Well, in Canada lots of people are complaining about housing, food, and fuel costs. n.b. Canada’s housing bubble hasn’t burst yet.

A sarcastic, “Yeah, right!” is the typical response when people are told that inflation is “under control.”

One thoughtful person said to me, “they fudge the numbers so they can shortchange all those pensioners.”

And you know this how?

Twofish: “Just because an argument is self-serving, doesn’t make it wrong.”

No but it certainly doesn’t make the argument right, and it makes it really suspicious. Especially for the outrageous claim that moral hazard doesn’t exist that plainly goes against our collective knowledge from hundreds of years in insurance and banking.

Twofish: “The trouble is that if you don’t bail out people whose troubles have nothing to do with the initial problem, this hardly seems fair. If someone loses their job because the company they work for had their money in a bank that went under, this isn’t fair.”

Are you serious? This is so loopy I scarcely know where to begin. Are you really suggesting that the government should insure every single business in the country against loss?

Trouble here is that ABCP’s *aren’t* backed by housing assets. ABCP’s have nothing to do with subprime mortgages other than the fact that you had the same investors in both. Also, prime MBS’s haven’t lost value. Prime MBS’s aren’t sensitive to housing prices, since they are lent based on the credit of borrower and there is enough capital reserve so that changes in housing prices don’t affect the security. A prime MBS can only be lent for 80% of the house value, which means that home prices have to drop a lot more before they get hit.

(Regarding capital reserves).
50 Cent: Well, Duh! The question is why didn’t they? The answer is greed and willful denial.

IB’s *did* have enough capital reserve to deal with this mess. No bank is coming close to failing.

50 Cent: Of course they did. LTCM’s assets were high quality but they could not liquidate them to meet margin calls. That is the very definition of illiquidity.

Why did they have to meet a margin call? Because they were overleveraged, and once you are bleeding everyone out there is going to try to take a piece of you. But ultimately LTCM didn’t have much to do with liquidity, because even if it had been able to liquidate everything, then it still would not have enough to stay afloat.

50 Cent: Thats easy: you inflate the value of your long positions and deflate the value of your short positions. The idea is to inflate the value of *your* assets. When you use mark-to-model accounting there is no reason why you have to be consistent.

Yes you do, because you have to post a valuation to your counterparty, and if the valuation is good for you, it’s bad for them, and they’ll start screaming. This stops working if you control your counterparties, which is what Enron did, but banks don’t control their counterparties, which means that banks (fortunately) can’t use accounting tricks to get out of their messes.

Suppose you get a letter from the bank saying that because they are running into some problems, they want to value the derivative contract that they are holding with you at some high value, which means you owe them more money.

50 Cent: Theoretically you can make “money” trading with yourself. And take a bonus for it.

No you can’t, at least for very long. Enron tried that. It didn’t work too well.

50 Cent: It is a mystery how Goldman made money on sub-prime. Maybe they didn’t and are merely playing a dangerous game of brazening it out. Who knows what skeletons they are hiding under their “Level 3″ accounting.

It’s pretty simple, really. The nice people at GS figured out that people were being idiots with subprime mortgages and sold people lots of rope to hang themselves with. Their profits come from massive short positions in sub-primes. The cool thing about Wall Street is that if you look around and see people being massively stupid, you can usually figure out a way of making money from it. You yourself said that it should have been obvious that something was going to break. Once that is obvious, the next step is to figure out how to make mega-bucks when it does…….

You have to ask yourself when you see reports of massive losses. Who are these folks losing money *to*?

50 Cent: Thats an exaggeration. In a liquidity crisis there are FEWER buyers and they demand bigger premiums. Why this is surprising to anyone is not clear to me.

To have a market, you need a buyer and seller. If you don’t have both, then you don’t have a market.

In a liquidity crisis there no transactions going on since buyers and sellers can’t agree on a price. If you have a situation in which the price just goes down but people are still buying and selling at the lower price, then you don’t have a liquidity crisis. If they buyers are demanding low prices, and there are no sellers at those prices, then you have a problem.

