Cobb

The Current of Wisdom

I'm truly enjoying riffing as I will from here on out, on Steven Berlin Johnson. He understands why. On page 47 he introduces one of those charts I think everybody needs to know like Maslow's Pyramid. He calls it The Long Zoom of Culture. It looks like this.

You might remember, if you were a geek like me, the old saying about how stupid people talk about themselves, ordinary people talk about other people and intelligent people talk about ideas. A presumably intelligent person would share this idea with you. I've heard it several times and find it impossible to resist the temptation to talk about myself hearing the idea several times. Paradoxical, that.

Nevertheless it's a good start. The question becomes, what ideas are worth talking about when you finally sit down with your brainy mates and not talk about yourselves and other people? Well, I like this long zoom because as you may know I got into the Long Now a year or so ago transitioning off politics at Cobb.

At that same time, I started reading Iain M. Banks' Culture novels and began looking at the sorts of social contexts from which scientific discovery might take its clues. Banks happens to be all the way out there at energy flows. Specifically, what happens to society if, relatively speaking, infinite energy and mindpower is at human disposal?  I concluded that it becomes pleasure-seeking, which is to say fairly unhinged from the disciplines we have generated throughout history on Earth. 

This also dovetails to the question I had not long ago about the cultural predisposition of what is considered a good solution to any social or personal problem. In that post, The Dirty Clothes Cycle, I asked what to do when my clothes, for lack of space, lie putrefying in the washing machine for hours:

Which solution to this problem I select depends upon my cultural favoritism. I might admire chemists and demand the detergent. Or I might admire carpenters and expand my closet. Or I might admire self-improvement and increase the throughput. Or I might admire child labor and make my kids do it. Or I might admire a revolutionary pose and rant against all parts of the the clothing cycle at once. ... Or I might dig on Christian charity and give more to the Salvation Army.

All of that supports my theory, inspired by Charlie Levy, inventor of the Xerox Documentor, that brains are a cheap commodity. But complicating that is the premise of Outliers. There is a deep sociological component to the successful individual. The right place, the right time, the right combination of luck and persistence; all the genius is not all you. People forget that their stomach doesn't work without microbes; our minds don't work in a vacuum either.

So just in case you're a researcher wondering if I understand, let me repeat the Sun God Theory. God is in the middle of the Sun and He communicates to other stars via electromagnetic propagations beyond our spectrum - nevertheless these forces act on our minds, they are part of a substrate of information that travels faster than light. Synchronicity (plate of shrimp) is remote entanglement. 

Brains being a cheap commodity are therefore to be herded like cattle and directed from grazing to grazing. We just haven't mastered the greater methods, and all that paradigm is shifting in our information revolution. A nice Lorite Interrogator would be useful now that I think of it, because it enables conservatism without the benefit of an actual social network of people. Everybody needs a Club of Honest Whigs, but only a few of us can afford the time. I certainly can't but it's been what I've been wishing for forever. 

I'm going to have to just leave this as a riff. It's too loaded to complete, and I haven't finished the book. My point is that I recognize the substrate of progress. I am only too aware of those forces that disrupt the links in the chain from the energy flows to the microbiologicals.

Feudalism in a Global Economy

This morning for the first time in a while, I rejoined my tradition of listening to the Bloomberg on the Economy series with Tom Keene. I've been putting in some head reorientation so that I can work on my new project and get in the proper groove for that, and it's put a few things aside. But here's the thing.

This morning the news was that both the UK and American journalists tend to make the mistake of thinking that their local economic screwups are the problem, when in fact the problem is truly global. There is no way of decoupling, in economic terms, and all the economists who thought so were chastened. But the problem is indeed global and China's current account deficit and buying of of US Treasuries is not an exacerbation the the crisis, it is part and parcel of the crisis.

So things may be going back to a refomation of the ideas before Bretton Woods II and an overturning of the kind of macroeconomic theories that helped us get to the place we are today. Which is to say, one of the operating theories of the 20th C was that the market is always at equilibrium - that everything operates at as efficient a clip as possible. People maximizing their enlightened self-interest and all that, may turn out to be rot. Now some people will think that takes us back from Friedman to somebody closer to Marx, but that's wrong too. So if capitalism is the worst, except for everything else, what happens when we have to rethink capitalism - on a global scale?

My inclination is to think of regimes of truth. I know this sounds Foucaultian and I'm not trying to entertain any relativism, but it does make sense that the Anglo American form of capitalism is different from the emerging Chinese form which is different from that driven by the values of India. Even though we are on a global capitalist planet, local economies count very much the way languages count, or so it seems to me. You cannot decouple education in India from education in America because labor will compete in global markets, but you also cannot simply teach what counts for education in America over in India, all colonial irony aside.

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Now on the other side of this coin, which is on the question of liberty, I got the following aphorism stuck in my head. The only freedom you deserve is the freedom you pay for.

I think about that when I think about who cares about Chinese human rights and civil rights in a global economy. On the one hand, there is a certain amount of literacy necessary and there is a lot of basic skills necessary to reach a certain baseline of social freedom. Call it basic self-sufficiency in a modern society. But as you ascend a financial ladder, more freedoms are available to you, whether or not you attain those finances through meritocratic means. Nobody stops Biggie Smalls from sipping champagne and nobody really stops to recognize the soveriengty of the homeless man. There's a continuum here. 

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According to the Bloomberg reports, construction, automobiles and financial services industries are all going to be crawling on their knees through some downsizing for a good while. It doesn't matter how enlightened your self-interest is. If you're working in the economy of automobiles, you've got limits. It doesn't matter how much you are brilliant in designing automobiles - the meritocratic rug has been pulled from under your feet. Nobody's going to be designing a lot of new autos for a long time, and you can't just jump out and start designing computer systems. You are stuck in a feudal domain.

Now I'm probably saying something in too many words that are obvious to people who study economics and political economy. Sorry, but I didn't. But as I try to make sense of things, these connections are pretty interesting to me.  What I think I've explained is how you can have a theory of market equilibrium that fails to account for inefficiencies that are baked into such feudal arrangements. There's nothing you can do to make the market for X serve in the same way as the market for Y even though they are connected and linked in a global economy. One king doesn't trade his knights to another. When the shogun gets defeated, ronin are on a rampage.

Or take my intellectual hero David P. Goldman. He has no reason to work for a hedge fund. Hedge funds are over, and now he's editing First Things. No money in that. No conversion of the acquired intellectual capital to work in the economy. He's working for a different king, one that doesn't pay anywhere near as much as his old king. And yet is he fulfilling some enlightened self-interest? I think so.

So there's a cultural component, as real as language, I think. That breaks us down into isolated regimes and the economic flows don't flow as smoothly as we would think, and yet we are all connected through a combination of dependencies that is dynamic and permanent. 

Injustice anywhere is a threat to justice everywhere, but...

(im)Proximate Causes

I recently re-listened to the SALT lecture that turned me on to Niall Ferguson, and I've been thinking about what he said about the biases of historians. He suggested that more historians ought to try to understand the lessons of chaos theory. This would enable them to check their bias against tipping points. The bias of historians is that they prefer large events to have large causes. It might not be true that the flap of a butterfly wing on one side of the planet causes Katrina on the other, but such things are possible.

Ferguson:

Chaos theory was something that inspired me when I was writing a book called Virtual History, because I was acutely aware of the sensitivity of political and social systems to initial conditions and the proverbial butterfly flapping its wings can cause the hurricane at the other end of the earth. It's important that historians understand this because historians have their own heuristic biases. Please let me make that clear, one of our heuristic biases is that we really do want great events to have great causes. We hate the idea that a war as big as the First World War could have origins that date back no further than July or June of 1914. We want big origins for big wars. We want the origins to be in at least the 1890s maybe even the 1870s and I have read books that date the origins of the First World War back to 1815 which is a hundred years before it broke out. Now that seems to me to be based on a fundamental misunderstanding of the historical process, that a small misjudgment, and I think there was a small misjudgment on the part of political actors in European capitals in 1914, sufficed to cause four and a quarter years of carnage.

So it was with that in mind that I have studiously avoided the headache of an over-skeptical read of Paul Krugman's pinning 'it' on Reagan, whatever 'it' may be. With this bias I have just stated in mind I will now read it and point out something.

OK. Here's Krugman:

Together with looser lending standards for other kinds of consumer credit, this led to a radical change in American behavior.

We weren’t always a nation of big debts and low savings: in the 1970s Americans saved almost 10 percent of their income, slightly more than in the 1960s. It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life, culminating in the near-zero savings rate that prevailed on the eve of the great crisis. Household debt was only 60 percent of income when Reagan took office, about the same as it was during the Kennedy administration. By 2007 it was up to 119 percent.

All this, we were assured, was a good thing: sure, Americans were piling up debt, and they weren’t putting aside any of their income, but their finances looked fine once you took into account the rising values of their houses and their stock portfolios. Oops.

Now, the proximate causes of today’s economic crisis lie in events that took place long after Reagan left office — in the global savings glut created by surpluses in China and elsewhere, and in the giant housing bubble that savings glut helped inflate.

All this mashes a lot of history into a few short paragraphs. Then again Krugman's NYT column inch real-estate is precious. But I specifically remember Reagan creating 401(k)s, Keoughs and IRAs specifically to address the lack of American household savings. He did so with the specific incentive of making interest earned on them tax free. Don't you remember that?

Somewhere in my pile of writing there is some observation of mine that reckons with the increasing exposure of Americans to credit cards and the stock market. Having been an actual bank teller in a downtown building with 30 foot ceilings, I specifically remember in 1981 that not a lot of ordinary people had credit cards. But they were made available.

I was a college student during most of the Reagan era, and I don't remember any of his speeches being oriented to goad me into being a highly leveraged consumer. At the time, the acknowledged geniuses of the era were Peter Drucker, the originator of the MBA and the authors of Megatrends and In Search of Excellence. I remember those guys, do you? The goat, the financial shitheel of the era was one Danny Wall, the redheaded stepchild who was supposed to be responsible for watching over the Savings & Loan industry. But my memory may be as faulty as Krugman's. The economic 80s, to me, were all about us recognizing with some finality that the Japanese could end up owning America so how were we going to fight back? If some people interpreted that as a Reaganomic exhortation for consumers to get over their heads in debt... well I don't recall it. I do seem to recall that his critics blamed Reagan for spending too much of America's money on Contras and weapons systems and stupid little wars in the Caribbean and in Central America.

Is it possible that all of the critics of Reaganomics were focused on the wrong specifics while Reagan was in office and that only now has Krugman got it right?

Insurance & Capitalism

As a kid, I hated insurance. I think there is something vital and visceral in young people, especially young men who ride motorcycles, that feels instinctively hostile to people who live in relative comfort emboldened by their ability to price risky behavior in people.

If I could reduce insurance to a very brief definition, it is just that - the business of putting a dollar value on life, and thus on the risks that human beings take.

My man David Goldman is talking about the soundness of the insurance business in this economic crisis. If there is a single industry that's even bigger than banking and more central to the functioning of our capitalist economy it is insurance. That's not only for the job that insurance does in making jagged edges smooth for investments, but for the fact that insurance companies hold a great deal of banking assets.

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I've lost the thread of this thought which was going somewhere else interesting other than the simple provocation of why socialists and the left love insurance but they refuse to accept its capitalist elements.

You see a friend of mine died in a motorcycle crash this week. I don't know for certain if he was insured, but I think it's a safe bet. What's a safe bet? That's the whole point. Managing risk, putting a number on it, putting a dollar value on it. I'm emotional about it now but the bottom line will still be the bottom line - how does the widow survive? It's always a question of prudent investment.

Chinese Citibank

David Goldman thinks like a mensh. Man I really love the way his mind works and he's got the stuff down cold. Here he pitches a scenario. 

First, Citigroup’s structured portfolio of “toxic” assets is extremely cheap and manageable now that it doesn’t have to be marked to market. You own a bunch of this garbage anyway, and fund managers turn up on your doorstep daily to pitch distressed investing. You can do a whole lot better buying a distressed bank and leveraging a distressed asset play. Secondly, you can sell off most of Citi’s operations for a modest profit. America doesn’t need another branch bank after Wells Fargo/Wachovia, Chase/Washington Mutual, and Bank of America. Citi should get out of its consumer businesses and devolve into an international wholesale bank. Its main profits should be the runoff on its portfolio, which out to be worth a lot more than $3 a share. Third, by owning a major bank you get a seat at the table of corporate America. You get a peak inside the kimono at every American corporation and the inside track on future mergers and acquisitions. The business intelligence value of owning the franchise has to be worth a few billion dollars. That’s not counting Citi’s international branch network, which would give you the inside track on a dozen countries you don’t know much about. Presuming that the Obama administration throws its political shield over the deal and hails it as a great win for the American taxpayer (presuming you pay a bit more than $3.25 a share so that the Treasury can book a profit on its own 36% of Citigroup), it could be a very wise move. I wouldn’t underestimate the governance problems of running a monster like Citi — your managers will experience great frustration dealing — but at roughly $20 billion, you can afford the experience. After all, you have to learn to run great international finance franchises some time. Why not now?

