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September 30, 2008

Comments

Nice to see you front-paging again, Sebastian, and I basically agree with everything you say :)

Last week I drove out to Ohio to see my family, and among the things I listened to in the car, in between bouts of bad economic news on the radio, was Arlo Guthrie singing Tom Paxton's song with this chorus:

I am changing my name to Chrysler
I am going down to Washington D.C.
I will tell some power broker
What they did for Iacocca
Will be perfectly acceptable to me
I am changing my name to Chrysler
I am headed for that great receiving line
So when they hand a million grand out
I'll be standing with my hand out
Yes sire I'll get mine

http://www.arlo.net/resources/lyrics/chrysler.shtml>The rest of the lyrics are here.

Of course, it's closer to a billion grand now. But other than that, plus ca change...

Yes that horrible WPA ... paying all those hungry people to build infrastructure we are still using and enjoying.

Sebastian:

I'm glad to see you wade in here, too.

I share your skepticism about the package, but, on the other hand, as we economists like to say (I'm not an economist, but on the other hand, neither are the economists): "I'm pretty sure that gooey substance landing on my head and all around me is in fact 'sky' ".

Two points:

I've no problem with the concept of large shareholders and debtholders feeling as much pain as possible. However, we live in a non-transparent proxy world these days and it is IMPOSSIBLE for most of the average shareholders and debtholders out there to analyze and define risk in their portfolio.

In fact, I'm convinced this financial crisis would be much worse if folks weren't so ignorant AND didn't have their ignorance reinforced daily by the endless parade of Wall Steet "optimists" raining their happy talk down on us.

Count me among them, and I've followed the markets closely for 25 years.

This, in spite of a quarter of a decade of "investors" being pelted by "financial education" to facilitate the "ownership" society.

Analyze a bank's balance sheet? The rating agencies couldn't even do it.

Secondly, I reject out of hand your rejection of the Chrysler bailout. Keeping Chrysler in business provided MORE competitve pressure on Ford and General Moters, not less. In addition, Toyota, and Honda, etc were a two-by-four across the snout of the American auto industry and it didn't even phase them.

I blame us. The big three gave us what we wanted and their finance arms gave us the means to make the stupid choice of keeping our gas-guzzling habits alive.

Chrysler or not, the other two would have behaved exactly as they have.


I don't really have an opinion either way about the Chrysler bailout. Other than that, I find myself in agreement with pretty much everything you've said here.

So here is my question.

Is it possible to structure a "bailout" in a way that greases the wheels for the credit markets, without mitigating the losses folks who made speculative investments in mortgage backed securities would otherwise experience?

In other words, assuming we want to retain the market discipline of risk, can we have our cake and eat it, too (even if it's not so sweet)?

I ask that understanding that, via 401ks and other vehicles, quite a few of us will be lining up for our haircut if this is possible.

I just want to know if it can be done.

Thanks -

"In other words, assuming we want to retain the market discipline of risk, can we have our cake and eat it, too (even if it's not so sweet)?"

I think so. The AIG loan/bailout seems ok. AIG turned down a buyout at about 80% and a few days later when the government bailed them out they got about 15% and the insurance market didn’t collapse. (It easily could have if AIG went down). The AIG board was apparently holding out for a better deal from the government. We specifically didn’t give it to them.

Now the fact that AIG went down at all seems to have been due to the regulatory changes in mark-to-market accounting rules: under the old system they would have just waited the market out. But that is a different discussion.

It isn't very often that Sebastian and I are even in 75% agreement, so I wish to record that this is one of those times - I especially agree with this:

I'm not happy that 'a' bailout failed yesterday. But I'm not at all sure that 'the' bailout really kept the most important principle in mind. Especially in its original form, it looked like a just do SOMETHING bailout. And not all SOMETHINGS are good.

That said: The problem with punishing the large investors for making bad decisions is that the large investors are frequently pension funds, &c - so the people most severely punished will be the people who had least to do with where the funds lost were invested.

A bailout ought to be targeted to the people at that end - the pensioners, the small-scale savers, the people who put their lives in hock to buy a house. Unfortunately, these are exactly the people whom the Republicans are certainly not interested in helping, and I somehow doubt they're on the top priority list for most Democratic Senators/Representatives either.

Also, what John Thullen said.


To whatever extent possible, the equity and bond investors who invested in the failing companies should lose their investments.

Absolutely. John Hussman forcely made this point in an open letter which was linked to by Yves Smith and referenced by Krugman today. It isn't just about equity, the bond holders have to take a haircut too.

I'm judging new proposals for this bailout using the following crude yardstick: any deal that is good enough for Buffett is good enough for us - we have more money and more negotiating leverage than he does. Anything less than that in a proposed bill, and you'll know right away that we are dealing with a giveaway package, not a rescue package.

Oh, also - Seb it is good to see you top posting. Please try to make it a habit.

Thanks!

Just to expand on what Jes said, I basically agree with Sebastian's narrow premises, namely 1) don't just do something for the sake of doing something, 2) don't remove the consequences for risky behavior and 3) governments often overreact during times of crisis (see Federalist #63 for application of this tendency in foreign policy, btw).

However, I'm much more wedded to those principles when the collateral damage from failures of large institutions isn't so great, when the consequences don't apply so broadly that innocent bystanders tend to suffer disproportionately. So to put it simply, rather than being held hostage to institutions that are *too big to fail*, we should be more aggressive in prophylactically not letting them get 'too big to fail'. We need to bring out our inner Teddy Roosevelts.

What's more, in the context of say, Adam Smith's ideal marketplace, large mergers and acquisitions are ANTI-COMPETITIVE. That is, sentiments like "we need to grow larger in order to compete" are complete oxymorons in terms of achieving a just and efficient market; the fewer the firms competing for business, the more distorted the market becomes.

So I'm willing to let the market *work*, provided it was a genuine, diverse, multi-party market in the first place.

I agree with everything you say here Sebastian. I would like to see more discussion on this though:

Now the fact that AIG went down at all seems to have been due to the regulatory changes in mark-to-market accounting rules: under the old system they would have just waited the market out.

I’ve stayed out of this mostly due to ignorance on my part but one possibility that I’ve keyed in on is mark-to-market rules. These rules seem to be at the heart of a lot of this. As opposed to throwing a ginormous pile-o-money at this (an arbitrarily sized pile that’s likely just to be sucked up by the same players that got us into this) – why not just suspend these rules for a time and see what happens?

My simplified understanding (again assume my ignorance so anyone who knows more please correct me) – companies have had to write down the assets on their books based on the last (price reduced) sale of a similar asset by another company. That reduction in (paper) assets may force them to sell assets at a yet further reduced price, forcing other companies to write down similar assets, and on in on in a vicious circle. This is an artificial reduction in asset values that spread across these companies. No one wants to extend credit to a company with no assets. The SEC uses mark-to-market to gauge the solvency of the companies. Company fails.

Take a bundle of sub-prime mortgages. The value is not realistically $0. The houses still stand. The land they sit on actually exists. But the book value has been artificially driven down to nothing.

I don’t know how you do it – I’ve seen suggestions like have someone (SEC? Third party?) establish a new valuation for the assets based on an average for some time before they cratered – then lift the mark-to-market requirements for a time and see if they start trading again. If they do then the valuations may reach a more realistic plateau. If it doesn’t work out then put the rules back and try something else.

I know it seems counter-intuitive to talk about easing regulations when everyone is screaming for more regulation (here anyway) – but not every regulation is smart in and off itself.

OCSteve:

The things that companies need to mark down to market may,/b> be worth more than the mark. They may not. Some of the securities really are worth $0, because they are the lower tranches of bonds that take the losses first. It doesn't take very many defaults before some of the stuff is worthless.

My problem with suspending mark-to-market accounting is that it eliminates the only check on companies just lying about how much their holdings are worth. Once you allow them to mark-to-model, it becomes impossible to have any confidence that the assets are worth what the holder says they are. The whole reason FAS 157 was created was because no one could trust the balance sheets that companies released.

If FAS 157 is going to be suspended, there must be something else installed to produce trust. My idea, which I could be persuaded is wrong, is that, rather than a wholesale suspension, it is case specific, and comes with requirements. If a company wants to avoid mark-to-market, it must petition the SEC to be allowed to do so. A condition of assent is that the company has to open up their books and make public all of the details of any asset that they are not marking-to-market. If you don't like the market price, fine, but the rest of us get to make that decision for ourselves.

I suspect that you won't find a whole lot of takers. The real problem is that companies don't want to admit what their assets are worth, not that they are forced to value them incorrectly.

Stop bold

OCSteve,

Marking assets to model (what the banks think they should be worth) rather than to market is what helped to create the "lost decade" in Japan following the collapse of their real estate bubble. I think a reasonable argument can be made that something like that would be the least-bad likely outcome in the US today but we need to be clear about what we are talking about - a slow motion recession which may last for close to a generation. Essentially you take the economic damage from a fast deleveraging and just spread it out over a longer period of time. In theory this is better than a fast deflation because the latter can overshoot on the way down due to short term fear and panic.

