A NeoAustrian Perspective

Solving the budget deficit

2010-11-17T08:14:00.001-08:00

The NY Times has a site up for addressing the budget deficit. In opposition to the usual Versailles claims about how hard it is to solve the deficit, I found it pretty easy. My proposal fixes it, essentially by returning to Clinton tax policy, taking the peace dividend, and taxing two activities with substantial negative externalities: CO2 emission and risky bank activities. I don't have to do a thing to Medicare or Medicaid. Other people with radically different political preferences don't seem to find it too hard either. Try it yourself!

Greece and stability

2010-02-07T16:40:00.000-08:00

Stability has been much discussed lately but with little useful results. The real problem is not Greece, but that irresponsible finances in *one* medium-to-small country of no major international significance (not a banking center, source of a critical natural resource, etc.) threatens the world economic system. That is seriously unacceptable instability. If the survival of the world economic system requires that *every* country with a GDP larger than um, Massachusetts behaves responsibly at all times, we're doomed.

(Posted as a comment to Naked Capitalism)

The Public-Public-Public-Public-Public-Public-Public-Public-Public-Public-Public-Public-Private Investment Partnership

2009-03-23T17:32:00.000-07:00

Timothy Geithner's plan to get money to the banks was released today. One of the guiding principles is:

Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.

But when you get into the details, you find the plan is for 50/50 public/private equity supported by 6:1 leveraged borrowing from the public sector. That means 12 dollars of public money goes in for every 1 dollar of private money, making this the PPPPPPPPPPPPPIP of the title. So, does Geithner actually believe that this is making the most of taxpayer resources? I have to grant that he seems to believe CDO's of mezzanine subprime MBS tranches are "undervalued", which is even less plausible. Foolish or dishonest? You decide.

In the "Legacy Securities Program" Geithner continues to promise he'll develop a plan - someday.

Borrowers will need to meet eligibility criteria. Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the underlying assetsBorrowers will need to meet eligibility criteria.

Yes, Geithner has known that we have a lot of bad loans since at least the fall of Bear Stearns a year ago. Yes, he has been involved in multiple negotiations trying to save companies loaded with bad debt over the past year. Yes, he has supposedly been working hard on this for at least 4 months.

No, that quote is not from the Onion.

The right amount of quantititative easing.

2009-03-20T09:02:00.000-07:00

Krugman has a post up expressing approval of the Fed's announced intent to buy 1 trillion in long-term bonds. I'm all for quantitative easing (I wonder what Orwellian instinct causes them to avoid the proper phrase "printing money") but not on this scale. M1 is only about 1.6 billion (and was less that 1.4 last summer) so this is about a 60% increase in the money supply, coming on the heels of some significant printing in Q3-Q4 2008. Crudely, you'd expect about 60% inflation from this and that's far too much. As Krugman points out, the prices of these bonds will drop as the economy recovers and interest rates decrease. So even if the Fed pulls back as hard as it can in a year or so we're still left with about a 15% increase and I very much doubt the Fed will pull back even that hard as IMO that would throw us into a depression.

I think a better guide would be to print enough money, excuse me, "quantitatively ease" enough, to keep the leading indicators moderately positive. That should be enough to get us out of recession without risking the worst inflationary shock since the Constitution was written.

Tranche warfare, in earnest.

2009-03-06T17:27:00.000-08:00

I have seen some discussions about how differing interests of differing tranches could potentially lead to some pathological results, but here's a real example : Carrington Investment Partners LP vs. American Home Mortgage Servicing.

Carrington bought some junior tranches that apparently have the right to control disposal of REOs in the pool (there are legal fights now over whether they do). As long as the REOs aren't sold, the junior tranche gets its scheduled payment. Once the REO is sold, the proceeds are dived starting from the seniormost tranche, which in this case will leave Carrington's tranches in the cold.

So Carrington is trying to force the servicer to keep the REOs, unsold, presumably until they rot into uselessness. Sure that screws over the senior tranches, nearby homeowners, and the economy as a whole, but hey! a hedge fund has to make a buck! Go free market!

Are you ready to be Geithnerized?

2009-02-10T11:26:00.000-08:00

Geithnerize, vb: To make somebody grossly overpay for something, and still end up not owning it.

The core problem for the banking sector is that the banks have lost far, far more money than they could have and remained solvent. As Yves Smith pithily puts it:

Let's start with the basics. The US banking system is insolvent. Got that? Insolvent. That does not mean every bank in the US is toast, in fact quite a few are probably just fine, and another large group is no doubt hurting and undercapitalized, but ... a significant portion of the very biggest banks are insolvent.

The fair solution is that the insolvent current banks have to be shut down, their owners wiped out, their managers fired, and new banks started with new owners, new managers, and new capital. Fair, efficient, and straightfoward - but it will ruin many of those responsible for the disaster, especially current bank management. Their solution? Make the taxpayer pay to keep them rich - via Geithnerization!