Of course Citi is too big to fail, for the obvious reason that it is too valuable to merely disappear. Once upon a time I figured Warren Buffet would buy it. Maybe Shell should, or maybe Shell doesn't need it at all. In any case, we will be learning who are really the last big capitalists standing. 

Reinflating the Housing Bubble

Some time ago, I expressed sympathy for a particular plan by Zingales to manage the problem with the housing market, which was one of the major causes for the current economic crisis. Everybody seems to want to talk about fatcat culpability these days, be they AIG execs, the Obama team or the Congressional firm of Frank, Dodd, Pelosi and Horsebottom. (Horsebottom being the senior partner). Of course there are also those with some historical facility and they remind us that it was Greenspan and monetary policy in general which is to blame. But let's go back to Zingales shall we?

Zingales' idea is this. You look for all of the mortgage holders by zipcode whose housing price has declined 20% or greater. Instead of them defaulting, they work out an agreement with the originator that reprices the mortgage with the provision that 50% of the profit from the sale of the house goes to the originator. Simple.

It allows the mortgage to be recalculated therefore lowering monthly payments, keeps the individual in their house, keeps people with a lot of equity from taking advantage, and doesn't involve any taxpayer money. Of course there will be no politicians to champion it because there's no end in it for them. It doesn't allow them to take any credit, spend any government money, raise or lower taxes.

Let's keep in mind that there are terms of art that people in the business are throwing around relatively quickly that we in the public aren't quite clear about. But what makes the assets toxic? It's the probability that they are mortgage backed securities and that those mortgages might default. The chances of that are somewhat unpredictable, but it's clear that the people who hold those mortgages who are underwater are more likely to default. If we look at that 20% group and work out deals then we know they are less likely to default but it also means a writedown of the value of the assets and the amount of coverage on the mortgage backed securities. But it's certainly a lot more concrete than what we have now.

So the question is without a Zingales plan in place, what is the Administration doing to keep people in their homes? I'm not sure what the answer is, but what I'd like to do is warn against any action that results in re-inflating the house prices. In simple terms, we can raise housing prices through some mechanism or we can lower them through some mechanism similar to Zingales. The latter is more prudent even though the former might be more politically popular.

This is the downside of monetary policy which the Administration hopes will get banks to loan. Loan what? Mortgages of course. The magic number being passed around is 4.25% which is something of a blockbuster historical low for 30 fixed conforming mortgage rates. There could be a huge refinance market, and this works miracles for affordability. But then what do we do with that but hope it invites a new class of Americans to the trought of cheap credit for home ownership and that clears homes off the market and starts the ecnomy going again. How? By raising home prices again. Reinflating the bubble.

The hard fact must be, I think, that without Zingales, all that happens is that people with some extra money (remember it's damned hard to get credit these days) can snap up homes from foreclosures. That may be all that's going to happen and everybody who lost equity just lost it for good. To get back to where we were before the crash is to re-enter the bubble. It sounds good for people eager for recovery, but that froth was the original problem.

What's a reasonable outcome for the housing market and mortgage rates? I don't know. I just want to sound that cautionary note, because it makes perfect sense to me. I hope the rates will stay low and that credit eases for the consumer.

I hope that for my own sake, all of the speculation in California ceases and the rise in home prices stabilizes to something like the other states. I hope that renegotiated debt for equity swaps puts healthy assets onto bank balance sheets and that helps keep home prices low, and I hope people who were burned playing with the equity in their homes can stay put and sell their jet-skis, chastened but not broken.

Economic Concsiousness Explained

For the past several months I have been making efforts to sharpen my economic reading. I feel pretty good about the effort. So I summarize.

Blogs
The first stop on the road to enlightenment is the blogosphere. So I've added and subtracted and aded blogs to my RSS aggregator, Google Reader. The survivors are as follows:

• Cafe Hayek
• Econbrowser
• Inner Workings
• Becker Posner
• RGE Global Monitor
• Marginal Revolution

Honorable mention goes to Brad De Long and Dan Dresner, who I used to read all the time but don't any longer.

I had a subscription to The Economist but I let it lapse. I found that it wouldn't say what the blogs were saying in the sort of analytical language I was looking for. Plus their classified ads are very depressing for people like me with no MBA.

Heads
I've got access to a blizzard stream of economic news by listening to Bloomberg podcasts. Every day I listen to at least three podcasts. Some days three hours of commuting and lunch would be filled with economic news and reviews. Through the efforts of two of the three finest journalists working today**, Ken Prewitt and Tom Keene really know their subjects and their topics.  When it comes to getting up close to people who know, Blomberg Surveillance is unmatched. There is a raft of folks with exemplary insights into the financial industry and they include:

• Robert Shiller
• Barry Eichengreen
• David Greenlaw
• Steve Hanke
• John Casesa
• Charles Colomiris
• Arthur Levitt
• David Goldman
• Richard Clarida
• Maryann Keller
• Mohammed El-Erian
• Tyler Cowen

Firms
I have only come to really think about two companies in all of this. Well maybe three. The first is Sanford Bernstein. If I had moola, I'd have them watch my moola. The second is Pimco. They know bonds, period. I am really fascinated by the bond industry and hope that as I get through Knuth I can build my own models and come to understand it a bit. The maybe third firm is Hambrecht & Quist, because they are a small venture capital firm and was always a sound player in my industry. Now that mega venture capital firms are shutting down, the cycle comes back to places like H&Q. I like that.

Ideas
There aren't major theories that I have learned so much over these past few months. I haven't approached it like that - so much as to become more familiar with the territory. I think I am coming to understand more about how folks make their money in the finance industry and even what I am not doing in my own corner of my industry that the big boys are actually doing. I'm a bit astonished to discover how little what my class of customers have been doing with regard to what can actually be done.

But there is one big thing I think I have learned which is the extent to which credit and banking fuels growth and how much working saved and leveraged money does in the American system.

Mysteries
I still don't understand how it is that businesses get to manage assets off their balance sheets, what those assets are and how they move. I don't understand all of the implications of the Federal Reserve printing money and the Treasury buying it up. Or is it the other way around? I don't understand how frequently ratings agencies get to do what they do and how material their judgments are in markets and if it makes a difference to them how a security is structured. 

Interests
I am interested to understand the bond market with more clarity. I want to know how bond auctions work, how liquid bond markets are and where currency arbitrage fits into the equation. I want to know how bond traders and investors read the motions in their markets and what makes the difference - what the key spreads are and how folks make money, where the volume is blah blah. 

What I See
What I see is a stronger America at the end of this crisis and recession. I see a chance to inflate safely out of it, but some really hard edges in the bond market emerging so that if they get past a certain tolerance truly drastic actions will have to be taken, and that depends on who defaults on what big obligations and when. I see most stocks going sideways for period of years - kinda like me working at Xerox in the 80s, and companies really boring and afraid to take risks with American employment consolidating into fewer, more giant and stagnant firms. Except for biotech as soon as it does what research says it might.

**The other journalist is Peter Windsor who is brilliant for the Speed Channel.

Roubini on Sachs vs Geithner

Some detailed examples on the mechanics of the PPIP.

In today’s FT Jeff Sachs makes a strong critique of the Geithner plan to deal with toxic assets based on the argument that the non-recourse loan will lead investors to vastly overpay for such assets compared to their fair expected value. Here is Sachs’ argument:

Obama’s bank plan could rob the taxpayer By Jeffrey Sachs Published: March 25 2009, Financial Times
The Geithner-Summers plan, officially called the public/private investment programme, is a thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks, by buying toxic assets from the banks at far above their market value. It is dressed up as a market transaction but that is a fig-leaf, since the government will put in 90 per cent or more of the funds and the “price discovery” process is not genuine. It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries. The plan’s essence is to use government off-budget money to overpay for banks’ toxic assets, perhaps by a factor of two or more. This is done by creating a one-way bet for private-sector bidders for the toxic assets, then cynically calling it “private sector price discovery”. Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset. Along comes the government and says it will finance 90 per cent of the investor’s purchase and, moreover, do so as a non-recourse loan. Non-recourse means the government’s loan is backed only by the collateral value of the toxic asset itself. If the pay-out is low, the loan is defaulted and the government ends up with the low pay-out rather than full repayment of the loan. Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction. Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor’s right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000. The idea of “private sector price discovery” is therefore flim-flam. There would be price discovery if the government’s loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank’s shareholders at hidden cost to the taxpayers. The banks could be saved without saving their shareholders – a better deal for taxpayers and without the moral hazard of rescuing shareholders from the banks’ bad bets. Most simply, the government could provide loans to buy the toxic assets on a recourse basis, therefore without the hidden subsidy. Alternatively, the plan could give the taxpayers an equity stake in the banks in return for cleaning their balance sheets. In cases of insolvency, the government could take over the bank, the much dreaded nationalisation, albeit temporary. At the end of the Bush administration, Congress voted for the $700bn (€517bn, £479bn) troubled asset relief programme (Tarp) on the assurance the taxpayer would get fair value for money (for example, by taking equity stakes in the rescued banks). The new plan does not offer that.Tim Geithner, Treasury secretary, and Lawrence Summers, director of the White House national economic council, suspect that they cannot go back to Congress to fund their plan and so are raiding the Federal Reserve, the Federal Deposit Insurance Corporation and the remaining Tarp funds, hoping that there will be little public understanding and little or no congressional scrutiny. This is an inappropriate institutional use of the Fed, the FDIC and the Tarp. Mr Geithner and Mr Summers should at the very least explain the true risks of large losses by the government under their plan. Then, a properly informed Congress and public could decide whether to adopt this plan or some better alternative.
Jeffrey Sachs is director of The Earth Institute at Columbia University

What should we make of Sachs’s critique? After discussing Sachs’ analysis with my co-author Matt Richardson we have come to the following conclusion: Sachs has a point but he has way exaggerated it with non-representative leverage. Let us first take his example and then make some general comments. For his example, assume interest rates are zero. The very maximum leverage available in the Geithner plan is 6:1 (and most likely much smaller), and the investor and government are 1:1, so let's use that ratio rather than the much higher leverage ratio used by Sachs in his example. If the investors bid 480, the investor will have used 60 of his/her own money and will expects to get zero 80% of the time in the bad state, and (60+ 0.5 x 520) 20% of the time in the good state. This gives expected value of 64, a small profit for the investor. So the overbidding is 480/360, actually 33% in the most extreme leverage case, and assuming risk neutrality and zero interest.  Clearly these are all strong assumptions: if investors, as likely are risk-averse the overbidding is much smaller; if interest rates are positive, say 2%, the overbidding is much smaller; if leverage is lower overbidding is smaller. So, in general the overbidding is much smaller than in the Sachs’ example given the parameters of the Geithner plan. Now reverse Sachs’ example with the following one. Suppose the asset has a 80% probability of 100 value and 20% probability of a 20 value. So, now the expected value of the asset is 840k. Then, in this case the investor will bid 880; thus, the investor will get expected value of 13.6 on an investment of 11. The overbidding will only be 5% rather than the 33% of the previous example or the almost 100% of the Sachs example. Clearly, the goal all along is for investors to competitively bid the price up due to cheap leverage to get banks to participate. We don't think there is any doubt about that and we said so in our New York Daily News op-ed. But at least it is a freebie that removes the bad assets. In conclusion, Sachs has clearly exaggerated the effect even in his example. But we agree that he has made a valid contribution - the banks have an incentive to offer up loan portfolios or securities with asymmetric payoffs and lots of volatility. This is potentially a big adverse selection problem. This suggests the government really needs to get full participation, In other terms, all the asset-backed securities and loans that would have naturally been securitized should be put into the list. The government should not let the bank cherry pick.

All well and good, but I cannot parse from this what happened to the stress test and which banks get this treatment and which do not. I already assume that the taxpayer gets screwed because it's Obama and he hasn't even bothered to flex the muscles of the FDIC and let recievership take its due course. Again, this is his overreach from the executive end of things trying to come up with an all-encompassing plan which forces us to use an all new toolset of his administration's invention, rather than applying some we know and have. This is paying for the steak sauce before you've herded the cattle. There once was a lot of talk about how consolidation in the banking sector was inevitable - but I don't hear that much.

It is fair to add that depending on the administration's policy on mark to market, many banks are indeed going concerns and few might head to bankruptcy at all were some holiday on that practice officially granted, but that is the effect of an accounting trick - the composition of the assets would still be roughly the same, and still unpriced. But there's no official word I can hear.

In the end, the government seems to be guaranteeing most of the securities anyway, the partnership appears a bit stingy. But somebody has got to bite, somebody with Sach's view at least.

