I hate economic news. Much of it is so dry I want to set a fire to it just to be entertained. Not understanding a lot of it also makes following it a bore.
But neither am a I a complete idiot. I can read and comprehend economic news if the subject is laid out and explained by someone who knows what they’re talking about.
Enter Brad DeLong who I have taken to reading lately given that the end of the world as we know it might be upon us. I used to read Kudlow but the guy was so relentlessly upbeat I got an overdose of sugar and had to swear him off for a while.
DeLong is a happy medium between Paul “The Sky is Falling” Krugman and Larry “Don’t worry be happy” Kudlow. Krugman has been predicting catastrophe for so long they kicked him out of the Cassandra Club for being wrong so often. Kudlow has been seeing the light at the end of the tunnel for so long that he’s been declared legally blind.
And forget trying to make your way through MSM business reporting. Unless you want to feel like your brain has been dropped in a vat of molasses where everything is murky and hard to navigate, stay away. Stay far away.
Which brings us to Mr. DeLong who has a lot of kewl graphs to explain the few real stats that he uses to amplify what he’s talking about. If you are reasonably intelligent and don’t mind re-reading a post a couple of times, I highly recommend his commentary for those of us who have trouble understanding capitalism’s more arcane forms.
We all know about the sub-prime mortgage crisis which is pretty easy to grasp. Greedy lenders gave a lot of money to risky borrowers evidently believing that housing prices would continue to go up 7% a year forever. The debate over bailing out the industry has been interesting. Do we reward companies who took a flyer on bad risk loans? Or do we reward the borrowers who didn’t read the fine print and got themselves in over their heads?
Rewarding stupidity or ignorance is not the way of capitalism. In a perfect capitalistic society, those who make their own bed should lie in it – even if it means a company goes belly up or people have their houses foreclosed on.
But what kind of capitalistic society would allow a multi-gazillion dollar corporation who may have overextended itself because its risk assessors got it wrong, collapse and take the entire financial system with it?
Mr. DeLong explains the dilemma:
Yet we are still in significant trouble. Why? Especially “why” because nothing terribly bad has happened to the real economy: unemployment has not risen much, production and incomes have not fallen, wildfires have not annihilated all the houses of California’s Riverside County driving their inhabitants into Bushvilles in the arroyos of the California desert—normally we would require that something bad have happened to the real economy before the financial side is in such a state.We are in such a state because:
- Quantitatively- and analytically-sophisticated Wall Street teams greatly overestimated their capability to assess and manage risk.
- Institutions greatly overestimated the extent to which the QaASWSTs (risk managers) were assessing risk as opposed to simply writing out-of-the-money puts they could not value and claiming they had lots of alpha.
- Investors greatly overestimated the extent to which institutions understood what their teams were doing.
And now we have something significantly worse than a financial-accelerator-deleveraging creating a credit crunch.
In short, if I may be so bold as to sum up Mr. DeLong’s analysis, the huge investment companies who manage the hundreds of funds that invest in securities were overconfident in their ability to manage everything from the risk of mortgage securities to the effect the bursting of the housing bubble had on the value of their portfolios.
They just got it wrong, that’s all.
So sorry. We’ll try harder next time, we promise. But in the meantime, would you please, Mr. Bernanke, pull our asses out of the fire?
The Federal Reserve took dramatic action on multiple fronts last night to avert a crisis of the global financial system, backing the acquisition of wounded investment firm Bear Stearns and increasing the flow of money to other banks squeezed for credit.After a weekend of marathon negotiations in New York and Washington, the central bank undertook a broad effort to prevent key financial players from going under, including the unprecedented offer of short-term loans to investment banks and an unexpected cut in a special bank interest rate.
As part of the deal, J.P. Morgan Chase, a major Wall Street bank, will buy Bear Stearns for a bargain-basement price, paying $2 a share for an institution that still plays a central role in executing financial transactions. Bear Stearns stock closed at $57 on Thursday and $30 on Friday. J.P. Morgan was unwilling to assume the risk of many of Bear Stearns’s mortgage and other complicated assets, so the Federal Reserve agreed to take on the risk of about $30 billion worth of those investments.
The Fed “is working to promote liquid, well-functioning financial markets, which are essential for economic growth,” Chairman Ben S. Bernanke said in a conference call with reporters last night. Treasury Secretary Henry M. Paulson Jr., who was deeply involved in the talks though not a formal party to them, indicated support for the actions.
