Life, Liberty & The Pursuit of Happiness

Enticing private capital? Call it a rescue effort, not a bailout.

by Rakinder Grover

Some information on the "toxic assets plan" expected to be announced by the Treasury next week has begun to surface.  It includes a lot of enticements to get private capital to participate in the purchase of "troubled mortgages".  One of the biggest potential obstacles in getting this all to "work" is politics.  An excerpt from an article in the NY Times:

"Still, the Treasury Department’s biggest obstacle may be the current political environment in Washington, where Democratic lawmakers are furious about the pay packages and bonuses received by executives at companies being rescued by taxpayers.

Many investment executives said they were worried that participating in any bailout program would expose them to political wrath and potentially steep new restrictions on their own pay.

Treasury and Fed officials have remained firmly against imposing any restrictions on pay for companies investing money in the rescue effort rather than receiving money from it."

Is there much of a difference between highly subsidized "investing" and just receiving money?  I expect some polished sales talk from the Treasury and the Administration to try and prevent the populist anger from rising as it did this last week. Oh, the sad circus continues....  if only the government would just stay out ...

Michael Lewis on AIG Bonus Ballyhoo

by AW

Michael Lewis offers timely wisdom on AIG bailout. Clear reasoning on a passion-arousing topic.

The complexity of the issues at the heart of the crisis paralyzes the political processes’ ability to deal with them intelligently. I have no doubt that, by the time this saga ends, we will all know what happened to every penny of that $165 million in bonuses and each have our opinion of the morality of it.

I doubt seriously we will ever understand the morality of the $173 billion payment that is the far more serious issue. For instance, Goldman Sachs, which received about 8 percent of the pile, or $13 billion, has claimed publicly that the money was, to them, a matter of indifference, as Goldman had hedged itself against a possible collapse of AIG -- by making bets against AIG.

This suggests that it was clear to at least one market player, before the collapse, that AAA-rated AIG was behaving in ways that might lead to its demise -- which is to say that there was really no responsible place to lay off these bets. (So why bail out those who made them?)

It also suggests that it is a matter of indifference to Goldman Sachs whether AIG lived or died, as either way it was protected. (So why bail it out?)

AIG: Moral Hazard and Corporate Looting

by AW

AIG is the mother of all TBTF ("too big to fail") institutions; it has already received 180 billion dollars of taxpayer money so far. This bailout is larger than that for any other financial institution, and it is widely expected to go higher. How could a staid insurance company be in the center of this?

James Hamilton in his EconBrowser blog explains the moral morass of "selling insurance" like snake oil. Here is an interesting story line that is emerging.

Helpful tools in (understanding) this mess

by Reena Kapoor

Check out these visualizations of the financial crisis and what led to it! Brilliant in their creativity as well as content.

The Last Time We Nationalized A Bank...

by Anurag Wadehra

In this podcast, William Issac talks about his experience in running a nationalized bank in the 1980s during the S&L debacle. He should know a thing or two, since he is one of the few people in the States who have hands-on experience on running a nationalized bank.

He is against nationalization today for three key reasons (also in this WSJ op-ed).

1. Can't stop at one bank: We won't be able to stop at nationalizing one or two banks. If we start down that path, the short sellers and other speculators will target for destruction one after another of our largest banks.

2. No reasonable exit strategy after nationalization. Today, who has the wherewithal, legal authority, and desire to purchase our largest banks? No one comes to mind, particularly if we rule out foreign groups, which I suspect would not pass muster due to national security concerns about ceding that much power over our economy to foreign powers.

3. Not enough people. Who will run these companies when we dismiss the existing senior managers and board members? We had significant difficulties attracting quality people to Continental even without today's limits on compensation.

Allan Meltzar of Carnegie Mellon University discusses his views on the Fed Reserve, the upcoming inflation and why banks must fail and why that is a good thing. Now, he too knows a thing or two about the Fed; he wrote the definitive 2-volume history of the Federal Reserve.

 

$62 Trillion Mathematical "Charlatanism"

by Anurag Wadehra

The Wired magazine has a cover story dedicated to a mathematical formula that brought down the financial markets. How? Because this was the formula used to price the most nefarious of derivative instruments: credit default swaps (CDS).

At the end of 2001, there was $920 billion in credit default swaps outstanding. Once the formula was unleashed in the marketplace, by the end of 2007, that number had skyrocketed to more than $62 trillion. This growth was made possible because the risk of hitherto intractable instruments was tamed using this financial model. Or, was it?

Ice-fishing Bankers: How Iceland Skated Off The Edge

by Anurag Wadehra

Michael Lewis has a rollicking article on Iceland's misadventures in high finance.

From 2003 to 2007, while the U.S. stock market was doubling, the Icelandic stock market multiplied by nine times. Reykjavík real-estate prices tripled. By 2006 the average Icelandic family was three times as wealthy as it had been in 2003, and virtually all of this new wealth was one way or another tied to the new investment-banking industry.

“Everyone was learning Black-Scholes” (the option-pricing model), says Ragnar Arnason, a professor of fishing economics at the University of Iceland, who watched students flee the economics of fishing for the economics of money. “The schools of engineering and math were offering courses on financial engineering. We had hundreds and hundreds of people studying finance.”

When their three brand-new global-size banks collapsed, last October, Iceland’s 300,000 citizens found that they bore some kind of responsibility for $100 billion of banking losses—which works out to roughly $330,000 for every Icelandic man, woman, and child.

The entire article is worth the read. I was most amused by the reference above: the rush to slavishly learn the Black-Sholes pricing formula. This is the very formula derided by Nassim Taleb in his book the Black Swan for underestimating the probability of the large shocks to financial system.

Bad Banks: The Road To Economic Hell

by Anurag Wadehra

Simon Johnson, of the brilliant blog Baseline Scenario, made two posts of exceptional clarity:

How to save the banks proposes a clear solution, the best one I've heard so far. Simply put, it is:

• Government should fire the bankers and maybe the board
• Then mark all illiquid assets to market value
• Sell all or parts of the bank to new private equity investors
• And then get out.

To do this, government shouldn't use stock with voting rights but warrants which convert to common stock after the restructuring, giving taxpayers the best shot at upside. 

Gaithner & the Dollhouse Bank

by Anurag Wadehra

I never thought I'd write these words: I love NPR!

I am only referring to the podcasts spearheaded by Planet Money team. Adam Davidson is one of the best journalist writing and speaking on financial issues today. He asks piercing, jargon-free questions and does a lot of homework to make complex simple: no mean task. In the podcast The Bad Bank, produced in collaboration with Ira Glass of This American Life, Adam explains in brilliantly lucid terms the balance sheet of a hypothetical bank. He goes further to explain what choices we face when we "bailout" a bank whose asset has gone "toxic" - in this case a dollhouse. 

Keynesian Mindbender - Paradox of Thrift

by Anurag Wadehra

Now that we are all Keynesian, or at least doomed to fund the ultimate test of his stimulus theory, it behooves all of us to understand what he claims. One way to do so is to read his book The General Theory of Employment, Interest and Money which is available for free at Marxists.org. No points for noticing the irony that both Houses of the Congress and the President are following the path laid out by one of the economists loved by Marxists. 

A more pleasant way is to listen to an honest exposition of Keynes by the a self-avowed Keynesian economist  Steve Fazzari. This exceptionally lucid  interview was conducted by the libertarian Russ Roberts of George Mason University. The best part is their discussion on the paradox of thrift. Fazzari uses an example: