIC will inherit the bad assets.

Let me first say that what I like about this solution is that it deals with the current problem instead of trying to fix the causes. In retrospect, credit was too loose and now its too tight. If we keep trying to deal with the issue of loose credit, we keep digging a hole.

Loosening reserve requirements is less expensive than the government fronting $700B, but what if the banks don't budge? What if the public becomes alarmed that their banks are taking greater risks by maintaining less reserves? I think there is a confidence issue in addition to a liquidity issue. And unlike most I don't think the government was necessarily going to spend $700B, the plan involved showing the country that the government was prepared to spend $700B.

I also think the downside risks of major banks failing is too high. When an airline enters bankruptcy, competitor airlines are not affected very much. The assets and liabilities of financial institutions are held by other financial institutions. Forcing a present liquidation of accounts could be contagious.

PD Shaw: I agree there are risks, including possible domino effects, which is why I would increase surveillance, but it seems better to start with a less risky plan that I think distorts the market far less and has far less potential for abuse, bad precedent-setting and further negative "unintended" consequences that may be difficult to foresee. It also better maintains the perceived independence of the Fed, which leads to your second point.

I emphatically agree that there is a fundamental confidence issue. The whole world, much of which invests its excess saving here, is watching. While I disagree with the fundamental point of the Hudson article Coldtype linked (charging interest is bad), there are some nuggets in it about how this kind of public intervention carries the danger of the US becoming, or being perceived as becoming, a Yetsin/Putin-style kleptocracy, which would have extremely ominous effects that go beyond even major and prolonged liquidity crunch. Problem now, of course, is that certain expectations have been built up around Paulson's plan.

"There is no potential profit for the government
Well, there is. $700B is going to be put at risk."

Nothing is at risk. The government can't 'lose' this money- they just print more. Of course that punts inflation (keep that word in mind, its gonna be very important in the next few years).

As far as netting a profit, again, that assumes the government would behave like someone with something to gain. The lawmakers will parse that paper out just like they parse our tax dollars out- to their friends and supporters. Think about it. These are not the people who know how to turn a dollar, mainly because they have no incentive to.

The Subprime Primer: (link).

#48 "Nothing is at risk. The government can't 'lose' this money- they just print more. Of course that punts inflation (keep that word in mind, its gonna be very important in the next few years)."

That is the risk, and every investor, foreign and domestic, is looking for signs that that is what the US is planning to do to "solve" its massive debt problem (public and private). Our creditworthiness is at risk. As a society, we have taken advantage of the benefits of (relatively) freely flowing credit (and most of this is legit.), but each participant has to be willing to take its lumps when a risky bet doesn't pan out.

Bank managers and shareholders are not going to willingly take a very big hit for the privilege of fulfilling their proper role in the economy. They would rather limit lending and wait for better days than sell junk to the gov't on the condition of having their equity diluted or pay reduced
-ricg

Thus a newly capitalized federal bank could fulfill the role that these institutions have abdicated, namely supporting the real economy.

A quick point of clarification. Hudson does not argue that charging interest is bad just that at a certain point debts have to be forgiven if the economy is to move forward. If a consumer's entire income is devoted solely to debt service then she has nothing left with which to participate in a consumer economy. The system collapses under the weight of its own debt.

ricg (#47)

European banking kleptocracy, or maybe, cryptocracy.

I agree with #41.

#51: "Thus a newly capitalized federal bank could fulfill the role that these institutions have abdicated, namely supporting the real economy."

Sure. In fact, to save time, we'll just increase the mandates of the existing GSEs, since they're so saavy. (Sigh.)

"A quick point of clarification. Hudson does not argue that charging interest is bad just that at a certain point debts have to be forgiven if the economy is to move forward. If a consumer's entire income is devoted solely to debt service then she has nothing left with which to participate in a consumer economy. The system collapses under the weight of its own debt."

There are two existing solutions for that problem. First, consumers could cease voluntarily incurring debt, or at least only do so responsibly. Second, discharge in bankruptcy is supposed to provide exactly the kind of "fresh start" you describe for the honest but unfortunate debtor.

At any rate, the problems we have don't come from a lack of participation in the consumer economy. Quite the contrary.

#46 PD Shaw.

I just thought of another drawback to loosening reserve requirements. If it goes wrong, whoever does it will be blamed for "deregulating."

Cause and Effect? [Mark Krikorian]

I really thought this was a joke, but it's not. WaMu's final press release, before it sank beneath the waves (h/t Sailer):

WaMu Recognized as Top Diverse Employer—Again

Company ranks in top ten of Hispanic Business’ Diversity Elite and earns perfect score on the Human Rights Campaign’s Corporate Equality Index

SEATTLE, WA (September 24, 2008) – Washington Mutual, Inc. (NYSE:WM), one of the nation’s leading banks for consumers and small businesses, has once again been recognized as a top employer by Hispanic Business magazine and the Human Rights Campaign. [press release continues–AJL]

Well, the basic problem is that efforts to help the banking industry are confounded by the public's desire to hurt the banking industry.

My office worked for FDIC and the Resolution Trust in the early 90s, and I've been thumbing through some old issues of bank failure news and FDIC briefing books. What I think libertarians like coldtype miss is how harmful bank failures are to the people without flush bank accounts, who need to borrow for a lot of things in life. What I particularly remember though were the retirement pensions that disapeared when Resolution Trust began stripping liabilities from assets for resale.

Has anyone seen this prophetic NYT article from 1999 that's making the rounds?

#27 from Grim at 7:47 pm on Sep 25, 2008

The problem for me is that I can't see how what we're looking at here is a setup of the sort you're describing. What I don't see, in other words, is why the value of the CDS payouts is so much greater than the total value of the homes on which all these mortgages were based? If the subprime default is valued at around $250B, and the CDS were simply insurance policies to make sure you get your investment back in case of default, then the payout should be roughly equivalent to the cost of the defaults -- i.e., not more than $250B if that's how big the defaulted loans were.

Grim, I am no expert, but I think the problem is the repackaging of the CDS is causing the numbers to balloon. So an example

>>>
James Banker: Oh great! Sally SubPrime defaulted on her $1000 mortgage. Good thing I set up insurance by way of a CDS with Hillary Investor. Hillary, by the terms of our agreement, you now have 30 days to pay me the $1000.

Hillary Investor: Great, now I owe James Banker $1000. Well, I don't have the cash available, but fortunately I set up an insurance policy by reselling this as part of a new CDS to Wally Wallstreet. Wally, by the terms of our agreement, you now have 30 days to pay me $1000.

Wally Wallstreet: But all of my money is tied up in stocks and other investments! With the market down, I can't cover this expense! Well, I do have a CDS on this that I sold to my good friend Oilman bin Saudi. Oilman, sorry, but you have 30 days to pay me $1000.

Oilman bin Saudi: Ah! All these American debts! My Prince will have my head! But praise be that I bought insurance on this from James Banker in America. James, you must pay me $1000 in the next 30 days.

