Well said!

I've said it before and I'll say it again.
The only socialists in America are the bankers. Their motto: socialism for bankers; capitalism for everyone else.

Okay, this is embarassing because I'm a financial journalist in real life... via Atrios and from Kevin Drum, we find out that things might not be as unusual as I suggested.

I'd still like Dean's perspective, but I'm sorry if I oversold the story here.

thosethingswesay.blogspot.com

Can you answer my question, above? Enquiring minds want to know.

I'll return to the question of a bail-out at the end, but there's a couple of points in Dean's post I would first address...

1. The idea that "many [hedge funds] could be wiped out" is flat wrong. Most hedge funds trade equities and other vanilla products; a handful of niche players are ABS specialists, some of whom have been shorting the ABS market since the start of the year.

So whilst it is true that some hedge funds will go under as a result of the subprime blow-out, I would suggest we are talking about a relatively small handful of thoroughly "unhedged" funds.

What all hedge funds are probably mindful of in the current environment is banks tightening their lending criteria. But even if these criteria are tightened, only the most highly geared funds will be effected, and the net impact at worst will be a limited sell-off of generally liquid assets.

2. I don't buy the idea that funds want to dump their ABS assets onto unsuspecting rubes. The actual issue is that the funds do not want to sell their assets, because at current market values they would realize significant, potentially terminal, losses.

I think what the ABS investor community wants is to ride out the turbulence, and revalue their portfolios when markets stabilize (btw, I think this is wishful thinking). Those that sell their assets will be those that are forced to do so, and if anything you can foresee them being picked off by opportunistic buyers.

3. The 1997 East Asian crisis was an "irrational panic"? Partly, IMO... The currencies of several of the Asian Tigers were pegged at unsustainable levels. Granted, there was a contagious regional panic when the capital flight began, but I'd hesitate to say the panic was wholly irrational. There were good reasons at the time - aside from IMF's (in)actions - to join the stampede.

4. The surge in defaults has been caused in the first place by the increased cost of servicing a mortgage - caused by both the Fed's tightening, and the abrupt resets of the teaser introductory rates. I don't disagree that the depressed housing market correlates with the increase in defaults, I'm just not sure you have nailed the causality.

In terms of your "meltdown" analysis, I would characterize the current crisis as of the #2(a) variety. There is panic in the market, stemming from the impact of increasing default rates, but fundamentally we have a problem because investors do not know how to factor this in and put a fair value on their ABS assets. The panic is because, as my old man is wont to say, folks are farming in the dark.

Fact is, the assets being held by ABS investors are impaired, but not Enron-esque junk. An ABS note, rated as BBB at issue (and bought by investors at face value, hoping for a yield of +200) is worth more than your standard recovery rate of 20 cents in the dollar. What the, eh, smart hedge fund people can't figure is whether the fair value now is 80 or 95 cents in the dollar. Or 70. (and then there are various second order structured credit products which are just as improbably difficult to value.)

This is all pretty unforgiveable, but it is what it is. A bunch of paper that no-one wants to buy, and no-one has an incentive to value. (Cue BNP Paribas to offer the equivalent of the Gallic shrug to the markets when it announced last week that it simply could not value the assets in its funds.)

The big question for me is whether we have a perfect storm in the real estate and institutional credit markets - two markets which are highly interdependent. On the real estate side, the specter of continued Fed tightening (anyone here think newbie Bernanke wants the inflation dove tag?), resetting mortgage rates and bulging inventories all feed the same narrative. Further, mortgage originators depend on being able to shift assets off balance sheet. If the buyside continues to wallow in an ABS cesspool, the market capacity for new loan origination is critically diminished.

On the institutional side, ABS note-holders have one source of income - mortgage repayments - and their assets are ultimately secured against real estate. So it ain't a pretty picture.

Still, the question is what to do, and whether opening the Federal spigot will have the desired effect. I think it would be a solution if this were simply a liquidity crunch (and if Dubya's fundamentals were indeed sound as sound as he believes).

But I see what the Fed has done as the equivalent as giving pain-killers to a patient with a brain tumor. Someone has to go in and force asset managers to mark down their portfolios - because that is the tumor, that is the painful operation that has to be undertaken.

I'd like to believe that the market would take care of this sort of thing - something really as intrinsically basic as marking to market - but the market is unwilling to do so. Worse, the market appears to be hoping for divine intervention or some miraculous new type of antibody to make the tumor go away, and thereby avoid going through the painful surgery and prolonged recovery.

However, there's no point Bernanke and Paulson playing GP at this moment. They need the patient in the operating theater run by the SEC. The alternative - leaving an unwell patient to his own panaceas - will result in an even sicker patient several months down the line, and a heck of a lot of wasted aspirin.

