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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 artichoke

    How did they get the market to accept those junk mortgages in the first place? Securitization! They were instant garbage, created only because they could be sold off that way.

    So we’ve already gone through the securitization stage. The problem is that the banks, rather than the government, did the securitization. And banks have finite liquidity and are profit-driven, so now that the value of those CDO’s is going down, they are fighting to get their money back. And they aren’t writing any more of those mortgages. So here we are, in a crisis.

    In contrast, if the government were doing the securitizing, they would just eat whatever losses they incurred, possibly without even calculating Mark-to-Market, and life would go on.

  • Posted by kaan

    Brad,
    Great post. Really Gillian Tett at FT was playing Cassandra for along time but markets simply ignored her for to long.
    Markets were distorted by informational asymmetry and agent-principal problems. Risks are held by entities with least risk carrying capability.
    The real upcoming problem is the reflexivity of the collateral. The current global boom is underpinned by double digit credit expansion. If credit expansion stalls collateral will deterioate very rapidly and hence new wave of bad debts.
    Also liquidity injections by CB are partly to blame for 81 USD oil.Reflation will not be costless this time around.
    I am on the record inthis blog that Prof Roubini will be proven as too optimistic.

  • Posted by Bernardo Aito

    Brad,

    Sterling appreciation, possibily one of the outcomes of the Northern Rock affair, casts further harm on the Euro-area economy.

    Best

    Bernardo.

  • Posted by Keypoints

    My reading of CDOs is that if the percentage of loan defaults in a CDO can somehow be maintained at a constant or a decreasing level throughout the home mortgage terms, then the 21st century CDO can continue be easily valued using 20th century model — thus, the big question is can the marginally-at-risk borrowers in coming ARM mortgage resets refinance or rent/sell its homes before defaulting or being foreclosed. And if the Fed by lowering its short-term rates can maintain the annual mortgage defaults rate to a constant low level year-afte-year, then we have a winning solution and a credit market returning with confidence in both new and existing CDO securities.

  • Posted by adimeuso

    Hi Brad,

    Great post. I think after this CDO saga, in future, the real investors (i.e pension funds, SIVs, trusts,..) will definitely be more wary of any package that their Saville Row suited bankers might be marketing to them.

    My view is, most probably the existing lemons are likely to be absorbed by the Governments, written off in a way. Otherwise, they might have to do some creative unsecuritization? Is that possible?

  • Posted by London Banker

    There have been so many, many changes to the system since the last big market downturn. Some of the ones that strike me as important to how supervisors manage the fall out this time include:

    - Basle II (pro-cyclical, tightening capital constraints as liquidity suffers)
    - FASB Accounting (mark-to-market/model/myth options and off balance sheet accounting)
    - Globalisation (moving the “book” around to make the numbers wherever necessary for reporting)
    - Hedge funds (11,000 ill-transparent, unsupervised, leveraged, unaudited players accounting for more than half of all equity market trading)
    - Crony capitalism (assumption among the rich that they should be bailed out by the government they own, while the poor should suffer the consequences of working hard for a living)

    The S&L crisis in the 1990s, probably the closest approximation of what’s coming to the banking sector from the sub-prime collapse, was prevented from harming the national economy by the FSLIC guarantee of depositors and the FDIC acting as receiver/liquidator of failed thrifts to recycle assets. These two institutions were crucial to managing the crisis and limiting systemic damage. With the sub-prime “assets” dispersed globally to many financial institutions which are not subject to either depositor guarantees or sympathetic liquidation, failures can be much more costly and disruptive to the real economy.

    I don’t know how the coming crisis will play out, but it could get ugly any number of ways.

  • Posted by OC

    Stanley fischer was the first one to call the 1990s crises as of a “21st Century” type.

  • Posted by Anonymous

    While securitization may have facilitated the creation of more credit risk, the fact is that this risk is distributed throughout the global financial system much more broadly than would have been the case had that risk been concentrated in the banks, as used to be the case (e.g. LDC loans).

    The bottom line is that it’s a cycle – and the time has come to take losses.

    The broad distribution of risk will cushion the macro blow, relative to what might have been a more concentrated loss in the commercial banking system.

    The aggregate losses may be massive in the end, but the world is a big place. And a process of ‘creative destruction’ in financial engineering will clear the way for the next cycle.