It isn't clear that following the Japanese path is even feasible for us, since they have a high savings rate and we don't.

To whatever extent possible, the equity and bond investors who invested in the failing companies should lose their investments.

And the top managers should be stripped of their golden parachutes. Alternatively, all top management severance package should be recalculated in terms in shares of the companies they've ruined.

I will not be bold.

Sebastian: reminder to put your name at the top of your post, please?

And good as always to see you posting.

What JMN said. As I understand it, the problem is that the banks actually do have trillions of dollars in CDS that are worth $0. And will stay that way unless housing prices miraculously increase 25% by tomorrow.

I’ve been trying to write a post on the mark-to-market question, but I haven’t been able to find enough good information on its effect on the crisis.

In principle it is exactly the type of regulation I would normally support—a transparency regulation. In fact when I heard about it a couple of years ago it seemed very sensible. If you have an asset with a declining value, that should be disclosed so that you don’t artificially inflate the values of your books and attract investors on the incorrect premise that your assets are valuable. This keeps failing companies from dragging on and on forever.

So far, so useful. The problem is when assets adjust to a bubble popping. The normal reaction by a large company with a long term outlook in valuable but formerly bubbly assets would be to let prices adjust, and then hold on to the assets for a couple of years while the asset prices recover (though likely not to the level of the bubble). At the very minimum they want to wait out the initial pop because if a big entity tries to dump the asset all at once, they become a part of the problem and drive the prices down further and faster. So normally a company like AIG would just refuse to sell into the panic and wait it out.

But with mark-to-market, those assets get valued at the panic market value and that changes your credit rating, making it much more expensive to get loans. In order to avoid this you have to sell the assets, making the panic value worse and worse. And if no one wants to buy because of the uncertainty, the price drops even further, triggering the same problem for even more assets.

Essentially mark-to-market has legislated away any hope of the long view when a large asset class has a bubble. You can’t hold on to the asset class even long enough to unwind it slowly. You almost have to sell into the panic.

Again, I want to point out that I would have supported this kind of rule a year ago. I’m not trying to score partisan points. In a normal market it probably is better than the other major systems because it lets failing firms fail. But it has a HUGE weakness in certain market situations because it causes failures when a medium term outlook involving not selling directly into the panic would avoid failure.

I agree that mark-to-market accounting regulations contributed to this situation.

But, what exactly is wrong with marking to ..... the market? Everything else gets marked to the market. Wages, for instance.

How much are those shoes?

Shoe salesman: (points to $100 sign and winks, then sotto voice) They are worth $30 bucks. For you, $42 bucks. But don't tell anyone, otherwise the truth might get out and Harry over there is cruising through life thinking everything's worth what the sign says it is.

Truth gets out and pretty soon the whole system goes shebang.

Better to let the advertising department lie and the accounting department cheat and you and me whispering among ourselves.

One of the built-in features of our system of government is that politicians have a huge incentive to do something. Not just for major crises, but even of small ones. The fact that most of them have no clue about the things that they are writing law on means that they will make the situation worse more often than provide solutions. And accomplish nothing relevant more often than either.

OCSteve the reason we got into so much trouble is because these banks were able to mark to model which allowed them to artificially inflate their numbers to the stratosphere. They then leveraged themselves on top of their inflated numbers.

The problem wasn't banks being forced to mark to market. The problem was that they were allowed to mark to model so long as there was no real sale. So long as everyone agreed to not look down Wile E Coyote could keep on hovering there above the ground without any support.

"Hey Chase how much are your tranches of MBS worth?"

"Our models say 200 billion. How about you?"

"Our models say 220 billion because they've increased in value in the past two minutes."

"They did? How do you know there haven't been any sales?"

"Our model says so."

"Guess what mines worth 240 billion now."

Did anybody else see this comment by Richard Kline on nakedcapitalism?

He suggests that we may have a partial decoupling between Wall St. and Main St., which is buffering the latter from the full impact of losses in the former, and that the moves which the Fed/Treasury are making now to prop up Wall St. are in the short term helping to cushion deflation but in the longer term may be highly inflationary in a manner somewhat similar to what happened in Russia and Argentina in the wake of their currency/banking crises.

what we presently have is a massive contraction of hyper-expanded faux credit. All this gearing by the shadow wankers didn't go into the real economy, it went on spinning prices in financial space. This is a large part of why the tremendous credit hoarding we have seen hasn't totally frozen the real economy in the US. It can, it can---but it hasn't. What has been frozen is the money-whirling motions of the vapor credit economy. This is why the banks are seized up, but Walmart still has full shelves and container ships pulling into port every day. It is not like the vapor economy and the financial economy are partitioned from each other, no; far from it. But they are not the same, and this is not adequately weighted in the 'balancing' spoken of by Rosenberg and others. Yes, we have a decline in consumption: that is manifestly recessionary. Not to be too fine, but we may get a Depression on Wall Street while only getting a Recession on Main Street.

John Thullen,
Wages are marked to market, true. (At least, if you don't work for the government.) But more like annually than daily. Which is what keeps things from the kind of panic spiral that we have seen in prices the last few weeks. If you are changing jobs, or looking for a raise, mark-to-market wages matter. But unless you are in a really odd position, you don't do that all that often.

co-sign jmn.

the liquidity crisis is not the result of a lack of buyers, but of a lack of sellers. put simply, the holders of the most toxic of mortgage-backed securities and other collateralized debt obligations don't want to look stupid by selling the instruments at a steep discount.

the last sizeable purchase of mbs/cdo's was by private equity shop, lonestar, for about 22 cents on the dollar. many economists theorize that the the reason credit markets have seized is that financial firms have been holding onto their mbs/cdo's in anticipation of a paulson rescue, in which the govt purportedly would have paid over and above fair market value (~22% of face value) for these instruments. once financial companies know that private buyers are the only game in town, they will begin to sell and a more orderly, liquid market will take shape.

the dow lost 7% yesterday, and gained back 2.5% today. by contrast, the dow lost 27% of its value on black monday. the sky is not falling.

That said: The problem with punishing the large investors for making bad decisions is that the large investors are frequently pension funds, &c - so the people most severely punished will be the people who had least to do with where the funds lost were invested.

I'm afraid I don't see the problem here. If a large pension fund wants minimum risk, it should invest in tbills, not exotic mortgage backed securities. If the fund is in a position to take a massive hit from this crisis, then that suggests to me that the fund made some very risky decisions in search of high yields. I don't see why anyone should bail out such investors. Making bad decisions because you get greedy is wrong whether you are poor or rich.

A bailout ought to be targeted to the people at that end - the pensioners, the small-scale savers, the people who put their lives in hock to buy a house.

Can you explain how to do this?

Also, I'm not really thrilled about bailing out people who put their lives in hock to buy a house. That seems like a very stupid decision. If you invest all your wealth in a single asset that is subject to massive bubbles, well, I'm not sure you deserve a bailout. You wouldn't deserve a bailout if you bought stocks on margin, would you?

wpa="long term problems"?

the fdr administration had its share of misteps, but the wpa damned sure wasn't one of them.

i suppose that looking at it from a classical free market point of view, one might have a problem with the government being an employer of last resort. i have a degree in economics, but i also have a lifetime of real world experience. from the bottom end, having a paying job is a hell of a lot more important than offending a professor's sensibilities, any time, any day. the wpa served its purpose well, as did the tva, the ccc, and most of the other new deal agencies. all the slander the free market idealogues can come with hasn't changed that fact.

From Seb's explanation, it seems that overly simplistic models of credit worthiness were the problem rather than mark to market accounting rules per se. If your assets tank in value, then you really are worth less, but your credit worthiness should likely include some judgment about how much you'll be worth in the future rather than how much you're worth right now...right?

"But, what exactly is wrong with marking to ..... the market? Everything else gets marked to the market. Wages, for instance."

No they don't. If wages in your job sector drop do you automatically get a pay cut? That almost never happens.

What Sebastian says surely seems sensible, but I wonder about one aspect.

Bondholders are not the only creditors of those holding the deadly assets. There are short-term lenders as well, institutions providing overnight credit and the like. So if you want wipe out the bondholders, shouldn't you wipe out these lenders as well? They're lenders too, with the same obligation to be careful about who they lend to. The only difference is the details of the loan.

But isn't the failure of these lenders part of what we're trying to stop? Isn't the "financial contagion" the cascading effect of defaults on credit lines and the like?

I don't intend this as a series of rhetorical questions. I honestly don't know the answers. I don't fully grasp this crisis and it puzzles me in many ways.

