Whatever Did The CDS Market Mean By That?

The credit default swap market is a modern Delphic Oracle.  It speaks loudly and profoundly – these days at regular intervals – albeit using somewhat arcane terminology.  And after major statements such as yesterday (or perhaps this week in general), it’s worth pausing to reflect on, and argue about, what it really means.

Thursday’s statement, to me, was about US banks (graph).

The risk of default for US banks, according to this market, is rising back towards levels not seen since mid-October.  That is striking enough – but remember what has changed since then: (1) the G7 promised not to let any more systemic banks fail, (2) Treasury has provided repeated recapitalization funds on generous terms, and (3) the Fed offers massive, nontransparent funding to anyone in distress.  How can it be that the credit market still or again feels the risk of default rising so sharply and to such high levels?

The most plausible interpretation – and here I’m willing to debate what the Oracle meant exactly – is that people expect the government will force the conversion of junior bank debt into equity.  The treatment of private preferred shareholders at Citigroup, last week, is seen as the harbinger of further losses for investors.

In a comprehensive systemic clean-up approach and complete recapitalization approach, debt-equity swaps could potentially play a sensible role, particularly in countries without the fiscal capacity to sustain guarantees of all bank liabilities.  But if they are done in chaotic crisis mode – as the government appears to be signalling – the additional damage to confidence around the world will be huge.

The events of mid-September 2008 were traumatic and awful to behold.  I saw that trailer and I don’t want to see the movie.  But it is exactly into that scary future that we now head.

It’s never too late to change policy, to make a difference, and to turn things around.  But it is already very late.

75 responses to “Whatever Did The CDS Market Mean By That?

  1. and how to turn it around in a policy environment which is anti stock market?

    “Citigroup’s decision to halt dividend payments on some of its preferred shares may be the final blow for certain bank preferred stocks and may further dry up the willingness of private investors to buy other bank securities…” http://www.financialweek.com/apps/pbcs.dll/article?AID=/20090305/REUTERS/903049964/1036

    “…equities… are forecasting the upcoming Obama crisis… Equities are ignoring stimulative monetary policy and instead are looking ahead at the worsening policy landscape in the tax, trade and regulatory domains. Policies in these areas are anti stock market…” http://www.realclearmarkets.com/articles/2009/03/policy_matters_now_profit_from_3.html

  2. OK, someone has to ask the question: What of economic value is left in the global or US financial system that makes it worth saving by governments and taxpayers?

    Whenever the phrase “increased systemic risk” or “too big to fail” is thrown out, it is almost always because the speaker, in hushed and worried tones, expresses concern about the stability of the financial system. What is left in the system that makes it worth saving? How much should we pay to save those parts (& no others)? What would really happen if AIG, C, BAC, HSBC, RBS, GE,… were denied access to public funds and went bankrupt?

    I’m tired of the innuendo about the massive global financial and economic chaos that would be generated by upsetting this financial system. Someone has to spell out what would happen and why we should care.

  3. From the graph does it say American Express has a 5 year spread of 652.2? Why is that the case? Most of their business is credit cards and travelers cheques yes?

  4. Spot on, Terry. And – yet again – why are these guilty big companies more deserving of support that innocent small ones?

  5. Terry,
    Amen. Massive public funds ahve been expended and there has been no–repeat, NO–attempt by any of these institutions or their defenders to justify their continued existence outside of anything other than a bankruptcy court. FUD has been the rule. Not one iota of fact–not even semi-quantitative, half-baked speculation, just FUD.

    As for Lehman, the BK was not a policy error; the error–and a severe one–was leading on the markets to believe there would not be one.

  6. It seems that the general consensus in this blog is that those making these huge decisions are not doing what they could to turn the financial sector of our economy around. This may be more of a political than economic question but it needs to be asked. Are they incompetent or are they purposefully acting?

  7. Simon,

    I agree with your theis on wider CDS spreads. I would note the spread is a 2 part equation: 1) probability of default and 2) recovery rate. As you suggest, I believe the higher spreads are pricing in lower recovery rates for unsecured creditors. We won’t flush anymore banks through Ch. 11 but we won’t repay the unsecured bondholders at PAR. This is the correct response; the US taxpayers should NOT subsidize the unsecured creditors.

  8. I am holding out hope that there is actually a broad and comprhensive bad bank nationalization contingency plan secretly being drafted, right now. If there is not, and Geithner, Summers, et al only hope rests on this idea of government sponsored mortgage SIVs/SPEs to mop up a mess that trillions in various other forms of triage havent heretofore been able to…well, we’re really in queue to watch that movie, arent we?

  9. While I’m sympathetic to Simon’s preferred “comprehensive systemic clean-up approach,” I’m quite ignorant about its practicalities. So could someone address two specific practical arguments I’ve read against this “comprehensive systemic clean-up approach”? (There are others, too, beyond the rote “private ownership is the right way to go for the US” claim and the debunked “the US couldn’t close and clean up its 7500 banks like Sweden did its banks in the 1990s” [as I understand it the top 4 US banks or so have the bulk of the problems] line.) So, thanks for addressing these two things. First, Ben Bernanke seemed to say to Sen. Graham (SC) the other day when discussing AIG that he in the Fed (and other potential mess cleaners?) lacked the tools to do things like Simon suggests (as I understood it). Did he mean he lacked new money or new authority (or both) and that he required Congress to do something to provide them the right tools? Second, I’ve read several articles saying that Treasury doesn’t have enough staff to be able do the right “comprehensive systemic clean-up” thing. The two withdrawals reported since yesterday are two examples. Is that true? What kind of staff is needed?

  10. It seems like our great policy makers promised not to make the same mistakes that were made in the first depression. They’ve just settled on making all sorts of new ones. Depression 2.0, coming soon to a theater near you (assuming its not bankrupt by then).

  11. “Moreover, all the bail-out and rescue money spent so far has landed in a blazing black hole, and you would need to spend the entire wealth of the nation before Stephen Hawking’s law of information returning from the hole would come into effect. We are simply witnessing the worst possible government policy imaginable…” – Ilargi at The Automatic Earth (blog)

    http://theautomaticearth.blogspot.com/2009/03/march-5-2009-toxic-values-and-faith.html

  12. @ spinchange –

    Hope was the last thing out of Pandora’s box.

    Pandora’box (as explained succinctly at Wikipedia):
    In Greek mythology, ”Pandora’s box” is the large jar (πιθος pithos) carried by Pandora (Πανδώρα) that contained evils to be unleashed on mankind — ills, toils and sickness — and finally hope.

  13. The only actions that can be taken at this time to reverse the collapse of the entire financial system AND the pillaging of the coffers of the average joe & jane, is to immediately stop the bailouts, to immediately create full transparency. Regardless, the world as we know it will change dramatically; that cannot be stopped. The question is really how much “money wealth” will be transferred from many to a few – how concentrated “money wealth” will become.

