Wall Street

by hilzoy

I don't know about you, but I find the news from Wall Street a tad unnerving:

"The American financial system was shaken to its core on Sunday. Lehman Brothers Holdings Inc. faced the prospect of liquidation, and Merrill Lynch & Co. was close to a deal to sell itself to Bank of America Corp.

"We have never seen anything like this," said analyst Glenn Schorr, who covers the investment banks for UBS AG. "There have been tough situations like Long-Term Capital Management and the crash of 1987, but the problem here is there is leverage in the securities under the microscope and in the banks that own them. And to try and unwind it all at once creates a one-way market where there are only sellers, and no buyers."

The convulsions could lead to even tighter credit, higher borrowing costs and moribund capital markets, as securities firms and commercial banks try to further limit risk and preserve capital. Those moves could cause the U.S. economy to slow further."

And that's not even the latest news: since that article was published, Merrill has decided to sell itself to BofA, Lehman Brothers seems to be about to file for bankruptcy, AIG has asked the Fed for help, though the WSJ adds that "it wasn't clear what (the Fed) could do", and the Fed, for its part, has expanded its lending facilities, prompting Yves Smith to comment:

"I guess it is now official. We no longer have functioning trading markets, at least in terms of serving their alleged purpose of giving companies access to capital."

Nouriel Roubini is generally pessimistic, but he's also generally right. Here's his take*:

"It is now clear that we are again – as we were in mid- March at the time of the Bear Stearns collapse – an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system."

I very much hope he's wrong. But it looks to be a wild ride.

* Ken Houghton at AngryBear adds a caveat:

"But the effect of LEH going out of business would not be so severe as the effect of BS going out of business for one reason that Roubini, for some reason, appears not to have mentioned.

Lehmann has no clearing business.

Had Bear gone out of business, about 30% of the hedge funds in the country would not have been able to execute virtually any transaction for the following thirty days. Not a payment. Not a redemption. Not a trade on a listed exchange. Not a receipt. Not a de-leveraging. Not a swap payment, not a CDS payment, not fulfilling an option exercised against them.

There's not just a "maybe" about financial collapse in such a scenario; P probably well in excess of 0.9944. $30 billion is a "bargain" in such a situation."

Comments

[El Cid]

Three Cheers for 4 MORE YEARS FOR PRESIDENT HOOVER!!!

You can't change horses in mid-dambust!

Only the people that brought you into the burning building can bring you out!

John S. Hoover McCain III and Carrie Palin Nation will put us aright by their plan for Change With Continuity AND Jesus!

[now_what]

This is good, people are scared. It's almost time to go shopping for financial stocks.

[Doctor Science]

So who, of the Serious Grown-Up Serious People, will say the "D" word first? Any bets?

[ken]

You can add to this the 30 billion dollar hole Treasury created overnight in the tier one capital of banks and insurance companies by their politically motivated elimination of preferred dividends for FNM and FRE.

Plus, preferred shares are the traditional way for financials to raise capital when needed. But Treasuries action has knocked the legs out the entire market for preferreds and they are egregiously expensive now for new issues.

And you cannot forget the WSJ editorial cowritten by McCain and Palin promising to fully privatize FNM and FRE and Obama's weasel out of a full commitment to extend the government gaurantees forever.

This led to the Treasury issuing a statement saying that the special preferred shares agreement between the UST and the GSEs is binding past 2009. The Chinese don't believe this. Nor do other central banks around the world. They know that Paulson will be gone in January and they want to see what Obama and McCain have to say about it.

So what happened - they simply stopped buying GSE debt even though Paulson says it is as good as government debt.

Obama and McCain have walked away from the leadership obligation to protect the 'full faith and credit' of the United States of America for the first time in history.

Bad times are ahead. Really bad times. And neither Obama nor McCain are offering anything but political expediency when some true leadership is needed.

Heck even Bush is outshining Obama here. At least his administration is handling the situation about half right. Obama cannot even get that.

[ThatLeftTurnInABQ]

Quick comment:

As best I can tell Ken Houghton is correct. LEH going under is not nearly as dangerous as BS was - because they are not involved in the system of credit default swaps (with notional values in the trillions) the way that Bear Stearns was. Metaphorically, LEH is a canary in the coal mine. BS was a hand grenade missing its pin which nobody could safely put down.

The biggest problem coming up as a consequence of LEH filing for bankrupcy is that up to now none of the major firms have been forced to really play by the rules of mark-to-market regarding the toxic paper they all have in their assets courtesy of the housing debacle. The Fed has been using all sort of tricks to help the big firms basically engage in mark-to-model accounting without admitting that this is what they are really doing.

Everybody involved has been whistling past the graveyard and hoping that if they stall for time long enough the problem will magically just go away (e.g., perhaps the housing market will re-inflate), because the alternative is admitting that they are so poorly capitalized that they will be required to sell off assets on a large scale (to reduce their leverage) and a 1930 style deflation may be triggered.

This fiction can only go on for so long before it becomes untenable and every time a major financial firm is forced to open its books to scrutiny (which going bankrupt will do) the veil of ignorance which Wall St. firms are hiding behind gets that much thinner and less opaque.

Visual picture: Wile E Coyote having run off the edge of the cliff, doesn't start falling until he looks down.

They will be holding their breath this week, hoping that as LEH is on the way out they don't hear something which sounds like "MEEEP MEEEP" which forces them to look down.

[treeme]

I remember Hilzoy having many posts about the "Culture of Corruption" in 2006.

I wonder if we will be so lucky to have her shed more light on this fiasco for us.

I'm skeptical given it involves a bunch of Democrats at the top.

Who are the top Recipients of Fannie Mae and Freddie Mac
Campaign Contributions? That's a great question.

Here are the top 4:

1. Dodd, Christopher J S D-CT
$133,900

2. Kerry, John S D-MA
$111,000

3. Obama, Barack S D-IL
$105,849

4. Clinton, Hillary S D-NY
$75,550

http://www.opensecrets.org/news/2008/07/top-senate-recipients-of-fanni.html

I blame Bush for Democrat corruption!

[treeme]

Who are these guys?

Franklin Raines and Jim Johnson

Not sure?

Obama advisors who served as CEO of Fannie Mae!

Now isn't that a shock!

The Culture of Corruption is alive and well.

[Gary Farber]

Ah, ken, there you are. Could you possibly respond to this, please?

Many thanks!

[ken]

TurnLeft,

Ken Haughton is wrong for the simple reason that institutional investors have more to lose if Roubini is right than they have to profit if Haughton is right.

Whenever this dynamic occurs fear of a loss always wins out over hope for a profit.

[Gary Farber]

"Who are the top Recipients of Fannie Mae and Freddie Mac
Campaign Contributions?"

First of all, any indicator that jams together PAC contributions, and ordinary citizen contributions that aren't bundled, is jamming together two disparate phenomenon, and thus makes no sense. Political Action Committee contributions are very much worth looking at with an eye to quid pro quo and who they give access to. So are bundled donations.

Donations that come from ordinary people that work somewhere, on the other hand: not so much.

Meanwhile, what, exactly is it that you are accusing these Democrats of doing, treeme? It seems to have slipped your mind that it might be necessary to mention that.

[ken]

Gary Farber,

You should stick to the lipstick threads. More your speed.

[Gary Farber]

"Ken Haughton is wrong for the simple reason that institutional investors have more to lose if Roubini is right than they have to profit if Haughton is right."

