Market vs. Government Failure

Excellent WSJ editorial by a Nobel laureate in economics----not that that always means anything.

The Great Recession and Government Failure

When comparing the performance of markets to government, 

markets look pretty darn good.

2008 Crash--unfettered government, not unfettered capitalism

Washington and Wall Street: The Revolving Door

The recent report of the Financial Crisis Inquiry Commission blamed all the usual suspects — Wall Street banks, financial regulators, the mortgage giants Fannie Mae and Freddie Mac, and subprime lenders — which is tantamount to blaming no one. “Reckless Endangerment” concentrates on particular individuals who played key roles. --NYT Sunday Book Review

In particular, "when the Clinton administration called for a partnership between the private sector and Fannie and Freddie to encourage home buying...[T]axpayers were unknowingly handing Fannie billions of dollars a year to finance a campaign of self-promotion and self-­protection."

In our mixed economy, statists like to blame capitalism---when it is actually the toxic mixture of free markets and government intervention that is so destructively destabilizing.

For explanations which counter "market failure" theories of our recent financial crash, read the rest of the book review, and then consider reading the book.

When Debt is the Problem

(HT Prof. Jeff Hummel on the Barstool Economist yahoo group)

2007-2010 Market failure--NOT

Another great post from Ideas Matter.



And from Max Broder-- "We should take away the lesson that long-term value creation cannot be achieved through short cuts. It's about a commitment to hard work and building a business - whether bank or bakery [or medical care]- one customer at a time."

SIGTARP Quarterly Report

January 30, 2010 Quarterly Report to Congress from the Office of the Special Inspector General for the Troubled Asset Relief Program.

Let the Executive Summary speak for itself:

The substantial costs of TARP — in money, moral hazard effects on the market, and Government credibility — will have been for naught if we do nothing to correct the fundamental problems in our financial system and end up in a similar or even greater crisis in two, or five, or ten years’ time. It is hard to see how any of the fundamental problems in the system have been addressed to date.

• To the extent that huge, interconnected, “too big to fail” institutions contributed to the crisis, those institutions are now even larger, in part because of the substantial subsidies provided by TARP and other bailout programs.

To the extent that institutions were previously incentivized to take reckless risks through a “heads, I win; tails, the Government will bail me out” mentality, the market is more convinced than ever that the Government will step in as necessary to save systemically significant institutions. This perception was reinforced when TARP was extended until October 3, 2010, thus permitting Treasury to maintain a war chest of potential rescue funding at the same time that banks that have shown questionable ability to return to profitability (and in some cases are posting multi-billion-dollar losses) are exiting TARP programs.

• To the extent that large institutions’ risky behavior resulted from the desire to justify ever-greater bonuses — and indeed, the race appears to be on for TARP recipients to exit the program in order to avoid its pay restrictions — the current bonus season demonstrates that although there have been some improvements in the form that bonus compensation takes for some executives, there has been little fundamental change in the excessive compensation culture on Wall Street


• To the extent that the crisis was fueled by a “bubble” in the housing market, the Federal Government’s concerted efforts to support home prices — as discussed more fully in Section 3 of this report — risk re-inflating that bubble in light of the Government’s effective takeover of the housing market through purchases and guarantees, either direct or implicit, of nearly all of the residential mortgage market.

Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car.

The emphases are added, although it seems much of this summary could be highlighted as important.

It it hard to read the motto under the SIGTARP logo, so let me reproduce it here:

"Advancing Economic Stability Through Transparency, Coordinated Oversight and Robust Enforcement"

Think they will live up to it?


HT Big Government via Dr. Lydia Ortega @ The Bar Stool Economists Yahoo Group

Financial Times' Feature Video on Banking

On Oct. 14, 2009 John Bird and John Fortune discussed Lehman, banking, CEO compensation, the housing market, CDO's, and the recent economic boom and bust. Their conversation is posted on the Financial Times.

There's no way to embed this 9 minute video, so you will have to go here to watch.

Enjoy!

The Essence of a Government Stimulus

Brought to you by The Rational Capitalist:

Obama: Please Try This at Home

If you want to understand why “stimulus” programs do not work in the sense of generating economic growth, try the following experiment at home or at your place of business.

Go up to someone and hand them $20 and tell them that by giving them this money, you intend to “stimulate” the local economy. Observe what happens. The recipient now has $20 to spend or do whatever. However, note that you have $20 less to spend. Therefore, there will be no net affect on the local economy. All that has happened is that the recipient has twenty of your dollars to spend on something he wants, and you have $20 less to spend on something you want.

The rest is just as pithy. Read it and enjoy!

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Ramblin' On

Peter Schiff often has a lot of good things to say, and he said quite a lot of them in his recent Henry Hazlitt Memorial Lecture at the Austrian Scholars Conference on March 13, 2009. Unfortunately, he frequently got side tracked and the speech in its entirety is long and rambling. Below are a few choice segments..and as lengthy as they are, the original article is much lengthier. If you prefer, you can meander along with Peter through the whole speech posted on the Ludwig von Mises Institute website--or you can read the highlights below.

