naked capitalism

The summary of the second report is due out this Friday. Oddly, this sneak preview appears, at least so far, only in the Financial Times (I checked the Wall Street Journal and the New York Times).

As described below, the second report delves deeper into the nature and scope of likely changes, and how they will affect various areas of the planet:

Climate change is threatening vital infrastructure such as road and rail networks, water and energy systems, and healthcare, and the damage is set to worsen, the world’s leading climate scientists will warn next week.

The damage will occur even as some regions, such as the UK and northern Europe, and parts of the Americas, enjoy some of the benefits from global warming.

Areas that now have cold climates will experience longer growing seasons and a greater variety of crops, as well as becoming more attractive to tourists. Melting ice may also allow for mineral extraction in areas such as Canada and Russia, and drilling for oil in the Arctic.

But warmer regions, such as southern Europe, the US south and parts of Asia, will suffer lower agricultural yields, droughts and the spread of human, animal and plant diseases, the scientists are expected to conclude.

On Monday in Brussels, the world’s leading climate scientists will meet to finalise their findings on the impact of global warming in the form of a report, six years in the making and drawing on the work of more than 2,500 experts. On Friday, they are scheduled to publish their summary, making up the second section of the report of the Intergovernmental Panel on Climate Change.

The Wall Street Journal reports tonight on its website, and presumably tomorrow in its print edition, that

Federal Reserve Chairman Ben Bernanke said Friday that ongoing issues in the subprime mortgage market could force bank regulators to rethink their enforcement of a 30-year-old law that requires banks to serve the credit needs in their communities….

“Recent problems in mortgage markets illustrate that an underlying assumption of the CRA — that more lending equals better outcomes for local communities — may not always hold,” he said, according to prepared remarks. “Whether, and if so, how to differentiate “good” from “bad” lending in the CRA context is an issue that is likely to challenge us for some time.” (See the full text of Bernanke’s speech.)…

The 30-year-old law was passed as a way to require banks to lend and reinvest in communities where they take deposits. Financial-services companies often complain that compliance with the law is costly and that regulators examine banks for their compliance with the rule and not the actual results of community investment.

Banks are given credit for lending to low and moderate income areas, as well as rural areas where financial services may not be readily available.

This year, rising default rates and foreclosure rates among subprime loan borrowers have shaken the mortgage and real estate markets. Subprime loans are made to people with weak credit histories, and these are the types of borrowers a bank could get credit for serving under the law.

Mr. Bernanke’s statements suggest a warning to banks that lenders should make these loans carefully, and not simply for the sake of complying with the CRA.

Now why does this sound, as the Australians would put it, a bit sus? This is the first time I’ve seen CRA invoked as a reason for the explosion in subprime lending. It was entirely profit driven, or now what we recognize as “fantasy of profit driven,” unless you were a mortgage originator and didn’t have to care much about what happened on the back end (it turns out agreements that the final buyers of subprime paper had with the mortgage originators to recoup losses if defaults exceeded certain levels proved to be worthless. Duh. An agreement is only as good as the party making it, and these originators had puny balance sheets relative to the volume of mortgages they were placing. Nevertheless, firms such as Credit Suisse and Bear Stearns are suing bankrupt and soon to be bankrupt subprime mortgage lenders like ResMae, to recoup whatever they can).

We also noted last week that, Roger Cole, the Federal Reserve’s director of supervision and regulation, was given a very hard time by both Republican and Democratic members of the Senate Banking Committee for the Fed’s failure to forestall the subprime mess. Cole didn’t muster much of a defense, even though we think the Fed actually isn’t to blame (customer protection isn’t part of the Fed’s charter, and the majority of subprime lending was performed by institutions out of the Fed’s reach). But it will still be hard for the Fed to escape criticism, particularly since it appears that the Office of the Comptroller of the Currency took a stronger stand than the Fed in trying to rein in subprime lending.

So this spurious invoking of the CRA may be a way to shunt blame from the Fed, by making it sound as if the primary aim of subprime lending was to meet regulatory requirements, and hence there was no reason for the Fed to intervene. Worse, this may be a warning: “Don’t expect banks to be able to meet their CRA obligations if you restrict their offerings.” That’s a terrible message, for it guts CRA. Yet that seems to be precisely what Bernanke is hinting at.

A story in Thursday’s Financial Times, “Global, universal, unmanageable? Why many are wary of bank mega-mergers,” by Peter Thal Larsen describes why most bank mergers fail to live up to their promise.

Even though the srticle was prompted by the possible Barclays-ABN Amro merger, its logic applies to much smaller deals. Most advocates of banking deals tout greater economies of scale as their main advantage. Yet these efficiencies are seldom achieved in practice. Indeed, look at Citigroup itself: it has announced a planned staff reduction of 15,000 because its expenses are out of line.

The FT article focuses on big, international banking mergers, which are understandably suspect (it’s hard to imagine how efficient one could become dealing with multiple regulatory regimes and national differences in product demand and marketing approaches). Surprisingly, the FT story fails to note that bigger banks appear to be no more efficient even in homogeneous markets.

It has been well known within the US banking industry for quite some time (see here for an example) that it exhibits a slightly increasing cost curve once a certain threshold is surpassed. That means that bigger banks have higher costs per unit of output.This finding has been confirmed repeatedly in academic studies; the only difference among them is the level at which the cost inefficiencies start, but no study had found it to be higher than $5 billion in assets.

There has been some speculation as to why larger banks are not as efficient as their smaller brethren. One theory is that credit decisions, like small business lending and mortgages, are done perhaps a bit better by branch staff who know their communities rather than by credit scoring systems and multi-level reviews. Another argument is that there really are economies of scale within various products, but they are offset by diseconomies of scope. In essence, bigger banks are in more products than smaller banks, and the cost of being in so many businesses offsets the advantage of being “big” in any one business.

Proponents of bank acquisitions, particularly in the US, may still take exception. Haven’t those big bank mergers taken out a lot of costs, and in particular, closed a lot of branches? Ah, yes, but the process of integrating two banks in and of itself is costly, meaning there are offsets (like IT integration) for the more visible sackings. And the increasing cost curve for the industry says any cost reduction could have been achieved without a merger. But for some reason, managers find it easier to cut heads in the wake of a deal.

So what is the real impetus for these deals? I see at least three causes. One, per the Barclay’s example, there is almost a romantic attachment to size as a proxy for leadership or quality. This view may be even stronger in the banking industry than in others, because in banking, one’s power is based on the span of operations one oversees (unlike investment banking, where power is based on revenue generation).

Second is Wall Street’s pressure for growth. Now if you are as big as Citigroup, growth beyond a very modest rate is an unrealistic expectation. If Citigroup were to exhibit high growth, it would very soon be bigger than world GDP. Very large companies inherently can’t exhibit much growth. But an acquisition does make even very large companies bigger, and you have at least two years of the analysts focusing as much on how the acquisition as on top line growth.

Third is that CEO pay in the banking industry is correlated with the size of the bank. So acquirers get to pay themselves more, and the CEO of the target gets a golden parachute. A win-win for everyone but the shareholders.

From the FT:

Shortly after John Varley took over as chief executive of Barclays in 2004, the bank’s top managers started using a new term to describe the scale of its ambitions. The idea, which they dubbed T5, was that Barclays should think and compete as if it were one of the top five banks in the world….

But if Barclays succeeds in buying ABN Amro of the Netherlands, Mr Varley and his team will need a new target. Based on current share prices, the combined group would be worth around $177bn (£90bn, €132bn) and would displace JPMorgan Chase as the fifth largest bank in the world…

The question, however, is whether this is a good idea. Many banking executives argue that large institutions benefit from economies of scale, especially in their use of information technology; have larger balance sheets that allow them to take on more risk; and produce an earnings stream that is more diverse and therefore more stable. But that case is unproven. Despite a decade of banking mergers, there is no evidence that big banks are any more efficient or profitable than their smaller rivals.

This is reflected in their share prices. In the past few years, the world’s largest banks have tended to trade on lower earnings multiples than smaller institutions. “When it comes to asking the stock market whether bigger banks are better, the current answer is a resounding ‘no’,” analysts at Citigroup wrote in a study published last year.

A prime example of the argument that big banks do not necessarily outperform is Citigroup itself. When Citicorp and Travelers combined in 1998, the merger seemed to herald the era of giant financial institutions that could offer a full range of financial services products anywhere on earth….

Nine years on, the reality has fallen some way short of the original vision. Citigroup’s idea of selling insurance products to banking customers failed to take off and it eventually spun off its insurance arm. Regulatory setbacks in the US, Europe and Japan rattled investors and raised questions about the ability of the bank’s management team to keep tabs on such a broad and diverse business…

The history of ABN Amro also offers a cautionary example that building a universal bank does not always work. Ever since it was created through a domestic merger in 1991, the Dutch lender has been eagerly expanding outside its home market, buying banks in the US, Brazil andItaly, while also building up its investment banking, private banking and asset management businesses.

But despite assembling this array of assets, it has failed to deliver any sustained growth in profits in recent years. It was not until The Children’s Investment Fund (TCI), the activist hedge fund, last month launched its campaign to shake up ABN Amro that the bank’s shares rose above the level they stood at in the spring of 2000.

ABN Amro’s performance is often blamed on poor management – and there seems little question that the bank could be better run. Stuart Graham, an analyst at Merrill Lynch, calculates that if ABN Amro’s ratio of cost to income were in line with that of its peers, profits would be 37 per cent higher.

Barclays’ management team would be likely to improve performance. But an alternative argument is that ABN Amro does not make sense in its current form and should be broken up, with its various subsidiaries sold to banks that could manage them better. Investment bankers are trying to assemble consortia that could offer to buy the whole of ABN Amro and, if successful, carve up the businesses among themselves.

In this context, Barclays’ talks with ABN Amro mark a critical moment in the development of the industry. If the deal goes ahead and is a success, it could transform the banking landscape, triggering a string of similar deals among European institutions as they rush to bulk up.

Yet if Barclays is outbid by a rival that splits ABN Amro into different parts, investors could rethink the value of large banks – and increase the pressure on those institutions that havedone big deals in the past to prove they really are worthmore than the sum of their parts.

Until a few years ago, most banking executives agreed that cross-border economies of scale in banking were limited to a handful of areas. The first of those is investment banking, because the corporations and institutional investors that are their main clients are likely to operate across borders. The second is in areas such as asset management, where the skills of fund managers can be centralised in “factories” and the products can be distributed to clients in different countries. The third is in mass retail products, including credit cards, which require huge investments in information technology but where the product is similar in different countries.

More recently, however, European banks have also begun to maintain that cross-border deals can make sense in retail banking. The first bank to explicitly make this case was Spain’s Santander, which bought Abbey National of the UK in 2004. Santander executives argued that they could cut Abbey’s costs by switching its IT systems to the Spanish bank’s proprietary platform, called Partenon. This suggested that big banks, which have the resources to develop state-of-the-art IT systems, would have an advantage when buying up smaller rivals, even in another country.

Other banks promptly followed suit. In several cross-border European deals, executives were proclaiming that – among other factors – the switch to a common IT platform could help to justify the costs of the acquisition. This argument is still unproven. Though Santander has cut costs at Abbey, it has done so largely through a greater than expected level of redundancies. Santander still expects to reap further benefits by introducing Partenon in the UK but it is not yet clear that this will make operations more efficient.

Another factor that could work in large banks’ favour is the introduction of new global rules for measuring banks’ capital. The framework, known as Basel II, allows banks to determine how much capital they need based on their internal risk management models. Over time this should allow big banks, which can afford to spend heavily on developing risk management systems, to operate with proportionately less capital than smaller rivals.

Yet all these benefits may also be available to medium-sized banks. While it seems clear that a bank with a market value of $10bn has access to capital and systems that a bank with assets of just $1bn does not, it does not necessarily follow that a bank valued at $100bn has the same kind of advantage over the $10bn bank.

Indeed, while size may offer some benefits, it can also introduce complexity into a business that makes it harder to manage effectively. HSBC is widely regarded as one of the world’s best-run banks, with operations in more than 80 countries. But even it was caught by surprise by the sudden decline in the US subprime mortgage market.

Whatever the arguments, the data suggest there is no evidence that big banks are better. Last year analysts at Citigroup measured the efficiency and profitability of a large group of banks relative to revenues and the size of their balance sheets and concluded there was no relationship between the two. They also calculated that big banks’ earnings were no less volatile and that, while they were better able to diversify risk, this applied to any bank with a market capitalisation of more than $20bn…

A key question is how the stock market values large banks. At the moment they generally trade at a discount to smaller institutions, suggesting that really big mergers are less attractive. However, this may be due to takeover speculation as well as to the growing influence of hedge funds, which tend to steer clear of large-cap companies in favour of smaller businesses that have a better chance of outperforming the index. If credit conditions were to tighten, investors would probably rush back to big banks as a safer place to put their money.

Others argue that the poor share price performance of Citigroup and HSBC in recent years is a reflection of specific problems at those banks that have nothing to do with their size. “Why do investors not like HSBC? It’s because they had a surprise and their earnings growth was disappointing,” says one executive. “It’s got nothing to do with whether they are big or small.”

Yet the longer the discount persists, the more pressure big banks will face to find a way to realise their true value. It is hard to pick apart a complex, regulated institution like a big bank – particularly if it does not particularly want to be broken up. But TCI’s campaign for change at ABN Amro has paid off handsomely. It is not too far-fetched to imagine TCI, or another activist, seeking to put similar pressure on other big institutions

Dear readers, I am afraid you will have to wait till later today at best to hear from me. This is the first time in the last day that I have been able to keep anything (including water) down, and being horizontal still feels like a better idea that being vertical.

For your information, according to the National Institutes of Health, there is no such thing as a 24 hour flu. It’s food poisoning.

Apologies for the dearth of posts so far today. The real world has intruded. Please be patient, we will have more goodies for you later.

This comment, “A market correction is coming, this time for real,” comes from William Rhodes, senior vice-chairman of Citigroup, and chairman, president and chief executive of Citibank. Consistent with the headline, Rhodes takes a bearish view (in fact, he says he has been concerned about leverage and indiscriminate pricing of risk for some time, and said he expected a market correction a year ago. Now not only does he say he expects a “market correction” in the next 12 months, but a “real correction,” which presumably means a correction in the real economy (does that mean a recession, or merely a marked fall in growth?).

It’s noteworthy that someone in a senior position in a major financial institution is forecasting a pessimistic (actually, quite pessimistic by the standards of this sort of thing) outlook for growth. And he was downbeat late last spring, and admits to having been premature. Now some financial services firms have bearish spokesmen they keep around (think Stephen Roach at Morgan Stanley, who is always worth listening to, even when he is wrong), so perhaps that is one of Rhodes’ roles. But the pernabear function is generally occupied by an economist doing market or economic forecasts, not a member of management. So it’s pretty certain Rhodes believes what he is saying (it’s not a house view) and it’s also pretty certain that it’s at least in part based on information that is not widely reported (someone like Rhodes either talks directly to or is one step removed from top corporate executives, very wealthy individuals, central bankers, regulators, other senior bank executives, and major investors).