Krugman vs Geithner

In case you missed it, the Nobel Laureate and darling of the BDS Left has skewered the Obama Administration's political calculations for bank bailout. 

But it’s immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.

Or to put it another way, Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard.

This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized. And I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won’t be able to come back to Congress for a plan that might actually work.

What an awful mess.

Ahem.  I beleive that one of the more recent comments about Obama is that 'he doesn't need to be defended'. That is pure zealotry, and Obama's latest meanderings into this economic crisis are officially dubious. 

Back in the good old days we had Federal budget deficits around 300-400 billion. Now it's 1.7 - 2.0 trilion. There's nowhere to run and nowhere to hide as Obama drives our great nation over a cliff of debt. 

The L

She was looking kind of dumb with her finger and her thumb in the shape of an "L" on her forehead. 

-- Smashmouth

I am coming around to behaving like a bear. The smartest people I know, and the smartest people I don't know are saying that there is no end in sight. So right about now is a good time to get into the spirit of The L, which is what I'm calling this Global Depression. 

At first I thought, why not some play on the Dust Bowl or the Rust Belt? But I realized those are just local phenomenon. This is Global. So I went to one of the prophets of doom, Nouriel Roubini's website, which I read on the daily, almost. His latest news is this:

I just arrived to Hong Kong and I will next visit India later this week. When  the first thing you hear - from your  driver upon arrival to the airport in Hong Kong - is that business  and occupancy in hotels is down more than 30% you already know this is a very ugly recession in the entire Asian region as Hong Kong is an economic barometer for trade and economic activity all over Asia. For those who argue that the second derivative of economic activity is turning positive (i.e. economies are contracting but a slower rate than in Q4 of 2008) the latest data don’t confirm this relative optimism. In Q4 of 2008 GDP fell by about 6% in the US, 6% in the Eurozone, by 8% in Germany, by 12% in Japan, by 16% in Singapore and by 20% in South Korea. So things are even more awful in Europe and Asia than the US. So let us discuss next why there is a rising risk of a global L-shaped depression that would be even worse than the current ugly and painful U-shaped global recession:

You see, nobody can decide whether it's a recession or a depression or if there is a risk of inflation, disinflation, stagflation or deflation. All I can say is that anybody who thinks about this long enough gets a headache. And there are only a few cures for those kinds of headaches, all sorts of hedges. How do you hedge against financial ruin when all of the hedge funds are out of business. You say, OK we're ruined, but it's not the end of the world - we can always...

In the L, we'll have an alternate 60s reprise. Hairy bodies will come back, personal discovery of the amateur sort. There will be goofy demagogues who will spread a jokey kind of distrust of everything that approaches logic - a funky Jon Stewart with a mustache to replace his arch irony with genuine distrust. And then we'll listen to Jon Stewart complain, as if he were actually wise instead of just richly cashing in on today's fledgling subculture of snark.

We'll take the L. We collectively in America will take it. Me, I'm trying to find a way to rebel against it. I'll probably put my entire life at risk. Pray that I don't become like Nixon.

The Beater Principle

If you listen to as much Bloomberg as me without screaming, one of the things you'll notice is that there are different attention spans in the various guests. I am getting to the point, after several months of being able to differentiate them. Here's one of the things I've just recently noticed. 

One of the premises of stimulus has to do with the solvency of the banking system and therefore the economy. But where this runs into a big problem is that to justify bailing out the banks, you have to be in fundamental agreement that more credit is what the economy needs. This is very easily illustrated when you talk about the stunningly low number of 9.1 million new cars sold on an annual basis. That's the rate today. Just last year, the figure was 13.2 million. That's a horrible drop, and the industry is freaking out. But of course they will say that part of the reason that not many cars are selling is that there's no financing. So a bailout of banks anticipates an increase of lending supply which we hope will generate more demand for auto loans which will float the number of new car sales and thus indicate a turnaround.

Except that's not going to happen. People are simply going to drive their current cars into the ground. 

I have a problem with the TARP. To the extent that I understand it, it seeks to stimulate the economy by getting banks to lend. Well how much lending is enough? 

I forget who said it brilliantly that Credit Default Swap market was like buying four fire insurance policies for the same house.

The bottom line here is that we Americans are going to eventually wise up and recognize that Obama and his crew are powerless to change the arc of the economy in such a way as to obviate our need to tighten our belts. The hedge fund industry is over and it's not coming back. Done. Finito. And when such other inevitabilities make themselves known in our culture, then we will adjust. Business as usual will be less business, we will do without the things we know we can do without. That means 9.1 million new cars instead of 13.2. It means maybe being a one car family instead of two. It means driving the beater, the beat up car just a little longer.

What I hear is that the average 401K has lost all of the gains made in 12 years. Ouch. So we all go back to 1997. How were you doing then? Suffering? Were any of us happy in 1997? Could we stand to live at that standard of living once again, or would it kill us?  It won't kill us, it only makes us weaker.

The New Class Warfare

Except for David Anderson, I don't know any CEOs that I like. But I know lots of people I would like to be CEO. When I think back, I can't ever remember any salesman I've ever known who ever met a CEO he didn't like, until he wasn't making his quota and then everybody's a bastard.

This Depression doesn't have a name yet but it's starting to get some character. As people's fears and prejudices and other humanly baggage rises to the surface we're going to start remembering things that have nothing to do with cause and effect, but are associated nevertheless with our conversations. We are retreating into our humanity and away from our work and minds. Or maybe it's better to say that our left brains are burned out and so we are seeking comfort in our right brains. There's safety in instinctual emotion, or so we are programmed to think. One of the casualties of this civil regression will be the relative ease with which we relate to each other across class lines. I'm starting to feel it.

This weekend, I did a bit of shopping - my own economic stimulus. Well, last week I dropped 800 bucks on the Transporter for some brake work and miscellaneous fixing. The local Firestone dealer had no waiting. Usually the bays are full and there are cars queued up in the lot, the TV is on the game in the lobby and there are bored customers sitting on the cheap divans. This time I walked right to the front and got handled right away. Business is slow they said, guys have their hours cut. I told my man that it's temporary because nobody is going to be buying new cars. He understands that's what corporate is saying, but it hasn't happened yet. Overall the folks at Firestone were cheery enough and they had enough time to discuss the finer points of caster, camber and toe in.

But this weekend's shopping had a little creepier vibe. I finally got over to Office Depot to get my favorite things, containers to organize all my stuff. I also got some index cards and CD cases and a big plastic container for old video games. All told it was about 80 bucks worth of stuff that nobody really needs, except that Office Depot has a store full of it on sale, and apparently they make a living. But when I got to the cashier, she had this look on her face that made me think I just spent enough money to put her kids through school. She would look at the item, ring it up, smack her teeth and then give me the stink-eye - item after item. It made me think about Cobb's Rule #14. Never trust anybody whose shoes cost more than you make in a day. They'll think nothing of walking all over you. At the time I was wearing $120 shoes. It made me scratch my head.

Later on, in between shuffling the girls to and from hiphop and cheerleading gymnastics class, I found myself at Radio Shack buying a little more in worthless trifles. Actually, all I really wanted was some batteries - the special lithium 123 batteries for my high=powered LED flashlight. That flashlight is one of the man-things that I keep in my Oakley computer bag. Also in there is my Calibri cigar torch and my CRKT. BTW, I've gotten the CRKT through airport security several times - sometimes I forget to unpack it. Anyway, being the gearhead that I am, I wanted to make sure that I had everything, and the store manager pounced on me.

I never, ever get store credit cards. In fact, I didn't realize I was getting this one. I thought it was just a membership club. So when he asked for my social, I gave him my phony social, which is off by a digit or two, but I do remember it just as well. As soon as I did he ran around and told all of his people to open the store to me. It was a little embarrassing. But having been a sales shark myself, I recognize a good game and I enjoy letting him do his magic. In the end I got 0% financing for a year on about 300 bucks worth of stuff. He even came out to the car and helped me carry out some goods. Now that's a man who appreciates good business. Still, there was an edge of rapaciousness when he wasn't looking directly - who knows what the other guy was thinking? But I've built systems for Radio Shack within the past two years down in Fort Worth, and I know they've got to be hurting.

What can I say? I'm a mark.

It's not just shopping any more. Having a wallet full of crisp bills feels like... it almost feels like being back in the hood. The Spousal Unit is feeling rather Detroit in all this. The other thing I did this weekend was to rewire some of Vault 107. In particular, I replaced my simple two prong outlet behind the wide screen with a six banger of grounded sockets. In doing so, I opened the curtains for some extra light. When she came in, she immediately closed them, not wanting anybody who passes by to see that we have a big screen TV. Nor does she want me to park the Transporter out on the street. Quoth she, you never know.

I am reminded of the quote about stupid cops and clever criminals. In fact, I used it on Boy a couple weeks ago when he told me in so many words that he sometimes feels the sociopathic urge. He was voted Freshman Prince at the big school dance last month and confessed that it's sometimes very easy to take advantage of people. So I reminded him that even if he gets away with it, he'll always have to look over his shoulder. Whenever you go over to the dark side, you run a tremendous risk. Cops can make all kinds of mistakes, but the bad guy only has to make one.

CEOs are now bad guys. And I'm far from a CEO - I don't even fall into the >250K bucket which is the new 'rich' in the Obama socialist universe. But I do have some fairly nice shoes, and occasionally some extra cash. I'm starting to pay attention when people become a little more obsequious. I've been called 'sir' and 'boss' in a thousand transactions since I was in my 20s, but I'm listening for an edge these days. Sure I listen to the news and I know we're heading for our own version of the Dust Bowl, but the real casualty is not the wealth, but the civility. I'm not extended past my own alien-observation level of hyper-scrutiny and paranoia, but I'm listening and I'm watching.

I shouldn't have to remind anyone that a nation that doesn't allow CEOs to make mistakes or get the glory of being team captain is by definition cannibalistic. And nobody can argue that today's CEOs aren't better than ever. But somehow the exceptional assholes are now considered to be the rule. The guys who provide more benefits for domestic partners than the states - the big diversity champions are all the big soft corporate bosses. If you don't remember all that, slow down and remember it on Casual Friday, because I'm going to remind you again then myself.

A Hamburger Economy

I'm driving to work as usual thinking about all of the economics I've stuffed into my head recently and paused to reflect about one thing. When I go to Vons to buy a steak, most of the time I get USDA Choice, but on occasion I'll get USDA Prime. So literally, 'choice' is by definition, 'sub-prime'.

Translate that to the economy. When I doubted all this calamity could befall us, looking at it from the point of failure of the leading subprime lender here in California back in 2007, I can remember being charged to take notice of Roubini. I did, in an indirect way and fell victim to the ranting exclamations of a socialist podcaster who said because Roubini says X we should head into some bizarre direction. I'll find it if I can, just to smack myself and everyone else for not going to the source.

The facts in question were exactly how many subprime and other mortgagees were defaulting or likely to default. The alarming news was something on the order of 4 percent, which was double the usual amount. And now as we squawk comfortably like Santelli, we rather blithely accept that about 92% of mortgage holders are not going to default.

When I get a 92% on any test, I consider that an A-. An A- is subprime. And similarly, people are freaking out that we have unemployment of 10% here in California. That would be 90% employment. Also an A-, also subprime.

Nobody on the planet knows how much wealth via securitization was leveraged on that now widely acknowldeged 8% of failed mortgages. But when you stop and think about it, as Taleb must certainly think, what in the hell were people thinking such that they would bet so much on the idea that the AIG cannot survive mere Choice financial steak?

Get ready for a hamburger economy. It really isn't that bad, is it?

Manny Hanny

I've been thinking about banks, like all of us. Do you remember Manny Hanny? It turns out that it has been all over the place. If it's any comfort, I find it difficult to imagine that whatever nationalization we do that the government will own them forever. Money changes hands. Always. 

Timeline of Mergers

• 1905 – NYS Chartered Citizens Trust Company of Brooklyn
• 1912 – Broadway Bank of Brooklyn
• 1914 – Manufacturers National Bank of Brooklyn
• 1914 – Name Change To Manufacturers-Citizens Trust Company
• 1915 – Name Change To Manufacturers Trust Company
• 1918 – West Side Bank
• 1921 – Ridgewood National Bank
• 1922 – North Side Bank of Brooklyn
• 1922 – Industrial Bank of New York
• 1923 – Columbia Bank
• 1925 – Yorkville Bank
• 1925 – Gotham National Bank
• 1925 – Fifth National Bank of the City of New York
• 1927 – Commonwealth Bank
• 1927 – Standard Bank
• 1928 – United Capitol National Bank and Trust Company
• 1929 – State Bank & Trust Company
• 1930 – Pacific Trust Company
• 1931 – Midtown Bank of New York
• 1931 – Bryant Park Bank
• 1931 – Midwood Trust Company
• 1932 – Chatham Phenix National Bank & Trust Company
• 1937 – Equitable Trust Company of New York (1930-1937)
• 1939 – Banca Commerciale Italiana Trust Co.
• 1942 – Standard National Bank, Woodside, N.Y.
• 1946 – Flatbush National Bank of Brooklyn
• 1947 – Fidelity National Bank in New York, The
• 1949 – National Bronx Bank of New York
• 1950 – Brooklyn Trust Company
• 1953 – Peoples Industrial Bank
• 1961 – Central Hanover Bank & Trust Company
• 1961 – Name Change To Manufacturers Hanover Trust Company
• 1991 –Goldome (assets)^[3]
• 1992 – Merge To State Chemical Bank

Two Counter Arguments

Every time I hear an argument against a tax holiday on payroll deductions, the answer is the same. In all of the conversations, this one point has tended to be remarkably diametrical. 