James Banker: Oh great! Now not only did Sally SubPrime stiff me, but now I've got Oilman bin Saudi breathing down my neck! I've got no money to pay him until Hillary pays me, and it's been almost two weeks now. If she defaults, what am I going to do?

>>>>
First off, it is more complicated than the above as the lending is more a star with each person now owing every other person money due to the numbers of loans defaulted on, but lets stick to the simpler scenario for now.

So now in the senario above, one default of $1000 is at risk of becoming a total of 5 defaults totaling $5000. Worse, since the clock has been ticking since Sally SubPrime defaulted, even if James got a $1000 loan to start the repayment cycle, it likely wouldn't get back to Hillary in time to keep her from defaulting, and Wally may be caught short as well. This means James would be tied up in a bankruptcy case to get the money he would need to square away the original debt. So to avoid all that, you need to loan out the $4000 everybody is owed (Sally already defaulted and gets nothing) and try to square the books later.

Again, I am no expert, but this is what I have managed to filter out of the dreck as to what is happening.

StargazerA5

As I read more on the subject, it sounds like these CDS started as insurance of the type we've been talking about: a genuine, risk-spreading practice. Yet it appears that it has also become a form of pure speculation, and a form of leveraging. The same device can be used to increase one's own risk, in order to increase profits on a solid investment; or to ensure it; or by two people unconnected to the actual mortgage at all, as a form of gambling on the market.

Would it be a useful reform to limit it to the "insurance" function? And, therefore, to require that CDS can be used only by people connected to the actual mortgage? That might address the cyclical problems described above, would certainly address the speculatory/gambling versions, and would eliminate the leveraging aspect.

Grim

Dead on in assessment of credit swaps. Sen Phil Gramm stuck them in a bill in 2002 that made them completely unregulated. They have miniscule reserve reqirements as well.
The real problem they cause in terms of you solution is the bad ones last as long as the underlyning paper. With the paper backed by 30 yr mortgages you begin to understand why no one will lend to anyone who owns this.

SEC Chr Cox concedes voluntary regulation doesn't work:
(link)

Now here is another real problem on fixing things. Sec Treasury Paulson was head of Goldman Sachs and pushed for volutary deregualtion. Given this is the situtation do you want him in charge of cleaning up the mess because 1) he is partially responsible, 2) his suggestions to date haven't worked and 3) in 113 days we will have a new President and Paulson can and in my opinion will walk away.

I say no he doesn't even get a sniff. We have to find someone to run it permanently(at least the next three years). To start the discussion how about Michael Bloomberg; not my first choice. Nor am I for binging back Greenspan given he never protected the punch bowl at the party but drank hearty.

[Bare URL. Fixed for you, this time. --NM]

The underlying problem is a massive miscalculation of risk. CDSs are a problem in that they create complacency. To the extent I think I've shifted a risk, I don't need to evaluate it. So instead of evaluating the underlying mortgage-backed securities, I look to the credit rating of the CDS counterparty.

Risk was spread through the CDSs and through securiization. Both good risk-spreading techniques, but they only work if defaults on the underlying mortgages are isolated. In the old days, if the local factory shut down, default would occur in the local economy, and the local bank might fail. By spreading the risk, these market mechanisms help banks. The underlying problem is that this is not a localized bad event. Defaults are rising in many areas -- this was not a localized bubble, but rather a national housing bubble. The availability of credit based on mortgages caused housing prices to rise as more people were able to finance, ironically having to take bigger loans. (Secondarily, this also caused a boom in refi's) More houses were built, oversupplying a market whose demand would collapse as interest rates rose.

In essence, the risk-spreading was insufficient, because the housing bust problem is national rather than local in scope. Those in the business of spreading risks: CDO risk sellers (including monoline insurers and re-insurers) are failing, so the CDOs they promised to pay-on are worthless. That means the CDO buyers are exposed to the risks they thought they'd gotten rid of, and their "no-risk" assets have to be shown as a liability -- somehow -- on their balance sheets. Since nobody knows what percentage of the mortages will fail or, because of the arcane and multilayered nature of the securities into which they're bunded, how much of exactly what levels mortgage-back risk each of the securities has, nobody wants to buy them, further (and in a sense artificially) depressing their market value (as opposed to their potential yield). That has a (probably artificially high) effect on a bank's balance sheet, which must now reflect massive risk the bank thought it didn't have, which means it cannot loan as much money, since it must dedicate more money to reserves to cover the increased risk.

So the gov't can do 3 things:

1. Nothing: That causes the credit crunch that affects all sectors of the economy that need to borrow money, i.e., nearly all sectors of the economy. If businesses can't borrow money, they often fail, causing job losses, etc.

2. Buy the bad securities from the banks at higher than market price. That frees up reserves for lending, and we hope that the eventual yield on the securites will suffice for the gov't to recoup its costs. That might work, if the gov't can be a rational actor that buys on market-based rationales (hard as that is for even the market now), unswayed by political considerations -- GOOD LUCK. The theory is, I think, that making funds available for lending, a major recession/depression can be avoided, and more people will pay their mortgage debts, increasing the yields to the government.

3. The alternative I've heard is to loosen the banks' reserve requirements. This allows them to lend but, of course, makes their position riskier. If it works, a major recession (as in #2) is avoided, and the yields on the bad assets are higher (as in #2), the banks are saved, the economy is saved. In this case, a few more banks will fail, which will strain the FDIC, so the gov't will probably have to loan it money. In essence, that worst banks will get weeded out and their bad assets will end up in the gov't's hands without us having to trust the gov't on how to price such assets. Maybe the gov't can be repaid through the yield. If it works, the gov't puts up less money, takes less risk, and the worst of the banks are removed from the market. As the bad assets disappear (they are "melting icebergs"), reserve requirements are gradually restored to safer levels.

(4.) There's also Coldtype's idea: the government can make direct loans to businesses. Problem here is that the gov't isn't set up for this and can't effectively do it quickly enough. (I could be wrong about that.) Also, there's no guaranty that the kind of politics that destroyed the GSEs wouldn't be at work in its lending practices.

Would it be a useful reform to limit it to the "insurance" function? And, therefore, to require that CDS can be used only by people connected to the actual mortgage?

We do have mortgage insurance, which is what I assume got AIG in trouble, no?

Thanks for all of your contributions here, ricg. Particularly #62, which puts it all in a nutshell.

I think its also worth pointing out that the S&L crisis was not a bailout of the S&L industry, it was a bailout of a government insurance program that was not actuarially sound in the face of a national downturn. Evaluating risk is not necessarily a science.

On comment #62, I advocate option 1. Although, the Congress should definitely repeal laws that fine banks for keeping sound portfolios, laws like the Community Reinvestment Act. And, I'm unconvinced, in fact I disbelieve, that ricg is right about a disastrous credit crunch on this option. Credit crunch? Yes. Disastrous? No. The bad money has to shake out.