We've already had a lot of Geithnerization already - the TARP, which overpaid by at least 87 billion for equity that doesn't carry voting rights; the Citibank bailout, where the US government gave Citibank guarantees so grotesquely underpriced they won't even let us find out what they guaranteed; and the similar BOA bailout. And the public is getting wise to the Geithnerization process.

So the new Geithner plan cleverly dresses up another (and huge!) round of Geithnerization with some platitudinous frills (but little substance) to disguise the ravenous monstrosity at the core of the plan. Lurking at the core:

a) TARP style useless equity in the "Capital Assistance Program". Undercapitalized banks get money from the treasury in return for preferred shares - inevitably underpriced, since the bank are undercapitalized. The preferred shares aren't voting, so no control over the bank for the taxpayer who's going to pay so much for it. Just like with Citi, we get to pay more than the banks are worth, and somebody else still owns it.

b) A "public-private investment fund" which will take equity mostly (read all) from the private sector to take loans from the public sector to buy assets that can't be valued accurately. Result: if the assets go up, the private investors take all the gains; if they go down private investors lose a little and the public loses a lot on the bad loan. Geithnerization for uncertain assets!

The plan has some nice-sounding frills calling for bank audits (but with no specifics), posting some information to the Web (but again, no details), and some expanded programs for mortgage modification. Of real merit is a plan to expand the Term Asset-Backed Securities Loan Facility (TALF) to 1 trillion. This really helps, because as I've said, the fundamental solution is to have new bank with new money take over lending. With the TALF the Federal Reserve will be doing it. Of course the point is that since Geithnerizing the public won't actually help the credit market, they needed to put in a program that would. We don't have to rip off the public to expand the TALF.

But no detail can disguise the 1 trillion plus plan to make the taxpayer pay for investors to own and get rich on assorted shady assets. But what do you expect when you appoint a Treasury secretary whose primary goal is saving the banks from nationalization?

Are you ready to be Geithnerized now?

Recessionary employment declines

2009-02-09T11:05:00.000-08:00

In response to some widely circulated and controversial charts of employment declines in major recent recessions, I took a look at the employment to population ratios. I looked at the recessions from an employment ratio perspective, starting at peak employment ratio and continuing until it recovered. The conclusions are somewhat surprising.

First, some recessions merge. The 1980 and 1981-82 recessions do, and we have never gotten out of the 2001 recession. 2001 on kind of looks like a Long Recession by this measure, and may be turning into a Long Depression. The current recession by itself (2007) does indeed show up as bad - it's the worst of all at 25 months. It's not quite as bad as the 1981-82, but it's very close, and it's worse than everything else, including 1974-75 (except of course 2001 with 2007 added on). Also, the lurch downward over the past 7 months is unprecedented and worse than anything else, although the 1974 lurch down is very close. Another bad month will make the 2007 recession unsurpassed.

Isakson Pro-Fraud Amendment passes

2009-02-08T07:12:00.000-08:00

Senator Isakson recently proposed an amendment to defraud the federal government of 10's of billions of dollars by paying people 15,000 to buy a house. Of course, even an idiot can see this will just make millions of homewoners swap houses with each other, collecting 15,000 from the federal government for doing NOTHING useful. Of course, he supports this because he's a realtor and hopes to collect vast fees assisting people in defrauding the government. Even more horrifyingly, the Senate passed this outrage unaninmously.

They should all be impeached, and Isakson should be indicted for corruption.

Um - try 23 years.

2009-02-06T11:39:00.000-08:00

Paul Krugman has a post about the fall in employment ratio to numbers not seen for sixteen years.

Except it's actually 23. And probably more to come.

Europe headed to the liquidity trap?

2009-02-05T07:22:00.001-08:00

Ugh. Now the Europeans want to join the US, Britain, and Japan in the liquidity trap. In England, banks are now no longer able to collect interest on some mortgages. What's that going to do to bank stability? But still they cut, in the face of evidence that extremely low interest rates are actively harmful to economic stability.

A better CPI

2009-02-04T12:39:00.000-08:00

From Mish Shedlock, here's a graph of the CPI with owner equivalent rent replaced by the Case-Shiller Index aka the CS-CPI. It would have led to much better Fed action in the current cycle. The Fed would have pulled back credit in 2003, tempering the bubble, and would be broadly inflating now, tempering the depression. Wouldn't it be nice to have a Fed that used good metrics?

Toxic loan modifications

2009-02-04T09:39:00.000-08:00

There has been a big push to address the current mortgage crisis via mortgage modifications, notably by Sheila Bair of the FDIC. For most borrowers, modding down loan principals to house values generally just recognizes reality; most borrowers either can't or won't pay far more than the value of their house to live in it. However, a lot of mods just reduce interest rates - here's a particularly spectacular million-dollar 1% balloon loan from WAMU. Not only do these mods not acknowledge reality, they are adding to the toxic debt problem.