Q. What's wrong with giving people a payroll deduction as part of the stimulus plan - basically why is government spending better than tax relief?

A. When the government spend money, it is actually spent. When people get a tax rebate, then they are more likely to save the money. What we need in stimulus is actual spending.

Blah blah blah.

So when did saving money suddenly become bad? Bad for whom? It's certainly not bad for me to have more money to spend or save as I choose. How about you?

But let's be economic about it shall we? 

1. Why did Morgan Stanley buy B of A? Because MS needed the deposits of a retail bank to offset the toxic assets on its balance sheets. When economists answer 'consumers will save the money' where do they assume we'll save it? Under our mattresses? If they are so sure we'll save instead of spend, it doesn't take a genius to see that we will either put it on deposit in banks or invest back into the stock market. Since when is that a bad thing?

2. What happens to the argument against wealth destruction by those who say saving is a bad idea? If I lost 30% of the value of my 401k in 2008, and now the market is at a bottom, I'd be a fool not to reinvest new money that I never had before. That's saving too. Plus it has the added benefit of stimulating the equity markets. Since when is that a bad thing?

OK so maybe this isn't two different counter arguments - they are part and parcel of the same argument, which is so long as consumers get the tax relief, the some part of the economy is guaranteed to benefit.  But I guess that is not the part of the economy that the Obama Administration wants to benefit. It wants that part which is aligns with his strategic spending goals to benefit, which is why if he spends a trillion the way he wants, he's going to run into a brick wall with Americans like me. 

The analogy is simple. America has been hit with a financial hurricane. Obama is quadrupling the budget for FEMA instead of giving us direct relief. 

If Barack Obama made 2009 the year that Americans paid no Federal Income Tax, he would go down in history as one of the greatest presidents ever. What are the chances of that? And what are the names of the people who are going to get their pockets lined by this stimulus package instead? 

The Problem With Aggregate Stimulus

One of the economic terms you'll hear tossed about is how Keynesian economists look at GDP in terms of aggregate demand. The basic theory is that if you stimulate the economy through spending, demand will increase and therefore supply must increase. Keynes found himself looking at zero or negative GDP growth and that was a problem. Think of it this way, a society with lots of good things outdoors and everybody wants to stay indoors. Keynesian stimulus means spending money on improvements to, say baseball stadiums so more people will come outside and play baseball, and spend money on tickets.

In the context of the government stimulus we can talk about 800 billion or 2 trillion because we think that is the cost of the size of a package to jumpstart a whole America full of people who have parked their asses and are not coming out to play in the market. There's a big problem. The problem is not that these economists are completely off base, the problem is that aggregate demand is simplistic but real demand is not, and when you give things over to the federal government to decide exactly how to stimulate demand and jumpstart the economy, their biases and inefficiencies will of necessity cause troubling dislocations.

This is why I say that a greater proportion of the stimulus should be in the form of a tax break, and in particular a payroll tax holiday and a sales tax holiday (leave state and local taxes alone). It is the most equitable form of stimulus because it reaches everybody who is a wage-earner today, immediately.

Notice that whatever the cost of the stimulus, taxpayers are going to evenly take up the burden. That will be shared as equitably as payroll taxes now.

Let's look at what looks to be an egregious but will likely be a typical example of such a dislocation, using the terminology already gaining political favor as we speak. The consensus is that infrastructure projects will be the sort that will have the appropriate 'multipliers' to jumpstart the economy, where x money in will result in 1.5x (say) of economic activity. Yay. Now we know that Caterpillar just laid of 20,000 employees last week. How long do you think those people will be unemployed before the political process of stimulus reaches an infrastructure project meeting the right criteria so that they can be hired again? What if you are in the medical information systems business? The government priority is on making health care work. If you are laid off today, how long will it be before the government hires you back?

Now think about your business, and the amount of money you get by doing business with the government. What if you were in some politically unpopular business, say like coal mining or tobacco farming or insurance? Let's say your business is not targeted for stimulus and you get laid off because of the softness in the industry. How long do you think you will be out of work?

And you know what the argument is that is being made against tax cuts? Well, people will just save their money. You mean like for a rainy day when we lose our non-stimulus sector jobs? You're damned right we'll save our money, and if and when we get dislocated and laid off because the government decided to see some other stupid company like GM as more important than my company, then the gross inequality of the stimulus package will become perfectly obvious.

What happens then? Lobbying. Incredibly fierce and intense lobbying for stimulus from every industry, every region, every sector of the economy. Some will get, some will not get. How do you think that's going to play out?

Across the board payroll tax holiday gets to everybody immediately. Equitably. Across the board sales tax holiday makes all goods and services cheaper immediately. Our GDP is 64-70% consumer spending. The overwhelming majority of us take our paycheck to the supermarket and the mall and that's what we do. The big ticket items we put on credit, but guess what, there is no credit. So the only place where real stimulus can be immediately made is in those things we all need every day. Don't believe me? McDonalds profits are up 7%. UP.

Bailouts are selective. Stimulus legislation is selective. Only across the board payroll and sales tax holidays are equitable.

What Do You Mean We?

Like the woman who was pregnant when she voted for Obama because she thought he'd change America's health care in time for her baby, a lot of people are going to be disappointed to find that this stimulus plan is not going to be as broad and timely as the economy will be in wiping out jobs.

The targets of the stimulus will be clear, a lot of government spending by government employees and their networks, which are incredibly slow. You will find, I predict, an astonishing reversal by Obama supporters when they start talking about 'no-bid contracts'. And the American people are going to find out what 'shovel ready' means the hard way.

But here's the real pain. How long will it take the government to find you when you get laid off? How long do you think? When is the last time you actually got a job through a government program?

Seven Year Belly Itch

Today's economic lesson comes from Bloomberg again talking to a top dog economist at the IMF who notes that the Treasury is going to be issuing a new bond - the 7 year bond. So the US is issuing a whole new class of debt, and there's speculation that Treasury may issue a 20 year bond as well.

Among bond traders and experts, there is something known as the 'belly of the curve' which is speaking about the yield curve of the treasuries. If I understand this correctly, a yield curve is a projected estimate of the return on bonds across the types of instruments. Here are the current numbers.

So there are long term and short term bonds and if you look at the middle, or the belly of the curve, that's where most of the interest rates that affect our lives are based. Considering the credit I get, I suppose they just take whatever that number is and multiply it times 7.

Now here's the strange thing I don't quite understand, among the millions of things I don't understand. The Treasury is issuing debt and the Federal Reserve is buying it. Somehow this allows the Fed to bail out somebody. It sounds awfully queer to me. The LAT explains it this way:

With its benchmark short-term interest rate already at rock bottom, the Fed can’t make any more use of that tool to influence market rates. So the central bank in mid-December signaled that it might buy Treasuries for its own portfolio as a way to pull longer-term rates down or at least keep them from rising.

The Fed, led by Chairman Ben S. Bernanke, went a step further after its meeting last week, saying it was "prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets."

Here’s the problem the Fed faces: Traders and investors have some legitimate reasons to push Treasury yields up from their recent record lows. For one, Wall Street knows it is facing a massive supply of new government debt to fund the financial-system bailout and economic stimulus plans.

The Treasury today said it would borrow $67 billion next week alone via sales of three-year, 10-year and 30-year bonds. To attract enough buyers, the government may just have to pay more.

What I know is that I understand stocks, and I understand options. I understands puts and calls. But I don't understand the bond market. I just know that I get sick of California initiatives that call for a bond. I always vote them down.

A long time ago when I used to work at a bank, I worked the Certificate desk. I really loved that job. I used to sell TCDs during the crazy days of the early 80s - the last time gold was up this high - but interest rates were crazy high then too. Now they're rediculously low. I especially liked the quirky kinds of securities and whatnot. In fact, now that I think about it, it used to be my job to hold collateral titles on boats and whatnot to secure various loans. It was at that desk that I learned about municipal bonds (munis) and commercial paper - stuff I've forgotten since. I used to crack up the loan officers when I used to tell them how much money I could make on munis and commercial paper, while the bank was losing money on TCDs. But nobody paid much attention to munis because at the time they were paying a miserable 5%. Well 5% is not miserable any more, and I wonder where I can get some.

Of course I wouldn't think about buying a bond from anywhere in California right about now, but that's another sad story.

Industrial Policy - Line Item by Line Item

I just happen to be auditing some corporate numbers today and of course me being the kind of certified professional I am, I have access to things like corporate salaries. So we're going to talk about micromanagement for a moment.

You see I have a big beef with the jawboning of bank CEO salaries. The government has no business doing this, not even in a crisis. And the idea of putting it up to a political kind of populist litmus test is really disturbing. So I'd like to put together an analogy which should give people who think this stuff is fair, a moment to consider something. First of all, think about yourself and where you work. Now think about your department and what it does. Now imagine the budget of your department waved around like a red flag in front of the bull of public opinion.

Hmm.

Now at the company I'm working at, I can see that with regards to salaries, the executives make a total of 26.7 million. Now everybody that works in marketing makes 26.5 million put together, and the folks who work under the heading of Administration make about 85 million. But since we just got finished dealing with the Super Bowl imagine a scenario in which Senator Frothmouth decides not to pick on executives, but on marketing.

The interesting thing is that for consumer products, we are very much the target of marketing. We may not know all the things a CEO is supposed to be judged on, but we know a bogus TV ad when we see one.  How about Budweiser ladies and gentlemen. Does anyone honestly believe that you are really going to change how many people drink Bud based on the TV ads?  Who else had stupid commercials? Hmm. Pepsi had a pretty cool one and a pretty stupid one. Cut half of the marketing team at Pepsico's salary in half!

The crowd I hang out with meets bigwigs on a semi-regular basis. Although I don't go for that sort of thing, I could probably wrangle a bunch of skybox seats in any given sport if I tried hard enough. That's all marketing too. We don't need skyboxes in this economy, any idiot can see that.

I think you get the picture. Any sort of anything can be singled out by politicians and their media flunkies for criticism and jawboning. That's not how you make policy, that's how you make enemies of business - the businesses we all depend on. Let's keep this whole thing simple. Buy it and take control of shutup.

There are only two intelligent choices in an economic crisis of this sort. Nationalization or Laissez Faire. In between those extremes is regulation and taxation. Read my lips, WE DON'T HAVE TIME. It is absolutely impossible under crisis conditions for the government to come up with an improved set of regulatory frameworks or tax incentives that will create the proper stimulus. I hope Obama gets the message very soon that half stepping doesn't work on a tightrope.
--

While I'm at it speaking of tax policy, I am in total agreement that a rebate is not going to produce stimulus. So while I would be personally psyched to get a payroll tax exemption (Oh my GOD, that would be cool!) I know exactly what I would do with it, which is the same thing most Americans would do, save it for a rainy day. The statistic is that when Bush mailed the checks last year, 83% of it went to savings. That's something of an astonishing figure but if it's true that means households are all hunkering down - everybody wants to spend nothing.

It is not entirely clear to me how consumer spending will get us out of the recession, but buying a pair of socks actually makes sense in macroeconomic theory. The equation is
GDP = C + I + G + (X − M). More on that later...

Armey on Keynes vs Heyek

Ripped off from the Wall Street Journal is this timely note from Dick Armey.

Classical economists up to that time had emphasized a balanced budget and government restraint as the primary goals of fiscal policy. The simplistic notion that "aggregate demand" drove investment and employment threw all of that out the window, but it had one particular convenience for policy makers. Government spending is, according to Keynes's construct, a key component in determining aggregate demand, so more spending, even to resod the Capitol Mall or distribute free contraception, drives the economy in the short run.

A father of public choice economics, Nobel laureate James Buchanan, argues that the great flaw in Keynesianism is that it ignores the obvious, self-interested incentives of government actors implementing fiscal policy and creates intellectual cover for what would otherwise be viewed as self-serving and irresponsible behavior by politicians. It is also very difficult to turn off the spigot in better economic times, and Keynes blithely ignored the long-term effects of financing an expanded deficit.