  14. So what does the collapse of the financial system mean?

    Imagine we have a system where every bank owns 1 dollar in capital, and loans out 30 dollars. A couple of those loans go bad (calling into question the rest of those loans). The rest of the loans are “marked to market” (good idea, but bad timing!) which means they trade at 40 cents on the dollar. Suddenly the bank is worth -5 dollars. Other banks, realizing this, all call in their loans to that bank (all short term).

    The bank goes under. Seeing this, all the banks start calling in all the loans at the same time, at which point money literally vanishes.

    Vanishes, you say? Money can’t disappear? Can it?

    Why, yes it can. Poof. Remember that bank with 1 dollar in capital which loaned out 30 dollars? If the bank decides to loan out only 15 dollars, that other 15 dollars literally goes away.

    So imagine that half the money in the world (or more) literally vanishes. At the same time, because asset values all plummet simultaneously (deflation due to less money chasing goods), virtually all collateral-backed loans in the world become net losses. Seeing this, we get a demand/jobs crisis, a “crisis of confidence” (which means expectations of contraction create the contraction), and the cycle intensifies (rapidly).

    All leveraged banks immediately have massively negative value. All go bankrupt. All the savings in them disappears (poof). Governments are left holding the bag (hopefully). Gold and “safe” assets skyrocket. All transactions are done in hard currency (literally, cash) or in barter (read about Russia in the early 1990s).

    So the chain of causality (unlike a “normal” recession) is:

    Bubble gets burst
    Banks, overleveraged, go under
    Panic ensues (e.g. Lehman Bros)
    Banks call in money, stop making loans
    Sudden contraction in money supply; cessation of activity
    Asset valuation plummets rapidly (e.g. September/November)
    Asset devaluation causes more banks to become insolvent
    Risk of bankruptcy/unemployment (or actual bankrupcy/unemployment) causes further credit contraction and decline in money supply
    Decrease in money supply causes asset devaluation

    It’s a fast ride down the international swirly toilet.

    How to stop it?

    Well, govts. have this great power – they can create money from nothing. Really. And they don’t have capital requirements. If they go insolvent, they can just create more money. So they backstop the banks (i.e. guarantee their losses).

    This has lots of problems (e.g. moral hazard – that means bad incentives). The other problem is that govt. can end up absorbing a LOT OF LOSSES – trillions of dollars.

    The gamble is this – if the government backstop is credible, and the economy recovers fast, then everything is good. Seeing that banks are no longer insolvent, the crisis of confidence stops, and assets reflate. 2 or 3 years later the government sells the banks it took over (often losing far less than initially expected – see the savings and loan crisis for instance).

    The problem is, this presumes that the crisis of confidence is the only real problem, and that (as John McCain stated) “the fundamentals of the economy are strong”. If the fundamentals really are strong, investors see this, smell a great discount on good assets, and buy them back up fast. This is called “recover”.

    But what if – no, really – what if the fundamentals of the economy are not strong?

    What if we owe 80% of our GDP in debt? If consumer debt is huge? Entitlement programs are swallowing up most of the federal budget, and growing? States are insolvent? Houses really never were worth what people paid for them? Manufacturing is gone, and good jobs don’t exist? Lack of financial regulation means that “AAA assets” like bonds backed by loans were vastly overrated?

    Uh oh… That’s a problem. Why would banks, or ayone, want to buy up those assets when they are really worth far less than thought? And that means the “paper losses” taken by banks are real losses.

    Well, that means a lot of highly leveraged institutions just got wiped out.

    Govt., seeing this, backstops all these losses (remember the moral hazard problem – too big to fail – bad incentives?). However, investors smell a rat. This isn’t just a crisis of confidence. The economy has _real_ problems. (This is the really real world.) So they don’t take the bait, and they cling to cash.

    Meanwhile, the whole bad cycle sets in, and banks can’t make loans fast enough and no one wants to buy the bad assets, so all those paper losses turn into real losses. Government (playing the same old “restore confidence in the banks routine) buys up everything at stupid prices and absorbs the banks (nationalization or whatever, it doesn’t matter). The owners of those bad assets – who had made trillions (yes, trillions with a T) – by leveraging themselves to the hilt now don’t have to face the downside of their bets. That’s right. They keep the upside (many millionnaires on wall street) that they made in the last 15 years, but the taxpayers absorb the downside.

    Are you mad yet? (you should be)

    First, it’s a crime that private banks have the power to create money by making 30 dollars in loans for every dollar they have. (That means rather than earning 5% on 1 dollar, they get 5%*30 or 150% on that dollar – and that’s why finance accounted for 40% of US corporate profit in 2006). But it’s a DOUBLE crime that when they lose, they keep previous gains and taxpayers soak the losses to preserve the “system”.

    But wait! It gets worse!

    Remember governments who backstop the banks? Well, they have this problem that if they print too much money to backstop their banks (relative to their ability to pay) that money loses value. Govts can make as much money as they want, but it is only as valuable as people’s willingness to take it.

    Enter Iceland. Tiny country of 300,000 (smaller than Cleveland metro area) backstops banks with many billions in losses. Currency evaporates overnight. The country can’t buy anything from abroad because no one takes their money. They go bankrupt.

    So what about the US? Well, the US is bigger than Iceland so we have more income (for the moment), BUT we don’t really want to inflate.

    Why?

    Economists have been trained by 30 years of Friedmanomics that inflation = badness. (This was like a teenage rebellion against their Keynesian parents who argued that deflation = even more badness.) So to avoid having the Federal Reserve print money (“quantitative easing”), the Fed instead borrows tons (literally – if you stacked $20 dollar bills up, it would be tons) of money from China and Kuwait and foreign banks, converts this money into dollars by issuing promises to pay these other govts. back (e.g. T-bills), and then uses this borrowed money to cover the losses to our banks because we’re terrified of a financial collapse (so am I) and are psychologically conditioned to hate inflation.

    That has the great benefit of keeping the US dollar strong so domestic jobs continue to flee the country, domestic consumers can continue to go in debt to foreign goods at artificially cheap prices, and we can temporarily prop up domestic consumption (and hence foreign exports).

    Unfortunately, the economy is still crippled by 20 years of falling wages and massive debt obligations at the national and private level that have crippled real spending power. Roubini has laid out this case flawlessly.

    THE PUNCHLINE:

    Credit is not going to “naturally” grow again, because investors realize this time that the system has been broken. They fundamentals are bad. They don’t want a piece of the next bubble. 2006 was the last hurrah.

    Depending on banks to extend (bad) loans to reflate the money supply is foolish, and doomed to failure.

    The amount of debt the govt. is absorbing to prop up domestic banks and foreign exports is crippling, and GROWING DUE TO ASSETS OWNED BY BANKS DEFLATING IN VALUE.

