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The less optimistic view of Treasury's handling of the crisis

yves@nakedcapitalism.com (Yves Smith) — Fri, 06 Nov 2009 19:09:16 -0800

By Edward Harrison of Credit Writedowns

The Obama Administration is captured. To understand why it has acted as it has, one doesn't have to take the view that its efforts to save the banking industry were a deliberate attempt to line bankers' pockets by transferring money from taxpayers to the banking industry. One need merely read the last post I wrote on this topic.

In their wildly optimistic view, the banking industry is solvent and always has been. All that was needed to ‘solve' than banking crisis was a lot of liquidity, government backstops and, most importantly, time. This blinkered view sees a looting of taxpayer money to bailout the banking industry as necessary to save banks whose credit is the ‘lifeblood of our economy.'

They are wrong. The banks did not need to bailed out. The banking industry industry needed to made solvent again. There is a big difference between those two sentences (banks versus banking industry and liquidity versus solvency) that goes to the core of the captured and politically damaging world view we have seen on display by the Obama Administration.

Change you can believe in

Think back some 18 months when Senator Obama was in a horse race with Hillary Clinton to see who would go up against John McCain in the Presidential election. If you asked any reasonable individual who had the least experience and the thinnest political resume of the three, he or she would have said Barack Obama. If Americans wanted someone long on inside-the-beltway experience, they would have chosen John McCain – or, at a minimum, Hillary Clinton, not Barack Obama.

So, Barack Obama did not best both Hillary Clinton and John McCain and get to the White House because Americans felt him more qualified for the job. Rather, Americans believed the U.S. was on the wrong path and wanted a qualified person to lead the country who would also change course. They believed that person was Barack Obama.

And when it came to the economy, the presence of two men, Paul Volcker and Warren Buffett, born some 80 years ago, gave one the sense that, despite Barack Obama's perceived relative youth or inexperience, he had the ablest of wise old men who would be his and our counsel in resolving this crisis.

Bailing out the banks

So when Barack Obama took office, it came as a rude awakening for many that he chose to bail out the too big to fail institutions with little or no strings attached, allowing them to later make record profits and pay record bonuses, while the economy was in a deep slump and ordinary Americans were being bankrupted and losing their jobs and homes at record rates. This was not change you can believe in.

What could or should the Obama Administration have done?

If you had listened to the chatter inside the beltway early this year, you would realize that Obama's team believed it was not politically feasible to ‘nationalize' Citigroup or Bank of America and force top executives to resign as was done at RBS, Bradford and Bingley or Northern Rock in the UK. This was a blinkered view which can only be described as captured (if not outright disingenuous). We need look no further than Fannie Mae and Freddie Mac to see that nationalization was an option.

But this is not the kind of solution we needed. What we needed was a solution by the Administration to take prompt corrective action in seizing bankrupt institutions, dismissing management, punishing any misdeeds and setting up a timetable to sell off the institution's assets. That is change you can believe in.

I laid this out fairly comprehensively in February in my post "America needs a pre-privatization plan." So I am not going to cover that ground here except to quote the key relevant passage in that post:

To my mind, there are three ways to deal with an insolvent financial institution:

Bankruptcy. Allow the institution to collapse (like Lehman Brothers)

Nationalization. Seize the assets of that institution and nationalize it (like Northern Rock, AIG, or Fannie Mae)

Bailout. Inject capital into the institution in order to allow it breathing room until it can meet capital adequacy levels.

As you can see, governments have tried all three solutions. However, there are vast differences between the three.

The bailout solution is the most ‘anti-free market' choice and seems to be the favored solution of governments everywhere. It props up organizations, giving them an unfair advantage at the expense of other more prudent institutions. It also acts as a subsidy, which favors domestic institutions over foreign rivals. Bailouts increase moral hazard by rewarding risky and reckless lending practices. And they are often the result of crony capitalism due to the power of the financial services lobby. There are many other problems with bailouts. All around, bailouts are a poor solution.

So what we have here is a case of crony capitalism and kleptocracy, plain and simple – whether by design or not is immaterial. And the American people are on to this. That is why people are resistant to other changes this Administration has put forth.

Don't let the media's spin fool you: Washington insiders are on to this too. Politicians in Congress realize that Obama's bailouts have cost him political capital and they are challenging his policy agenda as a result. This is why the health care bill, which Obama wanted passed before the summer recess, may not see the light of day before year's end.

Are we home safe?

I would advise the Obama Administration not to run any victory laps about having slayed the beast. The lingering effects of crisis are still there. The Fed's liquidity is still liquid. Impaired assets are still impaired. And zombie banks are still zombies. As I indicated in my depression piece:

In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized.

Since I covered this ground in that article, I will leave you to read my further thoughts there. What I want to turn to now is the ‘why.'

The Cheney-Rumsfeld replay

Now, I am not writing off Barack Obama's presidency. I do worry he still could see a recessionary relapse which would cause him to seem more Herbert Hoover than Franklin Roosevelt. But, despite his Nobel Prize, it is much to early to know what his legacy will be.

Nonetheless, I believe he has wasted a lot of political capital and this will make ushering through a meaningful legislative agenda very difficult.

Why did Obama throw it all away?

Here's my answer: I call it the Cheney-Rumsfeld replay.

When historians look back at the Bush 42 presidency, it will be defined by 9/11 and the wars in Iraq and Afghanistan. While George W. Bush was politically pre-disposed to the Neo-con world view, it was really advice from Dick Cheney and Don Rumsfeld which made Afghanistan and Iraq possible. George W. Bush was famously not well-versed in foreign affairs, having almost never travelled abroad. He was completely dependent on Dick Cheney and Donald Rumsfeld to make foreign policy (although he could have listened more to Colin Powell, his actual Secretary of State; again it goes to predisposition).

So, I see George W. Bush's presidency as having been defined by foreign policy and the War on Terror and, by extension, on Rumsfeld and Cheney.

Fast-forward to Barack Obama's presidency and you have an almost identical situation, this time with the economy instead of foreign policy and Tim Geithner and Larry Summers instead of Donald Rumsfeld and Dick Cheney.

But, as with George W. Bush, it goes to pre-disposition. Paul Volcker was a critical member of the Obama 2008 campaign. He also was a key member of Obama's economic policy team. But, he has been speaking a very discordant message that is not in sync with team Obama. So, as with Bush and his marginalization of Powell, one has to believe Barack Obama has chosen to side with Geithner and Summers over Volcker.

The obvious conclusion, therefore, is that Barack Obama shares the blinkered and captured view of his policy makers and that this is why he has decided to go down this chosen path. And when it comes to Obama's other ‘change' decisions on the Guantanamo closure, torture, rendition, state secrets, and health care, the same logic also applies.

Is this change we can believe in? I will leave that for you to decide.

Guest Post: Investor Psychology … Fear Turns People Into Sheep

yves@nakedcapitalism.com (Yves Smith) — Sat, 07 Nov 2009 04:23:05 -0800

By George Washington of Washington's Blog.

Investors are basically rational, right?

In fact, as many studies have demonstrated, the answer is no.

But instead of wading through all of the investment psychology research, let's look at research into people's basic reasoning abilities. Bear with me for a minute. A study in an area unrelated to investing sheds light on people's basic thinking processes.

Sociologists from four major research institutions investigated why so many Americans believed that Saddam Hussein was behind 9/11, years after it became obvious that Iraq had nothing to do with 9/11.

The researchers found, as described in an article in the journal Sociological Inquiry (and re-printed by Newsweek):

Many Americans felt an urgent need to seek justification for a war already in progress

Rather than search rationally for information that either confirms or disconfirms a particular belief, people actually seek out information that confirms what they already believe.

"For the most part people completely ignore contrary information."

"The study demonstrates voters' ability to develop elaborate rationalizations based on faulty information"

People get deeply attached to their beliefs, and form emotional attachments that get wrapped up in their personal identity and sense of morality, irrespective of the facts of the matter.