Houghton. It says right there: "Houghton." Not "Haughton."

Ken Houghton is a professional economist. I guess that makes him an "elitist," and thus your insights more reliable, then.

[Gary Farber]

"You should stick to the lipstick threads. More your speed."

It's good to know, ken, that you are still able to post content-free abuse. We're all very impressed. Be sure to work my mother in, next time.

Any interest in responding to substantive questions about your assertions?

I'll make it easy, and repeat them here:

"I can never forgive him [Barack Obama] for useing racism against the Clintons."

How did Barack Obama do that?

"But I also will no longer support afirmative action, preferential admission policies and other programs designed to assist minorities gain access to good job opportunities."

What does Barack Obama have to do with this?

"But we also know that when somone like him does not get accepted it is because they made room for a minority applicant with lower GPA. Skin color made all the difference."

How, exactly, do you know this? Please be specific.

"jes, Your comment about me is typical racism."

Can you please define what you mean by "racism"?

Thanks.

[ThatLeftTurnInABQ]

ken,

I'm not sure what you are getting at.

I was referring to Houghton's observation regarding the difference between BS and LEH insofar as the former had a large clearing business and the latter does not. A freeze up of the CDS in the wake of a BS collapse would have produced immediate problems (which is why the Fed rushed in to broker a deal over the weekend before it happened), whereas we can muddle along without LEH for some unknown finite period of time before larger problems ensue, and those problems have little to do with LEH specifically since their role in the markets is much less unique than was the case for BS.

Basically LEH is expendable, in a way that BS wasn't. That is why you don't see the Fed riding in to try to stop LEH from collapsing. "Too big to fail" really is as much about the specific role that each firm plays in our credit markets as it is about just pure size.

This doesn't mean we don't have much larger problems which may get really ugly any day now, but that is the case regardless of whether is it LEH or some other comparable firm which is imploding this week (or next week, and so on).

[ken]

Gary, I'll leave you to froth at the mouth for a while.

[felix culpa]

(Anyone seen the trollswatter?)

I imagine that in the near future those skilled and experienced, practiced, in the art of poverty, will be better fit for survival than other groupings. The leading authorities on Living with a Lot Less. Lots and lots of academic talent already embedded and ready on Day One. Bring on the collapse of intentionally stupid calculatedly appalling excess! ¡Viva pobres!
Kind of turns social Darwinism upside down and shakes it to see if any change falls out.
Now that would be change I’d welcome.
And believe.

[Dave C (the uppity newcomer)]

Okay, this is a serious question: is pretty much a forgone conclusion that tomorrow will be a bloodbath for the markets, or is there an upside waiting to be found somewhere?

[gwangung]

Gary, I'll leave you to froth at the mouth for a while.

Translation: I dislike it when I am being held accountable for my words.

Commentary: Yeah, I'd run, too....

[ken]

leftturn,

I see now that your comment was a lot narrower than I was reading it.

My response was addressing the near term full impact of the Roubini/Houghton split on the impact for broker dealers other than Lehman.

From an academic point of view perhaps Houghton should be correct. But in reality the markets fear of loss always wins out over hoped for profit. Traders are not going to go to their bosses and say 'hey Houghton says we should be able to trade with GS, so no problem' Their first impulse will be to decline trades with threatened firms.

Ergo the domino effect Roubini warns about is more likely to be true than is the 'all's clear' signal Houghton is sending.

[Hob]

Ken, I believe that crumpled-up ball of paper you're sitting on is the posting rules.

This is a pretty nice place but people's patience is not infinite, and you don't get to insult Gary or anyone else for saying you are wrong. At least that's my understanding; Hilzoy or other moderating peoples, maybe you could put in a word here?

[ThatLeftTurnInABQ]

My response was addressing the near term full impact of the Roubini/Houghton split on the impact for broker dealers other than Lehman.

OK, that makes more sense.

It ties in with something else I've been thinking about, while reading the depressing articles that Yves has been posting for months now.

We don't just have a problem with misallocation and excessive leverage of fiscal capital. We have the same problem with our "social capital", or to put it in less technical terms, we have a system built on trust and as fear kicks in there isn't enough trust left over to keep the markets working, or so it will be all too soon I expect.

What started me thinking about this was articles about the Libor spreads increasing and other indicators that banks don't trust each other to be solvent anymore, because their books have become too opaque and so now nobody knows who out there may be a dead-man-walking.

The way that these firms currently do business with each other was not designed to work under these sort of conditions, and it worries me that many of the measures which are being taken to deal with a scarcity of fiscal capital are having the unintended effect of destroying social capital by creating an ever more opaque situation with respect to how we value the assets being held by the actors in the credit markets.

[hilzoy]

ken: this is a warning under the posting rules. Do not -- repeat, do not -- insult other commenters, or I will, reluctantly, ban you.

[The Crafty Trilobite]

ken, I would also like to hear the answers to Gary's questions. You appear to have a personal grudge against Obama because your nephew didn't get into med school. The connection is not clear to me, and apparently not to Gary. And tho I'm sure you won't believe me, I'm not asking because I want ammunition against you. You provide plenty as it is on subjects of much more interest to me than your personal life. Actually, it's because I would like to have a reason to think better of you. So far, you have displayed poor reasoning skills at this blog (especially about why you oppose Obama), but hope springs eternal.

You did sort of answer one of Gary's questions: you said you knew that affirmative action programs were to blame for your nephew's problems because you have met many minority doctors who "knew" they were admitted unmeritoriously b/c their grades were poor. (by the way, were they good MDs?) Assuming that you're right about this, I still don't see why you changed your mind about affirmative action being fair when Obama came along. Frederick Douglass did pretty well for himself, did that prove slavery was not a problem? Or was it not Obama, so much as your own ox being gored?

Sorry for the threadjack, all -- but I suspect Ken will just flip me off anyway and we can all return to worrying about the economy. On which I have no competent opinion. The general picture seems clear & grim, the exact details would require much more study than I have time for. I shall continue to hope for the best, and remind myself that my extended family is big enough to shelter my kids even if I lose job, house, etc. Oh, and I shall practice saying, "I welcome the advent of our new Chinese overlords!"

[hilzoy]

Dave C (the newcomer): "this is a serious question: is pretty much a forgone conclusion that tomorrow will be a bloodbath for the markets, or is there an upside waiting to be found somewhere?"

I am not an economist, or a market whiz, or anything remotely like that, so please take what I'm saying with large bags of salt. But: I have yet to see anyone suggest an upside. The question seems to be whether it will just be pretty bad, or a total nightmare. A lot of people who know more than I do are sounding very, very alarmed.

[Ara]

Okay, I'm sick of not understanding this stuff. Done all that macro-micro econ, but it doesn't help with banking. I don't know the kinds of inferences people are making when they talk about this, and I really want to. Does anyone know of a good textbook? I really don't even know what the name of the topic is here that I should be learning about to become conversant in this stuff.

[ken]

ok Hilzoy, I'll stick to calling Gary a troll. That seems to be well within the posting rules.

Deal?

And how does ignoring someone constitute an insult anyway? Please explain.

[Ara]

Gary's a troll? That's the silliest thing I've heard in a while.

[CMatt]

'Oh, someone called me on my long and entirely unsubstantiated rant (that I have no interest in substantiating). Help! I'm being oppressed.'

Wah.