I read Hussman's letter and it makes some sense, but it looks to me like the bailout plan simply recapitalizes the banks a different way. You overpay for assets and take equity in the amount of the overpayment (plus a 25% premium? - is that still there?) once you know how much you've overpaid. A direct approach might be better, and Hussman's "super-bond" might be more palatable politically than what's been proposed, though I don't see how it wipes out bondholders.

"Also, I'm not really thrilled about bailing out people who put their lives in hock to buy a house. That seems like a very stupid decision. If you invest all your wealth in a single asset that is subject to massive bubbles, well, I'm not sure you deserve a bailout. You wouldn't deserve a bailout if you bought stocks on margin, would you?"

And actually I'm not even sure it is that bad. Most of the worst loans were near-zero down. The people who lose their home at that point have essentially just over-paid rent for a year.

Y'all don't pile on OCSteve. I think there is a real intellectual problem here.

On the one hand, mark-to-model is a bad idea, because it means that we have no good valuation of these assets. So we can't go there. On the other hand, mark-to-market is intolerable, as OCSteve, points out, IF it leads to a positive feedback cycle of devaluation. So we can't go there.

Somebody needs to think up another method of doing this.

wages are most certainly marked to market to the extent that the value of the dollar fluctuates with global demand.

If wages in your job sector drop do you automatically get a pay cut? That almost never happens.

Not automatically, there's some stickiness, of course. But there are lots of ways to get a pay cut over time - heavier work loads, reduced benefits, raises less than inflation, fewer advancement opportunities, layoffs. Also, workers newly entering the sector, who may have invested in training, do not get the wage they expected.

On the whole, I think it's reasonable to say that that human capital is marked to market in the sense that its returns drop.

"the wpa served its purpose well, as did the tva, the ccc, and most of the other new deal agencies."

Some elements of the National Recovery Administration (NRA) were among the over-reaching mis-steps. The well-intentioned "fair code" became a mess.

The National Industrial Recovery Act (NIRA) was also badly flawed, also leading to major messes of over-reaching bureaucracy.

These are a couple of the answers I thought publius might respond with, but I got impatient with waiting.

There were plenty of other mistaken lurches taken during the New Deal, as well, since FDR's approach was very much throwing whatever seemed like a good idea at the wall of the Depression, to see what stuck and helped, but yes, most of the New Deal ended up doing great good, contra conservative revisionsism.

I don’t like the idea of abandoning mark to market because of the transparency problem – marking to model is an invitation to corruption and cheating and defeats the price discovery function of the markets.

My understanding of the problem with mark to market is that it is what economists call procyclical (or contains what engineers and scientists would call a positive feedback loop, which is how you build instability into a system) but that feature was given additional salience when combined with another aspect of our system which is that the banks attempted to maintain constant levels of leverage as the asset bubble inflated.

They did this because they have a profit motive driving them to higher levels of leverage – up to whatever level of risk was considered acceptable for the returns being obtained, or until they hit regulatory limits (in the case of depository institutions for example).

The problem with this under a mark to market regime is that as the value of the assets you are holding rises during an inflationary bubble, your leverage will contract unless you make additional loans based on the same assets. This is what the banks did – they “geared up” as the bubble rose. If they had not done that, they would now be in a position to ride out the deflationary phase of the bubble without falling below their required level of capitalization.

It seems to me then that part of the solution we need to put in place after this mess has been cleaned up is to recognize that whatever regulatory regime we have to govern leverage needs to have a countercyclical component to it – some sort of negative feedback mechanism to counteract the positive ones already built into the system. The Fed was supposed to fill that role but they failed to do their job.


A direct approach might be better, and Hussman's "super-bond" might be more palatable politically than what's been proposed, though I don't see how it wipes out bondholders.

I think the key to Hussman's solution is that the new captial is injected in a way which makes it senior to existing stakeholders (both equity and bondholders), so if the firm is liquidated the Treasury is first in line to get repaid.

This will automatically devalue the existing bonds as they are repriced by the market to reflect the change in their risk level.

Note that this is exactly the way that private capital is recruited in this situation - if one of these banks were to pitch a proposal to a sovereign wealth fund, the SWF would demand senority. What Hussman is saying is that the US Treasury should invest in these banks under terms at least as good as what a SWF would demand.

It seems to me then that part of the solution we need to put in place after this mess has been cleaned up is to recognize that whatever regulatory regime we have to govern leverage needs to have a countercyclical component to it – some sort of negative feedback mechanism to counteract the positive ones already built into the system. The Fed was supposed to fill that role but they failed to do their job.

I think that last point is really the crux of the issue. The Fed completely failed in its job of protecting the stability of our economy. I would say that Greenspan was asleep at the switch, but it's actually worse than that. Not only did the Fed fail to pop the asset bubble as it was inflating, it actually contributed to the bubble by keeping interest rates unreasonably low.

Sebastian, thanks for trying to explain how mark mark-to-market accounting could create a problem (1:01 pm). I'm still not following some of the steps. It sounds like you think that lenders are making a mistake by asking for too high of an interest rate on loans to a company with these formerly bubbly assets. So why can't the company convince the lender that it's in better shape than mark-to-market accounting would suggest, and get a lower rate? And how would allowing the company to not report its mark-to-market values convince the lender to offer better terms? If lenders want to rely on mark-to-market values, it seems like they'd just charge a lot more to any company that doesn't share those numbers.

I also don't want to see why a company would want to sell these assets. If the company's credit rating is bad because they have to report these assets as being worth 22c on the dollar (when the company thinks they're worth more), how does selling them for 22c on the dollar (or less) improve the company's standing in the eyes of lenders? Or are they just predicting that the market price of these assets will drop further as other companies shed them, which will make their balance sheet look even worse, and so they're trying to get rid of theirs first?

"wages are most certainly marked to market to the extent that the value of the dollar fluctuates with global demand."

Since the average US consumer is overwhelmingly a domestic consumer (don’t have the numbers in front of me, but it is in the 80% range) that isn’t the case.

Not automatically, there's some stickiness, of course. But there are lots of ways to get a pay cut over time - heavier work loads, reduced benefits, raises less than inflation, fewer advancement opportunities, layoffs. Also, workers newly entering the sector, who may have invested in training, do not get the wage they expected.

On the whole, I think it's reasonable to say that that human capital is marked to market in the sense that its returns drop.

No that isn't the same at all. That would be like the old mark-to-model system. No one claimed it could prop up prices of a devalued asset forever. It just spread it out over time. The mark to market model mandates immediate devaluation. If the majority of paychecks could go DOWN every paycheck or if they were adjusted no less than every single quarter you would have something closer to a mark to market situation in wages. The problem is that you are confusing someone looking for a new job (his pay is determined by the market at the time of hire) with the large majority of people who already have a job. Someone looking for a job is ‘acquired’ at market price just like someone purchasing a new home today. The question is what about someone who already has a job. They are analogous to the held asset. If there is a permanent drop in value for that job/asset, the price will eventually reflect that. But most workers won’t have a $75,000 job for 2 years and then without getting fired (i.e. there is no sale of the asset) see their pay drop to minimum wage.
Wages are not similar to mark-to-market accounting.

So why can't the company convince the lender that it's in better shape than mark-to-market accounting would suggest, and get a lower rate?

I'm not Seb and although I earlier asked a related question, I have one guess: lenders lack the expertise. Their clients are going to sell them a story and they won't be able to figure out whether that story is true without a lot of domain specific knowledge. Lenders have to lend to all kinds of companies and if they now have to perform fine grained assessments about the future value of their clients' holdings, then they're going to have to develop as much knowledge about their clients' businesses as their clients have. Well, maybe not as much, but a whole lot more than they have now. I mean, if you're assessing a house, you don't need to know every detail about the local real estate market, but you do need a fair bit of specialized knowledge. And that knowledge is time consuming, and expensive to acquire. The beauty of mark to market accounting is that lenders don't need to build that expertise internally: they can rely on the market to provide that service for free. In theory, we might expect some super rating agency to step and fill this role, but the ratings agencies significantly contributed to the current crisis, in part because the incentives for how they got business and how they got paid were...problematic.

Blar, "It sounds like you think that lenders are making a mistake by asking for too high of an interest rate on loans to a company with these formerly bubbly assets. So why can't the company convince the lender that it's in better shape than mark-to-market accounting would suggest, and get a lower rate? And how would allowing the company to not report its mark-to-market values convince the lender to offer better terms? If lenders want to rely on mark-to-market values, it seems like they'd just charge a lot more to any company that doesn't share those numbers."

Because for a large number of the institutions in question they are not permitted to lend to companies with certain ratings.

"I also don't want to see why a company would want to sell these assets. If the company's credit rating is bad because they have to report these assets as being worth 22c on the dollar (when the company thinks they're worth more), how does selling them for 22c on the dollar (or less) improve the company's standing in the eyes of lenders?"

