Back-filling my blog (on 11/28/08) with excerpts from emails, as dated, about the financial crisis:
10/20/2008 10:28 AM
The contagion continues to spread because when they bail-out one set of symptoms the disease goes to another sector -- e.g., from Lehman to money market funds to comm'l paper and now with the bank bond & deposit guarantees, back to Fannie & Freddie who are trading down because bank spreads are higher with the same govt-guaranteed credit risk. And with all those guys guaranteed -- GSEs, all banks, CP, et al, who the heck wants to lend to anyone who isn't federally guaranteed? Before this is over, Starbucks gift cards will be under Paulson's tent. This happens, in part, because MTM occurs at the price of the marginal transaction and not at the weight of the total cashflows. To me, "principles based regulation" isn't about mimicking the CPAs who gave Enron, WorldCom, et al, unqualified opinions based on their "do not disturb" audits, but rather lies in understanding the economic, financial, and ... yes, political principles involved so that your tactics are directed/informed by an implicit or explicit strategies& goals with known or at least understandable mechanisms for success. Bail-out Bear, then simultaneously let 'too bigger too fail' Lehman go but not AIG-FP?! There's no discernible, strategies or principles in that. It was arbitrary, capricious, and unfounded on any known principles of economics, finance, or law.
09/22/2008 10:03 AM:
Over the weekend I've thought through the origins of the crisis from a financial/economic principles point of view which, among other things, explains why the feds bailouts of Bear, Fannie & Freddie, and AIG failed to stop the crisis. There were multiple defects or fault lines that were triggered by fraud and moral hazard in mortgages & MBS. Now, the feds are about to guaranty all financial obligations of all financial institutions (they may not realize they must guaranty all, but the crisis will keep going to the next most vulnerable fin’s sector). [e.g., money mkt funds, CP, Citi] This ~$700 bln fund may succeed in braking the fall, but the feds will be 'right for the wrong reasons' -- which, as before, means they're just laying the tracks for the next cycle. Having mortgaged the nation's GDP as collateral [federal bailouts are not greater than GDP] for past moral hazard, there's no limit to m/h going forward, and no more collateral. And we haven't even got to the phase where VAGLB and public-pensions collapse! (Of course Social Security and Medi-Care & -Aid dwarf them all.)
09/29/2008 03:11 PM
We are in such uncharted waters at this point. This is nothing like the Oct. '87 crash or any other financial crisis in our lifetime.Nationally, we are so over-leveraged at the federal, state & local, andconsumer level it's hard to say where it ends. The feds -- Treasury, SEC, and Federal Reserve -- have not handled things very well. Paul Volcker said the Fed went 'to the limit of its authority' with Bear Stearns; since then it's been Fannie & Freddie & AIG & WaMu & Wachovia, who only a week ago was supposed to be a 'white knight' to rescue Morgan Stanley. CreditSights said WaMu's holding company bondholders came out better than the bank sub's bondholders, the opposite of the legal hierarchy. What do you do when the regulators act without respect to law, policy, or principle? They don't even seem to know why they failed.
9/2/08 @ 8:51 am -- more than two weeks before AIG, Lehman:
The Fed & Treasury "keep doing the same thing over & over again, expecting a different result". [When it's bad enough to make me quote Bill Clinton, it's really bad! - 11/25/08] Collateral is the contagion; they can't stop it by throwing the public balance sheet onto the tracks. (I'll save that explanation & possible solution -- and the one about why Wednesday's rule on naked shorts won't work, for another email. "Principles-based regulation": if you understand the fundamental principles, then you know what rules to write and which ones will or won’t work, especially in a crisis; it also tells you wherein lies your regulatory leverage.)
