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CDS and human hubris.

Learning of the kinds of exotic instruments used by Wall Street in the years before the crash can be a mind-boggling experience. First, of course, because of the complexity of these things; but also because of the staggering sums of "paper wealth" they produced. AIG and other firms sold credit default swaps in such massive numbers that there was at one point insurance on $60 trillion in credit. In other words, they wrote so many CDS contracts that on paper they were insuring a credit market that exceeded, several times over, the GDP of the whole country. Try to wrap your mind around that.

Now they did this because each one of those swaps generated a steady revenue stream. Let's say I hold a mass of Lehman Brothers corporate bonds, and I start to get wind the Lehman Brothers may not be in the best shape. So I call the AIG Financial Products office in London and place an order for swaps protecting $10 million in Lehman debt. For this I agree to pay AIG, say, 150 grand in premiums every year for five years. I feel good because my Lehman debt is now insured. AIG feels good because they have another revenue stream -- my yearly premiums. Of course, I don't even have to actually hold any Lehman debt to buy the swaps. Maybe I just think Lehman's in deep trouble, and suspect that there could be a nice profit to turn if the poor company defaults. The CDS become a speculative instrument for me.

Nor is that all. Turns out you can purchase swaps on almost anything. Not just on companies, but on countries' sovereign debt (CDS on Icelandic debt soared in the days before its banks failed), on municipal bonds (CDS for cities and states is soaring right now, making their budgetry issues even more severe), on basically any kind of debt instrument imaginable. The New York Times reported in its excellent "Reckoning" series that Citibank had a mass of subprime mortgages bundled into what are called collaterallized debt obligations (CDOs -- a variation on the mortgage-backed security). According to the Times, Citibank's risk assessment on these CDOs "never accounted for the possibility of a national housing downturn." Ponder that for a moment.

Nor is that all. Remember that credit default swaps are desirable because they generate steady revenue streams. And one thing we have learned in all this mess is that where there's a revenue stream, Wall Street will devise a security. Sure enough, some hotshot operators were busy converting the revenue streams from credit default swaps into piles of CDOs! They securitized the revenue streams on derivatives.

Nor is that all. I have even heard (but not confirmed) that AIG was selling CDS on its own debt instruments. In short, it was selling contracts to insure counterparties in the event of a default on its own obligations. The only thing stupider in than that is the idea that someone out there actually purchased this paper.

So everyone knew there were technical obligations out there of unimaginable size, all interlocking in a web of abstract engineering, but they just pretended that the kind of default events that would trigger these obligations were essentially impossible. Months ago when some neophyte would point out that $60 trillion market in credit derivatives may not be the healthiest way to hedge default risk, he'd get some remark about "mere paper wealth." Not to worry. Lehman Brothers will never fail. It's Lehman Brothers for Pete's sake!

Except then it did, and the combustion of all this notional paper threatened spectacular detonations all over the world, of sufficent magnitude to bring down the whole financial system. I have it on good authority that when Paulson and Bernanke got a good look inside AIG in mid-September they literally turned white. That 300-man Financial Products office in London, once astoundingly profitable with its business in exotic derivatives, eventually racked up losses roughly equivalent to the entire 2009 budget of the state of Georgia.

And now every time I pull out my Citibank credit card to buy my morning coffee and egg sandwich, I get to be reminded that this lovely institution is now for all intents and purposes a nationalized bank, and that all the staggering myopia of these hotshots, combined with the Too Big to Fail doctrine, means that my country has been forced to embrace more ruinous socialism in the last three months than in the previous half century.

Comments (71)

Paul,

It is staggering just getting one's mind around all the issues related to our current financial problems. For you and W4 readers, I would also recommend these two excellent series of articles on this topic:

1) from the American Enterprise Institute:

http://www.aei.org/research/contentID.20080924093822815/default.asp

2) from the recent CATO Unbound discussion:

http://www.cato-unbound.org/

I do have a couple of questions related to the above discussion: yes, I understand AIG wanted the revenue from selling CDS, but a CDS is essential a form of insurance and isn't AIG in the insurance business? So why did they get the underwriting so wrong? Insurance companies presumably have someone on staff analyzing risk -- is AIG the only company that was selling CDS? If not, what is happening with all these other companies that sold CDS -- did they also do a bad job of analyzing risk? And finally, while I'm sure AIG loved the revenue from the CDS they were selling, I'm also sure they would prefer to not have to come begging to the government to save them...so again, why did AIG specifically screw up so badly?

While y'all continue to talk about yesterday's news (i.e., there had been a series of incisive articles concerning these for quite some months now at WSJ), the latest news evinces a most disturbing headliner:

Obama team considers $1 trillion stimulus http://www.msnbc.msn.com/id/28278398/

WASHINGTON - Anxious to jolt the economy back to life, President-elect Barack Obama is considering a federal stimulus package that could reach a whopping $1 trillion, dwarfing last spring's tax rebates and rivaling drastic government actions to fight the Great Depression.

Jeff on a previous thread you said;
If you can find me one scrap of evidence that Clinton-era Treasury regulations contributed to our current mess, I'd be open to your argument.

You have been provided numerous articles that give a chapter and verse account of Wall Street's bidding being performed by the Treasury, SEC and Federal Reserve Bank beginning in the Clinton era and extending to the present day. Why have you failed to respond? Could it be your ideological bias won't allow you to face reality and now all you're left with is a theatrical shrug of; why did AIG specifically screw up so badly?

Again, links spelling out the role our homegrown version of the Somalia Pirates played in destroying our economy;

When he was Treasury secretary during the Clinton administration, Mr. Rubin helped loosen Depression-era banking regulations that made the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period he helped beat back tighter oversight of exotic financial products, a development he had previously said he was helpless to prevent.

http://www.nytimes.com/2008/11/23/business/23citi.html?_r=1

Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures."

http://www.washingtonpost.com/wp-dyn/content/article/2008/10/14/AR2008101403343.html

Good questions, Jeff. I can't answer all of them. Certainly AIG was not the only firm selling CDS, but they were the big one. I gather that basically all the i-banks and most of the commercial banks were (and are) selling them. As for the underwriting, who knows? My sense is that everyone operated on the assumption that a massive default of one (not to mention several) of the big-name firms was so statistically improbable as to be essentially impossible. CDS on more risky, smaller firm was probably a saner operation, because the default event was much more likely and therefore the writers of this paper knew that it was a real possibility.

Let me note that I don't think CDS are inherently wicked. They can serve a useful purpose. Here's a useful article on one of their uses:

http://baselinescenario.com/2008/11/28/credit-default-swaps-bankruptcy-prediction/

One reform that occurs to me is requiring that a firm hold the underlying debt in question in order to purchase the swap. This would reduce their its use as purely speculative instruments.

Jeff (Singer), why do you think AIG did what it did? This isn't meant as a smart-alecky question, at all. I don't know a whole lot about this stuff, so I'm mostly listening to everybody talk and seeing who sounds like he is making the most sense.

Lydia (if I may answer a question put to Jeff): It's clear that a huge part of the reason AIG did what it did is that the CDS business was extreme profitable for quite awhile. I recommend you read the Times' Reckoning report on AIG:

http://www.nytimes.com/2008/09/28/business/28melt.html

Just a few brief excerpts:

Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable. [. . .] The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999. Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Globalization also played a large role. The interconnection of financial institutions was remarkable:

The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list. At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.” Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.

Almost no one truly grasped how much this interconnection exposed everyone to the sort of chain reaction we saw when Lehman went down.

For instance, I've heard stories about investors getting tense calls in October warning them about serious trouble in Iceland. (On one day in October the Icelandic stock exchange fell 75% [!!] and had to be shut down.)

"Why do I care about Iceland?"