I can't see a bail-out option here; no amount of fresh liquidity is going to clear up the mess. It seems the choice is pain now or more pain later... though I would add your rental proposal seems like a sane way to deal with the human tragedies that will accompany the impending - and, erm, tragic - hedge fund losses.

I enjoyed the article in the Times today attributing much of the hedge fund losses to herd mentality and following the same models. While not stated in the article, it would seem to follow that much of their past success would have the same cause, each purchase pushing up the value for the other purchases. So much for superstar wisdom. Glad they earned their special tax rates.

John

http://www.haberarts.com/

Seeing more whining from the banks, some of whom put together loan portfolios they thought they could sell and now can't, and from stock investors who assume that some bailout of the lenders in this case will either stop the market volatility or stop the bleeding.

On the hedge fund side, some people are losing their jobs and some funds are closing. But a lot of mortgage-backed buyers who haven't been hurt are bragging about their superior analytic abilities. It think there's the sense that even if a fund is highly levered that time's have changed so one big failure can't bring down the whole system any more, as Long Term Capital once did. That Amranth happened without a lot of collateral damage has made people confident.

thosethingswesay.blogspot.com

It's a fair brag, and it is superior analytics. These guys are usually the big broker/dealers who have lots of money to invest in risk management. Good risk management (i.e. credit risk) flag risk in the portfolio and allow the bank to balance their risk--i.e. buy safer instruments/portfolios. To be clear here, big broker/dealers are required by law to manage their risk and incented to do so since it frees up capital which they can use for short term investment: loans to other banks, or money markets when there is a scare in the market.

I've used this analogy many times on this site, but think of a bank as a casino. By law, Casino's have to keep a certain amount of cash on hand; the amount is determined by the statistical odds of the greatest jackpot payouts. Likewise banks must keep a certain amount of cash on hand which is determined by the statistical odds of their greatest exposure. Like a casino, any cash above and beyond that payout/exposure can be used by the bank/casino to loan to other banks, or invest in short term instruments. So both banks and casinos hire really smart mathameticains to number crunch their risk. The more sophisticated the math, the better accuracy of the risk. This usually frees up cash, which is an incentive to invest in risk management since it leaves more cash for investment.

Hedge Funds, for all their money, invest little in risk management. Remember, they are unregulated. Hedge Funds buy services from the big broker dealers (it's called Prime Brokerage services), but mostly the services include order processes and payment. They don't normally buy risk management.

So my prediction is that the credit crisis and bad subprime loans will be bourne mostly by the hedge funds. The bigger players (Citibank, Morgan Stanley, Goldman Saxe, Lehman Bros) are likely in a safe position oweing to their risk management practices.

/c

In the blogosphere every one is an expert, so no one is an expert.

Agree with both commenters' remarks except --- the eat-your-spinnach remedy.

Marking-to-market during a panic when there isn't a market to mark to smacks of a certain degree of self-righteousness. 

A steady drumbeat of failures over a period of time, even if it represents a small fraction of the whole, could be devastating. A mentor of mine once asked what the difference was between a correction and a collapse. The answer wasn't about the size of the correction, but the reaction of the market. Other than that, there was no difference.

If we're spooked we'll see every sign pointing south. The Fed may be pushing off the inevitable in order to calm Wall Street's neurosis. As you pointed out, August is a bad month since the bulls are out in the Hamptons leaving the bears at the helm.

What would I do if I were the Fed Chairman? Probably free up some cash, think about a rate reduction pending a few weeks of trend analysis, and then consult with the Whitehouse and Congress about new regulations governing risk in secondary markets. I wouldn’t want to use the SEC card until some new regs were in place. Washington also buys some time and headlines to give Wall Street some air. In a more deiscrete manner, I might also talk to other central bankers about regulations in the EU and Far East. This will act as a back door should Washington get all tied up in politics (premise being that it doesn’t matter where the regs originate from in order to get them in place).

At this point there are two problems: the real and perceived. Unfortunately, it probably takes a fix to perception in order to address the real.

/c

In the blogosphere every one is an expert, so no one is an expert.

Our VERSUS musical political parody website's Parody of the Week addresses the turmoil in "BEARISH" (to the Terry Kirkman song "Cherish"). "BEARISH" is on VERSUS at http://versusplus.com, and on YouTube at http://youtube.com/watch?v=37pal-PYTUQ.

We must be careful not to confuse the plight of distressed homeowners with the plight of the hedge fund crew. Dean Baker

--- or don't substitute anecdotes that tug at the heartstrings for rational judgment.

