naked capitalism

Bloomberg and the BBC report that Barclays, the third largest bank in the UK, borrowed “as much as ” 1.6 billion pounds ($3.2 billion) from the Bank of England.

The bank claimed it fell short of caah due to an error in its trade processing system, and it discovered the need for funding too late in the day to go to other banks for funding. But some are skeptical. For example, HousingPriceCrash notes

But traders have questioned the bank’s explanation, saying the loan was taken out at about 1100BST on Thursday – five hours before money markets shut and well before the problems hit the electronic trading system.

“When you add this to the senior resignations a week or so ago, you can understand why the stock is coming under pressure,” said Simon Denham, managing director of Capital Spreads. Edward Cahill, the man in charge of structuring debt investments at the bank’s investment arm Barclays Capital, unexpectedly resigned last week.

His sudden departure sparked panic that Barclays could be sitting on hefty losses as a result of the devaluation of these debt funds which are heavily tied to sub-prime US mortgages – well-known to be the key factor causing havoc in financial markets.

The Wall Street Journal, in “Bush Moves to Aid Homeowners,” reports that today the President will set forth a program to help stressed borrowers at risk of losing their homes. Main elements:

Allowing the FHA to guarantee loans to borrowers who are at least 90 days behind on their mortgages but still living in their homes;

Temporarily suspending the income taxes charged on cancelled debt when a house is sold or refinanced for less than the amount of the outstanding mortgage.

No wonder Bush chose the deadest Friday in the summer for this announcement. There’s much less here than meets the eye.

Now admittedly, the tax relief on cancelled debt is a big item and will at least keep those who suffered the indignity and cost of giving up their home from carrying the further financial millstone of a big IRS bill. But this is aid to those who have already given up their house. It doesn’t salvage anyone.

The FHA move is largely cosmetic. Even as envisioned, the Journal tells us it will help relatively few people:

By allowing the agency to back loans for delinquent borrowers, the FHA estimates it can help an additional 80,000 homeowners qualify for refinancing in 2008, bringing its total of refinancing guarantees to about 240,000, senior administration officials said. Mr. Bush also plans to announce that the FHA will begin charging “risk-based” premiums, a move that will enable the agency to help riskier borrowers since they can charge those individuals higher insurance rates. Right now, FHA premiums are a flat 1.5% of the loan, and the change would give the FHA flexibility to charge some borrowers as much as 2.2%.

Still, the move will help only a small portion of homeowners — and few in high-cost states such as California or New York — because the FHA faces constraints on the size of the loans it can back and strict rules that borrowers must meet. The Bush administration has been pushing Congress to enact overhauls that would eliminate the required 3% down payment and raise the size of the loans the FHA can insure to as much as $417,000 from $362,790.

Note this measure is an administrative change; Senate Banking Committee chairman Christopher Dodd plans to sponsor an FHA bill that will presumably extend its reach.

The fact that a borrower has to be 90 days in default before he can start the FHA process (and who knows how speedy that will be) may not be fast enough to rescue some homeowners. While most states deliberately make foreclosure a protracted process, in Georgia, it can take as little as 60 days from a mortgage borrower being declared in default to his house being seized.

The Wall Street Journal unwittingly implies Bush may be grasping at straws to find other remedies:

In another move, Mr. Paulson and HUD Secretary Alphonso Jackson have instructed their staffs to begin working with mortgage lenders and others to identify borrowers who are in danger of defaulting. They also are trying to work with private lenders and mortgage giants Fannie Mae and Freddie Mac to develop loans for borrowers who will likely face default if they can’t get more flexible terms.

Perhaps the author was a bit careless in how she wrote this up, but “working with mortgage lenders” is not the place to find borrowers in trouble. The great majority of housing loans went into mortgage securities, which means the party that needs to be consulted is the mortgage servicer. If Paulson and Jackson actually said they want to talk to mortgage lenders, they haven’t even started to engage this problem seriously.

Ditto the comment about “trying to work with….Fannie Mae and Freddie Mac.” That is pure spin. As Financial Times commentator John Dizard tells us in “Fannie, Freddie to the rescue? Don’t bet on it“:

At a time when America, or at least Wall Street, needs a spineless hack as the head of a key agency, it is saddled with a credible man of principle: James Lockhart, OFHEO’s director. Yale graduate, Harvard MBA, lieutenant in the nuclear navy, risk management software entrepreneur, senior insurance executive, and former head of the Pension Benefit Guarantee Corporation. “A real hard-ass” in the words of a mortgage finance executive. It doesn’t seem as though he can be intimidated by the threat of being sent back to Plano, Texas, to work in his uncle’s car dealership.

Lockhart was appointed in the middle of last year to the directorship when there was no immediate, obvious cost to anyone of having a competent, effective regulator who actually knows what those buttons on his computer are connected to.

What is worse, his resistance to Fannie and Freddie ballooning their balance sheets and loosening their controls is reinforced by his experience in a previous job. The Pension Benefit Guarantee Corporation, a thinly capitalised government insurance operation, which charged inadequate premiums for covering beneficiaries of failed pension funds, was in turnround, as they say in Hollywood, during his tenure from 1989 to 1993. Lockhart had to clean up other peoples’ messes and one can guess he doesn’t want to do that again.

So it will only be after many more problems surface and under strict conditionality that F&F will pump a bunch of new money into the housing finance pipelines. Enjoy this trading rally while you can. Try not to think about the nasty surprises that could still be out there.

Update 9/1, 1:20 AM: Dean Baker is also unimpressed with the Bush proposals for different reasons:

First, according to the Post article, the plan would allow the Federal Housing Administration (FHA) to waive the current 3 percent equity requirement and allow it to insure mortgages that exceed the market value of the home. In other words, the FHA will be helping moderate income homeowners to borrow $200,000 on a home that is worth $180,000. That doesn’t sound like a very good plan for the homeowner and is probably not an especially good use of government money. It essentially means paying off the current mortgage holder — who otherwise would be holding bad debt — with taxpayer money.

The other item that deserved some additional attention is the plan to temporarily waive the taxation on forgiven debts. The deal here is that if someone owes $400,000 on a home, which is subsequently sold in foreclosure for $350,000, then they have had $50,000 of debt forgiven. Under currently tax rules, this $50,000 is treated as taxable income. According to both the Post and Times, Bush’s plan would at least temporarily exempt this money from taxation.

It is important to recognize that most moderate income homeowners will face relatively low tax rates, so this tax break will probably not be of much benefit. On the other hand, many of the people now defaulting on their loans were relatively affluent people who were speculating in real estate. In the example given here, if an investor was in the 33 percent tax bracket, President Bush’s tax break would be worth $16,500, more than twice the average annual TANF payment for a family of four.

