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...Paulson is insisting that Congress release the remaining $350 billion of the now-misnamed Troubled Assets Repurchase Program so he can hand out more cash to his industry buddies. Congress will be damned if it gives Treasury any more money, given that the funds have so clearly been dispensed with no controls to favored parties. But since they don't dare say the taxpayer has been ripped off (that would call their judgment into question for acquiescing to the hastily drafted and aggressively sold TARP), they will pound on Treasury as many ways as they can.
- Yves Smith said...
- Anon of 2:27 PM,
The problem is that Paulson bullied (and I do mean bullied) Congress into passing this bill. He took the leadership and told them if the bill wasn't passed, there would be financial armageddon, which he apparently described in some detail. That was part of the reason for the revolt by the rank and file. They weren't included in the scare mongering lecture.
Now remember, the bill was considerably renegotiated. There was the 3 page original Treasury version, a version from Congress (not Frank, Dodd?) a 110 page version after that, and the final porky 400+ page monstrosity which substantively wasn't hugely different from the original once you took out the pork.
The reason I have trouble defending Paulson is that while the bill was being negotiated, I am told by people with direct knowledge of the proceedings that some of the key Congressional negotiators raised several times the issue of capital injections into banks. I am also told that Paulson did indeed have his change of heart before the bill was finalized.
If true, then why couldn't he have allowed language to be included that made that option more explicit and if he needed to save face, say something like, "Look, that isn't what we are contemplating, but other experts are saying we should look at that too. We'll put some non-binding language in and take it under advisement." Then he could come back and say. "You guys were right, this is a good idea."
This at best is childish and immature. The only reason I can think of for not allowing language to be put in that reflected his changed intent was that some constraints might be put around it, constraints that would help the taxpayer and keep this from being a handout to his buddies. There is no defensible reason for him not to have allowed a few phrases to broaden the possible uses to be slipped in WHILE the bill was being negotiated, particularly it was responsive to issues Congressmen were raising!It is remarkable (and admittedly late, but late is better than never) that Congress is developing a spine and pushing back at Hank Paulson's unprecedented land grab. Even better they got mad at something that made your humble blogger nuts. Trust me, I am highly confident that no Congressional aide picked up on the issue via this blog, but you did have to be paying attention to catch Paulson's dishonesty, and to their credit, they took notice.
Of course, this is all part of a larger Kabuki drama. Paulson is insisting that Congress release the remaining $350 billion of the now-misnamed Troubled Assets Repurchase Program so he can hand out more cash to his industry buddies. Congress will be damned if it gives Treasury any more money, given that the funds have so clearly been dispensed with no controls to favored parties. But since they don't dare say the taxpayer has been ripped off (that would call their judgment into question for acquiescing to the hastily drafted and aggressively sold TARP), they will pound on Treasury as many ways as they can.
But this is a central issue. Paulson was brazen enough to say that he had misrepresented his intentions while the bill was still being renegotiated. From our earlier post, "Paulson Now Admits Mendacity." And that means Congress can say they were sold a bill of goods:
From the text of Paulson's remarks today (boldface ours):
During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets—our initial focus—would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.
Either way you cut this, it's a lie. Either Paulson let his intentions be misrepresented via his silence, or he is now falsely claiming to have changed direction earlier than he did. Nouriel Roubini has claimed that Treasury was resisting the idea of of inserting language that would allow for capital injections into banks but that some members of Congress thought it was necessary, and put statements into the Congressional record via floor debates to allow for that interpretation. Roubini further contends that Paulson changed his mind only as a result of the adverse market reaction after the bill was signed.
But if Roubini is wrong and Paulson's statement is accurate, it is still completely in keeping with the conduct of an Administration that told the public that there were weapons of mass destruction in Iraq. The bill was drafted to be extraordinarily vague and sweeping, and yet did not clearly give Paulson the authority he now says he realized back then that he needed while it was still being renegotiated.
Now to the fulminating from the legislature, via the Financial Times:
A senior US Treasury official came under attack on Friday as critics of the $700bn bail-out from the left and the right questioned whether the Bush administration had deceived members of Congress over how the funds would be used.
Congressional leaders, including Chuck Schumer, a Democratic senator, and Spencer Bachus, a Republican congressman, applauded a Treasury move this week to scrap plans to purchase troubled securities in favour of direct capital injections into financial institutions.
But at a hearing on Friday, Dennis Kucinich, a liberal Democrat, and Darrell Issa, a conservative Republican, lashed out at Neel Kashkari, the Treasury official in charge of the bail-out, for ignoring “congressional intent”.
The criticism pointed to deeper unease about the Treasury’s handling of the rescue among rank-and-file legislators, which could make it more difficult for the administration to secure approval from Congress for the final $350bn of funds that it is expected to seek.
“I want to know whether Congress was lied to or whether there was a team all along that had an alternate idea of how the money was spent,” Mr Issa said, before demanding to know the “time and date” Hank Paulson, Treasury secretary, had decided to abandon his initial plan.
Mr Kashkari said the legislation authorising the $700bn bail-out had been designed to give the Treasury broad flexibility to adapt its strategies. At the same time, he said, as the bail-out was being negotiated in Congress, “credit markets were deteriorating much more quickly than we had expected”.
He also defended the Treasury against claims that it was not doing enough to immediately help homeowners at risk of foreclosure, arguing that “every American” would benefit from stability in the financial system....
Some lawmakers have expressed concern that, because Treasury will not be buying mortgage securities as planned, it will have less power to modify home loans on a large scale.
I welcome reader comment, but I assume the reason for beating up on Kashkari was 1) he was testifying and 2) it may have been hoped that someone not well seasoned in the art of speaking before Congress would be more likely to slip and make an embarrassing admission. But Goldman employees are well practiced in the art of minimal disclosure.
November 13, 2008 "Counterpunch"
Purge your mind for a moment about everything you've heard and read in the last decade about investing on Wall Street and think about the following business model:
You take your hard earned retirement savings to a Wall Street firm and they tell you that as long as you "stay invested for the long haul" you can expect double digit annual returns. You never really know what your money is invested in because it’s pooled with other investors and comes with incomprehensible but legal looking prospectuses. The heads of these Wall Street firms have been taking massive payouts for themselves, ranging from $160 million to $1 billion per CEO over a number of years. As long as new money keeps flooding in from newfangled accounts called 401(k)s, Roth IRAs, 529 plans for education savings, and hedge funds (each carrying ever greater restrictions for withdrawing your money and ever greater opacity) everything appears fine on the surface. And then, suddenly, you learn that many of these Wall Street firms don't have any assets that anybody wants to buy. Because these firms are both managing your money as well as having their own shares constitute a large percentage of your pooled investments, your funds begin to plummet as confidence drains from the scheme.
Now consider how Wikipedia describes a Ponzi scheme:
“A Ponzi scheme is a fraudulent investment operation that involves promising or paying abnormally high returns (‘profits’) to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi...One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – quite commonly reinvest (keep) their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus those running the scheme do not actually have to pay out very much (net) – they simply have to send statements to investors that show how much the investors have earned by keeping the money in what looks like a great place to get a high return. They also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time...The catch is that at some point one of three things will happen:
(1) the promoters will vanish, taking all the investment money (less payouts) with them;
(2) the scheme will collapse of its own weight, as investment slows and the promoters start having problems paying out the promised returns (and when they start having problems, the word spreads and more people start asking for their money, similar to a bank run);
(3) the scheme is exposed, because when legal authorities begin examining accounting records of the so-called enterprise they find that many of the 'assets' that should exist do not."
Looking at outcomes 1, 2, and 3 above, here’s where we are today. The promoters have clearly not vanished as in outcome 1. In fact, they are behaving as if they know they have nothing to fear. As over $2 trillion of taxpayer money is rapidly infused through Federal Reserve loans and over $125 Billion in U.S. Treasury equity purchases to keep these firms from collapsing, the promoters are standing at the elbow of the President-Elect in press conferences (Citigroup promoter, Robert Rubin); they are served up as business gurus on the business channel CNBC (former AIG CEO and promoter, Maurice “Hank” Greenberg); they are put in charge of nationalized zombie firms like Fannie Mae (Herbert Allison, former President of Merrill Lynch); they are paying $26 million and $42 million, respectively, for new digs at 15 Central Park West in Manhattan, where their chauffeurs have their own waiting room (Lloyd Blankfein, CEO of Goldman Sachs; Sanford “Sandy” Weill, former CEO of Citigroup, who put his penthouse in the name of his wife’s trust, perhaps smelling a few pesky questions ahead over the $1 billion he sucked out of Citigroup before the Fed had to implant a feeding tube).
We are definitely seeing all the signs of outcome 2: the scheme is collapsing under its own weight; there are panic runs around the globe wherever Wall Street has left its footprint.
But outcome 3 is the most fascinating area of departure from the classic Ponzi scheme. Legal authorities have, indeed, examined the books of these firms, except for one area we’ll discuss later. They found worthless assets along with debts hidden off the balance sheet instead of real depositor funds. Instead of arresting the perpetrators and shutting down the schemes, Federal authorities have developed their own new schemes and pumped over $2 trillion of taxpayer money into propping up the firms while leaving the schemers in place. Equally astonishing, Congress has not held any meaningful investigations. This has left many Wall Street veterans wondering if the problem isn’t that the firms are “too big to fail” but rather “too Ponzi-like to prosecute.” Imagine the worldwide reaction to learning that all the claptrap coming from U.S. think-tanks and ivy-league academics over the last decade about efficient market theory and deregulation and trickle down was merely a ruse for a Ponzi scheme now being propped up by a U.S. Treasury Department bailout and loans from our central bank, the Federal Reserve.
Fortunately for American taxpayers, Bloomberg News has some inquiring minds, even if our Congress and prosecutors don’t. On May 20, 2008, Bloomberg News reporter, Mark Pittman, filed a Freedom of Information Act request (FOIA) with the Federal Reserve asking for detailed information relevant to whom the central bank was giving these massive loans and precisely what securities these firms were posting as collateral. Bloomberg also wanted details on “contracts with outside entities that show the employees or entities being used to price the Relevant Securities and to conduct the process of lending.” Heretofore, our opaque central bank had been mum on all points.
By law, the Federal Reserve had until June 18, 2008 to answer the FOIA request. Here’s what happened instead, according to the Bloomberg lawsuit: On June 19, 2008, the Fed invoked its right to extend the response time to July 3, 2008. On July 8, 2008, the Fed called Bloomberg News to say it was processing the request. The Fed rang up Bloomberg again on August 15, 2008, wherein Alison Thro, Senior Counsel and another employee, Pam Wilson, informed the business wire service that their request was going to be denied by the end of September 2008. No further response of any kind was received, including the denial. On November 7, 2008, Bloomberg News slapped a federal lawsuit on the Board of Governors of the Federal Reserve, asserting the following:
“The government documents that Bloomberg seeks are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression. The effect of that crisis on the American public has been and will continue to be devastating. Hundreds of corporations are announcing layoffs in response to the crisis, and the economy was the top issue for many Americans in the recent elections. In response to the crisis, the Fed has vastly expanded its lending programs to private financial institutions. To obtain access to this public money and to safeguard the taxpayers’ interests, borrowers are required to post collateral. Despite the manifest public interest in such matters, however, none of the programs themselves make reference to any public disclosure of the posted collateral or of the Fed’s methods in valuing it. Thus, while the taxpayers are the ultimate counterparty for the collateral, they have not been given any information regarding the kind of collateral received, how it was valued, or by whom.”
As evidence that Bloomberg News is not engaging in hyperbole when it uses the word “cataclysmic” in a Federal court filing, consider the following price movements of some of these giant financial institutions. (All current prices are intraday on November 12, 2008):
American International Group (AIG): Currently $2.16; in May 2007, $72.00
Bear Stearns: Absorbed into JPMorganChase to avoid bankruptcy filing; share price in April 2007, $159
Fannie Mae: Currently 65 cents; in June 2007 $69.00
Freddie Mac: Currently 79 cents; in May 2007 $67.00
Lehman Brothers: Currently 6 cents; in February 2007, $85.00
What all of the companies in this article have in common is that they were writing secret contracts called Credit Default Swaps (CDS) on each other and/or between each other. These are not the credit default swaps recently disclosed by the Depository Trust and Clearing Corporation (DTCC). These are the contracts that still live in darkness and are at the root of why the Wall Street banks won’t lend to each other and why their share prices are melting faster than a snow cone in July.