So while this is one man’s view, he is likely to have better access to information than many of the pros….

The recent market turmoil should not have been un­expected. We are living in an increasingly interdependent world. Times have been good, even with the volatility of the past few weeks sparked by the Shanghai market and then fuelled by the subprime sector in the US. We have been living in extraordinary times in a global “Goldilocks” economy – not too hot, not too cold. The macro-economy still looks pretty good but the shaking of the trees over the past few weeks has, it is to be hoped, awakened investors and lenders to the risks in the marketplace.

High growth in emerging markets continues, as exemplified by the tremendous growth in China and India. Western and eastern Europe are growing. The Russian economy, driven by energy, has been strengthened well beyond what was expected a few years ago. The Middle Eastern oil-exporting countries are going through a boom fuelled by oil and gas: it is different from earlier periods of high oil prices because this time a substantial amount of the money is staying in the region, rather than being invested elsewhere as in the 1970s.

Africa is in many ways going through something of an economic renaissance. The Japanese economy also has improved and the US locomotive has continued, maintaining good growth of more than 3 per cent in 2006 notwithstanding the downward revision of fourth-quarter growth from 3.5 to 2.2 per cent.

However, much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve’s expansionary monetary policies early in the decade and the US administration’s fiscal stimulus. The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today. The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns.

Pockets of excess are becoming harder to ignore. Problems in the housing and mortgage area such as the subprime sector in the US are one such example of excess that should come as no surprise. As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface. Too many countries and companies with vastly different risk profiles are still commanding similar pricing.

It has been my experience that periods of economic expansion tend to last between five and seven years. We are entering the sixth year of expansion in the US. Against that background, I believe that over the next 12 months a market correction will occur and this time it will be a real correction. I said as much last spring during the Inter-American Development Bank meetings in Belo Horizonte, Brazil. Soon afterwards, in May 2006, the markets did experience a correction but it was so mild and short-lived that it was in a way less effective than no correction at all. I say that because it left the inexperienced with the impression that it would be smooth sailing from there on.

Market developments in the past few weeks should be seen as a warning. What has been evident for a number of months is that, in the US, we are seeing lagging inflation and slower growth. Whether this means that we are going to have to fend off recessionary tendencies is not yet clear. However, what is clear to me is that in the next year a material correction in the markets will occur.

During the last big adjustment that started in July 1997 in Thailand and spread to a number of Asian economies including South Korea, followed by Russia in 1998 – and led ultimately to the bail-out of Long Term Capital Management, the US hedge fund – a number of today’s large market operat­ors were not yet in the mix.

Today, hedge funds, private equity and those involved in credit derivatives play important, and as yet largely untested, roles. The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes. It is also possible that they could provide relief for markets that face shortages of liquidity.

Either way, this clearly is the time to exercise greater prudence in lending and in investing and to resist any temptation to relax standards.

A very good comment in Tuesday’s Financial Times, “The cheerleaders’ threat to global trade,” by Dani Rodrik, professor of international political economy at Harvard’s Kennedy School.

He makes the point that globalization fans may be their own worst enemy by taking the simpleminded point of view that if globalization is good, more globalization is of course better. Rodrik reminds us that globalization needs to be balanced against national interests, and some of the nations touted as big beneficiaries of more open trade markets, such as India and China, in fact did not open their markets to imports until their growth rates were increasing handily.

His most important observation is “If there is one lesson from the collapse of the 19th century version of globalisation, it is that we cannot leave national governments powerless to respond to their citizens.” Yet some of the proponents believe in the sovereignity of markets, that any attempt to intervene in markets will only yield bad outcomes, and will in any event be futile because the forbidden activity take place despite the barriers we try to erect (hhm, if we really believed that, we wouldn’t be using economic sanctions against Iran, now would we?).

It’s similar to an argument made by William Greider in a New York Times article, “The Truth Deficit,” in which he makes the case that the system we operate under isn’t free trade, it’s managed trade, and most other countries play the game in a way to produce better national outcomes (fewer lost jobs and trade surpluses). We seem to be running our trade policy not to optimize our national interest, but that of large international corporations, which is far from the same thing.

From Rodrik:

Which is the greatest threat to globalisation: the protesters on the streets every time the International Monetary Fund or the World Trade Organisation meets, or globalisation’s cheerleaders, who push for continued market opening while denying that the troubles surrounding globalisation are rooted in the policies they advocate?

A good case can be made that the latter camp presents the greater menace. Anti-globalisers are marginalised. But cheerleaders in Washington, London and the elite universities of north America and Europe shape the intellectual climate. If they get their way, they are more likely to put globalisation at risk than the protesters they condemn for ignorance of sound economics.

That is because the greatest obstacle to sustaining a healthy, globalised economy is no longer insufficient openness. Markets are freer from government interference than they have ever been….

Consequently, no country’s growth prospects are significantly constrained by a lack of openness in the international economy. Even if the Doha trade round fails, poor countries will have enough access to rich country markets to achieve what countries such as China, Vietnam and India have been able to do. Closed markets may have been a fundamental problem during the 1950s and 1960s; it is hard to believe they still are. The greatest risk to globalisation is elsewhere. It lies in the prospect that national governments’ room for manoeuvre will shrink to such levels that they will be unable to deliver the policies that their electorates want and need in order to buy into the global economy.

Globalisation’s soft underbelly is the imbalance between the national scope of governments and the global nature of markets. A healthy economic system necessitates a delicate compromise between these two. Go too much in one direction and you have protectionism and autarky. Go too much in the other and you have an unstable world economy with little social and political support from those it is supposed to help.

If there is one lesson from the collapse of the 19th century version of globalisation, it is that we cannot leave national governments powerless to respond to their citizens. The genius of the Bretton Woods system, which lasted for about three decades after the second world war, was that it achieved such a compromise. Some of the most egregious restrictions on trade flows were removed, while allowing governments freedom to run independent macroeconomic policies and erect their own versions of the welfare state. Developing countries were free to pursue their own growth strategies with limited external restraint. The world economy prospered like never before.

But what about China and India, which have taken off in the pastquarter-century? Are they not proof that poor nations need the current variant of globalisation instead of the Bretton Woods variant?

Actually, no. What is striking about China, India and a few other Asian countries that have done well recently is that they have played the globalisation game by the Bretton Woods rulebook. These countries did not significantly liberalise their import regimes until well after their economies had taken off; they continue to restrict short-term capital inflows. They have used industrial policies – many banned by the WTO – to restructure their economies and enable them to better take advantage of world markets.

Rich and poor nations need breathing space for different reasons. Rich countries need it so they can revive the social compacts that underpinned the success of Bretton Woods. They need flexibility to interfere in trade when trade conflicts with deeply held values at home – as, for example, with child labour or health and safety concerns – or severely weakens the bargaining power of workers. Poor nations need room to engage in exchange rate and industrial policies that will diversify and restructure their economies, without which their ability to benefit from globalisation is circumscribed.

It is time, then, to consider a new bar- gain. When rich and poor nations come together to negotiate the rules of the game they should stop thinking in terms of exchanging market access: “I will open my markets in x if you open yours in y.” They should consider ins-tead exchanging policy space: “I will allow you to protect your national social compact if you allow me to engage in development strategies that conflict with WTO and International Monetary Fund rules of good behaviour.” The challenge is to design procedures that enable the use of policy space for socially desirable purposes while limiting it for beggar-thy-neighbour purposes.