#65:

I have heard that there is evidence banks are exaggerating the credit crunch situation to get option #2 in place, so I'd be interested if anyone has recent data on credit availability. Obviously it's hard to predict how disasterous the current credit crunch will be, and it depends on where you sit. However, unemployment is already rising.

While I agree that a shake-out is in order, options #2 and #3, if they work, might make it less painful on the innocents.

Looking longer term, I don't really see much of a regulatory solution, but if I were king, the government would get out of subsidizing the housing industry. Faze-out mortgage interest deduct, Fannie, Freddie, loan guaranties, CRA-mandates, etc. Consumer-protection regulation is o.k. where it prevents rip-off scams and increases information to consumers facing home-ownership/financing decisions -- these help the market -- but the gov't's got to quit distorting the market.

Non-gov't institutions have, I think, mostly learned their lessons: banks, rating agencies, institutional investors, financial guaranty companies. The lesson is diligence. Don't buy/rate what you don't understand.

One concern I still have is the mortgage origination industry. Many of the players have passed out of existence, but the problem of policing the quality of mortgages at the lowest level - credit-checking consumers, appraising real estate - depends on the honesty of the folks doing this work, who are often incentivized based by closings rather than quality of the loans. I don't know much about it myself, but maybe states should consider increasing licensing standards and other measures (e.g., interstate blacklists) to increase market confidence.

When it comes to Wall Street, it seems that restored regulation of shortselling is necessary.

There's an interesting letter being circulated to Congress from the CEO of a bank that's still in sound condition. Worth reading both to show that not all financial institutions are involved or panicking, and as a list of desiderata from someone who was not caught playing with bad loans and derivatives.

My take is that the longer the discussion on Paulson's bailout goes on, the less likely it is to pass in anything like the original form. There don't seem to a lot of strong advocates other than the institutions benefitted, and those covering for them (and themselves) in Congress. The more people dig around, the more skanky details come on out on Fannie and Freddie, who helped them escape regulation, who might benefit from the doling out of $700b in largesse. (I am on record against the bailout.)

A decent proposal from Karl Denninger (hat tip to Mish):

_l. Force all off-balance sheet "assets" back onto the balance sheet, and force the valuation models and identification of individual assets out of Level 3 and into 10Qs and 10Ks. Do it now.

2. Force all OTC derivatives onto a regulated exchange similar to that used by listed options in the equity markets. This permanently defuses the derivatives time bomb. Give market participants 90 days; any that are not listed in 90 days are declared void; let the participants sue each other if they can't prove capital adequacy.

3. Force leverage by all institutions to no more than 12:1. The SEC intentionally dropped broker/dealer leverage limits in 2004; prior to that date 12:1 was the limit. Every firm that has failed had double or more the leverage of that former 12:1 limit. Enact this with a six month time limit and require 1/6th of the excess taken down monthly.

Once 1, 2 and 3 are put in place, then send in the OTS and OCC examiners and look at every financial institution in the U.S. All who are insolvent and unable to raise private capital immediately are forced through receivership where the debt is converted to equity and existing equity is wiped out. With the CDS monster caged, the systemic risk is removed, the bondholders provide the cushion for recapitalization (as it should be) and the restructured firm emerges with NO DEBT while the former bondholders are now the owners (of the equity) in the resulting firm.

With a clean balance sheet, the restructured firms remain in business and open the next morning able to raise and attract capital_

#67

I agree with that letter. Down with the bail-out, but I fear Congress will come-up with basically Paulson's plan and a bunch of other bad stuff. At least the auto industry subsidy failed in the Senate, so maybe there's hope.

How the entire Federal government aided and abetted Wall Street? Watch the time line; no party has clean hands:
big picture

Correction on the auto industry subsidy. It did pass the Senate. We'll never learn.

#63 from PD Shaw
We do have mortgage insurance, which is what I assume got AIG in trouble, no?

Think of CDS as a macro function to MI's micro - a batch of default instead of lots of small ones.
Most of the MI providers started getting hit last year, and continued this year. I'm pretty sure they were involved with this - but their bigger hit was treating CDS as part of their well known insurance industry. I think AIG's losses due to CDS was >$18B, while MI was ~$2B. Both this, and the warning due to this continuing to happen in the future, caused their bond ratings to collapse.

#67 from Tim Oren
There's an interesting letter being circulated to Congress from the CEO of a bank that's still in sound condition.
It's a good letter. I disagree on a couple of points, but I'm happy when people point out that everyone had a hand in this. I hate people calling out MTM now after it worked fine when everything went up. If it was called out for years, sure.
For those who care about bias - he does stand to gain quite a bit financially if other banks suffer. And, he's not complaining about the short selling ban which is covering him either.

#66 from ricg
_so I'd be interested if anyone has recent data on credit availability. _
Dunno. The TED spread is high. And Commercial Paper >3 month looks like it hit a big crater, but that could be more behavior than availability, running away from long term.
I think the FED releases Flow of Funds after the quarter ends, so maybe what they're seeing is the weekly rollups for that, combined with more specific numbers. And maybe what they are seeing is so bad despite earlier moves, they want to make sure this gets done before it gets leaked/released.

BTW - wasn't the bailout announced the same day Q2's Flow of Funds was released?

There won't be a bailout. There isn't even enough certainty left in these markets to attract a decent thief. A total fool might put down a bet down, but there's isn't enough information to even clue the fool in to what he's betting on, or against. You can stick a fork in this market. We're within a week of GRUNCH.

Verrry Late to the party here, some really fine points put forward. One thing I would add, however, is that while much of this mess can be attributed to the purchasing of exotic instruments that many did not fully understand, and thus led to faulty risk assessment that infected the entire system, there is another factor her as of yet little commented upon, namely the cynical and willing "devil take the hindmost" attitude that many of many of the major players exhibited by raking in huge bonuses even though they knew that the system was fundamentally flawed. In short they coldly booked profits until the day the system collapsed simply because the "rules of the game" allowed them to.

A classic example,and a fore-runner to all this that pre-dates Enron was the default of the AAA-rated muni bonds issued by WPPSS--Washington Public Power Supply System--or, as the bonds were so aptly called on Wall Street, "WHOOPS" bonds. These bonds were rated AAA on the basis of a supposed "iron-clad" agreement in which municipalities would "take or pay" for the product of 5 nuclear power plants then a-building. Brokers flogged these bonds up until midnight of their default,
despite published reports these plants were behind schedule and construction money was running out. When brokers voiced their concerns they were cynically told that "theirs was not to reason why, " etc., i.e., as long as the AAA rating held, then sell those bonds! Tens of thousands of retirees put their life's savings in those things.

When, predictably, the project went bankrupt, the municipalities went to court and won, and so the bond's NAV went to zero as dried-up cash flow meant: no mo' money means NO MO' MONEY! WHOOPS! People were wiped out, but the money the brokers made was free and clear. They had played by the "rules" hadn't they?