A Credit Default Swap can be used by a bank to hedge against default on loans it has made by buying a type of insurance from another party. The buyer pays a premium upfront and annually and the seller pays the face amount of the insurance in the event of default. In the last few years, however, the contracts have been increasingly used to speculate on defaults when the buyer of the CDS has no exposure to the firm or underlying debt instruments. The CDS contracts outstanding now total somewhere between $34 Trillion and $54 Trillion, depending on whose data you want to use, and it remains an unregulated market of darkness. It is also quite likely that none of the firms that agreed to pay the hundreds of billions in insurance, such as AIG, have the money to do so. It is also quite likely that were these hedges shown to be uncollectible hedges, massive amounts of new capital would be needed by the big Wall Street firms and some would be deemed insolvent.
Until Congress holds serious investigations and hearings, the U.S. taxpayer may be funding little more than Ponzi schemes while companies that provide real products and services, legitimate jobs and contributions to the economy are left to fail.
Pam Martens worked on Wall Street for 21 years; she has no security position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire. She can be reached at firstname.lastname@example.org
Dean Baker goes full bore after two deserving targets, Bob Rubin and Larry Summers, at TPM Cafe. Key excerpts:Along with former Federal Reserve Board chairman Alan Greenspan, Rubin and Summers compose the high priesthood of the bubble economy. Their policy of one-sided financial deregulation is responsible for the current economic catastrophe.
It is important to separate Clinton-era mythology from the real economic record. In the mythology, Clinton's decision to raise taxes and cut spending led to an investment boom. This boom led to a surge in productivity growth. Soaring productivity growth led to the low unemployment of the late 1990s and wage gains for workers at all points along the wage distribution.
At the end of the administration, there was a huge surplus, and we set target dates for paying off the national debt. The moral of the myth is that all good things came from deficit reduction.
The reality was quite different. There was nothing resembling an investment boom until the dot-com bubble at the end of the decade funnelled vast sums of capital into crazy internet schemes. There was a surge in productivity growth beginning in 1995, but this preceded any substantial upturn in investment. Clinton had the good fortune to be sitting in the White House at the point where the economy finally enjoyed the long-predicted dividend from the information technology revolution.
Rather than investment driving growth during the Clinton boom, the main source of demand growth was consumption...
The other key part of the story is the high dollar policy initiated by Rubin when he took over as Treasury secretary...
A lowered dollar value will reduce the trade deficit, by making US exports cheaper to foreigners and imports more expensive for people living in the US. The falling dollar and lower trade deficit is supposed to be one of the main dividends of deficit reduction. In fact, the lower dollar and lower trade deficit were often touted by economists as the primary benefit of deficit reduction until they decided to change their story to fit the Clinton mythology.
The high dollar of the late 1990s reversed this logic. The dollar was pushed upward by a combination of Treasury cheerleading, worldwide financial instability beginning with the East Asian financial crisis and the irrational exuberance propelling the stock bubble, which also infected foreign investors.
In the short-run, the over-valued dollar led to cheap imports and lower inflation. It incidentally all also led to the loss of millions of manufacturing jobs, putting downward pressure on the wages of non-college educated workers.
Like the stock bubble, the high dollar is also unsustainable as a long-run policy. It led to a large and growing trade deficit. This deficit eventually forced a decline in the value of the dollar, although the process has been temporarily reversed by the current financial crisis.
Rather than handing George Bush a booming economy, Clinton handed over an economy that was propelled by an unsustainable stock bubble and distorted by a hugely over-valued dollar...
While the Bush administration must take responsibility for the current crisis (they have been in power the last eight years), the stage was set during the Clinton years. The Clinton team set the economy on the path of one-sided financial deregulation and bubble driven growth that brought us where we are today. (The deregulation was one-sided, because they did not take away the "too big to fail" security blanket of the Wall Street big boys.)
For this reason, it was very discouraging to see top Clinton administration officials standing centre stage at Obama's meeting on the economy. This is not change, and certainly not policies that we can believe in.
11/12/2008 | Calculated RiskProfessor Duy writes a regular column at Economist's View called Fed Watch - it is definitely worth reading (as is Economist's View).
From Fed Watch: Misguided PoliciesFrom the wires:Dr. Duy offers some suggestions for policy makers:15:30 *PAULSON SAYS MARKET TURMOIL WON'T ABATE UNTIL HOUSING REBOUNDSSuch comments always leave me with a sick feeling in my stomach – if policymakers are waiting for the housing market to rebound, they had better be prepared for a long wait. ... I think the biggest potential for policy error lies in maintaining the delusion that preventing housing, and by extension, consumer spending, from adjusting is central to fixing the nation’s economy. Policy would be best focused on supporting the inevitable transition away from debt-supported consumer dependent growth dynamic.
Housing prices are falling because fundamentally the price of housing became unaffordable.
emphasis addedPolicymakers need to come clean with the American public: Future patterns of growth will simply be less dependent on consumer spending. We are entering a period of structural adjustment, and it will be painful. We spent decades pretending that the relentless focus on producing nontradable goods and relying on a ballooning current account deficit to hide our lack of productive capacity was an appropriate policy approach. But ultimately, those policies have failed us, with stagnant income growth for median income families and the deepest recession since the 1980’s (or even worse).Investment in infrastructure makes sense, especially since construction (and construction employment) is one of the hardest hit sectors of the economy. And with the commercial real estate slump picking up steam (and more construction job losses to come), what better area to invest than in the infrastructure of the U.S.A.?
This admission, however, in no way, shape, or form means policy options are limited. The admission simply defines your policy. In the short term, policy can cushion the transition by expanding the social safety net. In the medium term, if consumption is falling, and private investment is unable to compensate, then the federal authority should fill the gap. There is no shortage of sectors of the economy that offer opportunities for investment. In so many ways, we are running on the fumes of the infrastructure investment made by the last generation. Roads, bridges, channels, etc. – you name it, there is an opportunity. Or human capital, via education?... Reasonable policymakers free from ideological constraints can develop a host of potential projects without relying on bridges to nowhere.
took up the theme, admittedly with less choler:There does indeed seem to have been a visible change in Treasury policy since the election. Until that point, it cared a little about optics. Now, it's giving monster bailouts to the likes of AIG and American Express; it's dragging its feet on homeowner relief; and in general Hank Paulson's Wall Street buddies seem to be getting much better access than anybody in Detroit. And no one's even trying very hard to defend these actions in public: they know they'll be out of a job in January anyway, so they're just doing what they want to do and what they feel is right, without caring much whether anybody else agrees with themEd Harrison provided an alert on another bit of Treasury dishonesty, although the admission was coded, so you'd have to be paying attention to catch it. From the text of Paulson's remarks today (boldface ours):During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets—our initial focus—would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.Either way you cut this, it's a lie. Either Paulson let his intentions be misrepresented via his silence, or he is now falsely claiming to have changed direction earlier than he did. Nouriel Roubini has claimed that Treasury was resisting the idea of of inserting language that would allow for capital injections into banks but that some members of Congress thought it was necessary, and put statements into the Congressional record via floor debates to allow for that interpretation. Roubini further contends that Paulson changed his mind only as a result of the adverse market reaction after the bill was signed.
But if Roubini is wrong and Paulson's statement is accurate, it is still completely in keeping with the conduct of an Administration that told the public that there were weapons of mass destruction in Iraq. The bill was drafted to be extraordinarily vague and sweeping, and yet did not clearly give Paulson the authority he now says he realized back then that he needed while it was still being renegotiated.
As I said in a post titled, "Paulson's Cosmetic, Cynical Financial Regulation 'Reform'":
Why is it that the media feels compelled to take pronouncements from government officials more or less at face value? By now, they ought to know that if someone from the Bush Administration is moving his lips, odds are it's a lie.
Nothing has changed, neither the dishonest of the Bush crowd nor the reluctance of the media to call them on it.
- Max said...
- Cut the guy some slack, he is working overtime, and on sundays. I do feel sorry for him, considering the fact that he does _not have to_ do anything, legally that is.
And comparing the essentially powerless against whats' coming Paulson with the bloody neocon junta, that could do literally _what they wanted_ at the height of their misrule of deception, is too far, Yves. Not even the same sport.
- Anonymous< said...
- Assuming what he said was true and he's not an idiot, if you want to get totally down the rabbit hole on this ....
Assume what we wanted to do all along was give money to the banks, no strings. Perhaps the best way to do it is to first suggest overpaying for assets and then get "pressured" into giving money to banks instead. Either way he wins. If they go with (A), shovel in the money that way. If they go with (B), shovel in the money that way. If he had gone with direct capital injections to start and he got pushbank (and he was guaranteed to get pushback of some kind), he would have had no plan B. And the plan A before the plan A was to ask for total unfettered authority with the original 3 page request.
So, the direct injections with no strings would have seemed like a ridiculous giveaway if he started with that position, so he started with something even more ridiculous (overpaying for assets) which was still ridiculous, so he started with something even MORE ridiculous like a blank check. Eventually, capital injections seemed like bowing to public pressure and the no strings part was a "reasonable compromise".
Perhaps that's giving them too much credit.
The monetary blitz was welcomed in Brussels, where EU leaders were meeting yet again, just days after agreeing to the most comprehensive bank bail-out in history. "We are not at the end of the crisis, we are still living in dangerous times," said Jean-Claude Juncker, Luxembourg premier and Eurogroup chair.
He issued a stark reminder that life is going be very different for the banking elite as governments move to restore the lost discipline of the Bretton Woods financial order and attempt to "civilise" capitalism, the code word for clamping down on the City – dubbed "the Casino" in Europe.
"Let everyone remember after this crisis, who solved it. Politicians did, not bankers," he said. Mr Juncker added that this episode would have a profound effect on the euro debate in Britain.
"The British prime minister had to beg to be let into the room. I'm sure that when the storm is over, the British will think about whether they shouldn't become an equal in all decision-making bodies."
German Finance Minister Peer Steinbrück echoed the warning. "When a fire's burning in the global financial markets, it has to be put out, even if it's a case of arson. But then the arsonists have to be held responsible, and spreading flames must be outlawed.''
In a key change, the ECB is providing unlimited liquidity for longer-term loans to force down the market rates used to price mortgages in the Eurozone. The aim is to help banks pass along last week's half-point cut in interest rates before the region's economy starts to seize up altogether.
The standard for collateral has been slashed from A- to the once unthinkable level of BBB-, allowing distressed banks to offload securities that cannot be sold on the open market. It greatly widens the range of instruments and – crucially – lets banks use their dollar assets for the first time.
The radical shift in policy suggests that the ECB is now deeply alarmed by the crunch facing European banks as a violent unwinding of debt leverage across the world forces them to repay huge sums in dollars.
Goldman Sachs estimates that non-US banks have liabilities of $12 trillion (£6.8 trillion) on dollar balance sheets. The European, British, and Swiss banks make up the lion's share, and they have used leverage far more aggressively than US banks. Analysts say the European banks will need to raise $400bn in fresh capital – no easy feat at a time when burned investors are keeping their distance.
Published: October 24, 2008
It started acting up on Wednesday, spinning wildly as executives from the nation’s leading credit-rating agencies testified before Congress about their nonroles in the credit crisis. Leaders from Moody’s, Standard & Poor’s and Fitch all said that their firms’ inability to see problems in toxic mortgages was an honest mistake. The woefully inaccurate ratings that have cost investors billions were not, mind you, a result of issuers paying ratings agencies handsomely for their rosy opinions.
Still, there were those pesky e-mail messages cited by the House Committee on Oversight and Government Reform that showed two analysts at S.& P. speaking frankly about a deal they were being asked to examine.
“Btw — that deal is ridiculous,” one wrote. “We should not be rating it.”
“We rate every deal,” came the response. “It could be structured by cows and we would rate it.”
Asked to explain the cow reference, Deven Sharma, S.& P.’s president, told the committee: “The unfortunate and inappropriate language used in these e-mails does not reflect the core culture of the organization I am committed to leading.”
Maybe so, but that was a lot for my malarkey meter to absorb.
Then, on Thursday, my meter sputtered as Alan Greenspan, former “Maestro” of the Federal Reserve, testified before the same Congressional questioners. He defended years of regulatory inaction in the face of predatory lending and said he was “in a state of shocked disbelief” that financial institutions did not rein themselves in when there were billions to be made by relaxing their lending practices and trafficking in exotic derivatives.
Mr. Greenspan was shocked, shocked to find that there was gambling going on in the casino.
MY poor, overtaxed, smoke-and-mirrors meter gave out altogether when Christopher Cox, chairman of the Securities and Exchange Commission, took his turn on the committee’s hot seat. His agency had allowed Wall Street firms to load up on leverage without increasing its oversight of them. But he said on Thursday that the credit crisis highlights “the need for a strong S.E.C., which is unique in its arm’s-length independence from the institutions and persons it regulates.”