[now_what]

Done all that macro-micro econ, but it doesn't help with banking. I don't know the kinds of inferences people are making when they talk about this, and I really want to. Does anyone know of a good textbook?

The subject changes too fast for a textbook. Read the blogs.

Calculated Risk
The Big Picture
Credit Slips
Economist's View
Mish's Global Economic Trend Analysis

Plenty of others that could be pointed out. If you had read the above over the last year or two, none of this would have been surprising in the least...

[ken]

turnleft,

Sometimes I think it all started with FASB 157. This accounting rule change required financial institutions to mark to market their entire portfolios. There really was no good reason for this, in my mind. It forced them to take losses that they never would have taken in past economic slowdowns.

It would be like you earn 100k a year and you bought a house two years ago for 500k and now it is worth 300k just because your next door neighbor let his house deteriate and defaulted and the bank sold it a firesale. Now you would have to report your income, if you followed the same rules as the banks, at -100k, because other rules reguire you put up reserves against the potential loss on your house and those reserves are counted against your income. It doesn't matter that you don't intend to sell the house and your cash flow is still positive with your income actually exceeding your outflow.

So with all the hard to value assets held by financial institions built up before FASB 157 took effect and the requirment to put a price on them regardless, it is no wonder no one entirely trusts anyone else any more among the financials.

It is the perfect storm, a change in accounting rules at the same time we have a housing collapse and so even the good stuff has to written down to the price of the worst stuff, or at least to the price of whatever can be sold.

Instead of FASB 157 the regulators should have stepped in long ago and did their jobs.

Too late now.

[now_what]

Ken, you don't know anything about accounting.

That's all.

[nanook]

Ken -

I'm pretty sure your 12:26 comment qualifies.

[Tony P.]

S&P futures are down 41 points as of a few minutes ago. I don't ever remember seeing that number be more than 15 or so. As Atrios says: WHEEEEEE!

Still, I'm not sure panic is called for -- unless you happen to be a Wall Street whiz kid. The Dow might drop 1,000 points (or not!), but will that effect the price of cheese? Will the nation's chickens lay fewer eggs tomorrow? Will our houses shrink by 100 square feet?

I am an ignoramus about high finance, so I would appreciate a layman's explanation of how a "financial melt-down" translates into a loss of real wealth. Galveston TX being wiped out by a hurricane is an actual reduction in the nation's actual physical capital. An investment bank going bankrupt is surely a bad thing, but was the "capital" lost in such a case ever real to begin with?

--TP

[ThatLeftTurnInABQ]

Plenty of others that could be pointed out. If you had read the above over the last year or two, none of this would have been surprising in the least...

The shocking thing really is what a poorly kept secret it has been. This has to be one of the most over-predicted economic events ever.

A lot of the econ/finance blogs have been hollering for literally years now that we were due for a serious economic event, and pointing at both the housing market and the credit market as points of exteme vulnerability.

Bubbles and manias really aren't that hard to spot once you learn what to listen for, because they always bring out the same language - some variation of "it's different now", "the usual rules don't apply", "you can get rich", "all my friends are doing it", and "you better get aboard now because the train will leave the station without you".

Anytime you hear large numbers of people start saying stuff like that, we've entered into Tulip-land. The hard part is guessing how long the bubble will last before it collapses.

[Soylent Green]

Did you hear about the constipated broker/banker/trader? He could liquidate, but he couldn't consolidate.

[Gary Farber]

"Gary, I'll leave you to froth at the mouth for a while."

Okay, I should have known better than to dignify you by acting as if you might actually engage in a substantive exchange.

Back to ignoring you like the troll you show yourself (yet again) to be. T'were this Usenet, you'd hear the merry sound of a *plonk*.

[CMatt]

On preview, perhaps I should just ditto now_what (who, btw should also feel free to school me here)...

But I wont, so at the risk of bringing my ignorance into stark relief...

Ken,
If we posit your scenario, shouldn't insurers jump at the chance to offer, say, a 10k-15k hedge that the 500k is a rock-solid valuation of the house, rather than the 300k current market valuation (due solely to the neighbor's egregious mistakes, in your scenario)? Why would they ever leave that money on the table, if the 500k valuation is rock-solid? And why wouldn't the owner find that acceptable (though obviously still gripe about the necessity)?

[ken]

yeah, CMatt, my explanation is pretty sketchy and is just an rough anology to what is going on with the financial accounting right now.

The essential point being that a change in accounting rules took place at the worst possible time. Firms can no longer hold investments in what used to called 'held to maturity' (not sure what it is called today) without penalty. So most is moved over to one of the other two buckets that require firms put a price on them.

Perhaps now_what can fill you in on all the details of how all this exactly works. I don't partically care about the details but perhaps you do. The big picture is what I need to know.

He/she seems to think they know enough about it to post a content free personal insult about me in reply.

Not that I'm complaining, of course. Although it does seem particulary trollish, doesn't it?

[cleek]

Anyone seen the trollswatter

it's working fine.

[Amos Newcombe]

was the "capital" lost in such a case ever real to begin with?

No. That's the problem. But losing it will be real enough, if any of it found its way into your 401K. Then there's the real economic activity that might have been, but won't be, because someone can't get a loan to make it happen.

[Cyllan]

Still, I'm not sure panic is called for -- unless you happen to be a Wall Street whiz kid. The Dow might drop 1,000 points (or not!), but will that effect the price of cheese? Will the nation's chickens lay fewer eggs tomorrow?

I'm sure there are people more qualified than I am who could explain this more coherently. However, I'll give it a go.

A drop of 1,000 points in the Dow will do a fair amount of harm in both the short term and the long term unless it's a mere blip. There are a lot of people who have money invested in the stock market. As of 2002, nearly 50% of Americans owned stock. Many of those, including me and my mother, own stock through company 401(k) retirement plans.

For me, it's not really a big deal. I'm not anywhere close to retirement, and I've been tossing my 401(k) statements in a drawer for the last year while chanting "long-term investment" over and over. Looking at my mother, however, shows a bigger problem. She's 70, and while she personally has switched over to less volatile investments, a large number of people between her age and mine have not. Anyone who is in their late 50s and who has not been paying a decent amount of attention to their 401(k), is about to see a non-insubstantial percentage of their investment money go up in smoke.

It may not be a direct hit to the price of eggs right now, but those people are either going to be forced to work for longer, or they will have to cut back on their spending (either now or later). If they cut back now and pour more money into their investments, they'll do better (in theory) when they retire, but all of that money that they aren't spending now won't be going into our economy and doing the money-moving dance that fuels our fundamental economic engine. If they work past retirement age, those are jobs that they will be occupying that won't be turned over to the next generation. If they spend less in retirement, we will see a drop in future money-moving dances which makes our longer-term financial future bleaker.

Also, problems with financial powers generally weaken the economy because it tightens credit and limits the number of places someone can go to get money. Our economic engines depend really heavily on that money-moving dance, and when there are fewer dance clubs, fewer people get to participate, and the overall economy shrinks.

[bedtimeforbonzo]

LeftTurn: "Everybody involved has been whistling past the graveyard and hoping that if they stall for time long enough the problem will magically just go away . . ."

Hilzoy: "The question seems to be whether it will just be pretty bad, or a total nightmare."

Merrill Lynch, Lehman, AIG -- these are big, big names. I don't see how this whole thing winds up being anything but a nightmare.

I mentioned in another thread on Saturday how my livelihood depends on regular folks getting access to credit.