Because the largest portion of the credit worthiness is judged on the balance sheet. If you take the loss, it comes off the balance sheet. When you sell the 'bad' asset, even at a loss, you now have a higher percentage of 'good' assets on the books.

Turb: "From Seb's explanation, it seems that overly simplistic models of credit worthiness were the problem rather than mark to market accounting rules per se. "

Not really. The balance sheet is supposed to be the most important indicator of how a company is doing financially. If you are asking for the credit rating to be based largely on something other than the balance sheet you are just saying that you essentially saying the same thing as people who are saying that the balance sheet shouldn’t be mark-to-market.

This is a stupid question, but could the problems with mark to market be alleviated if asset values were based on a weighted average of relevant market prices over time? The trick here is that the amount of your weighting went back was tied to an independent regulator's estimate for where we were in the business cycle. So, when we're in the inflationary and deflationary phases of the cycle, the regulator sets the time window over which prices are average to something large (which lowers marks when the bubble is inflating and raises marks when the bubble is deflating) while setting the time window to something smaller during less bubbly periods. Does this make any sense or is the regulator's job objectively impossible?

It seems that benefits of mark to market accounting don't require that current market price information be completely integrated right away...or am I missing something here?


the liquidity crisis is not the result of a lack of buyers, but of a lack of sellers. put simply, the holders of the most toxic of mortgage-backed securities and other collateralized debt obligations don't want to look stupid by selling the instruments at a steep discount.

That is my thinking too - the credit market isn't frozen (as commentators on the MSM keep saying) so much as we have a seller's strike in progress. And this dynamic is being driven in part by expectation of a govt. bailout.

If Congress, the Fed and the Treasury were to collectively tell Wall St. tomorrow: "Drop dead - you are all on your own and you won't get any help from us", the markets would unfreeze and there would be a brief and very desperate scramble to make the best deals that they can get from private capital sources currently sitting on the sidelines. More than half of the firms would be losers in this Darwinian struggle, go bankrupt and be liquidated. The net result would be a dramatically smaller credit market (which is a good thing because we don't need even more liquidity now, we need to pay down our debts to a more sustainable level) and the few remaining firms would be much healthier after the shakeout than they are now.

What the US govt. and the Fed should be doing right now is creating a public infrastructure to act as lender of last resort to Main St. to keep the non-financial economy going while this Gotterdammerung of the IB’s and hedge funds is in progress, not trying to put off the evil day which will in any case arrive regardless of how hard we struggle to put it off.

In other words, this is a forest fire we cannot put out. It is time to put our efforts into scraping a fire line around what we can save and let it burn itself out.

"Since the average US consumer is overwhelmingly a domestic consumer (don’t have the numbers in front of me, but it is in the 80% range) that isn’t the case."

i have no idea what you mean by a "domestic consumer," but i hope you're not suggesting that consumers who buy goods and services exclusively within the u.s. are not impacted by fluctuations in the dollar.

at any rate, whether wages are truly mtm is beside the point. congress has lost its mind... it looks like the bailout plan is going from suck to blow.

I don't know if a weighted average would work. As I said before I would normally think that mark-to-market is a good thing, and if you had asked me a year ago I would have had no reservations. In a non-bubble market it is probably a good thing. But bubbles do happen, and I haven't heard of any reliable way to stop them from happening.

Mandated mark-to-market is new: it wasn't required until November 15, 2007. We clearly haven't worked all the kinks out. Which is part of the reason I’m hesitant about a sweeping government bailout. How many innocent-seeming things like that could be lurking if we change all the rules again? Mark-to-market was seen as a an investor-protection device (and again I almost certainly would have characterized it as an appropriate one if asked a year ago so I’m not trying to score partisan points on it). Very few people would have predicted that it would dramatically intensify the economy-wide effects of the housing market deflation to this extent. And this isn’t at all an argument for complete non-action. I’m just saying that we need to be very humble about our understanding.

All: I’m not saying my suggestion was fully baked or going to work, but certainly people that actually know about this stuff (as opposed to me) should be able to figure something out – that’s why I asked. ;)

But there has to be some happy ground between transparency and forcing these companies into a death spiral with this accounting rule.

And there has to be some way to re-establish a legitimate valuation on at least some of this stuff. Even those lower tranches have actual physical real estate associated with them. I understand that the securities are crap right now. I understand that the actual securities are based on the mortgages (many of which are now defunct) and not the real estate. I wouldn’t buy the securities. I might however buy a bank-owned house that’s at the other end of that tangled web. Who would that money go to in the end? How do we untangle that web and re-establish some kind of valuation on all that bank-owned real-estate? Put another way, the security was based on future mortgage payments that are now not going to happen. But who now owns the foreclosed homes? Babbling a bit but I guess I’m looking for a way to replace the defunct security with another security based on the potential value of all that foreclosed real estate…

If it’s not possible to untangle it, then what can be done with the securities themselves? If the Fed can pull that $750B number out of thin air, then why can’t they push the Staples Easy Button ™ and do some kind of reset on the valuations that can be shown to have been the victim of the death spiral? Then if not temporarily suspend mark-to-market at least tweak it to prevent this feedback effect?

That seems at least as worthy of attempting as buying the worthless assets directly…

TTL,

I see your point about the superbond being senior to existing debt. I think what puzzles me here is the notion of a failing firm. I thought the idea was to prevent the firm from failing by injecting capital in one form or another. If the firm survives then the bondholders won't be wiped out, though a lot of equity could disappear. Is the idea just to get it out of the system, and let it go? There might be some confusion between insolvency and illiquidity here.

Sebastian,

Yes, the changes I described take place over time.

I wasn't really arguing, I suppose, that wages are marked to market instantaneously, as much as that human capital - that is, workers' skills and experience - is. Of course there's no stated price on this capital, but its value as an asset depends on its expected future cash flows, so when they drop it's fair to say the asset value drops.

And of course this might have real immediate consequences for workers. If you see that happening you probably cut back on consumption, for example. So while you don't take an immediate pay cut your economic behavior changes in response to a drop in the wages in your sector.

I respectfully disagree with the criticisms of mark-to-market. Let me count the ways:

1. Libertarians have been touting the value of the unregulated market for about as long as I can remember. One of the key assumptions underlying the alleged superiority of the lack of regulation is the existence of the Rational Investor. You see, if people were systematically illogical, that would be an argument for government intervention, to cover the problems created by investor irrationality.

Live by that sword; die by it. I'm [email protected] sick and tired of fair-weather libertarians who go running to mama every time their philosphy bites them on the @ss. People who are libertarian on the upside but big-government conservatives on the down are in essence a bunch of hypocrites trying to privatize gains and socialize losses.

2. There's plenty of money out there. Warren Buffet is sitting on billions, as are the Saudi sovereign wealth funds. Mark-to-market gives them the best available information on the current value of assets that can be purchased and held. Remember the benefits of "creative destruction"? The new private money may result in a bunch of bankers being fired. My heart bleeds.

3. Let's remember the real problems out there. A. Bad mortgages. B. Leverage. Many financial institutions are technically bankrupt right now because they held such thin capital reserves, choosing instead to distribute gains to employees and shareholders. The only way out is to provide new capital to these financial institutions. The critical question is how.
But allowing the institutions to conceal their true current value increases the likelihood that the taxpayer is going to get screwed.

"What the US govt. and the Fed should be doing right now is creating a public infrastructure to act as lender of last resort to Main St. to keep the non-financial economy going while this Gotterdammerung of the IB’s and hedge funds is in progress, not trying to put off the evil day which will in any case arrive regardless of how hard we struggle to put it off."

I was wondering about this myself. I know nothing about this, frankly, so it was nice to see someone who does know something (compared to me, anyway) taking this view. Is it feasible?

ThatLeftTurn: part of the solution we need to put in place after this mess has been cleaned up is to recognize that whatever regulatory regime we have to govern leverage needs to have a countercyclical component to it – some sort of negative feedback mechanism to counteract the positive ones already built into the system. The Fed was supposed to fill that role but they failed to do their job.

Thanks TLT, Sebastian, and many commenters in between. This is the first moment in months of intermittent effort to understand the significance of 'mark to X' accounting that I feel as if I've begun to grasp the implications.

@Janie M: Arlo Guthrie sang a revised version of the song at Farm Aid a few weeks ago: I'm going to change my name to Fannie Mae...

I might however buy a bank-owned house that’s at the other end of that tangled web.

You would buy a shi**y mcmansion that's a hundred miles away from an urban center with no public transport nearby and that was built with such shoddy construction that it is still not worth the price of supplies that went into it even at auction? That seems like a dumb move. Fortunately for you, you're not actually doing that. By you, I mean the royal you of course. People are not rushing to buy these houses which is why the real estate market is not doing too well right now.