"We refer to this as ‘inferred justification, because for these voters, the sheer fact that we were engaged in war led to a post-hoc search for a justification for that war.

"People were basically making up justifications for the fact that we were at war"

"They wanted to believe in the link [between 9/11 and Iraq] because it helped them make sense of a current reality. So voters' ability to develop elaborate rationalizations based on faulty information, whether we think that is good or bad for democratic practice, does at least demonstrate an impressive form of creativity.

An article yesterday in Alternet discussing the Sociological Inquiry article helps us to understand that the key to people's active participation in searching for excuses for actions by the big boys is fear:

Subjects were presented during one-on-one interviews with a newspaper clip of this Bush quote: "This administration never said that the 9/11 attacks were orchestrated between Saddam and al-Qaeda."The Sept. 11 Commission, too, found no such link, the subjects were told.

"Well, I bet they say that the commission didn't have any proof of it," one subject responded, "but I guess we still can have our opinions and feel that way even though they say that."

Reasoned another: "Saddam, I can't judge if he did what he's being accused of, but if Bush thinks he did it, then he did it."

Others declined to engage the information at all. Most curious to the researchers were the respondents who reasoned that Saddam must have been connected to Sept. 11, because why else would the Bush Administration have gone to war in Iraq?

The desire to believe this was more powerful, according to the researchers, than any active campaign to plant the idea.

Such a campaign did exist in the run-up to the war…

He won't credit [politicians spouting misinformation] alone for the phenomenon, though.

"That kind of puts the idea out there, but what people then do with the idea … " he said. "Our argument is that people aren't just empty vessels. You don't just sort of open up their brains and dump false information in and they regurgitate it. They're actually active processing cognitive agents"…

The alternate explanation raises queasy questions for the rest of society.

"I think we'd all like to believe that when people come across disconfirming evidence, what they tend to do is to update their opinions," said Andrew Perrin, an associate professor at UNC and another author of the study…

"The implications for how democracy works are quite profound, there's no question in my mind about that," Perrin said. "What it means is that we have to think about the emotional states in which citizens find themselves that then lead them to reason and deliberate in particular ways."

Evidence suggests people are more likely to pay attention to facts within certain emotional states and social situations. Some may never change their minds. For others, policy-makers could better identify those states, for example minimizing the fear that often clouds a person's ability to assess facts …

The Alternet article links to a must-read interview with psychology professor Sheldon Solomon, who explains:

A large body of evidence shows that momentarily [raising fear of death], typically by asking people to think about themselves dying, intensifies people's strivings to protect and bolster aspects of their worldviews, and to bolster their self-esteem. The most common finding is that [fear of death] increases positive reactions to those who share cherished aspects of one's cultural worldview, and negative reactions toward those who violate cherished cultural values or are merely different.

Fear in the Economic and Financial Arenas

Has something similar happened in the economic/financial arenas?

Congressmen Brad Sherman and Paul Kanjorski and Senator James Inhofe all say that the government warned of martial law if Tarp wasn't passed. And Rahm Emanuel famously said:

Never let a serious crisis go to waste. What I mean by that is it's an opportunity to do things you couldn't do before.

Last year:

Senator Leahy said "If we learned anything from 9/11, the biggest mistake is to pass anything they ask for just because it's an emergency"

The New York Times wrote:

"The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress."
***

Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college.

Some are suspicious of Mr. Paulson's characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress's failure to act. This time, it is financial Armageddon supposedly on the doorstep.

"This is scare tactics to try to do something that's in the private but not the public interest," said Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at the Carnegie Mellon Tepper School of Business. "It's terrible."

Not Just Government

But it's not just government . . .

If the too big to fails say that the world economy will crash and there will be martial law unless they are bailed out, politicians – most of whom don't understand finance or economics – will believe them, and sound the alarm themselves.

As Karl Denninger wrote yesterday:

[AIG's CEO] left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner's attention–was a report on AIG's counterparty exposure around the world, which included "2.7 trillion of notional derivative exposures, with 12,000 individual contracts." About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: "$1 trillion of exposures concentrated with 12 major financial institutions."

Was that a threat?

And isn't threatening the United States (whether directly or otherwise) something you're not supposed to do?

Sounds like "Bail me out or I will crash everything."

Isn't that analagous to walking into a bank, opening one's coat to reveal an explosives-laced belt, and saying "gimme all the money or everyone dies!"

Yves Smith has previously used a similar analogy.

Fear Among Individual Investors

Investors – as with politicians or Americans in general – believe that "when [they] come across disconfirming evidence . . . . they tend to … update their opinions", but in reality, they cling to the beliefs they formed during certain heightened emotional states, such as fear.

Fear turns people into sheep. Once they are sheep, they will strive mightily to justify the actions of their "leaders" – whether those leaders gave trillions of dollars in bailouts or got us into war, and even if the leaders' justifications were false.

I believe this dynamic is also playing out in the fact that many Americans assume that the government has a real plan for fixing the economy, is working as hard as it can to do so, and that – eventually – things will improve.

Just as most Americans believe "since we're at war in Iraq, and since the government previously claimed that Saddam was behind 9/11, he must have been", they are probably thinking "since the government gave trillions to the giant banks and said that economists have figure out how to fix things, they must have done what was needed, and things will turn around in a v-shape recovery".

The lengths people go to rationalize a false link between Saddam and 9/11 is a great example, because it may reveal by analogy how far people will go to justify their trust in our economic leaders and in their own investment decisions.

Of course, the yearning for high returns is the other half of what drives investor psychology. But this essay focuses on fear.

Einhorn: First, Let's Kill All the Credit Default Swaps

yves@nakedcapitalism.com (Yves Smith) — Sat, 07 Nov 2009 08:13:09 -0800

David Einhorn, who enjoys his considerable reputation for hard-fought battles against firms with shaky finances and dubious accounting (Alliance Capital and Lehman), has taken aim at a new and equally deserving target: credit default swaps.

In an interesting bit of synchronicity, Einhorn's comments in a letter to investors overlap to a considerable degree with a post we wrote yesterday on why a clearinghouse for derivatives wasn't a solution to the dangers posed by credit default swaps (and note the Orwellian branding, the reforms are about "derivatives" which include benign ones, names simple interest rate and currency swaps, yet the bill has loopholes that will let many, indeed probably most, credit default swaps escape).

Credit default swaps have no redeeming social value. They are a fee machine for Wall Street and their supposed value is considerably overstated (the world pre credit default swaps functioned perfectly well) and their costs, which are considerable, are not given the attention they warrant. And I don't mean the failure of AIG, either.

Even though Einhorn gave a stinging, wide-ranging indictment, he missed one of the issues I find troubling, which is that credit default swaps result in information loss, which in turn lowers the quality of credit decisions. In other words, the product is inherently destructive.

In the world of old-fashioned fixed income investing, creditors would evaluate a borrower to make sure it had good odds of meeting its obligations. The lender could and usually did make inquiries about the borrower's income, and its other commitments. If it was a business, the bank might also want to assess information that would help it evaluate the stability of the borrowers income (for instance, learning who its main customers were to determine how diverse and solid they were).

Just as with securitiztion, credit default swaps lower the incentive to do borrower due diligence. Why bother, when the CDS spreads on the reference entity tells you what the market thinks and you can use CDS to reduce or lay off the credit risk? But the original lender is in a privileged position; he is able to gather data from the borrower that it non-public and thus will not be incorporated in a market price. Thus giving creditors an incentive not to do that work systematically lower the quality of credit decisions.

But that reason is a bit abstract, although the costs are real. Einhorn focused on more tangible types of damage wrought by CDS, as summarized by the Financial Times. First, CDS are a means of extortion:

"I think that trying to make safer credit default swaps is like trying to make safer asbestos," he writes in a recent letter to investors, adding that CDSs create "large, correlated and asymmetrical risks" having "scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay".