It's clear why Keynes's popularity endures in Congress. Intellectual cover for a spending spree will always be appreciated there. But it's harder to see any justification for the perverse form of fiscal child abuse that heaps massive debts on future generations.

This is a brilliant piece of writing which takes us directly into the heart of the matter facing us. I Hayekian, and it seems that when I've just about worn myself out on the crisis facing me as a geopolitical neocon, here comes another to pull me back in. Keynes vs Hayek, with the troglodytes of Congress weighing in on the Keynesian side.

Every you hear a Republican say 'mortgage our children's future' this is what they're talking about. The huge bill that will come due from all of this deficit spending. I think there may come a time in my life when, with regard to taxation, it will be cheaper for me to live in Canada.

I know Obama cannot control this Congress and this is his first test. He is either in the tank with them, fulfilling dreams of profligate programs, or he is powerless to constrain their appetite for uneconomic foolishness. I almost wish that he was a socialist at this point. At least he'd have the stones to actually take over the insolvent banks.

David Goldman's New Bank Math

I just need to get this on the blog so I can come back to it and try to understand what's going on.

Here’s how it all adds up: There are about $3 trillion of non-agency mortgage-backed securities outstanding. For the sake of simplicity, let’s say that 65% are so-called AAA’s, and all are selling around where the ABX index is selling, or 35 cents on the dollar. That’s about 35%  times 65%, or $682.5 billion of market value. The banks buy all of them. Over time, half of the non-agency (not guaranteed by the federal government) mortgages default, and the houses sell for 50 cents on the dollar (which is where the market seems to be clearing). With recovery costs, etc., the securities ultimately pay 75% of face. The $682.5 billion investment is worth $1.4625 triillion, or an increment of about $800 billion. That’s roughly what the banks have to write off this year.

That’s how the banks replenish their capital, provided, of course, that all the hedge funds and other prospective investors don’t get any. In fact, there’s plenty of other cheap paper out there, including $2.8 trillion of asset-backed securities and $1.3 trillion of Collateralized Debt Obligations. And if that doesn’t work, there’s the good old curve trade: with funding at 0%, banks can buy agency MBS and clip the coupons.

The trick is to keep asset prices low enough for the banks to buy it on the cheap, which sadly means bankrupting most of the hedge funds. Of course, the banks already own a ton of devalued paper, and a bit of creative accounting (of the sort proposed variously by the Group of 30, by Deutsche Bank’s Mike Mayo, and others) is required to paper over the insolvency of the system. The banks, as Goldman’s analysts said, becoe a public utility.

To get the securitized asset market moving again, first you have to find a home for all the miserably devalued securitized assets out there.

Here’s how it all adds up: There are about $3 trillion of non-agency mortgage-backed securities outstanding. For the sake of simplicity, let’s say that 65% are so-called AAA’s, and all are selling around where the ABX index is selling, or 35 cents on the dollar. That’s about 35%  times 65%, or $682.5 billion of market value. The banks buy all of them. Over time, half of the non-agency (not guaranteed by the federal government) mortgages default, and the houses sell for 50 cents on the dollar (which is where the market seems to be clearing). With recovery costs, etc., the securities ultimately pay 75% of face. The $682.5 billion investment is worth $1.4625 triillion, or an increment of about $800 billion. That’s roughly what the banks have to write off this year.

That’s how the banks replenish their capital, provided, of course, that all the hedge funds and other prospective investors don’t get any. In fact, there’s plenty of other cheap paper out there, including $2.8 trillion of asset-backed securities and $1.3 trillion of Collateralized Debt Obligations. And if that doesn’t work, there’s the good old curve trade: with funding at 0%, banks can buy agency MBS and clip the coupons.

The trick is to keep asset prices low enough for the banks to buy it on the cheap, which sadly means bankrupting most of the hedge funds. Of course, the banks already own a ton of devalued paper, and a bit of creative accounting (of the sort proposed variously by the Group of 30, by Deutsche Bank’s Mike Mayo, and others) is required to paper over the insolvency of the system. The banks, as Goldman’s analysts said, becoe a public utility.

To get the securitized asset market moving again, first you have to find a home for all the miserably devalued securitized assets out there.

Utility Bank of America

Well the financial blood is really starting to flow. Wells Fargo announced a 2.83 Billion dollar loss today on the quarter. Apparently it was a big fat hunking mistake for them to by Wachovia but they couldn't pass up on the deal. Then they bit into that big shiny and caught a mouthful of worms. But they're still talking as if they were the only good bank left in America.

Taleb as well as a bunch of other bears are over in Davos wearing denim amongst the glitterati and the notably absent princes of Wall Street. He gives me the only sort of nationalization I think I can live with and it goes a little something like this.

A 'utility' bank is basically the sort of bank that you and I use every day, and have been using all of our lives. Why, because the overwhelming majority of us have no business doing anything over the FDIC limit. So basically if that's all the bank you need, who cares who runs it? It can't be that hard, there isn't that much risk. Let the government nationalize all of those basic retail banking functions in a new class of institution. These banks will be insured and guaranteed never to fail. They have slim profit margins, tight regulations and no fat bonuses for executives. They are the boring banks of yesteryear, run by the kind of schmoe you think of when someone says 'dances like a banker'.

A capitalist bank is basically the sort of bank that does whatever the hell it wants. It's the kind that runs hedge funds, leveraged buyouts, any damned thing it wants. This is the kind of bank that NEVER gets bailed out by the government under any circumstances. It is a live by the sword, die by the sword, swashbuckling sink or swim pure market Club for Grown big swinging capitalist balls bank. You don't like it? Tough.

These are two extremes. What's in the middle? Well, what needs to be in the middle? If you ask me, I say every other kind of financial institution, except they don't all get aggregated into these banking towers of Babel. Citigroup. Citi is dead. So why should Traveler's suffer because of Citigroup's toxic banking assets? I'm sure a lot of people at Travelers are asking just that.

It's becoming clearer to me that this whole wave of consolidations was the first big mistake. Everything is 'too big to fail' but it's all still failing. Why? Because the rabbit holes in these huge financial conglomerates were so twisty and deep. So bust 'em up and let the nasty assets stick to the tarbaby bad banks. There are still a bunch of good names out there we still recognize that could be spun off - that must be spun off. I mean I liked my Providian Visa before it got eaten by Washington Mutual, but now JP Morgan Chase has it. Wells owns Wachovia that ate AG Edwards. What was wrong with AG Edwards? Split up that damned balance sheet and let some of these things die. The sooner the better.

It has become clear that nothing is too big to fail.

If I were Warren Buffett or Bill Gates, I'd start a new bank today. Brand new bank with no history. And I'd hire a bunch ofsmart banking people and start from scratch. The first investor group who does that is going to win marketshare. That is, after Obama gets Geithner and Summers to invent a reverse auction and start putting these assets to bed.

Time's a wastin'.

Eco Tripping

I am eco tripping. Eco for economics. Others are eco tripping. Eco for ecology.

Monday evening I got through about six or seven podcasts from Bloomberg and and picking up on several things, the latest of whom I think deserves to be in the T50 Project - for my project encompassing the top 50 thinkers I will focus on from here until the old deathbed. This new guy is David Zetland, economist focusing on the matter of water supply (and demand).

What I learned from Zetland the other night helps explain something I simply couldn't quite believe in a conversation I had last year with a water guy at Deet's house. The conversation drifted (because I pushed) onto the subject of water. If I remember correctly, there was some matter of controversy in which river(s) should be diverted to provide water for Southern California. My new associate turned opponent and said 'conservation' which angled him towards rationing and other such mandatory controls on consumption. I naturally replied that all you have to do is let the price rise and people will use less water. I couldn't believe that he opposed that suggestion, but he did.

I can't remember if he went into a diatribe about water being a right, and I wish I could find the blog entry where I'm sure I recounted the discussion. However Zetland tells me that most water districts do not price water. What? 

The way we have worked with water provision forever is as if it were unlimited. There has never been a supply problem and so the economics of water provision have always been cost plus a small margin. The water itself is free, you pay for the infrastructure of delivery and maintenance on that. So if you purchased 200 gallons a month or seventeen acre-feet, the marginal cost of water was zero. Now of course if you got 17 acre feet of water, chances are you've already paid for the huge fat pipe and are getting water at a somewhat different rate. However the difference between getting 17 or 25 was essentially zero, even during times of drought, because the water itself was free.

Zetland says that it regularly requires the equivalent of a bureacratic miracle for water providers to actually implement a progressive pricing system on their water supply. Why? Because this is the way we've always done it. And because ecologists and other environmentalists generally don't like the idea of saying that water is not free. Yet in fact pricing water in a progressive structure actually works better than regimes of conservation and mandated rationing, just like us market oriented people would think. 

That doesn't change the way most Americans, especially water bureaucrats think. That needs to change.

Starting to Miss McCain Already

The more I look at the line-item detail of Obama's Stimulus Package, the more I agree with David Brooks. This thing makes no coherent statement other than 'don't just stand there do something' and is hardly responsive to the particular problems we are in.

The bill has three essential failings. First, it lacks any strategic vision. This $825 billion bill has to be passed within weeks. There’s no time for fundamental rethinking or new approaches. Instead, there’s a sloppy profusion of 152 different appropriations — off-the-shelf ideas that mostly create costlier versions of the status quo.

The committee staff took the kernel of President Obama’s vision — infrastructure programs to create jobs — and surrounded it with an undisciplined sprawl of health, education, entitlement and other spending. There’s money for nurse training, Medicare, Head Start, boatyard support, home weatherization and so on. Eleven of the programs in the bill account for the vast majority of the actual job creation. The rest may be worthy or not, but they have little to do with stimulus. The total package is so diffuse, it costs $223,000 to create a single job.

I haven't heard the first person that Obama has told no when it comes to spending money. If closing GTMO would save Americans a single billion, that might have made 3/10 of 1% of difference. But this is just ridiculous. Here is truly a chance for a bold President to show how in touch he is with the people and not beholden to the status quo in Washington, but out of 258 lines, how many are for ideas that didn't already exist?

I expect this stimulus will be about equivalent to Bush's FEMA exercise in New Orleans. He should have just given us all the cash.

22 Billion for Homes in the Sticks

I just got a copy of a spreadsheet outlining the budget details for the Stimulus Packsage. There are some 22 billion in loans for what's called section 502 housing loans.

The Section 502 Rural Homeownership Loan Program of the Rural Housing Service (RHS) makes loans to low- and very low-income households (incomes up to 80 percent of area median) in rural areas to purchase, build, repair, renovate or relocate houses, including mobile/manufactured homes.¹  Loans can also be used to purchase and prepare sites and/or to provide water supply and sewage disposal facilities. No down payment is required, and interest rates are subsidized. Through the Section 502 direct loan program, RHS, a "lender of last resort," brings homeownership to those who otherwise could not afford it.

Households with adjusted incomes between 80 and 115 percent of median income, as defined by the Department of Housing and Urban Development (HUD), may qualify for the Section 502 single-family housing guaranteed loan program. In the guaranteed program, unlike the direct program, loans are made by banks or savings and loan institutions rather than by RHS.

But the administration is actually going to make 4 billion in direct loans of this sort. This is rather interesting to me. But there are probably a lot more interesting surprises in the Stimulus Package which now has about 280 line items adding up to about 362 Billion dollars.

..But It's Not Political

OneUnited Bank is a little bitty bank. But it's the biggest black owned and operated bank in the country. It was created, not long ago, through some clever merger work. Listen to their own words:

We are the first Black internet bank and the largest Black owned bank in the country, with offices in Los Angeles, Boston and Miami.

In 2008, 2007, 2006, 2005, and 2004, we were awarded the highest Bank Enterprise Award by the U.S. Department of Treasury for our community development lending. We are a designated Community Development Financial Institution (CDFI).

In the past five years, we have financed over $600 million in loans, including churches, affordable housing, office buildings and retail stores - most in low to moderate income communities such as South Central, Compton, Liberty City and Roxbury. However, we never participated in subprime lending. We have always maintained strong credit criteria.

In 2007, we have achieved record earnings and good asset quality, providing the fuel needed to continue to support our community development lending.

Our growth has been through acquiring community banks across the country that are equally dedicated to our mission including - Founders National Bank of Los Angeles, Family Savings Bank in Los Angeles, California, Boston Bank of Commerce in Boston, Massachusetts and People's National Bank of Commerce in Miami, Florida.

As some Cobb readers might know, I grew up in a black and Japanese neighborhood of Crenshaw, where the tallest building for miles around was the five story headquarters of Family Savings. It was where I deposited my first nickles and dimes. Later on, as I had my first job, I opened a checking account over at Founders. But some time around 1981 when I started working at City National I kept my money there for free. I kept money in Founders even though they had no ATM network and when I started my first business back in 87, I kept money in Founders. But I finally got fed up with their poor service and the fact that six years later, they still had no ATMs and didn't join an ATM network. That was the last time I entertained the usefulness of black banks.