My point in relating the outline of the WHOOPS collapse is that when ricg says@66 not to "buy/rate what you don't understand," his statement may indeed be necessary for an understanding of much of the problem, but not sufficient. Left out of his otherwise excellent input/analysis is the taking into account of those willingly blind
("None are so blind as those who will not see.") participants
who understood things all too well and who nonetheless decided to sit in the crows nest and drink champaigne as the ship sank because "the rules of the game" allowed them to, secure in the knowledge that their rescue boat (i.e., their golden parachutes) would arrive in time to step into the boat while everyone else below them had long since disappeared underwater.

As Lilly Tomlin once said: "Don't worry about your personal cynicism and paranoia--it can never match real life."

#74:

Maybe it's the late hour, but I'm not sure who you mean. Unlike muni bonds, CDOs are not available to the general public. I haven't heard that anyone was hoodwinked, they just relied on ratings and CDS counterparty ratings rather than doing their diligence. I admit that diligence would be hard because of the complex nature of the securites, but that should counsel against buying. I don't have the sense anyone is happy about this except for some shortsellers and perhaps the bankrutpcy bar. But even the shortsellers weren't hiding the problem -- they were the first to publicize it. Maybe there's some devious quants who knew when they designed these things that they'd never work in the long run and figured out a way to profit, but I haven't yet heard evidence of someone selling them with secret information not available to their buyer, or selling them to an unsophisticated buyer.

I did see that the FBI is investigating some of the players, but it's not clear to me what for. Accounting irregularities? If that's it, it's probably after the fact cover-ups to hide the already existing problem and maintain share values, but that's a run of the mill issue with distressed public companies and doesn't go to the underlying matter of actual CDO trading. Maybe I'm being naive.

According to Calculated Risk there is a general consensus forming around the following plan:

New proposal

Thoughts everyone.

The following are not addressed in the new proposal:

Issues

1) Is there going to be proper valuation of troubled assets or overpayment?

2) Why did we not get preferred senior shares convertible to common stock in exchange?

3) Why are we not injecting capital by way of preferred
shares in the institutions

4) Are dividends going to be suspended? Who is going to
provide new First Tier Capital(Private Equity?)
(Bank Holding Act issue)

5) Where is the debt mitigation to borrowers?

6) Where is there a guarantee that the capital
adequacy ratios will not be loosened and a new
bubble will ensue?

7) Where is the reform of regulations to provide
controls in the future?

[courtesy of "mammon" @ RGE Monitor]

Note that the text of the latest proposal has not been released. It needs to be.

ricg:

I'm not talking about "crimes" here, I'm talking about "mistakes," which are, as this current mess demonstrates, usually far, far worse than mere crimes. And these mistakes en grosso mondo are engendered quite often by the "rules of the game" set by the market regulators(SEC, Congress, the FED, etc) which allow/cynically encourage participants all to often to do things that, as in the case of the WPPSS bonds, while technically legal, are obviously very unwise.

It is the "rules of the game" that cause actions to be taken that, while rational/legal within the small bounded decision-making universe of each individual/institution, often paradoxically leads to highly dysfunctional outcomes for the greater universe of total decision-making systems as a whole,

My only point is that, when faced with the choice between doing something that _may/might_head off a potential disaster somewhere in the nebulous future, and booking quarterly profits and huge bonuses now, the emphasis will always be on the "now," which, while highly logical from the viewpoint of each individual decision-maker, inevitably leads to illogical and ultimately dysfunctional results for the whole. In short, the current "rules of the game" almost guarantee the inevitable
debacle we are currently witnessing.

VX,

O.k. I agree some regulatory changes are in order (e.g., with respect to shortselling), but I also caution against overdoing it. One place America has remained competitive is in financial services. A large reason for that is freedom of contract that allows for creativity and risk-taking. While I generally oppose bail-outs (including this one), I don't think we should screw up that atmosphere. I'm getting a tad nervous when the debate is framed in terms of "regulate - good, deregulate - bad." I know you didn't say that, but that's the narrative of Katy Couric (in the Palin interview), to name one influential voice. The principle should be to reduce regulation to the bare minimum to add information and prevent abuse. We should also be mature enough to understand that prudent risk-taking, while it generally brings rewards, doesn't do so always, so we have to take the good with the bad sometimes, always guarding against creating moral hazards.

In short, I hope Congressional zeal to show that they've doing "something" doesn't throw the baby out with the bathwater, because this country is running out of competitive babies.

Coldtype,

I was against it in its original form, but Congress appears to have made it worse. When you're talking about loosening credit markets, it boils down to confidence. The additions make the promised help less helpful, since less participation can be expected, thus increasing the chance that taxpayer money won't have the desired effect and won't be paid back. Thanks, Nancy and all you other panderers in both parties.

Here's my impressions of the issue you brought:

1) Is there going to be proper valuation of troubled assets or overpayment?

No. If this were possible, this subsidy wouldn't be needed. I don't think this question even has any meaning.

2) Why did we not get preferred senior shares convertible to common stock in exchange?

This would/will reduce participation, eroding confidence.

_3) Why are we not injecting capital by way of preferred
shares in the institutions._

The only ones that would do this are the ones that should be in liquidation. Good money after bad.

_4) Are dividends going to be suspended? Who is going to
provide new First Tier Capital(Private Equity?)
(Bank Holding Act issue)_

Don't understand what this is getting at.

5) Where is the debt mitigation to borrowers?

Non-germaine.

_6) Where is there a guarantee that the capital
adequacy ratios will not be loosened and a new
bubble will ensue?_

If you don't do 5, this shouldn't be a problem.

_7) Where is the reform of regulations to provide
controls in the future?_

That should not be in emergency legislation. It should go through thorough consideration using ordinary administrative and legislative procedures, with an opportunity for comment and debate, preferably after the election.

"O.k. I agree some regulatory changes are in order (e.g., with respect to shortselling), but I also caution against overdoing it. One place America has remained competitive is in financial services. A large reason for that is freedom of contract that allows for creativity and risk-taking"
-ricg

No ricg, America has remained "competitive" in the area of reckless speculation which has done nothing for the real economy. "Creativity and risk-taking" on Wall Street is a euphemism for fraud and moral hazard. Deregulation is what led directly to our present debacle. The hustlers offering the solution now where the very men responsible for the problem in the first place. Why is this such a difficult concept to grasp? Should the Chicago Crime Commission have included Al Capone? Hank Paulson and his Wall Street Banker Boyz are the problem not the solution.

*Is there going to be proper valuation of troubled assets or overpayment?

No. If this were possible, this subsidy wouldn't be needed. I don't think this question even has any meaning*
-ricg

Sure the question has meaning since the likely answer is "zero". Think this has any significance for the taxpayer who's being asked to overpay for this garbage?

*Why did we not get preferred senior shares convertible to common stock in exchange?

This would/will reduce participation, eroding confidence*
-ricg

What choice do the insolvent have in this matter?

*Why are we not injecting capital by way of preferred
shares in the institutions.