Second, CDS speculators win if companies die. Given that the volume of CDS outstanding is a significant multiple of the amount of bonds outstanding, they are not used primarily for hedging, but for creating "synthetic" exposures. And those on the short side have compelling reasons to influence outcomes. When a company gets in trouble, the best outcome is often an out-of-court restructuring of debt before it gets even further in trouble. As much as the Chapter 11 process has certain advantages, it is also costly and risky. A CDS holder (one with a significant short position) can buy some bonds (now at a cheap price) of a struggling company to assure it has a seat at the table in negotiations so it can block a renegotiation of the debt and force a bankruptcy filing so it can assure its payoff on the CDS. From the Financial Times:

CDSs are "anti-social", he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called "basis packages" buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors "have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors"

Einhorn also agrees with our contention, that a credit default swaps clearinghouse is not a viable solution. As we said yesterday in comments:

CDS are not economic if adequately margined. Adequate allowance for jump to default risk makes it very unattractive on a ROE basis. The way around that pre-crisis was making AIG and the monolines the bagholders. That game is over, but the Street is hooked on the revenues…..

….in invoking AIG, I am saying that an undercapitalized clearinghouse is a concentrated point of failure and a very big one too, a systemic risk all of its own.

Einhorn's views:

"The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity," he notes.

That's because it is almost impossible to adequately capitalise against such developments. "There is no way a clearing house could demand enough collateral," he says. "The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral."

I think you need more people recognizing that CDS serve the interests of the financial sector at the expense of the real economy, and calling for the product to be banned. Only then might you see radical enough action taken.

However, as much as I hate CDS, I have reluctantly concluded that they cannot be taken out overnight. They have become sufficiently enmeshed in our financial infrastructure that eliminating them is like disarming a web of nuclear weapons. If you make a mistake on any one, they all go boom. One (and this is far from the only) problem is that the big banks not only have large CDS exposures, but they have other hedges related to them (such as interest rate swaps). So simply putting CDS into runoff mode could lead to dislocations in other markets.

I prefer regulating them very intrusively (like insurance, to make sure the counterparties are adequately capitalized), limiting new CDS writing to hedging existing positions (that would need to be tightly defined and monitored) and limiting CDS writing to end users (which would include proprietary trading desks) to where the investor had an insurable interest, as in owned the bonds, and only up to his exposure. That plus increasing capital requirement over, say, a three year period, to reflect the true default risk of the product should shrink the market enough to allow regulators to then ascertain whether it could then be put in runoff mode. But the intent of policy should be loud and clear: to strangle CDS, with the hope of killing them.

And for those who hope netting might do the trick, reader Richard Smith disabuses us of that notion:

Another point is about the struggle to keep up with ‘financial innovation' in the OTC market. A problem for clients and regulators alike. CDS are probably the nastiest of these. They are so polymorphous – part of a basis trade, or a directional bet, or a sort-of-legit hedge, or a synthetic, depending on context; and no cap on speculation a la Gambling Act; and then vaguely like derivatives, or insurance, or short bond positions, or a prediction market.

But you couldn't rule out the possibility that equally nasty new products could be developed by some smart aleck. Maybe there should be a charge on the inventors to cover the cost of regulatory catch up. Or something equivalent to airworthiness regulations, which even libertarians accept without demur, as far as I understand. That would slow the innovators down a bit – proving the ‘wings' aren't going to come off their new financial products and kill all the passengers.

Another observation I'd been meaning to make on ‘CDS trade compression': the 20-40% that some commentators are so pleased about. I worked on an app like this for a large IB (recently unpopular in the guise of an mollusc) at the turn of the millennium. They had half a million daily NASDAQ trades at that time and their settlement IT guy in NY was freaking out as his mighty mainframe began to wilt under the volumes. Even with quite a conservative approach to compression (there are choices about how aggressively you net the trades – we thought we could get it down to 25,000 trades per day if we really went for it) we got 80% compression straight away, so, 100,000 netted trades per day. Of course those are highly standardized trades. The aggregation was something like stock, side, settlement date, counterparty, trade flags. NASDAQ is often characterized as an OTC market so it is really the product standardization that matters, rather than the nature of the venue perhaps. I think it went to 90% within a month or two as we got bolder but I may be confabulating; it's a while ago.

If they can only get 40% trade compression out of CDS, after a year, there must be an awful lot of detritus left over (especially when IIRC most of the counterparties are TBTFs). So things like contract clauses, reference entity, duration of cover must be all over the place in what remains. Difficult to hedge or lay off I should think. And some unconfirmed trades too no doubt. A total mess.

Ignoring all the other shortcomings of CDS the natural thing would be to standardize the product:: that's happened so many times before, but IBs hate standardization of course for the margin erosion it brings, and anyway now we get this cartel-like protection of the margins, under the guise of support for ‘finanical innovation'.

The implication is that what is on the banks' books now is a bit hairier to manage than they are ‘fessing up. As other experts who similarly hate the product, like Satyajit Das have observed, simply banning new protection writing would probably lead to hugely disfunctional behavior prior to the date and also lead to problems (as in big time losses, which in a worst case scenario could result in another bailout) as positions that were in runoff mode would be essentially frozen and could not be managed.

But if we can get agreement on aims, which is the product should be killed, then it becomes possible to debate the best (least painful and costly) means.

Links 11/7/09

yves@nakedcapitalism.com (Yves Smith) — Sat, 07 Nov 2009 09:41:24 -0800

Three bald bears perplex experts BBC

Antidepressants and Violence EconoSpeak. One of my pet peeves is how psychoactive medications are handed out like candy in the US. Just go to your MD, say you are exhausted, and once they eliminate anemia, chronic fatigue syndrome, and low thryoid, they assume it's in your head and will offer you all sorts of mood altering goodies.

What does Google Suggest suggest about the state of humanity? CNet

Jon Stewart spoofs Glenn Beck Ed Harrison. Too funny.

Landing a job like getting into Harvard CNN (hat tip Felix Salmon)

A Tsunami of Red Ink Michael Panzner

Wall Street still overestimating the American consumer The Economic Populist

JRE Keeps You Entertained All Weekend: It's not nice to make fun of Telstra Josh Reviews Everything. Two of my accomplishments when I lived in Australia were victories against Telstra. The first was getting Telstra to correct a large overcharge on my mobile phone bill. You have no idea what that entails. The second was, after I was told I would have to wait three weeks to get broadband (!) because there were no open ports in my local office, finding an open port on my own and using that info to insist they give me service sooner. This post is further confirmation that all the bad things said about Telstra are accurate.

"Demystifying Social Knowledge" Mark Thoma

Consumer debt drops for record 8th straight month MarketWatch (hat tip reader John D)

Report: 237 millionaires in Congress Politico (hat tip reader John D)

Bank of England says financiers are fuelling an economic ‘doom loop' Telegraph. It is striking how the BofE is willing to take on the banksters, when no one in the officialdom here will.

Nominally misguided (wonkish) Paul Krugman

Barking Up the Wrong Tree Roger Ehrenberg. Today's must read

Antidote du jour:

The wildly optimistic view of Treasury's handling of the crisis

yves@nakedcapitalism.com (Yves Smith) — Thu, 05 Nov 2009 17:50:45 -0800

By Edward Harrison of Credit Writedowns

I was reading Kid Dynamite's account of the recent Treasury – Finance Blogger meeting after having read a bunch of others (see them all in Abnormal Returns' Nov 4th links). And I was struck by his characterization of the thinking at Treasury in regards to the financial crisis. I want to highlight two points and ask the question: didn't the Treasury plan work as designed?

I will try not to editorialize and let you draw your own conclusions based on my (hopefully neutral) narrative of their stated goals.