  • Posted by Anonymous

    There are banks with discount window access – and then there’s everybody else.

    This has always been the case.

    There’s no real change in the configuration of the generic financial crisis as far as that’s concerned.

    And banks have always had contingent liabilities – as bankers to non-bank financial institutions.

  • Posted by bsetser

    anonymous –

    I think what may have changed (and I wrote this post in part to get a discussion going) is that the scale of “bank-like” activity being done by “everybody else” has increased. THe scale of the banks contingent liabilities associated with their affliated off-balance sheet vehciles (which sometimes do look like mini-credit hedge funds as much as any thing else) also seems to have increased — or it least their size was a shock to me.

    The consquences of all this, if it is a fair characterization? I am not sure — particularly as in a crisis, a lot of risks seem to be migrating back toward bank balance sheets. In that sense, i agree with mervyn king’s point that easy provision of liquidity encourages in a crisis the overuse of contingent liquidity facilities and the like. Certianly the ECB’s lending seems to have (in my view) facilitated the absorption of some european conduits and sivs back on banks balance sheets. At the same time, not providing liquidity right now would lead to forced sales, the mark-down of collateral and the like.

    so my sense is that some things have changed and some things haven’t, but in ways that likely make crisis resolution more difficult. does that mean central banks need to go toward the buiter solution and make markets for complicated securities to provide liquidity to a broader range of institutions? I am not sure — that seems to encourage complexity, as it reduces the cost of buying a set of securities which normally should be assumed to be illiquid in bad times. plus, i am not sure central banks are equipted to value these securities.

    “Creative unsecuritization” is a great phrase …. my sense, after the comments on a previous post and some of naked capitalism’s blogs, is that unsecuritization is actually quite hard. You basically need agreement among all the tranches to unwind an instrument, which means agreement on relative valuation ….

    In the near-term, it seems that either a lot of institutions will be holding illiquid instruments marked-to-model (or to myth), or enough will be forced to sell ..

    as for credit risk transfer/ risk dispersion — I want to see how this all plays out before drawing any strong conclusions. any subprime sold to real money pension funds has been dispersed out of the leveraged financial system, as has any sold to central banks or SWFs. But hedge funds borrow from broker dealers who borrow from banks, and SIVs turned out to be less off-balance sheet than initially thought. I don’t doubt that there has been a degree of risk dispersion but isn’t one potential lesson of the recent turmoil that a lot of risks that had apparently been dispersed hadn’t been dispersed that far?

    finally thanks for the on-topic discussion.

  • Posted by Guest

    “…But even if the Government’s decisiveness yesterday deserves some plaudits and will probably ensure that this crisis is resolved without taxpayers having to bear any actual costs[, this] near-catastrophe should be seen as the start, not the end, of a serious debate about the institutions that supervise Britain’s financial services and the competence of the people in charge…” http://www.timesonline.co.uk/tol/comment/columnists/anatole_kaletsky/article2477875.ece

  • Posted by Dave Chiang

    Never mind that the Spot Oil price this morning is at a record $81.57 per barrel and Gold is at a record $727 per ounce, the Federal Reserve is prepared to massively slash interest rates for the bailout of reckless Hedge Fund speculators; the Goldman Sachs balance sheet is leveraged 45 to 1. A Cheap money monetary policy was the cause for the massive misallocation of capital, why will even cheaper money rectify the situation? Due to the insatiable demand for commodities from China and India, the Federal Reserve explosion of cheap money from Helicopters over the Goldman Sachs headquarters will manifest in soaring prices for commodities, energy, and food. Hyperinflation is not out of the question. – DC
    http://money.cnn.com/data/commodities/index.html

    Bernanke cave-in to Wall Street speculators for “cheap” money monetary policy
    http://www.bloomberg.com/apps/news?pid=20601103&sid=avkq8LxPdSmU&refer=us

    Sept. 18 (Bloomberg) — The Federal Reserve will probably cut its benchmark interest rate today for the first time in four years. The Fed will be seen as caving in to funds that piled into the market for securities linked to subprime mortgages, those made to borrowers with poor or limited credit histories.