I'm definitely no expert, but it almost seems as if the credit markets are going to tighten and tighten and tighten until they strangle the economy.

[Bernard Yomtov]

but was the "capital" lost in such a case ever real to begin with?

A different angle than Amos and Cyllan:

The value of the equity in a company represents, roughly speaking, the present value of its future earning ability. When that ability drops then capital is destroyed, logically if not physically.

Imagine a successful manufactring firm that owns lots of equipment of all types - its physical capital. Now suppose that the firm's prospects dim, so the value of its output drops. Then the value of its physical capital drops as well, almost as if some had been destroyed, because it is no longer as productive as it was.

True, the machines still exist, and some might even be sold off, but depending on the reason for the firm's troubles, it might not fetch very much.

So yes, there has been a reduction in the value of real capital.

[hilzoy]

TonyP: my best, non-technical understanding is like this: there are all these big institutions, which in normal times get money from investors to people who want to put it to (allegedly) good use. This is key: imagine what would happen to, say, the construction business if instead of getting mortgages, people had to actually save up for their houses before buying them. Or, as bedtime notes, the auto industry. I paid cash for my last car, after selling a house in LA and buying one in Baltimore, but I'm very much the exception.

Now: all these firms are hugely interconnected. Imagine that they have all kinds of tangled strings leading to what they have imagined to be assets, assets which are in the keeping of someone else, and these strings lead from one to another in a huge tangled mess, the biggest tangle in the whole world. Everyone is trying to pull at their strings, to get their assets out before anyone else goes bankrupt. Everyone is trying to amass assets that they hold themselves, to avoid or withstand some possible future run on them. Worst of all, no one knows which assets are worth what, not just because value depends on what other people are willing to pay, but because a lot of these "assets" are so complicated that no one has a clue.

So everyone is fleeing for safety, and trying to get their own stuff out of the maelstrom, and to protect their own positions as best they can. Also, everyone is losing money.

In this situation, are they likely to be making loans to anyone? Not really. So we move closer to the situation in which everyone actually does have to save up for stuff before buying it, which might be better than the situation in which loans are offered with abandon, but is definitely a whole lot worse than the situation in which credit is available to good borrowers.

As noted above, think of the effects on the housing industry, and other industries that depend on credit. But also think of the effects on business investment. So you want to take out a loan to expand your business. You have, let's imagine, a good business model, and are a good bet. In normal times, you'd get that loan, expand, put more people to work (either directly or by buying stuff), etc. Now, not so much, and not just because times are bad and even good businesses have trouble, but because, above and beyond that, there is no credit.

In addition, if you think that a lot of consumer spending has relied on people using their houses as piggy banks via second mortgages etc., subtract that: that relies on housing prices going up, and of course on the availability of second mortgages, home equity loans, etc. So large chunks of spending that relies on equity in one's home stop happening.

I'm sure I've missed things, and/or misstated things, but it has seemed to me for some time that this crisis has been coming, and could be very, very, very bad.

[ThatLeftTurnInABQ]

hilzoy,

That was a good summary.

The other part of it is that large numbers of Americans are employed by the financial services sector (LEH alone has 25,000 employees IIRC) which pace Kevin Phillips has swapped places with manufacturing over the last half century in share of GDP. It used to be that manufacturing produced about 25% of GDP and financial services about half as much, now it is the other way around.

We don't make things as much as we used to, and much of the broader service sector (which overall is about 2/3rds of the economy) depends on credit for day to day operations to continue.

[Porcupine_Pal]

To relate the ongoing financial issues to the Presidential campaign....

As the lies and extraneous attacks mount on the McCain/Palin side, and as I hear people questioning the relative merits of the two presidential candidates, I have been struck by a common sense test that might be useful:

If a voter is in doubt about this election, it might be worth speculating as to each of us - which of these candidates would we feel more comfortable trusting all of our life savings to?

WHile the issues in this election are considerably more important than one's savings, if individual voters could project themselves into a transaction with Obama or McCain, and having to make a choice as to which one would be a more intelligent, prudent, trustworthy steward this election would be a landslide, favoring obviously Obama.

He has been unalterably consistent in his pursuit- honest, forthright, cautious, unemotional. And he gets criticized for it!

[ken]

"it has seemed to me for some time that this crisis has been coming, and could be very, very, very bad."

It is worse than that.

What we stand to lose is the value of the 'full faith and credit of the United States of America'.

Take a look at the currency in your wallet. Printed on each one is the statement that they are all Federal Reserves Notes. A note is a form of credit. Money is nothing but credit.

If the US should lose the trust of the world that we stand 100% behind our obligations and will never renounce them the money in your wallet and in whatever other form held will be essentially worthless. No place is safe unless the US dollar is safe. Not gold, not land, not Euros, not Yen; nothing is safe.

We stand on the precipice of total and complete economic wipeout and our Congressional leaders, and those who want to lead in the white house, have abandoned us all for sake of short term political expediancy.

I have been fearing this ever since Newt Gingritch, almost twenty years ago, told a group of bond traders that it would be a good thing if the US should default on its debt occasionally. As this notion has gained currency among the public and polticians I have remained frozen in my disbelief that our nation could ever be so stupid and so short sighted as to actually take this idea seriously.

Right now Bush and Paulson are getting things about half right, but we really need both McCain and Obama to step up and declare their unequivical backing of our debt obligations, no matter what. McCain has to be willing to prove he will sacrifice veterans and drastically raise taxes on the wealthy if that is what it takes to satisfy Chinese bond holders. Obama has to prove he is willing to sacrifice seniors and educators to do the same.

This is not me just talking my book. Everyone is in the same boat as me. I just follow this stuff closely so I can put a price on it. I know the risks and what is at stake. I also know there is no place to hide out should we lose the trust and confidence of the rest of the world in the value of our word. Our word, our credit, is the last line of defense against total calamity.

Everything else is just fluff.

With solid credit we can work our way out of this mess. Without it we have no chance.

[MeDrewNotYou]

Porcupine- which of these candidates would we feel more comfortable trusting all of our life savings to?

Two words: Keating Five.

[ken]

Porcupine- which of these candidates would we feel more comfortable trusting all of our life savings to?
-----
What Bush/Paulson got right:

1) GSE takeover and press release that US gaurantees extend permanently beyond 2009.

What Bush/Paulson got wrong:

1) A tepid press release is no substitute for the President and Treasury standing up before the world and declaring the uniquivicle backing of GSE debt.

2) Killing the entire market for preferred shares by wiping out 30 billion dollars in capital from banks and insurance companies when they eliminated the dividends on FNM and FRE preferreds. This capital must be replaced, plus additional capital must be raised, and right now there is no way to do so.

On balance Bush/Paulson got it about half right with the bailout but they left the future too much is doubt.

What McCain got right:

Nothing.

What McCain got wrong:

1) Publishing an op-ed in the WSJ telling the whole world he wanted to fully privatize FNM and FRE thereby elimating the Gov gaurantees.

What Obama got right:

Nothing.

What Obama got wrong:

1) Weasling out of stateing any strong position one way or the other on the matter of future US gaurantees to for GSE debt. He left the McCain option open, which in this environment is interpreted as an endorsement by global investors.

In summery your life saving is still at risk no matter who gets elected.

In fact it is actually safer now under Bush than it will be under either McCain or Obama. They have to get serious about the problems created uf we lose access to cheap global credit.