10/25/08:
Paulson & Co. are like the McNamara-vintage "It was necessary to destroy the [global financial] village to save it." First, Bear Stearns was the perfect opportunity to reverse 1984's Cont'l Illinois "too big to fail" doctrine. After that is when Paulson & Co. should have invoked, executed, Bagehot's 1873 maxim of central banks 'lending generously against good collateral at punitive rates' to stem contagion. Which, incidentally, Bagehot 'borrowed' from Henry Thornton, circa 1802. (See St.L Fed's "Review": http://research.stlouisfed.org/publications/review/08/09/Milne.pdf -- pages 521-523, abstract below)
10/20/2008 10:28 AM
The contagion continues to spread because when they bail-out one set of symptoms the disease goes to another sector -- e.g., from Lehman to money market funds to comm'l paper and now with the bank bond & deposit guarantees, back to Fannie & Freddie who are trading down because bank spreads are higher with the same govt-guaranteed credit risk. And with all those guys guaranteed -- GSEs, all banks, CP, et al, who the heck wants to lend to anyone who isn't federally guaranteed? Before this is over, Starbucks gift cards will be under Paulson's tent. This happens, in part, because MTM occurs at the price of the marginal transaction and not at the weight of the total cashflows. To me, "principles based regulation" isn't about mimicking the CPAs who gave Enron, WorldCom, et al, unqualified opinions based on their "do not disturb" audits, but rather lies in understanding the economic, financial, and ... yes, political principles involved so that your tactics are directed/informed by an implicit or explicit strategies& goals with known or at least understandable mechanisms for success. Bail-out Bear, then simultaneously let 'too bigger too fail' Lehman go but not AIG-FP?! There's no discernible, strategies or principles in that. It was arbitrary, capricious, and unfounded on any known principles of economics, finance, or law.
09/22/2008 10:03 AM:
Over the weekend I've thought through the origins of the crisis from a financial/economic principles point of view which, among other things, explains why the feds bailouts of Bear, Fannie & Freddie, and AIG failed to stop the crisis. There were multiple defects or fault lines that were triggered by fraud and moral hazard in mortgages & MBS. Now, the feds are about to guaranty all financial obligations of all financial institutions (they may not realize they must guaranty all, but the crisis will keep going to the next most vulnerable fin’s sector). [e.g., money mkt funds, CP, Citi] This ~$700 bln fund may succeed in braking the fall, but the feds will be 'right for the wrong reasons' -- which, as before, means they're just laying the tracks for the next cycle. Having mortgaged the nation's GDP as collateral [federal bailouts are not greater than GDP] for past moral hazard, there's no limit to m/h going forward, and no more collateral. And we haven't even got to the phase where VAGLB and public-pensions collapse! (Of course Social Security and Medi-Care & -Aid dwarf them all.)
09/29/2008 03:11 PM
We are in such uncharted waters at this point. This is nothing like the Oct. '87 crash or any other financial crisis in our lifetime.Nationally, we are so over-leveraged at the federal, state & local, andconsumer level it's hard to say where it ends. The feds -- Treasury, SEC, and Federal Reserve -- have not handled things very well. Paul Volcker said the Fed went 'to the limit of its authority' with Bear Stearns; since then it's been Fannie & Freddie & AIG & WaMu & Wachovia, who only a week ago was supposed to be a 'white knight' to rescue Morgan Stanley. CreditSights said WaMu's holding company bondholders came out better than the bank sub's bondholders, the opposite of the legal hierarchy. What do you do when the regulators act without respect to law, policy, or principle? They don't even seem to know why they failed.
9/2/08 @ 8:51 am -- more than two weeks before AIG, Lehman:
The Fed & Treasury "keep doing the same thing over & over again, expecting a different result". [When it's bad enough to make me quote Bill Clinton, it's really bad! - 11/25/08] Collateral is the contagion; they can't stop it by throwing the public balance sheet onto the tracks. (I'll save that explanation & possible solution -- and the one about why Wednesday's rule on naked shorts won't work, for another email. "Principles-based regulation": if you understand the fundamental principles, then you know what rules to write and which ones will or won’t work, especially in a crisis; it also tells you wherein lies your regulatory leverage.)
10/25/08:
Paulson & Co. are like the McNamara-vintage "It was necessary to destroy the [global financial] village to save it." First, Bear Stearns was the perfect opportunity to reverse 1984's Cont'l Illinois "too big to fail" doctrine. After that is when Paulson & Co. should have invoked, executed, Bagehot's 1873 maxim of central banks 'lending generously against good collateral at punitive rates' to stem contagion. Which, incidentally, Bagehot 'borrowed' from Henry Thornton, circa 1802. (See St.L Fed's "Review": http://research.stlouisfed.org/publications/review/08/09/Milne.pdf -- pages 521-523, abstract below)
In my "Panic of 2008" essay [posted Dec. 9th] I described two subtle but very fatal & systemic flaws: FAS-157's fatwa applying MTM to non- (or no longer) marketable assets, and to market & regulatory practices re: collateralizing CDS MTM. The flaw in the latter, beyond the simplified version in my essay, is the CDS underlying phenomenon is very different from virtually all other derivatives. (I don't think they really can be modeled using "geometric Brownian motion" – an assumption underlying virtually all other "continuous time finance".) To simplify w/analogy: an interest rate swap both begins and ends with a zero NPV as it's struck at market at the beginning ($0 NPV, excl' bid/offer spread) and matures at zero -- i.e., it goes to par value which is $0 for a swap and $100 (100%) for a bond. Defaults on the other hand have very lumpy distributions and don't model well as either a function of time (Poisson?) or # of events (normal, log-normal).
Thus, my remedy of the Fed becoming banks' & brokers' CSA Provider (on all swaps, not just CDS) becomes the circuit-breaker to the derivative MTM contagion they feared for Bear and got with Lehman. The Barney Frank Banks, Fannie & Freddie, were a separate disaster we've long known were lurking in the risk tails. Without looking, I've said I'd bet they failed due to on balance sheet MBS and not due to their guarantees – although losses are cumulative irrespective of source.
The contagion continues to spread because when they bail-out one set of symptoms the disease goes to another sector -- e.g., from Lehman to money market funds to comm'l paper and now with the bank bond & deposit gtys, back to Fannie & Freddie who are trading down because bank spreads are higher with the same govt-gtd credit risk. And with all those guys gtd -- GSEs, all banks, CP, et al, who the heck wants to lend to anyone who isn't federally gtd? Before this is over, Starbucks gift cards will be under Paulson's tent. This happens, in part, because MTM occurs at the price of the marginal transaction and not at the weight of the total cashflows.
"Principles based regulation" isn't about mimicking the CPAs who gave Enron, WorldCom, et al, unqualified opinions based on their "do not disturb" audits, but rather lies in understanding the economic, financial, and ... yes, political principles involved so that your tactics are directed/informed by an implicit or explicit strategies & goals with known or at least understandable mechanisms for success. Bail-out Bear, then simultaneously let 'too bigger too fail' Lehman go but not AIG-FP?! There are no discernible strategies or principles in that. It was arbitrary, capricious, and unfounded on any known principles of economics, finance, or law. By contrast, and mixing metaphor, when Putin marched into Georgia I could immediately see 6 or 7 strategic ends (e.g., put fear into "near abroad", threaten satellites & western Europe's energy supplies, both highlighting U.S. impotence, add territory, etc.) Reprehensible, but great strategic leverage with no downside. (Ironically, Mr. Market has also taken Putin down a few notches.)
Where does it end? Or, why do I saw the "village" was unnecessarily destroyed? The Chrysler Loan Gty Act of 1978 was debated & enacted by Congress & the President after much debate and with due process. Those were guarantees, not direct loans, and only one company benefited while many were harmed). In 7~8 months Paulson & Bernanke & Cox have done to the financial system by fiat, diktat, what Hillary tried but couldn't do to healthcare in '93. Don't think for a minute that Barney, Chuck, Chris, & friends haven't noticed that Paulson's banking equity cram-down just created nine more GSEs, making the entire U.S. capital allocation model subject to "suasion", moral or otherwise -- i.e., the "Friends of Angelo" program just went national in scope for the benefit of its 535 members and hangers-on. Or look at AIG: Congress ismicro-managing compensation for top producers (their resort spa tab). When did shareholders get to vote on these issues? What happened to the "takings" provision in the Constitution? (What's that exchange again between Sir Thomas More and Rich, about when the Devil turns, from Bolt's play, "A Man for All Seasons"?)
"Economic muscle"? When Lord Keynes' remedy for the Depression was to 'pay men to dig holes and fill them up again' he was speaking of a very unleveraged government. I don't see the Red Chinese or other SWF funds lending us more money to dig & fill even more holes -- that was last year's trade. I see them buying up on the cheap our shovels and our capital assets ... which eventually leaves us where? (Not a done deal by any means and not in just one cycle -- the Chinese may not end up being our heirs as either they continue slowly towards capitalism and/or have plenty of Ayers here anyway -- pun intended.)
The laws of finance & economics are as immutable and inevitable as those of physics. Yes, an airplane can defeat gravity, but only temporarily and only with application of skill (pilot), technology, (airframe, engines), and resources (fuel). Our system is built upon "fractional reservebanking" which cannot function w/o trust; on top of that we've added leverage. Our modern economic & financial system eliminated considerable friction, created huge efficiencies, which enabled a substantial increase in wealth/income. There are no bank runs on the isle of Yap but neither is there much wealth.
When I look at the long term and consider deficits, debt, unfunded mandates, etc., all in light of inexorable demographics, it's hard to see how to prepare one's financial survival.
JRB
11/28/08