He said that with a straight face, too.
There was more. Mr. Cox went on to suggest that his hapless agency should begin regulating credit-default swaps.
This, recall, is that $55 trillion market at the heart of almost every big corporate failure and near-collapse of recent months. Trading in these swaps, which offer insurance against debt defaults, exploded in recent years. As the market for the swaps grew, so did the risks — and the interconnectedness — among the firms that traded them.
During the years when these risks were ramping up unregulated, Mr. Cox and his crew were silent on the swaps beat.
How exasperating. After all the time and taxpayer money spent trying to resolve the financial crisis, we’re still in the middle of the maelstrom. The S.& P. 500-stock index was down 40.3 percent for the year at Friday’s close.
Yes, the problems are global, and made more complex by Wall Street’s financial engineers. And a titanic deleveraging process like the one we are in, where both consumers and companies must cut their debt loads, is never fun or over fast.
Still, as the stock market continues to grind lower, something more may be at work. And that something centers on trust and credibility, which have been lacking in corporate and government leadership in recent years.
Like the boy who cried wolf, corporate and regulatory officials have issued a lot of hogwash over the years. Until recently, investors were willing to believe it. Now they may not be so easily gulled.Companies, even those in cyclical businesses, routinely told investors that the reason they so regularly beat their earnings forecasts was honest hard work — and not cookie-jar accounting. They were believed.
Politicians proclaiming that the economy was strong and that the crisis would not spread kept our trust.
Brokerage firms insisting that auction-rate securities were as good as cash won over investors — and, as we all know now, that market froze up.
Wall Street dealmakers were fawned over like all-knowing superstars, their comings and goings celebrated. No one doubted them.
Banks engaging in anything-goes lending practices assured shareholders that safety and soundness was their mantra. They, too, got a pass.
Directors who didn’t begin to understand the operational complexities of the companies they were charged with overseeing told stockholders that they were vigilant fiduciaries. Investors suspended their disbelief.
And regulators, asserting that they were policing the markets, convinced investors that there was a level playing field.
Is it any surprise that virulent mistrust seems to own the markets now?
Janet Tavakoli, a finance industry consultant who is president of Tavakoli Structured Finance, said the stock market’s gyrations are a result of a severe lack of confidence in the very officials who are charged with cleaning up the nation’s mess.
“It is not enough to throw money at a problem; you also have to use honesty and common sense,” Ms. Tavakoli said. “In fact, if you leave out the last two, you are wasting taxpayers’ money.”
What Ms. Tavakoli means by common sense is a plan that will force institutions to get a fix on what their holdings are actually worth.
“If you are going to hand out capital, you have to first revalue the assets or take over so that you can force a mark to market,” she said. “Force restructurings, mark down the assets to defensible levels and let the market clear.”
She also suggests that financial regulators impose a form of martial law, allowing them to rewrite derivatives contracts that bind counterparties to terms they may not even comprehend.
“If I were queen of the world, I would wade in there with a small army of people and just start straightening out these books,” she said. “Start stripping them down and simplifying contracts so people can start to understand what they own. It would be unprecedented, but so is everything else we are doing.”
THAT move, which would begin the much-needed healing process for investors, would be unprecedented in another way. It might get the people who run our companies and our regulatory agencies into the business of telling the truth.
Naïve, I know. But something to wish for — I’d like to give my hypocrisy meter a breather.
By Anthony Faiola, Ellen Nakashima and Jill Drew
Washington Post Staff Writers
Wednesday, October 15, 2008; A01
A decade ago, long before the financial calamity now sweeping the world, the federal government's economic brain trust heard a clarion warning and declared in unison: You're wrong.
The meeting of the President's Working Group on Financial Markets on an April day in 1998 brought together Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt Jr. -- all Wall Street legends, all opponents to varying degrees of tighter regulation of the financial system that had earned them wealth and power.
Their adversary, although also a member of the Working Group, did not belong to their club. Brooksley E. Born, the 57-year-old head of the Commodity Futures Trading Commission, had earned a reputation as a steely, formidable litigator at a high-powered Washington law firm. She had grown used to being the only woman in a room full of men. She didn't like to be pushed around.
Now, in the Treasury Department's stately, wood-paneled conference room, she was being pushed hard.
Greenspan, Rubin and Levitt had reacted with alarm at Born's persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble -- deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time.
Unlike the commodity futures regulated by Born's agency, many newer derivatives weren't traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street's top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what.
Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them -- and if so, how.
Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures. Born's agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market.
At the April meeting, the trio's message was clear: Back off, Born.
"You're not going to do anything, right?" Rubin asked her after they had laid out their concerns, according to one participant.
Born made no commitment. Some in the room, including Rubin and Greenspan, came away with a sense that she had agreed to cool it, at least until lawyers could confer on the legal issues. But according to her staff, she was neither deterred nor chastened.
"Once she took a position, she would defend that position and go down fighting. That's what happened here," said Geoffrey Aronow, a senior CFTC staff member at the time. "When someone pushed her, she was inclined to stand there and push back."
Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today.
The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all.
In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas.
"We knew it was a big deal [to attempt regulation] but the feeling was that something needed to be done," said Michael Greenberger, Born's director of trading and markets and a witness to the April 1998 standoff at Treasury. "The industry had been fighting regulation for years, and in the meantime, you saw them accumulate a huge amount of stuff and it was already causing dislocations in the economy. The government was being kept blind to it."
Rubin, in an interview, said of Born's effort, "I do think it was a deterrent to moving forward. I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way. My recollection was, though I truly do not remember the specifics of the meeting, this was done in a more strident way."
Rarely does one Washington regulator engage in such a public, pitched battle with other agencies. Born's failed effort is part of the larger story of what led to today's financial chaos, a bipartisan story of missed opportunities and philosophical shifts in which Washington stood impotent as the risk of Wall Street innovation swelled, according to more than 60 interviews as well as transcripts of meetings, congressional testimony and speeches. (Born declined to be interviewed.)
Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system.A New Chain of Risk
Futures contracts, one of the earliest forms of a derivative, have long been associated with big market failures. Harry Truman's father was financially wiped out by agriculture futures, and rampant manipulation by speculators contributed to the market collapses of 1929. Regulators have long known that new trading instruments have a way of giving reassurance of stability in good times and of exacerbating market downturns in bad.
Futures -- essentially, a promise to deliver cash or something of value at a later time -- are traded on regulated exchanges such as the Chicago Mercantile Exchange, regulated by the CFTC. But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the "lack of basic information" allowed traders in derivatives "to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority."
The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.
By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy.
The global derivatives market topped $530 trillion as of June 30 this year, including $55 trillion in the suddenly popular credit-default swaps; that $530 trillion represents all contracts outstanding. The total dollars at risk is much smaller, but still a hefty $2.7 trillion, according to an estimate by the International Swaps and Derivatives Association.
To make sense of those figures, compare them to the value of the New York Stock Exchange: $30 trillion at the end of 2007, before the recent crash. When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay.
Instead of dispersing risk, derivatives had amplified it.The Regulatory Rift
Born, after 30 years in Washington, found herself on President Bill Clinton's short list for attorney general in 1992. The call never came. Approached about the CFTC job four years later, she took it, seeing a chance to make a public service mark, colleagues say.
For several years before Born's arrival at the futures commission, Washington had been hearing warnings about derivatives. In 1993, Rep. Jim Leach (R-Iowa) issued a 902-page report that urged "regulations to protect against systemic risk" as well as supervision by the SEC or Treasury. Sen. Donald W. Riegle (D-Mich.), while acknowledging that swaps helped manage risk, saw "danger signs, on the horizon" in their rapid growth. He and Rep. Henry Gonzalez, a Texas Democrat, introduced separate bills in 1994 that went nowhere. Mary Schapiro, Born's predecessor, made her own run at the issue through enforcement actions.
In an earlier decade, President Ronald Reagan had described the CFTC as his favorite agency because it was small and it had allowed the futures industry to grow and prosper. Born swept into the agency, the least known of the four major regulators with primary responsibility for overseeing the nation's financial markets, determined to enforce its rules and tackle hard issues.
"One theory at the time was she was so disappointed not to be running Justice -- that she got this tiny agency as a consolation prize and was hell-bent to make it important. I'm not sure that was in her mind, but it was a point of criticism," said John Damgard, president of the Futures Industry Association. Damgard disagreed with Born's approach but said he respected her for fighting for her principles.
Daniel Waldman, Born's law partner at Arnold and Porter and her general counsel at the futures commission, said Born let the industry know she meant business. "She got into a knock-down, drag-out fight with the Chicago Board of Trade over the delivery points for soybean contracts," he recalled. "She believed it was her obligation under the statute to review decisions by the exchanges. If they didn't meet agency requirements, she was going to say so, not look the other way."
Born didn't back off on derivatives, either. On May 7, 1998, two weeks after her April showdown at Treasury, the commission issued a "concept release" soliciting public comment on derivatives and their risk.
The response was swift and blistering. Within hours, Greenspan, Rubin and Levitt cited their "grave concerns" in an unusual joint statement. Deputy Treasury Secretary Lawrence Summers decried it before Congress as "casting a shadow of regulatory uncertainty over an otherwise thriving market."
Wall Street howled. "The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association.
Although Born said new rules would be prospective, Wall Street was afraid existing contracts could be challenged in court. "That meant anybody on a losing side of a trade could walk away," Brickell said.
He spent months shuttling between New York and Washington, working on Congress to block CFTC action. "I remember getting on an overnight train and arriving at Rayburn by 5:30 a.m.," he said. "I watched the sun rise and then went to work on my testimony without a whole lot of sleep."
Born, who testified before Congress at least 17 times, tried to counter the legal question by saying that regulation would apply only to new contracts, not existing ones. But she relentlessly reiterated her conviction that ignoring the risk of derivatives was dangerous.
In June 1998, Leach, who had become chairman of the House Banking committee, thrust himself into the regulatory rift. He herded Born, Rubin and Greenspan into a small room near the committee's main venue at the Rayburn House Office Building, thinking he could mediate. "This is the most unusual meeting I've ever participated in," Leach recalled. "I have never in my life been in a setting where three senior members of the U.S. government reflected more tension. Secretary Rubin and Chairman Greenspan were in concert in expressing frustration with the CFTC leadership. . . . She felt, I'm confident, outnumbered with the two against one."
Leach thought the futures commission lacked the professional bench to handle oversight. He pressed Born not to proceed until the Treasury and the Fed could agree which agency was best suited to the role. "I tried to take the perspective of, 'I hope we can work this out,' " he said. "Both sides -- neither side, gave in."
Rubin said, in the recent interview, that he had his own qualms about derivatives, going back to his days as a managing partner at Goldman Sachs. He later wrote in a 2003 book that "derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements," forcing dealers to put up more capital to back the swaps. "But that will almost surely not happen, absent a crisis."
Asked why he didn't suggest stricter capital requirements as an alternative in 1998, Rubin said, "There was no political reality of getting it done. We were so caught up with other issues that were so pressing. . . . the Asian financial crisis, the Brazilian financial crisis. We had a lot going on."Crisis and Ice Cream
When the warring parties faced off next, in the Senate Agriculture committee's hearing room July 30, 1998, it was not a neutral battleground to air their differences. Chairman Richard G. Lugar, an Indiana Republican, wanted to extract a public promise from Born to cease her campaign. Otherwise, Congress would move forward on a Treasury-backed bill to slap a moratorium on further CFTC action.
The committee had to switch to a larger room to accommodate the expected crowd of lobbyists representing banks, brokerage firms, futures exchanges, energy companies and agricultural interests, according to a Lugar aide. A dubious Lugar opened the hearing by telling Born: "It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth."
Born would not yield. She portrayed her agency as under attack, saying the Fed, Treasury and SEC had already decided "that the CFTC's authority should instead be transferred to and divided among themselves."
Greenspan shot back that CFTC regulation was superfluous; existing laws were enough. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," he said. "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."
The stalemate persisted. Then, in September a crisis arose that gave credence to Born's concerns.
Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-to-capital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don't know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript.
Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world." She spoke of an "immediate and pressing need to address whether there are unacceptable regulatory gaps."
The near collapse of Long Term Capital Management didn't change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market.
The battle left Born politically isolated. In April 1999, the President's Working Group issued a report on the lessons of Long Term Capital's meltdown, her last as part of the group. The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change -- a recommendation that brokerages' unregulated affiliates be required to assess and report their financial risk to the government.
Greenspan dissented on that recommendation.