Baker notes in an addendum that the plan isn’t as awful as the press made it sound. Tax relief will be available only to those who had owner-occupied homes, and will be capped. The FHA plan would keep in place the requirement that homeowners put up 3% of the equity.

I hope you don’t think this blog is in danger of becoming the “all Fed, all the time” channel, but this is an otherwise slow news period and central bankers are very much in the spotlight.

Willem Buiter has a long post on his blog which discusses the Fed’s limited independence compared to other central bankers. I’ve excerpted his remarks on that topic. His other thoughts, such as how a central banker acting as a market marker of the last resort (a policy suggestion of his) would discover prices for illiquid paper, are wonky but worthwhile as well.

A front page story in today’s Wall Street Journal, “Investors Default On Outsize Share Of Home Loans,” confirms Buiter’s view:

The darkening outlook for the housing sector has prompted economists at Goldman Sachs Group to predict that home prices nationwide will fall an average of about 7% both this year and next. Alarmed by such prospects, a group of top executives from home-building and supply companies are scheduled to meet next Wednesday with Federal Reserve Chairman Ben Bernanke to argue for Fed actions to support the housing industry.

The housing industry is not the Fed’s job. And even if it were, it’s not clear Bernanke could solve the underlying problem: the level of home ownership has risen to an unsustainable high. Some people who now own will become renters again because they never should have bought a home in the first place. That is an ugly reality (or is it? Some analysts have found that home ownership tend to lower rather than increase income by reducing labor mobility).

Importantly (and I’ve put that section in bold for reader convenience) Buiter thinks that that the idea that we need what he calls “techfin” is rubbish. If these complicated new instruments were to go belly up, the only losers would be the parties that had a direct stake in them, not commerce as a whole.

From Buiter:

Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee (and also a candidate for the Democratic nomination for the US Presidency) and by Hank Paulson, US Treasury Secretary, Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures from the Executive or from Parliament. Also, what operational independence the Fed has, is of relative recent origin. From 1942 until the Treasury-Federal Reserve Accord of 1951 released the Federal Reserve from the obligation to support the market for U.S. government debt at pegged prices and made possible the independent conduct of monetary policy, US monetary policy was made in the Treasury. For those 9 years, the Taylor rule was: i = 2%.

Even after the Accord, the fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. The strong populist, anti-banking currents in American politics in general, and in the Congress in particular, mean that the threat that what limited operational independence there is could be taken away is not perceived as an idle one by any Fed governor.

To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the three goals of monetary policy. The other two are maximum employment and moderate long-term interest rates. There is no quantitative or numerical definition of any of the three targets in the Act. Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out.

Both the Congress and the Executive branch of government lobby mightily for Fed actions aimed at preventing or at least limiting the losses on highly leveraged bets taken by hedge funds, private equity funds and a large number and variety of other financial institutions and special purpose vehicles – ‘conduits’, ‘structured investment vehicles’; the names vary but the economic essence of highly leveraged open positions is the same. Appeals to safeguard systemic financial stability often obscure the obvious truth. The special interests that would benefit most directly from such actions as a cut in the Federal Funds rate – highly leveraged Wall Street firms and tycoons caught on the wrong end of the increase in credit risk spreads and the disappearance of liquid markets for structured products and other contingent claims –claims that had often been touted as the ‘techfin’ solution to the illiquidity of traditional forms of credit such as secured (mortgages) and unsecured (credit card debt) – rarely play a systemically indispensable role in the intermediation of saving into investment or in the efficient management of financial wealth. Were they to go bust and disappear, they would be missed only by their shareholders and other stakeholders, and those who had lent money to them. If these shareholders and creditors are systemically significant, one assumes that the prudential regulatory regimes they are subject to would have ensured sufficient portfolio diversification for them to be able to absorb the losses caused by the insolvency of a number of highly leveraged funds/institutions

The news from rating agency land goes from bad to worse.

This Bloomberg article does much to explain why investors are avoiding subprime like the plague. AAA paper revealed to be CCC. Repeated incidents of financial institutions saying they have no/little subprime exposure, then shortly thereafter fessing up that they have a lot. And rating agencies, like the emperor who has suddenly realized he is naked, trying to disguise the fact that the data underlying their models isn’t germane.

While it was only $254 million of face value of CDO paper that was downgraded from AAA to CCC, that sort of downgrading is unprecedented. It’s worse than turning gold to lead, it’s closer to revealing that gold is actually nuclear waste. And the fact that it happened to several collateralized debt obligations suggests that other AAA rated tranches are similarly close to worthless.

From Bloomberg:

Last week, Standard & Poor’s butchered the ratings on $3.2 billion of debt from structured investment vehicles spawned by Solent Capital Partners LLP in London and Avendis Group in Geneva. About $254 million was slashed from the top AAA grade to CCC+ and CCC — slides of 16 and 17 levels, triggered by their investments in mortgage-backed bonds.

Think about that for a second. You left the office Tuesday owning a AAA rated security. By the time you got back to your desk on Wednesday morning, it was eight steps below investment grade in a category S&P defines as “currently vulnerable to nonpayment.” Try explaining that to your pension-fund trustees….

DBS Group Holdings Ltd., Singapore’s biggest bank, said on Aug. 7 it had S$1.4 billion ($921 million) at stake in collateralized-debt obligations. This week, it boosted that total to S$2.4 billion. It seems the bank had overlooked its commitment to a unit called Red Orchid Secured Assets….

A rare moment of comedy arises from what Moody’s Investors Service had to say about the oversight. “I don’t think DBS will be the only one who has missed something the first time,” said Deborah Schuler, a senior Moody’s analyst in Singapore….

Moody’s recently added some new phrases to its lexicon of code words. When the rating company refers to “updating its methodology” or “refining its risk assessments,” what it really means is that its historical models say absolutely nothing about how the future might turn out.

Last week, for example, Moody’s summarized “the most recent refinements” to how it treats bonds backed by so-called Alternative-A mortgages. “In aggregate, the change in our loss estimates is projected to range from an increase of approximately 10 percent for strong Alt-A pools to an increase of more than 100 percent for weak Alt-A pools,” Moody’s said.

So a mortgage-backed security with a rating based on, say, a 1.5 percent loss rate might now suffer 3 percent losses in its collateral, Moody’s said. How’s that for missing something the first time?

Here’s what is most worrying about the coming flood of downgrades and defaults. The U.S. Securities and Exchange Commission is investigating how the biggest brokerage firms priced securities caught up in the subprime meltdown as their values collapsed. My colleague Jonathan Weil last week detailed some of the accounting shenanigans that accompany how banks measure the “fair value” of their assets….