Risky? Yes. There is always the chance that such an approach would slide into protectionism, pure and simple. But the alternative is, if anything, more risky. Historians teach us that globalisation rests on delicate social and political pillars. The first order of business today is to strengthen these pillars, rather than to push market opening further.

Faithful readers may have read our recent posts on the limits to the Fed’s regulatory authority, both relative to the subprime mess and to the proliferation of new instruments (see here and here and here).

We had the spectacle last week of Roger Cole, the Federal Reserve’s director of supervision and regulation appearing before the Senate Banking Committee and have its members take him to task about the Fed’s failure to head off the excesses in the subprime market. Cole made only a weak defense, and we commented that, given the Fed’s charter, which is the safety and soundness of the banking system, that it isn’t clear that they were terribly remiss.

Now we have some good and bad news, both from a post on Calculated Risk, “OCC ‘concerned in 2002 with the growth of exotic mortgages.” The good news is the the Office of the Comptroller of the Currency, which supervises national banks, was on to the dangers of speculative mortgages early on, and took aggressive measures to curtail them (and note how a difference in charter produces a difference in outcomes: one of the OCC’s four objectives is “To ensure fair and equal access to financial services for all Americans”). But their efforts were largely ineffective because companies insistent on profiting from these products simply operate outside the OCC’s purview (and recall the subprime originators like New Century weren’t even banks. Mortgage brokers are subject to state regulation).

From Calculated Risk:

Emory W. Rushton, Senior Deputy Comptroller and Chief National Bank Examiner of the Office, of the Comptroller Of The Currency (OCC) provided testimony today to the House Committee on Financial Services. From Rushton’s oral testimony:

OCC became concerned in 2002 with the growth of exotic mortgages that have the potential for a big payment shock, and we responded in an escalating fashion, both formally and informally, privately and publicly. By 2005, we were instructing our examiners to more aggressively address the risks of these products during examinations of national banks – at a time, I might add, when home prices were still rising – because we concluded that standards had slipped far enough. That intervention is one reason why you will find few payment-option ARMs in national banks today. Shortly after that, we initiated the interagency process that resulted in the nontraditional mortgage guidance that was issued last Fall.

And from Rushton’s written testimony:

[T]he vast majority of subprime loans are not originated in the national banking system or supervised by the OCC. While some national banks and their subsidiaries help to serve the credit needs of the subprime market, their subprime lending last year amounted to less than 10% of the total of subprime mortgage originations by all lenders. … National banks and their subsidiaries that engage in subprime lending are subject to extensive oversight by OCC examiners and must operate in close compliance with the OCC’s rigorous safety and soundness and consumer protection standards. … Some have said, perhaps not surprisingly, that there is a direct connection between the rigor of the OCC’s supervision of subprime mortgage lending and the low level of this activity in national banks. Indeed, there have been recent instances in which banks have decided against converting to a national charter for this very reason.

In some ways this is comforting; apparently the national banks engaged in very limited option ARM and subprime lending.

Reader DS in on a roll. A couple of days ago, he sent us an e-mail which we posted, with a few comments of our own, as “Toothless Fed.”

DS focuses on another remark in New York Fed President Timothy Geithner’s speech last week, “Credit Markets Innovations and Their Implications,” which led him to consider the distinction between credit pricing and terms being set by “markets,” that is, markets for financial instruments, rather than other competitive processes.

In the early days of asset-backed securities, securitiztion did not have much impact on the lending process. You still had banks making loans backed by collateral (mortgages, or cars, or credit card receivables) that investment banks sliced, diced, packaged, and sold to investors.

But as this activity grew, the pricing of the paper in the secondary market began affecting first, credit decisions (even if you thought the loan was too risky, if Wall Street said they could sell it and you got an origination profit, why should you care?) and then even credit processes (Tanta of Calculated Risk described how the mortgage approval process has been so dumbed down as to be close to a charade).

DS elaborates:

Here’s another point that may or may not have been discussed by others. In his speech that you post, Geithner writes at the beginning of one of the paragraphs:

In systems where credit is more market-based

It’s a very telling phrase: ‘more market based’

Let’s unpeel it.

Market based instead of, ‘credit based’. I.e. in the ancient days of sound banking, credit was credit based. Indeed, even having to write that sounds dumb. Of course, ‘credit was credit based’ … what else could it be?

But, actually in the ancient days of sound banking, ‘credit was credit-market based’. That is, all banks participated in markets that offered credit. In local, housing markets, bank credit was ‘credit market based’ in the sense that there was a local market for credit and that market set the terms and approaches of competition — for competitors, for customers, for shareholders, etc.

Among those terms of competition were the now ancient idea that credit worthiness of a customer was something worth considering in whether to grant a credit. Yes, risk was also part of the equation. Folks took more or less risk as they liked. And, those folks making the choice to extend credit — the bank underwriters – had jobs that actually required them to evaluate the credit-worthiness of customers (in part, because as you point out, another aspect of ‘credit being credit-market based’ was that principal stayed on the banks’ books.)

But, Geithner’s phrase is speaking about a very different kind of market. He’s not referring to ‘local credit markets’, he’s referring to national and global financial markets. Now credit is ‘more market based’ in the sense that it is more based on these massive financial markets and HOW THEY PRICE AND BUY PAPER.

In these new, innovative massive financial markets, credit is offered according to very different rules of competition; including, credit scoring that is done not as a primary valuation of the borrower, but rather to ‘fit’ what the financial markets have appetite for.

In this new world, we don’t pay primary attention to the borrower — we pay primary attention to the buyer of our paper.

This, in turn, creates a new moral hazard. Geithner (Or maybe one of the others you’ve cited) speaks about the moral hazard of banks that are insured by the government. But that pales in insignificance compared to the moral hazard of granting credit based on ‘credit being ‘more market based’ in this new world of innovation.

Credit as ‘more market based’, then, means credit has become a trade-able financial instrument in capital markets that are beyond the reach of regulation and driven by people hell bent on getting theirs before the great Minsky moment bursts the bubble. Meanwhile, local credit that once drove sound development of local economies now drive people into unsustainable financial postures that, when joined by the forces of job insecurity, lower real wages and lessening real benefits, dual working households, way too much use of usurious credit cards and more, mean that local economies float on helium.

There is a terrific post by Barry Ritholtz at The Big Picture, “What is the Fed Really Thinking?” which was also picked up by Brad DeLong as an excellent example of Fed-watching.

Barry pointed out last week that the latest FOMC report clearly indicated stagflation. He later noted that the market’s peppy response to the report was a bit daft, because with the Fed signalling a greater likelihood of rate cuts, the Fed wasn’t proposing to cut rates for the good reason that the risk of inflation was lowering. No, it said that cuts would be in the offing if the economy got worse. That isn’t exactly good news for stocks.

Now Ritholtz argues (convincingly) that someone at the Fed called Greg Ip at the Wall Street Journal to tell him what the FOMC report meant, and Greg Ip dutifully wrote that up. And the market dutifully went down.

That begs the question, Why does is the Fed going to so much trouble to be understood? In a bit of synchronicity, another DeLong post today quotes Greenpan as saying in 1987:

Since I have become a central banker I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said…

Now one could simply attribute the Fed’s concern the misinterpretation of its latest report as a manifestation of Bernanke’s new policy of greater transparency. But calling the Journal, rather than waiting for one of the routine appearances of Bernanke or a Fed governor, seems to suggest they felt it awfully important to get the information out, and in a way it would be heard.

So what does that suggest to me? That the Fed didn’t like the market rally of last week.