The only ones that would do this are the ones that should be in liquidation. Good money after bad*

Ergo the insolvent (the ones with their hands out) should be nationalized. Finally we agree.

*Are dividends going to be suspended? Who is going to
provide new First Tier Capital(Private Equity?)
(Bank Holding Act issue)

Don't understand what this is getting at*

This means that the hustlers and crooks whose "creativity and risk-taking" led them to Congress with their hands out should not be paid dividends for running their institutions into the ground. The banksters should continue in their futile search for private money to recapitalize if the taxpayer terms are too onerous.

*5) Where is the debt mitigation to borrowers?

Non-germaine*
-ricg

Fascinating. Although I didn't expect for it to be put this blatantly it's good to hear bailout apologist admit in such stark terms that homeowners don't matter.

*Where is the reform of regulations to provide
controls in the future?

That should not be in emergency legislation. It should go through thorough consideration using ordinary administrative and legislative procedures, with an opportunity for comment and debate, preferably after the election*

So... we should not carefully deliberate over a proposal that gives dictatorial powers to an unelected appointed official whose ties to Wall Street (thus the crooks responsible) are not in dispute and who desires to give 700 billion tax dollars (for starters) to reckless investors who've only themselves to blame? After the new unelected Caesar has then redistributed from perhaps 700 billion to 5 trillion dollars from taxpayers to the wealthiest people in history with procedures that "cannot be reviewed by any court or legislative body", then we should carefully deliberate on and consider that which can no longer be changed short of revolution?

No ricg, America has remained "competitive" in the area of reckless speculation which has done nothing for the real economy. "Creativity and risk-taking" on Wall Street is a euphemism for fraud and moral hazard.

We obviously disagree on many points here. Please provide evidence of significant and relevant fraud here. Not doing diligence is not fraud, and moral hazard is only created by gov't intervention.

_ Deregulation is what led directly to our present debacle. The hustlers offering the solution now where the very men responsible for the problem in the first place. Why is this such a difficult concept to grasp? Should the Chicago Crime Commission have included Al Capone? Hank Paulson and his Wall Street Banker Boyz are the problem not the solution._

It's not a difficult concept to grasp, it's merely unproven. What "deregulation," aside from elimination of the uptick rule, are you referring to? Even that elimination of that rule was only a secondary, contributing factor. And why is it "our" debacle but for the gov't's intervention now? These are private institutions that made private mistakes given some artificial, gov't produced incentives. To the extent it is "our" problem, it's "ours" because gov't interference has made it ours. Hell, the gov't encouraged the bad loan-making at the bottom of the chain of causation through "affordable housing" regulation and extended low interest rates. The hell we're about to face was, and continues to be, paved by good intentions and the influence of lobbyists on legislators.

I disagree with Paulson's statist solution (in part because of the moral hazard problem), but I do recall that the Fed chairman supported his proposal. I don't think this kind of accusation against him is warranted without presentation of evidence.

_Is there going to be proper valuation of troubled assets or overpayment?

No. If this were possible, this subsidy wouldn't be needed. I don't think this question even has any meaning
-ricg

Sure the question has meaning since the likely answer is "zero". Think this has any significance for the taxpayer who's being asked to overpay for this garbage?_

Well, "zero" does not answer the question. The answer is "no," and the rest of the question has no meaning because no definition of "proper valuation" is given. You're preaching to the choir here. This is a significant problem.

-What choice do the insolvent have in this matter?

Why are we not injecting capital by way of preferred
shares in the institutions.

The only ones that would do this are the ones that should be in liquidation. Good money after bad.

Ergo the insolvent (the ones with their hands out) should be nationalized. Finally we agree._

We've always agreed there shouldn't be a subsidy and that insolvent banks should be liquidated. What it seems you don't grasp is that even solvent lenders are unwilling or unable to provide sufficient credit to keep the economy on track. For them, this medicine is worse than the disease. They simply won't participate, and won't make very many loans. Even those close to insolvency will only sell enough to stay afloat, not to make loans. So you won't have solved the actual problem, which isn't keeping banks open, but getting them to loan money to businesses that depend on credit, and that's when this thing spills onto Main Street, here and in Europe, which has also been taken credit from US Banks. When that happens, there's a recession, and defaults and foreclosures increase, not decrease, so the gov't's not even helping ordinary homeowners, even those who, until they lose their jobs in the recession, would have been capable of keeping the home their in or purchasing-up some of the housing that's finally becoming affordable. Guess what happens to the crap the gov't buys then? So now the debt explodes at the sametime revenue declines. Result, more debt. Excess debt is root problem. This is a very expensive bullet we're shooting ourselves in the foot with.

_Are dividends going to be suspended? Who is going to
provide new First Tier Capital(Private Equity?)
(Bank Holding Act issue)

Don't understand what this is getting at

This means that the hustlers and crooks whose "creativity and risk-taking" led them to Congress with their hands out should not be paid dividends for running their institutions into the ground. The banksters should continue in their futile search for private money to recapitalize if the taxpayer terms are too onerous._

I would support an emergency, temporary moratorium on dividends of all banks to help shore them up till the crisis passes. This is one area where VX may have a point. Banks distribute dividends even when it's bad to do so to avoid signalling they are having problems. I also understand the concept of stopping premiums for insolvent banks, but there's already mechanisms in place for that. In the context of buying the assets, though, this is just another stupid poison pill, as you explain it.

And what's the Bank Holding Act issue?

_5) Where is the debt mitigation to borrowers?

Non-germaine
-ricg

Fascinating. Although I didn't expect for it to be put this blatantly it's good to hear bailout apologist admit in such stark terms that homeowners don't matter._

First, when did I ever say that homeowners don't matter? I happen to be one.

Second, I'm not a bail-out apologist. Unlike your party and the "moderate" wing of the Republicans, I don't support this abomination either in its original form or after the panderers attached the poison pills and extraneous BS to it.

Third, the best way to help homeowners is to keep the economy out of recession. BTW, what form is this "help" supposed to take and why won't it be a moral hazard.

It's your position that's inconsistent. I wouldn't bailout anyone.

So... we should not carefully deliberate over a proposal that gives dictatorial powers to an unelected appointed official whose ties to Wall Street (thus the crooks responsible) are not in dispute and who desires to give 700 billion tax dollars (for starters) to reckless investors who've only themselves to blame? After the new unelected Caesar has then redistributed from perhaps 700 billion to 5 trillion dollars from taxpayers to the wealthiest people in history with procedures that "cannot be reviewed by any court or legislative body", then we should carefully deliberate on and consider that which can no longer be changed short of revolution

No, we should simply reject it. The question is about what regulation is appropriate to address the causes of the current crisis. I think this requires study rather than knee-jerk reactions.

No, we should simply reject it. The question is about what regulation is appropriate to address the causes of the current crisis. I think this requires study rather than knee-jerk reactions
-ricg

Exactly. And during our studies we should look to the past for examples of how similar crises were handled successfully. Scandinavia comes immediately to mind...