"Because you're in technical default on those CDOs we fashioned for you out of CDS on Iceland's sovereign debt." (Apparently Icelandic bonds were attractive because their interest rates were really high.)

It's that tyranny of the abstraction that I've harped on here for months. We're in subjection to this highly-sophisticated engineering. Wall Street made its fortunes on the back of elaborate manipulation of mathematical models, by shifting fractional risk around in countless barely-perceptible transactions. But it was extraordinarily fragile.

I was reading a sort of nutty guy (can't remember his name, but I don't think he's well-known, just somebody who turned up in a search on the Internet a couple of months ago) who is a hyper gold-standard advocate and actually said that these derivatives should be declared fraudulent or non-enforceable contracts or something like that. It was sort of interesting seeing someone who seemed obviously to be a sort of libertarian (in some sense) arguing for what might sound from one angle like a draconian form of regulation of, or refusal by government to recognize, a particular type of financial instrument. That's assuming I even understood correctly what he was proposing.

Probably Peter Schiff. He's been right on so many predictions that it's hard for even those hostile to him to ignore him.

I saw him yesterday on CNBC with Larry Kudlow, arguing that the Federal Reserve is all wet and will ruin us with its extraordinary inflationary policies. And sure enough, today the dollar fell against the Yen to an all-time low, and saw is sharpest single day fall against the euro ever. Unpleasant.

The term "quantitative easing" gives me the shivers.

And yeah, selling unregulated insurance without having to hold any resources in reserve to fund claims is a source of limitless profit.

At least the Fed has some ability to -- what's the term -- sterilize inflation. What gives me the shivers is trillion dollar Keynesian "stimulus" plans.

I thought the guy I read had an Hispanic name. But does this idea of just treating derivatives as legally non-existent or even outright fraudulent have any (bad pun alert) currency elsewhere? On the right? On the left? Among von Miseans? Or where?

Paul -- Sometimes I think we need to just call this investment (and most investment) what it is: gambling. I am of no mind to outright prohibit gambling (of any form), but any methods or "products"* that threaten to turn our economic foundations into a long night in Las Vegas I would be happy to curtail. If this were to effectively curtail the hallowed economic principle of Endless Growth, I would not cry.

* BTW, it's "product" a stupid word for something like a Credit Default Swap? It's the sort of contradiction a mind like GK Chesterton's could skewer with about ten words or fewer. Wish I were capable of the same.

While y'all continue to talk about yesterday's news

Ari,

It is absolutely essential we not allow any narrative to emerge that omits or obscures some very basic, well-established facts. Nor should we, in the name of national comity or existential urgency, shy away from demanding the answers to simple questions.

Standard banking practices of risk management, the routine application of probability of default and loss-recovery models, the common-sense skepticism of professional credit managers and rough-edged traders were abandoned, deformed or suppressed. How could the pedigree-rich environments of Wall Street and Washington indulge in such colossal risk-taking, willful self-deception and studied disregard of multiple warning signs and sounding alarms? Trotting out, as some have, completely discredited ideological shibboleths cannot conceal the true nature of what is a wide-scale and deep crisis of the spirit.

Note the parallel time-line, matching assumptions and corresponding behavior patterns present in our economic debacle to those that have shaped our disastrous geopolitical maneuverings. A relatively small Islamic terrorist network was able to inflict mass carnage on the streets of our major cities, while luring us into a series of bloody and costly national security blunders. We are, despite, or maybe because of our enormous technological superiority, in a very weakened and precarious state.

There is a profound message buried within all of this. Sheer self-preservation requires we decipher the meaning and embrace the reforms and disciplines necessary for survival. As Steve K, who served our nation in combat, rightly said on another thread; “Ideology poisons everything”, including our capacity to think clearly and act in accord with the tenets of our Christian faith.

"I have even heard (but not confirmed) that AIG was selling CDS on its own debt instruments. In short, it was selling contracts to insure counterparties in the event of a default on its own obligations."

AIGFP didn't write CDS on itself, it wrote super-senior protection on synthetic CDOs that it created. There's a big difference. (I'm not defending the synthetic CDOs or the super-seniors, I'm just saying super-seniors aren't the same thing as writing CDS on yourself.)

"Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said."

That's patently untrue. I wouldn't believe anything you read in the Times' "Reckoning" series. AIG's CDS were all "pay-as-you-go" (known as PAUG), which are marked-to-market and margined daily. AIG had also been posting collateral due to credit downgrades since early 2007. The WSJ understood this when it wrote its big story on AIGFP.

There are so many outright falsehoods in the Times' "Reckoning" series that I've lost count. The piece about AIG tried to suggest that the Fed bailed out AIG at the behest of Goldman Sachs, which the Times claimed (falsely) had $20bn in exposure to AIG. The piece failed to mention, however, that the Fed hired Morgan Stanley to advise them on the AIG bailout. Does the Times think Goldman somehow got Morgan Stanley to do its bidding with the Fed? Yeah, cause that's how Wall Street works....

Thanks for that, EC. I was a bit dubious about that "no collateral" claim myself. The modifier "synthetic" in front of CDOs amuses me. Perhaps some day someone will show us, in the flesh, an organic CDO. :)

Do you have a link to the WSJ story?

Chris:

Yes, I've often wondered what fun Chesterton would have at the expense of these financial engineers. My dream is to someday get a grasp of the whole situation sufficient to write an essay on it that approaches the level of third-rate Chesterton.

As I mentioned up-thread, one reform that seems obvious to me is to requirement that an investor actually hold the underlying debt in order to purchase the CDS. That would certainly put a crimp in the ruinous speculation.

I'm very prepared to believe that the Times tells lies about this stuff, but the fact remains that AIG wanted a bailout. That shouldn't have happened. From the barest commonsense perspective, they were clearly doing something unacceptably risky and then seeking the government's help (via ultimately taxes or money-creation/inflation) to get them out of the soup.

None of EC's comments materially change the record of AIG, one that was duplicated throughout the financial industry and is now part of Congressional testimony. Note the checkered grading of the firm's leadership and steadfast refusal to act on warning signs;

"Nell Minow of corporate governance research firm The Corporate Library, noted his firm initially believed transparency at AIG had improved following Greenberg's departure. The Library rated the effectiveness of AIG's board of directors a "D" in June 2002 and downgraded them to an "F" in January 2005, subsequently upgrading them to a "D" in December 2005 and a "C" in February 2006, as the company had engaged former U.S. Securities and Exchange Commission Chairman Arthur Leavitt as an advisory member and shed more than half of its former directors.

Minow and the Library ultimately downgraded AIG's board again to a "D" in November 2007, with Minow commenting that "neither of the CEOs that followed Greenberg sought to implement significant change at AIG, nor did the reconstituted board apply any real pressure on them to do so."

In subpoenaed written testimony, Joseph W. St. Denis, vice president of accounting policy at AIGFP from June 2006 to October 2007, said he had been marginalized by the unit's senior executives for his insistence on sound controls.

St. Denis, a former assistant chief accountant in the SEC's Division of Enforcement, said he became "gravely concerned" about the valuation of AIGFP's portfolio of senior secured credit default swaps after the unit received a multibillion margin call on certain transactions in early September 2007.

According to a redacted copy of minutes from the March 11, 2008, meeting of AIG's Audit Committee, PwC auditor Tim Ryan informed the company of more material weaknesses related to AIGFP's swap portfolio, including controls over the super senior valuation process and "significant deficiency" in control over access, roles and responsibilities of critical control functions."

Kevin,

Standard banking practices of risk management, the routine application of probability of default and loss-recovery models, the common-sense skepticism of professional credit managers and rough-edged traders were abandoned, deformed or suppressed.

Abandoned, deformed or suppressed?

