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The first true twenty-first century financial crisis?

by Brad Setser
September 17, 2007

Larry Summers – picking up on a phrase perhaps first used by Michel Camdessus — liked to call the Mexican crisis the first financial crisis of the 21st century.   Mexico’s decision to exhaust its reserves defending its dollar peg in 1994 led to difficulties rolling over its tesobonos in 1995– so Summers and Camdessus were ahead of the (naming) curve. 

But Mexico — because of the tesobonos — was the first sovereign financial crisis that could not be addressed by calling together a group of big banks and getting them to agree to modify the terms of their maturing loans to provide the borrower with more time to pay.  It consequently required a different kind of response.

The August 2007 subprime crisis is in some sense the first real financial crisis of the 21st century.    The bursting of the tech bubble in 2000 feels like the denouement of the roaring 90s.     Argentina’s 2001 crisis also feels like the conclusion of the mini-boom in emerging market sovereign bonds that characterized another part of the 1990s.   Argentina’s crisis was in some sense one the last of the series of emerging market crises that started with Mexico.   Brazil and Turkey still had trouble in 2002, but they – with more than a little help from the IMF – avoided default.    Today most emerging economies (setting some parts of Eastern Europe aside) are in a far, far better financial shape.    

The debts – and a lot of the instruments – that caused trouble in the late summer of 2007 are entirely a product of the 21st century. 

And a lot of the key (financial) players this summer seem to have names that could come straight from the droid wars.

SIVsABCPCDOsSynthenic CDOs.   If only a CPDO would get into real trouble … 

This crisis centers in the securities market, and indeed in some of its more esoteric corners. 

SIVs look like the securities market analogue to banks: they sold short-term securities (ABCP) to buy long-term securities that yielded more (often CDOS or MBS).    The mortgages that have caused so much trouble went straight from a mortgage broker into a security before that security (or parts of it) were repackaged into another security.    Many never seem to have spent much time on bank balance sheets – in part because the regulatory regime favors holding (now illiquid) MBS over holding (formerly illiquid) mortgages. 

Even Northern Rock — which this week is in the throes of an old-fashioned bank run, with depositors lining up to withdraw funds – got into trouble in no small part because it relied heavily on the interbank market rather than depositors for financing (its loan-to-deposit ratio was 300%).    And the interbank market has come under pressure in part because the banks’ sponsoring SIVs and conduits had to take them back on to their balance sheets, they had less money to lend out to other banks …   

The fact that this crisis centers on a set of acronymized securities that didn’t exist a few years ago has led naturally to a set of questions about whether the technology for addressing twentieth century financial crises still works. 

 

The technology for addressing twentieth century financial crises, at least  non-sovereign crises, arguably has two core components. 

  • Central banks that can act as a lenders of last resorts to the (regulated) banking system, helping to keep liquidity crisis from turning into something worse.
  • And securitizing bad loans to take them off banks’ balance sheets – and, one hopes, off the off-balance sheet portion of banks’ balance sheets. 

The problem now is that the banks aren’t the only institutions that now need of liquidity in a crisis  — and central banks are still set up to act as a lender of last resort to the banking system.  Central banks are understandably reluctant to extend credit (i.e. discount their illiquid but hopefully still good assets) to the unregulated parts of the market, or for that matter to inject liquidity into the market by making a market for some complicated and now illiquid securities.   So they are effectively providing liquidity to the banks and relying on the banks to provide liquidity to those who really need it.  The Fed has been quite explicit about this.  

Call it a twentieth-century solution to a twenty-first century problem.   The central banks lend to the banks and the banks decide who else gets credit.

It may just work.    One feature of the current crisis is that a lot of problems that a lot of different kinds of exposure that previously had been taken off bans' balance sheets is now either staying on the banks' balance sheet longer than expected or is migrating back to the banks' balance sheet.  That is one reason why the banks have been among the biggest sources of demand for liquidity – and rather unwilling to part with the cash they have. 

For example, a lot of LBO loans that previously would have been securitized are now sitting on bank balance sheets. And perhaps as importantly, a lot of the assets of the banks' off-balance sheet credit hedge funds are likely to emerge on banks' balance sheet.   

In some sense the liabilities of affiliated conduits were always part of the banks’ true balance sheet, even if their liabilities didn’t have to be disclosed to investors or counted against regulatory capital.    In bad states of the world, the banks commitment to provide financing to their affiliated conduits meant that they would effectively take them over.  SIVs apparently are a bit different:  they have slightly long-term liabilities than conduits, more mortgage exposure and at least in theory, smaller backstop facilities than conduits.   David Reilly, Carrick Mollenkamp and Robin Sidel of the Wall Street Journal report:

“The two kinds of vehicles [conduits and SIVs] are closely related, although SIVs can also issue longer-dated notes, can use leverage and have tended to have greater exposure to mortgage debt.  Banks affiliated with the vehicles typically agree to provide a so-called liquidity backstop — an assurance the vehicles' IOUs will be repaid when they come due even if they can't be resold, or rolled over — for all the paper in a conduit. For SIVs, three to five banks typically offer a liquidity backstop, but only for a portion of the vehicles' debt.”

