This Can Not Possibly be the U.S. Government's Position

So per the new 200+ page regulatory overhaul proposed by Bush administration Treasury secretary Paulson, the U.S. taxpayer could now, going forward, be held responsible for losses at U.S. investment banking institutions. Paulson says it (allowing investment banks direct access to the Fed's balance sheet, accepting of collateral of questionable value, etc.) will be done in the future, only in the case of emergency. Based on the current environment though, we have already defined any possibility of a large investment bank failure as an emergency. Therefore, effectively the major investment banks have implicit U.S. taxpayer backing, i.e. they are effectively to become government sponsored enterprises (GSE's), similar to Fannie Mae and Freddie Mac.

I won't even pass judgement as to whether or not this is appropriate, as given that more lending is being done outside of then inside regulated commercial banks, something has to be done. But the "something" that Paulson proposes is simply completely irrational and can't possibly be what the administration would actually hope would occur. Paulson actually proposes creating a new set of GSE's, and still, incredulously, is not proposing any real formal set of additional regulation of the proposed GSE investment banks. Rather then have any type of standardized set of rules for capital requirements for 30x leveraged investment banks dealing in unregulated and illiquid derivatives, rather then make any attempt to provide for regulating the $500 trillion+ shadow banking system, the Fed will be allowed to "collect information" and to "send swat teams" to investigate the investment banks books.

So is it then up to the arbitrary discretion of the individual swat teams, or the current Fed management at the time as to what to do with this information? Even from the investment bank point of view, this can't possibly be viewed as helpful, i.e. no standards, no defined set of rules, just leave it up to whoever at the Fed happens to be analyzing the "information" on the investment banks at the time to come up with his or her judgement as to what to do with this information. This is the desired so called system of oversight? What an absolute mess, for all involved. How is either side, the bank or the regulator, supposed to operate efficiently in such a "system". So, effectively Paulson is not just proposing U.S. taxpayer backing for the investment banks and the $500 trillion shadow banking system, but he is proposing that it be done with on the fly arbitrary regulation of it!

To get an idea of just how irresponsible this is, perhaps a bit of "what if" will do. In his previous role at investment bank Goldman Sachs, would Paulson have proposed that Goldman provide funding for say a similar set of players, the hedgefund industry, without having any set of known and agreed upon covenants regarding capital requirements, leverage levels, instruments traded, etc? Taking it even further, would any responsible bank of any type, commercial or investment, ever agree to take on potential liabilities under similar terms? In the extremely unlikely event that some inept bank would though, fine, let them do it, it's their choice.

In this case though, were not just talking about some bank, were talking the U.S. Government. The potential ramifications are absolutely stunning. So if in some strange twist of objectivity, the ratings agencies were to actually apply their criteria and were to downgrade the U.S. government debt to junk based on this silliness, what happens to "financial market stability" then Mr. Paulson? Even if they didn't, if you think that the dollar is weak now, who in their right mind would want to own the currency backing the shadow banking system while actually choosing to regulate via "we'll figure it out as we go along"? I know the so-called "strong dollar" policy of the U.S. treasury is not exactly taken too seriously these days, but isn't this a bit much?

Laissez-faire and Soviet Central Planning....When do we Stop with the Extremist Experiments?

Its actually stunning to comtemplate. It took a mere 9 years, post Glass-Steagall, an absolute grain of sand in time, for the Laissez-faire extremists experiment in going beyond deregulation to effectively no regulation, to bring the most economically successful capitalist system in the history of mankind to require a public bailout of one of their weak to avoid a potential meltdown and collapse.

In fact, the failure of extreme "hands off" unregulated Laissez-faire has been so complete that less then a full decade into their grand experiment in the "New Era" of High Finance, the bankers are reduced to begging for various forms of bailouts that would seem more Soviet Central planning then free market. Its kind of sad to comtemplate that at the opposite end of extremism, in another miserably failed attempt to go against the very basics of human nature, the Soviet Union was able to make it for almost 70 years, starting from a much weaker base to work with!

Getting back to the present, to those that are continuing the mantra of "do not regulate", what is it you are exactly proposing as the alternative going forward? Its not even the treasured Lazy, oops I mean Laissez, Faire, as that was gone anyways, once the public bailouts began...Laissez-faire finance sat on a wall, Laissez-faire finance had a great fall , all Ayn Rand's horses and all Ayn Rand's men couldn't put Laissez-faire finance together again.

US Government...Worlds Biggest Investment Bank?