Allow me to present herein a description of the very thing we are discussing by one individual very knowledgeable of the entire matter, President & CEO, Federal Reserve Bank of San Francisco, Ms. Yellen herself:

I’ll start with assets. Here, a part of the problem is with the new securities and related derivatives that have been used extensively in this decade in mortgage finance and, in fact, throughout the financial system. They were once considered “state of the art”—dazzlingly complex, capable of spreading risk, and constructed using sophisticated mathematical models to price the risk. But it turns out that their very complexity makes it incredibly difficult now to know where the risk actually resides or how to price it, giving rise to major concerns about counterparty risk.

As these comments seem to suggest, it was for the very purpose of risk management that these modern financial instruments were born in the first place, utilizing some of the latest, most complex mathematical models as a means to ensure minimization of risk. However, as the latter concludes, it was the very complexity of these things that ironically led to downfall and defeated their original purpose.

Ari, the complexity was convenient. It removed human judement and accountability in faver of a desired end generated by a computer. Still, we will learn of those who bucked the delusion and were shuuned.

In the meantime, this math is interesting;

The difference between the two amounts was his bonus, a rich reward for the robust earnings made by the traders he oversaw in Merrill’s mortgage business.
Mr. Kim’s colleagues, not only at his level, but far down the ranks, also pocketed large paychecks. In all, Merrill handed out $5 billion to $6 billion in bonuses that year.

But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

Unlike the earnings, however, the bonuses have not been reversed.”
http://www.nytimes.com/2008/12/18/business/18pay.html?pagewanted=1&_r=1&ei=5070&emc=eta1


Kevin,

"Ari, the complexity was convenient. It removed human judement and accountability in faver of a desired end generated by a computer. Still, we will learn of those who bucked the delusion and were shuuned."

If I might interject here, there was this dialogue I recall from 60 Minutes awhile back which I (finally) just now found a transcript thereof, containing the particular comments that should build on the previous point while acknowledging, even if somewhat, a point of your own concerning human judgment:


These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk.

“Obviously they turned out to be wrong,” Partnoy says. Asked why, he says, “Because you can’t model human behavior with math.”

“How much of this catastrophe had to do with the instruments that Wall Street created and chose to buy…and sell?” Kroft asks Jim Grant.

“The instruments themselves are at the heart of this mess,” Grant says. “They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today.”

“People don’t know what they’re made up of, how they’re gonna behave,” Kroft remarks.

“Right,” Grant replies.

Paul Cella writes: "CDS for cities and states is soaring right now, making their budgetry issues even more severe"

Let's remember that municipalities collect a great deal of income from property tax.

Property values were inflated by the housing bubble.

So the tax base in some areas has also burst, or will do so the next time property values are reassessed.

A question for my betters in economics:

Since so much of our economy was inflated in value, and this value has now collapsed, does this mean the danger of inflation from government money-printing and borrowing is now reduced?

“Because you can’t model human behavior with math.”

Only a man in a frenzied flight into abstraction would place so much faith in unaccountable technologies. The attempt to remove the human person from the drama of his own life will hopefully end as a result of this economic crash. The "machines made me do it" defense reveals a very destructive aanthropology and self-abasement.

In the meantime, pity TIME magazine. Their choice for Man of the Year ranges from Blago to Bernie Made-off to an Algorithm.

Kevin,

I had refrained from commenting on your previous "evidence" (as well as the links sent to me by Maximos) only because I wanted to read through the various articles and give myself time to respond. As you recall, the previous posts were closed to comments so I haven't had the chance to properly respond to you or Maximos.

I could say a lot about everything you directed me to read, but the scare quotes above just about say it all (along with the delightful comment from EC above). I will also suggest that many of the long and detailed articles I have linked to come to different conclusions about our current problems than the NYT series or the Joseph Stiglitz piece Maximos previously linked to (Stiglitz, like Paul Krugman, has traded on his justly deserved laurels for his academic work for a career as a shrill pundit who can write book reviews in the same NYT that Krugman works for offering faint praise for that modern-day prophet of doom, Naomi Klein).

I will also direct your attention to the November issue of "The New Criterion", which has all sorts of great essays, but the one relevant here is James Bowman's piece on the emerging media narrative that suggests all of our problems are do to free markets. The whole essay is excellent, but this section quoting Sebastian Mallaby is particularly apt:

"...the key financiers were the ones who bought the toxic mortgage products. If they hadn't been willing to buy snake oil, nobody would have been peddling it. Who were the purchasers? They were by no means unregulated. U.S. investment banks, regulated by the SEC, bought piles of toxic waste. U.S. commerical banks, regulated by several agencies, including the Fed, also devoured large quantities...blaming deregulation for the financial mess is misguided. But it is dangerous, too, because one of the big challenges for the next president will be to defend markets against the inevitable backlash that follows this crisis."

I would also suggest that Lydia in her concise and characteristically wise manner, got to the root of some of our current problems when she said above that from "the barest commonsense perspective, they [AIG] were clearly doing something unacceptably risky and then seeking the government's help (via ultimately taxes or money-creation/inflation) to get them out of the soup." Unless we allow companies to fail, moral hazard will ensue and the markets we are all discussing are far from "free".

Finally, I just want you to know I totally reject your characterization of the Bush years as "disastrous geopolitical maneuverings", but now that I'm on the record, it would be nice if we all didn't have to be reminded of your foreign policy views on every post here at W4 dealing with topics that have nothing to do with foreign policy. Crisis of the spirit indeed!


Lydia and Paul,

The reason I'm not convinced it was the profits to blame at AIG, is that those profits should have immediately induced other players in the market for CDS to enter and sell their products just as aggressively as AIG. I can't help thinking about that French trader who was caught not too long ago after making all sorts of money for his firm while at the same time hiding the fact that what he was doing was illegal (and it should be noted that he was being watched by all sorts of internal compliance monitors and outside regulators who raised red flags but nevertheless didn't stop him because he was able to stay one step ahead of everyone AND make lots of money for his firm). In other words, did everyone at AIG really not realize the risks involved or were there employees who did know but hid the truth?

Kevin,

Only a man in a frenzied flight into abstraction would place so much faith in unaccountable technologies. The attempt to remove the human person from the drama of his own life will hopefully end as a result of this economic crash.

This strikes me as rather Nietzschean in thought as it expresses such vehement displeasure at the very notion of abstraction and that harm to the individual that ultimately results from its sterile confines and draconian rigidity.

As a "rational" being, he now places his behavior under the control of abstractions. He will no longer tolerate being carried away by sudden impressions, by intuitions. First he universalizes all these impressions into less colorful, cooler concepts, so that he can entrust the guidance of his life and conduct to them.

This is how we behave "rationally", no?

Although, I am rather shocked that, out of all people here, you would come to invoke such an argument especially one that seems surpisingly similar to his; a person whose views I find, if it even needs to be said, most distasteful.

If you can find me one scrap of evidence that Clinton-era Treasury regulations contributed to our current mess, I'd be open to your argument

Jeff, so you offer neither a rebuttal or a retraction for the overwhelming evidence detailing Rubin's role at Treasury or Citi. Bizarre. I promise I won't bring-up any of the glowing Neo-con successes and promise to worry more about Prevailng Wage laws, if you start to offer facts instead of editorials from The Criterion. Deal?

Since you contend the markets were regulated, which regulations were violated in the mortgage securities, CDO and Credit Default Swap marketplaces?I would think you of all people anxious to prosecute those who have done so much to destroy faith in the markets. So fire away.

Oh, uh, Rubin and Prince could use your help;
Investor-plaintiffs in the suit accuse Citi management of overseeing the repackaging of unmarketable collateralized debt obligations (CDOs) that no one wanted - and then reselling them to Citi and hiding the poisonous exposure off the books in shell entities. http://www.nypost.com/seven/12042008/business/ponzi_scheme_at_citi_142511.htm


They were by no means unregulated. U.S. investment banks, regulated by the SEC, bought piles of toxic waste. U.S. commerical banks, regulated by several agencies, including the Fed, also devoured large quantities...blaming deregulation for the financial mess is misguided.