    The only way to restore balance is for the US to devalue its currency, for nominal asset values to reflate as more money gets created (stopping loans from turning bad), and for other countries (that have been net creditors) to increase their domestic consumption. However, they don’t share our Free Market Religion – and frankly, the more they look at us wallowing in our mess, the more discredited our economic theories become. So they would rather keep up their anti-import/pro-export policies (such as artificially devalued currencies) that have proven fairly successful in their eyes.

    When the US devalues its currency (effectively reducing the value of debt it owes and debt owed in dollars), the holders of that debt will suffer losses.

    So far, the US has done the opposite – it’s actually increased the value of the dollar (by borrowing heavily from abroad rather than printing money) even while asset prices plummet. This induces a deflationary spiral (read above).

    Yes, that’s right –

    US Govt. is CAUSING DEFLATION, which CAUSES ASSETS TO DROP IN VALUE, which CAUSES MORE BANK LOANS TO TURN BAD, which CAUSES BANKRUPTCIES AND JOB LOSS, which CAUSES DEFLATION.

    By borrowing money to keep the dollar strong and prevent moderate inflation now, the US is perpetuating the deflationary spiral, and absorbing ever-increasing losses to cover bad bank loans that balloon every day _precisely because of our refusal to permit inflation_. We are also stimulating the economy (with borrowed money) to prop up foreign exports and create a too-small number of US jobs.

    One would have thought that Ben Bernanke – the student of the Great Depression – would have known better, but apparently he’s all-talk-no-balls. And in fact, this was the biggest mistake the markets (myself included) have made – thinking that “helicopter Ben” understood just a little bit about debt-destruction.

    SO WHAT IS THE ANSWER?

    Print. Money. Now.

    Accept the inflation now – or it will get worse later, and/or risk total US insolvency. Devalue the currency (if China refuses, let them build up larger reserves of less valuable dollars).

    Looking forward (to prevent moral hazard), re-regulate financial services to prevent bad loans (e.g. 15% to 20% down on all home loans). Increase capital reserve requirements (e.g. decrease leverage, which should help give the government better control over monetary policy). Regulate all financial instruments and derivatives, and/or pass a law refusing to enforce contracts that are not regulated.

    However, I personally have given up hope – Team Obama has publicly committed themselves to their currently doomed course of action (btw, I voted for and donated money to Obama, and support his environmental, energy, and most of his health policies). However, Obama’s advisors are morons. Pure and simple.

  15. A big problem is that the economic outlook is looking worse and worse. Here’s a real world case. From Reuters:

    http://www.reuters.com/article/newsOne/idUSTRE52510120090306?sp=true

    “TOKYO (Reuters) – Citigroup plans to sell its 26 percent stake in Japanese online broker Monex Group Inc as part of the struggling U.S. bank’s efforts to raise cash, the Yomiuri newspaper reported on Friday.

    Shares in Monex, Japan’s second-largest online brokerage in terms of customer accounts, fell 8 percent on the report, cutting the value of Citigroup’s stake to 14.1 billion yen ($144 million).

    Citigroup, which has received $45 billion of U.S. taxpayer funded capital injections since October, appears to have already sounded out several financial institutions on the Monex stake, the Yomiuri reported.

    Yoshito Shimoyama, a spokesman at Nikko Citi Holdings Inc, Citigroup’s holding company in Japan, declined to comment.

    Citigroup is also trying to sell Nikko Cordial, a bricks-and-mortar retail broker with 109 branches across Japan.

    Japan’s top three banks — Mitsubishi UFJ Financial Group, Mizuho Financial Group and Sumitomo Mitsui Financial Group Inc — have shown an interest in buying Nikko Cordial, sources have told Reuters.

    The three banks may also jump at the chance to buy a stake in Monex, but would likely make it a first step toward seeking majority control, said Azuma Ohno, a brokerage industry analyst at Credit Suisse Securities.

    Mitsubishi UFJ owns a 51 percent stake in kabu.com Securities Co, the fifth-largest among Japan’s six major online brokers.

    “If it thinks Monex is cheap ( NB DON ), it might be interested in buying to expand its current operations,” Ohno said.

    Neither Sumitomo Mitsui nor Mizuho have an online brokerage unit, and buying a stake in Monex would allow them to make a full-fledged entry into the market.

    But the potential sale of the Monex stake comes as Japan’s online brokers struggle to maintain profitability ( NB DON ) with the benchmark Nikkei average hovering near a 26-year low.”

    So, in essence, Monex, Banamex, etc., are going to bring in less money now if they are sold, and that seems to be the case for the near future. It might also be the case for a longer future, meaning that the money paid to save Citi will grow and never be recovered. Citi needs to sell some assets.

    By the way, notice that they could sell these assets cheaply instead of borrowing so much, but they don’t want to do it. That probably makes sense for Citi, but taxpayers should be aware of that.

    Also, since Citi is a holding company, as we’re constantly being told, don’t these holdings like Monex and Banamex run themselves? What was so impossibly difficult about taking over Citi? Are they running the day to day operations of these holdings?

    I’m just asking.

  16. Frank Carmelo

    I’m no expert – but I think that letting these institutions fail could create bank panics, much, much higher unemployment (20%+), GDP contraction like -10% or more, steadily….

    In short, it would surpass the Great Depression.

    In the end, we might be better off after such a “clean up”….but do YOU want to go through such a scenario for 3,5,7 or however many years?

    The current situation looks to me like a holding pattern while debate is taking place behind the scenes. I think there are administration issues of any new regime that are very, very complex – Simon said as much on the radio the other day.

  17. Did not the bondholders accept the risk of default when they purchased the bonds?

    In the interest of simple justice, if not efficiency, why should the taxpayers bail out the people who voluntarily took on risk while seeking profit?

    Put another way, how is insuring bondholders’ returns any different from insuring CEOs bonuses?

  18. Perhaps relevant, interesting nonetheless, is this Bloomberg article:

    Warren Buffett and Jeffrey Immelt are among a handful of chief executive officers whose companies are rated AAA. Yet Buffett’s Berkshire Hathaway Inc. and Immelt’s General Electric Co. are being treated like junk in the market for credit-default swaps.

    “Funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be,” [Buffet} wrote.”

  19. The administration’s policy seems to be to permit a natural death (by a thousand cuts) of the big banks, in order to be demonstrably the only ones holding all the cards at the end. They are using the market to do the work for them. Having been screwed around by the banks’ lies about their true balance sheets an orderly market driven failure is the preferred policy. Wall Street financial engineering is being deliberately exposed as the disaster it has been for the US economy. Being killed of by entirely rational CDS trading is the final coup de grace. http://www.bloomberg.com/apps/news?pid=20601109&sid=aHwKEcyrDbu0&refer=home

  20. Stats guy – thanks for the great post, the second I have read from you over the last day or two. Clear and concise but chilling.

  21. Insuring bondholers is the great leap onward (just as not you forget keep up insuring the insurers).

    Ms. Bair there at the FDIC wants to insure even more deposits and future banks debt and previous bank debt and more banks bondholders with her +/- $ 19 bn. Just as shown by darling, the world savior, and told by the pimp&co.