[ara]

Bernard Yomtov, I liked your explanation a lot, but it leaves me wondering: isn't there a big difference between the real future earnings potential of a company and simply the market's assessment of the future earnings of the company? The loss of market capitalization could just reflect a market hiccup of some kind. That is, the stock could be underpriced.

In the case of the meltdowns we are seeing now, it seems, these aren't market hiccups but rather corrections: these companies are actually worth much less than they've been trading at. But TonyP's point still stands. In what sense was the capital real? To put the same question in your terms, I would ask: what is the relationship between the market valuation of the present value of the future earnings of the company and the present value of the *actual* future earnings of the company.

[ThatLeftTurnInABQ]

ara,

This capital is real in the sense that at some point in the near future large numbers of people expect to be able to convert it back into cash as a source of income, to do things like buy groceries and pay for health care. They not only expect to do this, they will have little or no choice in the matter, unless they have other sources of wealth to draw on.

If nobody was invested in the market via pension plans or 401k's in the market, or they had no short term need to draw on those funds, this would be more of a paper exercise, or we could just wait it out.

It isn't just retirees either. One of the signs of economic stress right now which has turned up in discussion on the econ blogs (sorry I don’t have time to dig up links to news articles right now – try googling within calculatedrisk for example) is that with the MEW (Mortgage Equity Withdrawal, aka the House as an ATM) spigot turned off, 401k withdrawals have surged upwards recently.

I don’t think that is due to people who have suddenly decided to retire early. It is most likely being caused by financially stressed people who have switched from Home Equity loans to raiding their 401k’s as a source of supplemental income to get by for now.

As I’ve said before on a couple of other threads, the root problem is a lack of income. The secondary problem is that having used liquidity of all sorts as a substitute for income, everybody involved from the little guy to the big investment banks are all in the same pickle – there are bills to pay and the only way not to go bankrupt (in one sense or another) is to scrape up some cash somehow.

There are really only two ways to do this (scrape up some cash): sell off equity to somebody else who has cash to spare, which ultimately is what will happen with most of our banks, or cut back on personal consumption so that spending is less than income so as to save money, which is what will happen to most individual Americans (since selling off title to part of their family to Asian central banks isn’t really an option).

Everything else is just shuffling deck chairs (= playing games with different forms of liquidity) around while the ship continues to take on water (= more debt) below deck.

[(The original) Francis]

My perspective:

step 1: The investment banks started borrowing $30 to $35 for every $1 of their own capital. The lenders? Pension funds, government sovereign wealth funds, high-net worth individuals, 401(k) funds. And (see today's paper) insurers like AIG.

step 2: The govt, insurers and private pension funds were desperate for conservative investments (AAA paper).

step 3: starting in the late 90's (and arguably having been given a green flag by Greenspan, long may he rot), the investments banks started aggressively pushing mortgage lenders to generate more mortgages. Why? Historically it was the best, most marketable (see Frannie) AAA rated paper around.

step 4: By 2006 all the good borrowers are in houses. By 2007, housing prices are insane, due to all the new money being flushed into the system. There aren't any new borrowers to bring into the system. As the people who could never afford their houses start to default, housing prices start dropping fast.

step 5: by now, a huge amount of the american economy is based on building grossly overpriced houses. So there is a huge amount of excess inventory. Between excess new inventory and defaulted houses coming back on the market with only a tiny number of new buyers (young families finally in a position to buy for the first time), prices start falling very very hard.

step 6: Back to the investment bank. At 33-1 leverage, it takes only a tiny number of defaults to wipe out the equity stake.

step 7: The purchasers of the big sh*tpile (as Atrios so pungently puts it) are everywhere and everyone. People want out of their allegedly AAA investment and into something safe. So the value of these investments start to fall hard also, possibly faster than they should given the relatively small number of actual defaults.

step 8: mortgage equity withdrawal -- as housing values skyrocketed, people borrowed against their equity. That's now gone. This creates two problems. One, all this new money is no longer coming into the system. Home Depot, Lowes, Target and other mid-level retailers are getting hammered. Two, many people now have a lot more debt that they have to pay off. Note that incomes are flat or even falling for many classes of society. More debt, less income and decreasing wealth is a nasty squeeze.

step 9: start tallying all this up. Investment banks are broke. (Bear, Lehman.) Insurers that bought former AAA paper now have to mark that paper to market, and find themselves billions in the hole on their capital requirements. (AIG) Mortgage banks that sold lousy paper are being forced to take it back, and driven to failure/merger. (Countrywide, with others to follow [WaMu?]). The building industry in Southern California, Nevada, Florida, New York has collapsed, eliminating thousands of high-paying jobs. These employees are now defaulting on their houses, worsening a death spiral. The banking industry is collapsing, eliminating more high-paying jobs. Banking and building industries' collapse are having huge secondary impacts, from massive declines in tax revenues, to slowdowns in work done by lawyers (ahem), accountants, suppliers etc.

step 10: according to macroeconomic theory, the collapse in wealth should result in a collapse of the dollar as americans can no longer to buy from abroad, and, as domestic wages fall, exports become competitive. (I may have this bit entirely wrong. Corrections welcome.) But it looks like China is playing a little hard ball. Also, China's demand for energy appears to be soaking up our fall in demand, so the raw cost of goods appears to be staying high.

step 12: Ways out? As the Man said, above my pay grade. But it looks like a combination of inflation (thereby impoverishing those on fixed and low incomes) plus a low dollar plus a commitment to rebuilding our export industries looks like the only solution I can see.

[The Crafty Trilobite]

Ara, speaking as an equally underinformed person, seems to me that capital is never an absolute. A common example from 100 or so years ago: a town builds some facility, say a stockyard, in anticipation of a planned railroad station. The railroad goes bust or otherwise changes its plans and the station is never built. Result: the stockyard is completely useless -- even though it's still there and just as well-built as the month before. Result, ghost-town. As this example shows, capital (both financial and physical) are valuable only to the extent someone can use them, which depends on the whole economy. Some of this variability is always factored in as "risk," and "discount to present value." But the value of beachfront property that might get hit by a hurricane is far greater than its value the day after the hurricane actually does hit and strips the coastline right off. Here, the value of, well, everything just dropped because a "hurricane" took out the availability of credit.

I guess.

Still don't really understand why the overvaluing of so much collateral makes it so hard to find credit, and maybe this is Ara's question rephrased. End of the day, there's still some value in the houses, etc. Everyone in the system owns a piece of a huge set of bad loans, so everybody owns less money than they thought...but why should that stop them from doing the lending-borrowing-building dance on a smaller scale, being that it's still the best way to make more money? Okay, most people in the dance are busy trying to pay back their bad loans, but is there no point up the chain at which someone has money to lend that is not tied up in debt maintenance? Is it that, with less money to lend, the lenders get choosier? That nobody feels like they know who is a good risk? Both?

[Porcupine_Pal]

Leverage.

Counter party risk - Derivatives.

These two elements have brought this issue to a boil. The leverage we all can understand. The banks, hedge funds, and brokerages, worked with leverage that a novice blackjack player would shy away from. 24:1..33:1..etc. Not much room on the downside.

The derivatives have caused a web of interconnectness to come into existence, such that size no longer dictates when a single player can jeopardize the system. E.g. Long Term Capital. Now, a relatively remote, unknown player can, under the right circumstances, threaten the liquidity of an entire market through defaults that affect a broad array of parties.