Here is point #1 I want to highlight:

The first point that caught my ear was the description of the stress tests as having been designed to restore a level of confidence in the banking system. The STO mentioned that the focus was now on reducing the footprint of economic intervention cautiously, quickly and prudently…

a number of STO's present in the room, who quickly banded together to clarify that no one knew the results of the stress tests before they happened, and that they were designed to restore confidence by identifying the levels of capital needed by the banks, and requiring them to raise such capital. I said that if they wanted to restore confidence, they should require banks to mark assets to market, and depict the true financial situation.

As I read it, Treasury wanted to show that it had a credible plan to identify any capital shortfalls amongst our biggest banks and to take corrective action. Their belief is this would restore confidence.

Here is point #2 to highlight – why the need for secrecy:

I [Kid Dynamite] mentioned that the problem was that even if we had a "Counterparty Risk Czar" who somehow managed to magically quantify the exposures of each firm (which may be quite a difficult task in itself), we'd see the same problems we saw when the government went to give out the TARP funds. The government didn't want to "bail out" select firms (ie, BAC and CITI) because they feared that the stigma attached to such assistance would create panic and runs on the bank – so they asked a large pool of financial institutions to take the money to hide the truly sick cows.

I read this to say that Treasury feared identifying ‘loser' institutions would have a negative impact and cause bank runs (think Washington Mutual). therefore, they had to hide the ball, so to speak. The same philosophy is behind the Fed's refusal to release more information to Bloomberg on the Fed's emergency lending counterparties.

The overall gist of the strategy was that Treasury wanted to identify the weak, give them time to grow stronger, and, in so doing, allow the panic phase to subside so that corrective action could be taken in a more normal economic environment.

Wasn't the plan wildly successful? Blogger Accrued Interest thinks so.

Now, before you give a knee-jerk response, please read the following from a post I wrote in April called "Channeling my inner Larry Summers," which was my attempt to read the intentions of Obama and his economic team (in the voice of Larry Summers). I think it dovetails nicely with what Kid Dynamite says were the actual goals of Treasury.

the question is how do we deal with this crisis. The first priority must be to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences. The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending. Is this re-flating the bubble? No, because deflationary forces will continue to extract a price even with these measures in place. The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.

But, spending alone won't get it done. Ultimately, we will need to increase credit availability. Just because people are spending more, does not mean the economy will grow. Growth depends critically on increasing credit in line with the growth of the economy.

I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing. The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government. What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.

Let me enumerate some mechanisms:

First we should try bank re-capitalization. Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that's number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money. What's more is it limits government interference. Remember – most of these institutions are having temporary problems. With enough capital, they can weather the storm. There is no need for heavy-handed government interference.

If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks' balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government's limitations. The PPIP and TALF can help achieve this.

Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.

Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.

So have Geithner and his team not avoided the pitfalls and accomplished their goals?

Goldman, Fed, Citi Getting Preferential Allotments of H1N1 Vaccine

yves@nakedcapitalism.com (Yves Smith) — Thu, 05 Nov 2009 22:50:22 -0800

It should come as no surprise that those at the top of the food chain get preferential treatment on all levels. But this still stinks to high heaven. Employees of the Goldman, the Fed, Citigroup, and other banks are getting H1N1 vaccine allotments out of proportion to what can be justified from a public health standpoint. In particular, Goldman has gotten more than Lenox HIll hospital, which needs it not just for the sick but more important, for workers (not only does the public need to keep front-line health care workers in as good shape as possible, but if they get the infection, they become disease vectors fast, given the number of people they see).

Then again, banks have become parasitic, so why should we expect anything different? And although Business Week broke the story, it did it press release style:

To the list of hundreds of schools, hospitals, and community health centers that have received limited allocations of the H1N1 swine flu vaccine, you can now add some of New York's largest employers. In the past week or so 13 companies, including Citigroup (C) and Goldman Sachs (GS), have begun receiving small quantities of the vaccine, according to city health authorities.

Citigroup has been supplied with 1,200 units and Goldman with 200, says Jessica Scaperotti, press secretary for the Department of Health & Mental Hygiene. The agency has so far approved orders by 29 employers—including 16 that have yet to receive any vaccine—after they were cleared by the U.S. Centers for Disease Control & Prevention (CDC). Big employers that have received or are scheduled to receive vaccine so far include Time Warner (TWX), JPMorgan Chase (JPM), Memorial Sloan-Kettering, New York Presbyterian Healthcare System, and New York University.

Health-care workers at those employers are bound by the CDC to distribute the vaccine only to populations deemed to be at high risk of developing serious complications from swine flu: pregnant women, children and young people aged 6 months to 24 years, people who live with or provide care for infants under 6 months (who cannot be vaccinated), people aged 24 to 64 with medical conditions that put them at higher risk for flu-related complications, and health-care workers and emergency medical personnel.

Yves here. Welcome to the class system in action. If you don't work for a big, influential company, go to the back of the queue. Why should companies be the nexus of distribution for vaccines? I guarantee no Goldman MD gets much of his routine medical treatment from the GS health workers on staff (emergencies or a fast diagnostic like a strep test are different). But if you work for a less privileged employer or are self-employed or between jobs, tough luck, go to the back of the queue, you have to try to get yours (assuming you can) from vaccination centers in New York City. How easy do you think that will be? The difficulty and queuing are certain to be much worse than for any of the big financial players.

And please, it strains credulity to think that someone on the payroll at these companies won't bend to pressure to make allotments at the margin according to who is most powerful. Do you think if Lloyd Blankfein or another member of the management committee was in a risk category that he would be denied it, assuming the firm did not have enough to go around? (and that is likely). Now given the brouhaha, Goldman may bend over backwards not to abuse this overmuch now that there is media pushback. But this serves to illustrate how the system has been suborned on just about every front. To wit, Goldman is getting 200 doses of the vaccine, the same number as Lenox Hill Hospital.

Guest Post: Was it "Nobody Saw It Coming" or "Everybody Who Saw It Coming Was a Nobody"?

yves@nakedcapitalism.com (Yves Smith) — Fri, 06 Nov 2009 09:29:03 -0800

By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

A number of economists, economic policymakers, regulators, and central bankers have attempted to explain away their failure to both foresee and mitigate the current financial crisis by asserting that no one saw it coming. The inference is that they cannot be held accountable for something so unusual, so extraordinary, and so unforecastable that that no one saw it coming. Robert Shiller, in a November 1, 2008 NYT OP-ED, noted the following example:

Alan Greenspan, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an "error" in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What's more, he said the Fed's own computer models and economic experts simply "did not forecast" the current financial crisis.

However, the Fed and other policymaking agencies cannot honestly claim that no one saw it coming. There is ample evidence that:

• Economist and commentators "saw it coming"; and

• Economists and others repeatedly brought their observations to the attention of the authorities including the Fed, but were ignored.

In fact, the Fed increasingly exhibited a willingness ignoring critics and criticism. The existence of this pattern at the Fed can be illustrated by looking at two presentations by Kohn. The first is from 2003 and the second is from 2005. But first, a return to Shiller's OP-ED piece:

Mr. Greenspan's comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It's just that the Fed did not take them very seriously.

Schiller blamed self-censorship and group think. Shiller reports that while he was a member of the economic advisory panel of FRBNY, he felt the need to use self-restraint and stated that he only gently warned about bubbles in the housing markets.

It is one thing for someone to practice self-censorship. It is another thing all together for an institution charged with a public responsibility to allow and foster an atmosphere in which someone well respected enough to be asked to sit on an advisory board feels as though he or she must temper their statements or pull punches. What was the role of the advisory board, if the members did not feel free to raise and discuss competing views or alternative policy paths? In the context of the dynamics of globalization and financial innovation, why was conformity to a static consensus tolerated and even encouraged?

Furthermore, while the Fed had a responsibility to promote economic and financial stability, Shiller did not. Once well respected economists and analysts highlighted the possible risks the Fed had an obligation to assess those risks. Shiller also reported that the group-think that ignored signs of the impending financial crisis extended well beyond the halls of the Fed:

I gave talks in 2005 at both the Office the Comptroller of the Currency and at the Federal Deposit Insurance Corporation. I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren't taking any of us seriously.