Seriously, a lot of the new home supply was based in exurbs such that living there might have made sense if commuting 3-4 hours a day by car was cheap. At $5/gallon, such commutes are not cheap. Oh, and a 3-4 hour per day driving commute is a good way to ruin your life, but Americans don't seem to care about that so much as the cost of gas. And as with many bubbles, the quality of construction in many of these homes is, shall we say, subpar. Just like pets.com was not really a well designed company worth investing in, a lot of new boom time construction isn't worth as much as you might think. Moreover, the value of real estate depends on what surrounds it, and a lot of new construction is sited in boom town developments that have become virtual slums. These places were only economically sustainable as long as boom time home prices and/or cheap gas continued and without that, some of them lack sufficient tax bases to support government services. So which houses are good investments? I don't know and I don't think most home buyers know and I know for a fact that Wall Street isn't interested in doing the research to find out, let alone in buying them up.

As much as the securities markets have covered themselves in liquid FAIL, I can't help but wonder how big an ocean of FAIL we'll discover if the government really tries to pump money into the asset values of actual houses.

Most of the worst loans were near-zero down. The people who lose their home at that point have essentially just over-paid rent for a year.
Those are the loans you'd expect already to be in default. If they've put nothing down, and falling housing prices have resulted in negative equity (e.g. owing $300,000 on a $180,000 property), their logical response is to walk away.

Further to Mike Shilling's point is this look at how many defaults/foreclosures we can expect based on estimates of how many mortgaged properties will be "underwater" (i.e., more owed on the mortgage remaining than the value of the property). Pretty sobering numbers.

Those are the loans you'd expect already to be in default.

If you mean, "those losses are what should be calculated by traditional default models", then I don't agree. The models were blown out in part because underwriting went straight to hell (stated income loans, I'm looking at you) so that the financial characteristics of buyers was very different from the buyer pool those models were based on.

If they've put nothing down, and falling housing prices have resulted in negative equity (e.g. owing $300,000 on a $180,000 property), their logical response is to walk away.

True, but people aren't rational, and they're particularly irrational when it comes to issues surrounding homeownership. Given the number of people whose sense of self worth and accomplishment is heavily invested in their being a homeowner, I would not expect perfectly rational behavior in this area. And those buyers were most economically marginal (and thus most in need of the ego boost associated with owning) are the ones who are most likely to default. Of course, that doesn't change the fact that they now have tremendous incentives to walk, but it does suggest than many of them might take a long time to reach that decision and might drag out the process for a very long time indeed. They're likely to try tapping other financial sources in all sorts of unsustainable ways before giving in and facing the inevitable. So I would not expect many of them to have defaulted by now.

@Janie M: Arlo Guthrie sang a revised version of the song at Farm Aid a few weeks ago: I'm going to change my name to Fannie Mae...

Yup, plus ca change...

Thanks, Nell. I might have known.

As I said before I would normally think that mark-to-market is a good thing, and if you had asked me a year ago I would have had no reservations. In a non-bubble market it is probably a good thing. But bubbles do happen, and I haven't heard of any reliable way to stop them from happening.

Wow, what a great thread. I'm leary of mark to market partly because there are a lot of things that just don't have a sufficent market to stablish a price. I mean if you're holding a bunch of MS stock - yeah that should be marked to market. But CDS?

Meanwhile mark to model is an epic fail, there's just too many opportunities to value it at whetever you want, and no I din't trust economists and their "scientific" models one bit.

Turbulence: Also, I'm not really thrilled about bailing out people who put their lives in hock to buy a house. That seems like a very stupid decision. If you invest all your wealth in a single asset that is subject to massive bubbles, well, I'm not sure you deserve a bailout.

For most people, a house isn't "a single asset that is subject to massive bubbles" - it's your home.

For most people, a house isn't "a single asset that is subject to massive bubbles" - it's your home.

No, a house really is a single asset and the market for real estate really is subject to bubbles. Most people may or may not believe those things, but that doesn't stop them from being true.

I don't know what most people think, but for me, home is where my family is rather than the place whose mortgage I've been paying. I'm not sure what you mean by home in that sentence or how it relates to the larger discussion. Can you clarify?

The Calculated Risk post I linked figures somewhere between a third and a half of mortgages with negative equity will default. Price drops vary enormously by specific metro area/region, but using a 35% drop, CR figures over 15 million underwater (negative equity) mortgages by the end of 2008.

@Turb: Jes is responding to the rather harsh attitude expressed toward people whose sole investment vehicle has been the house in which they live. That harsh judgement assumes that these people had the financial ability to make significant other investments and that they should have known they were engaging in very risky behavior by buying a home.

First, the degree to which the housing market is subject to bubbles varies by place (neatly expressed in this CR post recalling a Krugman post of several years ago).

Second, in this country home ownership is socially encouraged and governmentally encouraged. So it's more than just one investment/wealth creation option among others to people.

Thanks to an economy whose major engine is household consumption, after the shock of 2001 the government even more strenuously encouraged it, including avoiding regulatory scrutiny and steps that might have slowed the housing bubble that was clearly developing in several metro areas in the following several years. In particular, they did nothing to change the behavior of rating agencies, mortgage insurers, and mortgage brokers who backed the abandonment of traditional lending requirements.

For most people, a house isn't "a single asset that is subject to massive bubbles" - it's your home.

No, a house really is a single asset and the market for real estate really is subject to bubbles.

Save by predefinition, or category limitation, things aren't "really" any one thing. They're many things.

Since Jes prefaced her assertion with "for most people," her statement isn't overridden by the fact that houses are also other things.

Or, just to boil it down, your comment about bailing out mortgage holders comes off as blaming the victim. Most of these people were not embarked on a get-rich-quick scheme, but buying a home.

That is, they were responding to the social and governmental encouragement as well as the historical experience of home ownership as a reasonably sound and secure investment.

Not all, but most. I grant that many people did foolishly believe that home equity loans combined with ever-rising housing prices meant that the piper would never have to be paid. However, even in those cases I find it hard to pin all the blame on the borrowers alone.

even in those cases I find it hard to pin all the blame on the borrowers alone.

In this I may not be in the majority, since there is a rather strong Protestant-ethic punitive streak in U.S. public opinion.

And that punitive streak is reinforced by how easy and safe it is to direct anger and scorn at people in your own community, people without any more power than you, people like you but who've been living a little higher through over-easy credit, no scrimping, less thought for tomorrow.

Compare that with the anger and scorn that might instead (or in addition?) be directed at the expensively suited men and women in the AIG London unit, raking off $3.5 billion from more than $10 billion in profits from the same bet the over-mortgaged young McMansion dwellers made: that houseing prices would continue to go up.

Those AIG vampires don't show up at the local supermarket to be sniffed at vengefully. So much more satisfying to take it out on the neighbors who "got above themselves."

Most of these people were not embarked on a get-rich-quick scheme, but buying a home.

In some areas, perhaps, but not everywhere. I live in one of the biggest bubble zones (Los Angeles County), and the idea of house as investment is very strong here. The people selling houses and mortgages are quite explicit in describing a house as your single biggest investment. I could go on in great detail about how people treated their houses very much as investments rather than residences. It was exactly that attitude that inflated the bubble so much in the first place; bubbles only grow because people are speculating.

Jes is responding to the rather harsh attitude expressed toward people whose sole investment vehicle has been the house in which they live.

Nell, perhaps my situation is unique, but where I've lived, renting has tended to cost less than owning. In fact, looking at the price to rent ratio graphs that you've no doubt seen on CR, this has been true in many parts of the country for many years. Which means that for many people, renting would have saved them money. In my experience, people with spare cash have many opportunities for saving. Certainly, if you have enough cash that you're able to purchase a mortgage, you should have no trouble walking into your local bank's branch office and saying "I want to save some cash every month, what can you do for me". You won't get the best possible investments in the universe, but you'll do OK.

That harsh judgement assumes that these people had the financial ability to make significant other investments and that they should have known they were engaging in very risky behavior by buying a home.

See above. People who lived in places where renting was significantly cheaper than owning had excess cash and also had other investment opportunities. Every single person who ever signed a mortgage was engaging in very risky behavior and the papers that you have to sign in order to buy a house make this extremely clear: you are committing to pay a large chunk of cash every single month and if you fail to do that, you will lose your home along with whatever down payment you put into it. Since most people don't have iron clad guarantees that they will have sufficient income to pay their mortgage every month, buying a house is an inherently risky thing to do.

Second, in this country home ownership is socially encouraged and governmentally encouraged. So it's more than just one investment/wealth creation option among others to people.

Well, joining the military is also socially and govenrmentally encouraged, right? But no one would ever say that is the right choice for everyone or even any specific person without serious thought. That's why you can't join until signing some really scary documents, just like you can't get a mortgage until you sign some really scary documents. People respond to incentives but they are not controlled by them. And to the extent that social and governmental encouragement of home ownership is a bad thing, bailing out people who made bad home ownership choices only compounds the original mistakes.