Why the Meltdown Should have Surprised No One

Comparing the current recession to the dot.com recession:

When people bought stocks they pretty much bought it with their own money. And if they got a margin account, maybe they had to put 50 percent down. And many of the brokerage firms were requiring higher margins on Internet stocks. So, when the bubble burst, the losses were pretty much confined to the people that made the bad bets.

And at least when the losses happened, nobody tried to bail anybody out. If you lost money, you lost money. There was no one looking to the government to get their money back because they bought a dot-com stock that went to zero.

None of the brokerage firms failed. Nobody failed because they had loaned money to people to buy stocks.

This time around, of course, everybody who bought real estate did it with somebody else's money. Very few people were paying 100 percent. Many people were buying real estate with none of their own money; people were buying real estate with nothing down. Is it any surprise that people gambled when they had nothing to lose?...

On securitization and government guarantees:

The reason that it was so easy for people to borrow all this money to buy houses was because of securitization.

At first it started with Freddie and Fannie. If it wasn't for Fannie Mae and Freddie Mac, Americans couldn't have borrowed all this money to buy houses. The only reason they did it was because the US government was co-signing their mortgages.

And people knew, well, if you lend somebody money to buy a house and if they can't pay you back, the government will pay you back. And, so, people were able to borrow a lot more money than a free market would have allowed because the government was there co-signing it.

But there were some mortgages that the government wouldn't co-sign; these were the ones known as the subprime mortgages. But Wall Street figured out that, well, we can securitize these mortgages; the government won't guarantee them, but we're going to buy them all up and put them into these structured products, and by structuring them like this we're going to reduce the risk....

Well, but it was because Wall Street was able to securitize all these bonds and sell them to the Japanese and sell them to the Chinese and sell them to the hedge funds that there was demand. And, of course, why was there so much demand for high-yielding assets? Because the Fed had the interest rate too low. Everybody needed yield and they were willing to take risk to get it...

It used to be that the mission of Freddie/Fannie, before they went broke, was to try to make homes, homeownership affordable. Now their mission is to keep home prices high, to keep homes unaffordable, to make sure we have to mortgage ourselves to the hilt to buy a house.

The government solution is high prices but low mortgage payments subsidized by the government. The free-market solution is low prices. Because if real-estate prices go down, you don't need to borrow that much money to buy a house. So it doesn't matter that your mortgage payment is a little higher...

The Fed vs. the Free Market

President Bush, in one of his speeches, said that Wall Street got drunk. And he was right, they were drunk. So was Main Street. The whole country was drunk. But what he doesn't point out is, where'd they get the alcohol? Why were they drunk?

Obviously, Greenspan poured the alcohol, the Fed got everybody drunk, and the government helped out with their moral hazards, and the tax codes, and all the incentives and disincentives they put in — all the various ways that they interfered with the free market and removed the necessary balances that would have existed, that would have kept all this from happening...

Federal Ponzi Schemes

The US government, we don't pay our bills. We're like Bernie Madoff. People loan us money. How do we pay it back? We borrow more.

If somebody came to Bernie Madoff a couple years ago and wanted their money, they got it. Why did they get it? Because they were able to take in new money. They found another sucker who didn't know it was a Ponzi scheme.

Same thing the US government does. Every time a bond matures, we just go sell another one. And every time we need to pay interest on the national debt, we go borrow that too. Well, it works until nobody wants to lend us any more money, then we're going to have to default, just like Bernie did.

And there's only two ways we can default. We just legitimately don't pay, or we print money. That's it...

Growing the government instead of the economy

And, what's happening now, of course, is the government is using this economic crisis, that they caused, to get even bigger, to grow their power, to expand, to come to our rescue, to save us from the evil forces of capitalism with government, with socialism...

[President Obama]wants the US economy to have a sound foundation, but he wants to be the one that builds it. He thinks the government can erect a sound foundation; that central government planning can replace the market; that resources can be allocated efficiently by politicians who want to get votes, as opposed to entrepreneurs who are looking for profits. He wants to replace the invisible hand with the hand of the state. And he thinks that he can do it better...

It's all about bailing and stimulating:

The government right now — everything that they're doing — what is the government trying to do right now? They want to bail people out and they want to stimulate.

Well, the bailouts are the worst thing that you can do, because they want to bail out companies that should fail, that should be bankrupted. Bankruptcy is a good thing. It's the way the market cleanses the economy of companies that shouldn't be there.

Why shouldn't they be there? Because they're not generating profits; they are not effectively utilizing resources. Those resources need to be freed up. Right now they're being held hostage. We need to free them up so that we can use them productively...

But the stimulus, what is it that the government is trying to do with the stimulus? The government is trying to recreate the conditions that led to the crisis. Because when they talk about stimulating the economy, they're not talking about stimulating economic growth. They're talking about stimulating spending...

[W]e said, "Hey, we're actually getting wealthier!" — even as we were getting poorer, because we were spending money instead of saving money. But — and as we spent money, we counted that spending as GDP. And, so, as long as our GDP was rising, we thought our economy was growing.