Returning to the Fed, a speech by Kohn in February 2003 indicates that while Shiller was self-censoring, other commentators had been pointed enough in expressing their concerns to merit a response:

In particular, a number of commentators have raised the specter that imbalances are being created in the markets for consumer durable goods and houses–unsustainably high prices or activity–that will produce macroeconomic strains when, inevitably, they correct. These concerns obviously echo those expressed by some observers that monetary policy allowed run-ups in equity prices and capital spending in the 1990s that ultimately proved to be destabilizing.

In a footnote, Kohn went on to say:

Another possibility is that the buildup of debt associated with the strength in household investment will feedback adversely on financial conditions, especially as the boom unwinds. Such consequences could occur even in the absence of a "bubble" in housing prices if households were overextended and lenders had not taken adequate precautions against even a measured drop in collateral values… Moreover, loan-to-value ratios on mortgages have been about flat, leaving ample cushion for moderate housing price declines, should they occur. These observations suggest that widespread credit difficulties with important macroeconomic effects are unlikely when interest rates rise.

Kohn not only acknowledged the existence of the commentators and their concerns and took them seriously enough to present evidence that he thought should lay to rest those concerns to rest. He also suggests that the likely short-lived nature of the interest rate -driven increases in housing prices and real estate investment implied that any resulting macroeconomic or financial problem would be of a manageable scale:

Judging from this analysis, and bearing in mind its inherently tentative–if not speculative–character, it seems likely that as the economy strengthens and interest rates rise in response, household investment and prices are likely to soften some relative to recent trends, but not to break precipitously. Houses and cars would not be providing the impetus to economic activity they often have in past recoveries…

At the Jackson Hole Conference of 2005, a speech by Rajan, the then Chief Economist at the International Monetary Fund, "Has Financial Development Made the World Riskier?" and a response by Kohn allows us to get a read on Fed policymakers reactions to warnings about possible economic or financial dislocations two years later. In the opening paragraphs, Rajan argued that the transformation of the financial sector had made it more efficient, but at the expense of increased risk:

The expansion in a variety of intermediates and financial transactions has major benefits,…However, it has potential downsides, which I will explore ..

… the incentive structures of investment mangers today differs from the incentive structures of bank managers in the past in two important ways. First,… managers have a greater incentive to take risk. Second, their performance relative to other managers matters.

The knowledge that managers are being evaluated against other managers can induce superior performance, but also perverse behavior.

One is the incentive to take risk that is concealed from investors—since risk and return are related , the manger then looks as if he outperforms peers,,, typically the kind risks that can be concealed most easily… are known as tail risks.

Both behaviors can reinforce each other during an asset price boom…An environment of low interest rates flowing a period of high rates is particularly problematic, for not only does the incentive of some participants to "search for yield" go up, but asst prices are given the initial impetus which can lead to an upward spiral, creating conditions for a sharp messy realignment…..

…the most important concern is whether banks will be able to provide liquidity to financial markets so that if tail risk does materialize, financial positions can be unwound and….the real consequences to the real economy minimized."

The balance of the Rajan paper was a development of these ideas along with the presentation of considerable amount of supporting evidence. He referenced over 50 plus scholarly papers. Rajan never forecasted or predicted the crises which were to follow relatively quickly. However, he concluded:

a risk management approach to financial regulation will be important to attempt to stave off such states through the judicious operation of monetary policy and through macro-prudential measures. I argue some thought also should be given to attempting to influence incentives of financial institutions mangers lightly, but directly.

Kohn was a Discussant, but his response was not so much a discussion or rebuttal of the Rajan theses as it was simply a restatement of his and presumably the Fed's belief that the greater dispersion of financial risk away from banks necessarily implied lower levels of systemic risk. There was no discussion of the implication of the changes in incentive structures or herding behavior. Kohn dismissed concerns about tail risk citing reduced volatility of output and inflation over the previous twenty years. However, who believes that tail risk has to either manifest itself in a twenty year period, or be non-existent. Furthermore, the factors cited by Rajan had come to dominate the financial sector only during the prior ten years.

No mention was made of LTCM or the Tech bubble. Concerns that low interest rates may contribute to increased risk in the financial system were dismissed on the grounds that those policies contributed to greater stability in output and inflation. Kohn never addressed the point that the shift away from bank-center finance might leave the system short of liquidity should risks materialize.

In short, Kohn's response to Rajan's theses was nothing more than a curt dismissal when compared to his detailed response to the specter of imbalanced -induced concerns voiced by the unnamed commentators in 2003. It appears that the perceived need to respond, even if only in words, to well researched warnings by prominent economists had disappeared.

Furthermore, Kohn on this occasion and presumably others, never publicly revisited (to my knowledge) the contingencies which were in part the basis of his rejection of the warnings in 2003. Interest rates had risen very slowly amidst a jobless recovery and a failure of investment spending to propel the economy. Ten year Treasury yields were only about 25 bps higher and monetary policy remained accommodative. Loan to value ratios had started to erode as had lending standards. If Kohn had re-checked the reasons he cited in his in 2003 rejection of warnings he would have found that the conditions he had cited for being sanguine no longer obtained.

In summary, numerous people, including well respected economists and officials saw the grounds for economic and financial crises being laid. Furthermore, these warnings were brought to the attention of US policymakers. Assuming the two presentations cites above are representative, the warnings were at first treated as worthy of a serious response. However, even as evidence of serious imbalances and bubbles grew, the responses to warnings became perfunctory and devoid of serious analysis.

Houston, we have a problem.

The Fantasy of the Clearing House Magic Bullet

yves@nakedcapitalism.com (Yves Smith) — Fri, 06 Nov 2009 09:32:05 -0800

As Gillian Tett points out in the Financial Times today, clearing derivatives centrally has come to be viewed in policy circles as a magical solution. As a result, it has not gotten the scrutiny it deserves.

The reason for the enthusiasm is that, in theory, a clearinghouse would make sure all agreements were adequately backstopped, so that if customer defaulted, it would not produce cascading counterparty defaults. The clearinghouse would have enough margin and capital to absorb the loss. And observers take great comfort from the fact that no significant exchange (which also has central clearing) has failed in a very long time.

But that view is based on precedents that have limited relevance for credit default swaps, which is the product that is the biggest source of risk. First, the CDS market is dominated by a comparatively small number of very large counterparties. So the failure of any one would be a vastly more serious blow than any modern exchange has suffered.

Second, the cheery view of the safety of exchanges is based on the airbrushing out of a near failure. In the 1987 stockmarket crash, a large counterparty of the Chicago Merc had failed to make a large payment by settlement date, leaving the exchange $400 million short. Its president, Leo Melamed, called its bank, Continental Illinois, to plead for the bank to guarantee the balance, which was well in excess of its credit lines. The officer in charge said no, and it was only because the chairman walked in and authorized the backstop only three minutes before the exchange was due to open kept the Merc going.

Melamed has said repeatedly that if the Merc did not open that morning, it would not have opened again, and the head of the NYSE has said if the Merc did not open that morning, the NYSE would not have either, and it might never have repoened either.

Remember that. One decision with three minutes to spare kept the two biggest exchanges in the US from collapsing in the 1987 crash. See Donald MacKenzie's An Engine Not A Camera for details.

Third, a clearinghouse for credit default swaps is certain to be undercapitalized. That means it is an AIG, a concentrated point of failure. The reason is that the contracts will be undermargined. CDS are not true derivatives, but are the economic equivalent of credit insurance. When a "reference entity" has a "credit event" meaning a bankruptcy or default, CDS prices jump to default. That means they shoot up massively because a payout on the CDS is certain, the only item in question is the precise amount.

A large enough initial margin to allow for jump to default risk will make CDS uneconomic (that's an outcome I welcome, but that is contrary to the motives for the clearinghouse). So dealers and counterparties will fight for a lower margin, meaning the exchange will be undercapitalized relative to the risks it faces.