Thanks to an economy whose major engine is household consumption, after the shock of 2001 the government even more strenuously encouraged it, including avoiding regulatory scrutiny and steps that might have slowed the housing bubble that was clearly developing in several metro areas in the following several years. In particular, they did nothing to change the behavior of rating agencies, mortgage insurers, and mortgage brokers who backed the abandonment of traditional lending requirements.

I completely agree with you here. There's lots of blame to go around.

Or, just to boil it down, your comment about bailing out mortgage holders comes off as blaming the victim. Most of these people were not embarked on a get-rich-quick scheme, but buying a home.

I guess it is blaming the victim, but note that being a victim does not mean one has no responsibility for anything. One can be both a victim and a victimizer at the same time. Many people made highly leveraged bets that went bad. These bets were made with mortgage financing since most banks won't lend you $300,000 in cash to bet on the stock market, but that doesn't change the fact that they made bad bets. So again, why should tax payers who didn't make bad bets have to cover their bad bets? Why do they get to keep their houses even though it doesn't make any economic sense?

That is, they were responding to the social and governmental encouragement as well as the historical experience of home ownership as a reasonably sound and secure investment.

People who had done even a bit of research would have discovered that real estate in this country has a very low rate of return as an investment. I don't think people should be making highly leveraged investments if they cannot do that level of research. It is absolutely terrible that our culture has convinced so many people that you need to own a house to be a serious human being and that houses are a sure fire investment, but I don't see how transferring cash to people who believed these things does anything improve this culture. It would seem to do the exact opposite. The phrase "moral hazard" comes to mind. I understand that was quite important when considering a bail out of Wall Street.

However, even in those cases I find it hard to pin all the blame on the borrowers alone.

As do I. So, who exactly do you see blaming the borrowers alone? I have a great deal of contempt for mortgage brokers, regulators, rating agencies, companies that loaned with bad underwriting. Do I have to preface all my comments with that statement?

Seriously, can you please cite exactly who here has pinned all the blame on borrowers alone?

But bubbles do happen, and I haven't heard of any reliable way to stop them from happening.

We have several recent-vintage examples of how not to stop them, though. The Treasury Dept., Fed Chairman, and others in positions of responsibility simply did not want to take a close look at the shadow banking system -- partly because of ideological anti-regulatory commitment and partly out of a sense that the bubble was all that was keeping the economy afloat.

Nouriel Roubini's arguments were never seriously engaged; they were dismissed.

There were things that could have been done to put the brakes on: enforcement of mortgage lending requirements, reporting requirements for the new derivatives, steeper reserve requirements, and a long list of other regulatory moves.

Turb: You would buy a shi**y mcmansion that's a hundred miles away from an urban center with no public transport nearby and that was built with such shoddy construction that it is still not worth the price of supplies that went into it even at auction? That seems like a dumb move.

And it would be. ;)

However, there are plenty of bank-owned homes on the market right now that are in well established communities. Older homes with quality construction. Looking up some pre-bubble tax assessments on some of these, figuring, oh, offer about 80% of that… Tempting. So yes, it is an actual possibility and an actual question – if the home is at the end of one of these defunct tranches, who does that money ultimately go to? That foreclosed home is still a potential asset on someone’s balance sheet.

Can I ask a stupid question?

Why is it such a disaster if folks find themselves upside down on their mortgage?

If you need to move soon, if you need to borrow against your equity, or if your income drops, you might be in trouble.

But if you have a stable income, don't need the credit, and aren't going anywhere, why not just sit tight? You'll probably be OK again in a few years.

Yeah, you're still paying into an asset that is worth less that what you owe. That sucks. But it ain't gonna be that way forever. And in the meantime, you have a place to live.

This isn't directed at anyone's particular situation here, it's just a general question.

Thanks -

And that punitive streak is reinforced by how easy and safe it is to direct anger and scorn at people in your own community, people without any more power than you, people like you but who've been living a little higher through over-easy credit, no scrimping, less thought for tomorrow.

Here's the thing Nell: I don't care about those people. I'm not interested in punishing them. I was not particularly jealous of them. I just don't care. What I do care about are people who are struggling who for the most part did not lose while making bad real estate gambles. I don't think those people should have to forego lots of government services because the government has to waste tons of cash bailing people out of bad personal investments. Losing your house sucks, but it is not the worst thing in the world. I really don't want to see important government services sacrificed so that we can protect the egos of a bunch of homeowners who fracked up their leveraged investments. Just remember, for every home that government helps bailout, there are going to be a bunch of people that won't get enough unemployment or job training, a bunch of people that need healthcare that won't get it, a bunch of schools that will go underfunded.

The Episcopal Church has a program to provide gap funding for homeowners in the gulf coast trying to rebuild their homes: for those homeowners who can't get the banks to loan them all the cash needed, the Church will cover what the banks won't up to $40K. As long as the homeowner stays in the house for 5 years, the loan is forgiven. In the same communities where this gap funding is being applied, people of lesser economic means are seriously hurting for housing. This is...really bad policy. But it is illustrative of how Americans think when it comes to housing: giving tons of cash to ensure that relatively well off mostly white folks get to own their own home is much more important than helping relatively poor mostly black folks get a roof over their head or job training or economic development. I don't want to see this sort of bad policy run by the federal government. There's too much that people in this country need.

Compare that with the anger and scorn that might instead (or in addition?) be directed at the expensively suited men and women in the AIG London unit, raking off $3.5 billion from more than $10 billion in profits from the same bet the over-mortgaged young McMansion dwellers made: that houseing prices would continue to go up. Those AIG vampires don't show up at the local supermarket to be sniffed at vengefully. So much more satisfying to take it out on the neighbors who "got above themselves."

Again, please tell me who exactly you think holds this anger and scorn for people that shop in their supermarkets while not having much anger about people at AIG London. I know I'm not one of those people. Then, please tell me exactly how you know so much about what happens inside their heads and how what you're writing differs from a strawman.

I heard someone say, the other day, that they've advised people to walk away from their upside-down debt. I'm wondering at what point of upside-down-ness that starts to make economic sense, though. I'd guess there's a certain economic cost to having that default on your credit history, and then not being able to get financing for another house for seven years or so.

In case anyone noticed me not being around for a while, I've been up in the Boston area, visiting family.

Slarti, are you still in Boston? If you're up for it, I'll buy you a beer.

@Turb: I didn't mean to imply that you had been blaming the borrowers alone.

I started out explaining what in your comment Jes's comment was responding to (which Gary did a much better job of with his much shorter comment). The further ruminations about blaming the borrowers alone, I should have clarified, were not directly responding to your comment.

The argument for renegotiation of mortgage terms, for infusion of cash at the bottom, and for instructions to bankruptcy judges that will help people keep their mortgages going is not primarily that of helping those people, but of retaining more value in the mortgages and the securities built on them. And of the general multiplier beneficial effects of having the houses occupied: spending on goods and services, the preservation of real estate values within the neighborhood when fewer houses are vacant, etc.

It is absolutely terrible that our culture has convinced so many people that you need to own a house to be a serious human being and that houses are a sure fire investment, but I don't see how transferring cash to people who believed these things does anything improve this culture. It would seem to do the exact opposite. The phrase "moral hazard" comes to mind. I understand that was quite important when considering a bail out of Wall Street.

Wall Street is full of professionals who've chosen a business that requires knowing the relevant risks.

Main Street is full of people not trained in any of the requisite knowledge. We're in a dumbed-down culture with increasingly crappy schools, increasingly crappy role models, and where there has been a chorus from media, government, most families, and society at large that home ownership is The Best Thing.

Under the circumstances, I'm very disinclined to put anywhere near the blame on the 'end users' that I do on the middlemen and -women, the politicians and regulators who turned a blind eye, and the expert vultures at the top.

So yes, it is an actual possibility and an actual question – if the home is at the end of one of these defunct tranches, who does that money ultimately go to? That foreclosed home is still a potential asset on someone’s balance sheet.

It goes to the more senior tranches. The idea is that the individual homes aren't divided up among the tranches, with the best returns going to some and the worst returns going to others. Instead, the revenue from all of the mortgages (including money from selling houses that have been foreclosed on) gets pooled and divided among the holders.

The trick is that the division is unequal. If the world is good and everyone pays their mortgage in full, all of the tranche holders get paid in full. If some people default so that there's a revenue shortfall, the senior tranches get paid more and the junior ones get paid less, with the exact details depending on the specific investment setup. In general, things have to get pretty bad before the senior tranches lose out, which is why ratings agencies felt justified in rating them AAA. If the market really tanks, what little money comes in will go to the senior tranches and the junior tranches will get nothing. That's why everyone treats them as worthless.

@Turb: Please calm down. Our comments have crossed in the air, and I will this time not bury the lead: By 'you' in my 5:08 comment, I did not mean 'you, Turbulence'.

