What next?

Sorry I've been swamped at work and I've got to go for dinner, but I wanted to get at least a quick response to this comment:

So now what? The administration and Congressional leadership keep threatening that a bailout (take your pick as to which one) is the only option. But so far, two have failed.

What is the *worst* that could happen if no bailout is orchestrated?

September 30, 2008 8:16 AM

As for now what, I think it's safe to say that some kind of plan will get done in the next few days. There are a lot of plans being discussed now - and that's a very good thing, but hopefully the final version will look very different from what we've seen. This one seems to make a lot of sense to me, mostly because I don't think that the Paulson Plan is really targeting the problem. Of course, politics may trump economics and we could see no deal - that just doesn't seem likely based on some accounts of public reaction to the no vote yesterday. (Which is odd since there was overwhelming public opposition to the bailout over the weekend.)

The problem, as they've been telling us for the last 10 days is that we're in a crisis and commercial credit markets are dysfunctional. This will supposedly impact Main Street in a bad way, leading to a very hard recession. There are lot's of options here, but targeting the short term credit markets seems to make the most sense.

As to the worst that can happen, there is too much uncertainty to really know. I firmly believe that this whole thing has been overblown for political reasons. Yes, there is a problem. The solution should not entail simply "trusting" Hank Paulson.

If nothing happens at all, then there will be some chaos in the financial markets. This will spillover to some extent into everyone else's lives. But if that were to happen (if a really bad recession ensues), there will be incredible popular support for government to step up in the form of tax cuts, increased spending, etc. In my mind this is preferable; I'll try to address this in a later post.

UPDATE: This post was supposed to go up about 8 hours ago...

Big victory for democracy!

Some plan will likely go through, but the rendition defeated today was really not much better than the original proposed last weekend. Yes, there were some minor improvements, but the single biggest was the oversight (from Mish):

Fox Oversees Henhouse

The bill sets up an oversight board, which is directed to “ensure that the policies implemented” by Mr. Paulson are proper. Mr. Paulson is to be one of the five members of the board watching over his own actions. He is joined by the chairman of the Federal Reserve, the chairman of the Securities and Exchange Commission, the Housing Secretary and the director of the Federal Home Finance Agency.

The oversight board would have consisted solely of executive branch personnel, with the exception of the "independent" Ben Bernanke. This is really unbelievable, I'm just glad that so many Republicans got caught playing politics that the bill was defeated. Voter angst was the key here.

Anyway, I'll try to post more on this tonight, but for now let's just say that this is far from over.

MBSs, CDOs, CDO-squared, CDSs, oh my!

Okay, the title is either gibberish to you or it's just not really funny...

Sorry, but I'm not erasing it.

MBSs. This is where the problems begin. They are Mortgage Backed Securities. Think of yourself as a small bank. You've taken a bunch of deposits from people in your town or city and you lend those deposits out to a bunch of other people in your town or city. Let's just say you are a Savings & Loan (S&L). As an S&L you are limited to making mortgage loans and taking deposits. So you make your loans and those loans become the bulk of your assets.

[When a bank lends money, the loan is an asset. The borrower promises to make steady payments on their mortgage, so the bank (or S&L) sees this steady, predictable (mostly, except for defaults) stream of income coming in from all the mortgages they have made.]

Here's the basic model of banking:

So let's say you are an S&L in a small town and you have $1,000,000 in deposits. Banks (and S&Ls) have reserve requirements, so let's assume that you are required to hold 10% reserves or $100,000. If this is news to you, then think about it for a minute. The banks don't ever have all of their depositors asking for the full value of their accounts to be transferred, in fact they rarely see depositors withdraw more than the $100,000 in any given day. So this fractional-reserve system allows for the bank to make loans on 90% of their deposits, or $900,000 worth. So you make 9 mortgages for $100,000 each, taking full advantage of banking regulations because you make money on the mortgages (origination fees, plus mortgage interest to keep this simple).

Okay so at this point you have $100,000 in the bank vault, $1,000,000 in deposits (where you are paying a low rate of interest, say 3%), and a portfolio of mortgages worth $900,000 (where you are collecting a relatively high rate of interest of 7%, on average). You earn profits on fees and the difference between the interest rate you pay, 3%, and the interest rate you earn, 7%.

Again, this is how banking used to function.

Now we introduce MBSs. Instead of just sitting on those deposits and loans, you decide to sell the portfolio of loans to another bank. The other bank has investors that see the steady income coming from the portfolio, so to them it is just like a bond (a financial instrument that pays a steady amount over a specified period of time.) If your portfolio consists of all 30 year mortgages with everyone that you've lent to representing the lowest risk of default (all the people that borrowed from you have credit scores of 750 and no prior credit problems), then the investors expect a lower return, but very limited risk of losing money.