    Sorry, but the US and the UK are failed states. Regardless, they just keep up the attack with (quantitatively) more failed policies, cheered on by the we be all keynesian crowds.

    All this is getting extremly monthy phytonite.

  22. Erryl Mendenhall

    The basic concern is whether the problem is bigger than the political will to fix it. It is unlikely that the Obama administration could get much more money out of Congress for a bailout. It is also unlikely that the general public would continue to support more bailouts of the Wall Street banks with their tax dollars while the main street economic suffering is increasing. The big question then is whether or not they have enough money to prevent defaults. The bailout bucket can only hold so much.

  23. Simon,

    Paul Volcker has made repeated comments about the need properly align incentives for investment bankers, and in a bloomberg article today he says the mega-banks need to be broken up. While it is positive that a responsible and reasonable voice (and to me one of the more responsible and reasonable central bankers in history) is in the White House and can influence the direction of policy, is he really in position to make a difference on the administrations treatment of the mega-banks? Or will he be marginalized by the Wall Street insiders working for the White House?

  24. The “too big to fail” must be eliminated in the future. What happened to the U.S. anti-trust legislation? I hope the G20 forces the U.S. to some international standards since I don’t believe our partisan congress will be able to get anything done (let alone right).

  25. wanderingletter

    The spread on CDS versus preferred equity and bonds is a rational market reaction to the visible bailout policy.

    We accept as a given that bond and equity trades must price a chance of default. This has includes the risk of dilution, which has risen as the government preferred positions are seen converting into common equity.

    Unfortunately, the government appears to be treating the CDS market in the opposite way. In the course of protecting AIG from default, the government gives the reduces the risk of default on AIG CDS vehicles. The proper price response to this should be to raise their value, giving the appearance that the market is pricing a rise in the likelihood of bankruptcy while this could equally be a reflection of a fall in the likelihood of the CDS insurer defaulting.

    Now, AIG is not the only player in this market, but given the governments declaration of too-big-to-fail, the company is clearly significant. Plus, it seems likely that as the large basket of AIG CDS issues rise, they should pressure the rest of the CDS market.

    Additionally, if the rise is seen as a price indicator of weakness in the company’s viability, prices on exposed equity (beginning with common stock) should fall as the CDS prices rise. This would also contribute to a rise in the spread.

    The most troubling aspect though of the government support of CDS positions would be if this became significant enough that investors playing both sides of the spread found the guarantee of the CDS payout (protected by the government) outweighed the haircut normally associated bankruptcy. Bloomberg.com speculated on such a scenario for GM this week.

    Given the complexity of the market, I doubt this is the only side effect of preferencing CDS positions via AIG intervention.

    p.s. As for where the government money in AIG has gone, it is not going into a black hole. It is going to “losses” in the CDS instruments. In plain English, these are payments that should have defaulted when AIG collapsed.

  26. The US should have bailed out the sub-prime and Alt-A mortgages. They should have purchased these and held them for latter sale and guarantee payments. This would have stopped the UNWINDING of derivatives. It would have been much cheaper.
    Why did the US wait so long to put any rescue plan in place? They didn’t prevent the market free-fall and now they are using piece-meal tactics to try to stop the finance melt-down. Too many bad decisions got us here and too many bad recovery decisions are extending the pain and wealth/prosperity loss.

  27. Yeah, but a lot of hedges were bought from what were thought to be AAA rated insurers, but now can’t honor the guarantee. If you bought insurance for your car, paid your premiums regularly, then had an accident, and the insurance company declared bankruptcy. Your car is undriveable, and you don’t have enough money to fix it yourself. Your only asset is a worthless car, and a claim against the assets of your former insurance company, so nobody will loan you money to buy a new car either.

    Not saying you deserve a bailout, but the moral question becomes murky. The problem was, the people making the guarantees were unable to fulfill them. Should they go to jail? Yes. Is there enough money in the world to fix all these cars? Nope. Is it fair? Nope.

  28. if this discussion should include some reference to the credit rating agencies and mark-to-market accounting

    ‘SEC to Discuss Revamping of Rules Governing Credit-Rating Agencies':
    http://www.washingtonpost.com/wp-dyn/content/article/2009/03/04/AR2009030403396.html

    “…A House Financial Services subcomittee has scheduled a March 12 hearing on mark-to-market accounting rules – a dry-sounding topic that likely would have a massive impact on the struggling big banks and the wider economy if it were altered…” http://voices.washingtonpost.com/economy-watch/2009/03/report_house_panel_sets_hearin.html?hpid=topnews

  29. Pingback: A Quick Note on Bank Liabilities « The Baseline Scenario

  30. Interesting analogy. If you bought insurance from a company that cannot pay, I feel sorry for you. I would encourage any effort to prosecute those responsible. But would yours be the first charitable cause to which I would donate my money? No offense, but I do not think so.

    Also, the term I used was “just”, not “fair”. There is a difference, and I meant what I said. I do not expect the system to be fair. I do expect it to be just.

  31. forget the past – for anyone thats ever purchased a financial asset its the current price that matters – not what you initially paid for it

    as for the future – plenty of interesting policy recommendations, but we are in the midst of a very serious crisis situation, and we need interim action which will enable longer term resolutions, but more importantly keep the system afloat until we are in a better position to focus on the future

    wrt present: nope the govts haven’t got it completely right, but printing themselves out of this mess is the least worst scenario if you consider the amount of deleveraging forecasted just to bring us back to ‘normalised’ levels of debt vs economic growth .. and we have to be supportive of the govts, because this is the only option we have

    for those that believe we should let the markets decide, and wipe out bondholders/equity investors etc – think again: the systemic risk now is too great

    the major holders of bank debt and bank preferreds are insurance funds

    the major players in the bond markets are insurance funds and pension funds

    if we wipe out these guys – the implications to society go much further than some armani-suited gordon gekko type working on Wall St

    more importantly – all bank lending worldwide (except perhaps in the Arabian Gulf) will freeze – and the implications for individuals and businesses that have nothing to do with Wall Street will be seriously damaging – don’t think that you’ll be untouched: far from it, this will be like global version of Hurricane Katrina, and no one will escape the damage

    i believe in markets, and i believe in taking responsibility for my mistakes: but the amount of leverage in the global economy is too great to be isolated to a few individuals that work on Wall St: we will all be affected: our mortgage rates will rise, our credit card limits will shrink – hopefully you can pay your monthly balance, our employers’ leasing terms will get squeezed, our employers’ creditors and debtors will start playing up, and many of our employers will go bankrupt due to working capital shortages as well as the collapse in economic activity

    if you want to be smart: be constructive and be supportive – we are all in this together – remember what happened in the sports stadiums in Louisiana after the hurricane if you need a reminder of the social crises that will develop from all of this wealth destruction

    good luck

  32. a sad reminder of when things go bad for all of us, how serious the social issues become:

    http://www.cnn.com/2005/WEATHER/09/01/katrina.impact/index.html

  33. stats guy,

    great post indeed.