No doubt many SIVs have  tapped any available credit line, but some also have had to sell their assets to raise cash or call on their parents for more capital.  For all I know, some may still need to sell; they may have been holding out for a rebound.  That puts pressure on others holding the same asset.  

In addition to backstopping conduits and SIVs, the banks – and the broker-dealers – have also extended a fair amount of credit to the world’s hedge funds.  And right now the last thing the banks – or, for that matter, the world’s central banks – want  is for a large share of hedge fund assets to migrate to balance sheets of either the broker-dealers or the banks.  

It is hard for me to judge the relative scale of “deleveraging” and “reintermediation.”   But there is little doubt that both happened, on a significant scale.   

George Magnus argues that "reintermediation" will ultimately create a deeper crisis, since banks tend to act in ways that reinforce the economic and credit cycle.  But reintermediation, ironically, makes it easier to apply the world’s 20th century technology for resolving financial crisis to a 21st century technology.  

Central banks know how to supply liquidity to big banks – even if they debate whether or not they should do so.  The ECB, for example, has supplied euro 75b in three month money to the European financial system.  

Apparently some British banks — those with with European operations — were among those borrowing from the ECB, back at a time when the Bank of England was a bit less keen to supply liquidity to the market.   That may be changing though — Anatole Kaletsky suggests that Northern Rock may end up needing to borrow an awful lot of pounds from the Bank of England.   

What of the second tool for resolving twentieth century crises – securitization?   

Lots of twentieth century crises involved banks that made bad loans.    The solution to such crises often involved securitizing the bad loans in some way – and getting them off the banks balance sheet. 

The most obvious example if the LDC debt crisis of the 1980s.   The Brady plan turned syndicated bank loans to what are now called emerging economies into more easily traded bonds, and in the process moved the impaired asset off bank balance sheets.   

But securitization also played a role in the resolution of other crises – including crises that required the large scale injection of public money.   Rather than passing losses on to depositors (the creditors of a bank), governments often bought bad loans from bad banks with newly issued bonds (bonds that could in turn be discounted by the central bank, providing the bank with liquidity), and the repackaged the bad loans and sold them off into the market.   

This often took the form of securitization as well.   At a minimum, players who raised funds in the capital markets – not just banks – were big buyers of “distressed debt.”

This basic solution – taking bad bank assets, repackaging them in some way and selling them into the market — was applied to a range of crisis in the 1990s.   It was the solution the US generally suggested to emerging market banking crises, which were a regular feature of the 1990s.   But it was also the solution – to a degree – to Japan’s banking crisis.  The standard criticism of Japan’s response to its bubble economy is that it was too slow to take dud real estate loans off the books of the Japanese banks, leaving the banks in a position where they couldn’t extend much new credit.    If the banks had taken losses more quickly – something that likely meant that Japan’s taxpayers would have had to absorb losses to protect the banks depositors – and freed up their balance sheet to lend to new sectors, Japan’s economy could have recovered more quickly.  

Or at least Japanese housewives could have discovered their interest in taking a punt on the Aussie dollar – an interest apparently shared by Goldman’s in-house hedge fund – a bit more quickly.   

The problem?  It isn’t quite clear how you can solve a crisis of confidence in “securitization” technology with more securtization.   Many of the instruments at the heart of the August crisis involve payment streams that already have been securitized not just once (bundling a bunch of mortgages into a mortgage backed security) but twice (different MBS were bundled together in CDO) or even three times (CDOs of CDOs).   

Right now, a lot of market participants are now demanding simplicity.  Think T-bills. 

And some central bankers also think simpler, easier-to-understand, easier-to-value  and easier-to-trade instruments would facilitate the re-emergence of liquid markets.   

Simplicity was one virtue of the Brady plan, which helped to remove “subprime” emerging market debt off the banks balance sheet in the early 1990s.   True, Brady bonds were not necessarily the simplest of all bonds to price — many were collateralized, for one thing.   But repackaging a large number of loans into a smaller number of bonds with fairly standard terms still created an instrument that was far more liquid than the initial loan.  The risks associated with the resulting securities were relatively easy to understand: if you thought Brazil was a better bet than Argentina, you bought Brazil’s Brady bonds and sold Argentina’s Brady bonds.   

Try explaining why one CDO tranche is a better bet than another in a single sentence 

But how can the current set of hard to value complex securities that contain some subprime exposure (and thus are likely to experience real losses that someone needs to absorb) be turned into something that is less complicated and more liquid?    

Twentieth century financial technology created a blueprint for turning illiquid loans into more liquid securities in a pinch.   The technology for turning illiquid and now unloved securities into something more palatable to the market still seems to be under-development. 