Though it's exceedingly difficult to detect from your posts ricg, if you say you're against any bailout I'll take your word for it. Furthermore, there is nothing that guarantees that the current bailout/giveaway proposal will lead to a significant increase in lending. No ricg, insolvency remains the key issue. And 700 billion dollars will have no effect on the monstrous derivative market which is greater by orders of magnitude this figure.

Radical measures that represent a full paradigm shift are required here and have been for at least 18 months, yet Paulson and his merry band of Wall Street hucksters were desperately hoping to re-inflate the housing bubble in defiance of market realities.

The insolvent banks should be nationalized and those that wish to go it alone should be left to sink or swim. No bailout then, it's agreed.

#77 from Coldtype
Some of these a repeat from ricg.

1) Is there going to be proper valuation of troubled assets or overpayment?
No, there will not be proper valuation - not saying they won't try. If it's a reverse auction, it won't matter. If it involves dissecting existing MBS/CDOs, then maybe a bit more.
Yes, there will be overpayment, since otherwise they could be sold private.

2) Why did we not get preferred senior shares convertible to common stock in exchange?
Participation mostly

What choice do the insolvent have in this matter?
They're not insolvent yet. They have plenty of good assets - auto leasing, equity in other companies, their own buildings - they would risk having to sell to raise capital as they continue seeing losses. This in turn would signal they have having problems, and people would shy away from them.

_3) Why are we not injecting capital by way of preferred
shares in the institutions_
No confidence they will use this to go out and use this wisely, instead sitting on their new Pile of Cash instead of getting rid of worthless assets. If we hand them $20B for 5% of their company(or very low rate loan), they could wait for a year, absorbing losses, and hoping things turn around.
They could sit on them longer. Instead, we all do!

Take mediocre bank B. Mediocre bank B got a bit greedy, decided to take a stab at holding a subprime portfolio. They maintained enough cash to be ok. But now with it dropping, their potential assets drop. So, instead of being able to give you the faithful customer a loan to buy a new car, they sit on their money in case they lose more. With losses, they have to sell 10 branches to cover.

_4) Are dividends going to be suspended? Who is going to
provide new First Tier Capital(Private Equity?)_
Dividends and buybacks from participating companies aren't going to be suspended. To take this away - while a nice sounding punitive measure - might depress prices more. And if any bonds/ratings/whatever are tied to stock price, this could be problematic. Part of Enron's collapse was their inability to raise money once their share price went below ~$35.
Take AIG. As an example of what ricq said, they increased their buyback and dividend 2 years ago and again this year I believe. To make sure no one thought they were weakened. Oops!

Do you mean who is going to invest more money in these institutions?
I could not imagine the federal government going to CALPERS and saying "hey buddy! I'm putting $10B in cash into this bank. Your 1% equity means I'd like to see $100m from you, and soon." Let alone mutual funds, who are facing their own problems. I saw this suggestion somewhere, so I'm not sure if this is what you meant.

Outside of that, it's more of a wait and see if the nature of the markets will respond to these being healthier. There is some money out there - but no one is going to give it to them. Well, aside from all of us.

5) Where is the debt mitigation to borrowers?
Once the Treasury gets hold of the loan, then a borrower can renegotiate. If you're not in that pool, you're out of luck outside of normal means and other acts in the past year or two.

6) Where is there a guarantee that the capital adequacy ratios will not be loosened and a new bubble will ensue?
More regulatory than emergency. This way, the Republicans can drive towards making noise and really aiming for little, and the Democrats can drive towards making noise and aiming for a lot.

As much I think it could make for a fun October to have lawmakers debating the finer points of finance and existing regulation, it's not going to help the markets any. From that point of view, it's better to have them shut up for 2 months.

And - in order to do this, they'd have to lean on the Fed and Treasury. "Hey, we know you have this $700B to deal with, but care to come in and share your thoughts on how we should regulate bond grades?"

7) Where is the reform of regulations to provide controls in the future?
It'll be a fun January. Through July.

#81 from ricg
Unlike your party and the "moderate" wing of the Republicans,
You may want to wait to see what the vote is. The CoC came out for it (surprise). I'll bet at least one who votes against it will be gunning for Minority lead. Cantor and Ryan - pretty conservative - sound like they're going to be vote with it. Boehner isn't exactly moderate either, he's just trapped. Like we all are.

Note to self: check opensecrets for donations occuring after this point in time, up to the next election.

Sorry, I thought I made it clear in my first post. In any event, I clearly stated in my response to you in #37 that I'm against it, too. That said, if we are going to do it, it probably would have been better in the original form, but it's true that you'd have to trust Paulson. I trust him but can see why that would be politically difficult.

I do think credit liquidity is the key issue if it's really as bad as Treasury says, but I would like to know more about what the direct evidence is that credit is/will be dangerously unavailable if we do nothing.

I still think you're exaggerating problems with derivatives, which generally have good hedging, risk-spreading, liquidity and pricing effects. The bigger Wall Street problem was the complexity of the CDOs, a structured finance issue, and not something that requires much regulation in my opinion. It seems, however, that the FDIC has sufficient oversight powers, it just didn't see the problem either, but I could be wrong.

One might be able to make an argument to require more regulation of credit rating, though that's not something I know much about.

Over all, however, I think that many institutions made mistakes. It's wrong even though popular to simply blame and attack Wall St., even though some blame lies there. The services Wall St. provides are beneficial to the efficiency of the markets and thus the US and world economy.

Dave, now once again could explain how swallowing this garbage rather than nationalizing the insolvent and injecting capital directly into a newly federalized banking system is in the taxpayer's best interest? Hell, the argument can be made that using 700 billion to 1 trillion to pay down troubled mortgages directly would be a better plan than what's on the table now!

If the taxpayer's interests is the chief concern that is.

If not well... 700 billion (so far) to the Wall Street titans sounds like a pretty good deal since they can now operate virtually without risk, being too big and oh so important to fail and all.

The fact is that undercapitalization is by definition a solvency problem. The problem is not that good assets are temporarily hit with prices below their real worth and that new capital is needed to maintain debt to equity ratio. The problem is that all these debts were not worth their face value to begin with. The high inflated market values of these assets were held up by circular trading of debt by assuming that they could always be sold at still higher prices way beyond their true worth. Now that the market is finally adjusting the price bubble downward and a lot of firm who were incredibly profitable on the way up are falling like leave[s] in autumn in a bear market. The Fed is merely trying to inject money to keep prices not supported by fundamentals from falling. It is a prescription for hyperinflation. The only way to keep price of worthless assets high is to lower the value of money. And that appears to be the Fed unspoken strategy
-Henry C K Liu

I've seen or heard nothing yet that disproves this. This is not a crisis of liquidity but one of insolvency. The bailout will not reverse this fundamental fact. The housing bubble will not and cannot re-inflate so the taxpayer, if forced to swallow garbage, can only lose in this deal.

Could someone answer this?