    as i sit here in HK after watching 2 days of meetings in beijing on every single channel here, i have to say that china knows very well the scenario you’ve laid out and are going to play ball (to their own advantage of course, but they do see the writing on the wall).

    the 2 things that struck me most in wen jiabao’s comments are — (1) policies to stimulate domestic consumption and (2) expect 4% inflation for the coming year. that’s what he said — 4% INFLATION.

    i have a feeling that they’re planning to loosen the peg and start gradually increasing the RMB/$ curve. counterintuitive one might say given the 4% inflation comment, but only if you believe bernanke’s doublespeak.

    as much as i can see through china’s posturing propaganda, it’s quite refreshing to hear a bit of forthright honesty peeking through. the average citizen here in HK and in china is so much more astute to what’s really going on on a global scale than the sitting ducks in america.

    we’ve been blinded by the light of false treasure to not see that the light is actually an oncoming train coming straight for us.

    cheers

  34. Doesn’t all this government intervention strike fear into the most ardent, republican supporter? the way i view this whole credit crisis and CDO’s dilemma, is that the previous governments have allowed organised criminals to get into the driving seat, and now that the banks are morally and financially verging on bankruptcy (of the ones still considered solvent), they want the government to bail them out.

    Sounds to me like capitalism goes communist, because it suits the SUITS (A eupemism for corporate leaders in Australia and maybe in the USA too) who created this DOWnward spiral want Mama to wipe their bottoms! As a lecturer at university i have a heck of a laugh explaining the efficacy of governments and the federal banking system.

    LET EM FAIL, let’s clear the rot and rebuild a robust, reliable and regulated banking system.

  35. You’re implying that the Obama Administration is cleaning house and getting rid of these “organized criminals” you speak of. Geithner, Summers, all of them, have ties to wall street, and won’t let any of them go down without doling out billions to their friends.

    What happened to “transparency” in this administration that we heard so much of on the campaign trail? While the FRB CONTINUES to keep secret the monies being shoveled to wall street. Wasn’t THIS administration supposed to end all of that?

    Please. The utopian and unrealisitc ideals of the Obama campaign have crashed right into the cold, hard wall of economic reality. You are foolish to think otherwise.

  36. I think you lay out one interesting explanation of why the administration is not nationalizing the banks.

    But, in a sense are not them already wiped out after the bonds are so low?

    “the major holders of bank debt and bank preferreds re insurance funds

    the major players in the bond markets are insurance funds and pension funds

    if we wipe out these guys – the implications to society go much further than some armani-suited gordon gekko type working on Wall St”

  37. thank you so much for this, statsguy. i find your posts to be thoroughly credible.

    what I do not get is this:how is it possible that Obama — who is one of the most intelligent presidents we’ve ever had — being led down this path? are we quite sure that his established wisdom taking the long view of things has not yet become apparent to at least a few of us?

    I heard a comment this morning on NPR that no one –and the reporter emphasized NO ONE — inside Obamas camp will discuss what treasury is doing. Not an anonymous quote to be had.

    It just seems to me that there is still something they know that we don’t. Or am I just too hopeful?

  38. One can certainly hope Obama has a grand scheme in mind. If so, the performance of his team in managing public perception is lacking.

    There are valid reasons for delaying the onset of inflation, even if one knows it’s ultimately inevitable. For example, securing reliable sources of critical imports (e.g. oil). Filling the strategic petroleum reserve (and every spare container available). Trying to cut US consumption and replace sources as rapidly as possible.

    Perhaps their aim is simply to buy time till the G20, when they can begin a coordinated global monetary adjustment.

    Anything is possible, however there is no doubt that the uncertainty is creating huge risk premiums on virtually every type of economic activity – and increasing volatility, which is harming confidence thus investment/employment.

    Moreover, the distributional aspects of the economic policies that we can observe are dramatically punitive on the middle class(tax burden, no relief to homeowners who faithfully pay their mortgages), while extremely friendly to elements of society that caused this catastrophe (banks, and homeowners who took out mortgages they could not afford).

    I think much of the crisis of confidence stems from this fact – the part of Obama’s plan we can observe has clearly been executed with less than stellar competence (witness Geithner’s “bank plan” speech). This does not inspire hope that the part of Obama’s plan we cannot observe is much better.

  39. I agree with the inflation proposals. As I have said before on the blog and elsewhere – the following blog has some really really good ideas on this. The man is not a radical – but suggests a Fed announced price level target and a commitment to get it. Of course – if this crisis is going to blow up over the weekend or next week – and this article seems to imply – then it is too late for anything and we are all just toast and Roubini can gloat his way into the history books. But he makes me just want to gag.

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=4

  40. To the authors of this blog –

    Please please – what is your suggested approach to bank liabilities. I had thought you were a follow of Buiter – just smash the bond holders – just for the hell of it.

    But this quote from the article makes me think you are not as totally insane as he is. Is this true?

    “In a comprehensive systemic clean-up approach and complete recapitalization approach, debt-equity swaps could potentially play a sensible role, particularly in countries without the fiscal capacity to sustain guarantees of all bank liabilities.”

    What exactly is your suggested approach to the debt ?

  41. StatsGuy

    I agree with you on inflation. have you seen this blog? If not – take a look.

    http://blogsandwikis.bentley.edu/themoneyillusion/

  42. I had not come across this blog. Thank you!

  43. That chart tells me that fear has reached an extreme, and is likely to wane in the ensuing weeks. Of course, your mileage may vary.

  44. Stats,

    you remind me of the old Mark Twain quote, but in reverse, something like “my father was a lot smarter when i turned 21 than he was when i was 18″. Obama hasn’t changed one iota since before the election. Your perception, good fellow, has. Better luck next time.

  45. thank you again for your thoughts. it has been frustrating to not only have to take a crash course in economics, but trying to grasp the big picture and make sense of it without knee jerk reacting like so many talking heads do these days. i have given up on cable news/entertainment altogether. To paraphrase; “they know NOTHING” of what they speak.

    as an aside, my son and his friend are home from college for spring break and I was suggesting that they may both want to change their majors judging by the way things are going.

    My sons friend said, “I’m not changing anything, first of all, I WILL outlive this depression”

    That answer pretty much kicked my a$$. And made me smile for the future.

