Off balance sheet transactions and the need for financial reform

This is an excellent speech - clear, precise and short.

Frank Partnoy on Off-Balance Sheet Transactions (MMBM) from Roosevelt Institute on Vimeo.

The unknown dangers of cyberwar delayed its introduction

Would you believe there was a form of war the Bush administration was afraid to attempt back in 2003? According to the Global New York times there was.

In 2003, the Pentagon and American intelligence agencies made plans for a cyberattack to freeze billions of dollars in the bank accounts of Saddam Hussein and cripple his government’s financial system before the United States invaded Iraq. He would have no money for war supplies. No money to pay troops.

“We knew we could pull it off — we had the tools,” said one senior official who worked at the Pentagon when the highly classified plan was developed.

But the attack never got the green light. Bush administration officials worried that the effects would not be limited to Iraq but would instead create worldwide financial havoc, spreading across the Middle East to Europe and perhaps to the United States.

Fears of such collateral damage are at the heart of the debate as the Obama administration and its Pentagon leadership struggle to develop rules and tactics for carrying out attacks in cyberspace.

So we could have done it in 2003 but didn't know how far the collateral damage to the global financial system would have extended. So the Bush administration would do it.

But a mere conventional invasion of Iraq was alright. Sure there were certain to be many civilian casualties as collateral damage to a military invasion, but as long as no bankers got hurt ....

Of course, if a terrorist group were to develop the techniques, destroying the global banking networks that the West depend on just might be the goal instead of a nasty side effect to be avoided.

Here's a brief descripion of one of the worst things Wall Street did to the economy

Yet more on what bought the mortgage crisis on and killed off all five the biggest Wall Street Investment Banks together with AIG , the largest insurance company in the world, all of whom were too big to fail. This is from Vanity Fair. The very worst of it occurred because AIG in the form of their subsidiary AIGFP thought they could make a killing insuring risk (that is, buying the risk portion) of baskets of subprime (risky) mortgages through the use of credit-default swaps (essentially unregulated insurance policies) and because it reduced their projected costs, did not keep any loss reserves as protection against losses. Hey, that's what too big tofail means, doesn't it? In essence the credit default swaps stripped the risk off of the (inherently risky) subprime mortgages and sold it separately to gamblers. (Not all the gamblers realized they were gambling.) Then AIG's loss history got too high, so too late, they quit insuring those risks. But AIG's customers, the Wall Street Investment firms, were making a mint selling the baskets of subprime mortgages and had to have insurance on their product or the investors wouldn't accept that subprime mortgages could be safe enough to invest in. The story follows.

What no one realized was that it was too late. A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. “I’m convinced that our input into the system led to a substantial portion of the increase in housing prices in the U.S. We facilitated a trillion dollars in mortgages,” says one trader. “Just us.” Every firm on Wall Street was making fantastic sums of money from this machine, but for the machine to keep running the Wall Street firms needed someone to take the risk. When Gene Park informed them that A.I.G. F.P. would no longer do so—Hello, my name is Gene Park and I’m closing down your business—he became the most hated man on Wall Street.

The big Wall Street firms solved the problem by taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns, and the others were hundreds of billions in losses that might otherwise have been suffered by A.I.G. F.P. Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007. Lending standards had fallen, property values had risen, and the more recent loans were thus far riskier than the earlier ones, but still they gobbled them up—for if they didn’t, the machine would have ceased to function. The people inside the big Wall Street firms who ran the machine had made so much money for their firms that they were now, in effect, in charge. And they had no interest in anything but keeping it running. A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P. could have happened anywhere on Wall Street … and did.

So much as David Halberstam describe the "Best and the Brightest" who got America into Vietnam at great and unnecessary loss, the Best and the Brightest on Wall Street assumed they understood what they were doing when they sold the innovative financial products.

The current result is that America and the rest of the financial world has been thrown so close to a second Depression that there seemed to be no stopping it as economies around the world have declined over the last year or more. It has only been through some unprecedented, controversial, experimental and fantastically costly government interventions that the unemployment rate is only 9.5% so far. And that is just so far. There is no real assurance yet that the delay on the drop to Depression has been more than temporarily delayed.

Sleep well. The Best and the Brightest are hard at work trying to fix the economic crisis they earlier created. Feel safer yet?