Those thoughts were sparked (and I should have said this) by BBC person-on-the-street interviews of U.S.ians yesterday about the bailout and related issues, in which a remarkably high percentage of those interviewed expressed hostility to the idea of any help for people struggling with mortgages now.

I have seen and heard the same kinds of harsh judgment made around me for the last several years by neighbors. It's at least partly a generational thing; rural Virginians in their 70s and 80s remember another economic era, and they're really, really harsh about the choices their grandchildren are making. But the tee-vee and those grandchildren's parents and that nice Mr. Bush all send a different message.

russell: Why is it such a disaster if folks find themselves upside down on their mortgage?

If you need to move soon, if you need to borrow against your equity, or if your income drops, you might be in trouble.

As I cited in a comment upthread, CR estimates "only" about a third of such people would default/be foreclosed.

That it's as high as that is because people's income is dropping as the recession takes hold. And loss of a job is likely to lead to having to move (closer to the new job, which is also likely to pay less than the old job).

In areas where the underlying economy isn't trashed and the price drop is mostly bubble deflation, the wait wouldn't seem to be all that long before the price stabilizes at a level where the mortgage-payer can see what they've got (and at that point refinancing might also become easier). In areas like Detroit, where all the signs are telling younger workers 'Get the hell out now', those with upside-down mortgages have every incentive to drive away. To another state.

Those thoughts were sparked (and I should have said this) by BBC person-on-the-street interviews of U.S.ians yesterday about the bailout and related issues, in which a remarkably high percentage of those interviewed expressed hostility to the idea of any help for people struggling with mortgages now.

Ah, OK, thanks for clarifying Nell. Please forgive me for not seeing that in your original comments since it wasn't present. I just assumed that since you were analyzing the motivations of people, they might be people here rather than complete strangers.

The argument for renegotiation of mortgage terms,

How do you plan on doing this without giving a free ride to people that can but no longer want to pay their mortgage?

for infusion of cash at the bottom,

Well, I suppose there are those who complain that the US doesn't do enough to help homeowners at the expense of renters. Certainly giving homeowners cash would help remedy that problem.

and for instructions to bankruptcy judges that will help people keep their mortgages going is not primarily that of helping those people,

Regardless of what you may intend, the effect of those measures is to enrich one group of homeowners. I sure Paulson didn't intend for his plan to be a windfall for Goldman Sachs; that was just a happy coincidence.

but of retaining more value in the mortgages and the securities built on them.

I'm having trouble seeing how this would help. Are there any plans put together by economists with real numbers that project how much cash is needed and explain precisely how this would impact credit markets? I haven't seen any...

And of the general multiplier beneficial effects of having the houses occupied: spending on goods and services,

People are going to spend money no matter what. If they lose their houses, they're going to start renting property, thus generating other revenue streams.

the preservation of real estate values within the neighborhood when fewer houses are vacant, etc.

One risk that all homeowners sign up for is that, through no fault of your own, the value of your investment might tank because other people did stupid things. I don't see any reason to socialize that risk. That risk is built into the prices of homes: the reason home prices appreciate is because people endure that risk. Again, there's a giant moral hazard here.

We're in a dumbed-down culture with increasingly crappy schools, increasingly crappy role models,

I don't see any reason to believe this is true today. Schools have always sucked. Role models have always sucked. I don't think you'll be able to substantiate these two claims, but you're welcome to try.

and where there has been a chorus from media, government, most families, and society at large that home ownership is The Best Thing.

And yet millions of people refused to buy houses under unsustainable terms. Many of those people are not well off. I'm seriously confused as to why we should transfer tons of cash from those people to people gambled and lost. We don't do this with people who play the lottery for instance.

I'm wondering at what point of upside-down-ness that starts to make economic sense, though. I'd guess there's a certain economic cost to having that default on your credit history, and then not being able to get financing for another house for seven years or so.

I think people are beginning to understand that "you'll ruin your credit score" is an increasingly empty threat - when everyone has a bad credit rating, no one does.

@Turb: We're clearly going to socialize somebody's risk. The profits that have been made in the last eight years are privatized, and they ain't coming back other than through steeply progressive taxation.

I'm not aware of models and estimates of dollar amounts for minimizing defaults and foreclosures on the mortgages. But it just seems like common sense that since the increased default and underpayment rate on those mortgages that underlie the securities whose current near-worthlessness and mystery worthlessness is what's created the concerns about solvency that are congealing the credit markets, that shoring up those mortgages would help establish a floor. And that the knowable and known floor would enable the lending entities to make money available again at more reasonable rates.

If the whole thing's so leveraged that no amount of renegotiation and subsidy will make those securities and the further bets on them worth much, then neither infusions of Treasury money at the bottom or the top
on the scale currently contemplated will do the trick, and ThatLeftTurn's fireline approach -- with all the attendant pain and unintended consequences and probable further bank failures -- would seem the best way to avoid throwing in a trillion dollars that would have to be followed by another trillion dollars in the not too distant future.

What's your position on the bill that was voted on yesterday? Would you have voted for it? If not, how would it need to be changed so that you would?

Why is it such a disaster if folks find themselves upside down on their mortgage?[snip]
if you have a stable income, don't need the credit, and aren't going anywhere, why not just sit tight? You'll probably be OK again in a few years.

Because your mortgage is adjustable-rate and/or has a balloon payment coming up and you can't afford either. Refinancing won't be possible if the price keeps going down between now and when you need to refinance, b/c the asset won't support the new loan. Not an immediate problem for most of us, but scary.

Also, what Nell said.

I'm not aware of models and estimates of dollar amounts for minimizing defaults and foreclosures on the mortgages.

Um, if there are no experts who are willing to get behind a plan for "renegotiation of mortgage terms, for infusion of cash at the bottom, and for instructions to bankruptcy judges that will help people keep their mortgages going", then I don't think it is a good idea.

But it just seems like common sense that since the increased default and underpayment rate on those mortgages that underlie the securities whose current near-worthlessness and mystery worthlessness is what's created the concerns about solvency that are congealing the credit markets, that shoring up those mortgages would help establish a floor.

This common sense is not obvious to me at all. I mean, wasn't this one of the objections to Paulson's plan: that there was no plausible mechanism explained by which it would make things better?

What's your position on the bill that was voted on yesterday? Would you have voted for it? If not, how would it need to be changed so that you would?

I agreed with Krugman in that I would have preferred to see larger equity stakes and more oversight. I would have also liked to see a much more time limited bill.

Now I’m frightened as the SEC apparently agrees with me.

Nothing good can come of that.

Maybe I should have posted this here instead of at the Good Times thread:

I worry that people who presumably don't know better will look at the Dow's near 500 point jump today and figure talk of an economic crisis is much ado about nothing.

And I'd almost bet that the 500 point re-tracing, as they say on Wall Street, will only embolden the House Republicans even more.

A 500 point jump?

John McCain must have no idea where he stands now.

(Actually, I'd like someone who knows better than me here could explain such a one-day gain. In normal times, I'd accept the notion of "bargain hunting" -- but these aren't supposed to be normal times.)

---

I been getting hooked all day and haven't had time to read everyone's comments yet. FWIW I think Sebastian makes a good point here:

But I'm not at all sure that 'the' bailout really kept the most important principle in mind. Especially in its original form, it looked like a just do SOMETHING bailout. And not all SOMETHINGS are good."

---

Also, if push came to shove, does anyone think the government would let Ford or GM (I think one of them could be gone by this time next year) go down?

---

Finally: Please post more, Sebastian.


Also, if push came to shove, does anyone think the government would let Ford or GM (I think one of them could be gone by this time next year) go down?

Didn't they already get $50 billion in loans? So, I guess no. But they certainly do deserve to go down, IMHO.

Being in the business, I agree with John Thullen about this: "Chrysler or not, the other two would have behaved exactly as they have."

Hell, it was little over a year ago that GM thought the Hummer was going to be a big seller.

All I know is I saw another firing today -- this time, a close friend who is a manager -- and it ain't pretty on what the politicians have suddenly placed a premium on, that place called Main Street.

BTW, I'm seeing -- by that I mean, living it -- a style of management that completely, completely baffles and disgusts me:

The Titantic is sinking, so let's change the deck chairs. Maybe a new band would make things better, too.

btfbzo:

I've had an observation floating around in my head for awhile about the propensity of American business culture to believe that rearranging the deck chairs constantly (firing on short-term performance, hiring the hot hands, nine careers in a lifetime, which somehow feeds back into the housing crisis {people constantly moving, giving up equity in current homes to assume debt in larger homes}) and wrapped up in a baseball analogy (the Steinbrenner heads must roll approach versus the Oakland Athletics and Minnesota Twins approach of going with middling productive players, etc) ..........

.... maybe it will jell some time soon.

If baseball teams never traded or gave up on talented players and never fired managers and coaches, would their performance and productivity really suffer much at all.

Most of business is Three Stooges "busy-ness".