These derivatives are not regulated; and they are not adequately disclosed. Those are really the only two things that a government can provide in the way of market facilitation. E.g. On the day that Bear Stearns failed, it had a $65 book value. SO, the risks are not being overseen, and the investor has no way to enaluate them. That does not bode well for a public market.

[ThatLeftTurnInABQ]

Still don't really understand why the overvaluing of so much collateral makes it so hard to find credit, and maybe this is Ara's question rephrased

Because of leverage - see comment by (The original) Francis above for the messy, nasty details. The very high levels of leverage used by the shadow banking system are why the resulting deleveraging is now so destructive. For every 1 dollar of lost asset values (because the houses were overvalued), 30 dollars (or so) of credit are being destroyed.

If we end of seeing 2 trillion dollars in lost asset values, the result will be the forced withdrawal of roughly 60 trillion dollars worth of credit from the global credit markets that otherwise would have been available. You can run a heck of a big economy with 60 T worth of liquidity.

The shadow banking system was able to get away with using grossly irresponsible and dangerous levels of leverage because they were not regulated like old fashioned depository institutions (i.e. your grandparent's banks).

They were motivated to do so (despite the risks) because using more leverage increased their profit margins, and these needed to be inflated because they really weren’t adding much of anything in the way of value which could have been used to justify fat profit margins in a more rational system. They had to “gear up” to generate big profits, which was a calculated risk bound to end badly.

[hilzoy]

Crafty: in addition to TTLAABQ's leverage point, there's also the fact that (as I understand it, correct me if wrong) a lot of lenders right now feel the need for liquid assets. Mortgages themselves are not liquid: you're not going to get all your money back for years. They can be made to act liquid if they are e.g securitized. But since everyone has just gotten burned on mortgage-backed assets, and also since they are often really hard to understand and value, no one wants to buy them. So the decision to make a loan looks more like the decision to, you know, give the cash you might need tomorrow to someone else for 30 years, in exchange for interest than it did two years ago, when you might have thought: make the mortgage today, securitize it, sell it, get your cash back!

The need for liquid assets, assets that will not turn out to be un-sellable, to ride out the present crisis is a reason not to make loans.

[nader PAUL mckinney]

Sunday Bloody Sunday
The Wall Street Shuffle

ralph DR RON cynthia

What have they done to the earth?
What have they done to our fair sister?
Ravaged & plundered & ripped her & bit her
Stuck her with knives in the side of the dawn
& tied her with fences &
Dragged her down!

mike dennis jesse ross

[The Crafty Trilobite]

Thanks for the explanations, all. Hilzoy, following up your point, it makes me wonder how rational the potential lenders' concerns are. I.e., how much of the panic is short-term sticker shock and how much reflects actual inability to use the money? Is it actually very much harder to get liquidity out of debt in general, or is it "just" the mortgage-backed instruments that dried up? Then too, how necessary can that much liquidity be to the operation of the financial markets, considering that we didn't have it 10 years ago?

Do these questions even make sense?

[Bernard Yomtov]

Ara,

Thanks.

isn't there a big difference between the real future earnings potential of a company and simply the market's assessment of the future earnings of the company?

There's almost surely a difference, sometimes big, between the market's assessment and what will actually happen. The trouble is, of course, no one knows what will actually happen.

The loss of market capitalization could just reflect a market hiccup of some kind. That is, the stock could be underpriced.

In the case of the meltdowns we are seeing now, it seems, these aren't market hiccups but rather corrections: these companies are actually worth much less than they've been trading at. But TonyP's point still stands. In what sense was the capital real?

In the case of the investment banks that Tony was asking about the capital was real in the sense that it produced earnings. Lehman, let's say, knew (once) how to do things that made money. It didn't involve a lot of big machines and equipment and trucks, but it made money, just like Microsoft knows how to do things that make money. If you prefer, think of brand names. Anyone can make a cola drink and put it into red cans. But being able to label it "Coca-Cola" has enormous value. Is that privilege real?

To put the same question in your terms, I would ask: what is the relationship between the market valuation of the present value of the future earnings of the company and the present value of the *actual* future earnings of the company.

The market's valuation is an estimate of future cash flows, whose present value is determined by discounting them at a rate that reflects the current level of risk-free rates plus a premium for (certain kinds of*) risk. So the market's valuation can change based not only on what the future earnings are, but on that discount rate. This actually makes sense, because the rate tells us how willing we are to trade present consumption for future consumption - how much jam tomorrow we need to give up some jam today. Hence it tells us the value of capital.

*pedantic CYA parenthetical

[Ara]

TLTA:

This capital is real in the sense that at some point in the near future large numbers of people expect to be able to convert it back into cash as a source of income, to do things like buy groceries and pay for health care. They not only expect to do this, they will have little or no choice in the matter, unless they have other sources of wealth to draw on.

Thanks. That helps too. But I wonder about this. The original point was that these things shouldn't affect a firm's or economy's output (excepting of course output declines caused by the unavailability of short-term financing). So the argument goes: Even if the wealth goes away, if the output level is unchanged, you just have fewer dollars chasing after the same stock of goods. Prices fall, and the purchasing power of those dollars increases, and all is well.

[hilzoy]

Crafty: I keep worrying about the limits of my knowledge, but with better-informed commenters to tell me I'm wrong, here goes:

Say you make a 30 year mortgage. You have tied up your money for 30 years. If someone else asks you to repay all your debts all at once, and is not willing to take your mortgage, with its income stream, in lieu of cash, too bad.

Unless, of course, you can sell it to someone else. A lot of people wouldn't be interested in buying a mortgage per se: they are tiny pokey little things, and not liquid, and why do all that due diligence on something so small? and so on. But sometime Fannie Mae and Freddie Mac will help, and also you can securitize them, which lumps a whole lot of mortgages together, and so (allegedly) reduces the buyer's exposure to risk, since while the odds that one mortgage in your big pile'o'mortgages will go bad increases, the risk that the whole bunch will goes down. Plus, once they are sliced and diced and all that, a cautious buyer can buy an allegedly safer tranche.

When securitization vanishes, so does a lot of the potential for transforming mortgages into a liquid, convertible asset. Thus, if you make mortgage loans, you're more likely to e stuck with a bunch of illiquid mortgages.

And the same is true, mutatis mutandis, for other sorts of debt: a lot of them don't allow you to call in the debt whenever you feel like it, or need the cash. Car loans, credit cards, business loans: you generally cannot just appear at someone's door and say: hey, I need the cash. You need either to be able to do without that cash for the term of the loan, or to be able to turn it into cash by some other means.

The other means are vanishing. Also, the need for cash is increasing. Also, the amount of money people are willing to pay for bits of loans has shrunk, because so many people are trying to turn them back into cash. All told, not a good time to be making loans, unless your business model is: hold them for the duration and make money off the interest.

[ThatLeftTurnInABQ]

it makes me wonder how rational the potential lenders' concerns are. I.e., how much of the panic is short-term sticker shock and how much reflects actual inability to use the money?

Part of the problem is that the very complex contracts involved make it really hard to answer these questions for a number of reasons.

First off, the CDOs are incredibly complex and difficult to evaluate what they really are worth if there is uncertainty regarding the performance of the underlying loans. IIRC Warren Buffett was quoted earlier in the year as stating that just a single one of these CDO contracts which contained multiple layers of tranches of real estate loans would require somebody to read hundreds of thousands of pages of documents if they really wanted to find out what it was made out of down to the level of individual mortgages (and thus being able to evaluate which ones are going to default and which ones are OK).