The bailout tries to address problems in the financial industry. What about secondary problems that spread beyond it. I am not sure whether this is a relevant question or not but>

Any balance sheet lists cash and cash equivalents, which I have always taken to mean highly liquid financial instruments. The treasurers at these corporations are charged with investing in these cash equivalents.

Since we have, little by little come to see the problems that the financial industry has with these now illiquid assets, will we see a second and larger version of the problems appear throughout corporate America?

TOC I seriously doubt that those instruments will be handled the same way again. In fact, the investment banking industry that once made this feasible no longer exists.

PS. Wall Street may not be getting its taxpayer loot after all so perhaps there is a god.

What the hell is going on in Washington? The bill fails? Thats the worst possible outcome. If you dont have the votes, dont vote. The market is plunging.

What is going on? When was the last time a vote took place in Washington that wasnt fait accompli? Paging Speaker Pelosi? President Bush? Get your acts together, how hard is it to count noses? There are people in DC that have done nothing but that for decades.

Late to the party but:

Thanks ricg for the various explanations of some of the important arcana.

My concern is on a very different issue that has gone unmentioned in this thread. And not a peep in the Presidential debate or on as much of the Sunday talking-heads TV as I could bear to watch.

Here's the unasked question.

Consider the point of view of the (unfriendly) foreign nations which Paulson must convince to take on this additonal $700 billion in US Government debt: What's in it for them?

We have been discussing the bailout as though the only important issues are the size, scope, and details of the spending provisions of the final compromise bailout.

But what about the prospective creditors' point of view? What economic and political constraints will they impose on us, in exchange for the loans (handouts?) we are seeking?

Logically, if seeking out this extra $700 billion in loans is an inherently good idea with an inherently modest downside, then we (the U.S.) should have already sought this tranche from our prospective creditors. Weeks, months, years ago. For funding Medicare Part D, new bridges, missile defense, AIDS research, expanded Social Security entitlements, Head Start...

Is there another valid perspective? Should we be wondering whether Paulson and Congress are planning on 'accidentally' turning the sovereign wealth funds of China, Russia, Korea, Saudi Arabia, and Japan into the final stop in the daisy-chain of insolvencies that has brought us to this point already? What do the Chinese (etc.) think about that possibility, I wonder?

Disquieting thoughts brought on by reading Fabius Maximus, The most important news of the month. Perhaps the year.

29 September 2008. Summary:  The warnings continue from our foreign creditors, as they see the deeper significance of America’s financial crisis.  The post-WWII geopolitical regime is ending, and they are thinking about the future.  Through one of those peculiar episodes of blindness that shapes history, the more warnings America receives — the more indifferent we become to them.  China in particular has given a stream of warnings over the past few years.  The first were by obscure academics, very low key in nature.  Slowly they have grown more explicit, but we remain oblivious. 

[snip]

#90:

I've been watching that same basic set of articles, and wondering about it. Here's my question:

How much of this is a genuine warning by foreign governments that normally invest in America that they might take their money elsewhere, and how much is it just a reminder that they have a stake and want to be considered?

The reason for asking the question is this: where would you take the money if not here?

The usual answer is the EU. But the EU's banking system is in a full-throated crisis this morning. The American system, though certainly troubled, is decentralized enough that even the failure of the few state-backed giants (Freddie, Fannie) can't break the whole system.

More, the reason that Freddie and Fannie failed seems to have been a function of their giant, state-backed nature. When a mistake was made, it affected their entire internal system. With decentralized private banks, if one bank makes a bad mistake, it kills that bank -- but not the whole system. When you have a giant, you take down everything associated with that giant.

Right?

So the EU banks don't look like a good option to me. They're also in crisis, and the governments there are responding to the crisis by asserting direct state control of the banks. That only means that the number of actors who might be immune to bad decisions is on the decline there.

The UK pound similarly has fallen off sharply v. the dollar today.

As bad as things are here, I think they're about to get worse everywhere else. In a general decline, the US doesn't lose its relative position. It's not the American finance system that's breaking. It's the global system. It's all tied together. That means everyone takes a fall.

We do need to take these warnings to heart, whether or not we believe China might go elsewhere -- indeed, whether or not we believe there is anywhere else to go. China's position is more delicate than it wants to consider. A major economic downturn globally could collapse the Chinese state into famine and civil war, as brutal poverty has been held back there only by the rapid, sustained growth. There are similar concerns for India. We need to think carefully about helping avoid that, even if it means putting their interests on a level with our own -- perhaps, in certain cases, on a level above our own.

"What the hell is going on in Washington? The bill fails? Thats the worst possible outcome"
-MB

Hardly Mark, for the taxpayer it's the only fair outcome. Now is the time to work out a genuine solution that addresses the fundamental flaws and excesses of the current system. Here's a good place to start

Actually Mark this is what I meant to link

How much of this is a genuine warning by foreign governments that normally invest in America that they might take their money elsewhere, and how much is it just a reminder that they have a stake and want to be considered?

And how much of it is pointing the finger of blame at the Americans to appease angry citizens in their own countries. A lot of European countries have exprienced their own housing bubbles and not all of their financial institutions have weathered the storms.

Coldtype,

I think that what Mark B. meant was that putting forward a bill that failed a vote was the worst possible outcome, at least in terms of reassuring investors. This signifies that the leadership is in chaos right now, unable to even count votes accurately, much less put an acceptable plan together. (Though I'm not sure how much Pelosi can be expected to get trustworthy information from the other side about their vote count---but then she should be aware of that, too.)

That's exactly my point. Whether or not the bill ultimately becomes law, this display makes it look like nobody knows what they are doing or whats going on. The market thrives on stability and this is as far from stability as anything i've ever seen in Washington. All the smiling faces mugging for the camera yesterday result in this?

I can't excuse Pelosi for this. She couldnt get 60% of her own caucus to vote yea. Thats a serious problem. Republicans have made their opposition clear from the beginning, any of their votes should be gravy.

But I blame Bush just as much. Obviously nobody has really sat down with the House republicans and worked to get them on board.

McCain's little stunt is starting to look saner and saner, or would have if he had followed through on it (he should never have threatened to boycott the debate though, a few hours isnt going to matter, it just looked silly). There is a clear lack of leadership in Washington right now. Actually Obama has missed an opportunity as well. If HE cant get 2/3rds of the House Dems to vote for a bill, something is seriously wrong. But i suspect he is loath to have his name attached to this thing. Just like everybody involved.

Mark B: The market thrives on stability and this is as far from stability as anything i've ever seen in Washington.

As a marginal supporter of the bailout plan, if there is no support, I'd probably assume that Congress tell the markets that no aid is coming. Otherwise, the market remains frozen by uncertainty. At least some percentage of the freezing of credit had to have been lending institutions waiting to see what the lay of the land would be. Now it appears they may know:

Lend only to the obscenely rich.