But the whole time our GDP was actually going up, we weren't measuring real economic growth. We weren't measuring how much wealth we had been destroying or dissipating. We were simply spending. And we thought we were okay because some appraiser said that our house was worth more, or the stock market was still going up.

But all that was an illusion, and now that those bubbles have burst, there's no way to go back to it...

[W]hen you borrow money and you invest in productive capacity, you have a real asset and the asset can generate revenue...And we became the world's wealthiest economy because we borrowed to produce. What we've done recently is we've borrowed to consume. We didn't produce anything. We borrowed money and bought trinkets. We bought depreciating consumer goods. So how can we possibly pay the money back? We didn't acquire any income-producing assets to pay the money back....

Nothing fundamental has changed

[T]he combination of Obama/Bernanke is way worse than Bush/Greenspan, but it's the same philosophy. Nothing has changed. This might as well be the third Bush term. He is doing the same exact stuff.

The rhetoric is a little bit different, but the policies are all the same, the ideas are all the same: that economic growth is a function of people spending money and that we need more government to stimulate the economy; that we should bail out the people who fail and punish the people who succeed. And that we should have no interest rate. The Fed should be cranking out money...

And if we want to have a real economy, if we want to have production, then savings need to go to producers. Well, they're not going to go to producers if they're squandered by consumers. They're not going to go to producers if the government is borrowing all the money.

So what do we need? We need the government to eliminate the deficit and go to a surplus. We need the government to stop spending money and depleting our savings. We need consumers to stop spending money and rebuild their savings. We need a recession. We need it. We need one badly...

Toward the end of the article, Schiff draws and interesting parallel between what happened during the Great Depression and now. I know, I know, that comparison has been WAY over done. But, in pointing out that Hoover was mistakenly associated with a free market, just as Bush is today, and then was followed by Even-Bigger-Government Roosevelt, whose policies deepened and prolonged the depression, what President Obama is doing now is even less defensible. It's the same damn thing all over again!!

The popular notion is that we had a depression because Hoover was so irresponsible that he trusted the free market and he did nothing, and because he did nothing we had a depression. And then Roosevelt rode to the rescue and saved the day with big government.

Well, the reality, of course, is that we had a depression because, (a) we had a Federal Reserve that was too easy in the 1920s and created a boom.

And then when the boom bust, Hoover ignored the good advice of his secretary to the treasury — which maybe is the last time the secretary to the treasury ever gave anybody any good advice. And instead of allowing the free market to work, he came up with all kinds of crazy things to bail people out and to prop things up and to distort prices and fix wages and all kinds of things that created the depression.

And then Roosevelt came in and proceeded to make it worse. And everything that Roosevelt did exacerbated it and made the depression great...

And that's very similar to what's happening now. You got Bush, who is the Hoover now of this generation, who is now associated with the free market, who is nothing like the free market. And now we have Barack Obama, like Roosevelt, coming in to save the economy with big government. Of course, the government is already huge. Maybe he hasn't figured that out.

Wealth is not the problem. Wealth is the solution. But it has to be real wealth, based on production and investments from savings--not consumption based on debt and dollars created out of thin air.

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It's clearly time to use the "F" word

Fascism, also known as corporatism.

Where socialism sought totalitarian control of a society’s economic processes through direct state operation of the means of production, fascism sought that control indirectly, through domination of nominally private owners. Where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically.--The Concise Encyclopedia of Economics

Read this article from today's Wall Street Journal and see if you don't agree that our government is employing fascist tactics.

Busting Bank of America

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Perverse incentives

If you tax something, you will get less of it.
If you subsidize something, you will get more of it.


Keep this in mind while contemplating the following:


When businesses are taxed, production is taxed at least twice, and frequently more often: first, as corporate income tax, and then again when individuals are taxed on investment returns (dividend income and capital gains) --and the investments themselves were bought with previously-taxed personal income! Postmortem estate taxes add yet another layer of wealth expropriation by the government.

Then consider that interest expense and business losses are tax deductible. Multiple government programs exist to make "home ownership" (i.e. mortgages) more affordable. Failing businesses are (repeatedly) subsidized through government bailouts.


Production is taxed multiple times.
The cost of debt and failure is subsidized.

If you tax something, you will get less of it.
If you subsidize something, you will get more of it.

Government policies are the root cause of these artificial, inverted incentives. It is precisely these incentives which encourages excessive debt and risk-taking, and which in turn have led to the instability and eventual collapse of so many financial institutions. The solution is "Separation of Market and State" thus releasing proper market forces to supply the natural incentives of profit and loss with the resultant discovery of the most efficient use for scarce resources.

Wealth is not the problem.
Prosperity depends on production.
We need to let the producers produce, and reward success, not failure.

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Too Big to Succeed ( Intro)

I considered summarizing the article in the post below but decided that since the article speaks so well for itself, my time would best be used in other directions. The Freeman generously gives permission to reprint articles accompanied by appropriate credit, and so I am taking advantage of their offer.

In "Too Big To Succeed", from the April 2009 issue of The Freeman, Less Antman provides fascinating context to the ballooning of credit default swaps (CDS) and their contribution to today's financial debacle. The background Antman provides is one more (detailed) illustration that it decidedly is NOT free market forces which brought us today's instability, but rather the effects of government regulation and the failure of central planning. Antman explains how laws and regulations denied public trading in CDS, forcing them into the "shadows," away from public scrutiny and corrective market forces.

The April issue is now posted on The Freeman website. I also recommend you check out a few other articles. "The trouble with Keynes" by Roger Garrison outlines how Keynesian economic theory provides the (false) justification for shifting trade decisions away from the market (and efficient use of scarce resources) to government (and politically-motivated control of scarce resources.) Grennady Stolyarov, in his article "Globalization: Extending the Market and Human Well-Being," discusses the benevolent effects of the free market and the division of labor on promoting improved international relations as well as raising the standard of living for everyone. He concludes his article with an argument for lifting of all trade restrictions--pointing out how even if done unilaterally, the freest country will benefit most.

Several other article are worth reading, but those were my favorites.
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Too Big to Succeed (the article)

Too Big to Succeed

by Less Antman, April 2008, The Freeman

One widely cited culprit for the 2008 financial crisis was a supposed decision by the government not to regulate a relatively new type of financial instrument known as a credit default swap (CDS). In fact, this so-called "failure to regulate" refers to regulations that prohibited public trading of these instruments, concentrated risk in a small number of large firms, and massively increased the probability of a financial disaster. To add to the irony, one of the government officials most responsible for these interventions, then-Federal Reserve Chairman Alan Greenspan, recently apologized for having had too much faith in the free market when he should have apologized for not having had enough.

In 1999 Brooksley Born, head of the Commodity Futures Trading Commission (CFTC), tried to bring CDSs under the regulatory umbrella of her agency. Born was stymied by Greenspan, Treasury Secretary Robert Rubin, and Securities and Exchange Commission Chairman Arthur Levitt. She eventually resigned and the dispute was effectively settled in 2000 by the passage of the Commodity Futures Modernization Act(CFMA), which prohibited the CFTC from any further examination of CDSs. Details of the dispute can be found in an October 15, 2008 Washington Post article titled "What Went Wrong," by Anthony Faiola, Ellen Nakashima, and Jill Drew. But the article itself went wrong when it saw only deregulation and free markets in a fiasco caused by regulation and central planning. It failed to consider the full implications of the CFMA itself, nor did it address the disastrous side effects of an international agreement known as the Basel Accord, both of which made credit default swaps anything but a free-market failure.

Who's in Charge?

As neat and tidy as it might be to portray Born as the advocate of regulation and Greenspan, Rubin, and Levitt as opponents, it was actually a dispute among government officials over which of them should be in charge. The confusion derives from the nature of CDSs themselves.When someone borrows money the lender is always concerned about the possibility that the borrower will not repay the loan. There are various ways for the lender to protect against that risk. The lender can sell the loan to someone else, who assumes both the right to collect the payments and the risk that the borrower will fail to make them. The lender can require the borrower to find someone willing to guarantee the loan-that is, someone who agrees to pay if the borrower defaults. Or the lender can make a separate contract with an unrelated third party who, in exchange for a premium paid by the lender, agrees to make the same guarantee to pay the lender if the borrower defaults.

A CDS is an example of the third option. The party paying the premium-the lender in this example-is considered the buyer of the CDS. The seller of the CDS is essentially providing default insurance, so a CDS can be viewed as an insurance contract and might be subject to regulation by government officials who oversee the insurance industry.

It is also, however, a form of derivative-a contract -hat derives its value from another asset or contract (in his case, the actual loan), but which can be settled separately by a payment of cash or some other highly liquid asset. In fact the parties to a CDS don't actually need to have any relation to the loan: You and I can enter into a CDS in which I pay you a premium and you promise to pay me money in the event General Motors defaults on bonds that neither you nor I own. In this case, you and I are both speculating (or gambling) on a possible future event and neither one of us can be described as insuring the other against risk. Thus a CDS may be viewed as a form of futures contract and might be subject to regulation by government officials who oversee the futures industry.


Many of the biggest players in the CDS market turned out to be banks. Only about 40 of the more than 5,000 banks in the United States traded CDS contracts, with three of them-JP. Morgan Chase, Bank of America, and Citigroup-trading more of them than all other banks combined. Commercial banks ended up as major buyers of packages of loans known as mortgage-backed securities that were protected by credit default swaps, and many investment banks were involved in these transactions. Thus a CDS may be viewed as a product supporting banking and lending and might therefore be subject to regulation by government officials who oversee the banking industry.

Finally, since an overwhelming percentage of credit default swaps are associated with either publicly traded bonds or publicly traded mortgage-backed securities, a case could be made for classifying a CDS as a form of investment security, which might be subject to regulation by the government officials who oversee the securities industry.

Despite the Post's portrayal, Born may actually have come the closest to advocating a free-market policy. Although she was never able to get far enough to develop her ideas in detail, as head of the CFTC she likely would have had the authority to regulate CDS contracts that were traded on public commodity futures markets. The three men opposing her prevented these contracts from being publicly traded at all. As a result, credit default swaps could only be traded privately, keeping this market in the hands of a relatively small group of big players whose subsequent missteps might have been prevented or their impact minimized by such public trading.