We are bailing out lenders who made risky loans. We are bailing out some homeowners who should never have received the kind of loan so dependent on the rising value of their investment and a sellers market. We are bailing out Wall Street giants who failed in correctly assessing the risk in buying certain kinds of securities. And the Fed is pouring cash into the financial system to head off any problems in the near future.
Is this capitalism? Not the sort that conservatives are always talking about.
And DeLong thinks that eventually, we may have to bail out a lot more homeowners at the bottom in order to stabilize things at the top:
If the U.S. government has a vehicle to buy up (at a discount from face value) and then manage home loans that look shaky, and if it can set the price of such loans, it might be able to do so in a way that not only rescues the financial system but makes money for the taxpayer.[snip]
If I were working for the Treasury right now, I would be saying: make this happen on Monday. There isn’t time to set up a new bureaucracy—a HOLC, which is what Alan Blinder wanted to do as of three weeks ago. So use an existing bureaucracy: Fannie Mae. If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?
And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels. It seems to me that people on Wall Street need to be taught that betting that the Fed will not intervene to stabilize or that its interventions to stabilize will be unsuccessful is an unhealthy thing to do.
Basically, DeLong is arguing for Fannie Mae to come in and scoop up a lot of this bad paper and manage it on its own with the risk devolving to the government, rewarding both the little guy and the big guy for risky behavior.
Let’s remember what is at stake in a financial meltdown. We’re talking about hundreds of billions of dollars – real money, not government fantasy money. Those billions come from the money taken out of your paycheck for a 401K or some other retirement vehicle. It’s that $500 you put into a mutual fund every quarter or the dividends you invest in a risky bond fund. It’s the retirement savings of little old ladies and little old men. A meltdown would mean catastrophe for a lot of people.
So, the government must intervene and reward everyone who screwed up by bailing them out of trouble.
Was it trouble that could have been foreseen? I don’t really know enough to say for sure but common sense tells me that if banks and most mortgage companies turn someone down for a home loan and then your company goes ahead and lends the money anyway, it would seem pretty certain that both lender and borrower are aware that this is something more than just an iffy proposition. We don’t want a financial system where there must be a dead certainty that the borrower will not default. But neither do we want a crapshoot like a lot of these mortgages apparently were. Isn’t there a happy medium somewhere?
As for the Wall Street investment companies who bought these mortgage securities one might want to inquire as to how we got into this mess given that risk analysis is a large part of what these people do. DeLong points out that the risk managers got it horribly wrong. What’s to stop these guys from doing something equally stupid in the future?
If we’re going to throw true capitalism out the window – and make no mistake, that is what we’re doing with these bail outs – then the conservative rationale for capitalism goes with it.
Low regulation, open and free markets, individual and corporate responsibility – this is the conservative mantra when defending and promoting capitalism. I subscribe to this view of economics because it works as any resident of a capitalist country could tell you.
But now we are faced with the largest bailout in history and must question those comfortable assumptions. Maybe we need new regulation to prevent this from happening again. Maybe we need better monitoring and thus less “free” markets by the government. And what good is “individual and corporate responsibility” if the economy would be prostrate if we followed that dictum and just allowed economic Darwinism to rule the day and watch as millions lost their savings and millions were thrown out of work?
This entire post is probably making some of you more knowledgeable readers chuckle at my ignorance but how capitalistic a country can we really afford to have? And if the conservative rationale for capitalism is undermined in this fashion, what can replace it?
Perhaps on the micro level, capitalism will survive. But in the great, big, globalized world out there where governments can intervene in markets at the drop of a hat it’s difficult to see how true capitalism can flourish.
4:36 pm
I don’t think true capitalism was even capable of existing after the Federal Reserve Act. Corporate welfare, capitalism’s backup plan!
5:04 pm
> We are bailing out Wall Street giants who failed in correctly assessing the risk in buying certain kinds of securities.
Bailing out? A forced sale at $2 a share for what was over $50 the previous week isn’t my idea of a bail out. That is actually a liquidation of Bear but in a more orderly and controlled way than you would see if it was simply allowed to collapse.
Ask that Brit fellow who lost a billion dollars on his 9+% stake in Bear if he thought he’s just been bailed out.