Yes, and they did so because several of the assets classes were exempted from regulatory oversight, because leverage ratios were altered with respect to others, because regulatory authorities didn't trouble themselves to investigate the soundness of others, nor the many unsound practices that had developed in the financial sector. In other words, they were subject to formal regulatory oversight, but not a great deal of material, operational oversight.

We get it: For the proposition that deregulation, or inadequate regulation, of private sector actors contributed to the crisis there is no conceivable evidence or argumentation that you will accept. Government intervention in markets, irrational or malicious actors, or mysterious forces of nature can all be assigned some portion of the responsibility, but never, no never, can the myth of self-regulating markets be apportioned any blame. This has merely served as yet another illustration of the fact that public, intellectual discourse in this country reduces to a conflict of incommensurable narratives. It is never sufficient to state that the causation of the crisis is complex, and that it originates in failures at once political, economic, and cultural, and that there were both failures of intervention and failure to intervene; no, always must the Market be exculpated.

And no, I'm not writing this either in a state of high dudgeon, or with the deliberate intention of sounding shrill. Neither, for that matter, were Stiglitz and Ritholtz in the linked pieces; Stiglitz was rather dispassionate, and Ritholtz was reasonably outraged by the preposterous suggestion that CRA-mandated subprime lending was either the singular or predominant cause of the collapse. To the contrary, what I have written has had its genesis in a profound sense of resignation; discourse is impossible, as many have declared their refusal to accept certain evidences as evidences.

Kevin,

Rubin's "role at Treasury" is not the issue. The issue is what specific regulation (or lack thereof) that Rubin implemented (or refused to implement) "contributed to our current mess". You have not detailed an argument, but rather quoted me a bunch of folks who said statements like "Rubin opposed regulation of derivatives". The quote from the Washington Post vis The New Criterion points our that many heavily regulated banks bought bad debt -- either these regulations were in fact violated or this fact once again highlights the fact that regulators are not superhuman and the best regulation with respect to risk is the idea that no one will bail you out when you fail. The market works well when it aligns individuals self-interest with the harsh realities of success and failure.

And finally, the fact that investors are going after Rubin and Price suggests again, that regulation are in fact in place and that if Rubin/Price are found guilty (and pay a real price) the system will have worked! Like Madoff, who managed to bribe and/or con the SEC regulators crawling all over him, the issue has nothing to do with the free market or regulation and everything to do with good old fashioned lying, stealing, etc.

Those are legitimate observations as far as they go, Jeff, but all they accomplish is the shifting of the argument, its reframing, perhaps, such that the unwillingness of the establishment to articulate a regulatory regime appropriate to the financial innovations proliferating throughout the system becomes a decisive factor. It is all well and good to propose that the harsh disciplines of the market, within which no firm is too big to fail, may be the most appropriate remedy, but this, given the magnitude of the errors of both prudential judgment and technical risk allocation, essentially amounts to a different form of the socialization of risks: imprudent financial actors will profit during the expansionary phase of a bubble, and virtually everyone will suffer the consequences of of the collapse of such unsustainable expansions in speculative activity. While regulation, like virtually everything else in this life, is a prudential and imperfect art, it is indubitably true that, at a minimum, the worst excesses and effects of this crisis cold have been forestalled, had those critics of financial innovation been heeded, for there has been no shortage of skeptics and critics of the luxuriant growth of certain derivative markets; this being the case, it is clearly insufficient, both as a matter of policy and a matter of ethics, to permit destabilizing instruments and practices to proliferate while relying upon ultimate failure as the primary, or even exclusive, backstop.

Jeff,
1) I have not quoted a couple of guys. I have linked to 20 plus pages of public record, internal memos, congressional testimony and the legislation that created the CDS marketplace.

2) Rubin is subject to a blanket investor lawsuit that charges;
Rubin and other top insiders were able to keep Citi shares afloat until they could cash out more than $150 million for themselves in "suspicious" stock sales "calculated to maximize the personal benefits from undisclosed inside information,"

Again, any facts to support your contention that Clinton-era Treasury regulations DID NOT contribute to our current mess? Any?

Here's a solid prediction; the very people who hailed Rubin as a deregulator and free market Democrat in the '90's, will soon blame his stonewalling of Brooksley E. Born at the Commodity Futures Trading Commission for the crash.

Kevin Jones:

Since so much of our economy was inflated in value, and this value has now collapsed, does this mean the danger of inflation from government money-printing and borrowing is now reduced?

That there is the big question. The near-term threat is deflation, not inflation. Demand is contracting rapidly. Some of it is healthy (we're saving more, for instance; and there is early evidence that a sharp recession, hard on the heels of a good hard look at $4 gasoline, has produced permanent changes in driving behaviors: demand destruction in the oil sector has left OPEC looking marvelously impotent), but there is a real danger that we could slip into a deflationary spiral like that of the 1930s, where debt gains value while wages and prices decline. Nasty stuff. This is why Ben Bernanke's Federal Reserve has embarked on a course of extraordinary activity. "Quantitative easing" is the phrase: adding quantities to the money supply.

So he's combating deflation with aggressive inflationary policies.

Long-term, inflation could be a serious problem though. We can see that in the flattening of the yield curves on Treasury securities. People want to get into cash, but they know that off at the end, inflation is coming. In a sense, the moment the economy turns around, back into a growth dynamic, inflation will come roaring back. The amount of new dollars, new Fed lending facilities, new T-bills, etc, out there in the world is remarkable. Right now banks and countries and individuals are hoarding them. But that probably won't last.

Jeff Singer:

As I said up-thread, it wasn't just AIG that was in the exotic derivative business. Almost all the banks were involved. It was just that AIG was the most aggressive, and thus that when AIG faltered, Paulson and Bernanke knew that the chain reaction had to be stopped there.

I really do sympathize with the inclination to say, "AIG (or Lehman, or Citibank, etc) messed up, and ought to pay for it." Believe me I do. But problem is that the size of the credit derivative market was sufficient to bring down the entire world financial system. How many institution had written CDS on AIG debt, and would have come crashing down if AIG had been allowed to fail? How many institutions had written CDS on those institutions? Without a banking sector, how many businesses small and large could make payroll?

It's stinks to high heaven that we're all subject to the abstractions of high finance engineering. But we are. And we have been for decades, I'm afraid. It will be a long time in unwinding, and our task is to be vigilant that the madness doesn't repeat itself.

the best regulation with respect to risk is the idea that no one will bail you out when you fail.

Not really. Credit Default Swaps are an insurance instrument for CDOs. So why not the name; Credit Default Insurance? Because such a title would subject the financial institutions to state regulations requiring they hold reserves able to cover potential losses. The whole point of "Swaps" is for the issuer to avert regulation and the maintaince of reserves. The lack of common sense regulation of a $45 trillion marketplace was insane and is impossible to spin.

Credit Default Swaps are an insurance instrument for CDOs. So why not the name; Credit Default Insurance? Because such a title would subject the financial institutions to state regulations requiring they hold reserves able to cover potential losses. The whole point of "Swaps" is for the issuer to avert regulation and the maintaince of reserves. The lack of common sense regulation of a $45 trillion marketplace was insane and is impossible to spin.
Exactly. This is the age of nominalism, where semantics overcome and remake reality in accordance with our wills. If we want sanctioned buggery, why, just label it 'marriage'; if we want to avoid the reserve requirements of insurance, why, just label our product a 'swap'.

William of Ockham has triumphed.

Kevin:

So why not the name; Credit Default Insurance? Because such a title would subject the financial institutions to state regulations requiring they hold reserves able to cover potential losses.