Economist Raghuram Rajan warned in 2005 that the financial markets were in trouble

Economist Raghuram Rajan (a well-respected free-market economist) warned the Fed, bankers and economists that the financial system was headed for trouble, and much of what he specified has come to pass. Why was he ignored?

The Wall Street Journal has an article with one explanation and with links to other helpful articles. Here's part of the explanation from the Wall Street Journal:

The episode suggests one reason that the crisis went unchecked: A dangerous all-or-nothing orthodoxy had come to dominate the policy debate, where one was either for free markets or against them.

Another reason that many policymakers may have missed the risks is that macroeconomists didn’t have a good understanding of the changes that were occurring within financial markets and the banking system.

There has long been a marked distinction between economists who study finance and economists who study the broader economy, with limited communication between the groups. As a young Harvard University economist, Mr. Summers argued this was a dangerous shortcoming in a now famous screed, where he unfavorably compared finance specialists to “ketchup economists” who are too narrowly focused on their field of study, while also complaining about general economists tendency to continually rediscover conclusions that the finance specialists had come to long ago.

Finally, many academic economists privately worried that a housing bubble was building, and that it’s bursting would cause severe problems, but didn’t publicize their concerns. An exception is New York University’s Nouriel Roubini, who in 2006 said that the U.S. was almost certainly heading into a recession. Mr. Roubini is often characterized as a grand stander, but Mr. Rajan says that he deserves credit for acting on his convictions.

“Most academics are really reluctant to take part in the public dialog, because the public dialog requires you to have an opinion about things you can’t really be sure about,” says Mr. Rajan. “They fear talking about things where everything is not neatly nailed in a model. They stay away and let the charlatans occupy the high ground.” – Justin Lahart

While it is clear that the free market systems provide better overall results when compared to government run financial systems, it assumes the existence of free markets. That doesn't just mean no government interference. It means that information needs to flow freely and not be suppressed.

A free flow of information is opposed by bankers, often for good operational reasons over and above just the additional cost of collecting it. But a lot of data has to be available about the overall system, and to get that will require government collection and publication. That means regulation, such as that supposedly provided by the SEC. That's why the SEC is ultimately responsible for supervising, collecting and reporting financial information in corporate financial reports, for example. Without that regulation, each company would collect and report what it wanted to in whatever way it desired. Comparison between companies would be impossible. Standardization and enforcement of honest reporting are a clear government function. That's not government interference with the free market. It's government support for it by keeping data available so that it can do what it is supposed to do - flexibly provide the goods and services demanded by consumers and businesses and properly asses the risk that the bankers are taking making loans.

There are good arguments for getting government involved in the financial system other than just being there to try to pick up the pieces when it fails. It certainly has not been there enough for the last thirty years.

A better way to bail out companies "too big to fail"

A major problem with the Bush/Paulson bailout plan for Wall Street is that after Paulson let Lehman Bros. go bankrupt it frightened the rest of Wall Street and most of the world's investors. Since finance is the most globalized industry in the world, this had world-wide chilling effect on lending. That was a significant factor that led Paulson to go in and hand AIG tons of money instead of letting them go bankrupt, and on Paulson's use of the bailout money to recapitalize failing banks instead of letting them go bankrupt. Unfortunately, recapitalizing the banks hasn't given them any incentive to lend, leading to the current economic downturn that goes far beyond the financial industry. If you don't think so, just go look at the car companies.

Hilzoy, riffing off a two-part New York Times article, discusses the problems that have been created, including moral hazard and propping up failed banking institutions in ways that cause well-managed companies who are not on the government teat to fail.

I've always thought that one way to deal with this would be to find a way of bailing out firms while sacking their managers and wiping out their shareholders. Bankruptcy does this, of course, but when for some reason letting a firm just go bankrupt looks like a bad option, we ought to preserve the basic principle that even if a firm is saved, the individuals -- investors and managers alike -- who either took or profited from those risks should be slammed.

The point here is not punishment. It's creating incentives not to do stupid things. You might think of it as a way of turning the divergence of interests between principals and agents to good account. That divergence creates problems when an agent (e.g., a manager) who is supposed to be working for a principal (e.g., a firm) finds it in his interests to do things that damage the firm -- for instance, taking risks that produce short-term profits, and thus large bonuses for him, but that place the firm itself at unconscionable risk. But I think it can also be used for good.