Suppose regulators decide to play hardball on how the financial community marks to market, imposing rules that outlaw the existing freewheeling approach to how over-the-counter derivatives are assayed.

Moreover, suppose those new decrees come just as much of the underlying collateral is so tarnished as to be almost worthless compared with its initial valuation.

The ensuing carnage in the balance sheets of every financial-services company in the world would dwarf the damage wrought in the securities industry by the subprime crisis so far.

It will be hard enough for central bankers in the U.S. and Europe to set monetary policy at next month’s meetings when they have no way of knowing how bad the financial storm might get and how much it might hurt economic growth. The more things that go boom in financial markets in the coming weeks, the harder the task facing the rate setters will get.

Hedge funds, which even at their peak of popularity, were regarded with considerable suspicion, have taken a shellacking in the last few months as subprime tainted funds have folded or reported poor results, and “quant” strategies have failed spectacularly, due to extraordinary, allegedly unprecedented market turmoil. Of course, the problem with that defense is that extraordinary turmoil seems to happen roughly once a decade.

Now even though much of this criticism of hedge funds is deserved, it tends to lump them all together, when they in fact employ a variety of strategies. Yes, quant and various favors of fixed income investing are on the list, along with event driven (the new term for merger arbitrage), global macro, emerging markets, and equity long/short, to name a few.

One strategy that may deserve a better reputation than it currently enjoys is activist investing. Hedge funds, as well as some institutional investors (the giant California Public Employees Retirement System, or Calpers, is a leader) and individuals, ranging from old-style raiders like Carl Ichan to Harvard Law professor Lucian Bebchuk, buy shares in companies with poor governance practices, like pay way out of line with performance, and agitate for change, often via shareholder resolutions or trying to change the composition of the board.

In simple terms, activists seek to remedy a deficiency in the operation of stock markets. Corporate officers are supposed to work for shareholders (or at least balance their interests against those of other constituencies). However, in public companies, shareholders have only a small ownership position and lack the resources and leverage to oversee company executives effectively. This produces what in the economic literature is called an agency problem: they’ve hired an agent, but cannot control him, and the result is that the agent, in this case corporate top brass, take advantage of the lack of effective oversight.

Activists target the most extreme cases of self-serving corporate behavior. And company officers seek to demonize their efforts. Hedge funds are painted as being raiders in new clothing, out for a quick buck, shaking down companies and then moving on to the next victim, um, target.

But is this characterization accurate? AllAboutAlpha discusses two academic studies, both of which conclude that hedge funds are more effective activists than either institutional investors or individuals.

The first paper, by Nicole Boyson and Robert Mooradian of Northeastern University, finds that hedge fund agitation leads to improvement in cash flows and operating performance. The reason seems to be that hedge funds, unlike their counterparts, target smaller firms that have decent operating performance. By implication, the hedge fund pressure leads them to improve financial management (particularly getting rid of excess cash and curtailing excessive executive rewards) and sharpen their operational management as well.

By contrast, institutional investors target large, poorly performing companies that are overpaying executives. While the harsh scrutiny may lead to some corporate governance reforms, these companies are so badly led (or unfixable) that the activists are unable to produce any improvement in the business’s fundamentals. Another reason the big institutional investors fail to achieve as much is that their shareholdings are generally too small. By contrast, hedge funds typically acquire a 10% stake, making them a force to be reckoned with.

The authors also note that, contrary to popular perception, activists are not short term players. The average time of ownership is over two years, while the average time a NYSE share is held is a mere seven months.

The second study, by Harvard’s Robin Greenwood and Morgan Stanley’s Michael Schor, is less charitable, but still finds hedge fund activists more effective than their institutional investor peers. However, they attribute their success primarily to better targeting, and the best targets are companies that can be put in play. Note that the study doesn’t say that the hedge fund activists, like the raiders of old, are out to force the companies they pursue to put themselves up for auction. The activists persist and try to get board seats and effect change. But they produce the best financial outcome when a target is sold.

This discussion begs the question of whether hedge fund activism benefits anyone other than the hedgies and their investors. If policing is ineffective, their efforts might have a deterrent effect and discourage some of the worst abuses. In other words, vigilante justice is better than no justice at all.

Bloomberg tells us that the commercial paper market is shrinking rapidly.

This is a more serious issue than might appear. Commercial paper is an important, if not the most important, source of short-term funding for sizable corporations, mainly because it’s cheap and flexible. They can reading adjust the amount outstanding to reflect changes in their need for cash.

When CP matures, and an issuer cannot “roll” it, as in replace it with new CP, he has two choices. If he has the option, he can draw down standby lines of credit with his friendly bank. If he has no, or insufficient, backup lines, he has to get the cash somehow.

Both option 1 and option 2 have costs. Option 1 means he is using higher-cost funding and has limited the company’s alternatives for dealing with emergencies. But more important, the demand for cash at banks means it crowds out other bank lending, such as to small businesses.

Option 2 means the company goes into crisis mode, delaying payments to vendors, trying to accelerate payment from customers, possibly even deferring payroll if that is at all an option.

Now on a small scale, these moves would create a few casualties. But on a large scale, as is happening now, both will put a damper on the real economy. They suggest that the 4% GDP growth release for the second quarter may have perilous little relevance now.

From Bloomberg:

The U.S. commercial paper market shrank for a third week, extending the biggest slump in at least seven years, as investors balked at buying short-term debt backed by mortgage assets.

Asset-backed commercial paper, which accounted for half the market, tumbled $59.4 billion to $998 billion in the week ended yesterday, the lowest since December, according to the Federal Reserve. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion.

Commercial paper outstanding has fallen $244.1 billion, or 11 percent, in the past three weeks, suggesting the Fed’s Aug. 17 reduction in the discount rate has yet to entice buyers back into the market. More than 20 companies and funds including Cheyne Finance and Thornburg Mortgage Co. failed to sell new paper as investors fled to safer investments.

“I don’t think the Fed understands how critical the situation is,” said Neal Neilinger, co-founder of NSM Capital Management in Greenwich, Connecticut, in an interview today. “The market is going to overshoot itself and not lend money to people who deserve it.”…

The 11 percent decline over three weeks is the biggest since 2000, according to data compiled by Bloomberg….

Commercial paper is bought by money market funds and mutual funds that invest in short-term debt securities. In asset-backed commercial paper, the cash is used to buy mortgages, bonds, credit card and trade receivables, as well as car loans. Some of the programs are backed by subprime loans. Subprime loans are issued to borrowers with poor credit or high debt.

About 26 percent of asset-backed commercial paper outstanding as of July was used to fund purchases of mortgage- related securities, according to Standard & Poor’s. The yield on the highest rated asset-backed paper due in a month reached a six-year high today of 6.18 percent….