  • Posted by Guest

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aYBOOiT5mAO0&refer=home

    Jim Rogers Says Fed Rate Cuts Will Push Economy Into Recession

    By Carol Massar and Michael Patterson

    Sept. 18 (Bloomberg) — The U.S. economy will head into a “serious” recession and the dollar will “collapse” if Federal Reserve Chairman Ben S. Bernanke reduces interest rates, investor Jim Rogers said.

    “Every time the Fed turns around to save its friends on Wall Street, it makes the situation worse,” Rogers said in an interview from Shanghai. “If Bernanke starts running those printing presses even faster than he’s doing already, yes we are going to have a serious recession. The dollar’s going to collapse, the bond market’s going to collapse. There’s going to be a lot of problems in the U.S.”

  • Posted by Guest

    “as for credit risk transfer/ risk dispersion — I want to see how this all plays out”

    much of which has to depend on the (real) health of the underlying economies and sectors affected by it, perhaps raising the question – why do so many of the world’s wealthiest emerging market diaspora choose to live in London – and New York City. It can’t be the tax benefits alone.

    If along with the breathtakingly bigoted political machismo, if the real problem may be the costs of focusing too much attention on a few individuals and a narrow range of financial instruments at the expense of assessing other weaknesses – and strengths.

  • Posted by Guest

    “…recent events with regard to US subprime mortgages show markets can change rapidly and dramatically…” http://www.ft.com/cms/s/1/e06f16f4-6539-11dc-bf89-0000779fd2ac.html

  • Posted by Anonymous

    Appreciate the thoroughness of your response – much agreement.

    Some additional thoughts -

    Securitization as a broadly marketed product of commercial banking is about 20 years old.

    Banks may have become complacent about the ‘fat tail’ risk on their securitized contingent liabilities – due to very benign risk experience over 20 years.

    Complacency breeds risk sloppiness and pushing the envelope on new product design.

    And dispersion of risk may have deposited that risk in some highly leveraged entities – so dispersion doesn’t preclude leveraging of that risk after it is exported from the center (i.e. the banking system) to the perimeter.

    Interesting side question on finance – does the leveraging of ‘exported’ risk really add to the total risk, or does it just distribute it among smaller equity capitalizations in aggregate? I think the latter – reflecting the Miller-Modigliani theorem of finance – capitalization doesn’t change the value of the firm – just reorganizes the price and absorption of risk.

    So this may be the first great crisis of securitization – while also being the first great financial crisis of the 21st century.

    And this time is different because – this is the essentially the first time – for securitization.

    But not for contingent liabilities.

  • Posted by Guest

    Mortgage Defaults rising on multi-million dollar Mansions as even wealthly overextended
    http://www.palmbeachpost.com/localnews/content/local_news/epaper/2007/09/16/s1a_HIGH_FLYERS_0916.html

    The Palm Beach Post reports from Florida. “It turns out the rich are not so different after all. They default on mortgages, too. In the first six months of this year, 10 Palm Beach County mansions and a $2 million homesite headed for the auction block to satisfy lenders. Owners of another 43 high-end homes were notified that they could lose the elegant roofs over their heads.”

    “Consider the Boca Raton man who took out a 10.2 percent interest rate loan on a $1.1 million loan last year. The foreclosure judgment on his home in the tony gated community of Parkside at Boca Trail is for $1.16 million, or $60,000 more than the original note.”

    “When he began to struggle with the debt, terms of the loan effectively barred him from quickly prepaying his pricey mortgage and refinancing into a more tolerable deal. He stopped paying the mortgage less than six months after he signed it.”

  • Posted by Guest

    “…The lesson from Northern Rock is that the old tools don’t work. The Bank of England now has little power, legal or moral, to corral other lenders into a rescue… a clearer mechanism must be created to ringfence state-guaranteed deposits from the banks that gathered them in the event of a crisis… if all deposits are to be state guaranteed, there must be tighter supervision of banks by the Financial Services Authority, which may have taken its eye off the ball. Alternatively, if the UK’s bank-funded deposit insurance scheme is redesigned, the levies on banks must clearly penalise those lenders which choose to raise UK deposits but then take major asset or funding risks…” http://www.ft.com/cms/s/1/fbe9adca-65c2-11dc-9fbb-0000779fd2ac.html