That's not technically true. CDS aren't considered insurance because the contracts don't make payout contingent on the protection buyer suffering a pecuniary loss. If the standard ISDA docs for CDS made payout contingent on the protection buyer suffering a pecuniary loss, then they would plainly fall within the definition of an "insurance contract" under NY law (the jurisdiction where almost all CDS are written). The NY Insurance Department confirmed that CDS aren't insurance for this reason in a 2000 Circular. Without a link between payouts and pecuniary loss by protection buyers, the NY Insurance Department has no legal authority to regulate CDS.

That's not technically true.
Interesting fact. On the other hand, a CDS is, as a matter of essence if not technical legality, a kind of insurance policy; and if we called it an insurance policy, there would be some expectation that it might be regulated in some fashion similar to an insurance policy.

With apologies to Richard Weaver, language has consequences.

On the other hand, a CDS is, as a matter of essence if not technical legality, a kind of insurance policy...

Not really --

I mean, would I be able to buy insurance covering something you, in fact, own?

I see little point in back and forth assertion on the point. A CDS is a contract for a payoff in the event of some adverse occurrence. In an interconnected world, I don't have to own X to be at tremendous risk if X fails. (Anyone who cannot see this after the last few months is insane). A CDS is more insurance-like than anything-else-like: it packages up risk to be bought and sold.

Furthermore, the whole reason we have this crisis at all is because of the use of unregulated CDS's to insure mortgage backed bonds. If we got rid of all the CDS's specifically used to back real mortgage-debt assets and pay off to those asset owners in the case of a loss - that is, if we got rid of all the CDS's used to perform an insurance function - there very well might be no crisis, because a lot of high-risk homeowners could not have gotten mortgages; though there would doubtless still be other CDS's 'out there'.

So if you want to know where at least one key systemic failure is, it is in having what in essence were insurance policies (the nominalists can go to Hell on this one) but without the regulatory and reserve framework of insurance policies.

http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom/?refer=email&print=true

This link has been going around for a few weeks now, but in case anyone hasn't read it, and can tolerate some rough language, it gives an insider view of what happened. The main sense I got from it was how nobody, literally nobody, had the slightest respect for fiduciary responsibility.

the nominalists can go to Hell on this one

It will be standing room only after the books are closed on the modern age.

The main sense I got from it was how nobody, literally nobody, had the slightest respect for fiduciary responsibility.

They went from the prudent practice of mitigating against risk, to passing it off all together. Amass great wealth, evade any liability. Thanks to so many well-connected grifters, the rest of us can prepare to assume the position in The Servile State.

Kevin,

You say:

"I have not quoted a couple of guys. I have linked to 20 plus pages of public record, internal memos, congressional testimony and the legislation that created the CDS marketplace."

And then:

"Again, any facts to support your contention that Clinton-era Treasury regulations DID NOT contribute to our current mess? Any?"

I did you the courtesy of reading the links you provided me, I suggest you give me the same courtesy and read the stuff I linked to, then we'll talk.

Given everything else that was going on in the market (i.e. CRA, Mortgage-backed securities, Fannie and Freddie, loose money from the Fed, etc.) it is still not clear to me that a Treasury regulation that either banned CDS or put some sort of reserve requirement on them as if they were insurance would have prevented our current crisis (although I think Zippy and even Maximos make a strong case that the entire financial sector would be well served by more strict reserve requirements for everyone who wants to buy and sell derivatives). I should also note you ignored EC's delightful contribution to this debate:

"I wouldn't believe anything you read in the Times' "Reckoning" series. AIG's CDS were all "pay-as-you-go" (known as PAUG), which are marked-to-market and margined daily. AIG had also been posting collateral due to credit downgrades since early 2007. The WSJ understood this when it wrote its big story on AIGFP."

So how is it that an unregulated market for CDS still resulted in AIG posting collateral?


Maximos,

You say: "For the proposition that deregulation, or inadequate regulation, of private sector actors contributed to the crisis there is no conceivable evidence or argumentation that you will accept."

No, I just haven't been convinced by the "evidence" and arguments presented by you and Kevin. Look, I think I come at these issues in good faith, albeit with a sense (developed from the study of economics and history) that free markets are the best way to increase wealth and prosperity for all. As one example, I didn't think much about fiat money before this crisis but I have a good friend who is the kind of guy who attends "End the Fed" rallies and loved Ron Paul because of Paul's attack on the Fed. I used to ignore his economic analysis -- now I don't because he has presented me with a lot of good evidence and analysis that makes me think maybe fiat money does have its problems (plus my friend has made a killing in gold over the past two to three years). So I don't think of myself as a free-market ideologue and it would be nice of you (and Kevin) not to treat me as such.

You also say:

"Stiglitz was rather dispassionate, and Ritholtz was reasonably outraged by the preposterous suggestion that CRA-mandated subprime lending was either the singular or predominant cause of the collapse"

Here is a quote from the first page of the Stiglitz "analysis":

"But Volcker also understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing, and he found him in a devotee of the objectivist philosopher and free-market zealot Ayn Rand."

"Rather dispassionate" would not be the description I would use for Stiglitz's prose. In fact, it confirms my impression of Stiglitz as the worst sort of partisan hack and it is sad for me since I used one of his textbooks back in the day when I was getting my Economics BA!

As for Ritholtz, there was much I found to criticize in his analysis, but for now I'll just focus on CRA. Had you bothered to read the Wallison article I previously linked to you would understand that it wasn't the relatively small number of bad loans made to low-income home buyers that is the problem but rather the following:

"The important question, however, is not the default rates on the mortgages made under the CRA. Whatever those rates might be, they were not sufficient to cause a worldwide financial crisis. The most important fact associated with the CRA is the effort to reduce underwriting standards so that more low-income people could purchase homes. Once these standards were relaxed--particularly allowing loan-to-value ratios higher than the 80 percent that had previously been the norm--they spread rapidly to the prime market and to subprime markets where loans were made by lenders other than insured banks. The effort to reduce mortgage underwriting standards was led by the Department of Housing and Urban Development (HUD) through the National Homeownership Strategy published in 1994 in response to a request by President Clinton. Among other things, it called for "financing strategies, fueled by the creativity and resources of the private and public sectors to help homeowners that lack cash to buy a home or to make the payments."[9] Many subsequent studies have documented the rise in loan-to-value ratios and other indicators of loosened lending standards.[10]

After 1995 and the adoption of the new CRA regulations, homeownership in the United States grew rapidly. Having remained at 64 percent for almost twenty-five years, it grew to 69 percent between 1995 and 2005.[11] The increased availability of credit under CRA requirements probably also spurred housing demand, which doubled home prices between 1995 and 2007.[12] The key question, however, is the effect of relaxed lending standards on lending standards in non-CRA markets. In principle, it would seem impossible--if down payment or other requirements were being relaxed for loans in minority-populated or other underserved areas--to limit the benefits only to those borrowers. Inevitably, the relaxed standards banks were enjoined to adopt under CRA would be spread to the wider market--including to prime mortgage markets and to speculative borrowers. Bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better qualified borrowers. This is exactly what occurred. Writing in December 2007 for the Milken Institute, four scholars observed: "Over the past decade, most, if not all, the products offered to subprime borrowers have also been offered to prime borrowers. In fact, during the period from January 1999 through July 2007, prime borrowers obtained thirty-one of the thirty-two types of mortgage products--fixed-rate, adjust-able rate and hybrid mortgages, including those with balloon payments--obtained by subprime borrowers."[13]

As they say in the blogosphere, read the whole thing!