But thats not realistically the case. Everybody is already wondering what the next deal is going to look like. I'm pretty much in the same boat with you on the recovery plan- i'm deeply conflicted but come out in favor of it. But its no secret that if credit markets continue to dry up our economy is at risk for a true crash. Like DOW drops 50%. This is starting to affect all the economic activity in the country that relies on credit- which is all the economic activity in the country. What happens when American Airlines cant use their credit line to buy this months jet fuel? Or GM can't get their steel?

Marc@98: Ans? Barter economy. You think I'm kidding? I'm not talking survivalist or depression-type bartering, but you'll see major corporations and countries like Russia, China, etc., start to nibble around the edges in doing major deals in the commodities sector in particular.

It has been established that a giveaway is a non-starter, so now after essentially wasting two weeks perhaps Congress can seek the input of economist such as Nouriel Roubini, Michael Hudson, Henry C K Liu, and Dean Baker among others who'd called the housing bubble correctly years ago and warned that deregulation of the financial market would lead to catastrophe as it has. At minimum Paulson should be dismissed and the gang at Goldman Sachs marginalized. Once again as I referenced in the link above, the Swedes dug their way out of a similar crisis without rewarding those responsible. I have every confidence that we can do the same.

Mark B:

I've since heard a number of oddities about this afternoon's vote. The Republican leaders said they had 80 votes (which would have been enough) and a number of people close to the Speaker voted against it. I agree that this is odd. We may be in the midst of theatre.

But I think the markets would be better with an up or down. coldtype, aside, there is no desire among the American people to buy financial instiutions. ricg, aside, I sense no desire to lift capital restrications on banks; people are more scared today than last week. Up or down on immidate relief will allow us to look at longer term proposals like improving unemployment insurance, expanding bank failure insurance, improving public housing, and increasing the number of food kitchens. Unless they are not necessary, in which case, never mind.

Pelosi's speech could have helped, but any Republican who changed their vote out of pique ought to be tossed out of office.

Wouldn't it be nice if there was a way the country could toss everybody out of Congress and start from scratch?

Retiring Congressmen of both parties almost all voted Yes.

Congressmen of both parties (although more so Republicans) in tight re-election races voted No.

Boehner couldn't get enough Republicans to sign on for the bitter medicine, and even though I bet Pelosi could have twisted enough arms, there was no way to let the "Bush/Pelosi Bailout Plan" [note source of name] go forward without GOP fingerprints on the handle too.

One of my colleagues remarked that we're likely to get this thing plus 23 "bridges to nowhere" on Thursday.

I still hope he's wrong. Another thing to consider is the free-rider problem. Why should the US bear a disproportionate share of saving the global banking system and trying to avoid/minimize a recession?

Had another thought about what might be a hidden culprit that contributed to the crisis, which I think was mostly about a lack of diligence. There are a couple of causes for a lack of diligence, but I think one is a lack of time. The growth of computer networked, global trading, email, cell phones, etc. means there's very little slack in market-timing, since someone's always open and ready to sieze opportunities if you don't act quickly, so participants are being pressured to make snap decisions. I've noticed some shocking sloppiness as I look through some of these trades. Anyone seen data on how the speed of communications is making us reckless in the market?

More lessons from Sweden for Coldtype.

No ricg, I'm pretty sure that this is the better lesson

PS. Swedes enjoy longer life-spans and a higher standard of living than we Americans for many reasons ricg, but one of the more important ones is that their "high-tax" society and social democratic traditions ensure cradle to grave health care for its citizens. I'll say it again, there's a great deal we can learn from the Swedes.

[There was a space between the colon char and the URL I know it looks finny to leave it out. Trust the process. :) --NM]

Let's try this one ricg

[As above. Fixed. --NM]

The fundamental problem is the lending markets have totally gummed up. No bank will lend to another because they have no faith or transparency to see that the other bank is solvent. They don't believe they are solvent because of the reserve requirements attached to all the mortgage paper and mortgage related paper they hold(credit swaps) and the inability to price them.
I am against the bill as it is currently constructed, even though we have to have a bill that takes the unmarketable paper off the hands of financial institutions. The way I would approach this is set up a facility to buy ONLY the mortgage backed paper(FHA, FRE, FHMA, Alt-A and supbprime). The pricing mechanism I can not figure out. In return the institutions get cash.
I do not want the credit swaps because with the government facility owning the underlying asset and pricing them at what will inevitably be higher prices will automatically raise credit swaps value. This rise in price will lessen reserve requirements on the institutions and increase their ability to lend money. Further they now have an incentive to solve a crisis of their own making themselves.

The next thing is that the workout requirements for homeowners must become mandatory not voluntary. This will help price the mortgage paper because when paper of this type is issued there is a normal expectation of failure to pay with subsequent sales of homes at values below that of the underlying mortgage. These workouts will mean that new mortgages are issued at reduced values of the homes and will keep more people in their home and out of foreclosure. Foreclosure contributing to the downward spiral of home prices. These new mortgages replace the orginal one in the paper. This should add increased transparency to what the paper consists of. This in turn should help price the paper held by the federal facility.

This solution is not designed to find fault with the various parties. It is designed to find a way to reliquify(sic?) financial institutions and simultaneously stabilize the underlying assets of the mortgage paper, the homes. Politically it may be more palatable to the public as they participate by not having their neighborhoods destroyed by foreclosed homes.

#88 from Coldtype at 7:05 pm on Sep 29, 2008

TOC I seriously doubt that those instruments will be handled the same way again. In fact, the investment banking industry that once made this feasible no longer exists.

Thank you for your answer, but I obviously didn't express myself well.

Right now, let's say Boeing, John Deere and Dow have instruments that were considered liquid as part of their cash and cash equivalents line in their balance sheet, sold to them as part of packages by investment banks. What happens then and do we even know if this situation now exists?

Don't say i didnt warn you folks:

"The financial arm of the heavy equipment maker Caterpillar had to offer a hefty premium, almost three times what it had to pay a year earlier, to lure buyers to its recent $1.3 billion debt offering."

"Caterpillar considered itself lucky. The average premium that companies with similar credit ratings had to pay was even higher, according to a Merrill Lynch benchmark for corporate bond performance."

IHT

Start stuffing your pillow cases. That way when inflation roars into the game you'll have something to burn to keep warm.

Here's a good commentary

#110 from ricg at 4:42 pm on Sep 30, 2008

I agree there is something to this commentary,Fannie Mae and Freddie Mac were neither fish nor fowl and their lies the problem. and the lending policies of banks and other lending institutions bordered on the criminally insane.

But if fails to address the the amplification of the problem by investment banks creating "mortgage backed Securities", then leveraging them and the atrocious behavior of the companies like Moody's and Standard and Poor's in rating these as investments. i don't think that anyone can not think of this as collusion on the part of the investment banks and the ratings companies.

I know ther is more than enough blame to go around. Place your bets on the fultre here:

bet now

Courtesy The Big Picture

It doesn't matter what McCain would or wouldn't have said to the mainstream media illuminati, their opinions were formed. They're liberal elitist who will air what they want to air.