    “…Whatever they may say publicly, regulators cannot afford to allow a bank with a large retail deposit base to fail. The potential political and economic fallout is just too scary… Banks with a large deposit base – which, in effect, makes them too important to fail – could be subject to more stringent capital requirements… If deposit- taking banks live in a world of near guaranteed rescue by the state, they could eventually be required to run balance sheets with more slack.” http://www.ft.com/cms/s/1/008eebfa-64f2-11dc-bf89-0000779fd2ac.html

  • Posted by Guest
  • Posted by Guest

    Now that the Federal Reserve lending cartel’s interest rate experiments have gone awry and we witness the devastating effects of abusive monetary power concentrated in the hands of a few, it is time for Congress to strip the Fed of its interest rate setting authority. Instead of monopoly control, the market should be allowed to set rates through an intra-bank exchange where supply and demand determine the price of money.

  • Posted by Guest

    Structured Finance and the Dollar: Reduced issuance of structured products will give foreign investors fewer U.S. fixed-income securities to purchase, and the recent decline in yields reduces the relative attractiveness of traditional fixed-income securities such as Treasury, agency and corporate bonds. In sum, it seems likely that net capital inflows, which are needed to finance the gaping current account surplus, will weaken further. Therefore, we project that the dollar will continue to depreciate vis-à-vis most major currencies.”

    The -9.4 bln net foreign sales of Treasury coupons is the largest monthly liquidation in five and a half years: Both central banks and private accounts shed U.S. Treasury coupons in July. The strong demand of the last few years may be dying off. Over the last year net foreign purchases have summed to $208 bln while the Treasury issued only $139 bln of net new coupon debt over the same period. The large $69 bln excess of foreign demand over net new issuance has played an important role in holding down yields. The retreat of foreign investors has long been feared. We’d need to see a longer period of weakness before giving up on foreign investors.

  • Posted by Guest

    “…Should they leave the discount rate unchanged, they will also be saying that they believe the worst of the credit crunch to be over and that it is unnecessary to continue to encourage borrowing from this facility.” http://www.bmocm.com/publications/fxcom/busch/default.aspx

  • Posted by adiemuso

    “creative unsecuritization” maybe I will add that in my fund’s upcoming monthly report. :)

    Its already hard to share the war spoils peacefully. To share the costs? Huh..maybe dawn begins from the west.

    A rate cut now will only be a bailout. What a waste of taxpayers money.

  • Posted by bsetser

    anonymous. thanks for your equally thorough response. I broadly agree with it as well –

    certainly this isn’t the first crisis stemming from contingent liabilities. but my sense is that it is the first crisis stemming from contingent liabilities to securitization vehicles or perhaps vehicles set up to finance the purchases securitized products (i.e. SIVs) so some aspects seem to have changed.

    All — I would appreciate somewhat fewer comments that simply post a link without adding to the dialogue. i find that they disrupt the flow of the conversation. links that support a point are appreciated (and certainly better than lengthy excerpts). but my feeling is that perhaps too many links have been pasted in without explaining why the link is relevant over the past two hours.

  • Posted by Guest

    The lies of Alan Greenspan
    by William Greider
    http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2007/09/18/EDCLS7TH4.DTL

    The economic consequences of his rule are accumulating, and even the dullest financial reporters are stumbling on crumbs of truth about Greenspan’s legendary reign. It sowed profound and dangerous imbalances in the U.S. economy. That’s what happens when government power tips the balance in favor of capital over labor, favoring super-rich over middle class and poor, then holds it there for nearly a generation.

    Things get out of whack and now the country is paying enormously. A pity reporters and politicians didn’t have the nerve to ask these questions when Greenspan was in power.

    He retired only a year ago, but is already trying to revise the history – to explain away blunders that are now a financial crisis facing his successor; to rearrange the facts in exculpatory ways; to deny his right-wing ideological bias and his raw partisanship in behalf of the Bush Republicans.

    The man is shrewd. He can see the conservative era he celebrated and helped to impose upon the American economy is in utter ruin. He is trying to get some distance from it before the blood splashes all over his reputation.

  • Posted by Twofish

    On the other hand, maybe everything will work out in the end (perish the thought!!!!) Thus far, the sub-prime situation hasn’t spilled over in a big way to the broader economy. If it doesn’t, then this might demonstrate how the system works rather than how the system is broken.