A big part of toxic debt, and arguable the worst for the financial system, is debt which cannot be accurately valued by any method. This can arise from exceedingly complicated derivatives, but a relatively new problem arises from our being in uncharted economic waters. Predicting the value of a long-term security requires projecting the future, which in turn must be done with models from the past. However when you're in a strange and unprecedented situation, old models aren't going to be accurate. This means long-term securities become un-valuable - nobody can figure out what they're worth. Since market mechanisms are just an opinion-averaging system, market prices are as arbitrary and meaningless as the unfounded opinions they're based on.

When you have this "mystery meat" toxic debt, it becomes impossible to fix companies reliant on it, even with unlimited resources. There's no way to know how much to allocate to cover losses. Too little means the company is still bad. Too much is an unfair windfall. And almost any amount could be either - there's no way to know, except to wait and find out.

This WAMU balloon loan is exhibit A for a "mystery meat" toxic debt. What will currently overpriced houses be worth in 5 years? We have no idea, basically. How much of the underwater amount will the borrower be able to cover? We have no idea. How possible will it be to get a rollover loan in 5 years? We have no idea. So, what had been a relatively easy-to-value foreclosure has become a million-dollar slug of toxic mystery meat which has to molder on the plate for years until it can be resolved.

Instead of the garbage getting taken out, it's been added to the food. We are worse off than before. I'm all for constructive loan modifications, but these kinds of mods have to stop.

Drama Geisha?

2009-02-02T08:17:00.000-08:00

Yves Smith of Naked Capitalism passes on a report from Frank Veneroso decrying the massive collapse in Japanese manufacturing, which is the fastest on record for a major industrialized country. He complains that he's "crying from the rooftops" but it's "like a neutron bomb had gone off" because nobody cares. He blames the EEEVIL speculators, picking - of all agents to blame for a manufacturing depression - technical analysis traders. Blaming that fractious bunch earns him an "Oh Please" award.

Japan, a supercreditor nation, is now running a small trade deficit, which is what it should be doing, so the yen is about right. Of course they're getting a depression in switching from an insanely low manipulated exchange rate to a reasonable one, because they've had truly massive misallocation of resources over the past 30 years, due to the crazy low yen value. Basic economics, folks - bad prices cause bad decisions.

Venerosa is right that the rest of the world doesn't care - because we all know this is about where things should be. The depression which will result from this return to sanity isn't something we can do much about anyway. Normally there would be more sympathy but since Japan Inc. has been wrecking everybody else's manufacturing longer than most working people's memory nobody's going to feel too sorry for them now.

Maybe we can get a bunch of really, really small violins to play along with MITI's sob story about manufacturing disaster from unfair trade practices - their own. Heck, Japan's into miniaturization and classical music. Maybe they can provide the violins for us!

Thoughts of an unserious economist

2009-01-23T11:29:00.000-08:00

William Pesek writes:

No serious economist thinks Japan is going to crash.

This charming little argument from intimidation reminds me of the endless parade of pundits proclaiming that all the "serious" people supported the War in Iraq. Or, for that matter, all the "serious" mockery of housing bubble predictions.

It seems most people fall into a fallacy encouraged by standard macroeconomic thinking that savings automatically produces something useful and that all "productive capacities" are equally good. All investments are particular - they are to make or do something. Market action equalizing marginal benefit *normally* produces a very good set of particular investments so it's an acceptable approximation to view any investment as equally good. But markets do fail, and they can also be distorted. If this happens the investment is wasted - perhaps partially; perhaps totally.

Japan has a huge productive capacity, but if that productive capacity is for export products that nobody will buy for years, then it's virtually worthless - regardless of how much people thought it was worth last year, or the effort put into creating it. Likewise Japan's vast savings, insofar as they own worthless productive capacity or assorted foreign bonds that can't be paid, are also worthless.

If Japan's exports continue down 35% they will crash. Hard. Are the "serious" economists going to be wrong again?

So is it insider trading?

2009-01-23T08:21:00.000-08:00

An important point from Clusterstock:

Side note: if the government officials have been consulting with banking heads about the bad bank, and we hope they have been, does it count as insider trading when the banking chiefs buy their own stock?

This is a reference to large insider purchases by Dimon and Lewis of JPM and BoA. It's particularly interesting that both bought shares at the same time.

I have one disagreement with Clusterstock: This is not a side note. Not to say that Dimon and Lewis are necessarily guilty; but if they are this is a very big deal. This harkens back to a point I made about the Citi bailout: the connections between bank regulators and the banks are so strong that the incentives and opportunities for corruption are unbearable. Even apart from solvency issues, the banks (at least the big money center banks) have to be nationalized for governance issues while we figure out how to solve these problems.

A disturbing aspect of Obama's economic plan

2009-01-20T17:19:00.000-08:00

There's nothing on mortgages, foreclosures, bank management, bailouts, deriivative tangles, SIVs, or any of the other financial issues dragging us into depression. This site came up as soon as Obama assumed the presidency and doesn't appear to be pulling punches, as Obama did during the transition. Other issue pages put forward a clear, if somewhat mild, center-left agenda in basic agreement with his campaign promises. So Obama has at least not yet figured out how to address the real economic problems, not even to the point of putting out an outline.