In the case at hand, we want a firm (or significant parts of it) to survive, and we think that bankruptcy is, for some reason, not an option. We thereby risk moral hazard. But if we ensure that even though bad things do not happen to the firm, they absolutely do happen to its senior management and its investors, we might be able to create a set of incentives that work against taking unconscionable risks. After all, if managers know that if things go badly wrong, they will abruptly lose their jobs and their bonuses, they will not be nearly as likely to take those risks. And if shareholders know that they will not be made whole, they will be more likely to ask just how much risk a company is taking, and not to accept blithe assurances in place of real evidence.

But we haven't done this. We have not asked managers to resign. We have not tried to separate sound from unsound banks, or parts of banks. We have not tried to purge our financial system of the parts that got everyone into trouble. Instead, we have tried to prop up everyone, and to inflict as little pain on the financial wizards who created this mess as possible.

I think this is a profound mistake.

I thought from the beginning that the best solution was to nationalize the bank, wipe out the shareholders and replace the management, but keep the essential operations going. This was the solution used by the Bank of England with Northern Rock Bank failed because of problems with subprime mortgages. Northern Rock bank was nationalized in February 2008.

In my opinion the main reason this was not done was the belief in free market fundamentalism that permeates the Bush administration, the Republican Party, and some misguided Democrats. True it is an extreme decision, but it would put the good of the financial system and the American people as greater priority than the good of the bank managers and shareholders who are currently the ones being bailed out as the economy collapses around them.

Socialism? No. It's not. It's a form of bankruptcy that allows the financial system-critical portions of the failed organization to continue operating as the rest of the organization gets sold off as would happen is Chapter 7 bankruptcy. Face it. AIG was and remains bankrupt, as to most of Wall Street's investment banks. (I haven't heard of one that is still operating successfully on its own. The business model has failed.) AIG is not a going business. It is on life support because it has too many operations that are needed to keep the rest of financial system operating. In the long term the government does not want to be in the bank operating business, but in the short term it has to step in in some way to keep the financial system operating and help it come back to health.

But the health of the financial system is important to the government only because it is necessary to keep the economy operating. The government should not be bailing out failed managers and investors, which is what the current Bush/Paulson bailout operation is doing.

The Bush/Paulson market fundamentalism bailout is both not working, and too damned expensive. It is also rewarding the exact same people who caused the problem with taxpayer money. It's time for a complete rethink of the financial bailout without ideological blinders on.

Look at the value of Social Security now that Wall Street has collapsed

We have heard for years from Investment salespeople what a bad investment Social Security is and how much better we can do if you buy their snake oil investment products.

Yeah. Right. Nathan Newman, riffing off of a Wall Street Journal article points out that for all the money investors have lost in the recent Wall Street meltdown, financial assets provide only 15.4% of the income for those over age 65 while Social Security provides 39.6% of their income.

That social security income is not tied to Wall Street ups and downs. Instead it is contracted to be delivered regularly with annual updates for inflation. The WSJ article points out that this is "an inflation-adjusted immediate annuity." As such it has an immediate value to retirees and those nearing retirement that can be measured in thousands of dollars. It is also guaranteed by the government and cannot be taken away, unlike all Wall Street products.

That makes Social Security a damned good investment for most Americans.

Oh, and the scare tactic line the investment salespeople offer "It won't be there when you retire?" That's a load of crap. The very worst case scenarios suggest that after 2041 the income of the Social Security System will be only 89% of what is needed to pay full promised benefits. OK. Say the worst case scenario comes true. The law already states that if there is a shortfall in revenue the Social Security System will pay out the benefits at the level permitted by the incoming revenue, which means at worst, the promised benefits would be reduced 11%.

But the fact is that the estimates for future benefits have always exceeded the most likely estimates, with the worst case never having occurred.

Which would you prefer? A contractual annuity paid by a private insurance company that could go bankrupt as AIG just did, or a contractual annuity that is guaranteed by the U.S. government? The best you could hope for if you had a contract with AIG or a similar insurance company is that the government would step in and guarantee your benefits. With Social Security you already have that.

That makes Social Security a very good investment.

That means that Social Security is a much more certain and reliable source of retirement income than the more volatile wall street gambles investments can provide.

Ever wonder what a "financial panic" was?

As a person who enjoys reading history I keep running across the term "financial panic." As in "The panic of 1819" or "The panic of 1837." As a modern American I am familiar with the Great Depression, and also with Recessions, but the term "panic" didn't really click with me. Now It makes sense. Here's today's Paul Krugman editorial:

As recently as three weeks ago it was still possible to argue that the state of the U.S. economy, while clearly not good, wasn’t disastrous — that the financial system, while under stress, wasn’t in full meltdown and that Wall Street’s troubles weren’t having that much impact on Main Street.