As it happens, an old friend of mine may or may not be a hotshot at OneUnited. Either that or Broadway, I don't remember which. His aim has been to do good for the poor community and may be on the edge of Aggregation.

Anyway, OneUnited happens to have a friend in Barney Frank as the WSJ reports, and is being echoed around today.

Troubled OneUnited Bank in Boston didn't look much like a candidate for aid from the Treasury Department's bank bailout fund last fall.

The Treasury had said it would give money only to healthy banks, to jump-start lending. But OneUnited had seen most of its capital evaporate. Moreover, it was under attack from its regulators for allegations of poor lending practices and executive-pay abuses, including owning a Porsche for its executives' use.

Nonetheless, in December OneUnited got a $12 million injection from the Treasury's Troubled Asset Relief Program, or TARP. One apparent factor: the intercession of Rep. Barney Frank, the powerful head of the House Financial Services Committee.

Mr. Frank, by his own account, wrote into the TARP bill a provision specifically aimed at helping this particular home-state bank. And later, he acknowledges, he spoke to regulators urging that OneUnited be considered for a cash injection.

It's hard for me to judge how troubled OneUnited may or may not be, but it's clear that it takes minority lending a serious priority. Frank is making a cagey decision - for if OneUnited were to fail, the noise of the collapse would be amplified, not least by this blog.

Also in the story is another bank with which I have been personally involved, Ohio's National City, at which I spent several months last year helping them upgrade their IT systems. Hell, I almost bought stock in the joint, because before the credit crisis was fully upon us, they were clearly undervalued. They were very well on their way to making clear which assets belonged to whom, although I didn't understand how or why that would be complex when I heard the internal buzz. Later as I came to understand how CDO Swaps worked against loan tranches, I could see what they were on about. Nevertheless, they were very seriously fighting irresponsibility and recognizing the changes they would have to make in order to save their company and yet...

Several Ohio banks received funds after Ohio's congressional delegation complained bitterly about the treatment of Cleveland-based National City Corp., which regulators forced into a merger rather than provide with cash.

It just goes to show you, it's not what you know, but who you know. 

In other news, as I follow more and more economic blogs and drop more political blogs, the consensus seems to be that we're going to have zombie banks. Which means that if there's going to be some interesting stimulus down the pike, I may have to get my mortgage from the Fed since all of the banks will only lend to 800 FICOs. Wouldn't that be cool?

Obama Has Your Credit

Prediction: The Federal Government is going to suck up all the credit in America, and the American consumer won't be able to get any. 

Figure 1: Federal borrowing as a % of GDP: Roosevelt vs Obama's First Year

Spengler notes:

Before America entered World War II, Franklin Delano Roosevelt borrowed no more than 6% of gross national product in a given year. During his first year in office, Obama will have borrowed perhaps double that amount.

Roubini notes:

U.S. financial losses from the credit crisis may reach $3.6 trillion, suggesting the banking system is “effectively insolvent,” said New York University Professor Nouriel Roubini, who predicted last year’s economic crisis.

“I’ve found that credit losses could peak at a level of $3.6 trillion for U.S. institutions, half of them by banks and broker dealers,” Roubini said at a conference in Dubai today. “If that’s true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis.”

Losses and writedowns at financial companies worldwide have risen to more than $1 trillion since the U.S. subprime mortgage market collapsed in 2007, according to data compiled by Bloomberg.

President Barack Obama will have to use as much as $1 trillion of public funds to shore up the capitalization of the banking sector, following the $350 billion injection by the Bush administration, Roubini told Bloomberg News. Congress last year approved a $700 billion rescue fund, of which half remains to be disbursed.

No Hats

Dress code strictly enforced. No hats, oversized jeans, baggies or athletic wear.

There's a new luxury hotel in Las Vegas. It's called Encore and its proprietor is Steve Wynn. I stumbled upon the verbiage looking at his website - he's got a nightclub there called 'Tryst' and he's trying to set the scene.

Something like 68% of American GDP is the consumer economy. The surest way to get any multipliers via economic stimulus is to give cash to Americans and let them spend it in the normal ways they do - which would include wasting it in Las Vegas. Surely Steve Wynn doesn't need to expand - it's already done. He got the financing he needed for his new resort and casino so the crunch doesn't affect him so much. But if nobody shows, he'll start laying off staff and then the real painful part of the recession will begin. That's the great irony here. If the stimulus package doesn't come before people start getting laid off, it's just going to be welfare - keeping people alive between jobs, which won't come because nothing will have been stimulated, except perhaps pay-per-view.

Wynn sure picked a bad time to be exclusive. I think a lot more people are going to be wearing denim in the days to come.

The Rothschilds Hedge Against The Confederacy

I'm into Niall Ferguson's history of the world of finance. He tells an interesting story that I'd like to relate here tangential to our stories about Jews and usury.

You really can't talk about the history of persecution of Jews without eventually coming to the old prejudice that they are the 'international bankers' that control various aspects of world affairs. There's a little truth in that, but there is no particularly Jewish way to control the world, but there is the bond market. Masters of the bond markets are big balling shot callers, and back in 1800s, the Rothschilds were such giants. It turns out that there are still a bunch of them around today.

Anyway, it turns out that one of the most well known uses for government issued bonds is for the raising of capital during wartime. As Ferguson tells the story, the Rothschilds who had kicked butt by funding the Brits in their defeat of Napoleon at Waterloo were rather fat and happy after that time - having mastered enough of the market to beat out the Barings, their competitors. So while war was profitable for them around that time, when 1860s rolled around and various financiers were placing bets on the American North or South, the Rothschilds famously stayed out of the game.

Well somebody saw that as a big opportunity and decided to help the South issue and sell bonds. These particular bonds were collateralized by cotton. So over the course of the war, as cotton supplies dried up a bit, they became more valuable because the price was set at the prewar amount. If I remember correctly it was 6pence a bushel and went up as high as 26pence. So you can imagine the value of a bond going up when you could redeem it for cotton at about one fourth the going rate.

Well it turned out that long before the war was completely over, the South lost a battle at New Orleans. Then suddenly the price of these bonds collapsed and so did the economy of the South. Why? Because now that the Union Army controlled the Mississippi River, they weren't likely to let any cotton get through. That spelled economic disaster for the South, long before the shooting was over.

The Rothschilds called it. Speculators lost all their money, and Confederate dollars, even though they were based on the Gold Standard, long before the US had a Federal Reserve, soon became worthless. The rest, as they say, is history. But now you have some insight as to how some money played (or didn't play as in the case of the Rothschilds) into the determination of great events.

Hybrid Profitability

Last week listening to one of Bloomberg's guest experts on the auto industry I learned something new I didn't know. Hybrid automobiles are not profitable. This came as something of a shock. Nobody makes money on those things, not even Toyota, except perhaps when they license their Hybrid Synergy technology to other manufacturers.

Conservatives like to make a lot of noise about Congress dictating what automakers have to make in reaction to the possibilities that the Democrats may cram CAFE down the Big Three's throats, but there are subtleties here. One of them is that basic fact - the very fact that they're essentially broke means they want to build fewer of those things. The break-even point for GM is 12 million vehicles. No real profit until 13.5-14million. It's going to be a hard slog.

Tied to this, does anybody know which side of the fence bankruptcy judges are politically? Are the courts even staffed to handle the kind of crap they would deal with - or is everybody in the mortgage business retraining to be expert witnesses in bankruptcy court?

CRA & The Redline Revisited

A cat named Wallison at the American Enterprise Institute makes an extraordinarily astute observation about what has turned out to be a calamity. I'm going to paraphrase him. Basically what he's saying is that the Clinton Administration took the wrong tack in enforcing the CRA. In search of affordable housing and increased home ownership they forced bank regulators to change the very nature of lending instead of subsidizing constituents.

The difference is between the attitude that the system was corrupt because blacks weren't getting what was considered politically appropriate and the attitude that blacks needed help to get up to the standards of the system.

This is a very specific and important distinction to be made and part of the subtlety that is required in a review of the sorts of politics that got us to where we are today.

It is also important to note that Wallison understands that a great deal of attention has not been paid to what is known in the biz as 'rental stock'. Affordable housing starts at ground zero with low rent apartments. Part of the corruption of banking lending standards has to do with the fact that non-owner occupied housing was a big part of subprime lending.

Additionally, when people get tired of mouthing off about greed, they should think twice and three times about what incentives are created by regulations. So long as banks were able to bundle up and sell mortgages that they originated and those bundles were still allowed to have the Fannie & Freddie stamp of approval, why would anybody not?

Once upon a time we had a Savings and Loan industry.

Chapter 11

Now is the time for all broke men to file for the aid of their country.

It has come to my attention that a certain company in New England has made moves to purchase a small, broke bank in such a way as to be eligible for TARP funds. It has come to this. And clearly as transition happens in Washington, many slick operators will take advantage of the new trough the government has funded.

While there are dozens of political arguments as well as deep theories of economics that are brought to bear in this time of unprecedented chaos, it seems to me that the most certain way that we can avoid any excess of moral hazard in this entire bailout business, is for those companies most desperate to get at those funds should simply take the route of bankruptcy. If this economy has bankrupted you, then go bankrupt.

We could then fund TARP to give us more bankruptcy courts and officers.

Taleb Throws a Right Cross

The most exciting interview this morning with Keene and Prewitt was with Nassim Taleb who comes out swinging against Portfolio Theory. His watchword is that the more it looks like science, the less it works. His new direction is towards tinkering.

The bad news is that he finds that it's going to take a long time to get the current class of academics to change their ways. Those tenured academics who sit at the throne of Merton and Scholes are going to perhaps have to die off before the industry changes. There are a million miseduated MBAs out there according to Taleb, the auther of The Black Swan. His question is how do we survive economically in a world of imperfect information - how do we reverse the hubris of economists?

The answers may be deceptively simple. But understand this, Taleb says that quantitative risk management is essentially dead, and he says that he can prove it. His analysis includes 20million securities over 40 years and he finds that over half of them react to a single variable. The implications are that risk simply cannot me managed with math. There's probably a better way to say it, but he is unequivocal on the point.

His solution is tinkering. He says that the culture of America is especially amenable to an empirical bias. We accept small failures in this culture. We expect people to make mistakes and get back on the horse. Tinkering is encouraged. Trial and error.

Secondly he suggests that the way to manage risk is to only put a small fraction of one's portfolio at risk. The idea of spreading risk through weighting is dead says Taleb. You invest in zero risk or near zero risk items for the overwhelming majority of your portfolio and then let the rest be pure speculation. The result is low risk. What's near zero risk? You tell me.

Finally, he suggest that we pay particular attention to military discipline. Armies always plan for the impossible and highly highly unlikely scenario, and they constantly reassess that every day. What blew up today? It's a different kind of mentality than doubling down and playing the odds on the possibility that you can model the deck of cards.

We're thus going to end up with a different set of tools for managing assets in the future. Taleb invokes Steins rule, what can't go on forever will eventually stop. Portfolio theory cannot go on forever.

As GM Goes So Goes the Nation

A great discussion on Bloomberg this morning gets to the core of the failure of GM now that it's trying to merge with the even weaker Chrysler. John Casesa explains why Toyota can last through a recession whereas GM is failing.

Q. Does Toytota have a cas burn issue?

A.No. Toyota has no debt, is generating cash and Toyota can last through a very very long slowdown, not good for Toytoa but they've got the staying power.

Q: But they've got the balance sheet; it comes down to balance sheet analysis. When did we give up the balance sheet? When did GM and Ford and the others just give it away? Two years ago or ten years ago?

A: One thing I'd like to suggest is that you read Roger Lowenstien's book While America Aged about the pension crisis and there's a third of that book is about the history of labor relationships and benefits in the auto industry. Since the end of WW2 the US auto companies and the union have been negotiating ever richer wage, pension and health care benefits. It's been the cumulative effect of this .. and we probably passed critical point 20 years ago in the 80s; so guys like Rick Waggoner and Alan Mutually are trying to undo mistakes that were made 20 years ago... That's why they call it 'Generous Motors'...These companies in the early 60s had margins of 25% on the dollar now it's negative.

Anybody who knows the auto industry knows that these wage and benefit concessions are the sorts of things that have made the US uncompetitive with Japan. The quality of American cars is no longer the issue - people are plenty happy with the product, but that's not helping the balance sheets of GM, which according to the Bloomberg guys has evaporated.

The dirty secret is that unlike Social Security which can be smartly reformed, increases in health care spending are exactly the kinds of entitlements that will drown the Federal government and take its balance sheet into the same toilet as GM's. Right now we are about 17% of GDP spending on health care. Bump that up a few points and see what happens. America becomes GM.