Private Versus Public Trading

The distinction between private and public trading is important. Private contracts are those resulting from one party directly contacting another and negotiating a mutually acceptable agreement. While government courts claim jurisdiction over the enforcement of these contracts, the content of the contracts is generally up to the two parties.

Starting with the Securities Act of 1933, however, the federal government defined certain financial transactions as public matters and claimed the authority to regulate or prohibit them. Any contract that results from advertising or general solicitation, any use of an exchange that makes it possible for buyers and sellers to be matched up without knowing each other, or even the mere fact that one of the parties is an individual with a net worth under $1 million and an annual net income under $200,000 can be sufficient to claim the contract is a public matter.

The Commodity Futures Modernization Act, by prohibiting the CFTC from regulating credit default swaps, prevented it from authorizing public trading of CDSs on futures exchanges. In other words, the CFMA regulated public trading in the severest manner possible: It forbade it.

With only private trading permitted, the general public was effectively excluded. Furthermore, remember that private contracts must result from direct negotiations and that there is a prohibition on providing any public information about them that might be deemed advertising or general solicitation. This provided an overwhelming edge to the biggest players \who traded them the most, as the high costs of concac::i1g potential counterparties, negotiating contracts individually, and compiling private information created enormous economies of scale. Thus the federal government didn't merely declare credit default swaps off-limits to the CFTC; it also effectively created a trading cartel for the largest banks, insurance companies, and hedge funds catering to wealthy investors.

Credit default swaps were invented by a team led by Blythe Masters of J.P Morgan in 1997 as a tool for hedging the risk of default on loans. In a truly free market, regulated exclusively and severely by Messrs. Profit and Loss, she would today be hailed for this great invention. Prices are information, and the cost of a freely traded credit default swap provides a far better estimate of the risk on a debt instrument than the opinion of a credit rating agency that doesn't personally suffer from a default and expresses its opinion in the form of letters. The meaning of a AAA or BB rating is vague and debatable, while a CDS priced at 1.08 percent on an 8 percent bond indicates that it is the equivalent of a risk free 6.92 percent bond.

Furthermore, making the risk tradable would allow virtually all of us to choose, if we wished, to include small amounts of CDSs in our diversified investment portfolios. We could increase our personal investment returns modestly in exchange for sharing in a tiny portion of the total risk associated with lending. We wouldn't all need to become experts in them. Mutual funds could put together diversified portfolios of CDS contracts and develop track records to draw our investments, and asset managers would have the incentive to become more informed in order to serve clients better. As a personal financial adviser, I would love to have that option for the client portfolios I manage.

Finally, the widespread trading of CDS contracts would help minimize counterparty risk-the danger that the party with whom we've contracted will not honor his obligations. With many people able to trade them, the portion held by anyone player could be reduced and those who overexposed themselves to risk would have a ready market to hedge their own activities.

How Government Made the CDS a WMD

Unfortunately, government intervention helped make credit default swaps toxic. The explosion in the use of CDSs was not a free-market phenomenon. In 1988 the Basel Committee on Banking Supervision, an international body made up of representatives from all the major central banks, produced the Basel Accord, which went into effect in 1992 in the United States and most other participating countries. The accord set capital requirements for all banks that weighted assets based on their risk. The Basel II Accord was signed in 2004 to refine the requirements.

Under the Basel Accords the lowest capital requirements for a bank were not for the loans they personally originated and understood best but for AAA-rated securities. The safest direct loans are home mortgage loans to borrowers with excellent credit whose loan amounts don't exceed 80 percent of the property value. These loans to "prime" borrowers have a risk weighting of 35 percent under Basel II. But if such loans are packaged into a mortgage-backed security rated AAA, the risk weighting is only 20 percent, reducing the amount of capital the bank must keep on hand and increasing its profits. Thus a bank has the incentive to sell the loans it has originated and replace them with AAA securities. Indeed, Basel II virtually mandated that banks sell their loans if they wanted to be competitive. The biggest buyers, Fannie Mae and Freddie Mac, two government-sponsored enterprises operating as profit making businesses, benefited enormously from this regulation-inspired activity.

Not all loans are to prime borrowers with large down payments, however. Because of various government mandates, such as the Community Reinvestment Act, incentives were created to lend to less creditworthy borrowers with low or no down payments. Although most of these loans were not made by banks, they too were packaged into mortgage-backed securities, and many of them found their way to banks as AAA-rated securities.

How so? Why would a package of loans to subprime borrowers get the same high rating as a package of loans to prime borrowers? Through the magic of a CDS. Although the loans themselves might have a high risk of default they were protected by credit default swaps sold by entities that were themselves rated AAA, such as AIG Insurance, and CDSs were given AAA ratings as a result. A package of subprime loans might be rated BB (below investment grade), getting a prohibitive 350 percent risk weighting under Basel II, but that would be reduced to 20 percent weighting as a CDS-protected AAA security.