Paul,

Finally, I just wonder if AIG really was too big to fail...I mean despite the efforts of the Feds to prop up AIG, the credit market is still relatively frozen and we've seen other big financial firms either fail anyway or need their own hand-out. I still have to wonder if there weren't a couple of crooks at AIG who managed to lie to a lot of people about what their risk models really said about all those CDOs.

Jeff,

So how is it that an unregulated market for CDS still resulted in AIG posting collateral?

1) How much was that collateral good for; 5-10%-15% of their exposure? I'll have the figure for you tomorrow.

2) Sure they posted collateral after the downgrades, but their exposure began 7 years earlier.

3)Suffice it to their collateral wasn't large enough to cover their bets - which was the whole point of the Swaps game.

4) Knowing what you know now, would you still allow the reserve-free, no state agency oversight scheme happen again?


"...that free markets are the best way to increase wealth and prosperity for all..."

Rigged markets are not free, not without transparency, accountability and the assumption of liability on the part of the (heavily compensated) risk-takers. Few are going to call this ride a "free" one when all is said and done.

Acting as the Defender of Crony Capitalism and Protector of the Wall Street-Treasury complex is an impossible task. Abandon it my man. It is becoming embarrassing and 6 months from now you'll demand W4 erase your comments.

Jeff, there is a perversity intrinsic to this exchange, insofar as it appears as though it has been determined in advance that no sort of evidence that The Market failed can actually matter in a reckoning unless it can first be tied to, associated with, or seen to derive from, the unmitigated horror that is the CRA. Did the CRA mandate the issuance of NINJA loans outside communities covered by the CRA? Did the CRA somehow, by some mystical process as yet undisclosed, cause the Clinton Treasury to repudiate the suggestion that derivatives should be subject to greater regulatory scrutiny, and to pass the Commodities Future Modernization Act, or whatever the hell it was called exempting credit default swaps from regulation, the absence of adequate capitalization for these insurance instruments being integral to the collapse of the markets?

I was underwhelmed by the Wallison analysis when David Frum began touting it some weeks ago, in its preliminary form as it really amounts to the claim that, for the sake of argument, stupidity in one regulated sector somehow caused bankers to become colossally stupid in other sectors not subject to regulation, albeit thus wholly voluntarily. I'm exhausted, and the hour grows late, so instead of droning on, I'll just quote James Kwak:



At its core, the argument is that the government forced lenders to make bad loans in one market, so they went and decided to make bad loans in other markets. Even conceding some of the premises for the sake of argument, this is illogical. Wallison says “it would seem impossible–if down payment or other requirements were being relaxed for loans in minority-populated or other underserved areas–to limit the benefits only to those borrowers.” It doesn’t seem impossible to me: if you’re running a business, you should be able to understand that you have different target markets, and you have different products for those markets. In fact, if you (the bank) truly thought that you were being forced to make bad loans in one market, you would damned well keep those loans out of your other markets. If lenders are as stupid as Wallison’s argument implies they are, then the entire premise of the American Enterprise Institute - that government should leave businesses alone - starts to look shaky.

You can also tell an argument is shaky when an author says “it is difficult to prove cause and effect.” In areas like business, finance, and economics, where there actually are a lot of data, that generally means that it can’t be proven, or it would have been. Wallison’s evidence is that flexible mortgage products became available to the prime market. (Disclosure: I got an ARM when my wife and I bought our house, and we refinanced it into another ARM.) The most obvious explanation of that phenomenon is not that the CRA induced banks to make those products available to some customers, and that put them on a slippery slope to making them available to all customers, but that bank executives decided to make those products available to all customers. Still hoping to pin this on regulators, Wallison says, “Bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better qualified borrowers.” I don’t know where to start here: someone who is against regulation is trying to argue that the CRA tied the hands of regulators who otherwise would have clamped down on flexible mortgages to rich people? I’m in favor of tighter regulation of abusive mortgage products, but I don’t think the CRA is to blame for lack of regulation.



Bankers expanding risky lending outside the coverage of the CRA did so in order to feed the demand for securities and related derivatives, and did so wholly voluntarily, with the regulatory authorities more or less warming their hands by the bonfire of the vanities, and dismissing the skeptics as hidebound reactionaries who couldn't comprehend that uncertainty had been mastered by mathematics. In the end, the most that can be said for the CRA hypothesis is that it established a poor psychological precedent of one sort, which is a rather slender and pointed reed upon which to rest the weight of a defense of finance capitalism.

As regards Stiglitz's animadversions against Reagan for the latter's replacement of Volcker with Greenspan, well, I've been puzzling over that one for a while, and I cannot really come up with a satisfying answer, especially since Volcker still retains an aura of credibility, while Greenspan has FAIL stamped all over his person, and warrants an entire server on Failblog. While Stiglitz's hostile characterization is uncharitable, and contradicts the evidence of Reagan's prudence in the conduct of trade policy, it is not wholly unwarranted, in that it is entirely possible that advisers who could swallow Reagan's moderation on trade policy had a less constrained vision for the financial sector, and persuaded Reagan to make the switch. Who knows? But in retrospect, the decision was a dreadful one.

Maximos,

Thanks for that link...that is the first analysis you sent me that made some sense. I still don't think the author appreciates the entire Wallison argument (e.g. the efforts by HUD and Fannie and Freddie to expand homeownership which created part of the enormous market for mortgage-backed securities, etc.) but at least he makes a careful argument spending some time actually reading Wallison.

I checked out that guy's blog and came across a post that quoted a "2005 paper by Zvi Bodie and Robert Merton". Just as an amusing side note, I went to college with Zvi's daughter and had a massive crush on her. I wonder what she is up to these days?


Kevin,

You say "Rigged markets are not free, not without transparency, accountability and the assumption of liability on the part of the (heavily compensated) risk-takers. Few are going to call this ride a "free" one when all is said and done." I agree with everything in this quote, but will simply note that you left one item off of your list: massive government interference in the operation of markets, with the exception of regulations addressing market failures (e.g. agency problems or information asymmetry).

As for "Acting as the Defender of Crony Capitalism and Protector of the Wall Street-Treasury complex", I'm the one who thinks we should have let AIG fail...I suggest you direct your ire at Paul or Zippy who have made passionate arguments in defense of the AIG bailout and the necessity of TARP.

Jeff,
We have in this crisis the worst of both worlds. In the Fannie & Freddie aspect, it is the state creating a major distortion in the housing market and expanding the level of moral hazard into the system. The sub-prime, alt-A mortgages are $1 trillion in assets, or 10% of the marketplace.

In the Swaps aspect, we have the creation of an unregulated marketplace designed to maximize private gain while negating the normal brakes placed on institutional risk-takers. Swaps account for $45 trillion in assets.

Crony or state capitalism is an apt description, as a cadre of public sector and private enterprise insiders are able to ensure that money and power flow in the direction of a distant, concentrated and centralized source - which they happen to control.

The origins of the debacle begin with 2 ideologies, abstraction, and the eroding moral foundation of a culture built on unlimited consumption and massive debt. The historical record must be protected from those desperate to avoid the exposure and repudiation of their worldviews.

Kevin,

Abstraction is not an ideology -- it is something we all do to help us tame and use nature (e.g. an oven is in some sense an abstract fire, zero is an abstract concept, etc.) I'm not sure how "the eroding moral foundation of a culture" is an ideology either, but perhaps you'll clarify in another comment.

How are the markets for CDS "crony capitalism" -- weren't they sold on the open market and any institution (or trader) with the knowledge and money can buy them? And finally, the CDS market is big, but the market for derivatives is much bigger ($145T in interest rate contracts alone: http://en.wikipedia.org/wiki/Credit_default_swap). Throwing around big numbers without context or explanation seems to be your personal M.O. -- one could even call it an ideology!

Jeff,
Abstraction is not an ideology - I know it is an incubator for noxious isms, an alternative to reality, refuge for the manipulator, power-seeker and evader of responsibility.