If you think jobs are flowing overseas now, just you wait.

How I Generally See Obama's Tax Plan

Like these dudes Alan D. Viard, Alex Brill and Arthur C. Brooks in today's Washington Post.

To be sure, these "tax cuts" contain some sleight of hand. More than $400 billion of the money over the next 10 years would take the form of refundable tax credits paid in cash to people who already pay no federal income tax. It would be more accurate to refer to these cash outlays as cuts in payroll tax or -- even more accurately -- as transfer payments. Regardless of what the credits are called, though, they would put more money in the pockets of some American families. That sounds great in these tough economic times. Who can be against a boost to spending power and consumption?

We can. While a few of Obama's proposals may be sensible, the overall package would be bad for the economy. Unlike rate cuts for high incomes or reductions in investment taxes, most of Obama's proposed tax cuts would do little to reduce the tax penalty on work and saving. For some households, the penalty on work and saving would even increase because the new tax credits would be phased out as income rises. These proposals wouldn't deliver the economic growth that incentive-based tax cuts would.

Read the whole thing. As I think about it, again, there's the trend for 'stimulus packages'. Ick. It's a populist voter's rebate. We can't afford it. Have we simply given up the notion that Americans on the low end of the economic totem pole simply can't be incented to do anything smart with their money?

The Bet on Shale

Not long ago we were freaking out about the price of oil. Well, I wasn't freaking out but I was beginning to become a smart shopper for gasoline in ways I hadn't since college. I certainly realized that people were freaking out. And yet I still wanted, and still do want a Hummer. Turns out you can get them cheap nowadays. Well I'll have to move quickly because the price of oil is dropping like a rock.

Now I'm certain that I have said, somewhere in this blog, that the reason 'we' are not digging for shale oil is because the fact that it is increased demand from China and India that is driving up the price, not a short supply. The contradicts the direness of the Peak Oil scenario, but it was impossible to see the black swan of $70 oil once it was over $100/bbl and rising. Well I said that shale will be economic when it is, and we can continue on a regular pace of consumption because as the price goes up we'll exploit other types. But shale seemed to be economic at the time - yet investors were hedging against a decline in demand from China. If you put up a billion to build the infrastructure for extracting oil from shale at an economic price of 90 bucks a barrel, then you have to have a lot of confidence that price will remain stable at that level or higher for a long time. Nobody had that confidence to put the money out there. Looks like they were right.

Adam Sieminski the cheif energy analyst from Deutche Bank is forecasting $50 bucks for late 2009. Average prices will be about $60 which he sees as fair value. This is a sign of weakness in the economy. OPEC has even cut production and the price of oil keeps dropping. It's not oil itself that's driving all this. This is driven by consumption. Global growth GDP is 1.2% according to Sieminski. He's saying retail prices will come down. And by the way he's saying that the meaningful number for new exploration is now around $85/bbl.

Zingales' Debt to Equity Swaps

Luigi Zingales is in today's economic lesson. His idea is that there is a private solution to the problem with mortgages. The answer, which Tom Keene considered brilliant, is debt for equity swaps.

Zingales' idea is this. You look for all of the mortgage holders by zipcode whose housing price has declined 20% or greater. Instead of them defaulting, they work out an agreement with the originator that reprices the mortgage with the provision that 50% of the profit from the sale of the house goes to the originator. Simple.

It allows the mortgage to be recalculated therefore lowering monthly payments, keeps the individual in their house, keeps people with a lot of equity from taking advantage, and doesn't involve any taxpayer money. Of course there will be no politicians to champion it because there's no end in it for them. It doesn't allow them to take any credit, spend any government money, raise or lower taxes.

Zingales also noted that the decision by the FDIC to insure all bank debt going forward for 3 years will cost the government 150 Billion. I figured this was coming. But almost nobody talked about what the FDIC has been doing - it required no Congressional oversight.

Finally Zingales zings the Paulson plan for saying one thing (the wrong thing) and then doing the right thing. He sees it as a logical consequence of the current Administration having too many friends on Wall Street and not enough in the international academy of economists. I agree.

Frugal Is The New Black

I'm going to enjoy changing my lifestyle over the next 18 months as the economy goes south. Why? Because I was always one of those people who wondered how the hell anybody could make money with a Jamaba Juice franchise. And of course I resent those people who do, slightly. Now they're going to be out on the street and the buildings they occupy are going to be converted into eBay intermediaries, because everybody is going to have yard sales to raise cash. Maybe.

Yesterday's economic lesson was that we should expect GDP growth to be down to 2% from 4% and nothing opens up until this time next year when the unemployment target for Deutche Bank is about 7.4%. Sounds like 2003. Well 2003 was a horrid year for me when I was the brokest I've been since college - I ended up doing some housepainting to keep things alive. All props to Greg M, thanks for the work brother. I'm still not resentful of the Jamba-preneurs to make the tax code punitively progressive, as Mr. Obama would. I find it highly disrespectful at best. All that said, what goes around comes around and we don't need any assistance in bringing the mighty low, the economy does that in its cycles and unpredictability, and quite frankly you never know when you need somebody with wealth. Seems to me these are just those times. But I digress.

Apparently something around 70% of GDP is consumer spending. It's rather astounding when you think of it. 17% is investment and 19% is government spending according to the Hoover Institute (Net Exports are -6%) In this economy, it's an open question as to how long 70% is going to be consistent going forward. Tom Keene was asking if we dip two or three points on that figure. Yeah I can cut back. In fact I ought to think about how I spend my moola a bit closer. How can I save more, cut my spending and increase my savings?

I've been increasing my savings and staying out of the market all year. That has been my plan, as well as to get the job that I now have. So far everything has worked out very well. Because I've working on the broad strokes, I haven't focused on the details so much, but now it's time to get out ahead of that and deal with the short game. That means more WalMart and less Target. That means more home cooked meals and less Panda Express. And in those home meals, it means a higher percentage of soup and sandwiches. It means fewer first run movies and fewer DVDs. It means more exercise and fewer new clothes. It also may mean that I swap out the Transporter for some more pedestrian transportation, which interestingly might mean a Hummer, because those badboys are selling pretty cheap right now. I've got to make that change soon before people realize that oil is at a 13 month low, around 75 bucks a barrel.

What are you doing to tighten the belt?

The Zombie Factor

I've gotten two new pebbles for my economic slingshot. One is a big fat dictionary of terms, the other is the biography of Warren Buffett, The Snowball. So much to learn. Frugality is the new black.

Today's lesson has to do with the example of Japan. But first, what Bernanke has done is to emerge as the man with the last theory standing. His theory about what went wrong in the Great Depression is that the big banks were allowed to fail. This is apparently the wall that Bernanke is making against the storm of chaos we are facing - these banks will not fail.

But now that they have been reanimated, will they become zombies? Therein lies the danger, given the example of Japan whose banks were supported long enough to stay alive but not well enough to make the kinds of business decisions that are healthy for the economy. And so while the original idea of TARP, to buy off toxic assets, has turned out to be a dead idea within a week, what are we going to be thinking next week. As it stands, Bernanke's 250B into 9 top banks has been spent not on the bottom but the most preferred assets. So what encourages the bankers to do their best when the preferred stock is going to pay dividends not retained earnings? Basically if the top dogs at Citi would have gotten x% of a bonus pool from a 10% net profit in the old days and now a fraction of that net now goes directly to the new government shareholder, what's the point? Who knows what punitive taxes an Obama administration will tack on to that to satisfy the primal urges of the torch and pitchfork populists?

Moreover, what is the exit strategy? OK we agree with Brad DeLong that when it comes to central banking, everybody is a socialist. But how do we ultimately get government out of banking and everybody else and everything else they rescue?

Imagine this 250B works. Liquidity crisis over. Then what? What about that commercial paper market? What about the insolvency of everything else the Feds have taken a piece of? What's the fair market values for stuff the government owns, and who decides when the Feds take an L? I mean can you imagine some group of investors, you know, some multibillion dollar consortium wants to buy back all of the government stake in JPMorgan. But instead of some profit on the 10Billion share, they want to pay 8Billion. Who in government decides that's OK? What Critter is going to say OK, the taxpayer is stuck with the 2Billion net loss on the government investment, especially if we're in (when we're in) a deficit situation?

Yeah. Scary huh? Meantime? Zombie bank, not responsive to the real market. How do you turn a zombie back into a human again? That one's eating at my brain.

Ron Paul: Curiously Silent

Last December, when I officially declared Ron Paul to be a crackpot as far as I'm concerned, I found a chorus of animated naysayers who defended Mr. Paul on a number of grounds. As I think I'm on slightly more solid ground with regard to my economic savvy, but still not enough to brag, now is perhaps a good time to second guess what we were saying then.

My biggest run-in was with a cat named John Reading, who declared me an idiot and the Fed as counterfeiters.

The IRS is an extortion racket. The FED is a counterfeiting racket. The Selective Service is a slavery racket.

1. Money is not neutral. It's value depends upon its quantity.
2. Deflation does not need to be in check. There is nothing wrong with money growing in value.
3. Savings are encouraged by deflation because the saved money will have greater purchasing power in the future. Saving does not destroy liquidity or lock up cash. The savings are the basis of investing.
4. That I do not discuss something with you does not mean that I do not understand it and am "simplistic". You are running out of logic and turning to insults again.

I have already explained the clear and present danger of counterfeiting. It is a form of stealing, as any child knows.

I find you to be both ignorant and insulting, so I will let you have the last word. I'm done. I hope some of your readers will check out Austrian economics.

So are people lining up to ask Ron Paul for advice? Is there anything at all he was correct about with regard to our economic situation? I think he has gone to hide in a corner, and people are breathing a sigh of relief that he's not the GOP's guy. Not that this is any great comfort. But why not pile on Ron Paul?

 

Take It Or Leave It

I understand. You found paradise in America, you had a good trade, you made a good living. The police protected you and there were courts of law. And you didn't need a friend like me. But uh, now you come to me and you say - 'Don Corleone, give me justice.'.
-- Marlon Brando

Paulson has skipped the drama and come with the hardline. He didn't wait for the banks to come with their hands like cups, he basically said, here's the favor. You owe me. As the consensus of the economic heads have hoped, the offer comes in the form of preferred stocks, which means the Government gets their piece back first, just like the Godfather, when it comes to collecting that little favor.

So there's the bail.

Note this little para:

Another part of the government’s remedy is to extend the federal deposit insurance to cover all small-business deposits. Federal regulators recently have been noticing that small-business customers, which tend to carry balances over the federal insurance limits, had been withdrawing their money from weaker banks and moving it to bigger, more stable banks.

Hmm. I wonder if those small businesses make more than 250k?

Pretty Bouncy for a Dead Cat

The DJIA closed up 11 percent today. That pretty bouncy for a dead cat. It's the biggest one day percentage gain since 1933. Then again, we did sink pretty low. And once again, it's too late for me to be a day trader. I'm happy with my cash position.

I missed Squawk this morning, but I think maybe some of this has to do with Mitsubishi getting its stuff done with Morgan. I spoke briefly with Mr. Jones last Friday night and he shows some concern for the Automotive industry. So the rumor is that the Fed is likely to bail out GM and Ford too.

There is a difference between this sort of nationalization and socialism, but I'm pretty worn out today and will get into it later.

Jones, Last Bank & Insecurity

I am pleased to say that I do have a fairly solid understanding of what has gone wrong in the credit crunch. I don't believe that I have made any significant misstatements to date. I get the following from The Belmont Club - a summary of the causes and effects of the crunch. The example is first rate and for a good fifteen minute read, you can find all of the pieces and how they fit together.

Download Credit_Crunch_Report.pdf

The Report is what a board of accountants in Australia is telling its membership.

Preferred Assets

OK I think I finally understand another part of the Rescue puzzle. This goes back to what folks were saying between the Pelosi Dodgeball and the Senate passage of the TARP.

There are two ways under consideration, not counting the Irish Solution, that banks can be rescued. The first is the only way we talked about initially which is buying up all the toxic assets and then setting them aside - taking all of the question marks off of the books of the banks. The second way is the new interesting way which is to have the banks issue new preferred stocks for the Fed to buy. The Fed holds them and that encourages common shareholders to try and get the more secure capital, the new preferred stocks. The second way adds value directly with cash.

I'm not clear if the preferred stock sale is necessarily a new issue of stock or if most banks already have preferred stock. But this idea looks pretty simple considering how deflated most financial stocks are right now. Surely there are 50 regional banks whose total market cap is now below 5 billion. Putting a billion each into those with a preferred issue would increase them up to 20% and be relatively cheap. I assume that the Republicans would probably insist that such preferred stocks be non-voting shares, I'd bet the Dems will want the government to wrest control from evil capitalists.