On the other hand, if your portfolio consists entirely of sub-prime borrowers, then the risk that some of the people will not make their mortgage payments for the entire 30 years is greater and the investors would expect a higher return.

So you, the S&L, decide to bundle these mortgages and sell them off. Now you put the money you got from the other bank into your assets and the loans go away. You suddenly have the incentive to make a lot more loans, since your assets are all cash and you can make more money by lending out that cash. So you make more loans, package them as a bundle and sell them and continue on this path.

But why would you want to keep doing this, are you making any more money by selling the mortgages off? Yes, you earn fees on all of these transactions, but the reason you sell all your loans is to offload the risk of default. With the loans on your balance sheet, you lose when borrowers lose their job and can't pay their mortgages. Once you sell them, it's the investers that have to deal with that problem. Of course that's not really a problem when housing prices only go up. If any borrowers can't make their mortgage payments, they can just sell (for a profit) and exit the market.

However, when prices are declining this becomes a big problem.

To summarize, mortgage-backed securities (MBSs) are pools of mortgages with varying levels of risk (likelihood of "performing" - will borrowers be able to pay their mortgages or not?) that trade like bonds. This is key because of the role that the credit rating agencies had in this mess.

Please ask questions if this doesn't make sense. Tomorrow I'll move on to the ratings agencies, and then we'll discuss the more complex CDSs and other securities that are at the core of this crisis.

UPDATE: More here if you would like a slightly different perspective (with visuals).

This plan still won't work

I will admit that this is much better than what was initially proposed. This leads me to think that the first plan was floated to take your eyes off the ball.

The first plan was such an abuse of the Constitution that you had to get upset, but admit it... You kind of feel okay about the current plan.

1. You've got upside potential in the form of warrants (meaning that if the banks that are bailed out do well, taxpayers share in the good fortune).
2. There's oversight now.
3. Executive compensation is supposedly limited, the devil is in the details (in general, but more so on this point).
4. The initial outlay is $250 billion instead of just authorizing $700 billion (say the word billion and try to imagine how much money that really is).

Problem is, the plan still won't solve the underlying problem. This whole thing was a smokescreen. Pay no attention to that bailout over there, we're here to help.

I've mentioned already that I think this type of plan will give off the appearance of "working", but it's just a matter of time before everyone realizes that this was just one more transfer of wealth from the middle class to the wealthy. There's still plenty of money to be made on Wall Street, and even if this plan is constructed in such an iron-clad way that there's no obvious transfer of wealth, there will be too much reliance on the finance industry. America's brightest minds (our biggest resource) are wasting their time trying to configure the latest financial innovation, rather than advancing science or technology. Balance needs to be restored and this can only prolong the return to balance, costing our country plenty in the long run.

Ultimately the de-leveraging will take place. Home prices will continue to fall and the value of mortgage-backed securities will fall right along with them (not to mention the CDO-squared and CDS's). Only two things can happen, wages increase to catch up with home prices (in other words, lot's of inflation), or home prices fall back to historic norms. I'm leaning towards the latter.

On top of the likely continuation of de-leveraging (deflation), we'll see Wall St. put all of their new-found liquidity (cash and borrowing ability from the Fed), plus all that they've put aside as this crisis has unfolded, into the next bubble. That could be gold and other precious metals, but may include materials, energy and other commodities, amongst other things.

So that means that most people will likely see a reasonable increase in the value of their 401k and/or IRA, but more and more people will struggle to find solid employment and we'll see some "inflation" in the form of increases in gas and food prices that we've kind of gotten used to over the past few years. This is not stagflation. It is not a depression either. I'm sure someone will coin a better term for it, but let's call it Debtflation. People will be up to their ears in debt from the credit-induced spending binge that America has been on for the past 25 years, and they won't be able to afford a lot of things that they had grown accustomed to over that same time period.

[This is as good a time as any to say that people who overextended themselves with credit were just acting in their best interest, at least to some extent. Interest rates (real and nominal - that is, adjusted for inflation) had steadily come down to approximately zero (negative real, very low nominal) over this time period, providing very little incentive to save and loads of incentive to borrow.]

The amount of de-leveraging that needs to occur is staggering. De-leveraging just means debt/credit write-offs. Think of bankruptcy. The courts will write-off your bad debts - what happens to them from the perspective of the banks that you owe? They disappear. Your debts used to be an asset to them, but since you are bankrupt the value of their assets falls by the amount they write off.

I'm going to start another post right now to try to explain what kind of assets we have been talking about throughout this crisis.