Tett has some overlapping concerns:

And yet, as so often in the current regulatory debate, there is a crucial catch: most notably, that a clearing house can only offer that all-important sense of reassurance to investors, if it is always perceived to be absolutely rock solid – no matter what. And what is notable about the reform debate so far this year, is that there has been remarkably little public discussion among politicians – or even among regulators – about how to guarantee that any future clearing house will indeed be strong enough to withstand any future shocks….

I suspect the silence may also reflect delicate political sensibilities. If politicians were to demand that a clearing house should be so utterly rock solid that it could withstand even financial Armageddon, the future members of any clearing platform would have to make massive financial commitments. That would necessarily limit membership, to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage.

However, if a clearing house is made more accessible to a wider pool of members, then it will only carry real credibility if it is ultimately backstopped by the government itself, to ensure that trades are always settled, no matter what. And most politicians are not keen to highlight that option either, given the wider sense of public anger about the degree to which the government is bailing out the financial world.

Nevertheless, a few lone voices are now trying to stir up more debate, Gerry Corrigan, the former governor of the New York Fed, for example, recently declared that any future clearing house be placed under the supervision of central banks. More controversially, he also demanded that any clearing house for credit derivatives should have enough resources to withstand the failure of two large members on the same day and still keep trading. "I believe that the operational and financial integrity of such counterparty clearing facilities must be virtually failsafe," he sternly declared*.

These strike me as sensible suggestions. And behind the scenes, some policy makers strongly support what Corrigan has demanded. Yet, thus far, it is still unclear whether such tough standards will be imposed – even though some clearing houses are now emerging. And that is precisely why men such as Corrigan are growing uneasy.

After all, one lesson that financial history shows is that the issues which blow up the financial system are not usually those which caused the last crisis. Instead, the biggest threats tend to come from the areas swathed in a lazy consensus, or where there is a strong political impetus to clutch at easy solutions. That might yet apply to the clearing houses. In theory, I still believe that clearing houses could – and should – make the derivatives world safer. In practice, though, they could also end up creating new dangers if they are not put on a sound footing, particularly if the fact that no clearing house has ever failed before creates a false sense of complacency

Clearinghouses are the wrong remedy for CDS, but that horse has left the barn and is already in the next county. And I must confess, they sound deceptively appealing (I was a proponent early on) until you dig further into how they would work for CDS. They need to be regulated intrusively, with the intent of shrinking the market considerably over time, and like insurance, with tough capital requirements and frequent examinations of the capital adequacy and claims-paying ability of the sponsor. But the real need is to cut off the air supply to CDS to reduce the size of the market so the product itself no longer represents a systemic threat.

Links 11/6/09

yves@nakedcapitalism.com (Yves Smith) — Fri, 06 Nov 2009 10:18:32 -0800

Newborn Babies Cry in Native Tongue Live Science (hat tip reader John D)

Understanding long term chronic pain symptoms from minor motor vehicle accidents RFK Action Front, This is intriguing.

Second Life creates virtual world for businesses Raw Story (hat tip reader John D)

Fannie Mae's results – oh, and what if Bank of America reported the same way… John Hempton

Dollar rise *alert* FT Alphaville

Reed Apologies for Glass Steagall Repeal, Building Citigroup Bloomberg

Banks Thwarting Feinberg Pay Model by Changing Bonus Formulas Bloomberg. I'd post on this, but it has been in "story to follow" mode for three hours.

Federal Reserve Loses Expanded Powers Proposed By Obama Administration Shahien Nasiripour Huffington Post

Wells Fargo Takes Chance With a Loan Exchange Wall Street Journal. More smoke and mirrors at Wells.

Endless Summers Vanity Fair (hat tip Ed Harrison). I suggest you not read this if you have just eaten, you might lose your meal.

Goldman/Buffett/Fannie Tax Deal Inked a Month Ago Bruce Krasting

Wall Street: the Real Roadblock to Economic Recovery Ann Burger New Deal 2.0

Antidote du jour:

The creeping power grab by the executive branch and Federal Reserve

yves@nakedcapitalism.com (Yves Smith) — Wed, 04 Nov 2009 14:13:52 -0800

By Edward Harrison of Credit Writedowns

Yves is tied up in the never-ending ordeal that is writing a book, so I will fill in a few gaps by posting on NC today. Let's wish Yves well in getting this thing sorted.

The power grab at the Federal Reserve is a topic I first broached back in February when the Federal Reserve was creating its alphabet soup of liquidity programs to pull us back from the brink of financial disaster. I was troubled about Fed policy then and I am still troubled today.

I am equally disturbed by what is happening in shift in the balance of power to the executive branch. The Obama Administration seems to be following in the footsteps of the Bush Administration and making its own power grab and Congress has only just begun to wake up to this and start to push back.

At the risk of making this post overly broad, I want to make a few general comments about how executive power in government operates before I take on the specifics of the cases at hand. Everyone who has studied political science is aware that dictators and oligarchies use crises to invoke fear that allows them to usurp power using the cloak of ‘national security' as a Trojan horse to consolidate power.

I would argue, this is what has just happened in the U.S. post-9/11 and again after the Panic of 2008. I see these developments undermining Americans' faith in the political process and I hope an appropriate restoration of the checks and balances laid out in the Constitution can be restored. Having made my editorial statement, let me move to the specifics.

Executive Branch power grab

In September, after Lehman Brothers failed, US Treasury Secretary Hank Paulson asked for and received a blank check to disburse $700 billion to former colleagues and rivals in the financial services industry as he and his staff saw fit. In a brilliant act of cunning, Paulson had gotten approval to do anything he wanted from a gutless Congress more interested in loading the bill with sweeteners. This bill was not unlike the Patriot Act, passed after the 9/11 attacks, in that it increased the executive branch's ability to intervene in the economy as they saw fit. I called it the Economic Patriot Act.

Originally, the Economic Patriot Act was about marking to market. However, once Gordon Brown started recapitalising Britain, Paulson made an about-face and proceeded to dispense the money in a similar fashion (albeit with much fewer strings attached than in the UK).

When the Obama Administration came to town, the modus operandi were not much different. Other support programs were forthcoming and bailouts at Citi and BofA ensued.

With the economy and banks on sounder footing and much of the money returned to taxpayers, the Obama Administration has turned to regulatory reform – and, what do you know – they are looking for a blank check again to do as they please in resolving too big to fail institutions that run into trouble. Again, as with Bush in 2002, if Congress gives the executive branch any blanket authority, it will be used and Congress will be cut out of the process. This is NOT how the American system of government is supposed to be run.

The Fed is grasping for the brass ring too

Enter the Federal Reserve. The Fed has been engaged in a policy of acting in concert with the Executive Branch in a non-arms length fashion since this crisis began. All of the liquidity programs and backstops the Fed has implemented are not just about liquidity, they are subsidies that lower the cost of capital and increase profits in the banking sector. As such, these subsidies are actually a part of America's fiscal policy – stimulus, if you will. It is a clear no-no for the Federal Reserve to inject itself into fiscal matters. And to top it off, the Fed is refusing to be transparent about the process. Why would we make it the Systemic Risk Regulator?

Willem Buiter says it best so I will just quote him verbatim from his article, "Should central banks be quasi-fiscal actors?":

Any action going beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury. The central bank should be involved only as an agent of the Treasury – an expert assistant. It should not put its own conventional or comprehensive balance sheet at risk.

The two arguments against the central bank acting as a quasi-fiscal agent are, first, that acting as a quasi-fiscal agent may impair the central bank's ability to fulfil its macroeconomic stability mandate and, second, that it obscures responsibility and impedes accountability for what are in substance fiscal transfers. In the US such actions subvert the Constitution, which clearly states in Section 8, Clause 1, that the power to tax and spend rests with the Congress: "The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.".