    One problem in talking about finance is that there often isn’t historical depth. The current problems are immediate while the one’s in the past are remote. So often one refers to the present in terms of some golden age of the past when there were no financial crises, but if you look at the past closely there doesn’t seem to have been a golden age of finance. Certainly the great subprime crisis of 2007 is nowhere (yet) near as bad as the dot-com crash or the Asian flu, or any of the other situations that I can think of in the past 30 years.

    It’s possible that we haven’t fallen off the cliff yet, but what if there is no cliff…..

  • Posted by Twofish

    adimeuso: I think after this CDO saga, in future, the real investors (i.e pension funds, SIVs, trusts,..) will definitely be more wary of any package that their Saville Row suited bankers might be marketing to them.

    The trouble here is that investors are also under pressure from their stakeholders to show returns. The reason people have been going to complex products in the last few years is that the returns on the plain boring ones have been so low. The trouble with that is that, if (and it is big if) one believes in efficient markets, one can’t boost returns without boosting risk.

    adimeuso: My view is, most probably the existing lemons are likely to be absorbed by the Governments, written off in a way.

    So far the losses are in the US$250 billion range and that doesn’t require government intervention. The main thing that governments can do is to make sure that the feedback cycles don’t spiral out of control.

    One other big change since the late 1990′s is the passage of Graham-Leach-Biley Act of 1999 which set off a huge wave of financial consolidation in the United States. What you have are a few trillion dollar banks which the Fed monitors very closely which then extend credit to smaller regional banks and hedge funds.

    Also you have the computer revolution which put together massive amounts of computing power. These complex instruments that are common simply could not be sold in 1990 because the computers weren’t fast enough to price them. You also have the end of the Cold War which suddenly put a lot of out of work physicists on the market.

    The computer revolution has had the paradoxical effect that it allows for small mom-and-pop shops (i.e. hedge funds) to pop up because the compute power is in reach of small organizations, while at the same time encouraging consolidation since once you’d hired 50 physics and math Ph.D.’s and put together a grid of 1000 PC’s, it doesn’t care whether it is running a simulation of $100 billion or $1 trillion.

  • Posted by Guest

    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….

  • Posted by shrek

    Making any institutions (JPM BA C etc) is a tragic mistake. Markets can only function when all players are capable of failing. Assume this crisis passes, but then what? More bad lending with more moral hazard? Lets not be japan

  • Posted by Dave Chiang

    Henry Liu sums it up like this in his article, “The Rise of the non-bank system” — required reading for anyone who wants to understand why a stock market crash is imminent: Banks worldwide now reportedly face risk exposure of US$891 billion in asset-backed commercial paper facilities (ABCP) due to callable bank credit agreements with borrowers designed to ensure ABCP investors are paid back when the short-term debt
    matures, even if banks cannot sell new ABCP on behalf of the issuing companies to roll over the matured debt because the market views the assets behind the paper as of uncertain market value.

    “This signifies that the crisis is no longer one of liquidity, but of deteriorating creditworthiness system-wide that restoring liquidity alone cannot cure. The liquidity crunch is a symptom, not the disease. The disease is a decade of permissive tolerance for credit abuse in which the banks, regulators and rating agencies were willing
    accomplices.”
    (Henry Liu, The Rise of the Non-bank System, Asia Times,
    Sept 6, 2007, http://www.atimes.com/atimes/Global_Economy/II06Dj02.html)

    That’s right; nearly $1 trillion in worthless paper is clogging the system, putting the kibosh on the big private equity deals and spreading panic through the money markets. It’s a slow-motion train wreck and there’s not a thing the Fed can do about it.

    This isn’t a liquidity problem that can be fixed by lowering the Fed’s fund rate and creating more easy credit. This is a solvency crisis; the underlying assets upon which this world of “structured finance” is built have no established market value, therefore they’re worthless. That means that the trillions of dollars which have been leveraged against these shaky assets — in the form of credit default swaps (CDSs) and numerous other bizarre-sounding derivatives — will begin to cascade down wiping out trillions in market value.

    The downside of this is that once that banks write off these toxic MBSs and CDOs; the hedge funds, insurance companies and pension funds will be forced to do the same — dumping boatloads of this bond-sludge on the market, driving down prices and triggering a panic sell-off. This is what the Fed is trying to prevent through its $60 billion repo-bailout.