Hell, it was little over a year ago that GM thought the Hummer was going to be a big seller.

Indeed. I recall reading a quote a few years ago from a very senior exec at GM to the effect that gasoline prices don't really affect the cars that people buy.

I marked GM down as a likely bankrupt within a few years.

In an odd way, it may be that the troubles of Wall St and Detroit have this in common: too many people accepting the conventional wisdom of their industry; too many execs who only talk to each other; maybe just too much geographic concentration.

John:

Yes, and the Twins are in the playoffs again -- if they win tomorrow's one-game sudden-death match with the White Sox, that is.

Meanwhile, in the There Must Be a God Department:

The small-market Brewers are in the National League playoffs with a really fun, young team to watch -- and they beat out the gazillon-dollar payroll of the Mets (of course, that really makes me happy since I am a Philadelphia Phillies fan -- and, by nature, we hate anything New York).

Could not agree more with your "busy-ness" -- 9 times out of 10, that's all it freakin' is and I see it all the time, especially in economic downturns. Yet my owner just came back from a week-long vacation on his boat. Nice.

OCSteve: Now I’m frightened as the SEC apparently agrees with me.
Nothing good can come of that.

It's worse than you think! Pete DeFazio and Marcy Kaptur agree with you too.

They're my kind of members of Congress, but I'm not bowled over by their proposal. Particularly the anti-short-selling bits, which strike me as at best irrelevant to the situation and at worst harmful.

Much more appealing as a way to break the logjam is this:

If Congress takes the Dodd/Frank/Paulson bill, makes it an explicitly short-term $200 billion measure, adds needed meaningful oversight, and strengthens the equity warrant provisions, my guess is that you'll easily get enough Democrats on board to pass the bill -- and maybe even a couple extra Republicans. [main-page story by TrapperJohn at Daily Kos]

Also, Republican Congressional offices report calls running in favor of bailout/rescue/intervention. Constituents are freaked by the stock market drop, I imagine. Wonder if they'll all call back tomorrow taking it back and urging a 'no' vote.

The GOP actually shot an ad attacking the bailout bill before yesterday's vote. Lovely bunch.

Bernard: "I marked GM down as a likely bankrupt within a few years."

Our main competitor bought the land where just a few years ago stood the Lynnhaven, a local landmark that my late dad adored and would go to for special dinners. I went a couple times and it was a small, classy joint. Lobster was their specialty.

Anyway, they went out of business, and NuCar -- whose big lot was right next door anyway -- bought the property and built this gorgeous showroom that was to be exclusively for Hummer, sitting adjacent the Chevy building.

Now the Lynnhaven is gone, and there is this goregous building with no Hummers to put in there -- GM is trying to sell the brand and nobody's buying.

Postscript: NuCar was recently bought out.

Those thoughts were sparked (and I should have said this) by BBC person-on-the-street interviews of U.S.ians yesterday about the bailout and related issues, in which a remarkably high percentage of those interviewed expressed hostility to the idea of any help for people struggling with mortgages now.

It's exactly the same reason that people are opposed to bailing out Wall Street, even though that may penalize some small time investors and pension funds. We don't want to see speculators bailed out from their folly. And you'd better believe that there has been just as much speculation on Main Street as on Wall Street.

Those of us living in bubble zones know that because we've seen it first hand. We've heard our friends and neighbors brag about how much their home has gone up in value, and how they're going to cash some of that out to pay for high living or further real estate speculation. We've seen home prices go so high that we can't afford to buy the tiniest shack without taking on a suicidal loan.

And you can be that we're angry about it. We think that we've been behaving sensibly and responsibly, and we think that we should be able to get our turn. We don't want to see the home speculators bailed out from their folly while we continue to rent. And we certainly don't want to see some harebrained price stabilization scheme that will price us out of the market for the foreseeable future.

Most of business is Three Stooges "busy-ness".

I think everyone who has worked in an office environment has experienced the cult of busy-ness.

An interesting sports study was done a while ago: somebody somewhere was studying soccer goalie behavior and what they do and should do in response to penalty kicks. Turns out that the goalies jump for the ball to the left or right (sorry about terminology: not a fan) far more than they cover the middle of the goal, which is what they should be doing in most circumstances. The reason is pretty obvious: if you miss, would you rather be seen flinging yourself heroically to the side of the goal, or standing around in the center looking like a dope?

So a lot of busy-ness is ass-covering in case things go south. And in a riskier business like finance, you can imagine how this gets magnified. With the impending doom of the investment bank, it's going to be interesting to see how much of this frantic activity we can actually live without.

BTW, just to indulge for a moment, as I was still thinking about the Lynnhaven, my late Dad really knew fine food and drink -- unlike his son, who has very simple tastes: meatloaf, turkey and mashed potatoes (I'm in heaven on Thanksgiving -- turkey, cranberry sauce, football, and a couch); fine food for me means ravioli and meatballs:)

Nell: it just seems like common sense that since the increased default and underpayment rate on those mortgages that underlie the securities whose current near-worthlessness and mystery worthlessness is what's created the concerns about solvency that are congealing the credit markets, that shoring up those mortgages would help establish a floor.

Turb: This common sense is not obvious to me at all. I mean, wasn't this one of the objections to Paulson's plan: that there was no plausible mechanism explained by which it would make things better?

The mechanism seems at least as clear as Paulson's "buy the crappy paper at rates above what it's selling for now" plan (which is: The problem is that banks won't lend to other banks because they fear that the borrowing bank is secretly insolvent, that is, that an honest accounting of their balance sheets including the crappy paper would show them to be insolvent. Then we'll take a lot of the crappy paper off the balance sheets by buying it, which should improves the apparent solvency of the banks.) Today's SEC loosening of the mark to market requirement is another approach to the same problem.

The mechanism by which mortgage stabilization helps the situation is to assure the restoration of predictable (even if lower than originally agreed-on) payments on the mortgages that underlie the crappy paper, thus increasing the value of the paper. Particularly given the leverage involved, even small improvements in the performance of the underlying mortgages should have significant results in restoring value to the securities based on them.

Also, I want to clarify that I have not been proposing mortgage stabilization (through renegotiation and bankruptcy reform) as the major mechanism of an intervention, only a helpful part -- both to the balance-sheet aspect and socially/economically.

If you don't want to do it because it seems like too much moral hazard to you, that's one thing. But surely you can see how restoring those mortgages to revenue-producing propositions is helpful to sorting out the problem of mystery-worth leveraged securities based on them.

OC Steve and others discussing mark-to-market,

Regarding whether to use mark-to-market or mark-to-model, why not just let the firm choose either one? As long as you have rules for sticking to one or the other for a certain period of time (similar to subchapter-S designation) and it's public information, wouldn't that force a credibility test onto their officers?

I mean, having seen what's gone on lately, any company that in the future CHOOSES TO use mark-to-model is going to get a thorough body cavity search by any potential investor, whereas the *safer* method of mark-to-market would give potential investors more assurance that bonus-driven executives aren't cooking the books, making it easier for that firm to attract capital.

Thus, the market could be in actuality the discipliner that it's only been in theory up until now.

Wait a minute here...banks are scared to lend to each other right now because they don't have a good handle on exactly what the assets other banks own are worth. And people want to make it even harder to tell what the banks' assets are worth.

Am I reading this right? This makes sense to...anyone?

I don't know if you were referring to my idea specifically now_what, but my point was that the mere public declaration (at its choice) of a bank that it is using mark-to-model would be a warning flag to potential capital out there to either STAY AWAY or LOOK UNDER THE HOOD VERY CAREFULLY.

Despite the various objections, I remain a fan of mark-to-market rules, for pretty much the reasons Sebastian suggests. Intuitively, mark-to-market makes sense.

The objection seems to be that in market panic situations mark-to-market can lead to a downward spiral.

Yes, it can, but so what? The reason it does this is important - the market is thin. There are not a lot of buyers. I'm not sure this illiquidity shouldn't be reflected on balance sheets.

Let's say a troubled firm holds Treasuries, or stock in Microsoft for that matter. It needs to sell assets to remain financially viable, so it sells its Treasuries or MSFT into the market. Guess what. Unless the sales are massive, almost unimaginably massive in the case of Treasuries, the market price isn't going to drop much. Other firms holding the same securities, and marking them to market, are going to feel minimal effects.

It's only when the troubled firm is selling thinly traded assets that its sales will significantly affect others. And the effect is real. There are a finite number of buyers at a given price, and if you take some of them out by meeting their bids the next bid is lower. It's the new market price. Why isn't that the correct value to show on the balance sheet?

"Yes, and the Twins are in the playoffs again -- if they win tomorrow's one-game sudden-death match with the White Sox, that is."

I was in a time warp there. That sudden-death game was actually tonight -- White Sox 1, Twins 0. There will be talk of a Subway Series in Chicago any moment now.

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