There is one similarity though between bank crises and today’s securitization crisis. In order to securitize illiquid loans, the banks first had to be willing to recognize their losses.  The same holds with illiquid securities.  So long the securities are “marked to model” – or “market-to-myth” – it will be hard to for much to change.   Securities firms – and even some hedge funds – may be the new banks, determined to wait out a bout of bad news.    

Gillian Tett, as usual, is on top of an emerging debate over whether the regulators encouraged a bit too much credit risk transfer, and in the process, helped create today’s problem with the financial equivalent of lemons.   But the question of how to best avoid creating new lemons is in some sense distinct from the question of what to do with existing lemons

My wild guess is that some kind of new financial innovation will be necessary to end the (financial) droid wars …

Either that or there may be a lot of CDOs containing some housing exposure may be sitting around on various firms balance sheets for a very long time. 

At least in August those who didn’t have to sell – those who believed in the securities that they had bought – weren’t willing to sell at the current market price.    And those who really needed to sell had trouble finding buyers, since the buyers worried that those wanting to sell knew something about the security (or the particular tranche of the security) that they did not.

One big disclaimer: this post pushes a bit  beyond my true areas of expertise.  There is a meaningful risk that I have gotten a few details wrong.  If so, I apologize.  

Note: I edited the title of this post.  My first title was meant to allude to the twenty-second century sounding names of all the financial instruments at the heart of the crisis, but it was perhaps a bit too obscure. 

96 Comments

  • Posted by Twofish

    adiemuso: The point Im driving at is that after such an awful experience with such supposedly “safe” products, what is the likely reaction of the general genuine investors (think conservative pension funds, teachers retirement funds, union funds,) to further complex products in the time to come?

    Hard to say because there are a lot of complex products that *did* come through in this situation. Credit default swaps made money. If you are holding a senior-CDO you are still getting a regular cash stream of income. The way that derivatives work, if you lose money, generally there is someone else on the other side of the bet that made money.

    adiemuso: Well, to me the cut of 50bp says it all. Perhaps Ben and team have seen something worser than we know.

    He sees 1929 all over again…..

    Bernake’s actions make sense if you read anything he has ever written about the Great Depression, and he has written a huge amount about it. His thesis is that the Great Depression happened because you had this cycle in which loans failed which caused tight credit which caused more loan failures which caused tighter credit until everything spun out of control. This explanation is different from the Austrian explanation which involves misallocation of credit.

    Personally I find his explanation rather convincing because he went through a whole bunch of detail amassing evidence for this explanation.

    Also unlike some other people on this list, I really don’t know what is going on. I have some semi-educated guesses which might well be proven wrong by events.

  • Posted by Twofish

    shrek: Making any institutions (JPM BA C etc) is a tragic mistake. Markets can only function when all players are capable of failing.

    The trouble is that people (justifiably) get really angry when their bank accounts disappear through no fault of their own. Markets don’t function that well when people are exposed to risks that they have no control over.

    shrek: Assume this crisis passes, but then what? More bad lending with more moral hazard?

    The situation is that the Federal Reserve keeps a very close watch on the really big banks. There are some advantages in bigness. Being big means that you are more likely to withstand a big loss. Also, it is much easier to keep track of a few big banks than thousands of small ones.

    shrek: Lets not be japan

    The financial system of the US is fundamentally different from Japan because US banks cannot own stock in non-financial corporations. That changes a whole bunch of things…..

  • Posted by Guest

    re: “unlike some other people on this list” – you’re honest.

  • Posted by Shrek

    How can we cure problems that are the result of too much cheap money with even more cheap money? We’re just running around in circles and I think people know it. If there is one thing I am confident about is that the world is always changing and this system isnt going to survive.

  • Posted by Guest

    doesn’t mean it isn’t already evolving into something else, although not without some pain along the way

  • Posted by bsetser

    vitoria — thanks!

  • Posted by moldbug

    Shrek, infinity is a very large number. If you have to ask whether you’re there yet, you’re not.

    DC, the idea that gold has some kind of “intrinsic value” is ridiculous. Gold is an almost useless substance. A Krugerrand is the same Krugerrand it was a year ago. So is a dollar bill. Neither has changed at all. The exchange rate between the two is set by supply and demand, as with all goods. While it’s true that there are sensible reasons that this number changed today, they have nothing at all to do with the material properties of either of these objects.

    Gold, for example, is a good commodity to use for a commodity monetary system. So is silver and so is platinum. One could easily design a platinum-based monetary system in which the only people who demanded gold or silver would be people who had an actual use for it. This monetary system would be (unlike ours) stable, and it would work perfectly well, and the consequence of it would be that your Krugerrand would be worth, basically, squat. I suppose you could probably go to South Africa and spend it on a candybar.