These problems are thorny but they will not wait. It's very concerning that Obama does not yet have a road map he's willing to publish, and possibly no road map at all.

Me too!

2009-01-19T11:33:00.000-08:00

Felix Salmon wrote a great piece on Why Nationalization is the Best Alternative. It's been mentioned by Krugman, and in several comments threads. I don't have a great deal to add at the moment but it's well worth a read.

The stimulus plan: useful, but misses the point.

2009-01-15T12:30:00.000-08:00

The House Democrats have released a first draft of their stimulus plan. It's a mix of relief (medicare/unemployment) and infrastructure investment. With current bond rates, those are good ideas; but what we will need most are employment projects and there's not a whole lot of jobs here. Most proposals are capital-intensive. It's a good idea to do capital-intensive infrastructure when rates are low; but that won't help most people in fear of losing their jobs.

What I would add to the program is jobs-related programs. Do things that aren't done now, at least not enough, which don't require much skill or physical prowess, and which pretty much everybody likes. My initial ideas would be cleaning public spaces (especially of grafitti), neighborhood patrols, landscaping, ecological restoration (wetland recreation, elimination of invasive species), and public art. Not only would this make the country a nicer place, those kinds of activities feel constructive to the worker and make for good temporary work where the pay needs to be low.

4 million people at $8/hour is 64 billion a year, which is smallish compared to this overall proposal or to the TARP. In addition to the direct benefits, if we make it clear that we *aren't* going to get depression-level unemployment then other stimulus proposal can be addressed level-headedly without the kind of panic that was used to shove through the TARP.

Reforming the Federal Reserve

2009-01-08T17:23:00.000-08:00

The policy responses to the current crisis have exposed some bad governance problems with the Federal Reserve. Like most central banks, the Fed is fairly independent, and needs to be as otherwise there are massive incentives for electorally directed manipulation of the money supply. However, in the current crisis the Fed has used its independence to provide massive benefits to private interest, most notably with with Citibank bailout, ultimately from the pocketbook of the taxpayer.

Clearly it's totally unacceptable for any institution to effectively give hundred of billions of taxpayer money with no effective control. We'll pay for years covering the past year of thinly disguised giveaways. However, we don't want to put the Federal Reserve under the direct control of the President due to the need for independence.

To solve this dilemma, I have a simple proposal: the Federal Reserve will only be allowed to own debt explicitly guaranteed by the federal government. It will not be authorized to make any guarantees of any other assets, or to participate in any derivatives. It may make loans only when suitably collateralized by government-guaranteed debt. If the Fed needs to operate a discount window, it must first get guarantees from the political system, so it will no longer be able to effectively give away money without taxpayer control.

The Federal Reserve will still be able to control the money supply but it will only be able to use use its implicit call on taxpayer money to benefit government-guaranteed entities, which is restrictive enough. I think this proposal provides leeway for the Federal Reserve to perform its monetary function with adequate interference while ensure that benefits from government granted authority are controlled by Congress and the Executive branch.

What does it take?

2009-01-01T05:29:00.000-08:00

Right now the world faces a real risk of economic disaster, quite possibly a depression, as a result of a credit bubble set off by insanely low interest rates in 2001-2005. This is no surprise; if you set the price for something (credit in this case) you get overconsumption and efficiency losses; when the item in question (credit) is the most important single element of the economic system the waste has particularly dire results. Now Germany's finance minister blandly observes this obvious fact we are so painfully being reminded of.

And Paul Krugman finds this objectionable?

Seriously, what does it take for economists to accept basic economics? Mad Max?

Money equals debt

2008-12-22T08:31:00.000-08:00

I see a lot of people on various blogs complaining about a "debt based money system" so I just had to say this:

All money is debt.

Money is something that's valuable because other people will give you something for it and no other reason - which is to say debt. Money can't be anything else, because it's used to represent and account for two people making an exchange with a timing difference. During the gap the person who gave up his stuff first has the money - representing the debt the other owes him. When 7 billion people get involved it gets a lot more complicated but the underlying equivalence remains: money = debt. There's no point in getting upset about it; it's just the way it is.

Bank of the Fed Expands; Is Nationalization Imminent?

2008-11-26T17:05:00.001-08:00

Yesterday the Fed announced, not one, but two major lending programs: 200 billion for consumer credit and 600 billion for mortgages. This is the Fed moving further into the "Bank of the Fed" approach I advocated during discussion of the TARP bailout. The Fed is effectively taking "deposits" in the form of Treasury bill purchases and using the money to make loans to private entities. The loans are currently being made indirectly, by supports to private bank lending, because the Fed lacks the infrastructure to evaluate individual loans.

This has engendered a lot of concern about wasting money and crowding out private lending/borrowing; of which some concerns have made it to the mainstream media. These concerns are legitimate; during the TARP controversy I was particularly concerned with the Fed crowding out essential lending to make wasteful loans. However, I think at the moment there's just no choice. For whatever reason, banks are unable to convert virtually free money from the Fed into consumer and commercial credit except at exorbitant rates. We need credit for our society to function and apparently nobody but the Fed can do it.

Lending by the Fed, though, may very well drive what's left of the banking system out of business. The Fed has access to unbelievably cheap money; at this writing it can borrow for 3 months at a rate 0.04% (free, essentially) and for 30 years at the astonishing rate of 3.52%. There's no way private banks can compete with that. If the Fed loans to some people but not others it is effectively providing an enormous subsidy to the favored and will create monster distortions in the economy. In addition, the Fed will face severe political pressure, as we've seen with the attempt to give away the farm to the banks while the auto industry gets crumbs. So I think the Fed will have to be relatively even-handed in its lending, and this is going to leave the Fed dominating most lending much as Fannie and Freddie now dominate mortgage lending.

So in the very near future we will likely have a de facto nationalized banking system, with governmental standards determining who does and who does not receive loans. Good or bad, it's now basically inevitable since the private banking system used the freedom provided by deregulation to go out and commit suicide. It is truly ironic that the mad drive to deregulate of the past 25 years will lead to socialism on a scale not even considered seriously in America before. But, that's the situation, and we now have to start thinking about how the government will run the bank.

What do we have to invest in?

2008-11-19T08:35:00.000-08:00

Many pundits are proposing government-funded investments as a way out of the current recession. I wonder though, what is there to invest in? Certainly current infrastructure has deteriorated in the past few decades of neglect, but I haven't seen any indications that the deterioration is causing the enormous financial losses that would justify the kind of investment we need. Likewise we've seen in the past year that energy consumption can drop substantially in a relatively short time, with driving down 5.6% in one year. Green energy isn't needed so desperately if consumption declines.

Fundamentally investment is to increase production. But we really don't lack for goods, widgets, or entertainment. The real goal should be to improve lives, and I think at the moment that more time with family and fun is more worthwhile than fancier cars, bigger houses, or smoother roads for faster highway speeds. In an abstract sense, we might be better off with a smaller economy; happier, better connected, and more relaxed.

The problem, as with all major shifts, is that capital and human resources are misallocated for an American form of Dolce Vita. If we have that kind of shift in consumption many investors and workers will be left with no way to make a living. So perhaps the solution, rather than massive capital infrastructure investment, is investment in what we might call "home economics" training - teaching people how to live well and control spending, and how to help others do the same.

The Blogosphere and the Crisis

2008-11-09T10:52:00.000-08:00

Obama recently released his list of economic transition advisors and it's a real disappointment. Everybody is extremely middle-of-the-road mainstream. There are few who recognized the housing bubble before it popped and none who protested Greenspan's ultra-loose money policy which helped set it up. Many are from banking or the Clinton adminstration and involved in the regulatory changes that helped set it up.

So, while it's a group of competent workmanlike team members, it lacks anybody with the foresight to see the current crisis in advance. The puzzlement is that there's a large group out in the blogosphere which was far ahead of the curve in foreseeing this crisis. The star of course is Nouriel Roubini, whose far-out 12-step collapse process, ridiculed when it came out, has been pretty spot-on as a set of predictions. But almost any of the big economic blogs - check out Calculated Risk's links - has been ahead of the curve on this. So why is this large reserve of foresight, including academic heavyweights like Roubini and Krugman, unrepresented on Obama's transition team?

I am leaning to the idea that at this point being right isn't going to be enough. A lot of the more intellectual types (which would include me) tend to think that if you're publically right people will eventually start listening to you and implementing your ideas. But the current situation is about as much of a push for the "no more bubbles" policies advocated in the blogosphere as you could have asked for, and we're not seeing a thing. So it seems we need to connect with some kind of political movement as well. I'm not really sure how, because the "reality-based" blogosphere ideas seem to cut across party lines, based on the fight against the TARP. But I think it's something to start working for.

Baltic Dry Index levels off

2008-11-07T07:28:00.000-08:00

After an incredible plunge over the past year, the BDI appears to be leveling off in the low 800s. We had two days up followed by a leg down today. This is less bad than a continued plunge, but the numbers are, on an inflation-adjusted level, similar to the lows around 750 in the past recession, and in many cases below the operating costs of the ships. So the drop is halting because the BDI can't go any lower-at this point shipowners will just idle their ships.

So the financial and speculative crises are now starting to affect the real commodity market, reducing lading to the point that shipping capacity is being lost. The next question is how severe the destruction will be.

What's going on in Inflation-protected treasuries?

2008-10-31T08:34:00.000-07:00

Yesterday the face value yield on the 5yr inflation-protected treasury (TIP) (2.88%) was less than that of the regular 5-year treasury (2.81%). Theoretically, this should be impossible. The face value yield for the TIP is a floor value; it can't pay less even in deflation. If there's any meaningful chance for inflation then the TIP's face value should be below the 5-year. This has been part of a general drop in TIP yields to predictions of almost-zero inflation; but the drop has been most extreme in the 5-year.