  46. donailin,

    I don’t think “too hopeful” is the right phrase to describe your predicament. I think it’s best to remember that our President has never had a real job, not one that depended on doing something productive in the economy, whose profits depended on voluntary purchases by money-paying customers. He knows literally nothing, from his experience, about how our basic economy works from the producer side. This is painfully obvious from recent policy events, and from the arrogance of his presumed correctness, which leaks out in all manner of obnoxious and threatening ways. This is an arrogance that most successful small business people can’t afford if they want customers. In watching “Good Night and Good Luck” the other night, I was struck by the little vignette of Ike, from a newsreel, sternly affirming that in America, no man need fear another, just because the other has power over that man. We have due process in this country. It was Ike, a Republican, publicly rebuking Joe McCarthy. Damn it made me long for a straight-talking, clear-visioned, intelligent, decisive LEADER. President Obama is ushering in a very dark period in American life, one that will be very unpleasant before it’s finally over. It’s starting with the easy populist target, the evil rapacious banker. This type of politics never ends well, and that he would resort to this type of activity to push his agenda is a huge tell. Just ask the French, or reread “A Tale of Two Cities”, it’s a great read, and it’s entirely relevant.

    Or, more succinctly: what wisdom?

  47. carping demon

    Statsguy, I thoroughly enjoyed your original post. It pulls most of what I’ve read about the economic situation (and I’ve done little else since last Sept, unfortunately) together concisely and clearly. I have one quivel with your first reply post (8:45p) and it is:

    It is time to stop whining about the J6Ps who took out loans “they couldn’t afford”. That concept has become the nut in the bottle that traps the monkey because he won’t let go of it and leave it in time to make his escape.

    I took out a loan I couldn’t afford once, long ago. I induced someone to give me some of their property with the promise to pay them money–I couldn’t come up with the money, and they took it back. End of story. That was all I had to do. Lose, because I overreached my financial capacity. I didn’t get blamed for destroying the world economy. I didn’t destroy it, and neither did all those dopes who did the same thing with houses this last decade.

    There is no connection between an individual (or many individuals) borrowing more than they can pay back to buy a McMansion in Modesto and the price of furniture in Lithuania… UNTIL someone who has nothing to do with either of those two things “manufactures” a connection, (and nothing more than that) between them as part of a scheme to enrich himself. (These people are often called bankers, but there are more accurate appellations.)

    Hanging the insolvency of the biggest banks in the world, (and incidently the buggering of forty years of rational choice efficient markets) on the backs of a lower middle class family who want’s what they saw on tele and is accosted by voracious lower class loan originators thrusting money into their faces whenever they actually venture to do it, while understandable in the first shocked moments of foot stamping and screeching, becomes tired in a week, wheedling a month later, and finally downright disingenuous.

    We evidently can’t make the bankers play their proper roll in society, but we can damn sure stamp our feet and screech at old Joe Six Pack. Trouble is, J6P wasn’t much of the problem to begin with, and is none of the solution. Let go of the nut.

  48. Thanks for your very thorough discussion of my question about why the financial system is worth saving. A couple of counterpoints:

    –I think the real reason that the USD is appreciating is because the other economies and currencies of the world are in worse shape than we are; we are the strongest of the multitudinous weak. There may be a couple of exceptions, such as China, that have large reserves, but I think the basic argument stands.

    –I think your line of reasoning–with which I agree–points out that the current financial system is NOT worth saving–to do so would bankrupt any number of countries, including our own.

    –My policy prescription: Let the insolvent financial institutions fail. Regulate the (dickens) out of them, including banning the use of leveraged securities.

    –Final note: Like you, I voted for Obama. I have seen nothing in his economic policies so far that suggests “change we can believe in.” With Summers and Geithner, it’s more of the same with a little more PR flair and even less substance, all reactionary.

    So let the system fail and create a new one–NOW. We need a Bretton Woods III immediately.

  49. Frank–I think we are going to undergo the adverse scenario you suggest–maybe not quite as deep as the depression–even with the policies now trying to preserve the so-called “financial system.” The question is whether we want to throw trillions of American dollars and tens of trillions of dollars worldwide at a problem created by abusively greedy financiers. I do think NOT assuaging these urges would actually make the downside of the scenario shorter, and not much affect the recovery–which promises to be long and arduous.

  50. I still support his environmental, energy, and (most of) his health policies. My concern is that Team Obama’s incompetence at dealing with the short term economic issues will stifle the entire world’s ability to address the real long term crises (energy, environment).

    Moreover, I strongly doubt the alternative (McCain) would have been any better on the finance side.

  51. Backstopping mortgages directly in October (or earlier) would have almost assuredly cost less than going through this crisis and backstopping all the banks. So why didn’t they do it?

    1) Concern about creating moral hazard in the future. If we backstop the mortgages, we induce people to buy houses they can’t afford. (However, creating moral hazard for bankers? That’s OK…)

    2) Political blowback from this would have been intolerable for Obama and the Democrats (or so he thought).

    My response to the moral hazard issue is this: If we re-instate the 20% down payment requirement (as per Warren Buffett’s observation), the moral hazard issue with buying a too-big house would largely disappear. Other countries do this. We DID this (unofficially) until the 1990s. (And let’s be perfectly fair in allocating blame – Republicans and Democrats both share responsibility for much of the deregulation bonanza.)

    So, jk, the real answer is political: we did not act due to a combination of political weakness and misguided economic theories.

    If you would like a deeper understanding of the political elements of our nation that inhibited speedy and efficient action, simply tune into Rush “I want him to fail” Limbaugh on any weekday.

  52. I certainly do not mean to whine about “loans they could not afford”.

    The real situation is much more complex – among other things, free market economic theory is not sympathetic to a young family that needs to buy a house and get kids into a school district.

    Such a family knows houses are overpriced, but sees them going even higher every day – they have delayed buying for 5 years, but eventually they need to settle down. Meanwhile, the govt. is supporting loans and our President is saying “buy buy”.

    At the same time, real wages have been flat for years(largely due to globalization), but all the pros are talking up the economy.

    What is the “rational” thing to do? Continue renting while you raise your family, or buy at “inflated” prices?

    Economic theory and the real world often do not see eye-to-eye.

    For the uninitiated, classical macroeconomics does not understand things like “birth” and “death” very well. In the basic steady state mathematical models, households are immortal. They also have unlimited liquidity (e.g. don’t go bankrupt). They also don’t starve to death if they earn wages below subsistence levels.

    More complex evolutionary economic models, like Schumpeterian “creative destruction”, are not very amenable to the social stability required to raise a family.

    My general perception of the crowd arguing that it’s homeowners’ fault is that they do not have a home loan, and believe they should be rewarded for this fact.

  53. Pingback: Capital Comments » Blog Archive » Which country has the resources to bail out its banks?

  54. Great site – great comments! The real problem is that this current “world economy” does not work and we will ALL go thru a Depression. The world leaders of the today and the past have not had a clue to what their actions would do. Get your survival gear on – this is going to be a long ride down into the black hole. The discussion to come is what will work as a world economy in the future? Your thoughts and comments please. Cheers!

  55. StatsGuy… You have written the clearest, most concise, easy to understand, simple yet articulate summary of HOW and WHY we got here. Your observations (writings) should be widely published, WHO ARE YOU? Why do we not see YOU on the evening news (Rachel Maddow maybe?) or headlined in the NY Times or WSJ? With your permission I would like to assemble your comments above and send them to my family, friends, and business associates as being the most insightful, accurate, and best explanation yet of this fiasco we find ourselves deep-into..