But that was then.

The financial and economic news since the middle of last month has been really, really bad. And what’s truly scary is that we’re entering a period of severe crisis with weak, confused leadership.

The wave of bad news began on Sept. 14. Henry Paulson, the Treasury secretary, thought he could get away with letting Lehman Brothers, the investment bank, fail; he was wrong. The plight of investors trapped by Lehman’s collapse — as an article in The Times put it, Lehman became “the Roach Motel of Wall Street: They checked in, but they can’t check out” — created panic in the financial markets, which has only grown worse as the days go by. Indicators of financial stress have soared to the equivalent of a 107-degree fever, and large parts of the financial system have simply shut down.

There’s growing evidence that the financial crunch is spreading to Main Street, with small businesses having trouble raising money and seeing their credit lines cut. And leading indicators for both employment and industrial production have turned sharply worse, suggesting that even before Lehman’s fall, the economy, which has been sagging since last year, was falling off a cliff.

How bad is it? Normally sober people are sounding apocalyptic. On Thursday, the bond trader and blogger John Jansen declared that current conditions are “the financial equivalent of the Reign of Terror during the French Revolution,” while Joel Prakken of Macroeconomic Advisers says that the economy seems to be on “the edge of the abyss.”

And the people who should be steering us away from that abyss are out to lunch.

What we have here is a financial panic.

It doesn't help when the nation's first idiot (Bush 43) goes on TV and tells the American public that we are facing financial apocalypse if the Congress doesn't pass the ransom note inadequate piece of legislative garbage his Treasury Secretary shoved through the congressional mail slot telling them "Give me the money or else!"

Note the sentence I highlighted in the editorial above. Bush is a fool advised by power-mad greedy idiots. The tactics for getting the Paulson Proposal have all the earmarks of the paranoid Dick Cheney ("Give me all the power and an ungodly amount of money immediately without asking any questions.") Of course, no one worked to bring the House Republicans in on the deal, so they balked (right before an election Bush/Paulson are going to SOCIALIZE Wall Street? When three weeks ago the administration was saying "The fundamentals of the economy are strong?"

All I can say is - This is the Reagan Revolution at work. The individuals who are occupying the leadership roles in America couldn't lead angry dogs into a dogfight, partly because they are too busy stealing money from the public purse to even be aware that America was drifting into trouble. Enron, the Iraq war and occupation, and Katrina should have warned everyone just how bad conservatives are at governing. And most of the media still doesn't get it.

The path to the current disaster has been clearly marked, but everyone who matters has simply ignored the signs. Now we have arrived at the clearly predictable result of unregulated and uncontrolled banking together with trickle-down economics.

Now we are all going to go through an extended bad patch, followed by a lot of work as the adults have to try to repair as much of the damage the conservative have created as possible.

And I told you so.

So the larded up Treasury plan is all we have right now. Will it work? Back to Krugman:

...the fact is that the plan on offer is a stinker — and inexcusably so. The financial system has been under severe stress for more than a year, and there should have been carefully thought-out contingency plans ready to roll out in case the markets melted down. Obviously, there weren’t: the Paulson plan was clearly drawn up in haste and confusion. And Treasury officials have yet to offer any clear explanation of how the plan is supposed to work, probably because they themselves have no idea what they’re doing. [Snip]

I hope the plan passes, because otherwise we’ll probably see even worse panic in the markets. But at best, the plan will buy some time to seek a real solution to the crisis.

And that raises the question: Do we have that time?

A solution to our economic woes will have to start with a much better-conceived rescue of the financial system — one that will almost surely involve the U.S. government taking partial, temporary ownership of that system, the way Sweden’s government did in the early 1990s. Yet it’s hard to imagine the Bush administration taking that step.

We also desperately need an economic stimulus plan to push back against the slump in spending and employment. And this time it had better be a serious plan that doesn’t rely on the magic of tax cuts, but instead spends money where it’s needed. (Aid to cash-strapped state and local governments, which are slashing spending at precisely the worst moment, is also a priority.) Yet it’s hard to imagine the Bush administration, in its final months, overseeing the creation of a new Works Progress Administration.