Recognizing spin in economics reporting has always been Baker's forte. I used to look forward to his weekly analysis which might have been called "How have the NYT and WaPo misrepresented the economic facts this week? Let me count the ways!"

Actually, the Fed better have some idea of what's causing an economic disruption before it responds. For example, it would be pretty incredible if it responds to an increase in the inflation rate that is attributable to a fall in the dollar in the same way that it responds to an increase in the rate of inflation that is attributable to a slower trend rate of productivity growth, then it would be making a very bad policy mistake.

In the same vein, if it rushes to lower interest rates to prevent the hedge fund boys from taking a beating, then we need some new people at the Fed. If the underlying economy is as strong as Bernanke and the rest claimed in their statement last week (it actually isn't), then there is no reason for them to be lowering rates.  

I certainly agree the Fed shouldn't be in the business of settling scores. That is the Congress's job.

The political score should be settled by taking away the special privileges of lenders who got to lend (and create money) like a bank without following the rules and regulations that real bankers must. Now that the loans are going bad, the money these amateur, wannabe bankers created is disappearing. So the Fed must create more money to replace it.

Stock traders and speculators should've never been allowed to dabble in mortgages to begin with.

Another possible answer (speculation?).

There's close to $2.7 trillion invested in U.S. based money market accounts. A great deal of that money is loaned to banks at various short-term maturities, some as short-term as overnight.

The banks have been using these funds to invest in various risky and very untransparent and now, illiquid investments -- so-called structured finance.

Did the money market mutual fund managers suddenly become cautious and hesitant to roll over these short term loans? Is that why the banks began running out of money Thursday evening?

I'm not sure how humane that would be. Besides, I'm not in favor of depriving people of a proper education. There is nothing like getting your butt caught in a crack to concentrate the mind and facilitate learning. I ought to know, been there more than once. The other problem is I and others still have to borrow in that market for construction loans and the like. If you interfere with the process then investors will send their money to some safer place and I can't rehab that next house. This will happen all through my working class neighborhood. Making all of of us, renters and property owners, poorer.

That does give the do gooding types something to do but most days we would rather do it ourselves.

Jack

If it is sufficiently contractionary, then the Fed needs to ease to protect the ECONOMY. The Fed's job is not to settle political scores or decide who needs to get punished. It has bigger fish to fry.

I wish I could believe that the Fed would measure "sufficiently contractionary" by a truly impartial standard.  I'm not sure that one exists.  I expect few Americans really understand the Federal Reserve System, even pretty well educated types.  The mythology of impartiality and an even playing field is too well embedded, and the idea that the Fed isolates pristine-pure economics from nasty-old-politics is too well believed.

So I'm afraid that "sufficiently contractionary" will be defined by the guys at the clubhouse or whatever its equivalent is.  Some of this is purely human, and maybe not a bad thing.  After all, we notice when our friends are hurting and think "hmm, something's wrong".  But the Fed needs to broaden its circle of friends, MHO.

As for punishment and score-settling.  Occasionally doing the right thing accomplishes these as by-products.  Lots of fish to fry.  A very big grill. <grin></grin>

aMike

The qualifier "sufficiently" alone indicates a subjective standard for Fed action. While any number of observable and objective analytic tools can be employed to measure the economy and the markets, decisions still remain subjective. Greenspan, the myth, and the man, was credited and criticized for his direction in the 1990's when Asian markets started to panic. Some say his lowering of key rates softened the blow, others argue that it set up a bubble. Which was it? Measure all you like, the determination still comes down to (1) a fiscal philosophy, (2) the formative experience of the chairman and the board, and (3) dumb luck since one or two elements of the economy does not the economy make.

The explosion of finanacial instruments and globalized markets make the current financial world unchartered territory. We hope that Mr. Bernake's above referenced 1-2-3 pay out--especially his number 3. Can the Fed Chairman play politics and settle scores? Ask Mr. Greenspan about his about face re tax cuts. Mr. Bernake is no less exposed or protected as Mr. Greenspan was. Fed Chairmen are not hatched. They come to their jobs from other roles, firms and schools--all of which are formative on their views, both political and monetary.

We're not dealing with a cartesian god of pure rationality. More likely the greek model of irrational gods that mirror men.

/c

In the blogosphere every one is an expert, so no one is an expert.

Sentinel, a money market company, has been unable to rollover their commericial paper and now have frozen redemptions from their fund.

Daniel A. Greenbaum

As I've earlier said, before we can know whether there is, in fact, a liquidity crisis, we've got to understand what caused the big banks to run around like chickens with their heads cut off searching high and low for cash last Thursday evening. And here's another explanation.