This was an international phenomenon. In September a report of the Center for European Policy Studies described the bailout of AIG Insurance by the Federal Reserve as a bailout of the European banking system. AIG was exposed to nearly a half-trillion dollars in credit default swaps, $300 billion of it to provide regulatory capital relief to European banks subject to Basel II. On September 15, 2008, the credit-rating agencies Standard & Poor's and Moody's downgraded AIG's debt rating. Ironically, the price of credit default swaps on AIG itself had been rising for months, demonstrate the superiority of CDS pricing to credit ratings in the timely identification of borrower difficulties. This triggered contractual obligations for AIG to post tens of billions in additional collateral to guarantee its own ability perform on the CDS contracts it had sold. There was some evidence that AIG could have arranged financing through various hedge funds or American banks but it apparently didn't like the terms of these loans. It obtained a better deal from the Fed, even though the central bank has no oversight authority with respect to insurance companies. Had AIG not been able to post the additional collateral, the CDS protection it offered would no longer have preserved the AAA ratings of the securities in the European bank portfolios it was insuring, and capital requirements would have increased by as many as 16 ½ times for some of the assets held b\- these banks.

Jury Still Out

So how significant were credit default swaps in the financial meltdown of 2008? For the firms that went bankrupt such as Lehman Brothers, or those that were taken over, such as Bear Stearns, or those that had to cede significant control in exchange for government bailouts, such as AIG. wry. They were big players in the CDS market who made some bad bets and failed to hedge their own risks.

It is not nearly as clear that there is any systemic problem with credit default swaps. In a November 15, 2008 article, "The Meltdown That Wasn't," the Wall Street Journal noted, "Lehman Brothers was supposed to be exhibit A. The firm was on one end of roughly $5 trillion in CDS contracts, according to Moody's, and Lehman was itself the subject of $72 billion in CDS, in which other investors were betting on Lehman's success or failure. Here was the doomsday scenario, with a major player in CDS going bankrupt. It turned out to be the meltdown that never melted."

Lehman failed and the government let it fail. There is no evidence the liquidation had anything to do with problems for any other player. Businesses go bankrupt all the time, and it is best for the long-term health of an economy that incompetent managers cease to manage.

Credit default swaps didn't melt down at all. The market for them continued to function smoothly even as tl1euaditional credit markets were struggling. There were many causes for the housing boom and bust that played me biggest role in the financial panic of 2008, and it is quite plausible to wonder if CDS contracts are being scapegoated to distract from other more likely villains. The role of CDSs in satisfying regulatory capital requirements appears to have been a major reason for the explosion in their use. If there is any failure there, it is in the unforeseen consequences of the regulations that came from the Basel Accords. They should be modified or repealed.

The Born Supremacy

Still, had Born gotten her way in 1999, many good consequences might have come from it:

1) Publicly traded CDS contracts almost certainly would have priced the risk of various debt instruments more accurately than the credit-rating agencies have done. As mentioned, CDS prices showed AIG was in trouble before the rating agencies acknowledged it.

2) Large players in the CDS market would have had a convenient way to hedge excessive risk exposure without being limited to hedge funds, big banks, insurance companies, and the federal government.

3) The inefficiencies in pricing that have allowed players such as J.P

Morgan Chase to make large profits on the basis of superior information would have been replaced with a more efficient market and level playing field.

4) Individual investors would be able to diversify portfolios more and earn some of the returns available in this market instead of being available only as taxpayers to bailout the incompetent.

5) Counterparty risk would be massively reduced by the much greater number of participants in the market.

Born may be getting the last laugh. In October 2008 the Chicago Mercantile Exchange announced plans to establish exchange trading of credit default swaps. In spite of the posturing of some politicians there is enough recognition of the benefits of derivatives to ensure that the markets for them will be expanding rather than disappearing. While we can only hope exchange regulation will be limited to the enforcement of contracts, regulated public trading is better than none at all.

The democratization of credit default swaps has begun. Greenspan, Rubin, and Levitt may have meant well in trying to limit CDS trading to big players, figuring that the public wasn't ready to assume the risks associated with new financial instruments. Unfortunately the massive taxpayer-financed bailouts have shown that the public was going to bear the cost of failure in any event, and the primary result of their elitist attitude was to concentrate risk unnecessarily within a handful of firms whose exposure made them too big to succeed.

Diagramming Geithner's Plan

Geithner Plan I

Explanation of the Toxic Asset Theory of banks' failure to lend, and the Treasury's recent proposals to "solve the problem," including the original idea behind TARP as well as Geithner's new plan of Private-Public Partnership Investment
Program. (14 minutes)



But wait, there's more!
Caveat: The criticisms are good, but the speaker's proposed alternative solution is not.

Geithner Plan II (12 minutes)



These clips demonstrate how the new plan sets us up for yet even more government-subsidized risk through "investment" scenarios which end in either private gain or socialized loss. Additionally, the government's diagnosis is flawed on several levels.