That may seem a very strange idea (you’d normally expect the Fed to invervene in markets only to stem potentially damaging downward movements), but hear me out. First, back on May 8, 2000, the Journal ran a first page story about Greenspan’s interest in stock prices (as in the general level thereof, not stock picking) and was devoting considerable Fed economist resources to that task. That struck me as bizarre and worrisome, because the stock markets aren’t the Fed’s job.

Second, we have Greenspan talking about recession in Hong Kong, which appears to have contributed to the worldwide market decline of Feb. 27. Bernanke had a scheduled appearance before the House Banking Committee the next day, where he said reassuring things and the markets calmed down. Greenspan backed off a bit, but kept muttering about recession.

Now many observers thought that Greenspan was making Bernanke’s job difficult, but we suspected this could actually be a loosely-coordinated “good cop -bad cop” act, that Bernanke either wants or expects the market to go down for reasons known only to his army of Fed economists (like all that leverage and those non-existant risk premia for risky assets are going to end up badly) and he is trying to take the markets down gently. Thus, the clarification of the last FOMC report is part of this pattern, trying to let the air out of the bubble as gently as possible. Otherwise, why not let the market participants figure out, which they will in upcoming weeks and months, that they misread the Fed and react badly later? Perhaps Bernanke & Co. was concerned that if investors reacted later, the reaction would be more extreme.

And as Fed chairman, given the unknown but possibly very ugly impacton hedge funds (which are very big credit market particants) of a rapid fall in the markets, it might be argued to be within his purview to influence market prices (in a way, it’s the only way he can manage the solvency and safety of fiduciaries he does not oversee). We had people in a position to know tell us that if the meltdown of the Feb. 27th had progressed much further that week, there would have been enough margin calls to lead to more selling, and serious damange to a lot of hedge funds. And if enough hedge funds got hurt, the prime brokers wouldn’t be far behind.

So we think it may not be crazy to believe that the Fed is trying to manage not simply market perceptions, but even market prices.

And the fact that they are going to these lengths says they may indeed be concerned about systemic risk if certain scenaraios play out. Otherwise, calling the Journal to staunch a wee bit of optimism in the markets seems like overkill.

To Ritholtz:

Last week’s rally was ignited by a simple change of phrasing in the FOMC statement. Market took that to mean not only that increases are off the table, but — Hallelujah! — a rate cut is in the offing.

Not so fast.

Whenever the Fed says or does something that is subsequently misinterpreted, they have a few back door methods to correct the error. Two in particular were used fairly regularly. Call it the Fed edit/correction methodology.

When John Berry was at the Washington Post, he could be discretely contacted. He’s now the Fed columnist at Bloomberg, and while I’m sure he maintains his FOMC contacts, we haven’t seen him “break news” like his WaPo days. He primarily does analysis, and he is very insightful as to what the the Fed is thinking. That’s quite valuable, but its not the same as “getting the call.”

These days, that takes place with the WSJ’s Greg Ip. And in a page one article, he lays out what the news is from on high:

“When the Federal Reserve last week altered its post-meeting policy statement to soften the suggestion that it might raise interest rates, Wall Street was confused.

Was the Fed signaling that a rate increase was less likely because the outlook for the economy had darkened? Or was it simply reflecting the reality that interest rates are on hold for now?

The answer to both questions is, yes.”

With no one quoted, and no speech is cited, one has to assume this is straight from the horse’s mouth. The WSJ doesn’t print factual statements about the Fed on the front page without knowing this is precisely what they are thinking. That’s simply not how they roll.

So we can assume that Mr. Ip. is repeating what he was told by very senior Fed Sources. Consider the specifics of the following:

“The Fed is seeing increased risks to its forecast that the nation’s economy will grow moderately this year. Those risks include the surprisingly weak level of business investment and the hard-to-predict outcome of the current troubles at the riskier end of the mortgage market.

The Fed changed its statement last week to get the flexibility to cut interest rates in coming months if those risks grow. But it is unlikely to use that flexibility anytime soon, because the risks aren’t big enough and inflation remains uncomfortably high. (emphasis added)

I’ll bet you that the last underlined sentence came verbatim from the Fed. If it was not emailed, than it was spoken slowly and repeated. And the surprisingly weak CapEx chart? Yeah, you can assume that has the Fed nervous.

Here’s another classic insider line (and the word “Housekeeping” is classic bureaucracy speak):

“Housekeeping” played a part, as well. For several months, some officials saw the Fed’s previous policy statement, which had indicated rates could rise but not fall, as increasingly inconsistent with their own expectations of unchanged rates for the foreseeable future.

We are only to the middle of the article, and we get the conclusion:

The new statement reflects a Fed on hold. It contains no explicit reference to the direction of rates, saying only that “future policy adjustments will depend” on growth and inflation, but reiterates enough inflation concern to indicate lower rates aren’t on the table.

The rest of the piece is worth a read, but after this point its just a standard article.

Update: We’ll have a test of my possibly paranoid views. I had not realized that Bernanke was testifying before the Joint Economic Committee of Congress, as described in the FT, “Bernanke set to clarify Fed stance:”

Ben Bernanke will be under intense scrutiny on Wednesday when he testifies before the Joint Economic Committee of Congress – a week to the day after the Federal Reserve surprised the markets by adopting a confusing new policy statement.

At the time, the markets thought the Fed was signalling that its next move would be a rate cut; a week later, the market has substantially reversed its view.

The Fed chairman is likely to have to clarify what the new statement means. He might also be pressed to reveal where he stands on an emerging argument inside the Fed as to what its inflation objective should be.

Bernanke proved himself eminently capable of talking the markets up when he wants to, ss he did on February 28. We will see if he “clarifies” the Fed’s position (which as Ritholtz pointed out per above, was downbeat on the prospects both for growth and for inflation, even though no one seemed to want to hear that) or decides to fudge. The latter would prove my theory above to be wrong.

This is a great post by Tanta at Calculated Risk on the classic types of mortgage frauds and how they morphed into new forms due to a unique confluence of buyer naivete and broker/originator greed (oh, and sometimes buyer greed too).

She clearly discusses recent versus traditional procedures. Tanta lays considerable blame at the lending industry’s desire to lower costs and increase approvat rates to improve its apparent economics. This entailed removing steps in the credit/income verification process and in obtaining third-party appraisals, and getting rid of seasoned (costly) loan officers.

Now I have never been sympathetic with institutions that hand out money to borrowers based on cheery assumptions and no/little due diligence and are then surprised when they get their heads handed to them. I saw this first in the late 1980s when banks were eagerly lending to really dodgy LBOs (the end-pf-cycle transactions are always the worst) because they got big up front fees they could book as profits that quarter. Their eagerness to boost earnings led them to take on loans that went bust and imperiled institiutions (no joke, between the S&L crisis and failed LBO loans, the US banking industry was in serious trouble).

As someone who has been in and around the financial services industry, I’m still flabbergasted whenever I see institutions chasing current income and choosing to overlook principal risk (they are putting themselves in the position of losing orders of magnitude more than their current gains, but I guess a lot of them figure that any disaster will occur on the next guy’s watch). And the behavior these organizations fall into during these overly permissive phases is disconcertingly out of character. It’s as if your balding uncle who normally hangs out at the country club had gotten a tatoo and a nose ring, started going to raves, and developed a taste for Special K.

Tanta’s observation about lax proecedures and collusion are specific and informative.

To Tanta:

There is a tradition in the mortgage business of distinguishing between two major types of mortgage fraud, called “Fraud for Housing” and “Fraud for Profit.” The former is the borrower-initiated fraud—inflating income or assets, lying about employment, etc.—that is motivated by the borrower’s desire to get housing (not the same thing as “real estate”), by means of getting a loan he or she doesn’t actually qualify for. It may require some collusion by the loan originator or appraiser, but it may not. It is usually the least expensive kind of fraud to lenders and investors, since the goal is getting (and keeping) the property, so the borrower is at least usually motivated to make the payments…. Their only saving grace is that the lender tends to recover more in a foreclosure than in a fraud for profit case….