What happened this past weekend surely was historic and a real game changer. No, I'm not talking about the JPMorgan pouncing on opportunity, at the potential expense of the Federal Reserve via the Bear Stearns deal (As of November 2007, Bear had around $46 billion of MBS/ABS, Fed agreed to take the "most illiquid", i.e the worst $30 Billion of it). Far more monumental is the fleecing that the US investment banks have parlayed on the Federal Reserve.

The US government has effectively become a joint venture partner with the investment banks, one which though provides all, yes all of the upside to the investment banks, while giving the taxpayers nothing except for potential liability for future losses (yes I know technically the Fed is not the government, but they are responsible for printing Federal Reserve Notes (dollars) and those are fully backed by the US Government). The Fed has completely opened up their entire, theoretically limitless, balance sheet for the use of the investment banks, to use as collateral however they see fit in order to attempt to improve their profits (no not reduce losses, improve profits, just in the last week alone, we learned that last quarter, not year, right in the heart of the credit crisis, writedowns and all, Morgan Stanley checked in at $1.55 Billion in profits, Goldman made $1.5 Billion, and even supposedly shaky Lehman made $489 million). Listen to the words of the Lehman CFO herself as to what the Fed will now accept as collateral for the effectively limitless loans they will now provide to the investment banks;

"Its actually a very broad range of collateral...All BBB- assets or better, across all asset classes in fixed income"

"This is a fantastic decision, unprecedented"

Of course it is,...for the banks. A government guarantee, literally achieved overnight! The potential ramifications are enormous.

If this works in terms of stabilizing the financial system and if we do not head into a serious economic downturn, then perhaps the Fed's gambit will work. Down the line then, the Fed simply withdraws the line or at tells the investment banks that they have to play by the same rules and regulations as the commercial banks, i.e. enjoy both the benefits and the responsibilities of a post-Glass-Steagall world. The solution perhaps ends up in between.

On the other hand, consider if the economic forces leading to a significant downturn are just too strong. Rather then letting market forces take their course in terms of investment banks, cleaning out the excesses and the weak, i.e. Drexel, E.F Hutton, and Salomon Brothers, the Fed might find themselves in a rather untenable situation, actually weakening the investment banking sector by artificially supporting excesses and the weak, and paying a potentially vast sum in order to make things worse. I thought that it was pretty well accepted that even the AAA ratings on many securities were at the least very questionable in some cases. The Fed is accepting collateral all the way down to BBB-! Further, they are doing this right into the teeth of an economic downturn. Quite a high stakes gambit by the US government!

If Your Going to Talk Your Book, at Least Be Honest About it

Given the monumental implications of such a move, at the very, very, very least, can't the mainstream media sources simply attempt to question, with just a bit of skepticism, Pimco's well publicized "opinion" that parts of the mortgage industry should be nationalized via the Fed purchasing outright mortgage backed securities? Pimco is not exactly a disinterested party in the discussion, which is fine as that is their call, but if there is to be no questioning of this, how about at least a little disclosure during their media blitz today alone (CNBC here, CNBC here again , op-ed here)?

For years now, Pimco has had significant investments in Mortgage Backed Securites (MBS). From a December 2006 Pimco "In Focus", it appears to be around $200 Billion significant;

"PIMCO has traditionally overweighted mortgage-backed securities in its portfolios"

"Fannie Mae and Freddie Mac securities represent about $150 billion, or about three-quarters of what we own."

From August 2007, when the subprime problems really started to take hold in the markets (February's dip was apparently forgotten by then), Pimco reassured investors that they were in very high quality mortgages, no subprime;

"For some time, PIMCO has forecast that problems in subprime mortgages will lead to slower consumer spending and an eventual easing by the Federal Reserve. In our view, weakness in this sector could persist for a good while yet. Fortunately, PIMCO's mortgage-backed security (MBS) and asset-backed security (ABS) positions in PIMCO Total Return Fund currently remain unaffected by troubles in the subprime sector as our positions are very high quality."

Apparently, not only was Pimco comfortable with their MBS holdings, in at least their massive $104 Billion Pimco Total return fund , they even raised the stakes on their bet on MBS in the last half of 2007;

"Gross also raised the fund's holdings of mortgage-backed securities to 59 percent."

So, getting back to the present, please excuse me if I'm just a bit skeptical of how its truly for the greater good that the Fed should artificially prop up and subsidize the price of mortgage bonds by purchasing them. Remember though, just the "high quality" ones, you know the only ones that Pimco owns (via the op-ed piece mentioned);

"First, supplement monetary policy by getting the Fed to fill the void left by slowing moving fiscal agencies – through outright purchases of high-quality mortgage securities."

Securities Litigation for Dummies...