The problems Geithner's plan aims at solving appear to be primarily: (1) potential bank insolvency if "toxic assets" are sold at market price, and (2) the failure of banks to loan in spite of recent and copious money infusions from the government. The first aspect is to be addressed by providing banks with an indirect bailout--government assistance to buy off bad assets via shared equity-risk and non-recourse loans. In regard to the second, other reasons besides toxic assets may be why banks aren't lending, perhaps most importantly, the scarcity of credit-worthy borrowers. Bailing banks out from underneath their self-inflicted exposure to declining asset values won't change the fact that people who are good credit-risks aren't interested in acquiring more debt.

How can this possibly work?

Financial Rescue Nears GDP as Pledges Top $12.8 Trillion (Update1)

By Mark Pittman and Bob Ivry

March 31 (Bloomberg) -- The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s.

New pledges from the Fed, the Treasury Department and the Federal Deposit Insurance Corp. include $1 trillion for the Public-Private Investment Program, designed to help investors buy distressed loans and other assets from U.S. banks. The money works out to $42,105 for every man, woman and child in the U.S. and 14 times the $899.8 billion of currency in circulation. The nation’s gross domestic product was $14.2 trillion in 2008.

The following table details how the Fed and the government have committed the money on behalf of American taxpayers over the past 20 months, according to data compiled by Bloomberg.

===========================================================
                             --- Amounts (Billions)---
                              Limit          Current
===========================================================
Total             $12,798.14  $4,169.71
-----------------------------------------------------------
 Federal Reserve Total   $7,765.64  $1,678.71
Primary Credit Discount           $110.74        $61.31
Secondary Credit                    $0.19         $1.00
Primary dealer and others         $147.00        $20.18
ABCP Liquidity                    $152.11         $6.85
AIG Credit                         $60.00        $43.19
Net Portfolio CP Funding        $1,800.00       $241.31
Maiden Lane (Bear Stearns)         $29.50        $28.82
Maiden Lane II  (AIG)              $22.50        $18.54
Maiden Lane III (AIG)              $30.00        $24.04
Term Securities Lending           $250.00        $88.55
Term Auction Facility             $900.00       $468.59
Securities lending overnight       $10.00         $4.41
Term Asset-Backed Loan Facility   $900.00         $4.71
Currency Swaps/Other Assets       $606.00       $377.87
MMIFF                             $540.00         $0.00
GSE Debt Purchases                $600.00        $50.39
GSE Mortgage-Backed Securities  $1,000.00       $236.16
Citigroup Bailout Fed Portion     $220.40         $0.00
Bank of America Bailout            $87.20         $0.00
Commitment to Buy Treasuries      $300.00         $7.50
-----------------------------------------------------------
FDIC Total             $2,038.50     $357.50
Public-Private Investment*       $500.00          0.00
FDIC Liquidity Guarantees      $1,400.00       $316.50
GE                               $126.00        $41.00
Citigroup Bailout FDIC            $10.00         $0.00
Bank of America Bailout FDIC       $2.50         $0.00
-----------------------------------------------------------
Treasury Total          $2,694.00   $1,833.50
TARP                              $700.00       $599.50
Tax Break for Banks                $29.00        $29.00
Stimulus Package (Bush)           $168.00       $168.00
Stimulus II (Obama)               $787.00       $787.00
Treasury Exchange Stabilization    $50.00        $50.00
Student Loan Purchases             $60.00         $0.00
Support for Fannie/Freddie        $400.00       $200.00
Line of Credit for FDIC*          $500.00         $0.00
-----------------------------------------------------------
HUD Total                 $300.00    $300.00
Hope for Homeowners FHA           $300.00       $300.00
-----------------------------------------------------------
The FDIC’s commitment to guarantee lending under the
Legacy Loan Program and the Legacy Asset Program includes a $500
billion line of credit from the U.S. Treasury.

What Constitutes Perpetual Debt?

"I place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared. To preserve our independence, we must not let our rulers load us with perpetual debt."

--Thomas Jefferson, third US president, architect and author (1743-1826)

Our national debt is now calculated to be 11 trillion dollars ($11,000,000,000,000.)

Are we there yet?

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Laissez-Failure---Not

"If you bound the arms and legs of gold-medal swimmer Michael Phelps, weighed him down with chains, threw him in a pool and he sank, you wouldn't call it a 'failure of swimming.' So, when markets have been weighted down by inept and excessive regulation, why call this a 'failure of capitalism'?"

George Mason University professor Peter Boettke, quoted by Eamonn Butler in "Believers in Free Markets are Fighting Back"

You've got to see this

What does one TRILLION dollars look like?

Let's start with a stack of one million dollars.




(I'm told I need several stacks like this one in order to retire.)

Now think about some of the figures we've heard lately.

Annual Government spending for 2007 was just under $3 trillion. Revenue was $2.5 trillion. Budget deficit therefore was 1/2 a trillion dollars.

The U.S. GDP in 2007 was $14 trillion. In 2008, it was just over $14.5 trillion.

At the end of 2007, the national debt was $9.3 trillion. On Sept. 30, 2008 (the end of the fiscal year) it was just over $10 trillion.