The Fed lowered the interest rate it charges to lend to banks to encourage buyers of commercial paper after the market seized up for Thornburg, Countrywide Financial Corp. and other mortgage lenders.

The Fed “failed to bring money markets back to normal,” John Lonski, chief economist at Moody’s Investors Service in New York, said in an interview. “Credit markets are obviously in need of a rate cut.”

In a sign that buyers are still favoring safer assets, an $18 billion auction yesterday for two-year U.S. government debt drew the most demand since 1992.

The sale drew $3.97 for every $1 sold, the most since at least 1992, according to Bloomberg data. For the past 12 sales, the bid-to-cover ratio has averaged $2.77…..

The Federal Reserve Bank of New York said last week that it is accepting “investment quality” asset-backed commercial paper as collateral for loans. The central bank cut the discount rate, or the interest rate it charges banks, by 0.5 percentage point on Aug. 17 to increase demand for securities.

Futures as of yesterday show traders see a 46 percent chance the Federal Reserve will cut its target rate for overnight lending between banks to 4.75 percent at its Sept. 18 meeting.

“We need to get the banks to start lending again,” Plaut said. “Once we see that, we’ll start to see the positive impact on the financial markets.”

Frankly, this is pathetic. If Bernanke and his minions can’t take the heat of some well-deserved criticism from the highly-regarded Martin Wolf of the Financial Times, they don’t belong in public service.

To recap: yesterday, Wolf issued a stinging rebuke of Bernanke’s conduct on the Financial Times editorial page, in “Central banks should not rescue fools.”

Wolf first took aim at Bernanke for giving all appearances of having submitted to political pressure. The Fed chairman not only met with Henry Paulson and Senate Banking Committee chairman Christopher Dodd, but then appeared jointly with them. The Federal Reserve is supposed to be independent, yet as Wolf put it, “This showed Mr Bernanke as a performer in a political circus.”

His next criticism:

Policymakers must distinguish two objectives: the first is macroeconomic stability; the second is a sound financial system. These are not the same thing. Policymakers must not only distinguish these objectives, but be seen to do so. The Federal Reserve failed to do this when it issued statements, on prospects for the economy and on emergency lending, on August 17. This unavoidably – and undesirably – confused the two goals.

Enter Greg Ip of the Wall Street Journal. Ip is widely considered to be a preferred, if not the preferred, outlet for informal communications from the Fed.

Now as of this hour, the WSJ first page‘s “What’s News” column has this summary of an article by Ip as its lead item:

Bernanke is showing signs of a break with Greenspan by distinguishing between the Fed’s two main roles of maintaining financial and economic stability.

This is a direct rebuttal to Wolf, editorializtion masquerading as news.

It gets worse. From the article “Bernanke Breaks Greenspan Mold,” by Ip:

To Mr. Greenspan, market confidence and the economy’s growth prospects were so intertwined as to make the Fed’s two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998 to prevent investor reluctance to take risks from undermining the nation’s economic growth.

By contrast, Mr. Bernanke distinguishes between the central bank’s two functions. So, on Aug. 17, the Fed cut the interest rate and lengthened the term on loans to banks from its little-used discount window in hopes banks would use the window — or at least the knowledge it was available — to lend to solid borrowers having trouble getting credit amidst the market turmoil. The action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth.

Ip should be too seasoned a Fed watcher to buy this bunk (although some have suggested he serves as a scribe for the Fed). And it goes without saying that the existence of Wolf’s piece is never mentioned.

The discount window was not an effective mechanism for dealing with the seize up in the money markets, which was where the crisis lay. That problem resulted from a repudiation of asset backed commercial paper, which potential buyers feared might be tainted by subprime exposure. Many of the issuers who couldn’t roll it were either corporations or special purpose entities that had no access to the bank discount window. Thus Bernanke’s move was no remedy.

As we said at the time, the important act that day was not the discount rate cut, which was merely symbolic, but the Bernanke commitment via Dodd, that the Fed stood ready to act, which traders have taken as a promise that a Fed funds rate cut is soon coming. In fact, our reaction on August 17 was that Bernanke’s actions showed him to be the true heir of “Greenspan put” Al. But Ip would have us believe otherwise.

Our dim view is further confirmed by the fact that the Fed has allowed the Fed funds rate to trade below its target levels for most of the last two weeks (chart courtesy Calculated Risk):

Calculated Risk notes that this de facto easing is much less than during the 9/11 period.

So we can either believe Ip is an idiot or he is so loyal to his Fed sources that he will take a story line from them and faithfully write it up. I’m inclined towards the latter view. And if true, that is even more discouraging that what Wolf told us yesterday.

It must be miserable to be a central banker these days. Not only are they confronted with the worst mess in at least a generation, but too many interested parties, from the financial services industry to politicians and some members of the media, expect them to deliver the impossible, namely status quo ante.

The reassessment of Greenspan’s tenure is in full swing, and the focus has been on the wisdom of his policy moves. Many observers now argue it wasn’t such a good idea to have him drop rates every time things got a wee bit rocky, no matter how good it felt at the time.

We think Greenspan did damage in another way: he weakened the authority of the office.

Once upon a time, central bankers, to the extent they spoke at all, were voices of probity and reason, possessing the virtues of old-fashioned bankers but endowed with considerably more grey matter. But their stock has slumped as badly as the ABX (subprime) index, and the conditions were put in place by Greenspan.

Remember, a central banker actually has very few policy tools, and monetary policy is a blunt instrument. Moral suasion is one of their powerful but often not effectively used instruments. Greenspan, unfortunately, was an enabler, fond of impenetrable statements that left everyone perplexed but not worried since in the end he’d open the money tap in times of trouble. It was a hollowing out of the role of the central banker who, as William McChesney Martin famously remarked, was supposed to take the punch bowl away just when the party was getting good. Greenspan didn’t merely help create widespread asset inflation via overly aggressive rate cuts in 1998 and 2002, but also set a tone that makes it hard for his successor Bernanke to deliver tough messages.

If there were ever any doubts about Greenspan’s willingness to rock the boat, they were dispelled, irrevocably, on December 6, 1996. Greenspan, the evening before, had used the now famous phrase, “irrational exuberance,” as a question rather than a statement about a recent runup in the equity markets. The Nikkei fell 3% overnight. European markets traded down 2-3%. The Dow dropped 145 points before rallying late in the day.

And Greenspan took the trouble to clarify his remarks and retreat from any implication that stocks were too high.

Now readers might think this confirms Greenspan’s power, but actually it shows the reverse. The stock markets are not the Fed’s job. And worse, a Fed chairman should not try to talk the markets up. This revealed how Greenspan was hostage to the markets, and that attitude may have taken root at the Fed.