Not that there was really much doubt, i.e. the idea that 5th largest investment bank could go from "all is well" to "were going under" in a matter of hours, stretched even the most forgiving sense of credibility. Anyways, can you say "layup" when it comes to litigation, i.e. does it come any easier.....

Via the WSJ...

"Word began to spread among fixed-income traders nine days ago that European banks had stopped trading with Bear."

"Some U.S. fixed-income and stock traders began doing the same on Monday, pulling their cash from Bear for fear it could get locked up if there was a bankruptcy."

"On Tuesday, a major asset-management company stopped trading with Bear."

And then on Wednesday, via David Faber and CNBC, Bear CEO Alan D. Schwartz, aka "Pinocchio", amongst other claims...

"Were are not being made aware of anybody who is not taking our credit as counterparty"

How Do You Cure a Credit Bubble?

I'm a bit puzzled by some of the underlying thought processses behind those proponents of a massive government bailout of some sort of the US housing industry. On one hand, they seem, for the most part, to be agreeing with the premise that the state of the US balance sheet, whether our private (consumers) or our public (the government) is at minimum unsound and in the long term creates extreme risk. On the other hand, they seem to be saying that the only way out of our current difficulties is to continue to expand credit. Huh?

Via FT (a fine paper in many respects, but can't say I agree with this particular opinion);

"Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit."

"But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion."

So, were financially unsound and its in the public interest to become more financially unsound? Continued credit expansion, the so called "hair of the dog" approach is really what we need? When does it reach the point where it's time to enter a good detox center (managed credit contraction) instead? So, levering the entire world's output and the entire worlds stock market capitalization at over 10x thru derivatives alone isn't enough (estimated size of derivatives market $516 trillion divided by $48 trillion world GDP or by $51 trillion world stock market capitalization)? Keep the frat party going as long as possible, keep misallocating far too many resources into financial engineering and real estate?

Then of course, there are those within the "We'll fix our balance sheet by borrowing and leveraging some more crowd" who want to "fix" our situation via some sort of upside down Nixonian price controls, i.e. price floors. So is the thought process something along the lines of "Just because temporary price controls were a disaster doesn't mean temporary price floors won't work out just wonderful"? This via the Senate banking committee chairman (Chris Dodd);

"What we're trying to do here, in addition to providing assistance to the homeowner, is to create a floor..."

So what is the right price to set it at, i.e. the floor? Is it better set by free markets or by government subsidies? Furthermore, what if Chris Dodd and the like were to actually to "succeed" in putting a floor on house prices (doubtful but lets just play "what if"). Is having housing prices artificially subsidized at levels far above long term trends actually in the long term best interest of our economy? Further, is it in the best interest of those looking to buy a house both now and in the future to not only have to pay some of their tax money subsidizing the cost of housing, but to overpay once more in buying an artificially overpriced house?


It seems to me that trying reflate the bubble in some way shape or form is about the worst thing we can do. The only viable long term solution is to attempt to deleverage / contract the credit cycle to a market driven level of balance, but given the magnitude of the rise, to do it in some sort of managed fashion. As to the particulars of how best to manage it? There are plenty of arguments to be made on each step of the way, sure to provide plenty of fodder for discussion. Some of my own thoughts are here, including perhaps the less conventional belief that it may be time to consider putting away the interest rate tool after this coming week .

How Low Can We Go....the Dangerous Game of Interest Rate Cuts

Everywhere one turns, it seems that we are moving towards the general consensus in the US where recessions are to be avoided at all costs. When it comes to interest rate policy, "independently" determined by the Federal Reserve Board of Governors, somehow the main discourse seems to be not "if "we continue to cut rates, but by "how much and how quickly." At this point though, were getting quite close to the very low long term rates from 2001-2004 that many convincingly attribute as a primary cause of the mess we are in. From John Cassidy at Conde Naste;

"After adjusting for inflation, the cost of cash was close to zero. Investment banks, hedge funds, and other financial operators were able to obtain money at minimal cost and use it to finance risky investments. To a lesser extent, so could ordinary Americans. In a feat of levitation almost without precedent, the prices of nearly all speculative assets moved in the same direction: U.S. stocks went up; foreign stocks went up; residential real estate went up; commercial real estate went up; oil went up; gold went up; sugar went up; coffee went up; Treasury bonds went up; junk bonds went up. To make money, all you had to do was suit up, buy something, and sit back and watch it grow. In the real estate market, lenders competed frantically to make loans, and speculators flipped condos like burgers. With so much cheap money sloshing around, lenders had to work hard to find enough borrowers to mop it all up."