  56. This is what happened to some of ($50bn) of the AIG bailout money.

    Quelle Surprise! Who Gained From AIG Rescues? Goldman (and Deutsche) Tops the List (and Willer Buiter is REALLY Angry!)
    from naked capitalism by Yves Smith

    http://www.nakedcapitalism.com/2009/03/quelle-surprise-who-gained-from-aig.html

  57. One thing I find especially disturbing in this mess is the way in which the U.S. government continues to(effectively) transfer money to the financial elite, despite howls of protest from the public and a change in Administration.

    I therefore have to conclude that the financial oligarchy have more control over the Government than the voting public. In other words… the concept of the U.S. being a Republic/Democracy is a facade.

    This does not bode well if the powers that be make substantial changes the worlds financial system in response to this crisis. Does anyone not think that the Goldman Sacks of this world won’t emerge at the head of the food chain again.

  58. Pingback: Etl World News | Striking statements about the CDS market

  59. Pingback: Etl World News | Every bed a bank?

  60. carping demon

    Again, StatsGuy, extremely clear and complete. You must be a teacher. If not, you should be.

    There is a great chasm between micro, in which the family must act, and macro, in which academics, advisors, policy makers and politicians act. The attempt to build macro theories on extrapolations of micro theories has not worked well. Behavioural Economics may offer a way across, but that remains to be seen. I also think S’s creative destruction is too easily co-opted by anyone seeking to shift families’ gaze from the destruction wreaked by the manipulation of financial “markets” back on to their own micro travails.

    As you said above, the failure is fundamentally a political one, and economic theory, like statistics, is available to any political position taken.

  61. Anyone on here who agrees with StatsGuy – and I am among them – take a look at this blog:

    http://blogsandwikis.bentley.edu/themoneyillusion/

    Here is a striking post from the blog – which I think is entirely accurate.

    Beginning of post:

    Krugman has criticized people who view depressions as a necessary price to pay for our previous sins of profligate spending and borrowing, or as a way of purging excesses from the system. I think he is right that this attitude exists, especially (although not exclusively) among those on the right. I find that this mindset makes it especially hard to argue for monetary stimulus, even compared to fiscal stimulus.

    When most people visualize the myriad economic crises that we face, it seems as if we carry an almost unbearable burden on our collective shoulders. If someone comes along saying that we merely have to debase our currency, and the burden will be magically lifted, the solution seems incommensurate with the problem–it seems to good to be true. Even fiscal stimulus, often called a politician’s dream, evokes thought of future sacrifice, as we eventually must repay the massive debts we incur.

    FDR was probably the only U.S. president to deliberately set out to debase the dollar. Toward the end of 1933 he joked with his aides that he had used lucky numbers when deciding how much the dollar would be devalued that day. Even Keynes found this frivolity offensive. But it worked. Industrial production rose 57% in just his first 4 months in office, regaining half the ground lost in the previous 44 months. Prices also rose sharply. If the recovery had not been aborted in late July by his high wage policy, near complete recovery would have occurred by 1935.

    The sober puritan ethic is probably well-suited for all sorts of serious, long term economic problems. (Social Security reform?) For an economy facing deflation, however, nothing could be worse.

    End of post.

    What is going on now, I think, is that we are expecting disaster and therefore getting it. The deflationists are in full cry. We have become our own
    Andrew Mellon. They keep telling us: “you are Americans – you are too fat – you eat Twinkies – and you invaded Iraq. You are getting exactly what you deserve.”

    And we believe it. Just listen to Jim Grant. He just keeps saying it. Or Alan Abelson. He says it with a nice sneer. And it is going to go on and on and on. Until we have reduced our debt burden by deflationary horror. So Roubini tells us – with a nice big smile.

    Balderdash. We can inflate. Carefully and with no big fuss. Inflation can be controlled. A debt spiral into the dump cannot be controlled. And Bernanke can give us an inflation – just by announcing it.

  62. I believe that fixing the banks is not the first problem.

    To quote James Saft at Reuters – who thinks we had better inflate and right away quick – and who was quoting the biggest stock market bear in the universe, Albert Edwards at Societe Generale:

    “Banks aren’t the problem, they are a symptom of the problem.”

    Exactly. The problem is deflationary expectations. They have taken firm hold. Fixing the banks should be done only when they have been replace with inflationary expectations. And the Fed can do that. And they can do so quite quickly. Then we could and should fix the banks, in a systematic way – just as this blog here proposes. Bernenke should make a public commitment to do two things:

    1. Stop paying interest on reserves and start charging interest on reserves. The decision to pay interest was wildly radical and is deflationary. The stock market has not gone up for one single month after he announced that last year. It was not correct.

    2. Commit to a price level target. Not an inflation rate target – a price level target. In x years the price level in the U.S. will by y percent higher than it is now – and we at the Fed will do whatever we have to do to get that.

    We will believe that exactly because we know they can do that even if we don’t believe it. They can print and buy stuff. Or they can finance the whole Obama deficit with fresh cash. They should announce the target and commit to it. We will believe them and will start spending our now newly unattractive cash.

    To quote again from the blog:

    I could obviously go on and on. In a sense, my earlier “multifacted” proposal for monetary stimulus was aimed squarely at this endlessly complex and confusing phenomenon called the liquidity trap. It doesn’t boil down to any one thing. Just as AIDS patients do best with a “cocktail” featuring many drugs, the financial markets are desperately crying out for a credible, multifacted policy mix that would address the liquidity trap from all sorts of different angles at once. Once we scare this ghost away, we’ll see how weak it was all along (as FDR found out in 1933.)

    Conclusion:

    I keep searching for the perfect metaphor for how I envision monetary policy. Let me try this one out: I am an Archimedean. Archimedes claimed that given a fulcrum and a long enough lever (and a place to stand), he could move the world. I believe that the Fed is that fulcrum and the control of the supply (and perhaps demand) for base money is the lever. Give me (or anyone with similar views) control over that policy and we could stop the world’s nominal GDP from falling, and lift it back up. And do it surprisingly quickly.

  63. Beware of what you ask for.
    As someone old enough to have lived and worked in the ’70s, I remember the reality of inflation and price controls. You don’t want to go there.

    In a depression such as the ’30s, at least 75% of the population remained employed. Low prices weren’t a threat to them.

    In inflation it’s the other way around, those at the top and with assets make out OK, the majority suffers.

    One thing that should be apparent now is that it is unlikely that well paying jobs in the U.S. will come back in abundance (the competition from the global worker environment & other factors does not appear conducive to it).

    Combine lack of jobs with inflation and very soon the majority of Americans will be on par with the average Chinese. True it might be coming regardless, but I submit it will arrive sooner via the inflation route.