And his legacy lives on. Yesterday, in a Financial Times opinion, its top economics editor Martin Wolf lambasted Bernanke for succumbing to political influence and signalling his willingness to shore up financial markets. Wolf’s message was that the health of the system is not the sum of the health of the individual players. Firms that had bad business practices should suffer the consequences. Players that tout the virtues of capitalism and reap outsized rewards in bull markets shouldn’t have their mistakes socialized when the tide turns.

But Bernanke (and perhaps his ECB counterparts; unfortunately, even in the Financial Times, their remarks get little coverage) seem to be trying to both soothe rattled players yet maintain the pretense that they can and will be disciplinarians. But Greenspan has so compromised their ability to be candid that any truth will be interpreted through the Greenspan filter and read as worse than it is. And while the authorities don’t want to coddle market participants, they don’t want to feed their panic either.

Moreover their actions already belie that they can maintain both postures, that of being both supporter and disciplinarian. Like Greenspan, they seem to be coming down on the side of accommodation. Some examples:

While Fed officials had been trying to distance themselves from Senator Dodd’s “use all tools at his disposal” promise, even commentators that view Bernanke favorably and think he is being fairly tough, like Bloomberg’s Caroline Baum, still expect a Fed funds rate cut.

The Fed has implemented a de facto, if small, Fed funds rate cut already by letting it fall below the official level.

The ECB has also been more accommodate than most news reports suggest (hat tip The Prudent Investor).

The BBC, citing a study in Nature, informs us that climate change models have underestimated the risk of flooding. High atmospheric carbon dioxide levels mean plants suck less water out of the soil. Wetter soil means faster soil saturation in heavy rains, hence more serious flooding.

From the BBC:

Researchers say efforts to calculate flooding risk from climate change do not take into account the effect carbon dioxide (CO2) has on vegetation.

Higher atmospheric levels of this greenhouse gas reduce the ability of plants to suck water out of the ground and “breathe” out the excess.

Plants expel excess water through tiny pores, or stomata, in their leaves.

Their reduced ability to release water back into the atmosphere will result in the ground becoming saturated….

The higher the level of atmospheric CO2, the more the pores tighten up or open for short periods.

As a result, less water passes through the plant and into the air in the form of evaporation. In turn, this means that more water stays on the land, eventually running off into rivers when the soil becomes saturated.

The upside is that wetter soil should reduce the severity of droughts, but with higher temperatures, it’s not clear whether that effect is net positive.

Lucy Kellaway, a Financial Times columnist who writes about corporate fads, once said no new business technique is too ridiculous to be put into practice. The Springwise newsletter (“New business ideas for entrepreneurial minds”), demonstrates that the same can be said of new business concepts.

This week’s edition breathlessly describes what can only be depicted as technology enabled loan sharking:

Dutch consumers have a new way to take out loans: by SMS. Finnish Ferratum just launched its short-loan service in the Netherlands. Customers can borrow EUR 100, 200 or 300 for a term of 15 days, by texting Ferratum their name, date of birth, bank account and address. If they’ve pre-registered, the money is in their bank account within 10 minutes. First-time customers have to wait 24 hours. Speedy loans come at a cost: Ferratum charges a hefty 25% processing fee. Which means that consumers who borrow EUR 300 today, owe the company EUR 375 in 15 days time.

Do the math. On a simple interest basis, 25% for two weeks is 600% a year, a Mafia wet dream level of return. By contrast, payday lenders, under increasingly harsh scrutiny in the US, charge a mere 390%.

Now regardless of what you think of the ethics of this concept, it seems foolhardy to start a business that regulators are almost certain to shut down. But that line of thinking never deterred a bucket shop operator, nor does it discourage Springwise:

In Sweden, Estonia and Finland, where a handful of companies have started offering similar services over the past year, ombudsmen have been pushing for regulation. While critics claim that it’s unwise to offer people such effortless methods of sinking (further) into debt, one could also argue that consumers should be able to choose whichever form of credit works best for them. Though the rates smell of shark, the concept is definitely quick and easy ;-) One to look into if you’re in financial services or telecom. And for those of you seeking an antidote to fast credit: layaway is back.

Oh, I do so enjoy it when the Financial Times’ chief economics editor, the normally measured and thoughtful Martin Wolf, works himself into a lather.

Wolf blasts what he reads as the Fed’s vow of last week, uttered by Senate banking committee chairman Christopher Dodd, to keep the markets afloat (Dodd’s exact words were that Bernanke would “use all the tools at his disposal”). Traders took that as a promise that the Fed would cut rates at its regularly scheduled September meeting, although Fed officials had tried to dampen that notion. However, yesterday the Fed indicated that worsening conditions might warrant a policy response even sooner.

I admit I may have gotten this wrong. I saw having Dodd speak as a brilliant bit of stagecraft, since it might calm the markets (which were irrationally spooked) yet give the Fed chair plausible deniabilty. Note that the Japanese yen had spiked up sharply overnight and in European trading, which could have led to a massive unwinding of the carry trade and in turn, large scale selling into an already deteriorating market.

But the fact that Bernanke even met with Dodd (and Paulson) was troubling (meeting Dodd without Paulson would have been more appropriate. The only reason for Bernanke and Dodd to talk would be about regulations, not the state of the financial markets).

Nevertheless, I hadn’t realized that Bernanke was present when Dodd made his remarks. That puts an entirely different coloration on things.

Wolf’s article, “Central banks should not rescue fools,” (subscription required) is a bill of indictment. The Fed should not become politicized, which is what giving Dodd such a visible role suggested. It needs to more clearly parse out the actions it takes to promote its two, not always consistent goals of economic stability and soundness of the financial system.

Martin bluntly characterizes the current game as one of finding a new sucker (the latest candidate being the taxpayer) and calls our current situation a “lemon crisis.” His solution is not to bail out lemon vendors, but to force them to turn lemons into something better than mere lemonade or let bottom fishers set a market clearing price.

From Wolf:

Sometimes a picture is worth a thousand words. The one last Wednesday showing Christopher Dodd, chairman of the US senate’s banking committee, flanked by Hank Paulson, Treasury secretary, and Ben Bernanke, governor of the Federal Reserve, was such a picture. This showed Mr Bernanke as a performer in a political circus….The Fed has its orders: save Main Street and rescue Wall Street….

Policymakers must distinguish two objectives: the first is macroeconomic stability; the second is a sound financial system. These are not the same thing. Policymakers must not only distinguish these objectives, but be seen to do so. The Federal Reserve failed to do this when it issued statements, on prospects for the economy and on emergency lending, on August 17. This unavoidably – and undesirably – confused the two goals.