50 Cent: Thats a very self-serving argument for Wall St don’t you think? If the casino gives you chips to play on the house will that increase or decrease the size of your bets?

Just because an argument is self-serving, doesn’t make it wrong.

In any case, investment banks are going to lose money on sub-primes, and no one is suggesting thatt this isn’t a good thing. If someone loses money on because they invested money in sub-primes because of a problem in sub-primes, that’s a good thing. If someone loses money on something that has nothing to do with sub-primes (like asset-backed commercial paper), this probably isn’t a good thing.

50 Cent: And apart from the economic costs there is also the basic issue of fairness. Why isn’t the government bailing out *everyone* who has financial difficulties?

The trouble is that if you don’t bail out people whose troubles have nothing to do with the initial problem, this hardly seems fair. If someone loses their job because the company they work for had their money in a bank that went under, this isn’t fair.

I think we can summarize our differences in two points

1) Investment banks just can’t do what Enron did because there are too many internal and external checks and balances.

2) I think that the Fed did the right thing, because it started to look like that people who had nothing to do with the initial stupidity were starting to get hurt. In particular once you started having problems with asset-backed commercial paper, this was worrisome because ABCP’s have nothing to do with subprime mortgages.

Sorry but that is utterly predictable. People have been warning about the housing bubble for years now and if the assets behind your ABCP’s are MBSes of course they were going to lose value.

You can keep denying it all you want but even Jamie Dimon has now admitted that the SIVs have no economic purpose and will have to be shut down. Talk about closing the barn door too late..

Twofish: “The solution to this is to not even try to figure out exactly how the system fails, but to make sure that you have enough capital to withstand general failures.”

Well, Duh! The question is why didn’t they? The answer is greed and willful denial.

Twofish: “Let me give you a menu of all of the financial instruments now being traded, and I don’t think that you or I will be able to guess which one will be the next one to blow up, especially since the one we pick will have attention focused on it, and not blow up.”

The diversity in financial instruments is a mere illusion. A very large number of them were based on mortgages, others on LBO-debt. To any honest observer it was always clear that all of these securities were driven by cheap money and they were all going to be affected when it dried up.

Twofish: “LTCM didn’t blow up because of illiquidity. Once it blew-up, then you had a liquidity crisis, but there weren’t any liquidity problems that led to the blowup. The initial blow up was due to over-leveraging and much of the solution was to have the IB’s tighten up their lending to hedge funds.”

I don’t know how you can claim that LTCM did not blow up because of illiquidity. Of course they did. LTCM’s assets were high quality but they could not liquidate them to meet margin calls. That is the very definition of illiquidity.

Twofish: “Can you explain how this works? Because you can sell short, inflated asset values don’t always lead to big bonuses, and if your book is short, you want asset values to go as low as you can.”

Thats easy: you inflate the value of your long positions and deflate the value of your short positions. The idea is to inflate the value of *your* assets. When you use mark-to-model accounting there is no reason why you have to be consistent. Theoretically you can make “money” trading with yourself. And take a bonus for it.

Twofish: “That’s how Goldman made a bunch of money from sub-prime.”

It is a mystery how Goldman made money on sub-prime. Maybe they didn’t and are merely playing a dangerous game of brazening it out. Who knows what skeletons they are hiding under their “Level 3″ accounting.

Twofish: “There is a difference between asset values and liquidity. In a liquidity crisis, no one is buying or selling at any price.”

Thats an exaggeration. In a liquidity crisis there are FEWER buyers and they demand bigger premiums. Why this is surprising to anyone is not clear to me.

Twofish: “The thing about it is that it’s not clear that the super-SIV is going to work. People are still skittish about SIV’s and these sorts of structures.”

They are skittish with good reason. The SIVs are a scam, a shell game. How does this change anything about the appropriateness of Paulson’s actions?