    Furthermore, one could even design a paper or electronic financial system with a fixed monetary supply, using no commodity at all, although to make this work one would need a system of government which was (unlike ours) financially trustworthy. And the result would be the same. Your Krugerrand would be worth squat. Permanently, finally, and absolutely.

    So please stop talking about subjective value and go learn some economics. Try Mises’ Theory of Money and Credit. There is no math in the entire book, and I don’t think you’ll find any of it difficult.

  • Posted by moldbug

    Sorry, of course I meant “please stop talking about objective value”!

    There is no such thing as value – only price. Which is why there is no objective distinction between insolvency and illiquidity, but that’s another story.

  • Posted by adiemuso

    Twofish: “Also unlike some other people on this list, I really don’t know what is going on. I have some semi-educated guesses which might well be proven wrong by events.”

    Ha…there’s the nominee for understatement of the year award! 🙂

  • Posted by Guest

    re: “Bernake’s actions make sense if you read anything he has ever written about the Great Depression”

    “The End-of-Consumption Smoothing? …there is more than enough information, and a coherent Fed framework, to justify starting to cut rates now rather than later… there is no point in merely doing 25 b.p. Something like 50-75 b.p. spread over two meetings looks like the minimum response required… The simple conclusion we derive from all this is that the savings ratio tends to trend down when net worth is rising relative to income and credit availability is increasing… The forecasting conclusion is also very simple. There has been no other time in the past 15 years or so when all the factors discussed above point so clearly to the potential for a rise in the savings ratio… This is potentially a major and crucial change in consumer psychology… we think that the great consumption-smoothing machine in the US is running out of steam. This feels more like the beginning of what may even turn out to be a secular reversal towards higher savings rates… That is likely to have global implications, not all of them pleasant. But if that is correct, the world will ultimately be a better and more balanced place…”
    http://research-and-analytics.csfb.com/docpopup.asp?ctbdocid=804560021_1_EN

  • Posted by Guest

    Twofish >

    Well let us review the evidence shall we?
    1) More than $1T in sub-prime mortgages outstanding. And plenty of anecdotal evidence of abuse in the others Alt-A and prime ARMs too.
    2) The bad mortgages are only the starting point: how many other securities have been issued with these as collateral? What about the SIVs and ABCPs? So it is hasty to put a number such as $100B or whatever. Who knows it could well be much much larger than that.
    3) More losses separate from the mortgage market to be expected from other shaky debt instruments particularly CLO’s etc from the LBO madness.
    4) Wall St enjoyed 3+ years of bumper profits and bonuses. Where did that money come from? World economy grew only at 4% or so. Not that much of an increase in M1 supply and inflation measures low (not M3 funny money though). Only logical conclusion: there are hundreds of billions of losses being hidden somewhere. But where??

    Is there any other possible explanation?

  • Posted by Guest

    A question for Brad:

    The Chinese have just taken another hit to the value of their immense US bond hoard. They cannot be pleased. Why do they keep adding more US treasuries? Cannot they use their earnings instead of buy up commodities that can be stored (precious metals, nickel, etc., etc., oil that can be put into storage), why not Japanese bonds (since this would give them some clout over an old enemy), and real estate all over the world. The US may block their purchase of whole US companies, but what is to block their acquisition of commodities world wide? And why could they not even corner the silver market, say, and profit from that? The Hunts tried it but lacked the means to do it. China could probably do so. And if the US didn’t like it it could be a bargaining chip to open up the possibility of acquiring whole US companies. What is stopping them from being more aggressive in this way?

  • Posted by Michael Pettis

    brad, one very nitpicky thing: you say that mexico’s 1994-95 crisis “was the first sovereign financial crisis that could not be addressed by calling together a group of big banks and getting them to agree to modify the terms of their maturing loans to provide the borrower with more time to pay. It consequently required a different kind of response.” actually the 1930’s latin american debt crisis and most of the crises before also involved defaulted external or domestic bonds, and were usually only cleaned up over many years after very laborious processes of putting together bondholders’ committees. the 1980s crisis was pretty unique in affecting only syndicated bank loans and some domestic bonds (almost all external latin american bonds were paid on schedule during the 1980s). in that sense the 1994 tequila crisis reverted to the earlier model, although as eichengreen pointed out its closest analogue was probably the 1890 argentina crisis (about which by the way there is a new paper– http://www.nber.org/papers/w13403.pdf).

  • Posted by Dr.Dan

    what will happen to the $USD

    Now we were thinking abt a 25 bps cut…after evaluating the PCE deflator etc. WE got 50..what will happen to USD ? Your thoughts, Ladies and Gentlemen ?

  • Posted by Twofish

    Well let us review the evidence shall we?
    1) More than $1T in sub-prime mortgages outstanding. And plenty of anecdotal evidence of abuse in the others Alt-A and prime ARMs too.