Btw, I changed the settings so that you can now leave anonymous comments. I don't really even have time for the blog, let alone policing comments, but I'll give this a go since I haven't had comments since my first post. Please use comments to ask me questions - that is the original intent of the blog. Without questions I've just stood at the podium and streamed consciousness for the past week.

Crisis, that depends on what your definition of crisis is...

One of the biggest reasons that I am opposed to this bailout is that is becoming more and more obvious that this is way more about politics than finance or economics.

Last weekend we would have thought that we'd have armageddon on our hands by now if the initial Paulson Plan was not pushed "cleanly" through the legislature. Now that the public, the academic community, independent media and our political leaders have had some time to consider how to best deal with the crisis, and the world as we know it did not end, it is obvious that this "crisis" was engineered to at least some extent.

I'm not saying there are no problems, the problems are enormous and the consequences of ignoring the problems will be severe. However, there are many alternative plans making the rounds on the internets these days and virtually all of them are better than the initial plan floated one week ago today. Given another week or so of vetting these alternatives will lead to a better chance of properly dealing with Wall Street's crisis. Paulson and Bernanke were working on this plan for months before unveiling it last week, all the while telling America that things were not that bad (certainly nothing as bad as the Great Depression), the housing market is bottoming, and the U.S. Banking system is sound. Now we're supposed to drop everything and just watch as they engineer a massive transfer of wealth from the public to the very same people that got us here! (All while "earning" billions of dollars over the past several years.)

Oh yeah, banks that have largely stuck to banking, that is did not participate in the proliferation of Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs) - I'll try to explain these later, but suffice to say that they are a crucial part of the crisis - are doing OK. That is one reason why I like this plan.

On a completely different note, I have no idea how much of my intended audience is actually reading this blog. The idea was to sort of field questions and try to explain things as they came up. Since I'm functioning on limited sleep these days, my posts may ramble. Worse, I think, is that I have no idea if what I'm saying makes sense to anyone. When teaching in a classroom, it's pretty easy to tell if I need to back up and rephrase something. Please ask for clarification in the comments if something doesn't make sense, you think I may be wrong about something, or you just have a question that I'm not addressing.

I could also use feedback on the style of the blog. I could post quotes from all of these links along with my commentary, but that would add a lot of words to the posts. Anyway, I'm pretty much operating without a rudder here so please speak up if you've got an opinion on any of this.

Tide may be turning...

I have to say that this honestly just feels like more political posturing than anything (in other words the deal will go through in the next few days), but there seems to be a bit more than a little opposition by the House Republicans: http://www.cnbc.com/id/26885273.

Call me a cynic.

Anyway, here's a link to a letter that I asked to be a signatory to: Economists letter to Congress.

The outrage is being felt by our Congressmen/women. Frankly I do think something will get done, and soon, but there should at least be some significant changes to the legislation from it's initial form.

I want to clarify my last couple of posts, but I don't have time or energy at the moment. Let me just say that I fear that the bailout plan will fail no matter what provisions are added, though it may seem to be a success (maybe even a great success) over some short time frame (6 months - several years). I'll try to address this and a few other things this weekend.

Keep firing away at your Congressmen and Congresswomen

http://tw.youtube.com/watch?v=mbD62gNi9WE

Great rant by Rep. Kaptur D-Ohio regarding the bailout. If you get bored with it, go to the last minute anyway. At the risk of seeming callous, I'm starting to strongly lean against the bailout in any form. The underlying problem is ignored in any "solution" I've seen floated.

ht: Mish

Paulson's Plan - Good or Bad?

It is impossible to answer this question, but I'll give it a go...

First, the plan is still being crafted so there really is no way to see how it could work, but I've worked through the logic with a colleague and this is what we've come up with. (This is all largely dependent on trust in Paulson and Bernanke, something that should not be given lightly, if at all - particularly Paulson).

1. They are not going to literally buy all the bad assets of banks if the plan works.

• $700 billion is only 5% of outstanding mortgages. There are far more than that in bad assets - bad assets refers to mortgages that won't be paid (people walk away or go bankrupt). Way too many people bought way too much house in the last 6-7 years (or took out HELOCs or other second mortgages) to think that the default rate will slow down any time soon.
• They are just trying to discover the "true" market price of the assets that banks are holding. This can be pretty complex, but banks are holding mortgages, mortgage-backed securities (MBS's), and credit default swaps (CDS's) - all difficult to value. Most banks think their assets are worth more than they could sell them for, so they won't sell. The key is figuring out the true value of the assets (are they all worthless, probably not even close - but what are they worth? Because no-one knows, nobody is willing to bid on the assets). If the Treasury starts buying these assets, then others may also start buying them. Think of it this way, if the Treasury (somehow, there are ways but this is where it's a secret until after they get the money) figures out the "true" price of these assets, then private equity (very wealthy investors) will have some incentive to get into the market and buy some of these assets near that price, because they will be priced "cheaply". This will be a good thing for the market, the economy (sort of), and taxpayers since they will not be buying tons of toxic assets.