By May, Born had had enough. Although it was customary at the agency for others to organize an outgoing chairman's going-away bash, she personally sprang for an ice cream cart in the commission's beige-carpeted auditorium. On a June afternoon, employees listened to subdued, carefully worded farewells while serving themselves sundaes.
In November, Greenspan, Rubin, Levitt and Born's replacement, William Rainer, submitted a Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States."Toward Self-Regulation
Throughout much of 2000, lobbyists were flying in and out of congressional offices. With Born gone, they saw an opportunity to settle the regulatory issue and perhaps gain even more. They had a sympathetic ear in Texas Sen. Phil Gramm, the influential Republican chairman of the Senate Banking Committee, and a sympathetic bill: the 2000 Commodity Futures Modernization Act.
Gramm opened a June 21 hearing with a call for "regulatory relief." Peering through his wire-rimmed glasses, he drawled: "I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws -- and I think you could say the same about regulation -- is like asking a man to wear the same clothes he wore when he was a boy."
Greenspan and Rubin's successor at the Treasury, Larry Summers, still held sway on keeping the CFTC out of the swaps market. But Treasury officials saw an opportunity to push forward on a self-regulation idea from the Working Group's November 1999 report: an industry clearinghouse to hold pools of cash collected from financial firms to cover derivatives losses. But the report had also called for federal oversight to ensure that risk-management procedures were followed.
The swaps industry generally supported the clearinghouse concept. One amended version of the bill made federal oversight optional. Treasury officials scrambled to act, and a provision introduced by Leach requiring oversight prevailed.
The House passed the bill Oct. 19, but then the legislation stalled. Gramm was holding out for stronger language that would bar both the CFTC and the SEC from meddling in the swaps market. Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power.
On the night of Dec. 15, with the nation still focused on the Supreme Court decision three days earlier that settled the 2000 presidential election in George W. Bush's favor, the act passed as a rider to an omnibus spending bill. The clearinghouse provision remained. At the time, it seemed like a breakthrough.
A clearinghouse would have created layers of protections that don't exist today, said Craig Pirrong, a markets expert at the University of Houston. "An industry-backed pool of capital could have cushioned against losses while discouraging risky bets."
But afterward, the clearinghouse idea sat dormant, with no one in the industry moving to put one in place.'An Absolute Siege'
In 2004, the SEC pursued another voluntary system. This one, too, didn't work out quite as hoped.
For years, Congress had allowed a huge gap in Wall Street oversight: the SEC had authority over the brokerage arms of investment banks such as Lehman Brothers and Bear Stearns, but were in the dark about deals made by the firms' holding companies and its unregulated affiliates. European regulators, demanding more transparency given the substantial overseas operations of U.S. firms, were threatening to put these holding companies under regulatory supervision if their American counterparts didn't do so first.
For the SEC, this was deja vu. In 1999, the SEC had sought such authority over the holding companies and failed to get it. Late in the year, Congress passed the Gramm-Leach-Bliley Act, dismantling the walls separating commercial banks, investment banks and insurance companies since the Great Depression. But the act did not provide for any SEC oversight of investment bank holding companies. The momentum was all toward deregulation.
"I remember saying at the time, people don't get it -- the level of missed opportunities to address some of these problems," said Annette Nazareth, then the SEC's head of market regulation. "It was an absolute siege on regulation."
Five years later, the European regulators were forcing the issue again. Restricted by Gramm-Leach-Bliley, the SEC proposed a voluntary system, which the big investment banks opted to join. The holding companies would be permitted to follow their own computer models to assess how much risk they were taking; the SEC would get access to make sure the complex capital and risk-management models were up to the job.
At an April 28 SEC meeting, commissioner Harvey Goldschmid expressed caution. "If anything goes wrong, it's going to be an awfully big mess," said Goldschmid, who voted for the program.
Last month, the SEC's inspector general concluded that the program had failed in the case of Bear Stearns, which collapsed in March. SEC overseers had seen Bear Stearns's heavy focus on mortgage-backed securities and over-leveraging, but "did not take serious action to limit these risk factors," the inspector general's report said.
SEC officials say the voluntary program limited what they could do. They checked to make sure Bear Stearns was adhering to its risk models but did not count on those models being fundamentally flawed.
On Sept. 26, with the economic meltdown in full swing, SEC Chairman Christopher Cox shut down the program. Cox, a longtime champion of deregulation, said in a statement posted on the SEC's Web site, "the last six months have made it abundantly clear that voluntary regulation does not work."
It was too late. All five brokerages in the program had either filed for bankruptcy, been absorbed or converted into commercial banks.Second Thoughts
On Sept. 15, 2005, Federal Reserve Bank of New York president Timothy F. Geithner gathered senior executives and risk-management officers from 14 Wall Street firms in the Fed's 10th-floor conference room in lower Manhattan for another discussion about a voluntary mechanism. Also arrayed around the wood rectangular table, covered by green-felt tablecloths, were European market supervisors from Britain, Switzerland and Germany.
E. Gerald Corrigan, managing director of Goldman Sachs and one of Geithner's predecessors at the New York Fed, had reported in July that the face value of credit-default swaps had soared ninefold in just three years. Without an automated, electronic system for tracking the trades or collateral to back them, the potential for systemic risk was increasing. "The growth of derivatives was exceeding the maturity of the operational infrastructure, so we thought we would try to narrow the gap," Geithner said in an interview.
Talks have continued on a range of issues, including how to set up a clearinghouse with reserves in case of default -- the same concept in the 2000 legislation -- and what kind of government oversight would be allowed. But three years later, there is no system in place. Some major dealers have preferred to go it alone, and no one in the government told them they couldn't.
With last month's death spiral of American International Group, the world's largest private insurance company until it was seized by the government, regulators saw their fears play out. AIG had sold $440 billion in credit-default swaps tied to mortgage securities that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its credit-default swap contracts to post billions in collateral that it didn't have. The government swooped in to prevent AIG's default, hoping to ward off another chain reaction in the already shaky financial system.
The economic crisis has added momentum to the Fed's attempts to organize a voluntary clearinghouse. Geithner held two meetings last week with several firms and major dealers interested in setting up such a mechanism. Last week, the Chicago Mercantile Exchange announced it would team with Citadel Investment Group, a large hedge fund, to launch an electronic trading platform and clearinghouse for credit-default swaps. Other private companies and exchanges are working on their own systems, seeing opportunities for profit in becoming a shock absorber for the system.
The crisis has prompted second thoughts. Goldschmid, the former SEC commissioner and the agency's general counsel under Levitt, looks back at the long history of missed opportunities and sighs: "In hindsight, there's no question that we would have been better off if we had been regulating derivatives -- and had a clearinghouse for it."
Levitt, too, thinks about might-have-beens. "In fairness, while Summers and Rubin and I certainly gave in to this, we were not in the same camp as the Fed," he said. "The Fed was really adamantly opposed to any form of regulation whatsoever. I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets."
Researchers Brady Dennis and Robert Thomason contributed.
Nice try; no cigar. That was my reaction to the attempt of the banking community to forestall additional regulation, by recommending “a suite of best practices to be embraced voluntarily”. It was also the reaction of the policymakers meeting in Washington over the weekend. More regulation is on its way. After frightening politicians and policymakers so badly, even the most optimistic banker must realise this. The question is whether the additional regulation will do any good.
In an interim report on “market best practices”, the Institute for International Finance, an association of bankers, offers devastating self-criticism.* Here then are some of the weaknesses it identifies: “deteriorating lending standards by certain originators of credit”; a “decline of underwriting standards”; an “excessive reliance on poorly understood, poorly performing and less than adequate ratings of structured products”; and “difficulties in identifying where exposures reside”. Would you buy a voluntary code from people who describe their own mistakes in this brutal manner? I thought not. There are two powerful additional reasons for not doing so.
First, in such a fiercely competitive business, a voluntary code is almost certainly not worth the paper it is written on. When they can get away with behaving irresponsibly, some will do so. This puts strong pressure on others. That is what Chuck Prince, former chief executive officer of Citigroup, meant when he told the FT that “as long as the music is playing, you’ve got to get up and dance”. So, as Willem Buiter of the London School of Economics remarks: “Self-regulation stands in relation to regulation the way self-importance stands in relation to importance.”
Second, the industry has form. The IIF itself was founded in 1983 in response to the developing country debt crisis. At that time, big parts of the west’s banking system were in effect bankrupt. Now, many upsets later, we have reached the “subprime crisis”. The IIF was created not only to represent the industry, but to improve its performance. It is clear that this has not worked.
Do not just take my word for it. Last month, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard published an extraordinary paper on the long history of financial crises.** The chart shows that the incidence of banking crises (measured by the proportion of countries affected) has been as high since 1980 as in any period since 1800; that the incidence of crises is correlated with liberalisation of capital flows; and that there was, until 2007, a decline in the incidence of crises in the 2000s.
Yet why, I ask, should this industry have apparently failed to improve its standards of performance over the past century? After all, almost every other industry has done so. Consider how confident we are that the food we buy will not poison us. Yet adulterated food was once a threat.
Consider, by those standards, the failures of the banking industry, as admitted by the IIF itself. Its purely operational performance is now impressive. But competition does not work well in finance. The “product” of the financial industry is promises for an uncertain future, marketed as dreams that can readily become nightmares. Customers are readily swept away by exaggerated promises, irrational beliefs, misplaced trust and sheer skulduggery. So, too, are practitioners: basing risk management on limited data and inadequate models is a good example. Emotions count wherever uncertainties loom.
Boeing would not survive if the aircraft it built fell out of the sky. Yet in the financial industry, huge blunders are also almost always made in common. If everybody is in the dance nobody is to blame and, in any case, governments, horrified by the consequences of a collapsing financial system, will come to the rescue.
Until last August, I comforted myself with the thought that many of the crises of the past quarter-century occurred in relatively backward financial systems, even if institutions of the first world played a part in “seducing minors”. So things might, I hoped, be getting better.
That is no longer a plausible view. Once the US itself ran a large current account deficit the concomitant accumulations of internal debt generated huge losses, as the excellent new Global Financial Stability Report from the International Monetary Fund points out. The one good thing is that estimated losses of close to $1,000bn are widely distributed (see charts). That makes today’s situation less transparent, sadly. But it also means that the pain is more widely, and so much more safely, shared.
What then is to be done now? Interestingly, there is substantial convergence on the substance between the IIF and the authorities, as shown in a devastatingly critical recent report from the Financial Stability Forum on “enhancing market and institutional resilience”.*** Both agree, for example, that structures of compensation matter, as both I and others have argued. Both agree, too, that risk management was appalling.
The agenda laid out in the official report is lengthy. It includes: strengthening prudential oversight of capital, liquidity and risk management; enhancing transparency; changing the role and uses of credit ratings; strengthening the authorities’ responsiveness to risk; and improving arrangements for dealing with stress. But, it should go without saying, policymakers also believe regulation must be tougher. Given the damage done and the extent of the safety net provided, no alternative exists.
Yet I am not that optimistic about regulation either. Regulators are doomed to close the stable doors behind financial institutions that always find new and more exciting ways of losing money. It is, for this reason, crucial that the institutions, and unsecured creditors, feel some pain: the burned child fears the fire; singeing is less effective. Yet the fire must never burn too far, since that might destroy the entire economy.
If regulation is to be effective, it must cover all relevant institutions and the entire balance sheet, in all significant countries; it must focus on capital, liquidity and transparency; and, not least, it must make finance less pro-cyclical. Will it ever work perfectly? Certainly not. It is impossible and probably even undesirable to create a crisis-free financial system. Crises will always be with us. But we can surely do far better than we have been doing. In any case, we are doomed to try.
Both Democrats and Republicans want America atop the world's economic food chain. After all, it's better to be the Great White Shark than the seal. They differ on what to do to keep us there, of course. Generally, Republicans want businesses operating free of taxes and government intervention, while Democrats believe certain limits on businesses and our financial markets are necessary to keep Americans safe and prosperous.
Republican economic policy is based on the Theory of Natural Law first advanced by Aristotle. Since nature doesn't make intellectual decisions intellectualism is considered artificial, or unnatural. Regulation is an intellectual act, so it's not natural and therefore doomed to fail. Therefore our economy, Conservatives believe, if free of any regulation, will naturally fall into a stable balance of permanent prosperity. Regulations and intervention, they claim, are wholly unnatural and illegitimate.
Conservatives have been working for decades to deregulate markets and businesses. In 1999 they succeeded in removing important regulations set up after the Great Depression to ensure market safety. So why did the markets crash?
Because Natural Law economic theory never existed.