Even with this situation facing America and the world - Wall Street bankers are being advised to take numbers to line up for good "jumping" windows - two-thirds of the House Republicans still think the problem with the bail-out bill is that it requires too much regulation, threatens government takeover of failed banks and provides for too few tax cuts.

Guess what got us to this point? Conservatives in politics.That's what. And there are not enough of them in Congress or the administration together to provide the raw material for one thinking human being, but there are way too many to fit into an insane asylum.

Economic Disasters and Stupid Evil People

Mark C. Chu-Carroll explains how utterly stupid the Wall Street bankers have been in simple language. It's rather long, but Mark has much of the story wrapped up.

I've written about a lot of it, but I have not explained how insurance got mixed up into the rather fetid mess. This, however, it the kind of thinking that you can expect from investment bankers to whom the only thing that matters is how much the traffic will bear. The problem was that there were no regulators reviewing the banking system and pointing out the fact that securities being sold as safe investments were not and could not possibly be safe.

Mark starts out explaining how investors world wide wanted safe, secure investments that paid a decent return. So the investment bankers took mortgages (which home owners will do almost anything to pay first to keep their homes) and repackaged large numbers of them as big money securities. But there weren't enough mortgages to meet the demand, so the bankers lowered the standards for who could get mortgages so that the number of mortgages to securitize got larger. That worked so well they lowered the standards even more. The bankers needed more mortgages to meet the demand and lowering the standards for who could get a mortgage gave them more product to sell. Alan Greenspan had the authority to regulate the mortgage industry, but as a Libertarian banker he refused to do so.

The adjustments in standards might have caused the investors to question the safety of the mortgages, so the bankers creating the massive securities got other companies to provide sham insurance against mortgage default and then paid security ratings agencies to rate them as high grade secure investments. Of course, since the rating agencies got paid only when they provided a rating, they competed with each other to provide the highest possible ratings. Why not? The rating agencies had no skin in the game if the ratings were too high. Then they broke the securities up into what are called "tranches" - groups of mortgages of similar risk levels - which they sold separately from the overall security. The finance experts convinced the investors buying the tranches that they were getting safety through that magic financial word "diversification."

Then, operating on the theory that they were buying safe, secure, insured, highly rated investments, they began to leverage the purchases. The investors put up a small amount of money themselves and borrowed a lot more to buy these safe, secure investments. As long as the interest they paid was lower than the interest on their loons, they made ungodly amount of money and got equally ungodly bonuses every year.

Then they repackaged the loans they had bought with largely borrowed money and sold those packages to other investors who also borrowed money buy the new securities. Bear Stearns was borrowing $33 for every $1 of their own, and Lehman Brothers were also leveraged at 33 to 1. No regulator would have allowed that degree of leverage.

But the mortgages at the base of all this structure were not as secure as they were alleged to be, the ratings agencies were rating them too high, and the companies who sold the default insurance did not have the needed money to cover the losses if the defaults built up. This one paragraph summarizes the last two years of Wall Street as the wheels came off the entire set of scams.

Most of the people in the game were stupid. A few know what was going on and were simply evil. Most of the Wall Street people were too involved in their own little worlds and accepted what they were told about the security of the mortgages and the securities based on them. Some clearly knew how bad the information was - probably at the rating agencies and at the companies selling insurance. But there was not overall regulator responsible for seeing how all the pieces fit together, and no one who was selling those products could have kept their (extremely well-paid) jobs if they had told the public or their customers the truth.

Stupidity, greed, and a great deal of evil intent pushed the ideology of the free unregulated financial markets which was adopted by the individuals in the Reagan Revolution. That ideology was sold as offering a route to great prosperity, a route not offered by merely working hard and building products and businesses. But it's an ideology that inevitably leads to economic boom and bust, with each boom and each bust larger than the previous ones. That led to the bank and security regulations put into place in the 1930's after the Great Depression showed the failure of an unregulated financial industry.

But a lot of financial sales people with a lot of money found themselves frustrated by those regulations. Libertarians like Senator Phil Gramm worked to remove those regulations and the regulators (leading to among other things the collapse of Enron after a great deal of illegality and corruption.) And they have brought their inevitable financial disaster back to America and around the world. Again.

Among other things, America has specialized in banking while underpaying and underrating engineers and technicians who build and maintain real products.

Think anyone will get the message that conservatism is bad news?