If, as happened in the USA on a vast scale, the central bank allows itself to be used as an off-budget and off-balance-sheet special purpose vehicle of the Treasury, and refuses to provide to the Congress some of the information essential for the quantification of the fiscal transfers it has made, the central bank not only subverts the constitution. By attempting to hide contingent commitments and to disguise de-facto subsidies by not divulging relevant information on the terms on which the central bank has offered financial assistance, it undermines its own independence and legitimacy and impairs political accountability for the use of public funds – ‘tax payers' money'. It is surprising that a country whose creation folklore attributes considerable significance to the principle of ‘no taxation without representation' would have condoned without much outcry such a blatant violation of the equally important principle of ‘no use of public funds without accountability'. This indeed amounts to a quiet usurpation of the power of the legislature by the central bank.

Qualitative easing, or whatever you call it, must end. With the FOMC starting its two-day meeting tomorrow, and with the Reserve Bank of Australia having already hiked twice, it will be interesting to see if the Fed retracts its "extended period" language as many of us expect. While I think it premature in regards to the robustness of the economy, the Fed needs to show it is an independent actor.

Once lost, independence will not be easily restored.

Guest Post: US Dollar Very Long Term Chart and Empirical Observations

yves@nakedcapitalism.com (Yves Smith) — Wed, 04 Nov 2009 14:35:46 -0800

Served by Jesse of Le Café Américain

Here is an update of the US Dollar (DX) Very Long Term chart last shown on 3 April 2009 when the Eurodollar short squeeze was still abating.

We do not see any reason to change the longer term targets based on what appears to be a confirmation of the continuing decline.

The reasons for this decline are obvious, but so many miss this that we have to wonder what people are thinking. Despite the credit writedowns, and even a potential unwinding of the dollar carry trade which may be a bit overblown even as the demand for dollars in commercial lending is slack, most analysts are missing the bigger picture of a huge overhang of eurodollars that are becoming increasingly less useful to foreign holders, especially if the power of the petrodollar further declines.

There is a potential double bottom to be made at 71, with a possible target in the higher 80's based on the charts.

The fundamental scenario we would see supporting a reversal rally is a significant equity market dislocation and/or an exogenous geopolitical event that caused another artificial short term demand for dollars and the T bills. Currency dollars are, after all, sovereign debt of zero duration and in any panic there is a rush to the short end of the curve, to the point of accepting negative rates of return for the safety of capital as was seen in the last financial panic leg down.

But after that event, the decline of the dollar will gain again in momentum lower unless there is a profound financial systemic reform and a restructuring of the federal budget deficits.

A genuine reform may be unlikely, since even a reform Administration in the US seems to be attracted to maintaining several costly mega-banks, to act as the potential instruments of national financial policy on the world stage. But even clever frauds can work only so many times, and there is nothing particularly clever or sophisticated about Wall Street's latest antics, excepting of course their size and their audacity which the average mind cannot well grasp.

The US should not be surprised if the rest of the world does not view new proposals of financial innovations with AAA ratings as favorably as in the past. And as the 700 military bases around the world have proven, large inefficient constructs of empire are expensive to maintain, especially those in the financial world not so easily controlled and certainly more well paid than the usual deployment of ‘weapons of mass destruction.'

With regard to the shift of some dollar heavy central banks into a greater portfolio diversity, including some gold and even silver in the case of developing economies with less dollar reserves, this should come as no surprise to anyone who has been following the news, except those who dismiss anything the developing world might attempt to do in managing their own financial affairs. As stated at the bottom of the news piece here, the entire gold reserves of the IMF are not enough to slake the desire for a harder reserve asset like gold should China continue on its current diversification.

Interestingly enough, none of this has yet shown up in the NY Fed Custodial accounts, where the foreign central banks purchase US guaranteed debt obligations for their portfolios. But it should be remembered that this is a somewhat opaque set of holdings, and does not encompass all of the central bank dollar holdings at all, they being perfectly capable of purchasing dollar assets through commercial sources and open markets without the help of the NY Fed.

The TIC report helps a bit, but it also is not comprehensive and difficult to square with other sources because of some central bank secrecy and reporting lags and errors. Eurodollars have been even more difficult to track than usual, therefore, and as they are the one major component of M3 that is lacking, it makes it difficult to be estimated by those who generate faux M3 reports based on correlations and trends.

A Broader Trade Weighted Dollar Index

Here is an alternative index of the US dollar from the Federal Reserve that is much broader than the DX in its constituent components. It is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners.

Broad currency index includes the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia.

It shows the same Eurodollar squeeze and subsequent decline. As a point of order, the term eurodollar is a bit misleading from its historical roots. It basically refers to any US dollars being held overseas, and not just in Europe.

Trouble looms in Ireland after debt cut two notches and deficits soar

yves@nakedcapitalism.com (Yves Smith) — Wed, 04 Nov 2009 17:17:17 -0800

Submitted by Edward Harrison of Credit Writedowns

I am posting this in the interest of widening the discussion at Naked Capitalism to include some topics in Europe.

Fitch, the credit rating agency, has just downgraded the sovereign debt ratings for the Republic of Ireland from AA+ to AA-. That is two notches and is proof-positive that the ratings agencies are worried about the hole in Dublin's finances.

If you read the Irish press this morning, it is all doom and gloom and has a lot to do with the banks and budget deficit. It is not just about the ratings downgrades.

The EU has just released figures putting in doubt Ireland's rosy scenario for cutting budget deficits.

The Irish Independent says:

Next month's Budget may set the economy back further, but without it the country's national debt could reach 100pc of output (GDP) by 2011, the EU Commission has said in a new analysis.

The Commission is forecasting a decline of 1.4pc in Irish GDP next year. But Brussels is not taking the impact of next month's Budget into account, because the details are not yet known.

"Depending on the specific measures that are eventually implemented, a dampening effect on consumer demand cannot be excluded," the Commission says in its autumn economic forecast.

Correction

On the other hand, it says that faster correction of the economy's problems might give more support to consumption and investment by helping confidence.

The Government's plans include a correction of 4.3pc of GDP — around €8bn — in the Budgets for 2010 and 2011.

Unless there is a compensating boost from confidence, this could also reduce the modest 2.6pc growth forecast for 2011.

These forecasts are higher than those in the Commission's estimates last May, but it warns of the struggle facing the Irish economy in trying to return to strong growth.

Another top headline in the Irish Independent has the OECD warning that the Irish government should not rule out nationalising banks in addition to its bad bank programme, NAMA.

The Government shouldn't rule out temporarily nationalising the country's banks as they may require more capital to cushion against surging bad debts, the Organisation for Economic Cooperation and Development said.

The Government is setting up the so-called bad bank that will buy €77bn of property loans from banks at a discount of 30pc. Losses on those assets may leave the lenders needing extra capital.

"Further recapitalisation may be necessary as assets are being purchased below book value," the Paris-based OECD said in a report today. "Temporary nationalisation would have a number of drawbacks, but it should not be ruled out altogether."

The Government has already guaranteed all deposits at banks and some of their debts, pumped €7bn into Allied Irish Banks and Bank of Ireland and seized Anglo Irish Bank.

"Substantial" banking losses are likely to be met by the taxpayer and nationalisation should only be undertaken with the "utmost reluctance," the OECD said.

The FT's Stacy-Marie Ishmael has a piece out doubting the maths used in NAMA, which bolsters the OECD view that the bad bank may not be enough.

So you have a trifecta of bad news coming out of Ireland: a two-notch downgrade by a major ratings agency, a warning from the EU that the economy will be weak for sometime to come and that deficits targets will not be met, and another warning from the OECD that the banking situation in Ireland is still very grave.

Quite frankly, it is not looking good for an Irish recovery at this time without the help of the IMF. This all brings me back to my question one year ago: Is Ireland the next Iceland? They will be if the EU, IMF and Irish government do not take today's bad news seriously and take drastic action to bolster the Irish banks, economy, and government finances.