Fraud for profit is simply someone trying to extract cash—not housing—out of the transaction somewhere. If it is borrower-initiated fraud, it’s not a borrower who wants a house; it’s a borrower who wants to flip a piece of real estate or launder money or in some other way grab the cash and leave the lender holding the bag. Most of it, however, is initiated by a seller, real estate broker, lender, or closing agent (or all of them in collusion). It generally requires additional collusion by bribable appraisers, although it can certainly be initiated by a corrupt appraiser looking for a kickback, or can merely take advantage of a trainee or gullible appraiser. This is the flip scam, straw borrower, equity skimming, misappropriation of payoff funds, identity theft kind of fraud. It may not be as common as fraud for housing, at least in some markets, but it’s much, much more expensive to the bagholder. At minimum, the fraud-for-housing borrower wants to take clear, merchantable title to the property and maintain it at an acceptable level. That’s either unnecessary expense or (in the case of title) a hurdle to be gotten over by the fraud-for-profit participant.

The problem with this traditional distinction is that, recently, we seem to have an epidemic of predator meeting predator and forming an alliance: a borrower willing to commit fraud for housing meets up with a seller or lender willing to commit fraud for profit, and the thing gets jacked up to a whole new level of nastiness. Consider the “cash-back purchase” scam we keep hearing about: that’s a perfect example of a borrower who wants a house, a seller who wants an illegitimate profit, and a broker or appraiser or settlement agent who wants a kickback all conspiring to defraud the lender: it’s hard to call it either fraud for housing or fraud for profit because it’s both.

What, in the past, might have kept the two fraud types separate—the fact that a normal borrower would not see it in his or her best interest to borrow more money than necessary to pay more than fair market value for a home—disappeared in the mania of buy-more-borrow-more and pass the “screwing” on to the next sucker who buys it from you. As soon as borrowers became convinced that paying substantially more for the property than the current seller did just a few months ago is always and everywhere a good sign, you could no longer rely on the “rational agent” borrower to at least limit his fraudulent tendencies to lying on the loan application in order to get away from apartment life. You actually see them agreeing to sign “secret” sales contract clauses that will require them to borrow more than the fair market value of the property, and then give the excess loan proceeds to someone who won’t be helping to repay the debt. Or accepting “down payment assistance” from an interested party, in order to buy a property whose price is inflated by the amount of the “assistance.” That this doesn’t seem to strike them as self-defeating tells you a lot about how uninformed or misinformed we are, how far into a true mania we’ve gotten. In the old days, you used to be able to count on RE frauds to display basic self-interest, naked or camouflaged.

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didn’t do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, there’s a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but it’s small comfort when the losses rack up. With tongue only partially in cheek, I’m about to suggest a third category of fraud: Fraud for Bubbles.

Everybody likes to hear lurid or merely entertaining stories from veterans of the Loan File Wars about weird fraud cases….What I want to do instead is to make some general observations about why so much fraud is missed by lenders. Obviously, there are lenders who are colluding with borrowers, or who are defrauding investors or borrowers or some other party; that’s either “fraud for housing” or “fraud for profit” or the new hybrid of the two. To me, that’s the least interesting problem (although it’s an important one). I want to talk about the extraordinarily widespread “insufficient caution” problem in this industry: the lenders who are just too easy to defraud. It seems to me that this problem gets to the heart of a lot of the issues we keep talking about here: toxic mortgage products, loose standards, out of control home price bubbles, and the endless chain of “disintermediation,” outsourcing, temping, dumbing down, fragmenting, and otherwise morphing of the business of home mortgage lending into a big fraud magnet. It often seems as if the industry just stopped believing that it could ever really be at risk.

My theory of the Fraud for Bubbles is, in a nutshell, that it isn’t that lenders forgot that there are risks. It is that the miserable dynamic of unsound lending puffing up unsustainable real estate prices, which in turn kept supporting even more unsound lending, simply masked fraud problems sufficiently, and delayed the eventual “feedback” mechanisms sufficiently, that rampant fraud came to seem “affordable.” So many of the business practices that help fraud succeed—thinning backoffice staff, hiring untrained temps to replace retiring (and pricey) veterans, speeding up review processes, cutting back on due diligence sampling, accepting more and more copies, faxes, and phone calls instead of original ink-signed documents—threw off so much money that no one wanted to believe that the eventual cost of the fraud would eat it all up, and possibly more.

On the one hand, everyone does know that you can’t run a mortgage lending business with the same level of anti-fraud measures they use at Domino’s to keep from wasting pizzas on prank calls. On the other hand, we are starting to see—and I predict we will start to see a cascade of—stories of lenders with such lax internal controls that if they did remember the risks, you have to conclude they just tried to repress those memories….

I said I didn’t want to get into too much detail, but I’ll tell you right now that some kinds of fraud are so easy to spot it’s pathetic. You don’t need to have the borrower sign “M. Mouse” on the note. Asking for income documentation, ordering tax return transcripts prior to closing, requiring settlement agents to fax the final purchase contract to the lender for approval prior to close, enforcing arm’s-length transaction rules: this stuff isn’t hard to do, and it will not catch everything but it will sure catch a lot, and it’ll catch it before you close, which is really the cool part. So what’s the response whenever you suggest these things? It costs too much. It takes too long. It drives up transaction costs and therefore puts a drag on home prices. It “unfairly” takes its bites out of our favorite new borrower segment: first time homebuyers, self-employed entrepreneurs, real estate “investors.” It makes loans harder to sell and securitize instantly and cheaply. It makes it harder for an originator to make those representations and warranties based on the bliss of ignorance. It could bring down the whole secondary market as we know it!….

I suspect most of us feel, generally, that fraudsters—borrowers, lenders, anyone else—who get burned just got what they deserved. True enough. But lending fraud, like warfare, creates quite a bit of “collateral damage,” in all senses of the term. Those honest homeowners watching their neighborhoods collapse after the fraud-bombs finally detonated are not probably very comforted by the fact that it wasn’t their fault. So when we debate the question of potential “bailouts,” we keep running up against the question of who needs or deserves the bailout. If you want to do something to assist the honest homeowner who bought with an 80% loan but is now upside down because of the neighbors’ fraud, how do you do that without, inevitably, helping out the lender who facilitated that fraud, too? If you want to do something to protect the stability of the honest lenders, how do you do that in a way that doesn’t, inevitably, also protect the scumballs and incompetents?

Getting into a bubble is easy. Getting out?

This falls in the “Why didn’t I think of that” category. From Angry Bear:

Reader Eightnine2718281828mu5 sent me a couple e-mails. I realized that together they constituted a post. This one is by Eightnine2718281828mu5:

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I think part of the reason that median salaries don’t rise as fast as CEO salaries is that CEO’s know what other CEO’s make; most companies make it seem like a firing offense to discuss salaries among your co-workers. But because CEO compensation is a matter of public record, CEO’s can make a case that “I’m worth more than so-and-so” and it gives them leverage to bump their salaries.

If the average worker could say “Joe is a useless moron, but he makes 20% more than me” they would have leverage in salary negotiations. But because there’s asymmetrical information, it’s easy for companies to gain the upper hand. (Consider this story on CNN.com.)

If I was in Congress, I’d be pushing to make all salaries/wages a matter of public record to level the playing field. This would cause median salaries to rise without government intervention or by resorting to things abhorrent to the right like union membership.