    Regrettably, the Fed cannot hope to remove a half-trillion dollars of bad debt from the balance sheets of the banks or forestall the collapse of related financial institutions and funds which are loaded with these unmarketable time-bombs. Besides, most of the mortgage derivatives (CDOs) have been massively enhanced with low interest leverage from the carry trade.

    When the value of these CDOs is finally determined, which we expect will happen sometime before the end of the 3rd quarter, we can expect the stock market to fall sharply and the housing recession to turn into a full-blown economic crisis.

    - Henry Liu

  • Posted by Guest

    re: “You also have the end of the Cold War which suddenly put a lot of out of work physicists on the market.”

    “The Chronicle of Higher Education has a long article about the bleak job prospects facing academic scientists these days… one thing that I think could have been emphasized more is that, no matter how dismal the career path becomes for US scientists, there will still be foreigners from India, China and eastern Europe willing to try their luck, as well as a sprinkling of American-born obsessives (like me) who should know better. However, a significant number of talented Americans will simply choose to do something else…” http://infoproc.blogspot.com/2007/09/crisis-in-american-science.html

  • Posted by bsetser

    shrek — my guess is that we already are japan (and not just b/c of a real estate bubble that inflated the value of the land under central bank … or perhaps the land next to central park … to stratospheric highs). martin wolf argued that we shouldn’t have any institution too big too fail in his column a few weeks ago, and my immediate reaction was that we already likely have several institutions (post consolidation) that are either too big or too complex (i.e. it would be impossible to unwind all their offsetting positions) to fail. And perhaps some of the teams of 100 quants that can manage $1 trillion as easily as $100b are reaching the too big (or too complex) to truely fail size as well, tho that is a bit harder question. I suspect a few have reached the size that they are now big enough that they cannot fail without generating a big policy debate …

    I’ll second 2fish on one point — the banks pushing securities were responding to a very strong demand for yield when times were good. remember all the talk of a permanently low level of economic and market volatility? that is an environment that encourages risk taking.

  • Posted by Guest

    2fish – were nortel, enron, worldcom… dot.coms? there will be cliffs, as there were for those with enron etc.(see http://www.ft.com/cms/s/2/d5725a3c-624a-11dc-bdf6-0000779fd2ac.html) in their pension funds – and jobs affected by that ‘crisis’. but as everyone notes, because the fallout from this one is more distributed, it will be more difficult to assess underlying causes, damage, duration, harm to those damaged by it and windfalls to those who profit from it.

  • Posted by Guest

    the u.s. economy is not, and never will be japan then and now for many reasons.

    brad, if a democrat was in the whitehouse, with you back in the treasury, would you still interpret every symptom of global integration as another sign of america’s coming collapse?

  • Posted by moldbug

    Another new problem is that the rise of PM ETFs makes it very easy to move your savings from Northern Rock to the Bank of Amsterdam with a click or two of the mouse. Hm.

    All of these problems have and have always had one thing in common: maturity mismatching. Mises was right, Bagehot was wrong: maturity mismatching (borrowing short and lending long) is the real “barbaric relic.” It cannot exist in a free market. It has no place in a stable financial system. (“Fractional-reserve banking” is a type of maturity mismatching.)

    The definition of insanity is doing the same thing over and over again, and expecting a different result. If you take a long-term view, the question has to be not whether to transition the world’s financial system to a stable structure that does not systematically mismatch maturities, but how. It’s easy to throw up one’s hands and describe this as an unsolvable problem. Perhaps it is an unsolvable problem. But considering the number of people these days who get paid to work on unsolvable problems, surely a little attention could be devoted to this one.

  • Posted by Bernardo Aito

    Hi all,

    FED cuts half%. This makes for the argument that Bernanke may be willing to push down the Dollar even more in order , perhaps, to correct the external imbalance. Will now China want to sell Dollars? What will other investors do with their greenbacks?

    interestingly, on my blog’s poll, only 12% forecasted such a cut. The bloggers didn’t perform well this time, did they?

    Best

    Bernardo

  • Posted by Dave Chiang

    Guest writes,
    the u.s. economy is not, and never will be japan then and now for many reasons.