    And right now the default rates are at 10-20%. That gives a loss of about $100-$200 billion dollars. Sure if interest spike and the economy goes into recession, then we could see a negative feedback cycle, but Bernake is doing his darnest to make sure that this doesn’t happen.

    2) The bad mortgages are only the starting point: how many other securities have been issued with these as collateral? What about the SIVs and ABCPs? So it is hasty to put a number such as $100B or whatever. Who knows it could well be much much larger than that.

    Or maybe not. What about the SIV’s? What about the ABCP’s? Don’t assume that there is a monster in the closet. Open up the door and look. In the case of SIV’s and ABCP’s, I’m not seeing defaults or the possibility of default. I’m seeing liquidity issues.

    3) More losses separate from the mortgage market to be expected from other shaky debt instruments particularly CLO’s etc from the LBO madness.

    Again. Are you talking from “I don’t know what is going on so I’m assuming the worst.” or do you have a specific reason to think that things are bad? In the case of CDO’s, the whole point of CDO’s is to spread around risk so if some CDO’s end up bad, that takes away “badness” from the other ones. That’s the whole point of them. You carve up a cow, and part of it involves getting rid of the crap you end up with. That doesn’t mean that the whole cow is made of crap.

    People misunderstand the meaning of the term ‘toxic waste’. What happens is that you start with a mix of securities and then separate the good stuff from the bad stuff. The good stuff is easy to get rid of, but you need to figure out a way of getting rid of the bad stuff.

    4) Wall St enjoyed 3+ years of bumper profits and bonuses. Where did that money come from? World economy grew only at 4% or so. Not that much of an increase in M1 supply and inflation measures low (not M3 funny money though). Only logical conclusion: there are hundreds of billions of losses being hidden somewhere. But where??

    There may well be hundreds of billions of dollars in losses, but that is in the context of a world economy that is in the size of tens of trillions of dollars. If the size of the problem stays at the level of hundreds of billions of dollars, then there is nothing to worry about. You are seeing lots of thirty billion dollar hedge funds falling from the sky, and if the total loss is in the hundreds of billions of dollars, then this means that we aren’t likely to see new places where people are losing money.

    It’s only if there is a feedback loop which causes the total loss to mushroom that I start worrying, and again Bernake is trying to prevent that.

    Four percent aggregate growth in the world economy is *huge*. It means that the size of the world economy is doubling every 20 years. The industrial revolution happened when long run economic growth went from zero to two percent.

  • Posted by Twofish

    shrek: How can we cure problems that are the result of too much cheap money with even more cheap money?

    Except that we aren’t sure that the problem is due to cheap money. Von Mises would probably think so, but how do we know that he is right? This is one problem with reading lots of books. von Mises says one thing. Keynes says another. Friedman says another. Samuelson says another. Marx says something different. And all of them could be wrong.

    And even if this mess was caused by easy credit….

    You have a person that just suffered a heart attack. Maybe a big reason was that he didn’t get enough exercise, but that’s hardly a reason to force him to run to the hospital. Maybe the second he leaves the hospital he is going to go back to eating bad and smoking, and he is going to end up in the hospital again in a few months, but that doesn’t mean that you should withhold treatment. The ER is not the time or place to teach life’s lessons.

    The first thing to do in a crisis is to stabilize the situation so that you have time to think. The scary thing about financial crises is that they often happen so quickly that you don’t have time to think. There have been crises in the past in which the decision cycle time was measured in hours and in some cases minutes (classic example of the latter was the 1987 crash or the aftermath of Barings, where things were literally happening minute by minute.)

    We’ve gotten past that point, so that we can actually think and argue about what is going on, and what should be done.

    The fact that we have the luxury of time to argue about what is going on is one reason I’m optimistic. If you look at the great financial and political disasters (the start of World War I is the classic example of the latter), one common theme in a lot of them is that people just don’t have time to think. It takes months for central bank intervention to have an effect, years to make basic changes in economic policy, and decades to restructure an economic system.

    If you have minutes, then your options are limited, your first and only goal is to make sure the patient doesn’t die on you.

  • Posted by Guest

    Blackmail, larceny, daylight robbery. Twofish has gone over to the “Cramer side”, and appears to have acquired precog.

  • Posted by RebelEconomist

    Like Twofish, I admit that I don’t know what is going on either……but I suspect that in fact most people don’t.

    The question I would ask is: if the financial outlook is uncertain, at a given interest rate, would you lend more money, or less? I think the natural reaction would be to lend less. So how can the Fed get away with not allowing rates to rise, let alone cutting them? I can only surmise that there is a huge distortion building up somewhere, which may well be costly to unwind.

  • Posted by Anonymous

    ” The question I would ask is: if the financial outlook is uncertain, at a given interest rate, would you lend more money, or less? I think the natural reaction would be to lend less ”

    Lowering the fed funds rate lowers the ‘risk-free’ rate.

    The risk-free rate is the starting rate for the cost of capital and the expected return on capital for all lenders. Actual rates equal risk free rate plus risk premiums.