The statement on the economy was also premature. Everybody knows that the Fed’s job is to stabilise the economy and prevent deflation. Everybody knows, too, that the Fed will investigate the economic implications of the crisis in the credit markets at the next meeting of the open market committee. If prospects seem significantly worse, the Fed will, presumably, cut rates. But now a cut looks pre-announced. Monetary policy should not be made “on the hoof” in this way, except in the direst of circumstances.

This brings one to the second objective: ensuring the functioning of the financial system. The question is how to help the system without encouraging even more bad behaviour. This is such an important question because the system has been so crisis-prone, as Larry Summers points out (“This is where Fannie and Freddie step in”, August 27). I think of the underlying game as “seek the sucker”: sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer who rescues the players who became rich from lending to sucker number one and selling to sucker number two.

The most recent game is a particularly creative one. This time the geniuses seem to have created a “lemons crisis”, after the celebrated paper by the Nobel laureate George Akerloff*. Consider the market in used cars. Suppose buyers cannot tell the difference between good cars and bad ones (lemons). They will then offer only an average price for cars. Sellers will withdraw any good cars from the market. This may continue until the market disappears entirely.

What is driving this is “asymmetric information”: buyers believe sellers know more about the quality of what they are selling than they themselves do. This seems to be precisely what has now happened to trading in certain classes of security. The crisis is focused in markets in structured credits and associated derivatives. The cause seems to be rampant uncertainty. Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties. This, in turn, has led to the panic purchases of US Treasury bills shown in the chart.

Yet the difficulty is not a lack of general liquidity. Central banks have provided it freely. Some would argue that, in the case of the Fed, with its half a percentage point cut in the discount rate, provision has been too cheap and, in the case of the European Central Bank, provision has been too free. Nor is this a general crisis in lending. Credit spreads have not exploded for corporate or emerging market debt. They have merely become less unreasonable. Market volatility has increased, but not to extraordinary levels.

This then is a crisis in the market for financial lemons. So what should the authorities do about that? My answer is “nothing”. They should, of course, stand ready to provide liquidity to the market, at a penal rate (since insurance should never be free), and also to adjust interest rates to overall macroeconomic conditions. But they should not promote the survival of a market in lemons.

This is why I disagree with the suggestion by Willem Buiter and Anne Sibert, in the FT’s economists’ forum, that central banks should now become market-makers of last resort. Central banks could do this only if someone regulated not just the soundness of financial institutions (as now) but also the properties of all the products these institutions invent. Otherwise, the central banks might be forced to buy what they do not understand. They would, instead, be offering a commitment to be buyers of last resort in a market for lemons, thereby subsidising the creation of a market in junk. If central banks were to regulate products, however, they would be running the financial institutions. Ours would become a quasi-nationalised financial system.

Now suppose central banks did, instead, refuse to intervene in the afflicted markets. What would happen? Sellers must turn lemons into apples, pears, strawberries and all the rest. In other words, they must demonstrate the precise properties of what they are trying to offload. Where they cannot do this, they may have to hold securities to maturity. Meanwhile, vulture funds would invest in obtaining requisite knowledge. Losses will also have to be written off. How much of the market in securitised lending would survive this shake-out, I have no idea. But I do not care either. That is for the players to decide, after they realise the consequences of getting it wrong.

Burned children fear the fire. If some of the biggest and most powerful institutions in the world have been playing with fire, they need to feel the burns. It is not the central banks’ job to rescue them by creating a market in the incomprehensible. It is their job to preserve the banking system and the health of the economy. Neither seems now to be in grave danger.

Decisions made in panic are almost always bad ones. Stick to principles and let the masters of the financial system sort themselves out. They are paid enough to do so, after all.

Some reformers have argued that we are at the end of a regulatory paradigm and need to consider fundamental change in securities laws. A major obstacle, given that capital markets are now global, is the need for greater international cooperation and possibly even a new international body.

It turns out some foreign regulators are already making that case. As the New York Times tells us:

Politicians, regulators and financial specialists outside the United States are seeking a role in the oversight of American markets, banks and rating agencies after recent problems related to subprime mortgages.

Their argument is simple: The United States is exporting financial products, but losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks.

American regulators would have dismissed this view as lunatic fringe as recently as a month ago. After all, America’s financial markets set the standard for the world and if anything, what was needed was less, not more, regulation.

For example, the recent handwringing over the US’s loss of market share to London led to a couple of studies, one informally called the Paulson report, the other the Bloomberg/Schumer report, after their respective sponsors (see here for a very good write-up plus links). The subtext of each set of recommendations was that the US needed to become an even friendlier place for foreign issuers.

Although there were some differences (the Bloomberg/Schumer report called for lowering visa restrictions to make it easier to attract top talent), the two reports were broadly in concert, for example calling for some changes in Sarbanes-Oxley, limiting the liability of foreign issuers, capping auditors’ damages, limiting punitive damages, (Note that these reports argue for some pet corporate causes, namely, chipping away at Sarbox and restricting punitive damages. At least as big an issue for foreign companies is the confusion and uncertainty of being subject to both Federal and state law, but that admittedly unsolvable problem appears not to have been acknowledged).

The events of the last month have illustrated, vividly, how failings in our regulation can wreak havoc overseas. Recall that the European money markets seized up before ours did due to subprime fallout, first with German bank IKB, then with three Paribas funds that froze redemptions.

Given that the US is a chronic capital importer, foreigners may have more leverage than it might appear (although far and away the biggest source of overseas funds is central bank purchases of Treasuries, and it’s highly unlikely any of our creditors will use that bludgeon). And the demands are coming from many quarters. The Germans want rating agencies to be nationalized, complex debt to have much better disclosure, and large loans to be registered. The Chinese want standardized disclosure for asset backed securities. Even conservative French President Nicolas Sarkozy wants tougher rules:

President Nicolas Sarkozy of France, who has vowed to “moralize financial capitalism,” has asked his finance minister, Christine Lagarde, to prepare a proposal for stricter disclosure rules on market participants before an October meeting of finance ministers from the Group of 7. On Monday, in a foreign policy speech, Mr. Sarkozy called again for stronger global regulations to avoid financial crises.

Clearly, being right wing in France isn’t the same as being right wing here.

These calls for at least more international harmonization of rules, and perhaps even international oversight, should be welcomed in the US but instead are being rebuffed out of a misguided sense of exceptionalism and national pride.

We should take a lesson from the Japan. Its leaders are masters of invoking gaiatsu, or foreign pressure, when they want to force unruly domestic constituencies into line. Perhaps a little foreign arm twisting is precisely what we need to help overcome the obstacles to politically charged securities law reform.

BreakingViews (free subscription required) reports that the degree of deleveraging of corporate balance sheets may be exaggerated. Yet another reason to look at stocks with a wary eye.

Readers may know that the level of corporate borrowings relative to their equity and total assets has fallen since 2002. For example, Standard & Poors reports that debt to equity ratio for the non-financial firms in the S&P 500 dropped from 75% to 40%. Balance sheet strength is one of many measures used to evaluate stocks.

But the picture may be less rosy than these figures suggest. A UK based analyst, Andrew Smithers, started to examine government statistics on corporate gearing. He noticed that the authorities had had to adjust their own figures to conform with the private sector reports, and dug into their reconciliation methods. He wasn’t comfortable with what he found. He then had a look at US accounting and also found it wanting.

Smithers made some adjustments and determined that UK debt ratios actually got worse, not better, and the US improvement appeared considerably overstated.

As BreakingViews tells us:

Smithers noticed that the trend {of falling corporate debt ratios] was different in the UK….When the assets are valued at replacement cost, the debt-asset ratio has actually increased, from 45% to 52%.

The US statistics measured replacement costs, but with a large “statistical discrepancy” that seemed to be used to reconcile top-down calculations with individual corporate accounts. Take away that adjustment, and the decrease in US corporate debt burdens was cut by more than half – from 70% to 55% of equity.

As a check, Smithers compared the ratio of corporate debt to domestic output. That has also declined, but only from 100% to 90%. That’s the same level as at the last peak, in 1990. In the 1970s, the ratio was mostly in the 60-70% range. Similarly, the ratio of financial debt to GDP has increased from 96% to 107% since 2002. Some of that additional financial debt may actually be non-financial corporate debt in disguise.

What’s going on, precisely? It seems that higher asset prices have made their way onto company balance sheets. There are many possible mechanisms, including asset sale-leasebacks and accounting for financial portfolios at market values.

If the rise in asset prices does indeed account for a big part of the decline in reported corporate leverage, then companies could be more vulnerable than investors think to an economic decline, especially if it were accompanied by weak financial markets.

The Financial Times’ Lex column today takes issue with those who take comfort in the oft-quoted statistic that default rates are at a 25 year low. The article shows a long-term, unrelenting decline in average ratings and notes that bond defaults tend to peak two to four years after issuance. We’ve had an increase in lower rated debt thanks to a spike up in large leveraged buyout deals in the last couple of years.

What may make things different (and not necessarily better) this time is that many of the private equity deals were “cov-lite.” That means investors have much less protection. For example, borrowers were often required to keep a specified working capital ratio and level of interest coverage, and meet a net worth test. Failing those meant the creditors could accelerate the principal, as in demand repayment. That was a mechanism for forcing a restructuring.

Although I have not seen the documents on any of these deals, what I’ve heard from my buddies in private equity suggests that on some of these deals, the lenders can’t accelerate the debt even in the event of default. (Somebody, please, tell me this is wrong. It is just too deranged to be true).

Now that arrangement may seem hunky dory for the borrower, but consider: in this modern world of finance, the lenders (often banks who buy collateralized loan obligations or sometimes syndicated loans) still have to mark the assets to market. So when a borrower deteriorates, creditors reduce the value of their loan. This haircut is a balance sheet hit which damages earnings, and if enough deals come a cropper, reduces their capital. And they have no ability to remedy the situation.

I’m not sure how this all resolves, but expect things to get ugly.

From the Financial Times:

Dystopian visions of the future often portray humanity drowning in its own junk. The future is now. More than half the US issuers rated by Standard & Poor’s are currently graded as “speculative”. The proportion rated “B” or lower – well into junk territory – has jumped from one-fifth in 1997 to about one-third currently. The paradox is that the default rate for speculative grade bonds, globally, stands at a 25-year low…..

But the recent seizing-up of credit markets shows that many lenders are rediscovering the concept of risk. As refinancing becomes harder, the result is likely to be a sharp increase in defaults, particularly if the economy weakens significantly.

Easier lending terms – taken to the extreme with so-called covenant-lite agreements – strip out many of the usual default triggers. But that “see-no-evil” approach means credit can deteriorate out of the spotlight. Defaults can then occur with little warning and subsequent recovery rates are likely to be weak.

Optimists may point out that just 11 per cent of the $2,910bn of US corporate debt rated by S&P falls due by the end of 2008. But focusing on maturities misses the point. Analysis of defaults from 1971-2006 by Professor Ed Altman of New York University’s Stern School of Business shows that defaults for junk bonds tend to spike two to four years after issuance. Some 73 per cent of US paper rated “B-” or lower by S&P is less than five years old. History shows that, well before maturity, weak credits can struggle to pay interest and meet covenants.

Of the 28 speculative grade issuers that Moody’s assesses for “intrinsic liquidity” – a measure of reliance on market access for funding – 12 are described as “merely adequate” or weak….

Has Roubini gone to the Dark Side?

Nouriel Roubini, normally the voice of prudence, makes a marked shift in his latest post, “Fiscal versus Monetary Solutions to the Subprime Crisis. ” He sympathizes with those like Bill Gross of Pimco who call on the federal government to rescue mortgage borrowers at risk of losing their homes:

Bill Gross…is now proposing the creation of a fiscal institution …. to resolve the subprime credit problems. While this may sound as a fiscal bailout of borrowers (and by default of lenders) the alternative… is destructive home price deflation (as much as 10% fall in home prices…) and million of homeowners ending up in foreclosure. Folks at Goldman Sachs are actually predicting that home prices will fall as much as 15%…

Larry Summers… correctly argues ..that in situations of severe credit distress it is important to be pragmatic rather than religious on issues of moral hazard…

Dean Baker wants to help the victims (the subprime borrowers in his view) rather than the reckless lenders (the “bloated bankers); so he is suggesting changes in foreclosure rules to allow moderate and low-income homeowners to remain in their homes indefinitely as renters.

A number of authors – including analysts at BNP – have argued a fiscal solution is needed and that government sponsored agencies should be allowed to purchase more conforming loans.

Even the Bush Administration, that has opposed suggestions to have Fannie and Freddie expand their mortgage portfolios, is now suggesting that Federal Home Administration could help distressed borrowers….

[T]here is now a new and increasing recognition that severe credit and financial distress problems cannot be resolved with monetary policy alone…. The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue.

Now let me stress I have a great deal of respect for Roubini and normally am on the same page as he is. And he may well be correct that the political consensus is moving in the direction of Throw Money At This Problem.

I am probably being harsh because I have read too many calls to action, most of which have not given much (any?) thought to how their proposals might work on a practical level.

But Roubini lumps a whole variety of ideas together, some of which (Gross’s in particular) are just plain barmy (and for the record, the RTC bears little resemblance to what Gross is suggesting, except that it required a ton of money).

Before we discuss these recommendations, let’s address the big flaw in Roubini’s argument:

The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue

First, I had searched the logical suspect financial news sites, plus Google News and Google Blogs, and haven’t found a source for this “two million will lose their homes” factoid (this is the only reference I’ve seen besides Gross, which is hardly a well recognized source and cites unnamed studies).

I’ve seen other formulations, such as The Center for Responsible Lending saying that 2.2 million ARM mortgages will reset in the next two years. “Reset” does not mean “lose your home,” and “2.2 million” is clearly the high end of a range of estimates. Senator Christopher Dodd may be responsible for the recasting of The Center for Responsible Lending data. The Financial Times reported that he stated that 2.2 million (hhm, the very same number) could lose their homes in the next few years.

It’s one thing for a politician to take liberties with data. I would hope Gross and Roubini would hold themselves to a higher standard. And if I am wrong and there is a source that says over two million are likely to lose their homes (as opposed to face a reset and accompanying financial stress), I’d like to see it. I could have missed something, since I don’t have access to certain databases and search tools, but information like this usually shows up on the Web.

Nevertheless, the specter of “two million plus” losing their homes has become established fact.

The most granular analysis I’ve seen on mortgage resets (and I stress granular, it’s a very detailed analysis using two massive mortgage databases) is by one Chris Cagan of American CoreLogic, which projected 1.1 million foreclosures over 6-7 years. That’s bad but not catastrophic. Admittedly, things have gotten worse since the time of his estimate (March, when subprimes had already been under stress for a while), but I doubt if they are 2 times as bad. And most important, these losses are spread over time. Even if the total in the end is 2 million, it’s one thing if that happens in 2008-2009 versus over 6-7 years. The housing market will be better able to absorb the impact, as will the greater economy. But that 2 million number is becoming fact, and it’s being treated as if those defaults will hit all at once like a financial tsunami.

In keeping, the prospect of a 10% to 15% fall in house prices is being treated as if it would constitute the end of the world. Yet as we pointed out, quite a few economies have endured 25% or more housing price falls. They did not go into an economic black hole. They had short bad recessions.

The fear of recession in this country has gotten so bad that the Economist ran a story this week arguing that America needs a recession. I have no doubt they did that mainly to be provocative, but the horrified reactions from some quarters proves the point. This fear of recessions, and tendency to paint a recession in the dark colors of a depression, is dangerous and distorts policy decisions.

Now it would be fair to argue that a housing recession, given how leveraged the financial system is, will deepen an already careening deleveraging and could do real damage to the financial system. That would be consistent with Roubini’s world view, and would justify more radical measures. However, he didn’t make that case.

Now mind you, I am not saying we should do nothing, but a large scale bailout of homeowners, as I’ve argued elsewhere at considerable length, is a bad idea from the standpoint of equity and efficiency.

But there are some things worth doing. The real problem is that the thing that would be the most effective and surgical (the numbers 4 and 5 on this list) are the most difficult to implement (but vastly easier than acquiring 2 million mortgages and renegotiating them!).

1. Borrowers who were defrauded by lenders should get relief, ideally from the perp (and it is probably easiest if it also comes out of the hide of investors who bought securities with assets originated by the perp, although I am open to comments and ideas on this front. This notion would encourage much greater investor due diligence on sourcing methods).

I am all in favor of severe punishments. Organizations that institutionalized fraudulent activities should be fined out of existence. If four of the former Big Eight accounting firms perished due to their misdeeds, why should mortgage lenders get better treatment?

2. I have not thought about it deeply, but having Fannie and Freddie step up their activities is probably a good idea. Banks swing wildly from overoptimism to excessive caution, and there are signs they are now overly stringent with creditworthy borrowers.

3. Mortgage brokers and other consumer mortgage originators need to be regulated on the same footing as banks, as far as their disclosure standards are concerned, and all should be subject to tougher consumer protection requirements.

4. The best way to salvage financially stressed homeowners is via loan modifications. In the stone ages of finance when banks not only made loans but kept them, banks would when possible restructure a mortgage rather than foreclose (note that all borrowers cannot be salvaged, but banks in general were pretty good at judging who could make it).

What has screwed that up in our Brave New World of finance is that mortgage servicers are now responsible for managing the relationship with borrowers on behalf of the investors in the mortgage paper. Because the servicer has every reason to keep the borrower alive (they keep earning their servicing fees), most indentures on mortgage securitizations restrict the servicer ability to do loan “mods.” Some prohibit them altogether; others limit them, say, to 5% of the pool, which if a pool has a lot of subprime and/or Alt-A, is too low a ceiling in the current environment

The problem is that it isn’t easy to waive a magic wand and lift mod restrictions across the board. I am told the mortgage indentures are governed by state law, which means you’d need new legislation in the states where the big servicers are domiciled.

5. The last bit of borrower relief is to treat the mortgage debt of individuals who declare bankruptcy the same as corporations. As Credit Slips explained:

If a corporation can no longer afford the mortgage on its factory, it has powerful tools to rewrite the mortgage in bankruptcy. But if a homeowner is in exactly the same trouble following an interest rate hike, those same tools are unavailable….

MA company that cannot pay its mortgage can declare Chapter 11 and do two things: 1) separate the mortgage into its secured and unsecured portions (called bifurcation), and 2) pay the secured portion at current market rates under a new mortgage and discharge the unsecured portion. So, for example, a $1.2 million mortgage at 12% on a factory worth only $1 million will be bifurcated into a $1 million secured mortgage at, say, 7% interest, and the remaining $.2 million can be discharged. The economic insight behind permitting this move is that the mortgage company will get 100% of the value of the property paid over time, which is a LOT better than the much lower amount it would get in foreclosure. The second insight is that this is precisely the risk the lender took: that the property would decline in value and the debtor couldn’t pay. The Chapter 11 bankruptcy forces the lender to revalue the mortgage to the actual market value of the collateral.

But notice: If a homeowner can no longer afford her mortgage, the homeowner can declare bankruptcy and get rid of the credit card debt and doctor bills, but she cannot force the lender to write down the mortgage to the value of the home or to accept payments at the current market rate. All the homeowner gets is the right to make up past-due payments–in full, with interest. So, for example, a $120,000 mortgage at 12% on a home worth only $100,000 must be paid in full at 12%. In other words, homeowners get a lot less protection in bankruptcy than do businesses.

Giving individual mortgage borrowers the same treatment as corporations would reduce the need for federal bailouts, make sure right people took the pain (investors who chose to buy in mortgage paper, rather than taxpayers) and be vastly cheaper than creating a new federal bureaucracy.