Twofish: “Also, while people differ on this, I don’t really accept the moral hazard argument. If the moral hazard argument were the case, then people would be betting on the exact same thing over and over, and people don’t.”

Thats a very self-serving argument for Wall St don’t you think? If the casino gives you chips to play on the house will that increase or decrease the size of your bets? Of course moral hazard is a problem. It is just difficult to quantify exactly what it costs.

And apart from the economic costs there is also the basic issue of fairness. Why isn’t the government bailing out *everyone* who has financial difficulties?

Twofish: “For example, in this situation, you *didn’t* have a LTCM-like meltdown. There were only a few hedge funds that failed, and their failure didn’t cause anything like the turmoil that LTCM did. Part of the reason is that people have been spending the last few years monitoring systemic risk in hedge funds and that paid off this time.”

It is too soon to tell. We will see.

They aren’t.

http://www.bls.gov/cex/csxann05.pdf

Again, this is a situation in which you stop looking at the numbers for a while and go talk to people. With enough effort you can make any number say anything you want, so it works to just go out and take a walk to see if the numbers make any sense.

The BLS numbers roughly match my personal experiences. Now it could be that I’m particularly inflation proof, but I just don’t get the sense talking to people that inflation is that big of a concern in the United States.

Everyone always heads to the exits at the same time, but it’s always tough to figure out which exit they will head to. In the case of SIV’s, what happen was that people were dumping asset backed commercial paper to raise cash to handle redemptions. You can imagine things happening slightly differently and having a flight to quality in which people start buying up large amounts of asset backed commercial paper, in which case the risk structure that would save your rear end in one situation would kill it in another.

The solution to this is to not even try to figure out exactly how the system fails, but to make sure that you have enough capital to withstand general failures.

There are tens of thousands of financial instruments being traded. In summer-2006, it would have been very difficult to say “SIV’s will blow up in response to subprime mortgages.” Let me give you a menu of all of the financial instruments now being traded, and I don’t think that you or I will be able to guess which one will be the next one to blow up, especially since the one we pick will have attention focused on it, and not blow up.

50 Cents: Yeah thats what they said when LTCM blew up because of the exact same problem of illiquidity.

LTCM didn’t blow up because of illiquidity. Once it blew-up, then you had a liquidity crisis, but there weren’t any liquidity problems that led to the blowup. The initial blow up was due to over-leveraging and much of the solution was to have the IB’s tighten up their lending to hedge funds.

50 Cent: Wall St will continue to ignore or undervalue liquidity because that will allow them to artificially inflate asset values and earn big bonuses.

Can you explain how this works? Because you can sell short, inflated asset values don’t always lead to big bonuses, and if your book is short, you want asset values to go as low as you can. That’s how Goldman made a bunch of money from sub-prime.

There is a difference between asset values and liquidity. In a liquidity crisis, no one is buying or selling at any price.

50 Cent: His participation as Treasury secretary in creating the SIV is worth billions of dollars in added credibility. Billions that Citi is getting for free. And billions that the taxpayer pays for in terms of increased moral hazard.

The thing about it is that it’s not clear that the super-SIV is going to work. People are still skittish about SIV’s and these sorts of structures. Also, while people differ on this, I don’t really accept the moral hazard argument. If the moral hazard argument were the case, then people would be betting on the exact same thing over and over, and people don’t. The asset that causes problems in the next situation is always different than the one that caused the last situation. It’s always the same…. and always different….

For example, in this situation, you *didn’t* have a LTCM-like meltdown. There were only a few hedge funds that failed, and their failure didn’t cause anything like the turmoil that LTCM did. Part of the reason is that people have been spending the last few years monitoring systemic risk in hedge funds and that paid off this time.

HONG KONG (Reuters) - China has refused permission for a U.S. aircraft carrier and accompanying vessels to visit Hong Kong for a long-planned Thanksgiving holiday visit, the U.S. State Department said on Wednesday.

Thousands of US relatives of the crew had flown to HK for the visit. Too bad for them. LOL.