[ H/T to Digby ]

The government will have to take over the failed non-regulated investment banks

Compare Krugman's four step listing of what has happened in the financial markets in the previous post to Nouriel Roubini's similar list of how we got to the current stage of the crisis. Roubini states that what is happening is a run on banks generally, especially on the unregulated shadow banking system at the moment. This is a run which can only be stopped by government action.

The failed investment banks will have to be taken over, brought under regulation, and their assets sold off if taxpayer money is used to bail them out. According Io Nouriel Roubini's analysis, that is an inevitable action. The only decision left is how soon it can be done. Any delay will deepen the financial crisis and make the recovery cost more.

Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-­fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that ­prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.

We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.

The run on banks has spread to almost all the unregulated banks, and is going to take down many of the regulated banks soon. When that happens then the government is going to take over those regulated banks as Krugman states it should.

But only the government can stop the run on the unregulated banks. That means giving the unregulated banks access to the federal reserve's money through the discount window or by exchanging loans the bank holds for government cash as Paulson proposes. The price for that has to be that the unregulated banks accept regulation.

If the problem of bailing out the current gamblers running the banks with taxpayer money is to be avoided, then the government is going to have to treat the failed banks in the shadow banking system just like the rest of the regulated banks. They will also have to be taken over by the government and sold off, just as was done during the S&L crisis by the Resolution Trust Corporation (RTC.)

By the looks of these two analyses, Paulson's proposal will be left in the dust. The solution is going to have to be for the government to take over the failed banks. The problem is going to be that every delay in actually taking over the banks will increase the level of the crisis and cause the recovery to cost more.

Politically this is going to be very hard for the bankers and their tame Republicans to accept.

Newly published article by McCain praises bank deregulation, claims the same deregulation of health insurance

Well, well. Apparently the "born-again" banking regulator John McCain published an article in the current issue of Contingencies in which he proposed "Better Health Care at Lower Cost for Every American" (pdf). Steve Benen provides this quotation from the article

"Opening up the health insurance market to more vigorous nationwide competition, as we have done over the last decade in banking, would provide more choices of innovative products less burdened by the worst excesses of state-based regulation."

Barack Obama learned of this McCain authored article praising deregulation of banks and health care. They have put out this advertisement.



McCain's chutzpah claiming to be a born-again regulator is amazing. Either John McCain will say anything that he thinks his audience wants to hear to get elected President, or he is very, very confused. Or both.

Clearly John McCain is not competent to become President. We don't want him given the nuclear football.

It's been a financially scary day - the scary stuff isn't over yet, either

It's been a wild weekend followed by a bad Monday in the financial markets. Lehman Brothers was forced into bankruptcy when Treasury Secretary Paulson refused to hand over $billions in taxpayer dollars to save them, and the nation's largest stock broker, Merril Lynch, was folded into Bank of America. Of the five New York-based securities firms that dominated Wall Street in January, only two, Goldman Sachs Group Inc. and Morgan Stanley, remain today. Bear Stearns is gone, Lehman Brothers is in bankruptcy until it can be sold off, probably in pieces, and Merrill lynch has become another branch of Bank of America.

The world's largest Insurance Company, American International Group Inc (AIG) is on death watch, and the market is betting against the survival of the nation's largest Savings and Loan, Washington Mutual. This is the most massive restructuring of Wall Street since the Great Depression.

Today the stock markets reflected a lack of belief that the problems are over. The DOW Jones index dropped 4.42% and the broader S&P index dropped 4.71% today. The Wall Street turmoil spilled over into drops in the stock markets of Japan and South Korea.

The deal that Fed Chief Ben Bernanke and Treasury Secretary Henry Paulson worked out Sunday night is a patch on the set of problems. A lot of people are wonder how well it will last. Part of the deal according to Ian Welsh was to add more money to the system to be a backup against future problems. "Ten major banks kicked in 70 billion into a fund they can borrow against if they have problems and overnight the Fed added 70 billion to the banking system's reserves." In addition, the fed is going to kick in a 75 billion dollar lending facility led by Goldman and Chase. But that's not enough.

Bernanke and Paulson are really going all in on this, they're letting banks play with depositor money:

The Fed added that it was suspending a rule that normally prohibits deposit-taking banks from using deposits to help finance their investment banking subsidiaries to allow them to fund activities normally funded in the repo market on a temporary basis until January 30 2009.