Nature, in fact, places the most severe limits on animals and their behavior to make sure they stay balanced. Sharks don't have a "stop eating" mechanism in their biological blueprint. Under normal conditions sharks can't catch food fast enough to do themselves damage from over-eating. Nature has limited their ability to catch food. A shark in a feeding frenzy, however, given enough food, will eat until it quite literally bursts open like an overstuffed sausage. Its guts just explode out into the water. In some cases crazed, gut-busted sharks eat their own entrails, unable to distinguish between their innards and their kill.
A shark is just a dumb beast driven by a killer instinct. If nature's limits break down, so does the shark. The only thing keeping sharks from eating themselves to death are the physical limits nature places on all apex predators. Because nature has perfected the art of limitation, a shark eating itself to death is extremely rare, and usually occurs only when humans get involved and temporarily throw food supplies out of balance. Nature is nothing if not a series of carefully orchestrated restrictions. True Natural Law economics is not laissez faire it is structured guidance, like the rules in a football game. It's a bad idea to give 22 men pads, helmets and a football and say laissez faire, unless you want every one to get killed.
Animals have a complex system of internal and external limits to make sure they don't outgrow their eco-system either in body or population. In Aristotle's day nature had total control over human beings. His people could only move so quickly, gather and grow only so much food, and had only rudimentary tools. These and other physical limits contained human population growth for millennia. Human economic activity required minimal governmental oversight if any at all, so laissez faire seemed natural.
Today huge groups of human beings are largely free of nature's constraints. We, as a race, can, and will, apparently, out grow our eco-system- something Aristotle did not consider in his extensive writings on natural law. Given the political freedom 21st century human beings could and would extract every fish in the ocean in a few years time. But for nature's limits sharks would, too. Soon genetic engineering breakthroughs will clear away whatever constraints nature has left over humanity. Conservative economic theory, which depends entirely on constraints provided by nature, is fantasy.
Out growing nature's restraints means nature can no longer stop us from destroying ourselves if we get off track. With nothing to contain us we have to assume nature's former corrective role in all our endeavors and provide necessary limits ourselves.
We should not be afraid of limits. Everything growing thing in nature is limited in some way except cancer. Limitless, unregulated growth is disease, not freedom. If we strip our markets of all restrictions and let the sharks go into frenzy we will create cancer not growth.
In 1999, what I call the Cancer School of Economics succeeded in removing entrenched banking regulations created after the 1929 belly burst that triggered the Great Depression. Stripped of structure, predictably, America's powerful economic killer instinct has run amok ever since. America's economic sharks have gorged on fossil fuels, unfettered financial predation, incomprehensible budget deficits and Keating/Enron style corruption. They ate more than their eco-system allows and busted open yet again. Today America is no longer an apex predator in a sustainable food chain but a cancerous tumor on the world's economy.
A few months ago as the world's economic waters began running cloudy with America's guts, Bush, McCain and Fed Chairman Bernanke said the fundamentals of our economy were sound and strong. What else would a dumb beast say with a mouth full of its own entrails? A dumb beast only knows one thing: if it is eating its happy.
And just like a simple, natural, not at all pointy-headed or intellectual shark eating its own entrails, the Republicans and hapless Democrats are incapable of stopping their self destruction. They passed a bail out/rescue package with toothless over sight provisions that ignores the causes of the meltdown and is funded by borrowed money and a massive cash infusion from the treasury created out of thin air by printing dollars. Apparently they believe self cannibalization will stop us from eating ourselves to death. How very dumb beast of them. In effect we now have a bubble propped up by a bubble, or The Weimar Republic.
Conservatives see a Democrat in the character Quint from Steven Spielberg's still excellent 1975 blockbuster Jaws. Quint was a shark hunter. He shot little steel harpoons tied to big, buoyant barrels into sharks which severely reduced their ability to swim. Conservatives see every regulation as just another barrel slowly killing American business.
The Cancer School of Economics doesn't get that forcing Detroit to make cars safer back in the 50's and 60's through Government intervention in the market place made the auto industry more profitable. They can't see that safe cars increased the market for cars and increased dependence on cars which helped create a pervasive car culture and increased sales. That kind of thinking is for pointy-headed intellectuals, not simple, natural folk. All they can see is "bigguvment" got on the backs of poor, poor businessmen and tried to choke the auto industry. They still think we'd all be better off without brake lights, seat belts and turn signals waiting for Detroit to make safe cars.
Republicans don't see health and prosperity in regulation. They see Democrats and their regulations as another kind of shark competing for living space and fish- a smaller, less aggressive, toothless kind of shark who deserves to die, who unfairly restricts stronger sharks who should be allowed to run free and rule the seas. They don't see Democrats as noble or compassionate or evolved or helpful in the least. They see them as whiny, traitorous runts who have turned themselves into un-natural parasites who leech off of their larger, stronger brethren and therefore need to be wiped off the face of the earth lest everything die.
Anyone who wants no rules at all is an adolescent. Like a bratty teenager caught up in a rebellious tantrum, Republicans can't see any limit as healthy. Conservatives point to people who truly are parasitic runts and claim they were created by healthy limits which keep our economy from bursting.
All these Cancer School of Economics financial experts swimming around with their guts hanging out argue the finance, credit, loan and banking system is already the most heavily regulated industry in the nation. Governments don't heavily regulate the greeting card industry. Everything depends on financial stability, confidence, fairness and predictability. The financial markets need intelligent, tough, strictly enforced regulation so our nation's super sharks can do what they were born to do without bursting. Obviously it is the quality of regulation not the quantity that is the issue at hand. Funny -- with all the regulations on the financial industry conservatives targeted just the ones that if removed would cause a meltdown. Weren't interested in all the others, were they?
Republicans, like troubled teenagers, are unable to understand their own behavior is the problem. Conservatives look at the deregulation disaster that is the last eight years of Republican rule and have come to the conclusion that they were corrupted by eight years of power. Power doesn't corrupt. Washington is a petri dish for all one's latent dysfunction. Power revealed who Republicans truly are. They came to Washington and did exactly what they wanted to do and they destroyed themselves. Self knowledge is a bitch.
For all the evil Washington has done to Republicans, they sure don't want to leave. They most definitely want to stay despite the horrible things power does to one's conservative credentials.
To convince Americans they have learned their lesson and should be given the reigns of all-corrupting power one more time, conservatives have brought forward Sarah Palin, someone they advertise as too simpleminded to be affected by Washington's irresistible evil, like some kind of Alaskan version of Frodo Baggins. Basically, Republicans are promising Americans they'll be dumb as hell if we give them another chance in 2008.
The biggest problem Conservatives face right now is that no one has faith in unfettered predation anymore. America's corporate sharks are gut busted and floating belly up. Sarah Barracuda is meant to prove conservative economic ideology is still healthy, wholesome, natural and as dumb as a big fish. Conservatives think just by letting Sarah "Frodo" Barracuda swim into the White House our nation will return to prosperity.
Republicans don't understand there is no Quint slowing them down. Market regulations are not the equivalent of a barrel tied to a shark. The life sustaining financial regulations they greedily stripped away in 1999 were a positive structural force that provided stability, scale, security and confidence. Massive exploitation of resources coupled with an unrestricted financial system is not economic freedom. It is unbalanced, unstructured and un-natural. It is cancerism, not natural law. Limits on risking other people's money is not un-Godly interference, or the life sucking evil of parasitic runts, its protecting the human eco-system, which humanity must do for itself, because, after all we're not dumb beasts. Acting like one won't help anybody, Sarah.
Almost no one expected what was coming. It’s not fair to blame us for not predicting the unthinkable.“— Daniel H. Mudd, former chief executive, Fannie Mae
When the mortgage giant Fannie Mae recruited Daniel H. Mudd, he told a friend he wanted to work for an altruistic business. Already a decorated marine and a successful executive, he wanted to be a role model to his four children — just as his father, the television journalist Roger Mudd, had been to him.
Fannie, a government-sponsored company, had long helped Americans get cheaper home loans by serving as a powerful middleman, buying mortgages from lenders and banks and then holding or reselling them to Wall Street investors. This allowed banks to make even more loans — expanding the pool of homeowners and permitting Fannie to ring up handsome profits along the way.
But by the time Mr. Mudd became Fannie’s chief executive in 2004, his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.
So Mr. Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.
For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy.
Dozens of interviews, most from people who requested anonymity to avoid legal repercussions, offer an inside account of the critical juncture when Fannie Mae’s new chief executive, under pressure from Wall Street firms, Congress and company shareholders, took additional risks that pushed his company, and, in turn, a large part of the nation’s financial health, to the brink.
Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.
“We didn’t really know what we were buying,” said Marc Gott, a former director in Fannie’s loan servicing department. “This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears.”
Last month, the White House was forced to orchestrate a $200 billion rescue of Fannie and its corporate cousin, Freddie Mac. On Sept. 26, the companies disclosed that federal prosecutors and the Securities and Exchange Commission were investigating potential accounting and governance problems.
Mr. Mudd said in an interview that he responded as best he could given the company’s challenges, and worked to balance risks prudently.
“Fannie Mae faced the danger that the market would pass us by,” he said. “We were afraid that lenders would be selling products we weren’t buying and Congress would feel like we weren’t fulfilling our mission. The market was changing, and it’s our job to buy loans, so we had to change as well.”
Dealing With Risk
When Mr. Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.
Just two decades earlier, Fannie had been on the brink of bankruptcy. But chief executives like Franklin D. Raines and the chief financial officer J. Timothy Howard built it into a financial juggernaut by aiming at new markets.
Fannie never actually made loans. It was essentially a mortgage insurance company, buying mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan if the borrower defaulted. The only real danger was that the company might guarantee questionable mortgages and lose out when large numbers of borrowers walked away from their obligations.
So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.
Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.
With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.
All this helped supercharge Fannie’s stock price and rewarded top executives with tens of millions of dollars. Mr. Raines received about $90 million between 1998 and 2004, while Mr. Howard was paid about $30.8 million, according to regulators. Mr. Mudd collected more than $10 million in his first four years at Fannie.
Whenever competitors asked Congress to rein in the company, lawmakers were besieged with letters and phone calls from angry constituents, some orchestrated by Fannie itself. One automated phone call warned voters: “Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership.”
The ripple effect of Fannie’s plunge into riskier lending was profound. Fannie’s stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks.
Between 2001 and 2004, the overall subprime mortgage market — loans to the riskiest borrowers — grew from $160 billion to $540 billion, according to Inside Mortgage Finance, a trade publication. Communities were inundated with billboards and fliers from subprime companies offering to help almost anyone buy a home.
Within a few years of Mr. Mudd’s arrival, Fannie was the most powerful mortgage company on earth.
Then it began to crumble.
Regulators, spurred by the revelation of a wide-ranging accounting fraud at Freddie, began scrutinizing Fannie’s books. In 2004 they accused Fannie of fraudulently concealing expenses to make its profits look bigger.
Mr. Howard and Mr. Raines resigned. Mr. Mudd was quickly promoted to the top spot.
But the company he inherited was becoming a shadow of its former self.
‘You Need Us’
Shortly after he became chief executive, Mr. Mudd traveled to the California offices of Angelo R. Mozilo, the head of Countrywide Financial, then the nation’s largest mortgage lender. Fannie had a longstanding and lucrative relationship with Countrywide, which sold more loans to Fannie than anyone else.
But at that meeting, Mr. Mozilo, a butcher’s son who had almost single-handedly built Countrywide into a financial powerhouse, threatened to upend their partnership unless Fannie started buying Countrywide’s riskier loans.
Mr. Mozilo, who did not return telephone calls seeking comment, told Mr. Mudd that Countrywide had other options. For example, Wall Street had recently jumped into the market for risky mortgages. Firms like Bear Stearns, Lehman Brothers and Goldman Sachs had started bundling home loans and selling them to investors — bypassing Fannie and dealing with Countrywide directly.
“You’re becoming irrelevant,” Mr. Mozilo told Mr. Mudd, according to two people with knowledge of the meeting who requested anonymity because the talks were confidential. In the previous year, Fannie had already lost 56 percent of its loan-reselling business to Wall Street and other competitors.
“You need us more than we need you,” Mr. Mozilo said, “and if you don’t take these loans, you’ll find you can lose much more.”
Then Mr. Mozilo offered everyone a breath mint.
Investors were also pressuring Mr. Mudd to take greater risks.
On one occasion, a hedge fund manager telephoned a senior Fannie executive to complain that the company was not taking enough gambles in chasing profits.
“Are you stupid or blind?” the investor roared, according to someone who heard the call, but requested anonymity. “Your job is to make me money!”
Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie’s affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.
“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”
But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.