Who said the financial crisis was over? It is not.

Guest Post: Will the Democrats Lose in 2010 (or 2012) Because They Won't Pass Real Financial Reforms?

yves@nakedcapitalism.com (Yves Smith) — Wed, 04 Nov 2009 18:56:26 -0800

By George Washington of Washington's Blog.

Yesterday, Elliot Spitzer said that the White House's defense of the financial status quo will give Republicans powerful ammunition in the 2010 elections.

Democratic cheerleader Markos Moulitsas (the "Kos" behind Daily Kos) wrote the following about the Democratic losses in several state elections:

Democratic turnout collapsed. This is a base problem, and this is what Democrats better take from tonight:

… If you water down reform in favor of Blue Dogs and their corporate benefactors, you will lose votes…

If you forget why you were elected — … financial services … reform — you will lose votes.

Tonight proved conclusively that we're not going to turn out just because you have a (D) next to your name, or because Obama tells us to. We'll turn out if we feel it's worth our time and effort to vote, and we'll work hard to make sure others turn out if you inspire us with bold and decisive action.

The choice is yours. Give us a reason to vote for you, or we sit home.

People elected Obama in the hope that he would be different from Bush. But in the most important ways, he is just continuing Bushand Clinton's (think repeal of Glass-Steagall) worst policies.

Both the Republican and Democratic party leadership have become lapdops for the big banks and the status quo. Neither are open to real reform or change.

The Democrats haven't broken up the too big to fails. They haven't restored Glass-Steagall. They haven't really reined in credit default swaps. They haven't pushed for honest accounting or forced the giants to put their toxic SIV-hidden assets back on their books.

People are sick and tired of both parties' catering to the big boys. Indeed, given last night's election results and the Dems' utter failure to institute any real financial reform, trend forecaster Gerald Calente's prediction that a third party candidate will win the 2012 presidential election is sounding a little less crazy.

Guest Post: Wall Street Journal Admits Economists Were Wrong, But Fails to Discuss their INCENTIVE for Being Wrong

yves@nakedcapitalism.com (Yves Smith) — Wed, 04 Nov 2009 21:21:11 -0800

By George Washington of Washington's Blog.

The Wall Street Journal admits this week that economists blew it:

The pain of the financial crisis has economists striving to understand precisely why it happened and how to prevent a repeat…

The crisis exposed the inadequacy of economists' traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles…
"We could be looking at a paradigm shift," says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow

I have repeatedly pointed out the flaws in mainstream economics. See this, this, this, this and this.

But the Journal makes it sound like the policy-makers and economists who deployed faulty models were innocently ignorant of any larger truths:

The models "were not able to draw up the red flags," says Tim Besley, a professor at the London School of Economics who served on the Bank of England's policy-making committee until recently.

Barry Ritholtz has an excellent criticism of the article, pointing out:

There are many areas I would have liked to see the [journal's] article explore: The lack of Scientific Method, the mostly awful performance of economists, its misunderstanding of the value of modeling, the bias inherent in Wall Street variant of economics, and lastly, the corruption of economics by politics...

Let's start with the basics. Hard "science" — Physics, Biology, Chemistry, and all variants thereto — begins humbly. They try to describe the universe around us by creating theories, and then testing them. These theorems are always preliminary. Even when testing validates them, Science is always prepared — even eager — to replace them with newer theories that are proven to be even more valid.

The humility of science begins with an admission: We know nothing. We seek to learn through experiment and logic, and constantly evolve more and more accurate explanations. Scientific belief evolves gradually over time. Nothing is assumed, presumed, or hypothesized as true. Indeed, research is a presumption that current theories are inadequate or incomplete. The practice of science is a an ongoing search for better explanations, more proof, further verification — for Truth.

Science is the ultimate "show me" state.

Economics has a somewhat, shall we call it, less rigorous approach. Indeed, the arrogance of economics is that it is the polar opposite of Science. It begins with a few basic assumptions, many of which are obviously untrue; some are demonstrably false.

No, Mankind is not a rational, profit maximizing actor. No, markets are not perfectly, or even nearly, efficient. No, prices do not reflect the sum total of all that is known about a given market, sector or stock. Those of you who pretend otherwise are fools who deserve to have your 401ks cut in half. That is called just desserts. The problem is that your foolishness helped cut nearly everyone else's 401ks in half. That is called criminal incompetence.

Where was I? Ahhh, our sad tale of the practitioners of the dismal arts.

Starting from a false premise that fails to understand the most basic behaviors of the Human animal, economics proceeds to build an edifice of cards on a foundation of sand. (How could that possibly go astray?) Like a moonshot off by a few inches at launch, by the time the we reach further into time and space, the trajectory is off by millions of miles . . .

Economics … creates an illusion of precision where none exists. The belief in their models led to all manner of mischief, from subprime to derivatives to risk management…

The Behaviorists have been fighting the mainstream for decades now, trying to correct the errors of the basic building blocks of the dismal science.

But I would go further in my criticism of the economic profession by arguing that the decisions to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.

For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.

Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.

But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.

It is not like economists weren't warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was "inconvenient" to discuss this "impolite" issue.

Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.

However, as Huffington Post notes:

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.

"The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."

The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn't matter.

And – even now – mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.

As the Wall Street Journal article notes:

As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.

It is only "rediscovered" because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.

The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to hear that they can't make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.

Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:

The quest is bringing financial economists — long viewed by some as a curiosity mostly relevant to Wall Street — together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.

Note: I am not necessarily saying that mainstream economists were intentionally wrong, or that they lied because it led to promotions or pleased their Wall Street, Fed or academic bosses.

But it is harder to fight the current and swim upstream then to go with the flow, and with so many rewards for doing so, there is a strong unconscious bias towards believing the prevailing myths. Just like regulators who are too close to their wards often come to adopt their views, many economists suffered "intellectual capture" by being too closely allied with Wall Street and the Fed.

As Upton Sinclair said:

It is difficult to get a man to understand something, when his salary depends upon his not understanding it.

Mirabile Dictu! Goldman Lost Money Only One Day in Last Quarter

yves@nakedcapitalism.com (Yves Smith) — Thu, 05 Nov 2009 04:26:26 -0800

OK, I have heard all the explanations, spreads are wider because there are fewer market makers, asset prices are rallying (market making firms are structurally long; it's difficult and costly to go net short on that big a balance sheet), Goldman is currently the trading kingpin.

But I still find these factoids remarkable: Goldman lost money trading only one day last quarter and only two days the prior quarter.

Now maybe I am just hopelessly out of touch, or perhaps more accurately, the Fed has created such a ridiculously favorable environment for banks and traders that if you are moderately competent, making money is like shooting fish in a barrel. But a winning streak this consistent looks like a rigged game. Is this just, ahem, "information advantages"? Greater ease in pushing markets around that have fewer players? Just a function of those monstrously wide bid-asked spreads? I'm curious for a sanity check from people closer to the action.

The party line comes in the Financial Times:

The performance – revealed on Wednesday in a regulatory filing – compares with two losing trading days in the previous quarter and confirms that the authorities' drive to revive markets after the crisis is yielding huge windfalls for some banks.

Before the crisis, banks regularly recorded trading losses on several days in a quarter.

Goldman made more than $100m in profits on 36 of the 65 days in the three months to September and recorded more than $50m in profit on more than eight out of 10 trading days, the filing shows.

These figures were down from the second quarter, when Goldman reported record trading revenues and had 46 days with $100m-plus in profits. The smaller number of days with $100m-plus profits in the third quarter partly reflects the bank's decision to rein in risk-taking in areas such as interest rates and equities.

There is a suggestion here that banks like Goldman might be taking advantage of the Fed and Treasury (although that might be by design, yet another hidden subsidy), as has been intimated elsewhere:

Dealers say banks have made big profits by the timing of Fed purchases of government debt and subsequent Treasury debt sales, and by betting that the relationship between Treasury bonds and other fixed-income securities would normalise.