This is a dangerous game, because instead of firewalling that money away from investment subsidiaries, it allows banks to gamble that with depositor money they may be able to turn it around. This was exactly the sort of thing that Glass-Steagall was designed to make impossible - banks to not be in the brokerage business, insurance companies not in banking, and so on. Glass-Steagall was partially repealed in 1980 (part of what made possible the Savings and Loan fiasco), further parts in 99 under Clinton, and now the Fed has violated the fundamental principle that banks shouldn't be gambling with depositor money. Because, be real clear, if you don't really know how much in the hole you are, or how much further you could get, lending money to the unit that's in the hole is gambling.

It's also putting the FDIC (the organization which insures deposits) even more on the hook, and the FDIC does not have infinite money except in the sense that the Treasury can lend it infinite money. At this point the FDIC has about 50 billion. Banks have about 4.7 trillion in insured deposits. Yes, that's a bit of a gap.

When the FDIC runs out of money, then the taxpayers get tapped for more.

So Bernanke and Paulson are gambling without knowing what cards they hold in their had, and they are gambling with taxpayer money if they lose their bets. If Bernanke and Paulson win the bet, the taxpayers get none of the winnings.

That may be the best deal that is possible right now because this bail-out has been an emergency ad hoc operation put together at the last minute. Six months ago after Bear Stearns disappeared everyone was saying that there needed to be a plan in place to liquidate other companies in an orderly manner if they went under, and no one did squat. So the problem popped up again, twice as bad as before with no better plans in place to resolve it. There are doubts whether Goldman Sachs and Morgan Stanley can survive as independent entities.

So everyone is waiting for the markets to open tomorrow morning to see what happens next.

What to do about sub prime mortgages in foreclosure

The mortgage market is, as we all know now, in a Hell of a Mess. Not only are the still unknown and growing character and level of problems growing and adversely effecting the American and the world economies, people are getting evicted from their homes (So?) and worse, bankers are losing big money (oh the horror!) The Federal Reserve bankers and the government's economic experts are trying to protect the economy, the mortgage bankers and their lenders are trying to stem their (self-inflicted) losses, and a lot of people who thought they owned their home are trying to figure out how to keep it.

Here are two interesting articles on the subject, one from the point of view of the home owners and one from the point of view of the mortgage bankers who are trying to get the government to bail them out of the results of their poor judgment.

As we watch this crisis slowly play out, let's keep in mind who brought it to us. To that list of luminaries, we can add the Bush administration's mismanagement of its voluntary and unnecessary war in Iraq, at least according to Professor Stiglitz and another Clinton administration economist, Linda Bilmes, in their just published book, The Three Trillion Dollar War, which pulls together their research on the true cost of the war.

There are some borrowers who bought into deals that were too good to be true. The real blame belongs to the bankers and lenders who (according to their own statements when trying to prevent regulations on their industry) are sufficiently sophisticated to understand the risk they took, and worse, Alan Greenspan who was knowingly manipulating the economy to pay for an unforgivable war. They share the blame with the idiots in the Bush administration who refused to listen to experience when they invaded Iraq.

For the combined arrogant greed of the bankers and lenders and the stupidity of the self-blinding politicians and the people who put them in office, we all will be paying for the next century.

Why are the financial markets in such a panicky state?

Kevin Drum asks an interesting question.

"Employment is up smartly, but Wall Street still doesn't care. Is this because of the old high employment = tight job market = wage growth = inflation = higher interest rate cretinism that infests our economic elites? Or are the problems in the credit market even worse than us little people realize? Hmmm."

Here's my best guess for right now:

The problems in the credit market are serious, but they are long term and not likely to change by surprise tomorrow when the market opens.

The increased employment that will lead to inflation (as will the drop in the value of the dollar and the increase in the dollar-price of oil) are today, and together with the interest rate signals from the Federal Reserve are what is causing the day to day volatility in the market. These are all sources of day to day surprises. It is these day-to-day surprises that are causing the current volatility.

The volatility we are watching is mostly day-to-day and short-term players, and is based on new information entering the markets without any advance warning.

The problems in the credit markets, being already recognized and being medium term, have already been discounted. There was no new information regarding credit problems that would change the financial decisions already made. The volatility in employment has occurred for the last several reports, and has similarly been discounted for the most recent report. Since the information on those problems is not changing from what was expected, the market is not being effected by the credit problems or the increased employment. The volatility has come from things that were surprises that were not anticipated.

That's my bet, anyway.