5:06 pm
If I may summarize your summary of Mr. DeLong, we’re having a crisis of bullshit. A bunch of people convinced us they knew what they were doing, and they didn’t.
I’m self-employed, generally a capitalist, but I’ve never been comfortable with the quasi-religious faith conservatives have in the “magic” of the marketplace. A degree of regulation and oversight is required. Had we had more aggressive, more skeptical oversight, had we had more transparency, we might be in better shape today.
At a point where a Bear Stearns is simply too big for us to allow it to go under, and has to be rescued by government, we taxpayers have earned a say in how it handles its business.
5:43 pm
“Greedy lenders gave a lot of money to risky borrowers evidently believing that housing prices would continue to go up 7% a year forever.”
It’s more accurate to say that “Stupid lenders gave a lot of money to greedy/rookie speculators, evidently believing that housing prices would continue to go up 20-30% a year forever.”
A gain of 6-7% per year is realistic. The fools who wrote loans with valuations based on bubble pricing deserve to be stuck with paper that’s only worth 20 cents on the dollar.
12:39 am
“If I may summarize your summary of Mr. DeLong, we’re having a crisis of bullshit. A bunch of people convinced us they knew what they were doing, and they didn’t.”
And if I may add this: The biggest BS art form is when the Government creates a problem and then blames the ‘market failure’ when market participants, led down the primrose path by a credit bubble created by Fed pumping money in, encouraged by govt rules in the Community Reinvestment Act,
and further encouraged by the repeated ‘moral hazard’ of a govt that steps in and uses taxpayer money to make good on losses.
In other words, by socializing losses in the past, we encourage the creation of more speculative losses in the future. The moral hazard factor adds to the systematic risk of the financial system. so why do we do it? It juices up the credit flows, and can no more resist that than we can resist deficit spending.
“Low regulation, open and free markets, individual and corporate responsibility – this is the conservative mantra when defending and promoting capitalism. I subscribe to this view of economics because it works as any resident of a capitalist country could tell you.
But now we are faced with the largest bailout in history and must question those comfortable assumptions. ”
No we don’t. You see, our actions to do what is needed to save us short-term does not in any way change the justifiable view that free markets can sort these things out over time better. We have to understand that the cold-turkey path of getting away from Govt safety nets and bailouts is better for us long-term, because it would erase the moral hazard and Govt buble-creation factor (without which, the players would have been more responsible), but long-term we are dead and our children will forgive us for another short-term fix that will keep the economy a bit more stable now but set us up for another credit bubble/bust 10 years down the road.
12:42 am
“At a point where a Bear Stearns is simply too big for us to allow it to go under, and has to be rescued by government, we taxpayers have earned a say in how it handles its business.”
Bear Stearns has been ‘rescued’ by getting bought out for 1/40th of shareholder value of last monday. No taxpayer cost involved. And yes, that is far better than if it went out of business. the business can continue even if the shareholders were cleaned out.
A bloodless rearrangement of financial resources.
1:42 am
Greater transparency is the answer, not regulation. Compel all financial institutions to make a full daily disclosure of all debts and assets. Publicly release each disclosure 21 days later, so some level of confidentiality is maintained. Mark assets to market only where markets actually exist. Mark as “unknown value” any assets that have no public market. This system would give analysts the chance to understand a bank’s portfolio on a short term, evolving basis. The current system forces analysts to plow through an avalanche of quarterly data, and then wait three months for another avalanche. The same transparency would work for non-financial companies as well. Have them report daily revenue, expenditure, cash, debt, accounts payable and receivable and 30 days overdue. Again, release all the numbers 21 days later. I can’t help but believe that a daily system like this would have highlighted the disintegration at Enron and WorldCom months before they collapsed.
7:02 am
“It’s more accurate to say that “Stupid lenders gave a lot of money to greedy/rookie speculators, evidently believing that housing prices would continue to go up 20-30% a year forever.â€
Yep.
7:36 am
[...] Rick Moran wonders whether capitalism, and the conservative rationale for it, is dead. My answer: no it’s not. Both aren’t. The bailout about to happen is a major mistake. Once again, the US - like may other modern countries out there – will artificially help the market survive. The truth of the matter is, however, that the market needs to fall. After it, it will pick itself up again. The result: a more healthy market and, thus, a more healthy economy. The only thing for this to happen, though, is for the government not to do anything. If the government acts now, it’ll be forced to act many times in the future again. Share and Enjoy: These icons link to social bookmarking sites where readers can share and discover new web pages. [...]