2. So Treasury works out a plan to price these bad assets, by buying some of them and establishing a price. Others enter the market (there are billions of dollars potentially getting in the market) and buy more of the bad assets (this is why Paulson and Bernanke insist on so much money, they need lot's of participation in the market and they want to encourage this by showing the big wad of cash). All of this helps banks clear up their balance sheets and gets the banking system functioning again.

Okay, so what happens next? Probably inflation and lot's of it, though maybe not. There'll be another asset bubble, everything will seem fine - or even great, and eventually (6 months - 6 years later) that'll burst and we'll go through the Depression that we are now trying to avert.

Another potential short term outcome is that the plan will seem to work until everyone realizes that housing prices are still slipping. This would mean two very bad things are occurring: the value of all those assets that Treasury bought would be plummeting and there would be another round of bailouts necessary. This would be deflationary and lead to a recession/depression.

I don't think the plan will work, though it could sort of help for the short run. At best this is kicking the can down the road. Unfortunately, all of these problems won't go away until housing prices bottom out (in line with some historic valuation measure, like a ratio of cost of home ownership to cost of renting or the ratio of median home price to median income) Any solution that involves preventing housing prices from falling further will only prolong the inevitable.

It's a difficult prescription, but the economy needs to transition to a less credit driven economy with a drop in consumption spending and an increase in savings/investment - that is investment in real productivity, maybe investment in infrastructure. Our great success over the past couple of decades has been an illusion: credit-driven growth in our financial services industry along with earlier growth in the tech bubble in the 1990s - also due to increasingly available, cheap credit.

So this means a fall in GDP (or at a minimum, a slowdown in the growth rate of output, GDP). That is a recession, and that in turn means unemployment.

What can be done to improve the situation? I'll try to cover that next time, but it involves massive government spending.

Please email if you want me to clarify any of this, I'm happy to do it if I can.

Two views on the current crisis

It's only my second post and I'm already deviating from my intended (albeit loosely defined) script.

First up is a Libertarian investment advisor/blogger named Mish. Mish has some pretty radical views on solutions to this crisis, but he's right about a lot of the causes and is very much on top of the ways you can help (emailing, faxing, calling Senators and Congressmen). You can associate his views of the current crisis as most resembling the Great Depression (a massive, deflationary episode - I'll address this in future posts).

Since this is so early in my posting, I want to state very clearly that I disagree with a lot of what Mish has to say, but cannot deny the strength of his insight over the past few years.

Second is the gang at itulip. They're somewhere near Boston, so you may know people that know them, but anyway they essentially called the peak in the tech bubble back in 1999/2000 and made similar precient calls for housing in 2005/2006. You may not be aware of the tulip bubble in the 17th century, but that is where the name for their site comes from.

These guys have put forth a theory that we will go through deflation, then massive inflation. Again, I'll cover the details in a later post, but essentially this would be more like the 70's than the Great Depression.

I promise that I'll get back to my intended plan of bringing this all down to a level that most people can understand, but for now I just wanted to get Mish's link up so that you can contact the right people with opposition to the bailout. I added itulip to provide an opposing viewpoint.

This is pretty much my plan as far as it goes. I'll post a topic with an attempt at simplifying terms and try to support my arguments with links and counter-arguments when appropriate (mostly when I cannot predict the future and consider both [or several] opposing arguments to have merit). I'll also try to post links more directly relating to my post, rather than just sending you to another website to search for information.

Comments are more than welcome.

Title of the blog - can't believe it's still available

From an article at the WSJ,

At its core, the Minsky view was straightforward: When times are good investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.

We are certainly at a "Minsky moment", though the outcome is by no means certain. The point of this blog is to try to bring a lot of the current events down to a reasonably comprehensible level.

I received a lot of feedback from my email to friends and family this past weekend and felt that this was the best way to continue the conversation. I do not have the time to blog as well as the best (I find that blogs that don’t post often are inferior, maybe you don’t…), but will try to post at least once weekly (more like posting a weekly newsletter of sorts) unless circumstances dictate otherwise.

I also don’t really have a plan here other than to cover the basics of the unfolding crisis as best I can, answering questions as best I can from you. This blog is really directed to the friends and family that know me, but feel free to send traffic.