Tyler Cohen examines some implications:

We are used to invoking shareholder unanimity theorems, whether they are justified or not. But say the U.S. government owns twenty percent of each major bank. Exactly what instructions do they give the management? ("Hey, guys, just get stuff going again!"?) Presumably the twenty percent shareholder wants something different, and more in line with the public interest, than the desires of the remaining eighty percent. Are we to assume that the twenty percent wins out? Can managers be sued for violating their fiduciary responsibilities? Does the twenty percent explicitly tell the managers to do something other than maximize profit? What if the eighty percent votes to override them?

Hmm.

Today's Economic Meltdown Breakdown

Well, dour analytic geek that I am, I find it rather interesting to have something more exciting to talk about than geopolitics. That is the economic hash we're swimming through these days. I have found a new primary source of prime juicy information which is the daily Bloomberg On The Economy podcast hosted by Tom Keene. Every day I'm learning something new, so I will try to share what I understand here.

The Irish Solution
Today's talk circulated around the problem of LIBOR. LIBOR is the overnight interbank lending rate. Right now it's around 6% which is academic because banks are not lending each other money. They essentially don't trust each other. Ireland, who has had some problems in their banking industry has come with their angle and it is for the government to essentially guarantee all bank liabilities.

It turns out that the FDIC does indeed have the ability to do exactly that, and what raises eyebrows all around is that according to its charter, all it needs to do so is the agreement of the Federal Reserve, the Secretary of the Treasury (Paulson) and of the President. Guess whose input is not required? That's right, Congress.

But exactly how big is the sum total of all bank liabilities. According to today's guest, it's around 11Trillion dollars. American GDP for one year is 14T, so it's a very big number.

What's Broken
The economy is not. It's just part of the big business cycle with the small caveat that we are in a panic. The panic has a lot to do with the fact that an somehow incalculable amount of credit swaps are leveraged against a dicey set of mortgages which in turn are leveraged against real estate in a soft market. We are experiencing a rolling set of downturns starting in real estate markets which have affected the financial sector which in turn is restricting credit, which will have a negative effect on the ability to buy inventories. Everything will slow down.

The panic, the selling on Wall Street has destroyed a lot of capital, and today, now that the moratorium on short selling is off, cost the market another zillion in capital. But short sellers do help establish a bottom - or at least a psychologically quantifyable bottom to the market which is what we need. Once the panic is over, all we have is a slowdown, a real recession. The question of liquidity is very specific and is being addressed by the Fed which has it within its power to put money into the system and take money out if it gets inflationary.

What I've come to understand today is that although it is a precedent for the Fed to buy commercial paper, which helps particularly with inventories, since banks are not buying it, this can work. There are problems of course. What if they buy some and not others? Does this change the credibility of commercial paper ratings and rating systems? These are the unknowns.

Clearly there are a lot of options, I am coming to understand some of them - there are a huge number of things to learn here. But it's clear that those people who know how monetary policy and the Federal Reserve and money markets work, will have a close eye on developments. They are certainly not saying that our economy is broke.

Mark To Market
What I also heard today is that the idea of 'mark to market' pricing of financial assets is a good idea and has served us well. It's a common sense kind of logic behind that. Bottom line, when you mark to market it makes visible those assets which are in trouble. The alternative is to use a 'book' value of your assets. In the current crisis, the effect of marking assets by book value would be to mask the effect of losses in value to those assets.

Four Points from Roubini

Bank Triage

Deposit Guarantees

Preferred Share Purchase

Asset Repricing

I subscribed to the daily Bloomberg economics podcast last week and it's been rather revealing. I once looked over at Roubini, or what I thought was Roubini last spring and instead I got this rant from a guy whose name I forgot. At any rate, I highly recommend the Bloomberg podcast.

Bank Triage
The government has to decide which banks are going to succeed and which are to fail. Simple. Depositors and investors have had no way of knowing which banks were close to insolvency or which the FDIC was in the process of negotiating mergers. If you would have asked me two weeks ago if Wachovia, of all the major strong banks in America was in trouble, I would have been shocked.

Deposit Guarantees
Roubini favors a blanket guarantee on cash deposits. It ultimately makes sense and as a temporary measure, I don't see the risk. Cash should be cash, and people should not make a run on banks thinking that their cash might disappear. I don't know how you work the details of getting the FDIC capitalized to insure all that, but I agree that this is an important step. It was a goody thrown in to bump up the limit. So that's better than nothing.

Preferred Share Purchase
I'm starting to understand this part and I think I like it. Instead of the government buying the only the dirtiest and most dubious assets of a bank, let them buy the best assets. It creates a 'flight path to quality' for the common shareholders, and then allows those shareholders, over time to convert their common shares into the preferred shares. It creates a new class of trust in those institutions, not just bailing out their stupidity. It's a tricky proposition, but I think I get it.

Asset Repricing
This is clearly the most controversial part. I don't like the idea of the government seemingly arbitrarily deciding how much mortgages are ultimately going to be worth outside of any market mechanism. It's possible that I don't understand the thrust of this, but it sounds similar to what Biden was saying about having bankruptcy judges arbitrarily whacking principle off mortgages and house prices. Roubini is no fool and I'm sure he is aware of the moral hazard of such an idea of creating a new kind of bankruptcy. So I'm going to keep my ears open on this piece.

Roubini says, and I agree, that the Paulson plan was thrown together very quickly without the cooperation of an independent panel of economists, either academic or professional. My reaction was to the Democrat reaction and Pelosi's dodgeball.

What's not clear to me is that the Congressional action was a be-all end all and last effort. It better not be.

Yay India!

Through no choice of my own, I work for an Indian company. The company I work for was acquired by a company that was acquired by an Indian company. However, my company Rolta, is not your typical Indian IT company. Rather, I have been explaining it as the Perot Systems of India. But it's that and more, it's a global engineering services company. If you're going to build a large power plant, Rolta makes for a good partner.

Here's the news:

With an emphatic vote Wednesday, the US Senate assured that America will take part in India's $100 billion nuclear-energy sweepstakes.

The 86-to-13 vote to resume civilian nuclear trade with India for the first time since 1974 is a signature diplomatic achievement for the Bush administration, cementing ties with a nation seen as a counterweight to China.

But it is also a major piece of business. In 20 years, India aims to increase its nuclear power 10-fold, and will rely on international businesses to do it.

This is the excellent news we've been waiting for. It unlocks a bonanza of energy business.

The Best Take on the Origins & Effects of the Current Financial Crisis

I've had a pretty good understanding with most things right about this financial crisis, but this piece fills in several blanks. Although I understood that teaser rate mortgages and ordinary ARMs were a big part of the problem, I still don't know what percentage of those were offered at subprime, and non-conforming loans. Therefore it is difficult for me to understand (still) how much the insolvency of the GSEs was part of mismanagement there and how much was not their fault at all.

Still, the best summary I've seen is this one by someone with no name. The author makes no distinction between perjorative 'teaser-rate mortgages' and ARMs (adjustable rate mortgages), but the incentives for banks and brokers to sell them has always been the same. With Greenspan lowering interests rates, sooner or later those rates would come up - certainly within the lifespan of a mortgage - and those loan originators would want to get the benefit of those higher interest rates. So instead of fixed rate mortgages, they would sell ARMs knowing that more cash would be forthcoming as they adjusted.

The best (and scariest) part here is the description of the extent of the toxic chains.

If the loan is secured (as mortgages and many other links in debt chains are), the lender is typically less interested in the creditworthiness of the borrower. The lender relies primarily on the collateral, not the borrower, for assurance of repayment.

As a result, each financial intermediary can be thinly capitalized. So a company with $10.1 billion in assets and $10 billion in debt may have a small amount of net equity. Indeed, the more thinly capitalized a company, the higher the return it can make on its capital.

Unfortunately, what this means is that when A’s mortgage goes bad, it’s not just the loans up the chain that go bad – financial intermediaries in the chain often go bust as well. A thinly capitalized intermediary cannot absorb many losses. And that is why teaser-rate mortgage defaults triggered and are still triggering defaults and failures across the entire financial sector. Almost everyone was in the debt-chain business and extended themselves to the max to take advantage of the extraordinary profit opportunities of that business.

I’ve explained the transmission mechanism in terms of debt because readers have an intuitive understanding of how debt works. In fact, however, many of the most important links in the chain were not technically “debt.” Some were shares in “mortgage pools”; some, “derivatives”; some, “credit default swaps.” What they all had in common was that each transferred some risk of default up the chain to someone else. Wall Street sometimes calls links in such debt chains “toxic waste,” because today no one wants them.

Why is this scary?

..at least $500 billion more of teaser-rate mortgages are scheduled to reset over the next several years. In all likelihood, they too will go into default and become toxic waste. Nothing in Mr. Paulson’s original proposal was intended to do anything about this next $500 billion installment – or, indeed, to prevent lenders from making more teaser-rate mortgages in the future.

Similarly, Mr. Paulson’s proposal was not intended as a general Wall Street bail-out, although to some extent it would have had that effect. Note that the outstanding overhang of credit default swaps alone is estimated to be between $45 and $60 trillion – three to four times the size of our annual gross domestic product. The requested $700 billion, although the single biggest appropriation request in U.S. history, was miniscule when compared with the toxic waste problem as a whole. Mr. Paulson’s proposed solution was to cost just 1% of the size of the problem and was aimed only at a small part of that problem. (It is unnerving to realize that the U.S. government – the “beast” we have been starving for so long – may now lack the borrowing capacity to solve the problem as a whole. We need to get our financial house in order.)

Yike, and double yike.

Equity Warrants

Here is a good read. I have no idea nor do I care about the politics of advancing or rejecting the argument. It simply makes sense to me.

If I understand correctly, when nobody knows the real value of an asset, any agreeable price is legitimate. Letting the government be the buyer of last resort puts a real price on something nobody else can or will buy. The government, not being strapped for cash or needing to turn a profit in any short period of time, can make a price offer on an asset offer an equity warrant at the same time.

The equity warrant allows the seller some exclusive right to buy the asset back at a price fixed at the time of the sale.

So here's the example.

Let's say I have a portfolio of 100M of 'toxic assets'. It doesn't really matter what they are, I've valued them at 100M in a non- mark-to-market accounting basis. Meaning I'm stuck with them like the junk in my garage before the garage sale. Instead of actually emptying the garage and risking having to sell them at deep discounts, I sell that portfolio to the government in exchange for cash and warrants.

So lets say that the feds offer me 80M in cash and 20M in warrants. I get 80% liquidity. Boom that's great, but I also get a chance to buy 20M worth at some future date at a discount rate. The assets will have to appreciate for me to exercise those warrants - for them to be worth anything, but it's a cool deal for me because I can conceivably get the entire 100% of my non-market valuation at some point in the future. So basically I can buy some of my assets back when they are not toxic.

The problem with this entire scenario is that the government is not particularly equipped to do anything with those 'toxic assets' except sit on them until this whole mess boils over. Park them until the panic subsides. I think the issuing of warrants to the original asset-holders and to the investing public is a cool idea and it saves the feds cash.

The Return of Brown

All of the big investment banks are gone, but the little ones are still around. And guess what? That's where the big brains are going. Barnett and I am on the same page when he notes:

First Boston (Steve’s old shop) was gobbled by Credit Suisse back in 1988, then Salomon Smith Barney went to Travelers, later consumed by Citicorp. In 2000, PaineWebber went to UBS, J.P. Morgan went to Chase, and Donaldson, Lufkin and Jenrette went also to Credit Suisse. AG Edwards disappears inside Wachovia in 2007, and Bear Stearns went to J.P. Morgan a few weeks back. What happened last week was the last three big independents disappeared: Merrill Lunch to Bank of America, and Goldman Sachs and Morgan Stanley convert to commercial holding banks. Lehman simply goes bankrupt. Let me be clear here: the function of investment banking does not disappear, just the large-scale independent form (meaning, separate from a commercial bank).

As Hambrecht mentioned in the video I posted not long ago, there are plenty of sectors that are doing just fine and lots of business in America that doesn't require the unique things that Goldman offered. If you want a 100 million dollar IPO, the little guys like Raymond James, Piper Jaffray and Crowell Weedon will do just fine. In fact, I heard a Crowell Weedon commercial on the radio just this morning, and I think they are going to do some crowing. Schwab's not going anywhere.

I rather like this development because I remember Brown & Company, and I dug their attitude and their animated commercials. Of course they got eaten up by E-Trade, and I'm an E-Trade guy. Well, I am now because I'm definitely getting into the market right this minute. I'm going with Warren Buffet. Of course Brown is not coming back, but the idea of being a smart investor working with a small company is. That's going to be better than ever. I'll let you know how I make out come Christmas time.

Note: There's a difference between an investment bank and a brokerage house. I think E-Trade is strictly a brokerage house, which basically means they're traders - they own seats on the exchanges. All investment banks are brokers, but not all brokers are investment bankers.