Traditionally the difference between with TIP and the regular bond yield is used as an inflation estimate. The Cleveland Fed, which has published this in the past, has been forced to give up on that for the time being as the result is nonsensical.

If anybody can explain this I'm all ears. The fundamental I can think of is that the TIP has such a low face yield (0.65%) that it's almost a zero-coupon. If the government defaults late in the period that affects the TIP more than the conventional treasury. But, I've seen no indicators of an appreciable risk of default late in the period. BondGuy on CR proposed that it might be unwinding hedges selling their TIPs but to me it seems somebody should step in and buy those undervalued bonds, or at least swap 5-year treasuries for them.

Current Strange Swaps Spreads: What do they mean?

2008-10-23T11:12:00.000-07:00

A swap spread is the difference between the fixed rate equivalent (on the market) for LIBOR over a given period and the treasury bill rate for the same period. Normally they are very close, with the LIBOR swap slightly higher than the T-bill rate, presumably because there's a chance of default on the swap.

Recently, we have seen a very strange (historically) result. Short-term spread have been astronomical - over 4% for a short period - while long-terms spreads have been very low - down to 0% briefly yesterday. So what could this mean?

The fundamentals of the swap spread are easiest to understand in terms of an investor's choice. An investor with money to invest over a certain period could buy either a swap, from a financial institution, or a Treasury. If he buys the swap, he takes on a risk of default by the swapper; if he buys the Treasury he takes on a risk of default by the US government. An investor will also have to pay a fee to the swapper for the interest rate risk, which will normally increase with the length of the swap. For the investor to be indifferent, the following equation must hold (ignoring uncertainty):

Swap rate - interest fee - swapper default risk = Treasury rate - treasury default risk.

So the swap spread at equilibrium is

interest fee + swapper default risk - treasury default risk.

High short-term swap spreads are easy to explain: high default risk by the swappers (banks and other financial institutions). Many financial institutions have large unrecognized but likely losses and default is a real risk. But why is the long-term swap so low? Simple: although the short-term risk of a treasury default is low; long term it's fairly high. High enough, actually to outweigh both the substantial risk of swapper default *and* the interest rate risk for a 30-year swap.

Is this crazy? No, not at all. Suppose the US government was in Argentina's financial situation. Long-term LIBOR swaps might not be very different, but government bonds would be paying over 25% and the swap spread would be huge - and negative.

So current swap spreads are making a prediction: that the US government will assume so much debt that over 30 years its default risk substantially exceeds that of a typical major financial institution. While not certain, this is a rational prediction based on recent government actions. Governments worldwide have declared the intent to cover financial institution losses or give them capital, with the US having the most generous giveaway, a purchase of 125 billion in 5% preferred stock (less than half market rate) in 9 major banks.

Given the magnitude of current losses - estimates are as high as 5 trillion - if the government continues with a giveaway strategy it could certainly assume staggering losses and debt. Add in expenses to deal with the depression the credit markets are predicting and the US government could easily raise its default risk above that of current financial institutions.

I think this risk shows the government must be more cautious and efficient in its bailouts. It can't just hand out money to any financial institution that needs it, without any effort to clear the books or make investors take appropriate losses. A government struggling with default imposes enormous costs on its society. Taxes necessarily become extortionate and essential services skeletonized.

The events of the past few years have shown that we need a capable and responsible government which responds to the needs of the general population. But the markets are warning us that if we allow the government to continue unrestricted giveaways to the rich and well-connected we will lose that.

Europe Starts Facing Reality

2008-10-13T12:42:00.000-07:00

Several European governments today pledged 1.3 trillion Euros to fix the banking problems affecting their banks. In combination with the recent blanket banking protection from Britain (not yet explicitly valued but quite large) they have now offered to cover more than 2 trillion US dollars in losses. This action means the European governments have, roughly, promised enough to fix the problem on their end. The US and Japan should be able to manage interventions on similar scales to match the worldwide problem. We now have several remaining problems to deal with:

1) What about the non-EU countries, and the countries that everyone knows can't cover their commitments? UBS and the Irish banks are still exposed, as well as many smaller banks in East Europe. We still have major busts to come unless the EU acts as a whole (and why would they bail the Swiss?)

2) Can the world provide the borrowings the governments now need? In a sense they can, but I stand by my prediction they will have to borrow long for this and so long bond rates will soar. In principle, I think this is a better way to get to the "rebuilding" state than a classic panic; but the losses and the need to rebuild remain real. To put things in context, the Swedish action, which involved the injection of only 4% of GDP came with a 6% drop in GDP. Just today's intervention is 250% as much as the Swedish. Much is in the form of deposit guarantees, which obviously won't all have to be paid out, but a recession far worse than the mid-70's recession is probably unavoidable.

3) What about the shadow banking system? They aren't covered. IMO it's good ethically for the hedge funds to go down while the classic banks are protected but we'll still see a lot of damage. One good thing about that is that hedgie collapse may provide enough financial losses for the governmental interventions to fix the rest without strangling the economy. Still though, those losses will hurt.