Free markets work best when all parties operate in the context of the full and free flow of information; what free-marketer could complain about providing this vital piece of information to workers when negotiating with their employer?

Now folks on Wall Street are much better than people in industry in demanding pay. And people in one department had a way of sharing information that wasn’t problematic. Everyone put their annual comp and their seniority on a piece of paper, which was tossed into a hat, tabulated by a secretary, and redistributed to all the participants. You got transparency without the ego damage of having everyone knowing what you made (of course, you need a large enough group for this approach to assure that people won’t figure out what number goes with what person…..).

Michael Panzner at Seeking Alpha has a great post, “Donald Lambro’s Dangerous Suprime Delusions,” which I found a pleasure to read because he takes on a deserving target, namely, a pathologically optimistic piece by Donald Lambro,”Subprime Shakeout Just a Rough Patch.”

The piece is fun, in part because Lambro is such a deserving target, and Panzner goes after him with considerable gusto. Mind you, I’m not saying that there isn’t an intelligent version of an optimistic case. There is. It’s just that Lambro doesn’t articulate it. The plausible upbeat case boils down to, “Subprimes really aren’t that significant relative to the financial system.” And that is 100% true.

The problem isn’t subprimes per se, it’s that subprimes are the most visible and distressed example of a very widespread pattern of overly loose credit, which has fuelled high asset prices, particularly in US housing. So it’s really not that the “subprime contagion” is spreading. Rather, the subprime mess is making it acceptable to talk candidly about how the rest of the housing market is in the process of a correction.

But let me not detract from Panzner’s post, which is worth reading in its entirety:

A visitor asked if I’d care to comment on a recent article by Donald Lambro. After reading “Subprime Shakeout Just a Rough Patch,” my first inclination was to say “no,” because I was tired and felt it was so far removed from reality that those who aren’t caught up in the Wall Street-Washington fantasyland vision of today’s America would see straight through it.

But then I reconsidered, thinking that it was better to err on the side of stating the obvious than to have some unfortunate soul fall for this farce of a spin-job and end up with nothing more than a one-way ticket to financial disaster.

According to Mr. Lambro, “no one can know for sure what the precise impact of the subprime-mortgage-market collapse will be.” So far, so good. If he had stopped there, I would have said fine, I agree. However, he then adds:

But it is not going to deeply affect the long-term growth of our overall economy.

The reason: Our economy is too big, too resilient and its fundamentals too strong to inflict any long-lasting collateral damage to our economic infrastructure.

The number of subprime-mortgage bankruptcies and delinquencies is no doubt substantial, as last week’s industry data survey showed, and we don’t know how deeply that could dig into the larger mortgage companies. But reporting on this story, which rattled stock markets here and abroad, left out the financial context in which all this is occurring.

The subprime market’s bubble burst — as many predicted it would — at a time when the economy overall was on solid ground. Corporate profits have been spectacular overall, small-business growth has been strong. A low unemployment rate ( 4.5 percent) has pushed total employment to nearly 150 million (the highest in our history), and wages have continued to rise.

The “economy overall is on solid ground”? What about the fact that the nation’s personal savings rate and total debt as a percentage of gross domestic product have exceeded the dangerously unstable extremes last seen during the Great Depression?

“Corporate profits have been spectacular overall”? Yes, they have, but that is old news. Anyone who understands anything at all about economic history knows that the trend of corporate profit growth is one of the most reliably mean-reverting series in existence. In other words, there is only one way it can go from here, and that’s down.

“Wages have continued to rise”? Most analysts who are not in some sort of substance-induced haze acknowledge that real — inflation-adjusted — wages have lagged economic growth for several years now. Clearly, Mr. Lambro is either smoking something or is being disingenuous.

But there’s more to this bogusity:

Wall Street’s doom and gloomers, who see a recession around every corner, are myopically focused on trade deficits, budget deficits and the housing downturn, while ignoring both United States and global economic growth.

“Myopically focused on trade deficits, budget deficits, and the housing downturn”? I don’t know, I think a few are also focused on the projected $50 trillion-plus cost of social security, medicare, and other social programs that have not been properly accounted for. Or the $1 trillion of formerly hidden obligations, known as other post employment benefits, that state and local governments must now recognize under new accounting rules. Or the risks that stem from a $6 trillion financial safety net that includes government-sponsored disasters-in-the-making like Fannie Mae.

Still, Mr. Lambro carries on, spiraling downward like a heroin addict caught in the unrelenting grip of his destructive indulgences….

The piece concludes here. Enjoy!

This story in today’s Financial Times, “As America falters, policymakers must look ahead,” is remarkable because, as far as I can tell, it is the first time a prominent economist has come out and said the unwinding of the housing bubble is likely to have nasty consequences (actually, take that back, Paul Krugman had a New York Times article, “The Big Meltdown,” but it was an odd piece, more a badly spooked riff than a reasoned argument). No matter what you think of Summers as a Harvard president, he is still very well regarded in economics circles.

He uses surprisingly blunt language (for starters, “strong grounds for anticipating that the economy will slow down significantly in 2007″), and is also the first writer I have seen play out what the deflating of the housing market might mean for our global imbalances. He foresees a weaker dollar and higher inflation and lower growth. In other words, stagflation, a word we’ve used before and Fedwatchers read into the latest FOMC report. And he also anticipates, if the Fed isn’t successful in buffering the fall, the damage could feed on itself:

It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years. But with the sector littered with bankruptcies, this is not today’s problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.

It’s a bit tacky to pat ourselves on the back, but we have long pointed to what Summers contends: that too much has hinged on the spending of US consumers, and that overextended consumers have depended on housing as a piggy bank. Take that cash source away, and they have to rein in their spending. Frankly, this is obvious, yet for some reason commentators have been reluctant to connect the dots.

This article also coincides, and in a crucial matter, disagrees with an opinion piece by Mohamed El-Erian, the president of Harvard Management Corporation, and Nobel Prize winner Michael Spence, “Capital Currents,” that appeared in the weekend Wall Street Journal. It painted a fairly benign picture of global imbalances (meaning all that foreign capital financing US consumer spending) and depicted how they forestalled the normal corrections you’d see in a self-contained economy that had too much consumption and too little savings (oddly, acknowledges a host of global imbalances that exist in parallel with the capital influx, like compressed risk speads, but does not link them causally, nor does it mention asset price inflation). They depict the likelihood of an orderly reversal of these imbalances, while Summers anticipates a faster, and potentially disruptive reduction in foreign flows to the US.

From the WSJ:

Over time, emerging markets will inevitably divert more of their assets to more sophisticated investments abroad. That shift will have many effects, some of which depend on the decisions taken by emerging economies while others depend on the evolution of the global context. One effect will surely be to put upward pressure at some point on the cost of capital in the U.S., as the incremental demand for treasuries declines.

While the shift is inevitable, it would be unlikely that the emerging economies as a group would deliberately take actions that directly undermine global economic markets. There will also be domestic pressure on policy makers in emerging countries to gradually shift their emphasis away from the producer and towards the consumer. That will mean lowering the savings rate relative to investment, increasing consumption and letting it assume a more important role (relative to exports and global demand) in driving growth.

Under this state of the world, domestic consumption in the rest of the world picks up over time, facilitating the needed adjustment in the U.S. The result is a gradual journey to a more normal relationship between assets and income returns, with savings moving to a more normal long-run pattern.

But this process is not automatic and faces significant disruption risks; and it is particularly sensitive to “policy mistakes.”

Note that the scenario described by Summers below is not on their list of “significant disruption risks,” which seems particularly odd, since the article specifically mentioned, earlier, that “the potential pressure on house prices could also reduce household’s propensity to consume out of their accumulated equity windfall.”