The "the eroding moral foundation of a culture" is a condition brought on by imposing strange social regimens and economic theories on a people. The results are all around you.

How are the markets for CDS "crony capitalism" -- weren't they sold on the open market and any institution

See this is where ideology leads one. You are too threatened to acknowledge the instruments grew to $45 trillion because they were unimpeded by the normal safeguards and constraints placed on insurance vehicles. Yes, the derivatives marketplace is much bigger. So?
I mean the rest of us don't have to worry about our homes, jobs and well-being if they implode? Right?

Look you have all the passion and blinders of the true believer. But, unless you have the good grace to acknowledge the role your political religion played in all of this, I'd say we've arrived at a friendly standstill.

Kevin, I get the strong impression that Jeff Singer is watching the evidence here. He's actually said that he can see the point of reserve requirements for derivatives, which hardly sounds like an ideologue to me.

Jeff:

I don't believe I've ever made a passionate argument in defense of the AIG bailout. This because I think its amounts to a nice swift kick in the teeth.

Mostly my arguments have been an attempt to establish the severity of the crisis confronting officials in mid-September, and the utter urgency of the situation. In short, my arguments amount to a resigned defense of the prudential judgment of Paulson and Bernanke in the face of a terrifying crisis that very few people understood.

As for the TARP, I'm still a little baffled by why Paulson totally abandoned the original plan. One obvious factor is that he thinks buying preferred shares in the banks is a method more likely to result, off at the end, in taxpayers recouping the expenditure. Can't fault him for that.

Nevertheless, the toxic assets -- subprime CDOs, other securitized mortgages, CDOs fashioned from CDS revenue streams, etc. -- are still weighing on banks in a serious way. Maybe Zippy can help me out with why they abandoned buying up troubled assets.

As for the tyranny of abstractions, the point here is that, while any modern economy must deal to some degree in the abstractions of high finance. Our problem is that over the past two or three decades we let high finance abstractions, which should exist to serve productive enterprises, become the productive enterprises. Only they aren't productive. If you're running a good business in Gadget A worth $10 million per year, and a bank gets the notion that it can sell $100 million worth of credit derivatives on the debt you used to finance that business, for awhile it may appear that your business is has expanded dramatically. It truth it has not. All that's happened is that the bank (along with, probably, a mass of speculators) has exposed itself massively in the event of your default, and a bunch of your creditors think they're insured against this. They may be insured, if your default is an isolated event; but if it is part of a more systematic problem, then they're either (a) throwing their monthly premiums away or (b) relying on the expected government bailout.

In short, the whole scenario is an instance of high finance abstraction subjecting actual productive activity by his excess and recklessness -- a grave and ruinous imbalance between actual productive activity and abstraction.

Wow! The CATO Unbound discussion is really, really fascinating and now they posted an anonymous insider's view of the situation:

http://www.cato-unbound.org/2008/12/16/the-editors/reader-contribution-a-worms-eye-view-from-wall-street/

There is a lot of blame (at least in this guy's mind) to go around...and yes, he thinks part of the problem was inadequate reserves.

I get the strong impression that Jeff Singer is watching the evidence here. He's actually said that he can see the point of reserve requirements for derivatives, which hardly sounds like an ideologue to me.


Yeah, afer several months of postings and innumerable articles, we've dragged Jeff kicking and screaming to admit the fact that the CDS markets were designed to dodge state insurance regulations. Wow, the joys of a mind unencumbered by ideology. Do you think this anyone in the fiancial industry is would arguing otherwise? Jeff can thank God he is not one of my kids because if they revealed this level of resistance to concrete, factual reality they'd be experiencing an intensive de-programming therapy. Good Lord, this was painful.

The link you sent (with the Good Housekeeping seal of approval from your libertarian friends) serves as a good portal to other sources Jeff. Roubini along with Schiff are looking real good, though Roubini's forecast for 2009 should make everyone tremble.

Thanks for that link, Jeff. I'm not through the whole thing yet, but it's a good piece of the puzzle to have.

Maybe Zippy can help me out with why they abandoned buying up troubled assets.
I guess I would say two things:

1) I understand why the preferred-share investments were made at the time they were made, and I'm not sure 'to maximize the likelihood that taxpayers get their money back' was the reason: I could have thought of any number of more stringent terms to make that more likely, and I'm not even a professional. Everyone had suddenly become an avid student of the history of the Great Depression, and in the narrative of the GD a large part of the problem was unilateral action by various governments to protect their own interests, with no international coordination. The initial use of the TARP to buy preferred shares rather than CDS-tainted assets was a move structurally coordinated with (at least in theory) the actions of other governments. None of us is as dumb as all of us. Still, the equity infusions do seem to have helped in terms of the acute structural crisis.

2) I don't understand why the purchase of assets was abandoned as a TARP program, and its abandonment has made me pretty grouchy. I have two hypotheses, a scary one and a cynical one. The scary one is that Paulson realized the fact that (n.b. - I don't know if 'the fact' is true or not) $450 billion would not be enough to make a market in, and do price discovery on, CDS-tainted assets. The cynical one is that Bernanke and Paulson are coordinating who does what based on the various restrictions on their authority: the Fed has been buying CDS-tainted assets, I believe, without the oversight requirements placed on the TARP. The combined scary-cynical one is that the Fed is doing it because it looks so awful that making everything about it public through the oversight process would be harmful in itself.

This comes with all the usual disclaimers about whether a pseudonymous blogger named Zippy does or does not have any idea what he is taking about.

It's strange how badly ignored is George W. Bush's role in undermining one of the oldest and simplest credit standards: the down payment. At his October 15, 2002 White House Conference on Minority Homeownership, and on during speeches before and after that, Bush proclaimed his goal of adding 5.5 million minority homeowners, and attacked down payments on homes as the chief barrier to minorities achieving their fair share of the American Dream. This sent a big signal to the Administration's regulators not to maintain pressure in favor of down payments. Thus, the percentage of zero down first time home purchases in California, the epicenter of the mortgage meltdown, grew from under 7% in the last years of Clinton to over 30% in 2004 and to 41% in 2006.

This was part of Karl Rove's major political initiative, to lure Hispanics into the GOP. The idea was to use easy credit to turn Hispanics from renters to conservative homeowners with something to conserve. Of course, the no money down and other easy credit rules applied to everybody. Still, Hispanics led the way -- it's not at all a coincidence that half the foreclosures and the great majority of defaulted dollars were in the four rapidly Hispanicizing "Sand States" of California, Nevada, Arizona, and Florida. Total mortgage dollars flowing to Hispanics for home purchases increased an insane 691% from 1999 to 2006, versus 397% for blacks, but only 218% for the fast-growing but more prudent Asians and about 100% for whites. Half of subprime dollars in 2004-2008 went to minorities. Nobody has counted the defaulted dollars by ethnicity, but it's very likely that a sizable majority of unexpected losses (above the usual actuarial rate of family tragedies) are concentrated in minorities.

But nobody wants to talk about Bush and Rove's role in all this.

Kevin, your hatred of, and your rage against, conservatives of a libertarian bent just absolutely give me the willies.

Here we are, moving full speed ahead into Euro-Socialist-Multiculturalist territory, and spitting on the forlorn grave of the "free market" is all you have time for?

Brrr...

Steve: yes - it is, indeed, strange.

But it all makes sense, when when you think about it.

The Democrats don't want to admit that George W. Bush was, at heart, a multiculturalist liberal, because that would make their opposition to him look like so much irrational party-line hatred.

And the Republicans don't want to admit that George W. Bush was, at heart, a multiculturalist liberal, because that would make their support for him look like so much irrational party-line love.

So who's left to shame the devil by telling the truth?

Just you, I guess.