It may have been nothing more than the effects of the prior weeks' market volatility upon the answer given by the "value at risk" mathematical models the banks use to determine the cash "sound management doctrine" requires them to hold. In other words the "liquidity crisis" may have been nothing more than an artifact of the equations all those overpaid Wall Street M.I.T. quants have put in place.

Maybe, instead of dumping cash on the banks Bernanke should have said, "Change your models, morons!"

The banks were not "desperate" for cash.

Right! That's why they were willing to pay 75 basis points over the Fed funds rate?  They were just being generous?

Right you are, Ellen, they ARE desperate for cash and their friends aren't loaning it. Enter the Fed (actually the EU central bank stepped in first). They must keep enough cash on hand to cover short term exposure; it's the law. So cash now comes at a premium,as you noted.

Not generosity; neccesity.
/c

In the blogosphere every one is an expert, so no one is an expert.

I work in this industry so I have firsthand knowledge of what I am talking about. There is a lot of misformation and half-baked speculation floating around this thread.
Every day the Wall Street bank for which I work pledges its mortgage portfolio as collateral. Overnight Deutsche Bank (one of many banks to offer this service) goes through the proferred collateral with a fine tooth comb to verify that A) We own it B) The balance owed on the loans is what we say it is and C) the mortgages are not entailed by factors that make them unpledgeable (foreclosure, looming sale, incoming payoff etc.). Anything that that they disapprove of we have to make good on (or prove that they are wrong)
What I saw last week was a good old-fashioned panic: people behaving irrationally based on rumors, speculation and plain old paranoia. The Fed stepped in and threw cold water on the panic, which is one of the main reasons we have the Fed (see: Panic of 1907). There's less here than meets the eye, just a human version of a cattle stampede which was headed off by quick action from the Fed.

. . . a good old-fashioned panic: people behaving irrationally based on rumors, speculation and plain old paranoia.

And who were those people? Why, they were the Wall Street bankers themselves, my dear -- exactly the sort of "people" who would be in a position to know why they should be panicking.

And since those bankers are, of their own accord, unlikely to tell us, your mission, should you choose to accept it, is to determine why they were panicking.

Re: Why, they were the Wall Street bankers themselves, my dear -- exactly the sort of "people" who would be in a position to know why they should be panicking.

You are attributing superior intelligence or at least superior rationality to these folks. However, irrationality (AKA: Folly) is a generic human trait, and anyone is liable to it. The assumption that Those In Charge know what they are doing has lead many a people down the road to ruin. Barbara Tuchman even wrote a whole book about the phenomenon, The March of Folly (she died before the latest manifestation, the Bush administration foreign policy). Don't assume that Wall Street knows something you don't. It may not know as much, or, indeeed, may know too much of the wrong thing and thus be unable to see the forest for the trees. My take is that a whole lot of self-importantly silly people suddenly rediscovered something anyone with common sense already knows: there's no sure thing in life. And having rediscovered Risk when they thought they were living with God's own sworn word that they should know only Profit, they are acting like a mix of Chicken Littles and spoiled brats just finally told No.

I may do a separate reader-blog post, but here is a neat piece by Martin Wolf of the Financial Times of what we are witnessing.

I think it bears out two key points that we've been debating here:

1. The role of the Fed (and other central banks) is not to save "specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security." ["freely, at a penal rate" appears to be an oxymoron, but I think the meaning is that the Fed should be releasing funds at a premium, but without limit.]

This seems to clearly support Ellen's thinking around the recent OMOs.

2. The fundamental diagnosis offered is as follows: "Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging."

I'd agree with this, particularly the impliciation that loss recognition is critical to enable us to move on from the current crisis.

The whole article is worth a read - both for some general commentary on market panics, and the challenges central banks now face.

If the funds don't want to sell their bad debts to unsuspecting rubes, then I will find some bad debts to sell to them. I never thought that people on Wall Street were all that brilliant, but they also can't be entirely clueless. Surely some of them realize that the value of their MBS are not coming back. They are going to take a big hit and the hit will be bigger the longer they sit on them. 

If they still haven't paid attention to the underlying value of their assets that back up their assets (the houses), then it would be truly icnredible.  

Aug. 16 (Bloomberg) -- William Poole, president of the St. Louis Federal Reserve Bank, said the subprime mortgage rout doesn't threaten U.S. economic growth, and only a "calamity'' would justify an interest-rate cut now.

Guys with beards don't prevaricate, right? Right.

It is a legendary belief of technical analysts that the stock market is usually up in a year preceding a presidential election.