In the last half of 2008, government spending for bailouts and other guarantees related to the financial crisis resulted in new debt and obligations of an additional $8.7 trillion.

Keep in mind what that million dollar bundle looks like.

And now take a peek at one trillion dollars.





Do you see the guy standing in the left-hand corner?
Now imagine 9 more of these.

What the heck do we think we are doing?!

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CEO of BB&T discusses the Financial Crisis

New video by John Allison on the financial crisis

"The Financial Crisis: Causes and Possible Cures"

PDF file of talk slides

John Allison is CEO of BB&T, one of America's largest financial service institutions. Having held that position for 20 years, he offers a unique insider's point-of-view on the recent financial crisis in his talk "The Financial Crisis: Causes and Cures." Not all of his solutions are fully consistent with laissez-faire capitalism, but he none-the-less brings some interesting insights to our current financial problems and his suggestions take a large step in a better direction. Topics covered in the talk include:

The central role the Federal Reserve plays in managing and directing our financial system, and thus the central, fundamental roll it played as the ultimate cause of the current financial chaos.

How money creation by the Fed is used to fund government spending and in the expansion of the national debt.

How the Fed intentionally lowered interest rates in order to create an environment of low risk. This resulted in distorted signals and incentives which led to both the malinvestment of resources and the discouragement of saving.

How other policies of the Federal Reserve, the S.E.C., the FDIC undermined and destabilized banks by driving the increases in leverage and risk-taking, as well as the depletion of capital--and how these policies remain unchanged today.

The harmful contributions of the rating agencies and fair value accounting (mark-to-market)

The central role of the Fed, the FSLIC, Freddie and Fannie in encouraging and facilitating sub-prime lending which served as the proximate cause of this particular crisis.

The politically-driven misuse of legitimate credit instruments: CDO/SIV/CDO²/CDS

Bailouts: why they won't work; how they hurt healthy banks and stop private solutions

Why short-term pain is now unavoidable, and what strategies and policies might help shorten the correction period as well as work towards long-term stability and growth.

Identification of the underlying philosophy and ideology used to justify and direct government intervention into economic matters.

The talk is worth the 80 minute investment of time in order to hear a succinct overview and analysis of how we got here, and this banker's well-informed thoughts on steps that could be taken to get us back on track to financial security and rising prosperity.

During the boom, many people made good-faith economic calculations based on price signals distorted by government manipulation of the money supply. Others took advantage of lax lending standards, or committed outright fraud. Both types of borrowers are now suffering from home foreclosures, and we all are suffering from the effects of business bankruptcies and layoffs. For decades, this country has supported active manipulation of the money supply, directly by the Federal Reserve, and indirectly by Congress and the Treasury. The culpability is multifaceted.

Our next task is to orchestrate the transition from a mixed-economy to one of economic freedom. Figuring out how to dismantle the myriad of government interventions without causing more economic dislocation and destruction is not an easy or straight forward task. I understand the temptation to use government power and funding in order to stabilize the housing market, or to mitigate and repair the damage that government policies have caused. But, even in periods of transition, we must attend to the basic principle of individual rights. True solutions can not include any further violations of liberty or property. Even when wielded with intent to heal, such violations can only result in further harm.

Allison's recommendations are a good place to start the discussion, but further refinements must be made if we are to stay true the fundamental principles upon which this country was founded, principles which are both moral and practical: the individual's right to Life, Liberty and Property.

Would you like to go to a Tea Party?

Michelle Malkin reports on the wave of Tea Parties occurring across the country, protesting our government's efforts to redistribute wealth from those who earned it to those who blew it.

Read "Going Galt"

And check out the photos and letters from her readers.

Here's a few of my favorites:



And this little heart-breaker:

Credit Default Swaps and the U.S. Debt

What are Credit Default Swaps (CDS) and what can they tell us about the risk of the US government defaulting on our national debt?

When you purchase a CDS, it is something akin to buying insurance for your investment. It's an attempt to decrease your risk on a credit derivative. As a buyer of a CDS, you pay a premium to the seller, who then is obligated under the agreement to pay you a specified amount if the credit derivative covered by the CDS goes into default. The idea is to financially protect yourself no matter what happens to the value of the loans or bonds upon which the derivative is based. If the loans or bonds retain their value, you gain from your original investment. If they loose value, you get a payoff from whoever sold you the CDS.

If used appropriately, you are able to minimize your risk. In an interesting twist, because you don't have to own the underlying credit derivative, CDSs can also be bought and sold separately, taking on a life of their own and looking a lot more like gambling than investing (not that I have a problem with gambling, as long as it's clear that's what you're doing.)

Similar to short selling, CDSs have an important role in capital markets by reflecting the perceived value of various credit derivatives and the status of the bonds and debts from which they are derived. High "premiums" for a CDS signal that the underlying loans and bonds are considered to be at a greater risk for default.

So that brings me to the latest interesting piece of news: The cost of purchasing a CDS on U.S. Treasuries is now higher than the cost of buying a CDS on Pepsi or IBM--or even government debt from France!!



Probably has something to do with all those spending bills Congress has passed lately, don't you think?

HT George Washington's. Blog
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