    Lowering the risk free rate allows lenders to capture a higher risk premium in the actual rate they charge, while facilitating more borrowing, other things equal, because the general level of rates is lower than what otherwise might be the case. It’s all quite logical and economic.

  • Posted by Anonymous

    Of course, the short term t-bill rate is closer to the true risk free rate – fed funds is normally only a small premium over that – although lately this has been distorted as well. Nevertheless, the logic still works for borrowing rates and lending premiums for credit risk over and above the fed funds rate.

  • Posted by Guest

    liberals are pilloried for trying to introduce ‘socialised’ medicine, why aren’t conservatives pilloried for ‘socialised’ finance? clearly we aren’t living in a capitalist economy, but a globalised nanny state…

  • Posted by Guest

    ‘toxic waste’ (as applied to financial products) = “I don’t know what is going on so I’m assuming the worst”

    although interesting that it seems to be subordinating knowable, tangible toxic waste threats with significant macroeconomic consequences.

  • Posted by Guest
  • Posted by Guest

    re: “What is stopping them from being more aggressive in this way?”

    whether china may still be far too dependent on World Bank aid and the US to have a whole lot of leverage. how much of china’s reserves can be made available for foreign external investment? whether india may be the one to watch. financial capital flows are one indicator, but perhaps a better one is people.

    “… JPMorgan Chase & Co. and Prudential Plc also have had defections in India. Domestic brokerages are winning staff with signing bonuses of $2.7 million and more, plus equity stakes. The competition is about to worsen as unlisted local brokers plan initial public offerings to fund expansion and as India’s largest companies enter the industry… “Here they are owners of equity… In foreign firms they hit the glass ceiling: there isn’t enough freedom to do things your way. Here the decision making is left to them.”…” http://www.bloomberg.com/apps/news?pid=20601109&sid=aWqTafOfuC7c&refer=home

  • Posted by Anonymous

    ” re: “the first great crisis of securitization” – wasn’t that enron – and was it the first? at risk of being accused of thinking like a conspiracy theorist, was that the real issue or was it a distraction from something else? as for the ‘toxic’ securities, how much anyone may know about who/what ends up owning, and/or controlling the bulk of underlying assets – if any more than what we hear about the value and ownership/control of enron’s assets today….
    Written by Guest on 2007-09-18 11:58:47 ”

    Quite right on Enron – fraud is one end of the risk continuum

    Although Enron was specific rather than systemic securitization/fraud risk

    Interesting to recall that Skilling insisted on describing Enron as a ‘run on the bank’

    Compare with today’s contingent bank liability problem

  • Posted by Guest

    the fed stands ready and willing to max out its exorbitant privilege credit (get out of jail free) card…

  • Posted by RebelEconomist

    Anonymous:

    As you worked out for yourself, the Fed funds rate is not risk free; it is an interbank rate. And I imagine that the vast majority of lending and borrowing at the overnight rate is not risk free. If you have a floating rate bank deposit for example, last night’s action means that you get less return despite risks that seem to have increased in recent weeks. Why should you accept a lower return today than you did yesterday? What is the mechanism by which the Fed influences that return? I cannot believe that the bank can replace many deposits by borrowing from the Fed if the depositor does not accept the rate cut.

  • Posted by Guest

    enron is also interesting in that it is/was a strong brand with global recognition, but not a consumer brand. if i understand, its’ demise seemed to be driven by a complete loss of good will and a rapid change in shareholder’s ideas about the future prospects of the firm itself at a time when the market for its underlying businesses was just starting to boom. that accounting standards addressing brand value and intangibles focus on consumer brands and patents – and neither seem to address the rapid change in enron’s valuation – which seemed to be more of an intangible rather than a tangible asset valuation issue.

  • Posted by Guest

    “…Is General Electric Co. primarily a manufacturer or a financial-services company that happens to make lots of stuff? The answer could shape how GE classifies much of its assets and earnings…” http://www.bloomberg.com/apps/news?pid=20601039&sid=a6sCBG11bzBo&refer=home

  • Posted by Guest

    and while everyone obsesses over the management of financial product lemons, and as we may be getting to the end of this post, i’ll press the point that resolutions to those issues may look like child’s play if china’s real toxic waste problems are as serious, and unstoppable, as reported because the real consequences won’t be stalled or solved with official announcements, model tweaking or sudden injections of capital. if china’s one strength is its export market, then accumulating real toxic waste has the potential to be catastrophic on a global scale – in the toxins that may be recirculated, whether in toys, food or drugs, in reductions to china’s own productive capacity and priorities for the retention, attraction and allocation of its own capital – perhaps from building wealth to preventing the loss of wealth – and on its capacity to sustain and retain the people it needs to build its markets and the global confidence it needs to produce and sell its products…

    “…”You’ve got record low inventories. Wheat is the lowest it has been for 30 or 40 years. Alternative fuels – sugar, corn “China used to be an [agricultural commodity] exporter and is now becoming a net importer…” http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2459597.ece

    brand china abroad would suffer too if chinese firms are shown to be poor stewards on their own turf.