The free market spat first...knowing the subprime scheme would self-destruct Wall Street not only maintained the charade but leveraged it to the moon.

It may help to remember that great market proverb - "Bulls get rich, bears get rich, pigs get slaughtered."

Free market advocates should accept the insight in their creeds, just deserts and such.

Steve and Steve,

I can tell you what happens when one makes the minority point (which people have before in threads on this blog): Two or three commentators heap scorn upon the comment because "everybody knows" that that wasn't the "real" cause of the crisis, or that it was only "one small part" of the crisis, and so on, and so forth. And oh, by the way, only free market ideologue kooks bother to bring it up, because they are the ones who don't want to admit that somehow or other capitalism has now finally brought about its own demise.

No, Lydia, it's rather that I - I speak only for myself - tire of the ever flowing torrent of cant which has it that The Market didn't fail, because The Market, by definition or nature, cannot fail. This is an "all of the above" moment in American history, and if the center-left establishment are intent upon affixing blame to the masters of the universe to the exclusion of well-intentioned, but foolish, political interventions, well, isn't that precisely what we should expect of them? If I emphasize the failings of private sector actors in all of this, that is merely because I am a man of the Right, and a blindness to the fallibility of these institutions is the besetting sin of my tribe.

Of course, the no money down and other easy credit rules applied to everybody.

They sure did Steve. Wall Street acted no differently than the seasonal landscaping employee taking a no-money down mortgage from WAMU on a home priced 30 x his income. By the end of 2007, Morgan Stanley and Lehman had ratios of assets to shareholders' equity of 33 to 1. Merrill was at 28-1. All it would take for a wipe-out of those firms would be a 3% drop in the values in their portfolios. Truly amazing that our elites financial acumen was no better than that of a recent arrival from Mexico. Lets take heart that Rubin and the boys aren't part of the 8 million people facing foreclosure.

But nobody wants to talk about Bush and Rove's role in all this.

A lot of folks once had screen-savers with W. posing in his flight jacket in front of the Mission Accomplished sign. They are now suffering from failure overload and can't accept finding GOP finger-prints on the CRA, Freddie & Fannie fiasco.


Of course you need some degree of government oversight of the financial industry. Otherwise, fraud will run amok. A very simple bit of traditional standards -- requiring a down payment to get a home mortgage -- would have done much to prevent the Mortgage Meltdown. But Bush campaigned against down payments, sending a huge message to federal regulators to stay away from things like the corrupt tax-deductible "down payment assistance" charity/tax scam, a part of Bush's compassionate conservatism, which the IRS didn't finally rule was a scam until 2006.

A very simple bit of traditional standards like requiring reserves to cover losses, the elimination of off-balance sheet liabilities and negative growth scenarios in the risk models and we'd be dealing with the S&L Redux, not this economic cataclysm.

It is worth observing the curious irony that in the precipitating events of the crisis the proponents of "compassionate conservatism" and the proponents of "self-regulating markets" essentially collaborated - or, at a minimum, their respective interests coincided to a remarkable degree. One could say either that the masters of the universe exploited the do-gooders, or that the do-gooders turned the marketeers to their own purposes, but both claims, and others besides, would be true.

Here we are, moving full speed ahead into Euro-Socialist-Multiculturalist territory, and spitting on the forlorn grave of the "free market" is all you have time for?

The gravediggers are those who elevated the economic sphere above all else. Repeatedly the warning went out; don't allow the religious basis for our civilization to recede under the onslaught of economic theories, rationalist standards and technological efficiencies. The economic realm became an autonomous power with its own inner logic and morality to which everything else would be held in judgement. A new cult formed the basis for our social enterprise.

Private vice would be transformed into public virtue. Greed would be channeled into an engine for growth and rational self-interest would prevent abuse, corruption and the kind of state we are now mired in.

The defenders of what you term the "free market" have not simply argued over the interpretations of established facts, but the very existence of the facts themselves. And now, even as the real-time record unfolds before us, they engage in revisionism. Mock the prophets, pursue the profits. Anything it seems, as long as they are spared the painful process of reexamining their biases.

Want a E.U. style edifice here? Continue down your pejorative-laden, finger-pointing path of truth-twisting absurdity. The rest of us will undertake the necessary self-reform and serious reflection needed to avert the fate you and many others, as predicted, would help bring to fruition.

The rest of us will undertake the necessary self-reform and serious reflection needed to avert the fate you and many others, as predicted, would help bring to fruition.

Oh, really, Kevin. For goodness' sake.

What the deuce do you know about what cultural fate Steve Burton would, if he could, "bring to fruition"?

Little or nothing, I wager. Your comment just shows that you are, as so often, enjoying sounding eloquent...to yourself.

Follow the argument. This is the state he fears; the Euro-Socialist-Multiculturalist one. Circle the wagons around indefensible practices and that will be the reward. Engage in hair-splitting meanderings about "what is exploitation?" and people will in times of hardship, opt for unsavory solutions, rather than endure the insult of being told not to believe their own eyes.

In all of this, we don't even hear; the trouble with socialism is socialism and the trouble with capitalism is capitalists type of fallback. Nope, just an unyielding defense of our post-Christian elites, their corrupt practices and assaults on the closet Marxists amongst us. Embrace your delusions if you must, but don't shift the blame for the consequences. Seems only, and I know this word creates problems - just.

Kevin: I will try to find time for a substantive post on all this...but, for the moment, I'll just echo Lydia:

"Oh, really, Kevin. For goodness' sake."

It's strange how badly ignored is George W. Bush's role in undermining one of the oldest and simplest credit standards: the down payment.
Steve Sailor, Ignored no longer; http://www.iht.com/articles/2008/12/21/business/21admin.php
Kevin: I will try to find time for a substantive post on all this

Steve Burton,
I suggest a Mea Culpa, co-signed by your fellow bitter-enders and timed to take advantage of the traditional Christmas amnesty. As your cohort is buried under the avalanche of damning evidence, the desperate resorting to accurate, but irrelevant distractions;"the pompous prosecutor is in love with the sound of his own voice", and mendacious counter-accusations; "shining a light on the crown jewel of our economic system is collaborating with socialism", will not prevent history's unsparing verdict.

You have nurtured a monster into being with your acquiescence to a series of "neutral" doctrines and must choose now between submitting to a heresy even more malign than your own, or repenting and seeking refuge in catacombs, that prudence dictates, can only be open to the sincerely contrite.

The Office of the Inquisition is unamused that the Advent season has been blighted by the frantic obfuscations of the quilty. There are creches to visit, carols to be sung, and hearts to be warmed in these last days before we gather before the Crib. If you want a merciful disposition of your case, I suggest you have an epiphany, no later than the Epiphany.

Kevin,

It's Sailer, with an "e", and thanks for that link. History doesn't issue verdicts, although those of us who study history might have strong opinions about various historical actions taken by our ancestors.

With all due respect, for someone who argues that abstraction is dangerous I read your last comment for some concrete, particular point and can't find it. Instead I read about "bitter-enders", "distractions", and even a "monster" that Steve and I apparently have been nurturing all these years (and I thought Steve was busy nurturing his mother!) I also read about the "quilty", which I thought might be a sly reference to Nabokov's diabolical Clare Quilty, but on second thought it is probably just a typo.

Jeff,
The "quilty" might have been a Freudian slip as I'm knit, Madame Defarge-like, an Everest-size bill of indictment. Do not let the window-close on this opportunity for repentance and renewal. There are limits to my mercy!

Yeah, the current housing market is REALLY bad. There are tons of sellers, and barely any buyers. Any seller's best bet is to sell to a real estate investor for cash. There are a handful of them out there, but I know one is www.wellbuyit.net. They gave one of my friends a pretty decent offer! Not sure of any other ones, but I hope that helps someone.

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