8:32 am
Unfettered capitalism doesn’t work because it leads to concentration, monopoly. We would all agree that the same is true for government monopoly. We have developed a pretty good balance with our anti-trust free enterprise system. Not pure for the Ayan Rand types, but has shown for the long run stability. As John Nash would say, that way we all get laid.
8:34 am
>>Junk Science Skeptic Said:
5:43 pm
8:38 am
Don’t know why the first comment didn’t make it.
I wanted to add the greedy lenders and greedy brokers and greedy buyers, fed by the help of the US Gov’t and FED policies led to this unsavory situation.
The reckless buyers are now being bailed out at the expense of prudent buyers and they are also bailing out Wall Street.
Hollywood couldn’t write this stuff.
8:51 am
[...] – James Wigderson hates yard signs with a passion. – Why? Uncle Fred found a yard sign without the “paid for by” text. – Weasel Zippers found some sanity in Jolly Old England as female Islamic doctors no longer can use their religion to hide behind their veils – Kevin Fischer points out the inanity of Jim “Craps” Doyle’s (WEAC/Potawatomi-For Sale) position that in order to fix potholes, we have to raid the transportation fund that is designated to, among other things, fix potholes. – Tom McMahon shows off the best Pez dispenser evah (at least if you’re a guy). – Ragnar Danneskjold, R.I.N.O. Hunter, finds out John McCain still doesn’t get it on illegal immigration. – Jim Geraghty catches Hillary Clinton in a fish story. – Mark McNally breaks out in song on the Obama/Wright mess. – Mike points us to a great piece by Shelby Steele on the Obama/Wright mess. – Continuing on the Obama theme, Bruce has a few questions. – Erick at RedState has the phrase of the day – Demasochist Party. – The American Pundit and Gabriel Malor both report on a 85-year-old story of melting Arctic ice. Yep, Gorebal Warming’s been around that long. – Speaking of Gorebal Warming, Dean points out that bacteria pump out more carbon than we do. – Warner Todd Huston at Stop the ACLU has some good news on the “Fairness” Doctrine, at least for the next 10 months. – Alan Steinberg has the headline of the day – “Prices Going Up… Confidence in Government Going Down”. – Silent E is bucking for a fill-in gig for WSJ’s Best of the Web with his exposing of the Dumb Headline of the Day. – See-Dubya has some not-so-breaking news on the lack of conservatives in the LeftStreamMedia. – There’s so many places to choose from for news on freshly-minted New York Governor David Paterson’s admission that he cheated on his wife (and that she cheated on him), but I’ll go with Slublog’s fingering of the water supply in Albany. Also, don’t miss the comments that flashy dug up. – Speaking of New York, JammieWearingFool relays a report that the former governor was headed toward Swimmer territory in the alcohol department. – Skinbad does the math on Elliot Spitzer and Paul McCartney, and finds that it pays to pay by the day. – Rick Esenberg catches up on the flurry of ads in the Supreme Court race. – Rick Moran asks whether capitalism and hence conservatism is dead. – William Teach brings news that the UN doesn’t know what’s in its own “Universal Declaration of Human Rights”. – Jib questions the wisdom of touting plans to be number two when by the time the structure in question is built, it will be no better than number four. – You know sports doping is bad when Janet Evans catches a story on doping in German billiards. – Since the idiots at Fox won’t have a new season of “24″ until next January, the folks at Blogs4Bauer continue their strike replacement episodes with Episode 11. [link] [...]
9:17 am
The real problem is a typically American phenomenon: We took a good idea and drove it into the ground. Making loans to people, packaging them up, and selling them to investors is what has made home ownership possible for more people over the last 30 years or so. The idea is that, if you group a number of loans together with similar characteristics (region, credit profile, interest rate, etc.) you may have some failed loans but the vast majority (more than 95%) will be repaid on time; you can see this pattern over time. While it gets a little worse during times of economic downturns, it is not dramatically different.
So what do we do with such a simple idea? We take those packages, slice and dice them into unrecognizable pieces, and sell them (collecting a fee in the process). No one really understands what they own, or what effect a slowing economy or rising interst rates (which started last summer) will have on asset values. And we’ve seen this movie before—the credit crisis of 1994 came about for almost exactly the same reasons.
We probably could have survived if this was all that was happening (as we did in 1994 without any huge government intervention as I recall). But the really neat part about these sliced and diced packages is that they were given a AAA rating by the rating agencies (side note: why is Congress spending time and effort trying to decide if Roger Clemens took steroids when we should be asking why the rating agencies were asleep at the wheel?) That AAA rating enabled owners to borrow up to 90% of the value of the investments and—guess what?—buy more! The problem comes when, after borrowing that money, if the assets go down in value, the banks require you put up more collateral. Which is what’s been happening since last summer. The Carlyle Group took $1 billion and turned it into $22 billion, which has now all disappeared. Again, we’ve seen this movie before—it ran in the 1998 credit crisis with Long Term Capital Management almost dragging down the financial system.
So the moral of this story is not the investment itself. It probably is not even the financial engineering some bright whiz kid came up with to create some of these toxic investments. The real killer is leverage (borrowing against the asset to buy more of it). Leverage creates outsize returns if it works, but wreaks havoc if it doesn’t. The solution? Restrict the amount of money that can be borrowed against assets. Instead of borrowing 90% against assets like this, restrict it to 50% or 60%. The Fed has the power/authority to do this. It may not help totally avoid the problem, but it should reduce the impact.
That’s the best explanation of how these securities came into being that I’ve read to date. Thanks, brother.
ed.
9:38 am
Rick, I hate to send traffic to Kevin Drum, but he asked a question at 1:03pm on 3/17/08 on his blog, where he confesses his ignorance of the debt and liquidity crisis. Some of his usual knuckleheads respond, but there are some really useful comments by a number of people, including NY Math Teacher.
Check it out
http://www.washingtonmonthly.com/
Excellent. See also my brother’s comment above. He’s in the business of managing funds so he knows of what he speaks.
ed.
12:38 pm
Larry,
What is the reason for the 90% cap? Do you know why it isn’t lower? It seems to promote financial mischief almost by design.
5:27 pm
I think the rationale behind the 90% limit is that, because they are AAA rated and reasonably assured of paying back principal and interest on a timely basis, their value should not fluctuate too widely (think of U.S. government bonds). In “normal” times (whatever that means) this may be true, but as these securities got more complex, small changes in interest rates caused huge negative changes in value (bond values move in the opposite dirction of interest rates—it’s the way the math works out). You can see this reasoning in the fact that with stocks, for example, you can only borrow up to 70-75% of their value (depending on if their are big or small companies). Stocks tend to fluctuate in value more (witness the last couple of months in the stock market) and they hold a subordinate position for claims on a company’s assets if it goes bankrupt (subordinate to bank loans and bond holders); with that kind of risk, lenders are less interested in lending money on those securities.
I agree that the 90% rule tempts people to do things they shouldn’t. Usually, you could think of some economic reason to the rule, but I can’t see why anyone would try to double their investment, half with leverage. But then, I don’t work on Wall Street and have a home in the Hamptons, so what do I know.
10:51 pm
What!? No Wall Street office!? No home in the Hamptons!? Well, there goes all your street cred right out the window.
4:58 am
What about a Nhilistic view? As the world mass media seems to be cheerleading an economic collapse (economic chickens coming home to roost), I for one welcome it. Proportionally, if China is the world’s workshop then the US is the world’s customer.
Let the US ecomony “collapse” such that consumers buckle down, start saving, refuse to buy a new car from Japan every 1.4 years, put off or avoid buying the tons of junk from China year after year after year. Christ, even the statisticaly “poor” American families have more living space, a vehicle (sometimes two), home PC, colour flat screen etc etc. This is the “poor” segment of socienty mind you! That is what keeps Chinese workers employed and by extension, German and Italian workers who supply them with industrial machine parts, etc etc.
I say let the world discover the reality of an evil, unilateral, imperialistic so-called hyperpower who no longer spends beyond it’s means. I will glady accept 9% unemployment in the US if it exposes the leftist EU politicians to the wrath of thier coddled workers who no longer have “asshole” American customers.
In a worldwide economic meltdown, the first and fastest to recover will be the US, followed by similarly structured free-market ecomonies. Followed many many painfull years (yeepee!) later by Europe, China and then decades later by the entire Middle East.
Let’s see how the worldviews of the French shift when there’s no wine for thier children.