This wasn’t a problem when these contracts were being sold back in 2005-2006 because rough guesses were considered good enough in a rising market where home values had nowhere to go but up and the specter of widespread defaults didn’t enter into the picture. Not so much any more. Now the only way to figure out what these loan portfolios are worth is to sit back and wait to see how they actually perform over the lifetime of the loans in question, which will take years or decades. That means that they are both illiquid and very opaque in terms of pricing – “life is like a box of chocolates…”

To make it even worse, see Porcupine_Pal's comment above about how derivatives and credit default swaps have had the unintended effect of contaminating everyone in the system with risk by spreading it around in a very interconnected fashion (rather than compartmentalizing the damage), so that to understand how risky a given set of assets are you need a huge amount of data, including risk information from counterparties, and right now everybody involved is keeping that info under wraps because if they let everyone else take a good look at their dirty laundry, they risk ending up like Bear Stearns or Lehman.

Right now transparency is bad because it turns into an open invitation to be shunned by the rest of the credit market (for fear of being stuck with yet more toxic counterparty risk), which is a sure ticket to bankruptcy because access to liquidity (as a substitute for income) is the only thing keeping many of these firms alive right now. Needless to say this is a deeply dysfunctional way for a market to behave, a result of perverse incentives which are preventing the market from performing a price discovery function. Not only do we have a liquidity trap in effect, we also have a transparency trap as well, where firms have an incentive to hoard information as well as cash.

That is what I was alluding to earlier when I said that social capital as well as fiscal capital is being destroyed. FDR’s saying that we have nothing to fear but fear itself is very applicable to today’s situation.

[hilzoy]

Oh, and Crafty: you can go a long ways without liquidity so long as no one asks you for their money. Think of bank runs: the problem was that banks had their money tied up in mortgages etc., which was fine so long as their depositors didn't want it back in unusual numbers. Then, unfortunately, they did, and the banks needed liquid assets, not loans, and didn't have them.

It's partly a psychological problem, insofar as the depositors wanting their money back might be irrational. (But not necessarily.) But the need of those banks for cash wasn't psychological at all: they had committed to people's being able to withdraw cash at will, and needed actual cash to make good on that promise.

[Tony P.]

Folks, I know nothing but the vague outlines of the Tulip Mania in Holland in the seventeenth(?) century, but I suspect this is true: the bubble did not increase Holland's real capital in any way; its collapse did not diminish the country's real capital in any way; all that happened is that ownership of that capital changed hands. If you paid the price of a horse for a tulip bulb early on, and sold the bulb for the price of a house later on, you effectively traded a horse for a house -- and some fellow Dutchman traded a house for a horse. There was never any real wealth created or destroyed.

The housing bubble here in the US was a bit different: carpenters and plumbers got actual money for building the houses; the houses are still there; the nation's physical wealth did, in fact, increase. The only question is, who will end up owning what, after the dust settles?

The plumbers and carpenters don't have to give back the wages they got for building the houses -- not directly, anyway. To the extent they parked some of those wages in the "financial system" which made the housing bubble possible, they are at risk. The financial wizards who operated that system and got massive cash compensation for doing so don't have to give their cash back, either. To the extent they lent the cash to tradesmen to buy cars with, say, they are at risk of ending up owning repossessed cars they don't particularly want. Left entirely to itself, "the market" will redistribute the ownership of real cars and real houses, very possibly in capricious and counterproductive ways.

But "the market" is not the only force involved. Government gets to play, too. Government can not create wealth, as our GOP friends so often tell us, but it can take a hand in the distribution of it. For instance, government can tax the carpenters and plumbers to prop up the "financial system" so that bankers and real-estate investors don't lose too many of their shirts. Or it can wage "class warfare" on the opposite side, and nudge the market toward a flatter distribution of ownership of such real wealth as actually exists. In the long run, the government is us; in the short term it matters which "us" runs it.

If we have been profligate, as a nation, there is no question that we have to tighten our belts. It's just a matter of which of "us" end up getting pinched more, and which of "us" less.

--TP

[(The original) Francis]

Crafty: Globalization requires liquidity. People are buying and selling across the planet in a way that they did not a decade ago.

One primary goal of investment banks is to provide liquidity. A single mortgage is illiquid; tiny little payments come once a month and the risk of default is unknown without a lot of due diligence. A big pool of mortgages whose rate of default is NOT linked is liquid; payments come in big fat streams and rates of default can be estimated and priced.

Problem: what happens when your pool of mortages are linked? Answer: Default rates are much higher than expected. Consequence: What used to be a liquid security -- a piece of paper representing an interest in a pool of mortgages -- is no longer liquid because no one knows what the default rate on the pool will be.

Who cares? Well, everyone. These securities were used as short-term investments, with "short-term" being the critical issue.

Let's say you're a government that just borrowed a few billion to build a school. Between the date that the bonds sell and the date that you need to cut a check to the contractor, you need to park the money someplace, like in a nice quiet AAA-rated security. Note: you have no interest in holding this security until all the underlying mortgages have paid off. You're looking instead for a nice rate of return for a period of months to years.

Hey, what do you mean this paper is suddenly worth 80 cents on the dollar??!! We can't afford that loss!!!

ooops.

Ultimate point: very few investors are in a position to hold suddenly illiquid securities all the way to maturity in order to find out the "true" default rate. Only two come to my mind: very large pension funds (CalPers) and good old Uncle Sam. And only the USA can afford to buy these securities at face value, using the taxpayer to cover the losses as they become apparent over time.

(essentially this is what happened to Frannie. and the idea that the treasuries of the G8 along with sovereign wealth funds should buy up all these newly-illiquid securities at face value is receiving serious discussion from central bankers.)

[KCinDC]

A true tragedy:

Fannie Mae and Freddie Mac's regulator is blocking as much as $24 million in ``golden parachute'' severance payments to the companies ousted chief executive officers.

The Federal Housing Finance Agency notified former Fannie CEO Daniel Mudd and former Freddie CEO Richard Syron that they will not receive the exit pay called for in their employment contracts now that the companies are under federal control, the regulator said in a statement yesterday on its Web site.

[Bernard Yomtov]

Government can not create wealth, as our GOP friends so often tell us, but it can take a hand in the distribution of it.

Don't take our GOP pals too seriously.

[ThatLeftTurnInABQ]

The housing bubble here in the US was a bit different: carpenters and plumbers got actual money for building the houses; the houses are still there; the nation's physical wealth did, in fact, increase. The only question is, who will end up owning what, after the dust settles?

Tony P.,

The problem with this zero-sum analysis is that you are restricting it to people here in the US. But in fact many of these physical things which we would like to count as part of our wealth do not in fact belong in the fiscal or legal sense to anyone living in the US - they belong to [shudder] foreigners! And by that I mean that we did not pay cash money to purchase these things, we used money borrowed from abroad to buy them, so they don't belong to us until we finish paying off that debt. In the meantime the repo-man speaks Mandarin and/or Arabic (and sometimes a bit of German), and he will be coming for our houses, our cars, and our TVs, if we don't start making those payments.

Or we could repudiate our debts, and tell the rest of the world - "tough luck, possession is 9 points of the law", and then deal with the consequences of that action.