Even so, Fannie began buying huge numbers of riskier loans.
In one meeting, according to two people present, Mr. Mudd told employees to “get aggressive on risk-taking, or get out of the company.”
In the interview, Mr. Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.
Employees, however, say they got a different message.
“Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little,” said a former senior Fannie executive. “But our mandate was to stay relevant and to serve low-income borrowers. So that’s what we did.”
Between 2005 and 2007, the company’s acquisitions of mortgages with down payments of less than 10 percent almost tripled. As the market for risky loans soared to $1 trillion, Fannie expanded in white-hot real estate areas like California and Florida.
For two years, Mr. Mudd operated without a permanent chief risk officer to guard against unhealthy hazards. When Enrico Dallavecchia was hired for that position in 2006, he told Mr. Mudd that the company should be charging more to handle risky loans.
In the following months to come, Mr. Dallavecchia warned that some markets were becoming overheated and argued that a housing bubble had formed, according to a person with knowledge of the conversations. But many of the warnings were rebuffed.
Mr. Mudd told Mr. Dallavecchia that the market, shareholders and Congress all thought the companies should be taking more risks, not fewer, according to a person who observed the conversation. “Who am I supposed to fight with first?” Mr. Mudd asked.
In the interview, Mr. Mudd said he never made those comments. Mr. Dallavecchia was among those whom Mr. Mudd forced out of the company during a reorganization in August.
Mr. Mudd added that it was almost impossible during most of his tenure to see trouble on the horizon, because Fannie interacts with lenders rather than borrowers, which creates a delay in recognizing market conditions.
He said Fannie sought to balance market demands prudently against internal standards, that executives always sought to avoid unwise risks, and that Fannie bought far fewer troublesome loans than many other financial institutions. Mr. Mudd said he heeded many warnings from his executives and that Fannie refused to buy many risky loans, regardless of outside pressures .
“You’re dealing with massive amounts of information that flow in over months,” he said. “You almost never have an ‘Oh, my God’ moment. Even now, most of the loans we bought are doing fine.”
But, of course, that moment of truth did arrive. In the middle of last year it became clear that millions of borrowers would stop paying their mortgages. For Fannie, this raised the terrifying prospect of paying billions of dollars to honor its guarantees.
Sustained by Government
Had Fannie been a private entity, its comeuppance might have happened a year ago. But the White House, Wall Street and Capitol Hill were more concerned about the trillions of dollars in other loans that were poisoning financial institutions and banks.
Lawmakers, particularly Democrats, leaned on Fannie and Freddie to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply.
The White House also pitched in. James B. Lockhart, the chief regulator of Fannie and Freddie, adjusted the companies’ lending standards so they could purchase as much as $40 billion in new subprime loans. Some in Congress praised the move.
“I’m not worried about Fannie and Freddie’s health, I’m worried that they won’t do enough to help out the economy,” the chairman of the House Financial Services Committee, Barney Frank, Democrat of Massachusetts, said at the time. “That’s why I’ve supported them all these years — so that they can help at a time like this.”
But earlier this year, Treasury Secretary Henry M. Paulson Jr. grew concerned about Fannie’s and Freddie’s stability. He sent a deputy, Robert K. Steel, a former colleague from his time at Goldman Sachs, to speak with Mr. Mudd and his counterpart at Freddie.
Mr. Steel’s orders, according to several people, were to get commitments from the companies to raise more money as a cushion against all the new loans. But when he met with the firms, Mr. Steel made few demands and seemed unfamiliar with Fannie’s and Freddie’s operations, according to someone who attended the discussions.
Rather than getting firm commitments, Mr. Steel struck handshake deals without deadlines.
That misstep would become obvious over the coming months. Although Fannie raised $7.4 billion, Freddie never raised any additional money.
Mr. Steel, who left the Treasury Department over the summer to head Wachovia bank, disputed that he had failed in his handling of the companies, and said he was proud of his work .
As the housing crisis worsened, Fannie and Freddie announced larger losses, and shares continued falling.
In July, Mr. Paulson asked Congress for authority to take over Fannie and Freddie, though he said he hoped never to use it. “If you’ve got a bazooka and people know you’ve got it, you may not have to take it out,” he told Congress.
Mr. Mudd called Treasury weekly. He offered to resign, to replace his board, to sell stock, and to raise debt. “We’ll sign in blood anything you want,” he told a Treasury official, according to someone with knowledge of the conversations.
But, according to that person, Mr. Mudd told Treasury that those options would work only if government officials publicly clarified whether they intended to take over Fannie. Otherwise, potential investors would refuse to buy the stock for fear of being wiped out.
“There were other options on the table short of a takeover,” Mr. Mudd said. But as long as Treasury refused to disclose its goals, it was impossible for the company to act, according to people close to Fannie.
Then, last month, Mr. Mudd was instructed to report to Mr. Lockhart’s office. Mr. Paulson told Mr. Mudd that he could either agree to a takeover or have one forced upon him.
“This is the right thing to do for the economy,” Mr. Paulson said, according to two people with knowledge of the talks. “We can’t take any more risks.”
Freddie was given the same message. Less than 48 hours later, Mr. Lockhart and Mr. Paulson ended Fannie and Freddie’s independence, with up to $200 billion in taxpayer money to replenish the companies’ coffers.
The move failed to stanch a spreading panic in the financial world. In fact, some analysts say, the takeover accelerated the hysteria by signaling that no company, no matter how large, was strong enough to withstand the losses stemming from troubled loans.
Within weeks, Lehman Brothers was forced to declare bankruptcy, Merrill Lynch was pushed into the arms of Bank of America, and the government stepped in to bail out the insurance giant the American International Group.
Today, Mr. Paulson is scrambling to carry out a $700 billion plan to bail out the financial sector, while Mr. Lockhart effectively runs Fannie and Freddie.
Mr. Raines and Mr. Howard, who kept most of their millions, are living well. Mr. Raines has improved his golf game. Mr. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.
But Mr. Mudd, who lost millions of dollars as the company’s stock declined and had his severance revoked after the company was seized, often travels to New York for job interviews. He recalled that one of his sons recently asked him why he had been fired.
“Sometimes things don’t work out, no matter how hard you try,” he replied.
ROBERT H. FRANK
... ... ...
It isn’t simply “Wall Street greed,” which Senator John McCain has blamed for the crisis. Coming from Mr. McCain, a longtime champion of financial industry deregulation, it was a puzzling attribution, squarely at odds with the cherished belief of free-market enthusiasts everywhere that unbridled pursuit of self-interest promotes the common good. As Adam Smith wrote in “The Wealth of Nations,” “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”
Greed underlies every market outcome, good or bad. When important conditions are met, greed not only poses no threat to Smith’s “invisible hand” of competition, but is an essential part of it.
The forces that produced the current crisis actually reflect a powerful dynamic that afflicts all kinds of competitive endeavors. This may be seen clearly in the world of sports.
Consider a sprinter’s decision about whether to take anabolic steroids. The sprinter’s reward depends not on how fast he runs in absolute terms, but on how his times compare with those of others. Imagine a new drug that enhances performance by three-tenths of a second in the 100-meter dash. Almost impossible to detect, it also entails a small risk of serious health problems. The sums at stake ensure that many competitors will take the drug, making it all but impossible for a drug-free competitor to win. The net effect is increased health risks for all athletes, with no real gain for society.
This particular type of market failure occurs when two conditions are met. First, people confront a gamble that offers a highly probable small gain with only a very small chance of a significant loss. Second, the rewards received by market participants depend strongly on relative performance.
These conditions have caused the invisible hand to break down in multiple domains. In unregulated housing markets, for example, there are invariably too many dwellings built on flood plains and in earthquake zones. Similarly, in unregulated labor markets, workers typically face greater health and safety risks.
It is no different in unregulated financial markets, where easy credit terms almost always produce an asset bubble. The problem occurs because, just as in sports, an investment fund’s success depends less on its absolute rate of return than on how that rate compares with those of rivals.
If one fund posts higher earnings than others, money immediately flows into it. And because managers’ pay depends primarily on how much money a fund oversees, managers want to post relatively high returns at every moment.
One way to bolster a fund’s return is to invest in slightly riskier assets. (Such investments generally pay higher returns because risk-averse investors would otherwise be unwilling to hold them.) Before the current crisis, once some fund managers started offering higher-paying mortgage-backed securities, others felt growing pressure to follow suit, lest their customers desert them.
Warren E. Buffett warned about a similar phenomenon during the tech bubble. Mr. Buffett said he wouldn’t invest in tech stocks because he didn’t understand the business model. Investors knew him to be savvy, but the relatively poor performance of his Berkshire Hathaway fund during the tech stock run-up persuaded many to move their money elsewhere. Mr. Buffett had the personal and financial resources to weather that storm. But most money managers did not, and the tech bubble kept growing.
A similar dynamic precipitated the current problems. The new mortgage-backed securities were catnip for investors, much as steroids are for athletes. Many money managers knew that these securities were risky. As long as housing prices kept rising, however, they also knew that portfolios with high concentrations of the riskier assets would post higher returns, enabling them to attract additional investors. More important, they assumed that if things went wrong, there would be safety in numbers.
PHIL GRAMM, the former senator from Texas, and other proponents of financial industry deregulation insisted that market forces would provide ample protection against excessive risk. Lenders obviously don’t want to make loans that won’t be repaid, and borrowers have clear incentives to shop for favorable terms. And because everyone agrees that financial markets are highly competitive, Mr. Gramm’s invocation of the familiar invisible-hand theory persuaded many other lawmakers.
The invisible hand breaks down, however, when rewards depend heavily on relative performance. A high proportion of investors are simply unable to stand idly by while others who appear no more talented than them earn conspicuously higher returns. This fact of human nature makes the invisible hand an unreliable shield against excessive financial risk.
Where do we go from here?
Many people advocate greater transparency in the market for poorly understood derivative securities. More stringent disclosure rules would be good but would not prevent future crises, any more than disclosing the relevant health risks would prevent athletes from taking steroids.
The only effective remedy is to change people’s incentives. In sports, that means drug rules backed by strict enforcement. In financial markets, asset bubbles cause real trouble when investors can borrow freely to expand their holdings. To prevent such bubbles, we must limit the amounts that people can invest with borrowed money.
Oct. 3 (Bloomberg) -- The $700 billion rescue that the U.S. House considers today reflects the unintended consequences of decisions made by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke since March.
Beginning with the orchestrated purchase of Bear Stearns Cos. by JPMorgan Chase & Co., each step was a bold effort to forestall a collapse of the financial system. The economy grew in the first two quarters of this year, and financial distress eased for a while after the Bear Stearns rescue. Still, each decision to bail out or not created more instability, leading to further runs on securities firms, banks and insurers.
``Every time you tinker with this delicate system even small changes can create big ripples,'' said Dino Kos, former head of the New York Fed's open-market operations and now a managing director at Portales Partners LLC in New York. ``This is the impossible situation they are in. The risks are that the government's $700 billion purchase of assets disturbs markets even more.''
Paulson and Bernanke insist that the program to buy troubled mortgages and other securities is needed to revive lending and restore stability to markets. What they haven't discussed is the risk that they inadvertently make matters worse. By creating a government pool of distressed real-estate and bad debt, they could depress the housing market further. Risk may become even more concentrated through a wave of bank mergers that, if unsuccessful, would stick taxpayers with an even higher bill.
The decision to launch the biggest bailout in history came on a Sept. 17 conference call, when Bernanke and Paulson pulled the trigger on a proposal etched out over several months. Over the previous two days, they let Lehman Brothers Holdings Inc. fail and seized American International Group Inc. The reaction to their visible hand: a rout in financial stocks, paralysis in the trillion dollar inter-bank loan market, and flight from money market mutual funds.
Treasury and Fed officials had long been uncomfortable with the way the safety net had to be expanded to catch Bear Stearns. Not a single creditor had suffered a default as the company was swept into JPMorgan Chase & Co. with the help of a $29 billion Fed loan. Stock investors received about $10 each.
Their decision to pull back and let shareholders get wiped out in Fannie Mae, Freddie Mac, and then Lehman ``sent shivers through investors,'' said Peter Kovalski, who oversees financial-services stocks for Alpine Woods Capital Investors LLC's $12 billion portfolio. ``Everybody kind of backed off and said if this is the way the government is going to play the game, we don't want to risk our capital.''
Assumptions Thrown Out
Lehman's bankruptcy toppled other assumptions that investors had made. Bear Stearns, deemed too big to fail by the Fed and Treasury, had $399 billion in total assets. Lehman Brothers had $639 billion in total assets, possibly posing a bigger systemic risk than Bear.