4) Will they clean up the banks and stop the bad lending? That's necessary to get a Swedish result (bad recession followed by recovery) rather than a Japanese result (recession without end). Initial indications from Fannie/Freddie and the UK is that the governments will continue to force lending on houses, which is a very bad sign.

All in all, this permits a controlled clean-up and will probably protect the world from uncontrolled side effect disasters like rumored halts to world shipping. However, we know will find out how competent and prompt the clean-up is. And the real losses must be faced, no matter what we do.

Why the Central Banks Can't Fix This Credit Crunch

2008-10-09T10:44:00.000-07:00

As mentioned in my last post, the credit market is like any other market. True prices are given by the intersection of supply and demand; the government can manipulate the price by augmenting supply or interfering with demand; but attempting to set the price beyond its ability to manipulate freezes the market (the Soviet breadline situation).

Central banks create credit by issuing money. This money goes into the economy and creates credit and debt through fractional reserve banking. The way most central banks do this is by buying government bonds, which creates a "reserve" of those government bonds they can lend out in a crisis. In the case of the US Federal Reserve, that was about 850 billion dollars.

So the reserve is 850 bb, how much is the shortfall? Well, at US bank leverage (12:1) the 850 bb in cash would become about 10 trillion in credit. At European leverage (1:30) it would become about 25 trillion. In shadow banking, we have no idea what the leverage is but it's almost certainly higher than the European. Let's estimate with the median and say there's 25 trillion in credit.

Suppose 10% of that 25 trillion is lost to the massive housing bubbles and assorted LBO, consumer credit, and retail bubbles. Remember we have to count more than the US - Eurodollar losses will count too. The 2.5 trillion loss is far greater than 900 billion. It's too much - the Fed is not going to be able to hold down real rates. Perhaps I've been too pessimistic, but even a 4% loss in the credit markets - wildly optimistic at this point - is too much for them.

Note the losses are so large the Fed may not even be able to hyperinflate out of this. If the Fed confiscated all the real value of currency by hyperinflation and issued another 850 bb for a replacement currency, it still might not have enough - a total of 1.7 trillion is still less than 2.5 trillion. And of course, a hyperinflation will generate additional real losses that would need to be covered.

The Paulson plan technique of depositing Treasuries isn't going to help. At this point the government must borrow what it lends, so no net credit. Inflation, the only out, just isn't enough. A Paulson-style plan can reallocate credit from one market to another, and perhaps that's a good idea; but overall that just raises rates in one market to lower them in another.

Why haven't we seen this before? Well, first of all, this is the worst worldwide credit loss we've seen since the Great Depression, and perhaps ever in percentage terms. Second, leverage has generally increased over the past 20 years due to deregulation, so the central bank credit reserve is a smaller fraction than before. If, for example, we were at traditional US ratios, the central bank reserves would be 8% of credit, and with a 25% total inflation the central bank could cover a 10% shortfall. If losses were only 6% it wouldn't have to inflate at all. But when the problem gets bigger and the central bank (relatively) smaller they can't handle it.

For 75 we have stood on a solid ground of (apparently) unlimited central bank powers. If we came to a dip, we could step down. But that ground is not as indestructible as we thought and the raging torrent has swept it away and put us in the water. To step down now, to try to hold credit rates below any possible market-clearing rates, is to drown. It is time to swim.

Raise the Fed Funds Rate: The Old World Order has Returned.

2008-10-06T19:33:00.000-07:00

Right now sellers of credit won't sell to purchasers at the current price (interest rate). Were this any other market, economists would immediately say that, given the current supply and demand, the price is too low and prices (interest rates) should be allowed to go up. That was the recommendation for Soviet Russia grocery stores with their infamous lines. Increased prices reduce demand, increase supply and bring the market back into balance.

For over 70 years, however, the action of governments to credit crunches has been to increase the supply of credit by liquidity interventions. This was due to the fear of exacerbating the economic slowdown that inevitably accompanies a credit crunch. It has been so universal, and practiced so long (there is scarcely an economist alive who can remember any other way), that "increase liquidity" is a reflex response of all economists to a credit crunch. Economists have essentially forgotten that when supply is short and demand is set there are two possible actions; raise the price or increase the supply, and that normally economists recommend raising the price over increasing the supply directly.

Central banks, and the governments that back them, are mighty entities with great capacities. But like all human institutions, they have their limits. We have all become so used to the idea that governments can fill the credit supply shortfall created by low interest rates that we have forgotten they have limits and cannot supply infinite credit.

The current credit crunch has been caused by a truly massive worldwide destruction of financial capital. I have often read claims that the US housing bust, identified as the cause, isn't big enough to justify this. But there is much more than just a bust in US housing. There have also been massive real estate bubbles in many European economies, including England, Ireland, Spain, Poland, the Baltic states, and an old bubble in the Netherlands kept propped up for years. There is a major property bubble in China. There is a LBO bubble in most of the Western world, as well as extensive retail and hoteling bubbles. There is a large auto bubble in the US and large credit bubbles in the US and many other countries. Many have not yet gone bust, but the wise know at least most of them will, with vast additional losses.