We certainly would not be the first nation to do this, and others (Germany and Russia for example) have done it and come back later to rejoin the international economic community. Usually this has happened in the context major geopolitical events like large scale wars and revolutions, and the rejoining part happens much later after the bodies have been buried and the dust has settled.

But for the US to do this would shake the global economy to its very roots.

[Bernard Yomtov]

The original point was that these things shouldn't affect a firm's or economy's output (excepting of course output declines caused by the unavailability of short-term financing). So the argument goes: Even if the wealth goes away, if the output level is unchanged, you just have fewer dollars chasing after the same stock of goods. Prices fall, and the purchasing power of those dollars increases, and all is well.

Two things:

1. Short-term financing is crucial to many businesses. If it'shard to get the effect can be large.

2. Less revenue means less money to pay workers, buy raw materials, etc. You can't just keep turning out the same number of widgets. Output falls.

[bilco5]

Cozy oversight. Lax oversight. The SEC should be sued. Oh, right, hard to sue the government. More at: http://www.youtube.com/watch?v=Y4cK06nCtlU

[Tony P.]

TLTIABQ,

I take your point about furriners. In the context of the Tulip Mania, it could have been a Parisian who traded a French horse for a Dutch house, resulting in a net loss of "capital" for Holland. In financial terms, that means some Dutchman ends up paying rent to live in that house in future; in real terms, that means future production of, say, Gouda flows more toward Paris, less toward Amsterdam. Future Frenchmen eat a little better, future Dutchmen a little worse, because of how the Tulip Mania reshuffled ownership of real stuff.

I harp on "real" stuff because real stuff is all that matters in real life. (Don't take "stuff" too literally; it's just shorthand for "goodsandservices".) Financial wizards view stuff as a way to acquire money; simpletons like me view money as a way to acquire stuff.

Paul Krugman once described US-Japan trade as a mechanism for converting soybeans into Toyotas. His point was that it makes no difference whether we're talking about an actual magical machine or about international trade: real stuff gets exchanged for real stuff -- at some rate of exchange. How many tons of soybeans per Camry is a relevant ratio. People on both sides of the trade agree on the ratio at any given time. One side can extend credit to the other: we will send you more Toyotas today than correspond to the soybeans you're shipping us, today, in exchange for a claim against future production of soybeans. The implication of this deal is that there must come a time when Americans are shipping soybeans to Japan and not getting back as many Camrys as they've grown accustomed to. Financially-minded people would describe this as the US running a current-accounts surplus with Japan in the future. "Surplus" sounds good, but the underlying physical reality is future Americans toiling away at growing soybeans while driving around in used Chevy Malibus.

The saving grace is supposed to be the "fact" that "economics is not a zero-sum game". Americans can do a damn sight more than grow soybeans, and we have every confidence that we can produce more and better stuff in the future than we do today. Even if that confidence proves justified, though, we don't get to consume all that future stuff because we pledged it against extra Camrys today.

All of this is trite, not controversial. The controversy, I believe, arises from the fact that within the US, "the market" would distribute the pain of belt-tightening one way, "the government" could (if it chose to) distribute it a different way. If "the government" acts mostly on behalf of those Americans who got Learjets and penthouses out of the financial engineering of recent years, rather than those who got Camrys and Nintendos, I doubt the Japanese or the Chinese would care, as long as they get their soybeans.

--TP

[bedtimeforbonzo]

I think Bernard Yomtov sums up in two short points what's wrong with the economy with his comments at 5:43 p.m.

With the DOW's 500-point loss today, I'm afraid it's only going to get worse.

[efgoldman]

Plenty of posters (including me, most of all) admit to little or no knowledge of the complicated (NOT "sophisticated") financial instruments and behaviors that caused this mess.

But I work for a major brokerage and mutual fund company, one of the biggest (privately owned, thank whatever deity I don't believe in) and I can guarantee one absolutely predictable effect:

The Merrill/Bank of America purchase/merger BY ITSELF will result in tens of thousands of layoffs and job losses, at those two firms and at business partners/suppliers/vendors, etc.

This is no small potatoes. Financial jobs, even entry level, tend to be occupied by degreed, skilled individuals and pay significantly more than minimum wage (in our market, at least twice).

Even if everything else goes gliding merrily along - very, very unlikely in current conditions - these job losses alone, in a shrinking industry, will be a huge blow to the economy.

[ThatLeftTurnInABQ]

All of this is trite, not controversial. The controversy, I believe, arises from the fact that within the US, "the market" would distribute the pain of belt-tightening one way, "the government" could (if it chose to) distribute it a different way. If "the government" acts mostly on behalf of those Americans who got Learjets and penthouses out of the financial engineering of recent years, rather than those who got Camrys and Nintendos, I doubt the Japanese or the Chinese would care, as long as they get their soybeans.

TP,

Agreed about the social/economic justice aspect of how this adjustment gets distributed within US society, and also how foreign debt holders could care less how we go about doing it as long as they get their money back.

This is our problem, and we have the political and policy tools needed to deal with the "how to spread the pain around" issue, now the American people just need to summon the willpower to use those tools properly. They could start by paying attention for a change.

[hilzoy]

Tony P: One other thing is that the nature of a given bubble affects what stuff gets created. I was not wild about the creation of an endless number of shopping malls and office parks during the lead-up to the S&L crisis, and I am not wild about the creation of a whole lot of McMansions now. There are a lot of better uses we could have put that money to. Housing that doesn't presuppose an endless supply of cheap oil, for instance.

[hilzoy]

And efgoldman: definitely. I was just talking to someone who worked at Lehman until a year or so ago, in a unit that is apparently having a record year. Everyone seems to be out with nothing. (Though, as the person I was talking to quickly pointed out, they did have some pretty good years with embarrassingly large bonuses. Which is to say: I feel for them about losing their jobs, because work matters, but they are not in the same position that, say, the Lehman janitors will be in.)

[now_what]

With the DOW's 500-point loss today, I'm afraid it's only going to get worse.

Down a little over 4%. Nothing. We don't even get decent market-whackings anymore.

Industrial production is down 2% since January. That's a bigger deal than investment brokers disappearing, and in the time-frame of an investor, even that isn't that big of a deal. Business cycles happen.

If you're an investor in US stocks, here is what you should be worrying about.

The dismal saving rate in this country. That will impact what your equities are worth 30 years from now.

The fact that we are going to be paying huge interest payments to foreigners for the stupid crap we bought and consumed over the last decade.

The slowdown over the last 30 years in the world's population growth rate, from over 2% down to around 1. Not that this doesn't have its good points. But a lot of the growth in the price of equities over the last few decades was just a function of larger consumer markets.

The stupendous increase in inequality in this country. That never ends well.

Health care. At some point we choose between letting people die in the streets from easily treated conditions or raising the capital gains tax.

Energy. What is going to replace petroleum as it becomes more scarce?

Those are the things people investing (not speculating) in equities need to think about. A couple of has-been investment brokers getting clobbered into non-existence? Not so much. It's a blip. A buying opportunity. I buy stocks. I never sell them. I'll live off the dividends someday. I love it when they go on sale. The survivors in the financial industry are going to be vastly more profitable when the crisis is over, now that half their competition is gone.

Looking at my mother, however, shows a bigger problem. She's 70, and while she personally has switched over to less volatile investments, a large number of people between her age and mine have not

If you are nearing 70, invested largely in equities and in the situation where an 80 or 90% decline in the stock markets would severely impact your life, you're doing it wrong.