    That I agree with, but from a different rationale. The Japanese are avid savers of money through thick and thin. Thanks to the irresponsible Federal Reserve, any financial motivation to save money has been destroyed by reckless money printing policies resulting in skyrocketing inflation for energy, commodities, and food. Privatize the profits to Wall Street Banks, and socialize the cost through monetary inflation with estimated M-3 money supply surging at a 15 percent annual growth rate. Bernanke starts running those printing presses even faster with his interest rate cuts with the discount rate well below the “real” rate of inflation.

    Let the US history books record that “Helicopter Commander” Ben Bernanke has destroyed the monetary purchasing power of the American dollar.

  • Posted by adiemuso

    Hi Twofish,

    I am not saying that the Bankers are solely at fault for marketing this complex, structured, asset backed, securitized or whathaveyou product to their clients who are screaming for higher yielders, higher income or higher returns.

    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?

    As far as I know, the worse hit are not the big names, not the ones with deep pockets, and certainly not the wall street players but rather, are those decent, down to earth instituitions who find themselves holding on to worthless pieces of paper.

    This is what I personally think of and consider as moral hazard. You cant just package toxic and pass them off as sparkling mineral water from the Alps.

    Like twofish and most others have mentioned, problems that are due to the CDOs or products per se are rather limited. However, in reality, it is the spinsoffs that are worrisome. From my understanding, in the cash money markets, it is a case of credit/counterparty mismatch rather than a lack of liquidity that most are citing. What we have here are big hoarders refusing to release loans to “bad listed” names. And that is what exactly is driving up those Libors for the 1M,2M and 3M.

    Well, to me the cut of 50bp says it all. Perhaps Ben and team have seen something worser than we know. Either way, this cut have given the respite for all, irregardless whether you are the needy and or the less than welloff.

    And sad to say, I myself as a fund manager, the ideal free and efficient markets do not exist.

  • Posted by Dave Chiang

    My oil and metals stocks are soaring today, but that doesn’t mean I should intellectually support the destruction of the US dollar. My collection of gold coins is also up tremendously in nominal US dollar terms. A one ounce gold coin a year ago still weighs exactly one ounce today. Gold hasn’t appreciated; the US dollar has depreciated. Essentially, the US government is defaulting on all its debts through the printing press and the associated monetary inflation. Anyone who holds the US dollar will be totally screwed with its monetary purchasing power value rapidly destroyed by irresponsible Federal Reserve policies.

  • Posted by gillies

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

    the ordinary man or woman in the street (which is where irish customers of northern rock spend a lot of time queueing) will demand – simplicity – transparency – accountability – and perhaps a better matching of areas of financial regulation to areas of financial operation.

    america may have blown it. by ‘it’ i mean global toleration of their global financial leadership. the new financial innovation may originate in chinese thinking. something that they will ask in return for using their power as savers and creditors to ease the pain for the borrowers and debtors.

  • Posted by Dave Chiang

    Crude Oil Surges to Record $81.90 per barrel after Fed rate cut
    http://biz.yahoo.com/ap/070918/oil_prices.html?.v=22

    Read my lips.

    - Interest Rate cuts won’t help the depressed Housing market, there are simply too many McMansions built in the past decade.

    - Interest Rate cuts this time around will feed into surging energy, precious metals, commodity, and food prices.

  • Posted by Anonymous

    “..securitizing bad loans to take them off banks’ balance sheets – and, one hopes, off the off-balance sheet portion of banks’ balance sheets. ”

    Newbie question: what is the off-balance portion of a balance sheet? Why do banks have these? Doesn’t this violate the spirit and letter of regulations for banks?

    It seems we wouldn’t be in this pickle if the banks’ balance sheets actually reflected in full their balances. Or something???

  • Posted by gillies

    dave chiang – i often wonder if you are a plant. your discourse has remarkable similarities to the bush techniques of consistency, persistence, and repetition. and the insistence that the dollar will fall sits badly with your supposed championing of china, the economy which stands to lose much by such a process.
    would you agree that the dollar buys more real property than it would have done a month ago?

    there are many more kinds of bad end than a hyperinflationary bad end.

    i read different accounts of the total derivatives and suchlike in the world – is it 220 trillion, is it 700 trillion? or can anyone be sure ? suppose a percentage of those become not valueless so much as unmarketable ? that is to say financial constipation, rather than financial diahorrea. does bernanke have to administer the laxative on the same kind of scale to avert deflation ? in a volatile situation will everything he does be too little too late ?

    when you say, dave c, that “Gold hasn’t appreciated; the US dollar has depreciated.” you make a fundamentalist statement, one that is fairly meaningless.

    i suggest that holding gold is like holding your breath in a firestorm – a good policy for as long as you can keep it up.

    but if asset capital gains fade elsewhere as they are now in the housing market – the future will lie with a secure cashflow and saving to buy stuff later as prices steadily fall. if oil and gold are taking off – good luck to those with perfect timing – they may ‘spike’, but i think faith is now fading in those categories which are a ‘sure thing’, as property was so recently.