Some make the distinction, as Cassidy does, that it wasn't the low rates themselves that caused the problem, but the amount of time that the rates were left so low, especially given that an economic recovery had already begun to take hold. Again from Cassidy's interesting article;

"By the middle of 2002, however, it was clear that for whatever reason—low interest rates, the Bush tax cuts, increased military spending—the economy was staging an amazingly robust recovery. At that point, history and economic orthodoxy suggested that the Fed should have been tightening policy rather than loosening it.Again, Greenspan went his own way. Citing fears (which proved to be misplaced) of Japanese-style deflation spreading to the United States, he kept the federal funds rate at 1 percent until June 2004, by which point the economy had been growing steadily for more than two years. By failing to tighten monetary policy, Greenspan created an apparently limitless supply of cheap credit."

So, why not go back down to 1% or so, but this time we'll be smart enough to "take away the punch bowl" a lot earlier. Sounds logical actually, as its pretty hard to deny that things are a bit bumpy. One, more then just incidental problem though with the race to the bottom on interest rates line of thinking, is the dramatic and shocking increase, and even recent accelation that we are experiencing in the costs of commodities and the related fall in the US dollar. If, as in the tech bubble, Webvans or Microstrategy bubbles and goes bust, sure some people can get hurt, but the world goes on just fine. In our current situation, if the housing bubble after effects can cause this much pain, imagine how a widespread commodities bubble and a collapse of the US Dollar could ultimately effect us. At some point, the downside of rate cuts (I know, this coming weeks is pretty much "in the books") far exceeds the upside. A dollar collapse and a commodity bubble ultimately effects everything we do.....everybody eats, all of our widgets and gadgets are made of stuff and for the most part need hydrocarbon based energy to be made and / or work etc. Oh, and most of us at least here in the US have to use dollars to pay for stuff.

Surely, when it comes to outlier events such as the credit crisis we are now in, one can't just sit by and do nothing, can they? Of course not, and the Fed has already dramatically cut rates, which tend to work at a lag of up to 6 months or so, (from 5.25% to 3% now, and down to 2-2.5% by next week), as well as instituting a multitude of other actions (TAF, special term repo operations and increased TAF, TSLF, Bear Stearns temporary (hopefully) lifeline / bailout) meant to ease the crisis, as well. Are these going to "work"? If "work" means avoiding recession at all costs, perhaps not. If "works" means an orderly unwinding of the leverage bubble, and a more healthy longer term allocation of resources within our economy, then hopefully, these, and other non-rate cut steps can or will (of course the jury is still out and there is much to be debated as to the particular pros and con's involved in these steps). Before reaching for the easy elixir of rate cuts though, have a look at these long term 20-40 year monthly charts...

And last, but not least, going in the opposite direction unfortunately....

Shadow Banking System Redux?

In some ways I can see the reasoning behind the Fed’s action to accept mortgage backed paper as collateral, as “end of the tail” / outlier times call for creative thinking. Ater reading 2 bloomberg articles though I couldn’t help but hope were not opening the door to the recreation of the shadow banking system, this time though housed at the Federal reserve;

“The Federal Reserve, struggling to contain a crisis of confidence in credit markets, will for the first time lend Treasuries in exchange for debt that includes mortgage-backed securities.”

So, since the first mortgage backed security innocently appeared in 1970, we traversed thru……. numerous recessions, 1970’s stagflation with double digit inflation / unemployment, various periods of credit market difficulty such as massive banking failures via the S&L crisis, Michael Milken style junk bond bubbles, the late 90’s Asian crisis, country wide defaults ala Russia, etc……..yet the fed never felt it was a good idea to hold mortgage paper as collateral.

Don’t worry though, it’s only going to be the best stuff (from the same article)….

“Top-Rated Debt
The Fed said it will lend Treasuries for 28-day periods in return for debt including AAA-rated mortgage securities sold by Fannie Mae, Freddie Mac and by banks.”

So perhaps there is nothing to be concerned about. Hey some even say this AAA mortgage paper is undervalued. Then again, take a look at what’s passing for AAA these days via the 2nd Bloomberg article.

“None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.”

Hopefully, at least privately the Fed is able to own up to falling asleep in not effectively regulating the shadow banking system, one which allowed questionable debt and liabilities to simply disappear through Enron-like SIV’s and also to be supposedly “hedged” via a maze of illiquid derivatives. Further, hopefully, the Fed fully realizes how tempting it must be for the banking system to effectively start back up at least the off-balance sheet SIV business, but this time in an even better scenario for them, under Federal Reserve stewardship.

Grand Opening.....

Coming soon.....maybe not so grand, but none the less, I'm joining the blogosphere