Maybe they simply differ with Summers as to how bad things could get. But to not consider that possiblity would seem to be a serious oversight.

The full Summers article:

Three months ago I was able to write in this space that in economics “the main thing we have to fear is the lack of fear itself”. This is no longer true today. With clear evidence of a crisis in the subprime US housing sector, risks of its spread to other credit markets, sharp increases in market volatility, reminders of the fragility of global carry trades and signs of slowing economic growth, there is enough apprehension to go around.

While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very significantly in 2007. Whether in retrospect 2007 will prove to have been a “pause that refreshed” a nearly decade-long expansion like the growth slowdowns in 1986 and 1995 or whether it will see the end of the expansion is not yet clear.

It is clear though that the global economy has been relying on the US as an importer of last resort; that the US economy has been relying on the consumer for its primary impetus; and that until now consumers have been encouraged to spend their incomes fully or more than fully by being able to access the wealth in their homes.

This growth syllogism has appeared fragile for some time, but has continued longer than many observers expected as US consumers have kept spending even after it was clear that the housing market had peaked and foreigners – particularly those in the official sector in Asia and the Middle East – have been willing to continue financing, on very attractive terms, the US in importing nearly 70 per cent more than it exports.

But the growth syllogism is now in doubt. Recent developments in the subprime sector exacerbate housing’s brake on US economic growth. Foreclosures will bloat the supply overhang of houses. At the same time reductions in capital in the housing finance sector and more rigorous credit standards will reduce the demand for new homes. Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.

If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US that has financed imports far in excess of exports will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment in plant, equipment and commercial real estate.

How should economic policy respond to a potential fall-off in US demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday – buying assets that have already risen and selling those that have just lost their value – so also the worst economic policy decisions are made by policymakers who, instead of responding to current circumstances, seek to rectify past mistakes.

It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years. But with the sector littered with bankruptcies, this is not today’s problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.

Some argue that the Federal Reserve should have started tightening monetary policy earlier in the current cycle and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy, come what may, hardly follows. If, as may prove the case, the dominant economic concern becomes a shortage of demand, it is incumbent on the Fed to provide stimulus so as to maintain conditions for growth and financial stability.

Those in the rest of the world who have been insisting on the global imperative of increased US saving and a reduced US current account deficit should fear getting what they want too quickly. So also should those US observers who have insisted that foreign countries stop artificially holding their currencies down by purchasing dollar assets. While US current account adjustment is a medium-term imperative, an effort to bring it about rapidly in the face of an already declining economy could turn a soft landing into a hard one.

Similar principles can be extended to almost every macroeconomic policy area from fiscal policy to financial regulation. Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. It follows that when the dominant risk changes from complacency and overheating to risk aversion and economic slowdown, the orientation of policy must change as well.

Economic policymakers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war. We do not yet know how much economic conditions will change or whether current concerns will prove transitory. But if recent developments mark a genuine change, let us hope that policymakers look forwards rather than backwards.

The post below is from a reader, DS. He focuses on the fact that the Fed has basically admitted that its powers are limited due to the extent of financial activity that takes place outside its purview (the Fed supervises federally-chartered banks; securities firms, which are regulated by the SEC and hedge funds, which are not regulated as far as their investments or solvency is concerned, are increasingly the key players in the credit markets).

Yet the Fed is treated by pretty much everyone, including sophisticated investors who ought to know better, as having the ability to stem a crisis. In reality, its main power these days is moral suasion and its PERCEIVED clout, which is has used to great effect, but once that fails, it will not have much real firepower.

He goes further to tell us, quite persuasively, that financial innovations that may initially have been beneficial to many have moved into innovations that serve only the few, and can be argued to have corrosive effects (undue concentration of wealth, exploitation of the middle/lower class, weakening of values of prudence and deferred gratification) yet the powers that be keep defending them.

I have some related posts (here and here and here, time stamped earlier so that e-mail subscribers will get them in the right order).

To DS:

As often happens, I find reading across multiple posts — connecting dots — quite fascinating. Today, you observe that New York Fed president Geithner’s speech pointedly admits the Fed is toothless as a proactive guide in our contemporary financial markets. He declares the only thing — only, only, only thing — the Fed can do now that it has lost it’s capability and knowledge to guide in advance is to provide possible ‘shock absorbers’. The core admission of the Fed’s toothlessness with regard to proactivity comes here:

We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

Re-read that. “We do not have the capacity to monitor or control….” “We cannot identify….”

The Fed is now on the sidelines and utterly, completely lacks the capability or knowledge to understand what is going on…..

So, Geithner says, we can try our best to respond and provide shock absorbers. In other words, the Fed is now FEMA. And we’ve seen how well FEMA has fared under the Bush Administration and our new Culture of Greed and Incompetence. (Yes, there is some hope of the Fed’s supposed independence — but, then, one reads your post about the Fed’s manipulation of elections….)

Anyway, onto the Chemotherapy post. I’m guessing Barry Ritholtz is a really smart and savvy guy (and I mean that). So, I find it fascinating that his comments at the bottom of the quoted portion are written with the classic assumption that the Fed’s actions are to be read as proactive efforts to reign in pending problems etc (i.e. not just ‘shock absorber’ efforts from an institution that is incapable to provide any effective guidance because it is an institution that is flying blind — just like everyone else). Put differently, his language continues the deep seated assumption that the Fed is — well The Fed — not just FEMA.

And, in light of my concern that defining inflation so that it doesn’t include asset inflation like housing is missing something crucial, it’s also interesting to note that his cautions on that score remain the classic goods and services type — not the cancerous asset bubble type. He talks of oil and copper. He doesn’t speak to Geithner’s focus on how unregulated, unmonitorable financial innovation have created a world of finance that is beyond anyone’s understanding.

Last: both Geithner and Ritholtz blithely state things that strike me as yet more examples of a failure of imagination and nerve. Geithner speaks of “the substantial benefits of credit market innovation”. I’m struck that he would do well to spell out those benefits: what benefits and for whom? And how have both the nature of the benefits and those who benefited changed over time?

Go back to the 1980s and the innovation of mortgage backed securities. I believe history would say: major positive benefits and spread of benefits to people broadly.

But, look at cancerous Ponzi schemes of the past several years and ask same question. Has there been broad benefit spread across the economy? No. We see dramatic growth in income inequality. We see an economy where the top 1% have 40% of the assets. We see usurious, predatory abuse of folks in what used to pass as the middle and lower-middle class. And, by the way, we see corporate profits going to shareholders as opposed to either labor OR investment in the future.

We see profit grabs and Ponzi schemes. We do not see substantial benefits.

What may have begun as innovation in service of the economy has, by ‘natural forces’, become a cancer that, among other things, has converted the Fed into FEMA, eviscerated the middle class, turned the financial system into a casino, and seriously weakened the values (both in terms of real economic value as well as shared beliefs and behaviors such as ‘hard work’, ‘invest in future’, ‘be prudent’) on which the nation depends.

Geithner seems like a reasonable guy. And that is what ought to trouble us. He seems to have drunk the Kook Aid by which reasonable people believe it is important to continue to demonstrate reasonableness by assuming that others with great power are also reasonable. Yet, as we’ve seen in the political sphere, that is a fatal assumption. And, I believe we’ll see the same thing in the financial sphere. The folks in charge are not reasonable. They are after profits and wealth for themselves. And, while self-interest has a long storied past as a powerful motive force for the good when it is kept in check by reason, even Adam Smith noted that the assumption that reason would keep it in check was foolish.