I believe the losses simply exceed the ability of the current government to generate and reallocate capital. If so, no possible liquidity intervention will be able to hold credit prices to their current very low level (many real interest rates in the US are actually negative). Therefore, while governments should continue the current aggressive provision of liquidity, they should now raise interest rates until markets can once again clear given that additional (effectively subsidized) liquidity.

I say this is a return to the Old World Order because when currencies were meaningfully backed by gold and silver, governments were stringently limited in their ability to lower rates and create capital by the threat of specie flight. In those days, when a panic hit, interest rates had to go up. That Old World Order is now back; even with the considerable latitude provided by fiat currencies governments have hit their limits. Our credit is less than we might wish; we must choose which of our many competing targets will get it; and the most efficient way is by market allocation, which requires increased interest rates.

We can tolerate high real interest rates. Ask Paul Volcker. But we cannot tolerate failing credit markets. Our policymakers must accept their limits, encourge efficient allocation of limited capital, and restore public confidence by showing they understand this the realities of the credit markets.

(Hat tips to many people I've been discussing credit with, especially to evilhenrypaulson and AngrySaver. Anybody else who thinks they deserve a hat tip or link - tag me.)

What we need for this crisis

2008-10-04T14:23:00.000-07:00

We need to examine banks in detail, with fair valuation procedures. After this bank should be immediately recapitalized with enough government capital to keep going, with the government taking an appropriate equity share. The whole procedure should be accomplished as fast as possible. Market mechanisms will not work; revaluation without recapitalization brings disaster; recapitalization without revaluation brings trillions in losses for the taxpayer. Here's why:

In general the markets are very good at allocating capital. But sometimes the markets can go very awry, and it's possible for a central planner to surpass them. As I've expressed in my Naked Capitalism upgraded comment, I think *Paulson* will be substantially worse than even a deranged market, but that might not be true for a wiser Treasury secretary.

Markets inherently cannot correct for a major malinvestment of financial capital. Financial capital represents in the real world actions and resources allocated for coordination - obviously a very important thing. If those resources or lost via malinvestment they must be replaced, which requires high relative interest rates for financial investments. However, the losses mean that current financial investments are overvalued, which requires low relative interest rates to correct. So the market can't correct the problem.

The solution, then, must be imposed by non-market cooperative activities, which on this scale means government. The correct action is to force immediate write-downs of the bad assets and then to force recapitalization by having the government provide the capital, implicitly backed by its taxing authority and ultimately its legitimacy and guns.

The write-down could be accomplished by a Defazio-type plan (bank examiners) or approximated by a devaluation. Recapitalization could be done by a bazillion plans although I think in the context of American politics preferred stock purchase (as suggested by Stiglitz, Krugman, and many others) is the way to go. Note that you have to take *both* actions - one alone leaves part of the problem unfixed.

To be fair, if you do one, then the market *can* do the other. So if you do a DeFazio plan, real interest rates can soar to draw in capital. If you do only Stiglitz/Krugman, they can collapse to erase the post-recapitalization value of financial investments. From the viewpoint of the taxpayer, Stiglitz/Krugman without DeFazio is thus a bum deal, although it will repair the economy.

I think the reason there's near-unanimity in the blogosphere on the idea of "write-down and recapitalize", across a very wide political spectrum is simply that, on basic principles, it's the right action.

Here comes the catastrophe

2008-10-03T08:47:00.000-07:00

The House is clearly ready to pass Paulson's horror of a bill. This bill will give effectively unlimited discretionary power over the Federal government's economic policy to a man who's been wrong on almost everything for two years in office, who got rich passing off toxic garbage at Goldman Sachs, who just asked for authority to steal $700 billion dollars, and whose plan will cause a Greater Depression by sucking all the money out of the working capital markets and using it to prop up the prices of toxic mortgage derivatives. Oh, and both Presidential candidates have gone all-out for the plan.

Could it really get any worse?

Bank of the Fed Starts Operations

2008-10-03T08:16:00.000-07:00

Amidst all the bad news, there is some good news. The Bank of the Fed is open for business and it's helping a lot. The Fed tripled its working capital duration window on Monday and commercial paper volume in those durations (>20 days) is now running only moderately below the year's averages and about twice the rate of the last two weeks in September. The market has shifted hard to asset-backed paper, which I assume reflects a Fed collateral requirement. In the longer durations asset-backed paper is at volumes far above typical averages while all other CP markets are virtually shut down.

http://www.federalreserve.gov/
re...volumestats.htm

The A2/P2 spread is down, to "only" 2.93. Still twice that of the 74-75 recession, but probably an overestimate since the market is obviously restricted in its ability to handle that kind of paper. So perhaps the market is only predicting the worst recession since 1937 now rather than a depression.

http://www.federalreserve.gov/re...ov/releases/cp/