  • Posted by Dave Chiang

    The ludicrous carping over defective China made products is another made for television ratings, media circus. More food products from Mexico are rejected for contamination than from China, but the biased US news media coverage conveniently overlooks those facts. Columbia and Mexico also ship billions of dollars in pot, heroin and cocaine to the United States that is also conveniently ignored by the politically correct US news media. And the Chinese government doesn’t dump millions of its citizens to the United States as illegal aliens. Apple Computer, IBM, Hewlett Packard, Dell, Motorola, General Electric ship hundreds of millions of Chinese-built products to the United States with only a very small percentage defective.

  • Posted by bsetser

    Michael Pettis — right you are. I should have qualified my point a bit more. In some sense the syndicated bank loans to sovereigns were the real exception if you take a long enough view. they just happened to be the form the first major post-world war 2 private extension of credit to what are now called EMs took.

    Indeed, you could argue that the Mexican crisis was really the first crisis of domestic sovereign bonds, as the tesobonos were governed by domestic law. And in retrospect, my sense is that the banks played a bigger role in the crisis than was recognized at the time — a lot of tesobonos in practice seem to have been held by Mexican banks who borrowed $ from the big money center banks (though the bonds were often posted as collateral, and thus showed up in the int. data). So there was an element of a cross-border bank run to the whole crisis — US banks went from providing medium term credit directly to the government of Mexico (70s) to lending to mexican banks who bought the GoM’s domestic dollar linked debt. I rather suspect this was encouraged by the basle capital requirements in place at the time.

    As for why china ends up buying dollars, the easiest explanation is that they peg to the dollar (ok, manage their exchange rate primarily against the dollar), and if china redirected a large share of its flow away from the dollar, it would tend to put pressure on the dollar, and thus on its own exchange rate. i.e. without support from china, the dollar would be even weaker. in some sense buying depreciating dollars is the price china has to pay to sustain its chosen exchange rate regime and preference for export led rather than domestic demand led growth.

  • Posted by Guest

    “Enron was specific rather than systemic securitization/fraud”

    my understanding is that it was the poster boy in an environment of systemic securitization/fraud – whether or not bankruptcy costs made further action against other entities unfeasible – didn’t the costs of the world’s most expensive bankruptcy (whether or not it still is) exceed the estimated costs of the fraud? whether not enron may also serve as an example of outdated or inappropriate bankruptcy laws

  • Posted by Anonymous

    ” Anonymous:

    As you worked out for yourself, the Fed funds rate is not risk free; it is an interbank rate. And I imagine that the vast majority of lending and borrowing at the overnight rate is not risk free. If you have a floating rate bank deposit for example, last night’s action means that you get less return despite risks that seem to have increased in recent weeks. Why should you accept a lower return today than you did yesterday? What is the mechanism by which the Fed influences that return? I cannot believe that the bank can replace many deposits by borrowing from the Fed if the depositor does not accept the rate cut.
    Written by RebelEconomist on 2007-09-19 09:21:20 ”

    The spread over the risk free rate is now higher as a proportion of the risk free rate – i.e. the risk ‘mark-up’ or premium is proportionately higher, meaning the price of risk and the return for risk taken is proportionately higher relative to the risk free rate. That has some bearing on risk taking – e.g. investors probably prefer earning 4 per cent when the risk free rate is 2 per cent, than earning 6 per cent when the risk free rate is 4 per cent.

  • Posted by Anonymous

    ” “Enron was specific rather than systemic securitization/fraud”

    my understanding is that it was the poster boy in an environment of systemic securitization/fraud – whether or not bankruptcy costs made further action against other entities unfeasible – didn’t the costs of the world’s most expensive bankruptcy (whether or not it still is) exceed the estimated costs of the fraud? whether not enron may also serve as an example of outdated or inappropriate bankruptcy laws
    Written by Guest on 2007-09-19 12:39:15 ”

    Agree it was the poster boy for fraud – but unique re specific role played by securitization in the fraud.

  • Posted by moldbug

    Guest: oui.

  • Posted by RebelEconomist

    Anonymous:

    If the spread over the risk free rate is compensation for expected loss, there is no reason why it should be related to the risk free rate itself.

    This question is not so straightforward after all!

  • Posted by Guest

    Furthermore, one could even design a paper or electronic financial system with a fixed monetary supply, using no commodity at all, although to make this work one would need a system of government which was (unlike ours) financially trustworthy. And the result would be the same. Your Krugerrand would be worth squat. Permanently, finally, and absolutely.
    Written by moldbug on 2007-09-18 18:31:28

    You know moldbug, reading your description above you might as well be describing the Canadian Dollar. Call it a fiat-commodity monetary supply. As long as the Government of Canada remains dificit adverse (12 year trend to date) you are good to go. Commodity cycle and fiscal conservatism explains the 48% appreciation in 5 years.
    The only flaw I see is the over exposure to the American Market. If Canada sold 80% of its exports to the rest of the world, then I would say the Loonie is the next reserve currency. LOL.

    Maybe Aussie dollar is better.

  • Posted by Guest

    Twofish: You have a person that just suffered a heart attack. Maybe a big reason was that he didn’t get enough exercise, but that’s hardly a reason to force him to run to the hospital.

    That all fine in theory but what happens if the patient insists on bingeing again and again and has to be brought to the ER more and more often, each time with a bigger problem and more expensive procedures? At what point do you lock the patient up in a rehab facility and keep him under adult supervision?

    Twofish: The first thing to do in a crisis is to stabilize the situation so that you have time to think. The scary thing about financial crises is that they often happen so quickly that you don’t have time to think.

    Big words. The problem is someone forgot to tell Alan Greenspan to do the thinking part after the situation got stabilized in 2003-04. Why should we expect things to be different this time?

  • Posted by Anonymous

    ” If the spread over the risk free rate is compensation for expected loss, there is no reason why it should be related to the risk free rate itself.

    This question is not so straightforward after all!

    Written by RebelEconomist on 2007-09-19 15:39:29 ”

    Good point.

    I suspect there’s a counter, but I can’t summon it here.

    Cheers.

  • Posted by Anonymous

    Although with lower rates, the present value of the risk compensation will exceed the present value of the risk, due to the interacting effect of serial flows and bond yield convexity. This would drive prices higher and risk spreads lower.

  • Posted by RebelEconomist

    Anonymous:

    Clever argument, but I think that this effect should be fairly minor. There is also the point that there will be a risk premium on the risk compensation itself, which will probably vary with the risk free rate. But I don’t think this explains how central banks get away with what they do either. I have been thinking about this question for a while, and had a long discussion with jkh about it on a previous post. Ben Friedman’s NBER working paper 7420 shows that even the experts are puzzled.

    As I say, how central banks manage to set interest rates (at least without taking a substantial amount of one side of the market) remains a mystery to me, but I just wonder whether it is one explanation for disintermediation from banks – ie the market finds a way of detaching itself from the unrealistic rate set by the central bank.

  • Posted by Anonymous

    ” Anonymous:

    Clever argument, but I think that this effect should be fairly minor. There is also the point that there will be a risk premium on the risk compensation itself, which will probably vary with the risk free rate. But I don’t think this explains how central banks get away with what they do either. I have been thinking about this question for a while, and had a long discussion with jkh about it on a previous post. Ben Friedman’s NBER working paper 7420 shows that even the experts are puzzled.

    As I say, how central banks manage to set interest rates (at least without taking a substantial amount of one side of the market) remains a mystery to me, but I just wonder whether it is one explanation for disintermediation from banks – ie the market finds a way of detaching itself from the unrealistic rate set by the central bank.
    Written by RebelEconomist on 2007-09-20 05:06:26 ”

    Your second sentence is worthy of an award of some sort.

    Of course, the other obvious argument is that lower interest rates per se tend to reduce expected losses and credit risk at the macroeconomic level in a very general sense – and therefore tend to reduce risk premiums when the fed funds rate declines.

    Also, think of the difference between the fed funds rate and the risk free rate as the ‘senior tier’ of risk in the financial markets. Treasury bill rates plummeted prior to the fed funds decrease. The fed move narrowed that spread – paving the way for the proportionate narrowing in more junior ‘tranche’ spreads above fed funds.

  • Posted by EthanJ

    how central banks manage to set interest rates (at least without taking a substantial amount of one side of the market) remains a mystery to me…”

    Rebel Economist, you could do worse than start here: http://en.wikipedia.org/wiki/Federal_funds_rate

  • Posted by RebelEconomist

    EthanJ:

    If only the answer was so easy to find! In order to consider the problem I refer to, you first have to appreciate its existence…..checkout NBER WP 7420.

  • Posted by Charles A. Robinson

    All slight of hand theft.

    When you organize a banking/currency cartel, in secrecy so you won’t be exposed as the greedy thieves and rakes that you are – whatever your family names are- when you organize and rig economies and power structures across the world welding abstract, phantom, artificial, ponzi schemes of thievery and investment and then using this stolen wealth- created by honest work and creativity- to destroy healthy, organic, communal, symbiotic and humane communities in order to dominate, weld power and try to give yourselves a sense of security and a feeling of power. But you are insecure because your parents loved money not you. So, you worship the zeros behind the numbers and the power you feel you need because you are actually powerless. One world currency, one world government and one world manipulation of the population will never give you security or LOVE.

    Rhodes had the money and the ambition to immortalize the English speaking world But you all are vain , impotent and insecure.