    Anyway, we might not even have the option. One whiff that the U.S. is trying to inflate its way out of debt and the rest of the world (our creditors) will quickly eschew Treasuries. If that happens then the Fed will have no option other than to buy U.S. debt itself. Very soon that will become apparent & likely cause a run on the dollar (and I’ll be in that run). A lost of confidence in the USD will quickly result in game over.

    The very fact that many of you out there seem to be searching for this quick fix/silver bullet out of our predicament tells me that the days of yuppieism/unrealistic expectations aren’t over. It’s like the late night TV viewer paying $59.95 for these wondrous pills that magically melt fat away.

    I think the root of the problem to our downwards spiral is simple. The financial system is corrupt and broken. There’s a case of lost of confidence and wouldbe investors sitting on the sidelines if not fleeing.

    In the past, greed and physical/economic growth was enough to entice fresh money into Wall St, only now everybody smells a rat.

    NOTHING in the Obama administration so far, signals a change to me. Yes there’s some window dressing such as the stimulus bill (what a porkfest), Obama is making some talk… bla,bla,bla. Beyond that I see he condones that the REAL money is flowing to the status quo, same as always.

    Don’t know about you all, but lately I’ve been spending my weekends preparing for Financial Armageddon

    What I see as a primary underlying cause to our predic

  64. in a bad snow blizzard it takes about 3 hours for store shelves to be cleared of everything except colored plastic push pins. today we are all wired together. if there ever was an old fashioned bank panic, an ATM panic, in just a few days society would collapse. now most of us don’t know a thing about dipping candles or how to safely gut a pig or chicken even if we could find one. do you care?

  65. I don’t know if it still holds but up until last year most explanations of the still relatively strong dollar invariably concluded that inflation in the US would be the only game changer (the dollar would fall quite a lot), and that makes Treasuries an even bigger bubble for foreign holders so we’re not done yet with the bubble problems??? is that about right?

  66. terrific commentary. all very, very valuable.

    however, the issue raised was what the cds market was saying. simply put, mr. johnson suggested a forced trade from banks’ junior debt into common shares.

    I don’t think markets are that precise, esp. when the two objects of the forced trade are in tatters already. both are essentially worthless.

    i think we need to look for the message elsewhere, in a less precise, more all-encompassing way.

    the broad message, given the nature of mr. johnson’s intoductory remarks concerning the governmental backstop, in my estimation is that the backstop is itself in doubt, that we are in a much more serious situation than even the gloomiest can imagine, perhaps even that a crash is imminent.

  67. GregBillock

    I have a question for other readers. I have read about ‘slow money’ in the sense of scaling investment transactions to the real-world time scales of the assets backing these financial instruments. Would a move to make real-estate-dependent financial instruments non-transferable and forced to be held to maturity work?

    The idea is that there’s then a track for this kind of financing which is more appropriate to the sorts of mental images we have as human beings about the financial realities of something like a home. Instead of swapping the obligations around home financing several times per day, the high-finance angle looks more like big institutions paying to sign up for pensions with each other.

    It seems to me that this addresses the main two policy problems we have in this crisis. First: establishing whether these assets are really worth a lot less than their face value, and second, figuring out who is going to be forced to hold them until we learn the first answer.

    StatsGuy has some great posts above arguing that indeed these instruments are *not* worth their face value. Most of the plans I’ve seen involve various permutations of what it will take to get taxpayers hold these assets.

    But we can make new laws. What if we just declare these these assets are non-transferable and must be held to maturity? Would that be interpreted as “all banks just failed!” or would it be interpreted as “ok, so the problem is frozen in place for 30 years, and by that time, the right stock and bond and acquisition actions will have happened to make it come out ok.”

  68. Here’s a scenario:

    1. AIG et al fail. The risk of holding stocks and bonds becomes unlimited. To rebalance that, Investors start moving into cash.

    2. Panic ensues on all major exchanges as investors scramble to sell stock.

    3. Public companies see their stock driven to pennies and their bonds rejected. To get money, they turn to banks, which don’t credit as they are being liquidated themselves.

    4. Deep distress capital emerges and starts buying organizations at their commodity price. For example GOOG, C, BAC, INTC are all valued 1/10 of the market price of their buildings.

    5. Since the distress capital is not interested / does not know how to / does not have the funds to run these organizations, the people are booted out and the property is sold at scrap prices (valid economic behavior).

    6. Most sophisticated activities, such as banking, engineering, healthcare, education, logistics, etc are dramatically reduced as people who used to work in teams and produce IP for billions are now working alone selling T-Shirts at an makeshift parking lot bazaar.

  69. Statsguy,

    Thanks for providing a simple explanation of the current financial mess.

    Unfortunately, your proposed solution will only turn us into Zimbabwe or Argentina over the long haul. Look, we have had inflationary policies in this country for as long as I’ve been alive. Historically it never lasts long. The problem is the system; fractional reserve banking and fiat money have to go, or our republican form of government has to go. Take your pick.

    Inflationary policies equate to un-backed paper ‘money’ whose value can be manipulated at will by those in power. This explains why real wages have remained roughly the same since 1971, even while the rich get steadily richer and more powerful. At rock bottom, this is why our constitution is a dead letter today. This is why the ‘new boss’ is the same as the ‘old boss’ complete with the same crew of entrenched political hacks, pulling the same old strings. Sound money and sound banking place very real limits on both greed and power. Sound money and sound banking reward those who are thrifty and productive, no matter what hand they’ve been dealt at birth. Sound money and sound banking helped make us the richest, most powerful nation on earth well before the FED was born.

    Now look at us. In less then 100 years we have become the biggest debtor in the world. Our manufacturing is gone. The so-called information economy is going. Soon we will be a nation of hamburger flippers and used-car salesmen. We have been taught to endlessly consume, borrow, and buy, but have completely forgotten how to save, and how to produce for ourselves, and how to live within our means. Hell, everyone over 50 thinks the government owes them a healthy, worry-free retirement. We forget that ‘retirement’ itself was invented by our first socialist president, FDR. It was virtually unknown to previous generations.

    Something called ‘reality’ is setting in now that the blizzard of paper has been exposed as just so much kindling. You say we should just have more of the same, only faster. Well, we the poor and disenfranchised already know the paper in our pockets is worthless, and bound to get more worthless as time goes on.. but we’re not stupid and we’re not helpless.

    I’ll let you in on a little secret. Here in fly-over country, the local walmart can’t keep up with the demand for ammunition. There’s your next bull market.

  70. I’m way late to this party, but explain to me in more detail the first part of this – how does a bank with $1 lend $30? Where did the other $29 come from that is eventually going to vanish?

  71. For more on borrowing vs. printing see Chap 21 of Liaquat Ahamed’s Lords of Finance and how George Warren’s theories were used by FDR to start economic recovery in 1932. Interesting stuff.

  72. Very good question. Are they incompetent or even worse, is East Germany their model of an ideal state.