  • Posted by Anonymous

    Final entry today -

    Totally agree with your point – this is the first macro type crisis in securitization contingencies.

    The contingent liabilities associated with securitization were an aggressive extension of more traditional contingent liabilities assumed by the commercial banking system.

    Old-fashioned lines of credit (i.e. approved but undrawn credit) were probably the most elementary and original form of contingent bank liability.

    The original backup lines for commercial paper issuers as well – i.e. paper issued by ‘real industry’ issuers such as the car companies – as opposed to paper issued by packagers of nth degree leveraged CDOs.

  • Posted by bsetser

    off balance sheet means a lot of different things –

    it can mean derivative positions that modify the exposure shown on balance sheet (i.e. you have a fixed rate commitment on balance sheet but have done a swap off balance sheet that turns into a floating rate commitmment)

    or it can mean things like contingent credit lines to “affliliates” that theoretically are independent but have been set up by the sponsoring bank to take certain bets that the bank would rather not make with its regulatory capital — and that are also financed off balance sheet in the sense that an siv issues its own liabilities to buy a set of assets rather than relying on the bank for financing.

    I am pretty sure that doesn’t help — and i am sure a finance pro would find fault with it.

    there are a ton of reasons to do things off balance sheet –

    but they usually amount to either:

    there is a regulatory, tax or accounting reason not to do something on balance sheet

    and/ or derivatives are generally not shown on the balance sheet even tho they can substantially modify balance sheet exposures (indicentally, the imf requires that countries report their forward commitments along with their reserves, so this stuff can be transparently reported)

    if I have this wrong do tell –

  • Posted by Shrek

    I agree Brad, but where do we go from here? Our economy could not be sustained just based on finance. This is when we sholud be made at Asia for not letting the private sector determine interest rates.

    Moldbug- Is the last couple of years your definition of driving debt to infinity?

  • Posted by Vitoria Saddi

    Brad, Great piece with lots of innovative insights. Congrats! Vitoria

  • Posted by Twofish

    The other reason to move something off balance sheet is to limit liability for losses. Suppose you want to make a really risky investment. Instead of doing it as the bank, you create the XYZ corporation, put money in it, and if you lose the bet, then the XYZ corporation folds, you lose all of your original capital *and nothing else*.

    Legitimate as long as everyone knows what is going on, and this is why moving something off balance sheet is more than a regulatory dodge. If a bank does some risky investments as part of the XYZ corporation, then it keeps those risky investments from affecting the safe investments of bank, and that is what regulators care about.

    To answer the next question, what makes it different from Enron. The difference was that Enron was throwing good money after bad into the off-balance sheet entities, was hiding all of this from investors and regulators, and wasn’t marking losses to the off-balance sheet entities. In the case of banks, regulators look at these sorts of things, and if the bank’s bet goes bad, then the plug is pulled, XYZ corporation folds, and it is marked as a loss on the bank’s balance sheet.

    The problem is what happens if everyone pulls the plug at the same time……

  • Posted by Twofish

    gilles: i read different accounts of the total derivatives and suchlike in the world – is it 220 trillion, is it 700 trillion? or can anyone be sure ?

    Those huge numbers “nominal values” and are total bogus. Suppose I offer to pay you the difference between $1000 and the price of a $1000 T-bill a year from now. The “nominal value” of the bet is $1000 although the risk to me is nowhere near $1000.

    The number that banks look at is “value-at-risk” how much are we likely to lose if X happens.

  • Posted by Guest

    Notional (nominal) derivative values are not ‘bogus’ for intelligent interpreters.

    They’re the denominator for value at risk calculations.

    They’re only bogus for myopic traders who ignore the source and context for their risk numbers.

  • 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.