``There was a perception, right or wrong, that after Bear Stearns, that in any firm as big, the senior debt holders would be okay,'' said Karl Haeling, head of debt distribution at Landesbank Baden-Wuerttemberg, New York, Germany's largest state-owned bank. ``Obviously, that was the wrong bet.''
Bernanke and Paulson began their discussions at the end of the day on Sept. 17, when the Standard & Poor's 500 Financials Index fell 8.9 percent.
Investors concluded after the AIG takeover -- the price of an $85 billion loan -- that any future federal aid would come at a similar cost, and they fled.
`Oh, My God'
``Are we imploding right here?'' Joseph Saluzzi, co-head of Themis Trading LLC in Chatham, New Jersey, and his colleagues asked each other on Sept. 17. Shares of Goldman Sachs Group Inc. were down 21 percent at noon and Morgan Stanley lost 36 percent. ``People thought, `Oh, my God, if Goldman's going out, we've got a real problem.'''
Lehman's collapse caused the Reserve Primary Fund, the oldest U.S. money-market fund, to write off $785 million of debt issued by the investment bank, forcing the fund to break the buck, meaning its net asset value fell below $1 a share.
The run on money funds, prompted in part by the government's decision to let Lehman fail, caused yet another extension of the safety net by the Treasury and Fed.
On Sept. 19, invoking Depression-era authority, the Fed's Board of Governors authorized its Boston branch to provide emergency loans to commercial banks to purchase asset-backed commercial paper from money mutual funds to help them meet shareholder redemptions.
The Treasury is gambling that the $700 billion plan now being debated in Congress will kick-start capital markets and lending. If the government is a buyer of mortgage securities, they will trade higher, Paulson told Congress. If the banks are cleansed of bad assets, they will find new capital and the cycle of lending will start again.
Investors say once again the government's big-footing in the financial markets could create more problems than it solves.
Officials ``have designed a financial bailout plan that is not only misdirected, but may further exacerbate problems in the housing market,'' says Eric Hovde, chief investment officer at Hovde Capital LLC, which manages $1 billion in financial services stocks. ``Just as foreclosure sales are pressuring housing prices today, government sales will only make matters worse.''
To contact the reporters on this story: Craig Torres in Washington at email@example.com; Eric Martin in New York at firstname.lastname@example.org.
By STEPHEN LABATON
“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.
As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets — more than enough to weather the storm.
Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase — backed by a $29 billion taxpayer dowry.
Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom — Merrill Lynch sold itself to Bank of America, Lehman Brothers filed for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial banks.
How could Mr. Cox have been so wrong?
Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.
The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.
A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.
One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion.
“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”
Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation’s corporate laws after a wave of accounting scandals. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets.
Annette L. Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.
“I’m very happy to support it,” said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: “And I keep my fingers crossed for the future.”
The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.
After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.
With that, the five big independent investment firms were unleashed.
In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.
Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.
The 2004 decision for the first time gave the S.E.C. a window on the banks’ increasingly risky investments in mortgage-related securities.
But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority.
The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.
The few problems the examiners preliminarily uncovered about the riskiness of the firms’ investments and their increased reliance on debt — clear signs of trouble — were all but ignored.
The commission’s division of trading and markets “became aware of numerous potential red flags prior to Bear Stearns’s collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain” capital standards, said an inspector general’s report issued last Friday. But the division “did not take actions to limit these risk factors.”
Drive to Deregulate
The commission’s decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush.
A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies.
“It’s a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs,” said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.”
As was the case with other agencies, the commission’s decision was motivated by industry complaints of excessive regulation at a time of growing competition from overseas. The 2004 decision was aimed at easing regulatory burdens that the European Union was about to impose on the foreign operations of United States investment banks.
The Europeans said they would agree not to regulate the foreign subsidiaries of the investment banks on one condition — that the commission regulate the parent companies, along with the brokerage units that the S.E.C. already oversaw.
A 1999 law, however, had left a gap that did not give the commission explicit oversight of the parent companies. To get around that problem, and in exchange for the relaxed capital rules, the banks volunteered to let the commission examine the books of their parent companies and subsidiaries.
The 2004 decision also reflected a faith that Wall Street’s financial interests coincided with Washington’s regulatory interests.
“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).
“Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.
In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities. A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.
“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”
He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.
Mr. Bole, who earned a master’s degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements.
He said in a recent interview that he was never called by anyone from the commission.
“I’m a little guy in the land of giants,” he said. “I thought that the reduction in capital was rather dramatic.”
Policing Wall Street
A once-proud agency with a rich history at the intersection of Washington and Wall Street, the Securities and Exchange Commission was created during the Great Depression as part of the broader effort to restore confidence to battered investors. It was led in its formative years by heavyweight New Dealers, including James Landis and William O. Douglas. When President Franklin D. Roosevelt was asked in 1934 why he appointed Joseph P. Kennedy, a spectacularly successful stock speculator, as the agency’s first chairman, Roosevelt replied: “Set a thief to catch a thief.”
The commission’s most public role in policing Wall Street is its enforcement efforts. But critics say that in recent years it has failed to deter market problems. “It seems to me the enforcement effort in recent years has fallen short of what one Supreme Court justice once called the fear of the shotgun behind the door,” said Arthur Levitt Jr., who was S.E.C. chairman in the Clinton administration. “With this commission, the shotgun too rarely came out from behind the door.”
Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Mr. Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.
Under Mr. Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.
Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Mr. Paulson, the Treasury secretary, that proposed to reduce their stature — and that of the S.E.C. — Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency.
In the process, Mr. Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors.
‘Stakes in the Ground’
Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
“The last six months have made it abundantly clear that voluntary regulation does not work,” Mr. Cox said.
The decision to shutter the program came after Mr. Cox was blamed by Senator John McCain, the Republican presidential candidate, for the crisis. Mr. McCain has demanded Mr. Cox’s resignation.
Mr. Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general’s report have suggested that a major reason for its failure was Mr. Cox’s use of it.
“In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn’t oversee well enough,” Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005.
Mr. Cox declined requests for an interview. In response to written questions, including whether he or the commission had made any mistakes over the last three years that contributed to the current crisis, he said, “There will be no shortage of retrospective analyses about what happened and what should have happened.” He said that by last March he had concluded that the monitoring program’s “metrics were inadequate.”
He said that because the commission did not have the authority to curtail the heavy borrowing at Bear Stearns and the other firms, he and the commission were powerless to stop it.
“Implementing a purely voluntary program was very difficult because the commission’s regulations shouldn’t be suggestions,” he said. “The fact these companies could withdraw from voluntary supervision at their discretion diminished the mandate of the program and weakened its effectiveness. Experience has shown that the S.E.C. could not bootstrap itself into authority it didn’t have.”
But critics say that the commission could have done more, and that the agency’s effectiveness comes from the tone set at the top by the chairman, or what Mr. Levitt, the longest-serving S.E.C. chairman in history, calls “stakes in the ground.”
“If you go back to the chairmen in recent years, you will see that each spoke about a variety of issues that were important to them,” Mr. Levitt said. “This commission placed very few stakes in the ground.”
"Free our oil, Mr. President," said House Speaker Nancy Pelosi in a recent House debate. That gambit so far hasn't won White House backing.
Now some Bush regulatory appointees are moving aggressively to take charge. For more than a year, FDIC Chairman Sheila Bair used the bully pulpit to encourage lenders to act more forcefully to help home owners avoid foreclosure. Her speeches had little effect -- but the recent failure of IndyMac Bank is now giving her the power to carry out her ideas.
Immediately after the FDIC took control of IndyMac on July 11, she suspended all foreclosures-in-progress for the $15 billion mortgage portfolio directly controlled by the bank. Now she is trying to modify the terms by moving adjustable-rate loans into fixed-rate mortgages.
With many other banks expected to fail because of mortgage defaults, she's likely to have other chances to put her ideas in practice. She also hopes other banks will follow the FDIC's prescription themselves, if necessary. "I think we can lead by example," says Ms. Bair, a Republican who was nominated by President Bush to a five-year term in 2006.
Accumulation of Power
The Fed itself has seen the biggest accumulation of power, as Fed Chairman Bernanke and Treasury Secretary Hank Paulson, two Republicans, try to cope with the deepening economic problems. In mid-March, The Federal Reserve put $29 billion on the line to support the sale of Bear Stearns Cos., a huge investment bank that had begun to collapse and was forced into a shotgun marriage with J.P. Morgan Chase & Co.
The Fed is also lending money to four large investment banks. It has placed people inside those banks to scrutinize their holdings and capital -- an extraordinary step, given that the Fed doesn't have direct authority over the companies. On July 13, the Fed also agreed to lend money to Fannie and Freddie Mac, the two biggest mortgage-finance companies, prompting lawmakers to push for a bigger Fed role in monitoring the companies' soundness.
Though the steps have been viewed as temporary, Mr. Bernanke said this month that the central bank's lending powers to investment banks could last more than the six months originally envisioned.
Other government agencies are playing expansive roles, too. The Treasury Department is seeking Congressional approval to buy equity stakes in Fannie Mae and Freddie Mac and offer them unlimited lines of credit to prevent the companies from collapsing. The Federal Housing Administration has eased standards for government-insured mortgages.
Critics warn that turning power over to technocrats can lead to trouble. "The best and the brightest" of the Kennedy and Johnson administrations escalated, and then lost, the war in Vietnam. Federal and state officials still haven't rebuilt New Orleans and the surrounding area three years after the hurricane struck.
The Fed's reputation for independence could suffer if it is handed a larger regulatory role over banks and could produce a conflict of interest. If economic conditions call for the Fed to, say, raise interest rates to control inflation, would the Fed hold off because those higher rates could hurt the banks it regulates?
Former House Republican Speaker Newt Gingrich, who captained the Republican takeover of Congress in 1994 on a "small-government" platform, figures that any surge in government activism is bound to be short-lived because bureaucrats will blunder. "It's very dangerous to assume that some skill at managing the money supply (as the Fed has done) will lead to bureaucratic skills greater than any country possesses," he says.
Dealing with global warming may augur a further expansion of government power. The leading proposal in Congress would cap emissions of greenhouses gases by industries and allow them to buy and sell emission permits.
The legislation garnered 48 votes in the Senate in a June procedural measure, leaving it a dozen short of the 60 needed to get a vote on the bill. Both presidential candidates have made emissions-trading systems a centerpiece of their environmental platforms, all but assuring another Congressional effort after the election.
"Markets are groping" for guidance, says Fred Morse, a senior adviser to the U.S. solar-power subsidiary of Spanish utility Abengoa S.A. "You need government to lay out a policy."
Grasping Reality with Both Hands The Semi-Daily Journal Economist Brad DeLong
As usual, academics need to waste two paragraphs before getting to the point, which starts in the first bullet. To really enjoy this delicious prose you have to first read it all in one place. * Many colleagues are distressed by the notoriety of the Chicago School of Economics, especially throughout much of the global south, where they have often to defend the University’s reputation in the face of its negative image. The effects of the neoliberal global order that has been put in place in recent decades, strongly buttressed by the Chicago School of Economics, have by no means been unequivocally positive. Many would argue that they have been negative for much of the world's population, leading to the weakening of a number of struggling local economies in the service of globalized capital, and many would question the substitution of monetization for democratization under the banner of “market democracy.” Yes, there are people left on the planet who write and think this way, and no, I’m not making this up. Let’s read this more closely and try to figure out what it means.
Many colleagues are distressed by the notoriety of the Chicago School of Economics, especially throughout much of the global south, where they have often to defend the University’s reputation in the face of its negative image. If you’re wondering “what’s their objection?”, “how does a MFI hurt them?” you now have the answer. Translated, “when we go to fashionable lefty cocktail parties in Venezuela, it’s embarrassing to admit who signs our paychecks.” Interestingly, the hundred people who signed this didn’t have the guts even to say “we,” referring to some nebulous “they” as the subject of the sentence. Let’s read this literally: “We don’t really mind at all if there’s a MFI on campus, but some of our other colleagues, who are too shy to sign this letter, find it all too embarrassing to admit where they work.” If this is the reason for organizing a big protest perhaps someone has too much time on their hands. Global south I’ll just pick on this one as a stand-in for all the jargon in this letter. What does this oxymoron mean, and why do the letter writers use it? We used to say what we meant, “poor countries. ” That became unfashionable, in part because poverty is sometimes a bit of your own doing and not a state of pure victimhood. So, it became polite to call dysfunctional backwaters “developing.” That was already a lie (or at best highly wishful thinking) since the whole point is that they aren’t developing. But now bien-pensant circles don’t want to endorse “development” as a worthwhile goal anymore. “South” – well, nice places like Australia, New Zealand and Chile are there too (at least from a curiously North-American and European-centric perspective). So now it’s called “global south,” which though rather poor as directions for actually getting anywhere, identifies the speaker as the caring sort of person who always uses the politically correct word. The effects of the neoliberal global order that has been put in place in recent decades… Notice the interesting voice of the verb. Let’s call it the “accusatory passive.” “Has been put in place...” By who, I (or any decent writer) would want to know? Unnamed dark forces are at work. Many would argue that they have been negative for much of the world's population... weakening … struggling local economies I can think of lots of words to describe what’s going on in, say, China and India, as well as what happened previously to countries that adopted the “neoliberal global order” like Japan, Hong Kong, and South Korea. Billions of people are leading dramatically freer, healthier, longer and more prosperous lives than they were a generation ago. Of course, we all face plenty of problems. I worry about environmental catastrophes, and their political, social and economic aftermath. Many people are suffering, primarily in pockets of kleptocracy and anarchy. Life’s pretty bleak about 5 blocks west of the University of Chicago. In my professional life, I worry about inflation, chaotic markets, and their possible death by regulation. There is a lot for thoughtful economists and social scientists to do. But honestly, do we really yearn to send a billion Chinese back to their “local economies,” trying to eke a meager living out of a quarter acre of rice paddy, under the iron grip of some local bureaucrat? I mean, the Mao caps and Che shirts are cool and all, but millions of people starved to death. This is just the big lie theory at work. Say something often enough and people will start to believe it. It helps especially if what you say is vague and meaningless. Ok, I’ll try to be polite; a lie is deliberate and this is more like a willful disregard for the facts. Still, if you start with the premise that the last 40 or so years, including the fall of communism, and the [economic] opening of China and India are “negative for much of the world’s population,” you just don’t have any business being a social scientist. You don’t stand a chance of contributing something serious to the problems that we actually do face. the service of globalized capital.. was wondering who the subject of all these passive sentences is. Now I’m beginning to get the idea. This view has a particularly dark history. I’ll give you a hint: “Globalized capital” has names like Goldman and Sachs. many would question the substitution of monetization for democratization under the banner of 'market democracy.' What a doozy! What can this actually mean? Given the counterpoint “market democracy” (what we live in, I presume) I suspect “democratic” here means “democratic” as in “people’s democratic republic”, i.e. the government runs everything. Monetization is democratization; it means things are accessible to anyone, not just the politically connected. That observation was, among many other things, Milton Friedman’s genius. Once again, the verb tenses and subjects are telling. “The substitution.” Who did this substitution? Maybe globalized capital, or the international banking conspiracy? Maybe it’s the trilateral commission. The closing bullet point is fun as a reminder of how petty academic squabbles can be after we strip off all the big words, fancy pretentions and meaningless jargon. * In the interests of equity and balance, many of us feel that the University ought to reconsider contributing to the proposed Milton Friedman Institute, which will inevitably be a powerful magnet for scholars and donors who share a specific set of interests and values to the exclusion of others, whether this is openly acknowledged or not. Translation: we publicly charge the faculty committee who put this thing together, and promise a non-partisan non-directed research institute (me included), with lying through their teeth. This sentence adds a – well let’s be polite and call it a “factual inaccuracy.” The whole point is not “University contribution.” The whole point is to try to get private donors who see the benefits of Milton Friedman’s legacy to support economics research here. If the writers understood the first thing about money, that it is fungible, they might understand which side of their bread is buttered. Still others believe that, given the influx of private contributions to the MFI, the University now has the opportunity to provide roughly equivalent resources for critical scholarly work that seeks out alternatives to recent economic, social, and political developments. Finally, we get to the point! We can get over our “distress” at admitting where we work, but what we want is to do some of our own “substitution of monetization for democratization.” And with none of the niceties about non-partisan, non-ideological, open-minded research in the Milton Friedman founding documents either – this money is reserved for people who can get the right answers and belong to the right clubs. And we’re not planning to ask our sympathizers to pony up money either. Basically, we want the Friedman Institute money. Virtually all of us are distressed by the position the University has taken and by the process through which decisions have been made. And we end with good old “process.” When you can’t really complain on the merits, you can always gum up the works by complaining about “process.” Now you know why it takes so long for a university ever to do anything. If it’s sad to see what 101 professionally distinguished minds at the University of Chicago think about free markets at all, it is to me sadder still how atrociously written this letter is. These people devote their lives to writing on social issues, and teaching freshmen (including mine) how to think and write clearly. Yet it’s awful. The letter starts with two paragraphs of meaningless throat-clearing. (“This is a question of the meaning of the University’s investments, in all senses.” What in the world does that sentence actually mean?) I learned to delete throat-clearing in the first day of Writing 101. It’s all written in the passive, or with vague subjects. “Many” should not be the subject of any sentence. You should never write “has been put in place,” you should say who put something in place. You should take responsibility in your writing. Write “we,” not “many colleagues.” The final paragraphs wander around without saying much of anything. The content of course is worse. There isn’t even an idea here, a concrete proposition about the human condition that one can disagree with, buttress or question with facts. It just slings a bunch of jargon, most of which has a real meaning opposite to the literal. “Global South,” “neoliberal global order,” “the service of globalized capital,” “substitution of monetization for democratization.” George Orwell would be proud. I’m not a good writer. I admire great prose, and I attempt to fill the spaces between equations of my papers with comprehensible words. But even I can recognize atrocious prose when I see it. Really, guys and gals, if a Freshman handed this in to one of your classes, could you possibly give any grade above C- and cover it with red ink? I was quoted as saying “drivel,” and I meant it, not as an insult but as a technically correct description of a piece of prose. We can – and should – happily disagree on all sorts of matters of fact and interpretation, clearly stated, and openly discussed. But there’s nothing here to discuss, it’s just mush. The saddest aspect of this whole sorry affair is that 100 faculty at such a distinguished institution can sign their names – and with them their intellectual reputations and their sacred honor -- to such utter drivel. Milton Friedman stood for freedom, social, political, and economic. He realized that they are inextricably linked. If the government controls your job or your business, dissent is impossible. He favored, among other things, legalizing drugs, school choice, and volunteer army. To call him or his political legacy “right wing” is simply ignorant, and I mean that also as a technically accurate description rather than an insult. (Of course, he also has a legacy in the economics community as a first-rate researcher, which is what the MFI will do and honor.) So here’s my question: If you’re embarrassed by this legacy, if you worry that it will tarnish the University’s reputation, just what is it that you good-thinking guys and gals have against human freedom?
But, perhaps more seriously, Friedman ducked the big questions regarding the relationship between economic freedom and political liberty, and he was completely incapable of seeing that political liberty is both a negative and a positive liberty: freedom from tyranny and oppression but also the freedom and power to decide on and accomplish our common purposes. These are the master questions of history and moral philosophy, and for all his brilliance and hard work, Friedman is of absolutely no help in answering them. As Posner says, Friedrich Hayek’s Road to Serfdom "flunks the test of accuracy of prediction … [The] view that socialism of the sort that Britain embraced under the old Labour Party was incompatible with democracy [is] extreme and inaccurate." Yet Friedman bought into that Hayekian view. And in so doing, he ultimately led his followers, and tried to lead the rest of us, down a false path.
"privatizing profits and socializing losses is crony capitalism, pure and simple."
By Menzie Chinn
Or, who will be the Keating 5 of the 2000's? Perspectives from those of us who remember the East Asian crises of the 1990's.
From the NYT:
A 'Moral Hazard' for a Housing Bailout: Sorting the Victims From Those Who Volunteered
By EDMUND L. ANDREWS
Published: February 23, 2008
WASHINGTON -- Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for "financial innovation."
But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion.
A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government -- now that it is in trouble.
The proposal warns that up to $739 billion in mortgages are at "moderate to high risk" of defaulting over the next five years and that millions of families could lose their homes.
To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.
"We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market," the financial institution noted.
In practice, taxpayers would almost certainly view such a move as a bailout. If lawmakers and the Bush administration agreed to this step, it could be on a scale similar to the government's $200 billion bailout of the savings and loan industry in the 1990s. The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.
A rescue would also create a "moral hazard," many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.
If the government pays too much for the mortgages or the market declines even more than it has already, Washington -- read, taxpayers -- could be stuck with hundreds of billions of dollars in defaulted loans.
But a growing number of policy makers and community advocacy activists argue that a government rescue may nonetheless be the most sensible way to avoid a broader disruption of the entire economy.
One paragraph in the article I find quite amusing is this one:
Surprisingly, the normally free-market Bush administration has expressed interest. Treasury officials confirmed that several senior officials invited Mr. Taylor to present his ideas to them on Feb. 15. Mr. Taylor said he had also received calls from officials at the Office of Thrift Supervision and the Office of the Comptroller of the Currency, which is part of the Treasury Department.
To me, it is completely unsurprising that the Administration should be willing to bail out financial institutions. They are well connected in the way that the unemployed  or the uninsured  are not.
However, this is not a rationale for not intervening. As I've said before, "Just say 'no'" is not a viable policy. The key point is to realize that, just like some of the East Asian economies in 1997, we are well past the point about worrying about the impact of current policies on "moral hazard" (see this analysis [pdf]). We needed prudential regulation in the period leading up to the housing boom (sadly, policy makers failed in that respect). That is when contingent liabilities built up (see these posts on "looting" , ). Now, it is not possible for the government to credibly commit to not intervene, when the financial system's operation is at stake (i.e., as Krugman has said, the horse is out the barn door).
And make no mistake -- the financial system is to some degree already frozen, and there is little prospect for a complete unfreezing of the system without substantial government intervention. From Deutsche Bank Economics/Strategy Weekly (Feb. 22):
...Taking MBS spreads as an example, spreads have now widened beyond the levels reached in the convexity episode of 2003, and is approaching the highs of the LTCM crisis of 1998. We emphasize that it is important for the market not to anticipate the kind of mean reversion that occurred in those previous widening episodes. In 1998, the spread widening wasn't a result of a systemic problem (at least in the principal developed economies), but rather was narrowly addressed with the unwinding of LTCM's positions. Spreads moved back relatively quickly on GSE buying, as GSEâ€™s then were a reasonably large part of the mortgage market at that time, unlike the current moment, when the GSE's have been and are still hampered by regulatory and competitive restrictions, and thus are too small to serve as a stabilizing force.
In this sense, the current crisis is very much like the S&L crisis. And as it looks more and more likely that the government will have to spend billions of dollars bailing out investors, banks, and households, it seems to me that accountability is required. Who in the Administration pushed to prevent regulatory oversight? Who in Congress pushed the interests of the banks?
And we should look very carefully at the proposals that are being pushed by the financial industry, even as we acknowledge that laissez faire is not tenable, and we seek to establish procedures and institutional reforms that will prevent a replay. In particular, thinking about a well-funded, integrated, regulatory system that is insulated from political pressures would be a good place to start.
This post was by Menzie Chinn
It's apparent to the people who actually read through and interpret data and articles in there own way. A post asks why can't it be said what is really going on with inflation......because as BR knows it is career suicide to go against the normal channels of media and it's spin on any negative news that does't support the current administration's agenda.
Whether we like it or not (or want to admit it) our gov't is engaged in one of the largest frauds and financial chicanery that we've ever been witness to. Remember what happned in Hungary last year???
It will most likely never be exposed as the fraud it is however if it were it would make Watergate look like a children's picnic.
Remember inflation is not a problem if you do not drive anywhere or eat anything......just ask our gov't they'll tell you.
Sheeple in full effect
Posted by: michael Schumacher | May 16, 2007 1:16:06 PM
This fraud has been ongoing. So, although I consider the current adminstration to be far (far, far) worse than its predecessor, we need a mechanism to help us break the two-party duopoly. Indeed, the methodology of "choosing the lesser of two evils" does not guarantee that the *baseline does not get worse*!
We need competition in the political marketplace. Instant run-off voting would eliminate the concern -- "I don't want to waste my vote" -- people have for voting for 3rd party candidates.
We should also have redistricting done by algorithms that don't attempt to control the political makeup of those districts. (Ahnuld said he wanted to do this. I wish he had turned this into one of his propositions. I haven't read anything on it in years.)
Without systemic changes, we seem to be going from bad to worse.
How SEC Regulatory Exemptions Helped Lead to Collapse (September 2008)
Brokerage Collapse Was Our Fault (September 2008)
Agency’s ’04 Rule Let Banks Pile Up New Debt, and Risk
October 3, 2008
The Day the SEC Changed the Game